Deegan Afa 7e Sm Ch04

PART 3: ACCOUNTING FOR ASSETS

Chapter 4

An overview of accounting for assets

Review questions

4.1 The Conceptual Framework defines an asset as ‘a resource controlled by the entity as a result of past events and from which future economic benefits are expected to flow to the entity’.

In considering the above definition, there are three fundamental characteristics that should be present. These are:

the asset should be expected to provide future economic benefits;

the asset must be controlled (as contrasted to legal ownership); and

the event giving rise to the control must already have occurred.

In terms of recognition criteria, the Conceptual Framework provides the general recognition criteria for all elements of financial statements (assets, liabilities, income, expenses, equity). The criteria are:

An item that meets the definition of an element should be recognised if:

(a) it is probable that any future economic benefit associated with the item will flow to or from the entity; and

(b) the item has a cost or value that can be measured with reliability.

The recognition criteria enable the application of the definition of assets (and the other elements of financial statements). Note that the benefits must be ‘probable’ and capable of reliable measurement. It should be emphasised, however, that the recognition criteria rely upon a great deal of professional judgment. For example, while ‘probable’ is not defined in the IASB/AASB Conceptual Framework it is generally considered that the term ‘probable’ means that the chance of the future economic benefits arising is more likely rather than less likely—a very subjective test.

4.2 The majority of assets, with the exception of some land, will only provide economic benefits for a finite period. To ensure that assets as at a given date are not overstated, and that expenses are not understated, it is generally accepted that it is imperative that depreciation/amortisation be recognised each period. However, if an asset is determined to have an indefinite life, then periodic amortisation may not be employed. Rather, annual impairment testing is applied, which means that if the recoverable amount of an asset is below its carrying value, then an impairment loss must be recognised. An impairment loss is not to be confused with depreciation. Annual impairment testing is now the approach that must be used in relation to purchased goodwill and other intangible assets that are considered to have an indefinite life.

If an approach to accounting was adopted whereby we adjusted an asset’s value to fair value on an annual basis (often referred to as ‘mark-to-market’) the change in fair value of the asset, depending on the type of asset, could be treated as a revenue or expense of the period. No depreciation would be recognised. Mark-to-market accounting should not be confused with situations where an asset is recorded at fair value in accordance with AASB 116 or AASB 138 (based on asset revaluations). Where assets are valued at fair value by way of asset revaluations (with adjustments going to a revaluation surplus account), rather than

Solutions Manual t/a Australian Financial Accounting 7e by Craig DeeganCopyright © 2012 McGraw-Hill Australia Pty Ltd

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being left at cost, it is usual to still depreciate or amortise the asset on an annual basis. Revaluations are covered in Chapter 6.

4.3 Following the recognition of an impairment loss in an earlier period, it is possible that the recoverable amount of an asset might subsequently increase towards former levels. If, in a subsequent period, additional information becomes available that indicates that benefits are now probable, according to the IASB/AASB Framework the asset would be recognised when it so qualifies, even though this might involve amounts that had previously been recognised as expenses of the entity. As paragraph 4.42 of the IASB Framework states:

An item that, at a particular point in time, fails to meet the recognition criteria in paragraph 4.38, may qualify for recognition at a later date as a result of subsequent circumstances or events.

Therefore the subsequent recognition of an asset will require a credit to the entity’s profit or loss, perhaps labelled something like ‘gain from asset previously derecognised’ or ‘gain from reinstatement of asset previously written off’. This subsequent reinstatement of the asset is consistent with the requirements of AASB 136 Impairment of Assets, which states at paragraph 114:

An impairment loss recognised in prior periods for an asset other than goodwill shall be reversed if, and only if, there has been a change in the estimates used to determine the asset’s recoverable amount since the last impairment loss was recognised. If this is the case, the carrying amount of the asset shall, except as described in paragraph 117, be increased to its recoverable amount. That increase is a reversal of an impairment loss.

While the above is a general principle, which is supported by both AASB 136 and the Conceptual Framework, that assets that have been written off in previous periods can subsequently be recognised again as assets (with a resulting gain being taken to profit or loss) it needs to be appreciated that some accounting standards specifically exclude this reversal for specific types of assets. That is, in particular accounting standards relating to specific assets, once an asset is written off (that is, expensed) it must stay written off even if it becomes apparent that future economic benefits are probable. As Chapter 8 will demonstrate, pursuant to AASB 138 Intangible Assets, if an intangible asset (such as a brand name, patent or development expenditure) is initially expensed it cannot be recognised as an asset later, even where future economic benefits are deemed probable. In effect, such requirements (which can be deemed to be quite conservative) will cause the statement of financial position to understate the assets controlled by the entity. Hence, the requirements of AASB 136 Impairment of Assets in relation to reversals of prior period impairment losses are overridden by some other accounting standards that provide requirements for specific classes of assets.

4.4 For an asset to be recognised in the financial statements, the economic benefits should be capable of reliable measurement. With advertising, it would typically be argued that the benefits from the program are too difficult to quantify, and hence, generally accepted accounting practice is for expenditure on advertising to be expensed in the period incurred. Whilst this has been generally accepted practice for many years, paragraph 69 of AASB 138 Intangible Assets now specifically states expenditure on advertising and promotional activities (including mail order catalogues) shall be recognised as an expense when incurred.

An exception to this practice would be where the advertising is prepaid, and the services have not been performed at the end of the reporting period. At the end of the reporting


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period the reporting entity would have a claim against the advertising business for the unperformed services. The asset would be of the nature of a prepaid expenditure.

4.5 AASB 123 Borrowing Costs provides guidance in relation to this issue. It states that borrowing costs that are directly attributable to the acquisition or production of an asset that takes a substantial period of time to get ready for its intended use or sale must be capitalised as part of the cost of the asset. A ‘substantial period of time’ is generally regarded as being more than 12 months. The borrowing costs to be included would be those that would have been avoided if the expenditure on the asset had not been made. The capitalisation of the borrowing costs is to cease when substantially all the activities necessary to prepare the asset for its intended use or sale are complete. Hence, the borrowing costs associated with the construction of a building would generally be expected to be included as part of the cost of the building, rather than being treated as an expense in the period in which the interest was incurred.

4.6 We can look at a number of accounting standards to determine how the ‘acquisition cost’ of particular assets is determined. For example, in relation to intangible assets, AASB 138 Intangible Assets provides the relevant requirements. In relation to internally generated intangible assets there is a general rule (paragraph 66) that:

The cost of an internally generated intangible asset comprises all directly attributable costs necessary to create, produce, and prepare the asset to be capable of operating in the manner intended by management. Examples of directly attributable costs are:

(a) costs of materials and services used or consumed in generating the intangible asset;

(b) costs of employee benefits (as defined in AASB 119 Employee Benefits) arising from the generation of the intangible asset;

(c) fees to register a legal right; and

(d) amortisation of patents and licences that are used to generate the intangible asset.

AASB 123 Borrowing Costs specifies criteria for the recognition of interest as an element of the cost of an internally generated intangible asset.

Whilst the above requirement discusses ‘cost’, we actually need to know what ‘cost’ means. According to AASB 138:

Cost is the amount of cash or cash equivalents paid or the fair value of other consideration given to acquire an asset at the time of its acquisition or construction, or, when applicable, the amount attributed to that asset when initially recognised in accordance with the specific requirements of other Australian Accounting Standards, for example AASB 2 Share-based Payment.

In relation to property, plant and equipment, paragraph 7 of AASB 116 Property, Plant and Equipment requires:

The cost of an item of property, plant and equipment shall be recognised as an asset if, and only if:

(a) it is probable that future economic benefits associated with the item will flow to the entity; and

(b) the cost of the item can be measured reliably.


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The above requirement is consistent with the recognition criteria for the elements of financial statements. In relation to defining ‘costs’ in relation to property, plant and equipment, paragraph 16 of AASB 116 states:

The cost of an item of property, plant and equipment comprises:

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

(b) any costs directly attributable to bringing the asset to the location and condition necessary for it to be capable of operating in the manner intended by management; and

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

As can be seen above, AASB 116 makes reference to ‘directly attributable’ costs (as does AASB 138). According to paragraph 17 of AASB 116, examples of directly attributable costs are:

(a) costs of employee benefits (as defined in AASB 119 Employee Benefits) arising directly from the construction or acquisition of the item of property, plant and equipment;

(b) costs of site preparation;

(c) initial delivery and handling costs;

(d) installation and assembly costs;

(e) costs of testing whether the asset is functioning properly, after deducting the net proceeds from selling any items produced while bringing the asset to that location and condition (such as samples produced when testing equipment); and

(f) professional fees.

AASB 116 provides the same definition of cost as AASB 138. According to the standard:

Cost is the amount of cash or cash equivalents paid or the fair value of the other consideration given to acquire an asset at the time of its acquisition or construction or, where applicable, the amount attributed to that asset when initially recognised in accordance with the specific requirements of other Australian Accounting Standards, for example, AASB 2 Share-based Payment.

A number of other accounting standards also have definitions of ‘cost’ for the purpose of the item being addressed within the particular accounting standard. For example, AASB 102 Inventories notes (paragraph 10) that “the cost of inventories shall comprise all costs of purchase, costs of conversion and other costs incurred in bringing the inventories to their present location and condition”. ‘Costs of purchase’, ‘cost of conversion’, and ‘other costs incurred’ are further defined in the accounting standard.

4.7 An asset is defined in the Conceptual Framework as follows:

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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Given this definition, the three fundamental characteristics of an asset according to the Conceptual Framework are:

the asset should be expected to provide future economic benefits;

the asset must be controlled; and

the transaction or event giving rise to the control must already have occurred.

As we should appreciate, determining whether an asset is likely to provide future benefits will rely upon a deal of professional judgment. At times, it is also questioned whether an entity actually controls an asset or not (this is particularly an issue for heritage assets).

4.8 AASB 136 Impairment of Assets requires that when the recoverable amount of an asset (‘recoverable amount’ defined as the higher of an asset’s net selling price and its value in use) is less than its carrying amount (‘carrying amount’ of an asset is defined as the amount at which the asset is recorded in the accounting records as at a particular date—for a depreciable asset, it means the net amount after deducting any accumulated depreciation and accumulated impairment losses), the carrying amount of the asset must be reduced to its recoverable amount. The reduction is referred to as an ‘impairment loss’. Specifically, paragraph 59 of AASB 136 states:

If, and only if, the recoverable amount of an asset is less than its carrying amount, the carrying amount of the asset shall be reduced to its recoverable amount. That reduction is an impairment loss.

4.9 AASB 136 Impairment of Assets requires that when the recoverable amount of an asset (‘recoverable amount’ defined as the higher of an asset’s net selling price—or value-in-exchange—and its value in use) is less than its carrying amount, the carrying amount of the asset must be reduced to its recoverable amount. The associated expense is referred to an impairment loss. Hence, a consideration of both the ‘carrying amount’ and the ‘recoverable amount’ is necessary in determining the impairment loss. Within AASB 136 Impairment of Assets ‘recoverable amount’ is defined at paragraph 6 as follows:

The recoverable amount of an asset or a cash-generating unit is the higher of its fair value less costs to sell and its value in use.

The above definition of recoverable amount further requires definitions of ‘fair value less costs to sell’—which can also be defined as ‘value-in-exchange’, and ‘value in use’. ‘Fair value less costs to sell’ is defined in paragraph 6 as ‘the amount obtainable from the sale of an asset or cash-generating unit in an arm’s length transaction between knowledgeable, willing parties, less the costs of disposal’. ‘Value in use’ is defined as ‘the present value of the future cash flows expected to be derived from an asset or cash-generating unit’.

These definitions and requirements require us to further consider ‘present values’. In relation to present values, we can see that from the above definition of ‘recoverable amount’ and its reference to ‘present values’, it is apparent that AASB 136 requires the cash flows assessed in determining recoverable amount to be discounted where the recoverable amount is determined by reference to expectations relating to the asset’s value in use. Any discussion of present values raises the obvious issue of what discount rate should be used to discount the future cash flows when determining ‘value in use’. Paragraph 55 of AASB 136 Impairment of Assets requires:

The discount rate (rates) shall be a pre-tax rate (rates) that reflect(s) current market assessments of:


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(a) the time value of money; and

(b) the risks specific to the asset for which the future cash flow estimates have not been adjusted.

Paragraph 56 of AASB 136 further explains the use of discount rates. It states:

A rate that reflects current market assessments of the time value of money and the risks specific to the asset is the return that investors would require if they were to choose an investment that would generate cash flows of amounts, timing and risk profile equivalent to those that the entity expects to derive from the asset. This rate is estimated from the rate implicit in current market transactions for similar assets or from the weighted average cost of capital of a listed entity that has a single asset (or a portfolio of assets) similar in terms of service potential and risks to the asset under review. However, the discount rate(s) used to measure an asset’s value in use shall not reflect risks for which the future cash flow estimates have been adjusted. Otherwise, the effect of some assumptions will be double-counted.

Current practice therefore requires a two-step process in determining ‘value in use’. First, we estimate the future cash inflows and outflows to be derived from the expected continued use of the asset and its subsequent disposal. Second, we apply the appropriate discount rate to the cash flows.

4.10 Yes. The requirement is that the asset be controlled, not owned. That is, ‘control’ is one of the important attributes of the definition of assets. If an asset is controlled by an entity, then by definition that entity can use the asset to generate economic benefits in the same manner as if it owned the asset. Readers of the financial statements should therefore be made aware of the asset’s existence. Hence, we frequently find certain leased assets included in the statement of financial position (and also lease liabilities) where such a lease is long-term and the conditions of the lease are such that the lessee shall derive the same benefits and incur the same associated risks that they would incur if they owned the assets.

4.11 There is a general principle that if the probability of future economic benefits being derived from particular expenditure is not probable, then the expenditure should be expensed. This is consistent with the IASB/AASB Conceptual Framework that states:

An asset is not recognised in the balance sheet when expenditure has been incurred for which it is considered improbable that economic benefits will flow to the entity beyond the current accounting period. Instead, such a transaction results in the recognition of an expense in the income statement. This treatment does not imply either that the intention of management in incurring expenditure was other than to generate future economic benefits for the entity or that management was misguided. The only implication is that the degree of certainty that economic benefits will flow to the entity beyond the current accounting period is insufficient to warrant the recognition of an asset.

Where expenditure has been expensed, but in a subsequent period it comes to light that future economic benefits are probable, then there is a general principle that the expenditure can be reinstated as an asset. As paragraph 4.42 of the IASB Conceptual Framework states:

An item that, at a particular point in time, fails to meet the recognition criteria in paragraph 4.38, may qualify for recognition at a later date as a result of subsequent circumstances or events.


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As an example, an entity may have incurred some expenditure on acquiring a particular asset for the purpose of subsequent resale, but at the end of the reporting period it is considered improbable that there will be any customers. The entries in the first year would be:

Dr Asset 100Cr Cash/payables 100

Dr Impairment loss 100Cr Accumulated impairment loss—asset 100

In the subsequent period evidence may become available which indicates that it is probable that the item will sell for at least its original cost. In this case the asset would be reinstated and revenue would be recognised. The entry may be:

Dr Accumulated impairment loss—asset 100

Cr Gain from reinstatement of previous impairment 100

While the above discussion describes the general approach to reinstating assets, it needs to be appreciated that for intangible assets there is a requirement that if expenditure on an intangible asset is initially expensed then it cannot be reinstated even where future economic benefits are deemed probable. As paragraph 71 of AASB 138 states:

Expenditure on an intangible item that was initially recognised as an expense shall not be recognised as part of the cost of an intangible asset at a later date.

Students should be encouraged to consider whether this restriction is conceptually sound, or whether it is too conservative in approach.

4.12 Traditionally, current assets had been defined as assets that would, in the ordinary course of business, be consumed or converted into cash 12 months after the end of the reporting period. However, paragraph 66 of AASB 101 Presentation of Financial Statements now defines a current asset in the following way:

An entity shall classify an asset as current when:

(a) it expects to realise the asset, or intends to sell or consume it, in its normal operating cycle;

(b) it holds the asset primarily for the purpose of trading;

(c) it expects to realise the asset within twelve months after the reporting period; or

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

An entity shall classify all other assets as non-current.

As an entity’s ‘operating cycle’ might be greater than 12 months, assets that might not be converted to cash for a period in excess of 12 months can now be considered as ‘current’. Paragraph 68 of AASB 101 provides the following definition of an operating cycle:

The operating cycle of an entity is the time between the acquisition of assets for processing and their realisation in cash or cash equivalents. When the entity’s normal operating cycle is not clearly identifiable, it is assumed to be twelve months. Current assets include assets (such as inventories and trade receivables) that are sold,


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consumed or realised as part of the normal operating cycle even when they are not expected to be realised within twelve months after the reporting period. Current assets also include assets held primarily for the purpose of trading (financial assets within this category are classified as held for trading in accordance with AASB 139) and the current portion of non-current financial assets.

4.13 (a) The Gizmo Machine should be recorded at the fair value of purchase consideration. This would be calculated as follows:

Fair value

Cash $20 000

Land $140 000

Value of assumed liability $30 000

Total acquisition cost $190 000

(b) The accounting entries to record the acquisition would be:

Dr Plant and machinery—Gizmo Machine 190 000

Cr Cash 20 000

Cr Land 100 000

Cr Profit on disposal of land 40 000

Cr Bank loan 30 000

4.14 As we will see throughout the textbook, there are various measurement rules that must be adopted in relation to different classes of assets. For example:

Cash is measured at face value.

Inventory must be measured at the lower of cost and net-realisable value.

Financial assets such as shares in listed companies are measured at fair value.

With some exceptions, non-current assets such as property, plant and equipment can be measured on the basis of cost, or fair value.

Leased assets are measured at the present value of the minimum lease payments (if the leases are finance leases).

Foreign currency monetary assets must be measured on the basis of exchange rates in place at the end of the reporting period.

Biological assets shall be measured at fair value.

Investment assets held by general insurers and life insurers are to be measured on the basis of net-market value (to the extent that the investments are integral to the general insurance operations).

Students should be encouraged to consider whether it is conceptually appropriate that different measurement bases are required for different classes of assets. It should also be appreciated that some assets, such as many internally generated intangible assets (for example, expenditure related to research) shall not be included as an asset in the statement of financial position regardless of the related expenditure and perceptions about the


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probability of future economic benefits. For example, in relation to research expenditure, paragraph 54 of AASB 138 states:

No intangible asset arising from research (or from the research phase of an internal project) shall be recognised. Expenditure on research (or on the research phase of an internal project) shall be recognised as an expense when it is incurred.

The above approach, which requires all expenditure on a particular type of item to be expensed regardless of possible future economic benefits, is particularly conservative.

4.15 Firstly, whether it is realistic to consider that an amendment to the Conceptual Framework would be released which prescribes only one method of measurement is an issue that students should be encouraged to consider. Without a revision to accounting standards, reporting entities would not adopt the prescriptions embodied within the conceptual framework given that accounting standards have precedence over the IASB/AASB Conceptual Framework.

If a new basis of measurement were prescribed there could be widespread opposition and resistance to the change. Reasons for this could include:

Managers may consider that the new approach prescribed within the Conceptual Framework is inappropriate and that the method they are currently using most efficiently reflects the performance and financial position of their entity.

The reporting entity may have many accounting-based agreements in place (such as debt covenants) which may be adversely affected by the new rules.

Managers may consider that the new requirements are simply too costly to implement, relative to the benefits that would be generated by adopting the new requirements.

4.16 Instructors/students should refer directly to AASB 101 and list some of the various disclosures that are required to be made on the face of the statement of financial position, as well as those other disclosures that can be made in the notes to the financial statements (some of the disclosures vary depending upon whether assets are disclosed using the current and non-current dichotomy, or whether assets are presented in their order of liquidity). It should be stressed that a number of other accounting standards address specific assets and also include additional disclosure requirements in relation to those specific assets. In relation to AASB 101, specific reference can be made to paragraphs 54, 60, 61 and 66.

4.17 Intangible assets can be defined as non-monetary assets without physical substance. They would include brand names, copyrights, mastheads, goodwill and development expenditure. Intangible assets would be disclosed within their own class within the statement of financial position—this class being ‘intangible assets’. Where the entity discloses current assets separately from non-current assets (as opposed to disclosing assets in order of liquidity) then intangible assets would generally be disclosed as non-current assets. Within the broad class of assets identified as ‘intangible assets’, further breakdown into asset types would be provided; for example, goodwill, brand names, development expenditure, and so forth.

4.18 There are two basic approaches to presenting a statement of financial position. AASB 101 (paragraph 60) requires that, for the purposes of statement of financial position presentation:

An entity shall present current and non-current assets, and current and non-current liabilities, as separate classifications in its statement of financial position in accordance


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with paragraphs 66–76 except when a presentation based on liquidity provides information that is reliable and more relevant. When that exception applies, an entity shall present all assets and liabilities in order of liquidity.

As we can see from the above requirement, relevance and reliability are important considerations in determining how the statement of financial position will be presented. That is, relevance and reliability considerations are important in determining whether the statement of financial position should be presented in a way that separates current assets from non-current assets and current liabilities from non-current liabilities (which could be considered to be the ‘traditional’ approach), or in a way that lists the assets and liabilities in terms of their order of liquidity without any segregation between current and non-current portions.

Therefore, AASB 101 does not prescribe a single format for the presentation of the statement of financial position. In determining which format to use, the commentary to AASB 101 provides some useful assistance. According to paragraphs 62 and 63 of AASB 101:

62. When an entity supplies goods or services within a clearly identifiable operating cycle, separate classification of current and non-current assets and liabilities in the statement of financial position provides useful information by distinguishing the net assets that are continuously circulating as working capital (the current portion) from those used in the entity’s long-term operations (the non-current portion). It also highlights assets that are expected to be realised within the current operating cycle, and liabilities that are due for settlement within the same period.

63. For some entities, such as financial institutions, a presentation of assets and liabilities in increasing or decreasing order of liquidity provides information that is reliable and is more relevant than a current/non-current presentation because the entity does not supply goods or services within a clearly identifiable operating cycle.

AASB 101 also requires specific disclosures in relation to the duration of an entity’s operating cycle. It requires that where the entity presents current assets separately from non-current assets and current liabilities separately from non-current liabilities and the entity has a single clearly identifiable operating cycle greater than 12 months, the length of that operating cycle must be disclosed.

4.19 At issue is whether the expenditure incurred during the financial period improves the ability or capacity of an item to generate economic benefits relative to what it was at the commencement of the period. If the expenditure simply restores the asset to its former state in terms of its ability to generate future economic benefits, then the expenditure would not be capitalised. Rather, it would be expensed. As paragraph 12 of AASB 116 states:

Under the recognition principle in paragraph 7, an entity does not recognise in the carrying amount of an item of property, plant and equipment the costs of the day-to-day servicing of the item. Rather, these costs are recognised in profit or loss as incurred. Costs of day-to-day servicing are primarily the costs of labour and consumables, and may include the cost of small parts. The purpose of these expenditures is often described as for the ‘repairs and maintenance’ of the item of property, plant and equipment.

If an item of expenditure improves the ability of an asset to generate future economic benefits over and above its previous ability or state, then such expenditure would be considered to be an improvement and the associated expenditure would be capitalised.


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4.20 Firstly, why would Geelong Football Club (also known as the Cats) be prepared to pay the substantial sign-on fees? Probably because the skills of these players are such that they are expected to increase the likelihood of the Cats winning games and winning further premierships (other than those recently won in 2007, 2009 and 2011!). Arguably, winning games will increase the patronage of people at local games (which will increase gate receipts and hence, the cash flows of the club) and at the Geelong Leagues Club (which should increase the cash takings of the club). Hence, good player signings will, through winning more games, conceivably lead to increased earnings for the Cats; that is, to future economic benefits. If there is a link between the payments related to the signings and the future economic benefits, are the sign-on fees paid to the players to be treated as assets?

As we would know, the definition of an asset requires that there has been a past transaction and that the reporting entity controls the associated economic benefits. Does control exist in this situation; that is, does the football club control the players? This is an interesting issue, which should be used to generate some discussion between students. Some may argue that the terms of the contracts would probably mean that the club can restrict the players from playing for other clubs and that the contract would require the individuals to go on to the field and play football—hence, in a sense, the football club does control the benefits. Others may not agree with this perspective and could argue that the club cannot force the players to play and, hence, would not control the associated economic benefits.

It is the recognition criteria of assets which would most likely not be met in the case of player sign-on fees. As we know, for an asset to be recognised the associated economic benefits must be measurable and probable. As it would be difficult to assign a value to the economic benefits being generated by the expenditure (that is, the benefits are not measurable with reasonable accuracy) this in itself would typically be a reason not to record the expenditure as an asset, but instead to treat the expenditure as an expense. This would be a similar argument to one that would typically be used when arguing for advertising expenditure to be written-off as incurred, rather than being capitalised it as an asset (unless it was of the nature of a prepayment). However, if the players were paid in advance, then such ‘prepayments’ could be treated as assets.

4.21 (a) In the books of Point Lonsdale Ltd:

Dr Donation expense (or something similar) 100 000

Dr Accumulated depreciation—computer 70 000

Cr Plant and machinery—computer 170 000

(b) While the accounting entries are not required for this question, the entries in the books of Ocean Grove Ltd would be:

Dr Plant and machinery—computer 120 000

Cr Donation revenue (or something similar) 120 000

Because of the difference between book value and market value, there is a difference between the expense recognised by Point Lonsdale Ltd and the revenue recognised by Ocean Grove Ltd. With specific reference to this question, in the absence of a cost of acquisition, the inflow of assets is recognised at fair value, $120 000, with a corresponding credit to income—as indicated above. Opinions may vary as to the appropriateness of this treatment. Omitting it would leave assets understated but its recognition means that measures of performance include a once-off item that does not relate to any effort exerted by


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Ocean Grove or its management. Students who disagree with the accounting treatment should be encouraged to consider alternative treatment and/or supplemental disclosures.

4.22 If the destruction of the storage equipment had been accounted for correctly then the destruction should have been recognised as an expense in the 2013 financial year, with a corresponding reduction in assets. The omission of this event would be referred to as a ‘prior period error’. In relation to how to account for this prior period error, AASB 108 Accounting Policies, Changes in Accounting Estimates and Errors mandates a retrospective basis for the correction of errors, adopting the perspective that the financial statements be presented as though the error never occurred. Specifically, paragraph 42 of AASB 108 requires that:

an entity shall correct material prior period errors retrospectively in the first financial statement authorised for issue after their discovery by:

(a) restating the comparative amounts for the prior period(s) presented in which the error occurred; or

(b) if the error occurred before the earliest prior period presented, restating the opening balances of assets, liabilities and equity for the earliest prior period presented.

4.23 (a) The acquisition cost of an asset should include the direct purchase price (including associated legal costs) of an asset plus any costs associated with transporting the asset to its place of use, modifications necessary to make the asset work efficiently and any installation costs. Therefore, the cost of the asset to Cactus Ltd would be:

Amount paid to the manufacturer $85 000Delivery costs $2000Modifications $7000Installation $2000Total cost $96 000

The cost of the machinery ($96 000) would need to be depreciated over the periods in which the associated economic benefits were expected to arise.

(b) Borrowing costs will be included in the carrying amount of the asset if it is a qualifying asset, that is, if it needs to be constructed over a substantial period of time, such as one year or more (see AASB 123).

Challenging questions

4.24 There are two basic approaches to presenting a statement of financial position. AASB 101 (paragraph 60) requires that, for the purposes of presentation of the statement of financial position:

An entity shall present current and non-current assets, and current and non-current liabilities, as separate classifications in its statement of financial position in accordance with paragraphs 66–76 except when a presentation based on liquidity provides information that is reliable and more relevant. When that exception applies, an entity shall present all assets and liabilities in order of liquidity.

As we can see from the above requirement, relevance and reliability are important considerations in determining how the statement of financial position will be presented. That


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is, relevance and reliability considerations are important in determining whether the statement of financial position should be presented in a way that separates current assets from non-current assets and current liabilities from non-current liabilities (which could be considered to be the ‘traditional’ approach), or in a way that lists the assets and liabilities in terms of their order of liquidity without any segregation between current and non-current portions.

Therefore, AASB 101 does not prescribe a single format for the presentation of the statement of financial position. In determining which format to use, the commentary to AASB 101 provides some useful assistance. According to paragraphs 62 and 63 of AASB 101:

62. When an entity supplies goods or services within a clearly identifiable operating cycle, separate classification of current and non-current assets and liabilities in the statement of financial position provides useful information by distinguishing the net assets that are continuously circulating as working capital (the current portion) from those used in the entity’s long-term operations (the non-current portion). It also highlights assets that are expected to be realised within the current operating cycle, and liabilities that are due for settlement within the same period.

63. For some entities, such as financial institutions, a presentation of assets and liabilities in increasing or decreasing order of liquidity provides information that is reliable and is more relevant than a current/non-current presentation because the entity does not supply goods or services within a clearly identifiable operating cycle.

4.25 For most companies, one of the most valuable ‘assets’ is the employees. However, employees are not disclosed in the financial statements as assets. Unlike other ‘resources’, employees cannot really be controlled and hence would not satisfy the definition of assets provided in the IASB/AASB Conceptual Framework. (There is also the issue associated with the measurability of the benefits provided by the employees.) What we need to appreciate is that financial accounting provides only one of many sources of information about an organisation. There are many resources associated with an organisation that might not be measured in monetary terms. Information provided by financial accounting needs to be supplemented by reviewing other information, some of which is required by law and some of which is not. Some of the information will be provided by the organisation and some will be available from other sources. For example, Australian corporations legislation requires disclosures to be made about the names of (and payments made to) directors of an organisation—but names on their own mean little. Other sources will provide information about the reputation of the directors.

4.26 30 June 2014

Dr Power generator 17 361 050Cr Cash/Accounts payable (12 550 000 + 4 001 500) 16 551 500Cr Provision for restoration costs 809 550

As we can see above, at the end of the reporting year of 30 June 2014, a provision for restoration costs must be created. The provision is the best estimate of the expenditure required to settle the obligation. Provisions are to be recorded at present value, pursuant to paragraph 45 of AASB 137 Provisions, Contingent Liabilities, and Contingent Assets, which states:


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the amount of a provision shall be the present value of the expenditures expected to be required to settle the obligation.

The estimated site restoration costs of $809 550 ($2 100 000, payable in 10 years, discounted at 10 per cent, which equals $2 100 000 × 0.3855) are added to the cost of the power generator. The costs incurred in dismantling the power generator, removing it and restoring the site to its original condition are costs that are necessary to realise the future economic benefits embodied in the asset, and the required expenditure has been included in the cost of the asset.

Discounting the future obligation creates interest costs for future years. As paragraph 60 of AASB 137 states:

Where discounting is used, the carrying amount of a provision increases in each period to reflect the passage of time. This increase is recognised as borrowing cost.

The borrowing (interest) costs are allocated to specific years as follows:

Date Opening balance Interest at 10% Balance of site

restoration costs

1 July 2014 – 809 550

30 June 2015 809 550 80 955 890 505

30 June 2016 890 505 89 051 979 556

30 June 2017 979 556 97 956 1 077 512

30 June 2018 1 077 512 107 751 1 185 263

30 June 2019 1 185 263 118 526 1 303 789

30 June 2020 1 303 789 130 379 1 434 168

30 June 2021 1 434 168 143 417 1 577 585

30 June 2022 1577 585 157 759 1 735 344

30 June 2023 1 735 344 173 534 1 908 878

30 June 2024 1 908 878 190 888 2 099 766*

*slight rounding error given we have calculated present value using only 4 decimal points.

The journal entries to recognise the periodic interest charges are:

30 June 2015

Dr Interest expense 80 955

Cr Provision for restoration costs 80 955

30 June 2020

Dr Interest expense 130 379

Cr Provision for restoration costs 130 379

As we can see from the above entries, at the end of each period the amount recorded for the provision for restoration costs increases. By the end of the final period of the project the


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balance of the provision will be $2 100 000. This amount will then be eliminated when Midnight Boil Ltd undertakes the actual restoration work.

4.27 Assets such as Phar Lap are classified as heritage assets, which have been defined as physical assets that a community intends to preserve because of cultural, historic or environmental associations. There is much debate about the logic or, indeed, the lack of logic associated with measuring heritage assets in financial terms. (Chapter 9 of the text covers this debate in detail.) This question is included in the text to stimulate debate, rather than to provide a solution.

What does the $10 million valuation actually represent? Whilst Phar Lap can provide social benefits to museum visitors, does it really provide future economic benefits? How reliable is the $10 million valuation? Phar Lap is unique and hence reference to other Phar Laps is not possible. Equally we could argue that perhaps Phar Lap should be measured at $5 million or, perhaps, $100 million. Should this lack of ‘reliable’ measurement preclude its inclusion in the financial statements? As the museum will not be allowed to sell Phar Lap anyway, what relevance does the monetary valuation have? Also, because legislation or other rules will prevent the museum management from doing what it wants with Phar Lap, can we really say that the museum ‘controls’ the asset? It is probably not debateable that Phar Lap played an important part in Australian (and New Zealand) history and that having the ‘stuffed’ remains is a good idea and an attraction for the museum. Some people may question the need to attribute a financial value to Phar Lap. Students might provide some views about the necessity for placing valuations of Phar Lap and other heritage assets, such as Aboriginal artefact collections, war memorials or significant and long-lived trees, in financial statements. Perhaps accountants cannot accept that something is worth keeping unless we assign a value to it. What do you think? Is this taking financial accounting too far?

4.28 Present value of $250 000 initial payment $250 000

Present value of $300 000 for 5 years discounted at

8% ($300 000 × 3.9927—see Appendix B) $1 197 810

$1 447 810

1 July 2014

Dr Sand-dredging machine 1 447 810

Cr Bank 250 000

Cr Loan 1 197 810

30 June 2015

Dr Interest expense ( 1 197 810 x 0.08) 95 825

Dr Loan 204 175

Cr Bank 300 000

The accounting entry on 30 June 2019 will also have an interest component. To determine the interest expense we need to know what the present value of the liability would have been with one year to go; that is, what its present value was at 30 June 2018. At 30 June 2018,


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and after the second last payment had been made, the present value of the liability would have been $277 778 (which is $300,000 ÷ 1.08). The accounting entry therefore would be:

30 June 2019

Dr Interest expense ( 277 778 x 0.08) 22 222

Dr Loan 277 778

Cr Bank 300 000

4.29 What does the aggregated total actually represent? As we know, various measurement principles are applied to different classes of assets. For example, inventory is measured at the lower of cost and net realisable value; marketable securities can be measured at fair value; biological assets are to be measured at fair value; non-current assets, such as land, can be measured at fair value or cost; and accounts receivable will be measured at their face value less an allowance for doubtful debts.

Hence, when we add up the various classes of assets we are adding up the totals of various classes of assets which have perhaps each been measured in a different manner. (Students may be encouraged to consider whether, in a sense, this situation is similar to adding US dollars, Canadian dollars, New Zealand dollars, Singapore dollars and Australian dollars to give a total of ‘dollars’). Hence, the balance of ‘total assets’ does not represent cost, fair value or replacement value. Such an approach departs from the prescriptions of accounting researchers such as Raymond Chambers. He would argue that all assets should be measured on the same basis. Under his theory, Continuously Contemporary Accounting, all assets would be measured at their current cash equivalent and the total value attributed to assets would provide a measure of the entity’s capacity to adapt. (See Chapter 3.)

From a conceptual basis it could be argued that it is inappropriate for different classes of assets to be measured on different bases. Perhaps when or if a component of our conceptual framework is issued in relation to measurement issues we will be given guidance on which basis of valuation should be applied. However, this would represent a dramatic change to existing accounting practice and, hence, whether it is realistic to consider that one method (such as measurement on the basis of fair values) of measurement shall be applied to all assets is an issue worthy of consideration.

At the present time, reporting entities are required to measure various classes of assets on different bases given that they are required to comply with accounting standards. For some classes of ‘assets’—such as many internally developed intangible assets—there is also a prohibition on recognising them at all for the purposes of the statement of financial position. All these different approaches to asset measurement and recognition may cause some confusion for financial statement users. However, to alleviate some of this confusion, an accounting policies note is required to accompany the financial statements (however, whether most readers of financial statements can actually understand the accounting policy note is another issue).

4.30 (a) For this expenditure to be recognised as an asset (that is, for it to be capitalised), it must be considered probable that the item will generate net cash flows at least equal to $220 000 (plus related borrowing costs). In this case, if economic benefits of at least $220 000 are considered probable, the aggregated accounting entry would be:

Dr Machinery—surfboard-making machine (an asset) 220 000

Cr Wages payable 100 000


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Cr Raw materials inventory 75 000

Cr Accumulated depreciation—plant and machinery 45 000

Our next issue is to determine how to treat the interest expenses associated with the $150 000 loan. AASB 123 provides a general rule (which it refers to as the ‘core principle’). This core principle is provided at paragraph 1 of AASB 123, which states:

Borrowing costs that are directly attributable to the acquisition, construction or production of a qualifying asset form part of the cost of that asset. Other borrowing costs are recognised as an expense.

Hence, if an asset is deemed to be a ‘qualifying asset’ and borrowing costs have been incurred to acquire, construct or produce the asset, then such costs must be included as part of the cost of the asset. Conversely, if the borrowing costs cannot be attributed to a qualifying asset, then they would be expensed in the period in which the borrowing costs were incurred.

Obviously, the above requirement calls for a definition of ‘qualifying asset’. A ‘qualifying asset’ is defined in AASB 123 as ‘an asset that necessarily takes a substantial period of time to get ready for its intended use or sale’. A ‘substantial period of time’ is generally regarded as being more than 12 months. The borrowing costs to be included would be those that would have been avoided if the expenditure on the asset had not been made. The capitalisation of the borrowing costs is to cease when substantially all the activities necessary to prepare the asset for its intended use or sale are complete.

In this example, the item was being constructed for a total period of four months, which would probably preclude it from being considered as a qualifying asset. The borrowed funds were also outstanding for a period of six months—so even if the item was a qualifying asset, for the period after 30 April, the interest costs would be expensed and not included as part of the cost of the asset under construction.

(b) If the recoverable amount of an asset is less than its carrying amount then an impairment loss must be recognised. The recoverable amount is defined as the higher of an asset’s net selling price and its value in use. In this case, the net selling price would be $12 700, giving an impairment loss of $220 000 less $12 700, which equals $207 300. The accounting entry would be:

Dr Impairment loss—machinery 207 300

Cr Accumulated impairment loss—surfboard-making machine 207 300

(c)

Dr Accumulated impairment loss-surfboard-making machine 207 300

Cr Gain from reversal of previous impairment loss 207 300

4.31 It does represent the value of the reporting entity’s assets determined in accordance with generally accepted accounting principles (which includes the requirements of the various accounting standards). To understand what the total represents, readers of financial statements need to be aware of the accounting policies being adopted by the reporting entity (this knowledge may be gained through reading the reporting entity’s accounting policy note), and they need to also be aware of the various rules pertaining to asset valuations that are incorporated within generally accepted accounting principles. (Instructors should encourage students to consider whether this is a realistic expectation.) Without knowledge of generally accepted accounting principles, readers of financial statements may incorrectly


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interpret what total assets actually represents. It represents the total derived by applying the appropriate measurement rules to each class of assets with each class of asset often having its own specific measurement rules. It does not necessarily represent current market or fair values, replacement values or the historical cost of the assets acquired.

4.32 (a) In determining the cost of the asset, we must consider not only the direct costs of constructing the machine, such as wages and materials, but also the depreciation of items used to construct the asset. Hence, the total cost of constructing the machine would be $190 000. The accounting entry would be:

Dr Plant and machinery—Whizbang Machine 190 000Cr Salaries payable (or cash if already paid) 120 000Cr Raw materials inventory 45 000Cr Accumulated depreciation—manufacturing equipment 25 000

(b) As a general rule, assets should not be carried forward in the financial statements at an amount in excess of their recoverable amount. If the recoverable amount of the asset is deemed to be $160 000, then the asset must be written down to $160 000. That is, the asset must be written down by $30 000. The accounting entry to recognise this write-down would be:

Dr Impairment loss—machinery 30 000Cr Accumulated impairment loss—Whizbang Machine 30 000

4.33 (a) and (b) are answered in the following table. Part (b) also requires identification of items where an arbitrary or estimated allocation is required; note that on these items answers may vary.

Items (a) (b) Land Building

Purchase price of land $1 000 000 $1 000 000

Stamp duty and legal fees 80 000 80 000

Removal of buildings not required 20 000 20 000

Application to local government bodies for development*

10 000 10 000

Architects fees 100 000 100 000

Construction of spa buildings 1 500 000 1 500 000

Salary of manager overseeing project**

120 000 120 000

Costs excluding borrowing costs $2 830 000 $1 100 000 $1 730 000

Borrowing costs*** 180 000 100 763 79 237

$3 010 000 $1 200 763 $1 809 237

* The application for development can be interpreted as part of the cost of the buildings, or it could be interpreted as expenditure that enhances the value of economic benefits embodied in the land, or both.

** Assumed that 100% of the manager’s time is allocated to the project; some of the cost could have been allocated to land if the manager was involved in site selection.


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*** Assuming that land costs are incurred at commencement and that building costs are incurred evenly throughout the period, the interest is allocated to land as $180 000 x $1 100 000/($1 100 000 + 0.5 x $1 730 000) = $100 763, and the remainder of the $180 000 interest cost is allocated to the building. Different assumptions at this and earlier steps yield different allocations.

4.34 (a) To answer this question we need to determine whether the land is to be recorded at cost or at a revalued amount. As paragraph 29 of AASB 116 states:

An entity shall choose either the cost model in paragraph 30 or the revaluation model in paragraph 31 as its accounting policy and shall apply that policy to an entire class of property, plant and equipment.

If revaluations are made, the revaluations will be based on the fair value of the asset. For the purpose of this question we will assume that the land is to be valued on the basis of the ‘cost model’. Where the cost model is applied, the asset is to be recorded at the lower of cost and its recoverable amount. If the recoverable amount is less than cost, then an impairment loss must be recognised. AASB 136 Impairment of Assets defines an impairment loss as:

the amount by which the carrying amount of an asset or a cash-generating unit exceeds its recoverable amount.

AASB 136 also defines recoverable amount. According to the standard:

The recoverable amount of an asset or a cash-generating unit is the higher of its fair value less costs to sell and its value in use.

Date

Amount shown in statement of financial position (lower of cost and recoverable amount)

Explanation

31.12.12 $100 000 No impairment, recoverable amount $130 000 (remember, recoverable amount is the higher of fair value and value in use)

30.06.13 $100 000 No impairment, recoverable amount $120 000

31.12.13 $90 000 Impaired, $100 000 > $90 000 > $80 000. An impairment loss of $10 000 is recognised

30.06.14 $100 000 Impairment of $10 000 is reversed

(b) Tweed Ltd should recognise an impairment loss in relation to the land of $100 000 because future economic benefits are not probable. The asset can be reinstated in a subsequent period if it becomes probable that future economic benefits will flow to the entity.


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Documents

Deegan Afa 7e Sm Ch04