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Chapter 7 solutions Bina Nusantara University

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Chapter_7.docx

CHAPTER 7

ASSETS

 

Theory in Action 7.1 — R&D: implications of capitalism versus expensing decisions

 

1.   Explain the accounting treatment of research and development expenditure required by AASB 1011 ‘Accounting for Research and Development Costs’. Compare and contrast this with the accounting treatment prescribed by the International Accounting Standards Board.

 

AASB 1011 ‘Accounting for Research and Development Costs’ affords preparers discretion with respect to accounting for research and development (R&D) expenditure. The standard permits R&D expenditure to be capitalised provided the future economic benefits associated with the R&D expenditure are beyond reasonable doubt. For firms complying with Australian GAAP, it is not unusual to find R&D recognised as an asset on the statement of financial position.

 

IAS 38 ‘Intangibles’ distinguishes expenditure incurred in the research and development phases. Different accounting treatment is prescribed for research expenditure relative to development expenditure. No intangible asset arising from the research phase should be recognised as an asset. Such expenditure is to be expensed in the statement of financial performance in the year incurred. The rationale for this accounting treatment is that it is not possible to ascertain if the future economic benefits associated with research expenditure are probable. IAS38 allows expenditure associated with the development phase to be capitalised on the premise that by moving to the development phase the future economic benefits are more likely than less likely.

 

2.   Do you see any inconsistencies between the accounting treatment prescribed by AASB 1011 and the definition and recognition criteria in SAC 4?

 

According to SAC 4, ‘an asset should be recognised in the statement of financial position when and only when: (a) it probable that the future economic benefits embodied in the asset will eventuate; and (b) the asset possesses a cost or other value that can be measured reliably’ (SAC 4, para. 38). In the context of SAC 4, probable means ‘the chance of the FEBs arising is more likely rather than less likely’ based on the available evidence or logic (para. 40).

 

As noted previously, AASB 1011 permits R&D expenditure to be recognised as an asset provided the future economic benefits associated with the R&D expenditure are beyond reasonable doubt and exceed or are equal to the R&D costs and any subsequent costs necessary to give rise to the future economic benefits. The phrase ‘beyond reasonable doubt’ is a more stringent recognition criterion test relative to the ‘more likely than less likely’ test. This means that the recognition criterion in SAC4 is inconsistent with the recognition criterion applied in the accounting standard dealing with accounting for R&D expenditure.

 

Encourage students to think of any other accounting standards using a recognition criterion different to ‘probable’.

 

3.   In the case of research and development expenditure, do you think that Alfred Berkeley is suggesting that accounting regulation is affecting firms’ real decisions? If so, should this be of concern to regulators?

 

In the USA, accounting standards do not permit R&D expenditure to be capitalised. Such expenditure must be expensed in the statement of financial performance in the reporting period it is incurred. Berkeley is suggesting that firms are reducing expenditure on R&D because it is detrimental to their ‘bottom line’. Expenditure on R&D is essential if firms are to grow and create value. If the accounting treatment of R&D (for example, the requirement to expense) is altering firms’ R&D investment decisions, then long-term benefits are being sacrificed for short-term gains (for example, higher profits). If firms are reacting as suggested by Berkeley, the accounting treatment of R&D is creating economic consequences in the form of sub-optimal investment decisions and compromising long-term value creation.

 

Theory in Action 7.2 — Providing for liabilities

 

1.   Explain the meaning of a foreign currency hedge and the reason behind Newcrest Mining’s foreign currency hedge transactions.

 

A foreign currency hedge is designed to lock in the price today at which a future transaction in a foreign-denominated currency is to occur. The purpose of a hedge is to remove price uncertainty by having a derivative position that will offset any gains/losses associated with the underlying physical position.

 

Newcrest have significant forward US dollar sales. They are exposed to fluctuations in the US dollar – Australian dollar exchange rate. Given that their future revenue stream is in US dollars, an appreciation of the Australian dollar against the US dollar would reduce their revenue stream because less Australian dollars would be received per US dollar. To reduce this foreign currency risk, Newcrest have entered into forward contracts locking in the Australian dollar they will receive in the future per US dollar of revenue. If the Australian dollar appreciates, Newcrest’s Australian dollar receipts per US dollar fall; however, this is offset by the favourable forward contract position. Conversely, if the Australian dollar depreciates, Newcrest’s revenue stream increases when the US dollars are converted to Australian dollars at the spot rate. However, the depreciation of the Australian currency creates an unfavourable position in relation to the forward contract. If the firm was able to create a perfect hedge, the gains/losses would offset each other and foreign currency risk would be eliminated.

 

2.   Discuss whether you believe the provision for losses associated with the foreign exchange hedging positions constitutes a liability, applying the definition and recognition criteria in:

      (a) SAC 4

      (b) AASB 1044 ‘Provisions, Contingent Liabilities and Contingent Assets’.

 

According to SAC 4, liabilities should be recognised:

·      if the firms are presently obliged to make future sacrifices of economic benefits to a third party as a result of past transactions or other past events (liability definition)

·      the future sacrifice of economic benefits will probably be required and the amount of the liability can be measured reliably (recognition criterion).

 

The definition and recognition criteria for liabilities as per AASB 1044 ‘Provisions, Contingent Liabilities and Contingent Assets’ is consistent with those in SAC 4. A liability is defined in the standard as a future sacrifice of economic benefits that the entity is presently obliged to make to other entities as a result of past transactions, or other past events.

 

Provisions are distinguished from other liabilities on the basis of the timing or amount of the future sacrifice of economic benefits being less certain (although the probable criterion would still be satisfied).

 

AASB 1044 clarifies, interprets and discusses the definition and recognition criteria stipulated in SAC 4. Specifically, for the present obligation criterion to be met, the entity must have no realistic alternative but to make a future sacrifice of economic benefits.

 

The consistency in the definition and recognition criteria in SAC 4 and AASB 1044 means that the same decision regarding whether the provision for losses associated with the foreign exchange hedge positions constitute a liability should be reached. It is not truly a liability because it does not meet the definition of a liability given that the present obligation requirement is not met. Given that the contract has not expired, there is no present obligation for Newcrest to settle the difference. Between the current period and contract expiry, rates could move such that favourable (unfavourable) positions become unfavourable (favourable) positions. A contrary view that could be espoused is that there is a potential inflow of future economic benefits (foreign currency asset) or a potential reduction in outflows of future economic benefits. It should be noted that transactions excluded from AASB 1044 coverage include: (1) financial liabilities carried at fair value, (2) derivatives other than financial guarantee contracts (including letters of credit) that provide for payments to be made of the debtor fails to make payment when due, and (3) agreements equally proportionately underperformed except where the agreement is an onerous contract. Consequently, accounting for a forward exchange contract is not bound by AASB 1044.

 

Foreign currency hedging contracts are covered by AASB 1012 ‘Foreign Currency Translation’. Exchange differences on foreign currency monetary items hedging unspecific foreign currency purchases or sales are to be recognised as revenue and expenses in the statement of financial performance in the reporting period corresponding to the period in which the exchange rate change arises.

 

3.   Do you think AASB 1044 clarifies the definition and recognition criteria in SAC 4 in relation to liabilities?

 

AASB 1044 adds clarity to the liability definition and recognition criteria in SAC 4. The standard succinctly distinguishes liabilities, provisions and contingencies. Provisions are a subset of liabilities and separately tagged on the basis that there is greater uncertainty associated with the amount or timing of the future sacrifice of economic benefits. Contingencies fail the recognition criteria on the basis that they cannot be measured reliably and/or the future sacrifice of economic benefits is less likely than more likely. AASB 1044 discusses the meaning of ‘present obligation’ in the grey letter paragraphs, noting that only ‘obligations arising from past events and existing independently of the firm’s future actions or conduct of its operations’ satisfy the definition (para. 3.1.10). It notes that the mere intention to make a future sacrifice is insufficient to give rise to a present obligation. Accordingly, provisions for future losses (as per Newcrest) would not qualify as liabilities due to the absence of a present obligation.

 

Students should be encouraged to examine the examples of applying the criteria for the recognition of provisions contained in Appendix 2 of AASB 1044.

 

4.   Can you suggest some alternative accounting treatments for foreign currency hedges?

 

There are numerous alternative accounting treatments for foreign currency hedges, including fair value accounting, cost or lower of cost and net market value, and hedge accounting.

 

Using a fair value approach, gains and losses associated with changes in fair values are recognised as revenues or expenses in the period the changes occur. Interest payments and receipts related to financial instruments are also recognised as expenses or revenues in the period in which they occur.

 

The cost or lower of cost and net market value methods of accounting for financial instruments reflect conservatism, and defer recognition of gains resulting from the instrument until settlement.

 

The three broad means of hedge accounting are deferral hedge accounting, mark-to-market hedge accounting and comprehensive income hedge accounting. In general, hedge accounting involves mirroring the accounting treatment of the hedged item in the accounting treatment of the hedge instrument. Deferral hedge accounting involves ascertaining if the hedge instrument hedges a specific commitment or an anticipatory commitment. Accounting for the former can require the gain/loss on the hedging instrument to be deferred and incorporated into the carrying amount of the hedged item. For example, if the hedge is of a specific foreign currency commitment and involves establishing the price for the purchase or sale of goods and services, exchange differences occurring up to the date of sale or purchase and at the time of entering into the transaction are deferred and included in the measurement of the sale or purchase. Should the transaction hedge a net investment in a self-sustaining foreign operation, the exchange differences relating to monetary items are brought to account in the statement of financial performance in the period they relate to and, on consolidation, transferred to a reserve account — foreign currency translation. It can alternatively involve taking gains and losses to the current period’s earnings if the gains and losses on the hedged item are also taken to earnings. On the other hand, if the hedge is associated with an unrecognised anticipated commitment, the gain/loss is normally deferred as a separate item on the statement of financial position until the future transaction eventuates.

 

Mark-to-market hedge accounting involves marking to market both the hedged item and the hedging instrument, with associated gains/losses being recognised in earnings of the same period. It is based on the premise that the effects of changes in market rates or prices of the hedging instrument and hedged item should be recognised concurrently in the statement of financial performance. Theoretically, a perfect hedge results in the gain (loss) on the hedged item being exactly offset by the loss (gain) on the hedging instrument. Given that perfect hedges are unlikely, issues arise in respect of the extent to which gains or losses on hedged items should be matched with those on hedging instruments.

 

A comprehensive income approach to hedge accounting requires the hedging instrument to be marked to market with the accounting treatment differing according to whether the gain/loss is realised or unrealised. Realised gains and losses are taken to earnings in the period they are realised, as are the gains and losses on the hedged items. Unrealised gains/losses are taken to equity and transferred to earnings when realised, along with the gains/losses on the hedged items.

 

The three accounting approaches discussed — fair value, cost or lower of cost and net market value, and hedge — are not exhaustive of all approaches that could be adopted. Alternative approaches based on them are possible.

 

5.   The justification for the provision is that it reflects ‘proposed tougher accounting standards’. Presuming this comment refers to ‘mark-to-market accounting’, is the creation of a provision account consistent with such a measurement and recognition model?

 

Prior to accounting regulation governing provision accounts, firms were criticised for using provision accounts as ‘cookie jar reserves’. In ‘surplus’ (‘deficit’) earning years, firms bought forward (deferred) expenses via the provision accounts. As discussed above, AASB 1044 prescribes the requirements to be satisfied in order for a provision account to be created. This accounting standard has reduced flexibility associated with recognising provision accounts thereby imposing ‘tougher rules’ on preparers. As argued above, the tougher rules would most likely prohibit Newcrest recognising a provision for foreign exchange hedging positions if such transactions were within the standard’s scope.

 

An accounting standard dealing with the recognition and measurement of financial instruments (including derivatives) is expected in the future. It is anticipated that this standard will require financial instruments to be marked to market, with the gains/losses recorded as revenue/expenses in the reporting period unless strict hedge criteria are satisfied permitting gains/losses to be deferred. It could be argued that Newcrest has created a vehicle (the provision account) that will allow it to reduce expenses in future periods by reducing the provision account and thereby have the flexibility and mechanism for reporting higher earnings in future periods.

 

Theory in Action 7.3 — A taxing issue

 

1.   Does the conceptual framework shed light on the appropriate classification of convertible notes in the statement of financial position?

 

SAC 4 defines elements of financial statements, namely assets, liabilities, owner’s equity, revenue and expenses. It provides the generic definition and recognition criteria but does not apply the criteria to particular transactions or instruments. Given that SAC 4 defines equity as the residual interest in the assets of the entity after the deduction of its liabilities (para. 78), the liability definition would need to be applied to the convertible note instruments. If the definition and recognition criteria for a liability were satisfied then classification as a liability would be appropriate. If the liability definition were not met then the instrument would be classified as equity. SAC 4 does recognise that the distinction between equity and liabilities can be blurred in practice. Particular reference is made to preference shares, convertible debt and ‘perpetual capital notes’ in SAC 4, paragraph 97, stating that the classification should be based on considering the instrument’s risk and return attributes.

 

2.   What is the appropriate classification prescribed by AASB 1033 ‘Presentation and Disclosure of Financial Instruments’? Are there any difficulties in implementing these classification requirements?

 

AASB 1033 (operative for reporting periods post December 1997) requires a firm to report the economic substance of claims against the firm rather than their legal substance (where there is a difference) when classifying items in the statement of financial position.

 

AASB 1033 requires the terms and conditions of instruments to be examined and the instrument to be classified as debt or equity, or its components to be classified as debt or equity. This standard has implications for preference share and convertible instrument classifications.

 

For a converting instrument, the standard setter’s position is that classification depends on whether the holder of the instrument is exposed to equity risk. If the conversion price is fixed at the time of issue, the holder of the instrument is exposed to equity risk and thus the instrument has an equity component. If the conversion price is based on the market price at the time of conversion, no equity risk results until conversion, and the instrument would be classified as a liability. The treatment of the interim cash flows to the instrument holder as interest or dividends must conform to the instrument’s classification in the statement of financial position.

 

AASB 1033 requires that for instruments containing both a financial liability and an equity element, the issuer must classify the instrument’s component parts separately. With respect to a convertible note where conversion is fixed at the time of issue, the instrument is effectively a debt instrument with an equity option attached.

 

The difficulty in implementing the requirement to split accounts arises in relation to valuing the separate components. AASB 1033 does not prescribe how to value and assign a carrying amount to the respective components; although it suggests the following two approaches: (1) the residual approach where the more easily measured component is valued and the difference between the amount raised and this value is assigned to the less easily measured component; and (2) measure both components separately and pro rata any difference in the amount raised and the sum of the component values across the components.

 

3.   The conceptual framework and specific accounting standards specify economic substance over legal form. Do you believe this is appropriate?

 

Given that one of the objectives of financial reports is to provide information useful for decision making, it is appropriate that the financial report reflect economic reality. Accordingly, prescribing economic substance over legal form is warranted. This approach is criticised on the basis that determining economic substance introduces judgement and subjectivity and inconsistency, whereas legal form is objective.

 

4.   Discuss the implication for firms of having differences in accounting and taxation treatments.

 

Economic and legal form is often consistent; however, the case at hand illustrates a difference in accounting treatment and taxation treatment. Prior to the change announced in the federal Budget, the taxation treatment of convertible notes relative to other convertible securities was inequitable because the point at which a tax liability accrues was earlier for a convertible note (for example, at the time of conversion). The taxation changes announced mean that convertible note holders are no longer liable for capital gains tax at the point of conversion. A liability will not accrue until the instrument is sold. Modigliani and Miller (1961) argued that in perfect capital markets the firm’s financing decision is irrelevant to firm value. However, market imperfections, such as taxation, alter the risk–return attributes of instruments and thereby affect the firm’s cost of capital and hence firm value. This means that firms need to be cognisant of taxation and accounting treatments of financial instruments when making financing decisions. When considering raising finance, firms need to assess the impact on their statements of financial position and performance pursuant to the prescribed accounting treatment for the instrument. Differences in taxation and accounting rules mean they also need to consider the taxation implications of the instrument, as this will affect the rewards and risks attached to the instrument and the demand for the instrument in the market place. As suggested in the article, the previous taxation treatment of convertible notes made them less attractive to potential investors relative to alternative instruments, and this impacted on firms’ financing choices.

 

Questions

 

1.   The conceptual framework defines the elements of financial statements by reference to elements of the statement of financial position, particularly assets. What attributes must something possess in order to be defined as an asset? Why?

 

For something to be defined as an asset, it must possess the following attributes:

·      future economic benefits or services

·      be controlled by the entity

·      be the result of a past transaction or event.

 

These attributes ensure that whatever is defined as an asset is ‘worthwhile’ to the entity. Although future economic benefits or services are the essence of an asset, the definition ignores the present existence of an asset. The FASB’s view in ABB Statement No. 4 — that assets are economic resources — provides a more current perspective. In time, economic resources are capable of rendering future benefits or services.

 

2.   SAC 4 defines assets, liabilities and equity by reference to economic benefits.

      (a) What are the economic benefits that would be assets for SalzanCorp, a government business enterprise that constructs the physical infrastructure (roads, bridges, etc.) for the city of Huntersville?

      (b) Must economic benefits be revenue-generating, or can parks, roads or statues provide economic benefits?

 

(a)  An economic benefit is ‘scarce’ and has ‘utility’. Utility pertains to the future economic benefits or services. Because the resource is scarce and has future benefits, it has economic value. SalzanCorp — a government business enterprise constructing physical infrastructure for the city of Huntersville — would have assets comprising productivity resources to build the infrastructure (that is, equipment) and claims to receive money associated with contracts and money. If SalzanCorp retains ownership of the infrastructure assets and they are leased to the city of Huntersville, the infrastructure assets provide economic resources to SalzanCorp (that is, lease receipts) and constitute assets.

 

(b) Within the USA, the FASB in Statement No. 4 defined economic resources as ‘the scarce means available for carrying out economic activities’. The term, as used by accountants, is somewhat broader in meaning than used in economics. For example, economists prefer to distinguish between products of an enterprise, unless they are capital goods, and resources. Examples of economic resource benefits are:

·       productivity resources (such as raw materials, equipment, patents, or contractual rights to the use of resources of other entities)

·       products

·       money

·       claims to receive money

·       ownership interests in other enterprises.

 

      Economists do not insist that an economic resource be the result of a past transaction or event of an entity.

 

      Monuments, parks and/or roads provide service potential to the authorities providing and maintaining them because they enable those authorities to pursue their objectives. However, to the extent that the monuments, parks, and/or roads do not generate inflows or reduce outflows of cash (other than indirectly from increased rates or donations, etc.), they do not contribute economic benefits.

 

3.   The SAC 4 definition of assets requires future economic benefits to be controlled by an entity before they can be regarded as an asset. How does ownership differ from control? Which criterion (ownership or control) do you think should be applied in defining assets? Why?

 

The term ‘owned’ means different things to different people. Ownership is usually associated with legal ownership or entitlement. A criterion to meet the asset definition is that the entity controls the future economic benefits. The term ‘control’ is used rather than ‘owns’. Control is associated with the right to regulate access to, and use of, the future economic benefits. This implies that the entity has a legal right to receive the benefits. For example, for an operating lease, the lessee does not legally ‘own’ the asset, but it does have the legal right to receive the benefits or services of the asset.

 

4.   According to SAC 4, assets do not exist unless they result from past transactions or events. Determining whether a past transaction or event has occurred to give rise to an asset is not always straightforward. Explain the past transaction or event that triggers the existence of the following assets:

(a) accounts receivable             (d)  work in progress

(b) prepaid insurance                (e)  finance lease of manufacturing plant

(c) inventory                               (f)   goodwill (internally generated or purchased).

 

(a)  accounts receivable — the sale of the product or service

 

(b) prepaid insurance — the purchase of the insurance policy

 

(c)  inventory — the purchase of the inventory

 

(d) work in progress — the production activity

 

(e)  financial lease of manufacturing equipment — the signing of the lease agreement; or if the equipment is to be constructed, when the construction is completed

 

(f)  goodwill — the purchase of a company (purchased goodwill); the activity/activities generating reputation (internally generated goodwill).

 

Instructors might discuss the ‘reasonableness’ of the accepted past transaction or event for each of the assets mentioned above. For example, the relevant event for inventory could be the physical receipt of the inventory, especially because the timing of order, invoicing, receipt and payment, can vary in order and separation.

 

5.   What is an agreement equally proportionately unperformed (AEPU)? According to strict interpretations of SAC 4 definitions of assets, liabilities and equity, should AEPUs be reported on the statement of financial position? Why or why not?

 

Wholly executory contracts (agreements equally proportionately unperformed, or AEPUs) are not recorded because they involve only an exchange of promises. There is no performance yet to give ‘economic substance’ to the contract. That is to say, the signing of the contract is not regarded as the relevant past transaction or event to give rise to an asset or liability. Yet they are in question 4 above. The instructor may wish to discuss the reasons why. For a financial lease, there is a transfer of the asset to the lessee for his or her use. For a forward exchange contract, the contract may be sold and therefore the contract itself has value. In both cases, as far as accountants are concerned, something of value has been exchanged, not just promises.

 

Most wholly executory contracts would be recorded by firms complying with SAC 4 because the statement requires the recognition of both the asset and liability involved in such contracts. Given that the asset and liability definitions in SAC 4 would require AEPU to be recognised, firms opposed SAC 4 in its original form because existing reporting practices would alter. However, in its revised format, SAC 4 specifically excludes certain AEPUs from its scope.

 

6.   Under some market-based systems of accounting, asset definitions require that to be defined as an asset, an economic benefit must be both ‘severable and saleable’, sometimes described as ‘exchangeability’. Is that a requirement in the SAC 4 definition of assets? Why or why not? Do you think that severability is necessary to a definition of assets? Why or why not?

 

Those who favour exchangeability believe an asset should be ‘separable’, and have value of its own. They argue that the entity should be able to sell it, and an asset should be capable of separate identification in order that it can be measured (valued). Such a condition would exclude certain intangible assets (such as goodwill) and deferred charges (such as deferred income taxes) from assets. Using this approach, the purpose of financial accounting and of the statement of financial position is to report the value (cost) of a firm’s assets, not to report the value of the business as a whole. To value a business involves predicting its future earnings (or net cash flows) and is a function of the combination of resources rather than individual items.

 

Those who oppose exchangeability as a necessary feature of assets believe that this unduly emphasises a single way (exchange) of obtaining benefits from assets, and depends on a misguided view of ‘economic value’. They argue that value is only through their use rather than exchange. Assets are used jointly, and therefore in most cases their benefits cannot be precisely identified. There is no reason to believe that the contributions of certain intangible assets are proportionately less than tangible assets, or that they are less because there is no market to sell them separately. Because benefits received from using resources are unaffected by whether or not they are exchangeable, the condition of exchangeability is irrelevant in deciding whether an item is an asset. Economic value depends on scarcity and utility, not exchangeability.

 

To include as assets certain intangibles, such as goodwill, is not an attempt to value the firm as a whole, but an attempt to include in total assets the future benefits obtainable by the firm as a result of past transactions or events.

 

SAC 4 does not regard exchangeability as a criterion to apply in defining an asset. It recognises that if something is exchangeable for something else of value, then it has future economic benefit and is presumably an asset. However, it recognises that some assets may not be exchangeable. For example, roads and monuments may be unsaleable, but they have service potential for the organisation controlling them and are therefore assets under SAC 4.

 

7.   Are the following assets? If so, whose assets, and why?

      (a) Members of the Australian netball team

      (b) A 12-month lease agreement to rent a business office

      (c)  Expenditure on research and development

      (d) An unsigned, documented contractual agreement to build specialised equipment for a client

      (e)  A building bequeathed to a firm

      (f)  A 5-year option to acquire property, where the option was purchased by the company a year ago

 

(a)  Human resources. They meet the definition of assets, but because of the difficulty of placing a value on them they are not recognised. They meet the definition, but fail the recognition test. (If they are on a losing streak, are they still assets? As long as they generate future economic benefits, they remain assets whose measurement and probability may not warrant capitalisation as assets.) It can also be argued that as executory contracts they ought not to be recognised.

 

(b) Operating lease. For the lessee (tenant), there are no future benefits which he or she has control over unless the rent is prepaid or there is a contract specifying the rights to benefits. According to AASB 1008, there is no intent by the lessor to transfer substantially all ownership benefits and risks to the lessee. Nonetheless, once a contract is in place there is a right to control the inflow of economic benefits, and an obligation to pay for them. As such, both an asset and a liability do exist under SAC 4 definitions.

 

(c)  Research and development. AASB 1011 allows certain R&D costs to be capitalised if the technical feasibility of the product or process that they relate to has been demonstrated, and there is a clear indication of a future market for the product; or if the item is to be used internally, its usefulness can be demonstrated. Under SAC 4, if future economic benefits are probable, an asset exists.

 

(d) Contract. There is no basis for believing future economic benefits exist. Because there is no performance, it is possible that the buyer (client) may get out of the contract. The law does not recognise a sale for custom-made goods unless performance has begun. In this case, the contract for performance has not even been signed. There is no asset.

 

(e)  Bequest. An asset does not need to have a cost. The land is now under the control of the company, it has future benefits, and it arose from a past transaction (the donation) — therefore, by definition it is an asset. The company should record it at fair market value.

 

(f)  Option. At the time the option is purchased, it should be considered an asset. It gives the company the right to purchase the building and therefore has future benefit. If the building is actually purchased, whether the option should be considered part of the cost of the building is another issue. It can be argued that the option was purchased as part of an integrated plan to acquire an appropriate building, and therefore it is part of the cost of the building. On the other hand, does the purchase of the option make the building more valuable than the actual bargained price of the building? If the option lapses, it should be expensed.

 

Problems

(For a full outline of problems, please see text.)

 

7.1    Su Lamp Ltd, an electrical goods manufacturer, entered into the following transactions during the year 2000 (see pp. 523–4). Show how they should have been recorded by Su Lamp Ltd under Australian accounting regulations that year, and comment whether there are any differences in that reporting from what would be recorded if the company reported solely on the basis of SAC 4 requirements.

 

1.      This problem demonstrates the difficulty of determining whether an asset or liability exists. There is an asset if the realisation of the tax benefits will occur because of future income. AASB 1020 and SAC 4 are relevant. The reason for the loss can be identified as an isolated incident. The company has been continuously profitable over a long period of time, and assuming that it is more probable than not there will be sufficient taxable income in the future that the benefit will be realised, and an asset can be recorded.

 

         Deferred tax asset                                                                      $144 000

                   Income tax benefit from loss carry forward                                                $144 000

 

2.      This is a wholly executory contract. No entry to be made. There is no performance.

 

3.      SAC 4 is pertinent. At this point, there is insufficient evidence to say that it is ‘probable’ a liability has been incurred. There is no entry to record. Footnote only.

 

4.      Is there a liability? Su Lamp Ltd plans to appeal, and there is a possibility the decision could be reversed. However, there is presently an obligation as a result of past events, the payment is probable, and the amount is reliably determinable. As such, there is sufficient evidence to say it is ‘probable’ a liability has been incurred, and the amount can be reasonably estimated.

 

         Loss from lawsuit                                                                      $400 000

                   Lawsuit liability                                                                                           $400 000

 

  On the other hand, if the outcome of the appeal is favourable with more than 50% probability, then a liability should not be reported, although a contingency should be disclosed.

 

5.  No entry is to be made. The contract has only been signed. The fact that the contract is with the city hall and is a cost-plus contract makes no difference.

 

6.      AASB 1012 is relevant. Although the contract is signed only and there is no ‘performance’, there is an entry to record. The reason is that the contract can be sold. The contract itself has exchange value.

 

         Investment in forward exchange contract (asset)                      $70 423

         (¥100 000 ´ 1/1.42)

  Deferred loss on forward exchange contract                                                    $3 757

                   Forward exchange contract payable (100 000 ¥ ´ 1/1.5)                              $66 666

 

  When the equipment is acquired, the deferred loss is capitalised into the cost of the equipment.

 

7.      A liability does not have to be a ‘legal’ liability. Company policy can be the basis of an obligation. The bonus is based on past services rendered by the sales manager, and therefore an expense should be accrued.

 

         Salaries and wages expense                                                        $15 000

                   Salaries and wages payable                                                                           $15 000

 

7.2    Zanadriana Ltd is a start-up pharmaceuticals company with 50% of its operations in research and development. The following transactions and events occurred in year 1 (see pp. 524–5). Record them in the company’s accounts in accordance with Australian accounting regulations. If needed, an appropriate rate of interest is 8% p.a. (See compound interest tables in the appendix at the back of the book.)

 

1.      According to AASB 1011 this can be expensed; alternatively, it can be capitalised where future benefits are probable.

 

         Research and development expense                                         $250 000

                   Cash or Accounts payable                                                                            $250 000

 

         or

 

         Research and development cost (asset)                                    $250 000

         (The asset will be amortised in line with receipt of the future benefits.)

                   Cash or Accounts payable                                                                            $250 000

 

2.      This is a 100% purchase of Austin Power Ltd. Austin Power Ltd will be merged with Zanadriana Ltd, and therefore Zanadriana Ltd absorbs the former’s assets and liabilities. Because the transaction is a ‘purchase’, there is a new basis of accountability.

 

         Current assets                                                                           $ 140 000

         Land and buildings                                                                   1 700 000

         Goodwill                                                                                     310 000

                   Liabilities                                                                                                    $ 150 000

                   Cash                                                                                                            2 000 000

 

         It should be noted that goodwill is recorded. The accounting principle is that it can only be recorded when it is paid for. It may be interesting to discuss why. One reason is the cost principle. Another is the problem of measurability. It is difficult to know what the value of goodwill is until there is an actual transaction.

 

3.      Cost of purchase                                                                     $1 900 000

         Market value of net assets acquired                                       1 990 000

         Excess of market value over cost                                            $  90 000

 

         The $90 000 excess must be absorbed by the long-term assets.

 

         Current assets                                                                         $  240 000

         Land and buildings                                                                 $1 810 000

                   Liabilities                                                                                                    $ 150 000

                   Cash                                                                                                            1 900 000

 

         In order to avoid the recording of negative goodwill, the excess of book value over cost, after recognising the market value of current assets, serves to reduce the value of the long-term assets (except investments). This entry contradicts the market values placed on the building and land.

 

4.      The secret formula appears to meet the definition of an asset. But it will not be recorded, unless     (a) a patent is taken out, or (b) a market valuation can be obtained. This is because it was not purchased and the research and development costs have been expensed. A reliable measure needs to be obtained, and control ascertained.

 

5.      According to AASB 1008, this is a capital lease if there is a transfer of the rights and obligations of ownership, otherwise it is an operating lease. It is not possible to tell from the information given whether the lease is operating or capital, because the life of the machinery is not given, nor is the normal price of the machinery. Thus, it is impossible to tell whether the machinery can be acquired at a bargain purchase price at the end of three years, or whether the machinery is leased for a significant portion of its useful economic life.

 

         If the machine is leased under an operating lease:

         Lease expense                                                                             $50 000

                   Cash                                                                                                               $50 000

                  

         If the machine is leased under a capital lease:

         Leasehold asset                                                           

         (PV of $50 000 @ (12√1.08)% for 35 periods + $50 000 + PV of 5 y3a4 annuity of $3000 per month or $40 000, whichever yields the lower amount)

          Lease liability                                                                                

         (PV of $50 000 @ (12√1.08)% for 35 periods + $50 000 + PV of 5 y3a4 annuity of $3000 per month or $40 000, whichever yields the lower amount)

 

  Note that the tables at the back of the text (and most tables) do not offer the appropriate monthly compound interest rate to yield an 8% annual return, which is assumed at the start of this problem.

 

6.      The executives obviously represent future economic benefits to the company. The contracts with them are regarded as executory contracts, however. Despite the contracts being in place, the firm does not control the executives in a total sense, and when the services are received by the company an expense will be recorded. Unless the salaries are prepaid, there is no asset to record.

 

7.3    Kalmers & Meehan, a taxation partnership, is preparing its 30 June 2005 financial statements, and seeks advice from PK & Slug, a firm of reputable accountants. What advice would PK & Slug offer in relation to accounting for each of the following situations (see p. 525)? If a journal entry is required, what should it be?

 

1.          At the time that Kalmers & Meehan provided taxation advice to Petermans Ltd, Kalmers & Meehan would have deemed it probable that there would be an inflow of $70 000 for taxation advice. As such, there was a probable inflow of economic benefits as a result of a past transaction (taxation advice provision), and revenue would have been recognised. It is only now that the firm realises that the inflow is unlikely. As such, there is a reduction in probable future economic benefits as a consequence of the debate about the appropriateness of the advice offered by Kalmers & Meehan (this is the past event, along with Petermans Ltd’s refusal to pay). The firm should recognise a reduction in the revenue receivable asset, and recognise an expense (doubtful debts) to offset against the previously recognised revenue. Possibly, the expense should be bad debts rather than doubtful:

 

When advice was provided and it appeared probable that Petermans Ltd would pay:

           Dr      Accounts receivable                                                 70 000

                     Cr     Taxation advice revenue                                                              70 000

 

30 June 2005

           Dr      Doubtful debts expense                                            70 000

                     Cr     Accounts receivable                                                                      70000

 

2.        The fact that Jilsonade Jolly Vineyards Ltd has not yet delivered the wine does not mean that it is unlikely that the firm will do so. If Kalmers & Meehan deem it probable that the wine will be delivered, they have an asset in the future economic benefits: the wine can either be used within the firm, or sold. Furthermore, it is measurable. If it is deemed probable that the wine will be delivered, the asset and associated revenue should be recorded.

 

When advice was provided and it appeared probable that Jilsonade Jolly Vineyards Ltd would pay (whether in money or in wine):

 

           Dr      Accounts receivable                                                    5000

                     Cr     Taxation advice revenue                                                                 5000

 

         The fact that the accounts are being prepared six weeks after the invoicing and the wine has not been received is not necessarily unusual, and should not necessarily trigger doubts about receiving the wine. However, it if is deemed improbable (less than 50% probable) that the wine will be delivered, then no revenue or asset should be recorded. If they have already been recorded, they should be written-down or written-off, in the same manner as the entries recorded for part 1 of this problem (Petermans Ltd).

 

3.        The fact that Kalmers & Meehan was prepared to pay the cost of a walkway indicates that the firm deems it likely that the walkway will increase revenues (perhaps being more enticing to clients, or because it provides a more sophisticated/successful image). As such, it would be deemed an asset.

 

           Dr      Land & buildings                                                         3000

                     Cr     Bank/Loan payable/…                                                                    3000

 

7.4    Pip Lax Ltd manufactures high-quality sports equipment and sells it under a 2-year warranty. The company guarantees to replace any defective parts and repair equipment at no cost to its customers. Record the following events of 2003 (see p. 525). The company has a calendar reporting year.

 

The purpose of this problem is to discuss what constitutes a liability, and when it is recorded. Two methods to account for warranties are available to accountants. One of them involves the establishment of a liability account, and the other does not. As the circumstances are the same, is there or is there not a liability? Given historical trends, it is likely that there should be a liability recorded for probable future outflows of economic benefits related to labour, parts, etc. As such, option (a) below is the preferable answer. Option (b) is shown for comparative purposes only.

 

(a)     Accrual method entries for 2003 year:

 

                   Warranty expense                                                            $500 000

                            Estimated liability on product warranty                                             $500 000

 

                   Estimated liability on product warranty                          $800 000

                            Cash, Parts inventory etc.                                                                   $800 000

 

For ease of accounting, each year a warranty liability is increased for the probable warranty expenses based on the period’s sales. This liability is reduced as costs are incurred so that the balance should always be somewhere close to the expected cost of warranty repairs for the last two years’ worth of sales. There is no point reversing the warranty expense entry each year and starting afresh if warranty expense estimates are reasonably accurate.

 

(b)     Cash-basis method for 2003:

 

         During year         Warranty expense                                         $800 000

                                                    Cash, Parts inventory, etc.                                          $800 000

 

         The cash basis can be used if the amount of the warranty cost is not material, or the two criteria mentioned in SAC 4 — probability of incurrence of a liability and ability to estimate the amount — are not met. In this case, the company should be using the accrual method. At least to a limited degree, both methods are acceptable. The question is: Why does one method yield a liability, and for the other, there is none? The circumstances of giving customers a warranty are substantially the same, so that the condition of SAC 4 should be met. If there is a liability, then only the accrual method should be used, and the cash method should be declared unacceptable.

 

7.5   Sleech Ltd operates an information systems company. The firm is preparing its 30 June 2003 financial statements, and requires advice concerning the proper treatment of the following situations (see pp. 525–6). Explain how to deal with each situation, and prepare any required journal entries.

 

1.      As of the balance sheet date, there is no particular event to cause the company to believe that an asset has been impaired or a liability has been incurred. Expected losses, even if subject to reasonable estimation, do not satisfy the requirements of AASB 1044. The company may record an appropriation for self-insurance.

 

                   Retained earnings                                                            $500 000

                            Retained earnings appropriation — self-insurance                            $500 000

 

         When the loss actually occurs, then the following entry is to be made:

 

                   Loss from casualty                                                                        x

                            Asset (specific asset damaged)                                                                        x

 

         The appropriation should not be debited for the actual loss.

 

2.                Salary expense (bonus)                                                    $500 000

                            Paid up capital                                                                                    $500 000

 

3.      Labour strikes are considered a general risk contingency inherent in business operations. Although negotiations have terminated at present, they will probably continue at a later date. The threats and bluster of labour negotiations are common. No entry should be recorded. Disclosure is not necessary in the balance sheet.

 

4.      It is probable that a liability has been incurred, and the amount is reasonably determinable. The company knows the cause of the demand for refund (for example, overcharging of items). Therefore, the following entry should be made.

 

                   Loss from Danlon & Dolland contract                              $75 000

                            Liability on Danlon & Dolland Contract                                              $75 000

 

5.      There is sufficient evidence of impairment of asset values at the balance sheet date, because the foreign government has actually given notice of intent to expropriate. The amount is subject to reasonable estimation. Therefore, according to SAC 4, a loss should be recorded. At the time of actual expropriation, the specific assets would be written against the allowance for expropriation account.

 

         Book value of subsidiary                                                     $12 900 000

         Expected amount from government                                       9 000 000

         Loss                                                                                       $ 3 900 000

 

         Loss from expropriation                                                       $03 900 000

                   Allowance for expropriation                                                                     $3 900 000

 

Case Study 7.1 — Business wins tax break on debt

 

1.   Explain how the following satisfy the definition and recognition criteria to be included as assets:

(a) capitalised costs

(b) deferred tax balances

(c)  leases

(d) prepayments.

 

To be defined as an asset, the following need to be satisfied: (1) existence of future economic benefits, (2) controlled by the entity, and (3) the result of a past transaction or event. To be recognised in the statement of financial position, the future economic benefits must be (1) probable and (2) possess a cost or be capable of being measured reliably. The list of items in this question are permitted under accounting rules to be recognised as assets on the basis that each satisfied the definition and recognition criteria.

 

(a)  Capitalised costs. Examples of capitalised costs are research and development and capitalised borrowing costs. In the case of R&D, if the technical feasibility of the product or process to which they relate has been demonstrated, and there is a clear indication of a future market for the product, or if the item is to be used internally, its usefulness can be demonstrated. Under SAC 4, if future economic benefits are probable, an asset exists and the expenditure on the R&D represents the cost to be assigned to the asset. In the case of capitalised borrowing costs, if the costs incurred are associated with a qualifying asset then they can be recognised as part of the cost of the qualifying asset. Borrowing costs would be avoided if the qualifying asset were not proceeding so the borrowing costs are integral to the asset. This accounting treatment is permissible on the basis that the incurrence of the borrowing costs will result in future economic benefits embodied in the qualifying assets. The costs can be measured reliably as the actual borrowing costs incurred on that borrowing during the reporting period.

 

(b) Deferred tax balances. The future economic benefit is the realisation of the tax benefits (future economic benefits) — the entity controls the tax benefits and they have arisen as a result of a past transaction. To satisfy the recognition criteria, it must be more probable than not that there will be sufficient taxable income in the future that the benefit can be realised and the tax benefit is capable of being measured reliably. AASB 1020 stipulates that deferred tax assets represent income tax recoverable in future reporting periods from deductible temporary differences and carried forward unused tax losses. To recognise such an asset relating to the unused tax loss, it must be probable that future taxable amounts will be available to enable the tax losses to be recovered.

 

(c)  Leases. The future economic benefit associated with leased assets is the ability to use the assets to generate the future economic benefits. SAC 4 does not require legal ownership but the ability to control the future economic benefits. Provided the lease is structured in such a way that the risks and rewards of ownership are effectively transferred to the lessee, the lessee can control the access to, and use of, the asset. The past event would be the signing of the lease contract. It is probable that the leased asset will provide future economic benefits (otherwise why would the asset be leased) and the leased assets possess a cost or value that can be measured reliably (the value of the lease payments). AASB 1008 ‘Leases’ permits leased assets to be recognised on the statement of financial position where the lease terms transfer substantially all the risks and benefits incidental to ownership of the leased assets to the lessee (that is, a finance lease).

 

(d) Prepayments. A prepayment represents something that has been paid for, yet the future economic benefits as at the end of the reporting period have not been used. The firm controls the future economic benefits and they arise as a result of a past transaction (that is, the payment). The recognition criteria are satisfied as the future economic benefits will be realised, normally within the next reporting period; and as they have been paid for, the asset has a cost value.

 

2.   Why will treating these items according to accounting concepts boost most companies’ equity levels?

 

The Australian Taxation Office ruling permits these items recognised as assets for accounting purposes to also be recognised as assets for taxation purposes. The double-entry system of accounting means that recognising such items as assets could result in an increase in equity. Duality ensures that recognising one asset must have the dual effect of either (1) reducing another asset (in which case equity would remain unchanged), (2) increasing a liability (in which case equity would remain unchanged), or (3) increasing equity. Students should be encouraged to work through the dual effects of the transactions in question 1.

 

3.   The article suggests that the tax ruling will reduce the need for additional asset revaluations. Discuss.

 

The tax ruling discussed in this article relates to interest deductibility restrictions imposed of certain firms. If a firm’s debt-to-equity ratio exceeds 3, then deductibility of interest on excessive borrowings will be denied. The rule changes mean that certain accounting assets that were precluded from inclusion as assets when calculating a firm’s debt-to-equity ratio for taxation purposes are now able to be included in the asset base. The effect of asset revaluations is to increase assets and increase equity (via the asset revaluation reserve). The increase in assets and equity due to the rule change means that firms will be less reliant on asset revaluations to increase their equity in an effort to avoid breaching the prescribed gearing ratio.

 

4.   Compare the implications for a firm of breaching the Australian Taxation Office’s debt covenant with that in a loan agreement.

 

Breaching either the ATO’s debt covenant or the loan covenant has economic consequences for firms. Breaching a debt covenant in a loan agreement is a breach of contract. The ramifications associated with such a breach will depend on the magnitude and reasons for the breach. A technical breach may involve the debt contract being renegotiated. The consequence of a more extreme breach could be the contract being rescinded and the firm losing access to the debt facility. In either situation, costs are imposed on the firm although the magnitude of the cost imposition differs.

 

Breaching the ATO’s debt covenant denies the firm a tax deduction in relation to interest on borrowings. This will increase their tax liability and increase the tax payable.

 

The existence of debt covenants creates incentives for preparers to use the discretion and judgement afforded to them in accounting regulations to portray the financial statements in a particular manner. The alignment of taxation and accounting rules intensifies the incentives because accounting numbers are now specified in both lenders’ borrowing contracts and ATO rules.

 

Case Study 7.2 — A patent is like having a safety net

 

1.   How does a patent differ from a trademark?

 

Intellectual property rights is the term collectively given to rights such as trademarks, mastheads and patents. A patent is the right to an invention, design or product appearance. A trademark is the right to use a name in association with goods and services (for example, Coca Cola). A trademark denotes the origin of a product or service. Both patents and trademarks are recognised as intellectual property rights issued by a national government body to identify a firm’s goods and services (trademark) or right to an invention, design or product appearance (patent).

 

2.   Are patents and trademarks assets as defined under SAC 4? Should patents and trademarks be recognised in the statement of financial position? If so, how could they be measured reliably?

 

To qualify as an asset it is necessary that a future economic benefit that is controlled by the entity exists as a result of a past transaction. There is no doubt that the registration of trademarks and patents constitute past transactions. The registration conveys rights to the owner (in this case, intellectual property) and prohibits others from using the rights. The trademarks and patents are controlled by the entity. The issue with respect to deriving future economic benefits is more contentious. The recognition of trademarks as identifiable intangible assets is premised on the notion that consumers identify goods and services based on their trademark and this creates a demand for the goods and services that would not be parallelled in the absence of those naming rights. The future sales expected to be derived, as a result of consumer awareness with a trademark conveys future economic benefits to the firm. The derivation of future economic benefits associated with a patent is associated with the future revenue stream derived and protected from the sale of products governed by the patent. Satisfying the recognition criteria is more problematic. Future economic benefits are probable if the trademark is well established and recognised in the marketplace. The probability of future economic benefits associated with a patent is less obvious given that many patents do not result in successful products, and protecting future revenue streams via patents is not always successful. Patent challenges in court have often deemed patents to be invalid due to ineffective drafting.

 

SAC 4 does not allow recognition of any assets unless there is a cost or other value that can be measured reliably. In the context of trademarks and patents, the cost is readily measured — firms pay a price to register the trademarks and the patents.

 

3.   Given that Safe-T-Netts are not for sale, but custom-made for a particular site and then leased, should the nets be recognised as an asset?

 

The fact that the Safe-T-Netts are not for sale, but custom made for a particular site and then leased should not impede recognition of the nets as assets. The definition and recognition criteria do not include saleability; and so long as the specified asset definition and recognition criteria are met, the nets are assets of the firm. The Safe-T-Netts provide future economic benefits to the firm in the form of lease rentals. The future economic benefits arise as a result of a past transaction — the lease contract. The key issue is whether the firm controls the nets and future economic benefits that they generate once they are leased to the building and construction firms. If the lessor (the net manufacturer) effectively transfers the substantial risks and benefits of ownership to the lessee then the nets would be assets of the lessee rather than the lessor. The fact that the nets are custom made suggests that control of the nets effectively passes to the lessee.

 

4.   A major corporation has exclusive interstate and overseas licensing rights for the nets. Are the licensing rights assets as defined under SAC 4 and should they be recognised in the statement of financial position of the licensee?

 

Licensing rights would satisfy the asset definition and recognition criteria. The rights convey future economic benefits to the licensee as the rights would be expected to generate cash from future revenue streams for the licensee. The rights are controlled by the firm — as while they have the rights other parties are denied access to the rights. The signing of the agreement conferring the rights to the licensee constitutes the past transaction. The future revenue stream would be probable and the value of the rights can be measured reliably based on what the licensee paid for the rights. Many Australian firms recognise rights (for example, management agreements) and licensing agreements (for example, television licences) on their statement of financial position. (Recall that as at 30 June 2002, there is no Australian accounting standard prescribing the recognition and measurement of identifiable intangibles.)

 

Case Study 7.3 — Smarten up on intellectual property

 

1.   Using the information in the article, provide arguments and counter-arguments to each of the following to debate whether intellectual property might be regarded as an asset:

(a) whether the intellectual property generates future economic benefits that are probable

(b) whether the intellectual property is controlled by the firm

(c)  whether the intellectual property can be measured reliably.

 

The following table summarises the arguments in the article relating to recognising intellectual property as an asset.

 

Arguments for asset recognition

Arguments against asset recognition

(a) Future economic benefits that are probable

·      Protects future revenue stream

·      Market values intellectual property

·      Success of intellectual property such as patents is questionable

(b) Future economic benefits are controlled by the firm

·      Registration results in an enforceable legal right

·      Monopolistic right created by registration

·      Only 20% of patents tested in court are successful suggesting the control is not present in the majority of cases

·      Registering in one country does not mean that the control exists worldwide

 

(c) Future economic benefits can be measured reliably

·      Costs to register intellectual property

·      Application fees and associated costs do not reflect the economic value of the intellectual property

 

 

2.   Do you believe that additional criteria, such as separate identifiability and exchangeability, should be considered when deciding if an asset should be recognised?

 

In considering exchangeability and identifiability, the suggested solution to question 6 is reiterated.

 

Those who favour exchangeability believe an asset should be ‘separable’, and have value of its own. They argue that the entity should be able to sell it, and an asset should be capable of separate identification in order that it can be measured (valued). Such a condition would exclude certain intangible assets (such as goodwill) and deferred charges (such as deferred income taxes) from assets. Using this approach, the purpose of financial accounting and of the balance sheet is to report the value (cost) of a firm’s assets, not to report the value of the business as a whole. To value a business involves predicting its future earnings (or net cash flows) and is a function of the combination of resources rather than individual items.

 

Those who oppose exchangeability as a necessary feature of assets believe that this unduly emphasises a single way (exchange) of obtaining benefits from assets, and depends on a misguided view of ‘economic value’. They argue that value is only through their use rather than exchange. Assets are used jointly, and therefore in most cases their benefits cannot be precisely identified. There is no reason to believe that the contributions of certain intangible assets are proportionately less than tangible assets, or that they are less because there is no market to sell them separately. Since benefits received from using resources are unaffected by whether they are exchangeable, the condition of exchangeability is irrelevant in deciding whether an item is an asset. Economic value depends on scarcity and utility, not exchangeability.

 

To include as assets certain intangibles, such as goodwill, is not an attempt to value the firm as a whole, but an attempt to include in total assets the future benefits obtainable by the firm as a result of past transactions or events.

 

SAC 4 does not regard exchangeability as a criterion to apply in defining an asset. It recognises that if something is exchangeable for something else of value, then it has future economic benefit and is presumably an asset. However, it recognises that some assets may not be exchangeable. For example, roads and monuments may be unsaleable, but they have service potential for the organisation controlling them and are therefore assets under SAC 4.

 

3.   The international accounting standard on intangibles (IAS 38) prescribes that purchased and internally generated intangibles should be treated differently. Do you think the different accounting treatments are warranted? Why or why not? Is this approach consistent with the conceptual framework’s definition and recognition criteria for assets?

 

Separate treatment of intangibles based on their genealogy appears to be inconsistent with SAC 4 on the basis that whether an asset is or is not acquired at a cost does not form part of the definition and recognition assessment criteria. When deliberating IAS 38, asymmetrical accounting treatment for purchased versus internally generated intangibles was justified on the basis that genealogy does impact on the recognition criterion being satisfied. The justification for not permitting internally generated intangibles to be recognised is premised on their not having a cost or value that can be measured reliably. This treatment of internally generated identifiable intangibles is consistent with Australian firms not being permitted to recognise internally generated goodwill on the statement of financial position. Others would argue that the existence and acceptance of valuation methodologies (based on discounting revenue streams associated with the identifiable intangibles) suggests that such assets can be measured reliably. The subjectivity involved in the valuation process is of concern to regulators, as it is inconsistent with the requirement that financial statements be objective.

 

Students may also comment on the value relevance of intangible assets. Empirical studies suggest these assets are value relevant and their recognition is therefore providing useful information for decision making. This highlights the trade-off between the qualitative characteristics of relevance and reliability.

 

4.   Explain the reason behind the Group of 100’s statement that ‘intangible assets are by far the most important assets in the market capitalisation of most companies irrespective of whether they are recognised in the financial statements’.

 

The Group of 100’s statement is suggesting that the market recognises the importance of intangible assets and incorporates the future cash flows associated with such assets into the firm valuations. Students should be encouraged to use empirical evidence to support the Group of 100’s claim. If the market values intangible assets and if the financial reports are trying to provide information that is useful for decision making and reflective of economic reality, then an argument for recognising intangibles on the statement of financial position can be supported. The counter-argument is that the market is considering such assets despite their not appearing on the statement of financial position. Accordingly, there is no need to introduce subjectivity and compromise the reliability of financial information by recognising them in the financial statements.

 

Ideally this question could be set as a classroom debate exploring whether identifiable intangibles should be recognised on the statement of financial position; and, if recognised, how they should be accounted for.

 

5.   Given the comment by the Group of 100, what do you think their position on accounting for intangible assets is likely to be?

 

The Group of 100’s statement demonstrates the value of intangible assets to firms. The Group of 100 comprises financial executives from leading Australian public and private sector organisations. The Group usually engages in the lobbying process associated with accounting standard setting. The adoption of IAS 38 requirements has implications for the carrying value of a firm’s assets and reported earnings. Many Australian firms, including those represented in the Group of 100, recognise internally generated intangible assets and revalue such assets. A more restrictive treatment of intangible assets, such as that prescribed by IAS 38, would no longer permit such accounting practices. Consequently firms’ reported assets would be lower.

 

The inability to reflect the ‘value’ of the intangible assets in the statement of financial position may have implications for a firm’s value. The inability to purport the economic value of the assets in the balance sheet may impact on the market’s assessment of the firm’s growth opportunities. A more restrictive treatment also has implications for firms’ contractual arrangements. Firms with debt contracts containing covenants based on accounting numbers could be placed in a position of breaching such covenants. A technical breach of the covenants, imposed by a new accounting treatment, imposes costs on the firm that reduce firm value. It should be noted that covenants based on assets often exclude intangible assets due to the subjective nature of the valuations. If this is the case, the change in accounting treatment may have no implications for the covenants contained in the firm’s contractual arrangements. Remuneration contracts may also contain performance measures based on accounting income numbers. Thus, the compensation of managers may be adversely affected given that amortising the assets will reduce profit. Similarly, if the manager has shares or options and the inability to revalue intangibles affects the market’s assessment of the firm’s growth opportunities, the manager’s equity portfolio could reduce in value.

 

The Group of 100 has strongly supported harmonisation and international convergence. The Group of 100 developed their own Statement of Principles of Intangible Assets in 1995. In responding to the AASB’s request for comments on IASB’s proposed amendments to IAS 38, the Group of 100 noted that they were concerned about the adoption of IAS 38 and entities that recognise and revalue internally generated intangibles. Specifically they stated: ‘for some companies these assets represent a significant portion of total assets which under IAS 38 would be derecognised. This would have severe impacts on these entities…’.


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