Chapter 8

Liabilities and owners equity

Theory in Action 5.1 — Changing the boundaries

1. Who would have made the decision to break the group into at least three pieces —
transport, logistics and health?

The decision to split a single operating entity was made by the board of Mayne Group. But,
the decision was a response to external pressures. Part of the objective was to create separate
entities for sale, but also to delineate between the returns on core and adjunct business
activities. This reinforces the argument that accounting is about defining the reporting
boundaries, which can be defined to suit the purposes of those who control the entity.
Basically, an entity can be defined in any way required, and the Mayne decision certainly
lends significant weight to this view.

2. How can a company which has operated as a single entity simply decide to split into
three or more separate entities? How will this change the reporting boundaries?

The boundaries are defined by those who control the entity. Mayne has elected to adopt a
division of the firm based on activity; however, many firms will elect to draw geographic
boundaries. The organisational split will require that the owners calculate the total value of
the three subsets. But the point is that this split does not change the overall reporting
requirements of the group, because there is no change to ownership or real reporting lines.

3. Explain the external factors which have motivated the decision to break the group
up. Why should such external factors influence the structure of reporting entities?

External factors always influence a firm’s decisions and structures. Except in this case, the
factors have become acute because of the political and legal issues. Organisations do not live
in a vacuum, and the boundaries they draw are functions of internal and external factors. In
this case it is quite clear that external events have led to new boundaries, as the firm is keen to
sell all or part of some of its activities.

4. Explain why the company’s shares were trading ‘at a discount to sum of parts
valuations’.

The major reason is that the earnings forecasts have been reduced, and the expected return on
assets has therefore declined. Simply unravelling an entity into three entities does not
necessarily change the market value.

5. There appears to be a significant variance ($370 million to $560 million) as to the

estimated value of the logistics entity to be created by the Mayne break-up. Why would
there be such variance in the value of the new logistics entity?

The only way to find the value of the entity is to find an ‘arms-length’ buyer. The value of
assets held in an entity will not normally provide a simple base for value, but instead the
perceived value of the use of the assets will be factored in. The interpretation of this value
will be subjective and as such a significant variance in value will result.

Theory in Action 5.2 — The shifting perspective of accountability

1. How does reporting information to satisfy the interests of a broad range of interests
or viewpoints relate to the entity view, with its main focus on the owner
(shareholder)? Is it really possible to satisfy the demands of these competing
interests?

It is not possible to satisfy completely the interests of all parties who focus on the
performance of public companies. The shareholders have a direct interest and provide the risk
capital; however, firm reporting is a complex exercise as different groups will respond to
reported information and these responses may directly affect firm performance. The primary
focus will remain on shareholder perspectives, but it may be in the shareholders’ interests to
report information sought by lobby groups and other external stakeholders. Shell is a highly
visible (large) organisation in a very political industry. It is seeking to signal a commitment to
the green lobby and the broader community that it is a ‘good’ corporate citizen. It is certainly
in the interests of Shell shareholders to avoid the introduction of legislation (as a result of
lobbying by interest groups) that constrains activities and impacts on profits.

2. The Shell Group engages in activities that are environmentally and socially sensitive.
Will the nature of the industry in which a firm operates fundamentally drive its view
of stakeholders? If so, discuss the possibility of viewpoints of accounting being
classified along industry lines.

The nature of the industry in which a firm operates is already affected by disclosure
requirements. Firms operating in environmentally sensitive industries are required to provide
for and report on redevelopment and related costs. Requiring certain minimum disclosures
directly classified by industry sector would allow for some level of inter-firm comparison,
each financial period and across time. There are size and industry effects associated with
disclosures (see the discussion on political costs pp. 344–7). A firm with a higher political
visibility will seek to provide disclosures that support the demands of those groups likely to
influence the firm’s operations. As such, the disclosures by this firm may not represent the
information necessarily required, but the information the firm considers will reduce lobbying
to restrict existing or future activities.

3. What type of bottom-line indicators would be of greater interest to shareholders

compared with members of the ‘green’ political parties?

We could adopt the classic dichotomy of profits, dividends and capital growth for
shareholders; and impact on environment, commitment to environmentally friendly activities
and minimisation of the effect of activities on the environment for green political parties. This
is the case in reality, which to some extent places the two groups in inherent conflict.
However, it is in the interests of shareholders that firms engage in sustainable behaviour.
Encourage a class discussion as to whether the two groups have any points of common
interest, and how common disclosure measures might be achieved. It would be interesting to
ask whether the lobby groups should pay some of the cost of additional measurements, and
disclosures or whether the firms have a debt to society to make such disclosures.

4. Visit the Shell web site and undertake a review of the environmental and social
sections of the Shell 2000 and 2001 annual reports. How can the disclosures be
improved and what type of additional information could be included to improve our
understanding of the impact of Shell’s operations on both the environment and
society?

This question is designed to generate discussion and is based on the views and interpretations
of students. Prepare a list of all the students’ suggestions and have the class discuss how
effective the suggestions may be. It is important to reinforce that ‘usefulness’ will be a matter
of perspective and interest, so consider alternative stakeholders’ preferences and what would
drive them.

Theory in Action 5.3 — Trimming shareholders

1. Why would a company want to buy back its shares? Is buying back shares consistent
with entity theory?

Buying back shares will reduce the overall level of residual claimants against the company
and allow for consolidation of dividend and related policies. It also can reduce the threat of
takeover. Buying back shares is consistent with the entity theory, as the company is
considered to be completely autonomous to equity holders and therefore there would be no
issue with buying back or trading in its own capital.

2. Instead of buying back shares, should IAG invest the funds it would spend on the
buyback in generating greater returns for all shareholders?

This is really a decision for the management of the company. Will an additional investment
result in appropriate returns? Will reducing the level of equity actually lead to greater returns
for the remaining shareholders? The question really revolves around the best interests of the
company under entity theory versus the best interests of owners under proprietary theory.

3. How does IAG justify ‘trimming’ the share register at the same time that it makes a
$350 million reset preference share offer?

Ordinary share capital is very different to reset preference shares. Ordinary share capital has
voting rights, rights to dividends and the capacity to trade shares. This is different to reset
shares, which are initially a form of debt capital (no voting rights and a fixed dividend level,
with priority over payment of dividends to ordinary shareholders). Depending on the terms on
which the reset shares are issued, they could be converted to ordinary capital at some point in
the future. However, not all reset shareholders might take up this option, selling the shares
back to the company at an agreed rate instead.

4. The share value consists of a capital component and a dividend component. Explain
what this means in terms of the entity theory.
Of primary concern under the entity theory is profit. However, there are also other issues such
as tax credits and benefits that also need to be factored into the value of a share. The capital
component relates to the value of assets used by the firm; whereas the dividend component
relates to the firm’s capacity to pay dividends from current or previous accrued profits.

Questions

1. With respect to the proprietary theory:

(a) What is the objective of the firm?
(b) How important is the concept of ‘stewardship’?
(c) What is the relationship between assets/liabilities and the owner?
(d) How would you define revenues, expenses, profit?
(e) What are three effects on current practice?
(f) What are the theory’s limitations?

(a) The firm essentially is the proprietor. The firm is simply the proprietor’s instrument to
achieve his or her purpose, which is to increase his or her wealth. Income represents the
increase in the wealth of the proprietor in a given period.

(b) Stewardship is relatively unimportant, because accountability to outside parties is not

critical. The proprietor is, in effect, the firm, and therefore is in a privileged position to
know what is happening. Liabilities are usually short term, and therefore there is no need
to give a continual accounting to creditors.

(c) The assets are ‘owned’ by the owner, and the liabilities are ‘owed’ by the owner. This
shows that there is no separation between the firm and the owner. In the accounting
equation, P stands for the net worth of the owner.
A–L=P

(d) Revenue is the increase in proprietorship; expense is the decrease in proprietorship; and
profit is the net effect of proprietorship, excluding additional investments and withdrawals
by the owner. Revenue and expense accounts are truly subsidiary accounts of P. They
have the same algebraic characteristic as ‘net worth’ — increases in net worth are credits
and decreases in net worth are debits. The proprietary theory focuses on P in viewing
income. Revenues and expenses are caused by the decisions and actions of the proprietor.
The profit of the firm belongs to the proprietor and that is why P is affected in the
accounting equation.

(e) The following are examples of the effect of the proprietary theory on accounting practice:
 Dividends paid are a distribution of earnings, not an expense; and interest charges are an
expense.
 In a sole proprietorship or partnership, salaries to owners who work in the firm are not
considered an expense of the business. The reason is that the firm and the owner are
not separate entities; they are the same.
 The equity method for long-term investments focuses on the proprietary interest of the
investor company in the invested company.
 The parent company theory for consolidating financial statements views the parent as
‘owning’ the subsidiary. Minority interest is considered an ‘outside’ claim, and
logically should therefore be a liability on the consolidated statement of financial
position.
  The pooling of interests method for business combinations emphasises the uniting
(pooling) of the owners’ interests of the two combining companies.
 Common terms used reveal the proprietary interests of owners are: book value per
share, earnings per share and income to shareholders.
 The use of the consumer price index for general price level adjustments shows that the
‘consumer desires’ of owners are considered.
 The financial capital view is pertinent to owners.

(f) The proprietary theory does not accord with the realities of the large corporation. The law
recognises the corporation as a separate entity, distinct from the owners. The corporation
— not the shareholders — owns (controls) the assets, and is liable for the debts. For the
large corporation, withdrawals of cash or other assets by shareholders cannot be made
without running afoul of the law. This shows that the ownership rights of shareholders are
limited. Accountability to shareholders is significant; otherwise, shareholders have no
knowledge of the status and operations of the business. The assumptions of the proprietary
theory are not relevant to the shareholders of large firms.

2. With respect to the entity theory:

(a) What are the reasons for concentrating on the entity as a unit of accountability
rather than the proprietor?
(b) What is the objective of accounting?
(c) How important is the concept of ‘net worth’?
(d) What is the reason for modifying the accounting equation to Assets = Equities?
(e) On what side of the equation in (d) would retained profits appear?
(f) Why is there a stress on profit determination?
(g) How do the concepts of revenues, expenses and profits differ from the
proprietary theory? What about interest charges, dividends and income tax?
(h) What are three effects on current practice?

(a) Emphasis is on the entity, because in the 20th century the separation of owners from
management in the corporate form of business is common. Shareholders of large
corporations have little power to make decisions for the company. The corporation, the
entity, has a life of its own. It is therefore more realistic to view the entity as the unit of
accountability — that is, to see the accounting process from the point of view of the
entity. It is the entity (through its management) that has the power to make decisions that
affect the financial status and operations of the business.

(b) Stewardship or accountability to equityholders is of primary significance. The entity needs

to give an accounting to those who have supplied funds (shareholders and creditors).
There are two views of the entity theory, but both stress accountability to equityholders.
The conventional view emphasises stewardship because equityholders are seen as
‘associates’ in business. The newer view focuses on stewardship because of legal,
contractual requirements, and also to maintain good relations with equityholders in the
event the company may need more funds.

(c) The net worth of the owner is not a meaningful concept, because the owner is not
recognised as such but as an equityholder, a provider of funds. So-called owners are not
seen as having the power to make decisions for the firm. The net assets belong to the
entity. However, net worth can be a meaningful concept. An argument can be made that
the entity needs to know the worth of its net assets for its own purposes.
(d) The reason is that the entity is the focus of attention, and therefore creditors and owners
are seen simply as those who supplied the funds to the entity. Their financial interest in
the company is ‘equities’ — claims on the assets. Thus, they are seen as equityholders.
Their relationship with the company is a contractual one.

(e) Paton and Littleton argue that the shareholders have a contractual residual claim on the
assets, and it is for this reason that income is placed in the retained earnings account.
Shareholders get the leftovers after the creditors have been paid, in the event of liquidation
of the company. The newer view of the entity theory sees retained earnings as the firm’s
equity or investment in itself.

(f) Profit is stressed for two reasons:

 Profit is what equityholders are interested in, because it represents the results of their
investment in the company
 The firm is in business to make a profit — profit is essential to the firm’s survival.

(g) Revenue is the inflow of assets (increase in total assets) due to the events undertaken by
the firm with regard to its output. Under the proprietary theory, revenue is the increase in
proprietorship. Expense is the decrease in assets or increase of liabilities due to the
consumption of assets and services by the firm to generate current revenue. Under
proprietary theory, expense is the decrease in proprietorship.
For both the entity and proprietary theories, profit is the difference between revenues and
expenses. The entity theory, however, emphasises the left side of the accounting equation
(assets), whereas the proprietary theory concentrates on the right side (proprietorship).
The entity theory focuses on what the entity does, its performance; whereas the
proprietary theory focuses on the effect on proprietorship.
For the traditional entity theory, interest charges, dividends and income taxes should be
distributions of earnings. The theory considers these as payments to the equityholders for
the use of their funds. Of course, the government does not provide funds as the others, but
provides intangible services (funds?) such as protection from foreign powers. The newer
version of the entity theory sees interest charges, dividends and income taxes as payments
to ‘outsiders’, and therefore they are expenses.

(h) Although conventional accounting theory subscribes to the entity theory, the theory has
had little effect on actual practice. The reason is that the theory was formulated in the 20th
century, and many current practices were devised since the time of the Italian city–states
and are based on the proprietary theory. The following show the effect of the entity theory
on practice:
 The physical capital view is in consonance with the entity theory.
 Salaries to corporate employees who are also shareholders are expenses, because the
company is a separate, distinct entity from the holders.
 In consolidating financial statements, an entity theoretical approach can be taken.
Instead of concentrating on the proprietary interest of the parent (parent company
theory), the entity theory sees the consolidation from the point of view of the
consolidated entity.
 The use of profit and cost centres for internal purposes is based on the entity theory.
The centre is seen as an individual entity.
3. Liabilities are all ‘obligations’ under the SAC 4 definition of liabilities. What is an
obligation, and why does SAC 4 rely heavily on it in the definition?

A liability is a present obligation. An obligation may be legally enforceable in the courts or

simply ‘equitable’ or ‘constructive’. The SAC 4 definition emphasises the future sacrifice, but
it should be remembered that a liability exists now — it is a presently existing obligation.

4. If a liability is a present obligation, does that mean that a legally enforceable claim
must exist before a liability exists? Explain. Conversely, if a legally enforceable claim
exists, does that mean that a liability must exist? Explain.

A liability need not be legally enforceable. According to SAC 4, it may be equitable or

constructive. Most liabilities are legal liabilities, but company policy of a ‘moral obligation’
may give rise to a recordable liability as long as the intent is to transfer assets or render a
service to settle the obligation. Examples are Christmas bonuses that may be accrued if not
paid in December, or vacation pay. The past transaction or event is not as clear for non-legal
liabilities as for legal liabilities, and thus may be more difficult to recognise. For such
liabilities, the future sacrifices cannot be avoided without significant penalty, such as a
decrease in employee morale. Interpreting the meaning of significant penalty is a matter of
opinion.

A legally enforceable claim need not exist for an asset to exist according to SAC 4. Control is
the main criterion, not ownership.

On the other hand, if a legally enforceable claim against the entity exists, it is clear that there
is a present obligation, and presumably a liability.

5. Under some countries’ accounting regulations, unrealised foreign exchange gains

and losses are not immediately recognised in a firm’s statement of financial
performance. Instead, unrealised gains are put into a deferred credit account. Is this
a liability? Why or why not?

It is not truly a liability because it does not meet the definition of a liability. There is no
present obligation to sacrifice future economic benefits. To the contrary, there is a potential
inflow of future economic benefits (foreign currency asset) or a potential reduction in
outflows of future economic benefits.

6. Hunting Ltd is attempting to bring its accounts in line with Australian accounting
standards and statements of accounting concepts. Advise the accountant of Hunting
Ltd whether a liability exists in each of the following cases and, if so, what the
liability is:
(a) The company is being sued for environmental contamination. The outcome of the
lawsuit is highly uncertain.
(b) An order for raw materials has been placed with the firm’s regular supplier.

(c) There is a signed contract for the construction by Sugaz Ltd of a major item of
plant for Hunting Ltd.
(d) The firm has unsecured notes of $1 000 000 outstanding. Interest is payable 6-
monthly in June and December. It is now August.
 (e) At the end of the year, half of the firm’s employees have non-vested sick leave
owing.

(a) Contingent liabilities are not recorded, but are disclosed. A decision must be made on
whether these items are ‘straight’ liabilities or contingent liabilities. This decision is based
on two criteria: (1) it is probable that a liability has been incurred; and (2) the amount can
be estimated reliably.

In this case, there is no liability. According to SAC 4, the event must make it ‘probable’
that a liability has been incurred and the amount must be ‘estimable’. These two
conditions are not met.

(b) No liability. The pertinent event is not placing an order but receiving title to the goods.
When title passes, then a purchase has been made, and accounts payable is recorded.

(c) No liability. The contract is wholly executory. Until there is performance, there is nothing
to record.

(d) Interest payable for two months. Accrued interest is to be recorded. The event is the
passing of time; the company is using the money that was borrowed each day.

(e) No liability exists for the non-vested rights. The following four conditions can be
considered for the recording of an accrued liability for sick pay:
 the sick pay is based on services already rendered
 rights to sick pay are vested or ‘accumulated’ (earned but unused)
 payment is probable
 the amount can be reasonably estimated.

If sick pay benefits vest, an accrual should be made. If they ‘accumulate’ but do not vest,
accrual is not required.

7. Does SAC 4 adopt the principle of conservatism? Why or why not? Do you think
that conservatism is desirable in the definitions of assets, liabilities and equity, or in
their recognition criteria? Why or why not?

Conservatism calls for the recognition of liabilities on less stringent grounds than assets.
According to SAC 4, if it is ‘probable’ that a liability has been incurred and the amount can
be reasonably estimated, then it is to be recorded.

SAC 4 is not conservative in its approach. As such, liabilities (like assets) are to be recognised
when they are more likely than not to require a flow of service potential or economic benefit,
and when they can be measured. Since conservatism is a virtue according to general practice,
it is likely that SAC 4 will lead to less conservative recognition of liabilities than general
practice.

8. How does owners’ equity differ from liabilities? Give examples where they are
closely aligned, and examples of where they are not.

Owners’ equity represents the owners’ claim on the assets of the company. The owners have a
residual interest in the firm. The accounting equation (Assets – Liabilities = Owners’ equity)
expresses in mathematical terms the relationships involved. The amount of net assets equals
the amount of owners’ equity. We should remember that the valuation of owners’ equity is
not necessarily the same as the concept of owners’ equity. Owners’ equity can be described
without reference to a sum of money.

Owners’ equity differs from liabilities in that liabilities are claims that the entity is presently
obliged to settle with an outflow of economic resources. Owners’ equity is a residual
attributable to the owners after liabilities are discharged. Preference shares and convertible
notes possess characteristics of both liabilities and owners’ equity. Accounts payable and
general reserves are examples where liabilities and owners’ equity clearly differ.

9. When should the following be recognised as assets or liabilities?

(a) Accounts payable (e) Finance lease obligations
(b) Put options (f) Operating lease obligations
(c) Call options (g) Warranty commitments
(d) Raw materials inventory

Recognition rules are the GAAP, which give rise to recordable assets and liabilities. The
following accounts are discussed in terms of when they are first recorded.

(a) Accounts payable — a purchase has occurred on account; payment is probable.

(b) Put options — when option is sold.

(c) Call options — when option is sold.

(d) Raw materials inventory. If a perpetual system is used, a purchase has occurred. If
a periodic system is used, a physical count has occurred, indicating the amount of
inventory that the firm has title to.

(e) Finance lease obligations. According to AASB 1008, for the lessee, the following
rules must be met. First, there must be a non-cancellable lease. Second, one of the
following four criteria must be satisfied for a capital lease to exist, which
therefore creates a liability:
 The lease transfers ownership of the asset to the lessee.
 The lease contains a residual purchase option.
 The lease term is 75% or more of the estimated economic life of the asset.
 The present value of the minimum lease payments is 90% or more of the fair value of
the asset.

(f) Operating lease obligations — do not meet the criteria in AASB 1008 for the
leased assets to be recognised as assets and the lease obligations to be recorded as
liabilities.

(g) Warranty commitments — sale of the product, and existence of warranty contract.
Amount can be reasonably estimated.

10. When, if ever, should a firm recognise a superannuation liability, and why?
Superannuation commitments meet the definition of a liability. The important elements of a
liability are:
 present obligation
 asset or service to be transferred at a future date to another entity past event.

Superannuation is based on services already rendered by employees, but compensation will be

paid to them in the future in the form of pension benefits. Therefore, a present obligation
exists as the employee renders service.

The obligation is settled by payment of cash in the future.

The liability is created by a past event, the rendering of services by the employees. Under the
terms of most superannuation agreements, not only is the superannuation payment probable,
but also its measurement is reasonably reliable; so recognition, according to SAC 2, should
occur as the obligation accrues by virtue of the employee’s provision of service.

11. Explain the concept of capital maintenance, and how it can apply to different
concepts of capital.

The main source of income for an entity is an increase in the wealth of a firm resulting from
operations for the period. It was often described as the maximum amount that can be
distributed to owners and still leave the firm as well off at the end of the period as the
beginning. This is the concept of capital maintenance. So, capital cannot be distributed to
owners as dividends, only income.

Current cost accounting aims to ensure the firm’s physical/operating capital base is not eroded
during periods of inflation, as the otherwise inflated profits reported can result in increased
dividends that actually result in reducing the ‘real’ capital of the firm.

Under a general price level accounting system (GPLA, or CPP), income is recognised only
after the purchasing power of the start-of-period owners’ equity has been maintained.

Under CoCoA, the concept of capital is ‘adaptive capacity’ so income is not recognised until
the firm earns enough to maintain its operating adaptive capacity, as reflected in the net
realisable value of its assets, less liabilities.

12. A benefactor pays off a loan for a university. How should the university record the
transaction, and why?

As a donation. The entry is:

Loan*
Revenue

* According to SAC 4, donations should be classified as revenue because they are inflows of
probable future economic benefits other than contributions by owners.

13. How should a mining company account for a contract which stipulates that on
maturity of a cash loan to the company, it must pay the principal in cash or provide
a given quantity and grade of extracted minerals, whichever is the higher?
The recording of a liability is justified, because:
 a present obligation exists. The company is using borrowed money.
 the company will pay cash (an asset) or minerals (an asset) at a future date to settle the
obligation.
 the obligation arose out of a past event — the use of the borrowed money.

The liability meets recognition criteria in that a future outflow of economic benefits is
probable. Also, there is a reliable measure, even if it is not exactly the amount that will be
required to be repaid if the minerals extracted have a high value.

DR Cash
CR Loan (PV of expected cash outflows)

14. How should Shannondoah Ltd account for a cash loan to the company where the
contract requires that the principal will be redeemed in common shares at maturity?
Ten shares will be given for each $1000 bond. The current market value of the shares
is $120.

Because shares are to be given on the date of maturity, two questions arise:
1. Is the issuance of the bonds that convert to company shares a liability?
2. What amount should be recorded now?

According to the definition of a liability, a liability must be settled by transferring assets or

services at a future date. The ordinary shares of the company are not assets or services.
Therefore, the bonds do not appear at first to qualify as a liability. However, the classification
is not that straightforward, as explained below, and in AASB 1033 ‘Presentation and
Disclosure of Financial Instruments’, paras 4.1–4.5.

If the converting notes convert to a variable number of shares, depending on the market value
of the shares at the time of the conversion, then the issue of the converting notes is equivalent
to an issue of debt that is then repaid in cash, which the lender then invests in the shares of the
borrowing entity. The lender is not exposed to residual risk at all during the period of holding
the converting notes. As such, during the period prior to conversion, it is appropriate to
classify such converting bonds as liabilities.

On the other hand, if the converting notes convert to a fixed number of shares, then the issue
of the converting notes exposes the holder of the notes to residual risk from the outset. As
such, the converting notes are equivalent to an issue of equity, with a fixed dividend stream.
The lender is exposed to residual risk during the period of holding the converting notes. As
such, during the period prior to conversion, it is appropriate to classify such converting bonds
as equity.

In this case, the loan converts to a fixed number of shares, so it should be treated as equity.
The holder is subject to residual risk: if the value of the firm changes, they receive the same
number of shares on conversion (10 per $1000 bond), so they bear the risk of changes in the
value of the shares, and in the value of the equity.
What amount should be recorded? If we knew what the market value of the shares should be
on the date of maturity, we could find the present value of the amount of the total market
value of all the shares involved. But we do not know that.

Although the bondholders must have taken into account the current market price of the shares
when they purchased the bonds, and probably expected the market price to increase, the
recording of the sale of the bonds should be based on the value of the shares. The reason is
that it is too difficult to estimate market values of shares. The method used when a large share
dividend is declared provides a guideline.

On a per-bond basis, the following appears to be an appropriate record:

10 shares  $120 par = $1200

Cash $1000
Deferred discount on converting note issue $200
Share capital $1200

Interest will be paid each year based on the principal of $1 000 000. Should this be considered
interest expense or dividends? The interest is a periodic payment on an equity instrument
Therefore, it should be treated as a direct debit to equity, and as dividends.

Perhaps this bond issue is attractive to investors, because a specific amount of ‘interest’ each
year will be received by contract as opposed to actual dividends that may or may not be paid,
and the expectation of receiving more than the stated principal amount because of the
likelihood of the market value of the shares increasing in value.

15. Skipper Ltd financed the construction of its new office block by issuing securities for
$50 000 000 in 2000. Buyers of the securities received a 30% ownership interest in
the office block, and receive 30% of the rent revenue related to letting the offices.
The securities mature on 30 April 2015, when Skipper Ltd must redeem the
securities at 30% of the value of the office block or $50 000 000, whichever is higher.
What should Skipper Ltd have recorded in its accounts on 30 April 2000, and what
other journal entries should be recorded throughout the term of the securities?

The $50 000 000 issue constitutes a loan. It has the features of a loan because of the
following:
 It has a definite maturity date — 30 April 2015.
 It has a specified amount to be paid on the maturity date — either $50 000 000 or 30% of
the appraised value of the shopping centre, whichever is higher.
 It does not confer a residual claim to the value of the firm. The variable component of the
value of the loan is in relation to one specific asset, buildings.

Although an interest rate is not stated, there is something similar, which is 30% of the income
per year. The amount each year would not be the same, but this is true also for variable rate
bonds.

The 30% ownership of the shopping centre by the holders of the securities is, in effect, the
collateral on the loan. The ownership of the holders is temporary, only until the maturity date,
unless the company defaults.
Entries:
30 April 2000
Cash $50 000 000
Loan payable $50 000 000

When payment of the 30% of income is made each year:

Interest Expense x
Cash x

If the value of the probable payment on maturity exceeds $50 000 000, the loan should be
restated:

DR Buildings
CR Asset Revaluation Reserve
CR Loan Payable

Upon maturity:

DR Loan Payable
CR Cash

Problems

8.1 During 2004, the following events occurred in relation to Jessica’s Revals Ltd, a
property developer and real estate valuation firm.
(a) Jessica’s Revals Ltd purchased land from Denis Gibson for $1 000 000. This
land was adjacent to, and otherwise identical to, the block of land that
Jessica’s Revals Ltd had bought for $1 000 000 3 years ago and had then spent
an extra $50 000 improving to now have the same value as the land bought
from Gibson. Record the two blocks of land in the accounts of Jessica’s Revals
Ltd.
(b) Jessica’s Revals Ltd bought 500 ordinary shares in Charmers Construction
Ltd for $18 000 cash on 7 September 2004. This was 5% of the shares on issue
by Charmers Construction Ltd. The shares are held for investment purposes.
The parcel of shares had a market value of $16 000 at 31 July 2005. Record all
the transactions that Jessica’s Revals Ltd should record in relation to the
shares.
(c) At 31 July 2004, Jessica’s Revals Ltd valued its current assets at $20 000 above
carrying amount and its fixed assets at $600 000 above carrying amount. In
both cases, the valuations were based on market values. How should the firm
account for the increase in values?
(d) Jessica’s Revals Ltd purchased a development site for $81 000 and
immediately sold that site to Kathy Pratt Real Estate for $130 000. The
payment consisted of a 10-year non-interest-bearing note for $130 000. The
first equal payment ($13 000) is due 1 year after the sale. The normal rate of
interest for such a loan is 10% p.a. Record the sale of the land.
(e) Jessica’s Revals Ltd bought bricks with a recommended retail price of $18 000
and a cash price of $16 500. The firm paid for the bricks by paving part of the
roadway leading into the brick manufacturing plant. The cost of the paving
 was $12 000 and the regular contract price to provide the paving was $17 000.
Record the transactions.
(f) Jessica’s Revals Ltd issued 1000 of its ordinary shares in payment for a tract
of land. The market price of the shares was $83 per share at the time of
acquisition but the seller had offered to sell the land for $82 000 cash. What
journal entry should the firm make to record the land purchase?

The purpose of this problem is to show that determining cost or value in practice is not always
simple.

(a) The question indicates that the two blocks of land have identical values. As such, the
appropriate entries would be:
Land $1 000 000
Cash/other consideration $1 000 000

Unrealised loss on land value 50 000

Land 50 000

(b) This is a short-term investment, because Jessica’s Revaluations Pty Ltd intends to sell the
shares whenever it needs the cash. According to ASRB 1016, the lower of cost of market
methods is to be used.

7 Sept 2004 Marketable securities $18 000

Cash $18 000

31 July 2005 Unrealised loss 2000

Allowance for price decline 2000

(c) If Jessica’s Revals Ltd applies a strict historical cost measurement system, it can do
nothing about these increases in value, because to do so would violate the historical cost
principle. However, according to SAP 1, the current costs of the non-monetary assets are
encouraged to be disclosed as supplementary information.

Under the mixed measurement system in use by the vast majority of firms, the entry is not
clear, because there is no standard governing the accounting for current assets in general.
We recommend the following entry if the firm adopts a mixed measurement system:

July 31 Assets $620 000

Asset revaluation reserve $600 000
Unrealised gain on current assets (revenue) 20 000

(d) Initial acquisition:

July 31 Land $81 000
Cash/other consideration $81 000

The present value of the note must be recorded. Using the present value of an ordinary
annuity for 10 periods at 10%, the present value is:
$13 000 × 6.144567 = $79 879
 Notes receivable $79 879
Loss on Sale of Land 1 121
Land $81 000

Jessica’s Revals Ltd will have interest revenue to record each year.

(e) ASRB 1015 is relevant. There is an exchange of dissimilar non-monetary assets, and

therefore the earning process is assumed to be complete. This transaction can be
considered a sale. If it is objectively determinable, the value of the asset given should be
the basis for determining the value of the asset received. Assuming Jessica’s Revals Ltd
works for others at an established sales price, the contract price of $17 000 can be
considered objectively determinable.

A case could be made for recording the bricks at $16 500. This is a lower figure, and on
the basis of conservatism it can be argued that it should be recorded. However, following
the cost principle, the asset received should be at what is sacrificed, which in this case is
$17 000 worth of inventory. By paving the bricks, Jessica’s Revals Ltd is forgoing
$17 000 in revenue from another contract. Hence, this is the cost.

Materials (Bricks) $17 000

Sales revenue $17 000

Cost of goods sold 12 000

Inventory, labour, etc. 12 000

(f) There are two choices here: to record the land at $83 000 or $82 000. Following the cost
principle, the land should be stated at $83 000 because that is what was sacrificed: 1000
shares at $83 per share. There is a question as to whether 1000 shares constitute such a
large number that the share price would be affected. Assuming that 1000 shares would not
materially affect the share price, and given that the market quotation can be relied upon
because it is from the Sydney Stock Exchange, the $83 000 represents the cost of the land.

Land $83 000
Paid-up capital (1000 × $50) $83 000
8.2 Required: Comment on each of the four estimates with respect to its relevance and
reliability to you as a potential seller of the property.

1. Present value. For the decision at hand, this figure is highly relevant. Its reliability
depends on how good the estimates are. The use of 15% as the discount rate of return is
acceptable. The calculation is based on past experience. Future circumstances may
change, perhaps drastically over the next 20 years. However, anyone making a decision to
buy or sell an apartment building should make projections about expected cash flows in
order to have a rough price to work with. Any offer that is substantially lower than the
present value would be rejected. When compared with the fair value, the present value
seems to be conservative, which should give the seller confidence that it represents a
minimum value.

2. Fair value. This value is the most relevant of the four. It represents the market’s
assessment of what the property is worth, and is therefore a more objective value than
 present value. Present value represents the seller’s expectations of the value in use of the
assets over 20 years; fair value represents the market’s expectations if the asset were to be
sold now. In this case, you have the opinion of two appraisers as to what they believe the
market value is. Their estimates are presumably based on their expert knowledge of the
market. The average taken by the accountant of the two figures is a reasonable approach.

3. Carrying amount. The carrying amount is only relevant for computing the accounting gain
when the property is sold. It should not be used to determine whether the property should
be sold. Exchange value is determined in the marketplace.

One of the assumptions of accounting theory is the ‘going concern’. Based on this, the
notion is that allocated cost on the income statement is more pertinent than current value
because it shows the cost to the business for using the asset in a given period. Thus, the
purpose of the carrying amount is not for making decisions about the sale of the asset in
question. It represents unallocated cost — that is, cost that is still waiting to be allocated
to the income statement. Because land is assumed to have an indefinite life, the original
cost remains the unallocated cost.

If it were not possible to determine current value, at least the carrying amount can be seen
as a very conservative estimate of current value. It is conservative, because of the use of
historical cost in accounting and the existence of inflation.

4. Current cost. The current cost calculated on the basis of price indices involves a great deal
of estimation. The approach used by the accountant is mentioned in SAP 1. Is this a
market price? Although the price indices are market based, they are very general and do
not necessarily reflect the current costs in the particular area where the property is located.
Construction costs in Sydney could be quite different from those in Hobart, Melbourne,
Darwin or Oodnadatta. The deduction of 5 years of depreciation is an accounting
procedure, and is not market-based.

The current cost of constructing a building is not necessarily what it will sell for. A
contractor would wish to sell to make a gain. Also several buyers may want a particular
building and bid the price up.

The relevance of this figure depends on how reliable the computation is. If the computed
current cost is reflective of the market prices of the component factors in the area, then it
is very relevant. If for some reason, fair value cannot be determined then the computed
current cost is an alternative.

In summary, the relevance of the four figures in priority order is:

 Fair value
 Current cost (computed)
 Present value
 Book value.

Note, however, that present value is highly relevant as a comparison with fair value or
current cost to determine the merits of sale or replacement, based on the value in use of
the block of units.