Week 3 Tutorial Questions – Chapter 10 SOLUTIONS

Discussion questions

3. ‘One of the major changes in both corporations legislation and accounting standards is
the adoption of the reporting entity concept.’

This comment was made in a presentation at an accounting conference. One of the

directors of your entity, a Brisbane-based company that is a wholly owned subsidiary of a
Sydney-based company, was at the presentation and was concerned at his lack of
knowledge of this concept.

Explain to the director what is meant by the ‘reporting entity’ concept, the steps the
company needs to take to determine whether it is a reporting entity, and the potential
impact of this concept on financial reporting. Discuss as well whether or not the reporting
entity concept should be abandoned.

Currently, a reporting entity is defined in SAC 1 as an entity in which it is reasonable to expect

the existence of users who depend on general purpose financial reports for information to
enable them to make decisions about the allocation of scarce resources, i.e. economic
decisions. Note that these users do not have power to command that the entity supply them
with information. Hence, they are not entitled to special purpose financial reports. The users
that are expected to exist are in three categories.

1. Resource providers. This category includes employees, lenders, creditors, suppliers and
investors. In the case of non-business entities, the category includes donors, members of
clubs, taxpayers and ratepayers.
2. Recipients or consumers of goods and services, i.e. customers, beneficiaries, taxpayers and
ratepayers.
3. Parties performing a review or overseeing function. These include parliaments, governments,
regulatory agencies, labour unions, employer groups, media, and special-interest
community groups, e.g. environmental and conservation groups.

SAC 1 provides certain guidelines to be used to assess whether an entity is or is not a reporting
entity. These are as follows.

i. separation of management from economic interest

ii. economic or political importance/influence
iii. financial characteristics.

1
See section 10.3 of the chapter for further discussion of these guidelines. The consequences of
being a reporting entity is that the entity must prepare a general purpose financial report which
must comply with accounting standards issued by the AASB.

Should the reporting entity concept be abandoned? In 2007, proposals were put forward to do
away with the reporting entity concept in favour of using a size and public accountability test
for determining which entities should prepare a general purpose financial report. If an entity is
publicly accountable and satisfies the size test, it must prepare general purpose financial
reports which comply fully with the Australian equivalents of full IFRSs. If an entity is not
publicly accountable and does not satisfy a size test, then it should use merely the Australian
equivalents to the IFRS for small and medium entities (SMEs).

Following negative feedback on the IASB’s proposals, the AASB has tackled the problem
differently by issuing AASB 1053, Application of Tiers of Australian Accounting Standards in June
2010, which has adopted a Tier 1 and Tier 2 system of financial reporting, to be applied on or
after 1 July 2013. When preparing general purpose financial statements, those entities in Tier 1
shall apply full International Financial Reporting Standards (IFRSs) as adopted in Australia, and
those in Tier 2 can adopt Reduced Disclosure Requirements (RDR). The RDR involves
compliance with the recognition and measurement requirements of IFRSs, as already adopted
in Australia, but with disclosures substantially reduced compared with those that would be
required under full IFRSs. Figure 10.4 illustrates the key elements of the standard:

In the meantime, rather than abandoning the reporting entity concept, the IASB has proposed a
new definition of the reporting entity, namely:
 a circumscribed area of economic activities whose financial information has the
potential to be useful to existing and potential equity investors, lenders and other
creditors who cannot directly obtain the information they need in making decisions
about providing resources to the entity and in assessing whether management and the
governing board of that entity have made efficient and effective use of the resources
provided.

The focus is on equity investors, lenders and creditors, who are unable to obtain the
information necessary to make an economic decision, nor to assess the accountability of the
entity’s management. A reporting entity is seen as having three features.

(a) the conduct of economic activities

(b) the economic activities can be objectively distinguished from those of other entities and
from the economic environment in which the entity exists; and

2
(c) financial information about those economic activities is potentially useful in making
economic decisions and in assessing whether the management have made efficient and
effective use of the resources provided.

3
4. Briefly explain the nature of the Conceptual Framework for Financial Reporting, and
discuss the perceived advantages and disadvantages of having a conceptual framework.

A conceptual framework of accounting theory should enable standard setters to develop

standards which are consistent and logically formulated, provide guidance to accountants in
areas of accounting where standards have not been established, and enable standard users
to better understand standards and proposed standards.

The IASB and FASB are currently undertaking a joint project to amend the conceptual
framework. The overall objective of this joint project is to develop a common conceptual
framework that is both complete and internally consistent. The Boards want to develop a
framework which will provide a sound foundation for developing future accounting standards
that are principles-based, internally consistent, internationally converged, and that lead to
financial reporting which provides the information needed for investment, credit, and similar
decisions. That framework, which will deal with a wide range of issues, will build on the existing
IASB and FASB frameworks.

Are there any disadvantages in having a conceptual framework? Consider the cost of
developing the framework versus the benefits. Also, since it is not compulsory for standard
setters to follow the conclusions of the conceptual framework, will it be ignored?

4
5. Specify the objectives of general purpose financial reporting, the nature of users, and the
information to be provided to users in order to achieve the objectives, as provided in the
Conceptual Framework.

The IASB’s Framework specify the objectives of general purpose financial reporting as being
financial reports which are intended to meet the information needs common to a range of
users who are unable to command the preparation of reports tailored to satisfy their own
particular needs.
The purpose of the Framework is to:
(a) assist the AASB in the development of future Australian Accounting Standards and in its
review of existing Australian Ards, including evaluating proposed International Accounting
Standards Board pronouncements;
(b) assist the AASB 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 Australian
Accounting Standards;
(c) [deleted by the AASB];
(d) assist preparers of financial statements in applying Australian Accounting Standards and in
dealing with topics that have yet to form the subject of an Australian Accounting Standard;
(e) assist auditors in forming an opinion as to whether financial statements conform with
Australian Accounting Standards;
(f) assist users of financial statements in interpreting the information contained in financial
statements prepared in conformity with Australian Accounting Standards; and
(g) provide those who are interested in the work of the AASB with information about its
approach to the formulation of Australian Accounting Standards.

The IASB and FASB have adopted the ‘entity perspective’, i.e. it is the entity, not its owners and
others having an interest in it, which is the object of general purpose financial reporting. In
other words, the focus is placed on reporting the entity’s resources (assets), the claims to the
entity’s resources (liabilities and equity) and the changes in them. Shareholders are seen not so
much as owners of the entity but merely as providers of resources to the entity, in much the
same way as liabilities. Both present and potential equity investors, lenders and other creditors
are seen as constituting a single primary user group. This group makes decisions about the
allocation of resources as well as decisions relating to protecting or enhancing their claim on
the entity’s resources. Other potential user groups e.g. government and other regulatory
bodies, customers, employees and their representatives, are not the focus of the objective.

Hence, it seems that the objective in the IASB’s and FASB’s Conceptual Framework is narrowly
focussed on the needs of the primary user group. It also appears odd that in times when
environmental and social issues are of great importance to society, and the desire for triple-
bottom line reporting is growing, that these issues are ignored in the revised Conceptual
Framework.

5
6. From the current Conceptual Framework, outline the qualitative characteristics of
financial information to be included in general purpose financial reports.

The Conceptual Framework, issued by the IASB and the FASB, has divided qualitative
characteristics into two categories, namely, fundamental characteristics (relevance and faithful
representation) and enhancing characteristics (comparability, understandability, verifiability
and timeliness). See Learning objective 5 in the chapter for a discussion of each characteristic.

Exercise 10.1
Violation of reporting requirements

Several independent situations are described below.

1. The owner of the business included his personal dental expenses in the entity’s income
statement.
2. The company spent $25 000 on computer software development and recorded the cost as
an asset. As yet it is impossible to predict whether this cost will result in future economic
benefits.
3. Depreciation expense was not recorded because to do so would result in a loss for the
period.
4. The cost of three books (cost $165 each) was charged to expense when purchased even
though they had a useful life of several years.
5. A major lawsuit has been filed against the company for environmental damage, and the
company’s solicitors believe there is a high probability of losing the suit. However,
nothing is recorded in the accounts.

Required
(a) Indicate for each situation the accounting principle(s) or reporting characteristics (if any)
that are violated.

(LO5, LO6 and LO7)

6
(a)

1. Entity assumption. General purpose financial reports are to be prepared using an ‘entity
perspective’, separate from owners and other investors and creditors.

2. The definition of an asset, and, even if there are future economic benefits which means that
an asset exists, there would be violation of the asset recognition criteria in that the future
benefits are not ‘probable’.

3. Expense recognition, plus relevance and reliability (faithful representation).

4. Probably none. The items are probably not material in the company context.

5. The liability and expense recognition criteria are violated if a reliable estimate can be made
of the probable damages. But is there a liability?

Exercise 10.4
Asset definition and recognition

Goode Medical Laboratory Ltd, GMLL, a medical research entity, has discovered a cure for a
previously incurable disease. GMLL is protecting the drug’s formula by keeping it secure in
the company vault, rather than by patenting it. GMLL shortly plans to start discussions with
vitally interested pharmaceutical companies about producing the drug for commercial sale.
Being the first of its kind and, therefore, unique, GMLL has no idea as to the formula’s value.
Costs incurred to date in developing the formula are impossible to identify, given that the
cure was discovered as a by-product of another research project.

Required
(a) Outline how GMLL should account for the formula, justifying your answer by reference to
relevant definitions and recognition criteria.
(LO6 and LO7)

7
(a) The Framework defines an asset as a resource controlled by an entity as a result of past
events and from which future economic benefits are expected to flow to the entity’.

The formula satisfies the asset definition as: (1) it represents future economic benefits (via sale
of either the drug or licences to produce and sell it); (2) the benefits are controlled (GMLL owns
the formula and is keeping it secret, thereby being able to deny or regulate the access of others
to it); and (3) there is a past event (the formula was discovered during another research
project).

Under the Framework, an asset can be recognised only when: (1) it is probable that the future
economic benefits embodied in the asset will eventuate; and (2) the asset possesses a cost or
other value that provides a faithfully representative (reliable) measure.

The probability criterion is clearly met, as pharmaceutical companies are vitally interested in
being involved in producing the drug and so future sales are likely.

However, at this stage the formula fails the reliable (verifiable, faithfully representative)
measurement criterion. As the formula is the first of its kind and, therefore, unique, GMLL has
no idea as yet of the formula’s value. Furthermore, the cost to date of developing the formula
cannot be traced or identified, as the formula was discovered as a by-product of another
project.

Accordingly, the formula cannot (as yet) be recognised as an asset.

8
Exercise 10.7
Liabilities and liability recognition

Outline whether you would recognise each item below as a liability, justifying your answer by
reference to the Conceptual Framework’s liability definition and recognition criteria:
(a) Your parents have lent you $30 000 to buy a car and have told you to pay it back
whenever you like.
(b) You are guarantor for your friend’s bank loan:
i. You have no reason to believe that your friend will default on the loan.
ii. Your friend has been encountering serious financial problems and you think it is
likely that he will default on the loan.
(c) The court has ordered you to repair the environmental damage your firm has caused to a
park next to your firm’s premises. You have no idea as yet how much this repair work will
cost.
(d) Your firm has a 20-year history of donating $5000 each year to the Telethon Appeal. As
yet, no amount has been paid in the current year and nothing has been recorded in the
accounts.
(LO6 and LO7)

9
(a) Assuming that you are the accounting entity concerned, this fails the definition as it does not
constitute a future sacrifice of economic benefits. Paragraph 61 of the Framework states that
an essential liability characteristic is that the present obligation is such that the consequences
of failing to honour the obligation leave the entity little, if any, discretion to avoid the future
sacrifice.

If the entity obliged to make the settlement has a right to decide the settlement date, it has
complete discretion as to whether economic benefits are to be sacrificed. Accordingly, a liability
cannot exist in respect of this obligation.

Recognition criteria are thus irrelevant, as there is no liability under the Framework to
recognise.

(b)

(i) Definition is satisfied — future sacrifice of economic benefit (obligation cannot be avoided if
settlement is ultimately required); present legal obligation (under terms of guarantee
agreement); past event (agreeing to the guarantee).

Reliable measurement recognition criteria is met — amount owing can be measured exactly.

However, fails the probability test — Until the borrower defaults, it is not known whether the
guarantor will be required to honour the guarantee. The liability will only qualify for recognition
if and when it becomes probable that the borrower will default and settlement will be required.
At this stage the probability is close to zero.

Accordingly, no liability can be recognised. However, disclosure about the liability may be
warranted in the notes to financial statements, as information about the guarantee may be
considered relevant to the users in making and evaluating their economic decisions.

(ii) See (b)(i) for consideration of definition and reliable measurement recognition criterion —
both are met.

Probability recognition is now met as it is considered likely that default will occur.

Accordingly, the liability should be recognised (Dr expense; Cr liability).

10
(c) Definition is satisfied — future sacrifice of economic benefits (obligation cannot be avoided);
present legal obligation (Court order); past obligating event (whatever action caused the
damage).

Probability test is met — settlement must occur and so is certain.

However, fails the reliable measurement test — the cost of the required repairs is as yet
unknown.

Accordingly, no liability can be recognised. However, disclosure about the liability is warranted
in the notes to the financial statements, as information about the obligation may assist users in
making assessments of the present and expected future financial position of the entity.

(d) Definition is satisfied — future sacrifice of economic benefits (the social and/or political
consequences of failing to make the donation leave the entity little discretion to avoid the
obligation); present constructive obligation (longstanding history of making a $5000 donation
per year – constructive obligation); past event (its long-standing history of making such
donations each year).

Probability criterion is met — history shows that making the donation is more than less likely.

Reliable measurement test is also met — there is a long-standing (20 year) history of making a
$5000 per year donation.

Accordingly, a $5000 liability should be recognised (Dr expense; Cr liability).

11
Problem 10.17
Conceptual framework

Martindale Ltd uses the historical cost system. While reviewing the business activities of the
company, you discover that the following transactions and events were recorded. Ignore GST.

1. Ending inventory for the current year had a cost of $230 400 and a selling price of
$204 000. The inventory was valued at cost because the company’s accountant believed
that ‘the selling price will probably increase again during the next year’.
2. On 28 December of the current year, Martindale Ltd signed a contract with a customer
under which Martindale Ltd agreed to manufacture equipment for the customer during
January of the following year at a price of $78 000. Martindale Ltd received a cheque for
$15 000 from the customer on 28 December and made the following entry.

Accounts Receivable 63 000

Cash at Bank 15 000

Sales 78 000

3. A new vehicle was purchased at an auction for cash of $42 000. If purchased from the
company’s normal supplier, the cash price of the machine would have been $48 000. The
Vehicles account was debited for $48 000 and the following entry was made:

Vehicles 48 000

Cash at Bank 42 000

Gain from Bargain Purchase 6 000

4. Ignition security locks were installed in each of Martindale Ltd’s five delivery trucks at a
cost of $240 each. The trucks had an average remaining useful life of 5 years. The
transaction was recorded as:

Repairs Expense 1 200

Cash at Bank 1 200

12
5. Building improvements with an estimated useful life of 20 years were completed early in
the current year at a cost of $180 000. Martindale Ltd believed that the building to which
the improvements were made could be used for only 15 years. To record depreciation for
the current year, the accountant made the following entry:

Depreciation Expense 9 000

Building Improvements 9 000

Required
(a) For each of items (1) to (5), determine which accounting concept(s) (if any) is violated, and
explain why. For each violation, indicate the correct treatment.
(LO5, LO6 and LO7)

13
(a)

1. The qualitative characteristic of representation and the requirements of IAS 2/AASB 102
Inventories have been violated. The value of the inventory should be measured by its net
realisable value if lower than cost. The financial report must provide a faithful representation of
the transactions and events which have occurred; hence, if the price of the inventory has fallen,
the best representation of the fair value of the inventory is net realisable value at the end of
the reporting period. (But consider what to do if the fair value is above cost.)

[Link] Ltd has not yet performed under the contract. At this point, Martindale Ltd has
and should record a liability for $15 000. There is no revenue, and revenue recognition should
be deferred until performance is carried out in the following year. The cash receipts should be
recorded by a debit to Cash at Bank for $15 000 and a credit to Unearned Revenue (a liability)
for $15 000.

Is the accounting treatment different if the order placed with Martindale Ltd was for specialised
equipment, which only Martindale Ltd is licensed to make? Under IAS 18/AASB 118’s revenue
recognition criteria, it could be argued that no violation has occurred in the recognition of the
increase in the asset via accounts receivable, as the inflow may pass the probability test and can
be reliably measured. The credit entry, however, would be to a liability rather than to revenue,
as the contract is executory in nature.

3. The principle of valuing assets at cost as per IAS 16/AASB 116, and the definition of income,
have been violated. Under the accounting standard, the vehicle must be recorded (debit) at its
actual cost of $42 000 as measured by the amount of cash paid (credit) to acquire it.

4. No violation has occurred as the cost of the ignition security locks is probably immaterial. The
costs should be charged to expense during the current year.

5. The definition of an expense and the expense recognition criteria have been violated. Since
the building improvements are attached to the property, the future benefits of the
improvements are consumed over the life of the building, and should be depreciated over 15
years, which is shorter than the overall useful life of the improvements. Thus, the depreciation
expense on the building improvements should be recorded at $12 000 per annum rather than
$9000.

14