ACCT3563 Issues in Financial Reporting & Analysis Semester 1 – 2010 Version 0. 5. 0 1st April 2010 Contents Page 3 Page 7 Page 12 Page 17 Page 20 Positive Accounting Theory Ethics in Accounting Accounting for Physical Assets & Intangible Assets Accounting for Assets in Mining & Agricultural Industries ounting Accounting for Provisions Copyright © Ka Hei Yeh 2010 Fifth Revision published April 2010 2010. This work is licensed under the Creative Commons Attribution Attribution-Non-CommercialNo Deriva Derivative Works 2. 5 Australia Licence. To view a copy of this license, visit http://creativecommons. rg/licenses/by-nc-nd/2. 5/au/ or send a letter to Creative http://creativecommons. org/licenses/by nd/2. 5/au/ Commons, 171 Second Street, Suite 300, San Francisco, California, 94105, USA. Disclaimer: The author does not guarantee the accuracy of the notes available and will not be held liable for any damages (including lost marks etc. ) as a result of the use of these notes. Use at your own discretion with etc. ) caution. Do not rely on them; these notes are not intended to serve as a replacement for your own. Issues in Financial Reporting & Analysis – Semester 1 2010 2 Positive Accounting Theory
Positive Accounting Theory Background In previous accounting subjects, we explored what should happen when a firm uses a particular set of accounting principles and practices. However, in real life, we know this is not always the case. Hence, Positive Accounting Theory (PAT) tries to explain, and possibly predict, accounting practices. Assumptions As always there are some assumptions that PAT takes: • • • • Everyone takes measures to maximise their own self-interest; even at the expense of others. Rational behaviour. Efficient markets in that prices for shares and debt will adjust instantly to changes in the business.
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Price protection in that markets will continually and accurately adjust prices to reflect managerial actions. The Agency Problem The Agency Problem is one issue PAT tries to predict. The theory predicts that businesses will have mechanisms to align the interests of the owners and the managers. However, we know that there can be a conflict of interest between inside and outside equity holders. Inside equity holders are those who are more knowledgeable about the business and usually have a large stake in them such as family groups. One well known example is the Packer family.
Outside equity holders are just your regular shareholders that usually only have a small portion of their equity in the firm. Both these parties have different wants and views of the business. Since insiders have a larger stake in the business, they will want less risk and more immediate returns. Outsiders would rather have a higher risk and longer term returns since they have less money in the firm. Anti-Regulation? Since we have imperfect markets, we have transaction costs and information asymmetry. This means we will get residual agency problems.
PAT predicts that even without regulation, firms will voluntarily prepare publically available financial statements and have them audited. PAT argues that firms will select the best accounting method to represent the firm in the financial statements. Thus, PAT predicts that with regulation, firms will no longer be able to select the best available accounting method and the financial statements will no longer provide the best reflection of the firm’s performance. With this in mind, we can see that PAT includes an argument against regulation.
This view is seen as the Efficiency Perspective. Issues in Financial Reporting & Analysis – Semester 1 2010 3 Positive Accounting Theory Or Not? However, another way of looking at PAT – the Opportunistic Perspective – predicts that after all contractual arrangements have been set, individuals will seek out opportunistic behaviours within those constraints to maximise their self-interest. For example, a manager may have a contractual arrangement where he or she is paid a bonus depending on the firm’s profits for the year. This would be a result of trying to address the agency problem.
In this situation, the manager will try to increase profits as much as possible, meaning they may: • Select accounting methods that maximise profit instead of ones that better reflect the firm’s current position such as using a different depreciation method, accelerating revenue recognition or changing the level of depreciation. Try to manipulate accounting figures. Adopting a short-term focus instead of a long-term one. In this perspective, PAT is siding towards regulation. The Agency Costs of Equity One part of residual agency problems is the agency cost of equity.
This is because managers’ shirking (they become less productive because they see no need to work for no extra pay) and conflicts with outside equity interests reduce the value of the firm. To minimise this, monitoring and bonding costs are required to implement measures to minimise its detrimental effect on the value of the firm. It must be noted that no firm will completely eliminate this as costs will increase exponentially as one tries to eradicate more and more. Thus, there is an optimal trade-off point between monitoring costs and agency costs.
This is where the marginal monitoring and bonding cost equals the marginal shirk. The Agency Costs of Debt Much like the agency cost of equity, there is also one from debt. This is due to the fact that managers will always try to shift wealth from debt to equity holders. Managers have their stake in the firm’s equity and will thus, try to increase it at the expense of debt holders. Again, there are monitoring and bonding costs here and also an optimal trade-off point. Monitoring and Bonding So what constitutes monitoring and bonding when reducing the agency cost of equity?
They include: • • • • Publically available financial reports Managerial compensation plans Auditing Corporate governance • • Issues in Financial Reporting & Analysis – Semester 1 2010 4 Positive Accounting Theory • The risk of takeovers The managerial labour market is also meant to serve as a mechanism. This is because when a manager does something which is hugely detrimental to a firm, they will most likely be fired and any subsequent job they take up will take note of this and have less pay as a result. In theory, this should work because no one wants less pay and is a good deterrent.
However, in reality, managers in this situation usually get a new managerial position at a new company with a higher pay package. Thus, this is not generally considered a good method of monitoring and bonding. Monitoring and bonding mechanisms to reduce the agency cost of debt include: • • • Loan covenants Board member representing debt-holders Dividend restrictions Political Costs Political costs are costs that are incurred when the firm’s value is deducted due to government or special group actions. There is general consensus that the larger a firm is, the higher political costs are.
Examples of political costs are: • • • • Changes in tax brackets Changes in concessions Bad publicity in media* Government inquiries and investigations* *Generally only applies to large firms and not small firms. Factors Influencing Accounting Policy Choice We have taken a look at the opportunistic and efficiency perspectives of PAT which influence which accounting policies are undertaken. There are a few more such as: • Signalling: Firms may decide to permanently increase dividends or voluntarily disclose forecasts.
This discerns between high and low quality firms because low quality firms cannot afford to do these. Market Forces: Public pressure, criticism, local culture and the labour market can all influence on what kinds of policies a firm takes, especially in regards to human resources. AASB, IFRS & GAAP: Regulations will govern what a firm can or cannot use. • • Criticisms PAT is criticised by many because it only predicts and explains accounting practices. It is argued that if there is no prescription – something that must be done – then it is not a way of improving accounting.
Thus, in this argument, PAT is useless. Issues in Financial Reporting & Analysis – Semester 1 2010 5 Positive Accounting Theory Critics also argue that PAT is value-laden. That is, PAT it meant to be a theory where there is no guidance on what people do. However, the simple fact that people chose to use PAT and believe in maximising their own self-interests is a judgement and thus, not value-free. It is also scientifically flawed in that research carried out almost always contradicts what PAT would predict and try to explain.
Issues in Financial Reporting & Analysis – Semester 1 2010 6 Ethics in Accounting Ethics in Accounting Background Most corporate failures in the modern world are as a result of unethical practices. Increased regulation does nothing to solve this issue. It is down to our natural reasoning to do so. Every person has a conscience that distinguishes between right and wrong. Types of Ethical Theories Ethical theories attempt to explain how our conscious can distinguish between what is good and what is bad.
They fall into two broad categories: • Teleological Theories These theories state that behaviour is ethical as long as it results in something that is desirable. i. e. The end justifies the means. Deontological Theories These theories say that a person is ethical as long as they do their duty while following the rules/laws. • Teleological Theories There are a few teleological theories: • Ethical Egoism This is a self-centred theory where people act as though to maximise their own personal benefit whether it be for pleasure, contentment or anything.
Utilitarianism This theory believes that something is ethical if it benefits the most people. This theory underlies welfare economics. The richer are taxed more so that benefits can be given to the poorer. Ethical Elitism This theory is where something is ethical as long as it maximises the welfare of the elite groups in society. Ethical Parochialism This theory is where it is ethical when you maximise the welfare of your in-groups such as your family, country, team, employer etc. • • • Deontological Theories Deontological theories are heavily rule based.
You can explicitly do something and not other things. • Kantian Ethics It is ethical if it is done out of a sense of duty. It also states that the end does not justify the means; the opposite of teleological theories. Issues in Financial Reporting & Analysis – Semester 1 2010 7 Ethics in Accounting Nichomachean Ethics This is a theory created by Aristotle and refined by St Thomas Aquinas. Some say this is a deontological theory but others argue it is a teleological theory. It has rules but the underlying assumptions are self-evidently true when explained.
This theory states that every action we take has a purpose, and at the end, our aim is to achieve “the good”; also known as human flourishing. To do this, a person must acquire virtues. Note that the theory states that people are not born with virtues, but rather, must acquire them. The Moral Virtues There are thirteen moral virtues in this: 1) 2) 3) 4) 5) 6) 7) 8) 9) 10) 11) 12) 13) Courage Temperance Liberality Magnificence Magnanimity Proper ambition Justice Good –temperedness’ Truthfulness Wittiness/Tactfulness Friendliness Modesty Righteous Indignation
Since we are studying accounting, the four points in orange above are of most significance to us regarding accounting ethics. Each moral above is best at a point between the two extremes of excess and deficiency. i. e. We should not have too much of it or too little of it. Note that this optimal point is not exactly in the middle, it may be more skewed to one side than the other.
Below is a table showing these extremes: Deficiency Cowardice Insensibility Illiberality, Stinginess Pettiness Undue Humility Unambitious Lack of Spirit, Apathetic Self-Deprecatory Boorish Quarrelsome, Grouchy Shameless Malice Injustice of Deficiency Virtue Courage Temperance Liberality Magnificence Magnanimity Proper ambition Good-tempered Truthfulness Witty, Tactful Friendliness Modesty Righteous Indignation Justice Excess Foolhardiness, Recklessness Licentiousness Prodigality Vulgarity Empty vanity Excessive ambition Irascibility, Bad-tempered Boastful Buffoon, Clown Obsequious, Flatterer Shyness, Bashful Envy Injustice of Excess
Issues in Financial Reporting & Analysis – Semester 1 2010 8 Ethics in Accounting The Intellectual Virtues Aristotle states that moral virtues are necessary to attain the intellectual virtues and viceversa as well. The intellectual virtues are: 1) 2) 3) 4) 5) Technical Skill Scientific Knowledge Prudence Intuitive Reason Wisdom There are a further three minor intellectual virtues with can be call sub-virtues of prudence. 1) Sound deliberation 2) Understanding 3) Judgement Sound familiar?
In accounting, when doing things like creating financial reports or auditing them, we need to use our technical skill and knowledge in accounting along with the application of prudence to produce a fair and true view of a firm. Thomistic Ethics Thomas Aquinas changed a few things with Aristotle’s ethics. He, instead, divides the virtues into the cardinal (prudence, temperance, fortitude and justice) and the theological virtues (faith, hope and charity). Obviously, the theological virtues and out of the scope of this course!
Courage Courage is defined as a moral virtue which concerns our ability to control emotions of fear and confidence. We must not be a coward but at the same time, we must not be foolhardy and reckless. We must be able to recognise situations where it will be impossible to do something yet realise situations which are hard to do, but possible. Examples in Accounting: Cowardice Allow a client to manipulate you into overlooking certain accounting choices. Courage Telling a client that you will issue a qualified audit report to them.
Recklessness Using unorthodox accounting methods to boost profits and/or decrease debt and expenses. Prudence Prudence is about having the right reasons to do or not do something. Contrary to popular belief, it is not only about being cautious and avoiding risks. This is only a tiny portion of prudence. The integral parts of prudence are: • Have a memory of things past and present. (Memory) Issues in Financial Reporting & Analysis – Semester 1 2010 9 Ethics in Accounting • • • • • • • Knowledge of practical first principles. (Knowledge) Readiness to learn from others. Docility) Speed at grasping how to achieve a certain goal. (Shrewdness) Discursive reasoning abilities. (Discursive reasoning) Foresight of possible contingencies. (Foresight) Consider all relevant circumstances. (Circumspection) Avoid evil and obstacles. (Caution) Examples in Accounting: Imprudence by Deficiency Making rash accounting decisions, neglecting to look at the possible impacts it may have. Justice Prudence Classifying convertible notes as debt even if it seems probable that it can be converted. Imprudence by Excess Exploiting accounting choices to increase the firm’s standing.
There are two types of Justice. These are: • • Universal Justice This is just exercising all the virtues. Particular Justice This is justice is habitual (meaning it comes from a habit), to give everyone their rightful due. There are natural rights and rights determined by civil laws and legislation. There are three types of particular justice which are discussed further down. Injustice occurs when one person gets more or one gets less of their rightful share. Distributive Justice This is one of the particular justices.
When something is to be distributed, it should be distributed in a manner which is fair to all involved. From an accounting perspective, this usually occurs in the distribution of dividends. People must be paid dividends according to how many dividend-paying shares they have. Any returns on investment should also be distributed back based on how much each investor invested initially to reflect their risk profile. Remedial Justice This is justice where a remedy is imposed to correct a previous injustice. Say if someone was robbed, they have the right to have their possessions back.
In accounting, you can expect a supplier to compensate the firm for below-quality goods that it has supplied. Issues in Financial Reporting & Analysis – Semester 1 2010 10 Ethics in Accounting Commercial Justice In a transaction, what you give to the other party should be of equal value to what you get back as determined by active and liquid markets. It will be unjust if you do not get what you pay for. From an accounting perspective, if a customer buys a product that is faulty, they are entitled to get a brand new replacement because that is what they paid for.
Natural and Legal Justice Natural justice applies the same anywhere in the world. Genocide is always unjust. War crimes are always unjust. Legal justice is one that differs between countries because each country has a different set of laws. What can be seen as unjust in one country may be seen as just in another. It used to be legally just to conform to the AASB standards but since 2005, it is now legally just to conform to IFRS instead. Liberality Liberality means to be careful in how much you do. In an accounting sense, this usually means money.
Don’t spend too much, but don’t be too stingy either. Of course, this is always in relation to how much money one has. It must also be noted that it also depends what one spends that money on. For example, if we have a person on a low income that spends the majority of their income buying groceries, paying the bills and saving the rest in the bank, they would be considered liberal. However, a person on a low income that instead, spends all the money on cigarettes and alcohol is not liberal. Truth Telling the truth is where the hearer has a right to know the truth.
Not telling the truth is lying. Lying can either be where you say less than the truth or more than the truth. People lie because: • • • • They want to injure others or gain themselves. (Mischievous) For amusement with no harm intended. (Jocose) Intending to help another. (Officious) Want to appear as having substantial to say but only say little. (Waffling) So can truth ever be found in financial reporting? Yes, it can. However, you require 100% accuracy in book-keeping. Truth can then be reported as long as the other virtues and morals are applied such as prudence.
However, accounting standards are never perfect and there is always the conflict between insiders and outsiders in terms of knowledge and information. Thus, there is usually a short-fall in truth in accounting. Issues in Financial Reporting & Analysis – Semester 1 2010 11 Accounting for Physical Assets & Intangible Assets Accounting for Physical Assets & Intangible Assets Background Recall the definition of an asset. It is a resource that is controlled by the entity as a result of past events and from which future economic benefits are expected to flow to the entity.
Measurements The exact way of measuring the value of an asset differs for the type of asset. These are: • • • Inventory (Tangible): The lower of Cost or Net Realisable Value. Property, Plant and Equipment (Tangible): Cost or Fair Value Goodwill (Intangible): Cost Initial Measurement Property, Plant and Equipment The initial recognition of Property, Plant and Equipment (PPE) shall be the amount of cash or cash equivalents given to acquire and construct the asset. This includes costs required to ship the product and any import taxes etc.
In the case where you trade assets you currently hold for a new asset, the cost of the new asset will be the sum of the fair values of the assets you traded in order to buy the new asset. If the payment is to be delayed or be in instalments, the cash payments must be discounted back to the present. Borrowing costs that are incurred as a result of borrowing funds to purchase new assets can only be capitalised if they are directly attributable to the acquisition of a qualifying asset. A qualifying asset is one that takes more than 12 months to get ready for its intended use.
If the asset does not fit this description, then all borrowing costs must be expensed. Subsequent Measurements of Property, Plant and Equipment PPE subsequently can be measured either at cost (cost model) or fair value (revaluation model), as stated above. The cost model is simply the cost of the asset as determined at acquisition date minus any accumulated depreciation and any impairment losses. The revaluation model is where we take the fair value of the asset at the date of revaluation and minus any accumulated depreciation (after revaluation) and any impairment losses (after revaluation).
Fair value is the value at which the asset can be sold at an arm’s length transaction between two knowledgeable parties. The same model must be applied to the same class of assets throughout the company. You cannot value one company car under the cost model and another under the revaluation model. They must all be under the cost or revaluation model. Issues in Financial Reporting & Analysis – Semester 1 2010 12 Accounting for Physical Assets & Intangible Assets Revaluation of Assets When assets such as PPE and land are revalued, we increase the value of an asset to the newly valued fair value. . e. Dr Asset Cr Revaluation Reserve XXXXX XXXXX If we are revaluing downwards, we immediately have to expense it: Dr Loss on Revaluation of Asset Cr Asset XXXXX XXXXX Accumulated depreciation should always be “applied” following a revaluation. This means writing depreciation onto the asset and then revaluing the asset to its new value. Dr Accumulated Depreciation Cr Asset Example: A factory is valued at $1,000,000 on the balance sheet as the value at cost. Depreciation is straight-line at 10% per annum. 3 years after the factory was purchased, the firm decides to revalue its PPE.
The factory is subsequently found to be worth $750,000. The journal entries required at the end of year 3 would be: To “apply” accumulated depreciation Dr Accumulated Depreciation – Factory Cr Factory XXXXX XXXXX 300,000 300,000 To value up the asset by $50,000 ($750,000 – $700,000) Dr Factory 50,000 Cr Revaluation Reserve 50,000 Note that when revaluing assets, they cannot be aggregated together. If you have 3 blocks of land and each were revalued +$100,000, +$200,000 and -$50,000 respectively, you would have to do the journal entries separately.
You cannot aggregate them and do a single entry to revaluate upwards by $250,000. Revaluing after a Previous Revaluation When revaluing an asset in the opposite direction to which it was revalued previously, we need to eliminate the loss or surplus first before anything else. Example: Following from our previous example. Our factory now has a carrying value of $750,000. This was revalued upwards from $700,000 so we have a revaluation reserve of $50,000. In the same year, the fair value of the factory has dropped to $600,000. The journal entries required are:
Issues in Financial Reporting & Analysis – Semester 1 2010 13 Accounting for Physical Assets & Intangible Assets Eliminate against previous reserve Dr Revaluation Reserve Apply the loss Dr Loss on Revaluation Cr Land 50,000 100,000 150,000 The same principle should be applied when we have a gain and then need to reverse a previous loss. The journal entry would be: Dr Asset Cr Gain on Revaluation Cr Revaluation Surplus Accounting for a Disposal of a Revalued Asset When a revalued asset is sold, the gain or loss is calculated based on the current revalued carrying amount of the asset.
However, after we do this, we still have an amount attributable to the asset sold in our revaluation surplus. This amount can be transferred to our retained profits account. Impairment Testing Under AASB 136, firms are required to conduct impairment tests so long as they have indication that an asset may be impaired. These could be: • • • • • • • Damage to the asset Change in asset use Change in economic performance of the asset Increase in interest rates Adverse changes in the market Higher than expected decline in market value Net assets greater than market capitalization XXXXX XXXXX XXXXX
An asset is considered impaired if its carrying amount is greater than its recoverable amount. The recoverable amount is the higher of value in use or fair value minus costs of sale. Recognising an Impairment Loss Recognising an impairment loss differs depending on if the cost model or the revaluation model is being used. Under the cost model, we simply recognise it immediately as an expense. However, in the revaluation model, we treat it as a revaluation decrement. All the rules of a normal decrement apply here.
The journal entries under the cost model are: Dr Impairment Loss Cr Asset XXXXX XXXXX Issues in Financial Reporting & Analysis – Semester 1 2010 14 Accounting for Physical Assets & Intangible Assets The journal entries under the revaluation model are: Dr Impairment Loss Dr Revaluation Reserve Cr Asset Reversing an Impairment Loss The AASB standard allows for a reversal of an impairment loss only if there is a change in the estimated used to determine an assets recoverable amount. Reversing an impairment loss is simply reversing the entries we used to recognise the loss in the first place.
Cash Generating Units Cash Generating Units (CGUs) are the smallest identifiable group of assets that generates cash flows which are independent of other asset groups. For example, the Airport Line in Sydney is privately owned, but would not generate any cash unless state-owned RailCorp actually runs trains on the private railway. In this case, impairment greatly depends on whether RailCorp provides train services or not. As such, if the recoverable amount of an asset cannot be determined, we apply it to the CGU instead on a pro-rata basis.
However, remember that an asset’s carrying amount can never be below its recoverable amount. So if, on a pro-rata basis, application to the CGU would cause one or more of the assets to fall below their recoverable amount, we use a pro-rata basis on the remaining assets that will not fall under. In addition, if goodwill is part of the CGU, goodwill is impaired first before all other assets. Intangible Assets Intangible assets are identifiable non-monetary assets that are not physical. Such examples include: goodwill, brands, trademarks, patents and licenses.
Remember, we can only recognise these as assets if we can reliably measure their cost and if it is probable that future economic benefits will flow from it. Most externally acquired intangible assets generally satisfy this but internally generated ones usually require more inspection. Research and Development All research costs must be expensed. Research is defined as all expenditure that is undertaken to gain new scientific knowledge and understanding. Development costs are those costs incurred to put research findings into a plan or design. These too, must be expensed.
However, they may be classed as an intangible asset so long as it demonstrates all of the following 6 criteria: 1) the technical feasibility of completing the intangible asset so that it will be available for use or sale; 2) its intention to complete the intangible asset and use or sell it; XXXXX XXXXX XXXXX Issues in Financial Reporting & Analysis – Semester 1 2010 15 Accounting for Physical Assets & Intangible Assets 3) its ability to use or sell the intangible asset; 4) how the intangible asset will generate probable future economic benefits.
Among other things, the entity can demonstrate the existence of a market for the output of the intangible asset or the intangible asset itself or, if it is to be used internally, the usefulness of the intangible asset; 5) the availability of adequate technical, financial and other resources to complete the development and to use or sell the intangible asset; and 6) its ability to measure reliably the expenditure1 Other Internally Generated Intangible Assets Other internally generated intangibles such as goodwill, brands, titles, customer lists, trademarks and patents cannot be identified as intangibles.
This is because they cannot be distinguished from the cost of the developing the entire business. Intangible assets can only be recognised if they can be distinguished. In regards to goodwill, the AASB standards explicitly state, “Internally generated goodwill shall not be recognised as an asset. 2” Initial Measurement Initial measurement of an intangible asset should be at cost. There is only one time where this is different and it is if the intangible asset was acquired as a result of a business combination. In this case, we use the fair value of the intangible asset as identified at the date of acquisition.
Revaluation and Impairment of Intangible Assets Intangible assets are usually unable to be revalued since there is no active market for it. For those that do, the revaluation model can be applied. Intangible assets with a finite life are subject to amortisation over its useful life. Amortisation must be started the moment the intangible asset is used. This is treated as an expense. We only apply the impairment test if there is any hint of impairment. For intangible assets with an infinite life, we do not amortise it. However, it is subject to compulsory yearly impairment testing.
Goodwill Goodwill can only be recognised as an intangible asset acquired in a business combination. Goodwill is the difference between how much was paid to acquire the company and the net value of the acquired company’s assets. Goodwill is not revalued or amortised. It is subject to a compulsory annual impairment test and any impairment losses cannot be reversed. 1 2 AASB 138 Paragraph 57 AASB 138 Paragraph 48 Issues in Financial Reporting & Analysis – Semester 1 2010 16 Accounting for Assets in Mining & Agricultural Industries Accounting for Assets in Mining & Agricultural Industries
Background The mining industry is different to normal firms in that it has high risk and the time period between exploration and production is usually over a long period of time (over one year). Agricultural industries are also special in that they deal with biological assets. The Lifecycle of a Field The time period over which a mine or field is usually represented in the following way: 1) Exploration Finding the minerals, gas, oil etc. 2) Evaluation Seeing if it is feasible and economical to extract the raw materials. 3) Development Building of access roads/rail to the field. ) Construction Building and commissioning of facilities at the site. 5) Production Day-to-day extraction of raw materials from the field for sale. This lifecycle tends to go over many years, and thus, many accounting periods. Thus, special rules apply to the mining sector. Exploration and Evaluation Costs During the exploration and evaluation stage of the lifecycle, there are many preproduction costs including, but not limited to: • • • • • Exploration rights Geographical studies Exploratory drilling Sampling Trenching There are a few methods in deciding if we should expense or capitalise these costs.
The method used in Australia is the Area of Interest (AOI) method. The Area of Interest Method An AOI is defined as a single mine, deposit or field. For each area, the method states that all costs shall be expensed and can be partially, or fully capitalised if the area is current and that it fulfils at least one of the following criteria: Issues in Financial Reporting & Analysis – Semester 1 2010 17 Accounting for Assets in Mining & Agricultural Industries • • Costs are expected to be recouped. Exploration/Evaluation activities have not reached the point where a reasonable assessment can be achieved.
Measurement of Mining Assets Assets in the mining industry are initially measured at cost and can then use the cost or revaluation model. However, most assets in the mining industry are not revalued since there is usually never an active market available. Thus, revaluation is normally rare for these assets. Impairment As with normal assets, mining assets must also be tested for impairment when there is an indication that there is impairment. Most impairment in the mining sector arises from a drop in commodity prices. Indicators include: • • • • The right to explore is expiring (or expired) and will not be renewed.
Discontinuing activities in the AOI. Carrying amount of the asset is unlikely to be fully recovered. Substantial expenditure on further exploration/evaluation is not planned/budgeted for. Reclassification of Assets in Different Stages of the Lifecycle The mining lifecycle can be split into three parts: 1) Exploration and Evaluation (AASB 6) 2) Development and Construction (AASB 116/136) 3) Production (AASB 102) Reclassification to “development asset” Reclassification to “production asset” In between these stages, our assets must be reclassified. The related AASB standards that need to be used in each stage are as stated above.
Depreciation/Amortisation of Production Assets Depreciation and amortisation of production assets happens the minute the mine is being used to produce raw materials. It can be calculated based on two different methods: • Production Outputs Basis This is the preferred method. It takes the amount of raw materials output for that period and divides it by the estimated total yield of the field/deposit. It then uses this value to depreciate the asset accordingly. Example: A mine has reach production and it is expected that the yield of the deposit is 1,000 tons of copper.
The total production assets are valued at cost at $400,000 initially. In the first year, 200 tons is extracted and in the second year, 300 tons is extracted. Issues in Financial Reporting & Analysis – Semester 1 2010 18 Accounting for Assets in Mining & Agricultural Industries Depreciation would be: $400,000 x 200/1,000 = $80,000 in the first year. In the second year, depreciation would be $400,000 x 300/1,000 = $120,000. • Time Period Basis This is similar to the production outputs basis except that we use time instead of output as measurement. Agriculture Now, we turn our attention to the agricultural industries.
First, agriculture is defined as the transformation of biological assets for sale. Biological assets are defined as a living animal or plant that is used for the sole purpose of agriculture only. This does not include living animals and plants used for other purposes such as greyhound dogs, race horses and forests purchased for carbon credits. Note that AASB 141 (Agriculture), which we are examining here, only covers things that are produced by the animal/plant, not things that are produced from the raw material that is harvested. For example: When looking at cows, we only cover milk, not anything made from that milk afterwards like cheese.
Recognition and Subsequent Measurement A biological asset is recognised with the same criteria for PPE, except that we can say it is an asset even if its’ fair value or cost of the asset can be measured reliably. This differs in that PPE only allows the cost of an asset. Biological assets must have their own entry on the balance sheet but they are not required to be classified into current or non-current. Fair Value of Biological Assets Subsequent measurement must be done at reporting date. Biological assets must be valued at their fair value minus costs to sell.
If this cannot be measured reliably, we can use the cost of the biological asset minus all depreciation and impairment losses; this is rarely done. When holding a biological asset, if there are any gains or losses that arise at initial recognition, these go directly to profit or loss, if it is a gain or loss respectively in that period. For subsequent periods, fair value can be defined as following order: • • • If there is an active market, use quoted prices. If there is no active market, use the most recent market transaction price, or market prices for similar assets, or benchmarks if any exist in the sector.
If market prices are not available, we use the present value of the net cash flows of the asset For agricultural produce, its value is to be measured at the point it is harvested at fair value minus costs to sell. Issues in Financial Reporting & Analysis – Semester 1 2010 19 Accounting for Provisions Accounting for Provisions Background A provision is a liability that has uncertainty in its timing and/or amount. Common provisions include employee benefits. Short-Term Employee Benefits Employee benefits are all the forms of consideration that an employer gives to an employee as a result of the employee rendering services for the employer.
For short-term employee benefits (less than 12 months) such as wages, salaries, annual leave and sick leave, a company must: • • Recognise it when the employee has rendered service. That is, when the employee accumulates the working hours. Expense all these unless capitalisation is required by another standard, such as when employee costs may be associated with the acquisition of PPE. In this case, employee costs would be capitalised as part of PPE cost. Recognise a liability for benefits the employee has not taken (unused annual leave/sick leave etc. Recognise an asset to the amount overpaid on the required benefits (i. e. Leaving aside $1,000 for something only $800 in value. ) We do not discount any cash flows here since it is for a period less than one year. Annual Leave Annual leave is generally 20 days in a year for Australian employees. Annual leave is recognised by the employer as the employee works. How often this is recognised depends on the individual company’s policy. To recognise this, we use the following journal entry: Dr Annual Leave Expense Cr Provision for Annual Leave XXXXX XXXXX • •
When the employee does take annual leave, we use the following journal entry: Dr Provision for Annual Leave Cr Pay-As-You-Go Tax Payable Cr Cash XXXXX XXXXX XXXXX Tax is applicable because in Australia, you pay tax as you work, from your payroll, so that you will definitely have enough to pay tax at the end of the financial year. Issues in Financial Reporting & Analysis – Semester 1 2010 20 Accounting for Provisions Example: Bob has an annual salary of $55,000 and is paid fortnightly. His contract allows him to take up to 20 days annual leave each year at a loading rate of 17%.
This means that annual leave for Bob costs the company $55,000 x 4/52 x 1. 17 = $4,950 per year, or roughly $95 per week. Assuming that the company also does the annual leave journals every fortnight, the journal entry would be: Dr Annual Leave Expense Cr Provision for Annual Leave 190 190 If Bob decides to take a week off work to go on holiday, assuming a tax rate of 30% the journal entry required would be: Dr Provision for Annual Leave Cr Pay-As-You-Go Tax Payable Cr Cash Sick Leave An employee is, like annual leave, usually entitled with 20 days of sick leave per year.
Sick leave is comes in three forms: • Non-Accumulating Sick leave cannot be carried over to the next year. All unused sick leave it discarded. In this method, there is no provision. So the amount paid out in sick leave for that year is the expense. Accumulating and Vesting Sick leave can be carried over to the next year. Outstanding sick leave days can be paid out to the employee upon leaving the firm. This method is treated exactly the same way as annual leave. This method also always gives the highest provision amount. Accumulating and Non-Vesting Sick leave can be carried over to the next year.
However, outstanding sick leave days cannot be paid out upon leaving the firm. Example: A company has 10 employees. 5 of them used all their sick leave in the year, 3 used up 10 days and the remaining 2 used none. For simplicity, all employees are paid $50,000 salaries in the year. If Sick Leave is Non-Accumulating: The provision will be $0. The expense will be: 5/10 x 4/52 x 500,000 + 3/10 x 2/52 x 500,000 + 2/10 x 0/52 x 500,000 = $25,000. 1237 371 866 • • Issues in Financial Reporting & Analysis – Semester 1 2010 21 Accounting for Provisions
If Sick Leave is Accumulating and Vesting: The expense will be as above, $25,000, plus the increase in provision: 5/10 x 0/52 x 500,000 + 3/10 x 2/52 x 500,000 + 2/10 x 4/52 x 500,000 = $13,462. Thus the total expense for the period is $38,462. If Sick Leave is Accumulating and Non-Vesting: Assume that the people who did not take all their sick leave are going to take one week of sick leave next year. Thus, our expense will be, $25,000, plus the increase in provision: 5/10 x 1/52 x 500,000 = $4,808. Thus, the total expense for the period is $29,808.
Post-Employment Benefits In Australia, the most prominent post-employment benefit is superannuation. This is where the employer transfers funds to an independent superannuation fund on behalf of the employee. Only after a certain age, can employees access this fund. Superannuation funds can be split into: • Defined contribution funds These funds are where the benefits are based on the employer’s initial contributions (plus any interest earnings on those). The employer is obligated to make the initial contributions but all the risk falls on the employee.
In this case, the employer’s contribution is recognised as an expense. If it has not been paid yet, it is a liability. Defined benefit funds These funds are where the benefits are based on the employer’s agreement. The entity is only obligated to make the final payments and all risk falls on the employer instead. We recognise the PV of the defined benefit obligation as an expense. • Long-Term Employee Benefits For long-term employee benefits in general, they are treated as an expense and the obligation that arises is treated as a liability.
Measurement is based on the present value of expected payments in regards to that obligation. The discount rate to be used is the same as the interest rate on high quality corporate bonds that have the same maturity and currency. Long Service Leave Employees in NSW typically get 2 months of long service leave after they have been with the company for 10 years continuously and 1 month for every 5 years thereafter. These are divided into three periods: • • • 0-5 years: No entitlement 5-10 years: Pro-rata entitlement More than 10 years: Entitlement vests Issues in Financial Reporting & Analysis – Semester 1 2010 2 Accounting for Provisions An employer may not actually even pay the long service leave but they still must recognise the provision (liability) from the moment the employee is employed. To calculate how much long service leave will cost the company, we use the following steps: 1) Take the current salary and find the future value of it in the year the employee gains their long service leave. 2) Find the accumulated benefit: (Years employed / 10) x (8/52) x Projected Salary. 3) Find the present value of the above. 4) Multiply by the probability that the long service leave will be paid.
There is argument that employers deliberately fire staff who are reaching the 10th year of their employment to avoid having to pay long service leave. This is an ethical issue. Provisions vs. Contingent Liabilities Provisions are obligating events where a firm must do something. However, a contingent liability is one where it is possible the firm will have to do something. It is not wholly in the control of the company so they do not have full influence on its result. In short, a contingent liability is one that has a possible obligation and/or is not remote and/or has no reliable estimate of the expected outflow of cash.
Contingent liabilities are not recognised on the balance sheet but must be stated in the notes to the financial statements. Measurement of a Provision A provision is initially recognised at the best estimate (the amount that an entity will rationally pay, taking into account risks and uncertainties) of the expenditure to settle the obligation at the reporting date. For subsequent measurement, we adjust the provision to the current best estimate. If it is no longer probable, we reverse the provision. Examples of a Provision Remember, a provision must be an obligation.
There must be 100% certainty that the expense will occur. When it occurs and how much it will cost can be unknown. Thus, the following are provisions: • • • Announcing that the company will close down in a press release. Warranty claims for a manufacturer. The company causes environmental damage and is not allowed under law. The following are not provisions: • • Reaching an agreement with the board of directors to close down the company. Legal proceedings by consumers for damages arising from a faulty product. Probable that the entity will not be liable. Issues in Financial Reporting & Analysis – Semester 1 2010 23