Intermediate Financial Accounting

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Cameron Watkins
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1 Intermediate Financial Accounting CA 2001 The principal legislation regulating companies in Australia. It contains information about: - Formation and operation of companies - Duties of officers - Reporting obligations Small proprietary companies generally not required to prepare a financial report unless it is directed to do so by SH with at least 5% of the votes or ASIC. This is because in most cases the costs>benefits of doing so. Only disclosing entities must prepare half yearly reports. Financial statements and notes must give a true and fair view of financial position. Annual reports includes: Directors report, auditors report and directors declaration (and statement of comprehensive income, financial position, changes in equity, cash flows and notes to the accounts). Directors declaration to confirm (1) solvency, (2) compliance with the AASB (accounting standards), (3) compliance with CA 2001 requirements. Directors report to provide general and specific information on significant matters and events (including a review of operations and results, significant changes to state of affairs, etc) Auditors report required to state whether or not, in their opinion, the accounts comply with the AASB standards and give a true and fair view. Client prepares financial statements and the auditor reviews them. Financial report, directors report and auditors report must be sent to SH within 4 months of the reporting date, or the earliest of 4 months from the reporting date or 21 days before the next AGM for disclosing entities and public companies. Then must lodge the annual report with ASIC (disclosing entities: within 3 months, all others: within 4 months of reporting date). General Purpose Financial Statements (GPFS) Assumptions of GPFS are: accrual basis, going concern. Qualitative characteristics of financial statements: relevance, faithful representation (reliability), understandability, materiality, prudence, reliability, substance over form, neutrality, completeness, comparability. AASB Financial reports must comply with the accounting standards. Not all AASBs are relevant to all entities.

2 The Conceptual Framework The Framework is NOT an accounting standard. It is the basis on which the standards have been prepared. Conflict rises between an AAS (Australian Accounting Standard) and the Framework, AAS>Framework. It contains concepts to apply in preparing GPFS (concepts that underlie the preparation and presentation of financial statements for external users). It contains the objective of FS, qualitative characteristics, definition, recognition and measurement of accounting elements and concepts of capital and capital maintenance. Objective of FS: to provide info about financial position and performance and cash flows of an entity that is useful to users making economic decisions. Constraints on relevant and reliable information: timeliness, balance between benefit and cost, balance between qualitative characteristics. true and fair view the framework does not define this, but as long as accounting standards and QC are appropriately applied, should produce a true and fair view. ASSET: a resource controlled by the entity as a result of a part event and from which future economic benefits are expected to flow. LIABILITY: a present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits. (e.g. a contract is NOT a liability because there is no present obligation) EQUITY: the residual interest in the assets of the entity after deducting all its liabilities. INCOME: increases in economic benefits in the form of inflows or enhancements of assets or decreases in liabilities that result in increases in equity (other than those relating to contribution from equity participants) EXPENSE: decreases in economic benefits in the form of outflows or depletions of assets or incurrences of liabilities that result in decreases in equity (other than those relating to distributions to equity participants). Recognition criteria: probable future economic benefit and reliably measured.

3 MEASUREMENT OF THE VALUE OF AN ASSET AFTER ITS RECOGNITION. User either cost model or revaluation model. Cost model - Carry at cost less accumulated depreciation less accumulated impairment losses. - Recoverable amount (RA) is the HIGHER of valuein-use or the fair value less costs to sell (excluding finance costs). - RA<CA, impair the asset DR impairment loss asset CR acc. impairment loss asset - RA>CA, no need for any adjustments. Revaluation model - Carry at fair value (market price) less accumulated depreciation less accumulated impairment losses. - The revaluation amount is the LOWER of the fair value and recoverable amount. - Revaluation amount>ca, increment DR revaluation expense - CA>revaluation amount, decrement DR asset CR revaluation surplus THE NET METHOD - incremental 2. The asset is re-valued to the new higher fair value DR asset CR revaluation surplus THE GROSS METHOD - incremental 1. Take the old and new CAs and compare them percentage-wise (e.g. old CA = 375 and new CA = 330, therefore a 12% decrease). 2. Decrease the old CA and the acc. depn by 12% 3. Take the differences and adjust them in the journal entry accordingly DR asset (new gross amount - old GA) CR acc. depn (new AD old AD) CR revaluation surplus (new CA old CA) THE NET METHOD - decremental 2. The asset is re-valued to the new lower fair value DR revaluation expense THE GROSS METHOD - decremental 1. Take the old and new CAs and compare them percentage-wise (e.g. old CA = 375 and new CA = 450, therefore a 20% increase). 2. Increase the old CA and the acc. depn by 20% 3. Take the differences and adjust them in the journal entry accordingly DR acc. depn (old gross amount - new GA) DR revaluation expense (old AD new AD) (old CA new CA)

4 Increment after prior downwards revaluation THE NET METHOD The prior downwards revaluation (e.g. $20,000) must first be offset. 2. The asset is re-valued to the new higher fair value, BUT the revaluation surplus will be $X $20,000 DR asset $X CR revaluation surplus $X - $20,000 CR revaluation revenue $20,000 THE GROSS METHOD 1. Do as per normal, however entries are: DR asset CR acc. depn CR revaluation surplus $reval sur $20,000 CR revaluation revenue $20,000 Decrement after prior upwards revaluation THE NET METHOD The prior upwards revaluation (e.g. $15,000) must first be offset. 2. The asset is re-valued to the new lower fair value, BUT the revaluation expense will be $X $15,000 DR revaluation surplus $15,000 DR revaluation expense $X - $15,000 $X THE GROSS METHOD 1. Do as per normal, however entries are: DR acc. depn DR revaluation surplus $reval sur - $15,000 DR revaluation expense $15,000

5 LECTURE 2 ASSET ACQUISITIONS. 3 types of asset acquisitions: 1. Individual PPE item (AASB 116) 2. A business combination (AASB 3) 3. Control of another entity (AASB 127) 1. Individual PPE item. What is PPE? - Tangible - Used as part of operating activities (however it may not directly contribute to revenue, e.g. administration office) - Non-current PPE recognition. - Probable future economic benefits (can be indirect) - The cost of the PPE can be reliably measured (even if FV can be measured, if cost cannot then will not meet criteria and won t be recognised) Measuring the cost of PPE. PPE is measured at cost upon recognition. In this case, cost is considered the value of the consideration given to acquire the asset and have it in the condition and location ready to use as management intended. Examples are: cash, agreement to pay out or take over a loan or other debt, shares, credit. However, cost includes: - Its purchase price (the consideration, as above) after including import duties and non-refundable taxes (NOT GST) and deducting trade discounts and rebates. - Any directly attributable costs to get it into the intended condition and location (e.g. generally costs of a non-recurring nature such as employee wages arising from construction or acquisition, costs of site preparation, delivery and handling costs, installation and assembly costs, costs of testing to ensure proper function, professional fees such as legal or brokerage). - Estimated costs of dismantling the PPE and restoring the site on which it is located (e.g. a mining machine to be dismantled after mining has been completed). What is capitalised? - Cost of major overhauls (including major replacement components, e.g. replace seats on a plane) - Cost of improvements to the PPE that extend its life, improved the quality of its output or decreases the operating costs associated with it. What is written off? - Once the PPE has been brought into the condition and location for use, all subsequent costs are usually expensed unless they extend its life, improve the quality of its output or decrease the operating costs associated with it. - Spare parts (e.g. plane tyres) are expensed as spare parts - Costs of a recurring nature to service and maintain the PPE are expensed as repair and maintenance.

6 Qualifying assets. An asset that take a substantial period of time to get ready for its intended use or sale, e.g. a building. It is a qualifying asset until it is completed and in a condition and location ready for use. Often, these qualifying assets incur borrowing costs (interest and other costs that are incurred in connection with the borrowing of funds, such as interest and loan establishment fees). Treatment of borrowing costs: - Capitalise borrowing costs (interest) that are directly attributable to the acquisition, construction or production of the qualifying asset. - Expense any other borrowing costs that are not directly attributable. Interest incurred after the asset is completed is expensed. Acquiring a group of assets. When an entity makes a purchase of a group of assets which are not a business combination, then you need: 1. The FV of the consideration given to acquire the assets 2. The FV of the assets acquired Then pro-ration each asset by multiplying the FV of each asset by the (FV of consideration/fv of total assets). 2. Business combinations. Is a transaction in which an acquirer obtains control of a business (will be told if it is a business combination). Must apply acquisition method 1. Identify the acquirer (who gets control) 2. Determine the acquisition date (when control is obtained by the acquirer) 3. Recognise and measure the identifiable assets, liabilities and any non-controlling interests in the acquiree. A business may be acquired by a direct or indirect acquisition we focus on direct acquisition in which the acquirer purchases assets and liabilities from the acquiree. Identifiable asset: one that is separable (can sell it in its own right) or it arises from contractual or other legal rights (intangible assets, such as a patent or a licence). Measurement of IA and liabilities assumed: measured at their FAIR VALUES (market price) on acquisition date. Acquisition-related costs: costs such as finder s fees, professional fees, consulting fees and valuation fees must be EXPENSED, they cannot be capitalised (different to PPE). 4. Recognise and measure goodwill or a gain on bargain purchase. FVNA: assets liabilities = net assets. Goodwill: FVNA > consideration. Goodwill is recognised as an asset in the balance sheet and represents FEB arising from the other assets acquired in the business combination. Gain on bargain purchase: consideration > FVNA. Gain on bargain purchase is recognised as revenue in the P&L statement. Intangible assets. An intangible asset is an identifiable, non-monetary asset without physical substance. E.g: patents, trademarks, registered names, copyrights. Goodwill is a special case of an intangible asset, because although it does exhibit FEB, control and reliable measurement, it is not an identifiable asset. Thus, it is an unidentifiable intangible asset.

7 Goodwill. Internally recognised goodwill is not recognised as an asset because it cannot be reliably measured. Goodwill must be purchased. Recognition: goodwill is recognised at acquisition date at its cost (consideration FVNA). Impairment of assets. If an asset s Recoverable Amount (RA) falls below its Carrying Amount (CA), the asset must be impaired and an impairment loss is recognised. 1. Goodwill is the first to be impaired. DR goodwill impairment CR accumulated impairment of goodwill 2. Once the goodwill is gone then the assets themselves are impaired. DR impairment expense LECTURE 3 MEASUREMENT OF PPE AFTER ACQUISITION Entity must choose either cost model or revaluation model to revalue its PPE and this method must apply to an entire class of PPE to ensure consistency (class of PPE: grouping of assets of a similar nature and use, e.g. land, machinery, office equipment, motor vehicles, land and buildings). Cost model - USED FOR ASSETS THAT GO DOWN IN VALUE. - Each class of PPE to be measured at cost. - Carrying amount: cost/book value less accumulated depreciation less accumulated impairment losses. - Switching from cost revaluation - Recoverable amount (RA) is the HIGHER of value-in-use or the fair value less costs of disposal (excluding finance cost and income tax expense)/the net selling price. VIU: discounted net cash flows expected to be derived from using the asset over its estimated useful life. Revaluation model - USED FOR ASSETS THAT CAN GO UP/DOWN IN VALUE (AASB suggests revaluations every 3 5 years but should be made with sufficient regularity. Classes of PPE shall be revalued simultaneously to avoid selective revaluation of certain assets.) - Each class of PPE to be measured at fair value. - Carrying amount: fair value less accumulated depreciation less accumulated impairment losses - Switching from revaluation cost management must justify and disclose and must generate more reliable and relevant financial information. - Unrealised gains are not treated as part of income because it is possible for the firm to be coerced into distributing these gains to shareholders through dividends from profits. - The revaluation amount is the LOWER of FV and the recoverable amount. Revaluation increment: an asset is revalued upwards when the current value of the asset exceeds its carrying amount. It is CR to revaluation surplus and

8 - CA > RA, impairment loss DR impairment loss asset CR acc. impairment loss asset - RA > CA, no need for any adjustments. HOWEVER, if an asset has been previously revalued, then the impairment loss will be recognised by reducing (DR) the revaluation surplus account to extent that it becomes zero, and then impairing the asset directly. DR revaluation surplus CR machine DR impairment loss CR accumulated impairment loss If an individual asset cannot be separated from a group of assets, then the impairment of the whole group of assets shall be apportioned across each of the assets. DR impairment loss CR accumulated impairment loss asset #1 CR accumulated impairment loss asset #2 CR accumulated impairment loss asset #3 included as part of other comprehensive income and thus not part of P&L. THE NET METHOD incremental for a nondepreciable asset. Revalued amount > CA, increment DR asset CR revaluation surplus THE NET METHOD - incremental 2. The value of the asset is increased to reflect the revaluation increment DR asset CR revaluation surplus *any subsequent depreciation is based on the revalued amount. THE GROSS METHOD - incremental 1. Divide the new CA by the old CA (e.g. 450/375 = 1.2 and therefore we get a 20% increase). 2. Increase the old GA (gross amount) and the acc. depn by 20% 3. Account for the differences in a journal entry DR asset (new GA old GA) CR accumulated depn (new AD old AD) CR revaluation surplus (new CA old CA) Revaluation decrement: an asset is revalued downwards when the current value of the asset is less than its carrying amount. It is DR to loss on revaluation and included as part of other comprehensive income and thus not part of P&L. THE NET METHOD decremental, for a nondepreciable asset. CA > revalued amount, decrement DR loss on revaluation THE NET METHOD - decremental 2. The asset is re-valued to the new lower fair value DR loss on revaluation *any subsequent depreciation is based on the revalued amount.

9 THE GROSS METHOD - decremental 1. Divide the new CA by the old CA (e.g. 550/625 = 0.88 and therefore we have a 12% decrease). 4. Decrease the old GA (gross amount) and the acc. depn by 12% (x 0.88) and determine the differences between the new and old amounts. 5. Account for the differences in a journal entry DR accumulated depn (old AD new AD) DR loss on revaluation (old CA new CA) (old GA new GA) Increment after previous decrement The increment should offset the previous decrement by CR the loss on revaluation account that was previously DR and cannot exceed the previous revaluation decrement. Any excess is CR to the revaluation surplus. THE NET METHOD 2. The prior decrement (e.g. $20,000) must first be offset and then the increment accounted for. DR asset (new CA old CA) $X CR revaluation surplus $X - $20,000 (current increment minus prior decrement) CR revaluation revenue $20,000 (prior decrement reversed) Decrement after previous increment The decrement should offset the previous increment by DR the revaluation surplus account that was previously CR and cannot exceed the previous revaluation increment. Any excess is DR to loss on revaluation account. THE NET METHOD 2. The prior increment (e.g. $15,000) must first be offset and then the decrement accounted for. DR revaluation surplus $15,000 (prior increment reversed) DR revaluation expense $X - $15,000 (current decrement minus prior increment) (old CA new CA) $X THE GROSS METHOD 1. Divide the new CA by the old CA (e.g. 450/375 = 1.2 and therefore we get a 20% increase). 2. Increase the old GA (gross amount) and the acc. depn by 20% and determine the difference between the old and new amounts. 3. First reverse the previous decrement using a revaluation revenue account and then account for the differences in a journal entry DR asset (new GA old GA) CR acc. depn CR revaluation surplus $reval sur $20,000 CR revaluation revenue $20,000 THE GROSS METHOD 1. Divide the new CA by the old CA (e.g. 550/625 = 0.88 and therefore we have a 12% decrease). 2. Decrease the old GA (gross amount) and the acc. depn by 12% (x 0.88) and determine the difference between the new and old amounts. 3. First reverse the previous increment using a revaluation expense account and then account for the differences in a journal entry DR acc. depn DR revaluation surplus $reval sur - $15,000 DR revaluation expense $15,000 (old GA new GA)

10 Impact of revaluations on financial statement ratios. Incremental revaluation Increase NCA and equity Decrease ROA and ROE (deterioration in profitability) Decrease TL/TA (total debt) and TL/equity (debt to equity ratio) which leads to improved leverage. Decremental revaluation Decrease NCA and equity Increase ROA and ROE (improved profitability) Increase TL/TA (total debt) and TL/equity (debt to equity ratio) which leads to deteriorated leverage. Gain on the de-recognition of a revalued asset. Gain or loss = the difference between the net disposal proceeds and the carrying amount of the asset to be de-recognised. Gain on sale. DR bank DR accumulated depreciation CR gain on sale of asset Any amount in the revaluation surplus account is transferred directly to retained earnings (not income) when the asset is de-recognised. DR revaluation surplus CR retained earnings

11 LECTURE 4 INCOME TAX Accounting profit is derived by applying the GAAP and the accounting standards. Taxable profit is derived using the rules embodied in the Australian income tax legislation. There are a number of differences between income and expense recognition under the two profit measures, thus accounting profit taxable profit. We use the balance sheet approach to account for the treatment of income tax This method focusses on comparing the carrying amount of an entity s assets and liabilities with their tax base (aka comparing the balance sheet figures derived using accounting rules with the figure that would have been derived had we used taxation rules). Tax base: the amount that is attributed to an asset or liability for tax purposes. The Income Tax Assessment Act applies SUBSTANTIATION RULES this means that revenue and expenses will only be recognised and thus assessable or deductible after the associated substantiating event has actually taken place (expenses paid for/revenue is received). When the CA of an asset or liability differs from its tax base, a either a permanent or temporary difference arises. Permanent difference: some income is never assessable (some capital gains) and some expenses are never deductible (goodwill impairment and entertainment). Temporary difference: the difference between the carrying amount of an asset or liability and its tax base. This temporary difference will be either a taxable temporary difference or a deductible temporary difference. A taxable temporary difference will give rise to a Deferred Tax Liability (because this will lead to an increase in taxable profit in future years). A deductible temporary difference will give rise to a Deferred Tax Asset (because this will lead to a decrease in taxable profit in future years). CA > TB CA < TB Asset DTL DTA Liability DTA - DTA: accrued expense, unearned revenue, doubtful debts. DTL: prepaid expense, accrued revenue. Example of a DTL: A depreciable asset that cost $600,000 is expected to have a useful life of 4 years (straight-line, no residual value). The ATO only allows the asset to be depreciated over 3 years. The accounting profit before tax over the next 4 years is expected to be $500,000, $600,000, $700,000 and $800,000. Carrying amount ($) Tax base ($) Temporary difference ($) Asset 600, ,000 Less accumulated depn. 150, , , ,000 50,000

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