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School of Accounting ACCT 1511: Accounting and Financial Management 1B Session 1, 2012 Week 3 Assets (2): Application of Financial Reporting Principles Student Handout Contents: 1. Learning Objectives (LO) 2. Tutorial Questions 3. Lecture Materials Lecturer: Dr Per Tronnes Website: http://telt.unsw.edu.au

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Page 1: Week 4

School of Accounting

ACCT 1511: Accounting and Financial Management 1B

Session 1, 2012

Week 3

Assets (2): Application of Financial Reporting Principles

Student Handout

Contents: 1. Learning Objectives (LO) 2. Tutorial Questions 3. Lecture Materials

Lecturer: Dr Per Tronnes

Website: http://telt.unsw.edu.au

Page 2: Week 4

Introduction and Learning Objectives

At the end of this week, you should:

LO1. Understand the mechanics of revaluing assets.

LO2. Understand the mechanics of impairment testing.

LO3. Revisit the accounting treatment of inventory.

LO4. Be technically competent in journal entries and T-accounts relevant to asset revaluation, intangible assets, and inventory measurement.

LO5. Be able to identify and apply relevant accounting principles to accounting rules underlying each of these asset items.

Required Readings

Required Readings • Trotman & Gibbins (TG) – Chapter 8 (revision), 9.6-9.8, 9.10 • The accounting Framework. Additional References http://www.aasb.com.au AASB 3 Business Combinations AASB 116 Property, Plant and Equipment AASB 138 Intangible Assets AASB 136 Impairment of Assets

For Week 3 Lecture

1. Bring this handout (including all the attachment). 2. Bring a calculator.*

*Please make sure to get your calculator approved by the university prior to the exam (https://my.unsw.edu.au/student/academiclife/assessment/examinations/Calculator.html).

Page 3: Week 4

Tutorial Questions for Week 4 (Commencing 19th March) Tutorial Preparation Questions: Trotman and Gibbins:

• Problem 8.11 • Case 8C • Problem 9.22 • Problem 9.23 • Problem 9.27

Tutorial Homework Questions: Past Exam and Additional Questions (see below):

• Question 4 from mid-session exam 2011,

semester 2 (see below) • Additional homework question (see below)

Tutorial Group Work Allocation: Group 1: Question 2 from mid-session exam 2011, semester 2, part (a) Group 2: Question 2 from mid-session exam 2011, semester 2, part (b) and (c) Group 3: Additional Homework Question, Cost Method Group 4: Additional Homework Question, Revaluation Method

Page 4: Week 4

Homework Question: Comparison between cost and revaluation method Land Cost Method Revaluation Method*

Recorded Value

Journal Entry Recorded Value

Journal Entry

Y0 Buy for $100,000

Y1 Market value: $150,000

Y2 Market value :$120,000

Y3 Market value: $75,000

Y4 Market value: $110,000

*Revaluations are done every year.

Page 5: Week 4

Mid-session exam 2011, semester 2: Question 2 (8 MARKS) You are working as an accountant for MagicLand Pty Ltd. In the first year of business, MagicLand Pty Ltd purchased land for $5 million. In the second year, a reputable, independent property valuer’s report shows that the value of the land is estimated at $4 million. In the third year, the value of the land is estimated at $7 million. At the beginning of the fourth year, MagicLand Pty Ltd sold the land at $6 million and received cash in full. Assume no tax. Required: (a) Assume that MagicLand Pty Ltd adopts the revaluation method for land, and revaluation was applied both in the second and the third year. With respect to the land, write the journal entries for the following transaction or event. Revaluation of land in the second year of business [1 mark]: Revaluation of land in the third year of business [2 marks]: Sale of land in the fourth year of business [2 marks]: (b) With reference to the journal entries made in the third year above, briefly explain in what way the treatment above reflects Conservatism. [1 mark]

(c) Discuss the Relevance and Reliability of the value of land on the balance sheet under the revaluation method. [2 marks]

Page 6: Week 4

Lecture Workshop

2010 Session 2 Mid-semester Exam (Adapted) QUESTION 4 (5 MARKS) In the first year of business Yourcompany Pty Ltd purchased land for $1 million. In the second year you believe that it had risen in value and based on a reputable property valuer’s report decided to value it at $2 million. In the third year, you sold the land for $2.2 million. Assume no tax. Required: (a) Yourcompany Pty Ltd adopts the revaluation method for land. With respect to the land, write the journal entries for the following transaction or event. Revaluation of land in the second year of business [1 mark]:

DO NOT WRITE OUTSIDE THE BOX Sale of land in the third year of business [2 marks]:

DO NOT WRITE OUTSIDE THE BOX (b) Explain in what way is the treatment above asymmetric. [2 marks]

DO NOT WRITE OUTSIDE THE BOX

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ACCT1511 Assets (2)

More on Non-current Current: Inventory,

Receivables

Dr Per Tronnes QUAD 3095

[email protected]

Week 3

2

Accrual Accounting

Income Statement & Balance Sheet

Asset v. Expense

Recognition

Measurement

Effect

Revenue v. Liability v. Equity

Asset Expense Definition Revenue Liability

Equity

With thanks to Dr Cheng Lai

3

Different Methods for Measuring Value 1. Historical Cost – (what did we pay for it) e.g.

everything usually 2. Current or Market Value (value in exchange) – (what

could we get for it if we sold it) e.g. Financial assets of financial institutions

3. Value in use (present value) – (what is it worth to us) e.g. capitalisation of building/ mines, financial assets of financial institutions (when convenient to them)

4. Liquidation Value (what would we get if we had to sell if really fast) – e.g. Lehman Brothers

5. Price-adjusted Historical Cost – (what we paid for it adjusted for inflation) e.g. High inflation countries

Which method is reliable? Relevant? neither?

4

A simple Illustration

Thunderstruck bought some land for $50,000 five years ago. The company currently hires out the land for $5,000 a year, and the management believes they will do so for the next 10 years and then afterwards sell the land for $55,000. The company, however, have financial trouble, and have been looking into selling the property in order to raise cash. Management believes, with enough time to find a willing buyer, the property will fetch about $65,000, but if a quick sale is to be made, they may have to offer a significant discount and management believe they will only receive $45,000. Time value of money: 10 year government bond yields: 3.7% Annual Inflation Rate: 2.5%

5

Simple Illustration (cont.)

Historical cost: Current / Market Value: Value in Use: Liquidation Value: Price adjusted Historical Cost: We will not ask you to calculate present values in this course, but you should be familiar with the concept of “time value of money” and what

present value is (see appendix to Chapter 10).

6

Some things to note: At purchase date (i.e. at recognition): Historical cost=Market Value Fair Value: is the amount that for which an asset could be exchanged between knowledgeable, willing parties, in an arm‟s

length transaction (AASB 116, para 6). (i.e. Fair value is generally (an estimate of) market value)

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Measurement at Recognition: PPE

An item of property, plan and equipment that qualifies for recognition shall be measured at its cost (AASB 116, para 15)

Elements of costs: – Its purchase price, including import duties and non-

refundable purchase taxes after deducting trade discounts and rebates

– Any costs directly attributable to bringing the asset to the location and condition necessary for it to be capable of operating in the manner intended by management.

– The initial estimate of the cost of dismantling and removing the item and restoring the site on which it is located (if the company is required to do so)

8

Examples of cost that are directly attributable: – Cost of employee benefits (i.e. Salary, annual

leave, etc) arising directly from the construction or acquisition of the item.

– Cost of site preparation – Initial delivery and handling costs – Installation and assembly costs – Cost of testing if the asset is functioning properly – Professional fees (e.g. lawers‟ fee for fixing the

contract etc).

9

Illustration

25 Jan 2011, FloppPop Pty Ltd purchased a specialised machine for $25,000. The machine is fairly large and heavy and needed special delivery at a cost of $5,000. It hired two people to install the machine. Each person was paid $250. The machine was delivered and installed 1 Feb 2011. 15 Feb 2011, the company incurred $2000 in advertising costs for promoting the new product.

How much of the equipments costs are capitalised? And at which date do we start to depreciate the

Machine?

10

Illustration continued

Purchase Price: $25,000 Directly Attributable Costs:

Delivery $ 5,000 Installation $ 500 Machine Costs $30,500

Advertising is not a directly attributable to making the asset operate in a manner intended by management.

Depreciation begins when the asset is available for use. That is, when it is capable of operating in a manner intended by management: 1 Feb 2011

11

Measurement after Recognition: PPE

Two choices: the cost model and the revaluation model.

The cost model states that: After recognition as an asset, an item of property, plant and equipment shall be carried at its costs less accumulated depreciation and accumulated impairment. (so this is what you already know: record the asset at the historical costs and then depreciate)

12

The revaluation Model

Revaluation model: After recognition as an asset, an item of property plant and equipment whose fair value can be measured reliably shall be carried at a revalued amount, being its fair value at the date of revaluation less any subsequent accumulated depreciation and accumulated impairment losses.

Revaluations shall be made with sufficient regularity to

ensure that the carrying amount does not differ materially from what which would be determined using fair value at the reporting date.

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Asset revaluations

A revaluation may either be: – an increment – increasing the value at which

the asset is recorded. – a decrement – decreasing the value at which

the asset is recorded. Can only revalue an asset as part of a whole

class of assets. – Increments and decrements are judged from

the asset‟s CARRYING AMOUNT – that is, asset value less accumulated depreciation.

14

Asymmetric accounting

The tricky part is that we do not treat increments and decrements similarly.

Increment: Dr Asset Cr Revaluation Reserve

– an owners‟ equity account in balance sheet so it does not increase the period profit (but now in Other Comprehensive Income).

Decrement Dr Loss on Revaluation Cr Asset

– A loss in the income statement so it does decrease profit.

15

Increments that reverses previous decrements:

Dr Asset Cr Gain on Revaluation (until all prior losses are reversed) Cr Revaluation Reserve (if greater than previous decrements) Decrements that reverses previous

increments: Dr Revaluation Reserve (until revaluation reserve is zero) Dr Loss on Revaluation (if greater than previous increments) Cr Asset

16

Case Study: Revaluation Price Increment

Time Year 1 Year 2 Year 3

Discuss with the person next to you (2 mins) Q) Journal entry for Year 1, 2 and 3 (year end)? Q) Did the company make gain after all?

$520,000

Cost at initial recognition $500,000

$480,000

17

Answers:

Year 1: Year 2: Year 3:

18

Revaluation

What principles are invoked/ contradicted? – Recognise possible losses to P&L immediately,

even though unrealised – Defer possible gain recognition in income until

realised – But new treatment, include as Other

Comprehensive Income (week 6 lecture)

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Step 1 Update depreciation: Dr Depreciation expense Cr Acc. depreciation – Buildings

Step 2 Credit accumulated depreciation to asset

account to record the asset at the carrying value: Dr Acc. depreciation – Buildings Cr Buildings

Revaluation: 4 Steps

20

Step 3: Recording a revaluation If it is a increment (revaluation method):

Dr Building Cr Revaluation reserve (OE)/Gain on Revaluation (IS)

Gain on Revaluation is recorded if there is a prior net valuation decrement, and until all prior losses on revaluation is reversed.

If it is a decrement (revaluation method): Dr Loss on revaluation (IS)/Revaluation reserve (OE)

Cr Building

A debit to revaluation reserved is recorded if there is a prior net valuation increment, and until all prior upward revaluation is reversed.

21

Step 4: Recalculate Depreciation

If there is no changes in useful life, residual value or method of depreciation: If recording a valuation increment: Depreciable amount have increased and therefore yearly depreciation expense will be larger. If recording a valuation decrement: Depreciable amount have decreased and therefore yearly depreciation expense will be lower.

22

Revaluation and Disposal (example 1) Land is revalued from $100 to $220 in year 1 and to 200 in year 2 and is in beginning of year 3 subsequently sold for $200. Assume No TAX:

Y1 Dr Land 120 Cr Revaluation Reserve 120

Y2 Cr Revaluation Reserve 20 Cr Revaluation Reserve 20 Y3 DR Cash 200

CR Land 200 DR Revaluation Reserve 100

Cr Retained Earnings 100

23

Revaluation and Disposal (example 2) Land is revalued from $100 to $180 in year 1 and subsequently sold for $160 in year 2. Assume No TAX: Y1 Dr Land 80 Cr Revaluation Reserve 80 (OE) Y2 Dr Loss on sale of land 20 (IS) Dr Cash 160

Cr Land 180 Dr Revaluation Reserve 80

Cr Retained Earnings 80

24

Revaluation and Disposal (example 3) Land is revalued from $100 to $150 in year 1 and subsequently sold for $170 in year 2. Assume No TAX: Y1 Dr Land 50 Cr Revaluation Reserve 50 Y2 Dr Cash 170

Cr Land 150 Cr Gain on Sale 20

Dr Revaluation Reserve 50 Cr Retained Earnings 50

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Revaluation and Disposal (example 4) Land is revalued from $100 to $60 in year 1 and subsequently sold for $90 in year 2. Assume No TAX: Y1 Dr Loss on Revaluation 40 Cr Land 40 Y2 Dr Cash 90

Cr Land 60 Cr Gain on Sale 30

26

Intangible Assets: Measurement on Recognition An intangible asset shall be measured initially

at cost. Elements of costs:

– Its purchase price, including import duties and non-refundable purchase taxes after deducting trade discounts and rebates

– Any directly attributable costs of preparing the asset for its intended use

– For internally generated intangibles the cost is the sum of expenditure incurred from the date when the intangible asset first meet the recognition criteria (i.e. from the development phase).

27

Intangible Assets: Measurement after Recognition Two choices: cost or revaluation method. However, fair value needs to be determined

with references to an active market: – The items traded are in the market are homogenous – Willing buyers and sellers can normally be found at any time – Prices are available to the public

Since intangible assets tend to be unique by nature (patents, trademarks etc) rarely is an active market found. In Australia, there is perhaps an active market for taxi licences and possible carbon emission quotas.

28

Impairment

An entity shall assess at each reporting date whether there is any indication that an asset may be impaired (AASB 138, para 9.) Simply stated, at each reporting date we check whether there is an indication that any of the assets value are overstated. Note: Intangible asset with an indefinite useful life and Goodwill must, irrespective of indication or not, be tested for impairment at least annually.

29

Indicators of impairment

External Sources: 1) an asset market value has declined significantly, 2) changes with adverse effect in the technological, market, economic or legal environment.

Internal Sources: 1) obsolescence or physical damage of an asset, 2) changes making an asset idle, plans to discontinue or restructure operations to which asset belong, plans to dispose of asset before the previously expected date, 3) internal reporting indicates the economic performance of an asset will be worse than expected.

30

So how do we test for Impairment

So if there is an indication that an asset may be impaired, we must test for impairment. We test for impairment by compare the carrying value of the asset on the balance sheet with the highest value we think we can recover from the asset by either selling or using the asset.

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Impairment testing

We know the carrying value of the asset. But we need to find the recoverable amount. The recoverable amount is the higher of: 1. Fair value less cost to sell (the amount

obtainable from the sale of an asset in an arm‟s

length transaction between knowledgeable, willing parties, less cost of disposal)

2. Value in use (the present value of the future cash flows expected to be derived from an asset)

32

So to sum up the impairment test:

1. Find a) Fair value less cost to sell b) Value in use 2. The highest value of these two will be the

recoverable amount. 3. Compare the asset‟s carrying amount to the

asset‟s recoverable amount. If Carrying amount>recoverable amount impaired Carrying amount<recoverable amount not impaired

33

Asset is impaired, then what...

Writing down the carrying amount of the asset to its recoverable amount:

Dr Loss on Impairment XXX Cr Accumulated Impairment XXX

Unless the revaluation method is used, then any impairment loss is treated as a revaluation decrease (AASB 138, para 60) Dr Loss on Revaluation (or Revaluation Reserve) XXX Cr Asset XXX

34

Reversal of an Impairment Loss

If impairment loss have been recognised in a previous period, but the estimates of the asset‟s

recoverable amount have increased since the last impairment, then there is a reversal of the impairment loss. Dr Accumulated Impairment XXX Cr Gain on Reversal of Impairment XXX

35

Reversal of an Impairment Loss

Reversal of impairment cannot increase the carrying amount to exceed the carrying amount (net of depreciation or amortisation) had no impairment taken place. (AASB 138, para 117).

Cannot reverse impairment for Goodwill.

Unless asset is carried at revalued amount, then any reversal of impairment loss is treated as a revaluation increase (AASB 138, para 119) Dr Asset XXX Cr Gain on Revaluation (or Gain on Revaluation) XXX

36

Current Assets (ACCT1501)

Cash and cash equivalents can include overnight money market accounts and other very liquid investments

Short-term investments include trading securities and available-for-sale securities

Trade debtors and other receivables are reported net of allowance for doubtful debts

The proper presentation of inventories includes disclosure of basis of valuation, method of pricing and stage of completion in the case of manufacturing firms

Prepaid expenses are expenditures for benefits expected to be received within 1 year or the operating cycle

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Inventory (ACCT1501) Inventories are assets:

– held for sale in the ordinary course of business – in the process of production for such sale, or – in the form of materials or supplies to be consumed

in the production process or in rendering of services.

Inventory types: – raw materials – work in progress – finished goods inventory – merchandise inventory.

38

Background: Cost of inventory (ACCT1501)

The cost of inventories comprises:

– costs of purchase – costs of conversion – other costs incurred in bringing the inventories

to their present location and condition.

39

Inventory cost flows: Merchandising operation (ACCT1501)

Merchandise inventory

$$$ $$$

Cost of goods sold

$$$

40

Inventory cost flows: Manufacturing operations (ACCT1501)

Raw materials COGS

$$$ $$$

Labour Work in process

$$$ $$$ $$$

Overhead Finished goods

$$$ $$$ $$$

41

Cost of goods sold (ACCT1501)

Opening inventory

+ Purchases

= Goods available for sale

– Ending inventory

= Cost of goods sold

42

Comparison of inventory methods (ACCT1501)

In periods of rising prices: FIFO results in the highest ending inventory,

highest gross profit, highest net profit and the lowest COGS.

LIFO results in lowest ending inventory, lowest gross profit, lowest net profit and the highest COGS.

Weighted average results fall between FIFO and LIFO.

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Mis-measurement in Inventory (ACCT1501)

Overstatement of ending inventory leads to: – understatement of current period‟s COGS – overstatement of current period‟s profit.

Understatement of ending inventory leads to:

– overstatement of current period‟s COGS – understatement of current period‟s profit.

44

Lower of cost or market rule (ACCT1501)

Ending inventory is reported at lower of cost or market value (LCM).

Market value is net realisable value. Net realisable value < cost because of:

– obsolescence – damage – demand

Rule applied at item level. What principle is applied?

45

Inventory valuation (ACCT1501)

Inventory should be measured at the lower of cost and net realisable value (also referred to as lower of cost and market value).

Definition of net realisable value: – „… the estimated selling price in the ordinary

course of business less the estimated costs of completion and the estimated costs necessary to make the sale.‟

Any loss from the application of this rule is recorded as an expense in the accounting period in which the write down occurs. 46

LCM rule: An example (ACCT1501) Question: Assume that the cost of inventory is calculated to be $140 000. However, the net realisable value is only $125 000.

Required: Prepare journal entries to apply the lower of cost and net realisable value rule. Dr Inventory Loss (Expense) 15 000 Cr Inventory (Asset) 15 000 Why not Cr contra-asset?

47

Accounts Receivable & Doubtful debts (ACCT1501)

Estimate the doubtful debts (e.g. 3% of all credit sales, 10% of all debts outstanding for greater than 60 days)

Dr Bad debts expense xxx Cr Allowance for doubtful debts xxx Reliable? What principles come into play?

Write off all the bad debts (the definitely

uncollectible ones) Dr Allowance for doubtful debts xxx Cr Accounts receivable xxx

48

Lecture Workshop

Refer to Lecture Handout