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Chapter 3: Company operations

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1.

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Three essential characteristics can be derived from the definition of assets in


paragraphs 4.8-4.14 (53-59) of the Conceptual Framework.
(i)
A resource controlled by the entity,
(ii)
future economic benefits,
(iii)
past events.
Refer section 3.1.1 of the chapter and these are discussed further below:
Future economic benefit. (refer paragraphs 4.8- 4.11/53- 56)
Possession of a right, or of a physical object, does not constitute an asset in the
absence of future economic benefits (business entitiesgeneration of cash flow, nonbusinessproviding goods or services which satisfy the organisation's objectives). A
machine that produces unwanted output and has no resale value is not an asset.
Control (refer paragraphs 4.12- 4.13/57-58)
Ownership or title to a physical item is not necessary for that item to qualify as an
asset (for example, a leased asset). The issue is whether the entity can secure the
benefits and deny access to others.
Past transaction or event (refer paragraphs 4.13- 4.14/58- 59)
A past transaction or event ensures that we count as assets only present capacity to
obtain future benefits. Therefore, we exclude items that may provide future benefits
because we have budgeted their acquisition but which are not presently controlled
because acquisition has not yet occurred.
Also note the fact in paragraph 59 of the Framework that incurring a cost is not a
requirement for an asset.
To be recognised (included in the financial statements) an item must meet the
definition and recognition criteria. Paragraph 4.44/83 of the Conceptual Framework
states that an asset should only be recognised when it is probable that any future
economic benefit associated with the item will eventuate and that the asset possesses
a cost or other value that can be reliably measured. It is expected that the notion of a
reliable measure will be replaced by a faithfully representative and verifiable
measure in the conceptual framework.
Section 3.3.1 notes various measurement bases for assets. It is important to
understand that the criteria requires a cost or other value, so do not need to be able
to measure the value of the actual benefits to be received.
Initially many assets are measured at cost, however subsequent to this different rules
may apply depending on the nature of the asset. For example, inventory must be
measured at lower of cost or net realisable value; certain non-current assets may
remain measured at cost (subject to depreciation) or measured at fair value.
Accounting standards may specify the measurement required for particular assets. If a

choice of measurement is allowed this would be an accounting policy choice and


hence the measurement chosen should be one that provides relevant and reliable
(representationally faithful) information (refer section 3.6).
Section 3.1.2 of the chapter, discusses a proposed asset definition as outlined in the
discussion paper, A Review of the Conceptual Framework for Financial Reporting. A
new definition has been developed because of perceived shortcomings of the existing
definition. The definition proposed is:
a present economic resource controlled by the entity as a result of past events (para 2.11)

3.

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The Conceptual Framework (4.4.b/49.b) defines a liability as:


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.

Three essential characteristics can be derived from the definition of liabilities in the
Conceptual Framework, paragraphs (4.15-4.19/60-64).
(a)
present obligation to make an outflow of resources,
(b) future outflows of economic benefits,
(c)
past transactions or other past events.
See section 3.1.3 of the chapter.
Discussed further as below: Essential characteristics of liability are:
1. Future outflows of economic benefits
Note: Liabilities can be settled by transfer of assets of any type (cash not the only
assetsay deliver goods that have been pre-paid) or by provision of services and the
fact that the amount of the liability is not certain (for example, warranty obligations,
long service leave) does not preclude recognition as a liability. This actually falls
under the reliability of measurement rule.
2. Present obligation to make an outflow of resources
Essential notion is that the entity is presently obligated and cannot avoid settling the
obligationthere is no reasonable alternative other than to settle. The obligation may
be enforceable from legal sources such as contract or legislation administrative
regulation, or it may be constructive.
Also note: This must involve an external party as cannot be obligated to one-self.
Hence setting aside reserves (for example, for major overhauls, renewals of plant, etc)
does not constitute a liability. Further, decisions to acquire assets in the future do not
give rise to liabilities unless there is an irrevocable agreement.
3. Past event
This is required to ensure that only present obligations to make future outflows of
economic resources are included as liabilities.

The Conceptual Framework (4.38/91) specifies two criteria which must be satisfied
before an item that meets the definition (such as a liability) can be recognised
(a) it is probable that any future economic benefit associated with the item will flow
to or from the entity; and
(b) the item has a cost or value that can be measured with reliability.
Probable in this context means that the future outflow of economic benefits is more
likely than less likely, i.e. a greater than 50% probability.
It is expected that the notion of a reliable measure will be replaced by a faithfully
representative and verifiable measure in the conceptual framework.
Most liabilities are measured at nominal value, however for particular liabilities like
long service leave entitlements for employees and certain lease liabilities, the
discounted present value method is used. Other possible measurement suggestions are
value to the entity and discharge price. Note measurement may involve the use of
estimates. See section 3.3.2 of the chapter for further discussion of measurement
methods.
See also section 3.1.4 of the chapter which discusses possible changes to the
definition of a liability.
4. What are the essential characteristics of equity?
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5. Explain what is meant by the term recognition. Are all items that meet the
definition of an element of the financial statement always recognised? Discuss
how the proposed changes to the recognition criteria in the 2013 Discussion
Paper, A Review of the Conceptual Framework for Financial Reporting, could
impact on recognition of items.
Recognition is outlined in the Conceptual Framework (4.37/ 82):

Recognition is the process of incorporating in the balance sheet or income statement an


item that meets the definition of an element and satisfies the criteria for recognition set out
in paragraph 83. It involves the depiction of the item in words and by a monetary amount
and the inclusion of that amount in the balance sheet or income statement totals. Items
that satisfy the recognition criteria should be recognised in the balance sheet or income
statement. The failure to recognise such items is not rectified by disclosure of the
accounting policies used nor by notes or explanatory material.

Hence recognition is inclusion of an item in a financial statement. This can be


contrasted with disclosure which normally means that information is included
(disclosed) either in the statements or in the notes to the accounts.
Not all items that meet the definition will be recognised as the Conceptual Framework
(4.38/ 83) requires that the following criteria be met before an element can be
recognised:
An item that meets the definition of an element should be recognised if:
(a)
it is probable that any future economic benefit associated with the item will
flow to or
from the entity; and
(b)
the item has a cost or value that can be measured with reliability.

For example, a company may have an item that meets the definition of a liability but
not the recognition criteria (for example, has been found liable in a court case but the
amount to be paid has not yet been determined and cannot be estimated). In such
cases the relevant standard (AASB 137) requires disclosure of the item. As this does
not meet both the definition and recognition criteria it cannot be included on the face
of the financial statements. However information about this item would be disclosed
separately in the notes
Section 3.2.1 discusses the recognition criteria proposed in the 2013 discussion paper.
The significant change proposed is to abolish probability as recognition criteria. The
existing recognition criteria of probability means that any elements where there is less
than 50% likelihood of outflows being required to be made/or economic benefits
being received are excluded from recognition (subject to the requirements of specific
standards). The abolition of the probability threshold could result in such items being
included and probability of inflows/outflows would be reflected in the measurement.
Recognition would be subject to the cost constraint and considerations of relevance
and faithful representation.

9.

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Income is defined at paragraph 4.25/70 of the Conceptual Framework as meaning


increases in economic benefits during the accounting period in the form of inflows or
enhancements of assets or decreases of liabilities that result in increases in equity,
other than those relating to contributions from equity participants.
Income is sub-classified into revenue and gains. The Conceptual Framework
(paragraph 4.29/74) states that revenue arises in the course of the ordinary activities

of an entity and is referred to by a variety of different names including sales, fees,


interest, dividends, royalties and rent. It notes (paragraph 4.30/75) that gains can arise
either from ordinary activities or from other activities/sources and are no different in
nature, although presentation may vary. Gains are usually reported on a net basis,
unlike revenue.
Revenue is defined in AASB 118 Revenue as the gross inflow of economic benefits
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.
Paragraph 4.38/83 of the Conceptual Framework states that income should only be
recognised when it is probable these inflows or savings in outflows will occur and the
amount can be reliably measured (to be replaced by a faithfully representative and
verifiable measure).
Specific standards provide guidance or place restrictions on the recognition of
revenues.
For example, AASB 118 Revenue places further restrictions on the recognition of the
types of revenue within its scope in that it requires a control test and a cost test to be
applied. The control test requires the entity to transfer the significant risks and
rewards of ownership of the goods, and not to retain continuing management
involvement associated with effective control over the goods. The cost test requires
that all costs incurred or to be incurred in respect of the sale to be measured reliably.
For revenue from services, a stage of completion test is also required. Principles have
been established for an entity to apply in order to report useful information about the
revenue and cash flows arising from its contracts to provide goods or services to
customers, especially contracts which require performance over time. See section
3.2.2 of the chapter for further details.
The standard also provides requirements for the recognition of revenue from
dividends and interest. See section 3.2.2 for further discussion, and AASB 118
paragraphs 14-34.
Section 3.2.2 of the text also discusses the revised AASB 118 Revenue from Contracts
with Customers expected to apply from 2017.

10.

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Expenses are defined at paragraph 4.25/70(b) of the Conceptual Framework as


decreases in economic benefits during the accounting period 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. Paragraph 4.38/83
states that expenses should only be recognised when it is probable that the future
economic benefits will flow from the entity and the amount can be reliably measured
(to be replaced by a faithfully representative, verifiable measure). See section 3.2.3 of
the chapter for a brief discussion of the recognition of different types of expenses.

Expenses are usually classified in general-purpose financial statements by their nature


such as employee expenses or depreciation, or their function such as distribution and
administrative expenses. However, for internal reporting purposes, expenses can be
classified in a way that best suits the user of the financial statement e.g. variable v
fixed, controllable v non-controllable. See also Section 3.3.5 of the chapter.

12.

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Where a company has a constitution that provides for directors to declare a dividend,
then a dividend becomes a debt of the company once the dividend is declared. Where
no such statement exists in a companys constitution, then the debt will only arise
when the time for payment of the dividend arrives.
If a dividend has been declared (or paid) by the time of completion of the financial
report but not on or before the reporting date it must not be recognised as a liability as
at the reporting date. Instead such a dividend must be disclosed in notes as an event
after reporting date. See sections 3.4.1 and 3.4.2 of the chapter.

13. What factors determine the selection of accounting policies?


The overriding factor in the selection of an accounting policy is to determine whether
the policy provides users with information useful for making economic decisions.
In selecting accounting policies, AASB 108 Accounting Policies, Changes in
Accounting Estimates and Errors establishes a hierarchy for entities to follow in
preparing general-purpose financial statements.
Firstly, paragraph 7 of AASB 108 states that, when an Australian accounting standard
specifically applies to a transaction, other event or condition, the accounting policy or
policies applied to that item shall be determined by applying the Standard.
Secondly, in the absence of an Australian accounting standard that specifically applies
to a transaction, other event or condition, paragraph 10 requires management to use its
judgement in developing and applying an accounting policy that results in information
that is:
(a) relevant to the economic decision-making needs of users; and
(b) reliable, in that the financial statements:
(i) represent faithfully the financial position, financial performance and
cash flows of the entity;
(ii) reflect the economic substance of transactions, other events and
conditions, and not merely the legal form;
(iii) are neutral, that is, free from bias;
(iv) are prudent; and
(v) are complete in all material respects.

(For further discussion of relevance, faithful representation, neutrality and


completeness, see section 3.6.1 of the text.)
Thirdly, in making the judgement described in paragraph 10, paragraph 11 requires
management to refer to the following sources in descending order:
(a) the requirements in Australian Accounting Standards dealing with similar and
related issues; and
(b) the definitions, recognition criteria and measurement concepts for assets,
liabilities, income and expenses in the Framework.
Fourthly, in making the judgement described in paragraph 10, paragraph 12 then
suggests that management may also consider the most recent pronouncements of other
standard setting bodies that use a similar conceptual framework to develop accounting
standards, other accounting literature and accepted industry practices, to the extent
that these do not conflict with the sources mentioned in paragraph 11.
Finally, AASB 108 paragraph 13 requires that the accounting policies selected are
applied consistently for similar transactions, other events and conditions, unless an
Australian accounting standard specifically requires or permits categorisation of items
for which different policies may be appropriate. If an accounting standard permits
such categorisation, then the accounting policy selected shall be applied consistently
to each category.
15.

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AASB 101 para 54 describes the equity of a company as consisting of share capital
and reserves (retained earnings and other reserves).The term reserve is not defined in
any accounting standard or the Corporations Act. Guidance on the nature of a reserve
can be found by looking at what companies include as reserves in their annual
reports and what accounting standards refer to as reserves.
In addition to retained earnings, the most common type of reserves are general,
revaluation and foreign currency translation reserves. Retained earnings is one
category of reserves, according to AASB 101. Retained earnings represent the
balances of the profit and losses (before items of other comprehensive income) which
the company has made since incorporation, which have not been paid as dividends or
bonus share issues to shareholders, transferred to reserves, or used to buy back shares
(Henderson and Pierson, 2000, p 534).
Some other reserves arise as the result of accounting standards requiring amounts of
other comprehensive income to be accumulated in equity (eg. revaluation surplus)
and others arise from transfers from retained earnings (often known as general
reserves) due to generally accepted accounting principles. Some have arisen from
dubious accounting practices, now banned.
Students should realise that reserves do not represent cash balances. Reserves are
book entries and no cash is physically transferred or created by these entries.
Students should recognise that for example, the creation of a general reserve is a
transfer from profit, and profit does not necessarily represent cash.
What reasons may there be for no definitions being given for a reserve in the
legislation, accounting standards, and the conceptual framework ?

I would say that the reason there is no definition given for a reserve in the legislation,
accounting standards and conceptual framework is because it is not possible to
categorise reserves according to a homogeneous definition. Reserves may be created
in a number of different ways (accounting standards, GAAP, other dubious accounting
practices). It therefore would appear to be a very difficult task to establish a general
definition to include all reserves. Any definition may be too restrictive.