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Financial Accounting 8th rd e Craig Deegan-1

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About the Author
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ABOUT THE AUTHOR
CRAIG DEEGAN
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About the Author
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About the Author
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CRAIG DEEGAN, BCom (University of NSW), MCom (Hons)
(University of NSW), PhD (University of Queensland), FCA, is
Professor of Accounting in the School of Accounting at RMIT
University in Melbourne. Craig has taught at both undergraduate
and postgraduate level for about three decades. Prior to working
in the university sector Craig worked as a chartered accountant.
His research has tended to focus on various social and
environmental accountability and financial accounting issues and
has been published in a number of leading international
accounting journals, including: Accounting, Organizations and
Society; Accounting and Business Research; Accounting,
Accountability and Auditing Journal; Accounting and Finance;
British Accounting Review; Critical Perspectives on Accounting;
Journal of Business Ethics; Australian Accounting Review; and
The International Journal of Accounting. According to Google
Scholar, Craig’s work has attracted approximately 12,000
citations making him one of the most highly cited researchers
internationally within the accounting and/or finance literature.
Craig has regularly provided consulting services to corporations,
government, and industry bodies on issues pertaining to
financial accounting and corporate social and environmental
accountability, he was former Chairperson of the Triple Bottom
Line Issues Group of the Institute of Chartered Accountants in
Australia, for a number of years was involved in developing the
CPA Program of CPA Australia, and for many years was a judge
on the Australian Sustainability Reporting Awards. He is on the
editorial board of a number of academic accounting journals and
he has been the recipient of various teaching and research
awards, including teaching prizes sponsored by KPMG, and the
Institute of Chartered Accountants in Australia. He was the
inaugural recipient of the Peter Brownell Manuscript Award, an
annual research award presented by the Accounting and Finance
Association of Australia and New Zealand. He was also awarded
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About the Author
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the University of Southern Queensland Individual Award for
Research Excellence.
Craig is also the author of the leading financial accounting
theory textbook, Financial Accounting Theory, now in its fourth
edition. Financial Accounting Theory is widely used throughout
Australia as well as in many other countries.
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Contents In Brief
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Page vi
CONTENTS IN BRIEF
PART 1
THE AUSTRALIAN
ACCOUNTING ENVIRONM
ENT
Chapter 1
An overview of the
Australian external report
ing environment
Chapter 2
The conceptual
framework for financial re
porting
PART 2
THEORIES OF
ACCOUNTING
Chapter 3
Theories of financial
accounting
PART 3
ACCOUNTING FOR
ASSETS
Chapter 4
An overview of
accounting for assets
Chapter 5
Depreciation of property,
plant and equipment
Chapter 6
Revaluations and
impairment testing of no
n-current assets
Chapter 7
Inventory
Chapter 8
Accounting for intangibles
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Contents In Brief
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Chapter 9
Accounting for heritage
assets and biological asse
ts
PART 4
ACCOUNTING FOR
LIABILITIES AND OWNER
S’ EQUITY
Chapter 10
An overview of
accounting for liabilities
Chapter 11
Accounting for leases
Chapter 12
Accounting for employee
benefits
Chapter 13
Share capital and
reserves
Chapter 14
Accounting for financial
instruments
Chapter 15
Revenue recognition
issues
Chapter 16
The statement of profit or
loss and other comprehen
sive income, and the state
ment of changes in equity
Chapter 17
Accounting for sharebased payments
Chapter 18
Accounting for income
taxes
PART 5
ACCOUNTING FOR THE
DISCLOSURE OF CASH FL
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Contents In Brief
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OWS
Chapter 19
The statement of cash
flows
PART 6
INDUSTRY-SPECIFIC
ACCOUNTING ISSUES
Chapter 20
Accounting for the
extractive industries
PART 7
OTHER DISCLOSURE
ISSUES
Chapter 21
Events occurring after the
end of the reporting perio
d
Chapter 22
Segment reporting
Chapter 23
Related party disclosures
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Chapter 24
Earnings per share
PART 8
ACCOUNTING FOR
EQUITY INTERESTS IN OT
HER ENTITIES
Chapter 25
Accounting for group
structures
Chapter 26
Further consolidation
issues I: accounting for in
tragroup transactions
Chapter 27
Further consolidation
issues II: accounting for
non-controlling interests
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Contents In Brief
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PART 9
FOREIGN CURRENCY
Chapter 28
Accounting for foreign
currency transactions
Chapter 29
Translating the financial
statements of foreign ope
rations
PART 10
CORPORATE SOCIALRESPONSIBILITY REPORT
ING
Chapter 30
Accounting for corporate
social responsibility
Appendix A
Present value of $1
Appendix B
Present value of an
annuity of $1
Appendix C
Calculating present
values
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CONTENTS IN FULL
Remarks
halftitle
DEPRECIATION
Titlepage
copyright
About the author
Contents in brief
Preface
Acknowledgments
AACSB statement
How to use this book
Learnsmart
Credits
PART 1
THE AUSTRALIAN
ACCOUNTING ENVIRONM
ENT
CHAPTER 1
AN OVERVIEW OF THE
AUSTRALIAN EXTERNAL R
EPORTING ENVIRONMENT
Accounting, accountability and the role of financial accounting
Financial accounting defined
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Users’ demand for general purpose financial statements
Sources of external financial reporting regulations
The process of Australia adopting accounting standards issued
by the International Accounting Standards Board
Structure of the International Accounting Standards Board
International cultural differences and the harmonisation of
accounting standards
Accounting standards change across time
The use and role of audit reports
All this regulation—is it really necessary?
Learning objectives
Summary
Key terms
End-of-chapter exercises
Review questions
Challenging questions
References
CHAPTER 2
THE CONCEPTUAL
FRAMEWORK FOR FINANC
IAL REPORTING
Australia’s use of the IASB conceptual framework
What is a conceptual framework?
Benefits of a conceptual framework
Current initiatives to develop a revised conceptual framework
Structure of the conceptual framework
Building blocks of a conceptual framework
Measurement principles
A critical review of conceptual frameworks
The conceptual framework as a normative theory of
accounting
Learning objectives
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Contents In Full
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Summary
Key terms
End-of-chapter exercises
Review questions
Challenging questions
References
Page ix
PART 2
THEORIES OF
ACCOUNTING
CHAPTER 3
THEORIES OF FINANCIAL
ACCOUNTING
Introduction to theories of financial accounting
Why discuss theories in a book such as this?
Definition of theory
Positive Accounting Theory
Accounting policy selection and disclosure0
Accounting policy choice and ‘creative accounting’
Some criticisms of Positive Accounting Theory
Normative accounting theories
Systems-oriented theories to explain accounting practice
Theories that seek to explain why regulation is introduced
Learning objectives
Summary
Key terms
End-of-chapter exercises
Review questions
Challenging questions
Further reading
References
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PART 3
ACCOUNTING FOR
ASSETS
CHAPTER 4
AN OVERVIEW OF
ACCOUNTING FOR ASSET
S
Introduction to accounting for assets
Numbering of Australian Accounting Standards
Definition of assets
General classification of assets
How to present a statement of financial position
Determination of future economic benefits
Acquisition cost of assets
Accounting for property, plant and equipment—an introduction
Assets acquired at no cost
Possible changes in the requirements pertaining to financial
statement presentation
Learning objectives
Summary
Key terms
End-of-chapter exercises
Review questions
Challenging questions
References
CHAPTER 5
DEPRECIATION OF
PROPERTY, PLANT AND E
QUIPMENT
Introduction to accounting for depreciation of property, plant
and equipment
Depreciable amount (base) of an asset
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Determination of useful life
Method of cost apportionment
Depreciation of separate components
When to start depreciating an asset
Revision of depreciation rate and depreciation method
Land and buildings
Modifying existing non-current assets
Disposition of a depreciable asset
Depreciation as a process of allocating the cost of an asset
over its useful life: further considerations
Disclosure requirements
Learning objectives
Summary
Key terms
End-of-chapter exercises
Review questions
Challenging questions
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CHAPTER 6
REVALUATIONS AND
IMPAIRMENT TESTING OF
NON-CURRENT ASSETS
Introduction to revaluations and impairment testing of noncurrent assets
Measuring property, plant and equipment at cost or at fair
value—the choice
The use of fair values
Revaluation increments
Treatment of balances of accumulated depreciation upon
revaluation
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Revaluation decrements
Reversal of revaluation decrements and increments
Accounting for the gain or loss on the disposal or
derecognition of a revalued non-current asset
Recognition of impairment losses
Further consideration of present values
Offsetting revaluation increments and decrements
Investment properties
Economic consequences of asset revaluations
Disclosure requirements
Learning objectives
Summary
Key terms
End-of-chapter exercises
Review questions
Challenging questions
References
CHAPTER 7
INVENTORY
Introduction to inventory
Definition of inventory
The general basis of inventory measurement
Inventory cost-flow assumptions
Reversal of previous inventory write-downs
Disclosure requirements
Learning objectives
Summary
Key terms
End-of-chapter exercises
Review questions
Challenging questions
References
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CHAPTER 8
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ACCOUNTING FOR
INTANGIBLES
Introduction to accounting for intangible assets
Which intangible assets can be recognised and included in the
statement of financial position?
What is the initial basis of measurement of intangible assets?
General amortisation requirements for intangible assets
Revaluation of intangible assets
Gain or loss on disposal of intangible assets
Required disclosures in relation to intangible assets
Research and development
Accounting for goodwill
Is the way we account for intangible assets an improvement
over what we did in Australia prior to the introduction of IF
RS in 2005?
Learning objectives
Summary
Key terms
End-of-chapter exercises
Review questions
Challenging questions
References
CHAPTER 9
ACCOUNTING FOR
HERITAGE ASSETS AND B
IOLOGICAL ASSETS
Introduction to accounting for heritage assets and biological
assets
Accounting for heritage assets
Accounting for biological assets
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Learning objectives
Summary
Key terms
End-of-chapter exercises
Review questions
Challenging questions
References
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PART 4
ACCOUNTING FOR
LIABILITIES AND OWNER
S’ EQUITY
CHAPTER 10
AN OVERVIEW OF
ACCOUNTING FOR LIABIL
ITIES
Liabilities defined
Contingent liabilities
Contingent assets
Classification of liabilities as ‘current’ or ‘non-current’
Liability provisions
Some implications of reporting liabilities
Debt equity debate
Accounting for debentures (bonds)
Hybrid securities
Learning objectives
Summary
Key terms
End-of-chapter exercises
Review questions
Challenging questions
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References
CHAPTER 11
ACCOUNTING FOR LEASES
An overview of recent developments in the accounting
requirements pertaining to accounting for leases
The core principle and scope of the new accounting standard
on leasing
Exemptions for leases of 12 months or less, and for low-value
assets
What is a lease?
When to recognise a lease
Accounting for the service component of a contract that
includes a lease
The meaning of ‘lease term’
Accounting for leases by lessees
Accounting for leases by lessors
Implications for accounting-based contracts
Learning objectives
Summary
Key terms
End-of-chapter exercises
Review questions
Challenging questions
References
CHAPTER 12
ACCOUNTING FOR
EMPLOYEE BENEFITS
Overview of employee benefits
Categories of employee benefits
Accounting for employee benefits
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Employees’ accrued employee benefits and corporate collapses
Learning objectives
Summary
Key terms
End-of-chapter exercises
Review questions
Challenging questions
References
CHAPTER 13
SHARE CAPITAL AND
RESERvES
Introduction to accounting for share capital and reserves
Different classes of shares
Accounting for the issue of share capital
Accounting for distributions
Redemption of preference shares
Forfeited shares
Share splits and bonus issues
Rights issues and share options
Required disclosures for share capital
Reserves
Learning objectives
Summary
Key terms
End-of-chapter exercises
Review questions
Challenging questions
References
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CHAPTER 14
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ACCOUNTING FOR
FINANCIAL INSTRUMENT
S
Introduction to accounting for financial instruments
Financial instruments defined
Debt versus equity components of financial instruments
Set-off of financial assets and financial liabilities
Recognition and measurement of financial assets
Recognition and measurement of financial liabilities
Derivative financial instruments and their use as hedging
instruments
Compound financial instruments
Disclosure requirements pertaining to financial instruments
Learning objectives
Summary
Key terms
End-of-chapter exercises
Review questions
Challenging questions
References
CHAPTER 15
REVENUE RECOGNITION
ISSUES
New accounting standard on revenue recognition
Definition of income and revenue
Recognition criteria for revenue from contracts with customers
Measurement of revenue
Income and revenue recognition points
Accounting for sales with associated conditions
Interest and dividends
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Unearned revenue
Accounting for construction contracts
Summary of the steps to be taken when recognising revenue
Learning objectives
Summary
Key terms
End-of-chapter exercises
Review questions
Challenging questions
References
CHAPTER 16
THE STATEMENT OF
PROFIT OR LOSS AND OT
HER COMPREHENSIVE IN
COME, AND THE STATEME
NT OF CHANGES IN EQUIT
Y
Introduction to the statement of profit or loss and other
comprehensive income
Profit or loss disclosure
Statement of changes in equity
Prior period errors
Changes in accounting policy
Profit as a guide to an organisation’s success
Future changes in the requirements pertaining to how we
present information about comprehensive income
Learning objectives
Summary
Key terms
End-of-chapter exercises
Review questions
Challenging questions
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References
CHAPTER 17
ACCOUNTING FOR
SHARE-BASED PAYMENTS
Introduction to accounting for share-based payments
Background to the release of AASB 2
Overview of the requirements of AASB 2
Equity-settled share-based payment transactions
Cash-settled share-based payment transactions
Share-based payment transactions with cash alternatives
Possible economic implications of AASB 2
Disclosure requirements
Learning objectives
Summary
Key terms
End-of-chapter exercises
Review questions
Challenging questions
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CHAPTER 18
ACCOUNTING FOR
INCOME TAXES
Introduction to accounting for income taxes
The balance sheet approach to accounting for taxation
Tax base of assets and liabilities: further consideration
Deferred tax assets and deferred tax liabilities
Unused tax losses
Revaluation of non-current assets
Offsetting deferred tax liabilities and deferred tax assets
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Change of tax rates
Evaluation of the assets and liabilities created by AASB 112
Learning objectives
Summary
Key terms
End-of-chapter exercises
Review questions
Challenging questions
References
PART 5
ACCOUNTING FOR THE
DISCLOSURE OF CASH FL
OWS
CHAPTER 19
THE STATEMENT OF CASH
FLOWS
Comparison with other financial statements
Defining ‘cash’ and ‘cash equivalents’
Classification of cash flows
Format of statement of cash flows
Calculating cash inflows and outflows
Contractual implications
Potential future changes to the statement of cash flows
Learning objectives
Summary
Key terms
End-of-chapter exercises
Review questions
Challenging questions
References
PART 6
INDUSTRY-SPECIFIC
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ACCOUNTING ISSUES
CHAPTER 20
ACCOUNTING FOR THE
EXTRACTivE INDUSTRIES
Overview of accounting for exploration and evaluation
expenditures under AASB 6
Extractive industries defined
Alternative methods to account for preproduction costs
Abandoning an area of interest
Accumulation of costs pertaining to exploration and evaluation
activities
Basis for measurement of exploration and evaluation
expenditures
Impairment and amortisation of costs carried forward
Restoration costs
Sales revenue
Inventory
Disclosure requirements
Does the area-of-interest method provide a realistic value for
an entity’s reserves?
Research on accounting regulation pertaining to preproduction expenditures
Other developments in extractive industry reporting
The development of a new accounting standard for extractive
activities
Learning objectives
Summary
Key terms
End-of-chapter exercises
Review questions
Challenging questions
References
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PART 7
OTHER DISCLOSURE
ISSUES
CHAPTER 21
EVENTS OCCURRING
AFTER THE END OF THE R
EPORTING PERIOD
What is an ‘event after the reporting period’?
Types of events after the reporting period
Disclosure requirements
Learning objectives
Summary
Key terms
End-of-chapter exercises
Review questions
Challenging questions
Page xiv
CHAPTER 22
SEGMENT REPORTING
Advantages and disadvantages of segment reporting
An introduction to AASB
Defining an operating segment
Defining a reportable segment
Measurement of segment items
Required financial disclosures
Reconciliation of segment information to financial statements
Non-financial disclosures
Is there a case for competitive harm?
Learning objectives
Summary
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Key terms
End-of-chapter exercises
Review questions
Challenging questions
References
CHAPTER 23
RELATED PARTY
DISCLOSURES
Introduction to related party disclosures
Related party relationship defined
AASB 124 Related Party Disclosures
Section 300A of the Corporations Act 2001
Examples of related party disclosure notes
Learning objectives
Summary
Key terms
End-of-chapter exercises
Review questions
Challenging questions
References
CHAPTER 24
EARNINGS PER SHARE
Introduction to earnings per share
Computation of basic earnings per share
Diluted earnings per share
Linking earnings per share to other indicators
Learning objectives
Summary
Key terms
End-of-chapter exercises
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Review questions
Challenging questions
References
PART 8
ACCOUNTING FOR
EQUITY INTERESTS IN OT
HER ENTITIES
CHAPTER 25
ACCOUNTING FOR GROUP
STRUCTURES
Introduction to accounting for group structures
Rationale for consolidating the financial statements of different
legal entities
History of Australian Accounting Standards that govern the
preparation of consolidated financial statements
‘Investment entities’: exception to consolidation
Alternative consolidation concepts
The concept of control
Direct and indirect control
Accounting for business combinations
Gain on bargain purchase
Subsidiary’s assets not recorded at fair values
Previously unrecognised identifiable intangible assets
Consolidation after date of acquisition
Disclosure requirements
Control, joint control, and significant influence
Learning objectives
Summary
Key terms
End-of-chapter exercises
Review questions
Challenging questions
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References
Page xv
CHAPTER 26
FURTHER
CONSOLIDATION ISSUES
I: ACCOUNTING FOR INTR
AGROUP TRANSACTIONS
Introduction to accounting for intragroup transactions
Dividend payments from pre- and post-acquisition earnings
Intragroup sale of inventory
Sale of non-current assets within the group
Learning objectives
Summary
Key terms
End-of-chapter exercises
Review questions
Challenging questions
CHAPTER 27
FURTHER
CONSOLIDATION ISSUES
II: ACCOUNTING FOR NO
N-CONTROLLING INTERES
TS
Introduction to accounting for non-controlling interests
What is a non-controlling interest?
Non-controlling interests to be disclosed in the consolidated
financial statements
Calculating non-controlling interests
Learning objectives
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Summary
Key terms
End-of-chapter exercises
Review questions
Challenging questions
PART 9
FOREIGN CURRENCY
CHAPTER 28
ACCOUNTING FOR
FOREIGN CURRENCY TRA
NSACTIONS
Introduction to accounting for foreign currency transactions
Foreign currency transactions
Determination of functional currency and presentation
currency
Longer-term receivables and payables
Translation of other monetary assets such as cash deposits
Qualifying assets
Hedging transactions
Foreign currency swaps
Learning objectives
Summary
Key terms
End-of-chapter exercises
Review questions
Challenging questions
CHAPTER 29
TRANSLATING THE
FINANCIAL STATEMENTS
OF FOREIGN OPERATIONS
Introduction to translating the financial statements of foreign
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operations
Reporting foreign currency transactions in the functional
currency
Translating the accounts of foreign operations into the
presentation currency
Consolidation subsequent to translation
Learning objectives
Summary
Key terms
End-of-chapter exercises
Review questions
Challenging questions
Page xvi
PART 10
CORPORATE SOCIALRESPONSIBILITY REPORT
ING
CHAPTER 30
ACCOUNTING FOR
CORPORATE SOCIAL RESP
ONSIBILITY
Introduction to social-responsibility reporting
Social and environmental reporting defined
What are the responsibilities of business (to whom and for
what)?
Evidence of public social and environmental reporting
Why report?
To whom will the organisation report?
What information shall be reported?
How (and where) will the information be presented?
Other international initiatives to assist corporate social and
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environmental performance
Social auditing
The critical problem of climate change
Personal social responsibility
Concluding remarks
Learning objectives
Summary
Key terms
End-of-chapter exercises
Review questions
Challenging questions
References
Appendix A
Appendix B
Appendix C
Glossary
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Preface
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Page xvii
PREFACE
This is the eighth edition of a book that was originally
published in 1995. Since the first edition of this book was
published we have seen extensive changes in relation to the
practice and regulation of general purpose financial reporting.
These changes continue to occur and this book has always
attempted to carefully explain the nature of the changes as
well as the potential economic and social consequences which
might result from such changes.
In the period of time between when the seventh edition of this
book was published, and the writing of this eighth edition was
completed (writing was completed in March 2016) there have
been some rather significant changes in regulation and
guidance pertaining to external reporting. These changes have
been incorporated within this eighth edition and some of the
major changes we cover relate to such areas as financial
statement presentation, The Conceptual Framework for
Financial Reporting, accounting for leases, revenue
recognition, financial instruments, and corporate socialresponsibility reporting. Because many of these changes are
significant we will provide critical comparisons of the ‘old’ and
‘new’ requirements.
Each chapter of this eighth edition contains learning
objectives, chapter summaries and a comprehensive end-ofchapter exercise. A glossary of key terms is provided towards
the back of the book. The book provides material that will
enable the reader to gain a thorough grasp of the contents
and of the practical application of the majority of financial
accounting requirements currently in place in Australia. In the
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discussion of these requirements, numerous worked
examples, with detailed solutions, are provided throughout the
text.
As well as addressing how to apply the various accounting
requirements, this text also encourages readers to critically
evaluate the various rules and guidelines. The aim is to
develop accountants who are not only able to apply particular
accounting requirements, but who will also be able to
contribute to the ongoing improvement of accounting
requirements. The view taken is that it is not only important
for students to understand the rules of financial accounting,
but also to understand the limitations inherent in many of the
existing accounting requirements. For this reason, reference is
made to various research studies that consider the merit,
implications, and costs and benefits of the various accounting
requirements. Also, various newspaper articles discussing
different aspects of the accounting requirements are
reproduced for consideration and discussion. The permission
of copyright holders to reproduce this material is gratefully
acknowledged.
Social-responsibility reporting continues to be an important
area of accounting, and one that is rapidly developing. Its
importance is further highlighted by the growing evidence of
climate change, species extinction, and large scale poverty,
hunger and social inequities in many countries. While this
book predominantly considers financial accounting and
reporting, Chapter 30
focuses on social-responsibility
reporting and provides the most up-to-date and
comprehensive material available on this important topic with
additional material being added on the important topic of
Climate Changeboth from an accounting and scientific
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perspectiveas well as the inclusion of commentaries on various
alternative reporting frameworks.
Writing a text like this is an extremely time-consuming
exercise and it has been very gratifying that the effort
involved has been rewarded by so many institutions across
Australia (and also some outside Australia) electing to
prescribe previous editions of this book as part of their
accounting programs. Given the success of all previous
editions, every effort has been made to ensure that this eighth
edition is equally valuable to students and teachers, and that
it has been substantially and thoroughly revised.
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Acknowledgments
Page 1 of 3
Page xviii
ACKNOWLEDGMENTS
There are many people who must be thanked for their
contribution to the eighth edition of this book. First, our thanks
to the following reviewers of the current edition:
Bobae Choi, University of Newcastle; Sally Chaplin,
Queensland University of Technology; Victoria Clout,
University of New South Wales; Sajan Cyril, Australian
Catholic University; Colin Dolley, Edith Cowan University;
Peter Dryden, Federation University; Hermann Frick,
University of Queensland; Syed Haider, Victoria
University; Andrew Jackson, University of New South
Wales; Arifur Khan, Deakin University; Eric Lee, Monash
University; Janet Lee, Australian National University;
Jinghui Liu, Southern Cross University; Tracey McDowall,
Deakin University; Balachandran Muniandy, La Trobe
University; Puspalila Muniandy, Deakin University;
Gregory Phillip, University of Newcastle ; Pranil Prasad,
University of the South Pacific; Maria Prokofieva, Victoria
University; Glenn Rechtschaffen, University of Auckland;
Natasja Steenkamp, Central Queensland University;
Grantley Taylor, Curtin University; Suzanne Mary Taylor,
QUT Business School; Maria Tyler, CQUniversity Mackay
campus; Effiezal Aswadi Abdul Wahab, Curtin University.
This book has also been improved during the course of the first
seven editions by the feedback received from many people and
I would like to acknowledge the contribution that they have
previously made. These people include:
Maria Balatbat, University of New South Wales; Peter
Baxter, University of the Sunshine Coast; Poonam Bir,
Monash University; Phil Cobbin, University of Melbourne;
Lome Cummings, Macquarie University; Matt Dyki,
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Acknowledgments
Page 2 of 3
Charles Sturt University, Wagga Wagga campus; Natalie
Gallery, Queensland University of Technology; John
Goodwin, RMIT University; Deborah Janke, University of
Southern Queensland; Maurice Jenner, University of
Southern Queensland; Graham Jones, Flinders
University; Peter Keet, RMIT University; Janet Lee,
Australian National University; Steven Lesser, Charles
Sturt University, Wagga Wagga campus; Stephen Lim,
University of Technology Sydney; Janice Loftus,
University of Sydney; Wei Lu, Monash University; Diane
Mayorga, University of New South Wales; Kellie
McCombie, University of Wollongong; Malcolm Miller,
University of New South Wales; Lee Moermon, University
of Wollongong; Gary Monroe, Australian National
University; Richard Morris, University of New South
Wales; Anja Morton, Southern Cross University, Lismore
campus; Karen Ness, James Cook University; Cameron
Nichol, RMIT University; Gary Plugarth, University of New
South Wales; Lisa Powell, University of South Australia;
Jim Psaros, University of Newcastle; Michaela Rankin,
Monash University; Andrew Read, University of Canberra;
Kathy Rudkin, University of Wollongong; Dan Scheiwe,
Queensland University of Technology; Mark Silvester,
University of Southern Queensland; Stella Sofocleous,
Victoria University of Technology; Jenny Stewart, Griffith
University; Seng The, Australian National University; Len
Therry, Edith Cowan University; Matthew Tilling,
University of Western Australia; Irene Tutticci, University
of Queensland; Mark Vallely, University of Southern
Queensland; Trevor Wilmshurst, University of Tasmania;
Victoria Wise, University of Tasmania; Ann-Marie Wyatt,
University of Technology Sydney.
Thanks also go to many of my colleagues at RMIT University
for their friendship and encouragement. The team at McGrawHill Education (Australia) also deserve a great deal of thanks
for helping in the preparation of this book.
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Acknowledgments
Page 3 of 3
Lastly, but certainly not leastly, thanks again go to my 16year-old daughter Cassandra for all the love and support she
gives me in whatever I seem to be doing and for continually
helping me to put everything into perspective. As I have said
before, she is indeed my finest work (and my most valuable
‘asset’) and represents that aspect of my life of which I am
most proud.
The publisher would also like to thank
the following digital contributors: Victoria Clout, Parmod
Chand, Maria Prokofieva, Jackie Liu, Maria Balatbat, Eric Lee
and Matt Dyki.
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AACSB Statement
Page 1 of 1
Page xix
AACSB STATEMENT
McGraw-Hill Education is a proud corporate member of
AACSB1 International. Understanding the importance and
value of AACSB accreditation, Financial Accounting has sought
to recognise the curricula guidelines detailed in the AACSB
standards for business accreditation by connecting content
and exercises to the general knowledge and skill guidelines
found in the AACSB standards.
The statements contained in Financial Accounting and in its
digital resources are provided only as a guide for the users of
this text. The AACSB leaves content coverage and assessment
within the purview of individual institutions, the mission of the
institutions, and the faculty. While Financial Accounting and
the teaching package make no claim of any specific AACSB
qualification or evaluation, we have, within Financial
Accounting identified chapters as containing content and
labelled activities according to the general knowledge and
skills areas.2
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How To Use This Book
Page 1 of 6
Page xx
HOW TO USE THIS BOOK
Learning objectives
Each chapter starts with a list of the chapter’s learning
objectives. These flag what you should know when you have
worked through the chapter. Make these the foundation for your
exam revision by using them to test yourself. The end-ofchapter assignments also link back to these learning objectives.
Chapter introduction
Each chapter begins with an excellent overview of the material
to be covered, and places it in the broader context of how topics
in various chapters interrelate.
Worked examples
A wide range of detailed scenarios and solutions, some fairly
straightforward and some more complex, are provided
throughout the text and are a great learning aid, helping to
reinforce how the theory is applied in practice and their
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How To Use This Book
Page 2 of 6
relevance to actual situations.
Financial accounting in the real world
Accounting is often a major and controversial part of news items
that hit the headlines. Excerpts from the media put various
aspects of accounting under the spotlight, emphasising how
integral it is to business life. They also help students gain a
wider grasp of accounting by presenting opposing viewpoints in
relation to hot topics. Some show accounting in a historical
context; others relate to contemporary issues.
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How To Use This Book
Page 3 of 6
Figures
Figures provide a graphical representation of how events and
actions link.
Tables
Tables provide useful checklists.
Exhibits
Page xxi
These features contain extracts from actual company reports or
documents, or provide a commonly used format for accounting.
They highlight the relevance of the chapter content to the
practice of accounting, provide another element to the topics
covered and help to reinforce learning.
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How To Use This Book
Page 4 of 6
Chapter summary
Key points of the chapter are summarised in this section. Check
through it carefully to make sure you have understood topics
covered before moving on.
Key terms
Key terms are bolded in the text the first time they are used,
defined in the margin at that point, and listed at the end of each
chapter. They also appear in the glossary at the end of the book.
End-of-chapter exercise
A comprehensive exercise and worked solution is provided at the
end of each chapter. These are a great revision aid; work
through them before tackling the more challenging questions to
ensure you are on the right track.
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How To Use This Book
Page 5 of 6
Review questions
These questions ask you to reflect on key topics within the
chapter, and help cement your learning.
Challenging questions
These questions require a detailed problem analysis and help to
build problem-solving and critical thinking skills.
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How To Use This Book
Page 6 of 6
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Digital Resources
Page 1 of 6
Page xxii
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fuelled by LearnSmartthe most widely used and adaptive
learning resource proven to strengthen memory recall, increase
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Digital Resources
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Fuelled by LearnSmart, SmartBook is the first and only adaptive
reading experience available today. Starting with an initial
preview of each chapter and key learning objectives, students
read material and are guided to the topics they most need to
practise at that time, based on their responses to a continuously
adapting diagnostic. To ensure concept mastery and retention,
reading and practice continue until SmartBook directs students
to recharge and review important material they are most likely
to forget.
LearnSmart
LearnSmart maximises learning productivity and efficiency by
identifying the most important learning objectives for each
student to master at a given point in time. It knows when
students are likely to forget specific information and revisits that
content to advance knowledge from their short-term to longterm memory. LearnSmart is proven to improve academic
performance, ensuring higher retention rates and better grades.
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Digital Resources
Page 3 of 6
To find out more about SmartBook visit
www.mheducation.com.au/student-smartbook
Page xxiii
McGraw-Hill Connect is the only learning platform that
continually adapts to you, delivering precisely what you need,
when you need it.
Proven effective
With Connect, you can complete your coursework anytime,
anywhere. Millions of students have used Connect and the
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Connect will increase the likelihood that you’ll pass your course
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Digital Resources
Page 4 of 6
Connect support
Connect includes animated tutorials, videos and additional
embedded hints within specific questions to help you succeed.
The Connect Success Academy for Students is where you’ll find
tutorials on getting started, your study resources and
completing assignments in Connect. Everything you need to
know about Connect is here!
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Digital Resources
Page 5 of 6
Visual progress
Connect provides you with reports to help you identify what you
should study and when your next assignment is due, and tracks
your performance. Connect’s Overall Performance report allows
you to see all of your assignment attempts, your score on each
attempt, the date you started and submitted the assignment,
and the date the assignment was scored.
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Digital Resources
Page 6 of 6
To learn more about McGraw-Hill Connect, visit
www.mheducation.com.au/student-connect
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Credits
Page 1 of 1
Page xxiv
CREDITS
International Accounting Standards Board
Copyright IFRS Foundation. All rights reserved.
Reproduced by McGraw-Hill Education (Australia) Pty Limited
with the permission of IFRS Foundation®. Reproduction and
use rights are strictly limited. No permission granted to third
parties to reproduce or distribute.
The International Accounting Standards Board, the IFRS
Foundation, the authors and the publishers do not accept
responsibility for any loss caused by acting or refraining from
acting in reliance on the material in this publication, whether
such loss is caused by negligence or otherwise.
Australian Accounting Standards Board
Copyright Commonwealth of Australia 2016
All legislation herein is reproduced by permission but does not
purport to be the official or authorised version. It is subject to
Commonwealth of Australia copyright. The Copyright Act 1968
permits certain reproduction and publication of
Commonwealth legislation. In particular, s.182A of the Act
enables a complete copy to be made by or on behalf of a
particular person. For reproduction or publication beyond that
permitted by the Act, permission should be sought in writing
from the Australian Accounting Standards Board. Requests in
the first instance should be addressed to the Administration
Director, Australian Accounting Standards Board, PO Box 204,
Collins Street West, Melbourne, Victoria, 8007.
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Introduction
Page 1 of 1
Part 1
Page 1
THE AUSTRALIAN ACCOUNTING
ENVIRONMENT
CHAPTER 1
An overview of the Australian external
reporting environment
CHAPTER 2
reporting
The conceptual framework for financial
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Introduction
Page 1 of 2
Chapter 1
Page 2
AN OVERVIEW OF THE AUSTRALIAN
EXTERNAL REPORTING ENVIRONMENT
LEARNING OBJECTIVES (LO)
1.1 Understand the meaning of ‘financial accounting’ and
its relationship to the broader areas of accounting and
accountability.
1.2 Be able to explain who is likely to be a user of general
purpose financial statements.
1.3 Understand the scope of regulation relating to
Australian external financial reporting.
1.4 Understand the sources of accounting regulation within
Australia and thus be able to explain the general functions of
the Australian Securities and Investments Commission, the
Australian Accounting Standards Board, the Financial
Reporting Council and the Australian Securities Exchange.
1.5 Be aware of the requirements within the Corporations
Act that require the preparation of a Directors’ Declaration,
Directors’ Report and a Declaration by the Chief Executive
Officer and Chief Financial Officer.
1.6 Be able to explain the central requirement that
financial statements be ‘true and fair’.
1.7 Be able to explain the general functions of the
International Accounting Standards Board and its direct
relevance to Australian accounting standard-setting.
1.8
Understand the relevance of the IFRS Interpretations
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Introduction
Page 2 of 2
Committee to Australian financial reporting.
1.9 Understand the role of an accounting standard and the
process by which it is developed.
1.10 Understand that accounting standards change across
time, meaning that profits calculated in past years are not
directly comparable with current profit calculations.
1.11
Be able to explain the idea of ‘differential reporting’.
1.12 Understand the role of the auditor and the auditor’s
report.
1.13 Understand the magnitude of changes that occurred
in 2003 and 2004 to Australian Accounting Standards as a
result of the Financial Reporting Council’s strategic decision
that Australia produce financial statements that comply with
standards being issued by the International Accounting
Standards Board.
1.14 Be aware of some of the perceived benefits of
international standardisation of financial reporting.
1.15 Be aware of some research which suggests that
international standardisation of accounting ignores
international differences in culture.
1.16 Understand that the practice of financial accounting
is quite heavily regulated within Australia and be aware of
some of the arguments for and against the regulation of
financial accounting.
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Accounting, accountability, and the role of financial accounting
Page 1 of 5
Page 3
Accounting, accountability and the role of
financial accounting
LO 1.1
In this book we focus on financial accounting, and particularly
financial accounting undertaken by larger-sized organisations
(which we will generally refer to as reporting entities) that are
required to adopt accounting standards. But before we launch
into doing some ‘financial accounting’ it is useful to briefly
consider how financial accounting relates to the broader area
of ‘accounting’, and how accounting relates to the idea of
‘accountability’.
Financial accounting represents only a part of the broader
area of ‘accounting’. So what is ‘accounting’? Simply stated,
accounting can be defined as the provision of information
about aspects of the performance of an entity to a particular
group of people with an interest, or stake, in the
organisation—we can call these parties stakeholders. But what
‘aspects of performance’ should ‘accounting’ address? What
‘accounts’ are stakeholders entitled to? This really depends
upon judgements we make about the organisation’s
responsibilities and accountabilities. For example, if we were
to accept that an entity has a responsibility (and an
accountability) for its social and environmental performance,
then we, as accountants, should accept a duty to provide ‘an
account’ (or a report) of an organisation’s social and
environmental performance—perhaps by way of releasing a
publicly available corporate social responsibility report. If, by
contrast, we considered that the only responsibility an
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Accounting, accountability, and the role of financial accounting
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organisation has is to maximise its financial returns (profits)
then we might believe that the only account we need to
provide is a financial account.
We also need to consider the breadth of stakeholders who
should be provided with an ‘account’—for example, should it
be restricted to shareholders and/or creditors, or do
employees, local communities and others also have a right to
be provided with particular information about an organisation?
Gray, Owen & Adams (1996) developed an accountability
model that explains how organisations should deal with
stakeholders and proposes that since a firm’s activities affect
the wellbeing of a wide range of stakeholders, the firm is
morally responsible, and therefore accountable, to these
stakeholders. In more practical terms, Gray et al. (1997, p.
334) provide a broader notion of accountability:
Accountability is concerned with the relationships between
groups, individuals, organisations and the rights to
information that such relationships entail. Simply stated,
accountability is the duty to provide an account of the
actions for which one is held responsible. The nature of the
relationships—and the attendant rights to information—are
contextually determined by the society in which the
relationship occurs.
From this definition, we can see that accountability involves
two responsibilities or duties, namely:
1. to undertake certain actions (or to refrain from taking
actions) in accordance with the expectations of a group of
stakeholders; and
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Accounting, accountability, and the role of financial accounting
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2. to provide a reckoning or account of those actions to the
stakeholders
(Gray, Owen & Adams 1996)
Therefore, the broad role of ‘accounting’, and of a corporate
report (and corporate reporting) is to inform relevant
stakeholders about the extent to which the actions for which
an organisation is deemed to be responsible (which in itself is
a controversial issue as people can have very different views
about the responsibilities of organisations) have actually been
fulfilled. Reporting provides a vehicle for an organisation to
fulfil its requirement to be accountable. Such accounts do not
all have to be prepared in financial terms. For example, if an
organisation is considered to be accountable for its water
consumption, or its greenhouse gas emissions, then such
‘accounts’ may be presented in physical terms. If a company
is considered to be responsible for the people who are making
their products in developing countries then it might produce
‘accounts’ about how the organisation is ensuring that
factory workplaces in developing countries are safe for the
employees.
Of course, different people will have different views about the
responsibilities of organisations, and therefore will hold
different views about what ‘accounts’ should be produced by
an organisation. That is, they will have different views about
the extent of ‘accounting’ that should be applied.
Organisations will have many different responsibilities. These
differing responsibilities will lead to many different
accountabilities. If we are to accept a very restricted view that
organisations are accountable only for their financial
performance, then we would believe that organisations need
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only provide financial accounts. But if we are to accept that
organisations are responsible for their social performance and
their environmental performance, then we would also expect
the organisation to produce social accounts and environmental
accounts. The social accounts and the environmental accounts
would be of interest to a much broader group of
Page 4
stakeholders than would financial accounts. Financial
accounts would primarily be of interest to existing and
potential investors, lenders and other creditors. However, we
also acknowledge that there will be other stakeholders with an
interest in financial accounts.
This book focuses on financial accounting, and in particular, on
the rules (standards) used to generate general purpose
financial statements. However, it needs to be acknowledged
that not all ‘accounts’ prepared by an organisation will be, or
should be, of a financial nature. Therefore, the purpose of this
brief section is merely to emphasise that financial accounting
is just one form of ‘accounting’, and it provides information
primarily about only one aspect of performance—financial
performance—and the information is generally of major
interest to those stakeholders with a financial interest in the
organisation. If we are also seeking to find out information
about an organisation’s social and environmental
performance—and such information would be of interest to a
broader group of stakeholders—then we will also have to look
at other ‘accounts’ released by the entity using broader
methods of ‘accounting’. Chapter 30
of this book
specifically addresses these other forms of accounts.
Specifically, it looks at frameworks used to compile social
reports, environmental reports and what have been referred
to as sustainability reports. That chapter also explores the
idea of accountability in greater depth. At this point you, the
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Accounting, accountability, and the role of financial accounting
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reader, should take a little time out to consider what
responsibilities you think organisations should embrace and
what sort of ‘accounts’ they should produce. Indeed, you can
reflect on what the term ‘accounting’ means to you.
From the above discussion we can see that ‘accounting’ is
actually a very broad activity, or discipline, which is tied to the
concept of accountability. We therefore caution against narrow
definitions of accounting, as appear in many (other)
textbooks, which define accounting in terms of it simply being
a process of identifying, measuring and
communicating/reporting economic information to permit
informed decisions to be made. Accounting can be a much
richer process than just this. (As another example of a narrow
definition, Weygandt et al. 2013, p. 4, define accounting as
‘an information system that identifies, records and
communicates the economic events of an entity to interested
users’.)
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Financial accounting defined
Page 1 of 2
Financial accounting defined
LO 1.1
As we have noted above, in this book our focus is on one
aspect of accounting known as financial accounting, which can
be considered to be a process involving the collection and
processing of financial information to meet the decisionmaking needs of parties external to an organisation and who
have an interest in the financial performance of the entity.
Financial accounting can be contrasted with management
accounting. Management accounting focuses on providing
information for decision making—with such information also
typically being provided in financial terms—by parties within
the organisation (that is, for internal as opposed to external
users) and it is largely unregulated. Financial accounting, by
contrast, is subject to many regulations.
Because management accounting relates to the provision of
information for parties within an organisation—such as
preparing budgets for managers that focus on the likely future
costs and revenues associated with particular products or
services—the view is taken that there generally is no need to
protect the information needs or rights of these parties as,
being insiders, they can relatively easily access the
information they require.
By contrast, it is generally accepted that the information rights
of outsiders, who are not involved in the day-to-day
operations of an organisation (such as the shareholders of a
listed company), must be protected. Because financial
statements prepared for external parties are often used as a
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Financial accounting defined
Page 2 of 2
source of information for parties contemplating transferring
resources to an organisation, it is arguably important that
certain rules be put in place to govern how the information
should be compiled. That is, the adoption of a ‘pro-regulation’
perspective to protect the interests of parties external to a
firm requires some regulation relating to the accounting
information that such firms should disclose. (We will consider
pro-regulation and ‘free-market’ perspectives in more detail
towards the end of this chapter.)
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Users’ demand for general purpose financial statements
Page 1 of 4
Users’ demand for general purpose
financial statements
LO 1.2
General purpose financial statements may be used by an array
of user groups for many purposes. However, under the
Conceptual Framework for Financial Reporting issued by the
Australian Accounting Standards Board (a conceptual
framework of accounting seeks to satisfy a number of
objectives including identifying the objectives of general
purpose financial reporting as well as the qualitative
characteristics that financial information should possess),
general purpose financial statements are primarily directed
towards the information needs of ‘existing and potential
investors, lenders and other creditors’. Specifically,
Page 5
paragraph OB2 (‘OB’ indicates that the paragraph
comes from the chapter of the conceptual framework that
deals with the objectives of general purpose financial
reporting) states that:
The objective of general purpose financial reporting is to
provide financial information about the reporting entity that is
useful to existing and potential investors, lenders and other
creditors in making decisions about providing resources to the
entity. Those decisions involve buying, selling or holding
equity and debt instruments, and providing or settling loans
and other forms of credit.
In identifying the ‘primary users’ of general purpose financial
reports, paragraph OB5 of the conceptual framework states:
Many existing and potential investors, lenders and other
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Users’ demand for general purpose financial statements
Page 2 of 4
creditors cannot require reporting entities to provide
information directly to them and must rely on general
purpose financial reports for much of the financial information
they need. Consequently, they are the primary users to whom
general purpose financial reports are directed.
The Conceptual Framework for Financial Reporting also
acknowledges that there are other potential users of financial
reports (for example, management, regulators and other
members of the public), but they are not deemed to be the
‘primary’ users of general purpose financial reports and hence
these ‘secondary’ users are not the focus of the prescriptions
provided within the conceptual framework. As paragraphs OB9
and OB10 state:
OB 9 The management of a reporting entity is also interested
in financial information about the entity. However,
management need not rely on general purpose financial
reports because it is able to obtain the financial information it
needs internally.
OB 10 Other parties, such as regulators and members of the
public other than investors, lenders and other creditors, may
also find general purpose financial reports useful. However,
those reports are not primarily directed to these other
groups.
Some parties with an interest in the financial affairs of an
entity might be in a position to successfully demand financial
statements that satisfy their specific information needs. For
example, a bank might demand, as part of a loan agreement,
that a borrowing organisation provide information about its
projected cash flows. Such a financial statement would be
considered a special purpose financial statement —in this
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Users’ demand for general purpose financial statements
Page 3 of 4
case, a financial statement prepared specifically to satisfy the
needs of the bank.
Other parties with interests in the affairs of an organisation
might not have the necessary power to demand financial
statements that specifically address their own information
requirements, having instead to rely on financial statements of
a general nature released by the reporting entity to meet the
needs of a broad cross-section of users, such as investors,
potential investors, employees, employee groups, creditors,
customers, consumer groups, analysts, media, government
bodies and lobby groups. These financial statements are
referred to as general purpose financial statements , as
opposed to special purpose financial statements. As noted
above, general purpose financial statements are produced
primarily to meet the needs of existing and potential investors,
lenders and other creditors; however, the reports will often
also satisfy the information needs of a broader cross-section of
users, which might include employees, government, news
media, researchers, interest groups, and ‘the public’.
In this book, we are concerned primarily with general purpose
financial reporting. Our explanation of general purpose
financial statements is consistent with the definition used in
accounting standards. For example, paragraph 7 of AASB 101
Preparation and Presentation of Financial Statements defines
general purpose financial statements in the following way:
General purpose financial statements (referred to as ‘financial
statements’) are those intended to meet the needs of users
who are not in a position to require an entity to prepare
reports tailored to their particular information needs.
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Users’ demand for general purpose financial statements
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Examples of general purpose financial statements are the
financial statements and supporting notes included within an
annual report presented to shareholders at a company’s annual
general meeting (and thereafter typically made available to
shareholders and other interested parties on the organisation’s
website). Our focus in this book will be general purpose Page 6
financial reporting practices that would typically be
used by private sector profit-seeking entities. However, in
recent years there have been moves by governments and
government departments towards adopting the kind of
accounting procedures that are used by business entities in the
private sector. Therefore much of our discussion can be applied
to government, particularly government trading enterprises
that compete directly with private sector firms (for example,
government-controlled organisations involved in
telecommunications, public transport and shipping).
Nevertheless, there continue to be some differences between
the reporting practices of some government departments and
those of private sector entities, and there are some accounting
standards that are dedicated to government bodies (such as
AASB 1049 Whole of Government and General Government
Sector Financial Reporting).
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Sources of external financial reporting regulations
Page 1 of 51
Sources of external financial reporting
regulations
LO 1.3 LO 1.4 LO 1.5 LO 1.6 LO 1.11
There are four principal bodies involved in formulating,
interpreting and/or enforcing accounting regulations within
Australia, these being:
1. the Australian Securities and Investments Commission
2. the Australian Accounting Standards Board
3. the Financial Reporting Council
4. the Australian Securities Exchange.
The Australian Accounting Standards Board (AASB) is a
government body. As we will see in the discussion to follow, the
Financial Reporting Council (FRC) oversees the activities of the
AASB. The FRC was responsible for the decision (made in 2003)
that Australian reporting entities would adopt accounting
standards issued by the International Accounting Standards
Board (IASB) for accounting periods beginning on or after 1
January 2005.
As with the AASB, the functioning of the Auditing and Assurance
Standards Board (AUASB) is also overseen by the Financial
Reporting Council. Since July 2006, auditing standards released
by the AUASB have had legislative backing (as do the
accounting standards issued by the AASB).
We will now give further consideration to each of the four main
bodies involved in formulating and/or enforcing accounting
regulations within Australia.
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1. Australian Securities and
Investments Commission
The Australian Securities and Investments Commission
(ASIC) evolved from the Australian Securities Commission (AS
C). The ASC was established in 1989 by the Australian Securities
Commission Act 1989 (Cwlth), and it replaced the National
Companies and Securities Commission (NCSC).
The name of the ASC was changed to ASIC in July 1998 to
reflect the increased responsibility assigned to the ASC in
relation to monitoring and regulating various investment
products, including superannuation, approved deposit accounts
and retirement savings accounts. The website of ASIC (
www.asic.gov.au) provides an overview of its role. The inform
ation provided on the website about ASIC’s role is reproduced in
Exhibit 1.1 .
As indicated in Exhibit 1.1 , ASIC is solely responsible for
administering corporations legislation in Australia. It is
independent of state ministers or state parliaments, and reports
directly to an appointed Minister of the Commonwealth
Parliament. Among other things, the Corporations Act, which is
administered by ASIC, outlines the responsibilities of company
directors in relation to the nature of their conduct, financial
statement preparation, lodgement and distribution. Since the
Corporations Act enacts the majority of legislative requirements
pertaining to financial accounting, this discussion of ASIC will
include a look at a number of the Act’s requirements. For those
readers interested in reviewing the content of the Corporations
Act (as well as other Acts), free access to electronic versions is
available at a site known as ComLaw (www.comlaw.gov.au),
which, according to the website, is an integral part of the
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Australian Law Online initiative to bring the community low-cost
or no-cost access to the law and is maintained by the AttorneyGeneral’s department.
An important requirement of the Corporations Act is for directors
of public companies, large proprietary companies, organisations
with securities listed on the Australian Securities Exchange and
some small proprietary companies to present shareholders with
true and fair financial statements for a given financial year. (This
and other requirements of the Corporations Act do not apply to
organisations outside the ambit of the Act, for example, Page 7
partnerships.) ‘Financial statements for the year’ is
defined at s. 295(2) of the Corporations Act. Specifically, s. 295
(2) states:
The financial statements for the year are:
(a)
unless paragraph (b) applies—the financial statements
in relation to the company, registered scheme or disclosing
entity required by the accounting standards; or
(b)
if the accounting standards require the company,
registered scheme or disclosing entity to prepare financial
statements in relation to a consolidated entity—the financial
statements in relation to the consolidated entity required by
the accounting standards.
Therefore the above requirements rely directly upon accounting
standards, which are released by the AASB (and which are
generally developed at an international level by the IASB, which
is based in London). To determine which ‘financial statements’
would be included in a financial report we can refer to
Accounting Standard AASB 101 Presentation of Financial
Statements. Paragraph 10 of the standard states that a
complete set of financial statements comprises:
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(a)
a statement of financial position as at the end of the
period;
(b)
a statement of profit or loss and other comprehensive
income for the period;
(c)
a statement of changes in equity for the period;
(d)
a statement of cash flows for the period;
(e)
notes, comprising significant accounting policies and
other explanatory information;
(ea) comparative information in respect of the preceding
period as specified in paragraphs 38 and 38A; and
(f)
a statement of financial position as at the beginning of
the preceding period when an entity applies an
accounting policy retrospectively or makes a
retrospective restatement of items in its financial
statements, or when it reclassifies items in its financial
statements in accordance with paragraphs 40A–40D.
An entity may use titles for the statements other than
those used in this standard. For example, an entity
may use the title ‘statement of comprehensive
income’ instead of ‘statement of profit or loss and
other comprehensive income’.
Across time, terminology used in relation to financial statements
has changed. For example, within AASB 101 Presentation of
Financial Statements, reference is now made to the ‘statement
of financial position’. This is equivalent to what many people
traditionally called a balance sheet.
Exhibit 1.1 The role of ASIC
What we do
ASIC is Australia’s corporate, markets and financial services
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regulator.
We contribute to Australia’s economic reputation and wellbeing
by ensuring that Australia’s financial markets are fair and
transparent, supported by confident and informed investors and
consumers.
We are an independent Commonwealth Government body. We
are set up under and administer the Australian Securities and
Investments Commission Act 2001 (ASIC Act), and we carry out
most of our work under the Corporations Act.
The Australian Securities and Investments Commission Act 2001
requires us to:
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maintain, facilitate and improve the performance of the
financial system and entities in it
promote confident and informed participation by investors and
consumers in the financial system
administer the law effectively and with minimal procedural
requirements
enforce and give effect to the law
receive, process and store, efficiently and quickly, information
that is given to us
make information about companies and other bodies available
to the public as soon as practicable.
Our strategic priorities
ASIC’s priorities are:
1. Promoting investor and financial consumer trust and
confidence:
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education—investor responsibility for investment decisions
remains core to our system. We empower investors and
financial consumers through our financial literacy work
gatekeepers—we will hold gatekeepers to account
Page 8
consumer behaviour—recognising how investors
and consumers make decisions.
2. Ensuring fair, orderly and transparent markets:
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achieved through our role in market supervision and
competition, and corporate governance.
3. Providing efficient and accessible registration:
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with a focus on small business and deregulation.
Who we regulate
We regulate Australian companies, financial markets, financial
services organisations and professionals who deal and advise in
investments, superannuation, insurance, deposit taking and
credit.
As the consumer credit regulator, we license and regulate people
and businesses engaging in consumer credit activities (including
banks, credit unions, finance companies, and mortgage and
finance brokers). We ensure that licensees meet the standards—
including their responsibilities to consumers—that are set out in
the National Consumer Credit Protection Act 2009.
As the markets regulator, we assess how effectively authorised
financial markets are complying with their legal obligations to
operate fair, orderly and transparent markets. We also advise
the Minister about authorising new markets. On 1 August 2010,
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we assumed responsibility for the supervision of trading on
Australia’s domestic licensed equity, derivatives and futures
markets.
As the financial services regulator, we license and monitor
financial services businesses to ensure that they operate
efficiently, honestly and fairly. These businesses typically deal in
superannuation, managed funds, shares and company
securities, derivatives and insurance.
Our powers
The laws we administer give us the facilitative, regulatory and
enforcement powers necessary for us to perform our role. These
include the power to:
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register companies and managed investment schemes
grant Australian financial services licences and Australian credit
licences
register auditors and liquidators
grant relief from various provisions of the legislation that we
administer
maintain publicly accessible registers of information about
companies, financial services licensees and credit licensees
make rules aimed at ensuring the integrity of financial markets
stop the issue of financial products under defective disclosure
documents
investigate suspected breaches of the law and in so doing
require people to produce books or answer questions at an
examination
issue infringement notices in relation to alleged breaches of
some laws
ban people from engaging in credit activities or providing
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financial services
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seek civil penalties from the courts
commence prosecutions—these are generally conducted by the
Commonwealth Director of Public Prosecutions, although there
are some categories of matters that we prosecute ourselves.
Protecting consumers and investors
We have powers to protect consumers against misleading or
deceptive and unconscionable conduct affecting all financial
products and services, including credit.
SOURCE: www.asic.gov.au
As we have noted above, the Corporations Act requires financial
statements, as defined above, to be ‘true and fair’. The
requirement to produce true and fair financial statements is set
out in s. 297 of the Corporations Act. Specifically, s. 297
requires that:
The financial statements and notes for a financial year must
give a true and fair view of:
(a)
the financial position and performance of the company,
registered scheme or disclosing entity; and
(b)
if consolidated financial statements are required, the
financial position and performance of the consolidated entity.
But why do we need a ‘true and fair’ requirement? The
Page 9
answer to this is that it is generally accepted that it
would be unrealistic to assume that specific disclosure rules or
accounting standards could be developed to cover every possible
transaction or event. For situations not governed by particular
rules or standards, the ‘true and fair view’ requirement is the
general criterion to assist directors and auditors to determine
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what disclosures should be made and to consider alternative
recognition and measurement approaches. Although there is no
definition of ‘true and fair’ in the Corporations Act—which is
perhaps somewhat surprising—it would appear that for financial
statements to be considered true and fair, all information of a
‘material’ nature should be disclosed so that readers of the
financial statements are not misled. However, ‘materiality’ is an
assessment calling for a high degree of professional judgement.
It is not possible to give a definition of ‘material’ that covers all
circumstances. Paragraph 5 of Accounting Standard AASB 108
Accounting Policies, Changes in Accounting Estimates and Errors
provides that:
omissions or misstatements of items are material if they could,
individually or collectively, influence the economic decisions
that users make on the basis of the financial statements.
Materiality depends on the size and nature of the omission or
misstatement judged in the surrounding circumstances. The
size or nature of the item, or a combination of both, could be
the determining factor.
The definition of materiality in AASB 108 is consistent with how
the concept of materiality is utilised in the Conceptual
Framework for Financial Reporting (paragraph QC11) and also
consistent with the definition of materiality provided in other
accounting standards.
The above definition of materiality makes reference to ‘users’. Of
particular importance would be the accounting knowledge or
expertise of accounting that the users of general purpose
financial statements are expected to possess. In this regard,
paragraph QC32 of the Conceptual Framework for Financial
Reporting states:
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Financial reports are prepared for users who have a reasonable
knowledge of business and economic activities and who review
and analyse the information diligently. At times, even wellinformed and diligent users may need to seek the aid of an
adviser to understand information about complex economic
phenomena.
Moving on to other requirements of the Corporations Act, we
note that directors of large and listed companies, as well as
some other entities, are required by the Act to attach to the
company’s financial statements a Directors’ Declaration and a
Directors’ Report. The Corporations Act also requires a
declaration to be made by the chief executive officer and the
chief financial officer. We will consider each of these
requirements, in turn, below.
Directors’ declaration
Within the Directors’ Declaration, required pursuant to s. 295(4)
of the Corporations Act, directors must state whether, in their
opinion, the financial statements comply with accounting
standards, and that the financial statements give a true and fair
view of the financial position and performance of the entity.
Importantly, directors must also state whether or not in their
opinion there were, when the declaration was made out,
reasonable grounds to believe that the company would be able
to pay its debts as and when they fall due. Specifically, s. 295
(4) states:
The directors’ declaration is a declaration by the directors:
(c)
whether, in the directors’ opinion, there are reasonable
grounds to believe that the company, registered scheme or
disclosing entity will be able to pay its debts as and when they
become due and payable; and
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(ca)
if the company, registered scheme or disclosing entity
has included in the notes to the financial statements, in
compliance with the accounting standards, an explicit and
unreserved statement of compliance with international financial
reporting standards—that this statement has been included in
the notes to the financial statements; and
(d)
whether, in the directors’ opinion, the financial
statement and notes are in accordance with this Act, including:
(i)
section 296 (compliance with accounting
standards); and
(ii)
section 297 (true and fair view); and
(e)
if the company, disclosing entity or registered scheme
is listed—that the directors have been given the declarations
required by section 295A.
Should directors make such a declaration fraudulently, carelessly
or recklessly, it is possible that they might become personally
liable for any outstanding debts of the company. Exhibit 1.2
reproduces the Directors’ Declaration in the 2015 Annual Report
of BHP Billiton Ltd.
Exhibit 1.2 Directors’ Declaration of
BHP Billiton Ltd (reproduced from 2015
Annual Report).
Page 10
In accordance with a resolution of the Directors of the BHP
Billiton Group, the Directors declare that:
(a)
in the Directors’ opinion and to the best of their
knowledge the financial statements and notes, set out in
sections 7.1 and 7.2, are in accordance with the UK Companies
Act 2006 and the Australian Corporations Act 2001, including:
(i)
Complying with the applicable Accounting
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Standards; and
(ii)
Giving a true and fair view of the assets, liabilities,
financial position and profit or loss of each of BHP Billiton
Ltd, BHP Billiton Plc, the BHP Billiton Group and the
undertakings included in the consolidation taken as a
whole as at 30 June 2015 and of their performance for the
year ended 30 June 2015;
(b)
the financial report also complies with International
Financial Reporting Standards, as disclosed in note 41 ‘Basis of
preparation and measurement’;
(c)
to the best of the Directors’ knowledge, the
management report (comprising the Strategic Report and
Directors’ Report) includes a fair review of the development
and performance of the business and the financial position of
the BHP Billiton Group and the undertakings included in the
consolidation taken as a whole, together with a description of
the principal risks and uncertainties that the Group faces; and
(d)
in the Directors’ opinion there are reasonable grounds
to believe that each of the BHP Billiton Group, BHP Billiton Ltd
and BHP Billiton Plc will be able to pay its debts as and when
they become due and payable.
The Directors have been given the declarations required by
Section 295A of the Australian Corporations Act 2001 from the
Chief Executive Officer and Chief Financial Officer for the
financial year ended 30 June 2015.
Signed in accordance with a resolution of the Board of Directors.
Jac Nasser AO—Chairman
Andrew Mackenzie—Chief Executive Officer
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Dated this 10th day of September 2015
SOURCE: BHP Billiton Annual Report 2015
At this stage you, the reader, should try to obtain some recent
corporate annual reports. Find the Directors’ Declaration in each
report. You will see that, in most cases, the declaration will be
similar in form to the example shown here. As we discuss other
accounting requirements throughout this book, please make a
point of referring to your collection of recent annual reports to
see how the companies in your sample are complying with the
various requirements that we are discussing. Referring to
corporate annual reports as you progress through this book will
serve to give the material you read a more ‘real-world’ feel.
Most large, listed, Australian companies provide copies of their
annual reports on their websites. Indeed, in recent years
companies have provided their annual reports on their websites
as an alternative to posting them out to their shareholders. For
example, see the websites of:
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BHP Billiton (www.bhpbilliton.com)
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Westpac Banking Corporation (www.westpac.com.au)
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AMP (www.amp.com.au)
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Australia and New Zealand Banking Group Limited (
www.anz.com.au)
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National Australia Bank (www.nab.com.au)
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Commonwealth Bank (www.commbank.com.au).
The annual reports of corporations will typically be available by
clicking on an ‘investors’ or ‘shareholders’ option (or something
similar) that is commonly shown on the home page of a
company’s website.
Financial Accounting in the Real World 1.1
provides an
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extract from an article that emphasises that company directors
can be liable for the debts of a company if the directors sign the
directors’ declaration stating that there are reasonable grounds
to believe that the organisation will be able to pay its debts as
and when they become due and payable when perhaps there is
evidence that they knew, or should have known, that
Page 11
the organisation was unable to pay the debts as and
when they become due.
Directors’ report
In the Directors’ Report, required pursuant to ss. 298–300A of
the Corporations Act, directors must provide items of
information, such as the names of the directors, details of
directors’ emoluments, the principal activities of the company,
review of operations during the year, significant changes in the
state of affairs of the company, likely future developments and
results, significant post-reporting-date events and details about
compliance with environmental laws.
The Directors’ Report often includes a great deal of information
that is provided by corporations on a voluntary basis. That is,
while the Corporations Act stipulates the minimum level of
disclosure that must be made in a Directors’ Report, many
organisations voluntarily produce additional information (which
raises a number of interesting issues about why they elect to
disclose additional information when not required to—we will
consider this again in Chapter 3 ). For example, in recent
years it has been common to find companies voluntarily
providing information about community-based projects in which
they are participating, as well as employee-training schemes
and safety initiatives, and company-promoted environmental
initiatives. Review the Directors’ Reports of a number of
companies to see the variety of topics that are addressed in
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these reports.
1.1 FINANCIAL ACCOUNTING IN THE REAL
WORLD
High-stakes case for coal baron Tinkler
Gareth Hutchens
Liquidators have launched legal action against Nathan Tinkler
after the coal baron allegedly allowed one of his companies to
trade while insolvent.
The action follows a decision by the NSW Supreme Court on
Tuesday to approve a funding agreement between Blackwood
Corporation and the liquidators of Mulsanne Resources after
Mulsanne failed to buy $28.4 million of Blackwood shares last
year, despite agreeing to do so.
Blackwood said in a statement that if the court finds Mulsanne’s
directors liable for insolvent trading, it may make compensation
orders against them personally.
In a statement, Tinkler Group said: ‘The directors of Mulsanne
strongly deny allegations of trading while insolvent and will
strongly defend any legal action instigated by the liquidators.’
In documents tendered in the NSW Supreme Court, Ferrier
Hodgson said Mulsanne’s directors had no reasonable grounds to
believe the company could pay the $28.4 million when the time
came to do so.
SOURCE: Extract from ‘High-stakes case for coal baron Tinkler’ by Gareth Hutchens, The
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Australian, 3 May 2013
The Directors’ Report also has to include an operating and
financial review. The review should include information that
shareholders of the company would reasonably require to make
informed assessments of the operations, financial position and
future strategies of the organisation. Specifically, s. 299A(1) of
the Corporations Act states:
The directors’ report for a financial year for a company,
registered scheme or disclosing entity that is listed must also
contain information that members of the listed entity would
reasonably require to make an informed assessment of:
(a)
the operations of the entity reported on;
(b)
the financial position of the entity reported on; and
(c)
the ‘business strategies, and prospects for future
financial years, of the entity reported on.
Declaration by the chief executive officer and
chief financial officer
The chief executive and chief financial officers of entities with
securities listed on the Australian Securities Exchange are
required to provide a written declaration to the board of
directors that the annual financial statements are in accordance
with the Corporations Act and accounting standards and that the
financial statements present a true and fair view of the entity’s
financial position and performance. Specifically, s. 295A Page 12
(2) of the Corporations Act states that a declaration is
to be made that:
(a)
the financial records of the company, disclosing entity
or registered scheme for the financial year have been properly
maintained in accordance with section 286;
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(b)
the financial statements, and the notes referred to in
paragraph 295(3)(b), for the financial year comply with the
accounting standards;
(c)
the financial statements and notes for the financial year
give a true and fair view (see section 297); and
(d)
any other matters that are prescribed by the regulations
for the purposes of this paragraph in relation to the financial
statements and the notes for the financial year are satisfied.
As we can see from the Directors’ Declaration provided in
Exhibit 1.2 , towards the end, the Directors’ Declaration of B
HP Billiton specifically notes that the directors received the
declaration by the chief executive officer and the chief financial
officer.
Lastly, from time to time ASIC also releases regulatory guides
(previously referred to as policy statements) that relate to
various issues, including financial reporting. For example, ASIC
has released statements in relation to pension accounting,
related party transactions and valuing share options. To see
current ASIC regulatory guides go to ASIC’s website at
www.asic.gov.au.
2. Australian Accounting
Standards Board
While the Corporations Act, which is administered by ASIC,
requires corporations to comply with accounting standards (as
per s. 296 of the Corporations Act), ASIC does not actually
develop accounting standards. This responsibility is borne by the
Australian Accounting Standards Board (AASB).
The AASB began operations on 1 January 1991 and replaced the
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Accounting Standards Review Board. While its functions,
membership and structure were changed in 2000 as a result of
amendments included in the Corporate Law Economic Reform
Program Act 1999 (Cwlth), the body charged with formulating
accounting standards has retained the name ‘Australian
Accounting Standards Board’. The functions of the AASB are
listed in s. 227 of the ASIC Act and include to:
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develop a conceptual framework, not having the force of an
accounting standard, for the purpose of evaluating accounting
standards and international standards;
make accounting standards under section 334 of the
Corporations Act for the purpose of the national scheme laws;
formulate accounting standards for other purposes; and
participate in and contribute to the development of a single set
of accounting standards for world-wide use.
The AASB is responsible for ‘making’ accounting standards that
have the force of law pursuant to s. 334 of the Corporations Act,
and also for ‘formulating’ accounting standards that are to be
used in the public and non-profit sectors (that is, by entities that
are not governed by the Corporations Act). The difference in
terminology between ‘making’ and ‘formulating’ accounting
standards can be explained as follows. When the AASB develops
accounting standards that have the force of the Corporations
Act, it is said to be making standards. When it develops
accounting standards that are to be applied by entities other
than those governed by the Corporations Act, it is said to be
formulating accounting standards.
For many years within Australia we had two sets of accounting
standards: those that applied to corporations and other entities
that are governed by the Corporations Act (which had the prefix
AASB); and another set that applied to entities not governed by
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the Corporations Act (bearing the prefix AAS, which referred to
Australian Accounting Standards). Having two sets of accounting
standards was a source of confusion for many people. To
remove some of this confusion it became the practice of the
AASB to issue only one set of accounting standards (with the
prefix AASB), which have general applicability to the private,
public and not-for-profit sectors. That is, the AASB adopted a
‘sector-neutral’ approach to the development of accounting
standards.
We will consider the full list of AASB accounting standards later
in this chapter. It is worth re-emphasising here that the majority
of AASB standards underwent changes in 2003 or 2004 as
Australia moved towards adopting accounting standards
released by the IASB from 2005. We will focus on the
Page 13
AASB standards, which are mostly the same as the
standards issued by the IASB, throughout the balance of this
book.
The AASB reports to the Financial Reporting Council (FRC). The
FRC assumes an oversight function in regard to the AASB, and
appoints the 12 part-time AASB members. The part-time
members of the AASB come from a variety of backgrounds,
including the private sector, government, academia, Big 4
accounting firms and independent consultancy. Section 236B of
the ASIC Act requires that a person may not be appointed a
member of the AASB unless their ‘knowledge of, or experience
in, business, accounting, law or government qualifies them for
appointment’. The full-time chairperson of the AASB is appointed
by the delegated Minister within the Federal Government. (By
now it should be becoming clear how much control the
government is attempting to exert over accounting standardsetting.)
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The structure of Australian accounting standard-setting can be
summarised diagrammatically, as in Figure 1.1 .
Figure 1.1
Diagrammatic representation of the structure of Australian
accounting standard-setting
SOURCE: Adapted from © Australian Accounting Standards Board (AASB)
www.aasb.com.au
Referring to the diagram, the Federal Minister appoints the
chairman of the Australian Accounting Standards Board (AASB).
The Chairman of the AASB is accountable to the Minister in
respect of the operations of the AASB and the Office of the
AASB. The Office of the AASB provides technical and
administrative services, information and advice to the AASB and
is responsible to the Minister for financial management of the
Office of the AASB. The Chairperson of the AASB is also the chief
executive officer of the Office.
Figure 1.1 also identifies ‘focus groups’ as part of the AASB
structure. These focus groups are further divided into:
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User Focus Group; and
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Not-for-Profit (Private Sector) Focus Group.
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According to the AASB website, the ‘User Focus Group’ was
established to increase participation by analysts in the
accounting standard-setting process in order to enhance
feedback from the perspective of a significant group of users of
financial statements. The purpose of the User Focus Group is to
assist the AASB in raising awareness of how investors and
investment professionals, equity and credit analysts, credit
grantors and rating agencies use financial statements and of
their information needs.
The AASB’s Not-for-Profit (Private Sector) Focus Group is
designed to increase participation by those involved with these
entities in the accounting standard-setting process and to
enhance feedback from the perspective of a significant group of
preparers and users of financial statements. The Not-for-Profit
Focus Group comprises members who have expertise in, and are
involved in, charitable and related organisations; these members
are a key source of information in this area and provide
feedback to the AASB on selected projects.
As we can see from Figure 1.1 , the AASB also has
‘project advisory panels’. Experts in a particular field
Page 14
or topic area are invited to join an advisory panel to provide
advice that will assist the AASB in progressing specific standardsetting projects. Panels work with AASB staff to develop agenda
materials for consideration by the Board.
Interpretations advisory panels are another important
component of the AASB structure. Interpretations are required
from time to time in respect of how particular accounting
requirements are to be interpreted and applied in the Australian
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context. As stated on the AASB website: ‘Interpretations are
issued by the AASB to provide requirements concerning urgent
financial reporting issues’. At the international level there is the
IFRS Interpretations Committee—which functions under the
auspices of the IASB—which was specifically established to
provide official Interpretations of the standards being released
by the IASB and, therefore, being used within Australia. We
discuss the IFRS Interpretations Committee in greater depth
later in this chapter.
According to the AASB website, one of the features of the
‘Interpretations model’ is that the AASB decides on a topic-bytopic basis whether to appoint an advisory panel, which would
be constituted as a committee of the AASB. The role of advisory
panels is limited to preparing alternative views on an issue and,
where appropriate, presenting recommendations for
consideration by the AASB.
Each Interpretations Advisory Panel normally includes between
four and eight members, including the AASB chairman and at
least one other AASB member. Panel members are appointed on
the basis of their professional competence and practical
experience in the topic area. The AASB seeks to ensure that the
perspectives represented include those of preparers, users,
auditors and regulators.
Where an Interpretations Advisory Panel makes a
recommendation, the process would generally be as follows:
(a)
If an issue proposal relates to an Australian equivalent
to IFRS, the Panel will either:
l • recommend that the AASB take no action and give
reasons, or
l
• recommend to the AASB that the issue be referred to
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the IFRS Interpretations Committee for consideration for
inclusion in its work program.
Decisions by the AASB in respect of all rejected issue
proposals relating to Australian equivalents to IFRSs will
be sent to the IFRS Interpretations Committee for
information and be published on the AASB website.
Where the AASB refers an issue proposal to the IFRS
Interpretations Committee:
(i)
if the IFRS Interpretations Committee adds the
issue to its work program, the AASB will adopt the IFRS
Interpretations Committee decisions, and
(ii)
if the IFRS Interpretations Committee does not
add the issue to its work program, the AASB will assess
the reasons for its rejection and, depending on the
significance of the issue in Australia and before
publishing an agenda rejection statement on the AASB
website, decide whether further action, if any, should be
taken by the AASB. The AASB may decide to add the
issue to its work program and establish an advisory
panel. However, the AASB considers that a unique
domestic interpretation of an Australian equivalent to
IASB requirements will be required only in rare and
exceptional circumstances.
(b)
If the issue proposal relates to domestic requirements
that relate only to not-for-profit entities in the public and/or
private sectors, the Panel will either:
l • recommend that the AASB take no action and give
reasons, or
l
• recommend that the issue be added to the work
program and, if required, a panel be established to
prepare recommendations for consideration by the
AASB.
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The AASB website lists the various Interpretations on issue.
Organisations that are required by law to follow AASB
Accounting Standards are also required to follow the
Interpretations released by the AASB. This is made explicit in
AASB 1048 Interpretation of Standards. We will consider AASB
1048 again later in this chapter when we discuss the IFRS
Interpretations Committee’s functions more fully.
Having discussed the organisational structure of the AASB, we
now turn our attention back to accounting standards. Section
231 of the ASIC Act requires the AASB to carry out a cost–
benefit analysis of the impact of a proposed accounting standard
before making or formulating that standard (to the extent ‘to
which it is reasonably practicable to do so in the
circumstances’). Of course, working out the costs and benefits of
an accounting standard can be a very difficult, and sometimes
political, exercise. Section 231 of the ASIC Act states that:
(1)
The AASB must carry out a cost–benefit analysis of the
impact of a proposed accounting standard before making or
formulating the standard. This does not apply where the
standard is being made or formulated by issuing the text of an
international standard (whether or not modified to
Page 15
take account of the Australian legal or institutional
environment).
(2)
The AASB must carry out a cost–benefit analysis of the
impact of a proposed international accounting standard before:
(a)
providing comments on a draft of the standard; or
(b)
proposing the standard for adoption as an
international standard.
(3)
The AASB has to comply with subsections (1) and (2)
only to the extent to which it is reasonably practicable to do so
in the circumstances.
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(4)
The Minister may direct the AASB to give the Minister
details of a cost–benefit analysis carried out under this section.
The AASB must comply with the direction.
In the context of developing accounting standards, we are left in
no doubt that the FRC’s views carry considerable weight in the
standard-setting process. Section 232 of the ASIC Act states
that:
In performing its functions, the AASB must follow the broad
strategic direction determined by the FRC under paragraph 225
(2)(c). [emphasis added]
Once the AASB makes an accounting standard, which as we
know is generally the equivalent of a standard issued by the
IASB, it is the responsibility of the Commonwealth Parliament to
either allow or disallow the standard. Before being approved by
parliament, standards released by the AASB are referred to as
‘pending’ accounting standards. The accounting standards
themselves will generally provide guidance on how a
classification of items (for example, inventory) should be
identified, measured, presented and disclosed.
Once a pending accounting standard is approved by parliament,
directors are required to ensure that a company’s financial
statements comply with the standard. This is in terms of s. 296
of the Corporations Act, which requires a company’s directors to
ensure that the company’s financial statements for a financial
year are made out in accordance with accounting standards.
As already noted, from 2004 there is also a requirement within
the Corporations Act for the chief executive officer and chief
financial officer of listed companies to provide a written
declaration to the board of directors to the effect that the
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financial statements comply with accounting standards.
Most ‘small’ proprietary companies, however, are exempted
from complying with accounting standards released by the
AASB. While the thresholds do change from time to time, at the
time of writing, pursuant to the Corporations Act, s. 45A, a
proprietary company is considered to be ‘small’ if it satisfies two
of the following three tests:
1. Its gross operating revenue is less than $25 million (as
determined by applying accounting standards).
2. Its gross assets are less than $12.5 million (as determined by
applying accounting standards).
3. It has fewer than 50 equivalent full-time employees.
Section 296(IA) of the Corporations Act provides that:
the financial report of a small proprietary company does not
have to comply with particular accounting standards if:
(a)
the report is prepared in response to a shareholder
direction under section 293; and
(b)
the direction specifies that the report does not have to
comply with those standards.
The above requirement therefore needs to be read in
conjunction with s. 293. Section 293 states:
(1)
Shareholders with at least 5% of the votes in a small
proprietary company may give the company a direction to:
(a)
prepare a financial report and directors’ report for
a financial year; and
(b)
(2)
send them to all shareholders.
The direction must be:
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(a)
and
Page 27 of 51
signed by the shareholders giving the direction;
(b)
made no later than 12 months after the end of
the financial year concerned.
(3)
The direction may specify all or any of the following:
(a)
that the financial report does not have to comply
with some or all of the accounting standards;
(b)
that a directors’ report or a part of that report
need not be prepared;
(c)
that the financial report is to be audited.
Effectively, therefore, a small proprietary company
Page 16
does not have to apply accounting standards or have its
financial statements audited unless ASIC requests the company
to do so, or if shareholders holding at least 5 per cent of the
voting shares request the company to do so. If a proprietary
company is not considered small, it is classified as large, and
large proprietary companies are subject to more stringent
disclosure requirements.
Public companies and large proprietary companies will typically
have to prepare financial statements that comply with
accounting standards, have their financial statements audited
and send them to the members (shareholders) of the company
(or make them available on the corporation’s website if the
shareholder has not made a specific request to receive a hard
copy). The existence of this differential reporting requirement
for small and large proprietary companies is based on the
assumption that the limited number of parties with a material
interest in ‘small’ companies would conceivably be able to
request information to satisfy their specific needs. However, it is
assumed that the majority of shareholders in ‘large’ companies
do not have this ability. As organisations become larger there
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tends to be greater separation between ownership and
management (or, as this is often termed, between ownership
and control) and owners tend to become more reliant on
external reports in order to monitor the progress of their
investment. Further, as an entity increases in size, its economic
and political importance increases, and in general this increases
the demand for financial information about the entity.
Differential reporting
In relation to the issue of differential reporting, we know from
the above that the Corporations Act does provide some
reporting ‘let-outs’ for organisations such as small proprietary
companies. However, many other organisations are still required
to produce financial statements that comply with accounting
standards. Because so many organisations were required to
produce financial reports that complied with accounting
standards, this arguably created a reporting burden for some
organisations in situations where there were questionable
benefits to report users. With this is mind the AASB released
AASB 1053 Application of Tiers of Australian Accounting
Standards. AASB 1053 introduced a two-tier reporting system
for entities producing general purpose financial statements. Tier
1 general purpose financial statements are financial statements
that comply with all relevant accounting standards. Tier 2
comprises the recognition, measurement and presentation
requirements of Tier 1 but substantially reduced disclosure
requirements. Because the Tier 2 requirements do not change
the recognition and measurement requirements being applied,
the new differential reporting approach is consistent with the
position that has been taken by the AASB for a number of
years—this being that the same transactions and other events
should be subject to the same accounting requirements to the
extent feasible (that is, transaction neutrality), and this principle
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should apply to all entities preparing general purpose financial
statements (whether for-profit or not-for-profit).
Each Australian Accounting Standard will specify the entities to
which it applies and, where necessary, sets out disclosure
requirements from which Tier 2 entities are exempt. Complying
with Tier 1 requirements will mean compliance with International
Financial Reporting Standards as issued by the IASB (IFRSs).
Conversely, entities applying Tier 2 reporting requirements
would not be able to state that their reports are in compliance
with IFRSs (because of the reduced disclosure).
In identifying which entities shall apply Tier 1 reporting
requirements, paragraph 11 of AASB 1053 states:
Tier 1 reporting requirements shall apply to the general
purpose financial statements of the following types of entities:
(a)
for-profit private sector entities that have public
accountability; and
(b)
the Australian Government and State, Territory and
Local Governments.
In relation to ‘for-profit private sector entities’ (which would
include, for example, listed companies) we obviously need to
have some definition of ‘public accountability’ given its centrality
to the above requirement. Appendix A of AASB 1053 defines it
as follows:
Public accountability means accountability to those existing and
potential resource providers and others external to the entity
who make economic decisions but are not in a position to
demand reports tailored to meet their particular information
needs.
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The above definition links directly to the definition of ‘general
purpose financial statements’, which has been used widely
within financial reporting, and which has already been discussed
earlier in this chapter. General purpose financial statements are
defined in AASB 1053 (and elsewhere, as we have already seen)
as statements:
intended to meet the needs of users who are not in a position
to require an entity to prepare reports tailored to their
particular information needs.
The definition of ‘public accountability’ reproduced
Page 17
above provides a general principle. Appendix A to AASB
1053 provides practical application guidance. It states:
A for-profit private sector entity has public accountability if:
(a)
its debt or equity instruments are traded in a public
market or it is in the process of issuing such instruments for
trading in a public market (a domestic or foreign stock
exchange or an over-the-counter market, including local and
regional markets); or
(b)
it holds assets in a fiduciary capacity for a broad group
of outsiders as one of its primary businesses. This is typically
the case for banks, credit unions, insurance companies,
securities brokers/dealers, mutual funds and investment banks.
Paragraph B2 of Appendix B to AASB 1053 further states:
The following for-profit entities are deemed to have public
accountability:
(a)
disclosing entities, even if their debt or equity
instruments are not traded in a public market or are not in the
process of being issued for trading in a public market;
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(b)
co-operatives that issue debentures;
(c)
registered managed investment schemes;
Page 31 of 51
(d)
superannuation plans regulated by the Australian
Prudential Regulation Authority (APRA) other than Small APRA
Funds as defined by APRA Superannuation Circular No. III.E.1
Regulation of Small APRA Funds, December 2000; and
(e)
authorised deposit-taking institutions.
In relation to which entities are required to apply Tier 2
reporting requirements, paragraph 13 of AASB 1053 states:
Tier 2 reporting requirements shall, as a minimum, apply to the
general purpose financial statements of the following types of
entities:
(a)
for-profit private sector entities that do not have public
accountability;
(b)
not-for-profit private sector entities; and
(c)
public sector entities, whether for-profit or not-forprofit, other than the Australian Government and State,
Territory and Local Governments.
These types of entities may elect to apply Tier 1 reporting
requirements in preparing general purpose financial
statements.
Therefore, for example, if a proprietary company is not deemed
to be small (thereby not satisfying the ‘let-out’ provisions
included at section 296(1A) of the Corporations Act) then it
must, at the least, prepare Tier 2 financial statements. Such
financial statements would be referred to as complying with
Australian Accounting Standards—Reduced Disclosure
Requirements. As paragraph 16 of AASB 1053 states:
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Disclosures under Tier 2 reporting requirements are the
minimum disclosures required to be included in general
purpose financial statements. Entities may include additional
disclosures using Tier 1 reporting requirements as a guide if, in
their judgement, such additional disclosures are consistent with
the objective of general purpose financial statements.
The above requirements would also need to consider whether
the organisation is a reporting entity and therefore required to
produce general purpose financial statements. Organisations
producing financial statements that comply with Tier 2
requirements are still considered to be producing general
purpose financial statements. A reporting entity is defined in
AASB 1053 (and elsewhere) as:
An entity in respect of which it is reasonable to expect the
existence of users who rely on the entity’s general purpose
financial statements for information that will be useful to them
for making and evaluating decisions about the allocation of
resources. A reporting entity can be a single entity or a group
comprising a parent and all its subsidiaries.
An organisation that is not a ‘reporting entity’ and does not have
‘public accountability’ would not be impacted by the
requirements of AASB 1053 to the extent that the organisation
does not elect to produce general purpose financial statements.
In relation to the disclosures from which Tier 2 entities Page 18
are exempt, reference must be made to the
‘Application’ section of each Accounting Standard (which
typically follows the ‘Objective’ section within the Accounting
Standard) and within this section there will be a sub-heading
‘Reduced Disclosure Requirements’. Under this sub-heading will
be a statement:
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The following do not apply to entities preparing general
purpose financial statements under Australian Accounting
Standards—Reduced Disclosure Requirements:
A list of relevant paragraphs would then be provided. Some
Australian Accounting Standards are equally applicable to both
Tier 1 and Tier 2 entities. Therefore, such Standards do not
provide reduced disclosures for Tier 2 entities. Also, some
Standards apply only to Tier 1 entities, but Tier 2 entities may
elect to use them. Examples are AASB 8 Operating Segments
and AASB 133 Earnings per Share, which generally apply only to
listed entities.
While Australian Accounting Standards are generally equivalent
to standards issued by the IASB (IFRS), AASB 1053 represents a
departure from what is occurring at the international level. In
2009 the IASB issued its International Financial Reporting
Standard for Small and Medium-sized Entities. The IASB
standard allows small and medium enterprises (SMEs) to depart
from various recognition, measurement and presentation
requirements incorporated within IFRS. By contrast, the view
adopted by the AASB (as reported in the Basis for Conclusions
that supports AASB 1053) was that since Australia has adopted
full IFRSs, it would be logical to use the public accountability
notion used by the IASB in determining which entities in the forprofit sector should apply Australian Accounting Standards in full
(the definition of ‘public accountability’ as used by the AASB is
identical to that used by the IASB).The Reduced Disclosure
Requirements (RDR) reflected in AASB 1053 are fundamentally
different from the approach adopted in the IFRS for SMEs
because the RDR involve applying the same recognition and
measurement requirements as Tier 1, whereas the IFRS for
SMEs modifies the recognition and measurement requirements
of full IFRSs. The implications of the IASB approach to SMEs is
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that there will be disparities in the choice of accounting policies
by different entities because precedence will be given to the
conceptual framework over full IFRSs as the source of guidance
for determining accounting policies in the absence of a specific
requirement.
Other reasons identified by the AASB for why it elected not to
adopt the IASB’s approach to differential reporting included:
l
l
l
l
l
l
the additional initial and ongoing costs of training and
education for two sets of standards both for the profession and
at the tertiary level
that some subsidiaries of publicly accountable entities would
find it burdensome to apply the proposed IFRS for SMEs in
preparing their general purpose financial statements. They
would need to prepare financial information based on the
recognition and measurement requirements of full IFRSs for
the purposes of the parent entity consolidation
entities seeking to access international capital markets would
generally apply full IFRSs
a loss of comparability across all types of entities’ general
purpose financial statements within Australia
adoption of the IFRS for SMEs may be seen as a retrograde
step in a country that has already adopted full IFRS recognition
and measurement accounting policy options
in the event that an entity moves to, or from, full IFRSs, there
would be costs involved in migrating from the recognition and
measurement requirements of one Tier of reporting to another.
While AASB 1053 does represent a relatively major change to
the Australian financial reporting environment, the requirements
embodied within AASB 1053 are likely to be amended in the nottoo-distant future. As paragraph BC20 from the Basis for
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Conclusions to AASB 1053 states:
The Board regards AASB 1053 as a pragmatic and substantive
response to the need to reduce the burden of disclosure
requirements on Australian reporting entities. However, the
Board does not regard it as a complete or final answer to that
need. The Board intends continuing its deliberations on revising
the differential reporting framework with a view to ongoing
improvements (including having regard to decisions made by
the IASB in relation to its IFRS for SMEs). The Board concluded
that the reforms in AASB 1053 should not be delayed while
consideration of other possible areas of reform continues.
Apart from the issue of differential reporting as addressed in
AASB 1053, some AASB accounting standards are applicable
only to specific classes of companies (for example, companies
listed on the Australian Securities Exchange). Further, ASIC
may, from time to time and pursuant to the Corporations Act,
release a Class Order that grants relief from certain Corporations
Act provisions, such as the requirement to comply with Page 19
all accounting standards. As we have indicated in this
chapter, from 2000 the AASB has also been responsible for
issuing standards applicable to reporting entities that are not
governed by the Corporations Act (for example, large
partnerships and government departments).
As noted above, and pursuant to s. 285(2) of the Corporations
Act, AASB standards can apply to some entities that are not of a
corporate form—for example, to ‘disclosing entities’. This has
had the effect of increasing the ambit of accounting standards so
that all disclosing entities need to comply with the majority of
AASB accounting standards. According to the Corporations Act,
disclosing entities include:
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(a)
entities which have securities that are quoted on a stock
market of a securities exchange;
(b)
entities which have securities (except debentures) that
have been issued pursuant to a prospectus;
(c)
entities which have securities (except debentures) that
have been issued as consideration for the acquisition of shares
pursuant to a takeover scheme;
(d)
entities which have securities that have been issued
pursuant to a Part 5.1 compromise or arrangement; and
(e)
borrowing corporations.
Disclosing entities are required to comply with AASB accounting
standards, with only a limited number of exceptions. Hence,
many forms of organisations other than companies are now
required by law to follow the majority of AASB accounting
standards. This is despite the specific wording of some AASB
standards.
Before the release of AASB accounting standards, or the release
of components of the Conceptual Framework (to be discussed in
more detail in Chapter 2 ), the contents of the proposed
releases are subject to critical review. In the past, the typical
process involved when the AASB developed an accounting
standard was that, once a particular project was initiated,
relevant informed individuals were commissioned to develop a
discussion paper or theory monograph. This was done within
Australia. This paper was then released for public discussion to
determine whether key areas had been addressed, particularly
as they relate to the Australian context. After further
consideration by the regulatory bodies, a draft exposure draft
was developed for review by selected parties. Once it was
established that the draft document appropriately addressed the
issue of concern, an exposure draft was released for public
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discussion. After considering public comments, a draft standard
may have been released or, alternatively, a revised exposure
draft may have been developed. There was then a further period
for comment, following which an accounting standard or concept
statement might finally have been released. Exposure drafts do
not have the force of an accounting standard, but they do
provide an indication of future reporting requirements.
Central to the above process was that the development of the
accounting standard was undertaken very much within the
Australian context, with due consideration given to international
accounting standard developments. However, and as a result of
the decision made in 2003 by the FRC that Australia would adopt
accounting standards developed by the International Accounting
Standards Board (such standards now being referred to as
International Financial Reporting Standards or IFRSs), the
development of most accounting standards to be used within
Australia is now not directly under the control of Australian
accounting standard-setters (except to the extent that the
accounting standard relates to domestic issues and there is no
equivalent IFRS). AASB 1053 discussed earlier is one such
example. There are various costs and benefits associated with
this delegation of responsibility to the IASB. (Try to think of
what some of these costs and benefits might be.)
The true and fair view: further considerations
Before the early 1990s, the directors of a company could elect
not to comply with an accounting standard on the grounds that
applying the particular standard would cause the accounts not to
present a true and fair view. The ‘old’ s.298(2) provided that:
where a company’s financial statements for a financial year
would not, if made out in accordance with a particular
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applicable accounting standard, give a true and fair view of the
matters with which this division requires the financial
statements to deal, the directors need not ensure that the
financial statements are made out in accordance with that
accounting standard.
The above requirement, which allowed directors to elect not to
comply with an accounting standard if non-compliance was
deemed necessary to create true and fair accounts, was referred
to as the ‘true and fair override’. The perspective taken was that
in some isolated cases, certain accounting standards might not
be appropriate for a particular entity, and application of the
standards might actually make the financial statements
misleading. However, this view was abandoned some years
later, and the corporations law was amended and the override
withdrawn such that s. 296 of the Corporations Act requires that
‘[t]he financial report for a financial year must comply Page 20
with accounting standards’ (although, as we indicated
earlier, there is a ‘let-out’ for small proprietary companies).
Following the amendment, directors were therefore required to
comply with applicable accounting standards. If, in their view,
compliance did not generate a true and fair view, additional
information had to be presented in the notes to the financial
statements.
Numerous writers had argued that as the true and fair view
requirement is not clearly defined, directors could invoke the
‘true and fair override’ to justify not complying with particular
accounting standards. Without a clear definition of ‘true and
fair’, it is difficult for ASIC or its predecessors, the ASC and the
NCSC, to take action on the basis that the departure did not
enhance the truth and fairness of the accounts. As McGregor
(1992, p. 70) stated:
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The tendency of an increasing number of companies to
seemingly avoid complying with approved Accounting
Standards at will has, in the past, been accompanied by an
extreme reluctance on the part of the body responsible for
enforcing the law—in the main the National Companies and
Securities Commission (NCSC)—to pursue transgressors
through the courts because of a perceived difficulty of
successfully prosecuting the companies against the ‘true and
fair defence’. Henry Bosch, the former chairman of the NCSC,
has said: ‘No, there were no prosecutions, for the reason I
gave Mr Scholes earlier on—that the true and fair overrides. I
told you of a particular case where there was a flagrant breach
of an Accounting Standard—the goodwill standard. I was
advised that I would not win. It was also put that if we took the
case and lost, the dam would burst and everybody would see
that what we were saying could not be sustained in court. It
seemed too risky to go down that road.’
At present, it appears unlikely that the true and fair override will
be reintroduced. Further, if companies were permitted to depart
from accounting standards because they believed the departure
was necessary to present a true and fair view, then these same
companies could not thereafter claim to be presenting financial
statements in conformity with IFRS—something that is claimed
to be valuable to ‘the marketplace’.
So directors must comply with the applicable accounting
standards. Nevertheless, if directors believe that particular
accounting standards are not appropriate, they have the option
of highlighting this fact and explaining why. Specifically,
paragraph 23 of AASB 101 Presentation of Financial Statements
(the reference to ‘the Framework’ below relates to the
Conceptual Framework for Financial Reporting) states:
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In the extremely rare circumstances in which management
concludes that compliance with a requirement in an Australian
Accounting Standard would be so misleading that it would
conflict with the objective of financial statements set out in the
Framework, but the relevant regulatory framework prohibits
departure from the requirement, the entity shall, to the
maximum extent possible, reduce the perceived misleading
aspects of compliance by disclosing:
(a)
the title of the Australian Accounting Standard in
question, the nature of the requirement, and the reason why
management has concluded that complying with that
requirement is so misleading in the circumstances that it
conflicts with the objective of financial statements set out in
the Framework; and
(b)
for each period presented, the adjustments to each item
in the financial statements that management has concluded
would be necessary to achieve a fair presentation.
As we can see from the above, AASB 101 includes a rebuttable
presumption that if other entities in similar circumstances
comply with the requirement, the entity’s compliance with the
requirement would not be so misleading that it would conflict
with the objective of financial statements set out in the
Conceptual Framework.
A current problem is that our qualitative requirement (defined
below) of true and fair is very unclear. There is no legal
definition of ‘true and fair’. Even though the Corporations Act
requires directors to make sufficient disclosures to ensure that
financial statements present a ‘true and fair’ view, it provides no
definition of the concept. Nor has the Australian accounting
profession provided definitive guidelines relating to truth and
fairness. The Directors’ Declaration of BHP Billiton, reproduced in
Exhibit 1.2
above, shows how directors are required to state
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that the financial statements are true and fair. The auditors of a
company are also required to give an opinion on whether, in
their opinion, the financial statements are true and fair.
Exhibit 1.3
shows the opinion section of the auditor’s report
from Commonwealth Bank of Australia 2015 Annual Report.
Apart from the audit opinion section, an audit report of a
corporation also typically includes sections on the respective
responsibilities of directors and auditors.
Exhibit 1.3 Independent auditor’s
report to the members of
Commonwealth Bank of Australia
Page 21
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Page 22
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This opinion has been extracted from the 2015 Annual Report of the Commonwealth Bank of
Australia for illustrative purposes only. It should be read in conjunction with the full financial
report of the Commonwealth Bank of Australia.
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SOURCE: Commonwealth Bank of Australia, Marcus Laithwaite, 11 August 2015
In December 1993, the Legislation Review Board (now
disbanded) released a discussion paper entitled ‘A
Page 23
Qualitative Standard for General Purpose Financial
Reports: A Review’. In the discussion paper (p. 7), qualitative
standards (such as the true and fair view requirement) are
defined as:
the basis for establishing a benchmark to regulate the overall
quality of financial reports prepared under the relevant
financial reporting regime … the qualitative standard is
concerned with prescribing a certain total or overall quality for
the information contained in the financial reports that will
enhance their usefulness to users of those reports.
Within the discussion paper, three alternative qualitative
standards were proposed:
1. The first alternative was to retain the true and fair view
requirement, but to provide a technical meaning by way of a
definition, thus providing a way to remove existing ambiguities
relating to the meaning of the concept.
2. The second alternative was to amend the Corporations Act by
replacing the true and fair view requirement with a
requirement that general purpose financial statements of
companies comply with the explicit financial reporting
framework comprising statements of accounting concepts and
accounting standards. This would allow a qualitative standard
to be incorporated within this framework.
3. The third alternative was to require that general purpose
financial statements be prepared in accordance with generally
accepted accounting procedures (GAAP).
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The discussion paper did not support one alternative in
preference to another and at present the true and fair view
requirement is a very important part of Australian corporate
reporting. Nevertheless, as there has been such debate on the
issue it is possible that the true and fair view requirement will be
amended or removed in the future.
We will now further consider the organisation that oversees the
activities of the AASB, this being the Financial Reporting Council.
3. Financial Reporting Council
As noted previously in this chapter, the Financial Reporting
Council (FRC) oversees the activities of the AASB. There are 1
8 people on the FRC, who are nominated by a number of
interest groups (stakeholders), as well as a chairperson. The
website of the FRC at (www.frc.gov.au) provides the names
and occupations of those making up the membership of the FRC.
Section 235A(1) of the Australian Securities and Investments
Commission Act 2001 (ASIC Act)—also available on the ComLaw
website referred to earlier—provides that members of the FRC
are either appointed directly by the relevant Minister or,
alternatively, the Minister may specify an organisation or body
to choose someone to represent that organisation. In 2016,
members of the FRC were nominated by the Australian Institute
of Company Directors, the Investment and Financial Services
Association, Heads of Treasurers Accounting and Reporting
Advisory Committee, the Association of Superannuation Funds of
Australia, Chartered Accountants Australia and New Zealand, the
Institute of Public Accountants, the Securities Institute of
Australia, ASIC, CPA Australia, the Australian Securities
Exchange, the Federal Government, the New Zealand Minister of
Finance, the Group of 100, the Australian Prudential Regulation
Authority and the Business Council of Australia. (There is a
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notable absence of representation from groups that are not
concerned primarily in the financial performance of reporting
entities but might nevertheless be interested in other aspects of
the entities’ performance. For example, social, environmental or
employee lobby groups are not represented, despite the fact
that they would also have a legitimate interest in the financial
performance and position of various reporting entities. Do you,
the reader, consider that the FRC is appropriately representative
of the information needs of the broader community, or is it
appropriate that only people with a financial interest in
organisations are represented?)
While we are concerned primarily here with financial accounting
and not the auditing of financial reports, it is worth noting again
that in 2003 the federal government decided to extend the
responsibilities of the FRC to include overseeing the activities of
the Auditing and Assurance Standards Board (AUASB), which is
responsible for developing auditing standards within Australia.
From July 2006, auditing standards have the force of law. The
overall objective of the AUASB is to improve the quality of
auditing in Australia. In meeting this objective, the Board
develops and promulgates auditing standards and audit
guidance releases. In carrying out its functions, the Board seeks
to ensure that professional auditing guidance reflects
appropriate theory, practice and international developments,
and meets reasonable community expectations. The AUASB has
full regard to developments occurring within the ambit of the
International Auditing and Assurance Standards Board.
Section 225 of the ASIC Act details the functions and
powers of the FRC. These include:
Page 24
(a)
to provide broad oversight of the processes for setting
accounting standards in Australia; and
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(b)
to provide broad oversight of the processes for setting
auditing standards in Australia; and
(c)
to monitor the effectiveness of auditor independence
requirements in Australia; and
(d)
to give the Minister reports and advice about the
matters referred to in paragraphs (a), (b) and (c); and
(e)
the functions specified in subsections (2) (specific
accounting standards functions), (2A) (specific auditing
standards functions) and (2B) (specific auditor quality
functions); and
(f)
to establish appropriate consultative mechanisms; and
(g)
and
to advance and promote the main objects of this Part;
(h)
any other functions that the Minister confers on the FRC
by written notice to the FRC Chair.
With regard to what the FRC may not do, s. 225(5), (6), (7) and
(8) explicitly state that:
l
l
l
l
The FRC does not have power to direct the AASB in relation
to the development, or making, of a particular standard.
The FRC does not have power to veto a standard
formulated and recommended by the AASB (only
Parliament can do this).
The FRC does not have power to direct the AUASB in
relation to the development, or making, of a particular
auditing standard.
The FRC does not have power to veto a standard made,
formulated or recommended by the AUASB.
The above provisions were introduced in an attempt to ensure
the independence of both the AASB and the AUASB.
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4. Australian Securities Exchange
For those reporting entities that have securities listed on the
Australian Securities Exchange (ASX) , there are further rep
orting requirements over and above those provided within
accounting standards or in the Corporations Act. As of 1 April
1987 there has been one nationally operated securities
exchange in Australia. In November 1998 the ASX became a
public company with shares listed on its own exchange.
Therefore, while the ASX was previously predominantly selfregulated, it now falls under the control of the Corporations Act,
as well as its own listing rules. That is, although the ASX
develops and imposes regulations on other companies that are
listed on its exchange, it is ASIC that regulates the ASX.
Failure to comply with the ASX Listing Rules may lead to
removal from the Board. The ASX disclosure requirements help
to ensure that information about listed entities is disseminated
in an efficient and timely manner. They also reduce the
likelihood of individuals prospering through access to privileged
information.
The ASX Listing Rules are divided into 20 chapters (details of the
listing rules are available on the ASX website at
www.asx.com.au). Of particular relevance to us are
Chapters 3
and 4
of the Listing Rules, which relate to cont
inuous disclosure and periodic disclosure, respectively. You
would do well to take the time to review the Listing Rules.
Listing Rule 3.1 (relating to continuous disclosure) provides the
general principle that:
Once an entity is or becomes aware of any information
concerning it that a reasonable person would expect to have a
material effect on the price or value of the entity’s securities,
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the entity must immediately tell ASX that information.
The ASX also established the ASX Corporate Governance
Council. In 2003 the ASX Corporate Governance Council
released its Principles of Good Corporate Governance and Best
Practice Recommendations. These Principles, which are now
referred to as Corporate Governance Principles and
Recommendations, were most recently amended and rereleased in March 2014 and can be accessed on the ASX
website. As indicated in the principles document (p. 3):
Corporate governance is the framework of rules, relationships,
systems and processes within and by which authority is
exercised and controlled in corporations. It encompasses the
mechanisms by which companies, and those in control, are
held to account.
The basis of the ASX corporate governance disclosure
recommendations is that to assess the risk of an organisation it
is essential to know about the policies and procedures in place
that govern how the organisation is run (that is, to know about
the organisation’s corporate governance policies). As stated in
the recommendations (p. 5), pursuant to ASX Listing Rule 4.10,
companies are required to provide a statement in their Page 25
annual report disclosing the extent to which they have
followed the Corporate Governance Principles and
Recommendations in the reporting period. Where companies
have not followed all of the recommendations, they must
identify the recommendations that have not been followed, and
give reasons for not following them. This is often referred to as
an ‘if not, why not?’ approach to disclosure. Therefore, the ASX
principles do not compel organisations to change their
governance systems, but rather rely upon ‘market forces’ to
encourage adoption of best practice.
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Within the Corporate Governance Principles and
Recommendations the Corporate Governance Council has
proposed eight essential principles of corporate governance.
They are summarised in Exhibit 1.4 .
Disclosure pertaining to the eight essential principles must be
made in the annual report in a dedicated corporate governance
section.
Exhibit 1.4 The eight essential corporate
governance principles identified by the ASX
Corporate Governance Principles and
Recommendations
A company should:
1. Lay solid foundations for management and oversight
A listed entity should establish and disclose the respective
roles and responsibilities of its board and management and
how their performance is monitored and evaluated.
2. Structure the board to add value
A listed entity should have a board of an appropriate size,
composition, skills and commitment to enable it to discharge
its duties effectively.
3. Act ethically and responsibly
A listed entity should act ethically and responsibly.
4. Safeguard integrity in financial reporting
A listed entity should have formal and rigorous processes that
independently verify and safeguard the integrity of its
corporate reporting.
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5. Make timely and balanced disclosure
A listed entity should make timely and balanced disclosure of
all matters concerning it that a reasonable person would
expect to have a material effect on the price or value of its
securities.
6. Respect the rights of security holders
A listed entity should respect the rights of its security holders
by providing them with appropriate information and facilities
to allow them to exercise those rights effectively.
7. Recognise and manage risk
A listed entity should establish a sound risk management
framework and periodically review the effectiveness of that
framework.
8. Remunerate fairly and responsibly
A listed entity should pay director remuneration sufficient to
attract and retain high-quality directors and design its
executive remuneration to attract, retain and motivate highquality senior executives and to align their interests with the
creation of value for security holders.
SOURCE: ASX Corporate Governance Council, Good Corporate Principles and
Recommendations, ASX, Sydney, March 2014.
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The process of Australia adopting
accounting standards issued by the
International Accounting Standards Board
LO 1.7 LO 1.13 LO 1.14
As already indicated, in 2002 the Financial Reporting Council
(FRC), which we now know oversees the AASB, decided to
commit Australia to adopting accounting standards issued by
the International Accounting Standards Board (IASB). Such
standards are referred to as International Financial Reporting
Standards (IFRSs). When they were previously released by the
International Accounting Standards Committee (the IASB’s
predecessor), they were referred to as International
Accounting Standards (IASs). It would appear that the catalyst
for the FRC’s directive was a decision by the European Union
that all listed companies within the European Union should
adopt IASB standards by 1 January 2005 for the purposes of
preparing consolidated financial statements. This was Page 26
to support the ‘single market objective’ that has been
embraced within the European Union. The intention was for the
European Union to adopt International Financial Reporting
Standards directly without modification. This can be contrasted
with the Australian situation, where IFRSs are being turned
into Australian (AASB) Accounting Standards, each bearing the
prefix AASB.
In relation to the adoption of IASB standards, former deputy
chairperson of the AASB Ruth Picker made the following
comments (Picker, 2003):
The announcement in July 2002 by the Financial Reporting
Council (FRC) that all entities reporting under the
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Corporations Act would be required to comply with IASs, now
referred to as International Financial Reporting Standards
(IFRSs), with effect from 1 January 2005, has turned the
corporate accounting world on its head.
The ambit of the requirement for reporting under IASs is
extremely wide as it applies to all reporting entities under the
Corporations Act, both listed and unlisted, private and public.
This is in contrast to the situation in Europe where compliance
with IASs by 1 January 2005 will only be mandatory for listed
entities.
Furthermore, because the Australian Accounting Standards
Board only produces one set of accounting standards for
reporting entities, the IASs will effectively apply also to
reporting entities that are not Corporations Act entities.
Within Australia, our accounting standards are still referred to
as Australian Accounting Standards (with the AASB prefix, as
previously indicated), and they might have some minor
differences from the equivalent International Accounting
Standards (for example, they might include more explanatory
material and make reference, where necessary, to the
Corporations Act 2001)—but essentially they will be the same
as the International Accounting Standards (which, as we have
already indicated, are referred to as IFRSs). IFRSs are
developed for the ‘for-profit’ sector (for example, for profitseeking companies). Within Australia, however, AASB
standards have general applicability to the not-for-profit and
local government sectors (that is, they are sector-neutral).
Hence, material will need to be added by the AASB that
describes the scope and applicability of the standards in the
Australian context. Table 1.1
shows the accounting
standards in place within Australia as at early 2016 with
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reference to the equivalent IASs/IFRSs. Remember that the
standards issued by the IASB (and its predecessor, the IASC)
were formerly referred to as International Accounting
Standards. It is only recently that IASB-released accounting
standards have been referred to as IFRSs.
At this stage you should review Table 1.1
to gain an
understanding of the many and varied issues addressed by our
accounting standards. Appreciate, however, that even all these
accounting standards do not cover every conceivable
transaction or event, which is why Australia retains the
overriding qualitative reporting requirement that corporations
must prepare ‘true and fair’ financial statements. Many of the
accounting standards listed below will be covered in depth in
other chapters of this text. While Table 1.1
provides a list
of the standards in place as at early 2016, it should be
appreciated that new standards will be added, and particular
accounting standards might be withdrawn, over time. This
means that such lists of accounting standards do not remain
current for long. Further, and as indicated earlier, the wording
and requirements incorporated within particular accounting
standards will often change, so interested parties (such as
practitioners, students and researchers) should always check
the websites of standard-setters for the latest versions of
accounting standards.
Compliance with the AASB standard would still mean
compliance with the IASB standard. The AASB standards might
also require additional disclosures, particularly if pre-existing
AASB standards already have more detailed disclosure
requirements. Any difference from the equivalent IFRS will be
readily identified within the AASB standard (relevant amended
paragraphs will have the prefix Aus). The AASB will issue
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future standards in Australia at about the same time the
standards concerned are issued by the IASB.
Table 1.1 AASB accounting standards, with
details of equivalent IASs/IFRSs
Page 27
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AASB No.
Title
Equivalent IFRS/IAS
1
First-time Adoption of
IFRS 1
Australian Equivalents to
International Financial
Reporting Standards
2
Share-based Payment
IFRS 2
3
Business Combinations
IFRS 3
4
Insurance Contracts
IFRS 4
5
Non-current Assets Held
IFRS 5
for Sale and Discontinued
Operations
6
Exploration for and
IFRS 6
Evaluation of Mineral
Resources
7
Financial Instruments:
Disclosures
IFRS 7
8
Operating Segments
IFRS 8
9
Financial Instruments
IFRS 9
10
Consolidated Financial
Statements
IFRS 10
11
Joint Arrangements
IFRS 11
12
Disclosure of Interests in
Other Entities
IFRS 12
13
Fair Value Measurement
IFRS 13
14
Regulatory Deferral
Accounts
IFRS 14
15
Revenue from Contracts
with Customers
IFRS 15
16
Leases
IFRS 16
101
Presentation of Financial
Statements
IAS 1
102
Inventories
IAS 2
107
Statement of Cash Flows
IAS 7
108
Accounting Policies,
IAS 8
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SOURCE: © Commonwealth of Australia. Reproduced by permission.
From time to time the IASB will amend existing IFRSs. Page 28
This is done by way of what is referred to as ‘omnibus’
standards that explain the changes to particular accounting
standards. Following this process the AASB incorporates the
changes into what are now referred to as ‘compiled’ standards.
That is, ‘compiled standards’ represent the original standard,
with the subsequent amendments. A review of the AASB
website will reveal numerous ‘compiled standards’.
While the AASB will be issuing standards (with slight changes,
as noted above) to match those being issued by the IASB,
from time to time the AASB might issue standards to cover
areas not addressed by the IASB. That is, the AASB will
develop additional standards to cater for issues of a domestic
nature, and will also issue standards that are specific to the
not-for-profit sector and public sector. The AASB will also
advise the IASB of issues that it believes should be covered
within IASB standards.
The decision by the FRC that Australia would adopt IFRSs from
2005 produced a sweep of changes in Australian accounting
standards that has been unparalleled in Australian financial
reporting history. The decision required reporting entities to
prepare financial statements in accordance with IFRSs for
accounting periods beginning on or after 1 January 2005.
Given the significance of the FRC’s decision, we have
reproduced in Exhibit 1.5
the bulletin that was released by
the FRC in July 2002 outlining the FRC’s strategic direction.
Exhibit 1.5 FRC bulletin on the
Council’s strategic direction
Page 29
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BULLETIN OF THE FINANCIAL
REPORTING COUNCIL
2002/4—3 July 2002
Adoption of international accounting
standards by 2005
The Chairman of the Financial Reporting Council (FRC), Mr
Jeffrey Lucy, AM, today announced that the FRC has formalised
its support for the adoption by Australia of international
accounting standards by 1 January 2005.
Subject to the Government’s support at the appropriate time
for any necessary amendments of the Corporations Act, this
will mean that, from 1 January 2005, the accounting standards
applicable to reporting entities under the Act will be the
standards issued by the International Accounting Standards
Board (IASB). After that date, audit reports will refer to
companies’ compliance with IASB standards.
The FRC considered the issue at its meeting on 28 June and
formally endorsed the 2005 objective, in line with statements
made recently by the Parliamentary Secretary to the
Treasurer, Senator the Hon Ian Campbell. Mr Lucy paid tribute
to the Government’s strong leadership over the last five years
in pressing for the international convergence of accounting
standards. This objective is reflected in the Government’s 1997
Corporate Law Economic Reform Program initiative (CLERP 1)
and amendments made in 1999 to the Australian Securities
and Investments Commission Act 2001.
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The FRC fully supports the Government’s view that a single set
of high-quality accounting standards which are accepted in
major international capital markets will greatly facilitate crossborder comparisons by investors, reduce the cost of capital,
and assist Australian companies wishing to raise capital or list
overseas.
Mr Lucy said he understood that the 1 January 2005 timing is
somewhat later than the Government would have liked.
However, it is determined by the decision of the European
Union to require EU listed companies to prepare their
consolidated accounts in accordance with IASB standards from
that date, in support of the EU single market objective.
Australia certainly cannot afford to lag [behind] Europe in this
regard, Mr Lucy said. He also expressed his support for efforts
to encourage the United States to further converge its
standards with IASB standards with a view to eventual
adoption.
Mr Lucy was pleased to note that the Chairman of the IASB, Sir
David Tweedie, had issued a statement in London welcoming
the FRC’s decision. Sir David said that the FRC’s announcement
demonstrates growing support for the development and
implementation of a single set of high-quality global accounting
standards by 2005.
‘This vote of confidence is a reflection of the leadership role
that Australia continues to play in standard-setting, and will
increase momentum for convergence towards high-quality
international standards. The input and active participation of
interested parties in Australia and the Australian Accounting
Standards Board (AASB), under the leadership of Keith
Alfredson, are and will remain a vital element in ensuring the
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IASB’s success. It is through national standard-setters, such as
the AASB, and the members of our various committees that we
are able jointly to develop high-quality solutions to accounting
issues, leverage resources to research topics not yet on the
international agenda so as to expedite conclusions, reach
interested parties throughout the world and better understand
differences in operating environments, thus fulfilling our role as
a global standard-setter.’
While there will be a need for business and the accounting
profession to adapt to significant changes in some standards,
and to some complex new standards, the AASB has been
harmonising its standards with those of the IASB for some
years, resulting in substantial synergies between the two.
Nevertheless, Mr Lucy urged the accounting bodies to prepare
for the changeover through their programs of professional
development and their influence on accounting education. He
also urged the business community to participate fully in
commenting on exposure drafts of IASB standards issued in
Australia in the period ahead.
Mr Lucy noted that implementation issues would also need to
be considered by the FRC (to the extent they did not involve
the content of particular standards) and the AASB between
now and 2005. These could relate, for example, to the timing
of introduction of particular IASB standards in Australia before
1 January 2005 (which would be AASB standards until that
date), as well as to issues of interpretation.
The FRC and AASB will be doing everything they can to keep
constituents informed about these issues and to communicate
an overall strategy for adoption, Mr Lucy said.
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Mr Lucy also confirmed that Australia would be making a
substantial financial contribution, through the FRC, to the
International Accounting Standards Committee (IASC)
Foundation in 2002–03. This contribution will be sourced from
funds available to the FRC for the standard-setting process
contributed by the Commonwealth, State and Development
Account (as announced by Senator Campbell on 12 June).
Among the FRC’s functions are to further the development of a
single set of accounting standards for world-wide use and to
promote the adoption of international best practice accounting
standards in Australia if doing so would be in the best interests
of both the private and public sectors in the Australian
economy.
The IASB, which is based in London, is committed to
developing, in the public interest, a single set of high-quality,
global accounting standards that require transparent and
comparable information in financial statements. In pursuit of
this objective, the IASB cooperates with national standardsetters, including the AASB, to achieve convergence in
accounting standards around the world.
The AASB has been harmonising its standards with IASB
standards for a number of years and is now working in close
partnership with the IASB as a liaison standard-setter, aligning
its work program with that of the IASB and standing ready to
allocate resources to lead or support projects on the IASB
agenda. Recently, the AASB issued to its Australian
constituents invitations to comment on a number of exposure
drafts of IASB standards.
Australians are actively involved in the work of the IASB. Mr
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Ken Spencer is a member of the oversight body for the IASB,
the IASC Foundation Trustees (and Chairman of the
Foundation’s Nominating Committee). Mr Warren McGregor is a
member of the IASB, also designated the Liaison Member for
Australia and New Zealand. Mr Kevin Stevenson, a former
director of the Australian Accounting Research Foundation, is
the IASB’s Director of Technical Activities. Australians are also
on the IASB’s Standards Advisory Council (Mr Peter Day and
Mr Ian Mackintosh) and its Interpretations Committee (Mr
Wayne Lonergan).
SOURCE: Bulletin of the Financial Reporting Council 2002/4 - 3 July 2002
Page 30
What was apparent at the time was that the FRC’s
decision to adopt IFRSs was effectively presented to
the AASB as an accomplished fact. We would really have
expected more debate on the issue, rather than what
amounted to a unilateral decision. Further, we can question
whether the FRC went beyond what had been construed as its
‘proper role’ in the standard-setting process. As stated earlier
in this chapter, s. 225 of the ASIC Act details the functions and
powers of the FRC. These include providing broad oversight of
the process for setting accounting standards in Australia;
appointing members of the AASB; approving and monitoring
the AASB’s priorities, business plan, budget and staffing
arrangements; and giving the AASB directions, advice and
feedback on matters of general policy. Section 225(5) and (6)
explicitly states that the FRC does not have the power to direct
the AASB in relation to the development, or making, of a
particular standard.
These appear to be solid grounds for contending that the FRC
went beyond its purview. However, the reality is that the FRC’s
decision generated a great deal of work for accountants within
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Australia as they got familiar with a new set of accounting
standards. It would be an interesting exercise to try to quantify
the costs (and benefits) associated with the FRC’s decision that
Australia would adopt IFRSs. Indeed, Keith Alfredson, the
chairperson of the AASB at the time of the FRC’s decision,
openly questioned whether the FRC had adequately considered
the costs and benefits before committing Australia to adopting
accounting standards issued by the IASB (as reported in a
newspaper article written by Tom Ravlic that appeared in The
Age on 5 May 2003 entitled ‘Accountant queries standards
move’).
Prior to the formalisation of the FRC’s strategic direction
supporting adoption of IFRSs, Australia had, since 1995, been
involved in a process that would harmonise Australian
Accounting Standards with their international equivalents. The
‘harmonisation process’ required Australian Accounting
Standards to be as compatible as possible with International
Accounting Standards, but still allowed some divergence where
the Australian treatment was construed to be more
appropriate. The majority of Australian Accounting Standards
were changed as a result of the harmonisation process. Once
the harmonisation process was almost complete it was decided
that harmonisation was not sufficient and that Australia should
adopt the standards being issued by the IASB. This meant that
many of the standards that went through the harmonisation
process were changed yet again to converge them with their
international equivalents (that is, to remove any of the minor
differences that survived the harmonisation process). This
‘second round’ of changes within such a short time was a
source of frustration for both readers and preparers of financial
statements (not to mention authors of textbooks!).
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Australia was one of the first major accounting standardsetters to embark on a program that sought to harmonise its
accounting standards with those of the IASB (or, as it was then
known, the IASC). The harmonisation of Australian Accounting
Standards with their international equivalents was justified on
the basis that if Australia elected to retain accounting
standards that were unique, this would restrict the
Page 31
flow of foreign investment into Australia. (Do you, the
reader, think this is a realistic perspective?) This view was
promoted within the federal government’s Corporate Law
Economic Reform Program. CLERP’s 1997 document
Accounting Standards: Building International Opportunities for
Australian Business states (p. 15):
There is no benefit in Australia having unique domestic
Accounting Standards which, because of their unfamiliarity,
would not be understood by the rest of the world. Even if
these standards were considered to represent best practice,
Australia would not necessarily be able to attract capital
because foreign corporations and investors would not be able
to make sensible assessments, especially on a comparative
basis, of the value of Australian enterprises. The need for
common accounting language to facilitate investor evaluation
of domestic and foreign corporations and to avoid potentially
costly accounting conversions by foreign listed companies are
powerful arguments against the retention of purely domestic
financial reporting regimes.
The above view is consistent with that provided in Policy
Statement 4, ‘International Convergence and Harmonisation
Policy’ (issued in April 2002 by the AASB), which emphasised
the need for international comparability of financial
statements. As the policy statement notes in paragraph 2:
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There is considerable divergence between standards issued
by national and international standard-setting bodies. The
globalisation of economic activity has resulted in an increased
demand for high quality, internationally comparable financial
information. The AASB believes that it should facilitate the
provision of this information by pursuing a policy of
international convergence and international harmonisation of
Australian accounting standards. In this context,
‘international convergence’ means working with other
standard-setting bodies to develop new or revised standards
that will contribute to the development of a single set of
accounting standards for world-wide use. ‘International
harmonisation’ of Australian accounting standards refers to a
process which leads to these standards being made
compatible with the standards of international standardsetting bodies to the extent that this would result in high
quality standards. Both processes are intended to assist in
the development of a single set of accounting standards for
world-wide use.
While the FRC’s 2002 directive was for Australia to adopt
IFRSs, because of the requirements of the Corporations Act,
the standards had to be released by the AASB (which can be
contrasted with the situation within the European Union where
IFRSs are generally being used without any changes).
Specifically, the Corporations Act requires, pursuant to s. 296,
that financial reports must comply with ‘accounting standards’.
Section 334 further states that ‘the AASB may make
accounting standards for the purposes of this Act. The
standards must be in writing and must not be inconsistent with
this Act or the regulations.’ Hence, rather than simply
embracing IFRSs without change, the standards needed to be
issued by the AASB and to be ‘re-badged’ as AASB standards.
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For some reporting entities, the impact of adopting IFRSs in
place of the previous accounting standards was quite
significant. Some organisations had their reported profits
severely reduced and the assets greatly written down as a
result of applying IFRSs. This, in turn, impacted on such things
as gearing ratios (which might be utilised within borrowing
agreements with banks), and profit-based bonuses that might
be paid to employees. Earnings per share and other indicators
of performance were also affected.
While a number of countries throughout the world are now
adopting IFRSs, there are still differences between the United
States generally accepted accounting principles (GAAP) and
IFRSs, and these differences are expected to continue for some
time. For a number of years there was a joint project between
the IASB and the US Financial Accounting Standards Board
(FASB) aimed at converging IFRSs and FASB standards. There
was an expectation for some years that the US would
ultimately adopt IFRS, and the aim of the convergence project
was to work towards the time when a ‘true’ international
standardisation of accounting becomes a reality. In recent
years the wisdom of this has been questioned within the US by
the Securities Exchange Commission (SEC) and hence it is not
at all certain that the US will ultimately adopt IFRS as the basis
of its corporate reporting.
So, while there appears to be a long-term aim that ultimately
there will be one set of standards used internationally,
including within the US, the timing as to when the US will
adopt IFRSs (and some people still question if it will) is far
from certain. Obviously, for the IASB to achieve its aim of
developing ‘a single set of high-quality, understandable and
international financial reporting standards (IFRSs) for general
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purpose financial statements’ (as stated on the IASB website),
it will need to encourage the US to adopt its standards.
Page 32
What benefits can we expect
from all this international
standardisation?
As indicated earlier in this chapter, the Australian government
decided that Australia would adopt IFRSs because of perceived
benefits. The benefits that have been promoted by the FRC
include an increased ability for Australian entities to access
capital from international sources and, somewhat relatedly, an
increased ability of investors to compare the results of
Australian entities with those of overseas entities. There is also
the expectation that it will be more efficient for international
companies operating in Australia to prepare financial
statements internationally on the basis of the same set of
accounting standards. In the past, companies that are listed in
more than one jurisdiction had to bear the costs of preparing
financial statements under more than one accounting system.
All convergence and standardisation benefits come at a cost.
Such costs include the costs of educating accountants to adopt
a new set of accounting standards and the costs associated
with changing data-collection and reporting systems. Such
costs will be borne by large listed companies, as well as large
proprietary companies, not-for-profit entities and local
governments. These last three categories of reporting entities
are relatively unlikely to benefit from such things as increased
capital inflows. Yet they will still incur significant costs.
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Some of the perceived benefits of harmonisation were
discussed in paragraph 7 of Policy Statement 4 ‘International
Harmonisation and Convergence Policy’. The main benefits of
international harmonisation identified in this document
included:
(a) increasing the comparability of financial reports
prepared in different countries and providing participants in
international capital markets with better quality information
on which to base investment and credit decisions. It will also
reduce financial analysis costs through analysts not having to
recast information on a common basis and requiring
knowledge of only one set of financial reporting standards
rather than several;
(b)
removing barriers to international capital flows by
reducing differences in financial reporting requirements for
participants in international capital markets and by increasing
the understanding by foreign investors of Australian financial
reports;
(c)
reducing financial reporting costs for Australian
multinational companies and foreign companies operating in
Australia and reporting elsewhere;
(d)
facilitating more meaningful comparisons of the
financial performance and financial position of Australian and
foreign public sector reporting entities; and
(e) improving the quality of financial reporting in Australia
to best international practice.
In relation to the issue of being better able to compare the
financial performance of entities from different countries (point
(a) above), it is argued that while there are still differences in
the accounting standards issued by different countries, the
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difficulties in comparing the financial performance of reporting
entities from different countries will persist. The differences in
accounting rules can have significant implications for profit
comparisons. In this regard we can consider research
undertaken by Nobes and Parker (2004). They undertook a
comparison of the results of a small number of European-based
multinationals, which reported their results in accordance with
both their home nation’s accounting rules and US accounting
rules. Their comparative analysis shows, for example, that the
underlying economic transactions and events of the AngloSwedish drug company AstraZeneca in the year 2000 produced
a profit of £9521m when reported in conformity with UK
accounting rules, but the same set of transactions produced a
reported profit of £29707m when prepared pursuant to US
accounting rules—a difference of 212 per cent in reported
profits from an identical set of underlying transactions and
events!
Extending this analysis to a more recent period, the 2006
Annual Report of AstraZeneca (the final year that companies
with a dual home country and US listing had been required to
provide a reconciliation between their results using IFRS and
US accounting rules) shows that net income derived from
applying IFRS of $6 043m became a net income of $4 392m
when calculated in accordance with US accounting rules—this
time a difference of 27 per cent compared to the IFRS rules. In
its balance sheet (or as it is also known, its statement of
financial position), AstraZeneca’s shareholders’ equity at 31
December 2006 was $15 304m when reported in accordance
with IFRS, but this became $32 467m when determined in
accordance with US accounting rules, a difference of 112 per
cent. Although percentage differences of this size might be
unusual, examination of the financial reports of almost any
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company that reported its results in accordance with more than
one nation’s set of accounting regulations will have shown
differences between the profits reported under each set of
regulations and between the financial position reported under
each set of regulations.
A further dramatic example of the existence of differences
between the accounting rules of different countries is provided
by the US corporation, Enron. As Unerman and O’Dwyer
(2004) explain, in the aftermath of the collapse of Enron, many
accounting regulators, practitioners and politicians in Page 33
European countries claimed that the accounting
practices that enabled Enron to ‘hide’ vast liabilities by keeping
them off their US balance sheet would not have been effective
in Europe. In the United Kingdom this explanation highlighted
the differences between the UK and US approaches to
accounting regulation. It was argued that under UK accounting
regulations these liabilities would not have been treated as off
balance sheet, thus potentially producing significant differences
between Enron’s balance sheet under UK and US accounting
practices.
Having considered how different countries’ accounting rules
can generate significantly different profits or losses, as well as
different assets and liabilities, we should perhaps consider
whether such differences are a justification for all the activity
that is taking place to standardise accounting standards
internationally. What do you think? Certainly, this justification
has been used by Australian accounting standard-setters.
The view that harmonisation and subsequent adoption of IFRSs
would lead to cost reductions in Australia, as well as capital
inflows, is not a view that is necessarily supported (or refuted)
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by any empirical data, but the ASX nevertheless held the view
that general compliance with IASB standards would lead to
significant additional inflows of foreign investment. In this
regard, in May 2000, the International Organisation of
Securities Organisations (IOSCO) announced that it would
recommend adoption of IASC/IASB standards as a permissible
basis for the preparation of financial statements to member
exchanges throughout the world. The actions of IOSCO
reinforced the position of the IASB as a global accounting
standard-setter. Such a move meant that an organisation
whose reports already accord with IASB standards and which
was seeking listing in another country would not need to adjust
its reports to comply with particular national requirements.
More details about IOSCO can be found on its website at
www.iosco.org.
It should also be noted that from late 2007 the Securities
Exchange Commission (SEC) in the US adopted rules that
permitted foreign private issuers (but not US domestic
companies) to lodge, with the SEC, their financial statements
prepared in accordance with IFRS without the need to provide
a reconciliation to generally accepted accounting principles
(GAAP) as used in the United States. That is, foreign
companies that are listed across a number of securities
exchanges internationally, including within the US, can now
lodge their reports in the US even though the reports have not
been prepared in accordance with US accounting standards and
do not provide a reconciliation to US GAAP. The ruling of the
SEC requires that foreign private issuers that take advantage
of this option must state explicitly and unreservedly in the
notes to their financial statements that such financial
statements are in compliance with IFRS as issued by the IASB
(without modifications), and they must also provide an
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auditor’s unqualified report that explicitly provides an opinion
that the financial statements have been compiled in
accordance with IFRS as issued by the IASB
Hence, effectively there are two types of financial statements
being lodged within the US (as is the case in many other
countries). Foreign companies can lodge their reports within
the US in accordance with IFRS, whereas domestic US
companies must lodge their reports in accordance with US
GAAP.
Numbering system to be used for
AASB standards
As we can see from Table 1.1
provided earlier in this
chapter, there are three different numbering systems being
applied by the AASB. The AASB has devised a policy for
numbering according to which the numbering system will be:
1. AASB Standards 1–99 Series
Where a new IFRS is issued by the IASB its number as
determined by the IASB will be used by the AASB. For
example, IFRS 1 will become AASB 1.
2. AASB Standards 100–999 Series
Where a standard equivalent to an existing or improved IAS
is issued, it will be given a number from 100 on. For example,
AASB 101 would correspond to IAS 1 (standards issued by
the IASB now are referred to as International Financial
Reporting Standards and have the prefix IFRS; prior to 2003
they were referred to as International Accounting Standards
and bore the prefix IAS).
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3. AASB Standards 1000 + Series
A further numbering system for standards specifically relates
to the public or not-for-profit sectors or for areas of domestic
application only. Also to be used for those AASB standards
that are to be maintained as part of the post-2005 standards.
This numbering system is for standards that do not have an
international equivalent.
Because of the central relevance of the IASB to Australian
financial reporting we will now describe the structure of the
IASB.
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Structure of the International Accounting Standards Board
Page 1 of 9
Structure of the International Accounting
Standards Board
LO 1.5 LO 1.7 LO 1.8 LO 1.9
Page 34
Because the accounting standards being used within Australia
emanate overwhelmingly from the IASB it would be useful to
understand the structure of the IASB, and its predecessor, the
IASC.
The International Accounting Standards Committee (IASC) was
established in 1973 with the aim of bringing together parties
from throughout the world to develop accounting standards that
apply internationally. In April 2001 the IASC was replaced by the
IASB. The IASB is now responsible for releasing International
Accounting Standards or, as they have now become known,
International Financial Reporting Standards (IFRSs).
Until the early 2000s, standards issued by the IASC, and
subsequently by the IASB, were not of direct importance to
countries that had their own standard-setting processes in place.
They would, however, typically be referred to for an indication of
possible best practice when accounting standards were being
developed within these countries. They were also deemed to
provide useful guidance when no domestic standard related to a
particular accounting issue. Countries that did not have their
own accounting standards in place have been known to adopt
directly the standards developed by the IASC and later the IASB.
This has been the case especially in developing countries. In
more recent times, however, some developed countries have
established programs either to adopt IFRSs or to harmonise
their domestic standards with IFRSs. This was done because of
the perceived benefits associated with having globally consistent
accounting standards.
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Structure of the International Accounting Standards Board
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As noted above, there has been a change in the parties
responsible for developing International Accounting Standards.
In essence, with the establishment of the IASB, the standardsetting structure of the IASB became very similar to the
accounting standard-setting structure established in Australia.
There is a group of trustees who comprise the IFRS Foundation
(similar to the FRC in Australia) made up of 22 individuals, and
these trustees are responsible for the appointment of IASB
members as well as the members of the IFRS Interpretations
Committee and the Standards Advisory Council (SAC). The
trustees also exercise oversight over the IASB and are involved
in raising the funds needed by the IASB. The trustees come from
a number of different countries, and in 2016 six were from North
America, six from Europe, six from the Asia–Oceania region, and
four others from any region.
Members of the IASB shall be appointed for a term of up to five
years, renewable once. The website of the IASB explains how
accounting standards are developed and issued within the IASB:
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during the early stages of a project, the IASB may establish an
Advisory Committee to give advice on the issues arising in the
project. Consultation with the Advisory Committee and the
Standards Advisory Council (also part of the IASB) occurs
throughout the project;
the IASB may then develop and publish Discussion Documents
for public comment;
following the receipt and review of comments, the IASB could
then develop and publish an Exposure Draft for public
comment; and
following the receipt and review of comments, the IASB would
issue a final International Financial Reporting Standard.
Figure 1.2
provides a diagrammatic representation of how
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Structure of the International Accounting Standards Board
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accounting standards are developed by the IASB.
Figure 1.2 How the IASB develops accounting standards
SOURCE: IFRS Foundation, Who We Are and What We Do, International Accounting
Standards Board (IASB), January 2015.
Each IASB member has one vote on technical and other Page 35
matters. In relation to how many votes are required for
an IFRS or exposure draft to be approved, paragraph 36 of the
IFRS Foundation Constitution (as updated January 2013) states:
The publication of an exposure draft, or an International
Financial Reporting Standard (including an International
Accounting Standard or an Interpretation of the Interpretations
Committee) shall require approval by nine members of the
IASB, if there are fewer than 16 members, or by ten members
if there are 16 members. Other decisions of the IASB, including
the publication of a discussion paper, shall require a simple
majority of the members of the IASB present at a meeting that
is attended by at least 60 per cent of the members of the IASB,
in person or by telecommunications.
When the IASB publishes a standard, it also publishes a Basis
for Conclusions to explain publicly how it reached its conclusions
and to give background information that might help users of
standards to apply them in practice. These Basis for Conclusions
documents are publicly available. The IASB would also publish
dissenting opinions.
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The IASB website explains how the Board coordinates its
activities with national standard-setters, such as the AASB. The
Board believes that close coordination between the IASB’s due
process and the due process of national standard-setters is
important to the success of the IASB’s mission. Further,
according to the IASB website, the IASB is exploring ways to
integrate its due process more closely with that of its members.
Such integration might grow as the relationship between the
IASB and national standard-setters evolves. In particular, the
IASB is exploring the following procedure for projects that have
international implications:
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IASB and national standard-setters (such as the AASB) would
coordinate their work plans so that when the IASB starts a
project, national standard-setters would also add it to their
own work plans so that they can play a full part in developing
international consensus. Similarly, where national standardsetters start projects, the IASB would consider whether it
needs to develop new standards or revise its existing
standards. Over a reasonable period, the IASB and national
standard-setters should aim to review all standards where
there are currently significant differences, giving priority to
areas where the differences are greatest.
National standard-setters would publish their own exposure
documents at approximately the same time as IASB exposure
drafts are published and would seek specific comments on any
significant divergences between the two exposure documents.
In some instances, national standard-setters might include in
their exposure documents specific comments on issues of
particular relevance to their country or include more detailed
guidance than is included in the corresponding IASB document.
National standard-setters would follow fully their own due
process, which they would, ideally, choose to integrate with the
IASB’s due process. Such integration would avoid unnecessary
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delays in completing standards and would also minimise the
likelihood of unnecessary differences between the standards
that result.
In 2013 the IFRS Foundation established the Accounting
Standards Advisory Forum (ASAF), which provides technical
advice to the IASB. The ASAF has 12 members who come from
standard-setting bodies around the world, one member of which
(in 2016) came from Australia.
A last point to consider, and remember, is that the IASB is
simply a standard-setting body. It does not have any
enforcement powers. For example, in Australia we use IFRS
developed by the IASB, but the IASB has no power within
Australia to enforce its accounting standards. That power in
Australia resides with ASIC. Therefore, although many countries
throughout the world claim to be using IFRS, whether they are
actually being applied properly really is dependent upon the
enforcement and compliance policies in place within the
respective countries. Because some countries have very weak
enforcement strategies, the claim that their organisations are
complying with IFRS is often open to challenge. Questioning the
logic behind any belief that the efforts of the IASB will
realistically lead to international consistencies in accounting
practice, Ball (2006, p. 16) states:
Does anyone seriously believe that implementation will be of
an equal standard in all the nearly 100 countries that have
announced adoption of IFRS in one way or another? The list of
adopters ranges from countries with developed accounting and
auditing professions and developed capital markets (such as
Australia) to countries without a similarly developed
institutional background (such as Armenia, Costa Rica,
Ecuador, Egypt, Kenya, Kuwait, Nepal, Tobago and Ukraine).
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Even within the EU, will implementation of IFRS be at an equal
standard in all countries? The list includes Austria, Belgium,
Cyprus, Czech Republic, Denmark, Germany, Estonia, Greece,
Spain, France, Ireland, Italy, Latvia, Lithuania, Luxembourg,
Hungary, Malta, Netherlands, Poland, Portugal,
Page 36
Slovenia, Slovakia, Finland, Sweden and the UK. It is
well known that uniform EU economic rules in general are not
implemented evenly, with some countries being notorious
standouts. What makes financial reporting rules different?
Therefore, we should not simply accept claims that international
adoption of IFRS automatically leads to the adoption of uniform
accounting methods globally and to ‘better’ accounting.
IFRS Interpretations Committee
The IASB has a committee known as the IFRS Interpretations
Committee, which is the official ‘interpretative arm’ of the IASB.
The IASB website states that the IFRS Interpretations
Committee reviews, on a timely basis within the context of
existing International Accounting Standards and the IASB
conceptual framework, accounting issues that are likely to
receive divergent or unacceptable treatment in the absence of
authoritative guidance, with a view to reaching consensus on the
appropriate accounting treatment. While the IFRS
Interpretations Committee provides guidance on issues not
specifically addressed in IFRS, it also provides Interpretations of
requirements existing within IFRS. In developing
Interpretations, the IFRS Interpretations Committee works
closely with similar national committees and meets about every
six to eight weeks. All technical decisions are taken at sessions
that are open to public scrutiny. The IFRS Interpretations
Committee addresses issues of reasonably widespread
importance, and not issues of concern only to a small set of
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enterprises. The Interpretations cover both:
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newly identified financial reporting issues not specifically
addressed in IFRSs, and
issues where unsatisfactory or conflicting interpretations have
developed, or seem likely to develop in the absence of
authoritative guidance, with a view to reaching consensus on
the appropriate treatment.
Given that so many countries have now adopted IFRS, a central
objective of the IFRS Interpretations Committee is to achieve
consistent Interpretations of IFRS by IFRS-adopters
internationally. If IFRSs were interpreted differently within each
country, the purpose and benefits of promoting one set of global
accounting standards would be diminished. Indeed, the aim of
global uniformity in interpreting financial reporting requirements
has meant that many national standard-setters have disbanded
their own domestic Interpretations committees. For example,
within Australia, the AASB disbanded the Urgent Issues Group
(which was formerly the Australian equivalent of the IFRS
Interpretations Committee) because the AASB considered that
disbanding the UIG helped to ensure that IFRSs are being
adopted consistently on a worldwide basis.
According to its website, the primary responsibility for
identifying issues to be considered by the IFRS Interpretations
Committee is that of its members and appointed observers.
Preparers, auditors and others with an interest in financial
reporting are encouraged to refer issues to the IFRS
Interpretations Committee when they believe that divergent
practices have emerged regarding the accounting for particular
transactions or circumstances or when there is doubt about the
appropriate accounting treatment and it is important that a
standard treatment is established. An issue may be put forward
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by any individual or organisation.
The majority of issues raised with the IFRS Interpretations
Committee are not placed on its agenda. Where issues are not
accepted for consideration, the IFRS Interpretations Committee
issues a rejection notice, which is published on the IASB
website. The rejection notice sets out the reasons why the IFRS
Interpretations Committee did not place the issue on its agenda,
the typical reason provided being that the answer to the issue
raised is already available from existing accounting standards
and therefore there is no need to issue an Interpretation. The
IFRS Interpretations Committee Interpretations are subject to
IASB approval and have the same authority as a standard issue
by the IASB.
Within Australia, Interpretations issued by the IFRS
Interpretations Committee and by the AASB are given the same
authoritative status as accounting standards by virtue of AASB
1048 Interpretation of Standards, issued by the AASB.
AASB 1048 clarifies that all Australian Interpretations have the
same authoritative status. Australian Interpretations comprise
those issued by the IFRS Interpretations Committee as well as
those issued by the AASB, together with those that were issued
by the Urgent Issues Group and that have been retained for use.
For Interpretations to be mandatory in the Australian context
they need to be listed within tables included within AASB 1048.
AASB 1048 will be reissued as and when necessary to keep the
tables up to date and to give force to newly released
Interpretations.
The Interpretations can be found on the websites of the IASB
and AASB. More information about the IASB and the IFRS
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Interpretations Committee can be found on the IASB website at
www.ifrs.org.
As indicated above, the activities of national standard-setters,
such as the AASB, can impact on the activities of the IASB. The
AASB will from time to time make suggestions for new or
revised standards, or make comments on standards being
developed. The AASB could still also need, from time to Page 37
time, to issue domestic exposure drafts and standards
on topics not covered by the IASB; however, this would only be
in isolated circumstances. It would be desirable for the
Australian standard-setting body, when seeking to develop a
standard not already covered by the IASB, to offer to develop
the standard on behalf of the IASB.
At this point it should be noted that the IASB is also responsible
for developing a conceptual framework—a framework that is
used in developing accounting standards. Chapter 2
provides
an in-depth review of the IASB Conceptual Framework.
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International cultural differences and the harmonisation of accounting st... Page 1 of 4
International cultural differences and the
harmonisation of accounting standards
LO 1.6 LO 1.15
As we have emphasised in this chapter, globally countries
have adopted, or are moving to adopt, International Financial
Reporting Standards rather than accounting standards
developed domestically. We now consider some factors that
might impact negatively on global harmonisation or
convergence of accounting standards. There are a number of
potential barriers to global standardisation of accounting
standards and these would include the influences of different
business environments, legal systems, cultures and political
environments in different countries.
One of these ‘barriers’, which we will consider briefly, is
cultural differences. ‘Culture’ itself is described by Gray (1988,
p. 4) as a system of societal or collectively held values, where
values are defined as a broad tendency to prefer certain states
of affairs over others. Perera (1989, p. 43) describes culture
as an expression of norms, values and customs, which reflect
typical behavioural characteristics. There are many accounting
researchers (for example, Gray 1988; Perera 1989; Fechner &
Kilgore 1994; Eddie 1996; Chand & White 2007) who argue
that the accounting policies and practices adopted within
particular countries are to some extent a direct reflection of
the cultural and individual values and beliefs in those
countries. That is, the values in the accounting subculture are
directly influenced by society-wide values. Perera (1989, p.
43) argues that culture is a powerful environmental factor
affecting the accounting system of a country and, therefore,
that accounting cannot be considered to be ‘culture free’. In
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the same vein, Gray (1988, p. 5) states:
the value systems of accountants may be expected to be
related to and derived from societal values with special
reference to work related values. Accounting ‘values’ will, in
turn, impact on accounting systems.
For example, if a country is deemed to be basically
conservative, the argument is that the accounting policies of
that country will tend towards conservatism. Conservative
accounting policies would rely on traditional measurement
practices (such as historical cost) and would be more likely to
be used in countries in which the society is generally classified
as seeking to minimise uncertainty (Perera 1989). Gray
(1988, p. 10) argues that the degree of conservatism varies
by country, ranging from a strongly conservative approach in
the Continental European countries, such as France and
Germany, to a much less conservative approach in the USA
and the United Kingdom.
Countries might have cultural attributes that suggest they
tend more towards secrecy than transparency, and their
accounting disclosure requirements might reflect this cultural
bias. As with degrees of conservatism, Gray (1988, p. 11)
argues that the extent of secrecy seems to vary between
countries, with lower levels of disclosure—implying greater
secrecy—including instances of secret reserves, evident in the
Continental European countries, for example, compared with
higher levels of disclosure in the USA and the United Kingdom.
Eddie (1996) investigated the association of particular national
cultural values (identified by Hofstede 1991) with
consolidation disclosures made by particular entities within a
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number of different countries. Consolidation practices are
covered in a later chapter of this text; however, at this stage
consolidation can be defined simply as the practice of
combining the financial statements of various entities within a
group to form one set of consolidated financial statements.
Eddie found that particular cultural values or attributes—which
had been identified and measured in previous research—are
significantly associated with the extent of consolidation
disclosure and the degree of variation in the extent of
consolidation disclosures.
If national culture has impacted on the approaches and
decisions taken by accounting practitioners and accounting
standard-setters within their own particular countries, is it
appropriate to expect different countries, with varying cultural
values, to adopt internationally uniform accounting practices?
Perera (1989, p. 52) considers the potential success of
transferring accounting skills from Anglo-American
Page 38
countries to developing countries. He notes: ‘The
skills so transferred from Anglo-American countries may not
work because they are culturally irrelevant or dysfunctional in
the receiving countries’ context.’
Following from the above discussion, the issue of ‘culture’ and
international cultural differences might have some bearing on
whether the harmonisation or adoption of accounting
standards on a worldwide basis is a realistic, achievable and
sustainable goal. Gray (1988, p. 2) states that ‘fundamentally
different accounting patterns exist as a result of
environmental differences and that international classification
differences may have significant implications for international
harmonisation’.
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Perera (1989) argues that International Accounting Standards
themselves are strongly influenced by Anglo-American
accounting models and, as such, International Accounting
Standards tend to reflect the circumstances and patterns of
thinking in a particular group of countries. He argues therefore
that International Accounting Standards are likely to
encounter problems of relevance in countries with different
cultural environments from those found in Anglo-American
countries.
Perhaps it could be argued that with the increasing
globalisation of business, international cultural differences will
be reduced. Further consideration of this issue is really beyond
the ambit of this book but it is nevertheless an interesting
one.
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Accounting standards change across time
Page 1 of 2
Accounting standards change across time
LO 1.7 LO 1.10
Before concluding our introductory discussion on accounting
standards, one last thing we might need to know, or
remember, is that accounting standards frequently change
across time. Each year various existing accounting standards
will be changed, and new ones addressing new topics might be
introduced. The accounting standards themselves might retain
the same numbers (for example, AASB 101) but undergo
changes periodically. Sometimes these changes can be
significant. For example, how we account for intangible assets
has shown great change across the years and this has had
major implications for whether certain expenditures should be
treated as assets or expenses. Another major change is how
we are to account for leases. Recent changes have meant that
many more leased assets, and lease liabilities, are to be
recognised in the financial statements and this has also had
implications for expense recognition.
Many more examples could be given, but what should be
appreciated at this point is that it is a fairly silly (or ignorant)
exercise to compare the profits or losses of one company for
one year with its profits or losses as calculated some years
earlier. Effectively the profits or losses calculated in previous
years were generated when different accounting rules were in
place, which perhaps allowed certain expenditures to be
capitalised (that is, treated as assets) when now they must be
treated as expenses, or vice versa. Or perhaps certain
obligations—such as certain employee benefit-related
obligations—were not previously recognised as accounting
liabilities (with related expenses), but now they must be. To
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Accounting standards change across time
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use a sporting analogy, the ‘rules of the game’ have changed,
so old scores (profits) cannot really be meaningfully compared
with current ‘scores’ unless a number of adjustments are
made.
The above discussion should lead us to question some of the
analysis that we often see published in newspapers and other
media. For example, some people often provide charts that
show the trend in profits of a company over an extended
period of time, say five to ten years. But what such analysis
often ignores is that the accounting rules in place several
years ago can be quite different from the rules in place now,
so that we are really comparing very different things.
The other point that should be made is that because
accounting standards do change across time, some of what we
learn now (for example, some of what is included in this
textbook) might not be terribly relevant in say five or more
years. Therefore, to stay up-to-date, financial accountants
must continually keep abreast of ongoing changes and this in
itself is why professional accounting bodies typically require
their members to undergo continuing professional
development/education as part of their membership
requirements.
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The use and role of audit reports
Page 1 of 4
The use and role of audit reports
LO 1.8 LO 1.12
As we have discussed many of the reporting requirements for
general purpose financial statements (GPFSs), it would be
useful also to consider briefly the use and role of another
report that typically appears in corporate annual reports—the
audit report.
An audit is the independent examination of financial
information of any entity—whether profit-oriented or not and
irrespective of its size or legal form—where such an
examination is conducted with a view to expressing an opinion
on that financial information. The audit opinion is the output of
the audit process and is provided in the audit report. The
auditor’s opinion helps to establish the credibility and Page 39
reliability of the financial information. The user of this
information, however, should not assume that the auditor’s
opinion is an assurance of the future viability of the entity, or
of the efficiency or effectiveness with which management has
conducted the affairs of the entity—it is simply an opinion
about the financial statements. Also, it cannot be considered
with absolute certainty that all transactions have been
correctly recorded, even when the auditor provides an
unqualified opinion. The auditor does not test/check all
transactions; hence there is always the possibility that the
financial statements might be materially misstated. It is to be
hoped, however, that the probability of material misstatement
is kept to a low level. We provided an example of an audit
report earlier in this chapter.
In the private sector, decisions relating to the internal affairs
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The use and role of audit reports
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of an enterprise, as well as lending and investment decisions
of creditors and investors, must be made daily. In the public
sector, interested parties must decide whether managers are
complying with the controls placed upon them and whether
the entity is operating efficiently and effectively. Therefore,
managers must collect and report financial information about
the entity that summarises and communicates the results of
their activities to interested groups. To do this, they must
identify user needs for the purpose of establishing the nature
of the data to be communicated—that is, decisions must be
made as to what is ‘material’.
It should be remembered that the auditor is not responsible
for the preparation of the financial information; that
responsibility rests with management. The auditor’s
responsibility is to form and express an opinion on the
financial information. Arguably, the auditor’s report is the first
item a reader should review when looking at an annual report.
A review of the audit report might indicate that the financial
statements have not been properly prepared and, perhaps,
that they should not be relied upon for making resourceallocation decisions.
Preparers of financial information include the financial
managers of enterprises, each of whom might, at times, place
primary importance on maximising their own welfare. This
frequently results in the goals of the persons preparing the
financial information being different from the goals of those
using it. This conflict, which will be further considered in
Chapter 3 , might cause the preparers of financial informati
on to intentionally or unintentionally introduce misstatements
(or bias) into the financial data. Because of the potential bias
of management in identifying and presenting such
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information, there is a need for independent verification of the
financial data to assure fairness of presentation.
The users of financial statements need their information to be
unbiased in order to reduce the information risk they face—
that is, the risk of using materially misstated information—
when making economic decisions. An independent auditor’s
task is to reduce the potential bias and error that the
preparers of financial statements might introduce. The
reduction (or elimination) of bias makes it a ‘fairer game’ for
investors and creditors. When using unbiased financial
information, users are given a fairer chance of earning
reasonable returns on their investment. With biased
information, they might be forced into making inappropriate
investment decisions. (Of course, some people will argue that
all financial information is ‘biased’ because our current
accounting practices ignore many social and environmental
externalities being generated, and in a sense, might depict a
very successful/profitable organisation when the same
organisation might also be contributing to various social and
environmental problems, all of which are not reflected in
recorded profits—we will return to this issue in the final
chapter of this book.)
To lessen this risk, users of financial statements are willing to
incur an audit fee in return for some assurance that financial
statements are fairly presented. The managers of business
entities are also generally prepared to subject their financial
operations to an audit. Potential investors are thus able to
monitor past and future performance in a more confident
manner and this might motivate them to invest more funds at
a lower required rate of return than would otherwise be
required. Of course, the value of the independent audit will be
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tied to the reputation of the firm performing the audit.
Audits are typically required for all public companies, large
proprietary companies and a limited number of small
proprietary companies, as defined earlier in this chapter.
Small proprietary companies will be required to have their
financial statements audited if they are controlled by a foreign
company or if shareholders holding more than 5 per cent of
the voting shares request that the reports be audited. From
time to time, ASIC may also request that a small proprietary
company has its financial statements audited. Commonwealth
and state government departments, statutory authorities,
government companies and business undertakings and
municipalities also typically have their financial statements
audited. From 2006, auditing standards had legal backing.
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All this regulation—is it really necessary?
Page 1 of 10
All this regulation—is it really necessary?
LO 1.9 LO 1.16
As preceding sections of this chapter have discussed, financial
accounting is fairly heavily regulated within Australia. There
are numerous Corporations Act requirements, and there are
many accounting standards and interpretations, with additional
standards and interpretations being issued fairly frequently.
The ASX also provides extensive regulation for listed entities.
But is all this regulation really necessary? What if we Page 40
had no accounting standards, and reporting entities
could report whatever information they wanted and in
whatever format they considered appropriate?
Opinions on the need for regulation vary, and range from the
‘free-market’ perspective to the ‘pro-regulation’ perspective.
We will now briefly consider some arguments for and against
regulation—for a more detailed discussion, refer to a text
dedicated to financial accounting theory.
The ‘free-market’ perspective
Proponents of a free-market perspective on accounting
regulation often believe that accounting information should be
treated like other goods, with demand and supply forces being
allowed to operate to generate an optimal supply of
information about an entity. In support of their claims, a
number of arguments are provided. One argument, based on
the work of authors such as Jensen and Meckling (1976),
Watts and Zimmerman (1978), Smith and Warner (1979) and
Smith and Watts (1982), is that even in the absence of
regulation, there are private economics-based incentives for
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the organisation to provide credible information about its
operations and performance to certain parties outside the
organisation, otherwise the costs of the organisation’s
operations would rise. This view is based on a perspective that
the provision of credible information allows other parties to
monitor the activities of the organisation. Being able to monitor
the activities of an entity reduces the risk associated with
investing in the entity, and this in turn should lead to a
reduction in the cost of attracting capital to the organisation.
It has also been argued that there will often be conflicts
between various parties with an interest in an organisation,
and accounting information will be produced, even in the
absence of regulation, to reduce the effects of this conflict. For
example, if an owner appoints a manager, the owner might be
concerned that the manager will not best serve the interests of
the owner. To align the interests of both parties, the manager
might be provided with a share of profits, meaning that the
manager will work hard to increase profits, with higher
profitability also being in the interests of the owners. To
determine profits, accounting reports will be produced, and the
owners will demand that these reports be produced in an
unbiased manner.
As will be discussed in Chapter 3 , there is also an argument
that accounting reports can be used to reduce the conflict that
might arise between managers and the providers of loans
(debt holders). This is consistent with the usual notion of
‘stewardship’, according to which management is expected to
provide an ‘account’ of how it has utilised the funds it has been
provided. If an entity that borrows funds also agrees to provide
regular financial statements to the providers of the debt capital
(the debtholders), this ability to monitor the financial
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performance and position of the borrower will reduce the risks
of the lender. This should translate to lower costs of interest
being charged and hence provide an incentive for the borrower
(the reporting entity) to provide financial statements even in
the absence of regulation.
Further, depending on the parties involved and the types of
assets in place, it has been argued that managers of the
organisation will be best placed to determine what information
should be produced to increase the confidence of external
stakeholders (thereby decreasing the organisation’s cost of
attracting capital). Regulation that restricts the available set of
accounting methods (for example, banning a particular method
of amortisation that was used previously by some
organisations) will decrease the efficiency with which
information will be provided. It has also been argued that
certain mandated disclosures will be costly to the organisation
if they enable competitors to take advantage of certain
proprietary information. Hakansson (1977) used this argument
to explain costs that would be imposed as a result of
mandating segment disclosures.
While this discussion is about providing financial statements, a
related issue is that of external auditing of such reports. It has
been argued that even in the absence of regulation, external
parties would demand that financial statement audits be
undertaken. If such audits are not undertaken, financial
statements would not be deemed to have the same credibility
and, consequently, less reliance would be placed on them. If
reliable information is not available, the risk associated with
investing in an organisation might be perceived to be higher,
and this could lead to increases in the cost of attracting funds
to the organisation. It has therefore been argued that
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managers would have their reports audited even in the
absence of regulation (Watts 1977; Watts and Zimmerman
1983; Francis and Wilson 1988). That is, financial statement
audits can be expected to be undertaken even in the absence
of regulation, and evidence indicates that many organisations
did have their financial statements audited prior to any
legislative requirements to do so (Morris 1984). However, as
Cooper and Keim (1983, p. 199) indicate, for auditing to be an
effective strategy for reducing the costs of attracting funds,
‘the auditor must be perceived to be truly independent and
the accounting methods employed and the statements’
prescribed content must be sufficiently well-defined’.
There is also a perspective that even in the absence of Page 41
regulation, organisations would still be motivated to
disclose both good and bad news about an entity’s financial
position and performance. Such a perspective is often referred
to as the ‘market for lemons’ perspective (Akerlof 1970), the
view being that in the absence of disclosure the capital market
will assume that the organisation is a ‘lemon’. (Something is a
lemon if it initially appears or is assumed, perhaps owing to
insufficient information, to be of a quality comparable to other
products, but later turns out to be inferior. Acquiring the
‘lemon’ will be the result of information asymmetry in favour
of the seller.) That is, no information is viewed in the same
light as bad information. Hence, even though the firm might be
worried about disclosing bad news, it is assumed that the
market might make an assessment that silence implies that
the organisation has very bad news to disclose (otherwise, it
would disclose it). This ‘market for lemons’ perspective
provides an incentive for managers to release information in
the absence of regulation, as failure to do so will have its own
implications for the organisation. That is, ‘non-lemon owners
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have an incentive to communicate’ (Spence 1974, p. 93).
Drawing upon arguments such as the lemons argument above
and applying them to preliminary profit announcements,
Skinner (1994, p. 39) states:
Managers may incur reputational costs if they fail to disclose
bad news in a timely manner. Money managers, stockholders,
security analysts, and other investors dislike adverse earnings
surprises, and may impose costs on firms whose managers
are less than candid about potential earnings problems. For
example, money managers may choose not to hold the stocks
of firms whose managers have a reputation for withholding
bad news and analysts may choose not to follow these firms’
stocks … Articles in the financial press suggest that
professional money managers, security analysts, and other
investors impose costs on firms when their managers appear
to delay bad news disclosures. These articles claim that firms
whose managers acquire a reputation for failing to disclose
bad news are less likely to be followed by analysts and money
managers, thus reducing the price and/or liquidity of their
firms’ stocks.
Reviewing previous studies, Skinner (1994, p. 44) notes that
there is evidence that managers disclose both good and bad
news forecasts voluntarily. These findings are supported by his
own empirical research, which shows that when firms are
performing well, managers make ‘good news disclosures’ to
distinguish their firms from those doing less well, and when
firms are not doing well, managers make pre-emptive bad
news disclosures consistent with ‘reputational effects’
arguments (p. 58).
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Arguments that the market will penalise organisations for
failure to disclose information (which might or might not be
bad) of course assume that the market knows that the
manager has particular information to disclose. This
expectation might not always be that realistic, as the market
will not always know that there is information available to
disclose. That is, in the presence of information asymmetry
(which means that information is not equally available to all—
for example, a manager might have access to information that
is not available to others), a manager might know of some bad
news, but the market might not expect any information
disclosures at that time. However, if it does subsequently come
to light that news was available that was not disclosed, then
we could perhaps expect the market to react (and in the
presence of regulation, we could expect regulators to react, as
failure to disclose information in a timely manner might be in
contravention of particular laws). Also, at certain times,
withholding information (particularly of a proprietary nature)
could be in the interests of the organisation. For example, the
organisation might not want to disclose information about
certain market opportunities for fear of competitors utilising
such information.
So, in summary of this point, there are various arguments or
mechanisms in favour of reducing accounting regulation, as
even in the absence of regulation, firms have incentives to
make disclosures. We will now give some consideration to
alternative arguments in favour of regulating the practice of
financial accounting.
The ‘pro-regulation’ perspective
In the above discussion we considered a number of reasons
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that have been proffered in favour of reducing or eliminating
regulation. One of the most simple of arguments is that if
somebody really desired information about an organisation,
they would be prepared to pay for it (perhaps in the form of
reducing their required rate of return) and the forces of supply
and demand should operate to ensure an optimal amount of
information is produced. Another perspective is that if
information is not produced, there will be greater uncertainty
about the performance of the entity and this will translate into
increased costs for the organisation. With this in mind,
organisations would, it is argued, elect to produce information
to reduce costs. However, arguments in favour of a ‘free
market’ rely on users paying for the goods or services that are
being produced and consumed. Such arguments can break
down when we consider the consumption of ‘free’ or ‘public’
goods.
Accounting information is a public good: once it is
Page 42
available, people can use it without paying and can
pass it on to others. Parties that use goods or services without
incurring some of the associated production costs are referred
to as ‘free-riders’. In the presence of free-riders, true demand
is understated because people know they can get the goods or
services without paying for them. Few will have any incentive
to pay for the goods or services, as they can be relatively
confident of being able to act as free-riders. This dilemma, it is
argued, is a disincentive for producers of the particular good or
service, which in turn leads to an underproduction of
information. As Cooper and Keim (1983, p. 190) state:
Market failure occurs in the case of a public good because,
since other individuals (without paying) can receive the good,
the price system cannot function. Public goods lack the
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exclusion attribute, i.e. the price system cannot function
properly if it is not possible to exclude non-purchasers (those
who will not pay the asked price) from consuming the good in
question.
To alleviate this underproduction, regulation is argued to be
necessary to reduce the impacts of market failure. In relation
to the production of information, Demski and Feltham (1976,
p. 209) state:
Unlike pretzels and automobiles, [information] is not
necessarily destroyed or even altered through private
consumption by one individual … This characteristic may
induce market failure.
In particular, if those who do not pay for information cannot
be excluded from using it and if the information is valuable to
these ‘free riders’, then information is a public good. That is,
under these circumstances, production of information by any
single individual or firm will costlessly make that information
available to all … Hence, a more collective approach to
production may be desirable.
While proponents of a free-market approach argue that the
market, on average, is efficient, it can also be argued that such
‘on-average’ arguments tend to ignore the rights of individual
investors, some of whom might lose their savings as a result of
relying upon unregulated disclosures.
In addition, whether an individual is able to obtain information
about an entity might depend on the individual’s control of
scarce resources required by the entity. Although an individual
might be affected by the activities of an organisation, without
regulation and without control of significant resources, the
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individual might be unable to obtain the required information.
Regulators often use the ‘level playing field’ argument to justify
putting legislation in place. From a financial accounting
perspective, everybody should (on the grounds of fairness)
have access to the same information. This is the basis of laws
that prohibit insider trading and that rely upon an acceptance
of the view that there will not be, or perhaps should not be,
transfers of wealth between parties that have access to
information and those that do not. There is also a view (Ronen
1977) that extensive insider trading will erode investor
confidence to such an extent that market efficiency will be
impaired. Putting in place greater disclosure regulations will
make external stakeholders more confident that they are on a
‘level playing field’. If the community has confidence in the
capital markets, regulation is often deemed to be in ‘the public
interest’. However, we will always be left with the question of
what is the socially right level of regulation. Such a question
cannot be answered with any degree of certainty. Regulation
might also lead to uniform accounting methods being adopted
by different entities, and this in itself will enhance
comparability of organisational performance.
While we have provided only a fairly brief overview of the freemarket versus regulation arguments, it should perhaps be
stressed that this debate is ongoing with respect to many
activities and industries, with various vested interests putting
forward many different and often conflicting arguments for or
against regulation. The subject often gives rise to heated
debate within many economics and accounting departments
throughout the world. What do you, the reader, think? Should
financial accounting be regulated and, if so, how much
regulation should there be? If regulation is introduced, will the
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regulation favour some parts of the community more than
others? Will governments always act in the ‘public interest’ and
from whose perspective do we actually evaluate ‘public
interest’ arguments. There are many tricky issues when it
comes to the issue of regulation.
While we can argue about the merits or otherwise of
accounting regulation, the current extent of regulation can
reasonably be expected to be at least maintained and probably
increased in the future.
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Summary
Page 1 of 1
SUMMARY
Page 43
This chapter commenced with a discussion of
accounting and its relationship to accountability. As
we discussed, the term ‘accounting’ can be quite broadly
interpreted and can relate to providing various types of
‘accounts’, not all of which will necessarily be financial in
nature. As we emphasised, perspectives that restrict
definitions of accounting to matters that are only financial
seem to ignore the relationship between corporate
responsibilities and corporate accountabilities. This chapter
also provides an overview of the sources of regulation and
guidelines relating to financial reporting in Australia. In
Australia we have a system under which Australian Accounting
Standards are predominantly the standards developed by the
International Accounting Standards Board.
There are numerous rules relating to external reporting. The
body of rules is frequently amended (which also means that
care must be taken when comparing profits generated in
different years), and therefore accountants in practice (and
academia) must continually update their knowledge of the
rules. The Australian accounting profession, which is
dominated by three bodies—CPA Australia, Chartered
Accountants Australia and New Zealand, and the Institute of
Public Accountants—requires its members to undertake
continuing professional education throughout the period of
their professional membership.
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Key terms
Page 1 of 1
KEY TERMS
Australian Accounting Standards Board (AASB)
Australian Securities and Investments Commission
(ASIC)
Australian Securities Exchange (ASX)
conservative accounting policies
Financial Reporting Council (FRC)
general purpose financial statement
special purpose financial statement
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End-of-chapter exercises
Page 1 of 1
END-OF-CHAPTER EXERCISES
At the end of each chapter of this book, an exercise will be set that
addresses particular issues raised within the chapter. Generally,
these exercises will be of a practical nature requiring calculations.
However, in some chapters, such as this one, a number of questions
of a more theoretical nature will be posed and no answers will be
provided. In fact, for some questions there is no single right answer,
as any response will be dependent on subjective judgements and
personal opinion. The reader is encouraged to contemplate,
independently, the various factors that should be considered in
answering the questions. As a result of reading this chapter you
should be able to provide answers to the following questions.
1. What is a general purpose financial statement, and who are the
users of such statements? LO 1.1 , 1.2
2. Are some users of general purpose financial statements more
important than others? How would you make such an assessment?
LO 1.2
3. What are the various sources of financial accounting regulation?
Would you consider that financial accounting is over-regulated or
under-regulated? Why? LO 1.3 , 1.4 , 1.5 , 1.16
4. From the accountant’s perspective, what does ‘true and fair’ mean?
In your opinion, is the true and fair requirement useful, or
necessary? LO 1.6
5. How does the conceptual framework for financial reporting
contribute to the practice of financial accounting? LO 1.4
6. Australia has adopted IFRSs. As a result, does the Australian
Accounting Standards Board still have much relevance, and if so,
why? What are some arguments for and against Australia adopting
IFRSs? LO 1.7 , 1.13 , 1.14
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Review questions
Page 1 of 3
REVIEW QUESTIONS
Page 44
1.
Describe the roles of ASIC, the AASB, the ASX and the
FRC and the relationships between these regulatory bodies.
LO 1.4
2.
What is the IASB and how does it affect financial
reporting regulation in Australia? LO 1.7
3.
1.7
What enforcement powers does the IASB have? LO
4.
What is the role of the independent auditor, and why
would the manager or the users of financial statements be
prepared to pay for the auditor’s services? LO 1.12
5.
With all the regulations that companies must follow,
fulfilling the requirement for corporate reporting is an
additional expensive activity. What are some possible
arguments for and against disclosure regulation? LO 1.4
1.16
6.
Provide a justification as to why large companies
should have to produce financial statements that comply with
accounting standards but small companies should not have
to do this. LO 1.11
7.
Provide a brief description of the differential reporting
requirements in Australia as addressed by AASB 1053
Application of Tiers of Australian Accounting Standards. LO
1.9
8.
1.4
Define ‘generally accepted accounting procedures’. LO
9.
What is included in a directors’ declaration, and what
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Review questions
Page 2 of 3
are the implications if a director signs the declaration and the
organisation subsequently fails, owing millions of dollars that
it cannot repay? LO 1.5
10.
What does it mean to say that some financial
statements are ‘true and fair’? How would a director try to
ensure that the financial statements are true and fair before
he or she signs a directors’ declaration? LO 1.6
11.
How are International Financial Reporting Standards
developed and revised? Explain the role of the AASB in that
process. LO 1.9
12.
What is the relevance to Australia of Interpretations
issued by the IFRS Interpretations Committee? LO 1.8
13.
What authority do Interpretations issued by the IASB
and AASB have in the Australian financial reporting context?
If they do have authority, from where does this authority
emanate? LO 1.8
14.
What are the functions of the IASB? LO 1.7
15.
Although not permitted, outline some possible
theoretical advantages and disadvantages associated with
permitting directors to deviate from accounting standards in
situations where compliance with particular accounting
standards is perceived by the directors as likely to generate
financial statements that are not true and fair. LO 1.6
1.9
16.
What are some of the possible cultural impediments
to the international standardisation of accounting standards?
LO 1.15
17.
Why did the FRC decide that Australian Accounting
Standards needed to be consistent with those being issued
by the International Accounting Standards Board? LO
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Review questions
Page 3 of 3
1.13
18.
Explain why the adoption of of International Financial
Reporting Standards in Australia might have led to material
changes to reported profits. LO 1.13
1.14
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Challenging questions
Page 1 of 5
CHALLENGING QUESTIONS
19.
If directors believe that the application of a particular
accounting standard is inappropriate to the circumstances of
their organisation, what options are available to them when
compiling their financial statements? LO 1.6
20.
If a company adopted a particular accounting policy
that the ASIC considered to be questionable, in principle the
ASIC might consider taking legal action against the
company’s directors for failing to produce true and fair
financial statements. However, from a practical perspective,
why would it be difficult for the ASIC to prove in court that
the company’s financial statements were not true and fair?
LO 1.5 , 1.6
21.
Visit the website of a company listed on the ASX.
(Hint: some corporate website addresses are provided in this
chapter.) Review the company’s corporate governance
disclosures and determine whether the company complies
with the ‘Eight Essential Principles of Corporate Governance’
identified by the ASX. If the company discloses noncompliance, evaluate the reasons provided for noncompliance. LO 1.4 , 1.5
Page 45
22.
Considered together, does the set of existing
accounting standards provide guidance for all transactions
and events that might arise within an organisation? If not,
what guidance is available to the organisation? LO 1.3 ,
1.4 , 1.5
23.
The decision that Australia would adopt IFRS was in
large part based on the view that Australian reporting
entities, and the Australian economy, would benefit from
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Challenging questions
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adopting accounting methods that are the same as those
adopted internationally. Do you think that all Australian
reporting entities have benefitted from international
standardisation? LO 1.7 , 1.8 , 1.9
24.
Globally, there are variations in business laws,
criminal laws and so forth. Such international variations in
laws will be a result of differences in history, cultures,
religions and so on. While we are apparently prepared to
accept international differences in various laws, groups such
as the IASB expect there to be global uniformity in
regulations relating to accounting disclosure—that is,
uniformity in accounting standards. Does this make sense?
LO 1.15
25.
It is argued by some researchers that even in the
absence of regulation, organisations will have an incentive to
provide credible information about their operations and
performance to certain parties outside the organisation;
otherwise, the costs of the organisation’s operations will rise.
What is the basis of this belief? LO 1.16
26.
Any efforts towards standardising accounting
practices on an international basis imply a belief that a ‘onesize-fits-all’ approach is appropriate at the international
level. That is, for example, it is assumed that it is just as
relevant for a Chinese steel manufacturer to apply AASB 102
Inventories (IAS 2 Inventories) as it would be for an
Australian surfboard manufacturer. Is this a naive
perspective? Explain your answer. LO 1.15 , 1.16
27.
Provide some arguments for, and some arguments
against, the international standardisation of financial
reporting. Which arguments do you consider to be more
compelling? (In other words, are you more inclined to be ‘for’
or ‘against’ the international standardisation of financial
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Challenging questions
reporting?) LO 1.7
Page 3 of 5
, 1.9
, 1.13
, 1.15
, 1.16
28.
Evaluate the claim that ‘accounting is the language of
business’. LO 1.1
29.
Review a number of accounting standards and then
discuss how accounting standards are structured. LO 1.6
30.
You are a junior executive of a large mining company
and have been asked to show how the performance (as
measured in terms of profitability) of the company has been
improving over the past ten years. You subsequently
collected financial performance information from the previous
ten years and placed it on a graph. A trend of ongoing
improvements in profits was apparent and everybody was
very happy. The question is, should you have supplied such a
graph to your company without some adjustments? LO
1.10
31.
Do financial reports provide a good representation of
the ‘performance’ of an organisation? LO 1.1
32.
Identify some responsibilities that you think
organisations have in relation to how they conduct their
operations (they could be social, environmental or financial
responsibilities). Having done this, think of some ‘accounts’
that could be produced by the organisation to indicate how it
has performed in relation to those expected responsibilities.
LO 1.1
33.
What is the relationship between corporate
responsibilities, accountability and accounting? LO 1.1
34.
Evaluate and explain the following claim: Unless there
is consistency globally in the implementation of accounting
standards and subsequent enforcement mechanisms, we
cannot expect accounting practices to be uniform throughout
the world, despite the initiatives of the IASB, which
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Challenging questions
Page 4 of 5
encourage different nations to adopt IFRSs. LO 1.12
1.13
35.
,
As we know, there is a requirement within the
Corporations Act that financial statements be ‘true and
fair’. There is also a requirement that company
directors comply with accounting standards. In respect
of one such standard, AASB 102 Inventories, there is a
requirement that inventory be valued at the lower of
cost and net realisable value. There is also another
accounting standard, AASB 116 Property, Plant and
Equipment, which permits property, plant and
equipment to be measured at either cost or fair value.
Now assume that Angourie Ltd has assets with the
following costs and fair values (fair values can be
thought of as the amounts that the company expects
the assets could be sold for in the normal course of
business, and in a transaction between knowledgeable
parties that are not related):
Asset type
Cost
Fair value
Inventory
$ 11 000 000
$24 000 000
Machinery
$ 4 000 000
$ 6 000 000
Land
$16 000 000
$40 000 000
$31 000 000
$70 000 000
Total
Page 46
In accordance with the options available in the
accounting standards, Angourie Ltd decides to measure the
assets at cost and therefore discloses the assets in the
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Challenging questions
Page 5 of 5
statement of financial position (balance sheet) at an amount
of $31 million despite the fact that it could receive $70
million for them at that point in time if it sold them. Although
there is compliance with accounting standards, would such
financial statements be ‘true and fair’ if the assets were
disclosed at a total of $31 million when they could actually
be sold for $70 million? LO 1.6
36.
Lehman (1995) provides a definition of accounting,
this being that it is ‘both the means for defending actions
and the means for identifying which actions one must
defend’. He further states that accounting information should
‘form part of a public account given by a firm to justify its
behaviour’.
REQUIRED
Try to explain what Lehman is arguing in terms of the
meaning of accounting, and the role it plays within
society. Do you agree with Lehman? LO 1.6
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References
Page 1 of 4
REFERENCES
AKERLOF, G.A., 1970, ‘Market for Lemons’, Quarterly Journal
of Economics, vol. 84, pp. 488–500.
BALL, R., 2006, ‘International Financial Reporting Standards
(IFRS): Pros and Cons for Investors’, Accounting and Business
Research, International Accounting Policy Forum, pp. 5–27.
CHAND, P. & WHITE, M., 2007, ‘A Critique of the Influence of
Globalization and Convergence of Accounting Standards in
Fiji’, Critical Perspectives on Accounting, vol. 18, pp. 605–22.
COMMONWEALTH GOVERNMENT, 1997, Accounting
Standards: Building International Opportunities for Australian
Business, Corporate Law Economic Reform Program Proposals
for Reform: Paper No. 1, Australian Government Printing
Service, Canberra.
COOPER, K. & KEIM, G., 1983, ‘The Economic Rationale for
the Nature and Extent of Corporate Financial Disclosure
Regulation: A Critical Assessment’, Journal of Accounting and
Public Policy, vol. 2.
DEMSKI, J. & FELTHAM, G., 1976, Cost Determination: A
Conceptual Approach, Iowa State University Press.
EDDIE, I.A., 1996, ‘The Association between National Cultural
Values and Consolidation Disclosures in Annual Reports: An
Empirical Study of Asia-Pacific Corporations’, unpublished PhD
thesis, University of New England.
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References
Page 2 of 4
FECHNER, H.E. & KILGORE, A., 1994, ‘The Influence of
Cultural Factors on Accounting Practice’, The International
Journal of Accounting, 29, pp. 265–77.
FRANCIS, J.R. & WILSON, E.R., 1988, ‘Auditor Changes: A
Joint Test of Theories Relating to Agency Costs and Auditor
Differentiation’, The Accounting Review, October, pp. 663–82.
GRAY, R., DEY, C, OWEN, D., EVANS, R. & ZADEK, S., 1997,
‘Struggling with the Praxis of Social Accounting:
Stakeholders, Accountability, Audits and Procedures’,
Accounting, Auditing and Accountability Journal, 10, no. 3, pp.
325–64.
GRAY, R., OWEN, D. & ADAMS, C., 1996, Accounting and
Accountability: Changes and Challenges in Corporate and
Social Reporting, Prentice Hall, London.
GRAY, S.J., 1988, ‘Towards a Theory of Cultural Influence on
the Development of Accounting Systems Internationally’,
ABACUS, vol. 24, no. 1, pp. 1–15.
HAKANSSON, N.H., 1977, ‘Interim Disclosure and Public
Forecasts: An Economic Analysis and Framework for Choice’,
The Accounting Review, April, pp. 396–416.
HOFSTEDE, G., 1991, Cultures and Organisations, McGraw-Hill
International (UK), London.
JENSEN, M.C. & MECKLING, W.H., 1976, ‘Theory of the Firm:
Managerial Behaviour, Agency Costs and Ownership
Structure’, Journal of Financial Economics, vol. 3, October, pp.
306–60.
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References
Page 3 of 4
LEHMAN, G., 1995, ‘A Legitimate Concern for Environmental
Accounting’, Critical Perspectives on Accounting, vol. 6, pp.
393–412.
MCGREGOR, W., 1992, ‘True and Fair—an Accounting Page 47
Anachronism’, Australian Accountant, February, pp.
68–71.
MORRIS, R., 1984, ‘Corporate Disclosure in a Substantially
Unregulated Environment’, Abacus, June, pp. 52–86.
NOBES, C. & PARKER, R., 2004, Comparative International
Accounting, Harlow: Parson Education Limited.
PERERA, M.H.B., 1989, ‘Towards a Framework to Analyze the
Impact of Culture in Accounting’, The International Journal of
Accounting, 24, pp. 42–56.
PICKER, R., 2003, ‘Accounting World on its Head’, Australian
CPA, vol. 73, no. 4, pp. 64–6.
RONEN, J., 1977, ‘The Effect of Insider Trading Rules on
Information Generation and Disclosure by Corporations’, The
Accounting Review, vol. 52, pp. 438–49.
SKINNER, D.J., 1994, ‘Why Firms Voluntarily Disclose Bad
News’, Journal of Accounting Research, vol. 32, no. 1, pp. 38–
60.
SMITH, C.W. & WARNER, J.B., 1979, ‘On Financial
Contracting: An Analysis of Bond Covenants,’ Journal of
Financial Economics, June, pp. 117–61.
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References
Page 4 of 4
SMITH, C.W. & WATTS, R., 1982, ‘Incentive and Tax Effects of
Executive Compensation Plans’, Australian Journal of
Management, December, pp. 139–57.
SPENCE, A., 1974, Market Signalling: Information Transfer in
Hiring and Related Screening Processes, Harvard University
Press.
UNERMAN, J. & O’DWYER, B., 2004, ‘Basking in Enron’s
Reflexive Goriness: Mixed Messages from the UK Profession’s
Reaction’, paper presented at Asia Pacific Interdisciplinary
Research on Accounting Conference, Singapore.
WATTS, R.L., 1977, ‘Corporate Financial Statements: A
Product of the Market and Political Processes’, Australian
Journal of Management, April, pp. 53–75.
WATTS, R.L. & ZIMMERMAN, J.L., 1978, ‘Towards a Positive
Theory of the Determinants of Accounting Standards,’ The
Accounting Review, January, pp. 112–34.
WATTS, R.L. & ZIMMERMAN, J.L., 1983, ‘Agency Problems:
Auditing and the Theory of the Firm: Some Evidence’, Journal
of Law and Economics, vol. 26, October, pp. 613–34.
WEYGANDT, J., MITRIONE, L., RANKIN, M., CHALMERS, K.,
KEISO, D. & KIMMEL, P., 2013, Principles of Financial
Accounting, 3rd edition, Wiley, Milton, Queensland.
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Introduction
Chapter 2
Page 1 of 2
Page 48
THE CONCEPTUAL FRAMEWORK FOR
FINANCIAL REPORTING
LEARNING OBJECTIVES (LO)
2.1 Understand the meaning of a ‘conceptual framework’
for financial reporting.
2.2 Understand the need for, and the role of, a conceptual
framework.
2.3 Be able to explain the structure, or building blocks, of
a well designed conceptual framework.
2.4 Understand the history of the evolution of the
conceptual framework in use within Australia.
2.5 Understand the objective of general purpose financial
reporting.
2.6 Understand what is meant by the term ‘reporting
entity’ and understand the financial reporting implications of
being classified as a reporting entity.
2.7 Understand what qualitative characteristics should be
possessed by financial accounting information if such
information is to be considered useful to users of general
purpose financial statements. In particular, understand both
the fundamental qualitative characteristics of financial
reporting (relevance and faithful representation) as well as
the enhancing qualitative characteristics of financial reporting
(comparability, verifiability, timeliness and
understandability).
2.8 Be able to define the ‘users’ of general purpose
financial statements and understand the degree of
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Introduction
Page 2 of 2
proficiency in accounting that is expected of users of general
purpose financial statements.
2.9 Understand the concept of materiality and how this
influences decisions about the disclosure of financial
information.
2.10 Be able to define the elements of financial accounting
and be able to explain the recognition criteria for the various
elements of accounting.
2.11 Understand that measurement forms an important
component of a conceptual framework and understand that
measurement issues remain as an issue still to be addressed
within the IASB conceptual framework project.
2.12 Be aware of initiatives currently being undertaken by
the IASB to develop a revised conceptual framework for
financial reporting, and understand some of the changes that
might arise as a result of this initiative.
2.13 Be able to critically review the existing conceptual
framework.
2.14 Understand that a conceptual framework for general
purpose financial reporting represents a ‘normative’ theory of
accounting.
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Australia’s use of the IASB conceptual framework
Page 1 of 1
Australia’s use of the IASB conceptual
framework
LO 2.1 LO 2.2
Page 49
As noted in Chapter 1 , in Australia the Australian
Accounting Standards Board (AASB) was previously
responsible for the development of a conceptual framework
of accounting for use within Australia, the aim of which was to
define the nature, subject, purpose and broad content of
general purpose financial reporting. However, as a
consequence of adopting accounting standards issued by the
International Accounting Standards Board (IASB), there is also
a related requirement that we also adopt the conceptual
framework developed by the IASB. That is, as International
Financial Reporting Standards (IFRSs) have been developed in
accordance with the IASB Conceptual Framework for Financial
Reporting, and as we have adopted IFRSs, then we must also
adopt the IASB conceptual framework. Apart from Australia,
conceptual frameworks were also developed in a number of
other countries, including the United States, Canada, the
United Kingdom and New Zealand. Those countries that have
decided to adopt IFRSs similarly have adopted the IASB
framework and abandoned their domestically developed
frameworks.
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What is a conceptual framework?
Page 1 of 3
What is a conceptual framework?
LO 2.1 LO 2.2
There is no definitive or ‘absolute’ definition of a conceptual
framework. The Financial Accounting Standards Board (FASB)
in the USA defined its conceptual framework as a coherent
system of interrelated objectives and fundamentals that is
expected to lead to consistent standards. It prescribes the
nature, function and limits of financial accounting and reporting
(Statement of Financial Accounting Concept No. 1 Objectives of
Financial Reporting by Business Enterprises, 1981). The IASB
(2015b, p. 6) note that a conceptual framework “describes the
objectives of, and the concepts for, general purpose financial
reporting”. A central goal in establishing a conceptual
framework of accounting will be general consensus on:
l
l
l
the scope and objectives of financial reporting
the qualitative characteristics that financial information should
possess (tied to such notions as relevance and
representational faithfulness)
what the elements of financial reporting are, including
agreement on the characteristics and recognition criteria for
assets, liabilities, income, expenses and equity.
It is generally accepted that it is unwise, and perhaps illogical,
to develop accounting standards unless there is first some
agreement on key, fundamental issues, such as the objectives
of general purpose financial reporting; the qualitative
characteristics financial information should possess (for
example, relevance and representational faithfulness); how
and when transactions should be recognised; and who is the
audience of general purpose financial statements. Unless we
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What is a conceptual framework?
Page 2 of 3
have agreement on such central issues, it is difficult to
understand how logically consistent accounting standards can
be developed. Conceptual frameworks are developed to
provide guidance on key issues, such as objectives, qualitative
characteristics, definitions and recognition criteria.
While it is reasonable to accept that we need a conceptual
framework of accounting before we start developing accounting
standards (that is, we need to agree initially on the objectives
of general purpose financial reporting, and so forth), this has
not always been the view of accounting standard-setters. For
example, in Australia the first Statement of Accounting
Concept, released as part of the Australian Conceptual
Framework Project (SAC 1 Definition of the Reporting Entity),
was released in 1990. However, the first recommendations
relating to the practice of accounting were released in the
1940s, followed some years later by accounting standards. By
the time the first statement of accounting concept was issued
(which was an initial building block of the original Australian
conceptual framework of accounting), many accounting
standards were already in place. Reflecting the lack of
agreement in many key areas of financial reporting was the
high degree of inconsistency between the various accounting
standards, with different standards embracing different
recognition and measurement criteria. Accounting standards
were also being developed in many other countries in the
absence of a conceptual framework. The lack of agreement on
central issues prompted a surge of criticism. As Horngren
(1981, p. 94) stated:
All regulatory bodies have been flayed because they have
used piecemeal approaches, solving one accounting issue at a
time. Observers have alleged that not enough tidy rationality
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What is a conceptual framework?
Page 3 of 3
has been used in the process of accounting policymaking.
Again and again, critics have cited a need for a conceptual
framework.
Reacting to such criticism, the Financial Accounting
Page 50
Standards Board in the United States embarked on its
Conceptual Framework Project, with its first Statement of
Financial Accounting Concept (SFAC 1 Objectives of Financial
Reporting by Business Enterprises) being released in 1978. In
Australia, work on the Australian Conceptual Framework
commenced in the 1980s, with the first statement of
accounting concept (SAC) being released in 1990.
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Benefits of a conceptual framework
Page 1 of 2
Benefits of a conceptual framework
LO 2.2 LO 2.3
Paragraph 7 of Policy Statement 5, The Nature and Purpose of
Statements of Accounting Concepts highlighted some of the
benefits that are expected to result from having a conceptual
framework of accounting (and such benefits should flow to any
jurisdiction that utilises a soundly developed conceptual
framework). Utilising the discussion in Policy Statement 5, we
can summarise some of the benefits of having a conceptual
framework as follows:
1. Accounting standards should be more consistent and logical,
because they are developed from an orderly set of concepts.
The view is that in the absence of a coherent theory, the
development of accounting standards could be somewhat ad
hoc. As the FASB and IASB (2005, p. 1) state:
To be principles-based, standards cannot be a collection of
conventions but rather must be rooted in fundamental
concepts. For standards on various issues to result in
coherent financial accounting and reporting, the
fundamental concepts need to constitute a framework that
is sound, comprehensive, and internally consistent.
2. Increased international compatibility of accounting standards
should occur, because they are based on a conceptual
framework that is similar to that in other jurisdictions (for
example, there is much in common between the IASB and
FASB frameworks).
3. The AASB and the IASB should be more accountable for their
decisions, because the thinking behind specific requirements
should be more explicit, as should any departures from the
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Benefits of a conceptual framework
Page 2 of 2
concepts that might be included in particular accounting
standards.
4. The process of communication between the IASB and the
AASB and their constituents should be enhanced because the
conceptual underpinnings of proposed accounting standards
should be more apparent when the AASB or the IASB seeks
public comment on them. The view is also held that having a
conceptual framework should alleviate some of the political
pressure that might otherwise be exerted when accounting
standards are developed—the Conceptual Framework could,
in a sense, provide a defense against political attack.
5. The development of accounting standards and other
authoritative pronouncements should be more economical
because the concepts developed within the conceptual
framework will guide the AASB and the IASB in their decision
making.
6. Where accounting concepts developed within a conceptual
framework cover a particular issue, there might be less need
to develop additional accounting standards.
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Current initiatives to develop a revised conceptual framework
Page 1 of 6
Current initiatives to develop a revised
conceptual framework
LO 2.2 LO 2.4 LO 2.12
As noted earlier, Australia initially developed its own
conceptual framework of accounting, as did many other
countries. However, when Australia adopted IFRS in 2005, it
also adopted the IASB conceptual framework, initially entitled
Framework for the Preparation and Presentation of Financial
Statements. Following various amendments, it is now known
as the IASB Framework for Financial Reporting. In the
Australian context, it is known as the AASB Framework for the
Preparation and Presentation of Financial Statements.
It is generally accepted that there were numerous
shortcomings in the IASB framework. Similarly, the conceptual
framework developed and used in the US was also considered
to have many shortcomings. With this in mind, the IASB and
the FASB embarked on a joint project to develop a revised
conceptual framework for international use. Any revised
framework issued by the IASB would then be applicable within
the Australian context.
In July 2006 the FASB and the IASB jointly published a
discussion paper entitled Preliminary Views on an Improved
Conceptual Framework for Financial Reporting: The Objective
of Financial Reporting and Qualitative Characteristics of
Decision-useful Financial Reporting Information. As we have
already stressed, determining the objective of general purpose
financial reporting needs to be the first step when
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developing a conceptual framework for general
purpose financial reporting. That paper was the first in a series
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of publications jointly developed by the two boards as part of a
project to develop a common conceptual framework for
financial reporting. The boards released an Exposure Draft in
May 2008. The document was entitled Exposure Draft of an
Improved Conceptual Framework for Financial Reporting, and
this phase of the project specifically addressed the objective of
financial reporting and the qualitative characteristics and
constraints of decision-useful financial reporting information.
According to the Exposure Draft, the conceptual framework is
(IASB, 2008a):
a coherent system of concepts that flow from an objective.
The objective of financial reporting is the foundation of the
framework. The other concepts provide guidance on
identifying the boundaries of financial reporting; selecting the
transactions, other events and circumstances to be
represented; how they should be recognised and measured
(or disclosed); and how they should be summarised and
communicated in financial reports.
Again, and as the above definition indicates, the objective of
financial reporting is the fundamental building block for the
conceptual framework. Hence, if particular individuals or
parties disagreed with the objective of financial reporting
identified by the IASB and the FASB then they would most
likely disagree with the various prescriptions provided within
the balance of the revised conceptual framework.
The first phase of the joint IASB/FASB initiative was completed
in September 2010 and the IASB conceptual framework was
amended. It was at this point that it was renamed the
Conceptual Framework for Financial Reporting. The October
2010 revised version of the conceptual framework includes the
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first two chapters that the IASB has published as a result of its
first phase of the conceptual framework project, these being:
l
l
Chapter 1
The objective of financial reporting, and
Chapter 3
information.
Qualitative characteristics of useful financial
Chapter 2 , which has not yet been updated, will deal with
the reporting entity concept. The IASB published an Exposure
Draft on the reporting entity concept in March 2010. We will
consider this Exposure Draft when discussing the reporting
entity concept later in this chapter and we will also consider
the Exposure Draft released in May 2015. Chapter 4
contains the remaining text of the original IASB Framework
(1989). Therefore, if we were to look at the Conceptual
Framework for Financial Reporting, as released by the IASB as
at September 2010, we find the following sections (but
remember, the framework is still incomplete and there are
several projects that will be undertaken to address ‘missing’
chapters of the conceptual framework):
INTRODUCTION
l
Purpose and status
l
Scope
CHAPTERS
1. The objective of general purpose financial reporting
2. The reporting entity [to be added at a future date]
3. Qualitative characteristics of useful financial information
4. The Framework (1989):
l Underlying assumptions
l
The elements of financial statements
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l
Recognition of the elements of financial statements
l
Measurement of the elements of financial statements
l
Concepts of capital and capital maintenance.
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Following the 2010 amendments to the IASB framework, the
objective of financial reporting is now defined in the following
way (paragraph OB2):
The objective of general purpose financial reporting is to
provide financial information about the reporting entity that is
useful to existing and potential equity investors, lenders and
other creditors in making decisions about providing resources
to the entity. Those decisions involve buying, selling or
holding equity and debt instruments, and providing or settling
loans and other forms of credit.
This objective has been retained in the Exposure Draft Page 52
of the conceptual framework released in May 2015
and therefore represents the latest thinking of the IASB.
Hence, pursuant to the IASB (and AASB) framework,
information generated through the process of general purpose
financial reporting is generated principally to meet the
information needs of financial resource providers, as opposed
to other stakeholders.
It is generally accepted that conceptual frameworks will evolve
over time as information demands change, and as financial
systems change. Therefore, it is not surprising that the
conceptual frameworks of the FASB and the IASB, both of
which were initially developed more than two decades ago,
were considered to be in need of significant revision. The view
that conceptual frameworks will evolve over time is consistent
with comments made by the IASB and FASB. They state (IASB
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2008b, p. 9):
To provide the best foundation for developing principle-based
common standards, the boards have undertaken a joint
project to develop a common and improved conceptual
framework. The goals for the project include updating and
refining the existing concepts to reflect changes in markets,
business practices and the economic environment that
occurred in the two or more decades since the concepts were
developed.
Although the IASB and the FASB had been jointly developing a
revised conceptual framework for a number of years, in 2010
both Boards suspended their work on the joint framework. In
2012, after a short period of inactivity, the IASB restarted the
conceptual framework project, but it was no longer being
jointly undertaken with the FASB. According to IASB (2013,
p.15), for the remainder of the project, it would focus upon:
(a)
elements of the financial statements (including the
boundary between liabilities and equity);
(b)
recognition and derecognition;
(c)
measurement;
(d)
presentation and disclosure (including the question of
what should be presented in other comprehensive income);
and
(e)
the reporting entity.
Details of the progress of the revised conceptual framework
can be found on the IASB website (www.ifrs.org) by
following the links to the conceptual framework project.
In the balance of this chapter we will focus primarily on the
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IASB Conceptual Framework for Financial Reporting, as revised
and released in October 2010, as this is the conceptual
framework that must be applied within Australia (and other
countries that have adopted IFRS). For the balance of the
chapter we will simply refer to it as the conceptual framework.
As has already been mentioned, further changes are expected
to the conceptual framework, and a full Exposure Draft was
released in May 2015 with the intention that a revised
conceptual framework will be released in late 2016 or some
time shortly thereafter. Where appropriate, we will make
reference to ongoing work being undertaken by the IASB,
given that this work provides an indication of possible future
directions and changes.
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Structure of the conceptual framework
LO 2.3 LO 2.4
Prior to 2005, the year in which Australia adopted IFRS and the
IASB framework, Australia had its own conceptual framework
and this was comprised of four statements of accounting
concepts (SACs) that had been developed and issued within
Australia. That is, Australia was developing its conceptual
framework independently of other countries.
Since 2005 we no longer use the entire contents of the
conceptual framework that was developed in Australia in the
early to mid-1990s. Parts of this conceptual framework
(specifically, two statements of accounting concepts—SAC 3
Qualitative Characteristics of Financial Information and SAC 4
Definition and Recognition of the Elements of Financial
Statements) were initially replaced by the IASB Framework for
the Preparation and Presentation of Financial Statements—a
document initially prepared by the International Accounting
Standards Committee (IASC) in 1989 and in turn released by
the AASB in July 2004. Two of our pre-existing Australian
statements of accounting concepts—SAC 1 Definition of the
Reporting Entity and SAC 2 Objective of General Purpose
Financial Reporting—were retained after 2005 because the
related issues were not addressed in the IASB framework.
However, with the amendments made to the IASB conceptual
framework in 2010, the contents of the previous SAC 2 were no
longer applicable within Australia, given that work on defining
the objective of general purpose financial reporting—which had
been the subject of SAC 2—had been completed by the IASB
and incorporated into the framework released in September
2010. However, as the work being undertaken by the IASB has
not yet been completed in relation to definitional issues Page 53
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associated with the ‘reporting entity’ concept, SAC 1 Definition
of the Reporting Entity is still applicable within the Australian
context. However, the reporting entity concept has been
addressed in the Exposure Draft released by the IASB in May
2015.
It needs to be emphasised that the Australian conceptual
framework, which currently comprises the IASB conceptual
Framework plus SAC 1, is not an accounting standard, and as
such does not prescribe recognition, measurement or disclosure
requirements in relation to specific transactions or events.
Rather, the conceptual framework provides guidance at a
general, or conceptual level. Specific transactions and events
(such as, for example, how to account for the acquisition of
inventory or the acquisition of goodwill) are addressed by
particular accounting standards.
Previously, it was generally accepted that the conceptual
framework was a useful source of guidance, but was not
mandatory. However, the inclusion of two paragraphs in
Accounting Standard AASB 108 Accounting Policies, Changes in
Accounting Estimates, and Errors has changed this position so
that preparers of general purpose financial statements are now
required to follow the Conceptual Framework. Specifically,
paragraphs 10 and 11 of AASB 108 state:
10. In the absence of an Australian Accounting Standard that
specifically applies to a transaction, other event or
condition, management shall use its judgement in
developing and applying an accounting policy that results
in information that is:
(a) relevant to the economic decision-making needs of
users; and
(b)
reliable, in that the financial statements:
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(i)
represent faithfully the financial position,
financial performance and cash flows of the entity;
(ii)
reflect the economic substance of transactions,
other events and conditions, and not merely the legal
form;
(iii)
are neutral, that is, free from bias;
(iv)
are prudent; and
(v)
are complete in all material respects.
11. In making the judgement described in paragraph 10,
management shall refer to, and consider the applicability
of, the following sources in descending order:
(a) the requirements in Australian Accounting
Standards dealing with similar and related issues; and
(b) the definitions, recognition criteria and
measurement concepts for assets, liabilities, income and
expenses in the framework.
Hence, the Accounting Standard AASB 108, which has the force
of law pursuant to the Corporations Act, requires management
to refer to the conceptual framework where a specific issue is
not addressed in a particular accounting standard. That is, in the
absence of a specific accounting standard to address an issue,
reporting entities must be guided by the conceptual framework.
The development of a conceptual framework for accounting is
considered to involve the assembly of a number of ‘building
blocks’. The framework must be developed in a particular order,
with some matters necessarily requiring agreement before work
can move on to subsequent ‘building blocks’. Figure 2.1
provides an overview of the framework developed in the late
1980s by the International Accounting Standards Committee
(IASC), which was later adopted by the IASC’s successor, the
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International Accounting Standards Board (IASB). While the
earlier framework has been superseded by the IASB Conceptual
Framework for Financial Reporting, the building blocks
previously identified in the superseded framework are still of
relevance.
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Figure 2.1
Components of a conceptual framework (based on the
IASC/IASB framework)
As represented in Figure 2.1 , the first matter to be
addressed is the definition of financial reporting. Unless there is
some agreement on this it would be difficult to construct a
framework for financial reporting. Having determined what
financial reporting means, we may turn our attention to the
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subject of financial reporting, specifically which entities are
required to produce general purpose financial statements, and
the likely characteristics of the users of these statements. Then
we look at the objective of general purpose financial reporting,
which we have already briefly discussed in this chapter. Once we
have an accepted objective for general purpose financial
reporting, the next step is to determine the basic underlying
assumptions and qualitative characteristics of financial
information necessary to allow users to make ‘economic
decisions’. We do so later in this chapter.
It is to be expected that over time perspectives on the role of
general purpose financial reporting will change. Consistent with
this view, many, including accounting standard-setters, expect
the development of conceptual frameworks to continue—for
them to continually evolve over time.
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Building blocks of a conceptual framework
LO 2.3 LO 2.4 LO 2.5 LO 2.6 LO 2.7 LO 2.8 LO 2.9 LO 2.10
In this section we consider the definition of a reporting entity; perceived users of financial statements; the
objectives of general purpose financial reporting; the qualitative characteristics that general purpose
financial statements should possess; the elements of financial statements; and possible approaches to the
recognition and measurement of the elements of financial statements.
Definition of a reporting entity
A key question in any discussion of financial reporting is: what characteristics of an entity signal the need
for it to produce general purpose financial statements? Use of the term general purpose financial statements
signifies that such financial statements comply with accounting standards and other generally accepted
accounting principles, and are released by reporting entities with the aim of satisfying the general
information demands of a varied cross-section of users. Being ‘general purpose’ in nature, general purpose
financial statements cannot be expected to meet all the information needs of the various classes of users.
As the conceptual framework (paragraph OB6) states (and this has also been retained in the Exposure Draft
released in May 2015 by the IASB):
General purpose financial reports do not and cannot provide all of the information that existing and
potential investors, lenders and other creditors need. Those users need to consider pertinent information
from other sources, for example, general economic conditions and expectations, political events and
political climate, and industry and company outlooks.
General purpose financial statements can be contrasted with special purpose financial statements, which are
provided to meet the information demands of a particular user or group of users and which are not required
to comply with accounting standards (for example, a special purpose financial statement might be a cash
flow projection produced for a bank that is providing funds to the entity). As stated earlier, the guidance
that we consider in this chapter relates to general purpose financial statements.
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Clearly, not all entities should be expected to produce general purpose financial statements (with general
purpose financial statements being financial statements that are directed towards the common information
needs of a wide range of users). For example, there would be limited benefit from requiring an owner–
manager to prepare general purpose financial statements (that comply with the whole range of accounting
standards) for, say, a small corner shop. There would be few external users with a significant stake or
interest in the organisation.
The conceptual framework developed within Australia provided more detail on the reporting entity concept
than the IASB framework adopted in 2005. The IASB conceptual framework subsequently released in 2010
also did not address the notion of a ‘reporting entity’. That is, the chapter dealing with the reporting entity
concept (Chapter 2 ) was left blank when the 2010 document was released. Nevertheless, the IASB did
release an Exposure Draft in 2010 entitled Conceptual Framework for Financial Reporting – The Reporting
Entity. However, when the comments on the Exposure Draft were received, this coincided with the time at
which work on the conceptual framework was temporarily suspended (November 2010). Hence the
Reporting Entity chapter of the conceptual framework was not finalised. Nevertheless, the Exposure Draft
released in May 2015 does reflect the current thoughts of the IASB so we will also consider that in the
discussion below.
Because the conceptual framework, as released in 2010, does not address the reporting entity concept—
which is central to general purpose financial reporting—Australia elected to retain, for the time being, the
use of SAC 1 Definition of the Reporting Entity—which the AASB developed back in 1990—as a supplement
to the IASB Conceptual Framework for Financial Reporting.
In the joint work that that was undertaken by the IASB and the FASB, SAC 1 was used as a frame of
reference for developing the IASB/FASB perspective of the reporting entity concept. Specifically, FASB and
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IASB (2005, p.13) stated:
The Australian Accounting Standards Boards did issue in 1990 a Concepts Statement, ‘Definition of the
Reporting Entity’, that defined an economic entity as a group of entities under common control, with users
who depend on general purpose financial reports to make resource allocation decisions regarding the
collective operation of the group and examined the implications of that concept. The boards may find that
Concept Statement useful in developing a complete, converged concept of reporting entity.
Referring to SAC 1, as released by the AASB in 1990, it did provide a definition of a ‘reporting entity’, this
being:
Reporting entities are all entities (including economic entities) in respect of which it is reasonable to expect
the existence of users dependent on general purpose financial reports for information which will be useful
to them for making and evaluating decisions about the allocation of scarce resources.
The above definition of a reporting entity is consistent with the definition currently provided within AASB
1053: Application of Tiers of Australian Accounting Standards. AASB 1053 defines a reporting entity as:
an entity in respect of which it is reasonable to expect the existence of users who rely on the entity’s
general purpose financial statements for information that will be useful to them for making and evaluating
decisions about the allocation of resources. A reporting entity can be a single entity or a group comprising
a parent and all of its subsidiaries.
Pursuant to SAC 1, general purpose financial statements (GPFSs) should be prepared by all reporting
entities (remember that the full text of SAC 1, and the AASB conceptual framework and the various accoun
ting standards is available on the AASB’s website at www.aasb.gov.au). As previously stated, general
purpose financial statements are financial statements that comply with the conceptual framework and
relevant accounting standards. They can be contrasted with special purpose financial statements, as defined
in Chapter 1 . Paragraph 6 of SAC 1 further defines general purpose financial statements as statements
‘intended to meet the information needs common to users who are unable to command the preparation of
statements tailored so as to satisfy, specifically, all of their information needs’. This definition is consistent
with the definition currently adopted by the AASB in AASB 1053 Application of Tiers of Australian Accounting
Standards. In this standard, general purpose financial statements are defined as:
those financial statements intended to meet the needs of users who are not in a position to require an
entity to prepare reports tailored to their particular information needs.
If an entity is not deemed to be a ‘reporting entity’, it will not be required to produce general
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purpose financial statements—it will not necessarily be required to comply with all accounting
standards. Whether an entity is classified as a reporting entity is determined by the extent to which users
(of financial information relating to that entity) have the ability to command the preparation of financial
statements tailored to their particular information needs. Such a determination depends upon professional
judgement. When information relevant to decision making is not otherwise accessible to users who are
judged to be dependent upon general purpose financial statements to make and evaluate resourceallocation decisions, the entity is deemed to be a reporting entity. Where dependence is not readily
apparent, SAC 1 suggests that factors that might indicate that an organisation is a reporting entity include:
l
l
l
the separation of management from those with an economic interest in the entity—as the spread of
ownership and/or the separation of management and ownership increase, so does the likelihood of an
entity being considered to be a reporting entity
the economic or political importance/influence of the entity to/on other parties—as the entity’s dominance
in the market and/or its potential influence on the welfare of external parties increase, so does the
likelihood of an entity being considered to be a reporting entity, and
the financial characteristics of the entity—as the amount of sales, value of assets, extent of indebtedness,
number of customers and number of employees increase, so does the likelihood of an entity being
considered to be a reporting entity.
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Small proprietary companies (as defined in Chapter 1
Page 3 of 21
) are frequently not considered to be reporting
entities, as it is assumed that most people who require financial information about such an entity will be in a
position to specifically demand it. Clearly, the approach adopted in Australia to defining a reporting entity is
highly subjective and could produce conflicting opinions on whether or not an entity is a reporting entity.
Interestingly, Australian law, as opposed to the conceptual framework, developed more objective criteria for
determining when a company is required to provide financial statements that comply with accounting
standards. These criteria, which are set out in the Corporations Act, relate to measures such as gross
revenue, dollar value of assets and number of employees. Specifically, within the Corporations Act a
company is deemed by s. 45A to be a large proprietary company, and therefore subject to greater
disclosure requirements than ‘small proprietary companies’, if it meets two or more of the following tests:
l
Gross operating revenue for the financial year of $25 million or more
l
Gross assets at the end of the financial year of $12.5 million or more
l
Full-time-equivalent employees numbering 50 or more.
Unless specific conditions exist, as provided in s. 292(2) of the Corporations Act, small proprietary
companies do not have to prepare financial statements that comply with all accounting standards.
In this chapter we have already made reference to the current definitions of ‘reporting entity’ and ‘general
purpose financial statements’ as provided within AASB 1053 Application of Tiers of Australian Accounting
Standards. As we explained in Chapter 1 , AASB 1053 introduced a two-tier reporting system for entities
producing general purpose financial statements. That is, within the Australian context, where entities are
deemed to be ‘reporting entities’ they will either provide a higher level of disclosures (referred to as Tier 1
general purpose financial statements, which are financial statements that comply with all relevant
accounting standards), or lower levels of disclosures (being Tier 2 general purpose financial statements,
which will be financial statements that utilise the recognition, measurement and presentation requirements
of Tier 1 but have substantially reduced disclosure requirements).
In relation to which entities are required to apply Tier 2 (reduced) reporting requirements, paragraph 13 of
AASB 1053 states:
The following types of entities shall, as a minimum, apply Tier 2 reporting requirements in preparing
general purpose financial statements:
(a) for-profit private sector entities that do not have public accountability;
(b)
not-for-profit private sector entities; and
(c)
public sector entities, whether for-profit or not-for-profit, other than the Australian Government and
State, Territory and Local Governments.
These types of entities may elect to apply Tier 1 reporting requirements in preparing general purpose
financial statements.
Organisations producing financial statements that comply with Tier 2 requirements are still
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considered to be producing general purpose financial statements. Hence, although we have
provided a definition of a reporting entity, the level of reporting required of the reporting entity will be
further governed by the requirements of AASB 1053. An organisation that is not a ‘reporting entity’ and
does not have ‘public accountability’ would not be impacted by the requirements of AASB 1053 to the extent
that the organisation does not elect to produce general purpose financial statements.
In the Exposure Draft of the Conceptual Framework for Financial Reporting released by the IASB in May
2015, the IASB decided not to be prescriptive when defining the reporting entity. This is somewhat in
contrast to the current Australian position. The IASB decided not to provide a definition that reflected which
entities must, should, or could prepare general purpose financial statements. Rather, they decided to leave
such judgements up to various national jurisdictions. The 2015 IASB Exposure Draft simply states that:
A reporting entity is an entity that chooses, or is required, to prepare general purpose financial
statements.
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The 2015 Exposure Draft also notes that a reporting entity does not have to be a legal entity, and it can be
a portion of an entity. Hence we can see that very little guidance is provided by the IASB in deciding what is
a ‘reporting entity’.
Having considered the meaning of a reporting entity, and having learned that within Australia reporting
entities are required to produce general purpose financial statements, we will now turn our attention to the
perceived ‘users’ of general purpose financial statements.
Users of general purpose financial statements
If general purpose financial statements are to meet their intended purposes, then to be effective, reporting
entities need to identify potential users and their respective information needs. Within the conceptual
framework, the primary users of general purpose financial reports are deemed to be ‘investors, lenders and
other creditors’. As the conceptual framework (Chapter 1
, paragraph OB5) states (and this is also in the
2015 IASB Exposure Draft):
Many existing and potential investors, lenders and other creditors cannot require reporting entities to
provide information directly to them and must rely on general purpose financial reports for much of the
financial information they need. Consequently, they are the primary users to whom general purpose
financial reports are directed.
Within the conceptual framework there appears to be limited consideration of the ‘public’ being a legitimate
user of financial statements. In the previous conceptual framework released by the IASB, the ‘public’ had
been identified as a user of general purpose financial statements. However, in the conceptual framework
released in 2010, even though a primary group of users are identified, it is proposed that accounting
information designed to meet the information needs of investors, creditors and other users will usually also
meet the needs of the other user groups identified. As the conceptual framework (Chapter 1 , paragraph
OB10) states (and again, this view is also retained within the IASB 2015 Exposure Draft):
Other parties, such as regulators and members of the public other than investors, lenders and other
creditors, may also find general purpose financial reports useful. However, those reports are not primarily
directed to these other groups.
In explaining the reasons why the users of financial statements were identified as primarily being investors,
lenders and other creditors, the Basis for Conclusions that accompanied the release of the IASB conceptual
framework stated:
The reasons why the Board concluded that the primary user group should be the existing and potential
investors, lenders and other creditors of a reporting entity are:
(a)
Existing and potential investors, lenders and other creditors have the most critical and immediate
need for the information in financial reports and many cannot require the entity to provide the information
to them directly.
(b) The Board’s and the FASB’s responsibilities require them to focus on the needs of participants in
capital markets, which include not only existing investors but also potential investors and existing and
potential lenders and other creditors.
(c)
Information that meets the needs of the specified primary users is likely to meet the needs of users
both in jurisdictions with a corporate governance model defined in the context of shareholders and those
with a corporate governance model defined in the context of all types of stakeholders.
The issue of which groups should be considered to be legitimate users of financial information
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about an organisation is one that has attracted a great deal of debate. There are many, such as the
authors of The Corporate Report (a discussion paper released in 1975 by the Accounting Standards Steering
Committee of the Institute of Chartered Accountants in England and Wales), who hold that all groups
affected by an organisation’s operations have rights to information about the reporting entity, including
financial information, regardless of whether they are contemplating resource allocation decisions.
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Indeed, many people would question whether the need for information to facilitate users ‘making decisions
about providing resources to the entity’ is the only or dominant issue to consider in determining whether an
organisation has a public obligation to provide information about its performance. The activities of
organisations, particularly large corporations, impact on society and the environment in many different ways
and at many different levels. Such impacts are clearly not restricted to investors or people who are
considering investing in the organisation. In large part, the extent to which an organisation impacts on
society and the environment, and its ability to minimise harmful impacts, will be tied to the financial
resources under its control. As such, a reasonable argument can be made that various groups within society
have a legitimate interest in having access to information about the financial position and performance of
organisations, and to restrict the definition of users to investors, creditors and other lenders does seem a
little too simplistic. In its current work, the IASB appears to maintain a restricted view of the users of
general purpose financial statements (more restrictive than the previous Australian position) and tends to
disregard information rights and the needs of users who do not have a direct financial interest in the
organisation. Do you, the reader, consider that this perspective of ‘users’ of financial reports is too
restrictive?
Apart from considering the identity of report users, we also need to consider their expected proficiency in
interpreting financial accounting information. In considering the matter of the level of expertise expected of
financial statement readers, it has generally been accepted that readers are expected to have some
proficiency in financial accounting. As a result, accounting standards are developed on this basis. The
conceptual framework, (Chapter 3 , paragraph QC32) explains that (again, this has been retained in the
IASB 2015 Exposure Draft):
Financial reports are prepared for users who have a reasonable knowledge of business and economic
activities and who review and analyse the information diligently. At times, even well-informed and diligent
users may need to seek the aid of an adviser to understand information about complex economic
phenomena.
So financial statements are written for an audience that is educated to some degree in the workings of
accounting—this is an interesting observation given the many hundreds of thousands of financial statements
being sent to investors annually, most of whom would have no grounding whatsoever in accounting. To
usefully consider the required qualitative characteristics financial information should possess (for example,
relevance and understandability), some assumptions about the abilities of report users are required. It
would appear that those responsible for developing the conceptual framework have accepted that individuals
without any expertise in accounting are not the intended audience of reporting entities’ financial statements
(even though such people may have a considerable amount of their own wealth invested). Having
established the audience for general purpose financial statements, and their expected proficiency in
understanding financial accounting information, we now move on to consider the objectives of general
purpose financial reporting.
Objectives of general purpose financial reporting
According to Chapter 1 , paragraph OB1, of the conceptual framework (which deals with the objective of
general purpose financial reporting):
The objective of general purpose financial reporting forms the foundation of the Conceptual Framework.
Other aspects of the Conceptual Framework—a reporting entity concept, the qualitative characteristics of,
and the constraint on, useful financial information, elements of financial statements, recognition,
measurement, presentation and disclosure—flow logically from the objective.
In terms of the objective of general purpose financial reporting, paragraph OB2 states:
The objective of general purpose financial reporting is to provide financial information about the reporting
entity that is useful to existing and potential investors, lenders and other creditors in making decisions
about providing resources to the entity. Those decisions involve buying, selling or holding equity and debt
instruments, and providing or settling loans and other forms of credit.
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The above objectives have also been embraced within the 2015 Exposure Draft and therefore represent the
latest thinking of the IASB. Hence, the whole structure and contents of the conceptual framework (now and
in the likely future) are based around, and follow on from, the identified objective of general purpose
financial reporting.
Before moving on to consider some of the suggested qualitative characteristics of financial information, for
the sake of completeness we will briefly mention the underlying assumptions identified in the conceptual
framework. These underlying assumptions are simply that for financial statements to meet the objectives of
providing information for economic decision making, they should be prepared on the accrual and going
concern basis. Specifically, paragraphs OB17 and 4.1 state:
OB17
Accrual accounting depicts the effects of transactions and other events and circumstances on a
reporting entity’s economic resources and claims in the periods in which those effects occur, even if
the resulting cash receipts and payments occur in a different period. This is important because
information about a reporting entity’s economic resources and claims and changes in its economic
resources and claims during a period provides a better basis for assessing the entity’s past and future
performance than information solely about cash receipts and payments during that period.
4.1
The financial statements are normally prepared on the assumption that an entity is a going concern
and will continue in operation for the foreseeable future. Hence, it is assumed that the entity has
neither the intention nor the need to liquidate or curtail materially the scale of its operations; if such
an intention or need exists, the financial statements may have to be prepared on a different basis
and, if so, the basis used is disclosed.
Hence unless otherwise stated, it is assumed that a general purpose financial statement is prepared on the
basis that the entity adopts accrual accounting, and that the entity is a going concern.
Qualitative characteristics of financial information
If it is accepted that financial information should be useful for economic decision making in terms of
deciding whether to make resources available to a reporting entity, as the conceptual frameworks indicates,
a subsequent element (or building block) to consider is the qualitative characteristics (attributes or
qualities) that financial information should have if it is to be useful for such decisions (implying that an
absence of such qualities would mean that the central objectives of general purpose financial statements
would not be met).
Conceptual frameworks concentrate quite heavily on identifying the required qualitative characteristics of
financial information. The fundamental qualitative characteristics identified in the conceptual framework
released in 2010 are ‘relevance’ and ‘faithful representation’. This represents a departure from the previous
IASB Framework for the Preparation and Presentation of Financial Statements wherein the primary
qualitative characteristics were considered to be ‘relevance’ and ‘reliability’. That is, the ‘new’ framework in
place since 2010 has replaced ‘reliability’ with ‘faithful representation’. The use of ‘faithful representation’
has also been used in the 2015 Exposure Draft released by the IASB. In discussing the need for information
to be relevant and faithfully represented, paragraph QC17 of the IASB conceptual framework states:
Information must be both relevant and faithfully represented if it is to be useful. Neither a faithful
representation of an irrelevant phenomenon nor an unfaithful representation of a relevant phenomenon
helps users make good decisions.
Apart from ‘fundamental’ qualitative characteristics, the conceptual framework (and the 2015 Exposure
Draft) also identifies a number of ‘enhancing qualitative characteristics’ (which are important, but rank after
fundamental qualitative characteristics in order of importance). These ‘enhancing qualitative characteristics’
are comparability, verifiability, timeliness and understandability. As paragraph QC19 of the conceptual
framework states:
Comparability, verifiability, timeliness and understandability are qualitative characteristics that enhance
the usefulness of information that is relevant and faithfully represented. The enhancing qualitative
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characteristics may also help determine which of two ways should be used to depict a phenomenon if both
are considered equally relevant and faithfully represented.
We will consider each of these qualitative characteristics (two primary, and four enhancing qualitative
characteristics) in turn.
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Relevance
Relevance is a fundamental qualitative characteristic of financial reporting. Under the conceptual framework,
information is regarded as relevant if it is considered capable of making a difference to a decision being
made by users of the financial statements. Specifically, paragraph QC6 states:
Relevant financial information is capable of making a difference in the decisions made by users.
Information may be capable of making a difference in a decision even if some users choose not to take
advantage of it or are already aware of it from other sources.
There are two main aspects to relevance. For information to be relevant it should have both predictive value
and confirmatory value (or feedback value), the latter referring to information’s utility in confirming or
correcting earlier expectations.
Closely tied to the notion of relevance is the notion of materiality. General purpose financial statements are
to include all financial information that satisfies the concepts of ‘relevance’ and ‘faithfully represent’ to the
extent that such information is material. Paragraph QC11 of the IASB conceptual framework states that an
item is material if:
omitting it or misstating it could influence decisions that users make on the basis of financial information
about a specific reporting entity. In other words, materiality is an entity-specific aspect of relevance based
on the nature or magnitude, or both, of the items to which the information relates in the context of an
individual entity’s financial report. Consequently, the Board cannot specify a uniform quantitative threshold
for materiality or predetermine what could be material in a particular situation.
Considerations of materiality also provide a basis for restricting the amount of information provided to levels
that are comprehensible to financial statement users. It would arguably be poor practice to provide
hundreds of pages of potentially relevant and representationally faithful information to financial statement
readers—this would result only in an overload of information. Nevertheless, assessing materiality is very
much a matter of judgement and at times we might see it being used as a justification for failing to disclose
information that could be deemed to be potentially harmful to the reporting entity.
The definition of materiality provided in the conceptual framework is consistent with that provided in AASB
108 Accounting Policies, Changes in Accounting Estimates and Errors. Generally speaking, if an item of
information is not deemed material (which is, of course, a matter of professional judgement), the mode of
disclosure or even whether or not it is disclosed at all should not affect the decisions of financial statement
readers.
Paragraph 8 of AASB 108 explains that where an item or an aggregate of items is not material, application
of the materiality notion does not mean that those items would not be recognised, measured or disclosed. It
means, rather, that the entity would not be required to recognise, measure or disclose those items in
accordance with the requirements of an accounting standard.
In deciding whether an item or an aggregate of items is ‘material’, the nature and amount of the items
usually need to be evaluated together. It might be necessary to treat as material an item or an aggregate of
items that would not be judged to be material on the basis of the amount involved, because of their nature.
An example is where a change in accounting method has taken place that is expected to affect materially
the results of subsequent financial years, even though the effect in the current financial year is negligible.
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Again, if an item is not deemed to be material, the general principle is that you do not have to use a
particular accounting standard to account for it.
Worked Example 2.1
provides an example of how we might determine the materiality of an item.
WORKED EXAMPLE 2.1:
Determining the materiality of an item
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Cassandra Ltd has the following assets as at 30 June 2017:
$000
Current assets
Cash
1 000
Marketable securities
3 000
Accounts receivable
8 000
Inventory
1 100
13 100
Total current assets
Non-current assets
6 000
Investments
12 000
Property, plant and equipment
2 000
Intangible assets
Total non-current assets
20 000
Total assets
33 100
Profits for the year were $6 000 000 and total shareholders’ equity at year end was $12 000 000. Sales for
the year were $28 000 000 and related cost of goods sold was $12 000 000. Just before the year-end
financial statements were finalised it was discovered that sales invoices of $900 000 had accidentally been
excluded from the total transactions of the year. The related cost of goods sold pertaining to these sales was
$600 000.
REQUIRED
Determine whether this omission is likely to be deemed to be material.
SOLUTION
First, we need to determine the appropriate base amounts. If the sales were properly recorded, sales and
accounts receivable would have been $900 000 higher. Inventory would have been $600 000 lower and
cost of goods sold would have been $600 000 higher. Profit would have been $300 000 higher.
Recorded amount
Possible adjustment
Percentage adjustment
12 000 000
300 000
2.5%
6 000 000
300 000
5.0%
Sales
28 000 000
900 000
3.2%
Cost of goods sold
12 000 000
600 000
5.0%
8 000 000
900 000
11.3%
Shareholders’ equity
Profits
Accounts receivable
On the basis of the above information, we could argue that the impact on accounts receivable would be
material if the transaction was omitted from the financial statements. The impacts on the other base
amounts would probably not be deemed to be material, but because the impact on accounts receivable is
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deemed to be material this is sufficient to warrant the financial statements being adjusted to include the
omitted sales. But of course, this is all a matter of ‘professional judgement’.
Faithful representation
The other primary qualitative characteristic (other than relevance) is ‘faithful representation’. According to
the conceptual framework, to be useful, financial information must not only represent relevant phenomena,
but it must also faithfully represent the phenomena that it purports to represent. According to paragraph
QC12 of the conceptual framework:
To be a perfectly faithful representation, a depiction would have three characteristics. It would be
complete, neutral and free from error. Of course, perfection is seldom, if ever, achievable. The IASB’s
objective is to maximise those qualities to the extent possible.
In terms of the three characteristics of ‘complete’, neutral’ and ‘free from error’, that together reflect faithful
representation, paragraphs QC13, 14 and 15 of the conceptual framework state:
QC13
A complete depiction includes all information necessary for a user to understand the phenomenon
being depicted, including all necessary descriptions and explanations. For example, a complete
depiction of a group of assets would include, at a minimum, a description of the nature of the assets
in the group, a numerical depiction of all of the assets in the group, and a description of what the
numerical depiction represents (for example, original cost, adjusted cost or fair value).
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QC14
A neutral depiction is without bias in the selection or presentation of financial information. A neutral
depiction is not slanted, weighted, emphasised, de-emphasised or otherwise manipulated to increase
the probability that financial information will be received favourably or unfavourably by users. Neutral
information does not mean information with no purpose or no influence on behaviour. On the
contrary, relevant financial information is, by definition, capable of making a difference in users’
decisions.
QC15 Faithful representation does not mean accurate in all respects. Free from error means there are no
errors or omissions in the description of the phenomenon, and the process used to produce the
reported information has been selected and applied with no errors in the process. In this context, free
from error does not mean perfectly accurate in all respects. For example, an estimate of an
unobservable price or value cannot be determined to be accurate or inaccurate. However, a
representation of that estimate can be faithful if the amount is described clearly and accurately as
being an estimate, the nature and limitations of the estimating process are explained, and no errors
have been made in selecting and applying an appropriate process for developing the estimate.
Hence, from the above paragraphs we should understand that financial information that faithfully represents
a particular transaction or event will depict the economic substance of the underlying transaction or event,
which is not necessarily the same as its legal form. Further, faithful representation does not mean total
absence of error in the depiction of particular transactions, events or circumstances because the economic
phenomena presented in financial statements are often, and necessarily, measured under conditions of
uncertainty. Hence, most financial reporting measures involve various estimates and instances of
professional judgement. To faithfully represent a transaction or event an estimate must be based on
appropriate inputs and each input should reflect the best available information.
In terms of the sequence in which the two fundamental qualitative characteristics of relevance and faithful
representation are considered (that is, whether one fundamental qualitative characteristic should be
considered before the other), paragraph QC18 of the conceptual framework states:
The most efficient and effective process for applying the fundamental qualitative characteristics would
usually be as follows (subject to the effects of enhancing characteristics and the cost constraint, which are
not considered in this example). First, identify an economic phenomenon that has the potential to be useful
to users of the reporting entity’s financial information. Second, identify the type of information about that
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phenomenon that would be most relevant if it is available and can be faithfully represented. Third,
determine whether that information is available and can be faithfully represented. If so, the process of
satisfying the fundamental qualitative characteristics ends at that point. If not, the process is repeated
with the next most relevant type of information.
Of some interest is the fact that when the conceptual framework was released in 2010 it identified
representational faithfulness as a fundamental qualitative characteristic, rather than using the qualitative
characteristic of ‘reliability’ that was used in the former IASB framework (that is, relevance was replaced by
representational faithfulness when the 2010 document was released by the IASB). This has also been
embraced within the 2015 Exposure Draft released by the IASB. In explaining the rationale for this
replacement, paragraphs BC3.23 and 24 of the Basis for Conclusions that accompanied the release of the
conceptual framework in 2010 stated:
BC3.23 Unfortunately, neither the IASB or FASB framework clearly conveyed the meaning of reliability.
The comments of respondents to numerous proposed standards indicated a lack of a common
understanding of the term reliability. Some focused on verifiability or free from material error to
the virtual exclusion of faithful representation.
BC3.24 Because attempts to explain what reliability was intended to mean in this context have proved
unsuccessful, the Board sought a different term that would more clearly convey the intended
meaning. The term faithful representation, the faithful depiction in financial reports of economic
phenomena, was the result of that search. That term encompasses the main characteristics that
the previous frameworks included as aspects of reliability.
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Balancing relevance and representational faithfulness
Ideally, financial information should be both relevant and representationally faithful. However, it is possible
for information to be representationally faithful, but not very relevant, or the other way around. Such
information would, in this case, not be deemed to be useful. As we have previously indicated, paragraph
QC17 of the conceptual framework states:
Information must be both relevant and faithfully represented if it is to be useful. Neither a faithful
representation of an irrelevant phenomenon nor an unfaithful representation of a relevant phenomenon
helps users make good decisions.
For example, while we might be able to quote the acquisition cost of a building reliably (perhaps we have
the details of the original contracts and related payments), how relevant would such information be if the
building was acquired in 1970? If available, a current valuation of the building might be more relevant.
However, until such time as the building is sold, we might not know the amount that would actually be
generated on sale. That is, the valuation might not be very reliable or provide a faithful representation of
the underlying value (of course, we could try to make it more representationally faithful by obtaining a
number of valuations and possibly taking an average). There is often a trade-off between relevance and
representational faithfulness. For example, the earlier we can obtain the financial performance results of an
entity, the more relevant the information will be in assessing that entity’s performance. However, to
increase the representational faithfulness of the data, we might prefer to use financial information that has
been the subject of an independent audit (therefore, for example, reducing the likelihood of error). The
resultant increase in representational faithfulness, or reliability, will mean that we will not receive the
information for perhaps 10 weeks after the financial year end, at which point the information will not be
quite as relevant because of its ‘age’. Therefore, there can, in practice, be a matter of balancing one against
the other. However, if the data or information severely lacks one of the characteristics of relevance or
faithful representation, then that information should not be provided to financial statement readers.
Another consideration that needs to be addressed when deciding whether to disclose particular information
is the potential costs of producing relevant and representationally faithful information, relative to the
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associated benefits. In relation to costs, paragraph QC35 of the conceptual framework states:
Cost is a pervasive constraint on the information that can be provided by financial reporting. Reporting
financial information imposes costs, and it is important that those costs are justified by the benefits of
reporting that information. There are several types of costs and benefits to consider.
In considering the associated benefits of financial reporting, paragraphs QC38 and 39 of the conceptual
framework state:
QC38
In applying the cost constraint, the Board assesses whether the benefits of reporting particular
information are likely to justify the costs incurred to provide and use that information. When applying
the cost constraint in developing a proposed financial reporting standard, the Board seeks information
from providers of financial information, users, auditors, academics and others about the expected
nature and quantity of the benefits and costs of that standard. In most situations, assessments are
based on a combination of quantitative and qualitative information.
QC39
Because of the inherent subjectivity, different individuals’ assessments of the costs and benefits of
reporting particular items of financial information will vary. Therefore, the Board seeks to consider
costs and benefits in relation to financial reporting generally, and not just in relation to individual
reporting entities. That does not mean that assessments of costs and benefits always justify the same
reporting requirements for all entities. Differences may be appropriate because of different sizes of
entities, different ways of raising capital (publicly or privately), different users’ needs or other factors.
Hence, while it can be a difficult exercise balancing the costs and benefits associated with particular
disclosures, and related regulations, there is a general principle that the benefits derived from information
should exceed the cost of providing it. This principle will be considered by the IASB when new accounting
standards are being developed.
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Comparability
As we indicated previously, apart from the two fundamental qualitative characteristics of relevance and
faithful representation, there are also four ‘enhancing qualitative characteristics’. These enhancing
qualitative characteristics are comparability, verifiability, timeliness and understandability and each of these
qualitative characteristics is assumed to likely enhance the usefulness of information that is both relevant
and faithfully represented. As paragraph QC4 of the conceptual framework states:
If financial information is to be useful, it must be relevant and faithfully represent what it purports to
represent. The usefulness of financial information is enhanced if it is comparable, verifiable, timely and
understandable.
In relation to the enhancing qualitative characteristic of ‘comparability’, to facilitate the comparison of the
financial statements of different entities (and that of the financial statements of a single entity over time),
methods of measurement and disclosure must be consistent, but should be changed if no longer relevant to
an entity’s circumstances. Drawing on studies by Loftus (2003) and Booth (2003), Wells (2003) argues that
a key role of a conceptual framework should be to produce consistent accounting standards that lead to
comparable accounting information between different entities, as without such comparability it would be
difficult for users to evaluate accounting information.
Desirable characteristics such as comparability therefore imply that there are advantages in restricting the
number of accounting methods that can be used by reporting entities. However, other academics have
argued that steps that result in fewer accounting methods available for use by reporting entities lead
potentially to reductions in the efficiency with which organisations operate (Watts & Zimmerman 1986). For
example, management might elect to use a particular accounting method because it believes that for its
particular and perhaps unique circumstances that method best reflects the entity’s underlying performance
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(even though no other entity might use the accounting method in question). Restricting the use of such a
method might credibly be held to result in a reduction in the efficiency with which external parties can
monitor the performance of the entity, and this in itself has been assumed to lead to increased costs for the
reporting entity (this ‘efficiency perspective’, which has been applied in Positive Accounting Theory, is
explored in Chapter 3
).
If it is assumed, consistent with the efficiency perspective briefly mentioned here, that firms adopt particular
accounting methods because those methods best reflect the underlying economic performance of the entity,
it is argued by some theorists that the regulation of financial accounting—particularly calls for uniformity in
the use of all accounting methods (which enhances comparability)—imposes unwarranted costs on reporting
entities. For example, if a new accounting standard is released that bans the use of an accounting method
by particular organisations, this will lead to inefficiencies, as the resulting financial statements will no longer
provide the best reflection of the performance of those organisations. Many theorists would argue that
management is best able to select the appropriate accounting methods in given circumstances and that
government and/or others should not intervene by introducing a ‘one-size-fits-all’ accounting standard.
Arguments for and against regulation were provided in Chapter 1 . Obviously, the people in charge of
developing conceptual frameworks that include comparability as a key qualitative characteristic must believe
that the benefits of restricting the number of allowable methods outweigh the potential reductions in
efficiency that some organisations may experience as a consequence of their managers not being free to
select what they consider to be the most appropriate accounting method.
Verifiability
Verifiability refers to the ability, through consensus among measurers, to ensure that information represents
what it purports to represent, or that the chosen method of measurement has been used without error or
bias. In relation to the enhancing qualitative characteristic of verifiability, paragraph QC26 of the conceptual
framework states:
Verifiability helps assure users that information faithfully represents the economic phenomena it purports
to represent. Verifiability means that different knowledgeable and independent observers could reach
consensus, although not necessarily complete agreement, that a particular depiction is a faithful
representation. Quantified information need not be a single point estimate to be verifiable. A range of
possible amounts and the related probabilities can also be verified.
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Timeliness
A third ‘enhancing’ qualitative characteristic is ‘timeliness’. The more ‘timely’ (or up-to-date) that financial
information is, the more useful it will be. As paragraph QC29 of the conceptual framework states:
Timeliness means having information available to decision-makers in time to be capable of influencing their
decisions. Generally, the older the information is the less useful it is. However, some information may
continue to be timely long after the end of a reporting period because, for example, some users may need
to identify and assess trends.
Understandability
The fourth and final ‘enhancing’ qualitative characteristic is ‘understandability’, the view being that for
information to be useful it obviously needs to be understandable to the users. In the conceptual framework,
information is considered to be understandable if it is likely to be understood by users with some business
and accounting knowledge (as discussed earlier). However, this does not mean that complex information
that is relevant to economic decision making should be omitted from the financial statements just because it
might not be understood by some users. As paragraph QC32 of the conceptual framework states:
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Financial reports are prepared for users who have a reasonable knowledge of business and economic
activities and who review and analyse the information diligently. At times, even well-informed and diligent
users may need to seek the aid of an adviser to understand information about complex economic
phenomena.
Given that conceptual frameworks have been developed in large part to guide accounting standard-setters
in the setting of accounting rules (rather than as a set of rules to which entities must refer when compiling
their financial statements), this qualitative characteristic of understandability is perhaps best seen as a
requirement (or challenge) for standard-setters to ensure that the accounting standards they develop for
dealing with complex areas produce accounting disclosures that are understandable (irrespective of the
complexity of the underlying transactions or events). Based on your knowledge of accounting practice, how
successful do you think accounting standard-setters have been at meeting this challenge?
Definition and recognition of the elements of financial
statements
The previous discussion has addressed the objectives of general purpose financial reporting as well as the
qualitative characteristics expected of financial information. The Exposure Draft of the Conceptual
Framework for Financial Reporting released by the IASB in May 2015 signalled that no real changes are
being made to this area relative to the conceptual framework released in 2010. However, there are some
potentially significant changes being proposed in relation to the definitions and elements of financial
statements. In this section of the chapter we will consider the existing conceptual framework definitions and
recognition criteria after which we will then consider the recommendations included within the 2015
Exposure Draft.
The definition and recognition of the elements of accounting are incorporated in Chapter 4
of the
Conceptual Framework for Financial Reporting as released in 2010. This material was taken directly from the
previous IASB Framework for the Preparation and Presentation of Financial Statements, hence there were
no recent changes in how the elements of accounting are defined and are to be recognised. Nevertheless, as
we noted above, future changes in definitions and recognition criteria are highly probable.
Different approaches can be applied to determining profits (income less expenses). Two such approaches
are commonly referred to as the asset/liability approach and the revenue/expense approach. The
asset/liability approach links profit to changes that have occurred in the assets and liabilities of the reporting
entity, whereas the revenue/expense approach tends to rely on concepts such as the matching principle,
which is very much focused on actual transactions and which gives limited consideration to changes in the
values of assets and liabilities. Most conceptual framework projects, including the IASB conceptual
framework, adopted the asset/liability approach. Within these frameworks the task of defining the elements
of financial statements must start with definitions of assets and liabilities, as the definitions of all the other
elements flow from these. This should become apparent as we consider each of the elements of accounting
in what follows. In relation to the ‘asset and liability view’ of profit determination, the FASB and
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IASB (2005, pp. 7 and 8) state:
In both [FASB and IASB] frameworks, the definitions of the elements are consistent with an ‘asset and
liability view’, in which income is a measure of the increase in the net resources of the enterprise during a
period, defined primarily in terms of increases in assets and decreases in liabilities. That definition of
income is grounded in a theory prevalent in economics: that an entity’s income can be objectively
determined from the change in its wealth plus what it consumed during a period (Hicks, pp. 178–9, 1946).
That view is carried out in definitions of liabilities, equity, and income that are based on the definition of
assets, that is, that give ‘conceptual primacy’ to assets. That view is contrasted with a ‘revenue and
expense view’, in which income is the difference between outputs from and inputs to the enterprise’s
earning activities during a period, defined primarily in terms of revenues (appropriately recognized) and
expenses (either appropriately matched to them or systematically and rationally allocated to reporting
periods in a way that avoids distortion of income).... Some recent critics advocate a shift back to the
revenue and expense view. However, in a recent study about principles-based standards, mandated by the
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2002 Sarbanes-Oxley legislation, the U.S. Securities and Exchange Commission said the following:
‘ ...the revenue/expense view is inappropriate for use in standard-setting—particularly in an objectivesoriented regime ... Historical experience suggests that the asset/liability approach most appropriately
anchors the standard-setting process by providing the strongest conceptual mapping to the underlying
economic reality (page 30).
... the FASB should maintain the asset/liability view in continuing its move to an objectives-oriented
standard-setting regime (page 42).’
Five elements of financial statements are defined in the conceptual framework: assets, liabilities, expenses,
income and equity. We will consider each of these in turn, but notice, once again, as the discussion
proceeds, how the definitions of expenses and income depend directly on the definitions given to assets and
liabilities.
Definition and recognition of assets
The conceptual framework currently defines an asset as ‘a resource controlled by the entity as a result of
past events and from which future economic benefits are expected to flow to the entity’. This definition
identifies three key characteristics:
1. There must be a future economic benefit.
2. The reporting entity must control the future economic benefits.
3. The transaction or other event giving rise to the reporting entity’s control over the future economic
benefits must have occurred.
Future economic benefits can be distinguished from the source of the benefit—a particular object or
right. The definition refers to the benefit and not the source. Thus whether an object or right is disclosed as
an asset will be dependent upon the likely economic benefits flowing from it. In the absence of expected
future economic benefits, the object should not be disclosed as an asset. Rather, the expenditure might be
construed as an expense. As the conceptual framework states (paragraph 4.14):
There is a close association between incurring expenditure and generating assets but the two do not
necessarily coincide. Hence, when an entity incurs expenditure, this may provide evidence that future
economic benefits were sought but is not conclusive proof that an item satisfying the definition of an asset
has been obtained.
Therefore, cash is an asset owing to the benefits that can flow as a result of the purchasing power it
generates. A machine is an asset to the extent that economic benefits are anticipated to flow from using it.
The conceptual frameworks does not require an item to have a value in exchange before it can be
recognised as an asset. The economic benefits may result from its ongoing use (often referred to as valuein-use) within the organisation.
As indicated in the above definition of an asset, a resource must be controlled before it can be
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considered to be an ‘asset’. Control relates to the capacity of a reporting entity to benefit from an
asset and to deny or regulate the access of others to the benefit. The capacity to control would normally
stem from legal rights. However, legal enforceability is not a prerequisite for establishing the existence of
control. Hence it is important to realise that control, and not legal ownership, is required before an asset can
be shown within the body of an entity’s balance sheet (statement of financial position). Frequently,
controlled assets are owned, but this is not always the case. Organisations often disclose leased assets as
part of their total assets. For example, the 2015 consolidated balance sheet of Qantas includes leasehold
improvements (carrying amount of $539 million) and leased aircraft and engines (carrying amount of $1 796
million). In relation to control, the conceptual framework (paragraph 4.12) states:
Many assets, for example, receivables and property, are associated with legal rights, including the right of
ownership. In determining the existence of an asset, the right of ownership is not essential; thus, for
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example, property held on a lease is an asset if the entity controls the benefits which are expected to flow
from the property. Although the capacity of an entity to control benefits is usually the result of legal rights,
an item may nonetheless satisfy the definition of an asset even when there is no legal control. For
example, know-how obtained from a development activity may meet the definition of an asset when, by
keeping that know-how secret, an entity controls the benefits that are expected to flow from it.
In relation to ‘control’, it follows from the requirement that the relevant transaction must already have
occurred that future economic benefits that are not currently controlled are not to be recognised in the
statement of financial position.
There are many resources that generate benefits for an entity but that should not be recorded owing to the
absence of control. For example, the use of the road system generates economic benefits for an entity.
However, because the entity does not control the roads, they do not constitute assets of the entity.
Similarly, particular waterways will provide economic benefits to entities, but to the extent that such entities
do not control the waterways, they are not assets of those entities.
In addition to defining an asset, we also need to consider when we should recognise the existence of an
asset. According to the conceptual framework, ‘recognition is the process of incorporating in the balance
sheet or income statement an item that meets the definition of an element and satisfies the criteria for
recognition’.
In relation to the recognition criteria, the conceptual framework (paragraph 4.38) provides general
recognition criteria for all five elements of financial statements (assets, liabilities, income, expenses and
equity), these being:
An item that meets the definition of an element should be recognised if:
(a)
it is probable that any future economic benefit associated with the item will flow to or from the
entity; and
(b)
the item has a cost or value that can be measured with reliability.
Hence, for all of the five elements of financial accounting, both probability and measurability are key
considerations. Paragraph 4.44 of the conceptual framework specifically addresses the recognition of assets.
Consistent with the general recognition criteria provided above, paragraph 4.44 provides that:
An asset is recognised in the balance sheet when it is probable that the future economic benefits will flow
to the entity and the asset has a cost or value that can be measured reliably.
Again, we can see from the above requirements that the determination of ‘probable’ is central to the
recognition criteria applied to the elements of financial statements. Unfortunately, however, the conceptual
framework does not define ‘probable’. For guidance we can refer to the superseded SAC 4. Paragraph 40 of
SAC 4 defined ‘probable’ as ‘more likely rather than less likely’. If an asset (or another element of financial
statements) fails to meet the recognition criteria in one period but satisfies them in another period, the
asset can be reinstated (subject to requirements in particular accounting standards). As paragraph 4.42 of
the conceptual framework states:
An item that, at a particular point in time, fails to meet the recognition criteria in paragraph 4.38, may
qualify for recognition at a later date as a result of subsequent circumstances or events.
However, it is worth emphasising that while this is a general requirement, the ability to reinstate
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assets that have been written off will not be available for all assets. Some accounting standards
preclude the reinstatement of assets, regardless of whether or not they are subsequently deemed likely to
generate future economic benefits. As we have shown, in the hierarchy of rules, accounting standards
override the conceptual framework. As an example of a prohibition on reinstating assets we can consider the
requirements of AASB 138 Intangible Assets and its requirements in relation to any moves to reinstate
previously written-off intangible assets. Specifically, paragraph 71 of AASB 138 states ‘expenditure on an
intangible item that was initially recognised as an expense shall not be recognised as part of the cost of an
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intangible asset at a later date’.
While the above definition of an asset is the definition that currently must be used within countries that
have adopted IFRS (such as Australia), it should be noted that this definition will most likely change in
future years. Given the central importance of the definition of assets to financial reporting, any change to it
will conceivably have broad implications for financial reporting. In relation to work being undertaken by the
IASB, the IASB released, in March 2015, a document entitled IASB Staff Paper: Effect of Board
Redeliberations on Discussion Paper—A Review of the Conceptual Framework for Financial Reporting, which
noted that the existing definition of assets has a number of potential shortcomings. The IASB noted the
following (IASB 2015a, p.3):
The IASB believes that the definitions of assets and liabilities could be clarified. They contain references
to expected inflows or outflows of economic benefits. Some have interpreted these references as
implying that the asset or the liability is the ultimate inflow or outflow of economic benefits, rather than
the underlying resource or obligation. To avoid misunderstandings, the IASB’s preliminary view is that it
should amend the definitions to confirm more explicitly that:
(a)
an asset (or a liability) is the underlying resource (or obligation), rather than the ultimate inflow (or
outflow) of economic benefits; and
(b)
an asset (or a liability) must be capable of generating inflows (or outflows) of economic benefits.
Those inflows (or outflows) need not be certain.
On 21 May 2014, the IASB tentatively decided that:
(a)
Assets should be viewed as rights, or bundles of rights, rather than underlying physical or other
objects. The IASB noted that in many cases an entity would account for an entire bundle of rights as a
single asset, and describe that asset as the underlying object. An entity would account separately for rights
within a bundle only when needed to provide a relevant and faithful representation, at a cost that does not
exceed the benefits.
(b)
The reference to future economic benefits should be placed in a supporting definition (of an
economic resource), rather than in the definitions of an asset and of a liability.
(c)
The definition of an economic resource should not include the notion of ‘other source of value’ that
was suggested in the Discussion Paper. The guidance supporting the definition of an economic resource
should confirm that the notion of a ‘right’ is broad enough to capture any know-how that is controlled by
keeping it secret.
(d)
The term ‘present’ should be retained in the definition of a liability and, as proposed in the
Discussion Paper, should be added to the definition of an asset.
(e)
The phrase ‘as a result of past events’ should be retained in both the definition of an asset and the
definition of a liability.
On 21 May 2014, the IASB also discussed the role of uncertainty in the definitions of an asset and of a
liability and tentatively decided that:
(a)
The definitions of assets and liabilities should not retain the notion that an inflow or outflow needs
to be ‘expected’.
(b)
The definition of an economic resource should, as proposed in the Discussion Paper, specify that an
economic resource must be capable of generating economic benefits. The term ‘capable’ indicates that the
economic benefits must arise from some feature that already exists within the economic resource. The
term ‘capable’ is not intended to impose a minimum probability threshold, but rather to indicate that, in at
least some outcomes, the economic resource will generate economic benefits.
(c)
The notion ‘is capable of’ should not appear explicitly in the proposed definition of a liability. The
supporting guidance should clarify that an obligation must contain an existing feature that is capable of
requiring the entity to transfer an economic resource.
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To reflect the decisions above, the draft definitions are now as follows:
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(a)
an asset is a present economic resource controlled by the entity as a result of past events
(b)
a liability is a present obligation of the entity to transfer an economic resource as a result of past
events; and
(c)
an economic resource is a right that is capable of producing economic benefits.
On 21 January 2015, the IASB tentatively decided to replace the term ‘is capable of’ with the term ‘has
the potential to’ in the definition of an economic resource. This change is not intended to alter the
meaning of the definition of an economic resource. The Exposure Draft will define an economic resource
as follows:
An economic resource is a right that has the potential to produce economic benefits.
When the IASB released its Exposure Draft of the Conceptual Framework for Financial Reporting in May
2015, the above proposals were incorporated therein. Whether the proposals within the Exposure Draft will
ultimately form part of a revised conceptual framework is not something about which we can be sure. The
IASB sought comments on the Exposure Draft and will take these into account before releasing a revised
conceptual framework. However, what we need to appreciate is that given that the definitions of other
elements of accounting (equity, income and expenses) rely directly upon the definition of assets, any
change to the definition of assets, and the associated recognition criteria, will potentially have very
significant impacts on general purpose financial reporting.
Definition and recognition of liabilities
The conceptual framework currently presently defines a liability as ‘a present obligation of the entity
arising from past events, the settlement of which is expected to result in an outflow from the entity of
resources embodying economic benefits’. As for the definition of assets, three key characteristics are
identified in the definition of liabilities:
1. There must be an expected future disposition of economic benefits to other entities.
2. There must be a present obligation.
3. A past transaction or other event must have created the obligation.
As indicated, the present definition of a liability does not restrict ‘liabilities’ to situations where there is a
legal obligation. Liabilities should also be recognised in certain situations where equity or usual business
practice dictates that obligations to external parties currently exist. As the IASB conceptual framework
states:
An essential characteristic of a liability is that the entity has a present obligation. An obligation is a duty or
responsibility to act or perform in a certain way. Obligations may be legally enforceable as a consequence
of a binding contract or statutory requirement. This is normally the case, for example, with amounts
payable for goods and services received. Obligations also arise, however, from normal business practice,
custom and a desire to maintain good business relations or act in an equitable manner. If, for example, an
entity decides as a matter of policy to rectify faults in its products even when these become apparent after
the warranty period has expired, the amounts that are expected to be expended in respect of goods
already sold are liabilities.
Hence the liabilities that appear within an entity’s statement of financial position might include obligations
that are legally enforceable as well as obligations that are deemed to be equitable or constructive. When
determining whether a liability exists, the intentions or actions of management need to be taken into
account. That is, the actions or representations of the entity’s management or governing body, or changes
in the economic environment, directly influence the reasonable expectations or actions of those outside the
entity and, although they have no legal entitlement, they might have other sanctions that leave the entity
with no realistic alternative but to make certain future sacrifices of economic benefits. Such present
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obligations are sometimes called ‘equitable obligations’ or ‘constructive obligations’. An equitable obligation
is governed by social or moral sanctions or custom rather than legal sanctions. A constructive obligation is
created, inferred or construed from the facts in a particular situation rather than contracted by agreement
with another entity or imposed by government.
Determining whether an equitable or a constructive obligation exists—and therefore whether a liability
should be recognised in the balance sheet (the statement of financial position)—is often more difficult than
identifying a legal obligation, and in most cases judgement is required to determine if an equitable or a
constructive obligation exists. One consideration is whether the entity has any realistic alternative to making
the future sacrifice of economic benefits. If the situation implies that there is no discretion, then a liability
would be recognised. In cases where the entity retains discretion to avoid making any future sacrifice of
economic benefits, a liability does not exist and is not recognised. It follows that a decision of the
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entity’s management or governing body, of itself, is not sufficient for the recognition of a liability.
Such a decision does not mark the inception of a present obligation since, in the absence of something
more, the entity retains the ability to reverse the decision and thereby avoid the future sacrifice of economic
benefits. For example, an entity’s management or governing body may resolve that the entity will offer to
repair a defect it has recently discovered in one of its products, even though the nature of the defect is such
that the purchasers of the product would not expect the entity to do so. Until the entity makes public that
offer, or commits itself in some other way to making the repairs, there is no present obligation, constructive
or otherwise, beyond that of satisfying the existing statutory and contractual rights of customers.
Requiring liability recognition to be dependent upon there being a present obligation to other entities has
implications for the disclosure of various provision accounts, for example, ‘Provision for maintenance’.
Generally accepted accounting practice in some countries had traditionally required such amounts to be
disclosed as a liability, even though it does not involve an obligation to an external party. This issue is
partially addressed in paragraph 4.19 of the conceptual framework. It states:
... when a provision involves a present obligation and satisfies the rest of the definition, it is a liability even
if the amount has to be estimated. Examples include provisions for payments to be made under existing
warranties and provisions to cover pension obligations.
Thus, the conceptual framework requires estimated (and therefore uncertain) present obligations, which
have resulted from past events and are likely to result in an outflow of economic resources, to be treated as
liabilities. Provisions for maintenance, overhaul and the like would not be considered to be liabilities of a
reporting entity because of the absence of an obligation to an external entity.
The recognition criteria for liabilities are consistent with those for assets. Paragraph 4.46 of the conceptual
framework provides that:
A liability is recognised in the balance sheet when it is probable that an outflow of resources embodying
economic benefits will result from the settlement of a present obligation and the amount at which the
settlement will take place can be measured reliably.
As with the other elements of accounting, probability with respect to liabilities means ‘more likely than less
likely’. Hence, if Company A is assessed as having a 49 per cent probability of having to pay $100 million,
while Company B has a 51 per cent probability of having to pay $1 million, Company A would show no
liabilities on the face of the statement of financial position, while Company B would show $1 million.
However, given the amount involved and the relatively high probability of payment, Company A would be
required to disclose information about the potential obligation in the notes to its financial statements (shown
as a contingent liability).
Apart from the consideration of probabilities, where a liability cannot be reliably measured but is potentially
material the liability should be disclosed within the notes to the financial statements (again, as a
contingent liability).
Requiring liability recognition to be dependent upon there being a present obligation to other entities has
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implications for the disclosure of various provision accounts, such as a provision for maintenance. As
indicated previously, generally accepted accounting practice had typically required such amounts to be
disclosed as a liability, even though they did not involve an obligation to an external party. This practice is
now prohibited by virtue of AASB 137 Provisions, Contingent Liabilities and Contingent Assets. We consider
this standard in depth in Chapter 10
. In Appendix C to AASB 137, the example provided is of a furnace
that has a lining that needs to be replaced every five years for technical reasons. At the end of the reporting
period, the lining has been in use for three years. According to the Appendix, there is no present obligation
and hence no liability would be recognised. It is argued in the Appendix to AASB 137 that:
The cost of replacing the lining is not recognised because, at the end of the reporting period, no obligation
to replace the lining exists independently of the company’s future actions—even the intention to incur the
expenditure depends on the company deciding to continue operating the furnace or to replace the lining.
Instead of a provision being recognised, the depreciation of the lining takes account of its consumption,
that is, it is depreciated over five years. The re-lining costs then incurred are capitalised with the
consumption of each new lining shown by depreciation over the subsequent five years.
As we have already discussed, the IASB has recently suggested a revised definition of a liability,
this being:
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a liability is a present obligation of the entity to transfer an economic resource as a result of past events.
Again, as with the proposed change to the definition of assets, the suggested change to the definition of
liability could potentially have significant implications for financial reporting if it was ultimately incorporated
within the revised conceptual framework. But whether the above proposed definition ultimately becomes
part of the revised conceptual framework is a matter for debate.
Definition and recognition of expenses
The definition of expenses is dependent upon the definitions given to assets and liabilities. The conceptual
framework provides a definition for expenses. It states:
Expenses are decreases in economic benefits during the accounting period in the form of outflows or
depletions of assets or incurrences of liabilities that result in decreases in equity, other than those relating
to distributions to equity participants.
Therefore, unless we understand what assets and liabilities are, we will not be able to understand what an
expense is. Expenses may be considered to be transactions or events that cause reductions in the net assets
or equity of the reporting entity, other than those caused by distributions to the owners. The usual tests
relating to ‘probability’ and ‘measurability’ apply—as they do to all elements of financial statements. In
relation to expense recognition, the conceptual framework states:
Expenses are recognised in the income statement when a decrease in future economic benefits related to a
decrease in an asset or an increase of a liability has arisen that can be measured reliably. This means, in
effect, that recognition of expenses occurs simultaneously with the recognition of an increase in liabilities
or a decrease in assets (for example, the accrual of employee entitlements or the depreciation of
equipment).
If a resource is used up or damaged by an entity but that entity does not control the resource—that is, it is
not an asset of the entity—then to the extent that no liabilities or fines are imposed, no expenses will be
recorded by the entity. For example, if an entity pollutes the environment but incurs no related fines, no
expense will be acknowledged because ‘the environment’ is not controlled by the entity. This issue will be
examined further later in this chapter. It is also addressed in Chapter 32.
Definition and recognition of income
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As with expenses, the definition of income is dependent upon the definitions given to assets and liabilities.
The conceptual framework defines income as:
increases in economic benefits during the accounting period in the form of inflows or enhancements of
assets or decreases of liabilities that result in increases in equity, other than those relating to contributions
from equity participants.
Income can therefore be considered to relate to transactions or events that cause an increase in the net
assets of the reporting entity, other than increases in net assets that arise as a result of owner
contributions.
Income can be recognised from normal trading relations, as well as from non-reciprocal transfers such as
grants, donations, bequests or where liabilities are forgiven. Consistent with the recognition of all elements
of financial statements, income is to be recognised when, and only when:
(a)
it is probable that the inflow or other enhancement or saving in outflows of future economic benefits
has occurred; and
(b) the inflow or other enhancement or saving in outflows of future economic benefits can be measured
reliably.
Elaborating on the recognition of income, paragraph 4.47 of the conceptual framework states:
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Income is recognised in the income statement when an increase in future economic benefits related to an
increase in an asset or a decrease of a liability has arisen that can be measured reliably. This means, in
effect, that recognition of income occurs simultaneously with the recognition of increases in assets or
decreases in liabilities (for example, the net increase in assets arising on a sale of goods or services or the
decrease in liabilities arising from the waiver of a debt payable).
It should be noted that the conceptual framework currently draws a distinction between ‘revenues’ and
‘gains’. The category of ‘income’ consists of both revenues and gains. Under the conceptual framework,
‘revenue’ arises in the course of the ordinary activities of an entity and is referred to by a variety of
different names, including sales, fees, interest, dividends, royalties and rent. ‘Gains’ represent other items
that meet the definition of income and might, or might not, arise in the course of the ordinary activities of
an enterprise. Gains include, for example, those arising on the disposal of non-current assets. Some
measure of professional judgement will be involved in determining whether a component of income should
be classified as ‘revenue’ or as a ‘gain’.
Revenue is obviously a crucial number to users of the financial statements in assessing a reporting entity’s
performance and prospects. The IASB and the FASB together initiated a joint project to clarify the principles
for recognising revenue from ‘contracts with customers’. It applied to all contracts with customers except
leases, financial instruments and insurance contracts. As part of the project, an Exposure Draft Revenue
from Contracts with Customers was released in November 2011. This ultimately culminated in the release in
2014 of IFRS 15 Revenue from Contracts with Customers, which has the Australian equivalent of AASB 15.
While this Accounting Standard is discussed in depth in Chapter 15
of this book, at this point we can
summarise that the Accounting Standard incorporates the view that revenue recognition should be
consistent with the conceptual framework guidance and should incorporate the notion of ‘control’. That is,
revenue recognition should be a direct function of whether goods and services have been transferred to the
control of the customer (and not be a function of who holds the risks and rewards of ownership of the
asset—something that has been adopted in some accounting standards as the basis for determining whether
revenue should be recognised). As paragraph 31 of AASB 15 states:
an entity shall recognise revenue when (or as) the entity satisfies a performance obligation by transferring
a promised good or service (ie an asset) to a customer. An asset is transferred when (or as) the customer
obtains control of the asset.
Therefore, an entity satisfies performance obligations, and recognises revenue, when the customer receives
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the promised goods and services. Revenue reflects the transfer of the goods and services to customers, and
not the underlying activities of the entity in producing those goods and services.
As with assets and liabilities (as previously discussed), the IASB intends to make changes to the definitions
of income and expenses. The Exposure Draft released by the IASB in May 2015 provides the following
definitions:
Income is increases in assets or decreases in liabilities that result in increases in equity, other than those
relating to contributions from holders of equity claims.
Expenses are decreases in assets or increases in liabilities that result in decreases in equity, other than
those relating to distributions to holders of equity claims.
These definitions do seem clearer than the current definitions and in themselves do not represent major
changes from the current definitions. The major changes in income and expenses, however, relate to how
the IASB has changed the definition of assets and liabilities. The IASB has also proposed that the discussion
of income should no longer refer to revenue and gains, and the discussion of expenses should no longer
refer to expenses and losses. Of course, whether the recommendations will subsequently be incorporated
within the conceptual framework cannot be known with certainty.
Definition of equity
Paragraph 49(c) of the IASB conceptual framework defines equity as ‘the residual interest in the assets of
the entity after deducting all its liabilities’. The residual interest is a claim or right to the net assets of the
reporting entity. As a residual interest, equity ranks after liabilities in terms of a claim against the assets of
a reporting entity. Consistent with the definitions of income and expenses, the definition of equity Page 73
is directly a function of the definitions of assets and liabilities. Given that equity represents a
residual interest in the assets of an entity, the amount disclosed as equity will correspond with the
difference between the amounts assigned to assets and liabilities. As such, the criteria for the recognition of
assets and liabilities, in turn, directly govern the recognition of equity. Therefore, there is no need for a
separate recognition criterion for equity.
The definition of equity is not expected to change when a revised conceptual framework is released.
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Measurement principles
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Measurement principles
LO 2.11
Conceptual frameworks have tended to provide very limited
prescription in relation to measurement issues. Assets and
liabilities are often measured in a variety of ways depending
upon the class of assets or liabilities being considered and,
given the way income and expenses are defined—which relies
upon measures attributed to assets and liabilities—then, this
has direct implications for reported profits. For example,
liabilities are frequently recorded at present value, face value
or on some other basis, depending upon the type of liability in
question. Assets are measured in various ways—for example,
inventory is to be measured at the lower of cost and net
realisable value; some non-current assets such as property,
plant and equipment can be measured at historical cost less
accumulated depreciation or can also be measured at fair
value; while other assets such as financial assets are to be
measured at fair value. The multiplicity of measurement
principles currently in use has resulted in us using what is
often referred to as a ‘mixed attribute accounting model’. This
is despite the efforts of many accounting standard-setters and
accounting researchers who, over the years, have argued that
it would be more conceptually sound for a single basis of
measurement to be applied—for example, measuring all assets
based on fair values.
Measurement questions or issues appeared to represent a
stumbling block in the development of the FASB conceptual
framework. While the FASB framework was initially promoted
as being prescriptive, when SFAC 5 was issued in 1984 the
FASB appeared to sidestep the difficult measurement issues,
with the statement ending up merely describing various
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approaches to measuring the elements of accounting. SFAC 5
notes that generally five alternative measurement bases are
applied in practice: historical cost, current replacement cost,
current market value, net realisable value and present value. A
descriptive approach such as this was generally considered to
represent a ‘cop-out’ on the part of the FASB (Solomons
1986). The IASB conceptual framework explicitly recognises
the same variety of acceptable measurement bases as the
FASB framework, with the exception of current market value
(which could be regarded as comprising elements of current
replacement cost and net realisable (sale) value).
As we know, the IASB and the FASB were engaged in joint
efforts to develop a new, refined conceptual framework. In
relation to measurement, the FASB and IASB (2005, p. 12)
stated:
Measurement is one of the most underdeveloped areas of the
two frameworks … Both frameworks (the IASB and FASB
Frameworks) contain lists of measurement attributes used in
practice. The lists are broadly consistent, comprising historical
cost, current cost, gross or net realizable (settlement) value,
current market value, and present value of expected future
cash flows. Both frameworks indicate that use of different
measurement attributes is expected to continue. However,
neither provides guidance on how to choose between the
listed measurement attributes or consider other theoretical
possibilities. In other words, the frameworks lack fully
developed measurement concepts … The long-standing
unresolved controversy about which measurement attribute
to adopt—particularly between historical-price and currentprice measures—and the unresolved puzzle of unit of account
are likely to make measurement one of the most challenging
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parts of this project.
At present, assets and liabilities are measured in a variety of
ways, depending on the class of assets or liabilities being
considered. In relation to assets, there are various ways in
which these can be measured—on the basis of historical costs,
current replacement costs, current selling prices, present value
and so forth.
When the IASB released its Discussion Paper–A Review of the
Conceptual Framework for Financial Reporting in July 2013, it
defined ‘measurement’ as (p. 106):
the process of determining the amounts to be included in the
financial statements. The term ‘measures’ refers to the
amounts presented or disclosed.
In relation to its current thinking, IASB (2013, p. 112) Page 74
stated:
Consideration of the objective of financial reporting, and of
the qualitative characteristics of useful financial information,
has led the IASB to the following preliminary views about
measurement:
(a)
the objective of measurement is to contribute to the
faithful representation of relevant information about the
resources of the entity, claims against the entity and changes
in resources and claims, and about how efficiently and
effectively the entity’s management and governing board
have discharged their responsibilities to use the entity’s
resources
(b)
a single measurement basis for all assets and liabilities
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may not provide the most relevant information for users of
financial statements
(c)
when selecting the measurement to use for a
particular item, the IASB should consider what information
that measurement will produce in both the statement of
financial position and the statement(s) of profit or loss and
other comprehensive income
(d)
the selection of a measurement:
(i)
for a particular asset should depend on how that
asset contributes to future cash flows; and
(ii)
for a particular liability should depend on how
the entity will settle or fulfil that liability
(e)
the number of different measurements used should be
the smallest number necessary to provide relevant
information. Unnecessary measurement changes should be
avoided and necessary measurement changes should be
explained
(f)
the benefits of a particular measurement to users of
financial statements need to be sufficient to justify the cost.
When the IASB released its Exposure Draft of the Conceptual
Framework for Financial Reporting in May 2015 it defined
measurement as:
the process of quantifying, in monetary terms, information
about an entity’s assets, liabilities, equity, income and
expenses. A measure is the result of measuring an asset, a
liability, equity or an item of income or expense on a specified
measurement basis. A measurement basis is an identified
feature of an item being measured (for example, historical
cost, fair value or fulfilment value). Applying a measurement
basis to an asset or a liability creates a measure for that
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asset or liability and for any related income or expense.
The Exposure Draft grouped measurement bases into two
broad categories, these being:
(a)
historical cost; or
(b)
current value.
In terms of the factors to consider when selecting a
measurement basis, the Exposure Draft noted:
For information provided by a particular measurement basis
to be useful to the users of financial statements, it must be
relevant and it must faithfully represent what it purports to
represent. In addition, the information provided should, as far
as possible, be comparable, verifiable, timely and
understandable.
As with all other areas of financial reporting, cost constrains
the selection of a measurement basis. Hence, the benefits of
the information provided to the users of financial statements
by a particular measurement basis must be sufficient to
justify the cost of providing that information.
Again, as with the definitions of the elements of accounting,
the IASB’s ultimate decisions in relation to measurement has
the potential to have major implications for the reported
financial performance and financial position of reporting
entities.
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A critical review of conceptual frameworks
Page 1 of 9
A critical review of conceptual frameworks
LO 2.13
Having reviewed some of the documents that comprise the
conceptual framework together with information about current
efforts being undertaken by the IASB to develop an improved
conceptual framework, it would be useful to consider criticisms
of conceptual frameworks in general. Of course, there will be
many parties who disagree with the points that follow. You will
need to consider the merits of the respective arguments.
Some of the criticisms raised relate to the fundamental
objectives of conceptual frameworks. As we know, according to
the IASB conceptual framework, the objective of general
purpose financial reporting is to ‘provide financial information
about the reporting entity that is useful to existing
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and potential equity investors, lenders and other
creditors in making decisions about providing resources to the
entity’.
From this, it can perhaps be concluded that annual reports
presented by corporations—and these reports would
incorporate general purpose financial statements—should be
primarily economic in focus. Does this mean that social and
environmental issues—such as an organisation’s safety record,
environmental performance, employee training programs and
the like—should not be included in the annual report? If this is
the position taken by those responsible for formulating the
contents of a conceptual framework, it would appear to be
inconsistent with the views espoused by many accounting
academics (for example, Rubenstein 1992; Gray & Bebbington
2001; Gray, Adams & Owen 2014). The dissenting view is that
organisations should be accountable for both their economic
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and their social and environmental performance. Perhaps those
responsible for developing the IASB conceptual framework
believe that evidence of social and environmental
accountability is either not necessary, or perhaps can best be
provided in places other than general purpose financial
statements.
There are many philosophical positions taken in relation to the
general/overall responsibilities of business. The view of famous
economist Milton Friedman—perhaps an extreme one—is that:
there is one and only one social responsibility of business—to
use its resources and engage in activities designed to
increase its profits so long as it stays within the rules of the
game, which is to say, engages in open and free competition
without deception or fraud.
(1962, reported in Mathews 1993, p. 10)
An individual’s view of a business’s responsibilities directly
impacts on his or her perceptions of business accountability.
Those responsible for developing the conceptual framework do
appear to take a restricted view of the accountabilities of
business (with the primary audience being identified as
existing and potential investors, lenders and other creditors)—
which is perhaps not too different from the perspective that
might have been adopted by Friedman.
The Corporate Report (issued in 1975 by the Accounting
Standards Steering Committee of the Institute of Chartered
Accountants in England and Wales) provides what appears to
be a much broader view of the objectives of general purpose
financial reporting and of who should be perceived as a user of
financial statements. The report states in paragraph 25:
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The public’s right to information arises not from a direct
financial or human relationship with the reporting entity but
from the general role played in our society by economic
entities. Such organisations, which exist with the general
consent of the community, are afforded special legal and
operational privileges, they compete for resources of
manpower, materials and energy and they make use of
community owned assets such as roads and harbours.
Being principally economic in focus, general purpose financial
statements typically ignore transactions or events that have
not involved market transactions or an exchange of property
rights. That is, transactions or events that cannot be linked to
a ‘cost’ or a ‘market price’ are not recognised. For example, a
great deal of recent literature has been critical of traditional
financial accounting for its failure to recognise the damage to
the environment caused by business (Gray, Adams & Owen
2014; Deegan 2013). Let us consider a fairly extreme
example. Applying generally accepted accounting principles
(GAAP), if the environmental consequences of a business’s
operations were such that they led to a major reduction in local
water quality—thereby killing all local sea creatures and coastal
vegetation—reported profits would not be directly affected
unless fines or other related cash flows were incurred. That is,
no externalities would be recognised, and the reported
assets/profits of the organisation would not be affected. This is
because the waterways are not controlled by the entity (and
remember, according to the conceptual framework’s definition
of assets, control must be established before something is
deemed to be an asset of an entity), and therefore their use
(or abuse) is not recorded by financial accounting systems.
Adopting conventional financial reporting practices ,
consistent with the conceptual framework, the performance of
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such a polluting organisation could, depending upon the
financial transactions undertaken, be portrayed as being very
successful. In this regard, the view of Gray and Bebbington
(1992, p. 6) is that:
there is something profoundly wrong about a system of
measurement, a system that makes things visible and which
guides corporate and national decisions that can signal
success in the midst of desecration and destruction.
What must be borne in mind by the users of general
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purpose financial statements, however, is that the
financial information included within the financial statements
reflects only the financial performance of the entity as
determined by applying the rules incorporated within relevant
accounting standards: they do not provide a means of
assessing the social or environmental performance of the
entity. This in itself is seen by a number of accounting
researchers to be a fundamental limitation of financial
accounting as typically used in practice.
Following on from the above point, it has been argued that
focusing on economic performance in itself further reinforces
the importance of economic performance relative to various
levels of social and environmental performance. Several writers
such as Hines (1988) and Gray and Bebbington (2001) have
argued that the accounting profession can play a big part in
influencing what forms of social conduct are acceptable to the
broader community. Accounting can both reflect and construct
social expectations. For example, if profits and associated
financial data are promoted as the best measure of
organisational success, it could be argued that both the
organisation and the community will focus on activities that
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affect this measure. If accountants embrace other types of
performance indicators, including those that relate to the
environment and to social factors, this might, conceivably,
raise people’s expectations about organisational performance.
Nevertheless, at present, profitability as determined by the
application of the accounting system is typically used as a
guide to an organisation’s success.
A review of the financial press indicates that they, too,
generally use financial performance indicators as a guide to the
success and health of an organisation. For example, the
respected daily financial paper The Australian Financial Review
each day reports Australian listed companies’ earnings per
share, price–earnings ratio and net asset backing per share. It
also generally provides some commentary when there are
unexpected or major shifts in these indicators. Having said this
about financial performance indicators, it must be
acknowledged that many organisations do provide voluntary
social and environmental disclosures in their annual reports, or
in stand-alone corporate social responsibility or sustainability
reports. This practice of reporting will be considered in greater
depth in Chapter 30 .
Another criticism of conceptual frameworks for accounting is
that they represent simply a codification of existing practice
(Hines 1989), putting in place a series of documents that
describe existing practice rather than prescribing an ‘ideal’ or
logically derived approach to accounting. If the conceptual
framework is considered to represent a codification of GAAPs,
can such principles logically be used as a rationale for selecting
between alternative accounting methods? Perhaps not. In this
regard, it would be interesting to see how different from
existing practices any conceptual framework chapters
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pertaining to measurement issues might be (we currently do
not have one), and whether they would prescribe fundamental
changes to current generally accepted accounting procedures
(GAAPs). History seems to indicate that proposals for major
shifts in current practices are unlikely to succeed. Hines (1989,
p. 79) argues that accounting regulations, as generated by the
accounting regulators, are no more than the residue of a
political process.
An interesting case in point is the US experience in relation to
accounting for the extractive industries. In the USA, firms
involved in the extractive industries were permitted to use two
alternative methods to account for their pre-production costs—
the full-cost method and the successful-efforts method .
In July 1977, the Financial Accounting Standards Board (FASB)
in the USA released an Exposure Draft that recommended that
only the successful-efforts method be used. Ultimately this
became the requirement of Accounting Standard SFAS 19,
which was issued in December 1977. However, this
requirement represented a major departure from the practice
that existed at the time, as many organisations were using the
full-cost method. Following much lobbying and debate, a
revised standard was issued by the Securities and Exchange
Commission that took precedence over SFAS 19. The new
standard allowed organisations to use either the full-cost
method or the successful-efforts method—a return to the
original and preferred position.
As another example of how proposed significant changes to
existing accounting practice will ultimately not be accepted, we
can consider some of the events leading to the development of
the US Conceptual Framework Project. In 1961 and 1962, the
Accounting Research Division of the American Institute of
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Certified Public Accountants (AICPA) commissioned studies by
Moonitz, and by Sprouse and Moonitz respectively. These
researchers proposed that accounting measurement systems
be changed from historical cost to a system based on current
values. However, before the release of the Sprouse and
Moonitz study, the Accounting Principles Board of the AICPA
stated in relation to this study and another Moonitz study that
‘while these studies are a valuable contribution to accounting
principles, they are too radically different from generally
accepted principles for acceptance at this time’ (Statement by
the Accounting Principles Board, AICPA, April 1962).
In 1963, the Accounting Principles Board (APB)
Page 77
commissioned Paul Grady to prepare yet another
framework of accounting. It was published in 1965 and formed
the basis of APB Statement No. 4, Basic Concepts and
Accounting Principles Underlying the Financial Statements of
Business Enterprises. In effect, APB Statement No. 4 reflected
the GAAP of the time. Some years later in the United States,
Miller and Reading (1986, p. 64) noted that:
The mere discovery of a problem is not sufficient to assure
that the FASB will undertake its solution ... There must be a
suitably high likelihood that the Board can resolve the issues
in a manner that will be acceptable to the constituency—
without some prior sense of the likelihood that the Board
members will be able to reach a consensus, it is generally not
advisable to undertake a formal project.
The above argument suggests that conceptual frameworks and
accounting standards are based primarily on the dominant
accounting approaches in use at the time and that the
development of accounting regulation is a political process,
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with unpopular accounting approaches failing to be approved.
If we accept this, then, following Hines (1991), we may
question whether general purpose financial statements can
faithfully represent the activities of an organisation, or whether
reports that follow the accepted framework can be free from
bias—these qualitative characteristics (representational
faithfulness and freedom from bias) are included in the IASB
conceptual framework.
It has been argued that conceptual frameworks have been
used as devices to legitimise the ongoing existence of the
accounting profession. It is argued that they provide a means
of increasing the ability of a profession to self-regulate,
thereby counteracting the possibility of government
intervention. Hines (1991, p. 328) states:
CFs presume, legitimise and reproduce the assumption of an
objective world and as such they play a part in constituting
the social world ... CFs provide social legitimacy to the
accounting profession.
Since the objectivity assumption is the central premise of our
society ... a fundamental form of social power accrues to
those who are able to trade on the objectivity assumption.
Legitimacy is achieved by tapping into this central proposition
because accounts generated around this proposition are
perceived as ‘normal’. It is perhaps not surprising or
anomalous then that CF projects continue to be undertaken
which rely on information qualities such as ‘representational
faithfulness’, ‘neutrality’, ‘reliability’, etc., which presume a
concrete, objective world, even though past CFs have not
succeeded in generating Accounting Standards which achieve
these qualities. The very talk, predicated on the assumption
of an objective world to which accountants have privileged
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access via their ‘measurement expertise’, serves to construct
a perceived legitimacy for the profession’s power and
autonomy.
Hines (1989) suggests that conceptual frameworks have been
developed when accounting professions have been under
threat, and that they are a strategic manoeuvre to provide
legitimacy to standard-setting bodies during periods of
competition or threatened government intervention. In
supporting her case, Hines refers to the work undertaken by
the Canadian Institute of Chartered Accountants (CICA). CICA
had done very little throughout the 1980s in relation to its
Conceptual Framework Project. It had begun to develop a
framework in about 1980, a period Hines claims was ‘a time of
pressures for reform and criticisms of accounting standardsetting in Canada’ (1989, p. 88). However, interest waned until
another Canadian professional accounting body, the Certified
General Accountants Association, through its Accounting
Standards Authority of Canada, started to develop a conceptual
framework in 1986. This was deemed to represent a threat to
CICA, ‘who were motivated into action’.
Although the criticisms of conceptual frameworks as set out
here are varied, the discussion consistently reflects the political
dimensions of the accounting standard-setting process.
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The conceptual framework as a normative theory of accounting
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The conceptual framework as a
normative theory of accounting
LO 2.14
As the following chapter explains, theories can be classified in
a number of ways. One way of classifying theories is to label
them either ‘positive’ or ‘normative’ theories. While the next
chapter covers this issue in some depth, we can briefly point
out here that a positive theory of accounting is a theory that
seeks to explain and predict particular accounting practices.
That is, a positive theory of accounting will provide
explanations of some of the outcomes that might follow the
release of a particular accounting requirement (such as an
accounting standard), or perhaps predictions about which
entities are likely to favour particular accounting methods or
adopt particular accounting methods when there are
alternatives. By contrast, a normative theory of accounting
provides prescription about what accounting methods Page 78
an organisation should adopt. Hence, the difference
can be summarised by saying that a positive theory of
accounting attempts to explain or predict accounting practice,
whereas a normative theory of accounting prescribes a
particular accounting practice. Conceptual frameworks can be
classified as normative theories of accounting as they provide
guidance (prescription) to people involved in preparing
general purpose financial statements.
The next chapter of this text—Chapter 3 —provides an
overview of various theories of accounting. A number of the
theories to be described are positive theories that provide
insight into the possible implications of the release of
particular accounting regulations. For example, theories are
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discussed that provide insight into questions such as:
l
l
l
What motivates individuals to support and perhaps lobby
regulators for certain accounting methods in preference to
others?
What are the implications for particular types of
organisations and their stakeholders if one method of
accounting is chosen or mandated in preference to other
methods?
How will particular stakeholder groups react to particular
accounting information?
The next chapter also considers factors that motivate
organisations to make voluntary accounting disclosures (and
all organisations make many voluntary disclosures in their
annual report). Further, Chapter 3
reviews various
normative theories on how various elements of accounting
should be measured and provides insight into the question of
whether there is a ‘true measure’ of income.
The majority of financial accounting textbooks provide little or
no discussion of various theories of accounting. While we
acknowledge that the balance of this text could be studied
without reading Chapter 3 , we believe that a review of
Chapter 3
will equip readers to place the impacts of financi
al accounting in perspective as opposed to merely learning
how to apply the respective accounting standards. Accounting
plays a very important—pervasive even—role within society
and Chapter 3
provides important insight into this role.
Ideally, readers should not only understand how to apply the
rules embodied in various accounting standards, they should
have some understanding of the possible consequences of
standard-setters mandating particular requirements.
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The conceptual framework as a normative theory of accounting
Chapter 3
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provides the basis for such an understanding.
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Summary
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SUMMARY
In this chapter we considered the history of conceptual
frameworks, and we learned that from 2005 Australia has
adopted the conceptual framework that has been developed
and released by the IASB. Initially, in 2005, we adopted the
IASB Framework for the Preparation and Presentation of
Financial Statements (which was initially released by the
International Accounting Standards Committee in 1989). In
2010 the IASB released a revised framework, referred to as
the IASB Conceptual Framework for Financial Reporting (which
is effectively a work in progress with various chapters still to
be added), and Australia thereafter adopted this framework in
place of the previous IASB framework. Australia will also have
to adopt further revisions to the conceptual framework that
will subsequently be released by the IASB.
We learned that the role of a conceptual framework includes
identifying the scope and objectives of financial reporting;
identifying the qualitative characteristics that financial
information should possess; and defining the elements of
accounting and their respective recognition criteria. A number
of benefits of conceptual frameworks were identified, including
accounting standards being more consistent and logical; more
efficient development of accounting standards; accounting
standard-setters being accountable for the content of
accounting standards; and conceptual frameworks providing
useful guidance in the absence of an accounting standard that
deals with a specific transaction or event.
The chapter discussed the concept of the ‘reporting entity’ and
noted that if an organisation is deemed to be a reporting
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Summary
Page 2 of 2
entity (which would be determined by whether people exist
who rely upon general purpose financial statements for the
purposes of decisions relating to the allocation of resources),
then it is to release financial statements that comply with
accounting standards.
A number of qualitative characteristics were identified as being
important in terms of financial information. Two fundamental
qualitative characteristics were explained as being relevance
and representational faithfulness. A further four ‘enhancing’
qualitative characteristics were identified, and these are
comparability, verifiability, timeliness and understandability.
The concept of materiality was also introduced and we learned
that materiality is a threshold concept, which in turn assists a
reporting entity to decide whether particular information
needs to be separately disclosed.
The chapter discussed the five elements of
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accounting: assets, liabilities, income, expenses and
equity. We learned that the definitions of income and
expenses relied directly upon the definitions given to assets
and liabilities. We also learned that the recognition criteria of
the respective elements of accounting relied upon judgements
about probability and measurability.
We concluded the chapter with a critical analysis of conceptual
frameworks.
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Key terms
Page 1 of 1
KEY TERMS
asset
conceptual framework
control (assets)
conventional financial reporting practices
equity
expenses
full-cost method
future economic benefits
income
liability
notes to the financial statements
reporting entity
successful-efforts method
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End-of-chapter exercises
Page 1 of 1
END-OF-CHAPTER EXERCISES
Once you have read this chapter you should be able to answer
the following:
1. What is the difference in role between the IASB conceptual
framework and accounting standards? LO 2.1 , 2.2
2. What are the benefits that are generated as a result of
having a conceptual framework? LO 2.2
3. What are the definition and recognition criteria of the five
elements of accounting? LO 2.10
4. What is the difference between revenues and gains? LO
2.10
5. What ‘fundamental’ and ‘enhancing’ qualitative
characteristics should financial information possess? LO
2.7
6. What role does ‘materiality’ have with respect to deciding
whether particular financial information should be disclosed?
LO 2.7
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Review questions
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REVIEW QUESTIONS
1.
What is a conceptual framework of
accounting? LO 2.1
2.
2.5
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What is a general purpose financial statement? LO
3.
What is a reporting entity, and what factors would you
consider in determining whether an entity is a reporting
entity? LO 2.6
4.
What is the history of conceptual frameworks within
Australia? LO 2.4
5.
Do we need a conceptual framework in Australia? Why?
LO 2.5 , 2.6 , 2.7 , 2.13
6.
What is the objective of having a conceptual
framework? LO 2.2 , 2.13
7.
Should the general purpose financial statements of a
company be compiled in a manner that is understandable to
all investors? LO 2.8
8.
What is the difference between revenues and gains and
do you think it is useful to subdivide income into revenues
and gains? Explain your answer. LO 2.10
9.
What are the fundamental qualitative characteristics
that financial accounting information should possess? LO
2.7
10.
What is an enhancing qualitative characteristic, and
what role do enhancing qualitative characteristics have
relative to the role of fundamental qualitative characteristics?
LO 2.7
11.
What does it mean for financial information to be
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‘representationally faithful’? LO 2.7
12.
Who are the perceived recipients of general purpose
financial statements and what knowledge of financial
accounting are they presumed to have? LO 2.8
13.
If directors of a large listed Australian company
consider that the application of a particular accounting
standard is not appropriate to their circumstances, what
should they do? Do they have to comply with accounting
standards? LO 2.9
14.
What force of law does the conceptual framework
have? LO 2.4
15.
The IASB is currently revising the conceptual
framework. Explain why any changes it makes in the
definition of assets and liabilities will subsequently have
implications for the profits of reporting entities. LO 2.12
16.
What does a ‘qualitative characteristic’ mean as it
relates to financial information? LO 2.7
17.
Why don’t we need separate recognition criteria for
equity? LO 2.10
18.
Why is it preferable to have a well-developed
conceptual framework prior to the development of
accounting standards? LO 2.2
19.
Define the elements and recognition criteria of
financial statements as per the conceptual framework. LO
2.10
20.
What do ‘probable’ and ‘measured reliability’ mean
with respect to the recognition of the elements of financial
accounting? LO 2.10
21.
Define ‘relevance’ and ‘faithful representation’. Is
there a trade-off between the two? LO 2.7
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Review questions
22.
Identify and explain some of the perceived
shortcomings of the conceptual framework. LO 2.12
2.13
Page 3 of 3
,
23.
How would you determine whether an item is
material? LO 2.7
24.
What are the disclosure implications if an item is
deemed to be material? LO 2.7
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CHALLENGING QUESTIONS
25.
Explain what material means, including how you
determine whether an item is material. In doing so, you
should consider the materiality of an item in terms of the
statement of financial position, the statement of profit or loss
and other comprehensive income and the statement of cash
flows. LO 2.7
26.
An organisation has received an interest-free loan
from its parent company with no set repayment date. Should
the ‘loan’ be disclosed as debt or as equity, and how should it
be measured? LO 2.10
27.
As at the end of the reporting period, Ripslash Ltd has
gross assets of $4 million, total revenue of $11 million and 54
full-time employees who do not own shares in the
organisation. Is Ripslash Ltd a reporting entity? LO 2.6
28.
Possies Ltd considers that its most valuable asset is its
employees—yet it has to leave them off the statement of
financial position. Explain this situation. LO 2.10
29.
Hines (1991) argues that conceptual frameworks
‘presume, legitimise and reproduce the assumption of an
objective world and as such they play a part in constituting
the social world … conceptual frameworks provide social
legitimacy to the accounting profession’. Try to explain what
she means. LO 2.1 , 2.2 , 2.13 , 2.14
30.
For each of the independent situations identified
below, consider and conclude whether the entity is required
by the Corporations Act to prepare financial statements and,
if so, whether it is a ‘reporting entity’. You should also note
the reporting implications of your decision.
(a)
ABC Pty Ltd is a small proprietary company. The
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shareholders are Mr and Mrs ABC, who also manage the
company’s day-to-day operations. The company’s
bankers, The Bank, receive monthly management
accounts, budgeted cash-flow information, and the
year-end statutory accounts. LO 2.6
(b)
F Pty Ltd is a large company—one of only two in
Australia—involved in the manufacture of widgets.
Although the shares are tightly held—by family
members—the company employs more than 200 staff.
The company has a small number of major suppliers.
The company’s sole banker receives the company’s
statutory accounts under its borrowing agreement. LO
2.6
(c)
E Trust is a private trust wherein up to a
maximum of 30 members may deposit amounts to be
invested in blue-chip equities. Members’ funds consist
of units of $1 each. Quarterly reports are produced,
which disclose the market value of the trust assets and
the values of each member’s entitlements. LO 2.6
31.
Do you believe that it is appropriate that we have a
single, global set of accounting standards as well as one
conceptual framework that has global applicability? Explain
your answer. LO 2.13 , 2.14
32.
In a newspaper article that appeared in the Canberra
Times on 4 May 2015 entitled ‘Serco unable to detain the red
ink as $395 million loss posted’, it was noted:
Although the parent company injected an additional
$100 million of equity late last year, Serco Australia
reported net assets of only $32 million at year end. Its
parent, Serco Group Pty Ltd, reported an even worse
result, with a net loss of $490 million on
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revenues of $1.2 billion. Despite the injection
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of equity, Serco Group reported negative net assets of
$43 million at the end of 2014. This means the Serco
Group in Australia is technically insolvent as its
liabilities exceed its assets by $43 million.
Notwithstanding this result and the distress of
negative net assets, Deloitte has not qualified the
accounts or challenged management’s assertion that
the company’s accounts are appropriately prepared on
a going-concern basis.
REQUIRED
(a)
Pursuant to the conceptual framework, are general
purpose financial statements prepared on the assumption
that the reporting entity is a going concern? Does this
assumption appear reasonable given the evidence
provided above?
(b)
If an entity is not considered to be a going concern,
what implications does this have for how the financial
statements should be prepared? LO 2.3 , 2.5
33.
In an article entitled ‘Unwieldy rules useless for
investors’ that appeared in the Australian Financial Review on
6 February 2012 (by Agnes King), the following extract
appeared. Read the extract and then answer the question
that follows.
Millions of dollars have been spent adopting
international financial reporting standards to help
investors make like-for-like comparisons between
companies in global capital markets. But CFOs say
they are useless and have driven financial disclosures
to unmanageable levels. The criticism comes as the
United States, the world’s largest capital market,
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decides whether to retire its domestic accounting
standard (US GAAP) and adopt IFRS.
“In seven years I never got one question from fund
managers or investment analysts about IFRS
adjustments,” former AXA head of finance Geoff
Roberts said. “Investors...rely on investor reports and
management briefings to understand companies’
numbers.”
If analysts did delve into IFRS accounts, they would
most probably misinterpret them, according to
Wesfarmers finance director Terry Bowen. “Once you
get into the notes you have to be technically trained.
If you’re not, lot of it could be misleading,” Mr Bowen
said.
Commonwealth Bank chief financial officer David Craig
said IFRS numbers were disregarded by investors
because they could actually obscure an institution’s
true position.
You are required to explain which qualitative
characteristics of financial reporting, as per the
conceptual framework, do not, in the opinion of the
above quoted individuals, appear to be satisfied by
current reporting practices pursuant to IFRS. Also, you
are required to consider whether the views are consistent
with the view that corporate financial reports satisfy the
central objective of financial reporting as identified in the
Conceptual Framework. LO 2.5 , 2.7 , 2.8 ,
2.13
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References
Page 1 of 4
REFERENCES
ACCOUNTING STANDARDS STEERING COMMITTEE, 1975, The
Corporate Report, ICAEW, London.
BOOTH, B., 2003, ‘The Conceptual Framework as a Coherent
System for the Development of Accounting Standards’, Abacus,
39 (3), pp. 310–24.
DEEGAN, C., 2013, ‘The accountant will have a central role in
saving the planet …. really? A reflection on “green accounting
and green eyeshades twenty years later”’, Critical Perspectives
on Accounting, 24, pp. 448–58.
FINANCIAL ACCOUNTING STANDARDS BOARD, 2006,
Preliminary Views—Conceptual Framework for Financial
Reporting: Objective of Financial Reporting and Qualitative
Characteristics of Decision-Useful Financial Reporting
Information, FASB, Norwalk, CT.
FINANCIAL ACCOUNTING STANDARDS BOARD and
INTERNATIONAL ACCOUNTING STANDARDS BOARD, 2005,
Revisiting the Concepts: A New Conceptual Framework Project,
Norwalk, USA: FASB.
GRAY, R., ADAMS, C. & OWEN, D., 2014, Accountability, Social
Responsibility and Sustainability, Pearson Education, London.
GRAY, R. & BEBBINGTON, J., 1992, ‘Can the Grey
Page 82
Men Go Green?’, Discussion Paper, Centre for Social
and Environmental Accounting Research, The University of
Dundee.
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References
Page 2 of 4
GRAY, R. & BEBBINGTON, J., 2001, Accounting for the
Environment, Sage Publications Ltd, London.
HINES, R.D., 1988, ‘Financial Accounting in Communicating
Reality: We Construct Reality’, Accounting, Organizations and
Society, vol. 13, no. 3, pp. 251–61.
HINES, R.D., 1989, ‘Financial Accounting Knowledge,
Conceptual Framework Projects and the Social Construction of
the Accounting Profession’, Accounting, Auditing and
Accountability Journal, vol. 2, no. 2, pp. 72–92.
HINES, R.D., 1991, ‘The FASB’s Conceptual Framework:
Financial Accounting and the Maintenance of the Social World’,
Accounting Organizations and Society, vol. 16, no. 4, pp. 313–
31.
HORNGREN, C.T., 1981, ‘Uses and Limitations of a Conceptual
Framework’, Journal of Accountancy, April, pp. 86–95.
INTERNATIONAL ACCOUNTING STANDARDS BOARD, 2008a,
Exposure Draft of an Improved Conceptual Framework for
Financial Reporting, IASB, London.
INTERNATIONAL ACCOUNTING STANDARDS BOARD, 2008b,
Discussion Paper—Preliminary Views on an Improved
Conceptual Framework for Financial Reporting, IASB, London.
INTERNATIONAL ACCOUNTING STANDARDS BOARD, 2010,
Exposure Draft ED2010/2: Conceptual Framework for Financial
Reporting: The Reporting Entity, IASB, London, March.
INTERNATIONAL ACCOUNTING STANDARDS BOARD, 2010,
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References
Page 3 of 4
Conceptual Framework for Financial Reporting, IASB, London,
September.
INTERNATIONAL ACCOUNTING STANDARDS BOARD, 2013,
Discussion Paper DP/2013/1: A Review of the Conceptual
Framework for Financial Reporting, IASB, London, September.
INTERNATIONAL ACCOUNTING STANDARDS BOARD, 2015,
IASB Staff Paper: Effect of Board Redeliberations on DP: A
Review of the Conceptual Framework for Financial Reporting,
IASB, London, September.
INTERNATIONAL ACCOUNTING STANDARDS BOARD, 2015,
Exposure Draft ED/2-15/3 Conceptual Framework for Financial
Reporting, IASB, London, September.
LOFTUS, J.A., 2003, ‘The CF and Accounting Standards: The
Persistence of Discrepancies’, Abacus, 39 (3), pp. 298–309.
MATHEWS, M.R., 1993, Socially Responsible Accounting,
Chapman and Hall, London.
MCGREGOR, W., 1990, ‘The Conceptual Framework for
General-purpose Financial Reporting: Its Nature and
Implications’, Charter, vol. 61, no. 11, December, pp. 48–51.
MILLER, P.B.W. & READING, R., 1986, The FASB: The People,
the Process, and the Politics, Irwin, Illinois.
MOONITZ, M., 1961, ‘The Basic Postulates of Accounting’,
Accounting Research Study No.1, American Institute of
Certified Public Accountants, New York.
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References
Page 4 of 4
RUBENSTEIN, D.B., 1992, ‘Bridging the Gap Between Green
Accounting and Blank Ink’, Accounting Organizations and
Society, vol. 17, no. 5, pp. 501–8.
SOLOMONS, D., 1986, ‘The FASB’s Conceptual Framework: An
Evaluation’, Journal of Accountancy, 161 (6), pp. 114–24.
SPROUSE, R. & MOONITZ, M., 1962, ‘A Tentative Set of Broad
Accounting Principles for Business Enterprises’, Accounting
Research Study No.3, American Institute of Certified Public
Accountants, New York.
WATTS, R.L. & ZIMMERMAN, J.L., 1986, Positive Accounting
Theory, Prentice Hall, Englewood Cliffs, NJ.
WELLS, M., 2003, ‘Forum: The Accounting Conceptual
Framework’, Abacus, 39 (3), pp. 273–8.
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Introduction
Page 1 of 1
Part 2
Page 83
THEORIES OF ACCOUNTING
CHAPTER 3
Theories of financial accounting
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Introduction
Chapter 3
Page 1 of 4
Page 84
THEORIES OF FINANCIAL ACCOUNTING
LEARNING OBJECTIVES (LO)
3.1 Understand what constitutes a ‘theory’ and appreciate
why students of financial accounting should know about
various theories of accounting.
3.2 Be able to describe various normative and positive
theories of financial accounting.
3.3 Appreciate that there is no single unified ‘theory of
accounting’.
3.4 Understand what constitutes an ‘agency relationship’
and be aware of the major aspects of ‘agency theory’.
3.5 Understand the central tenets of Positive Accounting
Theory.
3.6 Understand that from a Positive Accounting Theory
perspective, accounting-based measures are often used to
resolve conflicts between managers and owners, and
managers and debtholders.
3.7 Understand the various pressures and motivations that
might have an effect on the accounting methods selected by
an organisation.
3.8 Understand that, pursuant to Positive Accounting
Theory, the choice of alternative accounting methods can
often be explained from either an ‘efficiency perspective’ or
an ‘opportunistic perspective’.
3.9 Understand the meaning of ‘political costs’ and how
the choice of particular accounting methods might be used as
a strategy to reduce political costs.
mk:@MSITStore:C:\Users\Administrator\Desktop\Financial%20Accounti... 2017/3/2
Introduction
Page 2 of 4
3.10 Understand what is meant by ‘creative accounting’
and why it might occur.
3.11
Be aware of some normative theories of accounting.
3.12 Know what a ‘systems-based theory’ is and
understand the basic tenets of Stakeholder Theory,
Legitimacy Theory and Institutional Theory as they can be
applied to explaining particular accounting disclosures.
3.13 Understand that there are theories which explain why
regulation—such as accounting regulation—is introduced and
understand the basic tenets of Public Interest Theory,
Capture Theory and the Economic Interest Group Theory of
regulation.
Page 85
Introduction to theories of financial
accounting
In the previous two chapters we discussed the bodies
responsible for regulating general purpose financial reporting
within Australia. We also discussed the IASB conceptual
framework and the current activities being undertaken to
revise the conceptual framework. As will be demonstrated in
this chapter, a conceptual framework can be described as a
normative theory of accounting. It prescribes, within a
particular framework, the objectives and the qualitative
characteristics that financial information should possess if it is
to fulfil the objectives (as defined within the framework) of
general purpose financial reporting.
In this chapter we explore some of the many theories—in
addition to conceptual frameworks—that relate to financial
mk:@MSITStore:C:\Users\Administrator\Desktop\Financial%20Accounti... 2017/3/2
Introduction
Page 3 of 4
accounting. We will see that different accounting theories have
different objectives. For example, we will discuss theories that
seek to:
l
l
l
explain and predict which accounting methods or approaches
management is likely to select when it has alternatives from
which to choose (these theories are commonly referred to as
positive theories)
prescribe which accounting methods should be used in
particular circumstances (these theories are commonly
referred to as normative theories, the conceptual framework
being an example of a normative theory)
explain how or why accounting regulation is developed (with
some theories arguing that accounting regulation is
developed in the ‘public interest’ and other economics-based
theories promoting the view that accounting regulation is
introduced to serve the interests of some parties at the
expense of the interests of others).
The theory overview in this chapter will provide readers with
knowledge of some of the various accounting theories that
have been developed. For more detailed coverage, refer to
specialised texts devoted entirely to accounting theory, a
number of which are listed under ‘Further reading’ at the end
of the chapter.
In this chapter, we will demonstrate that in the decade or so
leading up to the 1970s the notable accounting theories being
developed were predominantly normative in nature; that is,
they identified what accounting techniques and methods
should be applied by reporting entities. Reflecting the higher
inflation rates of the time, most of these normative theories
were concerned with providing guidelines on how to account
mk:@MSITStore:C:\Users\Administrator\Desktop\Financial%20Accounti... 2017/3/2
Introduction
Page 4 of 4
for assets and expenses in times of rising prices.
The attention of many accounting researchers continues to
focus on the development of normative theories of accounting,
such as the conceptual framework. However, in the 1970s a
number of accounting researchers developed a theory of
accounting known as Positive Accounting Theory, which seeks
to explain and predict the selection of particular accounting
policies and their impact, rather than prescribing what should
be done. Positive Accounting Theory therefore has a different
emphasis from normative accounting theories.
After reading this chapter, you will realise that, among
accounting researchers, there is a great deal of disagreement
on the role of accounting and of accounting theory; for
example, some people argue that theory should explain
practice, while others argue it should direct, improve or guide
practice (and some people think it should do both). These
contrasting types of theories have generated considerable
debate within the accounting literature, and this debate is
ongoing.
mk:@MSITStore:C:\Users\Administrator\Desktop\Financial%20Accounti... 2017/3/2
Introduction
Chapter 3
Page 1 of 4
Page 84
THEORIES OF FINANCIAL ACCOUNTING
LEARNING OBJECTIVES (LO)
3.1 Understand what constitutes a ‘theory’ and appreciate
why students of financial accounting should know about
various theories of accounting.
3.2 Be able to describe various normative and positive
theories of financial accounting.
3.3 Appreciate that there is no single unified ‘theory of
accounting’.
3.4 Understand what constitutes an ‘agency relationship’
and be aware of the major aspects of ‘agency theory’.
3.5 Understand the central tenets of Positive Accounting
Theory.
3.6 Understand that from a Positive Accounting Theory
perspective, accounting-based measures are often used to
resolve conflicts between managers and owners, and
managers and debtholders.
3.7 Understand the various pressures and motivations that
might have an effect on the accounting methods selected by
an organisation.
3.8 Understand that, pursuant to Positive Accounting
Theory, the choice of alternative accounting methods can
often be explained from either an ‘efficiency perspective’ or
an ‘opportunistic perspective’.
3.9 Understand the meaning of ‘political costs’ and how
the choice of particular accounting methods might be used as
a strategy to reduce political costs.
mk:@MSITStore:C:\Users\Administrator\Desktop\Financial%20Accounti... 2017/3/2
Introduction
Page 2 of 4
3.10 Understand what is meant by ‘creative accounting’
and why it might occur.
3.11
Be aware of some normative theories of accounting.
3.12 Know what a ‘systems-based theory’ is and
understand the basic tenets of Stakeholder Theory,
Legitimacy Theory and Institutional Theory as they can be
applied to explaining particular accounting disclosures.
3.13 Understand that there are theories which explain why
regulation—such as accounting regulation—is introduced and
understand the basic tenets of Public Interest Theory,
Capture Theory and the Economic Interest Group Theory of
regulation.
Page 85
Introduction to theories of financial
accounting
In the previous two chapters we discussed the bodies
responsible for regulating general purpose financial reporting
within Australia. We also discussed the IASB conceptual
framework and the current activities being undertaken to
revise the conceptual framework. As will be demonstrated in
this chapter, a conceptual framework can be described as a
normative theory of accounting. It prescribes, within a
particular framework, the objectives and the qualitative
characteristics that financial information should possess if it is
to fulfil the objectives (as defined within the framework) of
general purpose financial reporting.
In this chapter we explore some of the many theories—in
addition to conceptual frameworks—that relate to financial
mk:@MSITStore:C:\Users\Administrator\Desktop\Financial%20Accounti... 2017/3/2
Introduction
Page 3 of 4
accounting. We will see that different accounting theories have
different objectives. For example, we will discuss theories that
seek to:
l
l
l
explain and predict which accounting methods or approaches
management is likely to select when it has alternatives from
which to choose (these theories are commonly referred to as
positive theories)
prescribe which accounting methods should be used in
particular circumstances (these theories are commonly
referred to as normative theories, the conceptual framework
being an example of a normative theory)
explain how or why accounting regulation is developed (with
some theories arguing that accounting regulation is
developed in the ‘public interest’ and other economics-based
theories promoting the view that accounting regulation is
introduced to serve the interests of some parties at the
expense of the interests of others).
The theory overview in this chapter will provide readers with
knowledge of some of the various accounting theories that
have been developed. For more detailed coverage, refer to
specialised texts devoted entirely to accounting theory, a
number of which are listed under ‘Further reading’ at the end
of the chapter.
In this chapter, we will demonstrate that in the decade or so
leading up to the 1970s the notable accounting theories being
developed were predominantly normative in nature; that is,
they identified what accounting techniques and methods
should be applied by reporting entities. Reflecting the higher
inflation rates of the time, most of these normative theories
were concerned with providing guidelines on how to account
mk:@MSITStore:C:\Users\Administrator\Desktop\Financial%20Accounti... 2017/3/2
Introduction
Page 4 of 4
for assets and expenses in times of rising prices.
The attention of many accounting researchers continues to
focus on the development of normative theories of accounting,
such as the conceptual framework. However, in the 1970s a
number of accounting researchers developed a theory of
accounting known as Positive Accounting Theory, which seeks
to explain and predict the selection of particular accounting
policies and their impact, rather than prescribing what should
be done. Positive Accounting Theory therefore has a different
emphasis from normative accounting theories.
After reading this chapter, you will realise that, among
accounting researchers, there is a great deal of disagreement
on the role of accounting and of accounting theory; for
example, some people argue that theory should explain
practice, while others argue it should direct, improve or guide
practice (and some people think it should do both). These
contrasting types of theories have generated considerable
debate within the accounting literature, and this debate is
ongoing.
mk:@MSITStore:C:\Users\Administrator\Desktop\Financial%20Accounti... 2017/3/2
Why discuss theories in a book such as this?
Page 1 of 2
Why discuss theories in a book such as
this?
LO 3.1 LO 3.3
The study of financial accounting can be approached in a
number of different ways. One approach adopted in many
financial accounting textbooks is for the authors to provide an
explanation of the rules incorporated within particular financial
accounting standards and then illustrate how to apply these
rules. That is, a number of texts are predominantly procedural
in nature, failing to reflect any deeper thinking about the
impact of particular accounting standards and other
pronouncements. For example, many financial accounting
textbooks elect not to discuss how readers of financial
statements might react to the disclosures required by the
standards; whether newly mandated disclosures will have
positive or negative effects on the organisation; how particular
stakeholders affect the disclosure decisions of organisations;
and how particular accounting disclosures will influence an
organisation’s relationships with other parties within society.
In contrast with such texts, the author of this book believes
that not only is it useful to discuss the requirements of the
various accounting standards—as we do in depth in the
following chapters—but that it is important to provide
frameworks—as we do in this chapter—within which to
consider the implications of organisations making particular
accounting disclosures, whether voluntarily or as a result of a
particular mandate. We also think it is useful to consider the
various pressures, many of which are political in nature, that
influence the accounting standard-setting environment.
Of course, the balance of the material in this book
Page 86
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Why discuss theories in a book such as this?
Page 2 of 2
could be studied without reading this chapter. However,
because the impact of financial accounting resonates
throughout society, we believe this chapter provides readers
with the necessary background to understand the possible
implications of an organisation making particular disclosures.
The theories in this chapter also provide the basis for
understanding the various pressures that drive organisations
to make particular disclosures, even in the absence of
disclosure requirements pertaining to particular transactions
and events. By reading this chapter, together with the
material in other chapters of this book, we believe that
readers will gain a greater understanding of the broader
implications of various accounting standards and other
disclosure requirements.
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Definition of theory
Page 1 of 3
Definition of theory
LO 3.1 LO 3.2
Before we consider some of the theories of accounting, it
might be useful to discuss what we mean by a theory . There
is no one definitive meaning of the term ‘theory’. The
Macquarie Dictionary provides a useful definition: ‘a coherent
group of propositions used as principles of explanation for a
class of phenomena’.
The accounting researcher Hendriksen (1970, p.1) defines a
theory as ‘a coherent set of hypothetical, conceptual and
pragmatic principles forming the general framework of
reference for a field of inquiry’.
Hendriksen’s definition is very similar to the US Financial
Accounting Standards Board’s definition of its Conceptual
Framework Project, discussed in Chapter 1 : ‘a coherent
system of interrelated objectives and fundamentals that is
expected to lead to consistent standards’.
It is generally accepted that a ‘theory’ is much more than
simply an idea, or a ‘hunch’, which is how the term is used in
some contexts (for instance, we often hear people say that
they have a ‘theory’ about why something might have
occurred when they mean they have a ‘hunch’).
Accounting theories typically either explain and/or predict
accounting practice, or they prescribe specific accounting
practice. As indicated above, such theories are typically
referred to as positive and normative theories respectively.
According to Henderson, Peirson & Brown (1992, p. 326):
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Definition of theory
Page 2 of 3
A positive theory begins with some assumption(s) and,
through logical deduction, enables some prediction(s) to be
made about the way things will be. If the prediction is
sufficiently accurate when tested against observations of
reality, then the story is regarded as having provided an
explanation of why things are as they are. For example, in
climatology, a positive theory of rainfall may yield a
prediction that, if certain conditions are met, then heavy
rainfall will be observed. In economics, a positive theory of
prices may yield a prediction that, if certain conditions are
met, then rapidly rising prices will be observed. Similarly, a
positive theory of accounting may yield a prediction that, if
certain conditions are met, then particular accounting
practices will be observed.
Because positive theories seek to explain and predict
particular phenomena, they are often developed and
supported on the basis of observations (that is, they are
empirically based). The view is that by making numerous
observations we will be better placed to predict what will
happen in the future (for example, we might study many
managers within a particular industry to predict what
accounting methods they will select in particular
circumstances).
By contrast, normative theories are sometimes referred to as
prescriptive theories, because they seek to inform others
about particular practices that should be followed to achieve
particular outcomes. For example, a normative accounting
theory might, given certain key assumptions about the nature
and objective of accounting, prescribe how assets should be
measured for financial statement purposes. The prescriptions
about what should be done might represent significant
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Definition of theory
Page 3 of 3
departures from current accounting practice (for example, for
many years Raymond Chambers promoted a theory of
accounting that prescribed that assets should be measured at
market value—at a time when entities were predominantly
using historical cost). Therefore, it is not appropriate to assess
the validity, or otherwise, of a normative theory on the basis
of whether entities are actually using one method or another,
although this is a common method of evaluating or testing a
positive theory. A normative theory might prescribe a radical
departure from current practice.
The dichotomy of positive and normative accounting theory
provides a useful basis for the following discussion.
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Positive Accounting Theory
Page 1 of 41
Page 87
Positive Accounting Theory
LO 3.2 LO 3.3 LO 3.4 LO 3.5 LO 3.6 LO 3.7 LO 3.8 LO
3.9
The name Positive Accounting Theory can in itself cause
confusion. A positive theory is a theory that explains and
predicts a particular phenomenon. Positive Accounting Theory
(PAT) seeks to explain and predict accounting practice. It does
not seek to prescribe particular actions. Watts and Zimmerman
(1986, p. 7) state:
[PAT] is concerned with explaining [accounting] practice. It is
designed to explain and predict which firms will and which
firms will not use a particular [accounting] method … but it
says nothing as to which method a firm should use.
According to Watts (1995, p. 334), the use of the term ‘positive
research’ was popularised in economics by Friedman (1953) and
was used to distinguish research that sought to explain and
predict from research that aimed to provide prescription.
Positive Accounting Theory, the theory that was popularised by
Watts and Zimmerman, is one of several positive theories of
accounting. Legitimacy Theory, Institutional Theory and
Stakeholder Theory, all discussed in this chapter, are other
examples of positive theories. These other positive theories are
not grounded in classical economics theory, as is the case with
Positive Accounting Theory.
We can refer to the general class of theories that attempts to
explain and predict accounting practice in lower-case letters
(that is, as positive theories of accounting), and we can refer to
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Positive Accounting Theory
Page 2 of 41
Watts and Zimmerman’s particular positive theory of accounting
as Positive Accounting Theory (that is, with initial letters in
upper case). Hence, while it might be confusing, we must
remember that Watts and Zimmerman’s Positive Accounting
Theory is one specific example of a positive theory of
accounting. This confusion might not have arisen had Watts and
Zimmerman elected to adopt a different name (or ‘trademark’)
for their particular theory. According to Watts and Zimmerman
(1990, p. 148):
We adopted the label ‘positive’ from economics where it was
used to distinguish research aimed at explanation and
prediction from research whose objective was prescription.
Given the connotation already attached to the term in
economics we thought it would be useful in distinguishing
accounting research aimed at understanding accounting from
research directed at generating prescriptions … The phrase
‘positive’ created a trademark and like all trademarks it
conveys information. ‘Coke’, ‘Kodak’, ‘Levis’ convey
information.
Normative accounting theorists have criticised PAT because it
does not provide practitioners with guidance, even though it
does attempt to explain the possible economic implications of
selecting particular accounting policies.
PAT focuses on the relationships between the various individuals
involved in providing resources to an organisation. This could be
the relationship between the owners (as suppliers of equity
capital) and the managers (as suppliers of managerial labour),
or between the managers and the firm’s debt providers. Many
relationships involve the delegation of decision making from one
party (the principal) to another party (the agent): this is
referred to as an agency relationship . The delegation of
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Positive Accounting Theory
Page 3 of 41
decision-making authority can lead to a loss of efficiency and,
consequently, increased costs. For example, if the owner (the
principal) delegates decision-making authority to a manager
(the agent), it is possible that the manager will not work as hard
as the owner would, given that the manager does not share
directly in the results of the organisation. Any loss of profits
brought about because the manager underperforms is
considered to be a cost of decision-making delegation within this
agency relationship—an agency cost. The agency costs that
arise as a result of delegating decision-making authority from
the owner to the manager are referred to in PAT as agency costs
of equity.
PAT investigates how particular contractual arrangements, many
based on accounting numbers, can be put in place to minimise
agency costs. One of the most frequently cited expositions of
PAT is provided in Watts and Zimmerman (1978). In developing
PAT, Watts and Zimmerman relied heavily upon the work of a
number of other authors, notably Jensen and Meckling (1976)
and Gordon (1964).
PAT, developed by Watts and Zimmerman and others, is based
significantly on particular assumptions and methods used in the
economics literature and, in particular, on the central
assumptions of economics that all individual action is driven by
self-interest and that individuals will act in an opportunistic
manner to increase their wealth. Notions of loyalty and morality
are not incorporated within the theory (nor, typically, in many
other accounting theories). Organisations are considered
collections of self-interested individuals who have agreed to
cooperate. Such cooperation does not mean that they have
abandoned self-interest as an objective; rather it
Page 88
means only that they have entered into contracts that
provide sufficient incentives to gain their cooperation.
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Positive Accounting Theory
Page 4 of 41
Given the assumption (again, borrowed from economics
literature) that self-interest drives individual actions—an
assumption that is disdained by many accounting researchers,
as will be indicated later in this chapter—PAT predicts that
organisations will seek to put in place mechanisms that align the
interests of the managers of the firm (the agents) with the
interests of the owners of the firm (the principals). As we will
see, some of these methods of aligning interests will be based
on the output of the accounting system, such as providing the
manager with a share of the organisation’s profits. Hence the
theory’s direct application to explaining particular accounting
practices. Where such accounting-based alignment mechanisms
are in place, financial statements will need to be produced.
Managers are required to bond themselves to prepare these
financial statements. This is costly in itself and under PAT would
be referred to as a bonding cost. If we assume that managers
(agents) will be responsible for preparing the financial
statements, PAT would also predict that there would be a
demand for those statements to be audited or monitored.
Otherwise, assuming self-interest, agents would attempt to
overstate profits, thereby increasing their absolute share of
profits. In PAT, the cost of undertaking an audit is referred to as
a monitoring cost .
Various bonding and monitoring costs might be incurred to
address the agency problems that arise within an organisation.
If it was assumed, contrary to the assumption of ‘self-interest’
employed by PAT, that individuals always worked for the benefit
of their employer, there would be less demand for such
activities—other than, perhaps, to review the efficiency with
which managers operate businesses. As PAT assumes that not
all the opportunistic actions of agents can be controlled by
contractual arrangements or otherwise, there will always be
some residual costs associated with appointing an agent (known
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Positive Accounting Theory
Page 5 of 41
as residual loss).
Efficiency and opportunistic
perspectives of PAT
Research that applies PAT typically adopts either an efficiency
perspective or an opportunistic perspective. From the efficiency
perspective, researchers explain how various contracting
mechanisms can be put in place to minimise the agency costs of
the firm—that is the costs associated with assigning decisionmaking processes to an agent. The efficiency perspective is
often referred to as an ex ante perspective—ex ante meaning
‘before the fact’—as it considers what mechanisms are
introduced up front with the objective of minimising future
agency costs. For example, many organisations in Australia and
elsewhere voluntarily prepared publicly available financial
statements before regulation compelled them to do so. These
financial statements were also frequently subject to audit even
though there was no statutory requirement to do so (Morris
1984). Researchers such as Jensen and Meckling (1976) argue
that the practice of providing audited financial statements leads
to real cost savings as it enables organisations to attract funds
at lower costs (in other words, it is an efficient use of resources
to prepare financial statements and have them audited). As a
result of the audit, external parties have reliable information
about the resources of the organisation, which is thus perceived
to be able to attract funds at a lower cost than would otherwise
be possible. This is because, in the absence of information, it
would be difficult to assess the ongoing ‘health’ of an investment
in an entity, and this inability to monitor performance would
increase the risk associated with an investment. With higher
risk, the entity’s cost of attracting capital would increase.
Providing ‘credible’ information will arguably lead to a decrease
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Positive Accounting Theory
Page 6 of 41
in risk, and a consequent decrease in the costs of attracting
capital to the entity.
Within the efficiency (ex ante) perspective of PAT, it is also
argued that the accounting practices adopted by firms are often
explained on the basis that such methods best reflect the
underlying financial performance of the entity. Different
organisational characteristics are used to explain why different
firms adopt different accounting methods. For example, the
selection of a particular asset depreciation rule from among
many alternative approaches is explained by the fact that it best
reflects the underlying use of the asset. Firms that have
different patterns of use in relation to an asset are predicted to
adopt different amortisation policies. By providing measures of
performance that best reflect the underlying performance of the
firm, it is argued that investors and other parties will not need to
gather additional information from other sources. This will lead
to cost savings. As an illustration of research that adopts an
efficiency perspective, Whittred (1987) sought to explain why
firms voluntarily prepared publicly available consolidated
financial statements in a period when there was no regulation
requiring them to do so. (Consolidated financial statements are
constructed by aggregating the financial statements of
numerous organisations within a group of entities where the
group comprises a parent entity and its controlled entities.)
Whittred found that when companies borrowed funds, security
for repayment of the debt often took the form of guarantees
provided by entities within the group of organisations.
Consolidated financial statements were described as being a
more efficient means of providing information about the group’s
ability to borrow and repay debts than providing
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lenders with separate financial statements for each
entity within the group.
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If it is assumed, consistent with the efficiency perspective, that
firms adopt particular accounting methods because they best
reflect the underlying performance of the entity, then it is often
argued by PAT theorists that the regulation of financial
accounting imposes unwarranted costs on reporting entities. For
example, if a new accounting standard is released that bans an
accounting method being used by a particular organisation, then
this could lead to inefficiencies as the resulting financial
statements will no longer provide the best reflection of the
performance of the organisation. This in itself is believed likely
to lead to an increase in the firm’s costs, because if an
organisation is no longer able to provide information that best
reflects its financial position and performance, this increases the
risks of investors and debt providers, who consequently will
demand a higher rate of return. Many PAT theorists would argue
that management is best able to select which accounting
methods are appropriate in given circumstances, and
government should not intervene in the process (an antiregulation argument). Such theorists oppose a ‘one-size-fits-all’
approach to accounting regulation, in which particular
accounting standards are required to be used by all reporting
entities even though the nature of their operations, financial
structure and products might be greatly different.
The opportunistic perspective of PAT, on the other hand, takes
as given the negotiated contractual arrangements of the firm
and seeks to explain and predict certain opportunistic
behaviours that will subsequently occur. The opportunistic
perspective is often referred to as an ex post perspective—ex
post meaning ‘after the fact’—because it considers opportunistic
actions that could be taken once various contractual
arrangements have been put in place. For example, in an
endeavour to minimise agency costs (an efficiency perspective),
a contractual arrangement might be negotiated that provides
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managers with a bonus based on the profits generated by the
entity (for example, a manager might be given a bonus that is 5
per cent of reported profits). This will act to align the interests of
the managers with the interests of the owners as both parties
would likely prosper from increasing profits. Once the
contractual arrangement is in place, however, the manager
could opportunistically elect to adopt particular accounting
methods that increase accounting profits and therefore the size
of any bonus (an opportunistic perspective). For example,
managers might elect to adopt a particular depreciation method
that increases income even though it might not reflect the actual
use of the asset. It is assumed within PAT that managers will
opportunistically select particular accounting methods whenever
they believe this will lead to an increase in their personal wealth
(remember, PAT assumes that all individuals are driven by selfinterest).
PAT assumes that principals (or owners) would predict a
manager will be opportunistic. With this in mind principals often
stipulate the accounting methods to be used for particular
purposes. For example, a bonus plan agreement might stipulate
that a particular depreciation method such as straight-line
depreciation must be adopted to calculate income for the
determination of a bonus. However, it is assumed to be too
costly to stipulate in advance all accounting rules to be used in
all circumstances. Hence, PAT proposes that there will always be
scope for agents to opportunistically select particular accounting
methods in preference to others.
The following discussion addresses some of the various
contractual arrangements that might exist between owners and
managers, and between debt holders and managers, particularly
contracts that are based on the output of the accounting
system. Again, these contractual arrangements are assumed
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initially to be put in place to reduce the agency costs of the firm
(the efficiency perspective). However, it is assumed by Positive
Accounting theorists that once the arrangements are in place,
parties will adopt manipulative strategies to generate the
greatest economic benefits for themselves (the opportunistic
perspective).
Owner–manager contracting
A manager who also owns a firm (an owner–manager) bears the
costs associated with their own perquisite consumption ,
which could include consumption of the firm’s resources for
private purposes—acquiring an overly expensive company car or
luxurious offices or staying in overly expensive hotel
accommodation—or the excessive generation and use of idle
time. As the percentage of ownership held by the manager
decreases, managers begin to bear less of the cost of their own
perquisite consumption. The costs begin to be absorbed by the
other owners of the firm.
As noted previously, PAT adopts as a central assumption that all
action taken by an individual is driven by self-interest, and that
the major interest of all individuals is to maximise their own
wealth. Such an assumption is often referred to as the rational
economic person assumption . If all individuals are assumed t
o act in their own interests, owners would expect managers
(their agents) to undertake activities that might not always be in
the interests of the owners (the principals). Further, because of
their position within the firm, managers will have
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access to information that is not available to
principals—a problem frequently referred to as information
asymmetry —thus increasing the potential for managers to take
actions that are beneficial to themselves at the expense of the
owners. The costs of divergent behaviour that arises as a result
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of the agency relationship—that is the relationship between the
principal and the agent appointed to perform duties on behalf of
the principal—are, as indicated previously, referred to as agency
costs (Jensen & Meckling 1976).
It is assumed under PAT that principals expect their agents to
undertake activities that might be advantageous to the agents
but disadvantageous to the value of the firm (the opportunistic
perspective). That is, principals assume that agents will be
driven by self-interest. As a result, principals will price this into
the amounts they are prepared to pay managers. That is, in the
absence of controls to reduce the ability of managers to act
opportunistically, principals expect such actions and, as a result,
will pay their managers a lower salary. This lower salary
compensates the principals for, or protects them from, the
expected opportunistic behaviour of the agents/managers (often
referred to as ‘price protection’). Managers, therefore, bear
some of the agency costs of the opportunistic behaviours in
which they might or might not engage. If it is expected that
managers would derive greater satisfaction from additional
salary than from the perquisites that they will be predicted to
consume, managers might be better off if they are able to
commit or bond themselves contractually to reducing their set of
available actions, some of which would not be beneficial to
owners. To receive greater remuneration, managers must be
able to convince owners that they will work in the interests of
owners. Of course, before agreeing to increase the amounts paid
to managers, the owners of a firm would need to ensure that
any contractual commitments could be monitored for
compliance.
Managers could potentially be rewarded:
l
on a fixed basis, that is, given a fixed salary independent of
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performance;
l
on the basis of the results achieved; or
l
by way of a combination of the above two methods.
If managers are rewarded purely on a fixed basis, then,
assuming self-interest—a central tenet of PAT—they will not
want to take great risks because they will not share in any
potential gains. There will also be limited incentives for these
managers to adopt strategies that increase the value of the
firm—unlike equity owners, whose share of the firm might
increase in value. Like debtholders, managers with a fixed claim
want to protect their fixed income stream. Apart from rejecting
risky projects, which might be beneficial to those with equity in
the firm, the manager with a fixed income stream is also
reluctant to take on optimum levels of debt, as the claims of the
debtholders would compete with the manager’s own fixed
income claim.
Assuming self-interest drives the actions of managers, PAT
theorists argue that it can be necessary to put in place
remuneration schemes that reward managers in a way that is, at
least in part, tied to the performance of the firm. This will be in
the interests of managers as they will potentially receive greater
rewards and will not have to bear the costs of perceived
opportunistic behaviours (which might not have been engaged in
anyway). If the performance of the firm improves, the rewards
paid to managers increase correspondingly. Bonus schemes
tied to the performance of the firm are put in place to align the
interests of owners and managers. If the firm performs well,
both parties will benefit.
Bonus schemes generally
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It is common for managers to be rewarded in terms of the
profits of the firm, sales of the firm or return on assets; that is,
their remuneration is based on the output of the accounting
system (hence, depending upon the terms of the bonus scheme,
a change in profits might directly affect a manager’s personal
wealth). Table 3.1
provides a description of some of the
accounting-based remuneration plans found to exist in Australia.
It is also common for managers to be rewarded in terms of the
market price of the firm’s shares. This might be through holding
an equity interest in the firm or perhaps by receiving a cash
bonus explicitly tied to movements in the market value of the
firm’s securities.
Table 3.1 Accounting-based management bonus plans
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Accounting performance measures used in Australia
Percentage of after-tax profits for the last year
Percentage of after-tax profits after adjustment for dividends paid
Percentage of pre-tax profits for the last year
Percentage of division’s profit for the last year
Percentage of division’s sales for the last year
Percentage of the last year’s accounting rate of return on assets
Percentage of division’s sales for the last year plus percentage of firm’s after-tax
profits
Percentage of division’s sales for the last year plus percentage of division’s pre-tax
profits
Percentage of division’s sales for the last two years plus percentage of the division’s
pre-tax profit for the last two years
Percentage of firm’s sales for the last year plus a percentage of firm’s after-tax profit
Average of pre-tax profit for last two years
Average of pre-tax profit for last three years
Percentage of the last six months’ profit after tax
SOURCE: Craig Deegan, 1997, ‘The Design of Efficient Management Remuneration
Contracts: A Consideration of Specific Human Capital Investments’, Accounting and Finance,
vol 37, no. 1, May, pp. 1–40. Reprinted by permission of Blackwell Publishing.
Accounting-based bonus plans
Given that the amounts paid to managers might be tied directly
to accounting numbers—such as profits/sales/assets—any
changes in the accounting methods being used by the
organisation will affect the bonuses paid. Such changes can
occur as a result of a new accounting standard being issued. For
example, an article in CFO Magazine (April 2014, p. 8, entitled
‘Revenue Accounting Hits Loans, Bonuses’) notes how a new
accounting standard issued by the IASB—IFRS 15 Revenue from
Contracts with Customers—will affect the timing of when many
organisations recognise revenue and this in turn could affect
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bonuses tied to corporate sales or profits. As another example,
consider the consequences if a new rule is issued that requires
all Australian research and development expenditure to be
written off. (In Australia, subject to certain guidelines,
development expenditure can be capitalised and subsequently
amortised over future periods.) With such a change, profits
would decline and the bonuses paid to managers could also
change. If it is accepted, consistent with classical finance theory,
that the value of the firm is a function of its future cash flows,
the value of the organisation might change as cash flows
change. Of course, it is possible for the bonus to be based on
the ‘old’ accounting rules in place at the time the remuneration
contract was negotiated—perhaps through a clause in the
management compensation contract—but this will not always be
the case. (As indicated previously, it would be too costly to try
to stipulate in advance what accounting methods are to be used
subsequently for all transactions.) Contracts that rely on
accounting numbers might rely on ‘floating’ generally
accepted accounting principles . This means that changing an
accounting rule that affects an item used within a contract made
by the firm might consequently change the value of the firm
(through changes in related cash flows). Positive Accounting
Theory would argue that if a change in accounting policy had no
impact on the cash flows of the firm, the management of the
firm would be indifferent to the change.
Incentives to manipulate
accounting numbers
There are a number of costs that might arise if incentive
schemes are based on accounting output. For example, it is
possible that rewarding managers on the basis of accounting
profits can induce them to manipulate the related accounting
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numbers to improve their apparent performance and,
importantly, their related rewards—that is, accounting profits
might not always provide an unbiased measure of a firm’s
performance or value. Healy (1985) provides an illustration of
when managers might choose opportunistically to manipulate
accounting numbers owing to the presence of accountingbased bonus schemes (that is, they adopt an opportunist pers
pective). He found that when schemes existed that rewarded
managers after a pre-specified level of earnings had been
reached, managers would adopt accounting methods consistent
with maximising that bonus. In situations where the profits were
not expected to reach the minimum level required by the plan,
managers appeared to adopt strategies that further reduced
income in that period (frequently referred to as ‘taking a bath’).
This leads to higher income in subsequent periods when the
profits might be above the required threshold. For
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example, a manager might write off an asset in one
period when a bonus was not going to be earned anyway so that
there would be nothing further to depreciate in future periods
when profit-related bonuses might be paid.
In related research, Holthausen, Larcker and Sloan (1995)
utilised private data on a firm’s compensation plans to
investigate managers’ behaviour in the presence of management
compensation plans. Their results confirmed those of Healy
(1985), except that no evidence was found to support the view
that management will ‘take a bath’ when earnings are below the
lower pre-set bound of the earnings requirement.
Investment strategies that maximise the present value of the
firm’s resources will not necessarily produce uniform periodic
cash flows or accounting profits. It is possible that some
strategies might generate minimal accounting returns in early
years, yet still represent the best alternatives available to the
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firm.
Rewarding managers on the basis of accounting profits might
discourage them from adopting such strategies and might
encourage them instead to adopt a short-term, as opposed to a
long-term, focus.
In Lewellen, Loderer and Martin (1987), it was shown that US
managers approaching retirement are less likely to undertake
research and development expenditure if their rewards are
based on accounting-based performance measures, such as
profits. Working within a PAT framework, this is explained on the
basis that all research and development has to be written off as
incurred in the USA (as has already been mentioned and will be
seen in subsequent chapters, this is not the case in Australia).
In such circumstances, incurring research and development
costs will lead directly to a reduction in profits. Although the
research and development expenditure would be expected to
lead to benefits in subsequent years, the retiring managers
might not be there to share in the gains. The self-interested
manager who is rewarded on the basis of accounting profits is
predicted not to undertake research and development in the
periods close to the point of retirement. This can, of course, be
detrimental to the ongoing operations of the business. In such a
case, it would be advisable from an efficiency perspective for an
organisation that incurs research and development expenditure
to take retiring managers off a profit-share bonus scheme or to
calculate ‘profits’ for the purpose of the plan after adjusting for
research and development expenditures. Alternatively,
managers approaching retirement could be rewarded in terms of
market-based schemes, as addressed below. What we are
emphasising here is that particular accounting rules can create
real social consequences. For example, as a result of the
accounting requirements that research and development
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expenditure is required to be treated as an expense, some
managers—particularly those on accounting-based bonuses—
might decide not to undertake such research and development
and this can have subsequent implications for society (perhaps
some miracle cure was about to be found).
Market-based bonus schemes
Firms involved in some industries might have accounting
earnings that fluctuate greatly. Successful strategies might be
put in place that will not provide accounting earnings for a
number of periods. In such industries, Positive Accounting
theorists might argue that it is more appropriate and efficient to
reward managers in terms of the market value of the firm’s
securities, which are assumed to be influenced by expectations
about the net present value of expected future cash flows.
This can be done either by basing a cash bonus on any increases
in share prices or by providing managers with shares or options
to shares in the firm. If the value of the firm’s shares increases,
both managers and owners will benefit and, importantly,
managers will be given an incentive to increase the value of the
firm.
As with accounting-based bonus schemes, there are problems
associated with managers being rewarded in terms of share
price movements. First, the share price will not only be affected
by factors that are controlled by the manager but also by
outside, market-wide factors; that is, share prices might provide
a ‘noisy’ measure of management performance—‘noisy’ in the
sense that they are affected not only by the actions of
management but also largely by general market movements
over which the manager has no control. Further, only senior
managers would be likely to have a significant effect on the cash
flows of the firm and, hence, on the value of the firm’s
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securities. Therefore, market-related incentives might be
appropriate for senior management only. Offering shares to
lower-level management might be demotivating, as their own
individual actions would have little likelihood, relative to the
actions of senior management, of affecting share prices and,
therefore, their personal wealth. Consistent with this, in
Australia it is more common for senior managers to hold shares
in their employer than for other employees. Even at the senior
level of management, however, firm-specific events might occur
that reduce share prices, even though the manager has no
ability to influence the events. Consider the extract from the
article in Financial Accounting in the Real World 3.1
entitled ‘Oh no, they’ve killed Kerry’, which discusses how the
share price of Publishing and Broadcasting Ltd declined as a
result of a false report in 2000 that its head, Mr Kerry Packer,
had died.
In general, it is argued that the likelihood of
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accounting-based or market-based performance
measures or reward schemes being employed will be driven, in
part, by considerations of the relative ‘noise’ of market-based
versus accounting-based performance measures. The relative
reliance upon accounting-based or market-based measures
might potentially be determined on the basis of the relative
sensitivity of either measure to general market factors, which
are largely uncontrollable. Sloan (1993) indicates that chief
executive officer (CEO) salary and bonus compensation appears
to be relatively more aligned with accounting earnings in those
firms where:
l
l
share returns are relatively more sensitive to general market
movements (relatively noisy)
earnings have a high association with firm-specific movement
in the firm’s share values
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l
Page 19 of 41
earnings have a less positive (or more negative) association
with market-wide movements in equity values.
Accounting-based rewards have the advantage that the
accounting results may be based on subunit or divisional
performance. However, it needs to be ensured that individuals
do not focus on their division at the expense of the organisation
as a whole.
3.1 FINANCIAL ACCOUNTING IN THE Real
world
Oh no, they’ve killed Kerry
Luke Mcilveen
Kerry Packer has died and come back to life before, but Sydney
radio station 2UE was sure that yesterday was the end. The 3
p.m. news bulletin had the country’s richest man, who
underwent a kidney transplant a fortnight ago, back in Sydney’s
Royal Prince Alfred Hospital for minor surgery.
Eight minutes later, presenter Murray Olds was telling listeners
Mr Packer might have taken a one-way trip to the other side.
‘We got a phone call here a short while ago to tell us—and I
stress this is a phone call only, but we are trying to get this
confirmed—but there are reports whizzing around the city of
Sydney that Kerry Packer may have passed away,’ he said.
News of the apparent demise sent the fickle finance world into a
frenzy. Shares in Mr Packer’s company Publishing and
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Broadcasting closed 11.3c weaker at $12.907.
SOURCE: Extract from ‘Oh no, they’ve killed Kerry’, by Luke Mcilveen, The Australian, 8
December 2000, p. 1
Positive Accounting Theory assumes that if a manager is
rewarded on the basis of accounting numbers—for example, on
the basis of a share of profits—the manager will have an
incentive to manipulate the accounting numbers in an effort to
increase his or her own personal wealth. Given this assumption,
the value of audited financial statements becomes apparent.
Rewarding managers in terms of accounting numbers—a
strategy aimed at aligning the interests of owners and
managers—might not be appropriate if management is solely
responsible for compiling those numbers. The auditor will act to
arbitrate on the reasonableness of the accounting methods
adopted. However, it must be remembered that there will
always be scope for opportunism. As emphasised earlier, it
would be too expensive and, for practical purposes, impossible
to pre-specify a complete set of accounting methods to cover all
circumstances. In this regard, it should be remembered that the
existing accounting standards do not cover all types of
transactions and events, and hence there is much latitude for
discretion when compiling financial statements.
The above discussion indicates that incentive-based
remuneration contracts might act to motivate managers to take
actions that are in the best interests of the owners (that is, to
align the interests of managers and owners). Another
mechanism, which might complement the employment of
efficiently designed management remuneration plans and which
might motivate managers, is the threat that an underperforming
company might be the subject of takeover attempts. The
consequence of this is that underperforming managers/agents
might lose their jobs when alternative teams of managers target
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firms with resources that are currently being used inefficiently
by the incumbent management team. Given the assumption of
an efficient capital market—another central tenet of PAT—
managers might be motivated to use their resources efficiently
both for the benefit of the owners and because inefficient
utilisation might result in the firm being taken over and
subsequently in loss of employment for managers.
A well-informed labour market will motivate management to
work to maximise the value of its firm. Underperformance might
lead to dismissal and, if the labour market is efficient in
disseminating data, a ‘failed’ manager might have difficulty
attracting a position with comparable pay elsewhere.
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Positive Accounting Theory also assumes that labour
markets are efficient.
None of the mechanisms mentioned—private contracting, capital
markets and labour market forces—is deemed to be perfectly
efficient. However, it is assumed within PAT that the concurrent
existence of well-designed management compensation
contracts, the market for corporate takeovers, and a wellinformed labour market should ensure that management, on
average, will act in the best interests of owners.
Debt contracting
When a party lends funds to another organisation, the recipient
of the funds might undertake activities that reduce or even
eliminate the probability of the funds being repaid. The costs
that relate to the divergent behaviour of the borrower are
referred to in PAT as the agency costs of debt. For example, the
recipient of the funds might pay excessive dividends, leaving few
assets in the organisation to service or repay the debt.
Alternatively, the organisation might take on additional and
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perhaps excessive levels of debt. The new debtholders would
then compete with the original debtholders for repayment.
Smith and Warner (1979) refer to this practice as ‘claim
dilution’.
Further, the borrowing firm might also invest in very high-risk
projects. This strategy would not be beneficial to its debtholders.
They have a fixed claim and therefore if such a project
generates high profits they will receive no greater return, unlike
the owners who will share in the increased value of the firm. If
such a project fails, which is more likely with a risky project, the
debtholders might receive nothing. Therefore, while the
debtholders do not share in any profits (the ‘upside’) they do
suffer the consequences of any significant losses (the
‘downside’).
In the absence of safeguards that protect their interests,
debtholders will assume that management will take actions that
might not always be in the debtholders’ interest. As a result, in
the absence of contractual safeguards, it is assumed that they
will require the firm to pay higher costs of interest to
compensate for the high-risk exposure (Smith & Warner 1979).
If a firm contractually agrees—from an efficiency perspective—
that it will not pay excessive dividends, not take on high levels
of debt and not invest in projects of an excessively risky nature,
it is assumed that the firm will be able to attract debt capital at
a lower cost than would otherwise be possible. To the extent
that the benefits of lower interest costs exceed the costs that
might be associated with restricting how management can use
available funds, management will elect to sign agreements that
restrict its subsequent actions.
Early Australian evidence on debt contracts (negotiated between
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the providers of debt capital and the managers of the
organisation) is provided by Whittred and Zimmer (1986, p. 22).
They find that:
with few exceptions, trust deeds for public debt place
restrictions on the amount of both total and secured liabilities
that may exist. The constraints were most commonly defined
relative to total tangible assets; less often relative to
shareholders’ funds. The most frequently observed constraints
were those limiting total and secured liabilities to some fraction
of total tangible assets.
The above quotation makes reference to ‘public’ debt issues.
When we note that something is a ‘public issue’, it means that
the particular security (such as a debenture, unsecured note or
convertible note) was made available for the public to invest in
(with the terms of the issue typically provided within a publicly
available prospectus document). Investors in a public debt issue
would have a trustee who is to act in the interests of all the
public investors. By contrast, a private debt issue involves an
agreement between a limited number of parties (perhaps just
one party, such as a bank) to provide debt capital to an
organisation. Cotter (1998a, p. 187) provides more recent (than
Whittred and Zimmer) Australian evidence about debt contracts
used in private debt issues. She finds that:
Leverage covenants are frequently used in bank loan contracts,
with leverage most frequently measured as the ratio of total
liabilities to total tangible assets. In addition, prior charges
covenants that restrict the amount of secured debt owed to
other lenders are typically included in the term loan
agreements of larger firms, and are defined as a percentage of
total tangible assets.
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Where covenants restrict the total level of debt that may be
issued, this is assumed to lead to a reduction in the risk to
existing debtholders. This is further assumed to translate to
lower interest rates being charged by the ‘protected’
debtholders. It is worth noting that in her unpublished PhD
thesis, Cotter found that the commonly used definition of assets
allowed for assets to be revalued. However, for the purposes of
debt restriction, some banks restricted the frequency of
revaluations to once every two or three years, while others
tended to exclude revaluations undertaken by directors of the
firm. These restrictions lessen the ability of firms to
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loosen debt constraints by revaluing assets. Cotter
(1998b) found that, apart from debt-to-assets constraints,
interest coverage and current ratio clauses are frequently used
in debt agreements. Interest coverage clauses typically require
that the ratio of net profit—with interest and tax added back—to
interest expense be at least a minimum number of times. In the
Cotter study, the number of times interest must be covered
ranged from one and a half times to four times. The current
ratio clauses reviewed by Cotter required that current assets be
between one and two times the size of current liabilities,
depending on the size and industry of the borrowing firm.
In more recent research, Mather and Peirson (2006) undertook
an analysis of Australian public and private debt issues between
1991 and 2001. They showed that, relative to the earlier
samples used by Whittred and Zimmer, more recent public debt
issues show a ‘significant reduction in the use of debt to asset
constraints, such as covenants restricting the total
liabilities/total tangible assets, or total secured liabilities to total
tangible assets, with only 28 per cent of the sample of recent
contracts including these covenants’ (p. 292). However, Mather
and Peirson provide evidence that, while there is a reduction in
the use of covenants that restrict the amount of total liabilities
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relative to assets, there appears to be a greater variety of
covenants being used relative to earlier years. Among the other
covenants they found in debt contracts are requirements
stipulating required minimum interest coverage, minimum
dividend coverage, minimum current ratio, and required
minimum net worth. Again, as we know, if these minimum
accounting-based requirements are not met, the borrower is
considered to be in technical default of the debt agreement and
the lenders may take action to retrieve their funds. As we should
appreciate, the purpose of the various debt covenants is to
provide lenders with regular and timely indicators of the
possibility of a borrowing entity defaulting on repaying its debts.
A violation of a debt covenant signals an increase in the
likelihood of default. However, it needs to be appreciated that
the covenant measures are simply indicators of the chances that
an organisation will not repay borrowed funds, and that an
organisation simply being in technical default of a covenant is
not a perfect indicator that the entity would not have repaid the
borrowed funds.
When debt contracts are written, and where they utilise
accounting numbers, the contract can, as we indicated earlier,
rely upon either the accounting rules in place when the contracts
were signed (often called ‘frozen GAAP’) or the contract might
rely upon the accounting rules in place at each year’s reporting
date (referred to as ‘rolling GAAP’ or ‘floating GAAP’). Mather
and Peirson found that in all but one of the public debt
contracts, rolling (or floating) GAAP was to be used to calculate
the specific ratios used within the contracts. The use of rolling
GAAP increases the risk to borrowers in the sense that if the
IASB (and thereafter the AASB) issues a new accounting
standard that changes the treatment of particular assets,
liabilities, expenses or income, this has the potential to cause an
organisation to be in technical default of a loan agreement. For
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example, a new accounting standard might be released that
requires a previously recognised asset to be fully expensed to
the income statement (or the statement of profit or loss and
other comprehensive income). This could have obvious
implications for debt to asset constraints, or interest coverage
requirements. As another more specific example, we can
consider the release of IFRS 15 Revenue from Contracts with
Customers in 2014. For many firms this changed when they
recognised revenue, which in turn could have potentially
affected accounting-based debt covenants. That is, in the
absence of the organisation changing any aspect of its business,
a new rule in relation to revenue recognition could create
changes in measures used in debt covenants, and create various
costs associated with defaulting on debt contracts. This in itself
could provide the motivation for organisations to actively lobby
accounting standard-setters against a particular draft accounting
standard. As Mather and Peirson (2006, p. 294) state:
The use of rolling GAAP in Australia means that new (or
revisions to) accounting standards might cause breaches of
covenants not anticipated at the time of contract negotiation.
When comparing the use of covenants in public and private debt
issues, Mather and Peirson found that the mean number of
accounting-based covenants used in the sample of public debt
contracts is smaller (mean of 1.5) than the mean number of
covenants found in the sample of private debt contracts (mean
of 3.5). That is, more restrictions were placed on privately
negotiated debt agreements. Similarly, where debt covenants
restricted total liabilities to total tangible assets, Mather and
Peirson found that ‘the limits imposed in public debt contracts (a
mean total liabilities/total tangible assets of 82.2 per cent)
appear to be less restrictive that those in private debt contracts
(mean limit of 75.2 per cent)’. The fact that private debt
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contracts are more restrictive than public debt contracts can be
explained from an efficiency perspective. When a covenant is
violated, an organisation is in technical default of the debt
contract. If an organisation is in technical default, it often has
the option of negotiating with the debtholders to try to come up
with a compromise that does not involve immediate repayment
of the debt. However, it is very difficult, and sometimes nearly
impossible, to renegotiate a satisfactory outcome in a public
debt issue, as there are so many diverse parties involved—some
of which might not even be able to be contacted. Hence we
would expect to find the covenant restrictions to be less Page 96
restrictive in public debt contracts than in private debt
contracts. As Mather and Peirson (2006, p. 305) state:
In comparison to our sample of recent public debt contracts,
private debt contracts contain a greater number, variety and,
collectively, more restrictive set of financial covenants. We also
document differences in accounting rules associated with
financial covenants used in these contracts. Tailoring of the
definition of liabilities and earnings in private debt contracts
make them more restrictive compared with the definitions in
public debt contracts. Our findings support [the] theory that
suggests that covenant restrictive and renegotiation–flexible
contracts are more suited to borrowers contracting with
financial intermediaries in private debt markets than to public
debt markets that are characterized by diverse and numerous
investors.
As with management compensation contracts, PAT assumes that
the existence of debt contracts (which are initially put in place
as a mechanism to reduce the agency costs of debt and can be
explained from an efficiency perspective) provides management
with a subsequent (ex post) incentive to manipulate accounting
numbers—an incentive that increases as the accounting-based
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constraint approaches violation. As Watts (1995, p. 323) states:
Early studies of debt contract-motivated choice test whether
firms with higher leverage (gearing) are more likely to use
earnings-increasing accounting methods to avoid default
(leverage hypothesis). The underlying assumptions are that the
higher the firm’s leverage the less slack in debt covenants and
the more likely the firm is to have changed accounting
methods to have avoided default. This change is usually
interpreted as opportunistic since technical default generates
wealth transfers to creditors but it could also be efficient to the
extent that it avoids real default and the deadweight loss
associated with bankruptcy.
For example, if the firm contractually agreed that the ratio of
debt to total tangible assets should be kept below a certain
figure (and this is considered to reduce the risk of the
debtholders not being repaid), if that figure was likely to be
exceeded (constituting a technical default of the loan agreement
and thereby potentially requiring the entity to repay the funds
immediately) management might have an incentive to either
inflate assets (perhaps through an upward asset revaluation) or
deflate liabilities. This is consistent with the results reported in
Christie (1990) and Watts and Zimmerman (1990). To the
extent that such an action was not objective, management
would obviously be acting opportunistically and not to the
benefit of individuals holding debt claims against the firm. Debt
agreements typically require financial statements to be audited.
Other research to consider how management might manipulate
accounting numbers in the presence of debt agreements
includes that undertaken by DeFond and Jiambalvo (1994) and
Sweeney (1994). Both of these studies investigated the
behaviour of managers of firms that were known to have
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defaulted on accounting-related debt covenants . DeFond and
Jiambalvo (1994) provided evidence that the managers
manipulated accounting accruals in the years before and the
year after violation of the agreement. Similarly, Sweeney (1994)
found that as a firm approaches violation of a debt agreement,
managers have a greater propensity to adopt income-increasing
strategies (which also act to increase assets) compared with
managers in firms that are not approaching technical default of
accounting-based debt covenants. Income-increasing accounting
strategies include changing key assumptions when calculating
pension liabilities, and adopting LIFO cost-flow assumptions for
inventory.
Sweeney (1994) also showed that managers with an incentive to
manipulate accounting earnings might also strategically
determine when they will first adopt a new accounting
requirement. When new accounting standards are issued, there
is typically a transitional period (which could be a number of
years) in which organisations can voluntarily opt to implement a
new accounting requirement. After the transitional period, the
use of the new requirement becomes mandatory. Sweeney
showed that organisations which defaulted on their debt
agreements tended to adopt income-increasing requirements
early, and deferred the adoption of accounting methods that
would lead to a reduction in reported earnings. In further related
research, Franz, Hassabelnaby and Lobo (2014) report that
firms close to violating debt covenants are more likely to
manage their earnings in a way that reduces the risk of
covenant violation.
Debt contracts occasionally restrict the accounting techniques
that may be used by the firm, thus requiring adjustments to
published accounting numbers. For example, and as stated
above, Cotter (1998a) shows that bank loan contracts
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sometimes do not allow the component related to asset
revaluations to be included in the definition of ‘assets’ for the
purpose of calculating ratios, such as ‘debt to assets’
restrictions. These revaluations are, however, allowed for
external reporting purposes. Therefore, loan
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agreements sometimes require the revaluation
component to be removed from the published accounting
numbers before the calculation of any restrictive covenants
included within the debt contract.
Within accounting, management usually has available a number
of alternative ways to account for particular items and, thus, to
minimise the effects of existing accounting-based restrictions.
Therefore, it might appear optimal for debtholders to stipulate
in advance all accounting methods that management must use.
However, and as noted previously, it would be too costly and
impractical to write ‘complete’ contracts up front. As a
consequence, management will always have some discretionary
ability to enable it to loosen the effects of accounting-based
restrictions negotiated by debtholders. The role of external
auditors, if appointed, would be to arbitrate on the
reasonableness of the accounting methods chosen.
In relation to auditors, and following on from the discussion so
far, there would appear to be a particular demand for financialstatement auditing when:
l
l
management is rewarded on the basis of numbers generated
by the accounting system
the firm has borrowed funds and accounting-based covenants
are in place to protect the investments of debtholders.
Consistent with the above, it could also be argued that as the
managers’ share of equity in the business decreases and as the
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proportion of debt to total assets increases, there will be a
corresponding increase in the demand for auditing. In this
regard, Ettredge et al. (1994) show that organisations that
voluntarily elect to have interim financial statements audited
tend to have greater leverage and lower management
shareholding in the firm.
In summing up our discussion on debt contracting we can see
that accounting numbers can have significant implications for
the ongoing viability of an organisation. Many organisations
borrow funds with the terms of the borrowing being stipulated in
contracts that incorporate accounting-based debt convents.
Failure to comply with these negotiated covenants (often
referred to as a ‘technical breach’ of a convent or contract) can,
at the extreme, lead to the operations of the organisation being
suspended or placed in the hands of a party nominated by the
lender, while the lenders seek to gain access to their funds. In
this regard we can consider an article that appeared in The
Sydney Morning Herald in relation to surfwear company
Billabong Ltd entitled ‘Write-down puts Billabong in breach of
debt covenant’ (by Collin Kruger, 23 February 2013), which
stated:
BILLABONG’S path to redemption got tougher on Friday after
the surfwear group downgraded earnings guidance and said a
$537 million loss for the half-year put it in breach of debt
covenants. The breach led its banks to seek a secured charge
over most of the business ... The company said it was in
breach of its debt covenants owing to the $567 million worth of
write-downs for the half-year. The situation has since been
remedied, but at a price.
Billabong said it had agreed to move ‘as soon as practicable’ to
a secured banking arrangement with its financiers ‘whereby the
company will grant security over the majority of its assets’. The
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new chief financial officer, Peter Myers, said talks with the
banks had been ‘extremely constructive’.
As another example of how lenders can take control of an
organisation in the situation where there is a technical default of
a debt covenant we can consider the case of Nufarm Ltd. In an
article that appeared in The Australian entitled ‘Nufarm debt in
hands of bankers’ (by John Durie, 27 September 2010), it was
stated:
NUFARM’s banks are working towards a waiver on its debt
breaches but no agreement has been reached to clear the
company’s immediate future. The company is to unveil its
latest profit numbers tomorrow and, having issued five profit
downgrades in 18 months, is expected to come within its latest
guidance of an operating profit between $55 million and $60m.
But the bank clearance is the major news the market is waiting
for after Nufarm admitted in July it had breached one of its
debt covenants relating to the ratio of earnings to interest
payments. The banks have appointed McGrath Nicol to
represent their interests and the company has Gresham and
Deloittes advising on its future corporate structure. Any move
on that front will depend on the banks’ reaction because they
effectively control the company at present because of the
covenant violation.
While this material has discussed how accounting-based debt
covenants are often negotiated between borrowers and lenders,
we could perhaps expect that the level of reliance that lenders
place on accounting-based indicators, as a means of protecting
the funds advanced to an organisation, will be influenced by the
perceived integrity of the accounting systems in place within the
borrowing organisation. In this regard Costello and
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Wittenberg-Moerman (2011) find that if an organisation
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discloses information about internal control failures within its
accounting system, lenders will tend to decrease their reliance
on the use of accounting-based covenants. Rather, borrowers
who have had instances of poor internal controls tend to
encounter higher interest rates and additional security
requirements.
So, in summarising this discussion, we can understand that
many organisations have debt contracts in place that use
accounting numbers. The use of particular covenants within debt
contracts provides a vehicle for transferring certain rights and
decision making from shareholders/managers to
creditors/lenders when a company appears to be approaching a
situation of financial distress. The covenants thereby provide a
mechanism to limit managers’ ability to expropriate the wealth
of the creditors/debtholders. Consistent with PAT, this in turn
provides incentives to managers (assuming self-interest) to
adopt income/asset increasing accounting methods, particularly
when they are close to breaching debt covenants. In the
discussion that follows, we consider how expectations about the
political process can also affect managers’ choice of accounting
methods.
Political costs
The term ‘political costs ’ is used to refer to the costs that
particular groups external to the firm may be able to impose on
the firm, such as the costs associated with increased taxes,
increased wage claims or product boycotts.
Organisations are affected by a multitude of stakeholders,
including governments, trade unions, environmental lobby
groups and consumer groups. Research indicates (Watts &
Zimmerman 1978; Wong 1988; Deegan & Hallam 1991) that the
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demands placed on firms by interest groups might be affected
by the accounting results of the firm. For example, if a firm
records high profits, this might be used as a justification or an
excuse for trade unions to take action to increase their
members’ share of the profits in the form of increased wages.
Publicity, such as media coverage, is not typically given to the
accounting methods used to derive particular accounting
numbers. Rather, attention seems to be focused on the final
numbers themselves, without regard to how those numbers
were determined. In this regard, we can consider how
representatives of interest groups or political parties might use
profits or other accounting numbers as a justification for
particular actions. In this respect, a newspaper article appeared
in the Hobart Mercury on 9 March 2013 (entitled ‘Tax on big four
hits brick wall’) in which the Australian Greens political party
used the size of bank assets (measured in accounting terms) as
the basis for levying additional taxes on banks. In part, the
article stated:
The Greens want a levy of 0.2 per cent on all bank assets
above $100 billion in return for Federal Government
guarantees, which the independent Parliamentary Budget
Office has costed as raising $11 billion over the next four
years.
‘At a time when there’s pressures on the budget, and the
government is looking around for ways of raising revenue,
especially in light of the failed mining tax, who can afford to
pay it the most?’ Australian Greens’ Mr Bandt said yesterday.
‘If we don’t stand up to the big banks and the big miners,
then the Labor Party is going to come after the rest of us, like
they have with single parents, and like they are threatening
with the forthcoming budget.’
From the above extract we can see how an accounting number—
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total assets—had been used as the basis of justifying levying the
additional tax. While the proposal was rejected by the
government, it does show how accounting numbers are used in
political debates. In the same article, the banks responded by
noting how such a proposed tax would impact many people,
including retirees and the ‘working Australian’. Such a response
would be aimed at trying to dampen any future calls for
additional taxes:
The Australian Bankers’ Association warned that if the Greens’
policy was adopted it would effectively amount to a tax on
Australians’ retirement savings.
The association’s chief executive Steven Munchenberg said the
majority of bank profits were paid through dividends to mum
and dad shareholders and superannuation funds.
‘Taxing banks’ profits reduces those returns for working
Australians saving for their retirement through superannuation
accounts and to retirees who are increasingly dependent upon
positive business profit growth,’ he said.
Government departments can also come under political pressure
as a result of reported high profits. That is, government
departments can also be subject to political costs. As an
example of this, we can consider a story about New Zealand
Post (the government department responsible for mail Page 99
deliveries and other services). In an article entitled ‘40c
stamp follows $72.3 m profit’ (by Craig Howie, The Dominion,
28 June 1995), the New Zealand communications minister states
that the increasing profits of NZ Post were reaching a level at
which they could be considered by the community as being
‘obscene’. Possibly in expectation of a community backlash, NZ
Post reduced the price of its stamps following the announcement
of profit results. Perhaps such a price reduction would not have
occurred if NZ Post had not recorded such a large accounting
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profit, which in turn attracted negative media attention.
In Australia, banks have often been criticised for charging high
rates of interest at the same time as they are reporting high
profits. For example, in an article entitled ‘Banks in credit card
gouge’ (by Clancy Yeates, Canberra Times, 13 May 2013) it was
stated:
Big banks have failed to pass on most interest rates cuts to
their credit card customers, despite the Reserve Bank cutting
them to their lowest level in more than 50 years. Australians
charged $6.2 billion in credit card interest bills annually are
propping up the record half-year profits of $13.4 billion
reported by the big four banks.
Again, we can see that accounting profits can draw unwanted
attention to an organisation.
An industry’s high profits might also be used as a basis for
action by groups that lobby politically for increased taxes or
decreased subsidies on the grounds of the industry’s ability to
pay. For example, Watts and Zimmerman (1986) examine the
highly publicised claims about US oil companies made by
consumers, unions and government within the US in the late
1970s. It was claimed at the time that oil companies were
making excessive reported profits and were in effect exploiting
the nation. It is considered that such claims could have led to
the imposition of additional taxes in the form of ‘excess profits’
taxes. In a more recent Australian example of how an industry’s
profits might be used as a justification for calls for additional
taxes, we can consider this article entitled ‘Banks’ rate excuses
don’t add up’, which appeared in The Age (8 December 2011).
The article stated:
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Banks are in the business of making money, but at times they
seem to forget the costs of angering customers. The big four’s
show of silence following Tuesday’s 0.25-point rate cut by the
Reserve Bank was one such moment. Yes, the European debt
crisis is putting pressure on funding costs and only NAB, which
has the lowest standard mortgage rate, failed to pass on last
month’s 0.25-point rate cut in full. But Treasurer Wayne Swan
is right to insist that the big four banks, whose record profits
recently topped $24 billion, have little excuse for not passing
on the full rate cut … The difficulties of the rate-sensitive retail
and construction sectors ought to remind banks of their
responsibilities as corporate citizens. They owe a debt to
taxpayers who, through government support, stood behind
them in the GFC. Despite their desire to protect short-term
returns to shareholders, banks should not neglect their role in
sustaining the health of the Australian economy, which still
provides most of their income. If they don’t play ball, the
banks can expect support for a banking super-profits tax to
grow.
Governments seeking re-election could be motivated to take
action against unpopular firms or industries if it were considered
that there would be a net increase in electoral support. The
following extract from an article by Morgan Mellish and Jason
Koutsoukis entitled ‘MPs have banks in their sights’ (The
Australian Financial Review, 28 November 2000, p. 3) reports
the reaction of one banking executive to this possibility:
Commonwealth Bank chief executive Mr David Murray
yesterday said he was fearful of politicians increasing the antibank rhetoric in an effort to capitalise on community anger
towards banks. ‘There are a number of elections in Australia
next year and we know the political homework that’s been
done in the leadup to those elections includes banking as an
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issue at every level,’ Mr Murray said.
The view that politicians will target unpopular industries to
bolster their chances of re-election assumes that the actions of
most politicians are motivated by a desire to be re-elected—
perhaps not an unrealistic assumption and certainly consistent
with the PAT assumption that the actions of all individuals can
best be explained in terms of self-interest. Therefore, it is
argued that the reported accounting numbers, such as profits,
might result in the imposition of costs on the firm, perhaps
through increased taxes, calls for reduced prices or calls for
wage increases for workers.
Generally speaking, it is argued within PAT that accounting
numbers can be used as a means of providing ‘excuses’ for
effecting wealth transfers in the political process (Holthausen &
Leftwich 1983, p. 83). Politicians can rely on accounting
numbers to justify their own particular actions or provide
‘excuses’, given the expectation that it is costly for constituents
to ‘unravel’ accounting numbers derived from particular, and
perhaps alternative, accounting methods. It would also be costly
for constituents to determine the ‘real’ motivations for
politicians’ actions, or the economic consequences of those
actions. For example, a government might decide to reduce the
tariff protection of a particular industry and, in doing
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so, it could highlight the high profits that have been
reported by firms within that industry; that is, it could use the
profits as an excuse for the action. Consistent with the work of
Downs (1957), individual constituents will not have an incentive
to investigate more fully the actual motivations of the
government. They have only one vote in the political process
and the costs of being fully informed about the government’s
actions are assumed to be greater than any subsequent benefits
constituents could generate from the knowledge.
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As already indicated, high profits might also be used by
consumer groups to justify a position that prices are too high.
For example, consider the difficulties a firm might have
justifying a price rise for its goods or services if, at the same
time, it is recording high profits. Consistent with Watts and
Zimmerman (1978), if a firm believes that it is, or might be,
subject to political costs, there might be incentives to adopt
income-decreasing accounting methods.
In the discussion so far, we examined how representatives of
interest groups might use profits as a justification for particular
actions. Lower reported profits might reduce the likelihood of
demands for increased wages. Hence, if management considers
that there might be claims for increased wages in particular
years, or the industry might be the target for increased taxes or
consumer calls for price decreases, then managers might elect
to adopt income-decreasing accounting methods (for example,
managers might depreciate assets over fewer years, thereby
increasing depreciation expense and reducing profits). In this
regard, research in the US by Jones (1991) considered the
behaviour of 23 firms from five industries that were the subject
of investigations into government import relief from 1980 to
1985. These investigations by the International Trade
Commission sought to determine whether the domestic firms
were under threat from foreign competition. Where this threat is
deemed to be unfair, the government can grant relief in terms of
devices such as tariff protection. In making its decision, the
government relies upon a number of factors, including economic
measures such as profits and sales. The results of the study
show that, in the year of the investigations, the sample
companies chose accounting strategies that led to a decrease in
reported profits. Such behaviour was not exhibited in the year
before or the year after the government investigation (perhaps
indicating that politicians are fairly ‘short-sighted’ when
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undertaking investigations). In other US-based research, Cahan
(1992) undertook an investigation of the accounting methods
used by organisations subject to investigation by the US
Department of Justice and Federal Trade Commission and found
that firms under investigation tended to adopt income-reducing
accounting strategies. In more recent research of a related
nature, Hao and Nwaeze (2015, p. 195) reviewed accountingrelated behaviour of the US pharmaceutical industry at a period
when it became the target of public condemnation for rising
drug prices and at the same time faced the prospect of new laws
to curtail its revenues. Firms were expected to adopt accounting
methods that would lower their profits and thus reduce their
unpopularity for being highly profitable, thereby also reducing
calls from the public for additional legislation. The authors found
a variety of accounting actions were indeed employed that
reduced reported profits—consistent with a political cost
hypothesis. This study represented yet another example of
research that sought to confirm the ‘political cost hypothesis’—a
hypothesis that has been subject to repeated investigation for
approximately 40 years.
PAT in summary
Up to this point, we have shown the following:
l
PAT proposes that the selection of particular and alternative
accounting methods can be explained either from an efficiency
perspective or an opportunistic perspective. At times, it is very
difficult to distinguish which perspective best explains a
particular organisation’s accounting strategies. The selection of
particular accounting methods can affect the cash flows
associated with debt contracts, the cash flows associated with
management-compensation plans, and the political costs of the
firm.
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PAT indicates that these effects can be used to explain why
firms elect to use particular accounting methods in preference
to others. This would be of particular relevance to accountants
in practice. For example, auditors need to consider the factors
that might have motivated a firm to adopt particular
accounting methods in preference to others. PAT also provides
a basis for explaining why particular organisations might lobby
for or against particular proposed accounting requirements. As
we know from Chapter 1 , when new accounting standards
are being developed by the IASB or the AASB, the standardsetters will normally develop a draft accounting standard and
then ask for submissions from the public. PAT provides a
framework for explaining the lobbying positions taken by the
respective respondents and hence provides insights that would
be of particular relevance to accounting standard-setters and
regulators.
PAT indicates that the use of particular accounting methods
might have opposing effects. For example, if a firm adopts a
policy that increases income by capitalising an item, rather
than expensing it as it is incurred, this might reduce the
probability of violating a debt covenant and might
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also increase accounting-related management
bonuses. However, it could also increase the political visibility
of the firm on account of higher profits. Managers are assumed
to select accounting methods that best balance their conflicting
effects, while at the same time maximising their own wealth.
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Accounting policy selection and disclosure
Page 1 of 3
Accounting policy selection and disclosure
LO 3.7 LO 3.8
As noted earlier in this chapter, a firm might be involved in
many agreements that use accounting numbers relating to
profits and assets (for example, an organisation might have
instituted a bonus plan where bonuses paid to managers are
based on profits, or it might be subject to a debt covenant that
restricts its total debt to a certain percentage of its total
assets). Hence the decision to expense or capitalise an item
might have important financial implications for the organisation
and, potentially, for management.
It should be noted at this early point in the text that there is
much scope in accounting for applying professional judgement
in the selection of accounting policies. For example, some
companies might use a first-in first-out basis for valuing
inventories, while other companies might use a weightedaverage approach (both methods are allowed by AASB 102
Inventories). The method selected will have a particular effect
on income and assets. This inventory example is only one of
numerous choices a firm faces. The old adage that if you put a
hundred accountants in a room you might very well get a
hundred different figures for the profit or loss of the same
business is very true. As we have seen, PAT suggests that the
choices that affect profits might in turn have implications for
bonus payments to managers, for debt contracts and for
political costs.
As a result of the choices that confront the accountant, it is
imperative that financial statement users are aware of the
accounting policies adopted by reporting entities. Comparing
the financial results and position of reporting entities that use
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Accounting policy selection and disclosure
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different accounting methods might be a misleading exercise
unless notional adjustments are made to counter the effects of
using these different methods and policies. For such
adjustments, knowledge of each firm’s accounting policies is
necessary.
AASB 101 Presentation of Financial Statements requires that a
summary of accounting policies be presented in the initial
section of the notes to the financial statements.
Specifically, paragraph 117 of AASB 101 states:
An entity shall disclose its significant accounting policies
comprising:
(a)
the measurement basis (or bases) used in preparing
the financial statements; and
(b)
the other accounting policies used that are relevant to
an understanding of the financial statements.
In explaining the above requirement, paragraph 118 of AASB
101 states:
It is important for an entity to inform users of the
measurement basis or bases used in the financial statements
(for example, historical cost, current cost, net realisable
value, fair value or recoverable amount) because the basis on
which an entity prepares the financial statements significantly
affects users’ analysis. When an entity uses more than one
measurement basis in the financial statements, for example
when particular classes of assets are revalued, it is sufficient
to provide an indication of the categories of assets and
liabilities to which each measurement basis is applied.
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Paragraph 119 of AASB 101 further states:
In deciding whether a particular accounting policy should be
disclosed, management considers whether disclosure would
assist users in understanding how transactions, other events
and conditions are reflected in reported financial performance
and financial position. Each entity considers the nature of its
operations and the policies that the users of its financial
statements would expect to be disclosed for that type of
entity. Disclosure of particular accounting policies is especially
useful to users when those policies are selected from
alternatives allowed in Australian Accounting Standards.
When a company has changed its accounting policies from one
period to the next, comparing its performance in different
periods can become difficult. In this regard, AASB 108 requires
that, where there is a change in the accounting policy used in
preparing and presenting financial statements or group
financial statements for the current financial year, and this
change has a material effect on the financial statements or
group financial statements, the summary of accounting policies
is to disclose, or refer to a note disclosing, the
Page 102
nature of the change, the reason for the change and
the financial effect of the change. AASB 108, paragraph 14,
requires that a change in an accounting policy is to be made
only when it:
(a)
is required by an Australian Accounting Standard; or
(b)
results in the financial statement providing reliable and
more relevant information about the effects of transactions,
other events or conditions on the entity’s position, financial
performance or cash flows.
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Accounting policy choice and ‘creative accounting’
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Accounting policy choice and ‘creative
accounting’
LO 3.10
Those people responsible for selecting between the different
accounting techniques—which, as we have seen, should be
explained in the accounting policy notes —might select the
alternatives that they believe most effectively and efficiently
report the performance of their firm; in other words, they
might approach their selection objectively. As paragraph 10 of
AASB 108 states:
In the absence of an Australian Accounting Standard that
specifically applies to a transaction, other event or condition,
management shall use its judgement in developing and
applying an accounting policy that results in information that
is:
(a) relevant to the economic decision-making needs of
users; and
(b) reliable, in that the financial statement
(i)
represents faithfully the financial position, financial
performance and cash flows of the entity;
(ii)
reflects the economic substance of transactions,
other events and conditions, and not merely the legal form;
(iii)
is neutral, that is, free from bias;
(iv)
is prudent; and
(v)
is complete in all material respects.
By contrast, it is also possible for such individuals to select the
policies that best serve their own interests; in other words,
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they might approach their selection and application of
accounting techniques ‘creatively’. The term creative
accounting is frequently used in the media. It refers to insta
nces where those responsible for the preparation of financial
statements select accounting methods that provide the result
desired by the preparers. As we have already seen, PAT
provides an explanation of why firms might be creative—or
opportunistic—with their accounting (perhaps to increase the
rewards paid to managers, to loosen the effects of accountingbased debt covenants or to reduce potential political costs).
Indeed, we saw that there were three general hypotheses,
these being referred to as:
l
the debt hypothesis;
l
the management bonus hypothesis; and
l
the political cost hypothesis.
The debt hypothesis predicts that organisations close to
breaching accounting-based debt covenants will select
accounting methods that lead to an increase in profits and
assets. The management bonus hypothesis predicts that
managers on accounting-based bonus plans will select
accounting methods that lead to an increase in profits. And
the political cost hypothesis predicts that firms subject to
political scrutiny will adopt accounting methods that lead to a
reduction in reported profits.
With the range of accounting techniques available—and these
techniques will be highlighted throughout this text—account
preparers can be creative, yet at the same time follow
accounting standards. Although they might not be objective, it
might be difficult for parties such as auditors, with an
oversight function, to report that the account preparers are
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doing anything wrong. It is hoped, however, that the vast
majority of individuals preparing financial statements place
objectivity before self-interest—a hope that is perhaps in
conflict with a central assumption of PAT.
Griffiths, a British author, devoted an entire book to the issue
of creative accounting within the United Kingdom. The book is
entitled Creative Accounting: How to Make Your Profits What
You Want Them to Be, and in it Griffiths (1987, p. 1) stated:
Every company in the country is fiddling its profits. Every set
of published accounts is based on books which have been
gently cooked or completely roasted. The figures which are
fed twice a year to the investing public have all been
changed in order to protect the guilty. It is the
Page 103
biggest con trick since the Trojan horse. Any
accountant worth his salt will confirm that this is no wild
assertion. There is no argument over the extent and
existence of this corporate contortionism, the only dispute
might be over the way it is described. Such phrases as
‘cooking the books’, ‘fiddling the accounts’ and ‘corporate
con trick’ may raise eyebrows where they cause people to
infer that there is something illegal about this pastime. In
fact this deception is all in perfectly good taste. It is totally
legitimate. It is creative accounting.
This is a fairly extreme view of creative accounting, and not
one necessarily shared by the author of this book. If the
output of the accounting system lacks credibility and assuming
that such markets as the capital market are efficient, it would
be unlikely that they would use the output of the accounting
system in the design of contractual arrangements with such a
firm. However, evidence clearly indicates that the market does
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rely on the output of the accounting system. For example, the
bond (debenture) trust deeds of large, Australian listed firms,
as well as negotiated lending agreements with banks, without
any apparent exception, use the output of the accounting
system to control and monitor the behaviour of corporate
management. While we need to acknowledge that creative
accounting does exist, it is reasonable to argue that, with the
increased number of accounting standards being issued, the
scope for being creative has decreased.
Whatever the actual incidence of creative accounting, to
consider that all financial statements are developed on an
objective basis would be naive. This chapter has discussed
how the wealth of the firm, or particular individuals, might be
tied to the output of the accounting system. This can be
through the existence of accounting-based debt contracts and
accounting-based management compensation schemes, both
of which are, according to PAT, initially devised to increase the
efficient operations of the entity (the efficiency perspective).
The existence of political costs, which might be influenced in
part by such accounting numbers as ‘profits’, will also affect
the value of an organisation. Adopting the opportunistic
perspective of PAT, whenever individuals’ wealth is at stake,
there is always the possibility that opportunistic actions might
override the dictates of objectivity. Certainly, PAT assumes
that considerations of self-interest would drive the selection of
accounting policies. Whatever the case, creativity might be
employed, but hopefully not too often!
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Some criticisms of Positive Accounting Theory
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Some criticisms of Positive Accounting
Theory
LO 3.3 LO 3.5
Although PAT received fairly widespread acceptance from a
large group of accounting academics, there are nevertheless
many researchers who opposed its fundamental tenets.
Deegan (1997b) provides evidence of the degree of opposition
and the intensity of emotion that PAT had generated among its
detractors. The following discussion is based on the contents of
Deegan (1997b). Some of the rather unflattering descriptions
of PAT, made by well-regarded accounting academics, have
included:
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It is a dead philosophical
movement.
(Christenson 1983, p. 7)
It has provided no
accomplishments.
(Sterling 1990, p. 97)
It is marred by oversights,
inconsistencies and
paradoxes.
(Chambers 1993, p. 1)
It is imperiously dictatorial.
(Sterling 1990, p. 121)
It is empty and
commonplace.
(Sterling 1990, p. 130)
It is akin to a cottage
industry.
(Sterling 1990, p. 132)
It is responsible for turning
back the clock of research
1 000 years.
(Chambers 1993, p. 22)
It provides evidence of
doubtful value.
(Williams 1989, p. 456)
It suffers from logical
incoherence.
(Williams 1989, p. 459)
It is a wasted effort.
(Sterling 1990, p. 132)
These quoted criticisms clearly indicate the force of emotion
that PAT has stimulated among its critics, particularly the
normative theorists, who see the role of accounting theory as
providing prescription, rather than description. Some of you
might not have expected a theory of accounting (such as PAT)
to be capable of eliciting such a reaction. As students of
accounting, you might find it interesting to ponder why such a
theory has made some people so angry—after all, it is just a
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theory, isn’t it?
Although the descriptions of PAT quoted above are extremely
negative, it must be kept in mind that there are many
researchers who still favour PAT. That is, they still think that
the existence of accounting-based debt covenants,
management bonus plans and possible political costs will act to
influence the choice of accounting methods being used. What
should also be kept in mind is that any theory or model of
accounting will be based on certain key underlying
assumptions about such things as the purposes of accounting,
the purposes of accounting research, what drives individual
actions, and so forth. Not all researchers will agree
Page 104
with the assumptions, and hence it is to be expected
that there will not be total acceptance of any particular theory
of accounting. The discussion below will further highlight some
of the perceived shortcomings of PAT. Remember that these
‘shortcomings’ would conceivably be challenged by those who
favour PAT and/or conduct research under the banner of PAT.
One widespread criticism of PAT is that it does not provide
prescription and therefore does not provide a means of
improving accounting practice. It is argued that simply
explaining and predicting accounting practice is not enough.
Using a medical analogy, Sterling (1990, p. 130) states:
PAT cannot rise above giving the same answers because it
restricts itself to the descriptive questions. If it ever asked
how to solve a problem or correct an error (both of which
require going beyond a description to an evaluation of the
situation), then it might go on to different questions and
obtain different answers after the previous problem was
solved. If we had restricted the medical question to the
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description of the smallpox virus, for example, precluding
prescriptions to be vaccinated, we would need more and more
descriptive studies as the virus population increased and
mutations appeared. Luckily Edward Jenner was naughtily
normative, which allowed him to discover how cowpox could
be used as a vaccine so smallpox was eventually eliminated,
which made room for different questions on the medical
agenda.
Howieson (1996, p. 31) advances the view that, by failing to
provide prescription, Positive Accounting theorists might
alienate themselves from practising accountants. As he
asserts:
an unwillingness to tackle policy issues is arguably an
abrogation of academics’ duty to serve the community which
supports them. Among other activities, practitioners are
concerned on a day-to-day basis with the question of which
accounting policies they should choose. Traditionally,
academics have acted as commentators and reformers on
such normative issues. By concentrating on positive
questions, they risk neglecting one of their important roles in
the community.
A second criticism of PAT is that it is not value-free, as it
asserts, but rather is very value-laden (Tinker, Merino &
Niemark 1982). If we look at research that has been conducted
by applying PAT we will see a general absence of prescription.
There is no guidance on what people should do. This is
normally justified by Positive Accounting theorists on the basis
that they do not want to impose their own views on others.
They would prefer to provide information about the expected
implications of particular actions and thereafter let people
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decide for themselves what they should do. For example, they
might provide evidence to support a prediction that
organisations that are close to breaching accounting-based
debt covenants will adopt accounting methods that increase
the firm’s reported profits and assets. However, as a number
of accounting academics have pointed out, the very act of
selecting a theory such as PAT for research purposes is based
on a value judgement; deciding what to research is based on a
value judgement; believing that all individual action is driven
by self-interest is a value judgement; and so on. Hence, no
research, whether conducted under PAT or otherwise, is valuefree and to assert that it is value-free is, arguably, quite
wrong.
A third criticism of PAT relates to the fundamental assumption
that all action is driven by a desire to maximise wealth. To
many researchers such an assumption represents a
perspective of humankind that is far too negative. In this
regard, Gray, Owen and Adams (1996, p. 75) state that PAT
promotes ‘a morally bankrupt view of the world’. Certainly,
assuming that all action is driven by a desire to maximise one’s
own wealth is not an overly kind assumption about human
nature, but—and this is not a justification—such an assumption
has been the cornerstone of many past and existing theories
used within the discipline of economics. Nevertheless, it is
arguably a rather simplistic assumption.
Given that everybody is deemed to act in their own interests,
the perspective of self-interest has also been applied to the
research efforts of academics. For example, Watts and
Zimmerman (1990, p. 146) argue that:
Researchers choose the topics to investigate, the methods to
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use, and the assumptions to make. Researchers’ preferences
and expected payoffs (publications and citations) affect their
choice of topic, methods, and assumptions.
Many academics would challenge this view and would argue
that they undertake their research because of real personal
interest in an issue. Another implication of the self-interest
issue is that incorporating this self-interest assumption into the
teaching of undergraduate students (as has been done in many
universities throughout the world in the economics and
accounting fields) might result in students thinking that when
they subsequently have to make decisions in the workplace, it
is both acceptable and predictable for them to place their own
interests above others—after all, that was a key ‘ingredient’ in
the theories they were taught. It is perhaps
Page 105
questionable whether such a philosophy is in the
interests of the broader community. At the present time, there
are many social and ecological problems confronting the
planet, not the least of which is climate change. If we are to
embrace sustainability in any sort of meaningful way then it is
very difficult to understand how efforts to ensure that future
generations and the environment will not be disadvantaged by
current corporate activities (which would be required for a
sustainable future), and quests to maximise current wealth
(consistent with ‘self-interest’), can be considered to be
mutually compatible. What do you, the reader, think about this
issue? Does the teaching of theories that assume self-interest
perpetuate the acceptance of self-interest as a guiding
motivation?
Another criticism of PAT is that, since its beginnings in the
1970s, the theory has not developed greatly. In Watts and
Zimmerman (1978) there were three key hypotheses:
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1. The debt hypothesis—which typically proposes that
organisations that are close to breaching accounting-based
debt covenants will select accounting methods that lead to an
increase in profits and assets.
2. The bonus-plan hypothesis—which typically proposes that
managers on accounting-based bonus schemes will select
accounting methods that lead to an increase in profits.
3. The political-cost hypothesis—which typically proposes that
firms subject to political scrutiny will adopt accounting
methods that reduce reported income.
These three hypotheses were considered earlier in this chapter.
A review of the recent PAT literature reveals that these
hypotheses continue to be tested in different environments and
in relation to different accounting policy issues—approximately
40 years after Watts and Zimmerman (1978). In this regard,
Sterling (1990, p. 130) asks the following question:
What are the potential accomplishments [of PAT]? I forecast
more of the same: twenty years from now we will have been
inundated with research reports that managers and others
tend to manipulate accounting numerals when it is to their
advantage to do so.
As a last criticism to consider, it has been argued that PAT is
scientifically flawed. As the three hypotheses generated by PAT
(mentioned above) are frequently not supported by research
but, rather, are falsified, PAT should be rejected from a
scientific point of view. Christenson (1983, p. 18) states:
We are told, for example, that ‘we can only expect a positive
theory to hold on average’ (Watts & Zimmerman 1978, p.
127, n. 37). We are also advised ‘to remember that as in all
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empirical theories we are concerned with general
trends’ (Watts & Zimmerman 1978, pp. 288–9), where
‘general’ is used in the weak sense of ‘true or applicable in
most instances but not all’ rather than in the strong sense of
‘relating to, concerned with, or applicable to every member
of a class’ (American Heritage Dictionary 1969, p. 548) . . . A
law that admits exceptions has no significance, and
knowledge of it is not of the slightest use. By arguing that
their theories admit exceptions, Watts and Zimmerman
condemn them as insignificant and useless.
However, accounting is a process that is undertaken by people,
and the accounting process itself cannot exist in the absence of
accountants—it is hard to think of any model or theory that
could ever fully explain human action. In fact, to do so would
constitute a dehumanising action. Are there any theories of
human activity that always hold? What we must appreciate is
that theories are simplifications of reality.
While the above criticisms do, arguably, have some merit, PAT
continues to be used. A number of accounting research
journals continue to publish PAT research and many accounting
research schools throughout the world continue to teach PAT.
What must be remembered is that all theories of accounting
will have limitations. They are, of necessity, abstractions of the
‘real world’. Whether we individually prefer one theory of
accounting to another will depend on our own assumptions
about many of the issues raised in this chapter. In the
discussion that follows we turn our attention to normative
theories of accounting. As you might expect, such theories are
also subject to varied levels of criticism.
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Normative accounting theories
Page 1 of 12
Normative accounting theories
LO 3.2 LO 3.11
As the discussion so far in this chapter has indicated, PAT, the
theory based on the works of such individuals as Watts and
Zimmerman, and Jensen and Meckling, seeks to explain and
predict the selection of particular accounting policies and the
implications of that selection. Normative
Page 106
accounting theories , on the other hand, seek to pr
ovide guidance to individuals to enable them to select the most
appropriate accounting policies for given circumstances. The
conceptual framework, discussed in Chapter 2
can be
considered a normative theory of accounting. Its purpose is to
provide guidance to the individuals responsible for preparing
general purpose financial statements. The conceptual
framework identifies the objective of general purpose financial
reporting and the qualitative characteristics that financial
information should possess. The objective of general purpose
financial reporting is, according to the IASB conceptual
framework (as released in September 2010) deemed to be:
to provide financial information about the reporting entity
that is useful to existing and potential investors, lenders and
other creditors in making decisions about providing resources
to the entity.
This objective serves as a foundation for the various
components or chapters that form the Conceptual Framework
Project (this objective was also embraced in the Exposure Draft
of the proposed new conceptual framework released by the
IASB in 2015 and therefore represents the latest thinking of
the IASB). If we were to disagree with this central objective—
and many accounting academics do—we would be unlikely to
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Normative accounting theories
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agree with the subsequent prescriptions provided within the
framework.
Conceptual frameworks seek to provide recognition and
measurement rules within a coherent and consistent
framework. As also indicated in Chapter 2 , one definition of
a conceptual framework was provided by the US Financial
Accounting Standards Board as:
a coherent system of interrelated objectives and
fundamentals that is expected to lead to consistent
standards. It prescribes the nature, function and limits of
financial accounting and reporting.
The use of the term ‘prescribes’ supports the view that the
conceptual framework is a normative theory of accounting.
The IASB conceptual framework identifies a number of
qualitative characteristics that financial information should
possess (as discussed in Chapter 2 ). Two main qualitative
characteristics are identified as relevance and faithful
representation. In relation to faithful representation, the IASB
conceptual framework states:
Financial reports represent economic phenomena in words
and numbers. To be useful, financial information must not
only represent relevant phenomena, but it must also faithfully
represent the phenomena that it purports to represent. To be
a perfectly faithful representation, a depiction would have
three characteristics. It would be complete, neutral and free
from error. Of course, perfection is seldom, if ever,
achievable. The Board’s objective is to maximise those
qualities to the extent possible.
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Normative accounting theories
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As you have just read about PAT and how PAT researchers
work on the assumption that self-interest drives the actions of
all individuals—including those individuals who prepare
financial statements—it will now be clear to you that, to be
consistent, such researchers consider that managers would not
be overly motivated to produce financial statements that are
‘complete’ and ‘neutral’ or that ‘represent faithfully’ the
transactions of the business—particularly if there are
accounting-based contracts in place with associated cash-flow
implications. Objectivity and self-interest are, arguably,
mutually exclusive.
Apart from the conceptual framework, there have been a
number of other normative accounting theories developed by
individual scholars. At certain times, particular theories have
received support from various sections of the accounting
profession. A period in which a number of notable normative
accounting theories were developed was the 1950s and 1960s.
During this period, a great deal of the theory development
related to issues associated with changing prices and their
effect on profits and asset valuation. At this time, most
Western countries had high rates of inflation, generating a
pressing need for guidance on how to account for changing
prices. This need was considered to exist because in times of
inflation it was felt that historical-cost accounting overstated
accounting profits, which in turn could lead to the payment of
excessive dividends, eroding the future operating ability of an
organisation. The famous works referred to in Chapter 2
(Moonitz, The Basic Postulates of Accounting, 1961; and
Sprouse & Moonitz, A Tentative Set of Broad Accounting
Principles for Business Enterprises, 1962) acknowledged the
limitations of historical-cost accounting in times of rising
prices. They proposed a change from historical-cost accounting
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to a form of current-value accounting. As previously mentioned
in this book, although the theory development was sponsored
by the US accounting profession, the theories were not
embraced, possibly owing to the fact that they represented a
radical departure from practices that existed at the time—and
to a large extent still exist today.
Dominant normative theories developed in the 1950s Page 107
and 1960s, all of which addressed issues associated
with changing prices, can be broken into the three main
classifications (Henderson, Peirson & Brown 1992) of:
1. current-cost accounting
2. exit-price accounting
3. deprival-value accounting.
Reflecting the fact that there was no universal agreement on
the role of accounting—and there is still none—the alternative
normative theories provided conflicting prescriptions. In the
discussion that follows we will briefly consider some of the
normative theories. We will not consider the actual applications
of the various prescriptions in any great detail but, rather, we
will consider the main elements of the theories. It should be
noted at this point that there is currently little debate on the
issues associated with undertaking accounting in periods of
changing prices. This might reflect the low rates of inflation we
currently experience. Perhaps—and this is sheer conjecture—
issues associated with changing prices might again attain
prominence if inflation were to reach the heights of past
decades.
Current-cost accounting
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Current-cost accounting was advocated by many accounting
researchers, including Edwards and Bell in the USA (The
Theory and Measurement of Business Income, 1961) and
Mathews and Grant in Australia (Inflation and Company
Finance, 1958). Although there are variations within the
different models of current-cost accounting, the general aim of
the theory is to provide a calculation of income that, after
adjusting for changing prices, could be withdrawn from the
entity yet still leave the physical capital of the entity intact.
Such measures of income are often promoted as true
measures of income. As Henderson, Peirson and Brown (1992,
p. 40) state:
The essential characteristics of true income theories is that
they propose a single measurement basis for assets and a
consequent single or unique measure of income (profit). The
resulting income measure is regarded as the correct or true
measure of income. Almost by definition other measures of
income are incorrect or untrue and must, therefore, be
misleading. The true measures of income should be suited to
the needs of all users of the financial statements.
For the purposes of illustration, assume that a company
started the period with assets of $50 000. Let us assume also
that there are no liabilities, so that the owners’ equity also
equals $50 000. During the period, the business sells all of its
assets for $70 000. Under historical-cost accounting the profit
would be $20 000 and the closing owners’ equity would be $70
000, which would be matched by assets of $70 000 in the form
of cash. If the $20 000 was withdrawn in the form of
dividends, under historical-cost accounting the owners’ equity
of the business would remain as it was at the beginning of the
period. However, if we were to adopt current-cost accounting,
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the profit would not necessarily be the same. If, owing to rising
prices, it cost $60 000 to replace the assets that were sold
(their ‘current cost’), under current-cost accounting, the profit
would be only $10 000, as $60 000 would need to be retained
to keep the physical capital of the firm intact. The maintenance
of the firm’s physical capital or operating capacity is a central
goal of current-cost accounting. Proponents of this normative
theory argue that by valuing assets (and this would translate
to expense recognition) at their current costs—in some models
based on replacement cost—a ‘truer’ measure of profit is
provided than is reflected by the historical-cost system. A
frequently raised criticism of current-cost accounting is that it
introduces an unacceptable amount of subjectivity into the
accounting process, as some assets will not have a readily
accessible ‘current cost’. However, advocates of the approach
argue that the increased relevance of the information more
than offsets any disadvantages associated with its reliability,
compared with historical-cost data.
Exit-price accounting
One of the most famous expositions of a normative accounting
theory was developed by the Australian researcher Raymond
Chambers. He labelled his theory Continuously
Contemporary Accounting (CoCoA) . The theory was develo
ped principally between 1955 and 1965. Chambers (1955)
advanced the view that accounting research and accounting
theory should be developed with an underlying objective of
providing a better system of accounting, rather than simply
describing or explaining contemporary practices. (Until his
death in 1999, Chambers continued to be a strong opponent of
positive accounting research.) The most fully developed
exposition of Chambers’ theory was provided in his publication
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Accounting, Evaluation and Economic Behaviour, released in
1966. The theory relies on assessments of the exit or Page 108
selling prices of an entity’s assets and liabilities—
hence it is labelled an exit-price theory .
The development of CoCoA was based on the key assumptions
that:
l
l
l
firms exist to increase the wealth of the owners
successful operations are based on the ability of an
organisation to adapt to changing circumstances
the capacity to adapt will be best reflected by the monetary
value of the organisation’s assets, liabilities and equities at
reporting date, where the monetary value is based on the
current exit or selling prices of the organisation’s resources
(their current cash equivalent).
According to Chambers, a central objective of accounting
should be to provide information about an entity’s ability to
adapt to changing circumstances or, as he referred to it, an
organisation’s capacity to adapt . Capacity to adapt is directly
tied to the cash that could be obtained if an entity sold its
assets. Chambers’ theory advocated that an entity’s balance
sheet (now referred to as a statement of financial position)
should base the value of all assets on their respective selling
prices. If an asset is not readily saleable (and therefore does
not have a sales price), it does not contribute to an entity’s
capacity to adapt to changing circumstances. Further, the
profit for a period should also be tied to the changes in the
current exit prices of the organisation’s assets and, as such,
profit as a measure of performance should reflect changes in
an organisation’s capacity to adapt.
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Chambers proposed that his model of accounting would
provide information that would be useful to all financial
statement users. Chambers’ theory of accounting (CoCoA) is
often referred to as a ‘decision usefulness approach’ to
accounting theory development, in which he takes a decisionmodels approach. Proponents of the decision-models approach
develop models based on the researcher’s own perceptions
about what is necessary for efficient decision making. (By
contrast, an approach that develops models based on asking
other individuals what information they seek, perhaps through
using questionnaires, would be referred to as a decisionmakers emphasis.) Chambers’ decision-models approach
considers the decision-making requirements of financial
statement users to be the primary reason for developing a
particular accounting system. This necessarily requires an
initial judgement on what kinds of information are necessary
for informed decision making. Chambers takes the
responsibility for making such judgements on behalf of
financial statement users.
Under CoCoA, organisations that cannot adapt are considered
relatively more likely to fail. The more liquid or saleable an
organisation’s assets, the greater the perceived capacity to
adapt. If an organisation has very specialised assets, which do
not have a secondary market, such an organisation is
considered to have a low capacity to adapt. If
circumstances/markets change, an organisation with very
specialised assets would be more likely to fail.
Capacity to adapt should be reflected by the entity’s financial
statements, which will highlight adaptive capital. To this end,
and as noted above, Chambers prescribed that all assets
should be recorded at their current cash equivalents .
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Current cash equivalents were represented by the amounts
expected to be generated by selling the assets. The net sales
or exit prices were to be determined on the basis of an orderly
sale. Within the model, the balance sheet should clearly show
the expected net selling prices of all of the entity’s assets—net
selling prices would acknowledge any costs that would be
incurred in making a sale. Adaptive capital would be
represented by the total net selling prices of the various
assets, less the amount of the firm’s liabilities. Profit would
reflect the change in the organisation’s capacity to adapt that
had occurred since the beginning of the period. Because the
valuation of assets is to be based on their current cash
equivalents, depreciation expenses would not be recognised
within CoCoA.
According to the Chambers model, if assets cannot be
separately sold, for the purposes of determining the
organisation’s financial position they are deemed to have no
value. This in itself was considered to be too extreme for many
accounting practitioners and researchers, and represented a
radical alternative to the existing accounting practices. Assets
such as goodwill or some work in progress would be assessed
as having no net selling price and therefore would be attributed
zero value. Chambers argued that by using current selling
prices, accounting reports would be objective and
understandable to readers. By using a consistent valuation
approach, it was also more valid or even logical to add the
values of the various assets together to get an overall total
asset value. This can, of course, be compared with the system
we have today in which alternative classes of assets are to be
valued in a variety of ways but, nevertheless, are added
together for the purpose of financial statement
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presentation. Chambers argued that people can
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easily understand what valuation on the basis of net selling
prices means. Under CoCoA, assets are not valued on the basis
of arbitrary cost allocations or amortisation nor on the basis of
directors’ valuations.
As you would expect, there are many criticisms of CoCoA, such
as that it does not consider the ‘value in use’ of assets. If an
asset is retained, rather than sold, its value in use would likely
be greater than its current exit price. This could apply
particularly in the case of specialised resources such as a blast
furnace that is generating positive returns. It has a positive
value in use but if it cannot be sold separately, for the
purposes of CoCoA it has no value. As Chambers might argue,
however, if something generates a positive return, it should
have a market and a corresponding market value.
Another criticism of CoCoA is that, in valuing assets at their
perceived sales value, it is implied that the firm intends to
liquidate the assets. Obviously, this might not be the case.
Nevertheless, Chambers’ model does provide useful
information for determining an organisation’s capacity to
adapt—which he argues is a central objective of accounting.
Chambers’ model has also been criticised on the basis that the
exit prices are determined by the price that could be achieved
in an orderly sale. These sales might be at different times and
might not reflect values at reporting date. As values are based
on an opinion of perceived selling prices, it has also been
argued that such financial statements might not be useful for
monitoring the firm’s management.
Deprival-value accounting
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A further normative (or prescriptive) accounting theory that we
will briefly consider is deprival-value accounting. Deprival value
itself can be defined as the value to the business of particular
assets. It represents the amount of loss that might be incurred
by an entity if it were deprived of the use of an asset and the
associated economic benefits the asset generates.
In 1975, deprival-value accounting was recommended by the
UK Sandilands Committee. The deprival value of an asset to be
reported in the financial statements will be determined by
considering: the net selling price of the asset; the present
value of the future cash flows that the asset will generate; or
the asset’s current replacement cost . The deprival value is
the lower of current replacement cost and the greater of the
net selling price and present value (value in use). For example,
if an asset could be sold for a net amount of $100 or used to
generate a present value of $120, the best use of the asset
would be to keep it and use it to generate future cash flows.
The deprival value is then the lesser of the present value
($120) and the cost to replace the asset. To adopt this form of
accounting would require all assets and liabilities to be
considered separately in terms of their deprival value to the
business.
Some criticisms of deprival-value accounting have included the
concern that different valuation bases would be used within a
single financial statement—such as selling prices, presentvalue calculations and replacement costs. This can be
compared with Chambers’ CoCoA, which prescribes one
method of valuation—net selling prices. It has also been
argued that the valuation procedures would be particularly
costly and time-consuming, given that more than one method
of valuation might have to be used for particular assets. It
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might also not be clear which valuation approach should be
adopted for a particular type of asset.
The aim of the above brief discussion of three different
normative theories of accounting (which tell us how we should
account) is to show the difference between normative and
positive theories of accounting.
The following discussion focuses on yet another group of
theories, classified as systems-oriented theories.
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Systems-oriented theories to explain
accounting practice
LO 3.1 LO 3.2 LO 3.12
Apart from PAT and the normative accounting theories discussed
briefly above, there are numerous other theories applicable to
the accounting process. What should be stressed is that, as
mentioned previously, theories are abstractions of reality, and
no particular theory can be expected to provide a full account or
description of a particular phenomenon. Hence it is sometimes
useful to consider the perspectives or insights provided by
alternative theories. In some cases, different researchers study
the same phenomenon but from different theoretical
perspectives. For example, some researchers operating within
the Positive Accounting Theory paradigm (such as Ness & Mirza
1991) argue that the voluntary disclosure of social
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responsibility information can be explained as a
strategy to reduce political costs. Social responsibility reporting
has also been explained from a Legitimacy Theory perspective
(for example, Patten 1992; Deegan & Islam 2014), and from a
Stakeholder Theory perspective (for example, Roberts 1992).
The choice of one theoretical perspective in preference to others
will, at least in part, be due to value judgements on the part of
the authors involved. As O’Leary (1985, p. 88) states:
Theorists’ own values or ideological predispositions may be
among the factors that determine which side of the argument
they will adopt in respect of disputable connections of a theory
with evidence.
One branch of accounting-related theories can be referred to as
systems-oriented theories . According to Gray, Owen and Ada
ms (1996, p. 45):
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a systems-oriented view of the organisation and society …
permits us to focus on the role of information and disclosure in
the relationship(s) between organisations, the State,
individuals and groups.
From a systems-based perspective, an entity is assumed to be
influenced by the society in which it operates and in turn to have
an influence on society. This is simplistically represented in
Figure 3.1 .
FIGURE 3.1 The organisation viewed as part of a wider social
system
Three theories with a systems-based perspective are
Stakeholder Theory, Legitimacy Theory and Institutional Theory.
Within these theories, accounting disclosure policies are
considered to constitute a strategy to influence (or, perhaps,
manage) the relationships between the organisation and other
parties with which it interacts. In recent times, Stakeholder
Theory, Legitimacy Theory and Institutional Theory have been
applied extensively to explain why organisations might make
certain social-responsibility disclosures within their annual
reports or sustainability reports, rather than why they might
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elect to adopt particular financial accounting methods. The
theories could, however, also be applied to explain, at least in
part, why companies adopt particular financial accounting
techniques.
Social-responsibility disclosures themselves can relate,
among other things, to information about the interaction of an
organisation with its physical and social environment, including
the community, the natural environment, human resources,
energy and product safety. Stakeholder Theory, Legitimacy
Theory and Institutional Theory will be discussed in greater
detail in Chapter 30 , which considers social disclosures.
However, as this chapter considers accounting-related theories,
some attention here is warranted. We will briefly consider
Stakeholder Theory, Legitimacy Theory and Institutional Theory
in turn below.
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Stakeholder Theory
Stakeholder Theory can be broadly broken up into two
branches—an ethical (normative) branch and a managerial
(positive) branch. The ethical branch adopts the view that all
stakeholders have certain intrinsic rights (for example, to safe
working conditions and fair pay), and these rights should not be
violated. As Hasnas (1998, p. 32) states:
When viewed as a normative (ethical) theory, Stakeholder
Theory asserts that, regardless of whether stakeholder
management leads to improved financial performance,
managers should manage the business for the benefit of all
stakeholders. It views the firm not as a mechanism for
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increasing the stockholders’ financial returns, but as a vehicle
for coordinating stakeholder interests and sees management as
having a fiduciary relationship not only to the stockholders, but
to all stakeholders. According to the normative Stakeholder
Theory, management must give equal consideration to the
interests of all stakeholders and, when these interests conflict,
manage the business so as to attain the optimal balance
among them. This of course implies that there will be times
when management is obliged to at least partially sacrifice the
interests of the stockholders to those of the other stakeholders.
Hence, in its normative form, the Stakeholder Theory does
imply that business has true social responsibilities.
A stakeholder can be broadly defined as ‘any group or individual
who can affect or is affected by the achievement of the firm’s
objectives’ (Freeman 1984). Stakeholders would include
shareholders, employees, customers, lenders, suppliers, local
charities, various interest groups and government. Depending
upon how broad we wish to define stakeholders, stakeholders
also include future generations and the environment. From this
perspective, the organisation is seen as part of a larger social
system, as shown in Figure 3.1 . Within the ethical branch of
Stakeholder Theory, there is also the view that all stakeholders
have many rights, including a right to be provided with
information about how the organisation is affecting them
(perhaps through pollution, community sponsorship, provision of
employment, safety initiatives, etc.), even if they choose not to
use the information, and even if they cannot directly affect the
survival of the organisation. The fact that authors adopting an
ethical view espouse normative perspectives of how they believe
organisations should act towards their stakeholders does not
mean that these perspectives will actually coincide with how
organisations behave. Hence the various ethical perspectives
cannot be validated by empirical observation—as might be the
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case if the researchers were adopting descriptive or predictive
(positive) theories about organisational behaviour. As Donaldson
and Preston (1995, p. 67) state:
In normative uses, the correspondence between the theory and
the observed facts of corporate life is not a significant issue,
nor is the association between stakeholder management and
conventional performance measures a critical test. Instead a
normative theory attempts to interpret the function of, and
offer guidance about, the investor-owned corporation on the
basis of some underlying moral or philosophical principles.
Turning our attention away from the ethical (normative) branch
and to the managerial (or positive) branch of Stakeholder
Theory, we see that this branch seeks to explain and predict
how an organisation will react to the demands of various
stakeholder groups. As the research based on this branch of
Stakeholder Theory is used to make predictions, it is reasonable
to assess the validity of such research on the basis of its
correspondence with actual practice.
Within the managerial branch of Stakeholder Theory (see, for
example, Roberts 1992), the organisation identifies its group of
stakeholders, particularly those that are considered to be
important to the ongoing operations and survival of the
business. The greater the importance of the stakeholders, the
greater will be the expectation that the management of the firm
will take actions to ‘manage’ the relationships with those
stakeholders (hence why it is called the ‘managerial branch’). As
the expectations and power relativities of the various
stakeholder groups can change, organisations must continually
adapt their operating and disclosure strategies. Roberts (1992,
p. 598) states that:
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A major role of corporate management is to assess the
importance of meeting stakeholder demands in order to
achieve the strategic objectives of the firm. As the level of
stakeholder power increases, the importance of meeting
stakeholder demands increases also.
The power of stakeholders (for example, owners, creditors or
regulators) to influence corporate management is viewed as a
function of stakeholders’ degree of control over resources
required by the organisation (Ullmann 1985). The more critical
the stakeholder-controlled resources are to the continued
viability and success of the organisation, the greater the
expectation that stakeholder demands will be addressed. A
successful organisation is considered to be one that satisfies the
demands (sometimes conflicting) of the various
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powerful stakeholder groups. In this regard Ullmann
(1985, p. 2) states:
Our position is that organisations survive to the extent that
they are effective. Their effectiveness derives from the
management of demands, particularly the demands of interest
groups upon which the organisation depends.
Stakeholders’ power will be stakeholder-organisation specific,
and might be tied to such things as command of limited
resources (finance, labour), access to influential media, ability to
legislate against the company, or ability to influence the
consumption of the organisation’s goods and services. The
behaviour of various stakeholder groups is considered a
constraint on the strategy developed by management to best
match corporate resources with the entity’s environment. The
strategy of pursuing profits for the benefit of investors is not
sufficient in or by itself.
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Within the variant of Stakeholder Theory that adopts a
managerial (or positive) perspective, information, including
financial accounting information and information about the
organisation’s social performance, is a tool in controlling the
sometimes conflicting demands of various stakeholder groups.
Gray, Adams and Owen (2014, p. 85) state:
Here (under this perspective), the stakeholders are identified
by the organisation of concern, by reference to the extent to
which the organisation believes the interplay with each group
needs to be managed in order to further the interests of the
organisation (what Mitchell et al., 1997, call ‘salience’). The
more important (salient) the stakeholder to the organisation,
the more effort will be exerted in managing the relationship.
Information—including financial accounting and social
accounting—is a major element that can be employed by the
organisation to manage (or manipulate) the stakeholder in
order to gain their support and approval (or to distract their
opposition and disapproval).
As the level of stakeholder power increases, the importance of
meeting stakeholder demands increases. Some of this demand
might relate to the provision of information about the activities
of the organisation. According to Ullmann (1985), the greater
the importance to the organisation of the stakeholder’s
resources/support, the greater the probability that a particular
stakeholder’s expectations will be accommodated within the
organisation’s operations. According to this perspective, various
activities undertaken by organisations, including public
reporting, will relate directly to the expectations of particular
stakeholder groups. Furthermore, organisations will have an
incentive to disclose information about their various programs
and initiatives to the stakeholder groups concerned to clearly
indicate that they are conforming with those stakeholders’
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expectations. Organisations must necessarily balance the
expectations of various stakeholder groups.
In relation to corporate social disclosures, Roberts (1992, p.
599) states:
social responsibility activities are useful in developing and
maintaining satisfactory relationships with stockholders,
creditors, and political bodies. Developing a corporate
reputation as being socially responsible through performing
and disclosing social responsibility activities is part of a
strategy for managing stakeholder relationships.
Stakeholder Theory (of the positive, or managerial, variety)
does not directly provide prescriptions about what information
should be disclosed, other than indicating that the provision of
information, including information within an annual report, can,
if thoughtfully considered, be useful for the continued operations
of a business entity. Within the managerial branch of
Stakeholder Theory, it is a stakeholder’s control over limited
resources that are required by an organisation that influences
whether specific information is provided to that stakeholder—not
issues associated with rights to information.
The insights provided by Stakeholder Theory are of relevance to
various people within the accounting profession. For example,
accounting regulators will have a better understanding of why
some disclosures are being voluntarily made by organisations
(perhaps because they are demanded by powerful stakeholders)
while other seemingly important or relevant disclosures are not
being made (perhaps the related information is sought only by
stakeholders who are impacted by the operations of the
organisation, but they do not have the necessary power to
compel the organisation to make disclosures). This has
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implications for the need to potentially legislate particular
disclosures.
Legitimacy Theory
Legitimacy Theory is very closely linked to Stakeholder
Theory. It posits that organisations continually seek to ensure
that they operate within the bounds and norms of their
respective societies; that is, they attempt to ensure that their
activities are perceived by outside parties to be ‘legitimate’.
These bounds and norms, rather than being fixed, are Page 113
subject to change, requiring the organisation to be
responsive to the environment in which it operates.
Lindblom (1993) distinguishes between legitimacy, which is
considered to be a status or condition, and legitimation, which
she considers to be the process that leads to an organisation
being adjudged legitimate. According to Lindblom (p. 2),
legitimacy is:
… a condition or status which exists when an entity’s value
system is congruent with the value system of the larger social
system of which the entity is a part. When a disparity, actual or
potential, exists between the two value systems, there is a
threat to the entity’s legitimacy.
Legitimacy is a relative concept—it is relative to the social
system in which the entity operates and is both time-specific
and place-specific. Corporate activities that are ‘legitimate’ in a
particular place and time might not be legitimate at a different
point in time, or in a different place (for example, what is
legitimate behaviour in one country might not be legitimate in
another). As Suchman (1995, p. 574) states:
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Legitimacy is a generalised perception or assumption that the
actions of an entity are desirable, proper, or appropriate within
some socially constructed system of norms, values, beliefs, and
definitions.
Within Legitimacy Theory, ‘legitimacy’ is considered to be a
resource upon which an organisation depends for its survival
(Dowling & Pfeffer 1975; O’Donovan 2002). It is something that
is conferred upon the organisation by society, and it is
something that is desired or sought by the organisation.
However, unlike many other ‘resources’, it is a ‘resource’ that
the organisation is considered to be able to impact or
manipulate through various disclosure-related strategies
(Woodward, Edwards & Birkin 1996).
Researchers that use Legitimacy Theory often link ‘legitimacy’ to
the idea of a ‘social contract’. That is, they rely on the notion
that there is a social contract between an organisation and the
society in which it operates. An organisation is deemed to be
operating with ‘legitimacy’ when its operations are perceived by
society to be complying with the terms or requirements of the
‘social contract’. The social contract is not easy to define, but
the concept is used to represent the multitude of implicit and
explicit expectations that society has about how an organisation
should conduct its operations. The law is considered to provide
the explicit terms of the social contract, while other, nonlegislated societal expectations embody the implicit terms of the
contract. It is assumed that society allows the organisation to
continue operations as long as it generally meets society’s
expectations. Legitimacy Theory emphasises that the
organisation must appear to consider the rights of the public at
large, not merely those of its investors. Organisations are not
considered to have any inherent right to resources. Legitimacy
(from society’s perspective) and the right to operate go hand in
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hand. As Mathews (1993, p. 26) states:
The social contract would exist between corporations (usually
limited companies) and individual members of society. Society
(as a collection of individuals) provides corporations with their
legal standing and attributes and the authority to own and use
natural resources and to hire employees. Organisations draw
on community resources and output both goods and services
and waste products to the general environment. The
organisation has no inherent rights to these benefits and in
order to allow their existence, society would expect the
benefits to exceed the costs to society.
The idea of a social contract is not new—it was discussed by
philosophers such as Thomas Hobbes (1588–1679), John Locke
(1632–1704) and Jean-Jacques Rousseau (1712–1778). Society
expects the organisation to comply with the terms of this
‘contract’ and, as noted above, these expressed or implied
terms are not static. As Shocker and Sethi (1974, p. 67) state:
Any social institution—and business is no exception—operates
in society via a social contract, expressed or implied, whereby
its survival and growth are based on:
(1)
the delivery of some socially desirable ends to society in
general, and
(2)
the distribution of economic, social, or political benefits
to groups from which it derives its power.
In a dynamic society, neither the sources of institutional power
nor the needs for its services are permanent. Therefore, an
institution must constantly meet the twin tests of legitimacy
and relevance by demonstrating that society requires its
services and that the groups benefiting from its rewards have
society’s approval.
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As indicated in Deegan and Rankin (1996, p. 54), pursuant to
Legitimacy Theory, if an organisation cannot justify its continued
operation, the community may, in a sense, revoke the
organisation’s ‘contract’ to continue its operations. This might
occur through consumers reducing or eliminating the demand
for the products of the business, factor suppliers eliminating the
supply of labour and financial capital to the business, or
constituents lobbying government for increased taxes, fines or
laws to prohibit the actions that do not conform to the
expectations of the community. The notion of a social contract is
something corporate managers have been referring to for a
number of years. For example, in an article entitled ‘Westpac
chief admits banks failed in the bush’, which appeared in The
Australian on 20 May 1999 (by Sid Marris), it was stated:
The rush by banks to shut branches in rural areas over the past
decade was a ‘mistake’ and broke ‘the social contract’ with the
community, Westpac executive Michael Hawker said.
Given the potential costs associated with conducting operations
that are deemed to be outside the terms of the social contract,
Dowling and Pfeffer (1975) state that organisations will take
various actions to ensure that their operations are perceived to
be legitimate. One such action would be—and this is where we
get to the theory’s relevance to accounting—to provide
disclosures, perhaps within the annual report. Hurst (1970)
suggests that one of the functions of accounting, and
subsequently accounting reports, is to legitimate the existence
of the corporation. Within such a perspective, the strategic
nature of financial statements and other disclosures is
emphasised. From the perspective provided by Legitimacy
Theory, it is important not only that an organisation operate in a
manner consistent with community expectations (that is,
consistent with the terms of the social contract), but also that
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the organisation disclose information to demonstrate that it is
complying with community expectations. That is, if an
organisation undertakes actions that conform to community
expectations, this in itself is not enough to bring legitimacy to
the organisation—it must make disclosures to show clearly that
it is complying with community perceptions. It is society’s
perceptions of an organisation’s actions that are important in
establishing legitimacy and not necessarily the actual actions
themselves.
Because community expectations can change, the organisation
must make disclosures to show that it is also changing. In
relation to the dynamics associated with changing community
expectations, Lindblom (1993, p. 3) states:
Legitimacy is dynamic in that the relevant publics continuously
evaluate corporate output, methods, and goals against an ever
evolving expectation. The legitimacy gap will fluctuate without
any changes in action on the part of the corporation. Indeed,
as expectations of the relevant publics change, the corporation
must make changes or the legitimacy gap will grow as the level
of conflict increases and the level of positive and passive
support decreases.
The ‘legitimacy gap’ (used in the above quote) refers to the
difference between the expectations of the ‘relevant publics’
relating to how an organisation should act, and society’s
perceptions of how the organisation does act.
Legitimacy Theory (and Stakeholder Theory) explicitly considers
the organisation in its broader social context. Unlike PAT,
Legitimacy Theory does not rely upon the economics-based
assumption that all action is driven by individual self-interest
(tied to wealth maximisation), and it emphasises how the
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organisation is part of the social system in which it operates.
A number of studies, four of which are described briefly below
(relevant studies will be discussed more fully in Chapter 30 ),
have identified specific types of social-responsibility disclosures
that have appeared within annual reports and that have been
explained by the respective researchers as being part of the
portfolio of strategies undertaken by accountants and their
managers to bring legitimacy to, or to maintain the legitimacy
of, their respective organisations.
Patten (1992) focused on the change in the extent of
environmental disclosures made by North American oil
companies, other than Exxon Oil Company, both before and
after the Exxon Valdez disaster in Alaska in 1989. He argued
that if the Alaskan oil spill resulted in a threat to the legitimacy
of the petroleum industry, and not just to Exxon, Legitimacy
Theory would suggest that companies operating within that
industry would respond by increasing the amount of voluntary
environmental disclosures in their annual reports. Patten’s
results indicate that there were increased environmental
disclosures by petroleum companies for the post-1989 period,
consistent with a legitimation perspective. This disclosure
reaction took place across the industry, even though the incident
itself concerned primarily one oil company. Patten (1992, p.
475) argued that ‘it appears that at least for environmental
disclosures, threats to a firm’s legitimacy do entice the firm to
include more social responsibility information in its annual
report’.
In an Australian study, Deegan and Rankin (1996) used
Legitimacy Theory in an attempt to explain systematic changes
in environmental disclosure policies in corporate annual reports
around the time of proven environmental prosecutions. The
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authors examined the environmental disclosure
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practices of a sample of firms that were successfully
prosecuted by the New South Wales and Victorian Environmental
Protection Authorities (EPAs) for breaches of environmental
protection laws during the period 1990 to 1993. (Any
prosecutions by these agencies are reported in the EPA’s annual
reports, which are publicly available.) The annual reports of a
final sample of 20 firms—prosecuted a total of 78 times—were
reviewed to ascertain the extent of the environmental
disclosures being made. These annual reports were matched by
industry and size to the annual reports of a control group of 20
firms that had not been prosecuted.
Of the 20 prosecuted firms, 18 provided environmental
information in their annual report. However, the disclosures
were predominantly self-laudatory and qualitative in nature.
Only two organisations made any mention of the prosecutions.
Deegan and Rankin found that prosecuted firms disclosed
significantly more environmental information in the year of
prosecution than any other year in the sample period.
Consistent with the view that companies increase disclosures to
offset any effects of EPA prosecutions, the EPA-prosecuted firms
also disclosed more ‘favourable’ environmental information,
relative to non-prosecuted firms. The authors conclude that the
public disclosure of proven environmental prosecutions has an
impact on the disclosure policies of the firms involved. Changes
in disclosure practices are considered to represent a strategy to
alter the public’s perception of the legitimacy of the organisation
and this might be particularly important when the organisation
has received negative publicity about certain aspects of its
performance.
In a United States study, the choice of an accounting framework
was deemed to be related to a desire to increase the legitimacy
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of an organisation. Carpenter and Feroz (1992) argue that the
decision of the government of the State of New York to adopt
generally accepted accounting procedures (as opposed to a
method of accounting based on cash flows rather than accruals)
was ‘an attempt to regain legitimacy for the State’s financial
management practices’ (p. 613). According to Carpenter and
Feroz, New York State was in a financial crisis in 1975, with the
result that many parties began to question the adequacy of the
financial reporting practices of all the associated government
units. To regain legitimacy, the state elected to implement GAAP
(incorporating accrual-based accounting). According to
Carpenter and Feroz (pp. 635, 637):
The state of New York needed a symbol of legitimacy to
demonstrate to the public and the credit markets that the
state’s finances were well managed. GAAP, as an
institutionalized legitimated practice, serves this purpose … We
argue that New York’s decision to adopt GAAP was an attempt
to regain legitimacy for the state’s financial management
practices. Challenges to the state’s financial management
practices, led by the state comptroller, contributed to confusion
and concern in the municipal securities market. The confusion
resulted in a lowered credit rating. To restore the credit rating,
a symbol of legitimacy in financial management practices was
needed.
It is debatable whether GAAP was the solution for the state’s
financial management problems. Indeed, there is strong
evidence that GAAP did not solve the state’s financial
management problems.
New York needed a symbol of legitimacy that could be easily
recognised by the public. In the realm of financial reporting,
‘GAAP’ is the recognised symbol of legitimacy.
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According to Carpenter and Feroz, few would be likely to oppose
a system that is ‘generally accepted’—general acceptance
provides an impression of legitimacy. As they state (p. 632):
In discussing whether to use the term ‘GAAP’ instead of
‘accrual’ in promoting the accounting conversion efforts, panel
members argued that no one could oppose a system that is
generally accepted. The name implies that any other
accounting principles are not accepted in the accounting
profession. GAAP is also seemingly apolitical.
Within the context of companies that source their products from
developing countries, Islam and Deegan (2010) undertook a
review of the social and environmental disclosure practices of
two leading multinational sportswear and clothing companies,
these being Nike and Hennes & Mauritz. Islam and Deegan
found a direct relationship between the extent of global news
media coverage of a critical nature being given to particular
social issues relating to the industry, and the extent of social
disclosure. In particular, they found that once the news media
started running a campaign that exposed poor working
conditions and the use of child labour in developing countries, it
appeared that the multinational companies responded by
making various disclosures identifying initiatives that were being
undertaken to ensure that the companies did not source their
products from factories that had abusive or unsafe working
conditions, or used child labour. Islam and Deegan argued that
the evidence was consistent with the view that the news media
influenced the expectations of Western consumers, thereby
causing a legitimacy problem for the companies. The companies
then responded to the legitimacy crisis by providing
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disclosures within their annual report that focused
particularly on working conditions and the use child labour in
developing countries. Islam and Deegan showed that before the
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news media started running stories about the labour conditions
in developing countries (media attention to these issues
appeared to start in the early 1990s), the companies were in
general not making such disclosures. This was despite the fact
that evidence suggests that poor working conditions and the use
of child labour existed in developing countries for many years
before the newspapers starting covering these issues. Islam and
Deegan speculated that had the Western news media not run
stories exposing the working conditions in developing
countries—which created a legitimacy gap for the multinational
companies—then the multinational companies might not have
embraced initiatives to improve working conditions, nor provided
disclosures about the initiatives being undertaken in relation to
working conditions in developing countries.
Apart from Stakeholder Theory and Legitimacy Theory, another
theory that embraces a systems-oriented perspective and which
analyses corporate reporting decisions is Institutional Theory.
This theory, which we discuss next, explains that organisations
are subject to institutional pressures and as a result of these
pressures, organisations within a given environment tend to
become similar in their forms and practices.
Institutional Theory
Broadly speaking, Institutional Theory considers the forms
organisations take and provides explanations for why
organisations within particular ‘organisational fields’ tend to take
on similar characteristics and forms. DiMaggio and Powell (1983,
p. 147) define an ‘organisation field’ as ‘those organizations
that, in the aggregate, constitute a recognized area of
institutional life: key suppliers, resource and product consumers,
regulatory agencies, and other organizations that produce
similar services or products’. According to Carpenter and Feroz
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(2001, p. 565):
Institutional theory views organizations as operating within a
social framework of norms, values, and taken-for-granted
assumptions about what constitutes appropriate or acceptable
economic behaviour (Oliver, 1997). According to Scott (1987),
‘organizations, conform [to institutional pressures for change]
because they are rewarded for doing so through increased
legitimacy, resources, and survival capabilities’ (p. 498).
A major paper in the development of Institutional Theory was
DiMaggio and Powell (1983). They investigated why there was
such a high degree of similarity between organisations.
Specifically, in undertaking their research they asked (p. 148):
why there is such startling homogeneity of organizational forms
and practices; and [sought] to explain homogeneity, not
variation. In the initial stages of their life cycle, organizational
fields display considerable diversity in approach and form.
Once a field becomes well established, however, there is an
inexorable push towards homogenization.
According to DiMaggio and Powell, there are various forces
operating within society that cause organisational forms to
become similar. As they state (1983, p. 148):
Once disparate organizations in the same line of businesses are
structured into an actual field (as we shall argue, by
competition, the state, or the professions), powerful forces
emerge that lead them to become more similar to one another.
Dillard, Rigsby and Goodman (2004, p. 506) state that:
Institutional theory is becoming one of the dominant
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theoretical perspectives in organization theory and is
increasingly being applied in accounting research to study the
practice of accounting in organizations.
A key reason why Institutional Theory is relevant to researchers
who investigate voluntary corporate reporting practices is that it
provides a complementary perspective, to both Stakeholder
Theory and Legitimacy Theory, for understanding how
organisations interpret and respond to changing social and
institutional pressures and expectations. Institutional Theory
links organisational practices (such as accounting and corporate
reporting) to, among other things, the values of the society in
which the organisation operates and the need to maintain
organisational legitimacy. The view is held that organisational
form and practices might tend to some form of homogeneity—
that is, the structure of the organisation and the practices
adopted by different organisations tend to become
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similar to conform with what is considered to be
‘normal’. Organisations that deviate from the form that has
become ‘normal’ or expected will potentially have problems
gaining or retaining legitimacy. As Dillard, Rigsby and Goodman
(2004, p. 509) state:
By designing a formal structure that adheres to the norms and
behaviour expectations in the extant environment, an
organization demonstrates that it is acting on collectively
valued purposes in a proper and adequate manner.
Institutional Theory provides an explanation for how
mechanisms by which organisations might seek to align
perceptions of their practices and characteristics with social and
cultural values (in order to gain or retain legitimacy) become
institutionalised in particular organisations. Such mechanisms
might include those proposed by both Stakeholder Theory and
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Legitimacy Theory, but might conceivably encompass an even
broader range of legitimating mechanisms. This is why these
three theoretical perspectives (Legitimacy Theory, Stakeholder
Theory and Institutional Theory) should be seen as
complementary rather than competing.
There are two main dimensions to Institutional Theory that are
particularly relevant to our discussion of reporting. The first of
these is termed isomorphism and the second decoupling. Both
can be of central relevance to explaining voluntary corporate
reporting practices.
The term ‘isomorphism’ is used extensively within Institutional
Theory and is defined by DiMaggio and Powell (1983, p. 149) as
‘a constraining process that forces one unit in a population to
resemble other units that face the same set of environmental
conditions’. That is, organisations that adopt structures or
processes (such as reporting processes) at variance with other
organisations might find that such differences will attract
criticism. As Carpenter and Feroz (2001, p. 566) state:
DiMaggio and Powell (1983) label the process by which
organizations tend to adopt the same structures and practices
isomorphism, which they describe as a homogenization of
organizations. Isomorphism is a process that causes one unit in
a population to resemble other units in the population that face
the same set of environmental conditions. Because of
isomorphic processes, organizations will become increasingly
homogeneous within given domains and conform to
expectations of the wider institutional environment.
Dillard, Rigsby and Goodman (2004, p. 509) explain that
‘isomorphism refers to the adaptation of an institutional
practice by an organisation’. As voluntary corporate reporting by
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an organisation is an institutional practice of that reporting
organisation, the processes by which voluntary corporate
reporting adapts and changes in that organisation are
isomorphic processes.
DiMaggio and Powell (1983) set out three different isomorphic
processes (processes whereby institutional practices such as
voluntary corporate reporting adapt and change). These three
isomorphic processes are referred to as coercive isomorphism,
mimetic isomorphism and normative isomorphism. The first of
these isomorphic processes, coercive isomorphism, arises when
organisations change their institutional practices in response to
pressure from stakeholders upon whom the organisation is
dependent (in other words, this form of isomorphism is related
to ‘power’ and therefore has similar traits to Stakeholder Theory,
as discussed earlier in this chapter). According to DiMaggio and
Powell (1983, p. 150):
Coercive isomorphism results from both formal and informal
pressures exerted on organizations by other organizations upon
which they are dependent and by cultural expectations in the
society within which organizations function. Such pressures
may be felt as force, as persuasive, or as invitations to join in
collusion.
DiMaggio and Powell go on to advance the following two
hypotheses on coercive isomorphism:
Hypothesis 1: The greater the dependence of an organization
on another organization, the more similar it will become to that
organization in structure, climate, and behavioural focus.
Hypothesis 2: The greater the centralization of organization A’s
resource supply, the greater the extent to which organization A
will change isomorphically to resemble the organizations on
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which it depends for resources.
The above form of isomorphism is clearly related to the
managerial branch of Stakeholder Theory (discussed earlier)
whereby a company will use ‘voluntary’ corporate reporting
disclosures to address the economic, social, environmental and
ethical values and concerns of stakeholders who have the
greatest power over the company. The company is therefore
coerced (in this case usually informally) by its influential (or
powerful) stakeholders into adopting particular voluntary
reporting practices. With regard to applying coercive
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isomorphism to government’s selection of accounting
procedures, Carpenter and Feroz (2001, p. 571) state:
Other organizations that can provide resources, such as the
credit markets, can exercise power over government entities.
This power can be used to dictate the use of certain
institutional rules—such as GAAP.
Explaining this more directly in terms of the earlier definition of
isomorphism, the company is coerced into adapting its existing
voluntary corporate reporting practices (including the issues
upon which it reports) to bring these into line with the
expectations and demands of its powerful stakeholders (while
possibly ignoring the expectations of less powerful
stakeholders). Because powerful stakeholders might have similar
expectations to those of other organisations, there will tend to
be conformity in the practices being adopted by different
organisations—institutional practices will tend to some form of
uniformity.
The second isomorphic process specified by DiMaggio and Powell
(1983) is mimetic isomorphism. This involves organisations
seeking to emulate (perhaps copy) or improve upon the
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institutional practices of other organisations, often for reasons of
competitive advantage in terms of legitimacy. In explaining
mimetic isomorphism, DiMaggio and Powell (1983, p. 151)
state:
Uncertainty is a powerful force that encourages imitation.
When organizational technologies are poorly understood, when
goals are ambiguous, or when the environment creates
symbolic uncertainty, organizations may model themselves on
other organizations.
According to DiMaggio and Powell, when an organisation
encounters uncertainty it might elect to model itself on other
organisations. The authors provide the following example of
modelling (mimetic isomorphism) (1983, p. 151):
One of the most dramatic instances of modelling was the effort
of Japan’s modernizers in the late nineteenth century to model
new governmental initiatives on apparently successful western
prototypes. Thus, the imperial government sent its officers to
study the courts, Army, and police in France, the Navy and
postal system in Great Britain, and banking and art education
in the United States. American corporations are now returning
the compliment by implementing (their perceptions of)
Japanese models to cope with thorny productivity and
personnel problems in their own firms. The rapid proliferation
of quality circles and quality-of-work-life issues in American
firms is, at least in part, an attempt to model Japanese and
European successes. These developments also have a ritual
aspect; companies adopt these ‘innovations’ to enhance their
legitimacy, to demonstrate that they are at least trying to
improve working conditions.
DiMaggio and Powell go on to provide the following two
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hypotheses on mimetic isomorphism:
Hypothesis 3: The more uncertain the relationship between
means and ends the greater the extent to which an
organization will model itself after organizations it perceives to
be successful.
Hypothesis 4: The more ambiguous the goals of an
organization, the greater the extent to which the organization
will model itself after organizations that it perceives to be
successful.
As Unerman and Bennett (2004) explain in the context of a
study investigating stakeholder dialogue in corporate social
reporting:
Some institutional theory studies … have demonstrated a
tendency for a number of organisations within a particular
sector to adopt similar new policies and procedures as those
adopted by other leading organisations in their sector. This
process, referred to as ‘mimetic isomorphism’, is explained as
being the result of attempts by managers of each organisation
to maintain or enhance external stakeholders’ perceptions of
the legitimacy of their organisation, because any organisation
which failed (at a minimum) to follow innovative practices and
procedures adopted by other organisations in the same sector
would risk losing legitimacy in relation to the rest of the sector
(Broadbent et al. 2001; Scott 1995). Drawing upon these
observations, in the absence of any legislative intervention
prescribing detailed mechanisms of debate, a key motivating
force for many managers to introduce mechanisms allowing for
greater equity in the determination of corporate responsibilities
would therefore be their desire to maintain, or enhance, their
own competitive advantage. They would strive to achieve this
by implementing stakeholder dialogue mechanisms which their
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economically powerful stakeholders were likely to perceive as
more effective than those used by their competitors. It is
unlikely that these managers would readily embrace
mechanisms designed to facilitate widespread
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participation in the determination of corporate
responsibilities unless their economically powerful stakeholders
expected the interests of economically marginalized
stakeholders to be taken into account in this manner, and
these managers are only likely to implement the minimum
procedures which they feel their economically powerful
stakeholders would consider acceptable.
This argument links pressures for mimetic isomorphism with
pressures underlying coercive isomorphism. As Unerman and
Bennett (2004) maintain, without coercive pressure from
stakeholders, pressure to mimic or surpass the social reporting
practices (institutional practices) of other companies would be
unlikely.
The final isomorphic process explained by DiMaggio and Powell
(1983) is normative isomorphism. This relates to the pressures
arising from group norms to adopt particular institutional
practices. In the case of corporate reporting, the professional
expectation that accountants will comply with accounting
standards acts as a form of normative isomorphism for the
organisations for whom accountants work to produce accounting
reports (an institutional practice) that are shaped by accounting
standards. In terms of voluntary reporting practices, normative
isomorphic pressures could arise through less formal group
influences from a range of both formal and informal groups to
which managers belong, for example, the culture and working
practices developed within their workplace. These could produce
collective managerial views favouring or rejecting certain types
of reporting practices, such as collective managerial views on
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the desirability or necessity of providing a range of stakeholders
with social and environmental information through the medium
of corporate reports. DiMaggio and Powell provide the following
two hypotheses on normative isomorphism:
Hypothesis 5: The greater the reliance on academic credentials
in choosing managerial and staff personnel, the greater the
extent to which an organization will become like other
organizations in its field.
Hypothesis 6: The greater the participation of organizational
managers in trade and professional associations, the more
likely the organization will be, or will become, like other
organizations in its field.
Now that the three forms of isomorphism have been described
(coercive, mimetic and normative isomorphism), it is interesting
to note that such processes do not necessarily make
organisations more efficient. As DiMaggio and Powell (1983, p.
153) put it:
It is important to note that each of the institutional isomorphic
processes can be expected to proceed in the absence of
evidence that they increase internal organizational efficiency.
To the extent that organizational effectiveness is enhanced, the
reason will often be that organizations are rewarded for being
similar to other organizations in their fields. This similarity can
make it easier for organizations to transact with other
organizations, to attract career-minded staff, to be
acknowledged as legitimate and reputable, and to fit into
administrative categories that define eligibility for public and
private grants and contracts. None of this, however, ensures
that conformist organizations do what they do more efficiently
than do their more deviant peers.
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On the same point, Carpenter and Feroz (2001, p. 569) observe:
Institutional theory assumes that organizations adopt
structures and management practices that are considered
legitimate by other organizations in their fields, regardless of
their actual usefulness. Legitimated structures or practices can
be transmitted to organizations in a field through tradition
(organization imprinting at founding), through initiation, by
coercion, and through normative pressures … Institutional
theory is based on the premise that organizations respond to
pressure from their institutional environments and adopt
structures and/or procedures that are socially accepted as
being the appropriate organizational choice … Institutional
techniques are not based on efficiency but are used to
establish an organization as appropriate, rational, and modern
… By designing a formal structure that adheres to the
prescription of myths in the institutional environment, an
organization demonstrates that it is acting in a proper and
adequate manner. Meyer and Ronan (1977) maintain that
myths of generally accepted procedures—such as GAAP—
provide a defence against the perception of irrationality and
enhanced continued moral and/or financial support from
external resource providers.
While three distinct types of isomorphism have been described
here, in practice it will not necessarily be easy to differentiate
between them. As Carpenter and Feroz (2001, p. 573) state:
DiMaggio and Powell (1983) point out that it may not always
be possible to distinguish between the three forms of
isomorphic pressure, and in fact, two or more isomorphic
pressures may be operating simultaneously making it nearly
impossible to determine which form of institutional pressure
was more potent in all cases.
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In applying the various notions of isomorphism to accounting,
the decision to disclose particular items of information may be
more about ‘show’ than about ‘substance’. As Carpenter and
Feroz (2001, p. 570) state:
One manifestation of organizations in need of institutional
legitimacy is the collecting and displaying of huge amounts of
information that has no immediate relevance for actual
decisions. Hence those state governments that have adopted
GAAP, yet do not use GAAP information in making financial
management decisions (e.g. budgetary decisions), may have
adopted GAAP for purposes of institutional legitimacy.
Carpenter and Feroz (2001) used Institutional Theory to explain
four US state governments’ decisions to switch from a method of
accounting based on recording cash flows to methods of
accounting based on generally accepted accounting principles
(GAAP). In describing the results of their analysis, they state (p.
588):
Our evidence shows that an early decision to adopt GAAP can
be understood in terms of coercive isomorphic pressures from
credit markets, while late adopters seem to be associated with
the combined influences of normative and mimetic institutional
pressures … The evidence presented in the case studies
suggests that severe, prolonged financial stress may be an
important condition affecting the potency of isomorphic
pressures leading to an early decision to adopt GAAP for
external financial reporting.
They went on to conclude (p. 592):
All states were subject to normative isomorphic pressures from
the accounting profession, coercive isomorphic pressures from
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the credit markets, and from the federal government to adopt
GAAP from 1975 through 1984. Coercive isomorphic
institutional pressures were significantly increased in 1984 with
the passage of the Single Audit Act (SAA). And the formation of
the Government Accounting Standards Board (GASB). Since it
is likely that both normative and coercive isomorphic pressures
act in concert to move state governments to GAAP adoption, it
may be impossible to empirically distinguish the two forms of
isomorphic pressure … We note that all state governments
were subject to potent institutional pressure to adopt GAAP
after 1973. These institutional pressures were created by the
federal government, professional accounting associations, and
representatives of the credit markets. Thus state governments
were subjected to at least two forms of isomorphic pressures:
normative and coercive … We predict that all state
governments in the USA will eventually bow to institutional
pressures for change and adopt GAAP for external financial
reporting. Our prediction is based on insights from institutional
theory, coupled with insight on the potency of the institutional
pressures for change identified in our four case studies.
Turning to the other dimension of Institutional Theory,
decoupling implies that while managers might perceive a need
for their organisation to be seen to be adopting certain
institutional practices, and might even institute formal processes
aimed at implementing these practices, actual organisational
practices can be very different from these formally sanctioned
and publicly pronounced processes and practices. Thus, the
actual practices can be decoupled from the institutionalised
(apparent) practices. In terms of voluntary corporate-reporting
practices, this decoupling can be linked to some of the insights
from Legitimacy Theory whereby social and environmental
disclosures can be used to construct an organisational image
very different from actual organisational, social and
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environmental performance. Thus, the organisational image
constructed through corporate reports might be one of social
and environmental responsibility when the actual managerial
imperative is maximisation of profitability or shareholder value.
As Dillard, Rigsby and Goodman (2004, p. 510) put it:
Decoupling refers to the situation in which the formal
organizational structure or practice is separate and distinct
from actual organizational practice. In other words, the
practice is not integrated into the organization’s managerial
and operational processes. Formal structure has much more to
do with the presentation of an organizational-self than with the
actual operations of the organization (Curruthers, 1996).
Ideally, organizations pursue economic efficiency and attempt
to develop alignment between organizational hierarchies and
activities. However, an organization in a highly institutionalized
environment may face conflicts and inconsistencies between
the demands for efficiency and the need to conform to
‘ceremonial rules and myths’ of the institutional context
(Meyer & Rowan, 1977). In essence, institutionalized,
rationalized elements are incorporated into the organization’s
formal management systems because they maintain
appearances and thus confer legitimacy whether or not they
directly facilitate economic efficiency.
Insights about ‘decoupling’ are particularly relevant for people
who read corporate reports (such as investors, lenders,
regulators, researchers and other interested stakeholders) as
they provide a warning not to believe that the public disclosures
being made by organisations necessarily always reflect Page 121
what is actually occurring within an organisation. For
example, just because an organisation publicly discloses various
missions and values and policies which seem to reflect that the
organisation adopts best available environmental or social
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practices, this does not necessarily mean this is how the
organisation actually operates. As such, there is an overlap with
insights provided by Legitimacy Theory, Stakeholder Theory and
Positive Accounting Theory.
From the material provided in this chapter, it can be seen that
PAT, Stakeholder Theory, Legitimacy Theory and Institutional
Theory all provide different (but sometimes overlapping)
theoretical perspectives on why organisations might elect to
make particular disclosures. The relevance of such theories
would arguably be greater where there is no regulation
prescribing how organisations are to account for a particular
transaction or event, or how to disclose particular information.
In such a case, particular motivations, and not regulation, might
drive what disclosures are made and what accounting methods
are adopted. The various theories described above are
summarised in Table 3.2 .
Table 3.2 Theories of accounting summarised
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Theory
Type
Description
Positive Accounting
Positive
Seeks to explain and
Theory (PAT)
predict particular
phenomena, especially the
managers’ choice of
accounting methods.
Grounded in classical
economics, it focuses on
relationships between
various individuals within
and outside an
organisation and explains
how financial accounting
can be used to minimise
the cost implications of
each contracting party
operating in its own selfinterest.
Current-cost accounting
Normative
Aims to provide a
prescription for a
calculation of income that,
after adjustments are
made for changing prices,
could be withdrawn from
the entity while leaving its
physical capital intact. The
maintenance of the firm’s
physical capital or
operating capacity is
central to current-cost
accounting.
Exit-price accounting
(CoCoA)
Normative
The central objective of
CoCoA is to provide
information about an
entity’s ‘capacity to adapt’
to changing
circumstances, with profit
being directly related to
changes in adaptive
capacity. Profit is
calculated as the amount
that can be distributed
while maintaining the
entity’s adaptive capital
intact.
Deprival-value
accounting
Normative
Can be defined as the
value to the business of
particular assets.
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While there are numerous theories that can be applied Page 122
to explain managers’ choice of accounting methods or
disclosure strategies (particularly where there are no legislative
requirements), there are also a number of theories that have
been constructed to explain how and why accounting regulation
is developed (including theories explaining the introduction of
regulation). As with the other theories discussed in this chapter,
there is no one generally accepted theory of regulation. In fact,
there is much debate about what drives the introduction of
regulation. The following discussion will briefly consider some of
this debate.
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Theories that seek to explain why regulation is introduced
Page 1 of 13
Theories that seek to explain why
regulation is introduced
LO 3.13
As indicated in Chapter 1 , general purpose financial
reporting is subject to a great deal of regulation. For example,
listed companies must comply with a multitude of accounting
standards, as well as with the corporations legislation and
securities exchange listing requirements. In this section, a brief
overview is provided of some of the theories developed to
explain why regulation is introduced. Arguments in favour of or
against regulation (that is, the pro-regulation versus freemarket arguments) will not be considered here, as they were
briefly considered in Chapter 1 . In the material that
follows, you will see that different researchers have advanced
different arguments about what causes regulation to be
introduced. Some theories of regulation suggest that regulation
is introduced in the public interest, while other theories
suggest that regulation is introduced to benefit some people at
the expense of others, that is, in self-interest.
Public Interest Theory
According to Posner (1974, p. 335), Public Interest Theory
‘holds that regulation is supplied in response to the demand
of the public for the correction of inefficient or inequitable
market practices’. That is, regulation is initially put in place to
benefit society as a whole, rather than to benefit particular
vested interests, and the regulatory body is considered to
represent the interests of the society in which it operates,
rather than the private interests of the regulators. The
enactment of legislation is considered to be a balancing act
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between the social benefits and the social costs of the
regulation. The application of this argument to financial
accounting, given the existence of a capitalist economy,
implies that society needs confidence in the capital markets to
help ensure that resources are directed towards productive
assets. Regulation is deemed to be an instrument for creating
such confidence.
There are many people who are critical of this fairly simplistic
perspective of why regulation is introduced (for example,
Stigler 1971; Posner 1974; and Peltzman 1976). Posner (1974,
p. 337) states:
[There is] a good deal of evidence that the socially
undesirable results of regulation are frequently desired by
groups influential in the enactment of the legislation setting
up the regulatory scheme … Sometimes the regulatory statute
itself reveals an unmistakable purpose of altering the
operation of markets in directions inexplicable on public
interest grounds.
Proponents of the economics-based assumption of self-interest
would argue against accepting that any legislation was put in
place by particular parties because these parties genuinely
believe it to be in the public interest. Rather, they consider
that legislators will enact legislation only because it might
increase their own wealth (perhaps through increasing their
likelihood of being re-elected), and people will lobby for
particular legislation only if it is in their own interests.
Obviously, as with most theoretical assumptions, this
(simplistic) self-interest assumption is one that (hopefully!) will
not always hold. Nevertheless, and as is shown in this chapter,
the belief that ‘self-interest drives all’ is central to many
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theoretical perspectives.
Capture Theory
Researchers who embrace Capture Theory (capture theorists)
would typically argue that although regulation might be
introduced with the aim of protecting the ‘public interest’ (as
argued in Public Interest Theory, as briefly described above),
this laudable aim of protecting the public interest will not
ultimately be achieved, because in the process of introducing
regulation the organisations that are subject to the regulation
will ultimately come to control the regulator. The regulated
industries will seek to gain control of the regulatory body,
because they will know that the decisions made by the
regulator will potentially have significant impacts on their
industry. The regulated parties or industries will seek to take
charge of (capture) the regulator with the intention of ensuring
that the regulations subsequently released by the regulator
(post-capture) will be advantageous to their
Page 123
industry. As an example of possible regulatory
capture, we might consider the contents of a newspaper article
entitled ‘Aviation industry “captured” safety body’ (Canberra
Times, 4 July 2008), in which it was stated:
A former senior legal counsel to the Civil Aviation Safety
Authority for more than a decade has accused the regulator
of failing as a safety watchdog because it is too close to the
industry. Peter Ilyk, who left the authority in 2006, told a
Senate inquiry into CASA’s administration and governance the
authority had been ‘captured’ by the industry, making it
reluctant to deal decisively with air operators who fell short of
safety regulations … Another former staff member, Joseph
Tully, who was policy manager general aviation before he left
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last year, agreed CASA was too close to the industry. ‘You
have got to keep a professional distance when you’re a
regulator … we have become more of a partner than a
regulator in the last few years,’ Mr Tully said.
In another example of potential regulatory capture, this time in
relation to how certain large firms have effectively captured
the regulations pertaining to who can act in the role of a
liquidator, a report in The Australian Financial Review entitled
‘Seeing the wood for the trees and fees’ (by James Eyers, 15
October 2010) stated:
Having appeared as a witness before the Senate committee
that called last month for a shake-up of the cozy insolvency
club, barrister Geoff Slater wasted no time taking the cost of
liquidations to task … Slater told Federal Court judge Ray
Finkelstein on Wednesday the dispute was ‘really a fight over
fees’—and the intensity of the issue suggested the potential
fees on the matter would be very high. The court should
scrutinise ‘the economic dynamic of those fees’, Slater
argued, including the profit margins for particular types of
work and ‘in particular the tyranny of the hourly fee’ … Slater
pointed a finger at the Australian Securities and Investments
Commission, alleging it had become a victim of regulatory
capture. Commissioner Michael Dwyer, who has responsibility
for insolvency practitioners, had been a partner at KPMG for
most of his career and had been national president of the
Insolvency Practitioners Association for two years, Slater told
the court. ‘A layperson—rightly or wrongly—might be forgiven
for thinking ASIC has a bias towards the status quo,’ Slater
said. Furthermore, ASIC’s list of qualifications for insolvency
practitioners were nothing more than a device to exclude
everyone but the big firms, he said.
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Mitnick (1980, p. 95, as reproduced in Walker 1987, p. 281)
provides a useful description of the Capture Theory
perspective:
Capture is said to occur if the regulated interest controls the
regulation and the regulated agency; or if the regulated
parties succeed in coordinating the regulatory body’s
activities with their activities so that their private interest is
satisfied; or if the regulated party somehow manages to
neutralise or ensure non-performance (or mediocre
performance) by the regulating body; or if in a subtle process
of interaction with the regulators the regulated party
succeeds (perhaps not even deliberately) in co-opting the
regulators into seeing things from their own perspective and
thus giving them the regulation they want; or if, quite
independently of the formal or conscious desires of either the
regulators or the regulated parties, the basic structure of the
reward system leads neither venal nor incompetent regulators
inevitably to a community of interests with the regulated
party.
As with many other industries, at various times and in various
jurisdictions it has been argued that large accounting firms
have captured the accounting standard-setting process. This
was of such concern in the United States that in 1977 the
United States Congress investigated whether the Big Eight
accounting firms had ‘captured’ the standard-setting process
(Metcalf Inquiry). In Australia, Walker (1987) provides an
interesting analysis of the early existence of the Accounting
Standards Review Board (subsequently replaced by the
Australian Accounting Standards Board). Walker’s analysis is
consistent with the perspective that the Accounting Standards
Review Board (ASRB), a government body, was ‘captured’ by
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the accounting profession (using the definition of ‘capture’
provided above by Mitnick (1980)). Walker himself was a
member of the ASRB from 1984 to 1985. In commenting on
his motivation for documenting the case study of the ASRB,
Walker states (p. 285) that:
The main concern was to highlight the way that a set of
standard-setting arrangements designed to permit
widespread consultation and participation were subverted by
some likeable, well-meaning individuals who were trying only
to promote the interests of their fellow accountants.
Chapter 1
discussed some changes that were made several
years ago to the processes by which accounting standards are
developed in Australia. This involved taking accounting
standard-setting out of the hands of the profession and putting
it under the control of a government body. As
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indicated then, the motivation for the changes
seemed, at least in part, to be the view that the accounting
profession played too great a part in developing standards that
would be applied by the accounting profession. The profession
appeared to have captured the regulatory process in relation to
developing accounting standards.
Proponents of Capture Theory typically argue that regulation is
usually introduced, or regulatory bodies are established, to
protect the public interest. This would seem to be the case in
Australia with regard to the establishment of the Accounting
Standards Review Board (the predecessor to the AASB). Before
the establishment of the ASRB, accounting standards were
issued by the accounting profession, and sanctions for noncompliance (which were very rarely imposed) could be imposed
only against members of the profession. Walker (1987, p. 270)
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notes that throughout the 1970s (before the establishment of
the ASRB in 1984), monitoring activities by government
agencies revealed a high incidence of non-compliance with
profession-sponsored accounting rules. It was argued that this
non-compliance undermined public confidence in the capital
market, and this reduction in public confidence was itself not
deemed to be in the public interest. Government-sponsored
standards, through the establishment of the ASRB, together
with associated legal sanctions, should, it was thought, raise
the level of compliance and hence the confidence of the public
in company reporting practices. According to Walker (1987, p.
271):
The accounting profession strongly opposed the ‘costly and
possibly bureaucratic step’ of involving government in the
preparation of accounting rules. It publicised counterproposals that … legislative backing be extended to the
profession’s own standards. The files of the Commonwealth
Attorney-General’s Department relating to the establishment
of the ASRB (copies of which were obtained in terms of
Commonwealth Freedom of Information legislation) record
that National Companies and Securities Commission
Chairman Leigh Masel referred to a ‘concerted lobby by the
accounting profession’ on these matters.
According to Walker (1987), Masel telexed members of the
Commonwealth government’s Ministerial Council advising that
the NCSC (ultimately replaced by ASIC) had received
submissions opposing the profession’s proposals. Part of the
message stated:
A particular concern expressed in discussions with some
respondents was that, if the accounting profession’s proposals
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are accepted, the status and income of the profession would,
effectively, be accorded statutory protection without any
corresponding requirement for public reporting and
accountability by that profession. For reasons readily
apparent, there are many in the profession who would
welcome the safe harbour which legislative recognition would
provide.
By way of concluding remarks on the ASRB’s ‘capture’, Walker
(1987, p. 282) states:
During 1984–5 the profession had ensured the nonperformance of the ASRB and by the beginning of 1986 the
profession had managed to influence the procedures, the
priorities and the output of the Board. It was controlling both
the regulations and the regulatory agency; it had managed to
achieve coordination of the ASRB’s activities; and it appears
to have influenced new appointments so that virtually all
members of the Board might reasonably be expected to have
some community of interests with the professional
associations. The ASRB had been ‘captured’ by the profession
within only 24 months.
Chand and White (2007) also consider the issue of regulatory
capture. In doing so, they also explain government
involvement in the accounting standard-setting process, and
why, in the Australian context, the Financial Reporting Council
was established to oversee the activities of the Australian
Accounting Standards Board. Chand and White (2007, p. 612)
state:
Some jurisdictions, notably the US and Australia, have taken
the regulatory process under the wing of a government
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agency, to efface or avoid its being captured by the
profession. For example, the US has taken steps through the
Sarbanes-Oxley legislation to strengthen the regulator’s
independence (Herz, 2002; Schipper, 2003). Similarly, in
Australia the new standard-setting arrangements were
introduced in 1997, including the Financial Reporting Council
to oversee the Australian Accounting Standards Board
(Haswell and McKinnon, 2003, p. 10). Such remedial
measures were seen as necessary in these countries,
demonstrating that the regulatory process may have been
captured.
Page 125
Economic Interest Group Theory
of Regulation
Another theory of regulation is the Economic Interest Group
Theory of Regulation (or, as it is sometimes called, Private
Interest Theory of Regulation), which assumes that groups will
form to protect particular economic interests. Different groups
are viewed as often being in conflict with each other, and the
different groups will lobby government to put in place
legislation that economically benefits them (at the expense of
others). For example, consumers might lobby government for
price protection, or producers might lobby for tariff protection.
This theoretical perspective adopts no notion of public
interest—rather, private interests are considered to dominate
the legislative process. As Posner (1974) states, ‘the economic
theory of regulation is committed to the strong assumptions of
economic theory generally, notably that people seek to
advance their self-interest and do so rationally’.
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Theories that seek to explain why regulation is introduced
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In relation to financial accounting, particular industry groups
might lobby the regulator to accept or reject a particular
accounting standard. For example, in Australia an Accounting
Standard relating to the activities of general insurers was
released in 1990 (AASB 1023 General Insurance Contracts).
One requirement of this standard that was particularly
unpopular with some insurance firms was that their
investments had to be valued at net market value, with any
changes therein to be taken directly to profit or loss. To a
number of firms, this introduced unwanted volatility in
earnings, which they felt would negatively affect their
operations. They lobbied the Australian Accounting Standards
Board to amend the requirement. Another example is the fact
that many corporations lobbied the AASB to remove the former
requirement that purchased goodwill be amortised to the
income statement over a maximum period of 20 years
(previously required in Australia by AASB 1013), the argument
being that this affected their international competitiveness. The
accounting standards relating to goodwill and general insurers
were not amended to take account of these concerns.
However, they were subsequently amended as a result of
Australia’s decision to adopt IFRSs by 2005. If we accept the
Economic Interest Group Theory of Regulation, the lack of
initial success in this instance must have been due to the fact
that a more powerful interest group favoured the alternative
situation.
Watts and Zimmerman (1978) reviewed the lobbying
behaviour of United States corporations in relation to a
proposal for the introduction of general price level accounting—
a method of accounting that, in periods of inflation, would lead
to a reduction in reported profits. The authors demonstrated
that large, politically sensitive firms favoured the proposed
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Theories that seek to explain why regulation is introduced
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method of accounting, since it led to reduced profits. This was
counter to normal expectations that companies would generally
prefer to show higher, rather than lower, earnings. It was
explained on the (self-interest) basis that the larger firms
would be viewed more favourably by various groups in the
community if they reported lower profits. Reporting lower
profits was less likely to have negative wealth implications for
the organisations (perhaps in the form of government
intervention, consumer boycotts or claims for higher wages).
According to the Economic Interest Group Theory of
Regulation, the regulator itself is also an interest group—a
group that is motivated to embrace strategies to ensure reelection, or to ensure the maintenance of its position of power
or privilege within the community. We should remember that
regulatory bodies can be very powerful. The regulatory body,
typically government controlled, possesses a resource
(potential legislation) that can increase or decrease the wealth
of various sectors of the constituency.
According to this perspective of regulation, rather than
regulation being put in place initially in the public interest (as is
initially assumed within Capture Theory and also in Public
Interest Theory), it is proposed that regulation is put in place
to serve the private interests of particular parties, including
politicians who seek re-election. According to Posner (1974, p.
343), economic interest theories of regulation insist that
economic regulation serves the private interests of politically
effective groups. Further, in relation to the political process,
Stigler (1971, p. 12) states:
The industry which seeks regulation must be prepared to pay
with the two things a party needs: votes and resources. The
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Theories that seek to explain why regulation is introduced
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resources may be provided by campaign contributions,
contributed services (the businessman heads a fund-raising
committee), and more indirect methods such as the
employment of party workers. The votes in support of the
measure are rallied, and the votes in opposition are
dispersed, by expensive programs to educate (or uneducate)
members of the industry and other concerned industries …
The smallest industries are therefore effectively precluded
from the political process unless they have some special
advantage such as geographical concentration in a sparsely
settled political subdivision.
Under the Economic Interest Theory of Regulation, the
regulation itself is considered to be a commodity, subject to
the economic principles of supply and demand. According to
Posner (1974, p. 344):
Since the coercive power of government can be
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used to give valuable benefits to particular
individuals or groups, economic regulation—the expression of
that power in the economic sphere—can be viewed as a
product whose allocation is governed by laws of supply and
demand … There are a fair number of case studies—of
trucking, airlines, railroads, and many other industries—that
support the view that economic regulation is better explained
as a product supplied to interest groups than as an
expression of the social interest in efficiency or justice.
Reflecting upon the above discussion, do you think that
accounting standards are introduced in the public interest, or in
the self-interest of particular groups?
While our discussion of ‘theories of regulation’ (Public Interest
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Theories that seek to explain why regulation is introduced
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Theory, Capture Theory and Economic Interest Group Theory)
is brief and certainly does not include all theories pertaining to
why regulation is introduced, the discussion does provide some
insights into why particular regulations might have been
established. Because accounting is subject to a great deal of
regulation, it is often interesting to consider why particular
regulations were introduced (and perhaps why some other
proposed regulation was not ultimately introduced). The
theories briefly described above provide some insights that
may be helpful in answering such questions.
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Summary
Page 1 of 3
SUMMARY
This chapter has described various theories that relate to
financial accounting. It is stressed that no single accounting
theory is universally accepted. A theory itself is defined as a
coherent group of propositions used as an explanation for a
class of phenomena. The phenomena studied in accounting
theory obviously relate to the practice of accounting, but
which phenomena are selected for study from the many
available will depend on the theoretical approach that is
adopted.
The chapter has considered the differences between positive
and normative theories of accounting. A positive theory of
accounting is one that seeks to explain and predict particular
accounting-related phenomena, whereas a normative theory
of accounting prescribes how accounting should be practised.
The conceptual framework of accounting, which was
considered in some depth in Chapter 2
(and will be
revisited in other chapters throughout this book), is classified
as a normative theory of accounting.
One positive theory of accounting that we described was
Positive Accounting Theory—a theory that was popularised by
theorists such as Watts and Zimmerman. Researchers who
adopt a Positive Accounting Theory perspective typically study
issues such as the capital market’s reaction to particular
accounting policies; what motivates managers to select one
method of accounting from among competing alternatives;
and the reasons for the existence of particular accountingbased contracts. Positive Accounting Theory proponents
typically rely upon a fundamental assumption that individual
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Summary
Page 2 of 3
action can be predicted on the basis that all action is driven by
a desire to maximise wealth. As we have seen, such an
assumption is often criticised by researchers who adopt
alternative theoretical perspectives.
Normative accounting theorists typically argue that it is a
central role of accounting theory to provide prescription, that
is, to inform others about the optimal accounting approach to
adopt and why this particular approach is considered optimal.
In this view, to fail to provide such prescription is to neglect
one’s duties as an accounting academic. Normative theories
that are considered briefly in this chapter include the
conceptual framework, current-cost accounting, exit-price
accounting and deprival-value accounting. Each of the
normative theories of accounting differs from the others in its
prescriptions, depending on the perspective adopted on how
information is used by individuals and, linked to this, what
information is actually important to inform decision making.
This chapter also briefly considers systems-based theories.
These theories, which include Stakeholder Theory, Legitimacy
Theory and Institutional Theory, see the organisation as being
firmly embedded within a broader social system. The
organisation is considered to be affected by, and to affect, the
society in which it operates. According to these theories,
accounting disclosures are a way to manage relations with
particular groups outside the organisation. In a sense,
organisational activities and accounting disclosures are
perceived to be reactive to community pressures. How the
firm operates and what it reports will be influenced by a
consideration of various stakeholder expectations. Because
these ‘systems-based’ theories seek to explain and predict
particular corporate actions they can also be considered to be
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Summary
Page 3 of 3
‘positive theories’ (as opposed to being ‘normative theories’).
Apart from theories to explain or prescribe the
Page 127
selection of particular accounting methods, we also
considered theories that seek to explain how regulation is
developed, that is, we considered theories of regulation. We
saw that some theories of regulation suggest that regulation is
introduced to serve the public interest by regulators who work
for the public good, whereas other theories of regulation
assume that the development of regulation is driven by
considerations of self-interest.
This chapter has emphasised that the selection of one theory
in preference to another will depend on the views and
expectations of the researcher in question. We have seen that
there is often heated debate between individuals from the
alternative schools of thought. Theories, as abstractions of
reality, cannot be expected to perfectly explain and predict all
accounting-related phenomena, nor can they be expected to
provide optimal solutions in all cases. No one theory of
accounting can—or, perhaps, should—ever be definitively
described as the best theory. If we accept this, we will see
that different theoretical perspectives can, at various times,
provide us with valuable insights into accounting issues.
In the balance of this book, accounting requirements as
stipulated by the different accounting standards will be
considered. As appropriate, reference will be made to the
theories discussed in this chapter, thus providing insight into
the implications of the various accounting requirements and
reporting practices that organisations adopt.
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Key terms
Page 1 of 2
KEY TERMS
accounting-based bonus scheme
accounting policy notes
agency relationship
bonus scheme
capacity to adapt
Continuously Contemporary Accounting (CoCoA)
creative accounting
current cash equivalents
current-cost accounting
current replacement cost
debt covenant
debtholder
exit-price theory
generally accepted accounting principles
information asymmetry
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Key terms
Page 2 of 2
Institutional Theory
Legitimacy Theory
leverage
monitoring cost
net present value
net selling price
normative accounting theories
perquisite consumption
political costs
Positive Accounting Theory (PAT)
present value
rational economic person assumption
social contract
social-responsibility disclosures
Stakeholder Theory
systems-oriented theories
theory
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End-of-chapter exercises
Page 1 of 1
END-OF-CHAPTER EXERCISES
This chapter has raised a number of issues in relation to
various theories of financial accounting. To test your
comprehension of the various issues, try answering the
following questions. If you are unable to answer the questions,
consider re-reading some of the material provided in the
chapter.
1. What is a theory and how would you evaluate whether a
theory is a ‘good’ theory or a ‘bad’ theory? Is there actually
such a thing as a good or a bad theory? LO 3.1
3.3
2. Do you expect that we will ever have a single universally
accepted theory of accounting and, if not, why not? LO
3.1
3.2
3.3
3. What is the difference between a normative theory and a
positive theory? Is one more useful than the other or do they
perform different roles? LO 3.2
3.3
3.8
4. What is the role of Positive Accounting Theory and what are
its central assumptions? Given these assumptions, do you
think it is realistic for the conceptual framework to propose
that financial statements should be objective and free from
bias? LO 3.5
3.7
3.8
3.10
5. Can Positive Accounting Theory explain the existence of
creative accounting? LO 3.7
3.10
6. What is a systems-oriented theory of accounting? LO
3.12
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Review questions
Page 1 of 4
REVIEW QUESTIONS
1.
Page 128
Why is it useful for students of financial accounting to consider theories such as those
discussed in this chapter? LO 3.1
2.
3.
Why and how might management not act in the interests of the firm? LO 3.6
, 3.6
, 3.7
, 3.13
4.
How can management expropriate the wealth of debtholders? LO 3.4
5.
What is corporate social reporting? LO 3.12
, 3.6
, 3.7
, 3.8
Why would firms voluntarily present certain information, such as information about their
performance with regard to the environment? LO 3.9
7.
, 3.8
How can we use the output of the accounting system to help ensure that management’s actions are
in the interests of the owners? LO 3.4
6.
, 3.7
, 3.12
If firms are voluntarily producing information about the environment, about their initiatives with
respect to their employees or about their commitments to the local population, what does this imply
about their perceptions of who the ‘users’ of the information are? LO 3.12
8.
What are debt covenants and why are they put in place? LO 3.6
9.
What might be a goal of a well-designed management compensation scheme? LO 3.6
10.
, 3.8
, 3.8
What mechanisms could be put in place to motivate management to consider the interests of:
(a)
the owners?
(b)
11.
, 3.7
the debtholders? LO 3.6
, 3.7
What role does the auditor play in financial reporting? LO 3.6
, 3.7
, 3.10
12.
Why would a change in accounting policy affect a contractual agreement between a firm and a
manager or debtholder? LO 3.6
13.
According to Positive Accounting Theory, why could a change in the existing set of accounting
standards affect the value of a firm? LO 3.6 , 3.8
14.
Positive Accounting Theory utilises the concept of political costs. Briefly define political costs. What
actions might a firm’s management undertake in an attempt to minimise the political costs that
might be imposed on the firm? LO 3.9
15.
Explain why a firm’s management might be prepared to expend considerable resources to lobby
‘for’ or ‘against’ a proposed accounting standard. LO 3.6 , 3.7 , 3.8 , 3.9
16.
If management agrees to restrict its ability to transfer wealth away from debtholders—perhaps
through agreeing not to pay excessive dividends; not to take on excessive levels of debt; or not to
participate in excessively risky ventures—what effect should this have on the cost of debt capital of
the firm? LO 3.6 , 3.8
17.
Chambers’ theory of accounting, Continuously Contemporary Accounting, relies on the notion of
the ‘capacity to adapt’. What is the capacity to adapt and how is it determined? LO 3.2 , 3.11
18.
Professional accountants are expected to be objective when performing their duties. How would
you reconcile this expectation with the central assumptions of Positive Accounting Theory, and are
they mutually exclusive? LO 3.5 , 3.7 , 3.8 , 3.9 , 3.10
19.
Contrast the role of Positive Accounting Theory with the role of normative accounting theories. LO
3.2
20.
Under Positive Accounting Theory, what are agency costs of equity and agency costs of debt? Is it
possible to put in place mechanisms to reduce all opportunistic action? If not, why not? LO 3.4 ,
3.6
21.
If we accept the assumptions of Positive Accounting Theory, would you expect a manager who is
rewarded by way of a profit-sharing bonus scheme to prepare the firm’s financial statements in an
unbiased manner? Explain your answer. LO 3.7 , 3.8
22.
How could accounting regulators use the research conducted by Positive Accounting theorists? LO
3.5 , 3.6 , 3.7
23.
Some researchers who utilise Legitimacy Theory posit that organisations will attempt to operate
within the terms of their ‘social contract’. What is a social contract? LO 3.12
24.
Using Institutional Theory as your theoretical basis, explain why an organisation might voluntarily
elect to make particular financial disclosures. LO 3.12
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25.
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Within Institutional Theory, reference is made to isomorphism and decoupling. What do these
terms mean? LO 3.12
Page 129
26.
If we accept the assumptions of Positive Accounting Theory, would you expect a manager who is
employed by a firm that has negotiated lending agreements which include accounting-based debt
covenants to have a relatively greater incentive to manipulate the financial statements? Explain your
answer. LO 3.7
27.
3.8
, 3.9
, 3.10
The IASB’s Conceptual Framework for Financial Reporting indicates that financial statements
should provide unbiased representations of the underlying transactions. Is this realistic? LO 3.7
28.
Provide some arguments to explain what motivates regulators to introduce particular regulations.
LO 3.7
29.
, 3.13
An article entitled ‘A step too far crucifies small business’ appeared in the Australian Financial
Review on 4 June 2004 (p. 81) and is adapted below in Financial Accounting in the Real World
3.2 . Applying Stakeholder Theory, would the bank care about the concerns of the small business s
ector and regional business communities? LO 3.12
3.2 FINANCIAL ACCOUNTING IN THE Real World
Page 130
The NAB and the McMinns: bank policy and its effect on small business
Australian banks disseminate reports that small business is now getting a better deal from the banking
sector, though the fact that the National Australia Bank (NAB) is losing market share at the sole-proprietor
end belies that in the NAB’s case.
The journey of a Queensland small business from profitable concern to receivership demonstrates how
NAB’s policy changes over a period of years contributed largely to the fate of Alan and Wilma McMinn.
On the strength of their relationship with a NAB commercial manager who understood the childcare business
and the opportunities opened up in the sector by the population expansion on the Gold Coast, the McMinns
bought a childcare centre there in 1995. They decided to build a second centre next to the first and the plan
was approved by NAB following the McMinn’s 1996 financial year net profit of $250 000.
Success in the new venture rested on the centre being open at the beginning of the 1997 school year.
Although all the major banks began cost-cutting on a grand scale around this period, the replacement of the
McMinn’s bank manager under the regime of Frank Cicutto, NAB’s general manager of Australian financial
services, didn’t cause alarm bells as the subsequent manager reiterated in September 1996 that NAB was
committed to the new centre, despite the turmoil at the bank’s head office. The McMinns were told to go
ahead while waiting for formal approval paperwork, but in December were ordered to stop work
immediately. NAB didn’t give final approval for building for four months so the McMinns missed their 1997
deadline. They attribute the collapse of the business to the bank’s actions from 1995 to 2000, over which
period they had to deal with 16 different commercial managers. They have taken NAB to court; the bank
has followed its normal practice and made no comment.
Although the bank has been hurt by the scandal surrounding its $360 000 million foreign currency option it
appears that is what is actually driving SME customer loss is the NAB’s centralisation project where local
business bankers (around 110) were redeployed in the capital cities, and customers no longer had a face-toface banker.
Ian MacDonald, now head of NAB’s Financial Services Australia unit, has announced a reversal of the
centralisation policy and that NAB will again have a small business banker in its 110 business banking
centres Australia-wide and business bankers in branches if needed.
There has been criticism of the close relationship of NAB and CBA with their receivers by Evan Jones,
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University of Sydney Economics Faculty. Jones believes the banks call in the receivers too quickly and
without being questioned over their actions. He also blames corporate restructuring for customer loss.
SOURCE: Adapted from ‘A step too far crucifies small business’, by Stewart Oldfield, The Australian Financial Review, 4 June 2004, p. 81
30.
Read the adapted article by Kate Lahey and Leonie Wood in Financial Accounting in the Real
World 3.3
. This article is about the collapse of the financial institution Lehman Brothers. After rea
ding the article you are to answer the following questions:
(a)
(b)
(c)
What does ‘window dressing’ mean in the context of this article?
Using Positive Accounting Theory as the basis of your argument, why would the bank have
tried to manipulate the financial statements by understating debt?
What qualitative characteristics of the IASB conceptual framework would they have
potentially breached?
(d)
Are firms more likely to engage in ‘window dressing’ their financial statements when they
have relatively high levels of debt rather than low levels of debt? Why? LO 3.2
3.8 , 3.10
, 3.7
,
3.3 FINANCIAL ACCOUNTING IN THE real world
RBA right to doubt Lehman Brothers accounts
The Reserve Bank Australia (RBA) questioned Lehman Brothers representatives about transactions it
believed were being used to conceal a debt of billions of dollars well before the bank collapsed so
spectacularly in September 2008 and severely damaged the world financial markets.
It appears the RBA was right to question the bank.
A nine-volume, 2 200 page report into Lehmann’s bankruptcy by Anton Valukas, partner in the law firm
Jenner & Block and examiner for the bank, was released on 12 March 2010. It contains copies of emails
where Lehmann employees discuss whether to reveal to the RBA vague or detailed reasons for Lehman’s
accounting practices.
The report revealed the causes of the demise of Lehman, including unsecured mortgages and insistence on
collateral for loans sought by Lehman from its competitors Citigroup and JPMorgan Chase. The report
outlined the ‘materially misleading’ accounting practices used by Lehman to conceal its financial woes and
its dependence on borrowed money for survival, Senior Lehman executives and the bank’s accountants at
Ernst & Young were aware that $50 billion was ‘removed’ from the accounts in the months before the
collapse; Lehman’s CEO at the time, Richard Fuld Jr, certified the accounts were correct. The report said
Fuld was ‘at least grossly negligent’; he’d been warned by the treasury secretary, Henry Paulson Jr about
the need for Lehman to stabilise its finances or find a buyer to stave off the possibility of collapse.
Both Lehman and Ernst & Young had ignored Matthew Lee, a senior vice-president, when he wrote to senior
management and auditors about ‘accounting improprieties’. The report found Lehman’s board had not been
informed of Lee’s claims and were unaware of the suspect accounting practices.
Valukas stated that Lehman executives were involved in ‘actionable balance sheet manipulation,’ and made
‘nonculpable errors of business judgment’ and suggested that there was enough evidence against them,
and Ernst & Young, to support civil claims.
‘Our last audit of the company was for the fiscal year ending November 30, 2007. Our opinion indicated
that Lehman’s financial statements for that year were fairly presented in accordance with Generally
Accepted Accounting Principles (GAAP), and we remain of that view.’ This was the official response of Ernst
& Young to the report by its representative, Charles Perkins.
The accounting practice subject to scrutiny in a large part of the Valukas report is the use of repurchase
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agreements known on Wall Street as ‘repos’ and as ‘Repo 105’ at Lehman Brothers. Repo 105 transactions,
in use since 2001, moved billions off Lehman’s accounts when the bank came under scrutiny. It was use of
Repo 105 that the RBA had questioned. They were used extensively before the crash as Fuld Jr ordered his
executives to reduce Lehman’s level of debt.
Valukas quoted a Lehman executive’s email where it was said about Repo 105 that ‘It’s basically windowdressing’.
For example, the amount moved off balance sheets in the final quarter of 2007 was $39 billion, in the first
quarter of 2008, $49 billion, and in the second quarter of that year, $50 billion. At the same time the
Lehman executives were insisting in public that its finances were in good shape. Fuld denied knowledge of
the use of Repo 105 although it has been reported that Herbert McDade, Lehman’s ‘balance sheet czar’ told
Fuld about the use of Repo 105.
Following the release of the report Lehman’s current CEO, Bryan Marsal, said that they will consider the
report and ‘assess how it might help us in our ongoing efforts to advance creditor interests’.
Lehman’s creditors in Australia will also be hoping that the report will assist with advancing their interests.
Local councils and charities bought up to $1.2 billion of complex derivative instruments from Lehman before
its collapse. Lehman’s biggest creditors by a deed of company arrangement sought to protect Lehman and
third parties from claims from the councils. The councils are hoping the report strengthens their case to sue
but they are waiting for a High Court ruling on the issue.
SOURCE: Adapted from ‘Reserve Bank put heat on Lehman over accounting’, by Kate Lahey and Leonie Wood, The Age, 13 March 2010, Web.
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CHALLENGING QUESTIONS
31.
In an article that appeared in The Australian Page 131
on 28 July 2014 entitled ‘Southern Cross CFO
quit over writedown’ (by Darren Davidson) it was
reported that:
Mr Lewis joined Southern Cross after it issued a profit
downgrade in May. The owner of the 2DayFM radio
network said that it expected full-year net profit to fall
10 per cent below the previous year’s funderlying NPAT
of $89 million. Although the company’s gearing remains
within its banking covenant of less than 3.5 times
earnings before interest, taxes, depreciation and
amortisation, there is concern in the market the
company is slipping into a danger zone with its debt
covenants. Some market analysts believe that if
revenues continue to deteriorate, gearing of above three
times EBITDA could trigger a breach of banking
covenants.
REQUIRED
(a)
Why might the debt covenants have originally been
agreed to by Southern Cross?
(b)
Why would a reduction in earnings potentially affect
the debt covenants?
(c)
In general, and according to the ‘debt hypothesis’
often utilised within Positive Accounting Theory, if an entity
is close to breaching accounting-based debt covenants then
what action might the entity take? LO 3.5 , 3.6 ,
3.7 , 3.8 , 3.10
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32.
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Read the brief extract from Anthony Hughes’ article
‘Credit card profit soars but ANZ feels no guilt’ in
Financial Accounting in the Real World 3.4
and an
swer the following questions (be specific about the
theories you are using when providing your answers):
(a)
Why do you think the bank ‘unveiled a plan to
tackle community concerns’?
(b)
What do you think motivates the government to
take action against the banks?
(c)
The bank’s reported profit seems to be an issue
of concern. Do you think that community concern
about the actions of the bank would be as great if
the bank was not so profitable?
(d)
Do you think that community concerns about the
profits made by banks might motivate the banks to
adopt accounting policies that reduce their reported
profits? Explain your answer. LO 3.6 , 3.7 ,
3.8 , 3.9
3.4 FINANCIAL ACCOUNTING IN THE real
world
Credit card profit soars but ANZ feels no guilt
Anthony Hughes
ANZ denied yesterday it was overcharging customers after
reporting a 71 per cent increase in credit card profits. The bank
also reported a 93 per cent profit rise from mortgages.
The overall net profit for the March half was $895 million, a
record for the bank.
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The result comes just a week after the bank unveiled a plan to
tackle community concern about banking standards, including a
new customer charter, fee-free over-the-counter banking for
people over 65 and the appointment of a senior customer
advocate.
ANZ’s chief executive, Mr John McFarlane, defended the credit
card profits. ‘...These are not unfair businesses and we are not
getting unusual levels of returns,’ he said.
Mr McFarlane admitted the banks had been slow to recognise
the depth of community concern. ‘Whether we are going to be
regulated or not we are going to have to do things differently’.
SOURCE: Extract from ‘Credit card profit soars but ANZ feels no guilt’, by Anthony
Hughes, The Sydney Morning Herald, 27 April 2001, p. 3
33.
Read the brief extract from an article by Sue Page 132
Mitchell entitled ‘Rules hit retailers with rolledup leases’ that appeared in The Canberra Times on 23
April 2015 in Financial Accounting in the Real World
3.5
and answer the following questions:
(a)
Why would companies have preferred to treat
the leases as operating leases (if there is an
operating lease then the assets and liabilities
associated with leased asset are not shown on the
statement of financial position) rather than finance
leases (if the lease were a finance lease then the
liabilities and assets associated with the lease
would be shown on the statement of financial
position)?
(b)
Explain why the change in the accounting
standard for leasing might cause organisations to
breach covenants included within debt contracts.
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(c)
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What is the difference between debt covenants
that rely upon ‘floating GAAP’ and those relying on
‘fixed GAAP’, and which provide less risk to the
borrower?
(d)
Which organisations would be more likely to
lobby against the accounting standard? LO 3.5
3.6 , 3.7 , 3.8 , 3.10
,
3.5 FINANCIAL ACCOUNTING IN THE real
world
Retailers face multibillion-dollar hit from
proposed lease accounting changes
Sue Mitchell
Australia’s fastest growing retailers face a hit to their bottom
line profits under proposed accounting rules that will force them
to bring more than $40 billion worth of leases onto their balance
sheets for the first time.
Under the latest changes to lease accounting rules put forward
by the IASB, retailers such as Woolworths, Wesfarmers, Myer,
David Jones, JB Hi-Fi, Harvey Norman, Specialty Fashion and
Premier Investments will have to calculate the net present value
of future lease commitments and recognise them as debt on
their balance sheets.
Instead of recognising rent payments as costs incurred, retailers
will have to expense theoretical amortisation and financing
costs.
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According to a report by Morgan Stanley, the impact on retailers
will be ‘considerable’, blowing out gearing levels and reducing
return on capital employed, but will vary from retailer to
retailer.
KPMG audit partner Patricia Stebbens said the proposed changes
would boost gearing ratios, forcing some companies to
renegotiate debt covenants with bankers.
SOURCE: Extract from ‘Retailers face multibillion-dollar hit from proposed lease accounting
changes’ by Sue Mitchell, The Canberra Times, 22 April 2015. Web.
34.
Read the following extract from an article by Jennifer
Borrell entitled ‘Cave in by PM puts us all at risk’ that
appeared in the The Age on 23 January 2012 and then
answer the questions that follow.
Prime Minister Julia Gillard’s capitulation to the powerful
poker machine industry is a blow to democracy in this
country. Governments are meant to represent the
public interest, not be intimidated by industry
campaigns against reform in marginal electorates. In
this case, the reform was aimed at making the pokie
product safer and giving some control back to gamblers.
According to the Productivity Commission’s 2010 public
inquiry on gambling, 60 per cent of pokie revenue
comes from people who have a gambling problem or
are at risk, and about a third of regular players have a
problem or are at risk. If we were talking about such
figures with cars or pharmaceuticals, the product would
be immediately withdrawn until the problem was fixed.
The inroads made by the pokie industry into democratic
process are even more insidious than suggested by
recent events. As explained by Dr Peter Adams, the
University of Auckland’s Associate Professor of Social
and Community Health, civic institutions such as
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academic and research bodies, media, government
agencies and community organisations provide the
basis for the social involvement that underpins our
democracy. He argues that our very democracy comes
under threat when gambling revenue influences day-today decisions and processes within such vital
institutions.
This co-option of civic institutions may be subtle and
incremental or it may be blatant, as in the case of
mega-pokie businesses in New South Wales using their
club credentials and mobilising their membership for
commercial advantage. In either case, the cumulative
effect is the shaping of public views, which, in turn,
affects government policy and regulation. In this way,
the influence of gambling revenue infiltrates every level
and crevice of civic life, further entrenching the power
of gambling industries while weakening us all as a
society. It has been sad to see isolated
Page 133
church and community figures side with the
gambling lobby and speak out against reform, but it has
not been so surprising. What has been more worrying is
the consistency of their public statements with industry
‘talking points’. But industry spin requires dismantling,
as it so often amounts to misrepresentations that
shamelessly fly in the face of long-established evidence.
Based on the information within the extract above,
what theory of regulation would appear to explain the
apparent lack of controls or regulation to restrict
problem gambling? LO 3.13
35.
The Accounting Standard AASB 138 Intangible Assets
requires Australian companies to expense research
expenditure instead of treating it as an asset.
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REQUIRED
36.
(a)
Construct three hypotheses based on each of the
three major components of Positive Accounting
Theory to predict which companies are more likely
to prefer to recognise research expenditure as an
asset, rather than being required to treat the
related expenditure as an expense.
(b)
Suggest how a researcher might test these
hypotheses. LO 3.5 , 3.6 , 3.7 , 3.8 ,
3.9
In 2006 the Australian Government established an
inquiry into corporate social responsibilities with the aim
of deciding whether the Corporations Act should be
amended so as to specifically include particular social and
environmental responsibilities within the Act. At the
completion of the inquiry it was decided that no specific
regulations would be added to the legislation, and that
instead, ‘market forces’ would be relied upon to
encourage companies to do the ‘right thing’ (that is, the
view was expressed that if companies did not look after
the environment, or did not act in a socially responsible
manner, then people would not want to consume the
organisations’ products, and people would not want to
invest in the organisation, work for them, and so forth.
Because companies were aware of such market forces
they would do the ‘right thing’ even in the absence of
legislation).
You are required to explain the decision of the
government that no specific regulation be introduced
from the perspective of:
(a)
Public Interest Theory
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(b)
(c)
37.
Page 8 of 9
Capture Theory
Economic Interest Group Theory of regulation. LO
3.13
Read the following extract from an article by Greg
Barnes entitled ‘Time for Tasmanian tourism industry to
allow a free market’ in Financial Accounting in the
Real World 3.6 , which appeared in the Hobart Mercur
y on 8 December 2014 and then answer the following
questions:
(a)
Pursuant to Capture Theory, why would the
Tasmanian Government respond to the demands
of the tourism industry?
(b)
From a Capture Theory perspective, who
benefits from government regulation?
(c)
Would it be possible to ‘prove’ that the
Tasmanian Government has been ‘captured’ by the
tourism industry, and if so, what evidence would
provide such proof? LO 3.13
3.6 FINANCIAL ACCOUNTING IN THE real
world
Time for a free market in Tasmanian tourism
Greg Barnes
American economist George Stigler wrote ‘as a rule, regulation
is acquired by the industry and is designed and operated
primarily for its benefit’.
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Stigler’s theory of regulatory capture is a sound one and we are
witnessing its pernicious impact in Tasmania today.
The tourism industry in Tasmania, through its lobby groups the
Tourism Council and the Hospitality Association, is embarking on
a concerted campaign against...‘rogue’ operators. It wants
government to police barriers to entry into the tourism industry.
It is doing so because it wants to curtail competition and it is
dressing up its regulatory capture strategy by pretending that it
is campaigning on behalf of consumers.
The Tourism Council is an opponent of the website Airbnb. ...The
outrage is pure self-interest of course.
Regulatory capture is the curse of modern democracy. It erodes
competition, innovation and consumer choice. ...The Tasmanian
Government should ignore the media campaign being run by
vested interests that are afraid of the chill winds of market
forces.
SOURCE: Extract from ‘Time for a free market in Tasmanian tourism’, by Greg Barnes, The
Mercury, 8 December 2014. Web.
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Further Reading
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FURTHER READING
Page 134
The following texts are dedicated to financial
accounting theory and are useful references for
readers who want to gain additional insights in the topic:
DEEGAN, C., 2014, Financial Accounting Theory, 4th edn,
McGraw-Hill, Sydney.
GRAY, R., ADAMS, C. & OWEN, D., 2014, Accountability,
Social Responsibility and Sustainability, Pearson, London.
HENDERSON, S., PEIRSON, G. & HARRIS, K., 2004, Financial
Accounting Theory, Pearson Education, Sydney.
MATHEWS, M.R., 1993, Socially Responsible Accounting,
Chapman and Hall, London.
SCOTT, W., 2015, Financial Accounting Theory, 7th edn,
Pearson Education, Toronto.
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References
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REFERENCES
BROADBENT, J., JACOBS, K. & LAUGHLIN, R., 2001,
‘Organisational Resistance Strategies to Unwanted
Accounting and Finance Changes: The Case of General Medical
Practice in the UK’, Accounting, Auditing & Accountability
Journal, 14 (5), pp. 565–86.
CAHAN, S.F., 1992, ‘The Effect of Antitrust Investigations on
Discretionary Accruals: A Refined Test of the Political Cost
Hypothesis’, The Accounting Review, January, pp. 77–95.
CARPENTER, V. & FEROZ, E., 1992, ‘GAAP as a Symbol of
Legitimacy: New York State’s Decision to Adopt Generally
Accepted Accounting Principles’, Accounting, Organizations
and Society, vol. 17, no. 7, pp. 613–43.
CARPENTER, V. & FEROZ, E., 2001, ‘Institutional Theory and
Accounting Rule Choice: An Analysis of Four US State
Governments’ Decision to Adopt Generally Accepted
Accounting Principles’, Accounting, Organizations and Society,
vol. 26, pp. 565–96.
CHAMBERS, R.J., 1955, ‘Blueprint for a Theory of Accounting’,
Accounting Research, January, pp. 17–55.
CHAMBERS, R.J., 1966, Accounting, Evaluation and Economic
Behavior, Prentice Hall, Englewood Cliffs, New Jersey.
CHAMBERS, R.J., 1993, ‘Positive Accounting Theory and the
PA Cult’, Abacus, 29 (1), pp. 1–26.
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References
Page 2 of 11
CHAND, P. & WHITE, M., 2007, ‘A Critique of the Influence of
Globalization and Convergence of Accounting Standards in
Fiji’, Critical Perspectives on Accounting, vol. 18, pp. 605–22.
CHRISTENSON, C., 1983, ‘The Methodology of Positive
Accounting’, The Accounting Review, vol. 58, January, pp. 1–
22.
CHRISTIE, A., 1990, ‘Aggregation of Test Statistics: An
Evaluation of the Evidence on Contracting and Size
Hypotheses’, Journal of Accounting and Economics, January,
pp. 15–36.
COSTELLO, A. & WITTENBERG-MOERMAN, R., 2011, ‘The
Impact of Financial Reporting Quality on Debt Contracting:
Evidence from Internal Control Weakness Reports’, Journal of
Accounting Research, 49 (1), pp. 97–136.
COTTER, J., 1998a, ‘Asset Revaluations and Debt Contracting’,
unpublished PhD thesis, University of Queensland.
COTTER, J., 1998b, ‘Utilisation and Restrictiveness of
Covenants in Australian Private Debt Contracts’, Accounting
and Finance, vol. 38, no. 2, pp. 111–38.
DEEGAN, C.M., 1997a, ‘The Design of Efficient Management
Remuneration Contracts: A Consideration of Specific Human
Capital Investments’, Accounting and Finance, vol. 37, no. 1,
May, pp. 1–40.
DEEGAN, C.M., 1997b, ‘Varied Perceptions of
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Positive Accounting Theory: A Useful Tool for
Explanation and Prediction, Or a Body of Vacuous, Insidious
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References
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and Discredited Thoughts?’, Accounting Forum, vol. 20, no. 5,
pp. 63–73.
DEEGAN, C.M. & HALLAM, A., 1991, ‘The Voluntary
Presentation of Value Added Statements in Australia’,
Accounting and Finance, May, pp. 1–16.
DEEGAN, C. & ISLAM, M., 2014, ‘An Exploration of NGO and
Media Efforts to Influence Workplace Practices and Associated
Accountability within Global Supply Chains’, The British
Accounting Review, vol. 46, no. 4, pp. 397–415.
DEEGAN, C.M. & RANKIN, M., 1996, ‘Do Australian Companies
Report Environmental News Objectively? An Analysis of
Environmental Disclosures by Firms Prosecuted Successfully
by the Environmental Protection Authority’, Accounting,
Auditing and Accountability Journal, vol. 9, no. 2, pp. 52–69.
DEFOND, M. & JIAMBALVO, J., 1994, ‘Debt Covenant Violation
and Manipulation of Accruals’, Journal of Accounting and
Economics, vol. 17, pp. 145–76.
DILLARD, J.F., RIGSBY, J.T., & GOODMAN, C., 2004, ‘The
Making and Remaking of Organization Context: Duality and
the Institutionalization Process’, Accounting, Auditing &
Accountability Journal, 17 (4), pp. 506–42.
DIMAGGIO, P.J. & POWELL, W.W., 1983, ‘The Iron Cage
Revisited: Institutional Isomorphism and Collective Rationality
in Organizational Fields’, American Sociological Review, 48,
pp. 146–160.
DONALDSON, T. & PRESTON, L., 1995, ‘The Stakeholder
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References
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Theory of the Corporation—Concepts, Evidence, and
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Page 138
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Introduction
Page 1 of 1
Part 3
Page 139
ACCOUNTING FOR ASSETS
CHAPTER 4
An overview of accounting for assets
CHAPTER 5
equipment
Depreciation of property, plant and
CHAPTER 6
Revaluations and impairment testing of
non-current assets
CHAPTER 7
Inventory
CHAPTER 8
Accounting for intangibles
CHAPTER 9
Accounting for heritage assets and
biological assets
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Introduction
Page 1 of 3
Chapter 4
Page 140
AN OVERVIEW OF ACCOUNTING FOR
ASSETS
LEARNING OBJECTIVES (LO)
4.1 Understand the definition of an asset, the definition of
current and non-current assets, and the asset recognition
criteria.
4.2 Understand how to determine ‘future economic
benefits’.
4.3 Understand the process involved in determining
whether particular expenditures should be recognised as
assets (that is, capitalised) or expensed.
4.4 Understand how a number of different classes of
assets are measured and be aware of the meaning of, and
limitations of, the calculation known as total assets.
4.5 Know the meaning of ‘recoverable amount’ and be
able to calculate it.
4.6 Be aware of the disclosure requirements embodied
within AASB 101 Presentation of Financial Statements as
they pertain to a reporting entity’s assets.
4.7 Be able to explain how to calculate the acquisition cost
of an asset.
4.8 Understand how to determine the cost of an asset
when the payment for the asset is deferred.
4.9 Be able to account for an asset that has been acquired
at no cost (e.g. donated asset).
4.10
Be able to discuss various issues surrounding the
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Introduction
Page 2 of 3
capitalisation of interest.
4.11 Be aware of possible changes in the requirements
pertaining to financial statement presentation.
Page 141
Introduction to accounting for assets
In this book we will cover a range of issues associated with
accounting for assets. To begin with, in this chapter we will
consider:
l
l
l
l
how we define assets
an overview of how we might measure various classes of
assets
how assets are classified and disclosed within the statement
of financial position (balance sheet)
how we determine the acquisition costs of assets.
While the material provided in this chapter has general
application to assets, in subsequent chapters we will examine
how to account for specific types of assets. For example, in
Chapter 7
we will address how to account for inventory; in
Chapter 8
we will address how to account for intangible as
sets; and in Chapter 9
we will address how to account for
agricultural assets (for example, how to account for trees and
their produce, or livestock). As we will learn, there are
different rules to apply when we account for different types of
assets. Conceptually, you might have thought that all assets
should be measured in the same way, for example, at fair
value or at cost, but this is not the case as measurement rules
vary depending upon the type of asset in question.
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Introduction
Page 3 of 3
Across time, the value of the majority of assets will either
increase or decrease. Where the value decreases, we will need
to understand how to allocate the cost of an asset across its
useful life. To this end, Chapter 5
will address how we
depreciate non-current assets for accounting purposes. We
will also need to know how to account for valuation changes.
Chapter 6
will discuss how we undertake revaluations of n
on-current assets, and how we account for impairment losses
(which are deemed to exist when an asset’s carrying amount
exceeds its recoverable amount). After recapping on how
Australian Accounting Standards are numbered, we will
commence this chapter with a definition of assets.
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Introduction
Page 1 of 3
Chapter 4
Page 140
AN OVERVIEW OF ACCOUNTING FOR
ASSETS
LEARNING OBJECTIVES (LO)
4.1 Understand the definition of an asset, the definition of
current and non-current assets, and the asset recognition
criteria.
4.2 Understand how to determine ‘future economic
benefits’.
4.3 Understand the process involved in determining
whether particular expenditures should be recognised as
assets (that is, capitalised) or expensed.
4.4 Understand how a number of different classes of
assets are measured and be aware of the meaning of, and
limitations of, the calculation known as total assets.
4.5 Know the meaning of ‘recoverable amount’ and be
able to calculate it.
4.6 Be aware of the disclosure requirements embodied
within AASB 101 Presentation of Financial Statements as
they pertain to a reporting entity’s assets.
4.7 Be able to explain how to calculate the acquisition cost
of an asset.
4.8 Understand how to determine the cost of an asset
when the payment for the asset is deferred.
4.9 Be able to account for an asset that has been acquired
at no cost (e.g. donated asset).
4.10
Be able to discuss various issues surrounding the
mk:@MSITStore:C:\Users\Administrator\Desktop\Financial%20Accounti... 2017/3/2
Introduction
Page 2 of 3
capitalisation of interest.
4.11 Be aware of possible changes in the requirements
pertaining to financial statement presentation.
Page 141
Introduction to accounting for assets
In this book we will cover a range of issues associated with
accounting for assets. To begin with, in this chapter we will
consider:
l
l
l
l
how we define assets
an overview of how we might measure various classes of
assets
how assets are classified and disclosed within the statement
of financial position (balance sheet)
how we determine the acquisition costs of assets.
While the material provided in this chapter has general
application to assets, in subsequent chapters we will examine
how to account for specific types of assets. For example, in
Chapter 7
we will address how to account for inventory; in
Chapter 8
we will address how to account for intangible as
sets; and in Chapter 9
we will address how to account for
agricultural assets (for example, how to account for trees and
their produce, or livestock). As we will learn, there are
different rules to apply when we account for different types of
assets. Conceptually, you might have thought that all assets
should be measured in the same way, for example, at fair
value or at cost, but this is not the case as measurement rules
vary depending upon the type of asset in question.
mk:@MSITStore:C:\Users\Administrator\Desktop\Financial%20Accounti... 2017/3/2
Introduction
Page 3 of 3
Across time, the value of the majority of assets will either
increase or decrease. Where the value decreases, we will need
to understand how to allocate the cost of an asset across its
useful life. To this end, Chapter 5
will address how we
depreciate non-current assets for accounting purposes. We
will also need to know how to account for valuation changes.
Chapter 6
will discuss how we undertake revaluations of n
on-current assets, and how we account for impairment losses
(which are deemed to exist when an asset’s carrying amount
exceeds its recoverable amount). After recapping on how
Australian Accounting Standards are numbered, we will
commence this chapter with a definition of assets.
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Numbering of Australian Accounting Standards
Page 1 of 2
Numbering of Australian Accounting
Standards
Because we will be referring to accounting standards in this
and subsequent chapters, it might be worthwhile taking
another look at the numbering system applied to Australian
Accounting Standards (we referred to this in Chapter 1 ,
but in the interests of avoiding potential confusion we return
to it here).
Accounting standards issued by the International Accounting
Standards Board and its predecessor, the International
Accounting Standards Committee, were, until 2003, referred
to as International Accounting Standards and given the prefix
IAS. For example, the accounting standard relating to
intangible assets as issued in 1998 is IAS 38 Intangible
Assets. Accounting standards issued by the IASB from late
2003 onwards are to be referred to as International Financial
Reporting Standards and will have the prefix IFRS. For
example, the accounting standard issued in late 2003 that
relates to first-time adoption of International Financial
Reporting Standards is IFRS 1 First-time Adoption of
International Financial Reporting Standards. Where the IASB
has issued a standard as an IAS, whether or not it has been
the subject of subsequent ‘improvement’, to the extent it was
referred to as an IAS it will continue to be referred to as one.
Therefore, the IASB will have standards with different
prefixes—the ‘older’ standards (which might nevertheless have
had recent updates or amendments) will have the prefix IAS
and the ‘newer’ standards will have the prefix IFRS. By
contrast, when the Australian Accounting Standards Board
releases accounting standards they will all have the prefix
AASB. However, the number of the AASB standard will depend
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Numbering of Australian Accounting Standards
Page 2 of 2
upon whether the ‘adopted’ standard relates to an ‘old’ or
‘new’ international standard.
Where the adopted AASB standard relates to a standard that
has the IAS prefix, the Australian standard will be numbered
from AASB 101 to AASB 199. For example, our standard on
intangible assets will be AASB 138 Intangible Assets (the
international standard being IAS 38 Intangible Assets).
Where an Australian standard relates to a standard with the
IFRS prefix (one of the more recent standards issued by the
IASB), the Australian standard will be numbered from AASB 1
to 99. For example, our Australian standard AASB 15 Revenue
from Contracts with Customers equates to IFRS 15 Revenue
from Contracts with Customers, which was released by the
IASB in 2014.
In situations where Australia releases an accounting standard
that does not have an international equivalent (the AASB
might release standards that relate to particular issues of
domestic importance that are not covered by the IASB), the
numbering system will be from AASB 1001 to AASB 1099. For
example, we had an accounting standard issued in 2014 by
the AASB that does not have an equivalent, this being AASB
1056 Superannuation Entities.
Therefore, we have three different numbering systems for our
accounting standards—at least for the foreseeable future.
Hopefully, this explanation of the numbering system will
prevent confusion in this and following chapters.
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Definition of assets
Page 1 of 21
Page 142
Definition of assets
LO 4.1 LO 4.2 LO 4.3 LO 4.4
As we learned in Chapter 2 , the IASB Conceptual
Framework for Financial Reporting (hereafter referred to as the
conceptual framework) provides definitions of the elements of
accounting, these being assets, liabilities, equity, income and
expenses. We also learned in Chapter 2
that the IASB is
currently revising the conceptual framework and that this will
create changes in how assets are defined and recognised. A
review of Chapter 2
will provide information on the nature
of these possible changes.
The conceptual framework currently defines an asset as: ‘a
resource controlled by the entity as a result of past events and
from which future economic benefits are expected to flow to
the entity’.
Considering the above asset definition, an asset of an entity
should have three fundamental characteristics:
1. An asset is expected to provide future economic benefits to
the entity.
2. An asset must be controlled by the entity (but does not have
to be legally owned).
3. The transaction or event giving rise to the control must
already have occurred.
As we can see from the definition of assets provided above,
‘future economic benefits’ is the essence of assets. Future
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Definition of assets
Page 2 of 21
economic benefits represent the scarce capacity of assets to
provide benefits to the organisations that control them and
they provide the basis for organisations to achieve their
objectives. These characteristics are common to all assets
regardless of their physical form. In relation to the physical
form of an asset, the conceptual framework states:
Many assets, for example, property, plant and equipment,
have a physical form. However, physical form is not essential
to the existence of an asset; hence patents and copyrights,
for example, are assets if future economic benefits are
expected to flow from them to the entity and if they are
controlled by the entity.
Assets can take a variety of forms. For example, cash is an
asset because of the command over future economic benefits it
provides. It can be easily exchanged for other goods and
services, which in turn might provide economic benefits.
Accounts receivable are assets because of the cash inflows that
are expected to occur when customers pay their accounts.
Prepayments—such as prepaid rent or prepaid insurance—are
assets because they represent existing rights to receive
services. Plant and equipment are assets because they can be
used to provide goods or services. The conceptual framework
discusses the ways in which assets can generate economic
benefits. It states:
The future economic benefits embodied in an asset may
flow to the entity in a number of ways. For example, an
asset may be:
(a) used singly or in combination with other assets in the
production of goods or services to be sold by the entity;
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Definition of assets
(b)
exchanged for other assets;
(c)
used to settle a liability; or
(d)
distributed to the owners of the entity.
Page 3 of 21
We can draw a distinction between future economic benefits
and the source of those benefits. The definition of an asset
refers to the benefits; therefore, in the absence of expected
economic benefits, the object or right will not be considered to
be an asset. The consequence of this is that any assumption
that a particular object or right will always be an asset is
incorrect. For example, while a building would normally be
expected to generate future economic benefits, if it becomes
obsolete, unusable or is abandoned then the building would no
longer represent an asset (an example here might be a mining
town that is subsequently abandoned as a result of no
economically recoverable reserves remaining within the mine
site).
As indicated in relation to the definition of an asset provided
earlier, a reporting entity does not have to have legal
ownership of an asset to record the asset within its statement
of financial position. What is important is that the entity is able
to ‘control’ the item’s use. Control represents the capacity of
the entity to benefit from the asset in the pursuit of the entity’s
objectives and to deny or regulate the access of others to that
benefit. Therefore, because ownership is not essential, items
such as leased assets are often included as part of the assets
of entities, even though another organisation has legal title to
them. That is, many leased assets will be shown in an entity’s
statement of financial position, even though legal title to the
assets rests with another party. Leased assets will be discussed
further in Chapter 11 .
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Definition of assets
Recognition issues
Page 4 of 21
Page 143
Although the conceptual framework defines assets (see the
definition of assets provided earlier), such a definition on its
own is not operational. We need further guidance. The
conceptual framework provides criteria for the recognition of
assets. Specifically:
An asset is recognised in the balance sheet when it is:
l
l
probable that the future economic benefits will flow to the
entity; and
the asset has a cost or value that can be measured reliably.
‘Probable’ is not defined in the conceptual framework;
however, it is generally accepted that the term ‘probable’
means that the chance of the future economic benefits arising
is more likely rather than less likely. This definition of
‘probable’ would mean that something would be considered to
be an asset if the expected probability of future benefits arising
is greater than 50 per cent. Conversely, if it is not considered
probable that future economic benefits will flow to the entity,
an asset should not be recognised. The conceptual framework
states:
An asset is not recognised in the balance sheet when
expenditure has been incurred for which it is considered
improbable that economic benefits will flow to the entity
beyond the current accounting period. Instead such a
transaction results in the recognition of an expense in the
income statement. This treatment does not imply either that
the intention of management in incurring expenditure was
other than to generate future economic benefits for the entity
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Definition of assets
Page 5 of 21
or that management was misguided. The only implication is
that the degree of certainty that economic benefits will flow to
the entity beyond the current accounting period is insufficient
to warrant the recognition of an asset.
A change in company policies could mean that items once
considered to be assets might need to be written off in
subsequent periods—that is, expensed. For example, and
referring to an example provided earlier, a mining company
might be involved in mining operations in a remote location
around which a town has grown up. As a result of particular
circumstances, a decision might be made by the organisation
to abandon the mine site. The remote town might then
effectively become a ghost town. The buildings owned by the
mining company might once have generated economic benefits
and were therefore considered assets. However, if they are of
no further use to the reporting entity, they should be written
off. The write-off of the buildings should be treated as an
expense of the company and would typically be referred to as
an impairment loss.
Given recognition criteria such as ‘probable’, a high degree of
professional judgement might be necessary. It is, therefore,
possible that an expenditure that is deemed an asset by one
financial statement preparer might be considered an expense
by another. Such differences of opinion will have obvious
consequences for the reported profits of reporting entities.
They will also have implications for asset-based ratios such as
net asset backing per share (see Worked Example 4.1 ).
WORKED EXAMPLE 4.1:
Asset recognition and
consideration of probable economic benefits
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Definition of assets
Page 6 of 21
Assume that Kirra Ltd has assets of $1 million, liabilities of
$300 000 and, therefore, shareholders’ funds of $700 000. It
has issued a total of 100 000 ordinary shares. Assume that the
company then designs and manufactures an item of machinery
at a cost of $150 000. The machinery produces a new type of
flexible, transparent fin for surfboards. The cost of $150 000
comprises wages of $90 000, raw materials of $35 000 and
depreciation of $25 000. The depreciation relates to other plant
and machinery used to make the fin-making machine. The
wages are to be paid at a future date.
REQUIRED
(a)
Provide the accounting entry for the construction of
the machinery, assuming that the machinery satisfies the
criteria for recognition of an asset.
(b)
Provide the accounting entry assuming that the
machinery is subsequently revealed not to be an asset
because future economic benefits are not considered
probable.
SOLUTION
(a)
Page 144
For this expenditure to be recognised as an asset (that
is, for it to be capitalised), it must be considered probable
that the item will generate net cash flows at least equal to
$150 000. In this case, if economic benefits of at least $150
000 are considered probable, the aggregated accounting
entry would be:
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Definition of assets
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Dr
Machinery—
fin-making
machine (an
asset)
150 000
Cr
Wages payable
90 000
Cr
Raw
materials
inventory
35 000
Cr
Accumulated
depreciation—
plant and
machinery
25 000
Net assets will not change as a result of treating the
expenditure as an asset. That is, before the
expenditure, the net assets were $700 000 (which
equals assets less liabilities = $1 000 000 − $300
000). After the expenditure on the machine, the net
assets will still be $700 000. The manufacture of the
machine led to an increase in assets of $90 000 (the
increase in machinery of $150 000, less the raw
materials consumed, and less the increase in
accumulated depreciation). It also led to an increase in
liabilities of $90 000 (the wages payable), and hence
net assets (assets less liabilities) did not change. Net
asset backing per share would be $700 000 ÷ 100 000
= $7 per share.
(b)
If the probability that the machine will generate any
positive net cash flows is subsequently assessed to be below
50 per cent (that is, economic benefits are not probable), the
expenditure on the machine would be treated as an expense
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at the time such an assessment is made. The loss would
typically be referred to as an impairment loss. The accounting
entry would be:
Dr
Impairment
loss—
machinery
Cr
Accumulated
impairment
loss—
machinery
150 000
150 000
If the asset is treated as being fully impaired, the net
assets will fall to $550 000 and the net asset backing
per share of Kirra Ltd would become $5.50 per share.
The implications of a reduction in net asset backing per
share are not always clear, but it would seem to be a
reasonable proposition that a reduction in net asset
backing per share from $7.00 to $5.50 would reduce
the amount that potential investors would be prepared
to pay for securities issued by Kirra Ltd.
Again, it is emphasised that if, at a given time, expenditure is
not deemed likely to generate future economic benefits, such
expenditure should be expensed in the period in which it
becomes apparent that insufficient benefits will be realised.
While we will cover the impairment of assets more fully in
Chapter 6 , it should be appreciated at this point that there i
s an accounting standard that applies specifically to the
impairment of assets, this being AASB 136 Impairment of
Assets. AASB 136 requires that when the recoverable amount
of an asset (‘recoverable amount’, defined as the higher of an
asset’s net selling price and its value in use) is less than its
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Definition of assets
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carrying amount (‘carrying amount’ of an asset is defined as
the amount at which the asset is recorded in the accounting
records as at a particular date—for a depreciable asset, it
means the net amount after deducting any accumulated
depreciation and accumulated impairment losses), the carrying
amount of the asset must be reduced to its recoverable
amount. The reduction is referred to as an ‘impairment loss’.
Specifically, paragraph 59 of AASB 136 states:
If, and only if, the recoverable amount of an asset is less than
its carrying amount, the carrying amount of the asset shall be
reduced to its recoverable amount. That reduction is an
impairment loss.
Following the recognition of an impairment loss in an earlier
period, it is possible that the recoverable amount of an asset
might subsequently increase towards former levels. If, in a
subsequent period, additional information becomes available
which indicates that benefits are now probable, according to
the conceptual framework the asset would be recognised when
it so qualifies, even though this might involve amounts that
had previously been recognised as expenses of the entity.
Therefore the subsequent recognition of an asset will require a
credit to the entity’s profit or loss, perhaps labelled something
like ‘gain from asset previously derecognised’ or ‘gain from
reversal of previous impairment loss’. This subsequent
reinstatement of the asset is consistent with the
Page 145
requirements of AASB 136 Impairment of Assets,
which states at paragraph 114:
An impairment loss recognised in prior periods for an asset
other than goodwill shall be reversed if, and only if, there has
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been a change in the estimates used to determine the asset’s
recoverable amount since the last impairment loss was
recognised. If this is the case, the carrying amount of the
asset shall, except as described in paragraph 117, be
increased to its recoverable amount. That increase is a
reversal of an impairment loss.
For an example of a reversal of a prior period impairment loss
we can return to Worked Example 4.1 . Let us assume that
new information became available in a subsequent period that
indicated that the machine referred to in
Worked Example 4.1
would generate net cash flows equal
to at least $150 000 (and assuming it had already been subject
to the recognition of an impairment loss), the adjusting
accounting entry would be:
Dr
Accumulated
impairment loss—
machinery
150000
Cr
Gain from
reversal of
previous
impairment loss
150000
While this is a general principle, which is supported by AASB
136, that assets that have been subject to an impairment loss
in previous periods can subsequently be recognised again as
assets (such as in the illustration given above), it needs to be
appreciated that some accounting standards specifically
exclude this reversal for specific types of assets. That is, in
particular accounting standards relating to specific assets, if
expenditure on a particular item was initially expensed then
any related asset cannot subsequently be recognised even if it
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Definition of assets
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becomes apparent that future economic benefits associated
with the previous expenditure are probable. As Chapter 8
will demonstrate, pursuant to AASB 138 Intangible Assets,
expenditure on an intangible item that was initially recognised
as an expense shall not be recognised as part of the cost of an
intangible asset at a later date. In effect, such requirements
(which can be deemed to be quite conservative) will cause the
balance sheet (statement of financial position) to understate
the assets controlled by the entity.
As noted in Chapter 3 , the firm may be involved in many
contractual arrangements that use the accounting numbers
relating to profits and assets. For example, there might be
interest coverage clauses; clauses that restrict dividend
payments to some designated fraction of earnings;
management compensation clauses tying managers’ rewards
to reported profits; or clauses that specify debt-to-asset
constraints. Hence the decision to expense or capitalise an
item might be one that has direct implications for the value of
the organisation and for the wealth of the managers. As noted
in Chapter 2 , however, there is an expectation that general
purpose financial statements should be prepared in an
unbiased manner (see the conceptual framework), regardless
of any accounting-based contractual relationships that the
organisation and/or its managers might have entered.
Chapter 3
referred to research undertaken by Positive
Accounting theorists. These researchers, who work on the
assumption that individual action is driven by a desire to
maximise personal wealth, would argue that the existence of
accounting-based contractual arrangements will, at times,
motivate individuals within the firm to adopt particular
accounting methods in preference to others. Positive
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Accounting theorists propose that general purpose financial
statements will not always represent unbiased accounts of the
performance and financial position of the entity. The work
performed by the external financial statement auditors should,
however, help to increase the objectivity of the financial
statements and to minimise any potential bias.
For an asset to be recognised, it is required to possess a cost
or other value that can be measured reliably. At this stage, it
should be appreciated that the asset measurement rules may
vary depending on the class of assets being measured. Some
individuals consider, from a conceptual perspective, that all
assets should be measured on the same basis. In recent times
the approach of measuring assets at fair value, rather than at
historical cost, seems to have drawn increasing support, with
many new accounting standards adopting a ‘fair value’ basis
for valuing the respective assets. Nevertheless, while the value
of some assets is required to be measured at fair value, many
other assets are still measured at historical cost. So while
many individuals consider that one approach to measurement
should be applied to all classes of assets, such expectations do
not match current generally accepted accounting practices. For
example, as will be shown in subsequent chapters of this book:
l
l
l
inventory is recorded at the lower of cost and net realisable
value
property, plant and equipment may be measured at either
cost, or at fair value, which may be well in excess of cost.
certain intangible assets that have been acquired from other
parties (as opposed to being internally developed) and which
do not have an ‘active market’ (perhaps they are unique)
must be carried at cost less accumulated depreciation and
any accumulated impairment losses (that is, they cannot be
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Definition of assets
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revalued to fair value)
l
l
items such as internally generated brands, mastheads,
publishing titles, customer lists and items similar in substance
shall not be recognised as intangible assets
marketable securities may be valued at fair value.
Because different classes of assets are typically
Page 146
measured in different ways (and some intangible
assets are not permitted to be recognised as assets in the first
place), the sum of the total assets of an entity will not reflect
the cost of the assets, or their fair value. Table 4.1
provides a summary of some of the various asset
measurement rules currently used in Australia.
While conceptually it would seem to make good sense for one
method of measurement to be applied to all assets, such as
market value or fair value (which would mean that it would be
more appropriate to add together the various asset values as
they would be measured on the same basis), it does seem
unlikely that, in the foreseeable future, there will be any moves
to mandate one approach to measurement for all assets.
Indeed, recent work undertaken by the IASB on the conceptual
framework indicates that there is support for different
measurement approaches being used for different classes of
assets. In this regard, IASB (2013) noted:
l
l
a single measurement basis for all assets and liabilities may
not provide the most relevant information for users of
financial statements
the number of different measurements used should be the
smallest number necessary to provide relevant information.
Unnecessary measurement changes should be avoided and
necessary measurement changes should be explained
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Definition of assets
l
Page 14 of 21
the benefits of a particular measurement to users of financial
statements need to be sufficient to justify the cost.
When the Exposure Draft of a revised Conceptual Framework
for Financial Reporting was released by the IASB in 2015, it
also adopted the view that one measurement basis for all
assets was not required. Therefore, while there was some
speculation that the IASB might propose one uniform approach
to measuring assets, this now appears unlikely and a ‘mixed
measurement’ approach seems likely to continue for the
foreseeable future.
Table 4.1 Some classes of assets and their associated
measurement rules
Asset
Measurement rule
Cash
Face value
Accounts receivable
Face value less an allowance for doubtful
debts
Inventories
Lower of cost and net realisable value
Goodwill
At cost of acquisition—internally
generated goodwill is not to be
recognised
Property, plant and equipment
At cost, recoverable amount (if
recoverable amount is less than cost) or
revalued amount. If revaluations are
undertaken, the requirement is that the
valuations be based on ‘fair value’
Marketable securities
Fair value
Leased assets
At the present value of the expected
future lease payments
Biological assets
At fair value less estimated point of sale
costs
Also, the accounting standard-setting process is very political
in nature (Watts and Zimmerman 1986). Throughout the
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process of developing an accounting standard, the public is
invited to make submissions—typically at the exposure draft
stage. Significant changes to generally accepted accounting
practice are likely to be opposed by a significant proportion of
financial statement preparers.
Research has indicated that managers’ support for particular
measurement rules will be influenced by the industry to which
they belong. For example, Houghton and Tan (1995) undertook
a survey of the chief financial officers of the Group of 100, an
association of senior accounting and finance executives
representing major companies and government-owned
enterprises in Australia. They found that 80 per cent of the
respondents were satisfied with historical cost in its modified
form. In response to an open-ended question relating to the
positive attributes of historical cost, the respondents’ views
were that historical cost is objective and verifiable; easily
understood and widely known; and allows for consistency and
comparability. Of the 20 per cent of respondents who Page 147
did not favour historical cost, at least half thought
that historical cost was either meaningless or misleading.
Given these findings, Houghton and Tan (1995, p. 14) state:
The conclusion to be drawn from the results for this group of
Australia’s largest enterprises (as represented by the Group
of 100) is that there is a strong preference for historical
cost over present value or market value as a basis for m
easurement; the responses favour Historical Cost at the rate
of about four to one.
Perhaps the above findings are not surprising. If a firm adopts
some form of market or fair-value-based accounting, this will
typically introduce some degree of volatility into the financial
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statements, given that market values tend to fluctuate. This
volatility might not be favoured by management, particularly if
they have accounting-based debt contracts in place or are
themselves rewarded in terms of accounting profits. For
example, general insurers in Australia—that is, organisations
involved in providing insurance for losses associated with
events such as theft, storm, vehicle accidents, fire and flood—
are required to value their investments on the basis of the
assets’ fair values, with any changes in fair values being
treated as part of a financial period’s profit or loss. Many
managers of general insurance companies were particularly
opposed to the requirement to use market or fair value when it
was introduced. In their view it introduces unwanted and
unnecessary volatility into the accounts, given that market
values of investments can change quite drastically in either
direction during an accounting period.
When Houghton and Tan performed further analysis of the
responses to their survey, they found that the level of support
for historical cost or present value and market value seemed to
depend on the industry to which the respondent belonged.
Individuals working in financial institutions had a statistically
significant preference for present-value measures as opposed
to historical cost, while non-financial-institution representatives
had a significantly stronger preference for historical cost. To
explain this difference, the authors note (p. 36):
By their nature, a significant part of the activities of financial
institutions involves dealing with assets (investments and
other financial instruments) for which there are active
markets. Accordingly, information based on Present Values
might be seen by these users as being more appropriate in
evaluating financial performance and position.
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Although the Houghton and Tan study looked only at the
perceptions of financial statement preparers and not financial
statement users, the results do imply that perhaps it is not
appropriate to expect all industries to favour or implement a
single uniform basis of measurement such as market value.
The views of individuals working within financial institutions
differed significantly from those employed elsewhere. Such a
consideration might need to be borne in mind by the
international accounting standard-setters as they seek to make
recommendations on appropriate asset measurement principles
as part of any revised conceptual framework.
In other related research, Foster and Shastri (2010) report that
financial institutions are more likely to support fair value
measurements when security markets are stable or increasing
− but, of course, this might be because of the ‘favourable’
implications such measurement would create for the financial
statements. Navarro-Galera and Rodriguez-Bolivar (2010)
reported positive support for fair value measurements of assets
by chief financial officers of public sector organisations in
Spain. They considered that fair value accounting would
improve ‘the accountability of government financial statements
in terms of the transparency, understandability, objectivity and
reliability of financial reporting’, although this is thought to be
possible only if two conditions are met for the assets being
valued, these being that there needs to be a liquid market and
the fair value estimations need to be practical. As discussed in
Chapter 3 , another factor shown to influence management
support for particular asset measurement approaches is the
existence of debt covenants that are linked to accounting
numbers. For example, if an organisation is close to breaching
an accounting-based debt covenant (such as one that relies on
the ratio of debt to assets), then it will be more likely to favour
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a measurement basis that increases assets. Of course, while
managers of organisations might prefer using particular
measurement approaches because of the positive effects they
might have on balance sheets, ideally management should
select a particular measurement approach because it is either
required by an accounting standard, or the use of a particular
accounting method produces information that is relevant and
representationally faithful.
With all this said, at the present time the statement Page 148
of financial position (balance sheet) aggregated total,
referred to as ‘total assets’, typically represents a summation
of numerous asset classes—cash, accounts receivable,
inventory, land, buildings and marketable securities. See, for
example, Exhibit 4.1 , which shows the details of assets
held by the BHP Billiton group (in US dollars), taken from BHP
Billiton Ltd’s statement of financial position as at 30 June 2015.
Each asset class might have been measured on the basis of a
different approach from that used for the other asset classes,
yet we simply add them all together (perhaps like adding
apples to oranges?). The use of different measurement classes
within a single financial statement is in marked contrast to
suggestions made by accounting researchers such as
Chambers (see Chapter 3 ), but this is nevertheless a
generally accepted approach.
Exhibit 4.1
Details of total assets from the BHP Billiton
Ltd statement of financial position
ASSETS AS AT 30 JUNE 2015
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Definition of assets
Assets
Page 19 of 21
US$m
Current assets
Cash and cash
equivalents
6 753
Trade and other
receivables
4 321
Other financial
assets
Inventories
83
4 292
Current tax assets
658
Other
262
Total current
assets
16 369
Non-current assets
Trade and other
receivables
1 499
Other financial
assets
1 159
Inventories
Property, plant and
equipment
466
94 072
Intangible assets
4 292
Investments
accounted for using
the equity method
3 712
Deferred tax assets
2 861
Other assets
150
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In relation to the measurement of assets, classes of assets
other than those briefly considered above may cause further
problems in determining appropriate measurement bases. For
example, what would be the appropriate basis of asset
measurement for a building such as a museum or an art
gallery? How would we measure the value of a botanical
garden or a collection of ancient artefacts? The IASB
conceptual framework definitions of assets depend upon the
probable generation of future economic benefits . Do
museums, art galleries, botanical gardens or artefact
collections generate ‘economic benefits’? Certainly, many
people accept that they provide social and cultural benefits.
Such items are frequently referred to as heritage assets ,
which are typically held by government authorities for the use
of current and future generations. There is usually no
expectation that they will ever be sold, and any receipts, for
example from visitors, are generally less than the ongoing
expenses of maintaining such resources. They are often
considered to generate negative net cash flows. Are such
resources assets in accordance with the IASB conceptual
framework definitions? Chapter 9
will consider this issue
and others associated with accounting for heritage assets, but
what do you think? Do you consider that a resource such as a
museum collection, which has restrictions on its sale and use,
is an asset? Why? It is interesting to note that the Australian
National Museum valued the preserved body of Australia’s
most famous racehorse, Phar Lap, at $10 million—
Page 149
but what does this $10 million valuation actually
represent? There are certainly many restrictions on how Phar
Lap’s body can be used and displayed.
As a further issue to consider, how should assets such as trees
be valued? Many businesses rely upon trees to generate future
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cash flows, perhaps through the sale of timber or paper. For
example, an organisation might plant some pine tree seedlings
with the expectation that they will generate commercially
saleable timber in 14 years’ time. To assess the financial
position of the business, there might be an expectation that
the trees should be shown as assets in the statement of
financial position, but how would we measure their value?
Should they be valued at the cost of the seedlings; at the cost
of the seedlings plus further direct costs such as water,
fertilisers and so on; or at present value, which will include
assumptions about the timing of the milling, cash receipts, tree
survival rate and appropriate discount rates? If the same sort
of tree is in a botanical garden, or on the side of a road
maintained by a local council, as opposed to being in a timber
forest, would or should it have the same value? Should it be
considered to be an asset? You might be interested to know
that the 2014 Annual Report of the City of Melbourne shows a
value for trees of $38.46 million. But what does this value
actually represent? Why are trees on the side of the road
considered to be assets? The chapter that addresses heritage
assets, Chapter 9 , will also consider issues associated with
accounting for biological assets—a tree would be considered to
be a biological asset (which is defined in AASB 141 as a living
animal or plant).
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General classification of assets
Page 1 of 4
General classification of assets
Definition of current assets
Most of us would be used to a definition of current assets as
assets that, in the ordinary course of business, would be
consumed or converted into cash within 12 months after the
end of the financial period (the ‘12-month test’). This is what
is often taught in introductory courses in financial accounting.
However, AASB 101 Presentation of Financial Statements
requires us to consider an entity’s normal operating cycle
when determining whether assets (and liabilities) should be
classified as current or non-current for the purposes of
presentation in the statement of financial position (balance
sheet). According to paragraph 66 of AASB 101:
An entity shall classify an asset as current when:
(a)
it expects to realise the asset, or intends to sell or
consume it, in its normal operating cycle;
(b)
it holds the asset primarily for the purpose of trading;
(c)
it expects to realise the asset within twelve months
after the reporting period; or
(d)
the asset is cash or a cash equivalent (as defined in
AASB 107) unless the asset is restricted from being
exchanged or used to settle a liability for at least twelve
months after the reporting period.
An entity shall classify all other assets as non-current.
According to AASB 101, the operating cycle of an entity is the
time between the acquisition of assets for processing and their
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realisation in cash or cash equivalents. When the entity’s
normal operating cycle is not clearly identifiable, its duration is
assumed to be 12 months. As an entity’s ‘operating cycle’
might be greater than 12 months, assets that might not be
converted to cash for a period in excess of 12 months can be
considered ‘current’ within such entities.
The commentary to AASB 101 provides further discussion on
defining current assets. AASB 101, paragraph 68, states that:
Current assets include assets (such as inventories and trade
receivables) that are sold, consumed or realised as part of
the normal operating cycle even when they are not expected
to be realised within twelve months after the reporting
period. Current assets also include assets held primarily for
the purpose of trading (examples include some financial
assets that meet the definition of held for trading in AASB 9)
and the current portion of non-current financial assets.
Hence, unlike the traditional approach to classifying assets as
current or non-current, which used the 12-month test, some
professional judgement is now called for to determine the
entity’s ‘normal operating cycle’. The classification of assets
into current and non-current elements has
Page 150
implications for assessing the liquidity of the
reporting entity. For example, analysts typically use such
ratios as the current ratio (current assets divided by current
liabilities) to assess the ability of the firm to pay its debts as
and when they fall due. The decision relating to an entity’s
operating cycle will have implications for accounting ratios
such as this. Again, it is emphasised that if the ‘normal
operating cycle’ is not clearly identifiable, then the normal ‘12month test’ will apply to the classification of current assets.
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Definition of current liabilities
In this chapter our focus is on assets. However, since we are
discussing the statement of financial position, we will also
briefly consider the definition of current liabilities. While we
would probably be familiar with a definition of current
liabilities in terms of an obligation being due for payment
within 12 months of the end of the financial period (also a 12month test), AASB 101 requires us to consider the entity’s
normal operating cycle. Consistent with the approach taken to
define current assets, which considers the ‘normal operating
cycle’, paragraph 69 of AASB 101 provides that a liability is to
be classified as current when it satisfies any of the following
criteria:
(a)
it expects to settle the liability in its normal operating
cycle;
(b)
it holds the liability primarily for the purpose of
trading;
(c)
the liability is due to be settled within twelve months
after the reporting period; or
(d)
the entity does not have an unconditional right to
defer settlement of the liability for at least twelve months
after the reporting period.
An entity shall classify all other liabilities as non-current.
So, in contrast with traditional approaches, something might
now be disclosed as a current liability when that liability is not
expected to be settled for a period in excess of 12 months. As
the commentary within AASB 101 (paragraph 70) states:
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The same normal operating cycle applies to the classification
of an entity’s assets and liabilities. When the entity’s normal
operating cycle is not clearly identifiable, it is assumed to be
twelve months.
Therefore if there is no single, clearly identifiable operating
cycle, or if the cycle is less than 12 months, the 12-month
period must be used as the basis for classifying current assets
and current liabilities.
Apart from the current/non-current dichotomy, there are other
ways in which we classify assets. Assets may also be classified
as ‘tangible’ and ‘intangible’, both of which could be current or
non-current. Intangible assets can be defined as nonmonetary assets without physical substance, and include
brand names, copyrights, franchises, intellectual property,
licences, mastheads, patents and trademarks. Chapter 8
describes how to account for intangible assets, including
goodwill and research and development.
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How to present a statement of financial position
Page 1 of 7
How to present a statement of financial
position
As the discussion below will demonstrate, currently there are
two basic approaches to presenting a statement of financial
position. AASB 101 (paragraph 60) requires that, for the
purposes of statement of financial position presentation:
An entity shall present current and non-current assets, and
current and non-current liabilities, as separate classifications
in its statement of financial position in accordance with
paragraphs 66–76 except when a presentation based on
liquidity provides information that is reliable and more
relevant. When that exception applies, an entity shall present
all assets and liabilities in order of liquidity.
As we can see from the above requirement, relevance and
reliability are important considerations in determining how the
statement of financial position (balance sheet) will be
presented. That is, relevance and reliability considerations are
important in determining whether the statement of financial
position should be presented in a way that separates current
assets from non-current assets and current liabilities from noncurrent liabilities (which could be considered to be the
‘traditional’ approach), or in a way that lists the assets and
liabilities in terms of their order of liquidity without any
segregation between current and non-current portions.
Therefore, AASB 101 does not prescribe a single
Page 151
format for the presentation of the statement of
financial position. In determining which format to use, the
commentary to AASB 101 provides some useful assistance.
According to paragraphs 62 and 63 of AASB 101:
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62.
When an entity supplies goods or services within a
clearly identifiable operating cycle, separate classification of
current and non-current assets and liabilities in the statement
of financial position provides useful information by
distinguishing the net assets that are continuously circulating
as working capital (the current portion) from those used in
the entity’s long-term operations (the non-current portion). It
also highlights assets that are expected to be realised within
the current operating cycle, and liabilities that are due for
settlement within the same period.
63.
For some entities, such as financial institutions, a
presentation of assets and liabilities in increasing or
decreasing order of liquidity provides information that is
reliable and is more relevant than a current/non-current
presentation because the entity does not supply goods or
services within a clearly identifiable operating cycle.
AASB 101 also requires specific disclosures in relation to the
duration of an entity’s operating cycle. It requires that where
the entity presents current assets separately from non-current
assets and current liabilities separately from non-current
liabilities, and the entity has a single clearly identifiable
operating cycle greater than 12 months, the length of that
operating cycle must be disclosed.
Banking institutions such as Westpac, ANZ and the
Commonwealth Bank have all elected for some years to adopt
the liquidity approach to presentation. Exhibit 4.2
shows
how Commonwealth Bank of Australia structured its statement
of financial position (which it referred to as a ‘balance sheet’)
in its 2015 Annual Report.
Specific disclosures to be made
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on the face of the statement of
financial position
Paragraph 54 of AASB 101 requires that the face of the
statement of financial position is to include line items that
present the following amounts (these line items represent the
aggregates of a number of accounts and would typically be
supported by additional detail within the notes to the financial
statements):
(a)
property, plant and equipment;
(b)
investment property;
(c)
intangible assets;
(d)
financial assets (excluding amounts shown under (e),
(h) and (i));
(e)
investments accounted for using the equity method;
(f)
biological assets;
(g)
inventories;
(h)
trade and other receivables;
(i)
cash and cash equivalents;
(j)
the total of assets classified as held for sale and assets
included in disposal groups classified as held for sale in
accordance with AASB 5 Non-current Assets Held for Sale and
Discontinued Operations;
(k)
(l)
trade and other payables;
provisions;
(m)
financial liabilities (excluding amounts shown under
(k) and (l));
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(n) liabilities and assets for current tax, as defined in AASB
112 Income Taxes;
(o) deferred tax liabilities and deferred tax assets, as
defined in AASB 112;
(p)
liabilities included in disposal groups classified as held
for sale in accordance with AASB 5;
(q)
non-controlling interests, presented within equity; and
(r) issued capital and reserves attributable to equity
holders of the parent.
Exhibit 4.2
Illustration of the liquidity
approach to statement of financial position
disclosure
Page 152
Balance sheets
As at 30 June 2015
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Group
2015
($m)
Bank
2014
($m)
2015
($m)
2014
($m)
Assets
Cash and
liquid
assets
33 116
26 409
31 683
24 108
Receivables
due from
other
financial
institutions
11 540
8 065
9 720
7 457
26 424
21 459
25 135
20 572
Insurance 14 088
15 142
-
-
1 278
760
989
561
Derivative
assets
46 154
29 247
45 607
29 615
Availablefor-sale
investments
74 684
66 137
72 304
131 577
639 262
597 781
573 435
535 247
Assets at
fair value
through
Income
Statement:
Trading
Other
Loans,
bills
discounted
and
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SOURCE: Commonwealth Bank of Australia 2015 Annual Report
Additional line items can also be disclosed on the face of the
statement of financial position. According to paragraph 58 of
AASB 101, the judgement of whether additional items are
presented separately on the face of the statement of financial
position is based on an assessment of:
(a)
the nature and liquidity of assets;
(b)
the function of assets within the entity; and
(c)
the amounts, nature and timing of liabilities.
Page 153
Examples of presentation formats
The original version of AASB 101 (released in 2004) included
an appendix that provided illustrations of the format of the
statement of financial position under both the current/noncurrent approach, and the liquidity approach. The formats,
shown in Exhibits 4.3
and 4.4 , relate to consolidated
financial statements. The additional guidance provided in the
appendix was included in the Australian standard, but not in
the international standard (which is IAS 1). In 2006 the AASB
made a decision to remove the additional Australian guidance
that had been included in a number of accounting standards.
As a result, subsequent versions of AASB did not include the
appendix. Nevertheless, the appendix to the former version of
AASB 101 still provides applicable guidance and hence we still
use it here as a basis for describing the current requirements
of AASB 101. A review of the liquidity approach shown in
Exhibit 4.4
shows that it is very similar to the format used
by Commonwealth Bank of Australia, as shown in
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Exhibit 4.2
Page 7 of 7
.
Entities may choose to provide other subtotals in addition to
those shown in the above exhibits. For example, the statement
of financial position could be presented to show:
(a)
total assets less total liabilities equals net
assets/equity; or
(b)
total assets equals total liabilities plus total equity.
While the above approach to presenting a statement of
financial position is the approach currently required by AASB
101, it should be noted that in October 2008 the IASB issued a
discussion paper entitled ‘Preliminary Views on Financial
Statement Presentation’. This discussion paper suggested
some significant changes to the way the statement of financial
position, statement of profit or loss and other comprehensive
income and the statement of cash flows shall be presented. It
is anticipated that a revised accounting standard will not be
issued for a number of years, and indeed, in more recent years
there has been only limited discussion on altering the format of
the statement of financial position. Nevertheless, the final
section of this chapter provides a brief overview of the
proposals that were made within the IASB discussion paper as
these proposals give an insight into the types of changes that
might occur.
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Determination of future economic benefits
Page 1 of 9
Determination of future economic benefits
LO 4.2 LO 4.3 LO 4.5
As indicated earlier in this chapter, the IASB conceptual
framework indicates that the essence of an asset is the ‘future
economic benefits’ that the item will generate. Further, it must
be ‘probable’ that these economic benefits will be generated and
the asset must possess a cost or a value that can be measured
reliably.
Generally speaking, the economic benefits themselves can be
considered to come from two sources. The benefits can be
derived from the use of the asset within the reporting entity or
through the sale of the asset to an external party. If the
expected benefits to be derived from the use of the asset within
the organisation—often referred to as ‘value in use’—exceed the
market value, it would be expected that the entity would retain
the asset. Conversely, if the expected sales price exceeds the
asset’s expected value in use, it would be expected that the
entity would dispose of the asset.
Typically, assets are recorded initially at cost. Some assets, such
as property, plant and equipment, may subsequently be
revalued upwards if the net amount that is expected to be
recovered through the cash inflows and outflows arising from
their use and subsequent disposal exceeds their cost.
(Revaluations are covered in Chapter 6 .) Where the
recoverable amount of an asset is less than the asset’s cost
(‘recoverable amount’ is defined in AASB 136 Impairment of
Assets as the ‘higher of an asset’s net selling price and its value
in use’), according to generally accepted accounting practice,
the asset should be written down to its recoverable amount .
This write-down is referred to as the recognition of an
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‘impairment loss’. Where the recoverable amount of an asset is
to be based on its fair value less costs to sell—perhaps there is
an intention to sell it—to the extent that the asset is
Page 154
not of a specialised nature, it should be relatively easy
to determine the value of the future cash flows. If the asset’s
value is to be determined by its value in use, determining this
value can be highly subjective. This might be the case if the
asset is very specialised in nature and there is effectively no
market for it. Further, if the ‘value in use’ is calculated by
reference to the cash flows in a number of future periods, should
those cash flows be discounted to their present value? If so, how
should the appropriate discount rate be determined? AASB 136
requires that in determining ‘value in use’ for the purpose of
calculating ‘recoverable amount’ (and, therefore, possible
impairment losses), the expected cash flows should be
discounted to their present value. This is reflected in the
definition of ‘value in use’. Value in use is defined in paragraph 6
of AASB 136 Impairment of Assets as:
the present value of the future cash flows expected to be
derived from an asset or cash-generating unit.
Exhibit 4.3
Current/non-current presentation format
XYZ CONSOLIDATED LTD
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Statement of financial position as at 30 June 2018
Consolidated
2018
2017
($000)
($000)
Cash and cash
equivalents
XX
XX
Receivables
XX
XX
Inventories
XX
XX
Property, plant
and equipment
XX
XX
Other
XX
XX
Total current
assets
XX
XX
Other financial
assets
XX
XX
Property, plant
and equipment
XX
XX
Intangible assets
XX
XX
Deferred tax
assets
XX
XX
Other
XX
XX
Total non-current
assets
XX
XX
Total assets
XX
XX
Current assets
Non-current
assets
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The value in use is, according to paragraph 31 of AASB 136,
determined by:
(a)
estimating the future cash inflows and outflows to be
derived from continuing use of the asset and from its ultimate
disposal; and
(b)
applying the appropriate discount rate to those future
cash flows.
We will return to the subject of impairment of assets in
Chapter 6 .
For the purposes of illustration, and ignoring issues associated
with calculating the present value of expected future cash flows,
let us assume that a reporting entity has acquired an asset at a
cost of $25 000. It is expected that the asset will generate an
income stream over the next few years that has a present value
of only $18 000, after which time the asset will be scrapped. In
this event it will be necessary for the asset to be written down to
its recoverable amount. Its expected future economic benefits
from use (that is, its ‘value in use’) are less than the asset’s
cost, and the write-down will be treated as an impairment loss
of the reporting entity. This write-down would not be considered
to be depreciation. Depreciation involves the allocation of the
cost (or revalued amount) of an asset over its expected useful
life .
Exhibit 4.4
Liquidity presentation format
Page 155
ABC CONSOLIDATED LMT
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Statement of financial position as at 30 June 2018
Consolidated
2018
2017
($000)
($000)
Cash and cash
equivalents
XX
XX
Receivables
XX
XX
Inventories
XX
XX
Investment
securities
XX
XX
Deferred tax
assets
XX
XX
Other assets
XX
XX
Property, plant
and equipment
XX
XX
Intangible assets
XX
XX
Total assets
XX
XX
Payables
XX
XX
Current tax
liabilities
XX
XX
Provisions
XX
XX
Other liabilities
XX
XX
Deferred tax
liabilities
XX
XX
Assets
Liabilities
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If an asset is to be held for a number of periods, the
Page 156
service potential of the asset would be expected to
decline over time. This should be recognised in the financial
statements as an expense. Remember that the definition of an
expense relies, in part, on there being a consumption or loss of
a future economic benefit. It is generally accepted that the asset
should be amortised or depreciated over the period of its useful
life. If the expenditure on an item results in a uniform flow of
economic benefits to the business over a fixed period, that asset
should be expensed on a time basis. This applies, for example,
to prepaid property rates and land tax, prepaid insurance
premiums and prepaid rent.
Where the expenditure results in a benefit to the business for an
indefinite period with a specified minimum term, the expenditure
should be amortised over the minimum term. If the time over
which the future benefits are to be derived is indeterminate or
so extended that it is not practicable to determine an
apportionment of the expenditure based on assessments of
expected related revenue, the amortisation should be done on
a time basis over a short period (for example, an arbitrary
period of five years might be selected).
It will not always be clear whether future revenue will be
generated by current expenditures. Consider advertising
expenditure—obviously it would be economically irrational to
undertake such expenditure except with a view to generating
future benefits. Therefore, this would seem to fit the definition of
an asset. However, the linkage between expenditure on
advertising and future returns is not well defined. Because the
returns are uncertain, it is usual for expenditure such as
advertising to be written off (expensed) as incurred. The future
economic benefits to be derived from advertising cannot
generally be ‘measured reliably’, which is one of the criteria for
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asset recognition in the conceptual framework. AASB 138
Intangible Assets would also act to preclude the recognition of
advertising expenditures as an asset—we will consider intangible
assets more fully in Chapter 8 . If an advertising campaign
has been paid for upfront but the advertising services have not
been provided by the end of the reporting period, the
expenditure would typically be treated as a current asset in the
form of a prepayment. The article by Tony Thomas entitled
‘Bond auditor silent: Other queries raised on beer advertising
costs’ adapted in Financial Accounting in the Real World
4.1
discusses some of the concerns raised when Bond Corpor
ation capitalised certain beer advertising costs back in 1988.
Although this is not a recent event the arguments remain
interesting.
4.1 FINANCIAL ACCOUNTING IN THE real
world
Bond Corporation, its auditor and the cost of
advertising beer
It appears that the National Companies and Securities
Commission and the Institute of Chartered Accountants’
Accounting Practices Taskforce may be pushed into a cooperative inquiry into Bond Corporation following media criticism
of the company’s accounts, notably by ABC TV’s ‘Four Corners’
program.
The Bond Corporation’s auditor, Terry Underwood of Arthur
Andersen, Perth, dismissed the ‘Four Corners’ story as vague,
and refused to comment further.
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Other auditors agreed with Underwood that auditors don’t
comment on their clients and that they refer any queries back to
the client concerned. One auditor said that they investigate a
potential client and its business practices before taking them on
and then have to stand by the client.
The issue of Bond Corporation’s accounts in relation to
advertising costs for its beer fascinates some accountants.
Warren McGregor, the director of the Accounting Research
Foundation, says that very few companies in Australia or
overseas defer and amortise advertising costs because they are
not in a position to judge the future benefit on sales. ‘There’s
nothing special about beer advertising that I know of,’ he says.
Kevin Stevenson, the director of accounting research at Coopers
& Lybrand, says that advertising is normally an ongoing
spending item and to capitalise it is ‘fairly hairy’. The advertising
of some companies such as Coca-Cola is valuable and increases
the goodwill of the business but the extent can only be known in
hindsight, he says.
This contradicts the Bond Corporation explanation for its actions
that advertising costs ‘are expected to give rise to significant
additional revenues in future periods’. The result of Bond’s
treatment of its advertising meant its reported profit was higher.
SOURCE: Adapted from ‘Bond auditor silent: Other queries raised on beer advertising costs’,
by Tony Thomas, Business Review Weekly, 17 March 1989
If a firm capitalises certain expenditures, rather than Page 157
writing them off as incurred, its assets and profits will
obviously be higher in the year of deferral. It should be noted,
however, that in the years subsequent to the deferral, the
profits of a firm will be higher if it has already expensed items
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rather than capitalising them. This is because there is nothing to
depreciate/amortise in subsequent years. Firms that capitalise
such expenditures will report higher depreciation/amortisation
charges and therefore lower profits in future periods.
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Acquisition cost of assets
Page 1 of 4
Acquisition cost of assets
There are a number of accounting standards that are relevant
when determining the acquisition cost of assets. In situations
where there is a business combination, which is defined as the
bringing together of separate entities or operations of entities
into one reporting entity, there is a specific accounting
standard that deals with related asset acquisitions. We will
defer our consideration of assets associated with business
combinations until Chapter 25 .
In relation to intangible assets, which can be defined as nonmonetary assets without physical substance, a specific
accounting standard, AASB 138 Intangible Assets, deals with
how to determine the costs of such assets (see
Worked Example 4.2
for an example). Intangible assets a
re the subject of Chapter 8 , so we will limit our remarks on
intangibles at this point. However, we can note that intangible
assets would include such assets as patents, trademarks,
customer lists, development expenditure and goodwill. AASB
138 provides guidance on accounting for intangible assets
other than goodwill (with goodwill being covered by the
standard on business combinations). According to AASB 138,
an intangible asset is initially to be measured at cost.
WORKED EXAMPLE 4.2:
Accounting for the cost of
an intangible asset
Trigger Ltd is developing a new process for producing its
major product—surfboards. During 2017, related expenditure
amounted to $90 000. This expenditure related to salaries of
staff involved in developing the process. It also included the
costs of materials consumed in developing the process.
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In 2018 the related expenditure amounted to $10 000. This
related to wages of the staff involved in developing the
process. Some general administrative overheads were also
allocated to the development process.
It was only in 2018 that the entity was able to demonstrate
that the new process met the necessary conditions for being
considered an asset. The recoverable amount of the asset is
estimated as exceeding $10 000.
Required
Determine what the carrying amount of the asset should be in
2018.
Solution
At the end of 2018 the asset pertaining to expenditure
incurred on developing the new production process would be
recorded at $10 000. The carrying amount of $10 000 does
not exceed the recoverable amount of the asset. Because the
allocation of administrative overheads does not relate directly
to the development of the new production process, it would
not be included in the cost of the asset. The expenditure
incurred in 2017 would have been expensed at that time
because the recognition criteria for assets could not be met.
Because expenditure on such intangible assets cannot be
reinstated after being expensed—a requirement of 138
paragraph 71 of AASB Intangible Assets (which states that
‘expenditure on an intangible item that was initially
recognised as an expense shall not be recognised as part of
the cost of an intangible asset at a later date’)—the $90 000
expenditure incurred in 2017 will never form part of the cost
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of the new production process recognised in the statement of
financial position.
As we will see in Chapter 8 , AASB 138 Intangible Page 158
Assets specifically excludes the recognition of
certain intangible assets for statement of financial position
purposes. For example, internally generated goodwill,
research expenditure and expenditure on internally generated
brands, mastheads, publishing titles, customer lists and items
of similar substance are not to be recognised as intangible
assets. The accounting standard requires that such assets can
be recognised only if they are purchased from another party.
For intangible assets that can be recognised for statement of
financial position purposes (for example, development
expenditure), the cost of an internally generated intangible
asset comprises all expenditure that can be directly attributed
and is necessary to creating, producing and preparing the
asset for it to be capable of operating in the manner intended
by management. The cost includes, if applicable:
l
l
l
expenditure on material and services used or consumed in
generating the intangible asset
the salaries, wages and other employment-related costs of
personnel directly engaged in generating the asset
any expenditure that is directly attributable to generating the
asset, such as fees to register a legal right and the
amortisation of patents and licences that are used to
generate the asset.
Apart from determining the cost of intangible assets, we also
have standards that specifically address the ‘cost’ of assets
such as inventory (AASB 102), property, plant and equipment
(AASB 116), and biological assets (AASB 141). The
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determination of the cost of inventories and the costs of
biological assets are covered in Chapters 7
and 9
respectively. We will therefore restrict the following discussion
to determining the acquisition cost of property, plant and
equipment.
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Accounting for property, plant and equipment—an introduction
Page 1 of 33
Accounting for property, plant and
equipment—an introduction
LO 4.1 LO 4.2 LO 4.3 LO 4.4 LO 4.7 LO 4.8 LO 4.10
AASB 116 Property, Plant and Equipment deals with various
issues associated with the recognition, measurement and
disclosure of property, plant and equipment. AASB 116 is not
applicable to property, plant and equipment that has been
classified as being held for sale. There is a separate accounting
standard, AASB 5 Non-current Assets Held for Sale and
Discontinued Operations, that deals with such assets.
Property, plant and equipment are tangible assets and are
deemed to be non-current assets because they will be held
beyond the next 12 months or beyond the normal operating
cycle of the entity. Consistent with the recognition criteria
applicable to assets generally, paragraph 7 of AASB 116
requires that the cost of an item of property, plant and
equipment be recognised as an asset if, and only if:
(a)
it is probable that future economic benefits associated
with the item will flow to the entity; and
(b)
the cost of the item can be measured reliably.
Paragraph 15 of AASB 116 requires an item of property, plant
and equipment that qualifies for recognition as an asset (see
above test) to be measured initially at its cost. Specifically,
paragraph 15 states: ‘An item of property, plant and
equipment that qualifies for recognition as an asset shall be
measured at its cost’. However, after the initial recognition of
the asset at cost, the entity may decide to adopt either the
‘cost model’ or the ‘fair value’ model in measuring the asset.
As paragraph 29 of AASB 116 states:
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An entity shall choose either the cost model in paragraph 30
or the revaluation model in paragraph 31 as its accounting
policy and shall apply that policy to an entire class of
property, plant and equipment.
Paragraphs 30 and 31 further stipulate:
Cost Model
30.
After recognition as an asset, an item of property,
plant and equipment shall be carried at its cost less any
accumulated depreciation and any accumulated impairment
losses.
Revaluation Model
31.
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 the revaluation less any subsequent
accumulated depreciation and subsequent accumulated
impairment losses. Revaluations shall be made with sufficient
regularity to ensure that the carrying amount does not differ
materially from that which would be determined using fair
value at the end of the reporting period.
We will consider the cost model versus the
Page 159
revaluation model in Chapter 6 . However, at this
stage it should be appreciated that some assets—such as
property, plant and equipment—can be measured at cost, or at
their fair value.
Since property, plant and equipment can be measured at cost,
clearly we need to determine what is meant by ‘cost’.
According to paragraph 16 of AASB 116, the cost of an item of
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property, plant and equipment is to comprise:
(a)
its purchase price, including import duties and nonrefundable purchase taxes, after deducting trade discounts
and rebates;
(b)
any costs directly attributable to bringing the asset to
the location and condition necessary for it to be capable of
operating in the manner intended by management; and
(c)
the initial estimate of the costs of dismantling and
removing the item and restoring the site on which it is
located, the obligation for which an entity incurs either when
the item is acquired or as a consequence of having used the
item during a particular period for purposes other than to
produce inventories during that period.
According to paragraph 17 of AASB 116, ‘directly attributable
costs’ would include:
(a)
costs of employee benefits (as defined in AASB 119
Employee Benefits) arising directly from the construction or
acquisition of the item of property, plant and equipment;
(b)
costs of site preparation;
(c)
initial delivery and handling costs;
(d)
installation and assembly costs;
(e)
costs of testing whether the asset is functioning
properly, after deducting the net proceeds from selling any
items produced while bringing the asset to that location and
condition (such as samples produced when testing
equipment); and
(f)
professional fees.
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As also indicated above, the cost of an asset should include
installation and assembly costs. That is, if amounts are
incurred in installing and preparing an asset for use, such
expenditure should be included in the cost of the asset. For
example, consider a computer network that cost $250 000 to
acquire initially, plus $2000 to transport the equipment to its
place of use, plus an additional $50 000 paid to computer
consultants to make the equipment ready for use. The
acquisition cost of the asset would typically be treated as the
aggregate amount of the expenditure for the computer—$302
000. This total amount would subsequently be depreciated
over the future periods in which the benefits were expected to
be derived. Paragraph 19 of AASB 116 provides examples of
costs that do not form part of the cost of an item of property,
plant or equipment, these being:
(a)
costs of opening a new facility;
(b)
costs of introducing a new product or service
(including costs of advertising and promotional activities);
(c)
costs of conducting business in a new location or with
a new class of customer (including costs of staff training);
and
(d)
administration and other general overhead costs.
Fair value
While we would expect that the majority of the costs
associated with acquiring an item of property, plant and
equipment would be met with cash, property, plant and
equipment can also be acquired by other means, such as by
exchanging shares of the company for the assets, or
exchanging other types of assets for the property, plant and
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equipment. This raises questions in relation to determining
‘cost’.
AASB 116 requires that if an item of property, plant Page 160
and equipment is acquired in exchange for equity
instruments of the entity (for example, by issuing additional
shares), the cost of the item of property, plant and equipment
is the fair value of the equity instruments issued. AASB 13 Fair
Value Measurement defines fair value as the price that would
be received to sell an asset or paid to transfer a liability in an
orderly transaction between market participants at the
measurement date.
Usually, the fair value of the consideration (‘consideration’
being what is given in exchange to acquire a particular asset)
is used to measure the acquisition cost of an asset. However,
when the consideration is the purchaser’s own equity
instruments (such as shares that are not listed on a securities
exchange), the fair value of the asset acquired is used to
measure the value of the equity issue because it is considered
that the fair value of the asset acquired can be measured more
reliably.
An item of property, plant and equipment may also be acquired
through the exchange of another item of property, plant and
equipment. The cost of the acquired asset is measured at the
fair value of the asset given up, adjusted by the amount of any
cash, or cash equivalents, that are transferred. That is, when
an asset is exchanged for another asset, the carrying amount
(book value) of the asset given in exchange is not generally
relevant for determining the ‘cost’ of the acquired asset—it is
the fair value of the asset given in exchange that is relevant.
This is consistent with paragraphs 6 and 26 of AASB 116,
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which state, respectively:
6. Cost is the amount of cash or cash equivalents paid or
the fair value of the other consideration given to acquire
an asset at the time of its acquisition or construction or,
where applicable, the amount attributed to that asset
when initially recognised in accordance with the specific
requirements of other Australian Accounting Standards,
for example, AASB 2 Share-based Payment.
26. If an entity is able to determine reliably the fair value of
either the asset received or the asset given up, then the
fair value of the asset given up is used to measure the
cost of the asset received unless the fair value of the
asset received is more clearly evident.
Where an entity acquires an item of property, plant and
equipment by exchanging another asset, then a gain or loss on
disposal will be recognised, with the gain or loss being the
difference between the carrying amount of the asset being
exchanged, and its fair value. For example, let us assume that
we are acquiring some land in exchange for a ship we currently
own. If the carrying amount of the ship was $600 000 (and
AASB 116 defines carrying amount as ‘the amount at which an
asset is recognised after deducting any accumulated
depreciation and accumulated impairment losses’), made up by
an original cost of $800 000 less accumulated depreciation of
$200 000, but its fair value was $750 000, then we would
record the land being acquired at a cost of $750 000 and show
a net gain of $150 000 on disposal of the ship. Our journal
entries would be:
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Dr
Land
750 000
Dr
Accumulated
depreciation—
ship
200 000
Cr
Ship
800 000
Cr
Gain on
disposal of
ship
150 000
The net gain would be the difference between the proceeds
from the disposal of the ship (which is equated to the fair value
of the land) and the carrying amount of the ship.
In situations where the fair value of the asset being given up is
difficult to determine, perhaps because the asset is of a type
that is not commonly traded, it is permissible to use the fair
value of the asset being acquired as its cost. However, there
might be cases where neither the fair value of the asset being
given up nor that of the asset being acquired can be reliably
determined. Perhaps the assets are unique or highly
specialised and there is no active market for them. In such
cases, the accounting standard permits the cost of the
property, plant and equipment acquired in exchange for a
similar asset to be measured at the carrying amount of the
asset given up in the exchange.
While we have been discussing the initial acquisition cost of the
asset, it should be appreciated that subsequent accounting
periods will require adjustments to the value of the assets by
way of depreciation, recognition of impairment losses or,
perhaps, through asset revaluations. Subsequent chapters of
this book will consider how to account for such changes in
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value. Again, it is emphasised that for property, plant and
equipment there is a requirement that assets initially be
recorded at cost. However, following initial recognition, the
entity may elect either to continue to measure the asset at
cost (less appropriate depreciation and/or impairment losses),
or to revalue the asset to its fair value.
As a further example of the ‘fair value rule’ provided above, let
us assume that a reporting entity exchanged a block of land
(carrying amount of $20 000) with another entity for a truck
(recorded in the other entity’s books at $30 000). Is the
reporting entity better off after the transaction? Not Page 161
necessarily. It is the fair value that is relevant and
not the carrying amount. If the block of land had a fair value of
$35 000, the truck would initially be recorded at $35 000. If
the truck’s carrying amount and fair value were both $30 000,
the truck would be recorded at only $30 000, which is less
than the fair value of the exchanged land. In real terms the
reporting entity might actually be worse off, as it could have
sold the block of land for $35 000 (assuming a ready market),
acquired the truck for $30 000 and had a balance in cash of
$5000. However, from an accounting perspective, if the truck’s
carrying amount is based on historical cost, the reporting
entity has made a net gain for accounting purposes of $10 000
if the truck is considered to have a fair value of $30 000.
Opportunity costs are not recognised. This $10 000 gain would
be represented by the difference between the fair value of the
truck and the carrying amount of the land.
Worked Example 4.3
gives another example of how to det
ermine the acquisition cost of assets.
WORKED EXAMPLE 4.3:
Determining the acquisition
costs of assets
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Assume that Joy Ltd is acquiring a portable building from
Davies Ltd for the following consideration:
Cash
$150 000
Shares
100 000 shares with a
market value per share of
$1.90
Land
Joy is going to transfer title
of some rural land to Davies
(carrying amount of $120
000; fair value of $95 000)
Liabilities
Joy has agreed to take legal
responsibility for Davies’
bank loan of $65 000
Legal fees
Pertaining to the
acquisition: $9 000, which
will be paid one month later
Required
Determine the acquisition cost of the asset.
Solution
In determining the cost of the acquisition, it is the fair value of
the consideration that is relevant, not the historical book
values. AASB 13 defines fair value as the price that would be
received to sell an asset or paid to transfer a liability in an
orderly transaction between market participants at the
measurement date. Market participants are expected to be
independent of each other and they are assumed to be
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knowledgeable about the asset or liability.
Joy Ltd should account for the cost of the building as follows:
Cost
$
Cash
150 000
Shares
190 000
Land
95 000
Legal fees
9 000
Liabilities
65 000
509 000
The journal entry to record the acquisition would be:
Dr
Building
509 000
Dr
Loss on
disposal of
land
Cr
Bank loan
Cr
Cash
Cr
Legal fees
accrued
Cr
Land
120 000
Cr
Share capital
190 000
25 000
65 000
150 000
9 000
The asset—in this case the building—has a limited life and
therefore should subsequently be depreciated over the periods
in which the benefits are expected to be derived.
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As indicated in Worked Example 4.3 , where the purchase
consideration comprises shares or other securities, the
acquired asset should be recorded at the fair value of those
securities. Where the securities are listed on a securities
exchange, the price at which they could be placed on the
market will usually be an indication of fair value. However, it
would be necessary to make a valuation of the securities of an
unlisted company.
As indicated above, if the valuation of the assets being given
up in the exchange is difficult to determine (say, in the above
example, we realise that the valuation of the shares is difficult
owing to non-listing or a ‘thin market’), an alternative
approach is to value the acquired asset at its fair value if that
amount is more clearly determinable than what was given in
exchange.
Safety and environmental
expenditure
Certain items of property, plant and equipment might be
acquired for safety or environmental reasons. While these
items might not produce any direct economic benefits, the
expenditure on them might be necessary for the entity to
obtain future economic benefits from its other non-current
assets. In this regard, paragraph 11 of AASB 116 states:
Such items of property, plant and equipment qualify for
recognition as assets because they enable an entity to derive
future economic benefits from related assets in excess of
what could be derived had it not been acquired. For example,
a chemical manufacturer may install new chemical handling
processes to comply with environmental requirements for the
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production and storage of dangerous chemicals; related plant
enhancements are recognised as an asset because, without
them, the entity is unable to manufacture and sell chemicals.
However, the resulting carrying amount of such an asset and
related assets is reviewed for impairment in accordance with
AASB 136 Impairment of Assets.
Where expenditure, such as that referred to above, must be
incurred to enable an asset to continue to be used, and future
periods in which the asset is used are expected to benefit from
the expenditure, the expenditure shall be capitalised. If the
expenditure was not incurred, then the service potential of the
related asset, or assets, might not be realised. For example,
legislation might be promulgated requiring machinery to
comply with a minimum level of safety standards, or to fit a
device to limit harmful environmental impacts. This safety or
environmental expenditure is capitalised because it is
necessary (owing to legislative requirements) for the entity to
continue its manufacturing process, and failure to comply
would mean that the economic benefits embodied in the
original asset would not be obtained.
Another issue we need to consider in determining the costs of
an asset are any estimates of costs that might be required in
relation to dismantling or removing the asset, or restoring sites
as a result of using the asset. As we saw previously, paragraph
16 of AASB 116 states that the cost of property, plant and
equipment is to include ‘the initial estimate of the costs of
dismantling and removing the item and restoring the site on
which it is located, the obligation for which an entity incurs
either when the item is acquired or as a consequence of having
used the item during a particular period for purposes other
than to produce inventories during that period’. As an example
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of how this requirement applies, an oil company might
construct an offshore oil drilling platform. Before establishing
the platform, there would be an expectation that the platform
would be removed at the completion of the project and any
environmental disturbances rehabilitated. These expected
future costs would be estimated at the commencement of the
project and a liability would be recorded in accordance with
AASB 137 Provisions, Contingent Liabilities, and Contingent
Assets. The expected costs would be measured at their
expected present value and the amount would be included as
part of the cost of the asset—the drilling platform. The total
amount of the asset, including the estimated costs for
dismantling and removal, would be depreciated over the
expected useful life of the asset. One rationale for including the
costs of dismantling and removal would be that agreeing to
undertake such actions might be a necessary precondition for
enabling the asset to be available for use. An illustration of this
is provided in Worked Example 4.4 .
WORKED EXAMPLE 4.4:
Capitalisation of
expenditure to be incurred subsequent to the
acquisition of an asset
Page 163
During the reporting period ending 30 June 2018, Garratt Ltd
erected an on-land oil rig just outside Byron Bay. The cost of
the exploration rig and associated technology amounted to $6
567 000. Other costs associated with the erection of the oil rig
amounted to:
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$
Costs incurred in obtaining
access to the site
2 324 900
Transportation of rig
856 300
Erection
445 640
Resource consent
Engineers’ fees
1 657 000
900 200
6 184 040
The oil rig was ready to start production on 1 July 2018, with
actual production starting on 1 October 2018. At the end of the
rig’s useful life, which is expected to be five years, Garratt Ltd
is required by its resource consent to dismantle the oil rig,
remove it, and return the site to its original condition. After
consulting its own engineers and environmentalists, Garratt Ltd
estimates these costs to be:
$
Dismantling the oil rig
199 400
Transportation of rig
355 800
Environmental clean-up
costs
Replacement of flora and
fauna
4 854 500
690 300
6 100 000
Garratt Ltd plans to provide for these costs over the expected
life of the oil well. It uses a discount rate of 8 per cent.
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Required
Prepare the journal entries necessary to account for the oil rig
for the years ended 30 June 2018, 30 June 2019 and 30 June
2020. Ignore depreciation.
Solution
30 June 2018
Dr
Oil rig
Cr
Cash/Accounts
payable (6
567 000 + 6
184 040)
Cr
Provision for
restoration
costs
16 902 700
12 751 040
4 151 660
As we can see above, at the end of the reporting year of 30
June 2018, a provision for restoration costs must be created.
The provision is the best estimate of the expenditure required
to settle the obligation. Provisions are to be recorded at
present value, pursuant to paragraph 45 of AASB 137
Provisions, Contingent Liabilities, and Contingent Assets.
The estimated site restoration costs of $4 151 660 ($6 100
000, payable in 5 years, discounted at 8 per cent, which equals
$6 100 000 × 0.6806) are added to the cost of the oil rig. The
costs incurred in dismantling the rig, removing it and restoring
the site to its original condition are costs that are necessary to
realise the future economic benefits embodied in the asset, and
the required expenditure has been included in the cost of the
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asset.
Discounting the future obligation creates interest costs for
future years. As paragraph 60 of AASB 137 states:
Where discounting is used, the carrying amount of a provision
increases in each period to reflect the passage of time. This
increase is recognised as borrowing cost.
The borrowing (interest) costs are allocated to specific years as
follows:
Date
1 July 2018
Opening
balance
Interest at
8%
Balance of
site
restoration
costs
4 151 660
–
30 June 2019
4 151 660
332 133
4 483 793
30 June 2020
4 483 793
358 703
4 842 496
30 June
2021
4 842 496
387 400
5 229 896
30 June
2022
5 229 896
418 392
5 648 288
30 June
2023
5 648 288
451 712
6 100 000
The journal entries to recognise the periodic interest charges
are:
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30 June 2019
Dr
Interest
expense
Cr
Provision for
restoration
costs
332 133
332 133
30 June 2020
Dr
Interest
expense
Cr
Provision for
restoration
costs
358 703
358 703
As we can see from the above entries, at the end of each
period the amount recorded for the provision for restoration
costs increases. By the end of the final period of the project,
the balance of the provision will be $6 100 000. This amount
will then be eliminated when Garratt Ltd undertakes the actual
restoration work.
Page 164
Allocation of cost to individual
items of property, plant and
equipment
From time to time, a group of items of property, plant and
equipment might be acquired and paid for in a single payment.
For example, a number of computers could be acquired at the
same time for the development of a computer laboratory to be
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used by students. These computers would generally be
indistinguishable, so the allocation of the purchase price is
straightforward. For example, if 25 computers were acquired at
a cost of $145 000, the cost attributable to each computer
would be $5800.
However, where a number of individual items of property, plant
and equipment are acquired and a lump-sum payment is
made, the cost of the assets is still determined according to
the requirements of AASB 116; that is, pursuant to paragraph
16, the cost would include the fair value of the consideration
given, together with any directly attributable costs. How the
costs are to be allocated to individual items is not directly
addressed by AASB 116. However, generally accepted practice
would be for the cost to be allocated to the individual items in
proportion to their fair values at the time of acquisition. This is
demonstrated in Worked Example 4.5 .
WORKED EXAMPLE 4.5:
Allocation of cost to
individual assets
On 15 July 2019, Gilmore Ltd acquired a manufacturing plant
for $3 900 500. The purchase price included the land, building,
machinery and inventory of raw materials. An external valuer
employed by Gilmore Ltd believes the cost can be allocated to
the individual items in the following proportions:
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%
Land
55
Building
35
Machinery
8
Inventory
2
100
Required
Prepare the journal entry as at 15 July 2019 to record the
acquisition of the assets.
Solution
Allocation of purchase price:
%
$
Land
55
2 145 275
Building
35
1 365 175
Machinery
8
312 040
Inventory
2
78 010
100
3 900 500
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15 July 2015
Dr
Land
2 145 275
Dr
Building
1 365 175
Dr
Machinery
312 040
Dr
Inventory
78 010
Cr
Bank
3 900 500
Page 165
Components approach
Certain classes of property, plant and equipment, for example,
aircraft and ships, might comprise a number of individual
component parts, each of which has a different useful life. For
instance, an aircraft might comprise a number of components,
including the airframe, the engines and internal fittings. AASB
116 does not prescribe the unit of measurement for recognition
of individual components making up an item of property, plant
and equipment. Rather, it is left to the professional judgement
of the financial statement preparers. As paragraph 9 of AASB
116 states:
This Standard does not prescribe the unit of measure for
recognition, that is, what constitutes an item of property,
plant and equipment. Thus, judgement is required in applying
the recognition criteria to an entity’s specific circumstances. It
may be appropriate to aggregate individually insignificant
items, such as moulds, tools and dies, and to apply the
criteria to the aggregate value.
Each of the components might have a different useful life or
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provide economic benefits to the entity in different patterns. As
these individual components have different lives, each might
require different depreciation rates and methods. To ensure
that the individual components are accounted for separately,
paragraph 43 of AASB 116 requires:
Each part of an item of property, plant and equipment with a
cost that is significant in relation to the total cost of the item
shall be depreciated separately.
In explaining the above requirement, paragraph 44 of AASB
116 states:
An entity allocates the amount initially recognised in respect
of an item of property, plant and equipment to its significant
parts and depreciates separately each such part. For
example, it may be appropriate to depreciate separately the
airframe and engines of an aircraft, whether owned or subject
to a finance lease.
Deferred payments
It is possible for an entity to acquire an item of property, plant
and equipment and arrange with the vendor of the equipment
that payment will not be made for some time into the future.
In this regard, paragraph 23 of AASB 116 states:
The cost of an item of property, plant and equipment is the
cash price equivalent at the recognition date. If payment is
deferred beyond normal credit terms, the difference between
the cash price equivalent and the total payment is recognised
as interest over the period of credit unless such interest is
recognised in the carrying amount of the asset in accordance
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with AASB 123.
We will consider the requirements of AASB 123 in the next
section of this chapter, but essentially what the above
paragraph means is that the cost of an item of property, plant
and equipment is the cash price equivalent at the acquisition
date. This means that the cost of the item must be determined
by discounting the amounts payable in the future to their
present value at the date of acquisition. The difference
between the cash price equivalent and the total payment is
recognised as interest expense over the period of credit unless
such interest is recognised in the carrying amount of a
qualifying asset—and we will consider qualifying assets in the
next section of the chapter. The discount rate to be used is the
rate at which the acquirer can borrow the amount under similar
terms and conditions. An example of how deferred payments
are accounted for is provided in Worked Example 4.6 .
WORKED EXAMPLE 4.6:
Accounting for
the deferred payment of an asset
Page 166
On 1 July 2018, Double Island Point Ltd acquired a sanddredging machine. Double Island Point Ltd paid an initial
amount of $100 000 on the date of acquisition and agreed to
make a further eight annual payments of $150 000, starting on
30 June 2019. Double Island Point Ltd could borrow funds at 9
per cent per annum.
Required
Prepare the journal entries as at 1 July 2018, 30 June 2019
and 30 June 2020 to account for the acquisition of the
asset. You are not required to give the depreciation entries.
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Solution
Present value of $100 000
initial payment
$100 000
Present value of $150 000
for 8 years discounted at
9% ($150 000 × 5.5348—
see Appendix B)
$830 220
$930 220
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1 July 2018
Dr
Sanddredging
machine
930 220
Cr
Bank
100 000
Cr
Loan
830 220
30 June 2019
Dr
Interest
expense—
($830 220 ×
9%)
74 720
Dr
Loan
75 280
Cr
Bank
150 000
30 June 2020
Dr
Interest
expense—
([$830 220
– $75 280]
67 945
× 9%)
Dr
Loan
Cr
Bank
82 056
150 000
Accounting for borrowing costs
incurred when constructing an
item of property, plant and
equipment
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An area in which there has been some disparity in accounting
treatment is that of interest expenses incurred during the
construction of an asset. For example, an organisation might
need to borrow funds to finance the ongoing construction of an
asset such as a building. At issue would be whether the related
interest expenses should be treated as a cost of the asset or
whether the interest expenses should be expensed in the
period in which they are incurred. How do you think the
borrowing costs should be treated? Such a decision could have
a significant impact on the organisation’s reported profits and
assets. Accounting Standard AASB 111 Construction Contracts
relates specifically to accounting for construction contracts.
AASB 111 will be considered in greater depth in
Chapter 16 . The standard stipulates that costs relating dire
ctly to a construction contract or costs that can be allocated on
a reasonable basis to such a contract should be included in the
cost of the contract. Such costs might include borrowing costs.
Therefore it would appear that if interest costs can be
attributed directly to a construction contract—perhaps the
finance is project-specific—they should be treated as part of
the cost of that asset.
AASB 123 Borrowing Costs provides further guidance. AASB
123 defines borrowing costs as ‘interest and other costs
incurred by an entity in connection with the borrowing of
funds’. According to paragraph 6 of AASB 123, ‘borrowing
costs’ may include:
l
l
l
interest expense calculated using the effective interest
method as described in AASB 9;
finance charges in respect of finance leases recognised in
accordance with AASB 117 Leases; and
exchange differences arising from foreign currency
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borrowings to the extent that they are regarded as an
adjustment to interest costs.
AASB 123 provides a general rule (which it refers to Page 167
as the ‘core principle’). This core principle is provided
at paragraph 1 of AASB 123, which states:
Borrowing costs that are directly attributable to the
acquisition, construction or production of a qualifying asset
form part of the cost of that asset. Other borrowing costs are
recognised as an expense.
Hence, if an asset is deemed to be a ‘qualifying asset’ and
borrowing costs have been incurred to acquire, construct or
produce the asset, then such costs must be included as part of
the cost of the asset. Conversely, if the borrowing costs cannot
be attributed to a qualifying asset, then they would be
expensed in the period in which the borrowing costs were
incurred. Obviously, the above requirement calls for a
definition of ‘qualifying asset’. A ‘qualifying asset’ is defined in
AASB 123 as ‘an asset that necessarily takes a substantial
period of time to get ready for its intended use or sale’. A
‘substantial period of time’ is generally regarded as being
more than 12 months. The borrowing costs to be included
would be those that would have been avoided if the
expenditure on the asset had not been made. The
capitalisation of the borrowing costs is to cease when
substantially all the activities necessary to prepare the asset
for its intended use or sale are complete.
Paragraph 7 of AASB 123 provides further guidance in relation
to identifying whether a particular asset is a qualifying asset. It
states:
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Depending on the circumstances, any of the following may be
qualifying assets:
(a)
inventories
(b)
manufacturing plants
(c)
power generation facilities
(d)
intangible assets
(e)
(f)
investment properties
bearer plants.
Financial assets, and inventories that are manufactured, or
otherwise produced, over a short period of time, are not
qualifying assets. Assets that are ready for their intended use
or sale when acquired are not qualifying assets.
The consequence of including costs such as interest costs in
the cost of an asset is an increase in depreciation expenses in
subsequent years (assuming the asset is not being constructed
for sale). To the extent that the asset is being produced to sell,
the cost of sales will rise as a result of the inclusion of
borrowing costs in the cost of the asset. Hence the
capitalisation of borrowing costs simply acts to defer the
ultimate recognition of those costs.
The capitalisation of borrowing costs as part of the cost of a
qualifying asset begins on the ‘commencement date’.
According to AASB 123, paragraph 17:
The commencement date for capitalisation is the date when
the entity first meets all of the following conditions:
(a)
it incurs expenditures for the asset;
(b)
it incurs borrowing costs; and
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(c)
it undertakes activities that are necessary to prepare
the asset for its intended use or sale.
As long as the above conditions are met, borrowing costs
continue to be capitalised and included as part of the cost of
the asset. In relation to when an entity should cease including
borrowing costs as part of the cost of an asset, paragraphs 20
and 22 of AASB 123 state:
20. An entity shall suspend capitalisation of borrowing costs
during extended periods in which it suspends active
development of a qualifying asset.
22. An entity shall cease capitalising borrowing costs when
substantially all the activities necessary to prepare the
qualifying asset for its intended use or sale are complete.
When a qualifying asset is acquired with borrowed funds, either
such funds can be borrowed specifically for the purpose of
acquiring or constructing the asset, or the borrowed funds
might come from funds the organisation has borrowed for
general purposes.
Where funds are borrowed specifically for the purpose of
acquiring an item of property, plant and equipment, and the
asset is considered to be a ‘qualifying asset’, the amount to be
capitalised is the actual interest paid within the period. For
example, assume that on 1 July 2019 Fraser Island Ltd
borrowed $500 000 at 12 per cent per annum, for two years,
for the specific purpose of constructing an item of
Page 168
plant. The amount of interest capitalised as at June
2020 would be $60 000, which is $500 000 × 12%. The
journal entry to capitalise the interest borrowed would be:
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Accounting for property, plant and equipment—an introduction
Dr
Plant
Cr
Interest
payable
Page 29 of 33
60 000
60 000
If funds that have been borrowed are temporarily invested,
perhaps owing to a delay in the construction or acquisition of
the qualifying asset, then any investment income earned is
deducted from the borrowing costs incurred.
By contrast, where funds are borrowed for general purposes
and to fund various activities, and some of these funds are
used to acquire or construct a qualifying asset, then related
interest is still to be capitalised. In this case, paragraph 14 of
AASB 123 requires:
To the extent that an entity borrows funds generally and uses
them for the purpose of obtaining a qualifying asset, the
entity shall determine the amount of borrowing costs eligible
for capitalisation by applying a capitalisation rate to the
expenditures on that asset. The capitalisation rate shall be
the weighted average of the borrowing costs applicable to the
borrowings of the entity that are outstanding during the
period, other than borrowings made specifically for the
purpose of obtaining a qualifying asset. The amount of
borrowing costs that an entity capitalises during a period shall
not exceed the amount of borrowing costs it incurred during
that period.
For example, assume the same example above where on 1 July
2019 Fraser Island Ltd contracted to construct an item of plant
at a cost of $500 000. Let us further assume that the
organisation had previously borrowed $1 000 000 at 13 per
cent per annum, as well as another $2 000 000 at 10 per cent
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per annum, and that some of these available funds were used
to construct the asset. The weighted average cost of the
available funds would be:
Loan $
Interest rate %
Interest $
1 000 000
13
130 000
2 000 000
10
200 000
330 000
The average interest rate would be 330 000/$3 000 000 = 11
per cent. Therefore, the amount of interest capitalised would
be $55 000, which is $500 000 × 11%. The journal entry to
capitalise the interest borrowed would be:
Dr
Plant
Cr
Interest
payable
55 000
55 000
Prior research on interest
capitalisation
While borrowing costs relating to assets that are constructed
over a substantial period of time must now be capitalised (to
the extent that the capitalisation does not cause the carrying
amount of the asset to exceed its recoverable amount), this
has not always been the case. Historically, managers had a
choice about how to treat such borrowing costs. One study that
considered what motivates organisations to voluntarily adopt a
particular accounting treatment for dealing with interest
expenses incurred during the construction of assets was that of
Bowen, Noreen and Lacey (1981). Adopting Positive
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Accounting Theory (which is explained in Chapter 3 ), they
proposed that the choice to expense or capitalise interest
might be affected by the existence of management
compensation agreements tied to reported earnings;
accounting-based debt covenant constraints; and political costs
associated with higher reported earnings. As Bowen, Noreen
and Lacey state (p. 153), capitalising interest can have a
material effect on increasing the current period’s reported
profit, to which management compensation might be tied, and
on key financial variables that are constrained by contractual
agreements such as debt agreements. In their testing, they
assumed that management is free to choose particular
accounting methods and that the management compensation
contract does not specify the accounting method to be
adopted. Such an assumption is frequently made in Positive
Accounting research, but obviously it will not always be borne
out in practice.
The results of Bowen, Noreen and Lacey’s study indicated that
firms with management compensation contracts are no more
likely to capitalise interest than other firms. This was contrary
to the researchers’ expectations, but could in part be due to
the potentially naive assumption that the remuneration
contracts did not specify whether interest was to be capitalised
or expensed. In fact, the remuneration contracts might well
have limited the managers’ choice. However, Bowen, Noreen
and Lacey did find, as expected, that organisations that
capitalised their interest, thereby increasing reported profits
and assets, had financial ratios consistent with being closer to
the violation of debt covenants. The act of capitalising the
interest was, therefore, considered a means of loosening the
restrictions of the debt agreements and of moving
Page 169
the firm away from a potentially costly default on its
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debt contracts. Bowen, Noreen and Lacey also found that the
largest firms in the oil industry elected to expense interest,
rather than capitalise it. The effect of this was to decrease
reported income. The explanation for this seems to have been
that, in the period under investigation, the petroleum industry
was under intense public scrutiny and it was felt that higher
profits could attract more adverse attention for the
organisations. This potentially adverse attention could have led
to wealth transfers away from the firms. By adopting a method
of accounting that reduces reported income, the attention
focused on the organisation should, according to Positive
Accounting Theory, be reduced.
Repairs and additions to
property, plant and equipment
Following the acquisition of a non-current asset, additional
expenditure may be incurred. These costs can range from
ordinary repairs to significant additions. The major problem in
this area is the decision whether or not to capitalise these
expenses and, if the expenditures are capitalised, determining
the number of periods over which the expenditure should be
amortised. A general approach is to capitalise expenditures
that result in increased future benefits (often referred to as
‘improvements’), but expense those expenditures that simply
maintain a given level of services. Expenditure on periodic
overhauls or repairs would generally be expensed on the basis
that such expenditure does not improve the asset from its
former state.
The capitalised value of an item of property, plant and
equipment, together with the costs associated with any
subsequent improvements of the asset, will be depreciated
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over future periods, given that it is usual for non-current
assets to have a limited useful life; however, land can be an
exception to this general rule.
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Assets acquired at no cost
Page 1 of 5
Assets acquired at no cost
LO 4.9
Resources may also be acquired at no cost, for example,
through a donation. In such a case, if nothing is paid for the
item, can it be recognised as an asset? To the extent that the
item is expected to provide probable and measurable future
economic benefits, it should be recognised as an asset. This is
consistent with the conceptual framework, which states that:
The absence of related expenditure does not preclude an item
from satisfying the definition of an asset and thus becoming a
candidate for recognition in the balance sheet; for example,
items that have been donated to the enterprise may satisfy
the definition of an asset.
But what would the other side (the credit side) of the
accounting journal entry be? As we know, the conceptual
framework defines income as ‘increases in economic benefits
during the accounting period in the form of inflows or other
enhancements of assets or decreases of liabilities that result in
increases in equity, other than relating to contributions from
equity participants’. Since a donated asset would increase the
assets of the entity without increasing its liabilities, the
consequent increase in equity would mean that income would
be recognised. The conceptual framework further provides
that:
Income is recognised in the income statement when an
increase in future economic benefits related to an increase in
an asset or a decrease in a liability has arisen that can be
measured reliably. This means, in effect, that recognition of
income occurs simultaneously with the recognition of
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Assets acquired at no cost
Page 2 of 5
increases in assets or decreases in liabilities.
Worked Example 4.7
considers how to account for an
asset acquired at no cost.
WORKED EXAMPLE 4.7:
Accounting for an asset
acquired at no cost
Crescent Head Ltd decides as a goodwill gesture to give Point
Plummer Ltd, at no cost, a truck with a fair value of $90 000.
Point Plummer Ltd is a local not-for-profit organisation that
teaches children about water safety. The carrying amount of
the truck in the books of Crescent Head Ltd is $80 000 (cost of
$100 000; accumulated depreciation of $20 000).
Required
Provide the journal entries to record the asset transfer for:
(a)
Point Plummer Ltd
(b)
Crescent Head Ltd.
Solution
(a)
Page 170
The entry in the books of Point Plummer Ltd would be:
Dr
Truck
Cr
Donation
income (or
something
similar)
(b)
90 000
90 000
Before providing the journal entry in the books of
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Assets acquired at no cost
Page 3 of 5
Crescent Head Ltd, we need to determine whether the act of
giving up the asset represents an expense. Conceptually, it
would appear to represent an expense. It appears to be a
‘loss on disposal’ of an asset. Any associated benefits of
donating the asset would be too uncertain to allow them to be
recognised as an asset. While the conceptual framework is
silent on the issue of gifts or donations, it does state:
Expenses are recognised in the income statement when
a decrease in future economic benefits related to a
decrease in an asset or an increase of a liability has
arisen that can be measured reliably. This means, in
effect, that recognition of expenses occurs
simultaneously with the recognition of an increase in
liabilities or a decrease in assets.
Hence the accounting entry in the books of Crescent
Head Ltd:
Dr
Donation
expense (or
something
similar)
Dr
Accumulated
depreciation—
truck
Cr
Asset—truck
80 000
20 000
100 000
Note: Because of the difference between carrying amount and
fair value, there is a difference between the expense
recognised by Crescent Head Ltd and the revenue recognised
by Point Plummer Ltd.
It should be appreciated that while it appears conceptually
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Assets acquired at no cost
Page 4 of 5
correct for an organisation to recognise an asset for the
purpose of its statement of financial position (as we have
discussed above) even when the asset has been donated to the
organisation, this treatment is not embraced by AASB 116
Property, Plant and Equipment. The requirements of
accounting standards override the requirements within
conceptual frameworks. Specifically, paragraph 15 of AASB 116
states that ‘An item of property, plant and equipment that
qualifies for recognition as an asset shall be measured at its
cost.’
It would appear therefore that a strict application of the
standard would mean that if the item of property, plant and
equipment has been received as a result of a donation, no cost
would initially be recognised for the asset (which would mean
that no revenue would be recognised either). However, there
would be nothing to prevent the organisation from
subsequently revaluing the asset to its fair value. Revaluations
are considered in Chapter 6 . It is interesting to note that
AASB 116 provides an alternative treatment for not-for-profit
entities. Paragraph Aus15.1 states: ‘In respect of not-for-profit
entities, where an asset is acquired at no cost, or for a nominal
cost, the cost is its fair value as at the date of acquisition.’ (As
a general note, and as indicated in Chapter 1 , paragraphs
that have been added to an Australian standard and that do
not appear in the text of the equivalent IASB standard are
identified with the prefix ‘Aus’.)
At this point in the chapter we have covered many issues
associated with accounting for assets and, in particular,
accounting for property, plant and equipment. One issue we
have not considered is how to account for a ‘contingent asset’,
which is defined in AASB 137 as:
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Assets acquired at no cost
Page 5 of 5
A possible asset that arises from past events and whose
existence will be confirmed only by the occurrence or nonoccurrence of one or more uncertain events not wholly within
the control of the entity.
Chapter 10
addresses AASB 137 Provisions, Contingent
Liabilities, and Contingent Assets in some depth and hence we
will defer further discussion of contingent assets until then.
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Possible changes in the requirements
pertaining to financial statement
presentation
LO 4.6 LO 4.11
As noted earlier in this chapter, for a number of years there
has been some discussion about changing the format for how
financial statements are presented. For example, in October
2008 the IASB issued a discussion paper entitled ‘Preliminary
Views on Financial Statement Presentation’. The
Page 171
discussion paper proposed some significant changes
to the way financial statements are to be presented. In July
2010 a ‘staff draft’ of an Exposure Draft of a new Financial
Statement Presentation accounting standard was prepared
(because it was a ‘staff draft’ it was not open for public
comment) and the expectation was that an Exposure Draft for
public comment would be issued in 2011 with a final standard
to follow some years later. At the present time there is no clear
indication of when a new standard will be issued requiring new
formats of presentation for the financial statements.
The initial project to revise the format of how financial
statements are presented was motivated by the IASB’s and
FASB’s concerns that financial statements can currently be
presented in many alternative ways. This, in turn, makes it
difficult for analysts, investors and other users to compare the
financial statements of different reporting entities. Further, the
formats of the various financial statements do not make it easy
for users to see how the information in the respective
statements is linked. For example, the statement of cash flows
separates operating activities from financing activities, but that
distinction is not always apparent in the statement of financial
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position and the statement of profit or loss and other
comprehensive income. This makes it difficult to compare
operating income with operating cash flows—a step often taken
in assessing the quality of an entity’s earnings.
To provide more useful information, the IASB is seeking to
make the financial statements more ‘cohesive’; that is, the
objective is to format the information in financial statements so
that a reader can follow the flow of information through the
various financial statements. In this regard, IASB (2008, p. 30)
stated:
A cohesive financial picture means that the relationship
between items across financial statements is clear and that
an entity’s financial statements complement each other as
much as possible. Financial statements that are consistent
with the cohesiveness objective would display data in a way
that clearly associates related information across the
statements so that the information is understandable. The
cohesiveness objective responds to the existing lack of
consistency in the way information is presented in an entity’s
financial statements. For example, cash flows from operating
activities are separated in the statement of cash flows, but
there is no similar separation of operating activities in the
statements of comprehensive income and financial position.
This makes it difficult for a user to compare operating income
with operating cash flows—a comparison often made in
assessing earnings quality. Similarly, separating operating
assets and liabilities in the statement of financial position will
provide users with more complete data for calculating some
key financial ratios, such as return on net operating assets.
Paragraph 60 of IASB (2010) takes this further by stating:
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Financial statements that are consistent with the
cohesiveness principle complement each other as much as
possible. To that end, an entity shall display and label line
items in a way that clearly associates related information
across the statements and helps a user understand those
relationships. For example, an entity aligns the line item
descriptions of information presented in the statements of
financial position, comprehensive income and cash flows to
help users find an asset or a liability, and the related effects
of a change in that asset or liability, in the same place in each
financial statement. For example, an entity with long-term
debt presents interest expense and cash paid for interest in
the same section and/or category as the long-term debt and
labels the line items in such a way that a user of the financial
statements can understand that the amounts are related.
The IASB also proposed that financial statements should be
presented in a more disaggregated manner. In particular, it
was proposed that financial statements be prepared in a way
that separates an entity’s financing activities from its business
and other activities and, further, separates financing activities
between transactions with owners in their capacity as owners
and all other financing activities. The ‘Business’ section of the
financial statements would include all items related to assets
and liabilities that management views as part of its continuing
business activities. Business activities are those activities
conducted with the intent of creating value, such as producing
goods or providing services. It is proposed that the ‘Business’
section be further disaggregated into an Operating category
and an Investing category.
The ‘Financing’ section would include only financial assets and
financial liabilities that management views as part of the
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financing of the entity’s business activities (referred to as
‘financing assets and liabilities’). Amounts relating to
financing liabilities would be presented in the Financing
liabilities category and amounts relating to financing assets
would be presented in the Financing assets category in each of
the financial statements. In determining whether a financial
asset or liability should be included in the financing section, an
entity should consider whether the item is interchangeable with
other sources of financing and whether the item can Page 172
be characterised as independent of specific business
activities.
The following table represents the proposed format for
presenting information within the financial statements,
excluding the notes. (The section names are in bold italics;
bullet points indicate required categories within sections.)
Table 4.2 Proposed format for the presentation of
financial statements
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Statement of
Statement of financial
comprehensive
Statement of cash
position
income
flows
Business
Business
Business
• Operating assets and
• Operating income and
• Operating cash flows
liabilities
expenses
• Investing cash flows
• Investing assets and
• Investing income and
liabilities
expenses
Financing
Financing
Financing
• Financing assets
• Financing asset income
• Financing asset cash
• Financing liability
flows
expenses
• Financing liability cash
• Financing liabilities
flows
Income taxes
Income taxes
Income taxes
On continuing operations
(business and financing)
Discontinued
operations
Discontinued
operations
Net of tax
Discontinued
operations
Other comprehensive
income
Net of tax
Equity
Equity
According to the IASB (2010), each entity would decide the
order of the sections and categories but would use the same
order in each individual statement. Each entity would decide
how to classify its assets and liabilities into the sections and
categories on the basis of how an item is used (the
‘management approach’). The entity would disclose why it
chose those classifications. In explaining the use of the
management approach, IASB (2008 and 2010) notes that,
because functional activities vary from entity to entity, an
entity would choose the classification that best reflects
management’s view of what constitutes its business (operating
and investing) and financing activities. Thus, a manufacturing
entity may classify the exact same asset (or liability)
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differently from a financial institution because of differences in
the businesses in which those entities engage.
In relation to the presentation format proposed for the
statement of financial position (see table above), IASB (2008,
p. 16) stated:
The statement of financial position would be grouped by
major activities (operating, investing and financing), not by
assets, liabilities and equity as it is today. The presentation of
assets and liabilities in the business and financing sections
will clearly communicate the net assets that management
uses in its business and financing activities. That change in
presentation coupled with the separation of business and
financing activities in the statements of comprehensive
income and cash flows should make it easier for users to
calculate some key financial ratios for an entity’s business
activities or its financing activities.
In relation to the presentation format proposed for the
statement of profit or loss and other comprehensive income,
IASB (2008, p. 17) stated:
The proposed presentation model eliminates the choice an
entity currently has of presenting components of income and
expense in an income statement and a statement of
comprehensive income (two-statement approach). All entities
would present a single statement of comprehensive income,
with items of other comprehensive income presented in a
separate section. This statement would include a subtotal of
profit or loss or net income and a total for comprehensive
income for the period. Because the statement of
comprehensive income would include the same sections and
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categories used in the other financial statements, it would
include more subtotals than are currently presented in an
income statement or a statement of comprehensive Page 173
income. Those additional subtotals will allow for the
comparison of effects across the financial statements. For
example, users will be able to assess how changes in
operating assets and liabilities generate operating income and
cash flows.
While there has been limited work undertaken by the IASB in
recent times in relation to changing the format of the financial
statements, the above discussion provides an indication of the
type of changes that might occur in future years in terms of
how we present financial statements. Again, as accountants,
we must not assume that the rules we learn now will
necessarily be in operation in the future—financial accounting
requirements change regularly.
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Possible changes in the requirements
pertaining to financial statement
presentation
LO 4.6 LO 4.11
As noted earlier in this chapter, for a number of years there
has been some discussion about changing the format for how
financial statements are presented. For example, in October
2008 the IASB issued a discussion paper entitled ‘Preliminary
Views on Financial Statement Presentation’. The
Page 171
discussion paper proposed some significant changes
to the way financial statements are to be presented. In July
2010 a ‘staff draft’ of an Exposure Draft of a new Financial
Statement Presentation accounting standard was prepared
(because it was a ‘staff draft’ it was not open for public
comment) and the expectation was that an Exposure Draft for
public comment would be issued in 2011 with a final standard
to follow some years later. At the present time there is no clear
indication of when a new standard will be issued requiring new
formats of presentation for the financial statements.
The initial project to revise the format of how financial
statements are presented was motivated by the IASB’s and
FASB’s concerns that financial statements can currently be
presented in many alternative ways. This, in turn, makes it
difficult for analysts, investors and other users to compare the
financial statements of different reporting entities. Further, the
formats of the various financial statements do not make it easy
for users to see how the information in the respective
statements is linked. For example, the statement of cash flows
separates operating activities from financing activities, but that
distinction is not always apparent in the statement of financial
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position and the statement of profit or loss and other
comprehensive income. This makes it difficult to compare
operating income with operating cash flows—a step often taken
in assessing the quality of an entity’s earnings.
To provide more useful information, the IASB is seeking to
make the financial statements more ‘cohesive’; that is, the
objective is to format the information in financial statements so
that a reader can follow the flow of information through the
various financial statements. In this regard, IASB (2008, p. 30)
stated:
A cohesive financial picture means that the relationship
between items across financial statements is clear and that
an entity’s financial statements complement each other as
much as possible. Financial statements that are consistent
with the cohesiveness objective would display data in a way
that clearly associates related information across the
statements so that the information is understandable. The
cohesiveness objective responds to the existing lack of
consistency in the way information is presented in an entity’s
financial statements. For example, cash flows from operating
activities are separated in the statement of cash flows, but
there is no similar separation of operating activities in the
statements of comprehensive income and financial position.
This makes it difficult for a user to compare operating income
with operating cash flows—a comparison often made in
assessing earnings quality. Similarly, separating operating
assets and liabilities in the statement of financial position will
provide users with more complete data for calculating some
key financial ratios, such as return on net operating assets.
Paragraph 60 of IASB (2010) takes this further by stating:
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Financial statements that are consistent with the
cohesiveness principle complement each other as much as
possible. To that end, an entity shall display and label line
items in a way that clearly associates related information
across the statements and helps a user understand those
relationships. For example, an entity aligns the line item
descriptions of information presented in the statements of
financial position, comprehensive income and cash flows to
help users find an asset or a liability, and the related effects
of a change in that asset or liability, in the same place in each
financial statement. For example, an entity with long-term
debt presents interest expense and cash paid for interest in
the same section and/or category as the long-term debt and
labels the line items in such a way that a user of the financial
statements can understand that the amounts are related.
The IASB also proposed that financial statements should be
presented in a more disaggregated manner. In particular, it
was proposed that financial statements be prepared in a way
that separates an entity’s financing activities from its business
and other activities and, further, separates financing activities
between transactions with owners in their capacity as owners
and all other financing activities. The ‘Business’ section of the
financial statements would include all items related to assets
and liabilities that management views as part of its continuing
business activities. Business activities are those activities
conducted with the intent of creating value, such as producing
goods or providing services. It is proposed that the ‘Business’
section be further disaggregated into an Operating category
and an Investing category.
The ‘Financing’ section would include only financial assets and
financial liabilities that management views as part of the
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financing of the entity’s business activities (referred to as
‘financing assets and liabilities’). Amounts relating to
financing liabilities would be presented in the Financing
liabilities category and amounts relating to financing assets
would be presented in the Financing assets category in each of
the financial statements. In determining whether a financial
asset or liability should be included in the financing section, an
entity should consider whether the item is interchangeable with
other sources of financing and whether the item can Page 172
be characterised as independent of specific business
activities.
The following table represents the proposed format for
presenting information within the financial statements,
excluding the notes. (The section names are in bold italics;
bullet points indicate required categories within sections.)
Table 4.2 Proposed format for the presentation of
financial statements
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Statement of
Statement of financial
comprehensive
Statement of cash
position
income
flows
Business
Business
Business
• Operating assets and
• Operating income and
• Operating cash flows
liabilities
expenses
• Investing cash flows
• Investing assets and
• Investing income and
liabilities
expenses
Financing
Financing
Financing
• Financing assets
• Financing asset income
• Financing asset cash
• Financing liability
flows
expenses
• Financing liability cash
• Financing liabilities
flows
Income taxes
Income taxes
Income taxes
On continuing operations
(business and financing)
Discontinued
operations
Discontinued
operations
Net of tax
Discontinued
operations
Other comprehensive
income
Net of tax
Equity
Equity
According to the IASB (2010), each entity would decide the
order of the sections and categories but would use the same
order in each individual statement. Each entity would decide
how to classify its assets and liabilities into the sections and
categories on the basis of how an item is used (the
‘management approach’). The entity would disclose why it
chose those classifications. In explaining the use of the
management approach, IASB (2008 and 2010) notes that,
because functional activities vary from entity to entity, an
entity would choose the classification that best reflects
management’s view of what constitutes its business (operating
and investing) and financing activities. Thus, a manufacturing
entity may classify the exact same asset (or liability)
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differently from a financial institution because of differences in
the businesses in which those entities engage.
In relation to the presentation format proposed for the
statement of financial position (see table above), IASB (2008,
p. 16) stated:
The statement of financial position would be grouped by
major activities (operating, investing and financing), not by
assets, liabilities and equity as it is today. The presentation of
assets and liabilities in the business and financing sections
will clearly communicate the net assets that management
uses in its business and financing activities. That change in
presentation coupled with the separation of business and
financing activities in the statements of comprehensive
income and cash flows should make it easier for users to
calculate some key financial ratios for an entity’s business
activities or its financing activities.
In relation to the presentation format proposed for the
statement of profit or loss and other comprehensive income,
IASB (2008, p. 17) stated:
The proposed presentation model eliminates the choice an
entity currently has of presenting components of income and
expense in an income statement and a statement of
comprehensive income (two-statement approach). All entities
would present a single statement of comprehensive income,
with items of other comprehensive income presented in a
separate section. This statement would include a subtotal of
profit or loss or net income and a total for comprehensive
income for the period. Because the statement of
comprehensive income would include the same sections and
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categories used in the other financial statements, it would
include more subtotals than are currently presented in an
income statement or a statement of comprehensive Page 173
income. Those additional subtotals will allow for the
comparison of effects across the financial statements. For
example, users will be able to assess how changes in
operating assets and liabilities generate operating income and
cash flows.
While there has been limited work undertaken by the IASB in
recent times in relation to changing the format of the financial
statements, the above discussion provides an indication of the
type of changes that might occur in future years in terms of
how we present financial statements. Again, as accountants,
we must not assume that the rules we learn now will
necessarily be in operation in the future—financial accounting
requirements change regularly.
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Summary
Page 1 of 2
SUMMARY
The chapter explored a number of general issues that relate to
assets. Assets, we saw, are currently defined as resources
controlled by an entity as a result of past events and from
which future economic benefits are expected to flow to the
entity (this definition is likely to change). To apply the asset
definition, recognition criteria are necessary. The conceptual
framework states that for an asset to be recognised, future
economic benefits must be both probable and capable of
reliable measurement.
Given that the recognition criteria are based on assessments
of measurability and probability, the recognition of an asset
will frequently depend on professional judgement. This means
that accountants may differ in their judgements of whether
particular expenditure should be accounted for as an expense
or as an asset.
The chapter emphasised that classes of assets are typically
measured using different measurement rules. This, in itself,
raises questions about the meaning of the aggregated total
(‘Total assets’). The IASB conceptual framework contains no
general guidance on measurement rules for assets other than
noting that ‘a number of different measurement bases are
employed to different degrees and in varying combinations in
financial statements (paragraph 4.55)’. Instead, the
accounting standards that address individual methods of
accounting for particular classes of assets typically provide
measurement rules specific to those classes. There is some
overlap between the various accounting standards, for
example, a number of accounting standards now require
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Summary
Page 2 of 2
particular assets to be measured at fair value.
The chapter also considered the accounting standards on the
acquisition costs of assets. Specifically considered were AASB
116 Property, Plant and Equipment and AASB 138 Intangible
Assets. We noted the general principle that the cost of
acquisition of an asset is considered to be the purchase
consideration plus any costs incidental to the acquisition.
Purchase consideration is typically measured in terms of the
fair value of the assets given in exchange.
It should be noted that in May 2015 the IASB released an
Exposure Draft of a revised Conceptual Framework for
Financial Reporting. This Exposure Draft has proposed some
changes in the definition and recognition criteria for assets
that will in turn have implications for profit or loss. It is
anticipated that the new conceptual framework will be in place
from 2017. Chapter 2
of this book addresses some of the
expected changes that will flow from the Exposure Draft.
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Key terms
Page 1 of 1
KEY TERMS
amortisation
capitalise
control (assets)
current assets
current ratio
future economic benefits
heritage assets
historical-cost accounting
intangible assets
market-value accounting
present-value accounting
recoverable amount
useful life
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End-of-chapter exercises
Page 1 of 2
END-OF-CHAPTER EXERCISES
Page 174
Consider the following example. Cabarita Ltd
acquired a parcel of land, with a building thereon, in
exchange for the following consideration:
The value of the land is considered to be equivalent to the
value of the building.
REQUIRED
(a)
What are the cost of the land and the cost of the
building?
(b)
Provide the accounting journal entry in the books of
Cabarita Ltd. LO 4.2
4.3
4.7
SOLUTION TO END-OF-CHAPTER EXERCISE
(a)
The cost of the land and the cost of the building are
calculated as follows:
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End-of-chapter exercises
Page 2 of 2
Fair value of the
purchase
consideration
$
Cash
125 000
Shares at fair value—
200 000 at $1.50
300 000
Computing machinery
at fair value
20 000
Total
445 000
Therefore, as both the land and the building are of
equal value, the value of each is $222 500.
(b)
The accounting entry in the books of Cabarita Ltd is:
Dr
Land
222 500
Dr
Building
222 500
Dr
Loss on
disposal of
computer
15 000
Dr
Accumulated
depreciation
computers
15 000
Cr
Cash
125 000
Cr
Share
capital
300 000
Cr
Computer
machinery
50 000
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Review questions
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REVIEW QUESTIONS
1.
Differentiate between the ‘definition of assets’ and the
‘criteria for recognition of assets’ provided in the conceptual
framework. LO 4.1
2.
Should all expenditure carried forward to future periods
be amortised/depreciated? Why? LO 4.1 , 4.2 , 4.3
3.
If an asset is expensed in one financial year because
future economic benefits were not deemed to be ‘probable’,
can the same asset be reinstated in future periods if the
benefits are subsequently assessed as probable? In this
respect, does the ability to reinstate assets apply to all
assets? LO 4.3 , 4.4
4.
Why would advertising expenditure typically be
expensed in the period incurred? What would be an
exception to this general rule? LO 4.3
5.
Should borrowing costs associated with the
construction of a building be treated as part of the cost of
the building, or should the borrowing costs be expensed as
incurred? LO 4.10
6.
In accounting for the acquisition of assets, the assets
acquired are to be recorded at the ‘cost of acquisition’. How
would you determine the ‘cost of acquisition’? LO 4.7
Page 175
7.
Explain the essential characteristics of an
asset according to the IASB Conceptual Framework for
Financial Reporting. LO 4.1 , 4.3
8.
4.3
When should an ‘impairment loss’ be recognised? LO
, 4.5
9.
What is the difference between value-in-use and valuein-exchange and of what relevance is either to the
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determination of the amount at which an asset is to be
disclosed within the statement of financial position (balance
sheet)? LO 4.2 , 4.5
10.
Can an entity include an asset in its statement of
financial position that it does not legally own? Justify your
answer. LO 4.1
11.
Assume that, in a particular year, a reporting entity
acquires a patent for a solar-powered toothbrush, but the
probability of future economic benefits being generated by
the patent is considered to be less than 50 per cent. As a
result of changed circumstances in a subsequent year, the
outlook is that the benefits are more than 50 per cent
probable.
REQUIRED
Explain whether the patent may be recognised as an asset
i) when acquired or ii) when the probability subsequently
exceeds 50 per cent. LO 4.1 , 4.3 , 4.5
12.
How are current assets defined for the purpose of
presentation in a statement of financial position
(balance sheet)? LO 4.1
13.
Tea Tree Bay Ltd acquires a Gizmo Machine from
Jetsons Ltd for the following consideration:
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Cash
$20 000
Land
In the books of Tea Tree
Bay Ltd the land is
recorded at its cost
of $100 000. It has
a fair value of $140
000.
Tea Tree Bay Ltd also agrees to assume the liability of
Jetsons Ltd’s bank loan of $30 000 as part of the
Gizmo Machine acquisition.
REQUIRED
(a)
Calculate the acquisition cost of the Gizmo Machine.
(b)
Provide the journal entries that would appear in Tea
Tree Bay Ltd’s books to account for the acquisition of the
Gizmo Machine. LO 4.7
14.
What are some of the various asset measurement
rules currently utilised within accounting standards? LO
4.4
15.
If the IASB conceptual framework had a paragraph
inserted that addressed measurement and that paragraph
suggested that one basis of measurement, such as present
value, should be used by all reporting entities, thereby
excluding the use of historical cost, do you think that all
reporting entities would simply adopt this suggestion?
Remember, accounting standards take precedence over the
conceptual framework. What would you see as some of the
impediments to standard-setters switching to present values
as the basis for the measurement of assets? LO 4.4 ,
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4.8
16.
AASB 101 stipulates a number of disclosures that
many reporting entities are required to make. What specific
disclosures are required by AASB 101 in relation to assets?
LO 4.6
17.
What are intangible assets and how, according to
AASB 101 and AASB 138, should they be disclosed in a
reporting entity’s statement of financial position? LO 4.4
4.6
,
18.
AASB 101 provides alternative presentation formats
for a reporting entity’s statement of financial position.
Explain the alternative presentation formats, and describe
the issues to consider as part of the process of selecting from
the alternative presentation formats. LO 4.6
19.
According to AASB 116, would you expense or
capitalise expenditure incurred in repairing an asset? Explain
your answer. LO 4.2 , 4.3
20.
Assume that the Geelong Football Club signs up five
promising recruits by offering each of them a five-year
player’s contract. As an additional incentive, it also offers
each of the players a substantial sign-on fee. Do you think
these players, or the associated economic benefits that they
will generate, are ‘assets’ of the Geelong Football Club? How
would you account for the sign-on fee? LO 4.2 , 4.3 ,
4.4
21.
Believing that it will be good for future business
prospects, Point Lonsdale Ltd gives Ocean Grove Ltd some
computer machinery at no cost. At the time, Ocean Grove
Ltd is considering entering into a long-term agreement to
acquire raw materials from Point Lonsdale. Just before the
asset transfer, the computer machinery has a fair value of
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$120 000 and a carrying amount of $100 000 (cost of $170
000; accumulated depreciation of $70 000).
Page 176
REQUIRED
(a) Provide the journal entries in the books of Point
Lonsdale Ltd to account for the asset transfer.
(b)
Can the computer machinery be recognised by
Ocean Grove Ltd? Do you think that applying the
principles and prescriptions of AASB 116 results in a
meaningful statement of assets? LO 4.7 , 4.9
22.
A university spent $4 million on a swimming pool for
its staff. The expenditure was made in an endeavour to
improve their health and wellbeing. The staff will not be
charged any money for using the pool and the expected
operating costs of the pool are expected to be $450 000 per
year, meaning that the pool will not be directly generating
any positive financial returns. Explain whether the university
should recognise the $4 million cost of the pool as an asset,
or treat it all as an expense. LO 4.3
23.
Cactus Ltd acquires some printing machinery. The
amount paid to the manufacturer is $85 000, plus an
additional $2000 for delivery. Once the machinery is
delivered, it needs some modifications before it can be used.
The modifications amount to $7000. An additional amount of
$2000 is paid for installation.
REQUIRED
(a) For accounting purposes, what is the ‘cost’ of the
machinery?
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(b)
Could other costs be included in the measurement of
the cost of acquiring the printing machinery if its
construction and installation took a substantial period of
time? LO 4.3 , 4.7 , 4.8 , 4.10
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CHALLENGING QUESTIONS
24.
What factors would you consider when determining
the format to use in disclosing a reporting entity’s
statement of financial position? LO 4.6
25.
In an article that appeared in The Australian Financial
Review on 26 August 2011 (‘Apple could easily flounder
without its founder’ by Mark Ritson), it was reported:
The news that Steve Jobs has resigned from Apple and
will be replaced as CEO by Tim Cook made global
headlines yesterday. What has followed since has been
a frenzied discussion of what the loss of Jobs will mean
for new product development timelines, share price
issues and corporate culture. Apple‘s share price fell 5
per cent on the news of the resignation as questions
were raised about Apple‘s prospects without its creative
guru at the helm. But the real question for Apple as it
enters its post-Jobs period is how well the brand will
survive without the founder.
REQUIRED
The fact that the share prices fell following the departure
of Steve Jobs is consistent with the view that Jobs was
an ‘asset’ to the company. How do you think this ‘asset’
would have been disclosed in the financial statements of
Apple? LO 4.1 , 4.2 , 4.6 , 4.7
26.
During the reporting period ending 30 June 2018,
Midnight Boil Ltd constructed a nuclear power generator
just outside of Melbourne. The cost of the power
generator and associated technology amounted to $12
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Challenging Questions
Page 2 of 9
550 000. Other costs associated with the construction
amounted to:
$
Costs incurred in
obtaining access
to the site
Power permits
Engineers’ fees
2 500 500
400 500
1 100 500
4 001 500
The plant was ready to start generating power on 1 July
2018, with actual generation starting on 1 October
2018. At the end of the power plant’s useful life, which
is expected to be 10 years, Midnight Boil Ltd is required
by the government to dismantle the plant, remove it,
and return the site to its original condition.
Page 177
After consulting its own engineers and
environmentalists, Midnight Boil Ltd estimates these
costs to be:
$
Dismantling the plant
Environmental
remediation costs
Replacement of flora
and fauna
750 500
1 249 500
100 000
2 100 000
Midnight Boil Ltd uses a discount rate of 10 per cent.
REQUIRED
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Challenging Questions
Page 3 of 9
Prepare the journal entries necessary to account for the
power plant for the years ended 30 June 2018, 30 June
2019 and 30 June 2024. Ignore depreciation. LO 4.3 ,
4.4 , 4.5 , 4.7
27.
For financial accounting purposes, the Australian
National Museum placed a $10 million value on the preserved
remains of the legendary Australian racehorse Phar Lap.
REQUIRED
What do you think this valuation actually represents? LO
4.2 , 4.5 , 4.7
28.
On 1 July 2018, Point Lookout Ltd acquired a boat to
use in its surfing holidays business. Point Lookout Ltd paid an
initial amount of $250 000 on the date of acquisition and
agreed to make a further five annual payments of $300 000,
starting on 30 June 2019. Point Lookout Ltd can borrow funds
at 8 per cent per annum.
REQUIRED
Prepare the journal entries as at 1 July 2018 and 30 June
2023 to account for the acquisition of the asset. LO
4.3 , 4.7 , 4.8
29.
If we look at a reporting entity’s statement of financial
position, we will see a total given for all of the entity’s assets
(this is a requirement of AASB 101). This aggregate total is
derived by adding together the various classes of current and
non-current assets. Do you think it is appropriate that the
various classes of assets are simply added together, even
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Page 4 of 9
though they have probably been measured on a number of
quite different measurement bases? Justify your answer. LO
4.4
30.
Deebar Ltd has constructed an item of machinery at a
cost of $220 000. Construction began on 1 January 2018 and
was completed on 30 April 2018. The machinery produces a
new damage-resistant surfboard. The cost of $220 000
comprises wages of $100 000, raw materials of $75 000 and
depreciation of $45 000. The depreciation relates to other
plant and machinery used to make the machine. The wages
are to be paid at a future date.
Deebar borrowed $150 000 at a rate of interest of 7 per
cent to finance the construction of the machine. The
funds were received on 1 January 2018 and were repaid
on 30 June 2018. As part of securing the loan,
government taxes of $1500 were paid.
Deebar Ltd has a reporting date of 30 June.
REQUIRED
(a)
Provide the accounting entry for the construction of
the machinery, assuming that the machinery satisfies the
criteria for recognition of an asset. LO 4.3 , 4.4 ,
4.7 , 4.8 , 4.10
(b)
Provide the accounting entry, assuming that in June
2018 it becomes apparent that the surfboards made by the
machine appear to be unpopular with surfers and
consequently will not be bought. Further, assume that a
surfing historian is prepared to pay $15 000 to acquire the
machine, and that this appears to be the option that
provides the greatest economic benefits to Deebar Ltd. As
part of the sale of the machine, Deebar is required to pay
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Challenging Questions
Page 5 of 9
for transporting the machine to the purchaser, and the
transport costs amount to $2300. LO 4.2 , 4.5
(c)
Provide the accounting entry, assuming that on 1
August 2018 the demand for the surfboards suddenly
increases because Rick Manning, a surfing champion, won a
world title event on a prototype of the surfboard. It is now
expected that thousands of the board will be sold. Page 178
The surfing historian had previously indicated that
he no longer wished to proceed with the acquisition of the
machine. LO 4.2 , 4.5
31.
Does the statement of financial position item ‘Total
assets’ represent the value of a reporting entity’s
assets? Explain your answer. LO 4.4
32.
Double Island Ltd constructed a Whizbang Machine
and incurred the following costs in doing so:
Amounts paid to
employees to build
the machine
$120 000
Raw materials consumed
in building the
machine
$45 000
Depreciation of
manufacturing
equipment
attributed to the
construction of the
Whizbang Machine
$25 000
REQUIRED
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Challenging Questions
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(a)
Provide the journal entries that Double Island Ltd
would use to account for the construction of the asset.
(b)
Assume that immediately after the journal entries in
part (a) have been made, new information becomes
available that indicates that the recoverable amount of the
Whizbang Machine is only $160 000. Provide the adjusting
journal entries. LO 4.3 , 4.5 , 4.7
33.
Lighthouse Ltd acquired land for the purpose of
building Lighthouse Point, a health and beauty spa. The
following costs were incurred:
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Challenging Questions
Purchase price of land
paid in cash
Page 7 of 9
$1 000 000
Stamp duty and legal
fees
$80 000
Removal of pre-existing
buildings
$20 000
Application to local
government
bodies for
development
$10 000
Expenses incurred in
evaluating a
different site found
to be unsuitable
$30 000
Architects’ fees
Construction of spa
buildings
$100 000
$1 500 000
Salary of manager
overseeing the
Lighthouse Point
project for 18
months
$120 000
Borrowing costs
(interest) incurred
in relation to the
project
$180 000
The original buildings on the site were removed by
Lighthouse Ltd and sold for $50 000.
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Challenging Questions
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REQUIRED
(a)
Determine the cost of the Lighthouse Point health
and beauty spa.
(b)
Allocate costs between land and building so that a
depreciable cost can be determined for the buildings. (It is
not necessary to calculate depreciation.) Identify those
items for which an arbitrary or estimated allocation between
land and building was required. LO 4.3 , 4.4 , 4.7 ,
4.8
34.
On 15 September 2016, Tweed Ltd acquired land on a
remote island at a cost of $100 000. The land was held
for future development as a resort when transport to
the island was made available. At each reporting date,
Tweed Ltd made the following assessments of the net
selling price of the land and the value of the land to the
business if kept for future use:
Date
Net selling price
31 December 2016
Value in use
$110 000
$130 000
30 June 2017
$90 000
$120 000
31 December 2017
$80 000
$90 000
$120 000
$110 000
30 June 2018
REQUIRED
(a)
At what amount should the land be recorded in the
statement of financial position (balance sheet) of Tweed Ltd
for each reporting date?
(b)
Assume that on 30 September 2018 the government
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Challenging Questions
Page 9 of 9
cancelled all plans to provide transport to the island. There
is no prospect of selling the land. The cost to Tweed Ltd of
developing transport exceeds the present value of expected
future benefits of operating the resort. How should Tweed
Ltd account for this event? LO 4.2 , 4.5
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References
Page 1 of 2
REFERENCES
BOWEN, R.M., NOREEN, E.W. & LACEY, J.M., 1981,
‘Determinants of the Corporate Decision to
Page 179
Capitalise Interest’, Journal of Accounting and Economics,
August, pp. 151–79.
FOSTER, B. & SHASTRI, T., 2010, ‘The Subprime Lending Crisis
and Reliable Reporting: Limitations to the Use of Fair Value in
Unstable Markets’, CPA Journal, vol. 80, no. 4, pp. 20–25.
HOUGHTON, K. & TAN, C., 1995, Measurement in Accounting:
Present Value and Historical Cost—A Report on the Attitudes
and Policy Positions of Australia’s Largest Businesses, Group of
100, Melbourne.
INTERNATIONAL ACCOUNTING STANDARDS BOARD,
2008, Discussion Paper: Preliminary Views on Financial
Statement Presentation, IASB, London, October.
INTERNATIONAL ACCOUNTING STANDARDS BOARD, 2010,
Staff Draft of Exposure Draft—IFRS X Financial Statement
Presentation, IASB, London, July.
INTERNATIONAL ACCOUNTING STANDARDS BOARD, 2010,
Exposure Draft ED2010/2: Conceptual Framework for Financial
Reporting: The Reporting Entity, IASB, London, March.
INTERNATIONAL ACCOUNTING STANDARDS BOARD, 2013,
Discussion Paper DP/2013/1: A Review of the Conceptual
Framework for Financial Reporting, IASB, London, September.
NAVARRO-GALERA, A. & RODRIGUEZ-BOLIVAR, M., 2010, ‘Can
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References
Page 2 of 2
Government Accountability Be Enhanced with International
Financial Reporting Standards?’ Public Money and
Management, November, pp. 379–84.
WATTS, R.L. & ZIMMERMAN, J.L., 1986, Positive Accounting
Theory, Prentice Hall, Englewood Cliffs, New Jersey.
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Introduction
Page 1 of 6
Chapter 5
Page 180
DEPRECIATION OF PROPERTY, PLANT
AND EQUIPMENT
LEARNING OBJECTIVES (LO)
5.1 Understand the meaning of ‘depreciation’ and be able
to explain the necessity for calculating depreciation expense.
5.2 Understand the role of accounting in allocating the
depreciable amount of a non-current asset over the asset’s
expected useful life.
5.3 Be aware that the practice of calculating depreciation
expense requires a number of decisions to be made including
determining the ‘depreciable base’ of the asset, its ‘useful life’
and the appropriate method of cost apportionment.
5.4 Understand the various approaches (straight line, sum
of digits, declining balance, production basis) for allocating
the depreciable amount of a non-current asset to particular
financial periods.
5.5 Understand when to start depreciating a depreciable
asset.
5.6
Know how to separately account for land and buildings.
5.7 Know how and when to revise depreciation rates and
methods.
5.8 Know how to account for the disposal of a depreciable
asset.
5.9 Know the disclosure requirements of AASB 116
Property, Plant and Equipment as they pertain to
depreciation.
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Introduction
Introduction to accounting for
depreciation of property, plant and
equipment
Page 2 of 6
Page 181
The previous chapter considered how to account for the
acquisition cost of assets. Subsequent to their acquisition, noncurrent assets with limited useful lives will typically need to be
depreciated over the period during which economic benefits are
expected to be derived. This chapter will consider the
accounting requirements pertaining to depreciation.
Subsequent to acquisition many non-current assets are also
revalued. The next chapter will consider the revaluation of noncurrent assets, as well as issues associated with impairment
testing.
Depreciation expense represents a recognition of the
decrease in the service potential of an asset across time. When
non-current assets (apart from land perhaps) are acquired,
there is a general expectation that the economic benefits
related to the acquisition will not last indefinitely. With this in
mind, a proportion of the acquisition cost of the asset will be
allocated to particular financial periods throughout the asset’s
useful life. As the IASB Conceptual Framework for Financial
Reporting, paragraph 4.51, states:
Where economic benefits are expected to arise over several
accounting periods and the association with income can only
be broadly or indirectly determined, expenses are recognised
in the income statement on the basis of systematical and
rational allocation procedures. This is often necessary in
recognising the expenses associated with the using up of
assets such as property, plant and equipment, goodwill,
patents and trademarks; in such cases the expense is
mk:@MSITStore:C:\Users\Administrator\Desktop\Financial%20Accounti... 2017/3/2
Introduction
Page 3 of 6
referred to as depreciation or amortisation. These allocation
procedures are intended to recognise expenses in the
accounting periods in which the economic benefits associated
with these items are consumed or expire.
As the depreciable assets of a business might comprise a
significant proportion of the firm’s total assets, the choice of
depreciation policies can have a significant impact on the
profits of a business. The potential magnitude of depreciation
expense is evident from, for example, a review of BHP Billiton’s
consolidated results for the 2015 financial year, which
indicated that the total of the depreciation and amortisation
expenses amounted to US$9 158 million, in a year when profit
after tax—and therefore after consideration of amortisation and
depreciation—was US$2 878 million, and when total assets
were US$125 580 million (BHP Billiton reports its results in US
dollars). Another example, in the 2015 financial year, is Qantas
Ltd’s depreciation and amortisation expenses, which totalled $1
096 million in a year when profit after tax totalled $560 million,
and reported assets amounted to $17 530 million. As we can
see, depreciation expense can be quite significant.
In Australia, the accounting standard relating to the
depreciation of property, plant and equipment is AASB 116
Property, Plant and Equipment. The standard provides a set of
comprehensive instructions on how to account for tangible
non-current assets. AASB 116 addresses issues such as the
acquisition costs of property, plant and equipment (which we
addressed in Chapter 4 ) and subsequent measurement,
including the revaluation of property, plant and equipment
(which we address in Chapter 6 ), depreciation, and
disposal and derecognition.
mk:@MSITStore:C:\Users\Administrator\Desktop\Financial%20Accounti... 2017/3/2
Introduction
Page 4 of 6
While AASB 116 covers depreciation issues as they relate to
property, plant and equipment, AASB 138 Intangible Assets
provides rules in relation to the amortisation of intangible
assets. We consider intangible assets in more depth in
Chapter 8 .
From an accountant’s perspective, depreciation represents the
allocation of the cost of an asset, or its revalued amount, over
the periods in which benefits are expected to be derived.
Depreciation is defined in AASB 116 as ‘the systematic
allocation of the depreciable amount of an asset over its useful
life’.
Depreciation should not be confused with the decline in the
market value, or fair value, of an asset across time. An asset
might even increase in value over time, but a depreciation
charge might need to be recognised to take into account the
wear and tear that the asset might have undergone. As
paragraph 52 of AASB 116 states:
Depreciation is recognised even if the fair value of the asset
exceeds its carrying amount, as long as the asset’s residual
value does not exceed its carrying amount. Repair and
maintenance of an asset do not negate the need to depreciate
it.
In determining how to allocate the cost of the asset Page 182
to the period’s profit or loss, three issues must be
addressed:
1. What depreciable base should be used for the asset?
2. What is the asset’s useful life?
3. What method of cost apportionment is most appropriate for
the asset?
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Introduction
Page 5 of 6
While depreciation will frequently be treated as an expense in
the period in which it is recognised, at times the depreciation
of one asset will contribute to an increase in the value of
another asset. For example, an item of machinery might be
used to construct a particular item that will subsequently be
sold or used by the reporting entity. In such an instance, the
depreciation would be recognised by increasing the costs of the
asset being constructed, rather than simply treating the
depreciation as an expense of the period. As paragraph 48 of
AASB 116 states: ‘The depreciation charge for each period
shall be recognised in profit or loss unless it is included in the
carrying amount of another asset.’ In explaining this
requirement, paragraph 49 of AASB 116 states:
The depreciation charge for a period is usually recognised in
profit or loss. However, sometimes, the future economic
benefits embodied in an asset are absorbed in producing
other assets. In this case, the depreciation charge constitutes
part of the cost of the other asset and is included in its
carrying amount. For example, the depreciation of
manufacturing plant and equipment is included in the costs of
conversion of inventories (see AASB 102). Similarly,
depreciation of property, plant and equipment used for
development activities may be included in the cost of an
intangible asset recognised in accordance with AASB 138
Intangible Assets.
As an example of the above requirement, consider
Worked Example 5.1 .
WORKED EXAMPLE 5.1:
Depreciation charge
included in the carrying amount of another asset
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Introduction
Page 6 of 6
Point Impossible Ltd constructs and sells boats. In making a
boat, an electronic sander was used. The cost of the electric
sander is $9 000 and it is expected to have a useful life of 500
hours, and no residual value. During the financial year the
sander was used for 50 hours on the boat.
REQUIRED
Provide the journal entry to account for the depreciation of the
electric sander.
SOLUTION
The depreciation expense in this case would be based on the
expected life of 500 hours and would equal $9 000 × 50/500 =
$900.
The journal entry would be:
Dr
Boat—
inventory
Cr
Accumulated depreciation
900
900
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Introduction
Page 1 of 6
Chapter 5
Page 180
DEPRECIATION OF PROPERTY, PLANT
AND EQUIPMENT
LEARNING OBJECTIVES (LO)
5.1 Understand the meaning of ‘depreciation’ and be able
to explain the necessity for calculating depreciation expense.
5.2 Understand the role of accounting in allocating the
depreciable amount of a non-current asset over the asset’s
expected useful life.
5.3 Be aware that the practice of calculating depreciation
expense requires a number of decisions to be made including
determining the ‘depreciable base’ of the asset, its ‘useful life’
and the appropriate method of cost apportionment.
5.4 Understand the various approaches (straight line, sum
of digits, declining balance, production basis) for allocating
the depreciable amount of a non-current asset to particular
financial periods.
5.5 Understand when to start depreciating a depreciable
asset.
5.6
Know how to separately account for land and buildings.
5.7 Know how and when to revise depreciation rates and
methods.
5.8 Know how to account for the disposal of a depreciable
asset.
5.9 Know the disclosure requirements of AASB 116
Property, Plant and Equipment as they pertain to
depreciation.
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Introduction
Introduction to accounting for
depreciation of property, plant and
equipment
Page 2 of 6
Page 181
The previous chapter considered how to account for the
acquisition cost of assets. Subsequent to their acquisition, noncurrent assets with limited useful lives will typically need to be
depreciated over the period during which economic benefits are
expected to be derived. This chapter will consider the
accounting requirements pertaining to depreciation.
Subsequent to acquisition many non-current assets are also
revalued. The next chapter will consider the revaluation of noncurrent assets, as well as issues associated with impairment
testing.
Depreciation expense represents a recognition of the
decrease in the service potential of an asset across time. When
non-current assets (apart from land perhaps) are acquired,
there is a general expectation that the economic benefits
related to the acquisition will not last indefinitely. With this in
mind, a proportion of the acquisition cost of the asset will be
allocated to particular financial periods throughout the asset’s
useful life. As the IASB Conceptual Framework for Financial
Reporting, paragraph 4.51, states:
Where economic benefits are expected to arise over several
accounting periods and the association with income can only
be broadly or indirectly determined, expenses are recognised
in the income statement on the basis of systematical and
rational allocation procedures. This is often necessary in
recognising the expenses associated with the using up of
assets such as property, plant and equipment, goodwill,
patents and trademarks; in such cases the expense is
mk:@MSITStore:C:\Users\Administrator\Desktop\Financial%20Accounti... 2017/3/2
Introduction
Page 3 of 6
referred to as depreciation or amortisation. These allocation
procedures are intended to recognise expenses in the
accounting periods in which the economic benefits associated
with these items are consumed or expire.
As the depreciable assets of a business might comprise a
significant proportion of the firm’s total assets, the choice of
depreciation policies can have a significant impact on the
profits of a business. The potential magnitude of depreciation
expense is evident from, for example, a review of BHP Billiton’s
consolidated results for the 2015 financial year, which
indicated that the total of the depreciation and amortisation
expenses amounted to US$9 158 million, in a year when profit
after tax—and therefore after consideration of amortisation and
depreciation—was US$2 878 million, and when total assets
were US$125 580 million (BHP Billiton reports its results in US
dollars). Another example, in the 2015 financial year, is Qantas
Ltd’s depreciation and amortisation expenses, which totalled $1
096 million in a year when profit after tax totalled $560 million,
and reported assets amounted to $17 530 million. As we can
see, depreciation expense can be quite significant.
In Australia, the accounting standard relating to the
depreciation of property, plant and equipment is AASB 116
Property, Plant and Equipment. The standard provides a set of
comprehensive instructions on how to account for tangible
non-current assets. AASB 116 addresses issues such as the
acquisition costs of property, plant and equipment (which we
addressed in Chapter 4 ) and subsequent measurement,
including the revaluation of property, plant and equipment
(which we address in Chapter 6 ), depreciation, and
disposal and derecognition.
mk:@MSITStore:C:\Users\Administrator\Desktop\Financial%20Accounti... 2017/3/2
Introduction
Page 4 of 6
While AASB 116 covers depreciation issues as they relate to
property, plant and equipment, AASB 138 Intangible Assets
provides rules in relation to the amortisation of intangible
assets. We consider intangible assets in more depth in
Chapter 8 .
From an accountant’s perspective, depreciation represents the
allocation of the cost of an asset, or its revalued amount, over
the periods in which benefits are expected to be derived.
Depreciation is defined in AASB 116 as ‘the systematic
allocation of the depreciable amount of an asset over its useful
life’.
Depreciation should not be confused with the decline in the
market value, or fair value, of an asset across time. An asset
might even increase in value over time, but a depreciation
charge might need to be recognised to take into account the
wear and tear that the asset might have undergone. As
paragraph 52 of AASB 116 states:
Depreciation is recognised even if the fair value of the asset
exceeds its carrying amount, as long as the asset’s residual
value does not exceed its carrying amount. Repair and
maintenance of an asset do not negate the need to depreciate
it.
In determining how to allocate the cost of the asset Page 182
to the period’s profit or loss, three issues must be
addressed:
1. What depreciable base should be used for the asset?
2. What is the asset’s useful life?
3. What method of cost apportionment is most appropriate for
the asset?
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Introduction
Page 5 of 6
While depreciation will frequently be treated as an expense in
the period in which it is recognised, at times the depreciation
of one asset will contribute to an increase in the value of
another asset. For example, an item of machinery might be
used to construct a particular item that will subsequently be
sold or used by the reporting entity. In such an instance, the
depreciation would be recognised by increasing the costs of the
asset being constructed, rather than simply treating the
depreciation as an expense of the period. As paragraph 48 of
AASB 116 states: ‘The depreciation charge for each period
shall be recognised in profit or loss unless it is included in the
carrying amount of another asset.’ In explaining this
requirement, paragraph 49 of AASB 116 states:
The depreciation charge for a period is usually recognised in
profit or loss. However, sometimes, the future economic
benefits embodied in an asset are absorbed in producing
other assets. In this case, the depreciation charge constitutes
part of the cost of the other asset and is included in its
carrying amount. For example, the depreciation of
manufacturing plant and equipment is included in the costs of
conversion of inventories (see AASB 102). Similarly,
depreciation of property, plant and equipment used for
development activities may be included in the cost of an
intangible asset recognised in accordance with AASB 138
Intangible Assets.
As an example of the above requirement, consider
Worked Example 5.1 .
WORKED EXAMPLE 5.1:
Depreciation charge
included in the carrying amount of another asset
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Introduction
Page 6 of 6
Point Impossible Ltd constructs and sells boats. In making a
boat, an electronic sander was used. The cost of the electric
sander is $9 000 and it is expected to have a useful life of 500
hours, and no residual value. During the financial year the
sander was used for 50 hours on the boat.
REQUIRED
Provide the journal entry to account for the depreciation of the
electric sander.
SOLUTION
The depreciation expense in this case would be based on the
expected life of 500 hours and would equal $9 000 × 50/500 =
$900.
The journal entry would be:
Dr
Boat—
inventory
Cr
Accumulated depreciation
900
900
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Depreciable amount (base) of an asset
Page 1 of 2
Depreciable amount (base) of an asset
LO 5.1 LO 5.2 LO 5.3
As we have noted, in order to determine depreciation expense
we need to consider the depreciable base, the useful life, and
the most appropriate method of cost apportionment. First we
will consider the depreciable base. The depreciable amount
or, as it is also called, the depreciable base is the cost of a
depreciable asset, or other amount substituted for cost in the
financial statement, less its residual value. Paragraph 6 of
AASB 116 defines residual value as:
the estimated amount that an entity would currently obtain
from disposal of the asset, after deducting the estimated
costs of disposal, if the asset were already of the age and in
the condition expected at the end of its useful life.
For example, if an asset had a cost of $50 000 and it is
expected that the asset will be disposed of in five years’ time
for $10 000, the ‘depreciable amount’ (or base) is $40 000;
that is, $50 000 less the residual of $10 000. Determining the
amount to be recovered on disposal—the residual amount—
will typically be based on professional judgement, unless
perhaps a forward exchange arrangement is already Page 183
in place in which there is an agreement on how
much will be received from the sale of the asset at a future
point. Therefore, various estimates might be possible. If an
asset is relatively unique then it will be more difficult to
determine residual value relative to assets that are commonly
bought and sold. It should also be appreciated that residual
value is determined by reference to what the entity would
currently expect to obtain from the asset’s disposal based on
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Depreciable amount (base) of an asset
Page 2 of 2
its projected age and condition (again refer to the above
definition), and not what it expects to actually obtain at a
future date. The choice of a particular residual value will have
direct implications for future profits and recorded assets. A
higher estimate for the residual value will lead to lower
depreciation charges and a lower balance of accumulated
depreciation and, thus, a larger amount for total assets. For
example, in the case of the asset described above, if we
depreciate it on a straight-line basis over its expected useful
life of five years, given a residual value of $10 000, the yearly
depreciation charge would be $8000. At the end of year 2 the
accumulated depreciation of the asset would be $16 000 and
the carrying amount of the asset would be $34 000. However,
if we estimate that the residual value is $20 000, the yearly
depreciation charge would be $6000. At the end of year 2 the
accumulated depreciation would be $12 000 and the carrying
amount of the asset would be $38 000.
If the residual value of an asset increases so that it is equal
to, or greater than, the carrying amount of the asset, no
further depreciation is charged. As paragraph 54 of AASB 116
states:
The residual value of an asset may increase to an amount
equal to or greater than the asset’s carrying amount. If it
does, the asset’s depreciation charge is zero unless and until
its residual value subsequently decreases to an amount
below the asset’s carrying amount.
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Determination of useful life
Page 1 of 4
Determination of useful life
LO 5.2 LO 5.3
Having determined the depreciable amount of an asset, we
need to consider its useful life. For the purposes of AASB 116,
the useful life of a depreciable asset reflects its useful life for
the entity holding the asset, rather than simply its economic
life per se. AASB 116 defines useful life as:
(a)
the period over which an asset is expected to be
available for use by an entity; or
(b)
the number of production or similar units expected to
be obtained from the asset by an entity.
In Worked Example 5.1
we utilised production hours as
the basis of the asset’s useful life. The definition of useful life
provided above reflects the view that an asset’s useful life for
one entity may be different from its useful life within another
entity. In determining useful life, AASB 116 provides some
useful guidance. Paragraph 56 states:
The future economic benefits embodied in an asset are
consumed by an entity principally through its use. However,
other factors, such as technical or commercial obsolescence
and wear and tear while an asset remains idle, often result in
the diminution of the economic benefits that might have been
obtained from the asset. Consequently, all the following
factors are considered in determining the useful life of an
asset:
(a)
expected usage of the asset. Usage is assessed by
reference to the asset’s expected capacity or physical output
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Determination of useful life
Page 2 of 4
(b)
expected physical wear and tear, which depends on
operational factors such as the number of shifts for which the
asset is to be used and the repair and maintenance
programme, and the care and maintenance of the asset while
idle
(c)
technical or commercial obsolescence arising from
changes or improvements in production, or from a change in
the market demand for the product or service output of the
asset
(d)
legal or similar limits on the use of the asset, such as
the expiry dates of related leases.
The possibility of obsolescence, both technical and commercial,
is a factor regardless of the physical use of an asset.
Worked Example 5.2
helps to make this clearer.
Another factor that should be considered in some cases is the
legal life of the asset. For intangible assets (non-monetary
assets without physical substance) such as patents, licences,
franchises or copyrights, the legal life of the contract period
might be the limiting factor in the firm’s use of the asset.
Having determined the depreciable amount of the asset and its
useful life, it is necessary to determine how the depreciable
amount should be allocated or apportioned to future periods.
That is, what is the expected pattern of benefits? As with many
things in accounting, determining the useful life and the
pattern of benefits will depend heavily upon professional
judgement.
WORKED EXAMPLE 5.2:
Determination of
Page 184
useful life
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Determination of useful life
Page 3 of 4
Assume that a business has an item of plant with the following
characteristics:
l
l
l
The plant should continue to produce output in its current
manner for the next 12 years.
Demand for the output of the plant is expected to be
maintained for the next seven years, after which time the
demand will fall to such a low level that it will not be viable to
produce the goods.
A more technically advanced machine will probably be
available in five years and the firm believes that it will need
to switch to the new plant in order to remain competitive.
REQUIRED
Determine the period of time that should be used in the
depreciation calculation.
SOLUTION
Given the above information, the firm would use a period of
depreciation of five years, which is the shortest of the following
periods:
l
physical life—12 years
l
commercial life—7 years
l
technical life—5 years
Five years would represent the period of time the entity
expects to hold the asset. Before determining the periodic
depreciation expense, consideration should be given to the
expected residual value of the plant in five years’ time so that
the ‘depreciable amount’ can be determined. Consideration
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Determination of useful life
Page 4 of 4
also needs to be given to the expected pattern of the benefits.
Evidently, many judgements have to be made about
depreciation, and these judgements will have a direct effect on
depreciation expenses, and therefore upon reported profits.
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Method of cost apportionment
Page 1 of 3
Method of cost apportionment
LO 5.3 LO 5.4
Having considered the depreciable base and the useful life of a depreciable asset we will now consider the
method of cost apportionment to be applied to the depreciable asset. The method of apportionment should
best reflect the economic reality of the asset’s use. AASB 116 does not mandate the use of a particular
method of depreciation, but rather, AASB 116 indicates that the basis chosen should be that which best
reflects the underlying physical, technical, commercial and, where appropriate, legal facts.
There are two general approaches to cost apportionment. These are categorised as time-based and activitybased depreciation methods. If the decline in the asset’s value depends on its use, rather than on issues of
technical, legal or commercial concern, an activity-based depreciation method should be used. If the decline
in value is going to be greatest in early periods, owing to issues such as technical obsolescence, a method
that provides for greatest depreciation charges in early years should be used, such as the sum-of-digits
method or the declining-balance method (both of which are time-based). If the asset has a defined life,
perhaps legally defined by contract, and it is expected that it will be used uniformly, the straight-line
method of depreciation should perhaps be used. Again, it is emphasised that the depreciation method chos
en should best reflect the underlying economic reality. The choice of depreciation method might have a
significant effect on the firm’s profits and total assets. You can see the differences in expense that might
result from calculating depreciation expense in various ways by reviewing Worked Example 5.3 .
WORKED EXAMPLE 5.3:
A review of alternative depreciation methods
Page 185
Noosa Ltd acquires an asset for $25 000. It is expected to have a residual value of $5000 in five years’
time—its expected useful life to the entity.
Required
Calculate each period’s depreciation, using:
(a)
the straight-line method
(b)
the sum-of-digits method
(c)
the declining-balance method
(d)
units-of-production method
Solution
(a)
Straight-line depreciation
This is a time-based depreciation method and is the most easily understood and widely used
depreciation method. With this approach, the depreciable amount is divided by the number of
years in the asset’s useful life as follows:
(Cost – residual value) ÷ useful life = ($25 000 – $5000) ÷ 5 = $4000 per year
This method of depreciation would be appropriate when the pattern of benefits derived from the
asset are expected to be uniform throughout the asset’s useful life.
(b)
Sum-of-digits depreciation
The sum-of-digits method of depreciation is a time-based depreciation method and like the decliningbalance method considered below, is an accelerated form of depreciation. The use of
accelerated methods assumes that the asset will provide greater economic benefits in its earlier
years rather than in later years. In these circumstances, higher depreciation charges are
allocated in earlier years, with the depreciation expense decreasing in later years. In this
example, the asset is expected to be used for five years. The digits from one to the end of the
asset’s life, in this case five, are summed.
1 + 2 + 3 + 4 + 5 = 15
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Method of cost apportionment
Page 2 of 3
Or we could use the formula n(n + 1) ÷ 2,
which gives (5 × 6) ÷ 2 = 15
Year
Depreciation
1
5 ÷ 15 × ($25 000 − $5 000)
= $ 6 667
2
4 ÷ 15 × ($25 000 − $5 000)
= $ 5 333
3
3 ÷ 15 × ($25 000 − $5 000)
= $ 4 000
4
2 ÷ 15 × ($25 000 − $5 000)
= $ 2 667
5
1 ÷ 15 × ($25 000 − $5 000)
= $ 1 333
$20 000
Depreciation based on the sum-of-digits method would be appropriate where the economic benefits
expected to be derived from the asset will be greater in the early years than the later years.
(c)
Declining-balance depreciation (also referred to as the diminishing-balance method)
The diminishing-balance method is an accelerated method of depreciation. Rather than multiplying a
consistent balance (in this example $20 000) by a reducing fraction, a consistent percentage is
applied to a decreasing carrying amount. The percentage to be applied to the opening writtendown value (or carrying amount) of the asset is determined by using the following formula:
percentage = 1 − the nth root of (salvage value ÷ cost),
where n = the life of the asset, which in this case is 5
= 1.0 − 5√0.2
= 1.0 − 0.724 77
= 0.275 23
Year
Depreciation
1
0.27 523 × ($25 000)
= $ 6 881
2
0.27 523 × ($25 000 − $6 881)
= $ 4 987
3
0.27 523 × ($25 000 − $11 868)
= $ 3 614
4
0.27 523 × ($25 000 − $15 482)
= $ 2 620
5
0.27 523 × ($25 000 − $18 102)
= $ 1 898
$20 000
Page 186
As with the sum-of-digits approach, depreciation based on the declining-balance approach would be
appropriate where the economic benefits expected to be derived from the asset will be greater in the
early years than the later years.
(d)
Units-of-production method
To use this method—which is an activity-based depreciation method—we would need additional information. The
units-of-production method results in a depreciation charge based on the expected use or output of the asset.
Therefore we need more details about total expected use or output related to the asset, and the use or output
for the current accounting period. For this asset we will use expected use denominated in hours and we will
assume that the asset is expected to be used for a total of 1000 hours before its useful life is at an end. We will
further assume that in the current financial period the asset has been used for 210 hours. Depreciation,
therefore, would be calculated as:
Actual usage for the year divided by total expected usage multiplied by depreciable amount = (210 ÷ 1 000) ×
(25 000 – 5 000) = $4 200.
The different methods of depreciation just outlined will clearly lead to differences in accounting profits and
reported assets. Therefore, and as stressed throughout this book, the choice of an accounting policy might
be a choice with cash-flow implications for the organisation, particularly if specific agreements, such as
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Method of cost apportionment
Page 3 of 3
management bonus schemes or debt contracts with restrictive accounting-based covenants, are tied to
accounting profits or total assets. It is hoped, however, that management will be objective and select the
depreciation method that best reflects the pattern of benefits to be derived from the asset. Again,
objectivity and the expectation that accounting information should be free from bias is one of the key
qualitative characteristics of general purpose financial statements (according to the conceptual framework).
As an example of the variety of depreciation methods that might be used we can look at the accounting
policy note in Exhibit 5.1
from BHP Billiton Ltd’s 2015 annual report.
Exhibit 5.1 Details of the accounting policy note for depreciation of property,
plant and equipment from BHP Billiton Ltd’s 2015 Annual Report
Depreciation of property, plant and equipment
The carrying amounts of property, plant and equipment are depreciated to their estimated residual value
over the estimated useful lives of the specific assets concerned, or the estimated life of the associated mine,
field or lease, if shorter. Estimates of residual values and useful lives are reassessed annually and any
change in estimate is taken into account in the determination of the remaining depreciation charges.
Depreciation commences on the date of commissioning. The major categories of property, plant and
equipment are depreciated on a unit-of-production and/or straight-line basis using estimated lives indicated
below. However, where assets are dedicated to a mine, field or lease and are not readily transferable, the
below useful lives are subject to the lesser of the asset category’s useful life and the life of the mine, field or
lease:
l
Buildings
25 to 50 years
l
Land
Not depreciated
l
Plant and equipment
3 to 30 years straight-line
l
Mineral rights and petroleum interests
Based on reserves on a unit-of-production basis
l
Capitalised exploration
Based on reserves on a unit evaluation and
development of production basis expenditure
SOURCE: BHP Billiton Ltd 2015 Annual Report
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Depreciation of separate components
Page 1 of 3
Depreciation of separate components
LO 5.2
Page 187
As was indicated in Chapter 4 , AASB 116 requires the
‘components approach’ to be used when accounting for items
of property, plant and equipment. This requires the cost of an
item of property, plant and equipment to be allocated to its
various components and where these individual components
have different lives or where the consumption of economic
benefits embodied in the components differs, each component
must be accounted for separately. An example of this would
be an aircraft, where the engines, internal fittings and
airframe would be accounted for separately as they all have
different useful lives. As paragraph 44 of AASB 116 states:
An entity allocates the amount initially recognised in respect
of an item of property, plant and equipment to its significant
parts and depreciates separately each such part. For
example, it may be appropriate to depreciate separately the
airframe and engines of an aircraft, whether owned or
subject to a finance lease.
An example of the components approach to depreciation is
provided in Worked Example 5.4 .
WORKED EXAMPLE 5.4:
A components approach to
depreciation
At the beginning of the financial period, De Lange Ltd acquired
an aircraft for use in its travel business. The aircraft cost $3
569 000. De Lange Limited’s maintenance and engineering
department have provided the accounting department with the
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Depreciation of separate components
Page 2 of 3
following list of component parts and useful lives.
Airframe
Engines
Interior fixtures
and fittings
Useful life
(years)
Component cost
($)
15
10
1 830 000
1 324 000
5
415 000
3 569 000
These components and lives are consistent with those
previously used, and with what is currently used within the
industry.
Required
Assuming that the individual components of the aircraft are
depreciated on a straight-line basis over their useful lives, and
they will have no residual value, prepare the journal entries
necessary to account for the depreciation expense at the end
of the 12-month reporting period.
Solution
Calculating the depreciation expense
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Depreciation of separate components
Component cost
$
Page 3 of 3
Useful life
(years)
Depreciation
expense ($)
Airframe
1 830 000
15
122 000
Engines
1 324 000
10
132 400
415 000
5
83 000
Interior
fixtures and
fittings
3 569 000
337 400
Journal entry
Dr
Cr
Cr
Cr
Depreciation
expense
Accumulated
depreciation—
airframe
Accumulated
depreciation—
engines
Accumulated
depreciation—
interior
fixtures and
fittings
337 400
122 000
132 400
83 000
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When to start depreciating an asset
Page 1 of 1
When to start depreciating an asset
LO 5.5
Page 188
Having considered the depreciable base, useful life and method
of cost apportionment, the next step is to consider when we
should start depreciating the asset. The rule provided in AASB
116 is that depreciation charges are to be made from the date
when a depreciable asset is first put into use, or held ready for
use. Therefore, an asset being constructed would not be
depreciated until it is ready for use. If an item is able to be
used but will not actually be used for a number of periods, the
asset would nonetheless be required to be depreciated once it
is completed, even though it is not being used. Such
depreciation would account for the possibility of decreases in
service potential not caused by use but perhaps by technical or
commercial obsolescence. As paragraph 55 of AASB 116
states:
Depreciation of an asset begins when it is available for use,
that is, when it is in the location and condition necessary for
it to be capable of operating in the manner intended by
management. Depreciation of an asset ceases at the earlier of
the date that the asset is classified as held for sale (or
included in a disposal group that is classified as held for sale)
in accordance with AASB 5 and the date that the asset is
derecognised. Therefore, depreciation does not cease when
the asset becomes idle or is retired from active use unless the
asset is fully depreciated. However, under usage methods of
depreciation the depreciation charge can be zero while there
is no production.
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Revision of depreciation rate and depreciation method
Page 1 of 3
Revision of depreciation rate and
depreciation method
LO 5.7
The depreciation expense charged to each accounting period is
an estimate that involves the exercise of judgement. As it
takes into account technical, commercial and other
considerations, the basis for calculating the depreciation
expense should be reviewed annually to take changing
circumstances into account. For this to be achieved, two issues
must be considered: the useful life of the asset, and the
depreciation method used. How these two factors affect the
assessment of the annual depreciation charge is considered
below.
If it becomes apparent that the expected useful life of a noncurrent asset has changed, the entity concerned is required to
revise its depreciation rate. It might be decided that the useful
life of a non-current asset is different from that originally
expected because of a number of factors. For example, the
useful life might be extended because of certain expenditures
that improve the asset and lengthen its life. Alternatively,
technological changes or changes in the market for the
products of the asset might reduce the useful life of the asset.
Changes in the repair and maintenance policy of the entity
might also impact on the expected useful life of the asset. In
relation to expectations about the useful life (and the residual
value) of a non-current asset, paragraph 51 of AASB 116
requires that:
The residual value and the useful life of an asset shall be
reviewed at least at each financial year-end and, if
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expectations differ from previous estimates, the change(s)
shall be accounted for as a change in an accounting estimate
in accordance with AASB 108 Accounting Policies, Changes in
Accounting Estimates and Errors.
Apart from revisions of expectations about the useful life of an
asset, there might also be changes in expectations about the
pattern of benefits expected to be derived from the asset. In
this regard, paragraph 61 of AASB 116 requires the following:
The depreciation method applied to an asset shall be
reviewed at least at each financial year-end and, if there has
been a significant change in the expected pattern of
consumption of the future economic benefits embodied in the
asset, the method shall be changed to reflect the changed
pattern. Such a change shall be accounted for as a change in
an accounting estimate in accordance with AASB 108.
Revisions of depreciation rates can have very significant
impacts on profits. AASB 116 requires that, if a revision of
useful life or of the amounts expected on disposal causes a
material change in the depreciation charges of a firm, the
financial effect of that material change should be disclosed.
According to Paragraph 5 of AASB 108 Accounting Policies,
Changes in Accounting Estimates and Errors, an item is
deemed to be material if the omission or misstatement of the
item:
could, individually or collectively, influence the economic
decisions that users make on the basis of the financial
statements.
As emphasised earlier in this text, decisions pertaining to
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materiality are based upon professional judgement: what is
considered material by one party might not be considered to
be material by another.
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Land and buildings
Page 1 of 6
Land and buildings
LO 5.6
Page 189
Where land and buildings are acquired together, AASB 116
requires that the cost be apportioned between the land and the
buildings, and that the buildings be systematically depreciated
over time. Land itself would not usually be depreciated, given
its usually indefinite life. As paragraph 58 of AASB 116 states:
Land and buildings are separable assets and are accounted
for separately, even when they are acquired together. With
some exceptions, such as quarries and sites used for landfill,
land has an unlimited useful life and therefore is not
depreciated. Buildings have a limited useful life and therefore
are depreciable assets. An increase in the value of the land on
which a building stands does not affect the determination of
the depreciable amount of the building.
Paragraph 59 of AASB 116 further states:
If the cost of land includes the costs of site dismantlement,
removal and restoration, that portion of the land asset is
depreciated over the period of benefits obtained by incurring
those costs. In some cases, the land itself may have a limited
useful life, in which case it is depreciated in a manner that
reflects the benefits to be derived from it.
For example, if a land and building package is acquired at a
cost of $400 000 and it is considered that the land has a value
of $150 000, $250 000 would be attributed to the building and
this amount of $250 000 would need to be depreciated over
the useful life of the building (after consideration of its ultimate
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Land and buildings
Page 2 of 6
residual value).
Company directors have been known to complain about having
to depreciate buildings on the grounds that buildings’ value
typically increases over time. This argument, however, is
invalid. Generally, it is the land that increases in value, not the
buildings. Buildings generally have a limited useful life and this
must be recognised through depreciation charges.
Again, it should be emphasised that directors must depreciate
their buildings under existing accounting standards. Electing
not to depreciate buildings (and therefore failing to act in
compliance with AASB 116) will have the effect of increasing
the profits and total assets of the firm. However, these effects
may be reversed on the ultimate sale of the depreciable asset.
Although the above discussion has related to property, plant
and equipment, which are tangible assets, intangible assets
should also be systematically amortised over their useful lives.
As we know, ‘intangible assets’ are non-monetary assets
without physical substance and would include brand names,
copyrights, franchises, intellectual property, licences,
mastheads, patents and trademarks. The term ‘depreciation’ is
often used interchangeably with the term ‘amortisation’. The
terms have the same meaning; however, ‘depreciation’ is
generally used in relation to non-current assets that have
physical substance (such as property, plant and equipment)
whilst the term ‘amortisation’ is generally used in relation to
intangible non-current assets. We will consider intangible
assets in more depth in Chapter 8 . However, at this stage
we note that AASB 138 Intangible Assets applies to intangible
assets. AASB 138 requires that entities determine whether an
intangible asset has an indefinite or a finite useful life. For the
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Land and buildings
Page 3 of 6
purposes of AASB 138, an intangible asset is regarded as
having an indefinite useful life when, based on an analysis of
the relevant factors, there is no foreseeable limit on the period
over which the asset is expected to generate net cash inflows
for the entity. Where an intangible asset is considered to have
a finite life, paragraph 97 of AASB 138 requires that:
The depreciable amount of an intangible asset with a finite
useful life shall be allocated on a systematic basis over its
useful life. Amortisation shall begin when the asset is
available for use, that is, when it is in the location and
condition necessary for it to be capable of operating in the
manner intended by management. Amortisation shall cease at
the earlier of the date that the asset is classified as held for
sale (or included in a disposal group that is classified as held
for sale) in accordance with AASB 5 and the date that the
asset is derecognised. The amortisation method used shall
reflect the pattern in which the asset’s future economic
benefits are expected to be consumed by the entity. If that
pattern cannot be determined reliably, the straight-line
method shall be used. The amortisation charge for each
period shall be recognised in profit or loss unless this or
another Standard permits or requires it to be included in the
carrying amount of another asset.
Conversely, if an intangible asset is considered to have an
indefinite useful life, AASB 136, paragraph 107, states ‘an
intangible asset with an indefinite useful life shall not be
amortised’. Rather, the asset would be subject to annual
impairment testing. Impairment testing is addressed in
Chapter 6
and involves testing whether the recoverable am
ount of an asset—which is the higher of its fair value less costs
of disposal and its value in use—is greater or less than the
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Land and buildings
Page 4 of 6
carrying amount of the asset. If as a result of the
Page 190
testing it is found that the recoverable amount is less
than the carrying amount of the asset, then an impairment loss
shall be recognised.
Worked Example 5.5
further illustrates some of the issues
that we need to consider when determining how to depreciate
assets.
WORKED EXAMPLE 5.5:
A further consideration of
depreciable life
(a)
Ochillupo Ltd purchases a canning machine from a
major supplier holding a clearance sale. The machine
will start to be used in two years’ time, when Ochillupo
Ltd plans to expand the current business to include a
fruit-canning operation. The machine costs $150 000 at
the sale, a saving of $50 000 on its recommended retail
price. The machine will be kept in storage until it is
needed. It is reported to have a useful life of 10 years if
operating at full capacity.
(b)
Ochillupo Ltd recently purchased some new
commercial vehicles at a cost of $220 000. The
documentation that came with the vehicles boasts that
the useful economic life of these vehicles when they are
worked hard is approximately 150 000 km. Given the
size of the orchard in which the vehicles are to be used,
management estimates that it will take approximately
15 years to reach this level of usage. A new model
vehicle with exceptional advantages over the current
model is expected on the market within five years. The
company will probably update its vehicles when this
new model is released.
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Land and buildings
(c)
Page 5 of 6
An asset purchased six years ago for $100 000 had an
estimated useful life of seven years and accordingly will
be fully written off at the end of the next financial year.
The asset is being carried in the accounts as follows:
$
Cost
100 000
less Accumulated depreciation
(85 716)
14 284
A review by Ochillupo Ltd indicates that the machine can be
used effectively within the business for a further five years. It
has been established that the carrying amount of the asset is a
good approximation of the recoverable amount of that asset.
Required
Determine the appropriate depreciation treatment for the three
cases described.
Solution
(a)
Canning machine
The ‘depreciable amount’ will be the cost of the asset. The
recommended retail price is not relevant. The asset is not
earning revenue at present and is not expected to be used for
two years.
Depreciation should be charged from the time a depreciable
asset is first put into use or is held ready for use. Since the
canning machine is being held ready for use, it would seem
that depreciation should be charged immediately and
allocated over a period of 12 years.
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Land and buildings
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(b)
Commercial vehicles
These vehicles have a physical life of 15 years. However, they
are expected to be used by the present owner for only five
years—their technical life. Therefore the company should
depreciate the assets over five years.
The depreciable amount is the difference between the
carrying amount and the expected residual value. An estimate
of the residual value in five years is necessary.
(c)
Other assets
AASB 116 requires that an asset’s useful life should be
reviewed regularly. The company believes that the asset has
a useful life of five years and that the current carrying
amount is a good approximation of the recoverable amount of
that asset.
Thus the carrying value of $14 284 should be depreciated
over a revised estimated useful life of five years, providing a
revised depreciation charge of $2857 per year.
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Modifying existing non-current assets
Page 1 of 1
Modifying existing non-current assets
LO 5.2
Page 191
As indicated in Chapter 4 , when modifications or
improvements are made to existing non-current assets and
the expenditure is material and considered to enhance the
service potential of the asset, such expenditure should be
capitalised to the extent that particular accounting standards
do not preclude such capitalisation (for example, AASB 138
prohibits the capitalisation of expenditures on certain types of
intangible assets). Where expenditure is capitalised, the
expenditure would subsequently be depreciated to the entity’s
statement of profit or loss and other comprehensive income.
How we depreciate the modification or improvement will
depend upon whether the improvement or modification retains
a separate identity (perhaps an asset’s life is enhanced by
adding a component to the asset and that component can be
removed and used elsewhere if desired), or whether the
expenditure relates to something that becomes an integral
part of the asset and is not feasibly removable.
The depreciable amount of any addition or extension to an
existing depreciable asset that becomes an integral part of
that asset must be allocated over the remaining useful life of
that asset. The depreciable amount of any addition or
extension to an existing depreciable asset that retains a
separate identity and will be capable of being used after that
asset is disposed of must be allocated independently of the
existing asset, and on the basis of its own useful life.
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Disposition of a depreciable asset
Page 1 of 7
Disposition of a depreciable asset
LO 5.8
Items of property, plant and equipment can cease to be used
for a number of reasons. These include sale, exchange,
permanent withdrawal or destruction. Irrespective of the
method of disposal, the accounting treatments follow three
basic steps, these being:
l
eliminate the cost or revalued amount and the accumulated
depreciation
l
record the consideration received (if any)
l
record the gain or loss on disposal.
Sale
When an asset is sold, there will generally be either a profit or
a loss on the sale. In relation to calculating the gain or loss on
disposal of a depreciable asset, paragraph 71 of AASB 116
states:
The gain or loss arising from the derecognition of an item of
property, plant and equipment shall be determined as the
difference between the net disposal proceeds, if any, and the
carrying amount of the item.
The standard also states that ‘The gain or loss arising from the
derecognition of an item of property, plant and equipment
shall be included in profit or loss when the item is
derecognised’.
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Disposition of a depreciable asset
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As can be seen from the above material extracted from AASB
116, the standard adopts the term ‘derecognition’. The term
incorporates the retirement and disposal of an asset.
According to AASB 116, the carrying amount of an item of
property, plant and equipment is to be derecognised:
(a)
on disposal; or
(b)
when no future economic benefits are expected from
its use or disposal.
From the above requirements we can see that knowledge of
the ‘carrying amount’ of an item is necessary to determine the
gain or loss on ‘derecognition’ of an asset. As previously
indicated, the carrying amount of an asset is defined by AASB
116 as the amount at which an asset is recognised after
deducting any accumulated depreciation and accumulated
impairment losses (impairment losses, which arise when the
recoverable amount of an asset is less than its carrying
amount, are addressed in detail within Chapter 6 ).
Therefore, if a firm has decided not to depreciate an asset
(meaning the carrying amount will be higher), its profit on
sale would be lower than for a firm that had been depreciating
the asset.
For example, assume that a firm buys an item of plant for $25
000. It is expected to have a useful life of five years and no
salvage value. The firm sells the asset at the end of the third
year for $12 000. If the item has been depreciated according
to the straight-line method for three years, total depreciation
would amount to $15 000 and the carrying amount would be
$10 000. The profit on sale would be $2000. Hence the net
effect on profits over the three years would be negative $13
000 (profit on sale of $2000 less the accumulated depreciation
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Disposition of a depreciable asset
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of $15 000). If the item is not depreciated, its carrying
amount would still be $25 000, and the loss on sale Page 192
would be $13 000. The difference in expense
recognition would be a matter of timing.
Worked Example 5.6
looks at the disposal of a depreciabl
e asset.
WORKED EXAMPLE 5.6:
Disposal of a depreciable
asset
Sandon Point Ltd acquires an item of machinery on 1 July
2016 for a cost of $100 000. When the asset is acquired, it is
considered to have a useful life for the entity of five years.
After this time, the machine will have no residual value. It is
believed that the pattern of economic benefits would best be
reflected by applying the sum-of-digits method of
depreciation. However, contrary to expectations, on 1 July
2018 the asset is sold for $70 000.
Required
Calculate the gain or loss on disposal of the asset and provide
the appropriate journal entries in the books of Sandon Point
Ltd to record the disposal.
Solution
For an asset with a useful life of five years the sum-of-digits
depreciation is:
n(n + 1) ÷ 2 = 5 × 6 ÷ 2 = 15
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Disposition of a depreciable asset
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First year depreciation = 5
÷ 15 × $100 000 =
$33 333
Second year depreciation =
4 ÷ 15 × $100 000 =
$26 667
Total accumulated
depreciation at 1 July 2018
=
$60 000
Therefore the carrying amount of the asset is $40 000 as at
30 June 2018, made up of the historical cost of $100 000 less
the accumulated depreciation of $60 000. The gain on the sale
of the asset would therefore be represented by the difference
between the proceeds of the sale, and the carrying amount of
the machinery, which would give a gain of $30 000. Pursuant
to AASB 116, the gain or loss on disposal is recognised on a
‘net basis’. Using a ‘net basis’ means that the proceeds from
the disposal should not be separately treated as revenue.
The accounting entry would be:
Dr
Cash at
bank
70 000
Dr
Accumulated 60 000
depreciation—
machinery
Cr
Gain on sale
of
machinery
Cr
Machinery
30 000
100 000
Sale proceeds deferred
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When the receipt of the sale proceeds on the disposal of an
item of property, plant and equipment is deferred for a period
of time, the fair value of the consideration is to be recognised
initially at its ‘cash price equivalent’.
The requirement to record the sale proceeds at their current
cash equivalent is required by AASB 15 Revenue from
Contracts with Customers. The difference between the
nominal amount of the consideration and the current cash
equivalent is recognised as interest revenue. The discount rate
to be used is the rate at which the vendor could invest the
amount under similar terms and conditions. An example of
deferred sales proceeds is provided in
Worked Example 5.7 .
WORKED EXAMPLE 5.7:
Sale proceeds deferred
Assume the same information provided for Sandon Point
Limited in Worked Example 5.6
but this time the sale
proceeds of $70 000 will be received in two years’ time, on 30
June 2020. The applicable interest rate is 8 per cent.
Required
Provide the journal entries necessary to account for
the sale of the asset.
Page 193
Solution
Calculation of the present value of the consideration
receivable:
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$70 000 in 2 years at 8 % = $70 000 × 0.85 734 × $60 013
The journal entry at the date of the disposal is:
1 July 2018
Dr
Loan
receivable
60 013
Dr
Accumulated
60 000
Cr
Machinery
100 000
Cr
Gain on
sale of
machinery
20 013
At the end of the financial year, the increase in the value of
the loan receivable must be recognised. It will be calculated as
$60 013 × 8% = $4 801.
30 June 2019
Dr
Loan
receivable
Cr
Interest
revenue
4 801
4 801
Again, at the end of the second year, the increase in the value
of the receivable must be recognised, and then the receipt of
cash must be accounted for. The interest revenue to be
recognised equals ($60 013 + $4 801) × 8% = $5 186.
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Disposition of a depreciable asset
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30 June 2020
Dr
Loan
receivable
Cr
Interest
revenue
Dr
Cash at
bank
Cr
Loan
receivable
5 186
5 186
70 000
70 000
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Depreciation as a process of allocating the cost of an asset over its usefu... Page 1 of 4
Depreciation as a process of allocating the
cost of an asset over its useful life: further
considerations
LO 5.1 LO 5.2
As we have seen in this chapter, when we depreciate an asset
we are effectively allocating the cost (or revalued amount) of an
asset over its expected useful life . For example, if we acquire a
machine for $1000 000 that has an expected useful life of 10
years with no expected residual value we would recognise $100
000 in depreciation each year (assuming that the pattern of
benefits is expected to be uniform across the useful life of the
asset and assuming we have not revalued the asset). The effect
of this is that across the useful life of the asset we have reduced
profits by the cost of the machine, which was $1 000 000. What
must be appreciated, however, is that the cost of replacing the
machine might have increased across time so that it is greater
than the aggregate amount that we have recognised as a
depreciation expense. For example, if the cost of replacing the
machine after 10 years has doubled to $2 000 000, it could be
argued that we have not recognised sufficient expenses and
might have distributed to shareholders too much in dividends
(dividends being distributed out of profits). Indeed, this is one of
the main criticisms of historical-cost accounting (Chapter 3
briefly considered some alternative approaches to historical-cost
accounting, which take into account current valuations of
assets). We will address asset revaluations in the next chapter;
however, at this stage we should note that if assets are revalued
to fair value at regular intervals this has the effect of increasing
the total amount of depreciation being recognised, thereby
reducing profits and hence the amount available to distribute in
the form of dividends.
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It is not our intention to pursue the above issue about
depreciation any further at this point. Nevertheless, you should
consider whether you think that allocating the historical cost of
an asset over its useful life (and therefore recognising this cost
as an expense) is appropriate when the cost of that
Page 194
asset might be significantly increasing across time due
to factors such as inflation. The article adapted in Financial
Accounting in the Real World 5.1
by Roger Montgomery ca
lled ‘Airline losses masked as profits’, which appeared in The
Australian Financial Review of 19 December 2003, outlines some
interesting arguments in relation to the use of depreciation in
the airline industry. Consider whether you agree with the
arguments being presented in the newspaper article.
5.1 FINANCIAL ACCOUNTING IN THE real
world
A stark warning to investors in airlines
Roger Montgomery, director of Clime Asset Management, issued
a stark warning to small investors against choosing to invest in
airlines. He said that because airlines are ‘capital-intensive,
fiercely competitive and ultimately selling a commodity’ they are
not a secure long-term investment.
Capital-intensive businesses are allowed by present accounting
standards and practices to post a profit by depreciating big
items like equipment, plant and property based on historical
costs. As the business deducts inadequate expenses, not
reflecting the reality of the present day, the published profit
doesn’t accurately reflect the viability of the business.
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For example, in the airline business, the replacement cost of an
aircraft today, and the costs of servicing and maintaining it, are
far higher than the cost of a plane bought 20 years ago and
maintained and serviced for that period. Montgomery believes
that ‘depreciation’ should be substituted as an accounting entry
by something that reflects replacement cost.
He gave the following illustration of his thesis:
Take a business that purchased $1 million of machinery 25 years
ago. Over the ensuing 2.5 decades, profits have been reduced
by $1 million in depreciation, leaving an assumed total profit
over the period of $2.5 million. If we assume that machinery
with the same capacity has risen in price by the rate of inflation,
say 4 per cent, then the replacement cost of the machinery
would be $2.7 million. If the machinery is to be replaced so that
the business is in the same position, the cost to and the cost of
running the business is 2.5 times more than that which has been
accounted for.
For the business to continue it will have to outlay $2.7 million,
thus the accounting profits have been exaggerated by $1.7
million. The company has made an economic profit over the 25
years of $800 000, not the $2.5 million it declared.
Even worse, the company would have paid taxes on a higher
declared profit and may have paid dividends it could not afford.
Move from millions to tens of billions and you get some idea of
the magnitude of the problem.
When creditors refuse to extend further credit to businesses out
on a limb with debt and leasing arrangements, as happened with
United Airlines, shareholders suffer. The business collapses as
shareholders are asked to keep it afloat by continuing injections
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of funds.
Montgomery gives the example of an Australian airline where
although capital raising by shareholders rose 18 per cent each
year over five years and retained earnings averaged three per
cent annually, shareholders’ equity only increased by 5.56 per
cent over the period. Not a good result.
SOURCE: Adapted from ‘Airline losses masked as profits’, by Roger Montgomery, The
Australian Financial Review, 19 December 2003, p. 23
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Disclosure requirements
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Disclosure requirements
LO 5.9
AASB 116 provides a number of disclosure requirements in
relation to depreciation. As we will see below, the disclosures
will be required for each ‘class of property, plant and
equipment’. AASB 116 states that a class of property, plant
and equipment is a grouping of assets of a similar nature and
use in an entity’s operations. Examples of separate classes
would be: land; land and buildings; machinery; ships; aircraft;
motor vehicles; furniture and fixtures; and office equipment.
Paragraph 73 of AASB 116 requires (and these
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disclosures would be made in the notes to the
financial statements) the following:
The financial statements shall disclose, for each class of
property, plant and equipment:
(a) the measurement bases used for determining the gross
carrying amount;
(b)
the depreciation methods used;
(c)
the useful lives or the depreciation rates used;
(d)
the gross carrying amount and the accumulated
depreciation (aggregated with accumulated impairment
losses) at the beginning and end of the period; and
(e) a reconciliation of the carrying amount at the beginning
and end of the period showing:
(i)
additions;
(ii)
assets classified as held for sale or included in a
disposal group classified as held for sale in accordance
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with AASB 5 and other disposals;
(iii)
acquisitions through business combinations;
(iv)
increases or decreases resulting from
revaluations and from impairment losses recognised or
reversed in other comprehensive income in accordance
with AASB 136;
(v)
impairment losses recognised in profit or loss in
accordance with AASB 136;
(vi)
impairment losses reversed in profit or loss in
accordance with AASB 136;
(vii)
depreciation;
(viii)
the net exchange differences arising on the
translation of the financial statements from the
functional currency into a different presentation
currency, including the translation of a foreign
operation into the presentation currency of the
reporting entity; and
(ix)
other changes.
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Summary
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SUMMARY
The chapter considered a number of issues relating to the
depreciation of non-current assets. It made specific reference
to the applicable Accounting Standard AASB 116 Property,
Plant and Equipment for depreciation requirements as they
pertain to property, plant and equipment. The chapter also
referred to AASB 138 Intangible Assets for details of how
intangible assets should be amortised. The focus in this
chapter was predominantly on property, plant and equipment.
From an accounting perspective, depreciation represents the
allocation of the cost of an asset, or its revalued amount, over
the accounting periods expected to benefit from its use. That
is, depreciation is an allocation process rather than a valuation
process.
Three general issues arise when accounting for depreciation:
determination of the depreciable base of the asset; the useful
life of the asset; and the method to be used in allocating the
cost of the asset over the various accounting periods. There is
also a decision to be made about when to start depreciating
an asset. The depreciable base of the asset will be its
historical cost, or its revalued amount, less any anticipated
residual to be received from the ultimate disposal of the asset
at the end of its useful life, less any impairment losses that
have been recognised. The determination of useful life will
depend on judgements relating to the physical, technical and
commercial life of the asset. The method used to allocate the
cost of the asset should reflect the pattern of benefits being
derived from its use, taking into account issues associated
with the physical wear and tear on the asset and technical and
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commercial obsolescence. There are various methods of
depreciation, including the straight-line method; sum-of-digits
method; declining-balance method; and depreciation
calculated on a production basis. The method used should
reflect the pattern of benefits being generated by the asset.
Depreciation itself should start from the time when a
depreciable asset is first put into use or is held ready for use.
When a depreciable asset is ultimately sold, the difference
between the net amount received on disposal and its historical
cost, or other revalued amount substituted for historical cost,
less accumulated depreciation and less any accumulated
impairment losses must be recognised in the profit or loss of
the period.
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Key terms
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KEY TERMS
declining-balance method
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depreciable amount
depreciable asset
depreciation
straight-line method
sum-of-digits method
useful life
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End-of-chapter exercises
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END-OF-CHAPTER EXERCISES
Fistral Ltd acquires a blank-making machine—blanks are the
inner foam core of a surfboard—for the following amounts:
• Initial price paid to the
supplier on 1 July 2017:
$70 000
• Cost to deliver the
machine to the site:
$ 5 000
• Amount paid to an
engineer to make the
machine work:
$35 000
The engineer completes her work on 31 December 2017.
It is expected that the benefits from the blank-making
machine will be derived uniformly over 10 years and that the
machine will have no residual value.
On 1 July 2018, an additional component is acquired at a cost
of $60 000 and is attached to the blank-making machine
acquired on 1 July 2017. Although this does not extend the life
of the blank-making machine, it makes the machine more
efficient. The additional component is expected to have a
useful life of 20 years, and to be able to be used on other
machines when the useful life of the existing blank-making
machine is over. At the end of 20 years the component will
have no residual value.
REQUIRED
Determine the total depreciation expense for the blank-
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End-of-chapter exercises
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making machine and attachment for the year ended 30 June
2019.
LO 5.1
5.2
5.3
5.4
SOLUTION TO END-OF-CHAPTER EXERCISE
As the additional component can continue to be used beyond
the life of the blank-making machine, the two items should be
depreciated independently. As the benefits are expected to be
derived uniformly, it is appropriate to use the straight-line
method of depreciation.
The depreciable amount of the blank-making machine should
include the initial cost, delivery cost and the amount paid to
the engineer—that is, the costs necessary to get the machine
into a usable state. This gives a total cost of $110 000. One
year’s depreciation of this, assuming no residual and a life of
10 years, is $11 000.
The depreciation expense of the additional component will be
its cost allocated over 20 years. This gives an amount of $3
000. Hence the total depreciation expense for the year to 30
June 2019 is $14 000.
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REVIEW QUESTIONS
1.
Does depreciation reflect a change in the fair value of
an asset? LO 5.1
2.
Define ‘useful life’ in terms of the decision to depreciate
an asset. LO 5.2 , 5.3
3.
What effect does depreciation have on the statement of
profit or loss and other comprehensive income, and on the
statement of financial position? LO 5.2
4.
An item of plant is acquired at a direct cost of $110
000. It requires installation and modifications amounting to
$20 000 and $10 000, respectively, before it is efficiently
operational. It is expected to have a useful life of six years,
at which point it will have a residual value of $15 000.
REQUIRED
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Provide the depreciation entries for the first two years
using:
(a) the sum-of-digits method
(b)
the declining-balance method
(c)
the straight-line method. LO 5.3
, 5.4
5.
What is the difference between amortisation and
depreciation? LO 5.1
6.
You have been appointed the accountant of a new
organisation that is preparing its first set of financial
statements. In determining the depreciation for the first
year, what sorts of information would you need? LO 5.3
5.4 , 5.5
,
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7.
You are the accountant for a manufacturing company
and have decided to review the depreciation expenses being
recognised. Your review has caused the depreciation charges
for a number of factory machines to increase significantly. In
response to this change a number of the factory managers
are angry at you as they believe that they have put in place
maintenance schedules that will extend the workable lives of
the assets for a number of years and hence should have led
to a reduction in the depreciation expenses being recognised.
How would you justify your proposed increases in
depreciation expenses? LO 5.1 , 5.2 , 5.7
8.
The financial statements of ABC Ltd indicate that the
directors did not depreciate their buildings on the basis that
the increase in the value of the associated land more than
offset the decline in the value of the buildings, and the
increase in the value of the land was not treated as income.
Is this a valid argument? LO 5.1 , 5.2
9.
Staunton Ltd acquires a new tractor for its pineapple
farm. The tractor is expected to be operational for a period of
18 years, although a more economical version, which
Staunton Ltd’s competitors will probably acquire, will be
available in six years. It is envisaged that Staunton Ltd will
close down in 15 years, as its existing lease will expire.
REQUIRED
Determine the number of periods over which the tractor
should be depreciated. LO 5.1 , 5.3
10.
What could motivate management to use one method
of depreciation in preference to another? LO 5.3 , 5.4
11.
How is the gain or loss on the disposal of a non-
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current asset determined? LO 5.8
12.
Winkipop Ltd acquires an item of machinery on 1 July
2015 for a total acquisition cost of $90 000. The life of the
asset is assessed as being six years, after which time
Winkipop Ltd expects to be able to dispose of the asset for
$10 000. It is expected that the benefits will be generated in
a pattern that is best reflected by the sum-of-digits
depreciation approach. On 1 July 2018, owing to unforeseen
circumstances, the machinery is exchanged for a motor
vehicle. The motor vehicle is two years old, originally cost
$30 000 and has a fair value of $20 000.
REQUIRED
Provide the journal entry to record the disposal of the
machinery on 1 July 2018. LO 5.4 , 5.8
13.
What considerations would you take into account
when deciding to use one depreciation method, for example,
the straight-line method, in preference to another? LO
5.3 , 5.4
14.
If a company depreciates its property, plant and
equipment, what are the associated disclosure requirements?
LO 5.9
15.
Can an organisation switch depreciation methods
from one financial period to the next? LO 5.7
16.
On 1 July 2017, Bells Beach Tourist Operations
acquired an aircraft that can be used for taking wealthy
surfers to remote surfing destinations with lovely waves and
limited crowds. The aircraft cost $12 000 000. An engineer’s
analysis commissioned by the company determined that the
aircraft could be broken down into the following components:
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airframe, engines and fittings. The airframe comprised 55
per cent of the cost, while the engines were 40 per cent of
the cost, with the fittings comprising 5 per cent of the cost.
The airframe is estimated to have a useful life of 15
years. At the end of its useful life it will have an
estimated scrap value of $150 000. The engines have
an estimated useful life of 20 000 hours, while the
fittings are expected to have a useful life of five years.
Both the engines and the fittings are expected to have
no residual value at the end of their useful lives.
During the first year the aircraft was operating for
2920 hours.
REQUIRED
Prepare all journal entries necessary to account for the
acquisition of the aircraft, and its depreciation, for the
year ending 30 June 2018. LO 5.4 , 5.5
17.
Assume you are the accountant for an
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organisation and that the managing director
queries you about an item of machinery that is shown in the
financial statements at a cost of $200 000 less accumulated
depreciation of $60 000. He tells you that you need to
recognise more depreciation for the asset as he is convinced
that the fair value of the machinery at reporting date is only
$110 000. How would you respond to his query? LO 5.1 ,
5.7
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CHALLENGING QUESTIONS
18.
Is depreciation an allocation process or a valuation
process? Provide reasons for your answer. LO 5.1 , 5.2
19.
At the beginning of 2015, Lorne Ltd acquired an item of
machinery at a cost of $100 000. At the time it was expected
that the machinery would have a useful life of 10 years and a
residual value of $10 000. Until the end of the 2017 financial
year the depreciation expense was recognised on a straightline basis. At the beginning of the 2018 financial year the
remaining useful life was reassessed as being 11 years and the
residual value was reassessed at $14 000.
REQUIRED
Calculate the depreciation expense for the 2016, 2017 and
2018 financial years. LO 5.3 , 5.4 , 5.7
20.
Anglesea Ltd constructed a building in 2014 for a cost of
$960 000. The building was expected to have a useful life of 25
years after which time it would be demolished at an expected
demolition cost of $100 000. Being on the coast, the building
was subject to wild winds at times. At the end of the 2018
financial year the roof of the building was blown away and a
replacement was constructed at a cost of $200 000. It was
predicted that by replacing the building’s roof its expected
useful life would be extended a further 25 years after the end
of the 2018 financial year.
REQUIRED
Calculate the depreciation cost for the 2017, 2018 and
2019 financial years. LO 5.7
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21.
Lonsdale Ltd has a machine that makes one type of fin
for surfboards. The machine was acquired in 2016 at a cost of
$20 000 and it is expected that the machine will be able to
produce approximately 2000 fins before it would need to be
replaced. It is not expected to have any residual value. At the
beginning of the 2019 financial year an attachment for the
machine is acquired at a cost of $5000, which feeds the sheets
of fibreglass into the fin-making machine. The attachment is
expected to have a life of five years and can be utilised on
other machines if required. The attachment will act to extend
the useful life of the fin-making machine so that after 2019 the
fin-making machine is expected to be able to produce a further
1000 fins in total. The numbers of fins produced in 2016, 2017,
2018 and 2019 were 400, 600, 500 and 800, respectively.
REQUIRED
Calculate the depreciation expense for the fin-making
machine and attachment for each of the years from 2016
to 2019 and discuss whether the expense would be
included as part of the cost of inventory. LO 5.3 , 5.4
22.
Wastewater Ltd acquired an item of plant on 1 July
2016 for $3 660 000. When the item of plant was acquired, it
was initially assessed as having a life of 10 000 hours. During
the reporting period ending 30 June 2017 the plant was
operated for 3000 hours.
At 1 July 2017 the plant had a remaining useful life of
7000 hours. On 1 July 2017 the plant underwent a major
upgrade costing $234 600. Management believes that
this upgrade will add a further 2000 hours of operating
time to the plant’s life. During the reporting period ended
30 June 2018 the plant was operated for 4000 hours.
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On 1 July 2018 the plant underwent a further major
upgrade, the cost of which amounted to $344 900, and
this added a further 3100 hours’ operating time to its life.
During the reporting period ending 30 June 2019 the
plant was operated for 3800 hours.
REQUIRED
Prepare all the journal entries that Wastewater Ltd would
prepare for the years ending 30 June 2017, 30 June 2018
and 30 June 2019 to account for the acquisition,
subsequent expenditure and depreciation on the asset. LO
5.2 , 5.3 , 5.4 , 5.7
23.
On 1 July 2015 Sprintfast Couriers Ltd, which
has a year-end of 30 June, purchased a delivery
truck for use in its courier operations at a cost of $65 000. At
the end of the truck’s useful life it is expected to have a
residual value of $5000. During its six-year useful life,
Sprintfast Couriers Ltd expected the truck to be driven 246 000
kilometres.
REQUIRED
Calculate the annual depreciation charge for each of the
six years of the truck’s life using the following methods:
LO 5.4
(a)
the straight-line method
(b)
the sum-of-digits method
(c)
the declining-balance method
(d) the units-of-production method using kilometres
as the basis of use and assuming the following usage:
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Year
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Kilometres
2016
28 000
2017
34 000
2018
42 000
2019
55 000
2020
68 000
2021
19 000
246 000
24.
On 1 July 2015, Bear Island Ltd acquires a computer for
an initial cost of $50 000. To make the computer more efficient
in the workplace, a number of hardware modifications are
necessary before installation. These modifications cost $40
000. The computer is ready for use on 1 January 2016. The
computer is expected to be used by the entity for a period of
five years, after which time it will be scrapped. On 1 July 2017,
a high-speed disk drive is acquired at a cost of $20 000. This
disk drive will work only on the existing computer.
REQUIRED
Determine the total depreciation expense for the computer
and disk drive for the year ended 30 June 2018, using the
straight-line method, and provide the required journal
entries. LO 5.2 , 5.3 , 5.4
25.
Gazza Ltd acquires a machine for a cost of $29 000. It
is expected that the machine will continue to be operational for
seven years, during which time it is expected to run for 35 000
hours. The estimated residual value of the machine is $7 000
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at the end of its useful life.
REQUIRED
Calculate the depreciation charge for each of the first
three years, using the following methods:
(a)
the straight-line method
(b)
the sum-of-digits method
(c)
rate
the declining-balance method, using a 33 per cent
(d)
the units-of-production method, based on hours
of operation, given that operating times are as follows:
year 1
6 000 hours
year 2
7 000 hours
year 3
5 500 hours
LO 5.4
26.
First Point Ltd acquires an item of machinery on 1 July
2015 for a cost of $250 000. When the asset is acquired, it is
considered to have a useful life for the entity of six years. After
this time, the machine will have no residual value. It is
believed that the pattern of economic benefits would best be
reflected by applying the sum-of-digits method of depreciation.
However, contrary to expectations, on 1 July 2018 the asset is
sold for $110 000. The amount is to be received as follows:
$60 000 on 30 June 2019 and $50 000 on 30 June 2020. The
applicable interest rate is 6 per cent.
REQUIRED
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Calculate the profit on disposal of the asset and provide
the appropriate journal entries in the books of First Point
Ltd to record the disposal and the subsequent receipts of
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cash. LO 5.8
27.
Brisbane Ltd purchased a property 10 years ago for $3
000 000. Included in this amount is $350 000 that relates to
buildings constructed on the land. A recent valuation has
shown that the property is now valued at $5 400 000. The
valuer has suggested that the location of the property and the
quality of the soil are such that it is unlikely that the value will
ever drop below the initial cost of acquisition. The buildings on
the property are of a general nature.
REQUIRED
Describe the appropriate depreciation treatment. LO
5.1 , 5.2 , 5.6
28.
On 1 July 2016 Long Boards Ltd acquired a printing
machine at a cost of $120 000. At acquisition the machine had
an expected useful life of 12 000 machine hours and was
expected to be in operation for four years, after which it would
have no residual value. Actual machine hours were 3000 in the
year ended 30 June 2017 and 3 400 in the year ended 30 June
2018. On 1 July 2018 the machine was sold for $50 000.
REQUIRED
(a)
Prepare journal entries to record depreciation of
the printing machine for each of the years ended 30 June
2017 and 30 June 2018 using the straight-line method.
State the carrying amount of the machine at the end of
each period. Prepare the journal entry to record the sale
of the machine on 1 July 2018.
(b)
Prepare journal entries to record depreciation of
the printing machine for each of the years ended 30 June
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2017 and 30 June 2018 using the declining-balance
method with a depreciation rate of 40 per cent. State the
carrying amount of the machine at the end of each
period. Prepare the journal entry to record the sale of the
machine on 1 July 2018.
(c)
Prepare journal entries to record depreciation of
the printing machine for each of the years ended 30 June
2017 and 30 June 2018 using the sum-of-digits method.
State the carrying amount of the machine at the end of
each period. Prepare the journal entry to record the sale
of the machine on 1 July 2018.
(d)
Prepare journal entries to record depreciation of
the printing machine for each of the years ended 30 June
2017 and 30 June 2018 using the production basis. State
the carrying amount of the machine at the end of each
period. Prepare the journal entry to record the sale of the
machine on 1 July 2018. LO 5.3 , 5.4 , 5.8
29.
Malibu Ltd acquired a building on 1 July 2011 at a cost
of $800 000. The useful life of the building was estimated as 20
years with no residual value. Malibu Ltd used the straight-line
method of depreciation. On 30 June 2017 the estimate of the
remaining useful life of the building was revised to 15 years.
REQUIRED
Prepare journal entries for depreciation of the building for
the years ended 30 June 2016, 2017 and 2018, and state
the carrying amount of the building at the end of each of
the three reporting periods. LO 5.6
30.
Read the adapted article below in Financial
Accounting in the Real World 5.2
originally entitled ‘Doin
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g it tough? Let them watch pay TV’ by Lisa Murray, which
appeared in The Sydney Morning Herald on 4 August 2006, and
provide a reason to justify Austar’s change in depreciation
policy. LO 5.7
5.2 FINANCIAL ACCOUNTING IN THE REAL
WORLD
Austar results unaffected by tough times in
the regions
Austar, controlled by John Malone’s Liberty Group, a US media
company, reported a half-year net profit of $26.5 million (a 48
per cent increase). After a debt refinancing which decreased its
interest payments its plan is to pay a special dividend of $202
million to shareholders (at 16 cents per share).
The strong result was assisted by both increasing subscriber
numbers (there are now more than 570 000 in the regions) and
a change in accounting practice where installation costs are
depreciated over a longer period (five years not three), cutting
$6.3 million from depreciation expense in the current period.
The CEO, John Porter, believes petrol prices in regional Australia
have more impact on people than interest rate rises so expects
the latest interest rate rise will have no impact on Austar. People
who are staying at home because they are minimising car use
rely on their pay TV subscription for entertainment.
Porter predicts that in three to five years, without acquisitions,
Austar will double its business. The company has also moved
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into provision of broadband, launching in Wagga in June, but
would not confirm take-up numbers. Its plans include providing
broadband via its network in 25 other markets (a total of 750
000 subscribers) and, in a joint exercise with Unwired Group and
SP Telemedia (Soul), attempting to gain government funding to
extend the network to another 750 000 subscribers. After WIN
Corporation’s takeover bid for the pay TV company SelecTV
Austar shares fell to $1.30 (down 1.5 cents) but Porter denied
concern.
SOURCE: Adapted from ‘Doing it tough? Let them watch pay TV’, by Lisa Murray, The
Sydney Morning Herald, 4 August 2006, p. 21
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31.
Many organisations measure their property,
plant and equipment at cost, less accumulated
depreciation and accumulated impairment losses (while other
organisations might measure their property, plant and
equipment at fair value). You are required to discuss some of
the problems associated with basing depreciation expense on
historical cost (rather than some other value, such as
replacement cost). You are also required to explain why
managers might prefer to measure property, plant and
equipment using the cost model rather than measuring the
assets on the basis of fair value. LO 5.2 , 5.3
32.
Possoes Ltd acquired an aeroplane in 2016 for $75
million. Possoes does not revalue its assets, but instead
measures its aeroplanes at cost less accumulated depreciation.
If the cost of the same type of aeroplane increases to $110
million over the next three years, and assuming that the
organisation distributes all of its profits to shareholders (in the
form of dividends), then does the practice of basing
depreciation on historical cost create any possible problems for
the organisation? If, by contrast, the organisation periodically
revalues its assets to fair value, would this have acted to
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Challenging questions
alleviate such problems? LO 5.1
Page 10 of 10
, 5.2
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Introduction
Page 1 of 3
Chapter 6
Page 202
REVALUATIONS AND IMPAIRMENT
TESTING OF NON-CURRENT ASSETS
LEARNING OBJECTIVES (LO)
6.1 Be able to measure the cost of property, plant and
equipment.
6.2
Understand the meaning of ‘fair value’.
6.3 Understand how and when to revalue an item of
property, plant and equipment in accordance with AASB 116
Property, Plant and Equipment.
6.4 Understand how and when to revalue an intangible
asset in accordance with AASB 138 Intangible Assets.
6.5 Understand the meaning of ‘recoverable amount’ and
be able to calculate it.
6.6 Understand the difference in accounting treatments for
upward revaluations to ‘fair value’, as opposed to writedowns to ‘recoverable amount’.
6.7 Understand what an ‘impairment loss’ is and know
when and how to account for one in accordance with AASB
136 Impairment of Assets.
6.8 Understand how to account for revaluations that
reverse previous revaluation increments or decrements.
6.9 Understand how to account for accumulated
depreciation when a non-current depreciable asset is
revalued, and understand that, subsequent to revaluation,
new depreciation charges will be based on the revalued
amount of the non-current asset.
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Introduction
Page 2 of 3
6.10 Know how the profit on disposal of a revalued noncurrent asset is determined and understand how asset
revaluations can affect an organisation’s profits owing to
changes in depreciation expenses and in final gains or losses
on the sale of the revalued asset.
6.11 Understand the meaning of a ‘cash-generating unit’
and why it is relevant to calculating depreciation and
impairment losses.
6.12 Be able to explain possible motivations that might
drive an organisation to elect, or not elect, to revalue its
non-current assets to fair value.
6.13 Know the disclosure requirements pertaining to asset
revaluation and impairment losses.
Page 203
Introduction to revaluations and
impairment testing of non-current assets
Financial statements prepared under the historical-cost
accounting convention are frequently criticised on the ground
that recorded historical cost might bear no relation to the
current value of the assets concerned. Within Australia,
entities are permitted to revalue many of their non-current
assets, either upwards or downwards, to reflect their current
value. However, while many non-current assets may be
revalued, the revaluing of certain types of assets is specifically
excluded by virtue of some accounting standards. For
example, AASB 138 Intangible Assets will permit some
intangible assets to be revalued upwards only when there is
an ‘active market’ for the asset. An active market is deemed
to exist when the items being traded within the market are
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Introduction
Page 3 of 3
homogeneous, willing buyers and sellers can normally be
found at any time, and prices are available to the public. AASB
138 also specifically excludes the revaluation of many types of
internally generated intangibles, such as brand names,
publishing titles and so forth. We concentrate on intangible
assets in Chapter 8 . The requirements for undertaking
revaluations of property, plant and equipment (covered by
AASB 116) are not as strict as those imposed for intangibles,
and an item of property, plant and equipment may be
revalued to the extent that a ‘fair value’ can be determined. In
this chapter our discussion will relate chiefly to the revaluation
of property, plant and equipment.
So, within Australia, we have a system that allows many noncurrent assets to be revalued from cost to fair value.
Interestingly, while upward asset revaluations are not
permitted in some countries, such as the USA, they are
permitted in others, in particular, those countries that have
adopted accounting standards released by the IASB (such as
Australia, the United Kingdom and the European Union).
Revaluations have been permitted in Australia for many years.
In those situations where the carrying value of an asset
exceeds the recoverable amount , AASB 136 Impairment of
Assets requires that the non-current asset be written down to
its recoverable amount. Impairment losses, which we also
address in some depth in this chapter, should not be confused
with depreciation (which was covered in the previous chapter).
Depreciation is recognised even if the recoverable amount of
an asset exceeds its carrying amount .
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Introduction
Page 1 of 3
Chapter 6
Page 202
REVALUATIONS AND IMPAIRMENT
TESTING OF NON-CURRENT ASSETS
LEARNING OBJECTIVES (LO)
6.1 Be able to measure the cost of property, plant and
equipment.
6.2
Understand the meaning of ‘fair value’.
6.3 Understand how and when to revalue an item of
property, plant and equipment in accordance with AASB 116
Property, Plant and Equipment.
6.4 Understand how and when to revalue an intangible
asset in accordance with AASB 138 Intangible Assets.
6.5 Understand the meaning of ‘recoverable amount’ and
be able to calculate it.
6.6 Understand the difference in accounting treatments for
upward revaluations to ‘fair value’, as opposed to writedowns to ‘recoverable amount’.
6.7 Understand what an ‘impairment loss’ is and know
when and how to account for one in accordance with AASB
136 Impairment of Assets.
6.8 Understand how to account for revaluations that
reverse previous revaluation increments or decrements.
6.9 Understand how to account for accumulated
depreciation when a non-current depreciable asset is
revalued, and understand that, subsequent to revaluation,
new depreciation charges will be based on the revalued
amount of the non-current asset.
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Introduction
Page 2 of 3
6.10 Know how the profit on disposal of a revalued noncurrent asset is determined and understand how asset
revaluations can affect an organisation’s profits owing to
changes in depreciation expenses and in final gains or losses
on the sale of the revalued asset.
6.11 Understand the meaning of a ‘cash-generating unit’
and why it is relevant to calculating depreciation and
impairment losses.
6.12 Be able to explain possible motivations that might
drive an organisation to elect, or not elect, to revalue its
non-current assets to fair value.
6.13 Know the disclosure requirements pertaining to asset
revaluation and impairment losses.
Page 203
Introduction to revaluations and
impairment testing of non-current assets
Financial statements prepared under the historical-cost
accounting convention are frequently criticised on the ground
that recorded historical cost might bear no relation to the
current value of the assets concerned. Within Australia,
entities are permitted to revalue many of their non-current
assets, either upwards or downwards, to reflect their current
value. However, while many non-current assets may be
revalued, the revaluing of certain types of assets is specifically
excluded by virtue of some accounting standards. For
example, AASB 138 Intangible Assets will permit some
intangible assets to be revalued upwards only when there is
an ‘active market’ for the asset. An active market is deemed
to exist when the items being traded within the market are
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Introduction
Page 3 of 3
homogeneous, willing buyers and sellers can normally be
found at any time, and prices are available to the public. AASB
138 also specifically excludes the revaluation of many types of
internally generated intangibles, such as brand names,
publishing titles and so forth. We concentrate on intangible
assets in Chapter 8 . The requirements for undertaking
revaluations of property, plant and equipment (covered by
AASB 116) are not as strict as those imposed for intangibles,
and an item of property, plant and equipment may be
revalued to the extent that a ‘fair value’ can be determined. In
this chapter our discussion will relate chiefly to the revaluation
of property, plant and equipment.
So, within Australia, we have a system that allows many noncurrent assets to be revalued from cost to fair value.
Interestingly, while upward asset revaluations are not
permitted in some countries, such as the USA, they are
permitted in others, in particular, those countries that have
adopted accounting standards released by the IASB (such as
Australia, the United Kingdom and the European Union).
Revaluations have been permitted in Australia for many years.
In those situations where the carrying value of an asset
exceeds the recoverable amount , AASB 136 Impairment of
Assets requires that the non-current asset be written down to
its recoverable amount. Impairment losses, which we also
address in some depth in this chapter, should not be confused
with depreciation (which was covered in the previous chapter).
Depreciation is recognised even if the recoverable amount of
an asset exceeds its carrying amount .
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Measuring property, plant and equipment at cost or at fair value—the ch... Page 1 of 3
Measuring property, plant and equipment
at cost or at fair value—the choice
LO 6.1 LO 6.2 LO 6.4
The relevant accounting standard is AASB 116 Property, Plant
and Equipment. AASB 116 covers a number of issues, including
determining the cost of property, plant and equipment and the
depreciation, derecognition and revaluation of property, plant
and equipment. In this chapter we will concentrate on
revaluations and impairment of property, plant and equipment.
Once an item of property, plant and equipment has been
recognised by an entity, AASB 116 requires each class of
property, plant and equipment to be measured either at cost
(referred to in the standard as the ‘cost model’), or at fair
value (referred to as applying the ‘revaluation model’). It is
permissible for some classes of property, plant and equipment
to be valued at cost and other classes to be valued at fair
value, but an entire class must be measured on the same
basis. Specifically, the requirements of paragraphs 30, 31 and
36 of AASB 116 are as follows:
30. Cost model
Page 204
After recognition as an asset, an item of property,
plant and equipment shall be carried at its cost less any
accumulated depreciation and any accumulated impairment
losses.
31. 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 the revaluation less any subsequent accumulated
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Measuring property, plant and equipment at cost or at fair value—the ch... Page 2 of 3
depreciation and subsequent accumulated impairment losses.
Revaluations shall be made with sufficient regularity to ensure
that the carrying amount does not differ materially from that
which would be determined using fair value at the end of the
reporting period.
36. If an item of property, plant and equipment is revalued,
the entire class of property, plant and equipment to which
that asset belongs shall be revalued.
Again, it is emphasised that a class of property, plant and
equipment can be measured by using either the cost model or
the revaluation model (which adopts fair values as the basis of
measurement) as described above, but all assets within a
given class must be measured on the same basis. AASB 116
defines a class of property, plant and equipment as a grouping
of assets with a similar nature and use within an entity’s
operations. The following are examples of separate classes:
l
land
l
buildings
l
machinery
l
ships
l
aircraft
l
motor vehicles
l
furniture and fittings.
Once an entity elects to value a class of assets on the basis of
fair value—that is, it adopts the revaluation model—it is
expected to maintain this basis of valuation for this class of
assets. However, AASB 116 allows an entity to switch from the
fair-value basis of valuation back to the cost basis as long as
the change generates financial information that is more
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Measuring property, plant and equipment at cost or at fair value—the ch... Page 3 of 3
relevant and reliable and as long as adequate disclosures of
the change in accounting policy are made.
Clearly, by permitting some classes of non-current assets to be
valued on the cost basis and others to be valued at fair value,
we have not eliminated the confusion associated with
understanding what the total balance of non-current assets
actually represents. It is neither cost nor fair value, but a
combination of the two. How meaningful do you think this
aggregated number is?
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The use of fair values
Page 1 of 3
The use of fair values
LO 6.2
Where a revaluation of an item of property, plant and
equipment is undertaken (which under AASB 116 is the
‘allowed alternative treatment’ to the cost model), the
revaluation must be to fair value rather than to any other
value. A revaluation can be defined as the act of recognising a
reassessment of the carrying amount of a non-current asset to
its fair value as at a particular date, but excluding impairment
losses. Fair value is defined in the accounting standard and in
accordance with AASB 13 Fair Value Measurement as ‘the price
that would be received to sell an asset or paid to transfer a
liability in an orderly transaction between market participants
at the measurement date’. This definition of fair value is the
same as that of fair value used in other accounting standards.
Hence, under AASB 116 a specific valuation method has been
stipulated, this being fair value.
How does an entity determine
fair value?
The commentary in AASB 116 as well as the contents of AASB
13 provide some guidance on determining fair values. It is
emphasised that fair values are determined on the basis that
the entity is a going concern and there is no need or intention
to liquidate its assets. If there is an active and liquid market
for an asset, the market price represents evidence of the
asset’s fair value. Otherwise, reference should be made to the
price (based on the best evidence available) at which the asset
could be exchanged between knowledgeable, willing parties in
an arm’s length transaction.
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The use of fair values
Page 2 of 3
AASB 116 requires certain disclosures to be made in the notes
to the financial statements in respect of how fair values were
determined for the purposes of a revaluation. Specifically,
paragraph 77 requires, in addition to the disclosures required
by AASB 13 Fair Value Measurement, that:
If items of property, plant and equipment are stated at
revalued amounts, the following shall be disclosed:
(a)
the effective date of the revaluation;
(b)
whether an independent valuer was involved;
(c)–(d)
[deleted];
(e) for each revalued class of property, plant and equipment,
the carrying amount that would have been recognised had the
assets been carried under the cost model; and
(f) the revaluation surplus, indicating the change for the period
and any restrictions on the distribution of the balance to
shareholders.
Page 205
Valuations to be kept up to date
Once it has been decided to revalue a class of non-current
assets, the valuations (and, hence, fair values) must be kept
up to date. Paragraph 31 of AASB 116 requires that, if the fairvalue basis of measurement is adopted:
revaluations shall be made with sufficient regularity to ensure
that the carrying amount does not differ materially from that
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The use of fair values
Page 3 of 3
which would be determined using fair value at the end of the
reporting period.
The determination of ‘sufficient regularity’, as just referred to,
will depend upon the nature of the class of assets. The
standard suggests that where the value of revalued property,
plant and equipment changes frequently and the changes are
material, a revaluation could be necessary each reporting
period. Where such changes are not material, the commentary
suggests that revaluations every three to five years will be
sufficient.
Assets within a given class of non-current assets are expected
to be revalued at substantially the same time to avoid the
selective revaluation of assets. Specifically, paragraph 38 of
AASB 116 states:
The items within a class of property, plant and equipment are
revalued simultaneously to avoid selective revaluation of
assets and the reporting of amounts in the financial
statements that are a mixture of costs and values as at
different dates. However, a class of assets may be revalued
on a rolling basis provided revaluation of the class of assets is
completed within a short period and provided the revaluations
are kept up to date.
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Revaluation increments
Page 1 of 3
Revaluation increments
LO 6.3
AASB 116 requires that a revaluation increment be credited
directly to a revaluation surplus account that is part of
shareholders’ funds (equity). The increase in revaluation
surplus is not included as part of profit or loss, but rather, it is
included as part of ‘other comprehensive income’ within the
statement of profit or loss and other comprehensive income.
The format of the statement of profit or loss and other
comprehensive income is explored and discussed in
Chapter 16 . However, at this stage you need to remember
that while some gains and losses are required to be included in
profit or loss, some other gains or losses are explicitly excluded
by virtue of particular accounting standards. Rather, the
excluded gains or losses are to be included in ‘other
comprehensive income’. Exhibit 6.1
provides an example
of a statement of profit or loss and other comprehensive
income and shows where a revaluation increment would be
shown. In relation to the increase in the revaluation surplus,
paragraph 39 of AASB 116 states:
Exhibit 6.1 Example of a statement of
comprehensive income
Page 206
XYZ LIMITED
Statement of comprehensive income for the year ended
31 December 2018
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Revaluation increments
Page 2 of 3
2018
($000)
2017
($000)
390 000
355 000
(245 000)
(230 000)
145 000
125 000
(9 000)
(8 700)
(20 000)
(21 000)
Other expenses
(2 100)
(1 200)
Finance costs
(8 000)
(7 500)
Profit before
tax
105 900
86 600
Income tax
expense
(31 770)
(25 980)
74 130
60 620
5 000
10 667
20 000
4 000
Revenue
Cost of sales
Gross profit
Distribution costs
Administrative
expenses
Profit for the
year
Other
comprehensive
income:
Exchange
differences on
translating
foreign
operations
Gains on
property
revaluation
Income tax
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Revaluation increments
Page 3 of 3
If an asset’s carrying amount is increased as a result of a
revaluation, the increase shall be recognised in other
comprehensive income and accumulated in equity under the
heading of revaluation surplus. However, the increase shall be
recognised in profit or loss to the extent that it reverses a
revaluation decrease of the same asset previously recognised
in profit or loss.
As we can see from the above paragraph, there is an exception
to the general rule that revaluation increments shall go to
‘other comprehensive income’ rather than profit or loss, this
being where an increment reverses a previous decrement of
the same asset. We will discuss this exception later. At this
point, however, the general form of the entry for a revaluation
increment would be:
Dr
Asset
Cr
Revaluation
surplus
X
X
In this chapter we will not consider the income-tax effects of
recognising revaluations as this relies upon material that is
introduced in Chapter 18 . Chapter 18
will provide
further illustrations of the revaluation of non-current assets,
with consideration then being given to related tax effects.
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Treatment of balances of accumulated depreciation upon revaluation
Page 1 of 6
Treatment of balances of accumulated
depreciation upon revaluation
LO 6.9
There are two general approaches to dealing with accumulated
depreciation at the date of a revaluation. The most commonly
used approach, which is referred to as the net method,
requires that, if the revalued assets are depreciable assets, any
balances of accumulated depreciation existing for those
assets at the revaluation date be credited in full to the asset
accounts to which they relate. The asset accounts are then to
be increased or decreased by the amount of the revaluation
increments or revaluation decrements . Specifically,
paragraph 35(b) of AASB 116 directs that when an item of
property, plant and equipment is revalued, the accumulated
depreciation at the date of the revaluation is to be eliminated
against the carrying amount of the asset and the net amount
restated to the revalued amount of the asset. The amount of
the adjustment arising on the elimination of accumulated
depreciation forms part of the increase or decrease in the
carrying amount.
For example, assume we have a machine with a cost of $10
000 and accumulated depreciation of $1 000 (giving a carrying
amount of $9 000). Let us further assume that it is decided to
revalue the machine to its fair value of $14 000. To take
account of the accumulated depreciation we would initially
debit accumulated depreciation by $1 000—thus causing the
balance of accumulated depreciation as it relates to this asset
to be zero—and credit the asset account by $1 000. That is,
the journal entry would be:
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Treatment of balances of accumulated depreciation upon revaluation
Dr
Accumulated
depreciation
Cr
Machine
Page 2 of 6
1 000
1 000
Page 207
We would then debit the machine account by $5 000
and credit the revaluation surplus by $5 000. This would cause
the carrying amount of the asset to be $14 000, which is its
fair value. That is, the journal entry would be:
Dr
Machine
Cr
Revaluation
surplus
5 000
5 000
Subsequent depreciation after a revaluation is based on the
revalued amount of the non-current asset. It should be noted
that an entity cannot account for a downward revaluation
simply by increasing the amount of the accumulated
depreciation by the amount of the revaluation decrement, even
though the net effect would be the same.
Worked Example 6.1
illustrates the use of the ‘net metho
d’—which nets off accumulated depreciation against the asset
prior to recognition of the fair value increment or decrement.
WORKED EXAMPLE 6.1:
Revaluation of a
depreciable asset using the net-amount method
Assume that, as at 1 July 2018, Farrelly Ltd has an item of
machinery that originally cost $40 000 and has accumulated
depreciation of $15 000. Its remaining life is assessed to be
five years, after which time it will have no residual value. While
completing a regular revaluation of all machinery, Farrelly
decided on 1 July 2018 that the item should be revalued to its
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Treatment of balances of accumulated depreciation upon revaluation
Page 3 of 6
current fair value, which was assessed as $45 000.
REQUIRED
Provide the appropriate journal entries to account for the
revaluation using the net-amount method.
SOLUTION
The total revaluation increment will represent the difference
between the carrying amount and the fair value of the asset at
the date of the revaluation. In this case it would be:
$45 000 − ($40 000 − $15 000) = $20 000
The appropriate journal entries on 1 July 2018 would be:
Dr
Accumulated
depreciation—
machinery
Cr
Machinery
Dr
Machinery
Cr
Revaluation
surplus
15 000
15 000
20 000
20 000
According to AASB 116, future depreciation should be based on
the revalued amount of the asset. The depreciation charge for
the year to 30 June 2019 would be $9000 (the new carrying
amount of $45 000 divided by the remaining useful life of five
years). Where the depreciation charges for any financial period
have changed materially owing to a revaluation, the financial
effect of the change (that is, the increase or decrease in the
depreciation charges) should be disclosed in the notes to the
financial statements for that financial period.
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Treatment of balances of accumulated depreciation upon revaluation
Page 4 of 6
While the demonstrated procedure (applying the net-amount
method by which the accumulated depreciation for an asset is
adjusted to zero upon revaluation) is the general approach to
be followed for revaluations of property, plant and equipment,
AASB 116, paragraph 35(a), provides an alternative treatment.
This treatment requires that both the gross amount of the
asset and the accumulated depreciation of the asset be
adjusted. This method is sometimes used where reference is
made to newer assets than those being revalued. Specifically,
paragraph 35(a) of AASB 116 states that when an item of
property, plant and equipment is revalued, the accumulated
depreciation at the date of the revaluation can be restated
proportionately with the change in the gross carrying amount
of the asset so that the carrying amount of the asset after
revaluation equals its revalued amount. This approach is
referred to as the ‘gross method’. The gross method of
revaluation is applied in Worked Example 6.2 .
WORKED EXAMPLE 6.2:
Revaluation of a
depreciable asset—the use of the gross method
Page 208
Assume as in Worked Example 6.1
that on 1 July 2018
Farrelly Ltd has an item of machinery that originally cost $40
000 and has accumulated depreciation of $15 000. Its
remaining life is assessed to be five years. It is decided on 1
July 2018 that the item should be revalued to its current fair
value assessed as $45 000.
A review of a newer but comparable item of machinery
indicates that the newer machine has a market value of $72
000.
REQUIRED
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Treatment of balances of accumulated depreciation upon revaluation
Page 5 of 6
Adopting the gross method, provide the appropriate journal
entries to account for the revaluation.
SOLUTION
The gross carrying amount of the asset and the accumulated
depreciation account are to be restated proportionately, which
is the requirement of paragraph 35(a) of AASB 116. The
following steps show how this asset can be revalued using the
gross method.
STEP 1: Calculate the ratio of accumulated depreciation (AD)
over gross amount of the asset (GA) immediately prior to the
revaluation. The calculation is: 15 000/40 000 = 0.375
The ratio is 0.375, which means 37.5% of the gross amount
has been reduced by depreciation charges just before
revaluation. In other words, the accumulated depreciation
balance is 0.375 of the gross amount of the asset balance. This
ratio must be the same just after the revaluation.
STEP 2: Solve the
equation:
GA − AD = $45 000
We know from STEP 1
that:
AD = 0.375 × GA
therefore:
GA − (0.375GA) = $45 000
0.625GA = $45 000
GA = $72 000
We just worked out what the balance of the GA should be. It is
simple to work out the AD balance because GA − AD = $45
000, so AD = $27 000. Now we know what the balance of the
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Treatment of balances of accumulated depreciation upon revaluation
Page 6 of 6
AD account should be.
Notes:
l
l
$45 000 is the amount the asset is being revalued to = GA −
AD = the carrying amount
$27 000/$72 000 = 0.375 = the ratio calculated at STEP 1 so
we know we are correct
STEP 3: Do the journal entries to make the balances of GA and
AD equal to the balances that we calculated at STEP 2.
Dr
Machinery
32 000
Cr
Accumulated
depreciation
12 000
Cr
Revaluation
surplus
20 000
It should be noted that whether the net-amount method or the
gross method is used, the carrying amount of the non-current
assets will be the same. For example, the balances under both
methods after revaluation would be:
Machinery
Accumulated
depreciation
Carrying amount
Net-amount
method
Gross method
$
$
45 000
72 000
0
27 000
45 000
45 000
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Revaluation decrements
Page 1 of 3
Revaluation decrements
LO 6.3
Page 209
The concept of prudence was traditionally applied within
financial accounting. According to the former (pre-2010) IASB
conceptual framework, the exercise of prudence meant the
inclusion of a degree of caution in the exercise of the
judgements needed to make the estimates required under
conditions of uncertainty, such that income and/or assets are
not to be overstated, and expenses and/or liabilities are not to
be understated. The requirements of AASB 116 are consistent
with the notion of prudence. Consistent with the concept of
prudence (and conservatism), the requirements of AASB 116
are that if a class of non-current assets is revalued, the
revaluation decrement should be treated as an expense of the
period and referred to as a loss on revaluation (remember, the
revaluation increment went to the revaluation surplus, which
is part of equity but which is not recognised in profit or loss
but rather is treated as an item of ‘other comprehensive
income’). The first part of paragraph 40 of AASB 116 requires
that: ‘If an asset’s carrying amount is decreased as a result of
a revaluation, the decrease shall be recognised in profit or
loss’. While prudence seems to be embraced within AASB 116,
when the most recent edition of the conceptual framework
was released, reference to prudence was removed (although
when the Exposure Draft for a revised conceptual framework
was released by the IASB in 2015, it reintroduced an explicit
reference to the notion of prudence). The requirement now is
that financial statements should ‘faithfully represent’ the
underlying transactions and events. According to paragraph
QC12 of the conceptual framework, financial information
faithfully represents particular phenomena when it is
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Revaluation decrements
Page 2 of 3
complete, neutral and free from error. Therefore, the
asymmetric treatment of revaluation increments and
decrements does not appear to be totally consistent with the
revised conceptual framework (but, as we know, accounting
standards have precedence over the conceptual framework).
The accounting treatment for a revaluation decrement is
examined in Worked Example 6.3 . An exception to this
general rule, to be considered after Worked Example 6.3 ,
is the case where the decrement reverses a previous
increment relating to the same asset.
WORKED EXAMPLE 6.3:
A revaluation decrement
Young Ltd acquires some machinery at a cost of $150 000 on
1 July 2017. On 30 June 2018, the machinery, which has an
accumulated depreciation balance of $20 000, is assessed as
having a fair value equal to $100 000. Young Ltd measures
machinery at fair value.
REQUIRED
Provide the journal entries to reflect the revaluation
decrement.
SOLUTION
As noted previously, upon revaluation we would need to offset
the accumulated depreciation against the asset account
(unless reference is being made to a newer asset and the
gross method is used) before recognising the revaluation
decrement. The accounting entry would be:
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Revaluation decrements
Page 3 of 3
Dr
Accumulated
depreciation
Cr
Machinery
Dr
Loss on
revaluation
of machinery
Cr
Machinery
20 000
20 000
30 000
30 000
The loss of $30 000 represents the difference between the
carrying amount of the revalued non-current asset (in this
case, $130 000) and the fair value. This loss would be
recognised as an expense and would cause a reduction in
profits. Again, notice that the loss associated with the
reduction in fair value is treated as an expense and therefore
reduces profits, whereas if it had been a gain related to an
increase in fair value then it would not be treated as income
and would not increase profits (rather, the gain is included as
part of other comprehensive income and therefore does
increase total comprehensive income).
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Page 1 of 5
Reversal of revaluation decrements and
increments
LO 6.8
Page 210
With respect to a class of assets, reversals of previous
revaluations should, as far as possible, be accounted for by
entries that are the reverse of those bringing the previous
revaluations to account. For example, where a revaluation
decrement reverses a previous increment (or cumulative
increment) for an individual asset, it would be debited to the
revaluation surplus previously credited for that asset, rather
than being debited to the period’s profit or loss. The reduction
in the revaluation surplus would be shown as a negative item
in ‘other comprehensive income’ within the statement of profit
or loss and other comprehensive income. Any excess over the
previous revaluation increment would then be debited to the
profit or loss. That is, if there had previously been no
downward revaluation, the revaluation decrement would be
treated as an expense and therefore as a part of profit or loss
(as indicated in Worked Example 6.3 ). However, if there
has previously been a revaluation increment for the same
asset, the subsequent decrement for that asset is to be
adjusted against the balance in the revaluation surplus as it
pertains to that asset. As paragraph 40 of AASB 116 states:
If an asset’s carrying amount is decreased as a result of a
revaluation, the decrease shall be recognised in profit or loss.
However, the decrease shall be recognised in other
comprehensive income to the extent of any credit balance
existing in the revaluation surplus in respect of that asset.
The decrease recognised in other comprehensive income
reduces the amount accumulated in equity under the heading
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Reversal of revaluation decrements and increments
Page 2 of 5
of revaluation surplus.
Similarly, where a revaluation increment reverses a previous
decrement (or cumulative decrement), it would be credited to
the profit or loss (that is, treated as income). Any excess over
and above the previous revaluation decrement would then be
credited to the revaluation surplus. As paragraph 39 of AASB
116 states:
If an asset’s carrying amount is increased as a result of a
revaluation, the increase shall be recognised in other
comprehensive income and accumulated in equity under the
heading of a revaluation surplus. However, the increase shall
be recognised in profit or loss to the extent that it reverses a
revaluation decrease of the same asset previously recognised
in profit or loss.
Consider Worked Example 6.4 , which gives an example of
reversals of previous revaluation increments and decrements.
WORKED EXAMPLE 6.4:
Reversals of previous
revaluation increments and decrements
PK Ltd acquires a block of land on 1 January 2017 for $200
000 in cash. Due to increased housing demand in the area, the
land has a fair value of $290 000 on 30 June 2018. However, it
becomes known in the next year that the land and its
surrounding area was previously the site of a toxic dump. As a
result, the fair value falls to $140 000 on 30 June 2019.
REQUIRED
Assuming the firm makes revaluations on both 30 June 2018
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Page 3 of 5
and 30 June 2019, provide the appropriate journal entries, and
show how and where the revaluation increases and decreases
would be shown in the statement of profit or loss and other
comprehensive income.
SOLUTION
Page 211
1 January 2017
Dr Land
200 000
Cr
Cash
(to record the initial acquisition of land)
200 000
30 June 2018
Dr Land
90 000
Cr
Revaluation surplus
90 000
(to represent the increment in the fair value of land.
This increase would be treated as part of ‘other
comprehensive income’ but not as part of profit or loss)
30 June 2019
Dr Revaluation surplus
90 000
Dr Loss on revaluation of land
60 000
Cr
Land
150 000
(fair value of land falls from $290 000 to $140 000; the
loss of $60 000 represents the reduction over and
above the previous revaluation increment. The amount
of $90 000 would be a reduction in ‘other
comprehensive income’ while the amount of $60 000
would be a reduction to profit or loss)
While all the necessary amounts for various income and
expenses are unknown in this example, the following
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Page 4 of 5
statement shows where the amounts associated with the above
journal entries will be presented.
It should be noted that if the above land had not been revalued
in June 2018—that is, if it had been recorded at cost—
impairment testing would be required pursuant to AASB 136
Impairment of Assets. An impairment loss would be recognised
if the recoverable amount of the asset declines below its
carrying amount. That is, regardless of whether the cost model
or the revaluation model is used, an item of property, plant
and equipment shall not have a carrying amount in excess of
its recoverable amount. The recoverable amount is determined
as the greater of the value in use and the net selling price of
the asset. In this example, if the recoverable amount of the
asset is assumed to be the same as the net selling price—in
this case $140 000—and to the extent that this is below the
carrying amount of the asset (which would be $200 000 if no
revaluation was undertaken in 2018), an impairment loss of
$60 000 must be recognised. We will consider impairment
losses in more depth later in this chapter.
PK LTD
Statement of comprehensive income for the
year ended 30 June 2019
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2019
($000)
2018
($000)
xx xxx
xx xxx
(xx xxx)
(xx xxx)
xx xxx
xx xxx
Distribution costs
(xx xxx)
(xx xxx)
Administrative
expenses
(xx xxx)
(xx xxx)
Loss on
revaluation of
land
(60 000)
–
Profit before
tax
xx xxx
xx xxx
(xx xxx)
(xx xxx)
xx xxx
xx xxx
(90 000)
90 000
(xx xxx)
(xx xxx)
Revenue
Cost of sales
Gross profit
Income tax
expense
Profit for the year
Other
comprehensive
income:
Gains/(losses) on
property
revaluation
Income tax
relating to
components of
other
comprehensive
income
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Accounting for the gain or loss on the
disposal or derecognition of a revalued
non-current asset
LO 6.10
Page 212
AASB 116, paragraph 71, provides that:
The gain or loss arising from the derecognition of an item of
property, plant and equipment shall be determined as the
difference between the net disposal proceeds, if any, and the
carrying amount of the item.
In relation to the timing of the gain or loss, AASB 116,
paragraph 68, states that: ‘The gain or loss arising from
derecognition of an item of property, plant and equipment
shall be included in profit or loss when the item is
derecognised’. Paragraph 68 therefore does not require the
separate disclosure of the proceeds of the sale as revenue and
the presentation of the carrying amount of the asset as an
expense—only the net amount, the gain or the loss, is to be
presented. The term ‘derecognition’ as used in paragraph 68
refers to the point in time at which an item is removed from
the statement of financial position—that is, when it is no
longer recognised. According to paragraph 67 of AASB 116,
the carrying amount of an item of property, plant and
equipment is to be derecognised on disposal or when no
future economic benefits are expected from its use or
disposal.
Worked Example 6.5
sets out how to account for the gain
or loss on disposal of a revalued item of property, plant and
equipment.
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The accounting entries for the sale of revalued land, as shown
in Worked Example 6.5 , do not remove the balance of
the asset revaluation that is in the revaluation surplus as a
result of the revaluation undertaken on 1 July 2018. That is,
there is still a balance of $15 000 in the revaluation surplus,
even though the asset to which the revaluation relates has
been sold. What should be done with the remaining balance in
the revaluation surplus? AASB 116, paragraph 41, provides
some guidance in this regard:
WORKED EXAMPLE 6.5:
Accounting for a gain or
loss on disposal of a revalued non-current asset
On 1 July 2017, Bombo Ltd acquires a block of land at a cost
of $60 000. On 1 July 2018 it is revalued to $75 000. On 30
June 2019 the land is sold for $90 000.
REQUIRED
Determine the gain or loss on the sale of the land according to
AASB 116 and prepare the journal entry to record the sale.
SOLUTION
As the carrying amount of the land at the date of disposal is
$75 000 (owing to the earlier revaluation increment), the gain
on the sale of the land is $15 000. If the land had not
previously been revalued, the gain on sale would have been
$30 000.
The gain on the sale of the land—which would be included as
part of profit or loss—would be represented by the difference
between the proceeds of the sale and the carrying amount of
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the land. The gain on the sale would also need to be disclosed.
The accounting entry would be:
Dr
Cash at bank
90 000
Cr
Gain on sale
of land
15 000
Cr
Land
75 000
The revaluation surplus included in equity in respect of an
item of property, plant and equipment may be transferred
directly to retained earnings when the asset is derecognised.
This may involve transferring the whole of the surplus when
the asset is retired or disposed of.
So, to eliminate the balance of the revaluation
Page 213
surplus that relates to the land disposed of, the
following entry may be made (it is emphasised that, in the
terminology of the accounting standard, the entry may be
made, which implies an option to leave amounts in the
revaluation surplus for assets that have been derecognised):
Dr
Revaluation
surplus
Cr
Retained
earnings
15 000
15 000
AASB 116 specifically prohibits transfers from the revaluation
surplus to profit or loss. That is, when a revalued asset is
subsequently sold, any existing revaluation is not to be
eliminated by treating it as part of profits. The revaluation
increment would previously have been included in ‘other
comprehensive income’. Specifically, paragraph 41 of AASB
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116 states ‘Transfers from revaluation surplus to retained
earnings are not made through profit or loss’.
Worked Example 6.6
provides another example of how to
account for the revaluation surplus on the sale of an item of
property, plant and equipment.
In determining the gain on sale in Worked Example 6.6 ,
we need to calculate the difference between the net sales
proceeds and the carrying amount of the machine. At 1 July
2021 there would have been two years of accumulated
depreciation since the revaluation was undertaken in 2019. At
that point the asset was valued at $96 000 and it was
expected to have a remaining useful life of eight years. With
no residual value, this means that the annual depreciation
charge would be $12 000 per year. It should also be noted
that had the revaluation not been undertaken in 2019, the
written-down value of the asset (that is, the carrying amount)
would have been $60 000 in 2021 and the gain on sale would
have been $29 000 rather than $17 000—the difference being
the amount of the revaluation less the additional depreciation
in the following two years, or $16 000 − 2 × ($12 000 − $10
000).
It should be stressed at this point that companies do not have
to revalue their property, plant and equipment upwards for
the purpose of their financial statements, but once they elect
to measure property, plant and equipment at fair value, that
value must be kept up to date for that class of assets.
Therefore, a reporting entity may have a class of non-current
assets accounted for by way of the cost model with a carrying
amount (cost less accumulated depreciation and less
accumulated impairment losses, if any) that is significantly
below its current fair value, without its financial statements
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failing to comply with Australian (and international)
accounting requirements. This raises a number of issues. Why
would a company not revalue its assets to their fair value?
Conversely, what would motivate a company to perform an
upward revaluation?
WORKED EXAMPLE 6.6:
Sale of a
revalued item of property, plant and equipment
Page 214
Gunnamatta Ltd acquired a printing machine on 1 July 2017
for $100 000. It is expected to have a useful life of 10 years,
with the benefits being derived on a straight-line basis. The
residual is expected to be $nil. On 1 July 2019 the machine is
deemed to have a fair value of $96 000 and a revaluation is
undertaken in accordance with Gunnamatta Ltd’s policy of
measuring property, plant and equipment at fair value. The
asset is sold for $89 000 on 1 July 2021.
REQUIRED
Provide the journal entries necessary to account for the above
transactions and events.
SOLUTION
1 July 2017
Dr Printing machine
100 000
Cr
Cash/payables
(to recognise the acquisition of the machine)
100 000
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30 June 2018
Dr Depreciation expense
Cr
Accumulated depreciation—
10 000
100 000
printing machine
(to recognise depreciation expense for the year)
30 June 2019
Dr Depreciation expense
10 000
Cr
Accumulated depreciation—
100 000
printing
machine
(to recognise depreciation expense for the year)
1 July 2019
Dr Accumulated depreciation
20 000
Cr
Printing machine
20 000
(to offset two years’ depreciation against the cost of the
asset)
Dr Printing machine
16 000
Cr
Revaluation surplus
16 000
(to revalue the asset to its fair value of $96 000)
30 June 2020
Dr Depreciation expense
12 000
Cr
Accumulated depreciation—
12 000
printing machine
(to recognise depreciation expense for the year)
30 June 2021
Dr Depreciation expense
12 000
Cr
Accumulated depreciation—
12 000
printing machine
(to recognise depreciation expense for the year)
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1 July 2021
Dr Cash at bank
Dr Accumulated depreciation
Cr
Printing machine
Cr
Gain on sale of printing
machine
(to account for the sale of the asset)
89 000
24 000
96 000
17 000
1 July 2021
Dr Revaluation
16
surplus
000
Cr
Retained earnings
16 000
(to transfer the balance of the revaluation surplus to
retained earnings following the disposal of the asset)
If a company revalues a non-current asset, any subsequent
gain on sale (the gain being determined as the difference
between the carrying amount of the asset at the date of sale
and the consideration received and which would be included in
profit or loss for the period) will be reduced, compared with
the gain obtained if the asset had not been revalued. This was
demonstrated in Worked Example 6.5 .
Further, if the asset is depreciable, subsequent depreciation
charges will be increased. Depreciation charges are based on
cost or, if the depreciable non-current asset has been
revalued, on the revalued amount. So increasing the value of
the asset will increase subsequent depreciation charges.
Again, it must be remembered that the revaluation increment
goes to the revaluation surplus account and the increment is
included as part of ‘other comprehensive income’ and not as
part of profits (unless it reverses a previous decrement). A
further example of how a revaluation will affect subsequent
profits is given in Worked Example 6.7 .
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A review of the entries in Worked Example 6.7 shows that, for
the period from 2017, the accumulated effects on profits are
that, if a revaluation had not been undertaken, profits would
be $20 000 higher ($5714 less in depreciation and an
additional $14 286 gain on sale). This amount is equivalent to
the amount credited to the revaluation surplus. That is, from
the revaluing company’s perspective, the sum of the lower
profit (or greater loss) arising from the higher depreciation
charges and the lower gain on sale will be equal to the amount
of the revaluation. In some cases, firms might prefer to show
lower profits; perhaps because they are being accused of
being monopolistic and of earning excessively high profits. In
such cases an asset revaluation might be a
Page 215
preferred option, even though a decision to revalue
made on this basis would constitute ‘creative accounting’ and
would therefore not be consistent with the basic tenets
espoused in the conceptual framework.
WORKED EXAMPLE 6.7:
Profit comparison with and
without a revaluation
Drouyn Ltd acquires an asset for a consideration of $100 000
on 1 July 2017. The asset has an expected life of 10 years and
no expected residual value. As at 1 July 2020, the asset has a
fair value of $90 000. The asset is depreciated using the
straight-line method.
The asset is sold for $80 000 on 30 June 2022.
REQUIRED
Provide the journal entries, both without and with a
revaluation, for:
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(a)
years 1 to 3
(b)
year 4
(c)
year 5
SOLUTION
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Without a revaluation
With a revaluation
(a) Years 1 to 3
30 June 2018/2019/2020
30 June 2018/2019/2020
Dr
Depreciation
10
expense000
Dr
Depreciation
10
expense000
Cr
Accumulated
Cr
Accumulated
10
000
depreciation
10
000
depreciation
(b) Year 4
30 June 2021
Dr
Depreciation
10
expense000
Cr
Accumulated
1 July 2021
10
000
Dr
Accumulated
30
000
depreciation
Cr
Truck
30
000
depreciation
(to eliminate accumulated
depreciation for previous
three years)
1 July 2021
Dr
Truck
20
000
Cr
Revaluation
surplus
20
000
30 June 2021
Dr
Depreciation
12
expense857
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Managers might also elect to measure their property, plant
and equipment at fair value (and therefore undertake periodic
revaluations) because the valuations better reflect the value of
the organisation’s assets. It might also make the organisation
less likely to be taken over owing to undervalued assets.
Directors might consider that undertaking periodic
revaluations provides more relevant information for financial
statement readers’ decision making.
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Recognition of impairment losses
Page 1 of 16
Recognition of impairment losses
Page 216
LO 6.5 LO 6.6 LO 6.7 LO 6.11
Where an entity elects to change from the cost basis to a fairvalue basis for measuring a class of non-current assets, and
that class has previously been the subject of an impairment
loss —to be explained below—any increase in the carrying
amount of the asset must first be recognised as income
(thereby reversing the previous expense) to the extent that
the increase in value does not exceed the amount that would
have been recorded for the asset had no write-down previously
occurred. Any increase in the fair value of the asset above the
amount that would have been recorded for the asset had no
impairment loss been recognised is to be transferred to an
account known as the revaluation surplus. As we already know,
the revaluation surplus is part of owners’ equity.
For example, let us assume that we have an item of land
acquired in 2015 for $1 million. If the recoverable value of the
land in 2017 is considered to be $800 000, an expense of $200
000 would be recognised in 2017 (an impairment loss). If the
value of the land has then increased to $1.3 million in 2019
and a revaluation is undertaken, $200 000 would be
recognised as income (effectively reversing the previous $200
000 impairment loss) and $300 000 would be transferred to
the revaluation surplus.
Worked Example 6.8
provides an illustration of an asset
revaluation where there has been a previous impairment loss.
WORKED EXAMPLE 6.8:
Reversal of a previous
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Recognition of impairment losses
Page 2 of 16
impairment loss
Point Impossible Ltd acquired some land in 2017 at a cost of
$2.5 million. In 2018 it was determined that the recoverable
amount of the land was $2 million. In 2019 it was decided to
switch to the ‘revaluation model’ and to revalue the land to its
fair value, which was then assessed as having increased to
$2.8 million.
REQUIRED
Provide the journal entries to record the above movements in
value.
SOLUTION
First, where the ‘cost model’ is used there is nevertheless the
requirement to recognise an impairment loss when the
recoverable amount of an asset is less than the carrying
amount.
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Recognition of impairment losses
Page 3 of 16
2018
Dr
Impairment
loss—land
(to be
included in
profit or
loss)
Cr
Accumulated
impairment
loss—land
500 000
500 000
2019
In 2019 the organisation
has switched to the
‘revaluation model’
Dr
Land
300 000
Dr
Accumulated
impairment
loss—land
500 000
Cr
Reversal of
previous
impairment
loss—land
(to be
included in
profit or
loss)
Cr
500 000
Revaluation
300 000
surplus (gain
to be
included in
other
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Page 4 of 16
As indicated, the above impairment reversal would be treated
as part of income in 2019. The revaluation surplus is part of
equity. The accumulated impairment loss is a ‘contra asset’
account, which is shown as an offset against the asset—in this
case, against land.
AASB 136 Impairment of Assets imposes the general
requirement that a non-current asset should be written down
to its recoverable amount when its carrying amount is greater
than its recoverable amount. AASB 136 defines an impairment
loss as ‘the amount by which the carrying amount of an asset
or a cash-generating unit exceeds its recoverable amount’.
Pursuant to AASB 136, different approaches to
Page 217
accounting for an impairment loss of property, plant
and equipment will be required, depending upon whether the
cost model or revaluation model has been adopted. As
paragraph 60 of AASB 136 states:
An impairment loss shall be recognised immediately in profit
or loss, unless the asset is carried at revalued amount in
accordance with another Standard (e.g. in accordance with
the revaluation model in AASB 116). Any impairment loss of a
revalued asset shall be treated as a revaluation decrease in
accordance with that other Standard.
Therefore, if an asset has been revalued, the impairment loss
will be recognised by reducing (debiting) the balance of the
revaluation surplus as it pertains to the previous revaluation.
Otherwise, the impairment loss is recognised by recognising an
expense directly. Worked Example 6.9
provides an
example of this difference.
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Recognition of impairment losses
Page 5 of 16
WORKED EXAMPLE 6.9:
Recognition of an
impairment loss where either the cost model or fair-value
model is used
Coogee Ltd has a parcel of land that has a carrying value of
$500 000. As at the end of the reporting period, the
recoverable amount of the asset has been determined as being
equal to $350 000.
If we assume use of the cost model to account for this class
of asset, the entry would be:
Dr
Impairment
loss
Cr
Accumulated
impairment
losses—land
150 000
150 000
However, if the land was measured at fair value by way of an
asset revaluation (that is, the revaluation model was previously
adopted) and if we assume that the previous revaluation
increment was $60 000 (which would have meant a debit of
$60 000 to Land, and an equivalent credit to Revaluation
surplus), we would first eliminate the respective balance in the
revaluation surplus and then recognise an impairment loss as
follows:
mk:@MSITStore:C:\Users\Administrator\Desktop\Financial%20Accounti... 2017/3/2
Recognition of impairment losses
Page 6 of 16
Dr
Impairment
loss
90 000
Dr
Revaluation
surplus
60 000
Cr
Accumulated
impairment
losses—
land
90 000
Land
60 000
Cr
Where a non-current asset is measured on the cost basis, any
write-downs to recoverable amounts are not considered to be
revaluations. They are ‘impairment losses’. Hence the
recognition of an impairment loss in respect of a non-current
asset does not oblige the entity to revalue the whole class of
non-current assets to which that asset belongs. Paragraph 12
of AASB 136 identifies a number of factors which might signal
that the value of an asset has been impaired. It states:
In assessing whether there is any indication that an asset
may be impaired, an ent