Introduction to Financial Accounting

(a)The Corporations Act
The requirements of companies legislation differ from country to country. In Australia, the legislation governing companies is contained in the Corporations Act (2001). The Corporations Act is concerned primarily with what financial information companies should disclose in their financial reports to shareholders, rather than with how specific financial transactions are to be accounted for.

(b)Australian Stock Exchange Listing Regulations
The Australian Stock Exchange (ASX) affects corporate financial disclosure through its listing requirements. These requirements have traditionally been concerned with disclosure rather than with technical accounting issues. For corporate disclosure, the ASX has to a large extent relied on compliance with accounting standards and corporate legislation. However, where it has considered these regulatory mechanisms to have lagged behind, it has been quick to insert additional disclosure items into the listing requirements. For example, turnover (total revenue) and funds statements (since replaced by cash flow statements) were included in the listing requirements many years before they were required to be disclosed in accordance with accounting standards.

(c)Accounting standards
While the Corporations Act provides authoritative direction on required disclosure in the financial reports prepared by entities, it has generally not dealt with detailed, technical accounting principles and rules. This role has generally been filled by accounting standards. Accounting standards provide detailed rules on how particular types of financial transactions and other economic events should be dealt with in an entity’s accounting records. Accounting standards, for example, explain how inventory should be valued, and how costs should be allocated between the cost of goods sold and the cost of inventory on hand. Accounting standards are very important in ensuring that an entity’s income (profit and loss) statement, balance sheet and statement of cash flows are an accurate and fair representation of its performance and financial position. Accounting standards also prescribe various disclosure requirements for accounting information. Question 1.1.14

A conceptual framework is often described as or likened to a coherent body of accounting theory or a set of interrelated concepts. The primary purpose for this theory or set of concepts is to define the nature, scope and purpose of financial accounting and reporting. For example, a conceptual framework seeks to answer questions such as: What types of entities should be required to prepare financial statements and follow accounting standards? What are the objectives of financial reports? Whose interests should the financial reports serve? What are the qualitative characteristics (attributes) of useful information?

The United States Financial Accounting Standards Board (FASB) defined its conceptual framework as ‘A constitution; a coherent system of inter-related objectives and fundamentals that can lead to consistent standards and that prescribes the nature, function and limits of financial accounting and financial statements’ (FASB 1980).

As noted above, the primary purpose for a conceptual framework is to define the nature, scope and purpose of financial accounting and reporting. Implicit in efforts of accounting bodies to develop a conceptual framework is the recognition that a number of fundamental issues in accounting remain unresolved, are poorly understood or have failed to achieve general consensus among the community of accounting and business practitioners, academics and regulators. A conceptual framework can also lead to better understanding among accountants, auditors and users because all parties would be using a common set of definitions and criteria when interpreting company financial reports. The AASB’s Policy Statement 5 The Nature and Purpose of Statements of Accounting Concepts explicitly states the potential benefits of the conceptual framework as follows (paragraph 7):

(a)accounting standards should be more consistent and logical, because they are developed in the context of an orderly set of concepts;

(b)increased international compatibility of accounting standards should occur, because they are developed in the context of a conceptual framework that is similar to the conceptual frameworks used by the International Accounting Standards Board (IASB) and major overseas national standard setters;

(c)the AASB should be more accountable for its decisions, because the thinking behind specific requirements will be more explicit, as should any departures from the concepts which may be included in particular accounting standards;

(d)the process of communication between the AASB and its constituents should be enhanced, because the conceptual underpinnings of proposed accounting standards should be more apparent when the AASB seeks public comment on them; and

(e)the development of accounting standards and other authoritative pronouncements should be more economical because the concepts developed by the AASB will guide the AASB and the Urgent Issues Group (UIG) in their decision making.

The IASB stresses additional goals for its conceptual framework to reflect the Board’s international focus. These internationally orientated goals include to: assist the Board in promoting harmonisation of regulations, accounting standards and procedures relating to the presentation of financial statements by providing a basis for reducing the number of alternative accounting treatments permitted by international accounting standards; and assist national standard-setting bodies in developing national standards [paragraph 1 (b) (c)].

Question 1.1.21
Definition and recognition criteria for accounting elements are essential for determining the content of financial statements, or those transactions which should be included or excluded from financial statements. Not surprisingly, the definition and recognition criteria for accounting elements has so far proven the most controversial aspect of the conceptual framework project. This stands to reason given that the underlying profitability and financial position of companies can be materially affected depending on which definition and recognition criteria are used.

The AASB Framework guidelines are as follows (paragraphs 47–81):

1.An asset is defined as a resource controlled by the enterprise as a result of past events and from which future economic benefits are expected to flow to the enterprise.

2.A liability is defined as a present obligation of the enterprise arising from past events, the settlement of which is expected to result in an outflow from the enterprise of resources embodying economic benefits.

This definition stresses the obligation to make monetary payments or other outflows of resources to parties external to the entity. Most obligations are legally enforceable because they result from legally binding contracts or are government-imposed—such as income taxes or employer superannuation contributions. However, the definition of liabilities extends beyond the concept of legal enforceability and could include equitable obligations (arising from moral or social sanctions) and constructed (constructive) obligations. Constructive obligations are inferred or construed from the facts of a particular situation rather than contracted by agreement with an external party. For example, a constructive obligation exists where an entity adopts a practice of paying year-end bonuses to employees even though the company is not contractually bound to do so.

3.Equity is defined as the residual interest in the assets of the enterprise after deducting all its liabilities. Equity is therefore determined by subtracting the total assets from the total liabilities of an entity.

4.Income is 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. Note that a distinction is drawn in the Framework (Par74-6) between Revenue (Income from the ordinary activities of the entity) and Gains (which represent other items that meet the definition of Income) eg Gain on Sale of asset. Gains are usually reported separately from Revenue in the Income Statement. (ed)

The definition of income/revenue is therefore driven or derived from the definition of assets. The logical application of this definition in practice could result in important items not previously treated as revenues (under conventional accounting) being treated as revenues. For example, increases in the value of non-current assets above book value could justifiably be treated as revenues under the IASB definition.

5.Expenses are decreases in economic benefits during the accounting period in the form of outflows or depletions of assets or incurrence of liabilities that result in decreases in equity, other than those relating to distributions to equity participants. As with the definition of income, the definition of expenses follows the definition of liabilities.

Recognition of the elements of financial statements

According to the AASB Framework (paragraphs 82–98), an item that meets the definition of an element should be recognised if: 1.it is probable that any future economic benefit associated with the item will flow to or from the enterprise; and 2.the item has a cost or other value that can be measured with reliability. Recognition criteria only apply to assets, liabilities, revenues and expenses. Because equity is defined as a residual, the recognition criteria will be consequential to procedures used to recognise assets and liabilities. The recognition criteria have proven very controversial in practice.

A major controversy surrounds the word ‘probable’. The word ‘probable’ simply means ‘more likely than less likely’ (more or less than 50 per cent). This conceptualisation represents a fundamental departure from conventional accounting practice. Consider the example of revenue recognition. Conventional practice has long adopted the principle of revenue realisation, which requires revenue to be recognised only when there is a reasonably high degree of certainty of cash being received. The notion of ‘probable’ could result in some less scrupulous companies bringing to account doubtful revenues and assets.

Extended analysis questions
Question 1.1.33
(a) The issues to be resolved in determining whether the damages awarded against Zammit Ltd should be recognised as a liability are, briefly:

Will a future sacrifice of economic benefits be required?
Is there a present obligation for the future sacrifice of economic benefits? The specific issue to be considered here is the effect of the court award (which, in normal circumstances, would certainly represent a present obligation) and whether recognition of a liability is affected by the fact that the company intends to appeal. What is the effect of the company’s solicitor advising that an appeal is likely to be successful (does this constitute reliable evidence on the matter?)?

Has the item resulted from a past transaction or event (the fact that the customer had fallen down the stairs and that a court decision has been made would certainly satisfy this part of the definition)? Is the sacrifice of future economic benefits probable? This is very much dependent on the view as to whether any subsequent appeal will be successful. Is the amount of the liability capable of reliable measurement? Certainly it would seem that the amount awarded in damages, $500 000, represents a reliable measurement, given that it is the amount awarded by a court of law. However, is this altered by the fact that the company intends appealing the decision?

(b) Given the above issues, the most likely view is that the lawsuit should be recognised as a liability on the face of Zammit’s balance sheet. The fact that Zammit’s solicitor has advised that an appeal should be successful does not really represent ‘reliable evidence’ on the matter. The fact that the damages have been awarded by the court in this case really indicates that there is a present obligation (legally enforceable) that satisfies the probable test (that is, more likely rather than less likely).

If this liability were not to be recognised, AASB 132 requires ‘disclosure’ of contingent (or possible) liabilities. This is covered in week 8.

Additional tute problems Page 84 questions 1 – 4
1. Framework par 105: The concept of capital maintenance is concerned with how an entity defines the capital that it seeks to maintain. It provides the linkage between the concepts of capital and the concept of profit. It is a prerequisite for distinguishing between a return on capital and a return of capital. Only inflows of asset in excess of the amount needed to maintain capital may be regarded as profit. Capital maintenance concept recognises that the entity should be as well off at the end of the period as it was at the start of the period before a profit can be made. “Well off“ness can be measured either in terms of maintaining financial (ie in dollar terms) or physical (in terms of being able to command a certain level of goods and services) wealth after allowing for owner transactions. Historical cost accounting only considers capital maintenance in terms of financial capital. Question: is this sufficient?) It can be argued that in times of inflation, Historical Cost Accounting will overstate profit and lead to excessive distributions to owners and result in a decrease in operating capacity (Physical Capital) of the entity.

Profit represents the increase in wealth from one period to the next (after allowing for any capital contributions or withdrawals).This represents the amount an entity can withdraw and still be as well off at the end of the period as it was at the start. Profit can be measured from a stocks approach or a flows approach

A ‘stock’ is an amount at a point in time while a ‘flow’ measures changes over time. The definitions of income and expenses are flows that give rise to a change in a stock of assets or liabilities. For example, the payment of wages is an expense (a flow) that results in a reduction in the asset, cash at bank (a stock).

2. Using the Stocks Approach:
Profit is Wealth@end – (Wealth @start adjusted for owner transactions) Profit is Wealth@end – Wealth @start plus drawings minus capital contributed Profit =153,900 -105,200+60,000-30,000=78,700
Income is 78,700 x10=787,000
Profit = Income – Expenses
Expenses = Income – Profit
If profit =78,700 then expenses =787000-78,700 =708,300

3. Historical cost – original purchase price
Replacement cost (often called current cost)
Fair value or Realizable value or selling price or market value = amount obtainable in a market transaction Net realisable value (NRV) equals estimated selling price less any costs to sell Present value: any future amounts are discounted back to present day values.

(Students should consider each measurement method in terms of reliability and relevance)

4. Historical cost (To Webster entity) $12,000 Replacement cost $16,000
Net realizable value (7000-4000) $3,000
Fair value $1,000
Past Exam Question 1

From 1 July 2012, Cotchin Ltd developed and began selling a new product, the iFeel tablet which was capable of responding to human emotions. The company had previously sold computer monitors and was excited by the prospect of branching out into a new and very innovative product line. The company offers customers an extended warranty period of 3 years on the iFeel tablet. At 30 June 2013, management has estimated that two percent of products would be returned for repair at an estimated annual cost of $650,000 per annum based on predicted annual sales volumes. Required

Using the relevant definitions and recognition criteria found in the AASB Framework for the Preparation and Presentation of Financial Statements, justify how the company should account for the extended warranty.

Answer – how do you “account for” requires discussion of BOTH sides of JE

‘Definition Criteria’ of a liability comprised of three components. 1.Existence of a present obligation – Legally enforceable present
obligation exists, as warranties are provided with the sale of iFeel tablet. Chelsea Ltd has no discretion to avoid the future outflow of economic benefits, as they are legally obliged to fulfil the warranty.

2.Future outflow of economic benefits – Adverse financial consequences will arise, being the costs associated with repairing iFeel tablet returned during the warranty period.

3.Past transaction or event – the sale of the iFeel tablet is the past transaction creating the present obligation.

The definition criteria are satisfied. Once the definition criteria are satisfied, the recognition criteria must be considered.

‘Recognition Criteria’ of a liability comprised of two components

1.Probable future sacrifice of economic benefits

It is more likely than not that some customers will return their iFeel tablet during the warranty period. This is apparent from the accountants estimate.

2.Reliable measurement

It is not clear from the facts whether Chelsea Ltd can reliably estimate the future sacrifice of economic benefits based on experienced levels of claims arising in the past as they have not previously sold this type of product. It is unclear as to whether their experience with warranty claims on computer screens has application to iFeel tablet. Given the companies general experience in the computer industry the estimate would probably be acceptable but will accept either argument

In conclusion, if both the definition and recognition criteria appear to be satisfied and a provision for warranties should be recognised as a liability. If it fails RC, then record in notes. Also expect them to talk about expense definition and rc in DETAIL.