Tutorial Questions – Week 2

• Discussion Questions: 4, 5, 6, 8, 11

• Exercises: 10.1; 10.3, 10.15

• Chapter 10: Regulation and the Conceptual Framework

Discussion questions
4. Briefly explain the nature of the Conceptual Framework for Financial Reporting, and
discuss the perceived advantages and disadvantages of having a conceptual
framework.

A conceptual framework of accounting theory should enable standard setters to develop

standards which are consistent and logically formulated, provide guidance to accountants in
areas of accounting where standards have not been established, and enable standard users to
better understand standards and proposed standards.

The IASB and FASB are currently undertaking a joint project to amend the conceptual
framework. The overall objective of this joint project is to develop a common conceptual
framework that is both complete and internally consistent. The Boards want to develop a
framework which will provide a sound foundation for developing future accounting standards
that are principles-based, internally consistent, internationally converged, and that lead to
financial reporting which provides the information needed for investment, credit, and similar
decisions. That framework, which will deal with a wide range of issues, will build on the existing
IASB and FASB frameworks.

Are there any disadvantages in having a conceptual framework? Consider the cost of developing
the framework versus the benefits. Also, since it is not compulsory for standard setters to follow
the conclusions of the conceptual framework, will it be ignored?
 5. Specify the objectives of general purpose financial reporting, the nature of users, and the
information to be provided to users in order to achieve the objectives, as provided in the
Conceptual Framework.

The IASB’s Framework specify the objectives of general purpose financial reporting as being
financial reports which are intended to meet the information needs common to a range of users
who are unable to command the preparation of reports tailored to satisfy their own particular
needs.

The purpose of the Framework is to:

(a) assist the AASB in the development of future Australian Accounting Standards and in its review of
existing Australian Accounting Standards, including evaluating proposed International Accounting
Standards Board pronouncements;
(b) assist the AASB in promoting harmonisation of regulations, accounting standards and procedures
relating to the presentation of financial statements by providing a basis for reducing the number of
alternative accounting treatments permitted by Australian Accounting Standards;
(c) [deleted by the AASB];
(d) assist preparers of financial statements in applying Australian Accounting Standards and in dealing
with topics that have yet to form the subject of an Australian Accounting Standard;
(e) assist auditors in forming an opinion as to whether financial statements conform with Australian
Accounting Standards;
(f) assist users of financial statements in interpreting the information contained in financial statements
prepared in conformity with Australian Accounting Standards; and
(g) provide those who are interested in the work of the AASB with information about its approach to the
formulation of Australian Accounting Standards.

The IASB and FASB have adopted the ‘entity perspective’, i.e. it is the entity, not its owners and
others having an interest in it, which is the object of general purpose financial reporting. In other
words, the focus is placed on reporting the entity’s resources (assets), the claims to the entity’s
resources (liabilities and equity) and the changes in them. Shareholders are seen not so much as
owners of the entity but merely as providers of resources to the entity, in much the same way as
liabilities. Both present and potential equity investors, lenders and other creditors are seen as
constituting a single primary user group. This group makes decisions about the allocation of
resources as well as decisions relating to protecting or enhancing their claim on the entity’s
resources. Other potential user groups e.g. government and other regulatory bodies, customers,
employees and their representatives, are not the focus of the objective.

Hence, it seems that the objective in the IASB’s and FASB’s Conceptual Framework is narrowly
focussed on the needs of the primary user group. It also appears odd that in times when
environmental and social issues are of great importance to society, and the desire for triple-
bottom line reporting is growing, that these issues are ignored in the revised Conceptual
Framework.
 6. From the current Conceptual Framework, outline the qualitative characteristics of financial
information to be included in general purpose financial reports.

The Conceptual Framework 2010, issued by the IASB and the FASB, has divided qualitative
characteristics into two categories, namely, fundamental characteristics (relevance and faithful
representation) and enhancing characteristics (comparability, understandability, verifiability and
timeliness). See Learning objective 5 in the chapter for a discussion of each characteristic.

8. ‘To determine whether an entity should classify its costs either as an asset or an expense,
accounting standards must contain definitions of these terms.’

With reference to the above statement, discuss the concept of an asset and an expense
provided in the Conceptual Framework. Provide also a discussion of the IASB’s and FASB’s
alternative suggestion for amending the definition of an asset. Do you agree with the above
statement? Why or why not?

An asset is defined in the current Framework as ‘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’.
Expenses are defined in the 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’.
Note that the definition of an expense is driven by the definitions of assets and liabilities.

For a cost incurred to qualify as an asset, the cost must result in future economic benefits which
the entity controls. If this is not the case, then the cost automatically qualifies as an expense, as
there is a reduction in an asset or an increase in a liability which has the effect of decreasing the
entity’s equity. The purchase of an asset does not decrease equity and therefore does not create
an expense. An expense also arises whenever the economic benefits in the asset are consumed,
expired or lost.

The proposed definition of an asset in the Framework is that ‘an asset of an entity is a present
economic resource to which the entity has a right or other access that others do not have.’ This
means that when a cost is incurred, the questions to be asked will be, has a present economic
resource come into existence? and does the entity have rights to that resource that others do not
have?

It is important that accounting standards contain definitions of assets and expenses in order to
provide a mechanism by which preparers of financial statements can determine which costs are
assets and which are expenses.
 11. ‘I find the distinction between income, revenue and gains confusing.’ This is a
student’s statement overheard in a corridor. Help this student by discussing the
major issues involved.

The Framework defines income as ‘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.’

This definition of income is linked to the definitions of assets and liabilities. The definition is
wide in its scope, in that income in the form of inflows or enhancements of assets can arise from
the provision of goods or services, the investment in or lending to another entity, the holding and
disposing of assets, and the receipt of contributions such as grants and donations. To qualify as
income, the inflows or enhancements of assets must have the effect of increasing the equity,
excluding capital contributions by owners.

Income can exist as well through a reduction in liabilities that increase the entity’s equity. An
example of a liability reduction is if a liability of the entity is ‘forgiven’. Income arises as a result
of that forgiveness, unless the forgiveness of the debt constitutes a contribution by equity
holders.

Under the current Framework, income encompasses both revenue and gains. A more precise
definition of revenue arises in accounting standard IAS 18/AASB 118 Revenue as follows: ‘the
gross inflow of economic benefits during the period arising in the course of the ordinary
activities of an entity when those inflows result in increases in equity, other than increases
relating to contributions from equity participants.’

Revenue therefore represents income which has arisen from ‘the ordinary activities of an entity’.
On the other hand, gains represent income which does not necessarily arise from the ordinary
activities of the entity, e.g. gains on the disposal of non-current assets or on the revaluation of
marketable securities. Gains are usually disclosed in the income statement (statement of profit or
loss and other comprehensive income) net of any related expenses, whereas revenues are
reported at a gross amount.

Revenues arise from the ‘ordinary activities’ of the entity and gains may or may not be from
ordinary activities. What ‘ordinary activities’ means in any particular context is unclear; hence
the distinction between revenues and gains is unclear. Would we be better off abandoning the
distinction?
Exercise 10.1

Violation of reporting requirements

Several independent situations are described below.

1. The owner of the business included his personal dental expenses in the entity’s income
statement.
2. The company spent $40 000 on computer software development and recorded the cost as an
asset. As yet it is impossible to predict whether this cost will result in future economic benefits.
3. Depreciation expense was not recorded because to do so would result in a loss for the period.
4. The cost of three books (cost $110 each) was charged to expense when purchased even though
they had a useful life of several years.
5. A major lawsuit has been filed against the company for environmental damage, and the com-
pany’s solicitors believe there is a high probability of losing the suit. However, nothing is recorded
in the accounts.
6. Land was reported at its estimated selling price, which is substantially higher than its cost. The
increase in value was included on the income statement.
7. The company received a government grant of $60 000 to continue its research program into
finding a cure for diabetes. The company recognised the grant as an addition to capital.

Required

(a) Indicate for each situation the accounting principle(s) or reporting characteristics (if
any) that are violated.
(LO5, LO6 and LO7)

(a)

1. Entity assumption. General purpose financial reports are to be prepared using an ‘entity
perspective’, separate from owners and other investors and creditors.

2. The definition of an asset, and, even if there are future economic benefits which means that an asset
exists, there would be violation of the asset recognition criteria in that the future benefits are not
‘probable’.

3. Expense recognition, plus relevance and reliability (faithful representation).

4. Probably none. The items are probably not material in the company context.

5. The liability and expense recognition criteria are violated if a reliable estimate can be made of the
probable damages. But is there a liability?
6. Violation of IAS 16/AASB 116 if the land is held as a non-current asset (see the previous
chapter which requires such revaluation adjustments to be placed in a reserve rather than in
income). Consider also revenue recognition criteria under IAS 18/AASB 118, which may be
violated.

7. Violation of income recognition. Note the discussion in the text regarding the appropriate
treatment of government grants related to income under IAS 20/AASB 120. Such grants must
not be credited to equity (such as ‘capital’) but are to be recognised as income systematically
over the periods necessary to associate them to the related costs for which they are intended to
compensate. How is this to be done in practice? Explain the debit and credit entries necessary.

Exercise 10.3

Assets and asset recognition

Explain whether you would recognise each item below as an asset, justifying your answer
by reference to the Conceptual Framework’s asset definition and recognition criteria:
(a) a trinket of sentimental value only
(b) discovery (at insignificant cost) of evidence of mineral reserves
(c) specialised equipment with zero disposal value, which now, because of downsizing, is
surplus to requirements and has thus been retired from use
(d) your staff
(e) goods held on consignment for another entity.
(LO6 and LO7)

(a) Fails the asset definition as it does not constitute future economic benefits. Oxford English
Dictionary defines ‘economic’ as maintained for profit, on a business footing. Recognition
criteria are thus irrelevant, as there is not asset under the Framework to recognise.

(b) Definition is satisfied — Future economic benefits (assuming the mineral can be extracted
and there is a market for this mineral!), control (assuming the entity has rights over the
site/claim, etc.); and past event (the exploration has already been done). Probability Recognition
Criteria may be a problem — it may not be possible as yet to establish that it is probable that
future economic benefits will eventuate (cost of extraction may render extraction not viable,
market price of mineral may currently be depressed, etc.). There is also a problem with reliable
measurement — the extent of the find or its value may not yet be known. Unless and until both
recognition criteria are satisfied, this asset cannot be recognised under the Framework.

(c) Fails definition as it does not constitute future economic benefits — it no longer can help
generate profits as it is surplus to requirements. Recognition criteria are thus irrelevant, as there
is no asset to recognise.

(d) Definition is satisfied — Future economic benefits, control (at least during work hours!), and
past event (employment contract). Probability recognition criterion is satisfied — if future
economic benefits were not probable, would you sack the staff? Reliable (faithfully
representative) measurement is the problem — how does one place a dollar figure on a human
being? Human resources cannot be recognised as assets if no reliable measure is possible.

(e) Not an asset of the entity as the entity does not have control of the goods. See Chapter 6 for
further discussion.

Exercise 10.15

Ordering an asset

A well-known Australian airline has placed a non-cancellable order for a new Airbus A380. The price
between the airline and the manufacturer is fixed, and delivery is to occur in 24 months with full
payment to be made on delivery.

Required

(a) Should the airline recognise an asset or liability at the time it places the order? Discuss in line with
the Conceptual Framework definitions of assets and liabilities.
(b) One year later, the price of the Airbus A380 has risen by 6%, but the airline had locked in its
contract at a fixed, lower price. Under the Conceptual Framework, should the airline recognise
any asset (and income) at the time of the price rise? If the price fell by 6% instead of rising, should
the airline recognise a liability (and expense) under the Conceptual Framework?
(LO6 and LO7)

(a) Firstly define assets and liabilities.

i. 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.

ii. A liability is 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.

The Conceptual Framework states that transactions or events expected to occur in future do not , in
themselves, give rise to assets. The Conceptual Framework states:

A distinction needs to be drawn between a present obligation and a future

commitment. A decision by the management of an entity to acquire assets in the
future does not, of itself, give rise to a present obligation. An obligation normally
arises only when the asset is delivered or the entity enters into an irrevocable
agreement to acquire the asset. In the latter case, the irrevocable nature of the
agreement means that the economic consequences of failing to honour the
obligation, for example, because of the existence of a substantial penalty, leave the
entity with little, if any, discretion to avoid the outflow of resources to another party.

Note also, regarding recognition criteria for a liability, the following statement made in the Conceptual
Framework:
 A liability is recognised in the balance sheet when it is probable that an outflow of
resources embodying economic benefits will result from the settlement of a present
obligation and the amount at which the settlement will take place can be measured
reliably. In practice, obligations under contracts that are equally proportionately
unperformed (for example, liabilities for inventory ordered but not yet received) are
generally not recognised as liabilities in the financial statements. However, such
obligations may meet the definition of liabilities and, provided the recognition criteria
are met in the particular circumstances, may qualify for recognition. In such
circumstances, recognition of liabilities entails recognition of related assets or
expenses.

As the purchase order for the aeroplane is non-cancellable, it may qualify for recognition as an
asset and liability under the Conceptual Framework. What does ‘non-cancellable’ mean? Does
this mean that a significant penalty would be paid for cancellation of the contract? Could it be
argued that the liability at this stage is the penalty, not the future payment for the aeroplane? The
answer lies in management’s intentions. Do they intend to proceed with the purchase? If so the
liability would be for the future cost of the aeroplane?

Journal entry:

Aeroplane to be delivered Dr
Liability to manufacturer Cr

(b)

(i) If the price of the plane rises 6% but contract is locked in. Is there a gain?

Note the definition of income here. Has there been an increase/enhancement in the asset without
a corresponding increase in the liability? Yes.

Does the Conceptual Framework suggest that assets are to be valued at market price (or fair
value)? No. There is no clear guidance about appropriate measurement in the Conceptual
Framework. But if the entity uses market prices to measure the asset, a gain could be recognised.

But has there been an increase in future economic benefits to the airline as a result of this price
increase?

(ii) If the price falls by 6%, is there a loss?

Note the definition of an expense here: An expense is a decrease in economic benefits in the
form or outflows or depletions of assets resulting in a decrease in equity. An expense arises when
the economic benefits in the asset are consumed, expired or lost. Has this happened? Not
necessarily, but market forces which caused the fall in price would need to be investigated.

Note the impairment standard AASB 136 would apply here (discussed in a later chapter).