31/07/2014

Australian School of Business

Objective
1. Understand the definition and recognition criteria for
assets and expense, and why they are important.

ACCT1511
Topic 2

2 Be technically competent in calculating, depreciation and

gains/ losses on disposals and related journal entries as
well as constructing T-accounts.
3. Understand the link between cost, asset and expense.

Assets (1)
General Principles

Asset Definition
An asset is 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 (AASB Framework,
para. 49)
Consequently, Assets have three essential characteristics:
1. Future economic benefit (or service potential)
2. Controlled by the entity
3. Result of past events

Future Economic Benefits

The potential to contribute, directly or indirectly, to the flow of cash
and cash equivalents to the entity. (para. 53)
So the questions we must ask to determine whether an item has
potential for future economic benefits are, for example:
Does the item form part of operating activities? If yes, then it has a
potential to indirectly contribute to the inflow of cash.
Can we sell the item for cash (or convert it into cash)? If yes, then it has
the potential to directly contribute to cash inflow.
Does the item help us save on costs? If yes, then it has a potential
reduce cash outflow.

Future Economic Benefits

Control

Example 1: An asset used singly or in combination with other assets in

the production of goods or services to be sold by the company
generate future economic benefits because these goods or services
can satisfy the wants or needs of customers, customers are prepared to
pay for them and hence contribute to the cash flow of the entity.

An entity controls the asset if it controls the benefits expected to flow

to the entity (Framework, para 57).

Example 2: An alternative manufacturing process that generates less

waste and therefore saves the company money.

Note: Cash itself renders a service to the entity because of its

command over other resources. Therefore cash is deemed to be an
asset.

Dr Per Tronnes

Although the capacity of an entity to control benefits is usually the result

of legal rights, an item may nonetheless satisfy the definition of an
asset even when there is no legal control.
Example 1: A property held on a lease is an asset if the entity controls
the benefits which are expected to flow from the property.
Example 2: Know-how obtained from a development activity may meet
the definition of an asset when, by keeping that know-how secret, an
entity controls the benefits that are expected to flow from it.

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Past event / Past Transaction

Asset recognition

The assets of an entity result from past transactions or other past events (Framework,
para 58).
Entities normally obtain assets by purchasing or producing them. It the production or the
purchase has already happen then the requirement for past even or past transaction is
satisfied.

Even if an item satisfy the definition of an asset, it is not certain that the
asset can be recognised in the balance sheet. An asset can only be
recognised in the balance sheet if it meets the definition of an asset
and satisfy both of the recognition criteria:

However, other transactions or events may generate assets.

Example 1: Property received by an entity from government as part of a program to
encourage economic growth in an area.
Example 2: Discovery of mineral deposits.

The item must satisfy both recognition criteria (Framework, para 83):
1. It is probable that any future economic benefit associated with the
item will flow to the entity; and
2. The item has a cost or value that can be measured with
reliability.

Transactions or events expected to occur in the future do NOT, in

themselves, give rise to assets.
Example 1: An intention to purchase inventory does not, of itself, meet the definition of an
asset.

Asset recognition: probability

It is probable that any future economic benefit associated with the item
will flow to the entity.
- A reflection that there is no certainty when predicting the future, and
that there are uncertainties in the business environment.
- Probably means more likely rather than less likely or greater than
50% chance.
Important: Do not confuse probability of FEB in recognition criteria with
potential of FEB in Asset Definition. They are not the same.
Example: I have purchased a lottery ticket. Because I could win, that lottery ticket has
Future Economic Benefits as there is potential to contribute to the flow of cash. Because I
would also be able to control the flow of any benefits and the lottery ticket has been
purchase (i.e. past transaction), that lottery ticket is an asset. But, it is very unlikely that I
will win anything, so it is NOT probable that the FEB will flow to the entity. Therefore I
cannot recognise the asset on the balance sheet.

Assets: Definition & Recognition

Does the item have all the essential
characteristics of an Asset ?

No

Yes
Does the Asset meet both
the recognition criteria?

Yes
A recognised in the
entitys balance sheet

Dr Per Tronnes

Details might appear in

the annual report

No

Asset Recognition: Reliable measure

The item has a cost or value that can be measured with reliability.
Note that it is cost or value. That means that it is enough that one of
them can be measured with reliability.
In many cases, cost or value must be estimated. The use of reasonable
estimates is an essential part of the preparation of financial
statements and does not undermine their reliability.
When, however, a reasonable estimate cannot be made the item is not
recognised in the balance sheet or income statement.

Cost vs. Assets vs. Expenses

Is Cost/Expenditure and Expense interchangeable?
Answer: No!
Cost/expenditure = Amount of cash/equivalents paid or fair value of
consideration given.
We can account for that cost in two different ways:
1. Capitalise the cost and record it as an asset
2. Not capitalise the cost and record it as an expense.

Might be separately
disclosed in the notes

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Cost vs. Assets vs. Expenses

In many cases, recording costs as assets is a way of deferring the
recognition of expenses to later periods.
Why would that be beneficial?
Answer: the matching principle: That is, matching expenses used to
generate the revenue to the same period when that revenue is
recognised. In this way, a better view of the performance (i.e. profit)
of the company is obtained.

If a costs is incurred and expense is recognised in the same period:

Cost Expense
If a costs is incurred and expense is to be recognised in later periods:
Cost Assets Expense

Cost Assets Expense

Cost Assets Expense

Example 1: An office building with a cost of $20,000 is purchased with
cash, with a 20yr useful life and zero residual value. Depreciation is
calculated on a straight line basis. The building satisfy the asset
definition and the recognition criteria.
1. Capitalising the cost as an asset (Cost Assets)
Dr Building (asset)
Cr Cash (asset)

20,000
20,000

2. Transforming the asset to expenses in future periods (Asset Expense)

Dr Depreciation Expense 1,000
Cr Accum. Depreciation (contra asset)
(each year for the next twenty years)

Assets & Expense : Another Approach

Example 2: An inventory with a cost of $30,000 is purchased with cash.

The inventory was sold for 40,000 cash.
1. Capitalising the cost as an asset (Cost Assets)

We have incurred a cost/expenditure.

Dr Asset or Expense? XXX
Cr Cash/Accounts Payable XXX
Does the item have all the essential characteristics of an Asset?

Yes
Dr Inventory (asset)
Cr Cash (asset)

1,000

No

30,000
30,000

Does the Asset meet both

the recognition criteria?

No

Expense

2. Transforming the asset to expenses when revenue is earned (Asset Expense)

Yes
Dr Cash (asset)
Cr Revenue (income)
Dr COGS (expense)
Cr Inventory (asset)

40,000
40,000
30,000

Current vs. Non-current Assets

AASB 101, para. 57:
An asset shall be classified as current when it satisfy any of the
following criteria:
a)it is expected to be realised in, or is intended for sale or consumption
in, the entitys normal operating cycle;
b) It is held primarily for the purposes of being traded;
c) It is expected to be realised within twelve months after the
reporting date; or
d) It is cash or cash equivalent (as defined in AASB 107 unless it is
restricted from being exchanged or used to settle a liability for at
least twelve months.
All other assets shall be classified as non-current

Dr Per Tronnes

ASSET

30,000

Current vs. Non-current Assets

In short:
If it is cash current asset.
If it is inventory current asset.
If the asset is expected to be used up within the next 12 months
current asset
If the asset is expected to be used up within the entitys normal
operating cycle current asset

What is an entitys normal operating cycle?

The operating cycle of an entity is the time between the
acquisition of assets for processing and their realisation in
cash or cash equivalents (AASB 101, para 68).
When the entitys normal operating cycle is not clearly
identifiable, it is assumed to be twelve months (AASB 101,
para 68).
All other assets are non-current assets.

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Intangible Assets: Definition

An intangible asset is an identifiable non-monetary asset without
physical substance (AASB 138, para 8)

It must meet the essential characteristic of an asset: i.e.

control, FEB, past event/transaction
In addition, it must be identifiable:
An asset meets the identifiable criterion...when it:

a) It is separable, that is, is capable of being separated

or divided from the entity and sold, transferred,
licensed, rented or exchanged, either individually or
together with a related contract, asset or liability; or
b) Arises from a contractual or other legal right,
regardless of wether those rights are transferable or
separable from the entity or from other rights or
obligations

Intangible Assets: Recognition Criteria

Only when the item meets two recognition criteria (AASB 138,
paragraph 21):

1. It is probable that the expected future

economic benefit that are attributable to the
asset flow to the entity; and
2. The item has a cost that can be measured
with reliability.
- Notice that for intangible assets there must be a cost that
can be measured with reliability.

Separate Acquisition
Accounting for intangible assets when there is a separate acquisition is
actually quite simple.
Because....the effect of probability is reflected in the cost of the asset.
Therefore, the probability recognition criterion.....is always
considered to be satisfied for separately acquired intangible asset
(AASB138, para 25)
In other words, if we buy an intangible asset, for example a patent, we
recognise it as an asset on the balance sheet.

Dr Intangible Asset
XXX
Cr Cash/Accounts Payable XXX

Dr Per Tronnes

Intangible Assets: Definition

The definition excludes monetary items: i.e. financial instruments, for
example shares in another company, are not intangible assets
Typical intangible assets include, among others:

patents,
licences,
copyrights,
franchises,
trademarks

Intangible Assets:
Acquisition vs. Internally Generated
We treat intangible assets differently depending on whether they were
acquired or whether they were internally generated.
Separate acquisition: The intangible asset is purchased from outside the
company.
- Example: Company A purchases a patent regarding a new
technology for sharing messages for $20,000 from Company B.
Internally generated: The intangible asset is developed by the company.
- Example: Company A develops a new technology for sharing
messages.

Internally Generated Intangibles/R&D

Accounting for internally generated assets is
harder because it is difficult to assess whether
an internally generated intangible asset qualifies
for recognition because of two problems :
a) Determining whether there is an identifiable asset
that will generate expected future benefits?
b) Determining the cost of the asset reliably. (i.e. is the
cost incurred part of the day to day operation or is it
specific to the asset?).

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Internally Generated Intangibles/R&D

To assess, whether an internally generated assets
meets the criteria for recognition, an entity
classifies the generation of the asset into (AASB
138, para 52):
a) A research phase
a) A development phase

So what is development?
Development is the application of research findings or other knowledge
to a plan or design for the production of new or substantially improved
materials, devises, products, processes, systems or services before the
start of commercial production or use.
Typical activities that fall in under development:
1) the design, construction and testing of pre-production or pre-use
prototypes and models;
2) the design and tools, jigs, moulds and dies involving new
technology;
3) the design, construction and operations of a pilot plant that is not of
a scale economically feasible for commercial productions; and
4) the design, construction and testing of a chosen alternative for new
or improved materials, devices, products, processes, systems or
services.

Development Accounting Treatment

So what is Research?
Research is original and planned investigation undertaken with the
prospect of gaining new scientific or technical knowledge and
understanding.
Typical activities that fall in under research:
1) activities aimed at obtaining new knowledge;
2) the search from evaluation and final selection of, applications of
research findings or other knowledge;
3) the search for alternatives for materials, devices, products
processes systems or services;
4) and the formulation, design, evaluation and final selection of
possible alternatives for new or improved materials, devices,
products, processes, systems or services.

Research - Accounting Treatment

No intangible asset arising from research (or from the research phase
of an internal project) shall be recognised. Expenditure on research (or
on the research phase of an internal project) shall be recognised as an
expense. (AASB 138, para 54).
Why?
In the research phase of an internal project, an entity cannot
demonstrate that an intangible asset exists that will generate probable
future economic benefits... (AASB 138, para 55).
Therefore, all costs during the research phase are expensed:
Dr Expense
Cr Cash/Accounts Payable

XXX
XXX

Development Accounting Treatment

An intangible asset arising from the development (or from the

development phase of an internal project) shall be recognised if,
and only if, an entity can demonstrate all of the following (AASB
138 para 57):

In the development phase of an internal project, an entity can, in some

instances, identify an intangible asset and demonstrate that the asset
will generate probable future economic benefits. This is because the
development phase of a project is further advanced than the research
phase.

a) the technical feasibility of completing the intangible asset so that it

will be available for use or sale.
b) its intention to complete the intangible asset and use or sell it
c) its ability to use or sell the intangible asset
d) how the intangible asset will generate probable future economic
benefits....
e) the availability of adequate technical, financial or other resources
to complete the development and to use or sell the intangible asset
f) its ability to measure reliably the expenditure attributable to the
intangible asset during its development.

So if the company can demonstrate that it has technical feasibility and

the intention to complete the intangible asset, and ability to sell or use
the asset plus that it is probable the asset will generate future economic
benefits and that costs can be measured reliably, then costs in the
development phase can be capitalised:
Dr Intangible asset

XXX

Cr Cash/Accounts Payable
Dr Expense

XXX

Cr Cash/Accounts Payable

Dr Per Tronnes

XXX

If not, costs are expensed:

XXX

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Some Intangible asset are never recognised

as asset if they are internally generated.

Goodwill A special case

Internally generated brands, mastheads, publishing titles, customer

lists, and items similar in substances shall not be recognised as
intangible assets (AASB 138, para 63).

Goodwill is a non-current intangible asset, but it is not identifiable....

Why?
Expenditure on internally generated brands, mastheads, publishing
titles, customer lists and items similar in nature cannot be distinguished
from the costs of developing the business as a whole (AASB 138, para
64). In other words, if such assets are developed within the company,
they are not identifiable.
But if intangible assets such as those above are acquired, then they are
identifiable, and can be recognised as assets.

Recognising and Measuring Goodwill

Consider a simple case. Company A is purchasing Company B for
$30,000. In effect, Company A is purchasing Company Bs assets
and liabilities for $30,000. Let us say that the Company Bs assets
and liabilities had a market value of 40,000 and 20,000, respectively.
What is the Goodwill amount?
Goodwill as of the acquisition date is measured as:
1) The consideration transferred,
2) less the fair value of the net identifiable assets acquired and the
liabilities assumed.
That is, purchased goodwill is calculated as the amount paid for a
business less the estimated market value of the net assets
obtained.

Goodwill
Some things that you might have understood:
The 10,000 goodwill of Company B due to synergies, reputation, loyalty of
clients, staff knowledge or whatever it else it is can only be valued at
10,000 because company A acquired Company B.
Therefore, it was no goodwill in Company Bs books before Company A
acquired it. That is, before company A acquired Company B, a value could
not be put on the synergies, reputation, loyalty of clients, staff knowledge
etc.
As you can probably see, the goodwill is a somewhat funny accounting
concept. Pinning down exactly what the goodwill amount represent is
difficult. As it is measured, the more money Company A pay for Company B,
the higher the goodwill in Company As books. One way of interpreting
goodwill (somewhat critically) may be that Company A paid too much for
Company B.

Goodwill is an accounting concept meaning the value of an entity over

and above the value of its separate identifiable assets less liabilities.
- because of synergies, reputation, loyalty of clients, staff
knowledge etc.
- so goodwill is the value of all the things that is hard to
measure, and not separately listed on the balance sheet such
as buildings, inventory and so on.

(The following few slides are a somewhat simplification But you will
revisit goodwill in greater detail in Accounting 2B)

Simple Illustration
Cost of Business:
Fair Value of Identifiable Assets:
Fair Value of Liabilities Assumed:
Fair Value of Net Assets:
Goodwill:

$30,000
$40,000
$20,000
$20,000
$10,000

Journal entries in Company As books:

Dr Identifiable Assets
Dr Goodwill
Cr Liabilities
Cr Cash

40,000
10,000
20,000
30,000

Goodwill
To sum up:
Only purchased goodwill recognised.
Internally generated goodwill shall not be recognised as an asset
(AASB 138, para 48)
Why?
in some cases, expenditure is incurred to generate future economic
benefits....[and] is often described to as contributing to internally
generated goodwill. Internally generated goodwill is not recognised as
an asset because it is not an identifiable resources controlled by
the entity that can be measured reliable at cost (AASB 138, para
49)

Accounting for goodwill is, however, necessary. Without a debit to Goodwill in

Company As books, the journal entry would not balance.

Dr Per Tronnes

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Amortisation and Impairment of Intangibles

- An entity must assess whether useful life

is finite or indefinite.
- If finite, the intangible asses is amortised.
- E.g. leases, franchises, patents etc.

- If indefinite, the asset is not subject to

amortisation, but would need to test annually
for impairment (impairment is next week).
- E.g. goodwill.

Calculating depreciation (ACCT1501)

Depreciation starts when the asset is ready for use as
intended by the management.
To choose a depreciation method, we need to make
judgments on:
useful life
residual value (sale or scrap)
pattern of flow of benefits over the useful life.
i.e. the pattern of revenue will determine how
we allocate the costs in the appropriate
periods.
Useful life, residual value and pattern of flow will need
to be reassessed annually.

Useful life (ACCT1501)

Estimated useful life defined:
The period of time over which an asset is expected to
be available for use by an entity; or
The number of production or similar units expected to
be obtained from the asset by the entity.
Note:
Useful life relates to an assets expected utility to the
enterprise.
Useful life differ from physical life of the asset.

Dr Per Tronnes

Depreciation an expense (ACCT1501)

Property, plant, and equipment usually have limited useful
lives:
That is, the economic benefits are consumed over time.
For example, if a machine was purchased 10 years ago, the
future economic benefits are likely to be much less now than
when the machine was originally purchased.

Depreciation is the systematic allocation of the depreciable

amount of an asset over its useful life.
Depreciation is a process of ALLOCATION OF COST

Remember the Matching Principle

It is NOT method of VALUATION

Residual value (ACCT1501)

Residual Value defined:

The estimated amount that an entity would currently

obtain from disposal of the asset, after deducting the
estimated costs of disposal, if the asset were already
of the age and in the condition expected at the end of
its useful life
The residual value is used to calculate the depreciable amount (the
amount that must be allocated over the life of the asset).
Depreciable Amount = Asset Cost - Residual Value
The depreciable amount must be allocated on a systematic basis
over an assets useful life.

Depreciation methods
Three

Common Methods (ACCT1501):

straight-line
reducing balance
units of production

Issues to think about. Do these methods produce information to

users that are reliable? relevant?

All depreciation methods are an approximation

The apparent precision of any depreciation
method is illusory
But they are Verifiable (Reliable in the sense that it
uses established methodology)

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Depreciation - Journal entry

Illustration

For all depreciation methods:

A machine with an original cost of $50,000 and

accumulated depreciation of $24,000 (as at 30 June
2008)

Dr Depreciation expense
XXX
Cr Accumulated depreciation (contra asset) XXX

It was sold on 1 August 2008 for $21,000 cash.

The straight line method was used to record
depreciation on the old asset.
The annual amount of depreciation was $12,000.
Required: Prepare journal entries to record the events
explained.

Comparison of Terminology for Tangible

and Intangible Assets with Limited Useful Life

Illustration (Cont.)
Recording depreciation up until Historical Cost
the date of disposal
Acc Depn
Dr Depn Exp 1,000
Carrying/Book Value
Cr Acc Depn
1,000
Cash received (Market
Removing the non-current asset
Value)
from the companys books.
Accounting Gain/(Loss)
Dr Cash
21,000
Dr Acc Depn
25,000
Cr Machinery
50,000
Dr Loss on Sale
4,000

50,000

Tangible

Intangible

25,000

Tangible Asset
Depreciation Expense
Accumulated
Depreciation (Contra
Asset)
Depreciation Methods

Intangible Asset
Amortisation Expense
Accumulated
Amortisation (Contra
Asset)
Amortisation Methods

25,000
21,000
(4,000)

Why do we have estimation error?

- Because depreciation is allocation of costs, and not a method of valuation .

Dr Per Tronnes

Straight line
Reducing balance
Etc

Straight line
Reducing balance
Etc

In other words, same thing but different terminology