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UNIVERSITY OF SOUTH AUSTRALIA

UNISA BUSINESS SCHOOL

SCHOOL OF COMMERCE

ACCT 2005 (Study Period 2, 2014)

FINANCIAL ACCOUNTING 2

Study guide

Course coordinator Sue McGowan

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© University of South Australia 2014

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CONTENTS

HOW TO USE THIS STUDY GUIDE INTRODUCTION TOPIC 1: INTRODUCTION AND OVERVIEW OF REPORTING

ENVIRONMENT

TOPIC 2: PRESENTATION OF THE FINANCIAL STATEMENTS TOPIC 3: OTHER DISCLOSURE ISSUES TOPIC 4: EQUITY TOPIC 5: LIABILITIES TOPIC 6: ACCOUNTING FOR LEASES TOPIC 7: ACCOUNTING FOR INCOME TAX TOPIC 8: PROPERTY, PLANT AND EQUIPMENT

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HOW TO USE THIS STUDY GUIDE

Welcome to Financial Accounting 2. It is suggested that you use this Study Guide as your primary source of direction through the course material. The Study Guide lists the readings for each of the topics as well as a commentary on each topic. This commentary is an explanation of the topic material and a means of helping you to work your way through the textbooks and other required readings. Therefore, begin each topic with the Study Guide and follow the materials from there. At various points you will find the heading 'Activity'. Activities usually involve reading a section from the textbook, accounting handbook (or other required readings) to confirm or amplify a discussion that you have looked at in the Study Guide. The Study Guide is also important because it gives you detailed information about those sections of the required reading—in particular, the text book—that you are not required to deal with in order to satisfactorily complete this course. You will find that using the Study Guide to identify this material will save you considerable time that you otherwise may have spent on non-essential subject matter. It is essential that you are active in the learning process. A primary objective of this course is to provide students with the technical accounting knowledge required for entry into the accounting profession. To ensure that you understand the accounting principles and requirements, and can apply these, will require practice. It is not sufficient to simply ‘read’ through the materials and answers to questions provided. To achieve the level of competence required for professional accreditation it is essential that you attempt these questions yourself. You should note that not all topics require the same amount of time to work through. Topic review questions selected for each topic are detailed at the end of each topic in this study guide. These also indicate the topic area that is relevant to each question. The questions have been set to allow you to monitor your progress and identify any areas of difficulty. Answers to these questions will be made available to you on the learnonline site for this course. Sue McGowan Course Co-ordinator

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INTRODUCTION

In this course we will be examining a range of accounting standards. You should know from your previous accounting studies that Australia has been in the process of harmonising its accounting standards with those of the international accounting standard body since 1996. The set of ‘new’ Australian accounting standards based on the international accounting standards were issued in 2004 and applied to all reporting periods beginning after 1 January 2005 although there have subsequently been many changes to these standards. Changes are still being made to accounting standards, particularly as the international and US accounting bodies work towards convergence in anticipation of the US adopting international accounting standards. Given the lead time required for writing, editing and publishing text books, these may not incorporate the latest changes to standards. Therefore it is essential that you used the accounting standards as a primary source of information in this course. Where necessary this study guide will identify the changes in standards that are not reflected in the textbook.

Accounting Standards – what you need to learn? As noted above, in this course we will be examining various and numerous accounting standards. These are often complex and wordy and we will be selective in our application and often be considering relatively simple applications and examples. It is not an objective to memorise these standards, or any of their requirements. Indeed, as existing accounting standards are evolving and changing and new standards being introduced memorisation would be a waste of time and does not develop the analytical and life long learning skills required in your future careers. You need to become familiar with how to interpret and access the information in the standards themselves, rather than relying on the summaries in the text or study guide. As a professional accountant the accounting standards will be available as a resource and in this course you will have access to these in the examination. Students will be required to be able to: • interpret these standards; • to apply the principles espoused in these standards. For example,

AASB 116 includes requirements for revaluing items of property, plant and equipment. Students would need to understand the requirements of this standard, and be able to prepare the journal entries required to account for any revaluations and be able to prepare any disclosure notes required.

• understand the impact these requirements have on the financial reports (including the notes to the accounts).

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Terminology for Financial Statements As noted above accounting standards often change. In 2011 the Australian Accounting Standards Board (AASB) issued a revised version of AASB 101 Presentation of Financial Statements. Under this version the suggested titles of the financial statements are

• Statement of Financial Position (or the Balance sheet); • Statement of Profit or Loss and Other Comprehensive Income (this

is the equivalent to the Statement of Comprehensive Income). • Statement of Cash Flows (or the Cash Flow Statement) • Statement of Changes in Equity.

It should be noted that the use of these titles is not compulsory. However many companies will use these titles. In this course we will usually refer to these titles, although you should understand that some current company reports (and older reports) will use the previous or alternative terminology, and that as these titles are not compulsory you can use these interchangeably (e.g. the ‘balance sheet’ is the same statement as the ‘statement of financial position’; ‘statement of comprehensive income’ is the same statement as the ‘statement of profit or loss and other comprehensive income’).

AASB 101 also replaced the use of the term ‘financial report’ with the term ‘set of financial statements’. We will use the terms interchangeably but note that both of these terms refer to the 4 financial statements and the notes to these.

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TOPIC 1

INTRODUCTION AND OVERVIEW: FINANCIAL REPORTING ENVIRONMENT & GENERAL PURPOSE FINANCIAL STATEMENTS

OBJECTIVES By the end of this topic you should: • understand the nature of a company and the key characteristics that

distinguishes a company from other forms of business organisation • understand the purpose of general purpose financial reports and the

reporting entity concept • understand the role, status and relationship of the various accounting

pronouncements • understand the role of the conceptual framework • understand of the role of international accounting standards in Australian

standard setting • be aware of the pressures that led to the regulation of financial reporting • know the characteristics of the current regulatory and standard setting

environment, including the function and roles of the relevant bodies in the Australian context

• understand and apply the concept of materiality

REQUIRED READING

Resource: Text Leo et al, 2012, Chapter 1 and sections of Chapter 12, as directed.

Resource: Accounting Handbook AASB 1031 Materiality (you will need to read all of this standard)

Framework for the Preparation and Presentation of Financial Statements

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AASB 101 Presentation of Financial Statements (selected paragraphs only)

As directed in this guide.

OVERVIEW

Introduction The key focus of this course will be on the preparation of external (general purpose) financial statements, and the application of the underlying accounting principles and techniques. We will be concentrating on the financial statements, and associated requirements, as these apply to large public companies. As you progress through this course you will discover that the requirements for the preparation and presentation of such statements are both numerous and complex. The practice of financial reporting requires both the mastery of technical accounting rules and also the exercise of professional skill and judgement. In this topic, we will be considering the accounting pronouncements and the regulatory framework that determines the information that is to be included in the annual report prepared by a company. Further, we will begin our consideration of the accounting standards by looking at materiality. Later topics will be looking at some of the general disclosure requirements specified by the accounting standards for the preparation of the financial statements (and notes). Other topics will examine specific issues affecting these statements and notes, such as accounting for equity, assets and liabilities.

THE NATURE OF A COMPANY Given that we will be considering the preparation of financial statements for companies, it is useful first to consider the nature of the company structure. The basic company structure as a form of business organisation, although in existence for hundreds of years, emerged as a more common form in the nineteenth century. As a result of the increased capital required by businesses in, and following the Industrial Revolution, the company structure allowed numerous individuals to invest in an enterprise without the unlimited personal liability associated with other forms of business organisation such as partnerships. As the focus of this course is on the financial reporting for large public companies, you need to have an understanding of the nature of a company. A company is established when a group of persons fulfil statutory requirements. The company is then a legal entity in its own right. The key advantage of a public company is the ability to source funding (raise capital) from the public and much of the regulation relating to companies is to protect the public. The key characteristics of companies that distinguish them from other forms of business organisations are:

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• Legal personality - a company is a separate legal entity and has a legal identity separate from its owners

• Limited liability - owners are not liable for debts of the company and their personal liability is restricted to any unpaid amounts on their shares

• Ownership by share-each share represents a specified portion of ownership in the company. This enables investors to diversify and transfers of shares do not affect the structure of the company

• Perpetual succession-a company is not affected by circumstances (e.g. death, bankruptcy) of its owners. It continues as a legal entity until legally ‘wound up’.

• Ability to raise capital – a public company can invite the public to invest via shares (ownership) or lending

• Professional management- in many companies, those who manage the operations are separate from the owners. Power to direct operations is vested in the Board of Directors, elected by shareholders.

Activity Read sections 1.1 and 1.2 to 1.2.3 of the text that discuss the nature of a company and types of companies and note the following: • key differences between a proprietary and public company • definitions of listed and disclosing companies • we will not be accounting for foreign companies or no-liability companies in

this course Sections 1.3, 1.3.1 to 1.4 of the text discuss the formation and administration of a company. You should be aware of the legal requirements on formation and administration of a company, but a more detailed knowledge will be gained in other courses. Note: In this course you are not expected to recall/remember any specific legal references (i.e. sections of legislation). Read sections 1.5 and 1.5.1 of the text that discusses funding of a company. We will consider funding via shares in a later topic.

In this course we will not be examining in detail the nature of the company structure as such. However, you do need to have an understanding of the: • characteristics of the company structure; • advantages of the company as a business structure; and • disadvantages of the company as a business structure.

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NATURE, CONTENT AND PURPOSE OF A CORPORATE FINANCIAL REPORT In this topic we will examine the nature and purpose of external financial statements in the corporate context, why they need to be prepared and where the ‘rules’ for their preparation come from. Before proceeding further let us take a look at an example of an external financial report for an Australian company.

What does an external financial report look like?

Activity Obtain an example of the annual report of a company. If you hold shares in a company then you may have an annual report readily available. If not, most of the larger public companies include their annual report on their web site. The annual reports will include the financial statements (or reports or accounts). Remember earlier reports you will examine may not have been prepared using the current Australian accounting standards that we are considering in this course. Peruse the following: • The statement of financial position (or balance sheet) • The statement of comprehensive income (or income statement)

You should be familiar with the basic nature, purpose and elements of these statements from your previous study.

• The statement of changes in equity. • Cash flow statement. • Notes to the accounts. You will have noticed that the annual reports also contain information in addition to the financial statements and notes as listed above. Some of this information is required by law (for example the Directors Report); some is provided voluntarily by the company.

You should have noticed that these statements and notes are complex, and lengthy. In this course we will be concentrating on some of the common requirements for large public companies, and the underlying accounting procedures and principles.

Content of Annual Reports We noted that annual reports also contain information in addition to the financial statements and notes and that whilst much of this information is required by law (for example the Directors Report) other information is provided voluntarily by the company. Our key focus in the topics in this course will be on preparation of the financial statements and notes (and underlying accounting procedures) but you should be aware of other key requirements such as the Directors Report and declaration, and the auditors report.

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Activity Read sections 12.1 to 12.3 of the text that summarise the annual reporting requirements for companies. Note in particular the following: • In this course we only consider disclosing entities that would be Tier 1

entities (as per AASB 1053) so the reduced disclosure requirements do not apply

• true and fair view requirement (discussed later in this topic) • the issue of concise reports does not alleviate the need for a ‘full’ report • we will not be considering half-yearly reports You should also note that for companies listed on the securities exchange additional disclosures are required under ASX listing rules. We will not consider these specifically in this course.

Purpose of annual reports The financial report (which includes the financial statements and notes) within the annual report is an example of a general purpose financial report (GPFR). We noted earlier that accounting standards are required to be applied in the preparation of a GPFR. General purpose financial statements are defined in AASB 101 as: 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 (para 7).

The nature, purpose and objectives of GPFRs are discussed in the Framework for the Preparation and Presentation of Financial Statements and in para 9 of AASB 101.

It is important that you understand the objectives for general purpose financial reporting. Whilst some reporting requirements and disclosures must be made (such as the requirement to disclose details of the company’s tax expense) the actual disclosures made in other instances may be dependent on professional skill and judgement (for example, certain disclosures are only required if material). Such judgements will require consideration of the objectives of GPFRs.

General purpose financial reports (GPFRs) and the Reporting Entity Concept Historically, in Australia all entities that met the definition of a ‘reporting entity’ were required to prepare GPFRs and entities preparing GPFR’s were required to apply all of the accounting standards and their requirements.

Reporting entities are entities where it is reasonable to expect the existence of users who depend on information in GPFRs for their decision making. Guidance is provided in SAC 1 for determining whether such users exist and hence whether the entity is a reporting entity. You have considered SAC1 briefly in a previous course. The essential purpose of a GPFR is to provide information to users. The key purpose behind the reporting entity concept is to differentiate between entities on the basis of users. It makes sense that if there are no users who need the information in a GPFR for decision making, no report should be prepared. However, if users exist, an entity is required to

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prepare such a report and, prepare a GPFR in accordance with the full requirements of accounting standards.

This approach has changed. The IASB in July 2009 issued an IFRS for SMEs (Small and Medium Enterprises) which is one standard of less than 230 pages. This standard has reduced and changed accounting and disclosure requirements and is a standalone standard. The AASB has taken a different approach than the IASB where SMEs must apply the recognition and measurement requirements of all AASBs but have reduced disclosure requirements. As a result, in June 2010 the AASB issued AASB 1053 Application of Tiers of Australian Accounting Standards which introduced a 2 tier reporting regime (this is mandatory for reporting periods beginning on or after 1 July 2013 but can be applied earlier). This allows reporting entities that are not publically accountable to reduce the disclosures required (although the basic recognition, measurement and presentation requirements will still apply).You can access further information about these developments from the websites of the relevant organisations. The issue of differential reporting will not impact in this course as we will assume that all of the requirements of all of the accounting standards that we study need to be applied by the companies we are considering.

Activity Read sections 1.9.1 and 1.9.2 of the text. You should note the following: • difference between general-purpose and special-purpose financial reports • Note:

• In December 2013 the AASB issued Amendments to the Australian Conceptual Framework. This replaces the sections related to ‘objectives’ and ‘qualitative characteristics’ with those revised by the IASB/FASB and withdraws SAC2.

• The AASB in April 2014 stated their intention to move the application focus of Australian Accounting Standards from ‘reporting entity’ to entities preparing ‘general purpose financial statements’. It is expected that the current ‘reporting entity’ concept will be removed from Australian standards at some time in the future.

Usefulness of financial reports We have seen that the objective of GPFR’s is to provide information useful to users, primarily for decision making. However, users obtain information from various sources and do not solely rely on the annual reports. Further, there have been various criticisms concerning the usefulness of the annual reports.

Activity Consider the following: What are the limitations of the financial reports? What other information (e.g. environmental, social performance measures, forecasts) do you think would be useful that are not provided in financial reports? Annual reports are sometimes regarded as more of a public relations exercise than meeting users’ needs. Is there any indication from the reports you have looked at that annual reports are a marketing tool? You may also wish to consider the role of financial reporting in some of the more publicised company collapses (Enron, HIH, Harris Scarfes)!

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ACCOUNTING REQUIREMENTS AND GUIDANCE The Corporations law and Australian Securities Exchange (ASX) specify particular requirements for company reports and disclosures. The Corporations law regulates the financial reporting for companies. This requires that the financial statements and notes:

• provide a true and fair view, and • comply with approved accounting standards. These include

interpretations (via application of AASB 1048). Listed companies must also comply with rules specified by the ASX. In addition, the professional bodies (the ICAA and CPA Australia) require their members to comply with accounting standards and interpretations when preparing GPFR’s (general purpose financial reports). Professional sanctions could be imposed for non-compliance. In addition the conceptual framework provides guidance to the content of the financial reports (including notes), although the framework is not required to be complied with.

True and fair view requirement (and compliance with accounting standards) As noted it is a legislative requirement that the financial statements and notes disclose a true and fair view.

Activity Read the discussion under ‘compliance with accounting standards’ and ‘the true and fair view …’ in section 12.2.2 of the text (if you have not previously read this)

As the text notes, in Australia due to Corporations law requirements for the companies we are considering, the accounting standards must be complied with, even if the resulting financial statements and notes do not provide a true and fair view. Additional information is required if compliance does not result in a true and fair view. The requirements for this additional information are in AASB 101. You should note that the current international accounting standards (in limited circumstances and with extensive disclosure provisions) do provide for a true and fair ‘override’ (i.e. a true and fair override allows companies to depart from accounting standards where compliance with these would not provide a true and fair view). However the Australian equivalent, AASB 101, does not allow departure from accounting standards for the companies we are considering as legislation requires compliance with accounting standards.

Activity Refer to paragraphs 19 to 24 of AASB 101 to confirm the points above.

Accounting Standards & Interpretations A key focus in this course will be on the accounting standards. In Australia these are issued by the AASB. As we have noted, the Corporations law requires companies to comply with accounting standards. This compliance

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with accounting standards is emphasised by legislative requirements that directors and auditors explicitly state whether accounting standards have been complied with and identify any instance of non-compliance. Accounting standards specify the ways in which accounting concepts are to be applied in particular circumstances; for example, in accounting for revaluations of non-current assets or for research and development expenditures. Their aim is to 'standardise' general purpose financial reporting and to improve the quality of financial reporting across the whole range of reporting entities. The approach of the AASB is to ‘adopt’ the international accounting standards by issuing national equivalents (i.e. the AASB standards) and making minor changes where appropriate to the Australian context or issuing specific ‘local’ standards. The key differences between AASB and international standards are:

• changes made due to specific Australian regulatory environment; for example, application paragraphs will refer to the Corporations legislation

• additional requirements. These are indicated by an AUS prefix to the paragraph number. Examples include: paragraphs that specify requirements and application for not for

profit entities. The IFRS’s apply only to business entities whereas the AASB’s apply also to not for profits.

The AASB in 2006/2007 undertook to reduce the differences between the AASB standard and the equivalent international standards. This is continuing and hence differences would be expected to be minimal. In addition the AASB issues some specific Australian standards. For example, AASB 1054 requires additional disclosures which are not required under international accounting standards. You should also note that although accounting standards often have some paragraphs in bold type and some in ‘normal’ type all paragraphs must be applied. This is usually specified in a paragraph at the beginning of the standard. The example from AASB 1048 follows: Australian Accounting Standard AASB 1048 Interpretation and Application of Standards is set out in paragraphs 1 – 12. All the paragraphs have equal authority. In the absence of explicit guidance, AASB 108 Accounting Policies, Changes in Accounting Estimates and Errors provides a basis for selecting and applying accounting policies.

In this course we will consider few interpretations. However you should understand the nature of these and the requirements to comply with these (this is via AASB 1048).

Studying the accounting standards Many students seem to find the transition from the basic accounting principles (the DR’s and CR’s and bookkeeping) that they have undertaken in first year accounting courses, to the detailed and specific accounting standards difficult. This is often the first course in which students are required to directly consider the accounting standards. The standards are often long,

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complicated and as you will find, many of the requirements in relation to items, are interrelated and found across a number of standards. Whilst in practice many firms may use templates (and software) to assist in preparing their financial statements and notes, the objective of the second year level financial accounting courses of this university is to help students understand where the requirements in such ‘templates’ come from (i.e. the accounting standards, interpretations and framework) and provide students with the experience in sourcing and understanding and applying some of these requirements. An example to illustrate is Topic 6 which deals with leases. There are computer programs that effectively ‘do’ the appropriate schedules and accounting entries for finance leases (providing the correct parameters are input). However at university level our objective is not simply to teach students to ‘use’ various accounting packages (although you will have considered one in Financial Accounting 1). Our objective is that accounting students should understand the underlying rationale and basis for these entries and understand the impact of these requirements and where to source these. By achieving these objectives students will be able to explain these requirements and their impact to users, and also be able to determine if what has been ‘produced’ by accounting programs is correct. A further issue is that accounting requirements are constantly changing. Accountants need to be able to identify changing requirements and interpret and apply these – replying on ‘templates’ or ‘checklists’ alone is not sufficient in light of such potential changes. Hence it is important in this course that students read the accounting standards and become familiar with how to use these.

The conceptual framework The conceptual framework defines the nature, subject, purpose and broad content of general purpose financial reporting. The conceptual framework has been described as:

... a set of interrelated concepts that define the nature, purpose and broad content of general purpose financial reporting. It is an explicit rendition of the thinking of the standard setting body as it lays down requirements for general purpose financial reporting. (McGregor, 1990, page 48)

The Framework for the Preparation and Presentation of Financial Statements identifies key concepts in relation to financial reports including:

• The objective of financial reports • The definitions of the key elements (You should be familiar with these

definitions such as assets, liabilities, equity, income, expenses from your previous studies) and the criteria for these to be included in the financial statements, and

• The characteristics that financial information should have to meet the objectives of GPFRs and thus provides guidance on the selection of information for inclusion in these reports. These are known as qualitative characteristics.

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Activity Briefly look through the index for the Framework to confirm the points above.

Unlike accounting standards, application of the conceptual framework is not mandatory. Where there is a specific accounting standard then the standard must be followed (even if this is inconsistent with the conceptual framework). However note that the conceptual framework is required to be considered as guidance in the absence of a specific standard. Over the last decades the conceptual framework has been a key influence on the development of accounting standards. Although application is not mandatory, the very significant importance that continues to be placed on the conceptual framework by the professional accounting bodies and by standard-setters is evidenced by the incorporation into many of the standards of the concepts embodied in these statements. You should already have been introduced to this framework in your prior study. You should note:

• that the Framework is the equivalent to the international Framework. However SAC 1 & 2 have no international equivalents.

• There is currently a joint project by the IASB and the FASB (the US standard setting body) to review and update the Framework. These bodies have currently redrafted the objectives and qualitative characteristics sections.

Developments in relation to conceptual framework In December 2013 the AASB issued AASB CF 2013-1 Amendments to the Australian Conceptual Framework. This applies for periods ending on or after 20 December 2013, and:

• Retains much of the existing framework but replaces the previous guidance on the objective and qualitative characteristics of financial statements with Chapter 1 The objective of general purpose financial reporting and Chapter 3 Qualitative characteristics of useful financial information as redrafted by the IASB/FASB.

• Withdraws SAC 2 Objective of General Purpose Financial Reporting.

Note: Take care. The text was issued prior to these changes but does discuss some of this new framework (for example, the qualitative characteristics). Your handbook will probably not reflect these changes.

REGULATION OF FINANCIAL REPORTING FOR COMPANIES

Overview You may already have been introduced to the external reporting environment in Australia in your previous studies. This overview provides a brief outline with reference to sections of the text. The requirements for financial reporting are but a sub-set of the regulations that apply to companies and have developed over time, as have the regulatory arrangements and institutions. The CLERP (the Corporate Law Economic Reform Program) has, and is continuing, to impact on the regulation of companies (including the financial reporting requirements).

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Activity Read sections 1.6 and 1.7.1 of the text that provides an overview of the background to regulation of financial reporting for companies. You should note the following: • early corporate regulation required preparation of balances sheets (and later

profit and loss statements) but provided no guidance on content

• initial guidance was not compulsory. Accounting standards were prepared by the accounting profession but had no legislative backing.

• in 1983 compliance with approved accounting standards became compulsory (via corporations legislation) for companies, subject to a ‘true and fair view’ override. The ASRB was established, being a government body to initially approve accounting standards, although the profession exerted considerable influence through the AARF, which essentially provided technical support and direction.

• the AASB was established in 1991 and true and fair override was removed. Its role included development of standards as well as approval.

• in 1999 new standard setting arrangements came into place via CLERP.

The details relating to the history of regulation will not be examinable in this course. The focus will be on current standard setting arrangements.

The Corporations Law contains various requirements for the preparation of financial information both annually and half yearly by disclosing entities. When preparing these financial statements, the Corporations Law requires companies to comply with the AASB accounting standards and show a true and fair view of the financial position and performance of the company. As we noted earlier, the accounting standards must be followed but additional information is disclosed if necessary to provide a true and fair view.

Function and roles of the relevant authoritative bodies There are a number of bodies involved in the development of accounting standards and the regulation of financial reporting. We noted before that the financial statements of companies are required to comply with approved accounting standards. Hence, much of the detailed requirements for the preparation of these statements are contained, not in the legislation, but in the accounting standards themselves. You need to consider two aspects: 1. the standard setting arrangements.

Who develops and determines the content of accounting standards? 2. Regulation or enforcement

How is it ensured that companies comply with financial reporting requirements, such as the accounting standards?

Standard Setting Figure 1.1 in the text (section 1.7.4) depicts the current accounting standard setting arrangements in Australia.

Activity Read sections 1.7.2 to 1.7.8 of the text which outline the roles of the FRC, AASB, current Australian accounting standard setting arrangements and various

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international bodies. It is assumed that this is revision and that you are familiar with the roles of these bodies from your previous studies. Note: Many students initially view accounting rules (those for example contained in standards) as uncontroversial. However, the reality is that accounting has economic consequences and the development and implementation of accounting standards is a political process, hence the depiction of lobby groups in the standard setting arrangements. An extensive due process (a comprehensive process of consultation with various interest groups and stakeholders) is undertaken in the development of standards as a result of its political nature and potential impact.

The Role of International Accounting Standards Standard setting in Australia is not undertaken in isolation and there are a number of outside influences. In July 2002 the Financial Reporting Council announced that Australia would adopt the International Accounting Standards by 1 January 2005 and in 2003 the AASB decided that Australia equivalents of the international standards would be adopted in one big ‘hit’ (around April 2004) rather than in a staged process. The approach is to ‘adopt’ the international standards by issuing national equivalents (i.e. still issue AASB standards) and making minor changes where appropriate to the Australian context.

Enforcement The main body for enforcement of corporate financial reporting requirements in Australia is the ASIC.

Activity Read sections 1.8.1 and 1.8.3 to expand on the discussion above. Note:

• The role of the ASX in promoting harmonisation of accounting standards • ASIC undertakes regular reporting surveillance projects. Students wishing

to know more about the ASIC financial reporting surveillance program and results should visit the ASIC website.

• The text notes, in July 2006 the Financial Reporting Panel was formed to resolve disputes between ASIC and companies relating to accounting treatments in their financial reports. However this body has now been disbanded due to the low rates of referrals.

MATERIALITY Materiality is covered in AASB 1031, and is a basic overriding accounting concept that governs the preparation and presentation of financial reports. It explicitly recognises that the objective of general purpose financial reports (GPFRs) is to provide information useful to users for decision making (and the discharge of accountability). It should be noted that the Australian standard setters decided to issue a separate standard on materiality, as although this concept is used in the international standards and framework there is limited guidance. (There is no international standard equivalent to AASB 1031).

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Developments in relation to AASB 1031 Materiality

In June 2013 the AASB issued an exposure draft (ED 243) Withdrawal of AASB 1031 Materiality. This was issued as:

• consistent with policy of aligning with IFRS’s and not providing unnecessary local guidance (as noted previously, there is no equivalent international standard), and

• guidance on materiality is expected to be included in the revised conceptual framework.

Subsequently in October 2013 the AASB decided to proceed with withdrawing AASB 1031. In December 2013:

The Board considered practical approaches to effect its October 2013 decision to proceed with the withdrawal of AASB 1031 Materiality. As an interim measure to achieve withdrawal of the contents of AASB 1031, the Board decided to reissue AASB 1031 so that it serves only as a referencing Standard. References to AASB 1031 in other Standards and Interpretations will be removed as and when those Standards and Interpretations are amended for other reasons. Once all references to AASB 1031 have been removed, AASB 1031 will be completely withdrawn (AASB Action Alert, No 162).

In December 2013 issued a revised AASB 1031. This was amended to refer only to the definitions and limited guidance re materiality already existing in AASB 101, AASB 108 and the updated Framework. The rest of the content, including specific guidance (such as base amounts in para 13 and the presumptions in para 15) was removed. This revision does not change the nature or concept of materiality: it simply removes the detailed guidance that was provided. This revised AASB 1031 applies to reporting periods beginning on or after 1 January 2014 and early adoption is NOT permitted. Hence financial reports ending on 30 June 2014 cannot use this revised AASB 1031. Given this, in this course in 2014 we will not consider the revised AASB 1031. The Handbook will not include the revised AASB 1031 but will include the version of AASB 1031 that we consider in this course in 2014.

What is materiality? Materiality is defined as

Omissions or misstatements of items are material if they could, individually or collectively, influence the economic decisions of users taken on the basis of the financial report. 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. (Appendix, AASB 1031 & AASB 108 para. 5).

The essential question then in determining materiality is, could it influence the decision that a user is making? This requires consideration of the users of financial statements and their information needs, although these are not explicitly identified in the standard.

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Examples of questions that may have to be settled with reference to materiality are, should a standard (or any of its individual provisions) be applied; should the item be disclosed separately; should a change in accounting policy be disclosed? When we consider AASB 101 you will see that one of the requirements of this standard is that material items of income and/or expense be disclosed separately. Further, to be applicable, accounting standards are required to pass a test of materiality. Materiality is assessed in the context of the individual circumstances of the reporting entity (and its users). An example of the impact of the concept of materiality on the application of a standard or accounting policy is AASB 116 Property, Plant and Equipment (paragraph Aus1.4), which states

The requirements specified in this Standard apply to the financial report where information resulting from their application is material in accordance with AASB 1031 Materiality.

How do I determine if an item is material? This requires consideration of the potential influence of the item (information) on decision-making. There are no ‘strict’ rules and this decision requires consideration of both qualitative and quantitative issues. The decision is a matter of judgement requiring consideration of both the nature and amount (individual and aggregate) of items, however in some instances either alone might be decisive. The diagram below outlines the decisions to be made:

How to decide if item is material?

Do users need this information–could it potentially impact their decisions?

Need to consider BOTH

NATURE – Type of transaction/event

AMOUNT- size of the particular item

THIS IS criteria – this is what you are deciding

Guidance is provided in the standard to assist in considering whether the amount indicates materiality. It should be noted that this guidance does not override the need for judgement in light of the circumstances of the entity.

Activity Read paragraphs 7 to 19 of AASB 1031 and section 12.8 of the text. Note the explanation in paragraph 10 that because an item is immaterial does not mean that the item is ignored (not included at all) in financial records. For example, expenses for office items such as pens, note paper may be minimal for a particular company and hence immaterial but you would still need to measure this and record/count/include (i.e. recognise) with miscellaneous expenses.

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Can you think of an item that due to its nature would be material? Can you think of an item that would not be material due to its nature but the amount could mean material?

The following provides a summary of considerations in determining materiality.

SUMMARY OF DETERMINING MATERIALITY Materiality is as matter of professional judgment. CONSIDER: • Both nature and amount • Items of similar nature Singly & in Aggregate When considering amount: BASES (para 13) (a) if statement of financial position item, more appropriate of:

• equity (A-L),or • appropriate A or L class total.

(b) if statement of comprehensive income item, more appropriate of: • profit or loss for current year & appropriate income or expense, & • average of above over a no. of years

(c) if Cash Flow item, more appropriate of: • net cash from same activities for current year, & • average of above over a no. of years.

(note (b) may not be appropriate for non-profit entities). COMPARISONS (Para 15) If < or = 5% of base amount PRESUME immaterial; If > or = 10% of base amount PRESUME material; If > 5% but < 10% no presumption.

Note: The quantitative guidelines are arbitrary – need to consider the circumstances and users needs.

As most items are recorded without ‘separate’ individual tax adjustments, as the text notes the comparisons in para. 13 are normally against ‘before’ tax amounts. AASB 1031 indicates (para 16) that if the base amount is ‘after tax’ then the amount that you are comparing should also be ‘after tax’. Hence the basis of the comparison needs to be consistent: so if base amount is ‘after tax ‘would compare amount of item ‘after tax ‘as well (and vice versa).

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Topic Review Questions Question Topic 1. Review question 1, Leo et al, 2012, Chapter 1. You should

also discuss any disadvantages.

Nature of companies

2. (a) Review question 2, Chapter 12, Leo et al, 2012 (b) Review question 11, Leo et al, 2012, Chapter 1.

True and Fair

3. Review question 13, Leo et al, 2012, Chapter 1.

Standard setting arrangements and roles

4. The requirements under Australian accounting standards are not always identical to the requirements in the international accounting standards.

• How are changes from international standards identified in the equivalent AASB’s.

• Explain what differences might occur and why. • Will compliance with the AASB’s result in

compliance with the IASBs (and visa versa)?

Harmonisation

5. Distinguish between the following: • Accounting standard • Interpretation • Accounting framework or concepts statement

You should refer to specific examples of each of a standard/interpretation/concept statement in your explanation. Also explain which need to be complied with and why.

Differences between pronouncements

6. Refer to the Conceptual Framework and explain the following:

• What is the role of qualitative characteristics? • Do you think the Framework is needed? • Find an example of how parts of the conceptual

framework (for example, the definitions, recognition criteria, qualitative characteristics) have been included in accounting standards.

Suggested reading is: • paragraphs 1 to 3 and 24 to 46 of Framework for the

Preparation and Presentation of Financial Statements the Framework, or

• paragraphs OB1, QC1 to QC39 (Chapter 3) as outlined in the Amendments to the Australian Conceptual Framework.

Conceptual framework

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7. Leo et al, 2012, Chapter 12, Review question 13 How would you determine if an item is material?

Materiality

8. (a) Leo et al, 2012, Chapter 12, Case Study 3 (b) Leo et al, 2012, Chapter 12, Practice Question 12.7 Part A only Give reasons for your answers, In addition answer the following: • In June one of the directors spent $2,000 on personal

expenses. The director paid this from the company’s bank account and has agreed to repay this amount in August. The $2,000 has been included in receivables.

• Is this item material? Why? (NOTE: Answers for some parts of this question are already available. You should look at these for guidance as to how to answer these questions).

Materiality

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TOPIC 2

PRESENTATION OF THE FINANCIAL STATEMENTS – Overview and introduction to key statements & requirements

OBJECTIVES By the end of this topic you should be able to: • understand and apply the definition and recognition criteria for elements of the

financial statements • distinguish between recognition and disclosure in financial statements • be aware of the principles of measurement and classification of financial

statement elements • outline the considerations required in the preparation of the financial statements

as required by AASB 101 • understand and apply the format of the statement of financial position • understand and apply the classification of assets (into current and non-current;

classes/categories) • understand and apply the format of a statement of profit or loss and other

comprehensive income and the notes as required by AASB 101 • understand and apply the accounting requirements and disclosures in relation to

the statement of profit or loss and other comprehensive income and the asset section of the statement of financial position in accordance with AASB 101 and the notes as required by AASB 101

• understand and apply the disclosures required by AASB 1054

REQUIRED READING

Resource: Text Leo et al, 2012, sections of chapters 3 & 13 as directed in this guide.

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Resource: Accounting Handbook AASB 101 Presentation of Financial Statements (it is suggested that you read this standard in full).

AASB 1054 Australian Additional Disclosures

Framework for Preparation and Presentation of Financial Statements

Sections as directed in this guide

INTRODUCTION In this course we will be examining the financial reporting requirements of companies and the accounting procedures underlying their preparation. Many of the requirements for the accounting and disclosure of specific elements of the financial statements are found in accounting standards that apply to particular types of items or transactions. Our focus in this course will be primarily on a number of such accounting standards relating to accounting for statement of financial position items (for example, we will consider AASB 137 that applies to provisions and contingent liabilities) although these will also impact on other statements (such as the statement of profit or loss and other comprehensive income). There are also a number of accounting standards that, rather than for example relating to particular types of assets or liabilities, specify general requirements for preparing the financial statements and related disclosures. In this topic we will consider the first of these, AASB 101 Presentation of Financial Statements.

DEVELOPMENTS IN RELATION TO AASB 101 As noted in the introduction to this study guide, accounting standards are constantly changing. This means that there can sometimes be differences between the current standards (or other pronouncements) in your handbooks and the discussion in the text. This applies in relation to this topic. For example:

• In 2013 some minor changes were made to AASB 101 Presentation of Financial Statements. In relation to this course, the key changes were the introduction of more detail in relation to the requirements for comparative statements/information. As a result a number of paragraphs have been added (10(ea), 38A to 40D).

• AASB 1054 Australian Additional Disclosures was issued in May 2011 and applies to annual reporting periods beginning on or after 1 July 2011. We will consider this standard in this course however this standard is not discussed in the current edition of the text. The issue of this standard also resulted in some changes (mainly deletion of some paragraphs) to AASB 101.

It can be frustrating when there are differences between text and the handbook. However this is often unavoidable given the nature of accounting standards. Where there are differences this will be identified in this study guide.

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Overview of Key Reporting Standards The key accounting standards that prescribe the basic format and disclosures for the financial statements (this included the notes) for a reporting entity are: • AASB 101 – prescribes the basis, format, classification and certain disclosures

for the • Statement of financial position (also known as the Balance Sheet), and, • The Statement of profit or loss and other comprehensive income (this

incorporates the income, or profit and loss statement, and is also known as the Statement of Financial Performance or Statement of Comprehensive Income), and

• the Statement of changes in equity • AASB 107 – prescribes rules for preparation and disclosure for the Statement of

Cash Flows. Cash flow statements will be considered in a later course. The remainder of the accounting standards cover aspects of accounting that underlie the financial statements. These will impact on the individual financial statements themselves and/or disclosures. For example,

• AASB 101 requires that deferred tax assets and liabilities be included on the face of the statement of financial position, income tax expense be included in the statement of profit or loss and other comprehensive income, and AASB 112 prescribes how to account for income tax (and also prescribes additional disclosures).

• AASB 101 requires that inventories must be recognised in the statement of financial position, and AASB 102 specifies how to measure inventories (and also prescribes disclosures).

You should note that most accounting standards affect a number of statements and the notes. For example, AASB 136 Impairment of assets requires impairment adjustments to be made for assets included in the statement of financial position, impairment losses to be included in the statement of profit or loss and other comprehensive income, and additional information on impairment in the notes to the accounts.

Titles of Statements AASB 101 (para 10) uses the following titles for the specific statements:

• Statement of financial position (for the Balance sheet) • Statement of profit or loss and other comprehensive income (this includes

the profit or loss statement). Note: This title was introduced in 2011 and applies to annual reporting periods beginning on or after 1 July 2012. Prior to this the title of this statement in the standards was the Statement of Comprehensive Income. In this course you can use either of these titles for this statement.

• Statement of Changes in Equity (prior to 2010 companies could have instead an alternative Statement of recognised income and expense)

• Statement of Cash Flows (for the Cash Flow Statement) It should be noted that the use of these titles is not compulsory (refer para 10). However many companies will use these titles.

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Activity Useful resources for students examining annual reports are examples/ exemplars that are provided by some major accounting firms. For example, Ernst & Young and Deloittes provide ‘model’ financial reports (and notes) which can often be accessed from their web sites. Please note: if you do consider such model reports these document can be VERY large and lengthy (a couple of hundred pages) ! Also if you look at any examples take care to consider what dates of Australian accounting standards these relate to, and that these apply the version of AASB 101 that we are considering.

ELEMENTS OF THE FINANCIAL STATEMENTS

Definitions The basic components of the financial statements are the 5 elements; assets, liabilities, equity, income (which includes both revenues and non-revenue income items such as gains) and expenses (which include losses). These are defined in the Framework and you should be familiar with these from your previous study. You should recall that the conceptual framework is not mandatory; however the definitions of these elements have been explicitly embodied in many of the accounting standards.

Activity If you need to revise, read the definitions and discussion of these elements in paragraphs 47 to 80 of the Framework. Please ensure that you understand the following:

• the essential features or characteristics of assets and liabilities • definition of equity • definitions of expenses and income. Note the difference between revenues and

income.

For the purposes of this course we will be dealing in the main with basic accounting principles, practices and reporting requirements and so the emphasis is on understanding and applying these definitions in relatively simply/straight forward circumstances. In a later course you will examine these definitions (and problems in application/interpretation) in further detail.

Recognition Criteria It is not sufficient for an item to meet the definition of an element for it to be recorded in the financial statements. Inclusion on the face of the specific financial statements is a 2-step process; first, the definition of an element must be met, and second, the element must meet recognition criteria. If the recognition criteria are not met, the item cannot be recognised but may need to be disclosed in the notes to the accounts (subject to requirements of specific standards).

Activity Read paragraphs 82 to 88 in the Framework and sections 3.2 and 3.2.1 of the text and paragraphs 1, 47 to 50 of AASB 101 now, and ensure you understand:

• the difference between recognition and disclosure • that recognition depends on tests relating to ‘probability’ and an ability to measure

the item reliably

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• remember that a set of ‘financial statements’ would include notes and comparative information (refer AASB 101, para 10).

Measurement and classification of elements Inclusion on the face of specific financial statements requires that a number (a dollar amount) be shown for each item (or group of items). Once having met the definition and recognition criteria of an element of the financial statements, items need to be measured. Remember that to meet the recognition criteria an item must be able to be measured with reliability. However there may be a number of alternative reliable measures available and a choice between these may need to be made. Measurement is both a crucial and controversial issue in financial reporting. As yet the appropriate measurement basis for assets and liabilities is not specified in the conceptual framework. The present accounting model uses a 'multi-attribute' measurement basis and is a modified historical cost model. Examples of measurement bases currently practised in Australia, Hong Kong and the USA include cost, net realisable value, current cost, fair value and present value. We will not examine the theoretical basis for alternative measurements in this course. For the purposes of this course our primary focus will be on application of the measurements prescribed (or allowed) in the standards that we consider.

Classification Items are also ‘sorted’ or classified in the financial statements to assist interpretation and usefulness of the statements to users. We will consider the classification for specific elements later.

Activity Read section 3.3 of the text

INTRODUCTION TO AASB 101: PRESENTATION OF FINANCIAL STATEMENTS The diagram following provides as overview of the requirements in relation to the presentation of financial statements.

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As noted before the basic format and requirements for 3 of the financial statements are outlined in AASB 101. However, AASB 101 also contains ‘general’ features relating to the preparation and presentation of the financial statements. These include: • requirements that a financial report presents fairly. This relates to the faithful

representation of transactions and events (para. 15) • disclosures relating to compliance with IFRS’s (para 16): • application of the going concern and accrual basis (paras. 25, 27) • requirements relating to consistency of presentation, materiality, offsetting and

comparative information (paras. 29 to 46). AASB 101 also discusses the rare situation where compliance with accounting standards would result in misleading statements. Whilst AASB 101 (para 19) requires entities to depart from the requirements of the standards, you should note that the companies we are considering would not be allowed to do so due to statutory requirements. This is reiterated in AASB 101, para. Aus 19.1 which prohibits departures from standards for specific Australian reporting entities. If this applies, then the company is required to provide additional information (refer AASB 101, para 23). There are also general requirements about presentation and disclosures. These include for example: • language, period, currency, rounding (AASB 101, paras. 49-53) • information about sources of uncertainty that provide a risk of adjustments to the

measures of assets and liabilities (para. 125) • address, activities of company (AASB 101, para 138); although note these

disclosures may be made ‘outside’ the financial statements. AASB 1054 also requires disclosure of: • compliance with Australian accounting standards (para 7) • whether a general purpose or special purpose financial report (para 9) • payments to auditors (paras 10 and 11).

Activity Read sections 13 to 13.2.1 of the text. You should also refer to the relevant sections of AASB 101, in particular paragraphs 15 to 53, and 138. Also read paragraphs 7 to 11 of AASB 1054. Please note:

• The text in section 13 includes an example of a ‘statement of profit or loss and other comprehensive income’. Recall that this only applies for reporting periods beginning on or after 1 July 2012 so you will find that older ‘real reports’ will not use this title but will usually use ‘statement of comprehensive income’. You can consider these titles as interchangeable.

• The text has not included the changes that occurred in May 2011 with the issue of AASB 1054. Remember in this course the primary source of requirements should be the standards themselves – not the textbook.

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Statements versus Notes As noted above AASB 101 prescribes the basic format and requirements for 3 of the financial statements. The notes accompanying the financial statement are an integral component of the financial report. The requirements of many standards (including AASB 101) relate to information to be disclosed in the notes, and the notes are usually the largest section of the financial report of any company. This is probably the first course in which you need to consider (and prepare) these notes. As we will see when we consider the requirements of AASB 101 in more detail, in some instances a choice is required to be made as to whether to disclose information on the face of the statements or in the notes.

Activity Read sections 13.6 to 13.6.4 of the text and paragraphs 112 to 117, 125, 134, 137 to 138 of AASB 101. You have previously been referred to paragraphs 7 to 11 of AASB 1054. Note:

• Section 13.6.4 of the text does not reflect the changes that occurred with the issue of AASB 1054 thus: o Auditors remuneration is now required via AASB 1054 (para. Aus 138.1 of

AASB 101 has been deleted) o There is no longer any specific disclosure requirement relating to commitments

either in AASB 101 (para. Aus 138.6 has been deleted) or AASB 1054. • Think about why notes are needed. Why isn’t it enough to simply provide the

individual statements or alternatively why not include all information on the face of the individual statements themselves?

• We will consider notes in relation to accounting policies when we consider AASB 108 in a later topic.

• When we consider other standards in later topics these will often require further disclosures that may be in the notes.

• In some cases (such as for non-adjusting after reporting period events and contingent liabilities that we will consider in later topics) the information can only be shown in the notes (and cannot be included on the face of the statements).

In this topic we will consider the format and required disclosures for the statement of profit or loss and other comprehensive income and for the asset section of the statement of financial position and related notes. We will consider the liability and equity sections of the statement of financial position and the statement of changes in equity (and related notes) in later topics.

INTRODUCTION TO THE STATEMENT OF PROFIT OR LOSS AND OTHER COMPREHENSIVE INCOME AASB 101 Presentation of Financial Statements prescribes the basic content, and classification and additional disclosures for the statement of profit or loss and other comprehensive income (or statement of comprehensive income). You should recall from your previous study that the purpose of an income statement is to measure and report how much profit (wealth) the business has generated over a period. The key elements of this statement are income and expenses.

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Activity Read sections 3.1.6, 3.1.7, 3.3.4 and 3.3.5 of the text. Also read sections 3.2.1 & 3.2.2 of the text if you have not read these previously. You should note the following:

• Often the terms ‘income’ and ‘profit’ are used interchangeably and this can be confusing. These do not mean the same thing.

• The distinction between revenue and income – income includes revenues + other income (this other income would include gains)

• AASB 118 Revenue will be considered in a later course • Income is not defined in terms of particular sources of inflows – e.g. the inflows do

not have to arise due to the earnings process. • There are a number of other standards that contain more specific requirements

relating to recognition of revenues or expenses (for example, AASB 118 Revenue, AASB 123 Borrowing Costs). We will not be considering these in specific topics in this course.

• There is no ‘general’ standard on expenses, and note the role of the matching concept in the conceptual framework.

Overview:

Underling principles: Comprehensive Income AASB 101 requires a ‘statement of profit or loss and other comprehensive income’ based on the concept of comprehensive income. In your previous courses you may have only considered simple income statements. This concept of ‘comprehensive income’ is defined in AASB 101, para 7 as: Total comprehensive income is the change in equity during a period resulting

from transactions and other events, other that those resulting from transactions with owners in their capacity as owners.

You should see that this definition is consistent with the related definitions of income and expense in the Framework; i.e. that changes in equity from non-owner sources and/or transactions are part of the income and expense for the period. The basic concept of comprehensive income is not new. However prior to the major revision of AASB 101 in 2007, some standards allowed (and in a number of cases in fact required) certain items of income and expense to be excluded from the income statement. This occurred where another accounting standard required the income or expense to be recognised ‘directly in equity’. This is no longer permitted.

AASB 101 (para 88) requires that all items of income and expense in a period are recognised (i.e. included) in the profit or loss unless a standard requires or permits otherwise. Other comprehensive income items would meet the definition and recognition criteria of income or expense, but due to requirements of other standards, are excluded from the profit or loss and are instead included in the other comprehensive income section of the statement of profit or loss and other comprehensive income.

AASB 101 ‘splits’ comprehensive income into 2 parts which include: • items recognised in the ‘profit or loss’

o these are items that would have been included in the ‘traditional’ ‘income statement, and

• items of other comprehensive income.

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o These are items that were required under previous accounting standards not to be recognised in the profit or loss but instead directly to equity. This is no longer allowed and these items are required to be recognised in ‘other comprehensive income’.

In this course we consider only relatively simple transactions and events and hence the number of ‘other comprehensive income’ items that we consider will be limited. In Topic 8 we will consider revaluations of assets and you will then see that a change to revaluation surplus account results from an item of other comprehensive income.

Format AASB 101 (para 10A) allows an entity the choice of whether to present income and expenses either in one or two statements. As illustrated in the diagram following, • If only one statement is presented:

o both profit or loss items and other comprehensive income items are included.

• If 2 statements are presented: • One statement includes the profit or loss items. • The other statement will include the total of the profit or loss (from the

separate profit or loss statement) plus any components of other comprehensive income o Items of other comprehensive income also need to be presented

within 2 groups depending on potential reclassification in the future. o Further disclosures are required in relation to the amount of income

tax in relation to each component of other comprehensive income (either in the statement or in the notes).

The total of comprehensive income is to be presented in the financial statements.

In this course (consistent with the text) we will adopt a single statement approach.

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Activity The terms ‘profit or loss’, ‘total comprehensive income’ and ‘other comprehensive income’ are defined in paragraph 7 of AASB 101. Read these definitions now and confirm the following: • Items of other comprehensive income are excluded from the profit or loss for a period. • Examples of other comprehensive income • Total comprehensive income includes both the ‘profit or loss’ plus ‘other

comprehensive income’. • Also read paragraph 10A of AASB 101 which confirms option for presentation as 1 or

2 statements. • Also read sections 13.4 to 13.4.3 of the text.

o Section 13.4.2 discusses reclassification adjustments. We will not consider these in this course. As the text notes reclassification adjustments do not apply to changes in the revaluation surplus which we will consider in Topic 8.

Format AASB 101 prescribes the minimum presentation and disclosure requirements for the statement of profit or loss and other comprehensive income. AASB 101 sets out the requirements for the statement (and notes) by requiring:

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• inclusion of certain items in the statement itself; i.e. these must be included on the face of the statement (i.e. disclosure in notes is not sufficient). These include revenues, finance costs, tax expense, profit or loss, each component of other comprehensive income, total of other comprehensive income and total comprehensive income.

• disclosure of specific items. These include details of items of income and expense that are material.

• an analysis of expenses (by nature or function) either on the face of the statement or in the notes. If the analysis is by function para 104 requires additional information to be provided on the nature of expenses. Note: AASB 118 Revenues requires a similar analysis of revenues.

It should be noted that the standard does not specify a strict format but rather minimum requirements. An example from the international implementation guidance is reproduced as follows.

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Note: • This example includes the analysis of expenses on the face of the statement.

AASB 101 does not require this to be included on the face although this is encouraged (see paras 99 &100)

• The example illustrates the analysis by function. An alternative is by nature. • We will not consider associates or discontinued operations in this course.

Activity Read paragraphs 81A to 105 of AASB 101 which sets out the basic requirements for the statement of profit or loss and other comprehensive income and notes. Note the following:

• The headings before paragraph 81A of AASB 101 indicates that the information required in the paragraphs following must be included on the face of the statement whereas the heading before paragraph 97 indicates that the information required in the paragraphs following may be disclosed either on the face of the statement or in the notes.

• The text notes that the profit or loss before tax is not specified as a minimum required line item in either para 81A or para 82. However this is normally included (and we will include) in all statements that we prepare.

• Para 82 also does not state that expenses (apart from finance costs and tax) need to be included on the face of the statement. However, paragraph 85 requires ‘additional line item etc.. where relevant to an understanding of the entity’s financial performance’. It would be therefore reasonable to assume that a line item expenses (excluding finance costs and tax) would need to be included.

Also read the discussion in section 13.4.4 of the text beginning under the headings ‘profit and loss section’ and ‘Income- revenue and gains’. Also read sections 13.4.5 to 13.4.6 of the text.

• The text also notes (in section 13.4.4) that if there are any items of income that do not fall within the definition of revenue then an additional line item ‘other income’ would be required.

• In this course we will assume that finance costs are comprised only of borrowing costs (see the discussion in section 13.4.4).

• The example from the implementation guidance includes some items on the face (namely the analysis of expenses) that may be disclosed either on the face or in the notes. The examples in section 13.4.6 of the text also include the analysis of expense on the face (such as cost of sales) and so include more than the minimum requirements on the face of the statement.

• Remember to become familiar with the requirements and their location in the standard.

o As noted previously the only item of ‘other comprehensive income’ we consider in this course relates to revaluations. However as this is not considered until Topic 8 all of the statements of comprehensive income that you will be required to prepare will have no items of ‘other comprehensive income’. o For the purpose of this course you are only required to prepare disclosures in

accordance with specific accounting standards considered in this course (such as AASB 101, AASB 117 Leases) and not other accounting standards which have not been considered specifically (such as AASB 118 Revenue).

Income, Revenues and Expenses The accounting and reporting requirements for revenue (this basically covers income items from ordinary activities although ‘ordinary activities’ is much wider than simply sales or services revenues) are specified in AASB 118 Revenues. However other

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standards prescribe requirements for some other revenues and expenses, and other income items (such as gains from sale of particular assets). For example, AASB 111 Construction Contracts contains specific requirements relating to the recognition and disclosure of revenues and expenses from constructions contracts. In this course we will not be considering in detail AASB 118 Revenues. There is no equivalent ‘general’ standard on expenses.

Gain on sale of non-current assets Also required to be recognised in the statement of profit or loss and other comprehensive income (AASB 101, para. 34) are gains or losses on disposal of non-current assets. You need to understand how to account for such disposals. For example, assume a company sells for $5,000 cash a machine (a non-current asset) that originally cost $10,000 with accumulated depreciation of $6,000 to date of sale. A gain of $1,000 has been made on the sale; sales proceeds ($5,000) less the carrying amount ($4,000). The following entries would record the sale:

DR CR Cash 5,000 Accumulated Depreciation - Machine 6,000 Gain on sale (P&L) 1,000

Machine 10,000 (To recognise gain on sale and write off asset)

Alternatively, the following entries could be processed:

DR CR Cash 5,000

Proceeds from sale (P&L) 5,000 (To record gross proceeds from sale)

Carrying Amount of Machine Sold (P&L) 4,000 Accumulated Depreciation - Machine 6,000

Machine 10,000 (To recognise as expense the carrying amount sold)

However, regardless of the entries processed in the books of the entity, it is the gain (or loss), not the separate sales proceeds and expenses, from the sale that are required to be included in the statement of comprehensive income (included in the profit/loss). It should also be noted that this ‘gain’ is not revenue but is other income. Further the gain or loss on a sale of a non-current asset (such as an item of property, plant & equipment) would often require separate disclosure (refer AASB 101, paragraphs 97 & 98) as a material item either on the face of the statement or in the notes.

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Disclosure of specific items AASB 101 (paragraph 97) requires:

When items of income and expense are material, an entity shall disclose their nature and amount separately.

The overall aim of this requirement is to ensure information is provided about specific items where this would be expected to, or could, potentially influence decisions. AASB 101 (para 98) identifies a number of circumstances which would often result in the need to make separate disclosures of income and/or expense items. Note: As the heading above this paragraph indicates, these items can be either included on the face of the statement of profit or loss and other comprehensive income or in the notes. In practice these have been sometimes referred to as ‘significant’ items.

Activity Examples of disclosures in relation to material items can be found in almost all company financial reports. Remember copies of these can be accessed for most large companies from the company web page.

Extraordinary items A previous Australian standard on the income statement distinguished between items arising from ordinary activities and extraordinary items. Extraordinary items were expected to be rare and were items that were: • outside ordinary activities and • not recurring. AASB 101 does not have a category of extraordinary items and in fact explicitly excludes the presentation of any items as extraordinary either in the statements or in the notes (para. 87). However it would be expected that due to their nature, items that would previously have been treated as extraordinary items may be required to be disclosed as material items (as per paragraph 97).

INTRODUCTION TO THE STATEMENT OF FINANCIAL POSITION AASB 101 Presentation of Financial Statements prescribes the basic content, and classification and additional disclosures for the statement of financial position and related notes. You should recall from your previous study that the purpose of a statement of financial position is to measure and report the resources (and claims to those resources) of the business at a particular point in time. The key elements of this statement are assets, liabilities and equity.

OVERVIEW: FORMAT AASB 101 prescribes the minimum presentation and disclosure requirements for the statement of financial position. AASB 101 sets out the requirements for the statement of financial position by requiring:

• classification of assets and liabilities • inclusion of certain items on the face of the statement of financial position (i.e.

disclosure of these items in the notes is not sufficient). These relate to

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particular classes of assets and liabilities and also to components of equity and represent the minimum inclusions for the statement of financial position.

• additional disclosures for some items. In this topic we consider the requirements in relation to the asset section of the statement of financial position. We will consider the requirements in relation to liabilities and equity in later topics.

ASSETS: DISCLOSURES IN THE STATEMENT OF FINANCIAL POSITION & NOTES We will now consider the requirements in relation to assets in the statement of financial position as required by AASB 101. Assets represent the resources available to the company.

Definition and recognition of assets An asset is defined as: A resource controlled by the entity as a result of past events and from which future

economic benefits are expected to flow to the entity (Framework, para. 49(a)).

Activity Read section 3.1.1 of the text which discusses the definition of assets. Note in particular the following: • 3 essential characteristics • the fact that form (whether physical or intangible) and ownership are not essential

characteristics • Recall that it is not sufficient for an item to meet the definition of an asset to be

recognised in the financial statements; recognition criteria must also be met. • Section 3.1.2 discusses possible future developments. We will not consider these in

this course. • We will not consider contingent assets in this course.

Measurement and classification In the statement of financial position, assets must be categorised as current (normally expected to be settled with 12 months or one operating cycle) or non-current, unless a liquidity basis is more appropriate (AASB 101, para 60). The criteria for classifying an asset as current are provided in AASB 101, para. 66. In addition, within the current and non-current classification, assets must be sorted into classes. There are a number of major classes of assets that must be shown on the face of the statement of financial position (AASB 101, para. 54) if these apply to the entity. AASB 101 also requires additional line items to be included on the face of the statement of financial position if needed to understand the financial position of the entity (para. 55) and also allows further sub classification on the face (or notes) appropriate to the entity’s circumstances (para 77).

As we have noted before AASB 101 does not prescribe an exact format, but prescribes minimum disclosures if these are relevant, and allows further information to be included in the statement of financial position. The asset extract from the IASB

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implementation guidance providing an example using the current, non-current classification follows.

Note: • The implementation guidance notes that the guidance provides simple examples of ways in

which the requirements of the Standard for the presentation of the statement of financial position might be met. The order of presentation and the descriptions used for line items should be changed when necessary in order to achieve a fair presentation in each entity’s particular circumstances

• In Australia most companies have historically presented current assets (and liabilities) before non-current.

Activity Read sections 3.2 and 3.3.1 of the text if you have not read these previously. Also read sections 13.3 to 13.3.3 and the first paragraph of section 13.3.4 of the text that discusses the statement of financial position (balance sheet), notes and related disclosures. Read paragraphs 54 to 59, 77 to 78 and 125 of AASB 101.Note:

• the heading before paragraph 54 of AASB 101 indicates that the information required in the paragraphs following must be included on the face of the statement whereas the heading before paragraph 77 indicates that the information required in the paragraphs following may be disclosed either on the face of the statement or in the notes.

As noted in the text measurement of assets varies and depends on the nature of the asset. In some instances (for example, leased assets) the accounting requirements specify the actual measurement; in other cases the standards provide choices (such as cost or re-valued amount); in many cases the final measure will be subjective and/or rely on professional judgement (for example, estimating doubtful debts or depreciation). The subjectivity of alternative measurement techniques for many assets has traditionally supported the use of historic cost as the prime measurement basis for assets on the grounds of reliability. However, the relevance of historic cost for decision-making has been questioned, and has led to pressures to adopt other

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values (such as market value or present value). This is reflected in a number of specific standards. There are few accounting standards that prescribe how to account for assets in general. Rather individual accounting standards specify the requirements in relation to different types of asset. For example, an item such as a machine

• could be held for use (and so AASB 116 Property, Plant & Equipment may apply)

• could be held for sale as inventory (AASB 102 Inventories may apply) • could have previously been held for use (AASB 5 Non-current Assets Held

for Sale and Discontinued Operations may apply) • could be leased (AASB 117 Leases may apply) • could be under construction (AASB 111 Construction Contracts may apply)

In this course we will only consider a limited number of assets but you need to be aware that for other assets there may be a particular accounting standard that applies. You should remember that, in the absence of a specific standard the definition and recognition criteria for assets in the Framework provides guidance. This concludes our examination of the general requirements of AASB 101, the format and disclosures in relation to the statement of profit or loss and other comprehensive income and in relation to assets in the statement of financial position and related notes. We will consider the other elements of the statement of financial position and the statement of changes in equity, and related notes, in later topics.

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TOPIC REVIEW QUESTIONS Question Topic 1. (a) Explain what is meant by the term

‘recognition’? Distinguish this from disclosure. (b) What is the criterion for recognition of a financial statement item?

Concept of recognition

2. (a) Review question 1, Leo et al, 2012, Chapter 3. (b) Discuss the nature of revenue and income.

Elements

3. Traditionally the elements of the financial statements use historic cost as the measurement base. • Explain what is meant by ‘historic cost’. • Are there any problems with using this? If so,

why is it still used? • Using a ‘building’ as an example, what other

measures could be used in financial reporting?

Measurement – concepts and alternatives

4. (a) AASB 101 identifies a number of ‘general features’ in the presentation of financial statements in paragraphs 15 to 46. Briefly outline these and explain why these requirements are needed.

(b) AASB 1054 identifies some specific disclosures relating to preparation and type of financial statements. Identify these requirements.

AASB 101- general features

5. (a) Review question 11, Chapter 13, Leo et al, 2012. (b) Review question 12, Chapter 13, Leo et al, 2012.

Notes

6. Review question 6, Leo et al, 2012, Chapter 3

Classification

7. (a) Outline the disclosure requirements in relation to expenses in AASB 101. (b) Applying AASB 101, explain where & how each of the following items would be disclosed in the financial statements and whether these items would be separately disclosed. Give reasons for your answers

i. A bushfire destroy a part of a company’s pine plantation. Fire losses normally occur every four or five years.

ii. A company has as insurance expense of $150,000 for the current year that covers the building and contents of its corporate

Statement of profit or loss and other comprehensive income

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head office. Would your answer be different if in previous years this expense has averaged $80,000 and the increase was due to a number of claims due to theft of property at the head office in the previous period?

iii. A company has an item of plant. It bases its depreciation expense on the expectation that the plant will be used for 8 years and has recorded depreciation of $15,000 for this period.

iv. A company had an item of plant that was being used in production. This was sold during the current period for $300,000. Prior to sale it had a carrying amount of $210,000.

8. Use the information in Practice Question 13.4, Chapter 13, Leo et al, 2012. (a) Prepare a statement of profit or loss and other comprehensive income. This statement should be in format that meets the minimum requirements as per AASB 101 (i.e. if there is a choice to disclose in the statement or in the notes do not include the information on the face of the statement. E.g. The analysis of expenses is not to be on the face). (Hint in this case: o There are no items of other comprehensive

income. All items relate to the ‘profit/loss’ o the cost of goods sold is equal to $4,390,500;

i.e. raw materials + decrease in inventory). (b) Assume that the other expenses included $42,000 paid to auditors ($7,000 of this for tax advice). Prepare any note disclosure required and identify the accounting standard (and paragraph number) that requires this.

Statement of profit or loss and other comprehensive income

9. Using the information in the trial balance in Practice Question 13.14 Leo et al, 2012, Chapter 13 prepare the asset section only for the statement of financial position. (Note: Ignore the additional information provided in this question). Note: This asset section of the statement should be in format that meets the minimum requirements as per AASB 101 (i.e. if there is a choice to disclose in the statement or in the notes, do not include the information on the face of the statement).

Preparation of asset section of statement of financial position

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TOPIC 3

OTHER DISCLOSURE ISSUES – Accounting Policies, Changes in Accounting Estimates and Errors and Events After the Reporting Period.

OBJECTIVES By the end of this topic you should be able to:

• understand and apply the requirements and disclosures in relation to accounting policies (and changes to these) required in general purpose financial reports

• distinguish between changes in estimates and errors, understand and apply the accounting requirements and be able to prepare the required adjustments and disclosures

• distinguish between types of after reporting period events and understand and apply the related accounting requirements

REQUIRED READING

Resource: Text Leo et al, 2012, chapters 3, 12 & 13 as directed in this guide.

Resource: Accounting Handbook AASB 101 Presentation of Financial Statements as referred to in this guide.

AASB 108 Accounting Policies, Changes in Accounting Estimates and Errors

AASB 110 Events after the Reporting Period

AASB 1054 Australian Additional Disclosures as referred to in this guide.

(You should read all of AASB 108 & AASB 110)

INTRODUCTION AASB 101 prescribes the general features, disclosures and format for the statement of financial position (balance sheet), statement of profit or loss and other

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comprehensive income and statement of changes in equity. However, there are other standards that impact on the financial statements and the notes, and we will now examine a number of such accounting standards which impact on the financial reports of all companies. The first accounting standard that we will examine in this topic concerns accounting policies and is of particular importance as accounting policies influence virtually all aspects of financial reporting. For example:

• we noted when considering AASB 101 that this requires disclosure of the specific accounting policies used by an entity in the notes

• when we consider accounting for property, plant and equipment in a later topic, we will see that there is a choice of how to measure such items. This ‘choice’ is between 2 accounting policies.

AASB 108 ACCOUNTING POLICIES, CHANGES IN ACCOUNTING ESTIMATES AND ERRORS

Accounting Policies – selection, application and disclosure Accounting policies adopted by a company can have a significant impact on the way in which its results and financial position are reported. This means that the economic decisions and other evaluations by users of those statements could be influenced by such choices. For this reason, it is desirable that the choice of accounting policies is made considering the interests of users, and that users are provided with information about those policies.

What are accounting policies? The requirements in relation to the selection and application of accounting policies are contained in AASB 108. This also covers disclosures, although as we have noted AASB 101 also requires some disclosures in relation to accounting policies. Accounting policies include the underlying concepts (such as historical cost, accrual basis) and rules (such as depreciation of assets). Accounting policies need to be distinguished from accounting methods. For example,

• a decision to capitalise and depreciate expenditure (as compared to expensing) is an accounting policy choice

• a change from straight-line method to diminishing balance method to depreciate an item is not considered a change in accounting policy. In such cases the underlying policy (i.e. to depreciate systematically reflecting the pattern of consumption over its useful life) has not changed. Such a change in method is considered a change to an accounting estimate. We will consider these later in this topic.

A number of accounting standards do specify what is or is not considered an accounting policy, For example,

• AASB 116 Property, Plant & Equipment states that a change in depreciation method is a change in accounting estimate (para. 61) and that changes in useful life or the residual value of an asset (due to changes in expectations) are changes in accounting estimates (para 51).

• AASB 140 Investment Property identifies the choice of cost or fair value model for measurement as an accounting policy (para. 30)

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Activity Read the definitions of ‘accounting policies’ in paragraph 5 of AASB 108.

Selection and application of accounting policies The standard requires that, where applicable, the policies within specific accounting standards that have been issued be used. However the standard also provides guidance where there is no specific standard. This guidance is based on the qualitative characteristics of relevance and reliability embodied in the conceptual framework. The aim is to ensure that the policies that are chosen best reflect the underlying performance and position of the entity and avoid ‘creative accounting’ which is where those responsible select accounting policies that provide the result preferred (this is also known as opportunistic accounting policy choice). The need to choose appropriate accounting policies is reiterated in AASB 101 (para. 18) which states that:

An entity cannot rectify inappropriate accounting policies either by disclosure of the accounting policies used or by notes or explanatory material.

AASB 108 also provides direction as to other sources of accounting pronouncements to consider. Recall also that although some accounting standards specify a particular accounting policy to be followed, others allow a choice of accounting policies and that this guidance can assist in appropriate selection.

Activity Read paragraphs 7 to 13 of AASB 108 and sections 3.6 & 3.6.1 of the text. You should note the following:

• Meaning of relevance • Components of reliability including the fact that the substance, rather than legal

form, must be considered and reflected • Need to balance relevance and reliability • The role of the conceptual framework, other accounting sources and industry

practices in providing guidance • Need for consistency in selecting and applying accounting policies

Note: the text refers to sections of the conceptual framework updated and issued in September 2010 by the IASB and adopted by the AASB via the issue in December 2013 of Amendments to the Australian Conceptual Framework. This revised Framework includes changes to the qualitative characteristics; for example,’ reliability’ was replaced with ‘faithful representation’. References to the revised Framework are indicated by a paragraph number beginning with letters (such as QC). AASB 108 has not been updated to reflect these changes and still refers to the qualitative characteristics reflected in the previous Framework which is in your handbook. If you find the text discussion confusing please refer to the relevant definitions and discussions of these qualitative characteristics in the Framework in your handbook (or available from the AASB web site).

Changes in Accounting Policies Specific restrictions and disclosures are required under AASB 108 in relation to changes in accounting policy. The aim is to ensure that users can determine whether changes reflected in the financial statements (for example, changes in profit or asset levels reported) are the result of changes in underlying performance/ position or are due to changes in accounting procedures. Further, comparison

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between periods is more difficult if changes result merely from accounting decisions rather than actual transactions/events. The standard recognises that changes to accounting polices may be required (e.g. implementation of new standard) or desirable (e.g. to provide more relevant and reliable information). The basic premise in the standard is that accounting policies cannot be changed without justification and the reasons and effect of the changes must be disclosed.

How do we implement a change in accounting policy? If an entity decides to change its accounting policy, an important question is how to account for this change. For example, if an entity has always expensed development expenditure and then decides to capitalise (recognise as an asset and amortise) should it:

• ‘go back’ and change how it accounted for all the amounts it had previously spent on development (this is known as retrospective application)? or

• should it simply change the way it accounts for development from this point in time (this is known as prospective application)?

AASB 108 generally requires retrospective application (which requires adjustment of comparative figures and additional disclosures). This is subject to 2 exceptions:

• if the accounting policy change is due to the initial application of an accounting standard then any transitional provisions in that standard will apply. You should note that often these transitional requirements still require retrospective application but not always. Transitional provisions are often included in ‘new’ standards. For example, AASB 1 First-time Adoption of Australian Accounting Standards allows some exemptions to retrospective application.

• where it is impractical.

Example 1: Change in accounting policy Note: for simplicity, tax implications have been ignored in all the examples in this study guide for this topic. During the year ended 30 June 2010 (on 1 July 2009), Company A Ltd purchased and installed specialised equipment in all of its motor vehicles. The total cost of the equipment, $28m, was expensed as incurred. Assume the amount was material.

The journal entry prepared to account for the 2010 expenditure on vehicle equipment was:

Dr Expense $28m Cr Cash/Creditors $28m

The impact of this journal entry on the profit for the year ended 30 June 2010 was a decrease of $28m. In 2011 the directors of Company A Ltd decided that such equipment was a component of the vehicles and that the accounting policy that would be applied would be that such equipment will been capitalised when acquired and depreciated over the vehicles expected useful life (10 years). (Note: There was no expenditure on such equipment in the year ending 30 June 2011). For the purpose of this example, assume that this is a voluntary change in accounting policy.

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IF the policy of capitalising vehicle equipment had always been applied, the journal entries required for the acquisition and depreciation of the vehicle equipment for the years ended 30 June 2010 and 2011 would have been:

• For year ending 30 June 2010 Dr Vehicles $28m

Cr Cash/Creditors $28m • For the years ending 30 June 2010 & 2011 additional entries for depreciation

of: Dr Depreciation expense $2.8m

Cr Accumulated Depreciation vehicles $2.8m Thus, if this policy had always been applied the impact would be:

• Profit for the year ended 30 June 2010 would not include the $28m as an expense. Instead, profit would have been adjusted by $2.8m for depreciation for each of the years ended 30 June 2010 and 2011.

• The asset account for vehicles would have increased by a net amount of $25.2m (i.e. $28m - $2.8m) during the year ended 30 June 2010 and decreased by $2.8m during the year ended 30 June 2011. The net balance of the vehicles account in relation to these expenditures at 30 June 2011 would be $22.4m (Cost of $28m less accumulated depreciation of $5.6m).

In accordance with AASB 108 we need to:

• Adjust retrospectively the opening balance of each affected component of equity and other comparative amounts for the earliest prior period presented (para. 22)

• Disclose details of nature, reason, amount of adjustments in relation to this change (para. 29)

AASB 101 also requires that the impact on any retrospective adjustment as per AASB 108 to equity components (such as retained earnings) be disclosed on the face of the statement of changes in equity (AASB 101, para 106(b)). The journal entries made in 2011 to apply this policy and adjust this would be: Dr Depreciation expense $2.8m Dr Vehicles $28m Cr Accumulated Depreciation- vehicles $5.6m Cr Retained earnings (opening balance) $25.2m The financial statements for 2011 to reflect this change in policy would disclose the following:

• On the face of the statement of changes in equity: o A separate line item for the adjustment (increase) for change in policy

to opening retained earnings of $25.2m (as per AASB101, para 106(b))

• Comparative figures for 2010 o In the statement of financial position the following would be adjusted:

The end balances for 2010 (so opening for 2011 of property, plant and equipment; total non-current assets; total assets

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:increased by $25.2m ie $28 m less depreciation for 2010 of $2.8m) and retained earnings would be increased by $25.2m

Note also that the implementation guidance suggests that the comparative column should be clearly indicated as ‘restated’.

Also, although not required to be adjusted in this example, the opening balances for this statement would also need to be disclosed (as per AASB 101, para 10(f)).

o In the statement of profit or loss and other comprehensive income the following would be adjusted: Decrease expenses by $25.2m (i.e. $28m less depreciation for

2010 of $2.8) • If analysis of expenses is included on face of statement

then related components (e.g. depreciation and other related expenses would need to be adjusted as well as total expense figure)

Increase profit (recall we are not considering impact of tax in this example) by $25.2m

o Also any comparative figures in the notes would also need to be adjusted.

Extract from notes Note x: Change in accounting policy From the beginning of the financial reporting period ending June 2011 the company has changed its accounting policy in relation to specialised equipment fitted to vehicles and has decided to add the cost of this equipment to the cost of vehicles and depreciate over the useful life of the vehicles. This policy has been adopted as it better reflects the economic substance of the transactions and provides more relevant information to users of the financial statements. The policy has been adopted retrospectively from 1 July 2009, the first time this equipment was acquired. Previously this equipment was expensed as acquired.

The 2010 comparative amounts in the financial statements for the year ending 30 June 2011 have been restated to reflect this change in policy. As presented in the statement of changes in equity the opening retained earnings have been adjusted by $25.2m. The effect of the restatement on the end comparative figures for 2010 is summarised below. Increase in Property, plant & equipment $25.2m Increase in equity $25.2m Decrease in expenses ($25.2m) Increase in profit $25.2m The effect of this change in 2011 is to increase the opening balance of property plant and equipment by $25.2m and to decrease in profit by $2.8. Note: Also the accounting policy adopted for the acquisition of motor vehicle equipment would be included in the note summarising accounting policies in accordance with AASB 101 (para 117).

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Activity Read sections 3.6.2 and 12.7 of the text and paragraphs 14 to 27 of AASB 108. Note the following:

• The distinction between accounting ‘policies’ and accounting ‘methods’ discussed in the text

• What changes are not considered changes in accounting policies (refer to paragraph 16)

• Standards (and Interpretations) will often contain ‘transitional’ arrangements that prescribe treatment for initial adjustments on first application of the standard.

• If the change is accounting policy is voluntary (i.e. not required by a standard) then the change must be accounted for retrospectively- in other words the accounts adjusted as if the new policy had always applied - unless it is considered impracticable to do so.

The IASB implementation guidance also provides examples of the application of the requirements of AASB 108 in relation to changes in accounting policies. You may wish to consider this.

Disclosures of Accounting Policies The disclosure of the accounting policies used by an entity is required in the notes by AASB 101 Presentation of Financial Statements. The note relating to accounting policies is usually the first note to the statements and must include:

• the measurement basis/s used, and • all other accounting policies required to understand the statements (paras

112 & 117). AASB 1054 Australian Additional Disclosures also requires:

• a statement that the reports have been prepared in accordance with Australian Accounting standards (para. 7).

• The statutory basis of other reporting framework that the financial statements prepared under (para. 8)

• a statement that the report is a general purpose financial report or a special purpose financial report (para. 9).

In addition information needs to be provided relating to management judgments /decisions that have been made in applying those policies that have the most significant impact on the amounts in the financial statements, or in relation to key assumptions made where there have been estimates made. Disclosures for changes in accounting policies AASB 108 requires extensive disclosures of any changes made in relation to accounting policies including nature, reason for change and the financial impact.

In addition AASB 101 impacts on the disclosures where there has been a change in accounting policy and this has been applied retrospectively. As noted in the example above, AASB 101 para 106 (b) requires the impact on equity components be shown on the face of the statement of changes in equity. Further we noted in an earlier topic that AASB 101 (para 38) requires that comparative information needs to be included for the previous period for all amounts reported. However AASB 101 (para10(f)) states that:

A complete set of financial statements comprises:

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…. (f) a statement of financial position as at the beginning of the earliest comparative 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. (emphasis added)

Paragraphs 40A to 44 of AASB 101 clarify the requirements for this additional statement. Hence 2 sets of comparative figures for the statement of financial position (so in effect, 3 statements in all) will be required.

Activity Read paragraphs 10, 16, 40A to 40D, 106, 108, 110, 112 to 128 of AASB 101, paragraphs 28 to 31 of AASB 108, paragraphs 7 to 9 of AASB 1054 and sections 12.4 to 12.4.2, and 13.6.1 of the text. Also work through demonstration problem 1 in chapter 12. Also read para 30 of AASB 108. This requires disclosure of the non-application of any new accounting standards that are not yet effective, and the estimated impact.

ADJUSTMENTS FOR REVISIONS AND ERRORS When preparing the financial statements ‘mistakes’ can occur. AASB 108 distinguishes between different types of ‘mistakes’ (some are perhaps better referred to as inaccuracies) and specifies the accounting and disclosure requirements. AASB 108 distinguishes between: • Changes in (or revisions of) accounting estimates.

These are not regarded as errors but are a result of the inherent uncertainty in many accounting measures such that actual figures/amounts are unknown, so an estimate must be made based on the information available at that time. You will have used estimates in relation to depreciation. The impact of any revision in an estimate is recognised in the period of the revision. You are not permitted to revise estimates retrospectively. The nature and amount of the revision (both for current and future periods) are required to be disclosed if material, unless impractical (paras 39 and 40).

• Prior period errors Errors are where information was incorrectly used and so the previous statements either were incomplete or misstated. In such cases (if material) the statements need to be corrected. An error is to be corrected in the reporting period in which it is discovered and accounted for, unless impracticable, by:

• in the current financial statements either: • Restating prior period amounts in which error occurred (if these are

presented in current statements), or • Restating opening balances of earliest prior period amounts

presented. In other words, the error is adjusted retrospectively. This reflects the general approach that the international standards take that the statement of profit or loss and other comprehensive income only includes items related to the period. The disclosures required in relation to such errors are similar to those for changes in accounting policies and are found in paragraph 49 of AASB 108. As noted previously, AASB 101 para 106 (b) requires the impact of any retrospective adjustment on equity components be shown on the face of the statement of

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changes in equity. Further, as per AASB 101(10)(f) an additional statement of financial position is required. Paragraphs 40A to 44 of AASB 101 clarify the requirements for this additional statement.

Example 2: Change in estimate On 1 July 2008, Company X Ltd purchased an item of plant for use in its operations for $12m. It was estimated that the plant would have a residual value of $3m and a useful life of 6 years. Company X Ltd uses straight-line depreciation for such assets. Thus the annual depreciation was: $12m (cost) - $3m (residual value) 6 years = $1.5m On 1 July 2010 the company reassessed the useful life for this item of plant. The plant was operating more efficiently than originally anticipated and was now expected to have a total useful life of 9 years (i.e. 7 years remaining) and a residual value of $2m. At 30 June 2010 the carrying amount of the plant is:

Cost 12m Accumulated depreciation 3m

9m The change in estimate should be made prospectively (in accordance with AASB 108 para 36) by basing future depreciation expenses on the carrying amount at the date of change in estimate. Depreciation will be calculated on the basis of the new estimates of useful life and residual value. Hence depreciation for 2011 will be: $9m (carrying amount at time of change of estimate) - $2m (new residual value) 7 years (new estimate of useful life less years already elapsed) = $1m The journal entries for the year ended 30 June 2011 would be: DR Depreciation expense – plant $1m CR Accumulated Depn-plant $1m No adjustments are made for the previous periods. The change in an estimate is applied in the year the change in estimate actually occurs (AASB 108, para 36). If the change is material a note would be included in accordance with AASB 108, para 39. Extract from notes Note Y: Change in estimate During the 2011 financial year the company reviewed the operation of its plant and equipment. This has resulted in the following changes:

• The useful life was increased from 6 to 9 years • The residual value was reduced from $3m to $2m.

This has reduced the depreciation expense for the current financial year and future years from $1.5 to $1m.

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Example 3: Prior Period Error In June 2011 Company Y Ltd undertook an audit of its assets and discovered that the sale of an item of property, plant and equipment on 30 June 2009 had not been recorded. The item was an item of land. At the time of the sale it had a carrying amount (at cost) of $8m and had been sold for $12m cash. The cash from the sale had been recorded incorrectly as sales revenue (the company uses the periodic method for inventory and costs of sales were recorded correctly for the period). Assume Company Y Ltd

• has a 30 June year end for financial reporting purposes • normally provides comparative figures for one prior year only • for simplicity, tax implications have been ignored in this example.

In accordance with AASB 108 we need to:

• Adjust retrospectively (as per para 42). This means that the opening balances of assets, liabilities and equity must be restated for 2010 and as error occurred in year ended 30 June 2009 the beginning balances of 2010 of these comparatives are also adjusted (as per AASB 101 (10f)).

• Disclose details of the nature and amount of corrections in relation to this error (para. 49)

Further recall that AASB 101 also requires that the impact on any retrospective adjustment as per AASB 108 to equity components (such as retained earnings) be disclosed on the face of the statement of changes in equity (AASB 101, para 106(b)) The original entries journal entries made by Company Y Ltd were:

Dr Cash 12 Cr Sales revenue 12 The impact of this journal entry was to increase profit by $12m The entries that should have been made by Company Y Ltd if the error had not been made were: Dr Cash 12

Cr Land 8 Cr Gain on sale 4 The impact of this journal entry would be to increase profit by only $4m The entry that is required to be made in 2011 to correct the prior period error would be: Dr Retained Earnings (opening balance) $8m Cr Land (PPE) $8m The financial statements for 2011 would reflect the correction of this error as follows:

• On the face of the statement of changes in equity: o A separate line item for adjustment (decrease) for prior period error to

opening retained earnings of $8m (as per AASB 101, para 106(b)) • In the statement of financial position the comparative figures for the 30

June 2010 for the following beginning and ending balances would be adjusted:

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o Property, plant and equipment; total non-current assets; total assets and retained earnings would be reduced by $8m

o Note also that the implementation guidance suggests that the comparative column should be clearly indicated as ‘restated’.

• In the statement of profit or loss and other comprehensive income no adjustments would be shown as the comparative figures relate to 30 June 2010 and the error relates to income for 30 June 2009 o Note: AASB 101, para 10(f) requires beginning balances of

comparative statement of financial position to be shown. • Also any comparative figures in the notes would also need to be adjusted.

The extracts from the notes to the accounts shall be made in accordance with AASB 108 para 49: Extract from notes Note x: Prior Period error The sale of an item of land that was sold on 30 June 2009 had not been recorded and had incorrectly been recorded as sales revenue. The 2010 comparative amounts in the financial statements for the period ending 30 June 2011 have been restated to correct this prior period error. This has no effect in 2011. The effect of the restatement on the comparative figures for 2010 is summarised below. Decrease in Property, plant & equipment $8m Decrease in equity $8m As presented in the statement of changes in equity the opening retained earnings has been adjusted by $8m.

Activity Read sections 12.5 and 12.6 of the text that discusses revisions and errors. You have previously been referred to section 12.7 of the text that discusses issue of impracticability of retrospective adjustments. Read paragraphs 32 to 49 and the definitions of ‘a change in accounting estimate’ and ‘prior period errors’ in paragraph 5 of AASB 108. Also note the disclosure requirements in relation to errors and changes to estimates. The IASB implementation guidance also provides examples of the application of the requirements of AASB 108 in relation to errors. You may wish to consider this.

EVENTS AFTER THE REPORTING PERIOD: AASB 110 AASB 110 Events After the Reporting Period specifies the appropriate treatment and disclosure for ‘events after the reporting date’. (Note: This standard has been renamed. The previous title was “Events after the Balance Sheet Date’). Although the financial reports are prepared to reflect conditions existing on (or up to) balance date (often 30 June), the actual preparation of these reports is not completed until some time later. In the interim period, events can occur that may impact on the financial statements themselves, or otherwise be material to users.

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AASB 110: • Defines events after the reporting period and restricts these to those

events between the end of the reporting period and prior to the date when the financial statements are authorised for issue

• Specifies which of these events will (and will not) be reflected in the financial statements. This will be determined by classifying events into two types; adjusting and non-adjusting events after the reporting date.

• Specifies disclosures required. As is common with other accounting standards, the provisions of AASB 110 are subject to the materiality concept and only apply if the result is material.

Activity Read section 12.9 (including illustrative example 12.4 & demonstration problem 3) of the text, and the entire standard (this is not a particularly long standard). Ensure you understand the difference between the two types of events and the accounting and disclosure requirements. Note the following:

• Adjustments relating to the first type of event (those relating to conditions existing at the end of the reporting period) may also result in changes to notes if the event relates to items/information only/also disclosed in notes.

• Whether an event is adjusting or non-adjusting will be determined by the facts. For example, after the reporting period it may be discovered that a large amount of inventory has been damaged. You would need to consider whether the facts indicate that the damage occurred before or after the reporting period to determine the type of after reporting period event.

OTHER DISCLOSURES Above we have considered a number of the standards that provide the key source of many disclosures required by companies. However this has not been exhaustive and a brief perusal through the contents of the Accounting Handbook alone will reveal other standards that would be relevant to all companies, for example:

• AASB 124 Related Party Disclosures • AASB 133 Earnings Per Share • AASB 119 Employee Entitlements • AASB 134 Interim Financial Reporting

It is not an objective of this course that you have knowledge of all of the accounting standards or other reporting requirements applicable to companies. Rather it is hoped you have gained an appreciation of the breadth and impact of the accounting standards and reporting requirements and an ability to interpret and apply those key standards that we consider.

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TOPIC REVIEW QUESTIONS

1. Explain: What are accounting policies and how do these differ from accounting methods? Give an example of each.

Accounting policies vs methods

2. (a) Leo et al, 2012, Chapter 3, Review question 12 (b) Leo et al, 2012, Chapter 3, Review question 13 (c) Which accounting policies must be identified in the

initial note to the financial statements?

Accounting policy choice & changes & disclosures

3. (a) Distinguish between a change in an accounting estimate and a change in accounting policy. What disclose requirements apply to a change in an accounting estimate? (b) Leo et al, 2012, Chapter 12, Review question 10

Revisions/ estimates/errors

4. Explain whether each of the following would be treated as a change in accounting policy, change in accounting estimate or error or none of these. You need to give reasons for your answers.

i. The useful life of machinery is now assessed as 8 years (previously estimated at 5 years)

ii. It is now expected that at the end of its useful life, the machinery (in i above) will have no disposal value. It was previously expected to realise $10,000 on disposal.

iii. The company has previously only sold goods on a cash basis and hence no doubtful debts expense was recorded. In this period the company allowed sales on a credit basis and has recognised a doubtful debts expense of 1% of credit sales.

iv. The company has previously calculated its warranty provision as .05% of sales. However it has now been discovered that there was a problem with quality control in the previous period. It is now expected that claims for warrantees relating to sales from the previous period will increase to 1% of sales for that period.

v. It has been discovered that a sale to a customer in the previous period was incorrectly recorded at $2942 instead of $2429.

Revisions/ policies

5. Leo et al, 2012, Chapter 12, Review question 15

Events after the reporting period

6. Leo et al, 2012, Chapter 12, Practice Question 12.4 In addition, classify the event below. (i) A company is being sued. The company had

Events after the reporting period

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previously recognised a liability and had estimated that the damages awarded would be $5m. In late July the courts awarded damages of $47m. The company cannot afford to pay this amount and it is now expected to place itself into voluntary liquidation. (Note: This question is adapted from Alfredson et al, 2005)

7. Leo et al, 2012, Chapter 12, Practice Question 12.9

Changes in estimates/policy

8. Leo et al, 2012, Chapter 12, Practice Question 12.10 (Hint: take care with dates/periods as capitalisation on 1 January). Ignore taxation. Also prepare adjusting entries required to account for this change.

Change in accounting policy

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TOPIC 4

EQUITY: Share issues, dividends and reserves – Accounting issues, presentation and disclosures.

OBJECTIVES By the end of this topic you should be able to: • understand the nature of equity and its components • explain the nature of shares • understand the difference between ordinary and preference shares • account for the issue of company shares, including payment in full on

application and payment by instalments, and share issue costs • to account for excess application money (in limited cases) • understand the nature of forfeiture of shares and underwriting • explain the nature of dividends • account for the recognition and payment of dividends • understand the nature of reserves • account for the creation of, and transfers to and from, reserves • understand the nature and content of, and account for, retained earnings • understand, source and apply the key disclosure and reporting requirements

in relation to equity components including the statement of changes in equity

REQUIRED READING

Resource: Text Leo et al, 2012, sections of Chapters 2, 3 & 13 as directed in this guide

Resource: Accounting Handbook AASB 101 Presentation of Financial Statements

Sections as referred to in this guide

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INTRODUCTION We will begin our more detailed examination of particular areas of the financial statements by considering how to account for equity. Disclosures about equity are required in the statement of financial position and in the statement of changes in equity and in the notes to the statements.

Definition of equity Equity is defined as:

the residual interest in the assets of the entity after deducting all of its liabilities. (para. 49, Framework).

The key components of equity are: • contributed equity (often referred to as share or issued capital) • other components of equity (this includes reserves and reserves include

retained earnings and other reserves)

Activity Refer to sections 3.1.5 & 3.3.3 of the text. Please note: Financial instruments are not considered in detail in this course but will be considered in Financial Accounting 3. Guidance provided by the IASB on implementing AASB 101 provides an example of a statement of financial position, and in particular note the equity section that is reproduced below.

Note: In this course we do not consider minority interest so at present you should ignore these components.

You should also note the following note from the Implementation Guidance: The Standard sets out the components of financial statements and minimum requirements for disclosure on the face of the statement of financial position and the statement of comprehensive income as well as for the presentation of changes in equity. It also describes further items that may be presented either on the face of the relevant financial statement or in the notes. This guidance provides simple examples of ways in which the requirements of the Standard for the presentation of the statement of financial position, statement of comprehensive income and changes in equity might be met. The order of presentation and the descriptions used for line items should be changed when necessary in order to achieve a fair presentation in each entity’s particular circumstances.

In addition to these major components of equity, disclosures about distributions to shareholders (dividends) and other changes to equity are also required. There are alternatives as to how and where particular components of equity, or

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changes to these, can be reported and disclosed. Before we consider the reporting requirements we will consider the underlying accounting relating to each of the components and in addition dividends, which impact on equity. We will deal with share capital first by considering the issue of shares.

BACKGROUND TO SHARE ISSUES

What are shares? A share is defined in the Corporations Law (s 9) as a share in the share capital of a body. Once a company has been formed it has the right to issue shares. The first issue of shares, for a public company, usually provides its initial funding. Subsequent issues of shares can be (and often are) made to further fund operations or expansion. Depending on Corporations Law requirements shares may be issued to the public, to a specific entity (private placement), to employees or to existing shareholders. The exact requirements for the issue of shares will depend on the nature of the issue. For example, whenever the public is invited to apply for shares, a disclosure document (such as a prospectus) must be issued. In this course, we will focus on the accounting treatment of the issue of shares, and associated disclosures, and will not be concerned with the detailed legal requirements associated with such issues.

Liability under shares We noted earlier that a key feature and advantage of the company structure is to limit the liability of investors (owners). Shares are issued for a specific price, which is detailed in the disclosure document. A company can issue partly paid shares (i.e. where only part of the issue price is currently required to be paid). The liability of shareholders relates to any unpaid amount of the issue price of any share held.

Types of shares A company can issue different types of shares. The two types we will be dealing with in this course are 'ordinary' and 'preference' shares. Ordinary shares are the form for the basic 'ownership' of a company. Basically, an ordinary share represents a proportion of ownership rights. The proportion depends on the number of shares the company issues. For example, if a company has issued 200,000 shares and I own 10,000 shares, I have what represents a 5 percent share in the net worth of the company. This 'share' in the net worth may vary: for example, if the company issues more shares any individual share-holding will be diluted in terms of share of net worth. Ordinary shares normally have rights attached to them reflecting the concept of ownership, entitlement to share in any profits, to contribute to decision making via voting rights at shareholder meetings, and entitlement to share in capital if the company is wound up.

Preference shares have some preferential rights attached (e.g. the right of the shareholder to receive their dividend prior to ordinary shareholders) and often

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(although not always) have a fixed amount of dividend attached. The exact rights attached to shares are variable and determined by the company's constitution or a special resolution of the company. Variations in these shares may relate to voting rights, redemption or terms of redemption, and dividends (whether fixed, cumulative or participating). Depending of the terms of the issues these shares may be in the nature of a liability rather than equity.

The decision as to whether to recognise such shares as either debt or equity (or a combination of both) is governed by AASB 132 Financial Instruments: Presentation. In this topic we will assume all preference shares are in the nature of equity. It should be noted that as details of the different type of shares issued are required to be disclosed in the financial statements and/or accompanying notes, the issue of different types of shares need to be accounted for separately.

Activity Read the introduction to chapter 2 and section 2.1.1 of the text to confirm the main points above.

RECORDING SHARE ISSUES

Preliminary The first step in the issue of shares is for the directors to determine the terms of the issue. This will involve considerations of the need for capital and the most appropriate forms of financing. If a share issue is appropriate a number of decisions need to be made including:

• who shares will be issued to • type of shares to be issued • timing of the issue • number of shares • pricing of the shares • timing of payment (in full on application, part on allotment, part on future

calls) • whether issue will be underwritten

Depending on the terms of an issue a disclosure document (such as a prospectus) will need to be prepared and issued, inviting applications for shares. It is not until applications, with application moneys, are received that any accounting entries are required to be made.

Accounts used The accounts that may be used in a share issue are:

• cash trust account • application account • share capital account • allotment account

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• call account The accounting entries required will depend on the number of applications received (whether minimum subscription is received, whether any excess payments are refunded or used to reduce allotment money due, and in payment of future calls), and the timing of payments required under the terms of the issue. Note: Some other texts use the title 'paid-up capital' for the share capital account. As mentioned previously, where different types of shares are issued separate accounts must be used (e.g. preference share capital, ordinary share capital).

Activity Please read section 2.1.2 of the text to gain an understanding of the use of these accounts in the share issue process.

SIMPLE SHARE ISSUE: PAYABLE IN FULL ON APPLICATION Example 1: Share issue payable in full on application Kangaroo Ltd was formed on 1 July 2013. The directors decided to issue 400,000 ordinary shares at $2.40 to the public. The issue price was payable in full on application. A prospectus was issued with closing date for applications being 1 September 2013. At this date applications had been received for 400,000 shares. The shares were allotted on 3 September 2013. Journal entries to record this issue are below:

General Journal for Kangaroo Ltd

Entry Date Account Debit Credit

1 to 1/9/13 Cash trust Application

960,000 960,000

(Being receipt of application moneys of 400,000 @ $2.40)

2 3/9/13 Application Share capital

960,000 960,000

(Being allotment of 400,000 shares @ $2.40—amount received on application)

3 3/9/13 Cash Cash trust

960,000 960,000

(Being transfer of cash received from the share issue to general funds)

Important points to note from Example 1 are:

• Entry 1 in fact represents the cumulative effect of the receipt of applications and moneys from the date of issue of the prospectus to the closing date for applications. Moneys are required under Corporations Law to be held in a separate account until shares are allotted (issued).

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• Until (and unless) shares are allotted the application account represents a liability. The company is under an obligation to applicants to either refund the moneys received or allot (issue) shares.

• Entries 2 and 3 are all recorded on the same day—the day shares are allotted/issued.

• Entry 2 records the actual allotment/issuing of shares and reflects the legally binding contract now established between the company and the new shareholders. It is at this time that shareholders become liable for any unpaid amount of the issue price, although in this example as full payment was received on application, the shareholders have no further liability.

• Entry 3 reflects the fact that the funds previously received are now contributions by owners and can legally be used by the company.

Activity Illustrative example 2.1 in the text provides another example that includes the refund of moneys to unsuccessful applicants. Please work through this now.

SIMPLE SHARE ISSUE: PAYMENTS BY INSTALMENTS Example 1 assumes that the total issue price is payable in full on application. This method of payment is only one alternative available. As soon as shares are allotted (issued) shareholders are legally liable to the extent of any unpaid amount of the issue price. However, in many cases the company will not require that the entire issue price be paid in full on application, but could require:

• a part of the issue price be paid on application with the balance payable on allotment of shares, or

• a part of the issue price be paid on application, a further part of the balance payable on allotment, and the remainder when calls are made in the future.

In these situations we use separate accounts to record the amounts due and payable at, or subsequent to, allotment.

Example 2: Share issue – payment by instalments We will use the same data as in Example 1 except that the issue price of $2.40 is payable as follows:

• $1.00 on application • $0.80c on allotment • a further call (or calls) of the remaining $0.60c when required by the

directors A prospectus was issued with closing date for applications being 1 September 2013. At this date $400,000 had been received with applications for 400,000 shares. The shares were allotted on 3 September 2013. All allotment moneys were received by 2 October 2013.

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General Journal for Kangaroo Ltd

Entry Date Account Debit Credit

1 1/9/13 Cash trust Application

400,000 400,000

(Being receipt of application moneys of 400,000 @ $1.00)

2 3/9/13 Application Share capital

400,000 400,000

(Being allotment of 400,000 shares with—amount received on application 400,000 @ $1.00 = 400,000)

3 3/9/13 Allotment Share capital

320,000 320,000

(Being amount due on allotment 400,000 @ $0.80 = 320,000)

4 3/9/13 Cash Cash Trust

400,000 400,000

(Being transfer of cash received from the share issue to general funds)

5 2/10/13 Cash Allotment

320,000 320,000

(Being receipt of allotment moneys due—400,000 @ $0.80 = 320,000)

Important points to note are: • Entries 2 and 3 may be combined as follows:

- Debit - application 400,000 - Debit - allotment 320,000 - Credit - share capital 720,000

• The allotment account is in the nature of a receivable (although it is recognised in the equity section as a reduction in share capital, not as an asset in the statement of financial position (balance sheet)) and represents the specific debt of these shareholders to pay the company the $0.80 per share due on allotment.

• There is no requirement for the moneys paid on allotment to be deposited in a separate (trust) account. On issue of the shares the shareholders are formally liable to pay the amount requested and the company is entitled to utilise the moneys due on allotment as soon as these are received.

So far you should be able to see that although the issue price of the shares was $2.40, only $1.80 (the $1.00 received with the application for shares, and the subsequent $0.80 received on allotment/issue of the shares) has been paid. The

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company is entitled to ask to receive the remaining balance of the share issue price ($0.60) in the future. Shareholders are legally liable to pay this balance on request. When the company requires that this further amount (or part thereof) be paid it is referred to as a 'call'. The procedure for accounting for calls is demonstrated below. Example continued The following further information is provided. In relation to the 400,000 shares issued the directors made a call of $0.40 per share on 1 December 2013 with all money being received by the end of December. A further call for the remaining $0.20 per share was made on 15 June 2014. As at 30 June 2014 call money had been received on 360,000 shares.

General Journal for Kangaroo Ltd

Entry Date Account Debit Credit

6 1/12/13 First call Share capital

160,000 160,000

(Being call of $0.40 on 400,000 shares = $160,000)

7 31/12/13 Cash First call

160,000 160,000

(Being receipt of call of $0.40 on 400,000 shares = $160,000)

8 15/6/14 Second call Share capital

80,000 80,000

(Being call of $0.20 on 400,000 shares = $80,000)

9 30/6/14 Cash Second call

72,000 72,000

(Being receipt of call of $0.20 on 360,000 shares = $72,000)

The following points should be noted:

• The call account for the first call now has a balance of zero, as all call money requested was received. (Note: Entry 6, debited this call account for $160,000, and Entry 7 credited this same account for $160,000).

• The call account for the second call has a debit balance of $8,000. (Note: Entry 8, debited this call account for $80,000, and Entry 9 credited this same account for $72,000). This balance represents the amount of calls not yet paid (40,000 @ $0.20) and represents 'calls in arrears'. A separate 'calls in arrears' account is not normally established, however, these would appear on the internal statement of financial position (balance sheet) as follows:

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Share Capital Share capital (400,000 ordinary shares at $2.40, fully

paid) 960,000

less Calls in arrears (40,000 shares at $0.20) 8,000 Total Share Capital 952,000

Activity Illustrative example 2.2 in the text provides another example involving the issue of shares and payment by instalments. Please work through this now.

OVERSUBSCRIPTION AND UNDERSUBSCRIPTION

Oversubscription There may be instances where the amount received on application is greater than that requested. This could be due to:

a) applications being received for more shares than are available in relation to the issue, or

b) applicants forwarding amounts due on allotment and/or calls, on application, or

c) a combination of (a) and (b) above. Where (a) occurs directors may decide to reject a number of applications or issue shares on a pro-rata basis (or a combination of both). If applicants are not issued any shares, or the money received from them exceeds the total issue price of the shares issued to them, the money must be refunded. However, treatment of other excess moneys will be determined by the company's constitution and the terms of the issue as outlined in the disclosure document (e.g. the prospectus).

Activity Section 2.2.2 of the text discusses over-subscription. You should read this now. Illustrative example 2.3 involves retention of excess application money. Only simple examples of this will be accounted for in this course.

Undersubscription

Activity This is adequately dealt with in section 2.2.1 of the text. Please read this now.

FORFEITURE OF SHARES If shareholders subsequently fail to pay a call, then depending on the company's constitution, the shares may be forfeited. If the company’s constitution does not include specific rules, forfeiture is not permitted. Forfeiture effectively removes the amounts paid on these shares from the share capital account. The

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company's constitution will determine whether these shares are cancelled or reissued. In this course we will not be dealing with the detailed accounting entries for the forfeiture or reissue of forfeited shares. However, you should be aware of the basic principles involved.

Activity Please read the section 2.3.1 of the text to gain an understanding of the nature of forfeiture of shares.

UNDERWRITING, FORMATION AND SHARE ISSUE COSTS You are not required to be able to account for underwriting costs but are required to prepare journal entries for other share issue costs in this course. However, you need to understand the nature of underwriting costs and the accounting treatment required. Underwriting costs To avoid the possibility of an undersubscription an underwriter (usually a broking firm, or financial institution) may be used. An underwriter contracts to take up any shares not subscribed for by the public in return for an underwriting commission (fee). This commission is normally payable regardless of whether or not an undersubscription occurs. Where an undersubscribed share issue is underwritten the following will also need to be accounted for (in addition to the usual accounting entries for share issues):

• recognition of issue of shares to the underwriter and the underwriter's liability for moneys due on application; and

• the underwriting commission. The cash received from the underwriter in respect of moneys due on application and allotment is reduced by the amount of this commission. Other share issue costs Costs, including underwriting costs, incurred in the issue of shares are treated as a reduction in the share capital raised. As AASB 132 Financial Instruments: Presentation states

37. An entity typically incurs various costs in issuing or acquiring its own equity instruments. Those costs might include registration and other regulatory fees, amounts paid to legal, accounting and other professional advisers, printing costs and stamp duties. The transaction costs of an equity transaction are accounted for as a deduction from equity (net of any related income tax benefit) to the extent they are incremental costs directly attributable to the equity transaction that otherwise would have been avoided.

Such costs for a period would also need to be included as part of the requirements to disclosure changes in equity components (AASB 101, para 106).

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Activity Underwriting and other share issue costs are discussed in section 2.4 and 2.4.1 of the text. Please read this now and note that the treatment of costs depends on the nature of the issue (equity or liability) and the success of the equity placement. Also read section 2.4.2 of the text relating to formation costs.

RIGHTS, PRIVATE PLACEMENTS AND BONUS SHARE ISSUES In all the examples so far a company has issued shares to the public. However, companies may also be more restrictive in who shares are offered to. A rights issue is where shares are offered to existing shareholders; a placement is where shares are issued to specific (usually) institutional investors. In accounting for such issues the only difference is that as there is no requirement to hold money in trust no application or trust account is used. Companies may also issue what are known as bonus shares. In such cases shares are issued to existing shareholders (in proportion to their existing holdings) for no further consideration (i.e. no further cash is received). There are a number of possible reasons for such an issue. Although such an issue will not effect the proportionate ownership interest held by shareholders, and does not result in an increase in net assets, often bonus share issues are seen as increasing potential cash dividends since many companies try to maintain dividends per share at the same level over a number of years. Bonus dividends may be paid out of retained earnings or other reserves.

Activity Read sections 2.5 to 2.5.3 and 3.4.4 of the text and work through illustrative examples 2.6 and 2.7.

Disclosures in relation to share capital The amount of issued capital needs to be included on the face of the statement of financial position (AASB 101, para. 54). Details about each class of share capital (such as number of shares, rights) also need to be disclosed either on the face of the statement of financial position or in the notes (AASB 101, para. 79).

Changes in share capital (as a result of transactions with shareholders – this would include the issue of shares) and any changes in each class of share capital also need to be disclosed on the face of the statement of changes in equity (AASB 101, paras.106, 108).

RETAINED EARNINGS One component of equity is reserves. Retained earnings (this is also referred to as retained profits) are part of the reserves of an entity. Retained earnings (or accumulated losses) represent the balance of the profit and losses (i.e. before items of other comprehensive income) which the company has made since incorporation, which have not been paid as dividends or bonus share issues to shareholders, transferred to other reserves, or used to buy back shares (Henderson and Pierson, 2000, p 534).

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Changes to the retained earnings over a period can generally be calculated as: Retained earnings (beginning or opening balance) *Plus/less effects of any changes in accounting policy/errors Plus net profit for period (or less net loss for period) Less dividends paid or payable Less transfers to other reserves (or plus transfers from other reserves) = Retained earnings (ending balance) *As indicated above the balance can also be affected by adjustments due to changes in accounting policies/errors which in some cases may be required to be adjusted directly to retained earnings. We considered this in a previous topic.

Disclosures AASB 101 does not require retained earnings to be separately disclosed on the face of the statement of financial position but reserves (which would include retained earnings) are required to be separately disclosed on the face of the statement of financial position. Note: The example in the IASB implementation guidance does separate ‘other components of equity’ and ‘retained earnings’ on the face of the statement of financial position. Although this is not required it is allowed as per AASB 101, paras 55 and 77, and retained earnings are often shown separately in practice. Changes to the retained earnings during a period need to be disclosed on the face of the statement of changes in equity (AASB 101, paras. 106 & 108).

Activity Read section 3.8 of the text now. You also need to understand this reconciliation of retained earnings for future topics. Note in particular the fact that total comprehensive income is not transferred to retained earnings; only the profit/loss for the period.

DIVIDENDS As we noted above one of the components of the reserves is retained earnings. Retained earnings are affected by profits (or losses) made, distributions to owners and transfers to or from reserves. Dividends are the company equivalent of distributions to owners. These are often made from retained earnings, although can be made from other reserves. Cash dividends are the most common, but shares can also be distributed (known as a bonus share dividend). You should recall that much of the regulation of companies (particularly public companies) was to protect the public interest. Given that the payment of cash dividends transfers assets out of the company (and back to shareholders) thus reducing assets available to meet other claims and to continue operations, regulation imposes a number of restrictions on the making of such distributions. In accounting for dividends it is necessary to distinguish between when a company incurs a legal debt for dividends and when a liability is recorded (you should recall that the definition of a liability does not require the obligation to be legal and we consider this further in a later topic).

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It is important to understand when a liability for a final dividend can be recognised. This is impacted by AASB 110 and AASB 137.

• If a dividend is declared after reporting date then at that reporting date no liability can be recognised although these are required to be disclosed in the notes (as per AASB 101 para. 137);

• If the dividend is declared before reporting date and authorisation is not required (such as approval by shareholders) and there is no discretion for the company to revoke, then a liability is recognised. In this course unless otherwise and explicitly stated, it will be assumed that no authorisation is required and no discretion remains.

• If the dividend is recommended before reporting date and authorisation is required (such as approval by shareholders) or is still as the discretion of the company then a liability cannot be recognised at that reporting date (although again disclosure would be required in the notes).

Accounting entries for dividends

Activity Read paragraphs 12 & 13 of AASB 110. Also read sections 3.4 to 3.4.3 (including illustrative example 3.1) of the text, which provide an introduction to dividends and details some of the legal requirements concerning the issue, sources and payments of dividends. In addition note: • Difference between interim and final dividends – an interim dividend is any paid

during the period; a final dividend is determined at or after the end of the reporting period.

• Take care when accounting for dividends that you are clear about account being used. For example, an account title such as ‘Dividend’ is not appropriate- does this mean dividend payable, dividend declared?

• Common basis of dividend per share. The text discusses at 3.4.1 the legal requirements in relation to when dividends can be paid. As the text notes changes to section 254T of the corporation’s law were enacted in June 2010 and this in effect now requires a solvency test, but there is also a requirement that a company’s assets exceed its liabilities as measured in accordance with accounting standards. The wording of this section is drafted in the negative (i.e. a dividend can’t be paid unless it meets the tests). (ICAA, ANT, Issue 42). In this course we do not examine the legal requirements. We will assume that these requirements have been met, and this will not impact on the accounting entries or disclosures required in relation to dividends. Note: • On recognition of a dividend (either paid or payable) there are alternatives for the

debit entry; either to ‘Retained earnings’ or to ‘Dividend declared (or paid)’. As the text notes if the debit is not to retained earnings a closing entry is required at the end of the reporting period.

Work through illustrative example 3.1 to ensure you are able to account for these transactions. Note that in this example: • The entry to recognise dividends recommended on 30 June 2012 is not made

until the time of payment (i.e. in the year ended 30 June 2013) due to fact that given the constitution this is still at discretion of the company until the time of payment.

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• Given the constitution no entry is made in the year ended 30 June 2013 for the dividend recommended on 30 June 2013.

Disclosure of dividends As dividends recognised as liabilities in the period impact on the balances of retained earnings (or other reserves) these will be required to be disclosed as part of changes in equity components (as per AASB 101, para 106). Further details (such as amount per share) also needs to be disclosed either on the face of (or in the notes to) the statement of changes in equity (AASB 101, para. 107). As noted above, for dividends proposed but not recognised as a liability a note needs to be included (AASB 101, para. 137).

Bonus Share Issues

Activity You have previously been directed to read section 3.4.4 of the text. We will discuss reserves next.

RESERVES Reserves represent a further component of equity in the statement of financial position and we noted earlier that this includes ‘retained earnings’. Despite the requirement to disclose information about reserves there is no definition of the term ‘reserve’ in either the accounting standards or the corporations law. Reserves, other than retained earnings, now arise from 2 sources:

1. the application of accounting standards. For example if an asset is revalued upwards then AASB 116 normally requires recognition of a revaluation surplus. AASB 116 para 39 states:

the increase shall be recognised in other comprehensive income and accumulated in equity under the heading of revaluation surplus

Hence such a change on revaluation is recognised initially as a component of other comprehensive income but is then transferred to the revaluation surplus (this is also sometimes known as a revaluation reserve) in equity. This is a type of reserve that accumulates related other comprehensive income items and we will account for this surplus later in this course, and

2. from transfers from retained earnings (often known as general reserves). These transfers from retained earnings to other reserves are at the discretion of management and are often designed to indicate to shareholders that some part of retained earnings is not intended for the payment of dividends (at least currently). Instead, these reserves have been ‘set-aside’ for other purposes (Henderson and Pierson, 2000, p 534).

Activity Read sections 3.5 to 3.5.3 of the text to confirm the discussion above. Ensure that you understand the journal entries required to create /increase (or remove/reduce) a general reserve. Note: There are alternatives for the entry in relation to retained

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earnings and the journal entry can be a Dr to ‘Transfer to reserve’ or a CR to ‘Transfer from reserve’ instead of direct to retained earnings. If the entry is not to retained earnings a closing entry is required at the end of the reporting period. Note in particular the discussion that a reserve does not represent a balance of cash. Please ignore the journal entries in relation to any revaluation surplus. The entries here are not consistent with other sections of the text and we will consider this reserve, and associated entries, in detail later in this course. Consider: • Why would a company create a general reserve? Why not maintain the level in

retained earnings? • Does creation of a reserve (e.g. Plant replacement reserve) necessarily mean

funds/cash available? • What does the text mean in section 3.5.3 when it states ‘these are simply the

result of book entries’?

Disclosures The amount of reserves needs to be included on the face of the statement of financial position (AASB 101, para. 54). Changes to the each component of equity during a period need to be disclosed on the face of the statement of changes in equity (AASB 101, para. 106).

STATEMENT OF CHANGES IN EQUITY: PRESENTATION & OTHER DISCLOSURES We have already introduced the disclosures required in each of the major components of equity. You should recall that you are not required to remember or memorise these requirements, rather you need to be able to source the requirements from the standards. The key disclosure requirements relating to equity are found in AASB 101. However, there is no one exact format as the standard often allows alternative disclosure formats (for example, some disclosures can either be made on the face of the statement or in the notes). The majority of disclosures relating to equity are required in the statement of changes in equity (or related notes) and recall that AASB 101 para 106 requires all changes to components of equity be shown on the face of the statement of changes in equity. Guidance provided by the IASB on implementing AASB 101 provides an example of a statement of changes in equity that is reproduced below.

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The requirements relating to the statement of changes in equity essentially require all changes in equity to be disclosed on the face. In addition, to the disclosures already discussed this includes the total comprehensive income for the period, and any adjustments made directly to equity or accumulated in reserves and the nature of these changes (whether these be as a result of changes to accounting policies, errors or due to the requirements of accounting standards, such as those relating to revaluation of assets). When the total comprehensive income is allocated to the statement of changes in equity this will be ‘distributed’ amongst the various equity components that it relates to (so for example, the profit/loss for the period is accumulated against retained earnings, items of other comprehensive income will be added/subtracted to the existing balance of the items they relate to).

Activity Read sections 13.5 & 13.5.1 & 13.6.4 (section under dividends) of the text and paragraphs 54 to 56, 77 to 79, 106 to 110 and 137 of AASB 101. It is important that you became familiar with the standards and how to source requirements. You may wish to consider an actual example of a statement of financial position (balance sheet) and statement of changes in equity. Remember: most of the larger public companies include a copy of their annual report on their web site.

o As noted previously the only item of ‘other comprehensive income’ we consider in this course relates to revaluations. However as this is not considered until Topic 8 all of the statements of profit or loss and other comprehensive income that you will be required to prepare will have no items of ‘other comprehensive income’. This also means that for any statements of changes to equity that you are required to prepare the only amount transferred from the statement of profit or loss and other comprehensive income will be the profit/loss for the period (as there are no items of other comprehensive income).

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TOPIC REVIEW QUESTIONS Question Topic 1. Explain the meaning of a share. Distinguish

between an ordinary share and a preference share.

Nature of different types of shares.

2. Explain the process of accounting for share issues. In your answer describe the purpose of each of the accounts used to record the issue of shares.

Accounts in share issue

3. Leo et al, 2012, Chapter 2, Practice Question 2.1 Prepare journal entries only.

Simple share issue

4. (Adapted from Hoggett & Edwards, 2000, p. 735).

Issue by instalments

In February Argentina Ltd issued a prospectus inviting applications from the public for 20,000 ordinary shares. Applications for 22,000 shares were received by 28 March (the closing date for applications) with 70c included with these applications. On 30 April, Argentina Ltd made refunds to 2,000 applicants and issued 20,000 shares for $2 each, payable 70c on application, 60c on allotment and the remainder due in 2 calls on 30 June (call for 50c) and 31 August (call for 20c). All moneys due on allotment were received by 15 May. Share issue costs of $1,000 were paid on 31 May The moneys in relation to the first call were received by 28 July. As at 30 Sept all moneys had been received in relation to the final call except in relation to 3,000 shares where the amount due on the final call had not yet been received. Required: Prepare general journal entries required to account for the transactions and events above.

5. Sue Limited was formed in January 2004 and issued a disclosure document (prospectus) calling for applications for 120,000 ordinary shares on the following terms:

• issue price of $3.50 • $1.50 payable on application • $0.50 payable on allotment • $1.50 payable in future call/s (dates to be

determined by directors). It received applications for 135,000 shares with $1.50 paid. On 1 April Sue Limited issued the shares and made refunds to 15,000 applicants. All allotment monies were received by 15 May. Costs incurred in the share issue totalled $5,000 and were paid on 1 April 2004. On 4 June 2004, to provide capital to finance research and development, a call for $0.80 was made. Call monies were received by 25 June 2004 from holders of 114,000 shares. No further monies have been received. No shares have

Share Capital

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been forfeited. Required: What amount would be recorded against Share Capital in the statement of financial position as at the 30 June 2004. Show all calculations.

6. Leo et al, 2012, Chapter 3, Review question 14 Nature of reserves 7. Leo et al, 2012 Chapter 3, Review question 11

Also, identify and outline the accounting requirements in relation to disclosure of dividends. You only need to consider accounting standards studied in this course but you need to identify specific pronouncements and paragraph numbers.

Dividends and disclosures

8. Leo et al, 2012, Chapter 3, Practice Question 3.1

Journal entries for dividends, reserves and bonus issues.

9. The following is an extract from the statement of financial position of Monkey Ltd as at 1 July 2004.

Equity Share Capital 180,000 Other Reserves 70,000 Retained Earnings 60,000 Total Equity 310,000

1. During the year ended 30 June 2005 the following events/transactions occurred: • A final dividend of $45,000 that had been

declared (and provided for) in June 2004 was paid in November 2004.

• An interim dividend was declared and paid in February 2005 of $40,000 from retained earnings.

• Net profit (after tax) earned for the period amounted to $25,000.

2. At 30 June 2005, the directors resolved to • declare and provide for a final dividend of

$35,000 from retained earnings. • transfer $50,000 from a general reserve to

retained earnings Required: At what amount would the retained earnings in the equity section of the statement of financial position be shown at 30 June 2005? Show all calculations.

Retained Earnings

10. As at 1 July 2014: Journal entries and

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• The share capital of ABC Ltd as at 1 July 2014 was $3,555,000 (comprised of 1,200,000 ordinary shares issued and paid to $3.00, less share issue costs of $45,000).

• The balance of the general reserve was $1,600,000.

• The balance of retained earnings was $3,950,000.

Information about some events/transactions relating to ABC Ltd is below: • On 21 August 2014 a dividend of $480,000

was paid in cash. This dividend had been declared on 29 June 2014 from retained earnings and was not subject to further approval.

• On 1 September 2014 ABC Ltd issued a prospectus calling for applications for 1,700,000 ordinary shares from the public at an issue price of $4.50, payable $3.00 on application and $1.50 on allotment. By 1 November 2014 it had received 1,900,000 applications with $3.00 paid. On 15 November 2014 it issued the shares and made refunds to 200,000 applicants. Costs incurred in the share issue totalled $62,000. All allotment monies were received by 18 December 2014.

• At 30 June 2015, the directors transferred $450,000 to retained earnings from the general reserve

• On 1 July 2015 the directors declared a final dividend of $0.35 per share from retained earnings. This is not subject to further authorisation or approval.

Required: 1. Prepare the general journal entries required in the year ended 30 June 2015 to reflect the events/transactions for the year ended 30 June 2015. Show all calculations and dates for journal entries. 2. Assuming profit after tax for the year ending 30 June 2015 was $2,760,000, and there were no items of other comprehensive income, prepare a statement of changes in equity.

statement of changes in equity.

11. Identify TWO pieces of additional information required to be disclosed in relation to equity (or share issues) as per AASB 101.

Disclosures.

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TOPIC 5

LIABILITIES Accounting issues, presentation and disclosures.

OBJECTIVES By the end of this topic you should be able to: • understand and apply the definition and recognition criteria of liabilities • understand the nature of current and non-current liabilities and the key

categories of liabilities (including provisions) • understand the nature of contingent liabilities and apply the disclosure

requirements for contingent liabilities • understand, source and apply the key accounting, disclosure and reporting

requirements in relation to liabilities (including provisions) • prepare the liability section of the statement of financial position (balance

sheet) and accompanying notes in accordance with the requirements of AASB 101 and AASB 137.

REQUIRED READING

Resource: Text Leo et al, 2012, sections of chapters 3 and 13 as directed in this guide.

Resource: Accounting Handbook AASB 137 Provisions, Contingent Liabilities and Contingent Assets

AASB 101 Presentation of Financial Statements

As referred to in this guide.

INTRODUCTION We continue our examination of the financial statements by considering the liability section of the statement of financial position (balance sheet). A company

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will finance its operations usually by both equity and funds from external parties. Funds from external parties can include long-term borrowings such as: • bank loans (these may be secured) • debentures (these are loans from investors and certain companies may

borrow funds from the public via this means) • certain leasing arrangements (where the leases are in substance the

‘equivalent’ of a loan/financing arrangement) In addition, other parties (for example suppliers who have sold goods on credit, employees who are entitled to receive payments for leave) will also have claims against the company. Such claims, if they meet the definition and recognition criteria, will be included in the statement of financial position (balance sheet) as liabilities.

LIABILITIES: DISCLOSURES IN THE STATEMENT OF FINANCIAL POSITION (BALANCE SHEET) & NOTES We considered the requirements in relation to assets in the statement of financial position in an earlier topic. We will now consider the requirements in relation to liabilities in relation to the statement of financial position as required by AASB 101.

Definition of liability A liability is defined as:

A present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits (Framework, para. 49 (b).

Activity Read sections 3.1.3 (up to the paragraph beginning “the term ‘provision’ is..”), 3.1.4 and 3.2 (if you have not already read this before) of the text which discusses the definition and recognition criteria for liabilities. Note in particular the following: • essential characteristics • fact that such obligations are not limited to legal obligations • it is not sufficient for an item to meet the definition of a liability to be recognised in

(included on the face of) the financial statements recognition criteria must also be met

• although the majority of liabilities involve the outflow/payment of cash, the outflow of economic benefits involved may also be in the another form (e.g. provision of assets other than cash)

• we will consider provisions and contingent liabilities in detail later in this topic

Classification and Measurement In the financial statements, liabilities must be categorised as current (normally expected to be settled with 12 months or one operating cycle) or non-current, unless a liquidity basis is more appropriate (AASB 101, para 60). The criteria for classifying a liability as current are provided in AASB 101, para. 69.

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You should also note that this requirement results in some liabilities being ‘split’ into current/non-current components. In addition, within the current and non-current classification, liabilities must be classified into classes. There are a number of major classes of specific liabilities that must be shown on the face of the statement of financial position (AASB 101, para. 54). AASB 101 also requires additional line items to be included on the face of the statement of financial position if needed to understand the financial position of the entity (para. 55) and also allows further sub classification on the face or notes appropriate to the entity’s circumstances (para 77). As you can see AASB 101 does not prescribe an exact format, but prescribes minimum disclosures if these are relevant, and allows further information to be included in the statement of financial position (and/or notes). The IASB implementation guidance for AASB 101 provides an example using the current, non-current classification and is reproduced below.

Note: The Implementation guidance notes: • IAS 1 sets out the components of financial statements and minimum requirements for

disclosure in the statements of financial position, comprehensive income and changes in equity. It also describes further items that may be presented either in the relevant financial statement or in the notes. This guidance provides simple examples of ways in which the requirements of IAS 1 for the presentation of the statements of financial position, comprehensive income and changes in equity might be met. An entity should change the order of presentation, the titles of the statements and the descriptions used for line items when necessary to suit its particular circumstances.

• The illustrative statement of financial position shows one way in which an entity may present a statement of financial position distinguishing between current and non-current items. Other formats may be equally appropriate, provided the distinction is clear.

• In Australia most companies have historically presented current liabilities (and assets) before non-current.

Activity Read paragraphs 54 to 65, 69 to 78, and 125 of AASB 101. Also read section 3.3.2 of the text. You have already been referred to sections 13.3 to 13.3.4 in a previous topic

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which discusses the content and format of the statement of financial position and related notes. As noted previously the text has not been updated for some recent changes in standards. You should note that the discussion in section 11.6 .4 under ‘Commitments’ no longer applies as paragraph Aus138.6 of AASB 101 was deleted by amendments issued in May 2011 by the AASB. This is applicable to annual reporting periods beginning on or after 1 July 2011.

As the text notes there is no standard that deals with the measurement of liabilities in general, and in practice a range of measures is used. Although more recent standards on specific liabilities (such as AASB 119 Employee Benefits and AASB 117 Leases) suggest a trend towards present value or fair value measurements, in the absence of specific pronouncements, many liabilities are currently measured at face/nominal value (simply the amount of dollars required to settle the liability).

PROVISIONS AND CONTINGENT LIABILITIES Historically the term ‘provisions’ has been used for various items in the financial statements including:

• items that meet the definition of liabilities – e.g. Provision for Warranties, Provision for Long Service Leave

• items adjusting carrying amount of assets – e.g. Provision for Doubtful Debts (Note: this is not a liability and should be referred to an “allowance for doubtful debts” not as a provision)

• reserves – e.g. ‘Provision’ for Overhauls (Note: again reserves do not meet the definition of a liability and so should not be referred to as provisions).

A specific standard (AASB 137 Provisions, Contingent Liabilities and Contingent Assets) now defines provisions as:

a liability of uncertain timing or amount (para. 10) Hence the use of the term ‘provision’ should be restricted to items that meet this definition i.e. items that (a) are liabilities and (b) where there is uncertainty in relation to the timing or amount of the outflow. To be recognised as a provision the item must:

• meet the definition of a provision, and • meet the recognition criteria (ie can be measured reliably and it is

probable the outflow will be required. These recognition criteria are consistent with the Framework and are also specified in AASB 137 for provisions).

The basic principle is that unless the item meets both the definition and recognition criteria for a liability it cannot be included in the statement of financial position as a liability (this includes provisions). Provisions are required to be measured (as per AASB 137) at the ‘best estimate of the expenditure required to settle …at reporting date’ (para. 36). This involves consideration of such issues as uncertainty, present value and discount rates. In

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this course we will be considering simple applications and will not be considering provisions arising from recoveries, restructuring costs or onerous contracts.

Activity Read the rest of section 3.1.3 of the text and section 3.2.3. Read paragraphs 10 to 26 of AASB 137 Provisions, Contingent Liabilities and Contingent Assets and note the following:

• provisions are a type (sub-set) of liabilities. These meet the definition of a liability.

• a legal obligation is not required for a present obligation to exist; but there must be no realistic alternative to avoid a future outflow. An obligation can also be ‘constructive’. This is defined in para 10 and hence the concept of a ‘present obligation’ in accounting is not restricted to legal obligations. This broadens the number of items that meet the definition of a provision (liability).

• measurement is often by estimates • it is expected only rarely that reliable measurement would not be possible

Example 1: Accounting entries: Provision for Warranties Company A has commenced operations and manufactures and sells products and provides a 1 year warranty. This means that if within this period customers return goods that are faulty the company has undertaken to repair or replace these goods at no cost to the customer. The company has estimated that 1% of sales will be returned by customers for warranty service/replacement. The cost of meeting these warranty obligations is estimated at $32,000. The definition & recognition criteria for a provision are met (We will consider this in a similar example in the topic review questions). To recognise the provision the following entry would be included: DR Warranty Expense $32,000 CR Provision for Warranties $32,000 As claims under the warranties are made by customers and as the company meets these obligations the following entry/ies would be required: DR Provision for Warranties $x CR Cash/Inventory* $x

• $x would be the amount/cost incurred in relation to the particular claim from the customer

• *What is credited would depend on how the warranty obligation is met – whether customer provided with refund, replacement product or if product is repaired.

Activity Also read paragraphs 59 to 62 of AASB 137 which discuss the reversal and use of

provisions.

Contingent Liabilities In some instances there may be items that cannot be recognised, but which may or will result in outflows of economic benefits in the future. For example, the company may be being sued but there is no present obligation, or the company

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Provide Disclose contingent liability

Start

No

Yes

Do nothing

Possibleobligation?

Present obligation as a result of an obligating event?

Probable outflow? Remote?

Reliable estimate?

No No

Yes

Yes

Yes

Yes

No

No (rare)

may be obligated to clean up an oil spill caused by its oil tanker but the amount of the costs cannot be reliably estimated. For users, information about such potential or actual outflows would be relevant for decision making, however these items would not be included in the statement of financial position, as they would not meet both the definition and recognition criteria of a provision (or a liability). AASB 137 Provisions, Contingent Liabilities and Contingent Assets requires disclosure of information about such items (known as contingent liabilities) in the notes to financial statements. The standard states that such items would include: • provisions that fail to meet the recognition criteria (e.g. either probability of

future outflow cannot be established, or the amount cannot be measured reliably), or

• possible liabilities; items that do not yet (and may never) meet the definition of liability.

Note: AASB 137, para 27, explicitly states that contingent liabilities cannot be recognised. The diagram below (from the Handbook) illustrates the decisions to be made in accounting for provisions and contingent liabilities.

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Activity Read the definition of ‘contingent liability’ at paragraph 10 and read paragraphs 12, 13 and 27 to 30 of AASB 137 Provisions, Contingent Liabilities and Contingent Assets to confirm the discussion above. Refer to the Part A and the Decision Flow Chart in Part B of the Guidance on implementing AASB 137 which summarises the treatment of provisions and contingent liabilities. Part C provides examples. You should read all the Examples except 5 and 8 (we will not consider these in this course). You can also find examples of contingent liabilities and notes relating to provisions from the annual reports of actual companies. These are often available on the company web site.

Disclosures The standard requires various information to be disclosed in relation to provisions and contingent liabilities. In addition it allows for exemptions from certain disclosures if the disclosure of information

can be expected to prejudice seriously the position of the entity in a dispute with other parties (AASB 137, paragraph 92).

Activity Read paragraphs 84 to 88, 91 and 92 AASB 137 Provisions, Contingent Liabilities and Contingent Assets and note the following: information required in relation to each class of provisions exemption for some disclosures in relation to contingent liabilities where

possibility of the outflow is remote. Think about what is considered by ‘remote’. exemption, and the information required, where this exemption is applied. Part D in the guidance to the standard provides illustrations of the disclosures

required.

Example 2: Provision or Contingent liability? Part A: Company A manufactures and sells handbags. In May 2010 Company B sued Company A for producing and sell a range of handbags that Company B claims are ‘copies’ of its original designs and therefore is claiming a breach of copyright. Company B is seeking $70,000 in damages. The case is expected to be heard in a court hearing at a later date (yet to be determined). Company A had obtained legal advice. Their lawyers have indicated that although there are similarities between the handbags they believe that the claim can be defended in court as there are significant differences between the designs. The lawyers have indicated that if Company A defends the case in courts there is a 30% chance that Company A will lose the case and be required to pay damages. Company A should record this as a contingent liability in the notes to the accounts for the year ending 30 June 2010:

• It could be argued that the item meets the definition of a provision. The past event is the manufacture and sale of the handbags which have similarities to those of Company B. This has led to the company having a present obligation (would be considered constructive due to sale of handbags which potentially breach copyright of Company B and not a legal obligation as this time) to make an outflow (this is potential payment

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of cash via damages). There is clearly uncertainty about the timing and (possibly) the amount of any potential payment. However at this time the recognition criteria is not met as the potential outflow (i.e. payment of cash damages) is not probable. Hence this would be a contingent liability.

• Some may argue that at this time there is no present obligation. If the company believes that it did not breach copyright then could consider that it is unclear whether there is a liability and that this is a ‘possible liability’. This would still meet the definition of a contingent liability.

• As the possibility of an outflow is 30% this is not remote and hence would need to disclose in the notes. Given the fact that court case is proceeding may apply exemption. This would still require disclosure in the notes of the fact that has this litigation pending and that information disclosed has been limited as may be prejudicial.

Part B In November the case is decided in court and the court has found Company A liable and is required to pay $55,000 in damages to Company B. Company A would now account for this as follows: DR Expense for damages $55,000 CR Damages payable $55,000 Note:

• As the court has determined the amount and this is due for payment there is no uncertainty and hence this would not meet the definition of a provision and would be accounted for as a payable.

• Given the nature of this event this would be considered a material expense (refer AASB 101, paras 97, 98(f)) and hence details would need to be disclosed separately in the financial reports for the period.

Part C Ignore part B and assume that the court has not yet decided the case. However in November 2010 the lawyers for Company A are preparing the case and in considering further the evidence (and legal precedents) has advised that there is now a 60% chance that the Company A will be found liable. Legal advice suggests (given the case facts and precedents) that if found liable damages would be awarded of between $40,000 & $60,000. Company A would now recognise a provision: DR Expense for damages $50,000 CR Provision for damages $50,000 Note:

• The item would clearly meet the definition of a provision. The fact that legal advice suggests more that likely to lose indicates that actions of company (i.e. selling of similar handbags) has led to present obligation (this would still be regarded as constructive obligation as court decision has not been made) to pay potential damages. There is still uncertainty about timing and amount of payments.

• The recognition criteria are met. It is probable (more than 50%) that outflow in form of damages will be required. In addition there is an estimate of damages based on legal advice (remember- we only need to

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be able to reliably estimate; we do not need to be certain of the exact amount that will or may be paid).

• Given the nature of this event this would be considered a material expense (refer AASB 101, paras 97, 98(f)) and hence details would need to be disclosed separately in the financial reports for the period.

• Disclosures would also be required as per AASB 137 if provision still recognised at next reporting date.

LIABILITY DISCLOSURES AND PRESENTATION We have already introduced some of the disclosures required. You should recall that you are not required to remember or memorise these requirements, rather you need to be able to source the requirements from the standards. The key requirements relating to liabilities are: • categorised as current or non-current (AASB 101, para 69). • certain classes must be shown on the face of the statement of financial

position (AASB 101, para. 54)). • additional line items need to be included on the face of the statement of

financial position if required to understand the financial position of the entity (AASB 101, para. 55).

• further sub-classifications in either statement of financial position or notes (AASB101, paras 77 & 78).

• details re provisions and contingent liability classes as per AASB 137 (paras. 84 to 92).

In addition, other standards impose disclosure requirements. For example, AASB 116 requires details for items secured against liabilities.

Activity Recall that the disclosure requirements for liabilities that we are considering are found both in AASB 101 and AASB 137. You have been referred to the relevant sections previously. It is important that you became familiar with the standards and how to source requirements.

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TOPIC REVIEW QUESTIONS Question Topic 1. Review question 3, Leo et al, 2012, Chapter 3. Characteristics of liabilities 2. Review question 7, Leo et al, 2012, Chapter 3. Classification 3. Review question 5, Leo et al, 2012, Chapter 3. Provisions 4. Explain how a contingent liability can arise. Contingent liability 5. Applying the definition and recognition criteria for

liabilities, explain how the following items would be recognised /disclosed. Give reasons for your answers.

Liabilities – definition and recognition and disclosure

(a) Product warranties Pop-up Ltd manufacturers toasters. They sell the toasters with a warranty which states that Pop-up Ltd will fix any defects that appear within 3 years of the date of purchase. (b) Mortgage loan on land (15 year) Brown Ltd has borrowed $10,000 from a Bank to purchase some land. The loan is for 15 years and is secured by a mortgage over the land. (c) Damages in law case (case not yet

decided) Orange Ltd is being sued for damages by a customer who was injured when using one of the company’s products. Legal advice suggests that there is a 65% probability that the company will be found liable as the product was faulty. If found liable damages are estimated at between $18,000 and $22,000. The case will be decided in court at a later date. Would your answer change if the probability was 35%? (d) Damages in law case (case decided but

amount not yet determined) An oil tanker operated by Green Ltd ran aground and spilled oil, destroying valuable fishing grounds. Green was sued for damages and found liable. The amount of the damages has not been determined. (e) Costs of replacement of components in

machine

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Pink Ltd had noted that one of the critical machines in its factory was regularly causing electrical faults. An inspection has now revealed that some of the electrical components in this machine must be replaced. If not replaced within 2 months the machine would not be able to be operated at all. The factory cannot operate without this machine. The company is currently attempting to source the required components and the cost of replacing the components is estimated at $70,000.

6. Read the article by Gabrielle Costa (29 June 2004) ‘Optus to refund on failed phone deal’, The Sydney Morning Herald, page 20. This reading can be found on the on line resources for this topic from the course learnonline site. Applying the definition and recognition criteria as set out in AASB 137 Provisions, Contingent Liabilities and Contingent Assets discuss the matters that should be taken into account in determining whether or not Optus should recognise a provision, or disclose a contingent liability, with respect of the issue discussed in the article at the date of the article. (You should consider both the definition and recognition criteria in your answer). Remember to apply the facts of the case to justify your conclusions!

Liabilities – definition and recognition and disclosure

7. Using the information in Practice Question 13.14, Leo et al, 2012, Chapter 13 prepare: • the liability section only from the statement of

financial position (balance sheet) Note: This extract section should be in format that meets the minimum requirements as per AASB 101 (i.e. if there is a choice to disclose in the statement or in the notes do not include the information on the face of the statement)

• Identify: • one additional disclosure required in

relation to the liability section by AASB 101 • one additional disclosure required in

relation to the liability section assuming that AASB 137 applied.

Preparation of liability section

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TOPIC 6

ACCOUNTING FOR LEASES

OBJECTIVES By the end of this topic you should be able to:

• explain the nature of a lease • differentiate between finance and operating leases • classify and account for operating and finance leases in accordance with AASB

117 Leases from the perspective of the lessee • account for lease incentives in relation to operating leases from the perspective

of the lessee • apply the disclosure requirements for operating and finance leases in the

financial reports of the lessee in accordance with AASB 117.

REQUIRED READING Resource: Accounting Handbook

AASB 117 Leases UIG Interpretation 115 Operating Leases-Incentives As directed in this topic.

Resource: Text Leo et al, 2012, chapter 8, sections as specified in this guide.

INTRODUCTION A lease is an agreement whereby an owner of property (the lessor) makes that property available for use by another (the lessee) for a specified period, in return for a series of payments. The terms associated with a lease agreement are negotiated between the lessor and the lessee and may range from a simple rental agreement (for example, where a car is hired for a few days), through to a situation where substantially all of the

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risks and benefits of ownership of the property being leased have been transferred from the lessor to the lessee. It is important that the financial statements reflect the substance of the underlying transactions rather than merely the legal form, therefore the accounting treatment required to reflect different types of lease arrangements must also vary. In this topic we will consider different types of leasing arrangements and the related accounting and disclosure requirements of AASB 117 Leases. We will be looking at the accounting treatment and disclosure requirements required to be recorded by the lessee, but not from the point of view of the lessor. Accounting for leases remains a controversial issue in financial reporting.

Activity Read sections 8.1 and 8.1.1 of the text and the definition of a ‘lease’ in paragraph 4 of AASB 117. Also read paragraph 2 of AASB 117 which outlines the scope of the standard. It should be noted there is a separate standard for investment properties, which specifies treatment of such properties where these are leased.

NATURE OF LEASES Under AASB 117, leases are classified as either operating or finance leases. An operating lease is basically a rental agreement, whereas a finance lease is more like an arrangement to purchase, where substantially all of the risks and benefits of ownership have been transferred from the lessor to the lessee.

Classification Criteria The accounting treatment and disclosure requirements for leases will vary depending on whether a lease is classified as a finance lease or an operating lease, therefore the process of classification is very important, as it is important for the financial statements to reflect the substance of the underlying accounting transactions and the substance of an operating lease is very different to the substance of a finance lease. There can be incentives for companies to try to avoid the additional accounting and disclosure requirements associated with a finance lease by making a lease ‘appear’ as an operating lease, even though the economic substance of the transaction indicates that it is a finance lease. The standard provides guidance to assist in determining whether or not substantially all of the risks and benefits of ownership have been transferred from the lessor to the lessee. You should note that the key question in classifying a lease relates to the transfer of the risks and benefits of ownership; the guidance provides indicators but may not be conclusive. The flow chart (Figure 8.1 in the text) is provided below. This illustrates the guidelines for classifying a lease agreement as either a finance lease or an operating lease. Note that these guidelines help determine whether substantially the risks and benefits of ownership have been transferred from the lessor to the lessee. It is possible, however, for a lease to still be classified as a finance lease even though it does not meet the guidelines (i.e. if it were considered according to other evidence that the risks and benefits of ownership had been substantially transferred from the lessor to the lessee). Also note that meeting ‘one’ guideline would not necessarily result in classification as a

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finance lease. For example, if the lease term was for a major part of economic life, this may not indicate finance lease if the lease was cancellable.

Figure 8.1 Leo et al, 2012, p 337.

Activity Note the definitions of ‘operating’ and ‘finance’ leases in paragraph 4 of AASB 117. Read sections 8.2, 8.3 to 8.3.3 (up to example 8.1) of the text and read paragraphs 7 to 13 of AASB 117. Take care with interpreting/applying Figure 8.1 in the text as this can be confusing. The line on the right hand side does not mean that if any one of these questions is answered ‘yes’ that the lease is a finance lease. For example, a lease for a car for a few days

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could not be non-cancellable but would not be a finance lease. Note that the classification is essentially dependent on the economic substance of the transaction. Classification of a lease requires you to understand a number of new terms. When you are reading, make sure you understand the meaning of the following terms;

• Non-cancellable lease • Commencement of lease term vs inception of the lease • Minimum lease payments • Fair value. Note: For most items measured at fair value, the definition and

requirements of AASB 13 Fair Value Measurement must now be applied. However, the definition of fair value in AASB 117 differs from that in AASB 13. Paragraph 6A of AASB 117 (updated in 2013) specifies that AASB 13 is not applied in measuring fair value for leases in AASB 117.

• Guaranteed residual value • Interest rate implicit in the lease • Unguaranteed residual

These terms are also defined in paragraph 4 of AASB 117

Example 1: Classification of Leases (based on Henderson and Peirson example 14.4 on p 428) Assume Toby Ltd has entered into a leasing arrangement with Rentlo Ltd for some plant and equipment. The terms of the arrangement are as follows:

• There are eight annual lease payments of $5,000 payable at the beginning of each year commencing on 1 July 2002.

• The fair value of the equipment was $30,000. • The carrying amount of the equipment in the lessor’s books is $25,000. • The equipment has an estimated economic life of 12 years, with a residual value

of nil at the end of its economic life. • The guaranteed residual value at the end of the lease term is $12,838. • The lessee (Toby Ltd) has agreed to pay all of the associated costs such as

maintenance and insurance. • The lease is non-cancellable. • The interest rate implicit in the lease is 15% p.a. • Neither the lessor nor lessee have incurred any costs in negotiating or arranging

the lease. • It is assumed that the lessee will retain the equipment at the end of the lease

term (by paying the guaranteed residual on 1 July 2010). Would the lease be classified as a finance lease or an operating lease?

Answer The lease would be classified as a finance lease, as it appears from the information provided that substantially all of the risks and benefits of ownership have been transferred from the lessor to the lessee. Application of the classification guidelines in

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AASB 117, paragraph 10 will assist in the determination as to whether the risks and benefits of ownership have been transferred as follows

• The lease is non cancellable, • It is assumed that ownership will be transferred to the lessee at the end of the

lease term. Note: given the guidelines for the determination of a finance lease have been satisfied at this point, it would not be necessary to continue testing, however for the purpose of showing you how to apply the classification criteria, we will consider all of the guidelines.

• There is no ‘bargain’ purchase option included in the lease agreement to indicate reasonably certain will purchase at end of lease term.

• The lease term (8 years) is 67% of the remaining economic life of the asset (12 years). The standard requires us to consider if the lease is for the major part of the economic life of the asset. As the text notes there is no specific percentage applied to determine what is considered major. The approach used in the previous standard was to consider 75% as the benchmark. However as the text notes the decision to exclude a specific benchmark means that this will require judgment. Also remember that in determining whether or not the criteria (i.e. whether the risks and benefits associated with ownership have been transferred) are met can be indicated by factors both individually and in combination. For example:

• if the lease was cancellable even if the lease was for the majority of the useful life it could be classified as an operating lease, or

• If the lease was for a relatively minor proportion of the useful life it could still be classified as a finance lease if was non-cancellable and required the lessee to purchase the item at the end of lease.

• The standard requires us to consider whether the present value of the minimum lease payments equate with substantially all of the fair value of the leased asset. This guideline is considering whether the payments made, as well as providing a return to the lessor, are in effect reimbursing the cost of the leased asset. Again as the text notes there is no specific benchmark % for determining was is ‘substantially all’ of the fair value. The previous standard indicated 90% as a benchmark but no benchmark is included in the current standard. Remember you need to consider the overall substance of the lease and classify as a finance lease if substantially risks and benefits of ownership have been transferred. In this case, the present value of the minimum lease payments discounted at the rate of interest implicit in the lease is all of the fair value of the equipment at the beginning of the lease term: PV of MLP PV of first payment = 5,000 PV of annuity (5,000 x 4.1604*) = 20,802 PV of single amt (12,838x .3269**) = 4,197

PV of MLP 29,999

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FV of equipment $30,000 *using PV tables for annuity where i = 15% and n = 7 periods **using PV tables for single amount where i = 15% and n = 8 periods

From the above information, it does appear that substantially all of the risks and benefits of ownership of the equipment being leased have been transferred from the lessor to the lessee; therefore the lease should be classified in the books of the lessee as a finance lease.

Activity Work through illustrative example 8.1 of the text. Note: In this example there is an error in some editions of the text. At the bottom of the page (under Minimum lease payments) it states that in addition to the initial payment that there are 'four subsequent payments of $22,000'. This is incorrect and should state 'three subsequent payments of $22,000'. Also the text compares the PV of the MLP to the total of FV + IDC. This is not in accordance with the guidelines which require PV of MLP to be compared with FV only. Also read sections 8.4 to 8.4.2 of the text and note the following: • Incentives to classify leases as operating • Arrangements to avoid classification • Interpretations to assist in ensuring lease arrangements classified in accordance with

substance.

ACCOUNTING TREATMENT IN THE BOOKS OF THE LESSEE The classification of a lease as either an operating lease or a finance lease will determine the accounting treatment that is appropriate for the lessee to apply in accordance with AASB 117. For operating leases, the treatment is reasonably straightforward, where the minimum lease payments are accounted for as expenses in the profit/loss. For a finance lease, however, the accounting treatment is more complex, and involves the recognition of an asset and liability to reflect the substance of the lease transaction, and subsequent entries to reflect the reduction of the asset and liability over the term of the lease.

Accounting for Operating Leases AASB 117 requires that the lease payments for an operating lease be expensed on a straight–line basis, unless another basis is more appropriate (para 33). Hence in most situations, this requires the recognition of minimum lease payments as expenses in equal instalments over the period of the lease term. Using the data from Example 1, if the lease with Toby Ltd had been classified as an operating lease (i.e. assume that the lease was cancellable, that the residual was unguaranteed, and the asset was not retained by the lessee at the end of the lease term and hence it was determined that the risks and benefits of ownership has not been substantially transferred), and assuming the equipment being leased was used continuously during the lease term, the annual payments would have been recorded as follows:

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1 July 2002 – 1 July 2009 DR Prepaid lease rental 5,000 CR Cash 5,000 (Being recognition of lease rental payment paid in advance of the period in which the equipment was used)

30 June 2003 – 30 June 2010 DR Lease rental expense 5,000 CR Prepaid lease rental 5,000 (Being recognition of the lease rental expense in the period during which the equipment was used.) In the example above we have recorded the initial payment for the operating lease as a prepayment (asset) as this would meet the definition and recognition of an asset at the time of payment. You should note that in practice many such lease payments are initially recorded as an expense and (if necessary) a balance date adjustment made to recognise any prepaid lease rental as a balance date. For example,

• If the lease began on 1 October and payment for 1 year’s rental was made on that date of $5,000 then would need to make a balance date adjustment as at 30 June:

o If initially recorded as expense then adjustment would be: 30 June DR Prepaid lease rental 1,250 CR Lease rental expense 1,250 (Being recognition of the prepaid lease rental as at balance date; ¼ of $5000)

Activity Read sections 8.8, 8.8.1 and 8.8.2 and work through illustrative example 8.5 in the text. Also read paragraphs 33 to 35 of AASB 117. Note the disclosures and entries required in relation to operating leases (recall we will consider these for lessees only).

Accounting for Lease Incentives for Operating Leases Lease incentives are items or conditions provided by lessors to encourage potential lessees to enter into operating leases. For example, a rent free period or a cash payment may be offered. The accounting treatment for such incentives is outlined in UIG interpretation 115 Operating leases- Incentives. The basic principle is that any incentives are regarded as an integral part of the lease contract and are accounted for by reducing the lease/rental expense over the period of the lease.

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Example 2: Lease Incentive Small Ltd entered into a lease for a building with Big Ltd on 1 July 2007. The details of the lease agreement were as follows:

• The lease is non-cancellable and is for 8 years. • The lease has been classified as an operating lease. • Payments are made in arrears on 30 June each year with the first of the 8

payments of $50,000 to be made on 30 June 2008. • As part of the lease arrangements Big Ltd agreed to pay Small Ltd $16,000 in

cash on 1 July 2007 as an incentive to enter into the lease. The total cost of the lease to Small Ltd is $400,000 (8 payments of $50,000) less $16,000 cash received from Big Ltd = $384,000. This means that in substance it is costing Small Ltd $48,000 ($384,000/8 years) per year to lease the building. This is the amount of lease expense that needs to be recognised in the profit/loss for each year of the lease.

The journal entries for the year ended 30 June 2008 would be 1 July 2007 DR Cash 16,000 CR Incentive from Lessor 16,000 (Being recognition of the receipt of cash from lessor and liability to lessor)

30 June 2008 DR Lease expense 48,000 DR Incentive from Lessor 2,000 CR Cash 50,000 (Being recognition of lease payment and expense for period and reduction in lease incentive from lessor)

The journal entries for each of the remaining years of the lease would be: 30 June 2009-15 DR Lease expense 48,000 DR Incentive from Lessor 2,000 CR Cash 50,000 (Being recognition of lease payment and expense for year and reduction in lease incentive from lessor)

Activity Read section 8.8.3 and UIG Interpretation 115. This discusses how to account for lease incentives in relation to operating leases. Work through illustrative example 8.6 in the text. Note: As we only consider from perspective of lessee you do not need to consider entries for lessor in this example.

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Criticisms and possible future developments There has been debate for some time over whether or not the current differences between accounting for finance and operating leases should be maintained. This is particularly so where the lease is non-cancellable and for a long period of time. We noted earlier that there are a number of incentives for companies to continue to not recognise the commitments under operating leases as liabilities in the statement of financial position.

Activity Read section 8.10 of the text which discusses proposals to change the leasing standard. This proposes that the classification on the basis of operating versus finance leases is abolished, but there will be differential accounting treatment depending on whether a lease is classified as short term (12 months or less) or long term. Although a further exposure draft was issued in May 2013 there continues to be much debate. The current IASB work program expects to reconsider this issue again in the first half of 2014. . The IASB and FASB websites have more information about developments in this area.

Accounting for Finance Leases As a finance lease is one where substantially all of the risks and benefits of ownership have passed from the lessor to the lessee, it is in essence more like a purchase by the lessee than a rental agreement. It seems logical, therefore to account for a finance lease in the books of the lessee by creating an asset (to reflect the future economic benefits that will flow to the entity as a result of the use of the leased asset) and a liability (to reflect the future outflow that will be required by the payment of lease payments). The initial treatment of a finance lease in the books of the lessee, therefore is to record: • an asset equal to:

o fair value of leased property, or the present value of the minimum lease payments if this is lower,

o plus any direct costs of lessee, and • a liability equal to:

o fair value of leased property, or the present value of the minimum lease payments if this is lower (para. 20).

Note: • Paragraph 20 of AASB 117 states that initial measurement should be at fair value

unless the present value of MLP is lower. o Where the residual value is fully guaranteed by the lessee then the PV of

the MLP will equal the fair value of the leased property at the beginning of the lease only if there are no initial direct costs for the lessor.

• Remember that the amounts of the MLP do not include any unguaranteed residual, nor any reimbursement of costs etc.

Both the asset and liability will reduce over time, as the future benefits from the use of the asset are received, and as the payments under the lease are made. The following explains the accounting treatment for assets and liabilities arising as a result of a finance lease.

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Accounting for an Asset Arising from a Finance Lease The asset is reduced over time via depreciation, calculated in accordance with AASB 116 Property, Plant and Equipment and is also subject to impairment testing. The period of depreciation will depend on whether or not ownership is expected to be transferred to the lessee at the end of the lease term. If ownership is to be transferred to the lessee, the asset is depreciated over the useful life of the asset, which will be the lease term plus any period after the end of the lease that the entity will use the asset. If ownership is not expected to be transferred to the lessee, then the useful life of the leased asset is the period of the lease. Whether the asset will be depreciated to a residual value or to zero will depend on whether the asset will be retained by the lessee at the end of the lease term and whether the residual value is guaranteed. The following diagram illustrates the period of depreciation and the amount to which the asset should be depreciated in accordance with AASB 117.

Note: Traditionally the term amortisation has been used in relation to intangible assets (Note here that the leased asset is often considered as an intangible as represents benefits entitled via lease, as opposed to ownership of physical asset itself).

Diagram: Depreciation of Lease Rights Is ownership expected to be

transferred to the lessee at, or by the end of the lease

term?

YES NO Depreciate cost of lease

asset to its residual value at the end its useful life

Depreciate lease asset

over the lease term

Is the residual value

guaranteed?

YES NO Depreciate cost of lease

asset over lease term to its guaranteed residual

value

Depreciate cost of lease asset over

lease term to zero

Accounting for a Liability Arising from a Finance Lease Over the term of a finance lease, payments are made by the lessee to the lessor. The liability recorded in the books of the lessee is equal to the fair value of the leased

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property, or the present value of MLP if this is lower. When a payment is made, part of the payment is to reduce the principal (liability) outstanding, and part is to reflect the interest incurred as a result of the lease agreement. A lease payment schedule may be used to show the calculation of interest expense and reduction of the liability outstanding as each lease payment is made. Example 3 below demonstrates the accounting treatment for a finance lease.

Activity Read sections 8.5, 8.5.1 and 8.5.2 (up to illustrative example 8.2) in the text and paragraphs 20 to 30 of AASB 117.

Example 3: Accounting for Finance Lease (based on Henderson and Peirson example 14.4 on p 428). Assume the same data as in example 1, where Toby Ltd has a finance lease for some plant and equipment from Rentlo Ltd. The following shows the accounting treatment required to account for the finance lease from 1 July 2002.

Table 1: Lease Payment Schedule Date MLP Interest

expense Reduction in

liability Balance of

liability 30,000 (Note 1)

1 July 2002 5,000 - 5,000 25,000 1 July 2003 5,000 3,750* 1,250 23,750 1 July 2004 5,000 3,562** 1,438 22,312 1 July 2005 5,000 3,347*** 1,653 20,659 1 July 2006 5,000 3,099 1,901 18,758 1 July 2007 5,000 2,814 2,186 16,572 1 July 2008 5,000 2,486 2,514 14,058 1 July 2009 5,000 2,109 2,891 11,167 1 July 2010 12,838 1,675 11,163 4(rounding)

Note 1: We previously calculated the PV of the MLP at $29,999 which effectively equals the FV of $30,000. In this case the lease liability is equal to the fair value as:

• There are no direct costs of lessor (to impact on the interest rate implicit)

• The residual value is fully guaranteed by the lessee at the end of the lease term. * Interest expense is calculated as the balance of the liability multiplied by the implicit interest rate ($25,000 x 15% = $3,750) ** Interest expense is calculated as the balance of the liability multiplied by the implicit interest rate ($23,750 x 15% = $3,562) *** Interest expense is calculated as the balance of the liability multiplied by the implicit interest rate ($22,312 x 15% = $3,347)

The journal entries for the year ended 30 June 2003 would be: 1 July 2002

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DR Equipment under lease 30,000 CR Lease liability 30,000 (Being recognition of the asset and liability associated with a finance lease at the present value of the minimum lease payments)

1 July 2002 DR Lease liability 5,000 CR Cash 5,000 (Being initial lease payment)

30 June 2003 DR Interest expense 3,750 CR Interest payable* 3,750 (Being interest payable as at 30 June 2003)

• Note: Alternative account titles such as Accrued Interest could be used

30 June 2003 DR Lease depreciation expense 2,500 CR Accumulated depreciation 2,500 (Being depreciation of lease asset over its useful life*) *AASB 117, paragraph 28 states that where there it is reasonable certainty that the leased asset will remain with the lessee at the end of the lease, the asset should be depreciated over the useful life to its residual value at the end of this period (lease term + any period of use following). It is assumed that the residual value of the asset at the end of its useful life is nil. The amount of depreciation therefore is $30,000- $0/12 = $2,500.

The journal entries for the year ended 30 June 2004 would be: 1 July 2003 DR Lease liability 1,250 DR Interest payable 3,750 CR Cash 5,000 (Being lease payment)

30 June 2004 DR Interest expense 3,562 CR Interest payable 3,562 (Being interest payable as at 30 June 2004)

30 June 2004 DR Lease depreciation expense 2,500 CR Accumulated depreciation 2,500 (Being depreciation of lease asset over its useful life) The following would be included in the statements for year ending 30 June 2004:

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Extract from the statement of financial position 2004 2003 Current liabilities Interest payable 3,562 3,750 Lease liability 1,438 1,250 Non-current liabilities Lease liability 22,312 23,750 Non-current assets Equipment under lease 30,000 30,000 Less Accumulated depreciation (5,000) (2,500)

25,000 27,500 Extract from the statement of profit or loss and other comprehensive income Depreciation expense 2,500 2,500 Interest expense (would be part of finance costs) 3,562 3,750

The journal entries for the year ended 30 June 2005 would be: 1 July 2004 DR Lease liability 1,438 DR Interest payable 3,562 CR Cash 5,000 (Being lease payment)

30 June 2005 DR Interest expense 3,347 CR Interest payable 3,347 (Being interest payable as at 30 June 2005)

30 June 2005 DR Lease depreciation expense 2,500 CR Accumulated depreciation 2,500 (Being depreciation of lease asset over its useful life) The journal entries for the years ended 30 June 2006-2009 would be similar to those entries recorded above, however each year the interest expense and principal repayment would vary in accordance with the amounts shown on the lease payment schedule.

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The journal entries for the year ended 30 June 2010 would be: 1 July 2009 DR Lease liability 2,891 DR Interest payable 2,109 CR Cash 5,000 (Being initial lease payment)

30 June 2010 DR Interest expense 1,675 CR Interest payable 1,675 (Being interest payable as at 30 June 2010)

30 June 2010 DR Lease depreciation expense 2,500 CR Accumulated depreciation 2,500 (Being depreciation of lease asset over its useful life) The journal entries for the year ended 30 June 2011 would be: 1 July 2010 DR Lease liability 11,163 DR Interest payable 1,675 CR Cash 12,838 (Being final lease payment. The information in the question states that it is assumed that the asset will be retained by the lessee at the end of the lease term and that the guaranteed residual value is to be paid on 1 July 2010). * Note: Given rounding errors this would leave a $4 balance in the lease liability account. This is clearly immaterial. Upon payment of the guaranteed residual value legal ownership reverts to Toby Ltd hence an additional entry is required to recognise the asset as owned (as opposed to leased). 1 July 2010 DR Equipment 30,000 DR Accumulated depreciation 20,000 CR Equipment under lease 30,000 CR Accumulated depreciation 20,000 (To recognise transfer of asset from leased to owned) Note: In this example this final payment was made on 1 July 2010. If the payment had been made on 30 June 2010, this would affect entries as:

• Interest would not be accrued as at 30 June 2010

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• Entries to account for payment and to recognise as ‘owned’ asset would be made on 30 June 2010.

Entries if residual value guaranteed but ownership not transferred at end of lease If the lessee had returned the asset to the lessor at the end of the lease term (in this case assumed to be on 1 July 2010), the asset would have been depreciated over the lease term to the guaranteed residual, rather than over the useful life to its residual value at the end of this period (i.e. the amount of depreciation per period would have been ((30,000-12,838)/8 = $2,145 pa). The journal entries at the conclusion of the lease therefore would have been as follows:

1 July 2010 DR Accumulated depreciation 17,162 CR Equipment under lease 17,162 (Being entry to transfer balance of accumulated depreciation account to asset account prior to return of asset to lessor)

1 July 2010 DR Lease liability 11,163 DR Interest payable 1,675 CR Equipment under lease 12,838 (Being entry to record return of asset to lessor at conclusion of lease agreement)

This assumes that the lessor will sell the asset which has been returned to it and realise at least the guaranteed residual value. If the lessor did not receive at least the amount of the guaranteed residual value the lessee would be required to pay the difference. This would be recorded as an expense.

Example 4: Accounting for Finance Lease where residual value not guaranteed (based on Henderson and Peirson example 14.4 on p 428). Assume the same data as in example 1, where Toby Ltd has a finance lease for some plant and equipment from Rentlo Ltd. except that the residual value is not guaranteed and the lessee is not expected to purchase the equipment at the end of the lease term. The present value of the minimum lease payments (which in this case excludes the residual value as this is not guaranteed) is discounted at the rate of interest implicit in the lease to calculate the amount of the leased asset and liability at the beginning of the lease term.

PV of MLP PV of first payment = 5,000 PV of annuity (5,000 x 4.1604*) = 20,802

PV of MLP $25,802 (Note: This is lower than the fair value of $30,000 so this amount would be used as the basis for measuring the leased asset and liability).

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The following shows the accounting treatment required to account for the finance lease from 1 July 2002. Table 2: Lease Payment Schedule Date MLP Interest

expense (15%)

Reduction in liability

Balance of liability

25,802

1 July 2002 5,000 - 5,000 20,802

1 July 2003 5,000 3,120 1,880 18,922

1 July 2004 5,000 2,838 2,162 16,760

1 July 2005 5,000 2,514 2,486 14,274

1 July 2006 5,000 2,141 2,859 11,415

1 July 2007 5,000 1,712 3,288 8,127

1 July 2008 5,000 1,219 3,781 4,346

1 July 2009 5,000 652 4,348 *2 rounding

* rounding The journal entries for the year ended 30 June 2003 would be: 1 July 2002 DR Equipment under lease 25,802 CR Lease liability 25,802 (Being recognition of the asset and liability associated with a finance lease at the present value of the minimum lease payments. Recall there are no costs to lessee so the asset & liability are equal)

1 July 2002 DR Lease liability 5,000 CR Cash 5,000 (Being initial lease payment)

30 June 2003 DR Interest expense 3,120 CR Interest payable 3,120 (Being interest payable as at 30 June 2003)

30 June 2003 DR Lease depreciation expense 3,225 CR Accumulated depreciation 3,225 (Being depreciation of lease asset over lease term*)

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*As there is no reasonable expectation that the leased asset will remain with the lessee at the end of the lease and the residual value is un-guaranteed, the asset should be depreciated over the lease term to zero. The amount of depreciation therefore is $25,802/8 = $3,225 The journal entries for the year ended 30 June 2004 would be: 1 July 2003 DR Lease liability 1,880 DR Interest payable 3,120 CR Cash 5,000 (Being lease payment)

30 June 2004 DR Interest expense 2,838 CR Interest payable 2,838 (Being interest payable as at 30 June 2004)

30 June 2004 DR Lease depreciation expense 3,225 CR Accumulated depreciation 3,225 (Being depreciation of lease asset over its useful life)

The following would appear in the statement of financial position as at 30 June 2004:

Extract from the statement of financial position 2004 2003 Current liabilities Interest payable 2,838 3,120 Lease liability 2,162 1,880 Non-current liabilities Lease liability 16,760 18,922 Non-current assets Equipment under lease 25, 802 25,802 Less Accumulated depreciation (6,450) (3,225)

19,352 22,577

The journal entries for the year ended 30 June 2005 would be:

1 July 2004 DR Lease liability 2,162 DR Interest payable 2,838 CR Cash 5,000 (Being lease payment)

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30 June 2005 DR Interest expense 2,514 CR Interest payable 2,514 (Being interest payable as at 30 June 2005)

30 June 2005 DR Lease depreciation expense 3,225 CR Accumulated depreciation 3,225 (Being depreciation of lease asset over the lease term)

The journal entries for the years ended 30 June 2006-2009 would be similar to those entries recorded above, however each year the interest expense and principal repayment would vary in accordance with the amounts shown on the lease payment schedule.

The journal entries for the year ended 30 June 2010 would be: 1 July 2009 DR Lease liability 4,348 DR Interest payable 652* CR Cash 5,000 (Being lease payment) * Note: Given rounding errors this would leave a $2 balance in the lease liability account. This is clearly immaterial.

30 June 2010 DR Lease depreciation expense 3,225 CR Accumulated depreciation 3,225 (Being depreciation of lease asset over the lease term)

Subject to rounding, following these entries there would be no leased asset or lease liability in the statement of financial position as at 30 June 2010. It is assumed (as per question) that leased asset returned to lessor.

Example 5: Accounting for Finance Lease: payments 30 June Assume the same data as in example 1, where Toby Ltd has a finance lease for some plant and equipment from Rentlo Ltd. However assume the following changes:

• There are eight annual lease payments of $5,000. • The first payment of $5,000 is payable on 1 July 2002. • There are 7 payments of $5,000 payable on 30 June each year commencing

from 30 June 2003. • It is assumed that the lessee will retain the equipment at the end of the lease

term (by paying guaranteed residual value on 30 June 2010)

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The following shows the accounting treatment required to account for the finance lease from 1 July 2002. Table 3: Lease Payment Schedule

Date MLP Interest expense

Reduction in liability

Balance of liability

30,000 (Note 1) 1 July 2002 5,000 - 5,000 25,000

30 June 2003 5,000 3,750 1,250 23,750 30 June 2004 5,000 3,562 1,438 22,312 30 June 2005 5,000 3,347 1,653 20,659 30 June 2006 5,000 3,099 1,901 18,758 30 June 2007 5,000 2,814 2,186 16,572 30 June 2008 5,000 2,486 2,514 14,058 30 June 2009 5,000 2,109 2,891 11,167 30 June 2010 12,838 1,675 11,163 4*rounding

Note 1: We previously calculated this in example 1 & 3. This calculation does not change- the only changes in this example are the dates of payments.

The journal entries for the year ended 30 June 2003 would be: 1 July 2002 DR Equipment under lease 30,000 CR Lease liability 30,000 (Being recognition of the asset and liability associated with a finance lease at the present value of the minimum lease payments)

1 July 2002 DR Lease liability 5,000 CR Cash 5,000 (Being initial lease payment)

30 June 2003 DR Lease liability 1,250 DR Interest expense 3,750 CR Cash 5,000 (Being lease payment as at 30 June 2003: The interest expense is NOT accrued in this example as payment made on 30 June)

30 June 2003 DR Lease depreciation expense 2,500 CR Accumulated depreciation 2,500 (Being depreciation of lease asset over its useful life*)

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*AASB 117, paragraph 28 states that where there it is reasonable certainty that the leased asset will remain with the lessee at the end of the lease, the asset should be depreciated over the useful life to its residual value at the end of this period (lease term + any period of use following). It is assumed that the residual value of the asset at the end of its useful life is nil. The amount of depreciation therefore is $30,000- $0/12 = $2,500. The journal entries for the year ended 30 June 2004 would be: 30 June 2004 DR Lease liability 1,438 DR Interest expense 3,562 CR Cash 5,000 (Being lease payment as at 30 June 2004)

30 June 2004 DR Lease depreciation expense 2,500 CR Accumulated depreciation 2,500 (Being depreciation of lease asset over its useful life)

The following would be included in the statements for year ending 30 June 2004: Extract from the statement of financial position 2004 2003 Current liabilities Lease liability 1,653 1,438 Non-current liabilities Lease liability 20,659 22,312

22,312 23,750 Non-current assets Equipment under lease 30,000 30,000 Less Accumulated depreciation (5,000) (2,500)

25,000 27,500 Note: Compare this with the extract in example 3. You will see as the payment has been made on 30 June:

• the amount of the liability has been adjusted for this payment • there is no accrued interest or interest payable as at 30 June as this has been

paid in the lease payment on 30 June.

Extract from the statement of profit or loss and other comprehensive income Depreciation expense 2,500 2,500 Interest expense (would be part of finance costs) 3,562 3,750 The journal entries for the year ended 30 June 2005 would be:

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30 June 2005 DR Lease liability 1,653 DR Interest expense 3,347 CR Cash 5,000 (Being lease payment at 30 June 2005)

30 June 2005 DR Lease depreciation expense 2,500 CR Accumulated depreciation 2,500 (Being depreciation of lease asset over its useful life)

The journal entries for the years ended 30 June 2006-2009 would be similar to those entries recorded above, however each year the interest expense and principal repayment would vary in accordance with the amounts shown on the lease schedule.

The journal entries for the year ended 30 June 2010 would be: 30 June 2010 DR Lease depreciation expense 2,500 CR Accumulated depreciation 2,500 (Being depreciation of lease asset over its useful life)

30 June 2010 DR Lease liability 11,163 DR Interest expense 1,675 CR Cash 12,838 (Being payment of residual value at end of lease to purchase asset) * Note: Given rounding errors this would leave a $4 balance in the lease liability account. This is clearly immaterial.

Upon payment of the guaranteed residual value legal ownership reverts to Toby Ltd hence an additional entry is required to recognise the asset as owned (as opposed to leased). 30 June 2010 DR Equipment 30,000 DR Accumulated depreciation 20,000 CR Equipment under lease 30,000 CR Accumulated depreciation 20,000 (To recognise transfer of asset from leased to owned)

Activity Work through illustrative example 8.2 of the text. Note this example: • Includes direct costs of lessor

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• Includes $1900 in payments relating to reimbursement of executory costs (for insurance and maintenance). Such payments are not part of the MLP and are treated as ‘normal’ expenses.

• Has a partly guaranteed residual. The residual value of the vehicle at the end of the lease term is estimated to be $15,000. The lessee has guaranteed $7,500 (1/2) of this. Only the part that is guaranteed by the lessee is included in the MLP.

• The lease payments are made in this example on 30 June so no balance day adjustments are required except for the executory costs.

Read section 8.5.3 of the text and paragraph 31 of AASB 117 which outlines disclosures required by lessees for finance leases.

Example 6: Accounting for finance lease – no initial payment and payments made 30 June & costs of lessee Assume Toby Ltd has entered into a leasing arrangement with Rentlo Ltd for some equipment on 1 July 2002. The terms of the arrangement are as follows:

• There are eight annual lease payments of $5,000. • These are payable in arrears with the first payment due on 30 June 2003. • The fair value of the equipment was $27,500 • The equipment has an estimated economic life of 12 years, with a residual value

of nil at the end of its economic life. • The residual value at the end of the lease term is $15,500. The lessee (Toby)

has guaranteed $9,000 of this residual value • The lessee (Toby Ltd) has agreed to pay all of the associated costs such as

maintenance and insurance • The lease is non-cancellable • The interest rate implicit in the lease is 15% p.a. • The lessee (Toby Ltd) incurred costs of $2,000 in negotiating this lease. • It is assumed that the lessee will retain the equipment at the end of the lease

term (by paying the guaranteed residual on 30 June 2010) This has been classified as a finance lease. Note: Details of the lease have been changed from the previous examples. The following shows the accounting treatment required to account for the finance lease from 1 July 2002. The present value of the minimum lease payments (which in this case excludes part of the residual value as this is not fully guaranteed) is discounted at the rate of interest implicit in the lease to calculate the amount of the leased asset and liability at the beginning of the lease term.

PV of MLP PV of annuity (5,000 x 4.4873*) = 22,436.5 PV of guaranteed residual value (9,000 x 0.3269**) = 2,942.1

PV of MLP $25,378.6

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*This is where number of periods is 8 & interest rate is 15% **This is single amount at end of 8 periods & interest rate is 15% Note: This is lower than the fair value of $27,500 so this amount would be used as the basis for measuring the leased liability. As lessee has costs of $2,000 this would be added to lease asset.

Table 4: Minimum Lease Payment Schedule Date MLP Interest

expense Reduction in liability

Balance of liability

1-Jul-02 - $25,379 30-Jun-03 5,000* 3,807 1,193 24,186 30-Jun-04 5,000 3,628 1,372 22,814 30-Jun-05 5,000 3,422 1,578 21,236 30-Jun-06 5,000 3,185 1,815 19,421 30-Jun-07 5,000 2,913 2,087 17,334 30-Jun-08 5,000 2,600 2,400 14,934 30-Jun-09 5,000 2,240 2,760 12,175 30-Jun-10 14,000** 1,826 12,174 1

*Note: There is no initial payment here at the beginning of the lease so the first payment includes interest. **At the end of the lease (i.e. 30 June 2010) the regular payment of $5,000 is due as well as the guaranteed residual of $9,000. These 2 payments must be shown together (in one line) as these are due on the same date. The journal entries for the year ended 30 June 2003 would be: 1 July 2002 DR Equipment under lease 27,379 CR Cash/payable 2,000 CR Lease liability 25,379 (Being recognition of the liability at the present value of the minimum lease payments and asset at the present value of the minimum lease payments plus lessee’s costs associated with a finance lease)

30 June 2003 DR Lease liability 1,193 DR Interest expense 3,807 CR Cash 5,000 (Being lease payment as at 30 June 2003: The interest expense is NOT accrued in this example as payment made on 30 June)

30 June 2003 DR Lease depreciation expense 2,282 CR Accumulated depreciation 2,282 (Being depreciation of lease asset over its useful life*)

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*AASB 117, paragraph 28 states that where there it is reasonable certainty that the leased asset will remain with the lessee at the end of the lease, the asset should be depreciated over the useful life to its residual value at the end of this period (lease term + any period of use following). It is assumed that the residual value of the asset at the end of its useful life is nil. The amount of depreciation therefore is $27,379- $0/12 = $2,282.

The journal entries for the year ended 30 June 2004 would be 30 June 2004 DR Lease liability 1,372 DR Interest expense 3,628 CR Cash 5,000 (Being lease payment as at 30 June 2004)

30 June 2004 DR Lease depreciation expense 2,282 CR Accumulated depreciation 2,282 (Being depreciation of lease asset over its useful life)

The following would be included in the statements for year ending 30 June 2004:

Extract from the statement of financial position

2004 2003 Current liabilities Lease liability 1,578 1,372 Non-current liabilities Lease liability 21,236 22,814

22,814 24,186 Non-current assets Equipment under lease 27,379 27,379 Less Accumulated depreciation (4,564) (2,282)

22,815 25,097 Extract from the statement of profit or loss and other comprehensive income Depreciation expense 2,282 2,282 Interest expense (would be part of finance costs) 3,628 3,807 The journal entries for the years ended 30 June 2005-2009 would be similar to those entries recorded above, however each year the interest expense and principal repayment would vary in accordance with the amounts shown on the lease payment schedule. The journal entries for the year ended 30 June 2010 would be:

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30 June 2010 DR Lease depreciation expense 2,282 CR Accumulated depreciation 2,282 (Being depreciation of lease asset over its useful life)

30 June 2010 DR Lease liability 12,175 DR Interest expense 1,826 CR Cash 14,000 (Being payment of residual value at end of lease to purchase asset) * Note: Given rounding errors this would leave a $-1 balance in the lease liability account. This is clearly immaterial.

Upon payment of the guaranteed residual value legal ownership reverts to Toby Ltd hence an additional entry is required to recognise the asset as owned (as opposed to leased). 30 June 2010 DR Equipment 27,379 DR Accumulated depreciation 18,256 CR Equipment under lease 27,379 CR Accumulated depreciation 18,256 (To recognise transfer of asset from leased to owned)

Leases of Land and Buildings In the examples so far we have considered the leasing of a single asset. However, a common lease is for land and buildings. AASB 117 (paragraphs 15A to 18) requires that the land and building under such a lease by considered separately, with some exceptions. You will not be required to account for such leases in the examination for this course.

Sale and Leaseback If the owner of an asset is in need of some cash but still requires the use of the asset, one way that this could be achieved is through a ‘sale and leaseback’ arrangement. In this situation, the owner sells the asset to say a finance company and then immediately leases it back from the new owner. In this way the original owner receives cash from the sale of the asset, but still continues to use the asset, in return for the payment of lease payments. AASB 117 specifies the accounting treatment required for the treatment of sale and leaseback transactions. As with other leases, the accounting treatment will differ depending on whether the lease is classified as an operating or finance lease. If the lease is a finance lease, the implication is that the asset has ‘not really’ been sold to the lessor in the traditional sense. In this situation, any differences between the gain on the

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‘sale’ (i.e. any excess of the proceeds received by the lessee and the carrying amount of the asset) must be deferred and amortised over the life of the lease term (para. 59). Hence in addition to the entries to account for a finance lease the following need to be accounted for:

• Initial recognition of a deferred profit on the sale. The accounting standard does not specify how the deferred profit should be disclosed in the statement of financial position. We will assume that it would be included as a liability.

• Amortisation of this deferred profit over the lease term.

When the lease is classified as an operating lease, a sale is recorded under AASB 117. For sale and leaseback transactions involving an operating lease, different accounting treatments are required, which are determined by the relationship between the assets carrying amount, its fair value and the proceeds from sale. We will not be considering sale and leaseback transactions in this course.

Activity If you wish to consider sale and leaseback transactions read sections 8.9 and 8.9.1 of the text and work through illustrative example 8.7. Read the first 2 paragraphs of section 8.9.2 of the text only. Also read paragraphs 58-63 of AASB 117. You will not be required to account for sale and leaseback transactions in this course.

DISCLOSURE The disclosure requirements for leases for lessees are outlined in AASB 117 and in sections 8.5.3 and 8.8.2 of the text. You have been referred to these previously.

Finance Leases Information that must be included in the financial statements for a finance lease includes:

• Carrying amount of each class of lease asset • Lease liabilities classified by the time to payment and reconciliation with present

value • A general description of the lessee’s leasing arrangements

Operating Leases Information that must be included in the financial statements for an operating lease includes:

• Total rental expense • For non-cancellable leases information relating to minimum lease payments

classified by time • A general description of the lessee’s leasing arrangements

Please note: This topic is expected to be studied over 2 weeks.

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TOPIC REVIEW QUESTIONS This topic is to be studied over 2 weeks. It is suggested that you attempt questions 1 to 7 (parts A.1 only) in the first week, and the remainder in the next week. In addition some revision questions for this topic are available from the course home page.

Question Topic 1. (a) Review question 1, Leo et al, 2012, Chapter 8.

(b) Explain the difference between operating and finance leases and how this decision (i.e. classification) is made.

(c) In addition explain the rationale (reason behind) classification and different treatment of leases as operating or finance. Do you think this different treatment is valid?

Classification of leases

2. On 23 May 2003, Emerson Ltd signed a lease agreement with Amber Ltd for equipment that would cost $50,000 if it were to be sold in the current market.

• Emerson Ltd has previously recorded the equipment at $45,000. • The lease of the equipment commences from 1 July 2003. • Annual lease payments over the period of five years of $11,000 per

year are to be paid in advance by Amber Ltd. • The first payment is to be made at the beginning of each year

commencing 1 July 2003. • Associated costs such as insurance and maintenance are to be paid

by Amber Ltd. • The interest rate implicit in the lease is 7%. • At the end of the lease term the residual value is estimated to be

$2,442. This is guaranteed by Amber Ltd. • The economic life of the equipment is six years with no residual value. • At the end of the lease term, Emerson Ltd will retain the equipment. • The lease agreement can be cancelled only with the permission of

Emerson Ltd, or Amber Ltd agrees to pay a penalty of $25,000 upon cancellation.

• Amber Ltd is not expected to purchase the equipment at 1 July 2008. • Neither the lessee nor the lessor incurred any direct costs on entering

into the lease.

(a) Answer the following questions by referring to the facts of the case above. You should provide explanations to support your answers in the context of the definitions in AASB 117 Leases. • Who is the lessee?

Terms & classification

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• Who is the lessor? • Is this a cancellable or non-cancellable lease? • What is the lease term? • What is the date of the inception of the lease? • What is the commencement of the lease term? • What is the fair value of the equipment at the

beginning of the lease term? • What is the carrying amount of the equipment? • What is the unguaranteed residual value of the

equipment? • What is the guaranteed residual value? • What are the minimum lease payments

(MLP)? • What is the economic life of the equipment? • What is the useful life of the equipment? • What is meant by the interest rate implicit in

the lease? • What is the present value (PV) of MLP of the

lease at the beginning of the lease? • If the residual value at the end of the lease

term was not guaranteed, what would the PV of the MLP of the lease be at the beginning of the lease?

• What are initial direct costs? (b) Classify the lease as a finance or operating lease. Give reasons for your answer.

3. Please refer to the facts below to determine whether the lease should be classified as a finance lease or an operating lease. • There are 5 annual lease payments of $9,000

payable at the beginning of each year commencing on 1 July 2003.

• The carrying amount of the machine in the lessors book is $40,000

• The current market selling value of the machine is $45,000

• The estimated economic life of the machine is 10 years, with a residual value of zero at the end of its useful life

• The lease is non cancellable • The unguaranteed residual value at 1 July

2008 is $20,730. • The interest rate implicit in the lease is 15%

Classification

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p.a. • The machine is to be returned to the lessor at

the end of the lease term. • The lessor is responsible for all the repair

costs and insurance

4. Luxton Ltd signed an agreement with Mansfield Ltd on 25 May 2003 for Mansfield Ltd to lease a machine. The provisions of the lease agreement are listed below: • The lease is non cancellable • The lease term is for five years beginning on 1

July 2003. • The annual lease payments of $6,500 are

payable at the beginning of each year commencing on 1 July 2003.

• The carrying amount of the machine in Luxton Ltd’s book is $48,000

• The current market selling value of the machine was $45,000

• The estimated economic life of the machine is 10 years, with a residual value of zero at the end of its useful life

• The interest rate implicit in the lease is 10% p.a.

• Luxton Ltd will retain the machine at 1 July 2008

• Luxton Ltd is responsible for all the repair costs and insurance

• The residual value of the machine at the end of the lease is unguaranteed

(a) Assume that the lease with Mansfield Ltd has

been classified as an operating lease. Prepare journal entries for the years ending 30 June 2004 and 30 June 2005 to reflect the transactions that would result from the lease agreement in Mansfield Ltd’s book.

(b) Provide the extracts of items relating to this lease, from Mansfield Ltd’s statement of profit or loss and other comprehensive income and statement of financial position for the financial years ending 30 June 2004 and 30 June 2005.

(c) For the year ending 30 June 2004 only, how would you answers to parts (a) and (b) above

Accounting for operating lease

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change if the lease began on 1 October 2003 and payments were made on this date.

5. (a) Review question 12, Leo et al, 2012, Chapter 8

(b) Practice Question 8.2, Leo et al, 2012, Chapter 8 Assume that first payment made on 30

June of year 3. Also prepare the journal entries for Year 1. (Note: Only prepare entries in relation to lessee – not lessor)

Operating lease & incentives

6. (a) Explain how the amount to be initially recognised for the leased asset and liability arising from a finance lease is determined. (b) Explain how depreciation of the leased asset is calculated in the situations below,

a. residual value is guaranteed and ownership expected to be transferred to lessee

b. residual value is guaranteed and ownership is not expected to be transferred to lessee

c. residual value is unguaranteed and ownership is not expected to be transferred to lessee

Leased asset/liability

7. Practice Question 8.7, Leo et al, 2012, Chapter 8, Part 1 only:

In addition: (a) Explain how your answers to 1 would

change if in addition Wellington Ltd had incurred costs of $600 in negotiating the lease

(b) Ignoring (a) above prepare the journal entries for the year ending 30 June 2014 if the annual payments made by Wellington Ltd were $152,000 as these included $2,000 for reimbursement of insurance which is paid by Christchurch Ltd.

Finance lease

8. On July 2001, Bearing Ltd entered into a lease with Available Finance Ltd of a fleet of ten prime movers. The fair value of the fleet was $3,400,000. They would have economic life of ten years if purchased by the company and an

Finance lease

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estimated scrap value of $380,000. The lease payments are as follows:

• initial lease payment of $641,000 on 1 July 2001

• eight annual payments in arrears of $600,000 commencing on 30 June 2002.

• guaranteed residual at the end of the lease, 30 June 2009 is $400,000.

• There is an option to purchase by paying $100,000 in addition to paying the guaranteed residual at 30 June 2009.

The lease is non cancellable and the interest rate implicit in the lease is 16 %

Required Assume that the lease is classified as a finance lease and that Bearing Ltd intends to purchase the equipment at the end of the lease term. (a) Calculate the amount of the leased asset and

liability and draw up a schedule allocating lease payments between lease liability and interest.

(b) Provide journal entries required to account for the lease for the years ending 30 June 2002 and 2003.

(c) Provide the extracts, relating to this lease, from Bearing’s statement of profit or loss and other comprehensive income and statement of financial position for the financial years ending 30 June 2002 and 2003.

(Based on Jubb, Langfield-Smith and Hasswell, chapter 10, question 10.12) HINT: The guaranteed residual value and the purchase option (of $10,000) will both be included in the minimum lease payments.

9. Explain what entries are required at the end of the lease term in the situations below:

a. residual value is guaranteed and ownership expected to be transferred to lessee

b. residual value is guaranteed and ownership is not expected to be transferred to lessee

c. residual value is unguaranteed and

End of lease entries

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ownership is not expected to be transferred to lessee

10. Please refer to the provisions below to determine

whether the lease should be classified as a finance lease or an operating lease. • The lease is for 5 years and there are 5 annual

lease payments of $7,000 payable at the beginning of each year commencing on 1 July 2003.

• The fair value of the machine is $40,000 • The estimated economic life of the machine is

6 years, with a residual value of $2000 at the end of its useful life.

• The lease can only be cancelled with the permission of the lessor

• The guaranteed residual value at the end of the lease is $17,407

• The interest rate implicit in the lease is 10% p.a.

• The lessee is responsible for all the repair costs and insurance

• The lessee has the option of purchasing the machine at the end of the lease term (30 June 2008) for the guaranteed residual value

• There were no direct costs (either by lessee or lessor) in arranging the lease.

Classification

11. Using the information from question 10 above, Assume that the lease is classified as a finance lease and that the lessee will purchase the machine at the end of the lease term (i.e. on 30 June 2008). (a) Provide journal entries for the years ending

30 June 2004 and 30 June 2005 (i.e. for the period 1 July 2003 to 30 June 2005) for the lessee to reflect the transactions that would result from the lease agreement.

(b) Prepare the extract relating to the lease from the statement of profit or loss and other comprehensive income and statement of financial position as at 30 June 2005 (including comparatives for previous year)

Accounting for finance lease

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(c) Prepare journal entries required on 30 June 2008 to account for purchase of the asset by lessee.

12. Using the information from question 10 above,

EXCEPT that the residual value at the end of the lease term is NOT guaranteed. Assume that the lease is classified as a finance lease and that the lessee will not purchase the machine at the end of the lease term. (a) Provide journal entries for the years ending 30

June 2004 and 30 June 2005 (i.e. for the period 1 July 2003 to 30 June 2005) for the lessee to reflect the transactions that would result from the lease agreement below.

(Note: To do this you will need to prepare a new schedule). (b) Prepare the extract relating to the lease from

the statement of profit or loss and other comprehensive income and statement of financial position as at 30 June 2005 (including comparatives for previous year)

(c) Prepare any journal entries required at the conclusion of the lease term on 30 June 2008.

Accounting for finance lease

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TOPIC 7

ACCOUNTING FOR INCOME TAX

OBJECTIVES By the end of this topic you should be able to: • understand the basic differences assumed between accounting and

taxation treatments for various accounting items; • understand the rationale for the ‘balance sheet’ approach to tax effect

accounting; • explain the reasons for variations between pre-tax accounting profit and

taxable profit, and calculate current tax liability; • identify, classify and calculate any deferred tax assets or liabilities and

apply the recognition criteria; • prepare a tax worksheet and prepare journal entries based on the

principles of AASB 112 to apply the balance sheet approach to accounting for tax;

• be aware of the disclosure requirements of AASB 112 • account for the payment of tax.

REQUIRED READING

Resource: Text Leo et al, 2012, Chapter 6 as directed in this guide.

Resource: Handbook AASB 112: Income Taxes.

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OVERVIEW

Introduction In this topic we will examine how to account for company income tax. This has been a source of debate in the accounting profession for a number of years. AASB 112 Income Taxes which outlines the requirements for the accounting treatment of income tax or tax effect accounting as is it often known. This standard is both lengthy and complex. In this topic we will not be examining all of the complexities of accounting for income tax, rather we will concentrate on an understanding of the rationale and general principles, simple applications of the accounting requirements and the disclosures required. Note: Companies may also pay other taxes (such as the GST - Goods and Services Tax). AASB 112 applies only to income taxes (which includes capital gains tax).

PRELIMINARIES

Revision of accrual accounting concepts and balance day adjustments To be able to understand and implement the general principles of accounting for income tax it is essential that you understand the purpose and nature of balance-day adjustments and the accrual accounting system. To successfully implement tax accounting you will not be required to journalise balance day adjustments. However, you will need to understand and be able to determine the impact such adjustments have on the accounting records (the statement of profit or loss and other comprehensive income, and the statement of financial position). It is assumed that from your previous study you understand the basic principles of accrual accounting, the need for balance day adjustments, and the resultant impact on the financial statements.

TAXATION OF COMPANIES – GENERAL PRINCIPLES We briefly considered the characteristics of companies earlier in this course. Before studying accounting for income tax you should note the following: 1. Companies as separate legal entities are taxed in their own right. This

can be contrasted with sole proprietors and partnerships where the owners as individuals pay tax on their share of profits. Owners of companies (shareholders) do not pay tax on company profits directly; only on those parts of profits that are distributed to them (as dividends).

2. Company income tax is treated as an expense, rather than an appropriation of profits and the amount actually payable (and yet to be paid) to the taxation authority is reported as a liability in the statement of financial position.

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3. Tax on companies is not levied on reported accounting profit but on taxable profit as determined in accordance with the income tax legislation (in Australia this is the Income Tax Assessment Act). A company must prepare a tax return that complies with the taxation legislation. This legislation contains extensive sets of rules and regulations that determine the amount of taxable profit (and thus tax payable) for the period. As the taxation rules differ from accounting rules, there will usually be a difference between the amount of accounting profit and taxable profit.

4. The taxation of companies is complex and is a specialised area of accounting practice. Students are not expected to have knowledge of taxation rules and regulation beyond those discussed in the texts and study guide. The text (and study guide) make some simplifying assumptions about taxation rules.

Differences between accounting and income tax treatments The complexities involved in accounting for income tax result from the differences between the accounting rules and taxation rules. There are a number of reasons why the rules may differ. The differences between the accounting rules and taxation rules are partly caused by the differing objectives of the two systems. You should recall from our earlier discussions that the objective of general purpose financial reporting is to provide information useful for decision making. In contrast, the taxation system has a range of objectives including raising revenues of government and encouraging behaviour which the government perceives to be in the national interest, such as undertaking research (Henderson and Peirson, 2000, p 290). A comparison of the components of the taxation return and the accounting in the profit and loss section of the statement of profit or loss and other comprehensive income is depicted below.

Income Statement (P & L)

Income Tax Return

Income (Revenues & gains) Taxable Income Less: Expenses Less: Allowable Deductions = Accounting Profit (Loss) = Taxable Profit* Calculated using accounting

rules/standards Calculated as specified by

taxation legislation

The standard (AASB 112) refers to ‘taxable profit’. This is the net amount that the company is required to pay tax on for the period. The text uses the term ‘taxable income’ (which is the term used in the Australian taxation legislation). In this course we will use the term ‘taxable profit’ which is consistent with the standard, although the terms can be used interchangeably. Amounts such as revenues (or other income) and expenses in the accounting statement of comprehensive income are determined by the accounting requirements (such as accounting standards) and generally

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accepted accounting principles (such as accrual accounting) that you will be familiar with from your accounting studies. Taxable income includes any amounts that will attract payment of tax in the current period. Allowable deductions are amounts that reduce the amount on which tax is payable in the current period. What amounts are included as taxable income and taxable deductions to determine the taxable profit for a particular period are determined by the requirements found in the taxation legislation.

What tax rules do you need to know? In this course we assume that students do not have knowledge of specific taxation rules and current requirements. Rather, we will:

• make some simplifying assumptions about how certain items are treated for taxation purposes

• identify the assumed taxation treatment for particular items. Whilst these assumptions and assumed taxation treatments may at times follow many of the actual requirements in Australian taxation legislation, at other times these will be inconsistent with current tax rules. The principle in AASB 112 is that IF there is a difference between the accounting and taxation treatment of an item we need to account for this difference. In this course the objective is not to teach students the taxation legislation. The objective is for students to be able to account for taxation in the financial statements, given any differences between accounting and taxation treatments that may occur. By taking this approach this means that even if the taxation (or accounting) requirements change, or if you are considering tax legislation in a different jurisdiction (such as a different country) you should be able to apply the principles in AASB 112 to determine how to account for taxation.

In this course we will assume that unless otherwise stated, sales (and related cost of goods sold) are treated on an accrual basis for both accounting and taxation purposes. However for other items there may be a difference between accounting and taxation treatment of items. For example,

• The text notes that often tax treatment/rules of other items may follow cash flows; for example, revenues received in advance in cash may be

assumed to be included for taxation purposes when the cash is received, whereas accrual accounting requires that revenues only be recognised when it is probable that the increase in net assets has occurred

for example, payments for annual leave or long service leave to employees will be assumed to be included (deductible) for taxation purposes when the cash is paid, whereas accrual accounting requires that such expenses be recognised as employees accrue these benefits

• Depreciation for accounting purposes is based on an assessment of the useful life and expected residual value that is specific to the

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reporting entity, whereas taxation rules often specify depreciation rates for particular items. This means that the depreciation expense for accounting and the depreciation deduction allowed for taxation for a period will often differ.

• Some items are only recognised for either tax or accounting purposes but not for both. For example: It is assumed that taxation does not allow a deduction for

goodwill or for certain expenses that are included for accounting purposes (such as fines or entertainment expenses)

Remember: You are not expected to know detailed taxation rules. The text (and this study guide) makes some simple assumptions about taxation treatments. We will follow the assumptions made in the text, unless otherwise indicated. Assumptions about differences between the taxation and accounting treatments will be explicitly stated in this course in examinations. The purpose of this topic is not to outline the actual taxation rules; rather it is for students to be able to account for taxation where there is any difference between the tax and accounting rules/treatment of items.

Activity Read the introduction to Chapter 6 & section 6.1 of the text to confirm the above discussion. Table 6.1 lists common differences assumed between accounting and tax treatments. You should consider how the taxation records and accounting records would differ in relation to these transactions. Can you think of reasons why: • Fines (for example, parking fines or fines for breaching environmental

regulations) would not be allowed as deductions for taxation purposes; • The basis for depreciation of assets would differ between taxation and

accounting systems; • Provisions (such as for annual leave, long service leave) or allowances (such

as doubtful debts) would be treated as an expense in accounting records, before being allowable as a deduction for taxation?

RATIONALE FOR TAX EFFECT ACCOUNTING

Why don’t we use the ‘cash’ (Tax payable) method for accounting for tax expense? The easiest way to account for tax would be to recognise the amount payable for the year (calculated from the taxation return) as the tax expense for that year. This is known as the tax payable method and is not allowed under the accounting standard. This is the simplest method and would probably be preferred by most accounting students! Let’s consider an example where taxation rules differ from accounting rules, and consider the impact on the financial statements if the tax payable method were followed.

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Example 1: Rationale for tax effect A company receives one years consulting fees in advance of $12,000 on 1 April 2001. Thus, at reporting date (30th June 2001) the company would have recorded in its accounts, under accrual accounting: • revenue of $3,000 (1/4 of amount received) for consulting for the period

in the profit/loss; • a liability (Consulting Fees Received in Advance or Unearned Consulting

Fees) for the future outflows of consulting services required to be provided in the next year, of $9,000 in the statement of financial position;

• increase of $12,000 in cash at bank (asset). If we assume that taxation will include this amount when received in cash, then in the taxation return for the same period, the company would record the full $12,000 (cash received) as taxable income. If a statement of financial position were prepared based on taxation rules there would be no liability recorded in relation to Consulting Fees Received in Advance (or Unearned Consulting Fees).

So if we compare the accounting and taxation ‘results’: • accounting profit is $9,000 lower than taxable profit under taxation treatment, and • the accounting statements record an additional liability (as compared to

taxation) of $9,000. Assuming a tax rate of 30% (and that no other revenues or expenses occurred) the tax payable for the year 2001 would be $3,600 (12,000 x .30). Under the tax payable method this amount would be recorded as the tax expense for the period.

For the next year (2002), assuming no other transactions, the remaining $9,000 consulting fees received in advance would be recorded as revenue for accounting purposes. Therefore, • accounting profit would be $9,000 higher than taxable profit, and • no liability would be recorded in either the accounting or taxation records.

There would be no tax payable for the year 2002 as there is no taxable profit for taxation purposes, and so no tax expense would be recorded in the accounting records under the tax payable method. If we compared the profit and loss section of the statement of profit or loss and other comprehensive income in the accounting records for the company over the 2 years, using the tax payable method, we would see the following:

Year 2001 Year 2002 Revenue 3,000 9,000 Tax Expense* 3,600 0

Profit (Loss) (600) 9,000 *under tax payable method this is based on actual tax paid/payable

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Consider: Do these statements adequately reflect the economic substance of the ‘performance’ of the company over the 2 periods? The answer is no. This is because the tax payable method does not recognise both the current and future tax consequences of transactions.

You should see that the tax payable approach ignores the future tax consequences of transactions. In this example, in Year 1, we have paid tax on accounting revenues that will arise in Years 1 and 2. This future tax consequence is a result of the difference between accounting and taxation treatments which is reflected in the differences in liabilities recorded (accounting at the end of year 1 records a liability; tax does not). In Year 2, when we recognise the majority of the revenue for accounting purposes and extinguish the liability we will not have to pay any tax as this was paid in the previous period. In effect, we have ‘pre –paid’ tax in Year 1 and have the future benefits of paying less tax in the future (the following year) due to this ‘prepayment’. The standard recognises that these benefits meet the definition of an asset, and requires that such assets be recognised, subject to specific recognition criteria (just as we would recognise an asset for prepayment of insurance). So the future tax consequences of the transaction that arise due to the liability (Consulting Fees Received in Advance) are reflected in the recognition of a deferred tax asset under tax effect accounting.

THE BALANCE SHEET APPROACH TO ACCOUNTING FOR INCOME TAX General Principles The approach in the standard is described as the balance sheet approach as the emphasis is on the determination of tax assets and liabilities from the examination of statement of financial position items. You should recall that the definitions of assets (and liabilities) refer to future economic benefits (outflows). The standard is based on the principle that both the current and future tax consequences of transactions and events need to be recognised, and that future consequences may give rise to deferred tax liabilities or assets. The tax expense to be included in the accounting records is derived from movements in both deferred tax assets/liabilities and from current tax obligations.

Activity Read sections 6.2 and 6.2.1 of the text and the section titled ‘Objective’ at the beginning of AASB 112 to confirm the above discussion.

Steps in Tax Effect Accounting The steps to take in accounting for income tax follow. These steps reflect the fact that both current and future tax consequences need to be considered.

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Step 1: Recognise Current Tax Consequences (I) Calculate current taxable profit This requires calculation of taxable income and allowable deductions for the current year, to determine taxable profit. (II) Calculate current tax liability This is based on taxable profit x tax rate. (III) Prepare journal entry to account for current tax consequences The journal entry to account for the current tax consequences of transactions can be prepared based on the current tax liability for the period.

Step 2: Recognise Future Tax Consequences (I) Determine the carrying amount and tax base of assets/ liabilities As tax effect accounting is based on a balance sheet approach we need to compare the items in the accounting statement of financial position with those in a tax ‘balance sheet’. To do this we first need to determine the amounts in the respective balance sheets. The amounts of assets and liabilities in the tax ‘balance sheet’ are called the tax base, and the standard contains rules for determining these amounts. (Note: In reality there is no actual tax balance sheet, so the equivalent tax balance sheet is referred to as a ‘notional’ balance sheet). (II) Compare amounts to identify and classify any temporary differences Any differences between the accounting carrying amounts and tax bases for items are identified (such differences are known as temporary differences) and then classified to determine whether the differences give rise to deferred tax assets or deferred tax liabilities. (III) Calculate the amounts of any deferred tax assets and liabilities The amounts of any taxable and deductible temporary differences are totalled to determine the amounts of any deferred tax assets and liabilities at the end of the period. (IV) Prepare journal entries to account for future tax consequences The journal entry/ies to account for the future tax consequences of transactions can be prepared from the calculation of any deferred tax asset/liability in (III) above, taking into account any existing balances. (A worksheet is used in Step 2 and is illustrated later in this topic).

The discussion of these steps in the text does not follow the exact order as set out above. Note: In this topic we will not be accounting for the treatment of tax losses.

STEP 1: RECOGNISE CURRENT TAX CONSEQUENCES: CURRENT TAX ASSETS/LIABILITIES As noted above we need to account for the tax payable to the taxation authority in the current period to recognise the current tax consequences of transactions and events. The amount due to be paid to the taxation authority

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will be recorded as a current liability. This liability is described as Current Tax Liability in the standard and the text (also often known as Tax Payable).

We noted earlier that tax on companies is not levied on reported accounting profits but on taxable profit as determined in accordance with the Income Tax Assessment Act. A company must prepare a tax return which complies with the taxation legislation. Hence, to determine the current tax liability we need to calculate the company’s taxable profit.

Activity Read the definition of current tax in paragraph 5 of AASB 112, paragraph 12 of AASB 112, and the initial paragraph of section 6.3 of the text to confirm the points noted above. These references also confirm that the current tax liability is be recognised at the nominal amount. You should also note the following: • we will not be considering tax losses in this topic • we will not be considering changes to tax rates in this topic

(I) CALCULATING TAXABLE PROFIT Recall that as taxation rules may differ from accounting rules, there will usually be a difference between the amount of accounting profit and taxable profit. We noted earlier the differences between the accounting and taxation records. The taxable profit for a period is often determined by adjusting accounting profit for differences between taxation treatment and accounting treatment of items. The simplest method to determine taxable profit from the accounting profit is:

1. Identify any items that are treated differently under taxation and accounting systems. You need to consider for each item: • what is the accounting expense/income recorded • what is the allowable deduction/taxable income that should be

included in taxable profit • what adjustment is required

2. Reverse the impact of these items on accounting profit. For example assume: • Non-deductible fines have been treated as an expense for accounting

purposes. These would have reduced the amount of accounting profit, so need to be added back to reverse the impact.

• Depreciation of $10,000 based on 10% straight line has been included as expense for accounting purposes (tax allows 20% deduction based on 20% straight line). The $10,000 would need to be added back to reverse the impact on accounting profit.

• Income/revenue has been included in accounting profit that is exempt (never taxable) for taxation purposes. This would have increased

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accounting profit so needs to be deducted to reverse the impact on accounting profit.

3. Include the taxation treatment for these items. You need only consider items that are treated differently for taxation and accounting purposes. Note: • Allowable deductions will be subtracted, and taxable income items will

be added. • Where tax includes on a cash basis you will need to calculate the

amount of cash paid or received in the period to determine the amount to be included for taxation purposes.

Example 2 following provides an illustration of the calculation of taxable profit using a particular ‘set out’. (Note: The equivalent ‘set out‘ in the text, Figure 6.3 in section 6.3, and in demonstration problem 2 is slightly different. You can use which ever of these set outs that you prefer – either the set out in this study guide or the set out in the text.) Example 2 (part a): Calculation of Taxable Profit A company’s accounting profit for the current year (year ended 30 June 2001) is $80,000. Assume this is the first year of operations. The accounting profit includes the following:

Sales revenue 100,000 Consulting revenue 10,000 Interest expense 4,000 Fines paid and payable 6,000 Depreciation expense-machine

2,500

Additional information: • During the year, $12,000 of consulting revenue was received in advance

on 1 April 2001. $3,000 of this is included as revenue in the profit/loss. A liability of $9,000 (Revenue received in Advance) has been recorded in the statement of financial position as at 30 June 2001. Consulting revenues are taxed for taxation purposes when the cash is received.

• The interest relates to a loan taken out on 1 January this year for $100,000. Interest is calculated at 8% per annum and is payable on December 31. Tax only allows interest as a deduction when paid.

• Fines are not allowable deductions for taxation purposes. • The machine was purchased one year ago and originally cost $10,000.

Depreciation is calculated at 25% for accounting purposes but at 50% for taxation purposes.

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Calculation of Taxable Profit Accounting Profit (before tax) 80,000 To reverse accounting treatment: Deduct:

Consulting revenue (10,000) Add:

Interest Expense 4,000 Fines Paid 6,000 Depreciation -machine 2,500 82,500

To include taxation treatment Add:

Consulting (cash received) 19,000 Deduct:

Interest expense - Fines paid - Depreciation- machine (5,000)

Taxable Profit 96,500 Current Tax Liability (assuming 30% rate)

28,950

Note the following: • Consulting revenue included for taxation is the $10,000 revenue recorded

for accounting purposes plus the remaining $9,000 received in advance • The $4,000 interest expense recorded for accounting purposes has not

yet been paid in cash. Therefore it cannot be included as a deduction for taxation purposes.

Activity Read the rest of section 6.3 of the text and carefully work through illustrative example 6.1 in the text. In this topic you will be required to calculate taxable profit (and the current tax liability) by reconciling accounting profit and taxable profit. Note: • many students initially find the determination of taxable profit from

accounting profit difficult. You will need to work through a number of examples to ensure you have mastered this skill;

• in relation to each item the text discusses whether this will result in future tax consequences. We consider this aspect later in this topic.

Calculating Cash Amounts As noted previously you will need to calculate the amount of cash paid/received in many cases to determine the amount to be included for tax purposes. It is assumed that you have considered this in your first year accounting courses. However many students have difficulty with determining cash paid/received. To assist in this some revision material (in the form of a series of multiple choice questions) on how to calculate cash amounts is available from the on line course resources. It is suggested that you work through this NOW.

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In addition you can find some explanation on how to calculate cash flows in Chapter 14 of the text (although note that Chapter 14 explains how to calculate a broad range of cash flows. In this topic we will primarily be need to calculate cash flows only in relation to accrued and prepaid expenses and income/revenues and provisions).

(II) CALCULATE CURRENT TAX LIABILITY Here we are only considering ‘current tax’; this is the amount of tax payable on taxable profit for the period. We calculate the current tax liability (and related expense) by multiplying the taxable profit by the tax rate. This has been calculated at the bottom of the reconciliation of accounting profit to taxable profit in (I) above.

(III) PREPARE JOURNAL ENTRY FOR CURRENT TAX CONSEQUENCES AASB 112 states that

..current tax and deferred tax shall be recognised as income or an expense and included in the profit and loss for the period….(para. 58)

Note: In this topic we will not consider: • transactions or events arising outside of the profit or loss, and • tax losses (so current tax will only result in an expense).

Subject to offsetting which will be discussed later, the journal entry to record the current tax consequences of transactions and events for the period (in relation to example 2) is:

June 30 Income Tax Expense Current Tax Liability

DR 28,950 CR 28,950 Being recognition of current tax liability from example 2(a)

STEP 2: RECOGNISE FUTURE TAX CONSEQUENCES The future tax consequences of transactions under tax effect accounting are reflected in deferred tax assets and/or liabilities. To identify such assets/liabilities requires us to identify and analyse any differences between the accounting and tax ‘balance sheet’ items. Thus first we must calculate the amounts of items in the respective ‘balance sheets’.

(I) DETERMINE THE CARRYING AMOUNT AND TAX BASE OF ASSETS/ LIABILITIES

We noted earlier that as tax effect accounting is based on a balance sheet approach we need to compare the items in the accounting statement of financial position with those in a tax ‘balance sheet’. The amounts of assets and liabilities in the tax ‘balance sheet’ are called the tax base, and the standard contains rules for determining these amounts. Any difference between the carrying amount and the tax base of an item is known as a ‘temporary difference’ and may give rise to a deferred tax asset or liability (this will be discussed in the next section).

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Calculating the carrying amount and tax base The carrying amount is simply the amount recorded in the accounting records at reporting date. It is expected that students are able to determine these amounts. The concept of the tax base is crucial in the application of accounting for tax in accordance with AASB 112.

Tax base for assets The tax base for assets is ‘the amount that will be deductible for tax purposes against any taxable economic benefits that will flow to the 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’ (paragraph 7). The carrying amount we noted before is simply the amount recorded in the accounting records (net of any depreciation etc). Future taxable amounts are amounts that would be taxed in the future for income tax purposes (i.e. amounts that will be included as taxable income). As the text notes, the future taxable amount for an asset is assumed to be at a maximum the carrying amount. Future deductible amounts are the amounts that will be allowable as a deduction for tax purposes in the future.

The tax base for assets can be calculated as follows: Tax base = Carrying amount - Future Taxable

amount + Future Deductible

amount

Illustrative Example 6.2 (text)

Let’s apply this formula to the asset considered in Illustrative example 6.2, at Year 1. In this example an item of plant has been purchased for $10,000 at the beginning of the year. It has an estimated useful life of 4 years (with no residual value). Depreciation for accounting purposes is calculated on a straight line basis (i.e. 25% per annum) and for tax purposes on a straight line basis at 50% per annum. • The carrying amount (the amount recorded in accounting records) is

$7,500 (the original cost of $10,000 less accounting accumulated depreciation of $2,500).

• The future taxable amount would be $7,500. This is the current carrying amount of the asset and we would expect the asset to generate at least this amount of economic benefits that would be taxable in the future.

• The future deductible amount is $5,000. The total amount that would be allowable deductions in relation to this asset is its original cost ($10,000). In Year 1 tax has already allowed $5,000 in allowable deductions, so only a further $5,000 ($10,000 less the $5000 already allowed as a deduction) would be allowable as deductions in the future.

• Applying the formula Tax base = Carrying amount - Future Taxable

amount + Future Deductible

amounts

$5,000 = $7,500 - $7,500 + $5,000

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Activity Read the definitions of ‘temporary differences’ and ‘tax base’ in paragraph 5, and paragraphs 7, 9 & 10 of AASB 112. Read sections 6.4.1 and 6.4.2 (relating to the tax base for assets) of the text to confirm the above discussion. Note: In this topic we will not be dealing with revalued assets. You should work through each of the scenarios 1-6 in illustrative example 6.3 in the text carefully and ensure that you understand how the tax base has been calculated. AASB 112 provides further examples under paragraph 7. Remember that for some assets the future taxable amount will not equal the carrying amount (for example, for accounts receivable as it is assumed that tax also applies accrual basis and hence the sales revenue has been included in taxable income at time of sale).

Tax base for liabilities 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’ (para. 8). Thus for all but one type of liability (revenue received in advance which will be considered separately), the tax base can be calculated as follows: Tax base = Carrying amount - Future deductible

amount

The carrying amount we noted before is simply the amount recorded in the accounting records. There is no future taxable amount for a liability in the formula as this, as the text states, is assumed to be zero. The future deductible amount is the amount that will be allowable as a deduction for tax purposes in the future.

Example 3: Tax base for liabilities. Assume that a company has a loan taken out on 1 January 2001 of $100,000. Interest is payable at 8% per annum and is payable on December 31. Thus, at reporting date (30 June 2001) the company would have recorded in its accounts, under accrual accounting:

• an expense of $4,000 (100,000 x 8% x ½) for interest accrued for the period in the profit and loss section of the statement of profit or loss and other comprehensive income;

• a liability (Interest Accrued) for the future outflows of cash that it is obligated to make in the next year, of $4,000 in the statement of financial position.

• The future deductible amount is $4,000. We assumed that interest expense is allowed as a deduction when it is paid in cash for tax purposes. The total amount that would be allowable deductions in relation to this liability is $4,000. In the year that we have accrued this interest no deduction will be allowed, but all of this will be allowed as a deduction when the cash payment is made in the following year as this payment will include the $4,000 interest accrued to 30 June 2001.

• Applying the formula

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Tax base = Carrying amount - Future deductible

amounts

0 = 4,000 4,000 Tax Base of liabilities in the nature of ‘revenue received in advance’. The exception to tax base for liabilities is in relation to liabilities in the nature of ‘revenue received in advance’. The formula for calculating the tax base for such liabilities is (as per AASB 112, paragraph 8): Tax base = Carrying amount - Revenue received in advance which will

not be taxable in future periods.

Example 1 continued: Tax base for liabilities re revenue in advance Let’s apply this formula to the circumstances in Example 1 that we considered earlier.

• The carrying amount of the liability recorded would be $9,000 (representing the future outflows of economic benefits in the form of consulting services required to be provided in the next year);

• $12,000 has been included in taxable profit in the current period (there are no previous periods in this example) and of this $9,000 is revenue received in advance.

• Applying the formula Tax base = Carrying amount - Revenue received in advance which will

not be taxable in future periods.

0 9,000 9,000

Activity Read sections 6.4.2 of the text relating to tax base for liabilities and paragraph 8 (related examples) in AASB 112 to confirm the above discussion. • You should work through each of the scenarios 1-6 in illustrative example 6.4

in the text carefully and ensure that you understand how the tax base has been calculated.

Tax bases for transactions with future tax consequences only These circumstances are discussed at the end of section 6.4.2 of the text and paragraph 9 of AASB 112.

(II) COMPARE AMOUNTS TO IDENTIFY AND CLASSIFY ANY TEMPORARY DIFFERENCES

This step identifies any differences between the accounting carrying amounts and tax bases for items (such differences are known as temporary differences) and then classifies these to determine whether the differences give rise to deferred tax assets or deferred tax liabilities.

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To calculate the amount of any deferred tax liabilities or assets we apply the tax rate to any temporary differences, so the process of determining deferred tax assets or liabilities is as follows: Carrying amounts of assets or liabilities

- Tax bases of assets or liabilities

= Taxable or deductible temporary differences

Taxable or deductible temporary differences

x Tax Rates = Deferred tax liabilities or assets

You should see that to determine deferred tax assets/liabilities we first need to identify any temporary differences and then classify these as taxable or deductible.

Temporary differences – identifying and classifying Any difference between the carrying amount and tax base for an asset (liability) is defined as a ‘temporary difference’.

Activity Read the definition of ‘temporary differences’ in paragraph 5 of AASB 112.

To determine whether a deferred tax asset or liability has arisen, you need to consider the type of temporary differences. Temporary differences can be either ‘taxable’ (which result in an increase in tax payable in the future – a liability) or ‘deductible’ (which result in a decrease in tax payable in the future – an asset). • ‘taxable temporary differences’ The consequences are that in the future there will be an increase in

taxable profit (and resulting tax payable) and hence such differences will give rise to a deferred tax liability. These occur where the carrying amount of an asset is greater than the tax base (or where the carrying amount of a liability is less than the tax base).

Illustrative example 6.2 in the text provides an example of a taxable temporary difference resulting in a deferred tax liability.

• ‘deductible temporary differences’ The consequences are that in the future there will be a decrease in

taxable profit (and resulting tax payable) and hence such differences will give rise to a deferred tax asset. These occur where the carrying amount of a liability is greater than the tax base (or where the carrying amount of an asset is less than the tax base).

Activity Read section 6.4.3 of the text and paragraphs 15, 17, 21 & 22 (including the example), 24 and 26 of AASB 112. In this topic we will only be dealing with excluded or exempt taxable temporary differences in relation to: • goodwill, and

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• buildings where the cost is not deductible for tax purposes. Please note: The Australian taxation rules can be complex for buildings. In some instances (if purchased prior to a particular date) then no deductions are allowed. In other instances technically no depreciation is allowed however an equivalent deduction may be allowed but this impacts on any future capital gains tax. For the purposes of this topic we will assume that for all buildings no cost or associated depreciation is allowed for taxation purposes and hence that in this topic any temporary differences for buildings will be exempt or excluded.

You should note that: • not all assets will give rise to temporary differences (see for example

scenario 2 in Illustrative example 6.3 of the text); • some liabilities will not give rise to temporary differences (see for example

scenario 3 Illustrative example 6.4 in the text); • we will not be accounting for tax losses in this topic.

(III) CALCULATE THE AMOUNTS OF ANY DEFERRED TAX ASSETS AND LIABILITIES What are deferred tax liabilities or deferred tax assets?

Activity Read the definitions of these in paragraph 5 of AASB 112. The essential point to note is that deferred tax liabilities represent a future outflow of economic benefits as ‘more’ tax will be payable in the future by the company; and deferred tax assets represent a future economic benefit as ‘less’ tax will be payable in the future.

When does a deferred tax liability or asset arise? In simple terms these will generally arise when there is a temporary difference between the amount recorded (or that would be recorded) in the accounting and taxation records for an asset or liability. You should note that there are some exceptions which we refer to as exempt or excluded temporary differences. This is where although there is a temporary difference no deferred tax asset or liability is allowed to be recognised (this is discussed in section 6.4.3 of the text which you have previously been referred to). In this topic we will only be dealing with excluded taxable temporary differences in relation to goodwill, and buildings (where the cost is not deductible for tax purposes).

Formulae for Calculation of Deferred tax assets (liabilities) As we noted above, to calculate the amount of any deferred tax liabilities or assets we apply the tax rate to any temporary differences, so the process of determining deferred tax assets or liabilities is as follows: Carrying amounts of assets or liabilities

- Tax bases of assets or liabilities

= Taxable or deductible temporary differences

Taxable or deductible temporary differences

x Tax Rates = Deferred tax liabilities or assets

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Activity Reconsider illustrative example 6.2 in the text. Note the following: • We calculate the deferred tax liability for Year 1 as follows:

Carrying amount of asset

- Tax bases of asset

= Taxable temporary differences

7,500 5,000 2,500 Taxable temporary difference

x Tax Rate = Deferred tax liability

2,500 30% 750

• This illustrates the future tax consequences of the differences between the tax base and the carrying amount. Initially tax allows a greater deduction for depreciation (and hence the tax base is lower than the carrying amount). This gives rise to a taxable temporary difference as the entity will pay more tax in the future (a deferred tax liability). At present the entity is paying less tax, as the tax deduction is greater than the accounting expense (depreciation). The future consequence is that in later years (3 and 4) no tax deduction will be allowed, so more tax will be paid in those periods.

• Note that in the future (Years 3 and 4) the deferred tax liability is settled. At the end of Year 4 there is no longer any temporary difference, as the tax base and carrying amount are the same (zero).

• Temporary differences arising from assets will not always result in a deferred tax liability. If the tax base is greater than the carrying amount for that asset a deferred tax asset will arise (see for example scenario 3 in Illustrative Example 6.3 of the text).

The diagrams below summarise the derivation of deferred tax assets and liabilities.

(Prepared by Lisa Powell, 2002)

Recognition You should recall from your previous studies that under the conceptual framework to be recognised, assets and liabilities must meet recognition criteria (these relate to probability and reliable measurement). We will

Assets

CA<TB Liabilities CA>TB

Deductible Temporary Difference

Less tax payable in future

DTA

Assets CA>TB

Liabilities CA<TB

Assessable Temporary Difference

More tax payable in future

DTL

Taxable Temporary Difference

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consider recognition issues later in this guide, but for the moment will assume that any recognition criteria have been met.

Measuring Deferred tax assets/liabilities Initially we noted that AASB 112 is based on the principle that both the current and future tax consequences of transactions and events need to be recognised, and that future consequences may give rise to deferred tax liabilities or assets. The tax expense to be included in the accounting records is derived from both movements in deferred tax assets/liabilities (future consequences) and from current tax obligations, so each of these needs to be measured. We have already considered how to measure current tax consequences. We also noted previously that AASB 112 (paragraph 47) requires that the amount of any deferred tax liabilities or assets be measured at applicable tax rates. Taxable or deductible temporary differences

x Tax Rates = Deferred tax liabilities or assets

Example 2 (part b): Calculation of deferred tax assets/liabilities We will continue with example 2 to illustrate the calculation of deferred tax assets and deferred tax liabilities. We noted earlier that a worksheet is used in Step 2 (determining future tax consequences). The worksheet is simply a tool to assist us in identifying and classifying temporary differences and in summarising movements in deferred tax assets/liabilities. You will need to use this worksheet which is illustrated in this example. In the worksheet following is shown the assets and liabilities for the company. We have previously discussed how to determine the tax base for statement of financial position items and to identify where a temporary difference has occurred and how to classify these. It is assumed that the recognition criteria are met, a tax rate of 30% and this is first year of operation.

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Carrying

amount Future

Taxable amount

Future

Deductible amount

Tax base Taxable

temporary differences

Deductible temporary

differences

Assets Cash 105,000 0 0 105,000 0 - Accounts Receivable

14,000 0 0 14,000 0 -

Machine 7,500 7,500 5,000 5,000 2,500

Liabilities Accounts payable 5,000 0 0 5,000 0 - Loan 100,000 0 0 100,000 0 - Interest accrued 4,000 0 4,000 0 4,000

REVENUE RECEIVED

IN ADVANCE Carrying amount

Amount included which will not be taxed in

future periods

Tax base

Consulting revenue received in advance

9,000 9,000 0 9,000

Temporary Differences 2,500 13,000 Exempt Differences Net Temporary differences 2,500 13,000 Deferred tax liability 750 Deferred tax asset 3,900 Beginning balances 0 0 *Movement during the year 0 0 Adjustment 750 3,900

This worksheet: shows the calculation of the tax bases for all assets and liabilities; shows the identification, classification and summarisation of temporary

differences; measures the deferred tax asset and liability at the end of the period, and measures the adjustments required to adjust the beginning balances of

the deferred tax asset and liability to the balances required at the end of the period (as calculated in this worksheet). These adjustments are the basis for the accounting entries required in relation to tax expense (income) and deferred tax asset/liability.

Note: You will not be required to make any entries in the row headed ‘Movement during the year ‘ in this topic. Changes during the year (for example, those resulting from changes in the tax rate or revaluations) would be adjusted via this row.

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The Exempt differences row has not been used in this example. This is where adjustments relating to exempt or excluded temporary differences would be made. For example, if a temporary difference was identified in relation to goodwill, the standard does not allow a related deferred tax liability to be recognised and hence you would use this row to deduct such temporary differences to arrive at net temporary differences to be accounted for. There are examples of these in the topic review questions.

The text sometimes includes the current tax liability in this worksheet and sometimes omits this. As the current tax liability will not result in a temporary difference we will not include this in the worksheets in this course.

(IV) PREPARE JOURNAL ENTRIES TO ACCOUNT FOR FUTURE TAX CONSEQUENCES When we have determined the amounts of deferred tax assets and liabilities at the end of the period we can prepare our journal entries to recognise the future tax consequences. This will involve:

• Accounting for tax expense/income • Adjusting any deferred tax asset or liabilities. To do this we will need

to consider any initial balances of these items at the beginning of the period.

• Whether any offsetting is required. This is discussed later in this topic. In this course you are not required to offset.

Determining the amount of tax expense (income) AASB 112 states that

..current tax and deferred tax shall be recognized as income or an expense and included in the profit and loss for the period ,except…. (para. 58)

(Note: This is subject to exceptions but in this topic we will only be dealing with exceptions relating to goodwill and buildings) We considered ‘current tax’ above; this is the amount of tax payable on the taxable profit for the period.

Thus a tax expense will result where: • tax is payable in the period; • there has been an increase in the balance of deferred tax liability • there has been a decrease in the balance of deferred tax asset.

Tax income will result where: • a tax loss has occurred in the period; • there has been an increase in the balance of deferred tax asset. • there has been a decrease in the balance of deferred tax liability.

The following extension of example 2 illustrates the calculation of tax expense/income for the period.

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Example 2 (part c): Calculation of tax expense Recall that in example 2 (part b) we assumed that this is the first year of operation for the company, so there will be no existing balances of any deferred tax assets or liabilities. Further we will assume that the recognition criteria for deferred tax assets/liabilities are met. Calculation of Tax Expense/ Income Amount Tax

Expense Tax Income

Current Tax Liability 28,950 28,950 Increases in deferred tax assets 3,900 3,900 Increases in deferred tax liabilities 750 750

Subject to offsetting which will be discussed later, the journal entries to record the current and future tax consequences of transactions and events for the period June 30 Income Tax Expense

Current Tax Liability DR 28,950

CR 28,950 Being recognition of current tax liability from example 2(a)- as before

Deferred Tax Asset DR 3,900 Income Tax Income/Expense CR 3,900 Being recognition of increase in deferred tax assets from example 2(b)

Income Tax Expense DR 750 Deferred Tax Liability CR 750 Being recognition of increase in deferred tax liabilities from example 2

(b)

Activity Read section 6.6 of the text and carefully work through illustrative example 6.5. Note the following: • The first step is to determine the taxable profit. This is derived primarily from

the accounting profit and loss section of the statement of profit or loss and other comprehensive income. In this example the current tax liability is assumed to be $12,000. The resulting journal entry to record the taxation payable for the current year will be: DR Tax Expense By the amount of tax payable

based on taxable profit for the period

CR Current Tax Liability

• The second step is to identify and classify any temporary differences. This focuses exclusively on the statement of financial position. You should note: ⇒ The text uses a worksheet to calculate the tax base and carrying amount

for each asset /liability and to classify any identified temporary differences. This is a useful tool in accounting for income tax and students are required to understand and use this worksheet.

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⇒ The worksheet combines the types of temporary differences to arrive at the overall amounts of taxable temporary differences and deductible temporary differences, so that only one journal entry accounts for the changes in each of the deferred tax liability and deferred tax asset respectively. Journal entries are not made for individual temporary differences.

Offsetting tax assets and liabilities

Activity Read paragraph 74 of AASB 112, and section 6.6.1 of the text. In this course will be assuming that the conditions required for offsetting are satisfied, unless explicitly stated otherwise. Note in this topic we will not be considering changes in the tax rate (as discussed in section 6.7 of the text).

In our example 2 (part c), if offsetting were applied, the resulting journal entries would be: June 30 Income Tax Expense

Current Tax Liability DR 28,950

CR 28,950 Being recognition of current tax liability from example 2(a)- as before

Deferred Tax Asset DR 3,150 Income Tax Income/Expense CR 3,150 Being recognition of net increase in deferred tax assets (after offsetting

deferred tax liabilities) from example 2(b) and related tax income

ACCOUNTING FOR INCOME TAX IN FUTURE YEARS So far the example we have considered from the text and in example 2(c) have assumed that it is the first year of operations. When accounting for future years we need to consider: • In calculation of taxable profit, when determining the amounts included for

accounting and taxation purposes the beginning balances of any accruals/deferrals.

• The balance of any deferred tax assets and deferred tax liabilities at the beginning of the period, as the tax expense/income relates to adjustments to these balances.

Example 2(d) provides an illustration of accounting for income tax in future periods. Example 2(part d): Future Years We will continue with our previous example. A company’s accounting profit for the next year is $180,000. This includes the following:

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Sales revenue 100,000 Consulting revenue 30,000 Interest expense 8,000 Depreciation expense-machine

2,500

Doubtful/Bad Debts expense 2,500

The extract from the statement of financial position for the second year of operations (i.e. year ended 30 June 2002) shows the following assets and liabilities:

Assets Cash 80,000 Accounts Receivable 20,000 Less Allowance for Doubtful Debts (2,100) 17,900 Machine 10,000

Acc Depn (5,000) 5,000 Deferred tax asset 3,900 Liabilities Accounts payable 10,000 Loan 60,000 Interest accrued 4,000 Deferred tax liability 750 Additional information:

1. The company decided to recognise an allowance for doubtful debts. The company wrote off $400 in bad debts in the period. Assume tax allows a deduction only when bad debts are written off.

2. The balance of the deferred tax asset assumes no offsetting of deferred tax liability (750) against deferred tax assets (3,900).

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Step 1: Calculation of Taxable profit and current tax liability Accounting Profit (before tax) 180,000 To reverse accounting treatment: Deduct:

Consulting revenue (30,000) Add:

Depreciation -machine 2,500 Doubtful/ bad debt expense 2,500

155,000 To include taxation treatment Add:

Consulting (cash received this period – 30,000 less 9,000)

21,000

Deduct: Bad Debts (amount written off) (400) Depreciation- machine (5,000)

Taxable Profit 170,600 Current Tax Liability (assuming 30% rate)

51,180

Note: • No adjustments are required for interest expense this period. As the loan

had been taken out in the previous period there would be no difference in amounts recorded for interest expense in taxation and accounting records as in this year (second year) payment of $8,000 in interest would have been made and would be allowable as a deduction for tax purposes. Accounting would have recognised half of the payment made as interest expense for the previous period and accrued half of the next payment (due this period) as interest expense.

• Consulting revenue includes $9,000 received in advance in previous period. As no revenue received in advance is in the statement of financial position at the end of this period, the cash actually received is the amount expensed less the amount previously received in advance.

The journal entry to be processed would be: Income Tax Expense Current Tax Liability

DR 51,180 CR 51,180

Step 2: Here we: • Determine the carrying amount and tax base of assets and liabilities • Compare amounts to identify and classify any temporary differences • Calculate the amounts of any deferred tax assets and liabilities • Prepare journal entries to account for future tax consequences As before, we will use the format of the worksheet in the text.

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Carrying amount

Future

Taxable

amount

Future

Deductible amount

Tax base Taxable Temporary

differences

Deductible Temporary differences

Assets Cash 80,000 0 0 80,000 - - Accounts Receivable less Allow Doubtful Debts

17,900 0 2,100 20,000 2,100

Machine 5,000 5,000 0 0 5,000

*Deferred tax asset 3,900 - - - - Liabilities Accounts payable 10,000 0 0 10,000 - - Loan 60,000 0 0 60,000 - - Interest accrued 4,000 0 4,000 0 4,000

*Deferred tax liability 750 Temporary Differences 5,000 6,100 Exempt Differences Net temporary difs 5,000 6,100 Deferred tax liability 1,500 Deferred tax asset 1,830 Beginning balances ** (750) (3,900) Adjustment 750 (2,070)

*The worksheet above includes a deferred tax asset and liability. These are included for completeness. We do not consider this further in our analysis as the purpose of our analysis is to identify changes in any deferred tax accounts (either deferred tax asset or deferred tax liability). The text does not include this in their worksheet and its inclusion is optional.

You should see that the net movement is: • An increase in deferred tax liability of $750 to a balance of $1,500; • A decrease in deferred tax asset of $2,070 to a balance of $1,830. Journal entries required (no offsetting and assuming recognition criteria met) In addition to the journal entry required in relation to current tax liability the following entries would be processed: June 30 Income Tax Expense DR 2,070 Deferred Tax Asset CR 2,070 Being recognition of decrease in deferred tax assets (from 3,900 to

1,830)

Income Tax Expense DR 750 Deferred Tax Liability CR 750 Being recognition of increase in deferred tax liabilities (from 750 to

1,500)

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Journal entries assuming offsetting If we offset the deferred tax assets and liabilities we will wish to show a deferred tax asset of $330 ($1,830 - $1,500). The current balance shown in the statement of financial position, if previously offset, is a deferred tax asset of $3,150 so would need to make an adjustment to reduce this. The journal entry to be processed would be: Income Tax Expense Deferred Tax Asset

DR 2,820 CR 2,820

Being recognition of movement in net deferred tax asset.

You could also calculate adjustment amounts by: Initial balance in deferred asset 3,150 Less reduction in deferred tax asset this period (2,070) Less increase in deferred tax liability this period ( 750)

Adjustment required 2,820

Activity You should now carefully work through the demonstration problem 2 in the text. Note: This includes exempt temporary differences in relation to goodwill and buildings.

Recognition of deferred tax assets and liabilities You should recall from your previous studies that under the conceptual framework to be recognised, assets and liabilities must meet recognition criteria (these relate to probability and reliable measurement). You should also recall that whilst applications of accounting standards are mandatory, the conceptual framework is not. AASB 112 differentiates between deferred tax liabilities and deferred tax assets in specifying recognition criteria. Deferred Tax Liabilities AASB 112 assumes that both the probability and measurement criteria are satisfied in respect of deferred tax liabilities. No specific or additional criteria are specified, or guidance provided.

Activity Read section 6.5.1 of the text, and paragraph 16 of AASB 112 to confirm the points noted above.

Deferred Tax Assets AASB 112 contains more specific guidelines on meeting the probability recognition criteria of deferred tax assets than it does for deferred tax liabilities. This is specified in paragraph 24 (and paragraph 28 explains this further). You should recall that the future economic benefits embodied in a deferred tax asset are the reduction in tax in the future. For example, consider the circumstances in Illustrative example 6.4, scenario 4 in the text, where a provision has been recognised in the accounting records in relation to Long Service Leave. A deferred tax asset has been

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recognised. The future economic benefits are the reduction in payment of tax when the long service leave is actually paid in cash to the employees and is then an allowable deduction for tax purposes. The entity will only realise these benefits if in the future if earns sufficient taxable income to offset the allowable deduction. If in the period in which the long service leave is actually paid, the entity has no taxable profit it will pay no tax in that period, and hence gain no reduction in tax payable in that period from the payment of long service leave. If the entity continued to have no taxable profit in future periods, any future economic benefits embodied in the deferred tax asset would not eventuate. The AASB 112 criteria requires ‘probability’ to be determined and notes that this is a matter of judgement, and provides guidance in relation to assessing deferred tax assets.

Activity Read paragraphs 24, 28 & 29 of AASB 112 and section 6.5.2 of the text to confirm the points noted above.

In this topic, unless explicitly stated, we will assume that it is probable that taxable amounts will be available and so recognition requirements for deferred tax assets are met. You should also note that the standard requires that all deferred tax assets be reviewed at each reporting date (refer to section 6.5.4 of the text). This is to ensure that the probability criterion is still satisfied for those assets recognised, and to permit recognition of such assets where the probability criterion has now been met. We will not be considering such reviews. In this course we are assuming that the probability criteria is met for the total amount of any deferred tax asset and will not be considering the circumstances where the tax asset can only be recognised to extent of tax liability.

PRESENTATION AND DISCLOSURES The standard specifies the presentation and disclosures required in relation to accounting for income tax.

Activity You should read section 6.9 of the text which illustrates the disclosure requirements. In this course you will not be required to prepare notes re disclosure but need to be aware of requirements.

PAYMENT OF TAX In this course, we will assume that tax is paid in one single payment. However you need to be aware of the requirements of how to account for the payment of tax by instalments and of how to account for any over or under provisions.

Activity You should read section 6.10 of the text and work through illustrative example 6.9

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TOPIC REVIEW QUESTIONS This topic is to be studied over 2 weeks. You should attempt questions 1 to 6 in the first week, and the remainder in the next week. Question Topic 1. Leo et al, 2012, Chapter 6, Review question 1. Comparison of

taxation treatments and accounting.

2. Distinguish between the tax payable method and the balance sheet method for accounting for income tax. What is the rationale for adoption of the balance sheet method?

Conceptual basis

3. Leo et al, 2012, Chapter 6, Practice Question 6.4, Cases 1 to 3 only (Case 4 involves a loss which we will not be considering in this course).

Calculation of taxable profit and current tax liability.

4. (Adapted from Leo et al, 2005, p152-3)

Calculation of taxable profit and current tax liability

The internal income statement before tax for Simon Ltd for the year ended 30 June 2007 is as follows:

Income Sales 640,000 Rent 20,000 Prize for employer of month 5,000 665,000 Expenses Cost of goods sold 370,000 Depreciation of buildings 3,200 Depreciation of plant 30,000 Depreciation of computers 25,000 Depreciation of vehicles 15,000 Salaries and wages 85,000 Insurance 20,000 Long service leave expense 3,000 Other expenses 38,800 590,000 Profit before income tax 75,000

Additional information: • Rent revenue for the year relates to one floor of the company’s head office

building. This was previously surplus to requirements and so was rented out but in February 2007 Simon Ltd required this office space and ceased

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renting this floor. The balance of rent received in advance in the statement of financial position as at 30 June 2006 was $7,000.

• Simon Ltd was awarded (and paid) $5,000 in March 2007 as part of a government scheme to reward ‘good’ employers. This prize is not taxable (i.e. exempt from tax).

• The building was purchased on 1 July 2006 for $80,000 and is depreciated at 4% straight-line on cost per annum (with no residual value).

• The plant was purchased on 1 July 2005 for $220,000 and is depreciated for accounting straight-line over 7 years with a residual value of $10,000. Tax depreciates at 10% of cost.

• The computers were purchased on 1 July 2004 for $100,000 and are depreciated for accounting straight-line over 4 years with no residual value. Tax depreciates at 50% of cost.

• The vehicles were purchased on 1 July 2003 for $90,000 and are depreciated for accounting straight-line over 5 years with a residual value of $15,000. Tax depreciates at 25% of cost.

• In the statements of financial positions for years ended 30 June 2006 and 2007 there are no balances of accrued wages or salaries (or prepayments).

• The balance of prepaid insurance was $18,000 at 30 June 2006 and $24,000 at 30 June 2007.

• The balance of long service leave provision in the statement of financial position was $3,000 at 30 June 2006 and $6,000 at 30 June 2007.

• Other expenses include $11,000 of entertainment expenses. The balance of accrued entertainment expenses in the statement of financial position was $5,000 at 30 June 2006 and $7,000 at 30 June 2007.

• Sales (and cost of goods sold) are recognised on an accrual basis for both accounting and tax purposes.

• Rent revenue, salaries and wages, long service leave and insurance are recognised for tax purposes on a cash basis.

• Entertainment expenses and depreciation for buildings are not allowable as deductions for tax purposes.

• The tax rate is 30%.

Required: Prepare a statement reconciling accounting profit to taxable profit and calculate the current tax liability as at 30 June 2007.

5. (a) Leo et al, 2012, Chapter 6, Review question 4.

(b) The following assets were shown in the statement of financial position for year ended 30 June, 2006. For each asset:

Calculate the tax base Identify whether or not a temporary difference

exist (and explain why) Classify any temporary differences as taxable or

deductible (explain your answer) 1. $10,000 Cash 2. Accounts Receivable of net $73, 000

($85,000 less Allowance for Doubtful Debts of $12,000). Would your answer be different if there were no allowance for doubtful debts.

Tax bases for assets/ temporary differences and classification.

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3. Inventory of $17,000. 4. Interest accrued of $2,000 (earned from

$60,000 invested in 12 month deposit on 1 March 2006 which matures in one year and earns 10%). Assume is taxed when cash received.

5. Investment $60,000 (cost) 6. Plant 50,000 net (This amount is less

accumulated depreciation). This was purchased on 1 July 2004 at a cost of $70,000. It is expected to have a useful life of 7 years and no residual value. Taxation depreciates at 25% straight line.

7. Vehicles of $14,000 (net. i.e. less accumulated depreciation). This was purchased at a cost of $42,000 on 1 July 2002. It is expected to have a useful life of 6 years with no residual value. Taxation depreciates at 25% straight line.

8. Equipment $9,000 (net). This was purchased on 1 July 2005 for $18,000 and is expected to have a useful life of 2 years with no residual value. Tax depreciates at 33% per annum.

9. Prepaid insurance $2,000. A payment of $6,000 for 12 months insurance was made on 1 November 2005. Assume tax deduction allowed when paid in cash.

10. Land 190,000 (at cost). 11. Research and Development $60,000. In July

2005 $80,000 was spent on research and development expected to provide future economic benefits over the period 1 July 2005 to 30 June 2009. Tax allows a deduction when cash spent.

12. Goodwill of $50,000 was recorded in the accounts. Assume goodwill is not deductible for tax purposes.

13. Buildings of $90,000 net ($100,000 less $10,000 accumulated depreciation). Depreciation of such buildings is not deductible for tax purposes.

6. (a) Leo et al, 2012, Chapter 6, Review question 5.

(b) The following liabilities were shown in the statement of financial position for year ended 30 June, 2006. For each lability:

Calculate the tax base Identify whether or not a temporary difference

exists (and explain why) Classify any temporary differences as taxable or

deductible (explain your answer) 1. Bank Overdraft $60,000

Tax bases for liabilities: temporary differences and classification

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2. Accounts Payable $37,000 3. Entertainment Expenses payable $7,000.

These were incurred in June 2006 but have not yet been paid. These expenses are not deductible for taxation purposes.

4. Provision for Long service leave $16,000. Assume deductible for tax only when paid.

5. Provision for Product warranties $3,000. Assume deductible for tax only when paid or services (e.g. repairs) provided.

6. Revenue from rent received in advance $6,000. Assume tax treats on a cash basis.

7. Loan $600,000 8. Interest accrued $3,000. This relates to loan.

Interest payments are due on 15th of each month. Interest accrued from 15th June to 30 June 2006 amounts to $3,000. Assume deductible for tax only when paid in cash.

9. Advertising expenses payable $5,000. Assume deductible for tax only when paid.

7. Explain whether the deferred tax asset arising from rent revenue received in advance would meet the definition of an asset as in the Framework.

Deferred tax assets.

8. Leo et al, 2012, Chapter 6, Practice Question 6.14 Part B only Note: Also assume that rent, and long service leave and annual leave are taxed on a cash basis. Goodwill is not deductible for tax purposes. You are not required to do offsetting for journal entries Worksheet has been provided.

Worksheet and journal entries

9. This is based on a past exam question. Note: Worksheet has been provided

Current tax liability and Worksheet and journal entries

The accounting profit before tax for Silly Ltd for the year ended 30 June 2006 was $820,000 and included the following revenue and expense items:

Depreciation of plant $7,500 Long service leave expense $60,000 Doubtful debts expense $35,000 Rent revenue $20,000 Entertainment expenses $45,000 Depreciation of building $50,000

Additional information: • The Plant was purchased on 1 July 2001 for $65,000. The plant has an

expected useful life of 8 years and a residual value of $5,000 and is depreciated using straight-line method for accounting purposes. Tax depreciates at 25% per annum straight line on cost.

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• Long service leave paid to employees in the year to 30 June 2006 totalled $90,000.

• Total bad debts written off during the year were $25,000. • Rent revenue relates to the building and is paid to Silly Ltd in advance.

The balance of Rent Revenue Received in Advance was $8,000 as the beginning of the period (i.e. as at 1 July 2005) and $12,000 at the end of the period (ie as at 30 June 2006).

• Long service leave and rent revenue are recognised for tax purposes on a cash basis.

• Entertainment expenses and depreciation for buildings are not allowable as deductions for tax purposes.

• Bad/doubtful debts are only allowable as deductions when written off. • The tax rate is 30%.

The extract from the statement of financial position for Silly Ltd as at 30 June 2006 is as follows:

Assets

Cash 80,000 Inventory 720,000 Accounts Receivable 400,000 Allowance for Doubtful Debts 50,000 Deferred Tax Asset 38,000 Plant 65,000 Accumulated Depreciation –Plant 37,500 Building 400,000 Accumulated Depreciation –Building 80,000 Land 350,000

Liabilities

Accounts Payable 60,000 Provision for Long Service Leave 100,000 Rent Revenue Received in Advance 12,000 Deferred Tax Liability 6,500 Loan 220,000

(a) Prepare a statement reconciling accounting profit to taxable profit. (b) Complete the tax effect worksheet which is attached (c) Prepare the journal entries required to account for income tax as at

30 June 2006. (d) If the beginning balance of deferred tax liabilities was $11,000 how

would this impact on your journal entries in (c) above.

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WORKSHEET FOR QUESTION 8

Carrying Amount

Future Taxable Amount

Future Deductible

Amount

Tax Base Taxable Temporary Differences

Deductible Temporary Differences

$ $ $ $ $ $ Assets Cash

Inventory

Receivables (net)

Office supplies

Plant (net)

Buildings (net)

Goodwill (net)

Liabilities A/cs payable

LSL payable

Annual leave payable

Rent in adv

Temporary differences

Exempt differences

Net Temp. Differences

Deferred tax liability

Deferred tax asset

Beginning balances

Movement during year

Adjustment

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WORKSHEET FOR QUESTION 9

Carrying Amount

Future Taxable Amount

Future Deductible Amount

Tax Base Taxable Temporary Differences

Deductible Temporary Differences

$ $ $ $ $ $

Assets

Cash

Inventory

Accounts receivable (net)

Plant (net) Buildings (net) Land

Liabilities

Accounts payable

Provision for Long Service Leave

Rent revenue

received in

advance

Loan Temporary differences

Exempt difs Net temp. differences

Deferred tax liability Deferred tax asset Beginning balances Movement during year

Adjustment

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TOPIC 8

PROPERTY, PLANT AND EQUIPMENT

Accounting issues, measurement, presentation and disclosures.

OBJECTIVES By the end of this topic you should be able to: • determine whether an item is an item of property, plant and equipment • understand and account for the measurement of property, plant and equipment

following acquisition using; • the cost model, and/or • the revaluation model

• understand and apply the requirements relating to ‘impairment’ of assets • understand, source and apply the key disclosure and reporting requirements in

relation to property, plant and equipment • account for the disposal of items of property, plant & equipment

REQUIRED READING

Resource: Text Leo et al, 2012, chapters 7, 11 & 13, sections as specified in this guide.

Resource: Accounting Handbook AASB 101 Presentation of Financial Statements

AASB 116 Property, Plant and Equipment

AASB 136 Impairment of Assets

INTRODUCTION We have examined in a previous topic the general format and disclosures for assets in the statement of financial position. These general disclosure requirements are

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outlined in AASB 101. However there are a number of accounting standards which outline the accounting procedures and disclosures required in relation to particular assets. For example, an item such as a machine

• could be held for use (and so AASB 116 Property, Plant & Equipment may apply)

• could be held for sale as inventory (AASB 102 Inventories may apply) • could have previously been held for use (AASB 5 Non-current Assets Held

for Sale and Discontinued Operations may apply) • could be leased (AASB 117 Leases may apply) • could be under construction (AASB 111 Construction Contracts may apply)

In this course we are not able to consider all of these standards. In your previous studies it is assumed that you have considered the accounting and disclosure requirements in relation to the major classes of current assets (such as inventory and accounts receivable). We will consider in this topic the accounting standards relating to one type of non-current assets: property, plant & equipment.

ACCOUNTING FOR PROPERTY, PLANT AND EQUIPMENT As noted previously, accounting standards often apply to particular types of assets. Non-current assets often represent the majority of the resources of many companies and hence the way they are accounted for impacts significantly on the financial statements. Items such as property, plant and equipment often represent the majority, or at least a significant part of the non-current assets of an entity. You should recall that property, plant and equipment is one of the categories of assets that must be shown on the face of the statement of financial position at a minimum (AASB 101, para. 54), although in practice many companies divide this category into sub classes in the statement of financial position or notes. AASB 116 Property, Plant and Equipment specifies the key accounting treatments and disclosures for these items. Changes to AASB 116 Property, Plant and Equipment AASB 116 was updated in 2013 (and this updated version is in the 2014 Handbook) due to the application of AASB 13 Fair Value Measurement which applies to reporting periods beginning on or after 1 January 2013. AASB 13 defines fair value and outlines the techniques (a framework) to be applied in determining fair value and specifies required disclosures. If an item is measured using fair value then (with some exceptions, such as for leased assets) AASB 13 is applied. You will consider AASB 13 in detail in a later course. The previous version of AASB 116:

• Included a different definition of fair value. Although in substance these are similar, the definition as per AASB 13 will be used in this course.

• Specified techniques for measuring fair value. As fair value is now determined in accordance with AASB 13, references in AASB 116 to such techniques are no longer appropriate and have been deleted.

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• Had additional disclosures required where the measurement basis was fair value. As disclosures relating to fair value are now incorporated into AASB 13 these have been deleted from AASB 116.

Take care as previous versions of the Handbook and the discussion in the current edition of the company accounting text, do not refer to the current version of AASB 116.

What are property, plant and equipment?

Activity Read section 7.1 of the text and paragraphs 2 to 5 and the definition of property, plant and equipment in paragraph 6 of AASB 116. Note the following: • Property, plant and equipment are tangible items and are non-current, as the

definition applies to items used for more than one period. • If held for sale this standard does not apply, so this is only applied where held for

continuing use.

Initial recognition of items of property, plant & equipment In this topic we consider the measurement of items of property, plant & equipment subsequent to acquisition. It is assumed that students are already familiar with how to account for the acquisition of assets (such as items of property, plant and equipment) from their previous studies. This would include how to:

o determine the costs of items of property, plant & equipment o account for the initial acquisition of items of property, plant and

equipment (whether acquired individually, with multiple assets, or in a business combination).

If you need to revise this material please read relevant sections of the text (sections 7.2 to 7.3.3; 10.1 to 10.2.2; 10.3 to 10.5.1 & 10.6). Students in Financial Accounting 2 are not required to work through these sections of the text. This is only required for students who feel that they need to revise their knowledge in this area.

MEASUREMENT OF PROPERTY, PLANT & EQUIPMENT AFTER INITIAL RECOGNITION You should recall that the general principle is that items of property, plant & equipment are initially recorded at the cost of acquisition. We will now consider subsequent measurement of these items. After initial recognition the measurement of items of property, plant and equipment needs to consider:

• The measurement basis to be used (cost or revaluation model); • Depreciation (we will consider this is the next section), and • Impairment

Depreciation Assets represent future economic benefits and by definition items of property, plant and equipment are non-current assets which represent future benefits that will not all be ‘used’ up in the current reporting period. The accounting method to allocate the cost (or revalued amount) of non-current assets and recognise the related expense is

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called depreciation. It is assumed that you are familiar with the basic concept of depreciation from your previous study and in this course the following is provided for revision purposes only. AASB 116 defines depreciation as ‘the systematic allocation of the depreciable amount of an asset over its useful life’ (para. 6) and requires after recognition that accumulated depreciation be deducted. Depreciation requires consideration of:

1. the types of assets to be depreciated. Depreciation applies to non-current assets with a limited useful life. All property, plant and equipment items apart from land have limited useful lives, although the useful life may be quite long (e.g. for some buildings).

2. the total amount to be depreciated. This is known as the ‘depreciable amount’ (as defined in AASB 116, para. 6), and is essentially cost (or revalued amount) less residual value (the amount expected to be received when the asset is disposed of). We consider revaluations in the next section of this guide.

3. the period over which depreciation expense is to be recognised. This is generally the period of time over which the asset will be used by the particular entity (its ‘useful’ life as defined in AASB 116, para.6). Note: This will vary depending on the entity’s use of the asset. For example, two companies may purchase an identical motor vehicle. If one uses as a courier service could expect to use for say 4 years; if the other uses only to collect mail etc could expect to use for 7 years.

4. the method of allocation. There are a number of alternative methods. You are expected to understand both the straight-line and diminishing balance methods, but in this course will only be required to apply the straight-line method. .

Activity If you need to revise this concept read section 7.5.1 of the text. It is assumed that this is largely a revision of concepts from your previous accounting studies. Consider the following: Do you think all accountants would arrive at the same depreciation expense amount for a particular asset? What does this say about the objectivity and reliability of financial reports?

Choice of measurement basis to be used (cost or revaluation model) AASB 116 (para. 29) requires that an entity choose between 2 measurement models for each class of property, plant and equipment. The 2 models are: • The cost model, and • The revaluation model.

Activity Read section 7.4 of the text and paragraph 29 of AASB 116. Note the following: • That the choice of measurement model is an accounting policy choice. The text

discusses AASB 108 Changes in Accounting policies, Changes in Accounting Estimates and Errors. We considered this standard in an earlier topic.

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o Also note the text discussion of how a change in the measurement model to revaluation model is accounted for as per AASB 108 (para 17).

• The requirement is that the choice be made for the entire class. In other words, all items in that class of assets must use the same measurement model.

Cost Model The cost model requires measurement of an item of property, plant and equipment at cost less any accumulated depreciation less any impairment losses (para 30).

Activity Read paragraph 30 of AASB 116 and section 7.5 of the text and note the following: • differences between costs of maintaining an item and those costs incurred that

increase future economic benefits • we will consider impairment later in this topic as this is required for both measurement

models.

Revaluation Model Historically non-current assets such as property, plant and equipment were generally recorded at cost (less accumulated depreciation) with no adjustment for changes in the market value of the assets. The market value of many of these assets however may change quite significantly subsequent to acquisition, and the relevance of ‘cost’ to users was questioned. For example, imagine what the current value of land purchased for $20,000 in Sydney’s CBD in 1970 would be. The ‘revaluation’ of non-current assets has been part of accounting practice for some time. However, historically revaluations tended to be selective and irregular and subjective. The revaluation model requires measurement of an item of property, plant and equipment at fair value less any accumulated depreciation less any impairment losses (para. 31). Fair Value is defined as:

Fair value 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. (See AASB 13 Fair Value Measurement) (AASB 116, para. 6).

In other words fair value is what the company would receive if it sold the asset in a normal market transaction. The standard does not specify the method of determining fair value. This is specified in AASB 13. In this topic you will be ‘given’ the fair value and will not need to determine or calculate fair value. Also to avoid selective and irregular revaluations the standard requires that: • if any item of property, plant and equipment in a class is revalued then all items in

the class must be revalued (para. 36) • that revaluations occur regularly so that the carrying amounts of the items reflect

their current fair values (para. 31)

Activity Read section 7.6 of the text and paragraphs 31 to 38 of AASB 116. You should have noted:

• nature of class of assets • that all assets in a class must be revalued at the same time (or progressively)

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• a company can elect to measure some classes of assets at cost and some at fair value; the choice between cost and fair value is made for each class

• revaluations must be kept up to date • potential problem discussed in the text where some items in a class cannot be

measured reliably at fair value

Accounting for revaluations Although the standard requires all assets be revalued in a class the revaluation of each individual asset within the class is accounted for separately. This involves for each asset in that class: 1. Updating the carrying amount of the item (either up or down) so it is included

at current fair value in the statement of financial position. This involves 2 steps: • eliminating accumulated depreciation to the date of revaluation You should recall that the carrying amount of a depreciable asset is represented by the amounts in the asset account and the amounts in the accumulated depreciation account. The standard requires that the amount of accumulated depreciation be credited to the asset account. The amount in this account will then equal the carrying amount prior to revaluation. (AASB 116, paragraph 35(b)). (Note: para. 35 (a) allows a different method where both the accumulated depreciation and gross amount of the asset are proportionately restated. We will not consider this method in this course). • Updating the carrying amount of the item to its current fair value

2. Accounting for the change in the carrying amount The treatment of any changes in the carrying amount of an asset on revaluation depends on: • whether there is an increment (increase) or decrement (decrease), and • whether there have been previous revaluations in relation to that asset. The standard requires that: • revaluation increments be credited to other comprehensive income and

accumulated in a revaluation surplus (this is a type of reserve and is an equity account) and decrements be debited to the profit and loss (as an expense). This treatment is subject to the exception that if reverses a previous revaluation of that item, first need to reverse out the effect of that previous revaluation (to extent of the current revaluation).

3. Account for tax effect & adjustment to revaluation surplus (if required) If in changing the carrying amount of the asset we have recognised other

comprehensive income we will need to make further entries to ensure that we account for tax correctly and to adjust the revaluation surplus. This will be explained later in this topic.

Let’s consider a simple example. We will initially consider revaluations of an asset where there have been no previous revaluations.

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Example 1: Initial Revaluation upwards of a depreciable item A company purchased an item of property, plant and equipment (equipment) on 1 July 2006 for $105,000. It is estimated to have a useful life of 5 years and a residual value of $5,000. At 30 June 2007 the carrying amount of this item was $85,000 (cost of $105,000, with accumulated depreciation of $20,000). The carrying amount in the statement of financial position of the company is therefore:

Equipment (at cost) 105,000 Less Accumulated Dep’n 20,000 Carrying amount 85,000

The company has chosen to revalue this class of assets (so no previous revaluations for this item) and at reporting date the fair value of the equipment is $97,000. The initial entry would be to transfer the accumulated depreciation:

Debit Credit

Accumulated Depreciation 20,000

Equipment 20,000

(transfer of accumulated depreciation to record asset account at carrying amount prior to revaluation)

We can now update the amount of the asset to its current fair value by the following entry:

Debit Credit

Equipment 12,000

Gain on revaluation (OCI)* 12,000

(to revalue asset up $12,000 to fair value; $97,000 fair value - $85,000 carrying amount prior to revaluation)

Note: • AASB 116, para 39 requires changes (whether an increase or decrease) in

the revaluation surplus to be included in other comprehensive income (OCI) in the statement of profit or loss and other comprehensive income. This is consistent with the concept of comprehensive income i.e. that changes in equity from non-owner sources and/or transactions are part of the total income/expense for the period.

• The ‘gain’ here is an item of other comprehensive income. This gain is NOT the same in nature as other gains (e.g. from the sale of non-current assets) that would be included in the profit/loss for the period. You will see later in this topic that gains from revaluations can be credited to the profit/loss where these reverse previous decrements. However in this case the gain is not included in the profit/loss but is an item of other comprehensive income. From Topic 2 you should understand that the statement of profit or loss and other comprehensive income (or statement of comprehensive income) has 2 sections: 1 relates to the profit and loss and the other section to other comprehensive income items

• Take care with this account title –you need to clearly indicate that this is an OCI item.

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Next, we need to recognise the tax associated with this item of other comprehensive income. AASB 101 para 90 requires disclosure of the amount of tax associated with each item of comprehensive income. In our example we credited other comprehensive income (via the gain (OCI)) by $12,000. To account for the tax effect of this adjustment we would need to process the following entry (in addition to the previous entries):

Debit Credit

Tax Expense (OCI) 3,600

Deferred Tax Liability 3,600

(to recognise tax effect of gain in OCI on revaluation)

Note: • The ‘expense’ here is NOT the same item as the tax expense included in the

profit/loss for the period. In this case the tax expense is related to an item of other comprehensive income and so would be presented against other comprehensive income items (and be disclosed separately either on the face, in the section of the statement of profit or loss and other comprehensive income relating to other comprehensive income items, or in the notes).

• Again, take care with this account title –you need to clearly indicate that this is an item of other comprehensive income (OCI).

Further, you should recall that in relation to revaluation increments AASB 116 para 39 normally requires that ‘the increase shall be recognised in other comprehensive income and accumulated in equity under the heading of revaluation surplus’.

The following entry accounts for this transfer of the gain in other comprehensive income to the revaluation surplus:

Debit Credit

Gain on Revaluation (OCI) 12,000

Tax Expense (OCI) 3,600

Revaluation Surplus 8,400

(to accumulate net OCI gain on revaluation to revaluation surplus)

Note: • Whilst this entry ‘eliminates’ effectively the tax expense recognised initially in

the previous entry this CANNOT be combined with the previous entry and ‘netted off’ (so that in effect there are no entries to this tax expense item). This is because AASB 101, para 90 requires disclosure of the tax associated with items of other comprehensive income.

• This entry is the equivalent to a ‘closing entry’. You should recall from your previous studies that income and expense items are temporary items. Where these are profit or loss items these are ‘closed off’ each period to the P&L Summary (and the net of this is subsequently transferred to retained earnings). This entry has a similar purpose. Items of other comprehensive income are also income and expense items (although not in the profit or loss) and are transferred to appropriate equity accounts (in this case, the revaluation surplus).

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• The revaluation surplus is an equity account and would be considered in the nature of a reserve.

• When the total comprehensive income is allocated to the statement of changes in equity this will be ‘distributed’ amongst the various equity components that it relates to (so for example, the profit/loss for the period is accumulated against retained earnings) and the proportion of any other comprehensive income that relates to the revaluation surplus will be shown as an adjustment to the existing balance of the revaluation surplus in the statement of changes in equity.

All of these entries would be required for each item being revalued upwards in that class (assuming no previous revaluations).

Activity Look at the Illustrative statement of profit or loss and other comprehensive Income in section 13.4.6 of the text. Note the following:

• how in the first part of Figure 13.10 one of the items under other comprehensive income is ‘gains on property revaluation’. This shows the total gain (OCI) on revaluation before any tax associated, with the tax included in the line item ‘Income tax relating to items not reclassified’.

• The second part of Figure 13.10 shows an alternative presentation; where items of other comprehensive income are show on the face net of tax. It is still required however that the tax associated with the items be disclosed in the notes.

• You will also notice in this example that items of other comprehensive income are grouped into 2 categories; those that will not be reclassified to the profit and loss and those that may be. This reflects changes made in September 2011 which requires grouping of other comprehensive income items on the basis of whether they are potentially reclassifiable to profit or loss subsequently. We do not consider reclassification adjustments in this course and further AASB 101, para 96 states that ‘reclassification adjustments do not arise on changes in revaluation surplus recognised in accordance with AASB 116’.

Look at Figure 13.13, the illustrative statement of changes in equity in section 13.5.1 of the text and note the line ‘Total comprehensive income for the year’. This ‘allocates’ the total comprehensive income across the components of equity (e.g. retained earnings is allocated the proportion of total profit attributable to owners of the parent). A portion of total comprehensive income is allocated to the revaluation surplus. Also note the column for non-controlling interests - recall we do not deal with group accounts in this course.

Explanation for Tax Effect entry The tax effect of the increase in the value of the asset also needs to be considered. You should recall from accounting for tax that the future taxable amount of an asset is assumed to be equal to the carrying amount (we expect to earn at least this amount in assessable income). If the carrying amount of an asset has increased then this indicates that we need to increase the future taxable amount. When we considered tax effect accounting in an earlier topic, where the carrying amount of an asset was greater than the tax base a deferred tax liability was recognised in the statement of financial position. A corresponding tax expense was recognised in the profit/loss with the following entry recorded:

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Debit Credit

Tax Expense x

Deferred Tax Liability x

(x being taxable temporary difference times tax rate)

When a deferred tax liability arises as a result of an asset revaluation however, it is sometimes necessary to adjust an item of other comprehensive income rather than the tax expense/income account in the profit/loss. AASB 112 requires that if the deferred tax liability relates to an amount that was not recognised in the profit/loss (e.g. recognised in other comprehensive income) then the deferred tax liability must also be adjusted in the same way (e.g. to other comprehensive income). This results in the amount of the change in the revaluation surplus at net of tax effect. Hence, for example, where a deferred tax liability is a result of an initial upward revaluation of an asset (i.e. resulting in a credit to the Gain on revaluation (OCI)) the entry would be as follows:

Debit Credit

Tax Expense (OCI) x

Deferred Tax Liability x

(x being taxable temporary difference times tax rate)

You should note that in the following discussion we will be looking at the tax entries that arise as a result of the revaluation of an asset. Other differences between the carrying amount and tax base of an asset may occur due to, for example, differences in depreciation rates used for accounting and tax purposes. The tax effect of such differences will be taken into account in the end of period tax worksheet. Returning to our example,

• The taxation authorities normally also allows us to deduct the cost of assets against any income/revenues received. For depreciable non-current assets held for use this is via depreciation deduction for tax. Assuming in this case that tax uses the same depreciation method as accounting, in the previous period this would have allowed us to deduct $20,000 as a deduction for depreciation for tax. In the future we will be allowed to deduct the remaining cost ($85,000) against any revenues we receive.

• So in our example (before the revaluation) the carrying amount of $85,000 would represent the amount of benefits we would be taxed on in the future and we would also be able to claim the remaining (un-depreciated) cost of $85,000 as a deduction, so in the future this asset (given the assumptions made) would not result in the net payment of tax or tax expense.

• However, following the revaluation: o The carrying amount has increased to $97,000 and so it is assumed

the benefits we will receive and be taxed on in the future have increased by $12,000 (ie. Future taxable amount has increased).

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o The amount that will be allowed as a deduction in the future will not change (as the cost has not changed) so we will still only be able to claim a deduction in the future of $85,000.

o This leads to an increase in tax to be paid in the future of $3,600 ($12,000 x the tax rate of 30%). We would normally (in accounting for tax at the end of the period) account for this, based on the ‘new’ carrying amount, by:

DR Tax Expense $3,600 CR Deferred Tax Liability $3,600

• AASB 112 Income Taxes however does not allow a tax expense in the profit/loss to be recognised where the deferred tax arises from amounts recognised in other comprehensive income. Hence the tax expense in the profit/loss is not adjusted but the standard requires the deferred tax to be adjusted against other comprehensive income (paras 58 and 61A in AASB 112). This means that if, on revaluation, we adjust via an item of other comprehensive income (such as gain on revaluation (OCI)) the adjustment for any tax would also be made to other comprehensive income.

• As a result of this the revaluation surplus will be increased (or decreased) by the amount of revaluation net of tax. You should see from example 1 above that the total revaluation upward was $12,000. After all entries are processed this is reflected in:

o An increase in the revaluation surplus of $8,400, and o An increase in the deferred tax liability of $3,600.

Activity Read paragraph 39 of AASB 116 and section 7.6.1 of the text and work through the examples 7.2 and 7.3.

Remember that the previous discussion considered the tax effect entries that arise as a result of the revaluation of an asset. Other differences between the carrying amount and tax base of an asset may occur due to, for example, differences in depreciation rates used for accounting and tax purposes and these will be taken into account in the end of period tax worksheet. The text discusses this worksheet in relation to example 7.4. You will not be required to account for revaluations in the tax effect worksheet in this course.

Revaluation Decrements Let’s now consider an example where the fair value of the asset is less that its carrying amount.

Example 2: Initial Revaluation downwards of a depreciable item A company purchased an item of property, plant and equipment (equipment) on 1 July 2006 for $105,000. It is estimated to have a useful life of 5 years and a residual value of $5,000. At 30 June 2007 the carrying amount of this item was $85,000 (cost of $105,000, with accumulated depreciation of $20,000). The carrying amount in the statement of financial position of the company is therefore:

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Equipment (at cost) 105,000 Less Accumulated Dep’n 20,000 Carrying amount 85,000

The company has chosen to revalue this class of assets (so no previous revaluations for this item) and at reporting date the fair value of the equipment is $77,000. If the value has fallen (i.e. the fair value is less than carrying amount) the same entry would be required in relation to accumulated depreciation as in our previous example.

The initial entry would be to transfer the accumulated depreciation:

Debit Credit

Accumulated Depreciation 20,000

Equipment 20,000

(transfer of accumulated depreciation to record asset account at carrying amount prior to revaluation)

The standard requires that any decrements be debited to profit and loss (as an expense). This treatment is subject to the exception that if it reverses a previous revaluation of that item, we first need to reverse out effect of that previous revaluation (to the extent of current revaluation). In this example we have assumed no previous revaluations so the entry would be:

Debit Credit

Loss on revaluation (P&L) 8,000

Equipment 8,000

(to revalue asset down by $8,000 to fair value; $85,000 carrying amount prior to revaluation – fair value of $77,000)

This would be done for all items being revalued downwards in that class (assuming no previous revaluations). Tax effect entries As the entries above do not involve recognition of any item of other comprehensive income no additional entries are required to account for the any deferred tax when we revalue the asset. The impact on tax will be accounted for in the end of period tax-effect worksheet. No further entries are required on revaluation.

Revaluations where there are previous revaluations Recall that AASB 116 (paragraphs 39 and 40) standard requires that: • revaluation increments be recognised in other comprehensive income and

accumulated in the revaluation surplus in equity except to the extent this reverses a previous revaluation decrease recognised as an expense for that asset

• decrements be debited to profit and loss except to the extent this reverses a previous revaluation increase recognised in other comprehensive income

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and accumulated in the revaluation surplus in equity (to the extent that a credit balance exists in the revaluation surplus for that asset)

The examples we have considered so far have assumed no previous revaluations. Now let us consider some examples where there is a reversal of a previous revaluation.

Example 3: Revaluation upwards where previous revaluation downwards A company purchased an item of property, plant and equipment (equipment) on 1 July 2006 for $105,000. It is estimated to have a useful life of 5 years and a residual value of $5,000. At 30 June 2007 when the carrying amount of this item was $85,000 (cost of $105,000, with accumulated depreciation of $20,000) this item was revalued to its fair value of $77,000. The carrying amount in the statement of financial position of the company in June 2008 is therefore:

Equipment (at revalued amount) 77,000 Less Accumulated Dep’n 18,000 Carrying amount 59,000

Its fair value at 30 June 2008 is $70,000. The only change will be in the treatment of the revaluation increment as the standard requires that where an increment reverses a previous decrement, that amount (to the extent of previous decrement to the profit and loss) be recognised in the profit and loss. The initial entry would be to transfer the accumulated depreciation:

Debit Credit

Accumulated Depreciation 18,000

Equipment 18, 000

(transfer of accumulated depreciation to record asset at carrying amount prior to revaluation)

You should recall that revaluation increases are normally recognised as other comprehensive income and accumulated in the revaluation surplus. However, AASB 116 para 39 states:

the increase shall be recognised in the profit or loss to the extent that it reverses a revaluation decrease of the same asset previously recognised in the profit or loss.

Taking this into account, we can now update the amount of the asset to its current fair value by the following entry:

Debit Credit

Equipment 11,000

Gain on Revaluation of Equipment (P&L) 8,000

Gain on Revaluation of Equipment (OCI) 3,000

(to revalue asset up $11,000 to fair value; $70,000 fair value - $59,000 carrying amount prior to current revaluation)

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In addition as we have recognised as other comprehensive income (via the credit to the gain (OCI)) would need to process the following tax effect entry:

Debit Credit

Tax Expense (OCI) 900

Deferred Tax Liability 900

(being the adjustment of $3,000 x the tax rate of 30%)

Note: This entry relates only to the tax effect of the previous adjustment (gain) to other comprehensive income. Any tax effect of the gain on revaluation to the profit/loss will be accounted for in the tax effect worksheet and so no separate entry is required on revaluation.

The following entry accounts for the transfer of the net gain in other comprehensive income to the revaluation surplus (and hence net increase in this surplus):

Debit Credit

Gain on Revaluation (OCI) 3,000

Tax Expense (OCI) 900

Revaluation Surplus 2,100

(to accumulate net OCI gain on revaluation to revaluation surplus)

How is the carrying amount at 30 June 2008 (prior to revaluation) calculated? To determine the carrying amount prior to any revaluation we need first to calculate the depreciation. Recall that if the asset has been previously revalued the accumulated depreciation up to the date of that revaluation would have already been eliminated. AASB 116 (para. 6) defines ‘depreciation’ as: The systematic allocation of the depreciable amount of an asset over its useful life, and ‘depreciable amount’ as: The cost of an asset, or other amount substituted for cost, less its residual value.

When this equipment was previously revalued we substituted the fair value ($77,000) for its original cost. Further we need to consider the useful life. From the date of the previous revaluation (i.e. 1 July 2007) this equipment had a useful life of 4 years (recall that its original useful life was 5 years but had already been used for 1 year (from 1 July 2006 to 30 June 2007). Hence depreciation for the year ended 30 June 2008 is: $77,000 (fair value substituted for cost) - $5,000 (residual value) 4 years (useful life remaining) = $18,000 So carrying amount is $77,000 - $18,000 = $59,000.

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Example 4: Revaluation downwards where previous revaluation upwards

A company purchased an item of property, plant and equipment (equipment) on 1 July 2006 for $105,000. It is estimated to have a useful life of 5 years and a residual value of $5,000. At 30 June 2007 when the carrying amount of this item was $85,000 (cost of $105,000, with accumulated depreciation of $20,000) this item was revalued to its fair value of $97,000. The carrying amount in the statement of financial position of the company in June 2008 is therefore:

Equipment (at revalued amount) 97,000 Less Accumulated Dep’n 23,000 Carrying amount 74,000

Its fair value at 30 June 2008 is $65,000. The only change will be in the treatment of the revaluation decrement as the standard requires that where a decrement reverses a previous increment, that amount (to the extent of any balance in the revaluation surplus for that asset) be adjusted via other comprehensive income (and would then reduce the amount accumulated in the revaluation surplus).

The initial entry would be to transfer the accumulated depreciation:

Debit Credit

Accumulated Depreciation 23,000

Equipment 23, 000

(transfer of accumulated depreciation to record asset at carrying amount prior to revaluation)

In this case, as the amount of the current decrease in the asset is less than the increase recognised previously, all of the current decrement will be recognised in other comprehensive income (and ultimately reduce the amounts in the revaluation surplus and deferred tax liability). We can now update the amount of the asset to its current fair value by the following entry:

Debit Credit

Loss on Revaluation of Equipment (OCI) 9,000

Equipment 9,000

(to revalue asset down by $9,000 to fair value; $65,000 fair value - $74,000 carrying amount prior to current revaluation)

In addition as we have recognised as other comprehensive income (via the debit to the loss on revaluation (OCI)) we would need to process the following tax entry:

Debit Credit

Deferred Tax Liability 2,700

Tax Expense (OCI) 2,700

(being the adjustment of $9,000 x the tax rate of 30%)

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Recall that AASB 116 para 40 states that where reversing a previous increment where there is a credit balance in the revaluation surplus:

The decrease recognised in other comprehensive income reduces the amount accumulated in equity under the heading of revaluation surplus

The following entry accounts for the transfer of the net loss in other comprehensive income to the revaluation surplus (and hence net decrease in this surplus):

Debit Credit

Revaluation Surplus 6,300

Tax Expense (OCI) 2,700

Loss on Revaluation (OCI) 9,000

(to accumulate net OCI loss on revaluation to revaluation surplus)

Note: After the entry the balance in the revaluation surplus would be $2,100. This asset was initially revalued upwards by $12,000. We have now revalued this downwards by $9,000. The $3,000 difference is reflected in the revaluation surplus of $2,100 and a deferred tax liability of $900.

How is the carrying amount at 30 June 2008 (prior to revaluation) calculated? When this equipment was previously revalued we substituted the fair value ($97,000) for its original cost. Further we need to consider the useful life. From the date of the previous revaluation (i.e. 1 July 2007) this equipment had a useful life of 4 years (recall that its original useful life was 5 years but had already been used for 1 year (from 1 July 2006 to 30 June 2007). Hence depreciation for the year ended 30 June 2008 is: $97,000 (fair value substituted for cost) - $5,000 (residual value) 4 years (useful life remaining) = $23,000 So carrying amount is $97,000 - $23,000 = $74,000.

Example 5: Revaluation downwards where previous revaluation upwards & downwards This continues from example 4. A company purchased an item of property, plant and equipment (equipment) on 1 July 2006 for $105,000. It is estimated to have a useful life of 5 years and a residual value of $5,000.

• At 30 June 2007 when the carrying amount of this item was $85,000 (cost of $105,000, with accumulated depreciation of $20,000) this item was revalued to its fair value of $97,000.

• At 30 June 2008 when the carrying amount of this item was $74,000 this item was revalued to its fair value of $65,000.

• The carrying amount in the statement of financial position of the company in June 2009 is therefore:

Equipment (at revalued amount) 65,000 Less Accumulated Dep’n 20,000 Carrying amount 45,000

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• Its fair value at 30 June 2009 is $40,000. Recall that the standard requires that where a decrement reverses a previous increment, that amount (to the extent of previous increment) be recognised in other comprehensive income (and adjusted in the revaluation surplus). This equipment was originally revalued upwards by $12,000 at 30 June 2007. However at 30 June 2008 $9,000 of this was reversed when we revalued the equipment downwards. Thus the current revaluation decrement of $5,000 will be accounted for as follows:

• $3,000 will be recognised in other comprehensive income and reverse out the previous balances remaining in the revaluation surplus and deferred tax liability)

• $2,000 as an expense in the profit/loss The initial entry would be to transfer the accumulated depreciation:

Debit Credit

Accumulated Depreciation 20,000

Equipment 20,000

(transfer of accumulated depreciation to record asset at carrying amount prior to revaluation)

We can now update the amount of the asset to its current fair value as follows:

Debit Credit

Loss on revaluation of equipment (OCI) 3,000

Loss on revaluation of equipment (P&L) 2,000

Equipment 5,000

(to revalue asset down by $5,000 to fair value; $40,000 fair value - $45,000 carrying amount prior to current revaluation)

In addition as we have recognised other comprehensive income (via the debit to Loss on revaluation of equipment (OCI)) we would need to process the following tax entry:

Debit Credit

Deferred Tax Liability 900

Tax expense (OCI) 900

(being the adjustment of $3,000 x the tax rate of 30%)

We also need to reduce the amount in the revaluation surplus. The following entry accounts for the transfer of the net loss in other comprehensive income to the revaluation surplus (and hence net decrease in this surplus):

Debit Credit

Revaluation Surplus 2,100

Tax Expense (OCI) 900

Loss on Revaluation (OCI) 3,000

(to adjust net OCI loss on revaluation to reduce revaluation surplus)

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Note: After the entry the balance in the revaluation surplus in relation to this asset has been completely eliminated (so zero). Further the balance in the deferred tax liability in relation to revaluations of this asset was eliminated in the previous entry.

How is the carrying amount at 30 June 2009 (prior to revaluation) calculated? When this equipment was previously revalued we substituted the fair value ($65,000) for the previous fair value. Further we need to consider the useful life. From the date of the previous revaluation (i.e. 1 July 2008) this equipment had a useful life of 3 years (recall that its original useful life was 5 years but had already been used for 2 years (from 1 July 2006 to 30 June 2008). Hence depreciation for the year ended 30 June 2009 is: $65,000 (fair value substituted for cost) - $5,000 (residual value) 3 years (useful life remaining) = $20,000 So carrying amount is $65,000 - $20,000 = $45,000.

Activity Read paragraph 40 of AASB 116 and section 7.6.2 of the text and work through examples 7.5, 7.6 and 7.7 of the text. Also read section 7.6.5 of the text

Recognition of revaluations of items of property, plant & equipment in the statement of profit or loss and other comprehensive income

You should see from our discussion and examples that all revaluations of these items are recognised in the statement of profit or loss and other comprehensive income. As noted previously this is consistent with the concept of income/expense being all changes in equity from non-owner sources. However the placement of items resulting from revaluations will differ. Revaluation decrements will be either:

• Included as an expense in the profit/loss (if does not reverse previous increment), or

• Included as other comprehensive income item (as a loss) if reverses previous increment, and will reduce the balance of the revaluation surplus accumulated in equity.

Revaluation increments will be either: • Included as other comprehensive income item and accumulated in (added

to) the revaluation surplus in equity, if does not reverse a previous decrement, or

• Included as other income (not revenue) in the profit/loss, if reverses a previous decrement to the profit/loss.

Subsequent effect of revaluations

Where an asset has been revalued this amount (the revalued amount) is used as the basis for determining:

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• future depreciation expense as AASB 116 (para. 6) defines depreciable amount as ‘ cost of an asset, or other amount substituted for cost, less its residual value’

• profit/loss on disposal of the asset (AASB 5). The effect of these 2 consequences of revaluation means that where an asset is revalued upwards future profits will be reduced (due to the increased depreciation expense, and due to the increased carrying amount on disposal).

Revaluation of all Assets in class In the examples we have considered a single asset. Remember that the standard requires that all assets in that class be revalued if the revaluation model has been chosen for that class.

Activity Read section 7.6.3 of the text which discusses this, and also section 7.7 which considers possible motivations for choosing between cost and revaluation models.

Use of the Revaluation surplus

The revaluation surplus is part of equity. Whilst there are no mandatory requirements relating to the transfer of this surplus, AASB 116 (para. 41) provides some restrictions and guidance.

Activity Read paragraph 41 of AASB 116 and section 7.6.4 of the text that discusses the use of the revaluation surplus/reserve.

IMPAIRMENT We noted previously that under either the cost or revaluation models the carrying amount of items of property, plant and equipment need to be adjusted for any impairment loss. Recall:

• The cost model requires measurement of an item of property, plant and equipment at cost less any accumulated depreciation less any impairment losses (para 30).

• The revaluation model requires measurement of an item of property, plant and equipment at fair value less any accumulated depreciation less any impairment losses (para. 31).

The requirements for determining impairment losses are found in AASB 136 Impairment of Assets. Changes to AASB 136 Impairment of Assets AASB 136 was updated in 2013 (and this updated version is in the 2014 Handbook) due to the application of AASB 13 Fair Value Measurement which applies to reporting periods beginning on or after 1 January 2013. As noted previously, AASB 13 defines fair value and outlines the techniques (a framework) to be applied in determining fair value and specifies required disclosures. If an item is measured using fair value then (with some exceptions, such as for leased assets) AASB 13 is applied. You will consider AASB 13 in detail in a later course.

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The new version of AASB 136:

• Includes the definition of ‘fair value’ as in AASB 13. Although in substance this is similar to the previous definition, the definition as per AASB 13 will be used in this course.

• Refers to ‘fair value less costs of disposal’. The previous version referred to ‘fair value less costs to sell’. These are in substance the same and for the purpose of this course these terms have the same meaning.

Take care as previous versions of the Handbook and the discussion in the current edition of the company accounting text, do not refer to the current version of AASB 136. This standard applies to a range of assets, not just to property, plant and equipment. The aim of this standard is to ensure that the amounts of assets reported in the statement of financial position are not overstated.

Activity Read sections 11.1 & 11.1.1 of the text.

Testing for Impairment An asset is considered impaired if its carrying amount is greater than its recoverable amount. The standard requires the following: 1. that at each reporting date the entity determine whether an impairment test is

required to be undertaken o For most assets an impairment test is only required IF there is any

indication that a particular asset may be impaired • The standard provides guidance as to how to identify when an asset

may be impaired, including information that must be considered in making this assessment.

o Some assets must be tested for impairment (for example, goodwill and some intangibles).

Activity Read sections 11.2 & 11.2.1 of the text and paragraphs 7 to 17 of AASB 136.

2. If an impairment test is required to be undertaken then we need to:

(a) Estimate the recoverable amount of the asset The ‘recoverable amount’ is the higher of it’s:

o fair value less costs of disposal, and o value in use – which is the present value of the future cash flows

expected to be generated from the asset (or cash-generating unit) (b) Compare the carrying amount with the recoverable amount If the carrying amount is higher than the recoverable amount there is an impairment loss.

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If the carrying amount is lower than the recoverable amount there is no impairment loss and no adjustment is required to the carrying amount of the asset in relation to impairment.

3. Any impairment loss must be recognised as:

• an expense in the profit and loss, if relates to assets not measured at revalued amount,

• a revaluation decrement, for revalued assets.

Activity Read sections 11.3 to 11.3.2 of the text and paragraphs 6, 18 to 23, 25 to 32 and 58 to 63 of AASB 136. Note:

• Ensure that you understand the definitions of ‘value in use’, ‘fair value’, ’costs of disposal’ and ‘recoverable amount’.

• The text and standard discusses issues in relation to determining /calculating the value in use and/or fair value less costs of disposal. In practice there can be difficulties in estimating these amounts. However in this course you will not need to estimate these as these amounts will be provided to you where appropriate.

• That if an impairment loss is recognised this will impact on subsequent depreciation (refer paragraph 64).

Impairment of a single asset Let’s look at a simple example of an item of property, plant and equipment.

Example 6: Impairment of individual asset measured using cost model A company purchased an item of property, plant and equipment (equipment) on 1 July 2006 for $105,000 that it uses in operations. It is estimated to have a useful life of 5 years and a residual value of $5,000. This item is measured at cost. At 30 June 2007 the carrying amount of this item was $85,000 (cost of $105,000 less accumulated depreciation of $20,000).

There is evidence of potential impairment. The value in use (discounted) at 30 June 2007 has been estimated at $75,000. The fair value less costs of disposal has been estimated at $72,000. Hence the recoverable amount at 30 June 2007 is $75,000 (the higher of these).

The following entry would be processed:

Debit Credit

Impairment Loss (expense) 10,000 Accumulated Depreciation & Impairment Losses 10,000

(being the adjustment to recoverable amount) Note: • As disclosures in AASB 116 (para. 73 (d)) require accumulated depreciation and

impairment losses to be aggregated these are normally accounted for in one account.

• Future depreciation is based on the new carrying amount.

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Example 7: Impairment of individual asset measured using revaluation model A company purchased an item of property, plant and equipment (equipment) on 1 July 2006 for $105,000. It is estimated to have a useful life of 5 years and a residual value of $5,000. At 30 June 2007 when the carrying amount of this item was $85,000 (cost of $105,000 less accumulated depreciation of $20,000) this item was revalued to its fair value of $97,000. The carrying amount in the statement of financial position of the company at 30 June 2008 is therefore:

Equipment (at revalued amount) 97,000 Less Accumulated Dep’n 23,000 Carrying amount 74,000

In June 2008 there is indication of possible impairment and its recoverable amount is estimated to be $60,000. Hence we have an impairment loss of $14,000 that needs to be accounted for in accordance with revaluation decrements. This would require us to:

• Reverse any accumulated depreciation • Restate the asset’s carrying amount to recoverable amount • Recognise the decrement in profit and loss (except to extent reverses previous

revaluation increment; ie any credit balance in revaluation surplus for this asset)

The initial entry would be to transfer the accumulated depreciation:

Debit Credit

Accumulated Depreciation 23,000

Equipment 23000

(transfer of accumulated depreciation to record asset account at carrying amount prior to revaluation/recognition of impairment loss)

The following entries would be processed to recognise loss and update asset’s carrying amount:

Debit Credit Loss on Revaluation (P&L) 2,000 Loss on Revaluation (OCI) 12,000 Equipment 14,000

(being revaluation downwards required to adjust to recoverable amount)

In addition as we have recognised other comprehensive income (via the debit to the loss on revaluation (OCI)) we would need to process the following tax entry:

Debit Credit

Deferred Tax Liability 3,600

Tax Expense (OCI) 3,600

(being the adjustment of $12,000 x the tax rate of 30%)

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Recall that AASB 116 para 40 states that where reversing a previous increment where there is a credit balance in the revaluation surplus:

The decrease recognised in other comprehensive income reduces the amount accumulated in equity under the heading of revaluation surplus

The following entry accounts for the transfer of the net loss in other comprehensive income to the revaluation surplus (and hence net decrease in this surplus):

Debit Credit

Revaluation Surplus 8,400

Tax Expense (OCI) 3,600

Loss on Revaluation (OCI) 12,000

(to adjust net OCI loss on revaluation against revaluation surplus)

Note: After the entry the balance in the revaluation surplus in relation to this asset has been completely eliminated (so zero). Further the balance in the deferred tax liability in relation to revaluations of this asset was eliminated in the previous entry.

Activity Read section 11.3.3 of the text. PLEASE Note:

• There is an error in some prints of the text. In section 11.3.3 the journal entries do not take the adjustments reversing the previous revaluation increment to other comprehensive income but directly to the revaluation surplus. (It appears that they ‘forgot’ to update this chapter when chapter 7 was updated). You need to prepare the journal entries as outlined in chapter 7 (and in the first part of this topic in this study guide) to account for revaluation decrements.

• You need to use the same account titles as you would for revaluations if there is an impairment loss associated with assets measured using the fair value basis. DO not use titles such as ‘Impairment loss” – this is not an account used in revaluations and the standard requires impairment losses associated with such assets to be accounted for as a revaluation decrement.

Cash-generating units So far we have considered examples where the cash flows to be generated from the individual assets could be determined. However, many assets do not (of themselves) generate direct cash flows; for example assets such as a corporate office, or photocopiers often do not produce cash flows directly but rather contribute to cash flows of the entity in combination with other assets. This will often be the case for many items of property, plant and equipment. In such cases we will not be able to determine a ‘value in use’ for the item as we cannot identify cash flows from the item on its own, and so we will need to consider the ‘cash-generating unit’ that the item belongs to. A cash-generating unit is defined (para. 6) as:

The smallest identifiable group of assets that generate cash inflows that are largely independent of the cash flows from other assets or groups of assets.

The treatment of any impairment loss in relation to such units is affected by whether there is any goodwill allocated to the cash-generating unit. We will first consider the situation where there is no goodwill.

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Activity Read paragraphs 66 to 76, 104 to 107 of AASB 136 and sections 11.4 to 11.4.2 of the text and work through example 11.1. Please note the following: • To determine if there is any impairment loss we compare the recoverable amount of

the entire unit to the total of the carrying amounts of the assets in the unit. It is only if the carrying amount of the unit exceeds the recoverable amount of the unit that any adjustment to individual assets needs to be considered.

• The adjustments to individual assets (except goodwill) are pro-rata on the basis of carrying amounts (subject to limits below)

• The same basis is used for accounting for impairment losses as for individual assets (so for example, if relates to revalued assets any impairment loss is accounted as a revaluation decrement)

• There are limits set as to how far the carrying amount of any particular asset can be reduced. This is the higher of:

o Fair value less costs of disposal (if measurable) o Its value in use (if determinable); and o Zero.

This may result in the need to ‘reallocate’ some of any impairment loss.

Allocation to assets in cash generating unit: inventory

AASB 136 (para. 104) requires that any impairment loss for a cash generating unit be allocated first to goodwill and then to the other assets of the unit on the basis of their carrying amounts. You should note that inventory will often be one of the assets found in a cash generating unit. However you should recall that AASB 102 (para. 9) requires that inventory is to be measured at the lower of cost or net realisable value. ‘Net realisable value’ is the estimated selling price less costs to complete and costs to sell. We can consider this the equivalent to fair value less costs of disposal. This means that when accounting for an impairment loss associated with a cash generating unit that contains inventory, none of the impairment loss will be allocated to inventory. The current carrying amount of inventory included in any cash generating unit will already meet the limits set in AASB 136 (para 105) in relation to adjusting the carrying amounts of assets therefore no further reduction in the carrying amount of any inventory is possible. The carrying amount of inventory will not be adjusted and so the measurement of inventory will remain at the lower of cost and net realisable value as required by AASB 102 (para. 9). This treatment is also consistent with paragraph 2 of AASB 136 which states that this standard does not apply to inventories. In summary, although the carrying amount of inventory will be included in determining the carrying amount of the cash generating unit, and hence in deciding whether or not the unit has an impairment loss, no portion of any impairment loss will be allocated to inventory. Let’s now look at an example of an impairment loss for a cash generating unit.

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Example 8: Impairment of cash generating unit without goodwill The following 4 assets comprise a cash-generating unit (CGU).

Carrying amount

Machine 40,000

Vehicles 60,000

Land 100,000

Inventory 20,000 The following information is provided:

• The fair value less costs of disposal of the CGU is estimated at $190,000. • The value in use of the CGU is estimated at $210,000.

Given this the recoverable amount is $210,000 (the higher of fair value less costs of disposal and value in use). As the carrying amount of the CGU is $220,000 this means that the unit has incurred an impairment loss of $10,000. (Part a). All assets are measured using the cost model. We need to apportion any impairment loss on the basis of the carrying amounts (subject to limits). The table following shows this allocation. No allocation is made to inventory (see previous explanation).

Carrying amount

Proportion Allocation of impairment loss

Net carrying amount

Machine 40,000 40/200 2,000 38,000

Vehicles 60,000 60/200 3,000 57,000

Land 100,000 100/200 5,000 95,000

200,000 10,000

The journal entry to allocate the loss would be: Debit Credit Impairment Loss (P&L) 10,000 Accumulated Depreciation and Impairment Losses

(Machine) 2,000

Accumulated Depreciation and Impairment Losses (Vehicles)

3,000

Land 5,000 (to recognise impairment loss and adjust carrying amounts of cash generating unit)

(Part b) Let’s change our assumptions and assume that the land could be sold, less costs of disposal, for $98,000. All assets are still measured using the cost model.

If we allocated as in the table above the carrying amount of land would be less than its fair value less costs of disposal. Hence we can only allocate $2,000 of the impairment loss to land. The remaining $3,000 that would have been allocated to

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land needs to be apportioned to other assets on the basis of their (new) carrying amounts.

The allocation of this $3,000 is shown in the table following:

Carrying amount after initial allocation

Proportion Allocation of impairment loss

Net carrying amount

Machine 38,000 38/95 1,200 36,800

Vehicles 57,000 57/95 1,800 55,200

Land

95,000 3,000

The journal entry would be:

Impairment Loss (P&L) 10,000 Accumulated Depreciation and Impairment Losses

(Machine) 3,200

Accumulated Depreciation and Impairment Losses (Vehicles)

4,800

Land 2,000 (to recognise impairment loss and adjust carrying amounts of cash generating unit)

(Part c) Let’s change our assumptions again. Assume that land is measured using the revaluation model. It was last revalued upwards by $9,000. This resulted in a net credit (after tax) of $6,300 to the revaluation surplus (recall this would have been recognised as other comprehensive income and accumulated in the revaluation surplus in equity). The fair value of the land less costs of disposal is $90,000.

In this case the allocation of the impairment loss would be as previously calculated in part (a) however the impairment loss in relation to the land would need to be treated as a revaluation decrement. The resulting journal entries would be: Impairment Loss (P&L) 5,000 Loss on revaluation of land (OCI) 5,000 Accumulated Depreciation and Impairment Losses

(Machine) 2,000

Accumulated Depreciation and Impairment Losses (Vehicles)

3,000

Land 5,000 (to recognise impairment loss and adjust carrying amounts of cash generating unit)

Further we would need to do additional entries in relation to the revaluation decrement for land to:

• recognise associated tax effect in other comprehensive income • reduce the balance of the revaluation surplus

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Debit Credit

Deferred Tax Liability 1,500

Tax Expense (OCI) 1,500

(being the adjustment of $5,000 x the tax rate of 30%)

Debit Credit

Revaluation Surplus 3,500

Tax Expense (OCI) 1,500

Loss on Revaluation (OCI) 5,000

(to adjust net OCI loss on revaluation against revaluation surplus)

Note: In this example:

• Impairment loss relating to land is treated as a reversal of previous revaluation increment

• If the asset measured using the revaluation model had accumulated depreciation this would also need to be reversed prior to accounting for this impairment loss.

Impairment and goodwill You should recall from your previous studies that on acquisition of a business combination purchased goodwill may be recognised. You note that goodwill is not amortised (depreciated) but is subject to impairment testing. AASB 136 requires that most assets be tested for impairment if there is an indication of impairment. However, goodwill is required to be tested annually, regardless of whether any indication of impairment is apparent (para. 10). In testing for impairment we need to consider which of the entity’s cash generating units any goodwill can be linked, and allocated, to. The standard (para. 80) sets lower and upper limits to allocation of goodwill:

• The smallest unit it can be allocated to is the unit used by the internal management of the entity,

• The largest unit it can be allocated to is a reporting segment (we will not consider segment reporting in detail in this course). AASB 8 Operating Segments requires additional disclosure in the notes about the components of the entity. These disclosures ‘split’ the entity into different areas/businesses /activities which have different risk/return and growth profiles. It is argued that simply providing details of the overall results etc would not enable any evaluation of past performance nor enable adequate analysis of future profitability and or degrees of risk and growth profiles.

If an impairment loss is identified then this is first adjusted against any goodwill allocated to the cash generating unit (para 104). If any impairment loss remains after reducing goodwill to zero then this would be allocated across individual assets in the unit (as previously considered). The example following illustrates this.

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Example 9: Impairment of cash generating unit with goodwill The following 4 assets comprise a cash-generating unit. It was determined that the unit had incurred an impairment loss of $10,000. Assume that all assets are measured using the cost model.

Carrying amount

Goodwill 6,000

Machine 40,000

Vehicles 60,000

Land 100,000

We would first need to allocate the impairment loss to the goodwill. This would reduce the goodwill to zero (as the impairment loss of $10,000 is greater than the total amount of goodwill allocated to this unit). The remaining amount of the impairment loss (i.e. $4,000) would be allocated to the remaining assets on basis of carrying amounts (subject to the limits for allocation to individual assets).

The table following shows this allocation.

Carrying amount

Proportion Allocation of remaining impairment loss

Net carrying amount

Machine 40,000 40/200 800 39,200

Vehicles 60,000 60/200 1,200 58,800

Land 100,000 100/200 2,000 98,000

200,000 4,000

Assuming that the carrying amounts of the assets after this allocation are above the limits specified in AASB 136 (para 105), the journal entries to allocate the impairment loss would be:

Impairment Loss (P&L) 6,000 Goodwill** 6,000

(to recognise impairment loss allocated to goodwill & eliminate goodwill)

**Alternatively this can be credited to ‘Accumulated impairment losses: Goodwill’

Impairment Loss (P&L) 4,000 Accumulated Depreciation and Impairment Losses

(Machine) 800

Accumulated Depreciation and Impairment Losses (Vehicles)

1,200

Land 2,000 (to recognise impairment loss and adjust carrying amounts of other asset in cash generating unit)

Note: These 2 entries could be combined.

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Activity Read sections 11.5 and 11.5.1 of the text Note:

• The carrying amount of the unit includes the carrying amount of goodwill allocated • That goodwill must be tested annually (but that this does not necessarily mean at

the end of the reporting period). • Also take care with the journal entry – as goodwill is not depreciated/amortised

you cannot use an accumulated depreciation account to record impairment of goodwill.

Reversals of Impairment Losses What happens if an impairment loss has been recognised and in the future the recoverable amount increases? Can we reverse the previous impairment loss? The standard allows reversal (after consideration of evidence etc) except for goodwill. In this course you will not need to prepare entries to account for the reversal of impairment losses but need to be aware of the general requirements, including rationale for not allowing impairment losses for goodwill to be reversed.

Activity Read paragraphs 110, 114 of AASB 136 and sections 11.6 to 11.6.3 of the text. You can also now work though Demonstration problems 1 & 2 in Chapter 11 and Demonstration problem 2 in Chapter 7 of the text.

Summary of Measurement of Property, Plant and Equipment as per AASB 116 The diagram following summarises the difference between fair value & cost models for items of property, plant and equipment (as per AASB 116).

Comparison of Revaluation and Cost Model

Individual items of PPE acquired recorded at cost

Make election on valuation basis for each CLASS of assets FAIR VALUE OR COST

Revaluation Model Adopted • Revalue regularly • Revalue all assets in the class • Increment/decrement

accounted for each asset individually

• Impairment losses treated as per revaluation decrements

Cost Model Adopted • All assets in class at cost basis • Impairment losses taken to profit

and loss as expense

Assets ‘sorted’ by Class

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Disposal and Derecognition We have already noted that AASB 116 applies to items of property, plant & equipment held for use for more than one period. However, if such an item is sold (or no longer used and has no sale value) AASB 116 (para 68) requires that the net gain or loss be included in the profit or loss for the period. AASB 101 (para 34) also requires that such gains (or losses) be included in the profit or loss for the period.

Activity Read paragraphs 67 to 72 of AASB 116 and section 7.8 of the text and note the following:

• You are expected to be able to account for the disposal of such items.

• The text entries show the alternative entries that are allowed (refer to topic 2). However, the gain (or loss), not the separate sales proceeds and expenses, from the sale are required to be included in the profit/loss. Further the gain or loss on a sale of a non-current asset (such as an item of property, plant & equipment) would often require separate disclosure (AASB 101, para 97) as a material item.

• Any gain on sale is not considered revenue, but is other income. • You are not expected to apply the requirements of AASB 5 Non-current Assets

Held for Sale and Discontinued Operations in this course.

Other assets In this topic we have primarily concerned ourselves with accounting for property, plant and equipment held for use. As noted previously there are a number of other standards that details the requirements for specific assets. In this course we will not be able to consider these other standards in detail.

DISCLOSURES AND PRESENTATION We have already introduced some of the disclosures required. These include the general requirements relating to the disclosure of assets in the statement of financial position, such as: • categorised as current or non-current (AASB 101, para 66) • certain classes must be shown on the face of the statement of financial position

(AASB 101, para. 54) Given the impact that property, plant and equipment can have on a company’s statement of financial position (and performance) specific disclosures are required in relation to these items. In addition, we noted requirements in disclosures about other comprehensive income items in the statement of profit or loss and other comprehensive income and changes in reserves (including the revaluation surplus) in relation to the statement of changes in equity. AASB 116 also has specific disclosure requirements in relation to property, plant and equipment.

Activity Read section 7.9 of the text and paragraphs 73 to 79 of AASB 116. As noted previously recall that some disclosures relating to fair value are now required under AASB 13 and have been removed from the current version of AASB 116. In this course we will not consider specific disclosure requirements in relation to AASB 136.

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TOPIC 8: TOPIC REVIEW QUESTIONS This topic should be studied over 2 weeks. You should attempt questions 1 to 4 in the first week, and the remainder in the next week. Question Topic 1. Applying the definition of property, plant and equipment

in AASB 116 which of the following would be considered items of property, plant & equipment:

i. Machine being used in production process ii. The machine (in (i) above) is a unique design

constructed by the company. The company now holds the patent for this machine.

iii. Machine previously used in production process and awaiting disposal

iv. A photocopier that has been purchased and is being held for sale (the company is a wholesaler of office equipment)

v. Building leased by the company as corporate headquarters

vi. Land and building (factory) being currently used by the company. The company plans to relocate to the factory in 3 years time and at expects to realise a substantial capital gain on sale

vii. Land purchased 2 years ago. The company does not currently use this land but has leased it and expects to sell this in the future. The timing of sale will depend on market conditions.

viii. Land and grape wines owned by a company that produces wine.

Nature of property, plant & equipment

2. Practice Question 7.1, Leo et al, 2012, Chapter 7. (Hint: Take care with calculating depreciation as only for ½ year)

Measurement & revaluation of assets

3. Practice Question 7.2, Leo et al, 2012 Chapter 7 (Hint: Remember any amount already in the revaluation surplus will be net: i.e. after adjustment for tax)

Measurement & revaluation of assets

4. Practice Question 7.9, Leo et al, 2012 Chapter 7 except assume that all of the bonus share issue is made from the general reserve.

Measurement & revaluation of assets

5. (a) Do we need to test all assets for impairment? How it is determined if there is an impairment loss? Outline the requirements for accounting for an impairment loss? Why do we need an impairment test? (b) Case Study 11 Chapter 11, Leo et al 2012

Impairment

6. The following values relate to an item of machinery at 30 June 2014 for which there is an indication of impairment: Cost is $70,000

Measurement of assets

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Accumulated Depreciation to date if measured using the cost model $30,000

Fair Value at 30 June 2014 is $35,000 Costs of disposal $500 Value in use (at Present value) is $45,000. Required: (i) State the value(s) at which the machinery would be recorded in the accounting records if the company: (a) has adopted fair value model for machinery (b) uses cost model for machinery (ii) Would your answers to (i) above be different if the value in use was $37,000? (iii) Case Study 1, Leo et al, 2012, Chapter 7.

7. Case Study 4 & Case Study 7, Leo et al, 2012, Chapter 11.

Cash-generating units

8. (a) Practice Question 11.1, Leo et al, 2012, Chapter 11 Assume that all assets are measured using the cost model. (b) Assume that the fair value less costs of disposal of the land was $140,000. How would your answers to (a) be different given the following information about the equipment? The carrying amount of the equipment was $120,000 (this was after deduction of $20,000 accumulated depreciation). The equipment had previously been revalued upwards by $10,000, resulting in a net increase (after accounting for tax effect) of $7,000 to a revaluation surplus. The tax rate is 30%.

Impairment

9. Practice Question 11.2, Leo et al, 2012, Chapter 11 Assume that since acquisition the cost model is used to measure assets.

Measurement/ Impairment

10. Practice Question 11.6, Leo et al, 2012, Chapter 11. Assume all assets are measured using cost model.

Impairment

11. Using the information in Practice Question 11.4, Leo et al 2012, Chapter 11, prepare the journal entries for Broome Ltd at 30 June 2013 only. (Assume that the value in use is higher than the fair value less costs of disposal of the unit)

Impairment