ACC00106- Contemporary Issues in Accounting

1. ACC00106- Contemporary Issues in Accounting Lecture 2 Topic 2- Measurement in Accounting Lynn Barkess

2. TOPIC 2 – Measurement in Accounting Lynn Barkess • Suggested Study Time • Study learning materials 4 hours • Read supplied readings 8 hours • Undertake activities and review activities • 12 hours • TOTAL 24 hours

3. Topic 2 – Measurement in Accounting- Lecture Outline Lynn Barkess What is Measurement? Measurement of Assetsdefinition, recognition criteria Measurement of Income definition and recognition criteria Normative theories of asset measurement Concepts of Capital IASB Framework, CPPA, CCA, CoCoA Creative Accounting inappropriate revenue recognition off balance sheet financing.

4. Measurement Lynn Barkess What is measurement? “the process of determining the monetary amounts at which the elements of the financial statements are to be recognised and carried in the balance sheet and income statement” (IASB Conceptual Framework para. 4.54)

5. Measurement of Assets- Definition of an asset: ‘… a resource controlled by the entity as a result of past events and from which future economic benefits are expected to flow to the entity’ (IASB Framework, para. 49(a)) Recognition criteria: An asset shall be recognised when: • it is probable that any future economic benefit associated with the item will flow to the entity, and • the item has a cost or value that can be measured with reliability (IASB Framework, para. 83)

6. Measurement of Assets Lynn Barkess • Value of asset – present value of its service potentials- ability to be exchanged for cash- ability to be exchanged for other goods and services- ability to settle liabilities • - based on the future economic benefit embedded in the item. • Non essential characteristics • Exchangeability – thus goodwill can be recognised as an asset

7. Existing asset valuation rules AASB102 Inventory: Lower of cost and net realisable value AASB 139 Financial Instruments & AASB 140 Investment Property: fair value “mark to market” AASB116 P,P&E :Historical cost or revaluation to fair value; Depreciate; Test for impairment. AASB138 Intangible assets: Cost; revalue only if active market exists AASB3 Business combinations: Goodwill – refer to ACC00145 studies AACSB 136 Impairment test: “Recoverable amount”

8. Normative Accounting Theories Lynn Barkess • This topic introduces the following normative theories of accounting. • IASB Conceptual Framework • Current Purchasing Power Accounting (CPPA) • Current Cost Accounting (CCA) • Continuous Contemporary Accounting (CoCoA) • You are not required to prepare sets of accounts using CPPA, CCA or CoCoA • You are required to know: • How assets and income are measured using each theoretical approach, and • The justifications that underpin each theory

9. Normative Accounting TheoriesIASB- Conceptual Framework Lynn Barkess Capital Maintenance – Financial Capital –This concept is adopted by most entities when preparing their financial statements. Under a financial concept of capital, such as invested money or invested purchasing power, capital is synonymous with the net assets or equity of the entity. Physical Capital –operating capability, capital is regarded as the productive capacity of the entity based on, for example, units of output per day.

10. Normative Accounting TheoriesIASB- Conceptual Framework Lynn Barkess Concepts of capital maintenance and the determination of profit. only inflows of assets in excess of amounts needed to maintain capital may be regarded as profit (IASB 4.60) Financial capital maintenance - profit is earned only if the financial (or money) amount of the net assets at the end of the period exceeds the financial (or money) amount of net assets at the beginning of the period, after excluding any distributions to, and contributions from, owners during the period. Financial capital maintenance can be measured in either nominal monetary units or units of constant purchasing power (IASB 4.59 (a)).

11. Normative Accounting TheoriesIASB- Conceptual Framework Lynn Barkess Concepts of capital maintenance and the determination of profit (cont.) Physical capital maintenance. Under this concept a profit is earned only if the physical productive capacity (or operating capability) of the entity (or the resources or funds needed to achieve that capacity) at the end of the period exceeds the physical productive capacity at the beginning of the period, after excluding any distributions to, and contributions from, owners during the period (IASB 4.59 (a)).

12. Normative Accounting Theories-CPPA Lynn Barkess Current Purchasing Power (CPPA) Information assumed to be required by usersan entity’s ability to maintain purchasing power Concept of capital maintenancePhysical although not explicitly stated

13. Normative Accounting Theories-CPPA Lynn Barkess Measurement Purchasing power losses arise only as a result of holding net monetary assets (Deegan , p. 174) Monetary assets- NB: most liabilities would be considered to be monetary assetsNet monetary assets = monetary assets less monetary liabilities. Holding gains/losses on net monetary assets are recognised in the income statement Non-monetary assets -Historical cost of goods restated to current purchasing power- no gain or loss is recognised.

14. Normative Accounting Theories-CPPA Lynn Barkess • Issues • Which price index to use, CPI? Does this represent the changes in the prices relating to specific commodities? See example on page 172 • Information generated by CPPA statements might be confusing? • What do you think?

15. Normative Accounting Theories-CCA Lynn Barkess Current Cost Accounting (CCA) HC and CPPA were rejected and CCA adoptees included Paton (1922) and Edwards and Bell (1961) CCA differentiates between profits/losses from trading and gains/loses that result from holding an asset. Information assumed to be required by usersan entity’s ability to maintain operating capacity

16. Normative Accounting Theories-CCA Lynn Barkess Holding gains may be realised or unrealised. Depending on the concept of capital maintenance adopted. May be either physical or financial Physical –holding gains/losses can be treated as a capital adjustment- recognised as a reserve (equity) Edwards and Bell- operating income = realised revenues less the replacement cost of stock. This is equal to the amount that can be distributed while maintaining operating capacity. (See Deegan p. 183 for an example). Neither realised or unrealised holding gains are available for distribution.

17. Normative Accounting Theories-CCA Lynn Barkess Holding gains may be realised or unrealised. Depending on the concept of capital maintenance adopted. May be either physical or financial Financial – holding gains and losses can be treated as income. Measurement Non-monetary assets – are recorded at replacement cost. Expressions with the same meaning include entry price, current cost deprival value. Depreciation based on replacement cost.

18. Normative Accounting Theories-CCA Lynn Barkess Issues: Which replacement cost? How to determine replacement cost? May not plan on replacing asset. Then replacement cost meaningless. Replacement cost does not reflect selling price if firm wishes to dispose of asset. Why separate holding gains and losses from other income . May argue that judicious purchases of assets in advance of price increases is another indication of efficiency of management. Allows comparison of operations between firm irrespective of date assets were purchased.

19. Normative Accounting Theories-CoCoA Lynn Barkess Continuously Contemporary Accounting (CoCoA) Chambers (1955, 1966) Information assumed to be required by usersan entity’s adaptive ability Profit is directly related to changes in the adaptive capital based on total exit value of the entities’ assets. Profit is calculated as the amount that can be distributed while maintaining the adaptive capital.

20. Normative Accounting Theories-CoCoA Lynn Barkess Concept of capital maintenance – Financial No distinction drawn between realised and unrealised gains/losses Measurement Non-monetary assets –market value, exit price, fair market value, selling price, “Value in exchange”. No depreciation Profit- realised and unrealised holding gains/losses are based on changes in the exit price of non-monetary assets and are recognised in income.

21. Normative Accounting Theories-CoCoA Lynn Barkess • Issues- • Exit values allow additivity- • How relevant are exit prices? • Would the asset be replaced ? • Is there a market for the asset? BHP blast furnace. • How does the assumption of a going concern fit with concept of exit prices? • Underlying separability assumption. No value for goodwill.

22. Creative Accounting Lynn Barkess • Brought about by loopholes in accounting standards and general acceptance in the business community • The use of form over substance • Methods of creative accounting • Inappropriate revenue recognition • For example Sunbeam in Enron DVD • Off balance sheet financing • Special Purpose entities • Leasing • Operating leases • Finance leases

23. Creative Accounting Lynn Barkess • Measures of Income • Definition of Revenue - AASB118.7 • Is the gross inflow of economic benefit during the period arising in the course of ordinary activities of an entity when those inflows result in increases in equity, other than increases relating to contributions from equity participants

24. Creative Accounting Lynn Barkess Revenue recognition IAS 18 -provides guidance for recognising revenue on the Sale of Goods Revenue arising from the sale of goods should be recognised when all of the following criteria have been satisfied: [IAS 18.14] A) the seller has transferred to the buyer the significant risks and rewards of ownership B) the seller retains neither continuing managerial involvement to the degree usually associated with ownership nor effective control over the goods sold C) the amount of revenue can be measured reliably D) it is probable that the economic benefits associated with the transaction will flow to the seller, and E) the costs incurred or to be incurred in respect of the transaction can be measured reliably

25. Creative Accounting Lynn Barkess Revenue recognition (cont) See Activity 2.12 Oscar sells to Bunny an item of machinery. Sales contract includes a clause (put option) that gives Bunny (buyer) the right to require Oscar (seller) to buy back the machine for a specified amount on a specified date. Seems that the risks and rewards of ownership have not been transferred according to IAS 18.

26. Creative Accounting Lynn Barkess • Off- Balance sheet financing • Used by companies to keep debt of the balance sheet • Most common is the operating lease • Allowed under (AASB 117, IAS 17) • FASB and IASB (ED/2010/09) • Special Purpose Entities (SPE’s) • a legal entity (usually a limited company or a limited partnership) • typically used by companies to isolate the firm from financial risk. They are also commonly used to hide debt (inflating profits), hide ownership, and obscure relationships between different entities which are in fact related to each other (see Enron). (Wikipedia) • IFRS 10, 11,12

27. Summary- Topic 2 Measurement Lynn Barkess Normative theories of Accounting Concepts of Capital maintenance Measures of Income Valuation of Assets Creative Accounting Next- Topic 3 Regulation of Accounting