School of Accounting ACCT 1511: Accounting and Financial Management 1B Session 1, 2012

Week 3

Assets (2): Application of Financial Reporting Principles

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

Lecturer: Dr Per Tronnes

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

Introduction and Learning Objectives

At the end of this week, you should: LO1. Understand the mechanics of revaluing assets. LO2. Understand the mechanics of impairment testing. LO3. Revisit the accounting treatment of inventory. LO4. Be technically competent in journal entries and T-accounts relevant to asset revaluation, intangible assets, and inventory measurement. LO5. Be able to identify and apply relevant accounting principles to accounting rules underlying each of these asset items.

Required Readings
Required Readings Trotman & Gibbins (TG) Chapter 8 (revision), 9.6-9.8, 9.10 The accounting Framework.

Additional References http://www.aasb.com.au AASB 3 Business Combinations AASB 116 Property, Plant and Equipment AASB 138 Intangible Assets AASB 136 Impairment of Assets

For Week 3 Lecture

1. Bring this handout (including all the attachment). 2. Bring a calculator.*
*Please make sure to get your calculator approved by the university prior to the exam (https://my.unsw.edu.au/student/academiclife/assessment/examinations/Calculator.ht ml).

Tutorial Questions for Week 4 (Commencing 19th March)

Tutorial Preparation Questions: Trotman and Gibbins: Problem 8.11 Case 8C Problem 9.22 Problem 9.23 Problem 9.27

Tutorial Homework Questions: Past Exam and Additional Questions (see below): Question 4 from mid-session exam 2011, semester 2 (see below) Additional homework question (see below)

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

Homework Question: Comparison between cost and revaluation method Land Cost Method Recorded Value Y0 Buy for $100,000 Journal Entry Revaluation Method* Recorded Journal Entry Value

Y1 Market value: $150,000

Y2 Market value :$120,000

Y3 Market value: $75,000

Y4 Market value: $110,000

*Revaluations are done every year.

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

(b) With reference to the journal entries made in the third year above, briefly explain in what way the treatment above reflects Conservatism. [1 mark] (c) Discuss the Relevance and Reliability of the value of land on the balance sheet under the revaluation method. [2 marks]

Lecture Workshop

2010 Session 2 Mid-semester Exam (Adapted)

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

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

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

DO NOT WRITE OUTSIDE THE BOX

Week 3

Accrual Accounting
Asset v. Expense Revenue v. Liability v. Equity

ACCT1511
Assets (2) More on Non-current
Current: Inventory, Receivables
Dr Per Tronnes QUAD 3095 p.tronnes@unsw.edu.au
1 2

Definition

Asset

Expense

Revenue

Liability

Equity

Recognition

Measurement

Effect

Income Statement & Balance Sheet

With thanks to Dr Cheng Lai

Different Methods for Measuring Value

1. 2.

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

3.

4. 5.
3

Historical Cost (what did we pay for it) e.g. everything usually Current or Market Value (value in exchange) (what could we get for it if we sold it) e.g. Financial assets of financial institutions Value in use (present value) (what is it worth to us) e.g. capitalisation of building/ mines, financial assets of financial institutions (when convenient to them) Liquidation Value (what would we get if we had to sell if really fast) e.g. Lehman Brothers Price-adjusted Historical Cost (what we paid for it adjusted for inflation) e.g. High inflation countries Which method is reliable? Relevant? neither?
4

Annual Inflation Rate: 2.5%

Simple Illustration (cont.)

Historical cost: Current / Market Value: Value in Use: Liquidation Value: Price adjusted Historical Cost:
We will not ask you to calculate present values in this course, but you should be familiar with the concept of time value of money and what present value is (see appendix to Chapter 10).

Some things to note: At purchase date (i.e. at recognition): Historical cost=Market Value Fair Value: is the amount that for which an asset could be exchanged between knowledgeable, willing parties, in an arms length transaction (AASB 116, para 6). (i.e. Fair value is generally (an estimate of) market value)
6

L1

Measurement at Recognition: PPE

An item of property, plan and equipment that

Examples of cost that are directly attributable:

Cost of employee benefits (i.e. Salary, annual leave, etc) arising directly from the construction or acquisition of the item. Cost of site preparation Initial delivery and handling costs Installation and assembly costs Cost of testing if the asset is functioning properly Professional fees (e.g. lawers fee for fixing the contract etc).
8

qualifies for recognition shall be measured at its cost (AASB 116, para 15)
Elements of costs:

Its purchase price, including import duties and nonrefundable purchase taxes after deducting trade discounts and rebates Any costs directly attributable to bringing the asset to the location and condition necessary for it to be capable of operating in the manner intended by management. The initial estimate of the cost of dismantling and removing the item and restoring the site on which it is located (if the company is required to do so)
7

Illustration
25 Jan 2011, FloppPop Pty Ltd purchased a specialised machine for $25,000. The machine is fairly large and heavy and needed special delivery at a cost of $5,000. It hired two people to install the machine. Each person was paid $250. The machine was delivered and installed 1 Feb 2011. 15 Feb 2011, the company incurred $2000 in advertising costs for promoting the new product.
How much of the equipments costs are capitalised? And at which date do we start to depreciate the

Illustration continued
Purchase Price: Directly Attributable Costs: Delivery Installation Machine Costs $25,000 $ 5,000 $ 500 $30,500

Advertising is not a directly attributable to making the asset operate in a manner intended by management. Depreciation begins when the asset is available for use. That is, when it is capable of operating in a manner intended by management: 1 Feb 2011
10

Machine?
9

Measurement after Recognition: PPE

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

The revaluation Model

Revaluation model: After recognition as an asset, an

item of property plant and equipment whose fair value can be measured reliably shall be carried at a revalued amount, being its fair value at the date of revaluation less any subsequent accumulated depreciation and accumulated impairment losses.
Revaluations shall be made with sufficient regularity to

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

11

12

L2

Asset revaluations
A revaluation may either be: an increment increasing the value at which the asset is recorded. a decrement decreasing the value at which the asset is recorded. Can only revalue an asset as part of a whole

Asymmetric accounting
The tricky part is that we do not treat increments and

decrements similarly.
Increment:

class of assets.
Increments and decrements are judged from the assets CARRYING AMOUNT
that is, asset value less accumulated depreciation.
13 14

Dr Asset Cr Revaluation Reserve an owners equity account in balance sheet so it does not increase the period profit (but now in Other Comprehensive Income). Decrement Dr Loss on Revaluation Cr Asset A loss in the income statement so it does decrease profit.

Case Study: Revaluation

Increments that reverses previous
Price Increment
$520,000

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

Cost at initial recognition $500,000

Time Year 1 Year 2 Year 3

Decrements that reverses previous

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

$480,000

Discuss with the person next to you (2 mins) Q) Journal entry for Year 1, 2 and 3 (year end)? Q) Did the company make gain after all?
16

15

Answers:
Year 1: Year 2: Year 3:

Revaluation
What principles are invoked/ contradicted?

Recognise possible losses to P&L immediately, even though unrealised Defer possible gain recognition in income until realised But new treatment, include as Other Comprehensive Income (week 6 lecture)

17

18

L3

Revaluation: 4 Steps Step 1 Update depreciation:

Dr Depreciation expense Cr Acc. depreciation Buildings

Step 3: Recording a revaluation

If it is a increment (revaluation method):
Dr Building Cr Revaluation reserve (OE)/Gain on Revaluation (IS) Gain on Revaluation is recorded if there is a prior net valuation decrement, and until all prior losses on revaluation is reversed.

Step 2 Credit accumulated depreciation to asset

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

If it is a decrement (revaluation method):

Dr Loss on revaluation (IS)/Revaluation reserve (OE) Cr Building A debit to revaluation reserved is recorded if there is a prior net valuation increment, and until all prior upward revaluation is reversed.
20

19

Step 4: Recalculate Depreciation

If there is no changes in useful life, residual value or method of depreciation: If recording a valuation increment: Depreciable amount have increased and therefore yearly depreciation expense will be larger. If recording a valuation decrement: Depreciable amount have decreased and therefore yearly depreciation expense will be lower.
21 22

Revaluation and Disposal (example 1)

Land is revalued from $100 to $220 in year 1 and to 200 in year 2 and is in beginning of year 3 subsequently sold for $200. Assume No TAX:
Y1 Y2 Dr Land 120 Cr Revaluation Reserve Cr Revaluation Reserve 20 Cr Revaluation Reserve DR Cash 200 CR Land DR Revaluation Reserve 100 Cr Retained Earnings 120 20

Y3

200 100

Revaluation and Disposal (example 2)

Land is revalued from $100 to $180 in year 1 and subsequently sold for $160 in year 2. Assume No TAX:
Y1 Dr Land 80 Cr Revaluation Reserve 80 (OE) Dr Loss on sale of land 20 (IS) Dr Cash 160 Cr Land 180 Dr Revaluation Reserve 80 Cr Retained Earnings 80
24

Revaluation and Disposal (example 3)

Land is revalued from $100 to $150 in year 1 and subsequently sold for $170 in year 2. Assume No TAX:
Y1 Dr Land 50 Cr Revaluation Reserve 50 Dr Cash 170 Cr Land Cr Gain on Sale Dr Revaluation Reserve 50 Cr Retained Earnings

Y2

Y2

150 20 50

23

L4

Revaluation and Disposal (example 4)

Land is revalued from $100 to $60 in year 1 and subsequently sold for $90 in year 2. Assume No TAX:
Y1 Dr Loss on Revaluation Cr Land Dr Cash Cr Land Cr Gain on Sale 40 40 90 60 30

Intangible Assets: Measurement on Recognition

An intangible asset shall be measured initially

at cost.
Elements of costs:

Y2

Its purchase price, including import duties and nonrefundable purchase taxes after deducting trade discounts and rebates Any directly attributable costs of preparing the asset for its intended use For internally generated intangibles the cost is the sum of expenditure incurred from the date when the intangible asset first meet the recognition criteria (i.e. from the development phase).

25

26

Intangible Assets: Measurement after Recognition

Two choices: cost or revaluation method. However, fair value needs to be determined

Impairment
An entity shall assess at each reporting date whether there is any indication that an asset may be impaired (AASB 138, para 9.) Simply stated, at each reporting date we check whether there is an indication that any of the assets value are overstated.
Note: Intangible asset with an indefinite useful life and Goodwill must, irrespective of indication or not, be tested for impairment at least annually.
28

with references to an active market:

The items traded are in the market are homogenous Willing buyers and sellers can normally be found at any time Prices are available to the public Since intangible assets tend to be unique by nature (patents, trademarks etc) rarely is an active market found. In Australia, there is perhaps an active market for taxi licences and possible carbon emission quotas.

27

Indicators of impairment
External Sources: 1) an asset market value has

So how do we test for Impairment

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

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

29

30

L5

Impairment testing
We know the carrying value of the asset. But we need to find the recoverable amount. The recoverable amount is the higher of: 1. Fair value less cost to sell (the amount
obtainable from the sale of an asset in an arms length transaction between knowledgeable, willing parties, less cost of disposal) 2. Value in use (the present value of the future cash flows expected to be derived from an asset)

So to sum up the impairment test:

1. Find a) Fair value less cost to sell b) Value in use 2. The highest value of these two will be the recoverable amount. 3. Compare the assets carrying amount to the assets recoverable amount. If
Carrying amount>recoverable amount impaired Carrying amount<recoverable amount not impaired

31

32

Asset is impaired, then what...

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

Reversal of an Impairment Loss

If impairment loss have been recognised in a previous period, but the estimates of the assets recoverable amount have increased since the last impairment, then there is a reversal of the impairment loss.
Dr Accumulated Impairment XXX Cr Gain on Reversal of Impairment XXX

Dr Loss on Impairment XXX Cr Accumulated Impairment XXX

Unless the revaluation method is used, then any impairment loss is treated as a revaluation decrease (AASB 138, para 60) Dr Loss on Revaluation (or Revaluation Reserve) XXX Cr Asset XXX
33 34

Reversal of an Impairment Loss

Reversal of impairment cannot increase the carrying amount to exceed the carrying amount (net of depreciation or amortisation) had no impairment taken place. (AASB 138, para 117). Cannot reverse impairment for Goodwill. Unless asset is carried at revalued amount, then any reversal of impairment loss is treated as a revaluation increase (AASB 138, para 119)
Dr Asset XXX Cr Gain on Revaluation (or Gain on Revaluation) XXX
35 36

Current Assets (ACCT1501)

Cash and cash equivalents can include overnight money

market accounts and other very liquid investments

Short-term investments include trading securities and

available-for-sale securities
Trade debtors and other receivables are reported net of

allowance for doubtful debts

The proper presentation of inventories includes

disclosure of basis of valuation, method of pricing and stage of completion in the case of manufacturing firms Prepaid expenses are expenditures for benefits expected to be received within 1 year or the operating cycle

L6

Inventory (ACCT1501)
Inventories are assets: held for sale in the ordinary course of business in the process of production for such sale, or in the form of materials or supplies to be consumed in the production process or in rendering of services. Inventory types: raw materials work in progress finished goods inventory merchandise inventory.
37 38

Background: Cost of inventory (ACCT1501)

The cost of inventories comprises: costs of purchase costs of conversion other costs incurred in bringing the inventories to their present location and condition.

Inventory cost flows: Merchandising operation (ACCT1501)

Merchandise inventory $$$ $$$

Inventory cost flows: Manufacturing operations (ACCT1501)

Raw materials $$$ COGS $$$

Cost of goods sold $$$

Labour $$$

Work in process $$$ $$$

Overhead $$$

Finished goods $$$ $$$

39

40

Cost of goods sold (ACCT1501)

Opening inventory + = = Purchases Goods available for sale Ending inventory Cost of goods sold

Comparison of inventory methods (ACCT1501)

In periods of rising prices: FIFO results in the highest ending inventory, highest gross profit, highest net profit and the lowest COGS. LIFO results in lowest ending inventory, lowest gross profit, lowest net profit and the highest COGS. Weighted average results fall between FIFO and LIFO.
42

41

L7

Mis-measurement in Inventory (ACCT1501)

Overstatement of ending inventory leads to: understatement of current periods COGS overstatement of current periods profit. Understatement of ending inventory leads to: overstatement of current periods COGS understatement of current periods profit.

Lower of cost or market rule (ACCT1501)

Ending inventory is reported at lower of cost

or market value (LCM).

Market value is net realisable value. Net realisable value obsolescence damage demand

< cost because of:

Rule applied at item level. What principle is applied?

43 44

Inventory valuation (ACCT1501)

Inventory should be measured at the lower of

LCM rule: An example (ACCT1501)

Question: Assume that the cost of inventory is calculated to be $140 000. However, the net realisable value is only $125 000. Required: Prepare journal entries to apply the lower of cost and net realisable value rule. Dr Inventory Loss (Expense) Cr Inventory (Asset) 15 000 15 000

cost and net realisable value (also referred to as lower of cost and market value). Definition of net realisable value:
the estimated selling price in the ordinary course of business less the estimated costs of completion and the estimated costs necessary to make the sale.

Any loss from the application of this rule is

recorded as an expense in the accounting period in which the write down occurs.
45 46

Why not Cr contra-asset?

Accounts Receivable & Doubtful debts (ACCT1501)

Estimate the doubtful debts (e.g. 3% of all credit

Lecture Workshop

sales, 10% of all debts outstanding for greater than 60 days) Dr Bad debts expense xxx Cr Allowance for doubtful debts xxx Reliable? What principles come into play?
Write off all the bad debts (the definitely

Refer to Lecture Handout

uncollectible ones) Dr Allowance for doubtful debts Cr Accounts receivable

47

xxx xxx
48

L8