20-Dec-10. Elements of financial statements. What are some of the current projects before IFRIC? Chapter 3 Company Operations. Prepared by Emma Holmes

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1 Chapter 3 Company Operations Prepared by Emma Holmes Elements of financial statements The Framework contains the definition and recognition criteria for the 5 main elements in the financial statements 5 main elements are Assets Liabilities Equity Income Expenses IASB/FASB joint project proposes changes to the definitions of assets, equity as well as the introduction of verifiability test into the recognition criteria. What are some of the current projects before IFRIC? Ruth Picker Managing Partner Ernst & Young Melbourne 1

2 Assets current definition A resource controlled by the entity as a result of past transactions or events from which future economic benefits are expected to flow to the entity. Three essential characteristics: 1. Future economic benefits > refers to the potential to contribute, directly or indirectly to the flow of cash (and cash equivalents) to the entity. Physical form is not a prerequisite 2. Control > does not imply ownership therefore leased items may be assets 3. Past events > a past event or transaction must have occurred. Anticipated purchases are not assets Liabilities - definition Future sacrifices of economic benefits that the entity is presently obliged to make to other entities as a result of past transactions or other past events. Three essential characteristics: 1. Present obligation > a mere intention is not sufficient. Present obligation may be legal or constructive 2. Future sacrifices > must involve a sacrifice, involving the settlement of resources in the future 3. Past events > a past event or transaction must have occurred. Anticipated purchases are not assets Equity current definition The residual interest in the assets of the entity after deduction of its liabilities. Assets liabilities = equity Therefore, cannot be defined independently of the other elements 2

3 Income - definition Inflows or other enhancements, or savings in outflows, of future economic benefits in the form of increases in assets or reductions in liabilities other than those relating to contributions from owners, that result in an increase in equity during the reporting period. Income arises due to changes in assets and liabilities balance sheet emphasis Existence of income does not depend on an earnings process Income encompasses revenue and gains Revenue is a subset of income Revenue are gross inflows relating to an entity s ordinary activities (AASB 118.7) implies an earnings process Income from outside an entity s ordinary activities are referred to as gains Income - definition AASB101 Presentation of Financial Statements was reissued in September 2007 Requires the disclosure of Total comprehensive income Represents the change in equity [net assets] during a period resulting from non owner related transactions and other events. Expenses - definition Consumptions or losses of future economic benefits in the form of reductions in assets or increases in liabilities of the entity, other than those relating to distributions to owners, that result in a decrease in equity during the reporting period. Th it f i The opposite of income Also depends on changes in assets and liabilities Classification of transactions as assets or expenses is a challenging area for accounting professionals Key to correct classification lies in determining whether the entity has control over expected economic benefits Expenses encompasses losses as well as expenses arising in the ordinary course of business 3

4 Recognition criteria The same recognition criteria are applied to all 5 elements of the financial statements 1. It is probable that future economic benefits associated with the item will flow to/(from) the entity; Probable = more likely than less likely; >50% chance and 2. The item has a cost or other value that can be measured reliably Information is considered to be reliable when it is free from material errors and can be depended upon by users to represent faithfully the economic substance of the transactions and events that have occurred. Recognition criteria REVENUE AASB 118 Revenue provides additional recognition criteria in relation to revenue to that included within the Framework Separate recognition criteria are provided for revenue from: The sale of goods The provision of services Interest, royalties and dividends Recognition criteria EXPENSES Under the Framework expense recognition is not tied to the matching process Emphasis in the Framework is on a balance sheet approach The Framework accepts the use of the matching process, but requires that it be discarded if it creates dubious assets and liabilities E.g. provisions where there is no present obligation As the Framework has not been built into accounting standards and is not mandatory guidance the matching process still has influence in practice No overall AASB for expenses (unlike AASB 118 for revenue). Individual AASBs for specific types of transactions must be referred to Fewer regulations in relation to recognition of expenses 4

5 Recognition criteria PROVISIONS Additional recognition criteria contained within AASB 137 Provisions, Contingent Liabilities and Contingent Assets The amount recognised should be the best estimate of the expenditure required to settle the present obligation at the reporting date Note that the IASB proposes replacing provisions with non-financial liabilities CONTINGENT LIABILITIES AND CONTINGENT ASSETS Such amount are not recognised in financial statements Disclosed by way of footnote Note that the IASB proposes removal of these terms Measurement Determination of the value of an item: on initial recognition or subsequently Most common measurement bases used: Historical cost Current cost Realisable value Present value ASSETS Measurement and classification Initially measured at cost. Cost is defined as: Cash or cash equivalents paid of the fair value of other consideration given to acquire an asset Subsequently measured in accordance with relevant accounting standards. For example Per AASB 102 Inventories, inventory is recorded at lower of cost or net realisable value Per AASB 116 Property, Plant & Equipment, plant & equipment is recorded at either cost or fair value AASB 101 Presentation of Financial Statements requires that assets be classified in the statement of financial position: by nature (e.g. inventories, receivable, intangibles) sub-classified as current or non-current 5

6 Measurement and classification LIABILITIES Most valued at nominal or face value Some recorded at discounted present value. For example Per AASB 119 Employee Benefits, liabilities for long- term employee benefits such as long service leave are recorded at discounted present value Per AASB 117 Leases, finance lease liabilities are values using present value techniques AASB 101 Presentation of Financial Statements requires that liabilities be classified in the statement of financial position: by nature sub-classified as current or non-current Measurement and classification EQUITY A residual, so no separate measurement methods AASB 101 Presentation of Financial Statements requires that equity be classified in the statement of financial position by source (contributed or earned) Major components are: Contributed equity Reserves Retained earnings Measurement and classification INCOME (REVENUES AND GAINS) Under AASB 118 Revenues, revenue is measured at the fair value of consideration received AASB 118 requires that revenue be classified by nature Major components are: Revenues from sale of goods Revenues from services rendered Interest, royalties and dividends 6

7 Measurement and classification EXPENSES Most expenses are measured based on the cost of consumption or loss of economic benefits in the current period AASB 101 Presentation of Financial Statements requires that expenses be classified in the Statement of Comprehensive Income by nature or function Dividends Represent a distribution of profits to the shareholders of the company Dividends can only be paid once the company satisfies a test of solvency (this is a recent change introduced in 2010; previously dividends were paid out of profits). Power to declare dividends at any time rests with directors (s254u) Dividends may be in the form of cash, bonus shares or assets Constitution usually provides for the declaration of two types of dividends: Interim (declared and paid during the year) Final (declared this year, paid next) Commonly expressed as a certain amount of cents per share Dividends When does a legal debt arise for dividends? If constitution states that once declared a dividend is not subject to further approval a legal debt arises on declaration dividend payable recorded at date of declaration If constitution requires approval by shareholders at a meeting of shareholders a legal debt arises on the approval by shareholders dividend payable recorded once approval obtained If there is no constitution/constitution is silent a legal debt arises on the nominated payment date 7

8 Dividends INTERIM DIVIDEND PAID Dr Retained earnings $x Cr Cash $x (Payment of interim dividend) FINAL DIVIDEND DECLARED Dr Retained earnings $x Cr Dividend payable $x (Declaration of final dividend) Final dividends that are declared after year end or require the approval of shareholders are not recorded in the financial statements, but are referred to by way of note disclosure. Preference dividends Preference dividends are normally paid before dividends to ordinary shareholders Rate of dividend normally set at time of issue and may be quoted as % or cents per share Dividends may be cumulative, that is, undeclared dividends accumulate and must be paid before dividends are paid to ordinary shareholders Preference shareholders may also get an additional participating dividend Source of dividends The basic principle in relation to dividends is that they can only be paid if the company meets a solvency based test. Under this test the following must be satisfied: The company s assets exceed it s liabilities immediately before the dividend is declared and the excess is sufficient to cover the dividend payment; The payment of the dividend is fair and reasonable to the company's shareholders; and The payment does not materially prejudice the company s ability to pay its creditors. This solvency test was introduced in 2010, replacing the profit based test that was used previously. 8

9 Bonus share issues Involves the issue of additional shares to existing shareholders Shares are issued at no cost in lieu of cash dividend Can be paid from profits or reserves The entry required is: Dr Retained earnings/reserve xx Cr Share capital xx Reserves Term not defined Reserves arise as a result of: 1. requirements of Accounting Standards Asset revaluation reserves Foreign currency translation reserves 2. appropriations of profits General reserve Contingencies reserve 3. application of the Corporations Act Forfeited shares reserve Lapsed options reserve Reserves APPROPRIATION OF PROFITS Such transfers do not involve cash transfers or creation of secret cash balances The transfer can signal to shareholders that these profits will not be distributed as dividends Creation/increase in reserves: Dr Retained earnings xx Cr Reserve xx 9

10 Retained earnings Retained earnings (opening balance) + current year profit/loss + transfers from reserves dividends paid and provided transfers to reserves = Retained earnings (closing balance) Movements in retained earnings are disclosed in the statement of changes in equity or in the notes to the financial statements Financial statements Four main financial statements in a set of financial statements are Statement of Comprehensive income > measures company's total comprehensive income for the period Statement t t of changes in equity > shows how the company s capital, reserves and retained earnings have changed during the period Statement of Financial position > shows assets, liabilities and equity Statement of Cash flows > shows sources and uses of entity s cash resources Financial Statements STATEMENT OF COMPREHENSIVE INCOME Prepare reporting date adjustments as necessary to ensure that all revenues and expenses are correctly and completely recorded for the period Prepare a final trial balance Prepare a final trial balance Classify all expenses and revenues Calculate net profit after tax for the period Refer Figure 3.5 of Illustrative Example 3.3 Identify any other non-owner changes in equity to determine total comprehensive income. 10

4 Financial statements STATEMENT OF FINANCIAL POSITION Using the final trial balance classify all assets, liabilities and

11 Financial Statements STATEMENT OF CHANGES IN EQUITY Including total comprehensive income (from the statement of comprehensive income) for the year. Refer Figure 3.6 of Illustrative Example 3.4 Financial statements STATEMENT OF FINANCIAL POSITION Using the final trial balance classify all assets, liabilities and equity Prepare statement of financial position Prepare notes as necessary to explain or support figures on the balance sheet Refer Figure 3.7 of Illustrative Example

8/26/2008. Chapter 2 Financing company operations. Issue of shares. Key features of share capital. Prepared by Emma Holmes

8/26/2008. Chapter 2 Financing company operations. Issue of shares. Key features of share capital. Prepared by Emma Holmes Chapter 2 Financing company operations Prepared by Emma Holmes Issue of shares A company can issue shares on any terms or conditions it determines Share capital may include different classes: Ordinary