AssetsSession 6

Course : F0812 – Accounting TheoryYear : February 2011

GODFREYHODGSON

HOLMESTARCA

CHAPTER 7 ASSETS

Assets defined

• IASB (AASB) Framework for the Preparation and Presentation of Financial Statements:

– an asset is a resource controlled by the entity as a result of past events and from which future economic benefits are expected to flow to the entity

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Assets defined

Three essential characteristics:– future economic benefits

– control by an entity

– past events

• exchangeability

• recognition rules

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Future economic benefits

• Future economic benefits are the potential to contribute, either directly or indirectly, to the flow of cash and cash equivalents to the entity– profit seeking entity– not-for-profit entity

• Relate to economic resources– scarcity– utility

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Future economic benefits

• An asset is something that exists now• Has the capability of rendering service or

benefit currently or in the future• Distinguish between the object, such as a

building or machine, and the service or benefit embodied in it

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Control by an entity

• The economic benefit must be controlled by the entity

• An entity’s right to use or control an asset is never absolute

• Ownership is often concurrent with control, but it is not an essential characteristic of an asset

• Does not rely on legal enforceability

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Past events

• Control as a result of a past event• Planned assets are excluded• Event can be interpreted in different ways– executory contracts

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Exchangeability

• Some argue that a 4th essential characteristic is that an asset be exchangeable

• Separable from an entity

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Exchangeability

• MacNeal

A good that lacks exchangeability must lack economic value because its purchase or sale must forever remain impossible, and thus no market price for it can ever exist

– goodwill• subject to evaluation not measurement

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Asset recognition

• The extent and timing of the recognition of assets is important because it can have economic consequences for preparers and users of financial statements

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Asset recognition

• Recognising assets on the balance sheet involves recognition rules– conventions and authoritative pronouncements

• Recognition criteria– the future economic benefits must be probable– the asset must be capable of being measured

reliably

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Asset recognition

• Past recognition criteria– reliance on the law– determination of economic substance of the

transaction or event– use of the conservatism principle: anticipate

losses, but not gains

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Asset measurement

• All the elements of accounting are linked and measurement of profit flows from measurement of the change in net assets

• The rules and practices governing asset recognition and measurement will also affect measurement of profit and, in turn, capital (equity)

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Asset measurement

• Once the definition and recognition criteria have been met, the accountant must decide how to measure the asset– several measurement approaches available– qualitative characteristics of financial information

• Once measured – on balance sheet– restricted to just note disclosure

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Tangible assets

• Traditional approach has been to measure assets at historical cost

• IASB standards permit subsequent remeasurement using a number of approaches– fair value• exit value or value in use

• UK and Australian firms could use values other than historical cost for many years

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Intangible assets

• Accounting measurement has generally been conservative– cost (less accumulated amortisation and

impairment) is commonly used– fair values from an active market– internally generated intangibles cannot be

recognised

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What are the divergent arguments for recognising customer relationships in a business combination? Is

it a true intangible asset?

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Financial instruments

• FASB/IASB– derivatives are measured at fair value rather than

cost

• IASB – committed to the use of fair value measurement

for financial instruments

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What are the objectives of the fair value measurement project?

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Challenges for standard setters

• FASB/IASB intend to address the issue of measurement in Phase C of the conceptual framework project– consider measurement concepts, principles and

terms– evaluate and rank measurement methods• qualitative characteristics

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Which measurement model?

• Fair value is the frontrunner• Both the IASB and FASB support greater use of

fair value measurement

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What are the arguments for and against fair value measurement?

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How to calculate fair value measurement• Various valuation techniques to calculate fair

value– the market approach • observable prices • actual transaction data

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How to calculate fair value measurement• Various valuation techniques to calculate fair

value– the income approach• conversion of future amounts - cash flows or earnings

– to a single discounted present amount

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How to calculate fair value measurement• Various valuation techniques to calculate fair

value– the cost approach• the amount that currently would be required to replace

its service capacity (current replacement cost)

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In response to the credit crisis the IASB changed the rules to allow entities to choose to reclassify some financial instruments from a fair value

measurement basis to a cost basis. Under what circumstances is this reclassification allowed?

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How to calculate fair value measurement• The valuation must emphasise market inputs– assumptions and data that market participants

would use in their estimates of fair value

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How to calculate fair value measurement• Three hierarchical levels for the inputs– Level 1 – quoted prices for identical items in active

markets, without adjustment – Level 2 – quoted prices for similar items in active

markets, adjusted as appropriate for differences– Level 3 – estimated fair value using multiple

valuation techniques consistent with the market, income and cost approaches

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Issues for auditors

• Auditing fair values creates difficulties because it requires the application of valuation models, and, frequently, the use of valuation experts

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Issues for auditors

• Auditors need to– understand the client firm’s processes and

relevant controls for determining fair values– make a judgement on whether the client firm’s

measurement methods and assumptions are appropriate and likely to provide a reasonable basis for the fair value measurement

– appreciate management’s potential biases and likely errors• incentives

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Issues for auditors

• There is the potential that corporate failures will lead to legal action against auditors who failed to approach their audit of asset fair values appropriately

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Summary

• Defining assets• Recognition and measurement criteria• Asset recognition and the measurement of income and capital

are interrelated• Mixed attribute measurement model and fair value

measurement methods• Issues arising for standard setters and auditors

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Key terms and concepts

• Assets• Definitions• Future economic benefits• Control• Past events• Exchangeability• Asset recognition• Asset measurement• Fair value measurement

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