AF314

Chapter 3
Company Operations

Presenter

Associate Professor Parmod Chand

 The Conceptual Framework
• The “Conceptual Framework” contains the definition
and recognition criteria for the five main elements in
the financial statements
• Five main elements are
– Assets
– Liabilities
– Equity
– Income
– Expenses
 Assets – current definition
A resource controlled by the entity as a result of past
transactions or events from which future economic benefits
are expected to flow to the entity.
Three essential characteristics:
1. Future economic benefits > refers to the potential to
contribute, directly or indirectly to the flow of cash (and cash
equivalents) to the entity. Physical form is not a prerequisite
2. Control > does not imply ownership – therefore leased items
may be assets
3. Past events > a past event or transaction must have
occurred. Anticipated purchases are not assets
 Liabilities – current definition
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:
1. Present obligation > a mere intention is not sufficient. Present
obligation may be legal or constructive
2. Past events > a past event or transaction must have occurred
3. Settlement must involve giving up resources in the future
(e.g. cash payment, provision of services, transfer of an asset,
undertaking another obligation or conversion of obligation to
equity)
 Equity – current definition
The residual interest in the assets of the entity after
deduction of its liabilities.
Assets – liabilities = equity
Therefore, cannot be defined independently of the other
elements
Main components comprise:
- Contributions by shareholders
- Reserves
- Retained earnings
 Income - definition
Income is increases in economic benefits during the
accounting period in the form of inflows or enhancements of
assets or decreases of liabilities that result in an increase in
equity, other than those relating to contributions from equity
participants
• Income arises due to changes in assets and liabilities –
balance sheet emphasis
• Income does not depend on an earnings process
• Income encompasses revenue and gains
• Revenue is a subset of income
• Revenue > gross inflows relating to an entity’s ordinary
activities – implies an earnings process
• Gains > income from outside an entity’s ordinary activities
 Income - definition
• AASB101 (IAS 1) Presentation of Financial Statements
requires the disclosure of “Total comprehensive income”
• Reported in two components
– Profit or Loss for the period
– Other comprehensive income
• Represents the ‘change in equity’ [net assets] during a
period resulting from non owner related transactions
and other events
– This is consistent with the definition of
income and expense in the Framework
 Expenses - definition
Expenses are decreases in economic benefits during the
accounting period in the form of outflows or depletions of
assets or incurrences of liabilities that result in an decrease
in equity, other than those relating to distributions to equity
participants (Framework para. 49(b))
• The opposite of income
• The ‘asset or expense’ decision is a challenge for professional
accountants
– Does the entity have control of the economic resource?
• Expenses encompasses losses (reported on a net basis) as well as
expenses arising in the ordinary course of business (reported on a
gross basis)
 Recognition criteria - general
• The same recognition criteria are applied to all five
elements of the financial statements
1. It is probable that future economic benefits associated
with the item will flow to/(from) the entity;
and
2. The item has a cost or other value that can be measured
reliably

• Information is considered to be reliable when it is free from

material errors and can be depended upon by users to
represent faithfully the economic substance of the
transactions and events that have occurred.
 Recognition criteria - revenue
• AASB 118 (IAS 18) Revenue provides additional
recognition criteria in relation to revenue to that included
within the Conceptual Framework

• Separate recognition criteria are provided for revenue

from:
– The sale of goods
– The provision of services
– Interest, royalties and dividends

• AASB 118 (IAS 18) – to be revised for 2017 onwards

 Recognition criteria - expenses
• Under the Conceptual Framework expense recognition is not
tied to the matching process
• Emphasis in the Conceptual Framework is on a balance
sheet approach
• The Conceptual Framework accepts the use of the matching
process, but requires that it be discarded if it creates dubious
assets and liabilities E.g. provisions where there is no present obligation

• As adherence to the Conceptual Framework is not

mandatory the matching process still has influence in
practice
• No overall AASB/IAS for expenses (unlike AASB 118/IAS 18
for revenue). Individual AASBs/IASs for specific types of
transactions must be referred to
Recognition criteria - provisions
• AASB 137 (IAS 37) Provisions, Contingent Liabilities and
Contingent Assets
– A provision …is a liability of uncertain timing or amount (para. 10)

• Recognition of provisions as liabilities:

– Depends on the usual probability and reliable measurement criteria
– Is problematic given the significant uncertainty in relation to the timing
and amounts of future expenditures

• The amount recognised should be

– The best estimate of the expenditure required to settle the present
obligation at the reporting date
Recognition criteria – contingent
liabilities and contingent assets
• Such amount are not recognised in financial
statements

• Disclosed by way of note

• Note that the IASB proposes removal of these terms

Question 1

Explain how you would account for the following items, justifying your answer by
reference to the Framework’s definitions and recognition criteria.
a. A trinket of sentimental value only.
b. You are guarantor for your friend’s bank loan:
(i) You have no reason to believe your friend will default on the loan.
(ii) As your friend is in serious financial difficulties, you think it is likely that he
will default on the loan.
c. You receive 1 000 shares in X Ltd, trading at $4 each, as a gift from a grateful
client.
d. The panoramic view of the coast from your café’s windows, which you are
convinced attracts customers to your café.
e. The court has ordered your firm to repair the environmental damage it caused
to the local river system. You have no idea how much this repair work will cost.

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Q1 Solutions

(a) Trinket of sentimental value

• Fails the para 49(a) asset definition as it does not constitute future economic benefits,
defined in para 53 as the potential to contribute, directly or indirectly, to the flow of cash
and cash equivalents to the entity.
• Recognition criteria are irrelevant, as there is no asset to recognise.

(b) Guarantor for friend’s loan

(i) Friend unlikely to default on his loan

• Meets the para 49(b) liability definition: (1) present obligation – legal obligation via the
guarantor contract; (2) past event – signing the guarantor contract; (3) settlement
involving outflow of economic benefits – payment of the guarantee.
• Fails probability recognition criterion, as it is not likely that you will be required to pay on
the guarantee. Hence, no liability can be recognised. However, note disclosure of the
guarantee may be warranted (para 88).

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Q1 Solutions...

(ii) Friend likely to default on his loan

• Again, meets the liability definition as per (i) above.

• Meets both recognition criteria – probable that outflow of economic benefits will be
required, and settlement amount can be reliably measured (amount owing). Hence, a
liability should be recognised.
• Also meets the expense definition and recognition criteria. Definition: (1) decrease in
economic benefits in the form of a liability increase – you now owe the amount of your
friend’s loan; (2) during period – the liability increase arose during period; (3) results in
equity decrease – if liabilities increase and assets do not change, equity decreases.
Recognition criteria: The decrease in future economic benefits has arisen, as you now
owe the amount of your friend’s loan. The bank can advise exactly how much your
friend owes and so it can be reliably measured.

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 Q1 Solutions...

(c) Receipt of 1,000 shares in X Ltd, trading at $4 each, as a gift from a grateful client.
• The receipt of the shares meets the asset definition: (1) represent FEBs (via future
sales or dividend stream); (2) controlled by you (only you can benefit from either selling
them or receiving dividends); (3) past event (their receipt).
• They also meet the asset recognition criteria: probable that FEBs will eventuate (via
sale or dividend stream); and the shares have a value (they are trading at $4 each) that
can be reliably measured (this value can be verified via stock exchange etc).
• The shares also meet the income definition and recognition criteria. Definition: (1)
increase in EBs in the form of an asset increase – you now own the shares; (2) during
period – the shares were received during period; (3) results in equity increase – if
assets increase and liabilities do not change, equity increases. Recognition criteria: The
increase in FEBs has arisen, as you now own the shares (asset). The shares’ value is
known and so can be reliably measured.

17
Q1 Solutions...

(d) Café’s panoramic view

• The view fails the definition as the entity does not control the FEBs that are expected to
flow from the view – the entity cannot deny or regulate access by others to the view.
• Recognition criteria are irrelevant, as there is no asset to recognise.
(e) Court order to repair environmental damage caused to the local river system. You
have no idea how much this repair work will cost.
• The court order meets the liability definition: (1) present obligation – legal obligation;
(2) past event – order has been made; (3) settlement will involve outflow of EBs –
future payment for repair of damage.
• Fails reliable measurement recognition criterion, as you have no idea as yet how much
the repair work will cost. Hence, no liability can be recognised. However, note
disclosure of the court order may be warranted (para 88).
• However, if you know a minimum amount that you will have to pay, then the reliable
measurement criterion is met for this amount. The probability criterion is met as it is
certain (given that you have been ordered by the court) that you will have to pay the
repair cost. Again, note disclosure may still be warranted advising that the cost may be
well in excess of this amount.
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 Measurement
• Measurement involves the process of determining the monetary
amounts at which the elements are to be recognised and carried
in the financial statements.
• Requires the determination of the value of an item:
– on initial recognition and subsequently

• Most common measurement bases used:

– Historical cost
– Current cost
– Realisable value
– Present value
Measurement and classification -
assets
• Initially measured at cost. Cost is defined as:
Cash or cash equivalents paid of the fair value of other
consideration given to acquire an asset
• Subsequently measured in accordance with relevant accounting
standards. For example
– Per AASB 102 (IAS 2) Inventories, inventory is recorded at
lower of cost or net realisable value
– Per AASB 116 (IAS 16) Property, Plant & Equipment, plant &
equipment is recorded at either cost or fair value
• AASB 101 (IAS 1) Presentation of Financial Statements
requires that assets be classified in the statement of financial
position:
– by nature (e.g. inventories, receivable, intangibles)
– sub-classified as current or non-current
Measurement and classification -
liabilities
• Most liabilities are valued at nominal or face value
• Some recorded at discounted present value. For example
– Per AASB 119 (IAS 19) Employee Benefits, liabilities for
long-term employee benefits such as long service leave
are recorded at discounted present value
– Per AASB 117 (IAS 17) Leases, finance lease liabilities
are values using present value techniques
• AASB 101 (IAS 1) Presentation of Financial Statements
requires that liabilities be classified in the statement of
financial position:
– by nature
– sub-classified as current or non-current
Measurement and classification -
equity
• Equity is calculated as a residual, so no separate
measurement methods apply

• It is common to classify equity in the statement of

financial position in three major components:
– Contributed equity (eg Share Capital)
– Reserves
– Retained earnings
Measurement and classification -
income
• Under AASB 118 (IAS 18) Revenues, revenue is measured
at the fair value of consideration received

• AASB 118 (IAS 18) requires that revenue be classified by

nature
• New IFRS 15 — Revenue from Contracts with Customers

• Major components are:

– Revenues from sale of goods
– Revenues from services rendered
– Interest, royalties and dividends
Measurement and classification -
expenses
Most expenses are measured based on the cost of
consumption or loss of economic benefits in the current
period

AASB 101 (IAS 1) Presentation of Financial Statements

requires that expenses be classified in the Statement of
Comprehensive Income by nature or function

Nature vs Function classification discussed in more detail in CH 5

 Dividends
• Represent a distribution of profits to shareholders
• Dividends can only be paid once the company satisfies a test
of solvency
• Power to declare dividends at any time rests with directors
• Dividends may be in the form of cash, bonus shares or
assets
• Constitution usually provides for the declaration of two types
of dividends:
– Interim (declared and paid during the year)
– Final (declared this year, paid next)
• Commonly expressed as a certain amount of cents per share
 Dividends
When does a legal debt arise for dividends?
• If constitution states that once declared a dividend is not
subject to further approval
– a legal debt arises on declaration
– dividend payable recorded at date of declaration
• If constitution requires approval by shareholders at a meeting
of shareholders
– a legal debt arises on the approval by shareholders
– dividend payable recorded once approval obtained
• If there is no constitution/constitution is silent
– a legal debt arises on the nominated payment date
– no dividend payable recorded
 Dividends
INTERIM DIVIDEND PAID
Dr Retained earnings $x
Cr Cash $x

FINAL DIVIDEND DECLARED

Dr Retained earnings $x
Cr Dividend payable $x
Dividend paid/declared accounts are often used in the above entries and
closed to retained earnings as part of the annual closing process

Final dividends that are declared after year end or require the approval of
shareholders are not recorded in the financial statements, but are referred
to by way of note disclosure.
 Preference dividends
• Preference dividends are normally paid before
dividends to ordinary shareholders
• Rate of dividend normally set at time of issue and
may be quoted as % or cents per share
• Dividends may be cumulative, that is, undeclared
dividends accumulate and must be paid before
dividends are paid to ordinary shareholders
• Preference shareholders may also get an additional
‘participating’ dividend
 Bonus share issues
• Involves the issue of additional shares to existing
shareholders
• Shares are issued at no cost in lieu of cash dividend
• Can be paid from profits or reserves

The entry required is:

Dr Retained earnings OR reserve $xx

Cr Share capital $xx
 Reserves
• Not defined in The Conceptual Framework, Accounting
Standards or Corporations Act
• Reserves arise as a result of:
1. Requirements of Accounting Standards
• Asset revaluation surplus Discussed in later chapters
• Foreign currency translation reserve

2. Appropriations of profits
• General reserve
• Contingencies reserve
3. Application of the Corporations Act
• Forfeited shares reserve
 Reserves
APPROPRIATION OF PROFITS

• Such transfers do not involve cash transfers or creation of

‘secret’ cash balances
• The transfer can signal to shareholders that these profits will
not be distributed as dividends
• Creation/increase in reserves:
Dr Retained earnings (tfr to reserve) xx
Cr Reserve xx
• A “transfer to/from reserve” account is often used in the above entries
and closed to retained earnings as part of the annual closing process
 Question 2

• Practice Question 3.1 (Leo 10e)

Q2 Solution…

1. Retained Earnings/Interim Dividend Dr 200 000

Cash Cr 200 000

2. Retained Earnings/Dividend Declared Dr 420 000

Dividend Payable Cr 420 000

3. Revaluation Surplus Dr 65 000

General Reserve Cr 65 000

4. Retained Earnings/T’fer to Reserve Dr 120 000

General Reserve Cr 120 000
5. General Reserve Dr 300 000
Share Capital Cr 300 000
 Accounting Policies
• Accounting policies are the principles, bases or rules
adopted by a company in preparing and presenting its
financial reports

• Policies apply to both initial recognition

of items and subsequent accounting for such items

• AASB 108 (IAS 8) Accounting Policies, changes in

Accounting estimates and error is the accounting standard
which deals with:
– Setting accounting policies
– Changing accounting policies
– Disclosures in the financial statements concerning
accounting policies
 Selecting Accounting Policies
• AASB 108 (IAS 8) requires accounting policy choices
based on qualitative characteristics

• The current Framework reflects a hierarchy:

– To be useful, information must have both Fundamental
characteristics:
• Relevance (which now incorporates materiality)
• Faithful Representation (previously a component of Reliability)
– Enhancing characteristics
• Comparability, Timeliness, Understandability & Verifiability
• Are not essential but can improve the usefulness of information
Accounting policies - Relevance
• Relevant information is that which enables users to:
– Make predictions or form expectations about the
future performance of an entity
– Confirm or refute past evaluations
– Assess the accountability rendered by the preparers
of the financial statements
• Information may be relevant due to its size or nature
• To be relevant, information must be timely and
understandable
 Reliability and Faithful
Representation
• Reliable information is that which is free from material error and
bias and can be depended upon by users to represent faithfully
that which it purports to represent

• Faithful Representation requires any depiction of an event to be

– Complete
– Neutral and
– Free from error
 Changing Accounting Policies
• Comparability requires consistent application of accounting
policies over time
• AASB 108 – Accounting policies can only be changed in the
following circumstances:
1. Required by an accounting standard
2. The change will provide reliable and more relevant information
• Adopting an existing standard due to changes in operations is not
a change in accounting policy
• It is important to distinguish
– Changes in accounting policy, from
– Changes in accounting methods (which should be considered a change in an
accounting estimate)
 Chapter 4
Fundamental concepts of
corporate governance
 Corporate governance

• Deals with the way corporations are managed and

governed
• Influences how:
– the objectives of the company are set and achieved
– risk is monitored and assessed
– performance is optimised

• Describes the framework of rules, relationships, systems

and processes within which and by which authority is
exercised and controlled in corporations
Corporate governance theories –
Agency theory

• Arises due to the:

– Separate legal status of a corporation
– Separation of ownership and management

• Best practice recommendations generally centre on

the board remaining independent of management so
that it can exercise control on behalf of the
company’s owners
• Is the theory most used to justify corporate
governance reform
Corporate governance theories –
Stakeholder theory

• Focuses less on maintaining and enhancing

shareholder value and more on providing value to all
the company’s stakeholders
• Differences between agency theory and stakeholder
result in different expectations for corporate
governance recommendations and processes
• Hybrid stakeholder-agency approaches have
developed recently
• Hybrid approaches emphasise that if shareholders are
to maximise their returns, they need to ensure they
satisfy the company’s various stakeholders
 Corporate governance theories –
Other theories

Team production theory

• Proposes that companies provide value by combining
the key factors (labour, capital and debt) of production
in a manner that markets cannot
• The board exists as a mediating hierarchy between the
various factors of production
• Sees the board as the ultimate power in the firm

Resource dependant theory

• Proposes that boards exist to provide access to capital,
information, power and other important inputs
 Corporate governance theories –
Other theories

Class hegemony theory

• Marxist based theory that conceptualises the upper
class or business elite as a group manipulating the
governance of corporations to perpetuate its power
base

Managerial hegemony theory

• Argues that the real power in corporate governance lies
with management and that management can take
advantage of shareholder weakness to pursue self-
interest
 Directors’ and officers’ duties

• Definition of director includes:

– A person appointed as a director
– People who act in the position or are accustomed to acting
in the position
• Definition of an officer includes:
– Someone participating in the decision making of the
business; can significantly affect the financial standing of
the company; or whose instructions the directors are
accustomed to acting on
– Receivers, administrators, liquidators and trustees
• External advisors and senior managers may be classified as
officers
• Nearly all directors’ duties are also applicable to the
company’s officers
 Directors’ and officers’ duties

• Key duties included in Corporations Act:

– To act in good faith for a proper purpose
– Not to misuse the position
– Not to misuse information
– To act with due care and diligence
– To ensure the company does not trade insolvently

• Other duties include:

– To avoid a conflict of interest

 Issues for listed companies

Sarbanes-Oxley Act (SOX)

• Issued by US federal government in 2002 in response to

Enron, WorldCom and other corporate collapses
• Applies to all entities that issue (or list) in the US are
bound by the legislation, even if domiciled outside of the
USA
• Enforced by the US Securities & Exchange Commission
(SEC)
• Aims to restore confidence in the accounting profession,
improve financial reporting, improve directors and
officers performance
 Issues for accountants

• Significant implications for auditors

• Implications for the flow of information

• Increased responsibilities for accounting professionals

• Whistleblowing
– Improved protection for whistleblowers recently
introduced
 International corporate governance
• No consistent international approach
• Two main systems dominate
Anglo systems
• Commonly referred to as ‘outsider’ or ‘agency’ systems
• Used in Australia, UK, USA, NZ
Pluralist systems
• Commonly referred to as ‘insider’ or ‘stewardship’
systems
• Used in Europe, Asia
• Different forms of Boards arise from the different
systems
 Tute Questions

Leo 10e Chapters 3 & 4

Chapter 3
1. Review Question 2
2. Case Study 1
3. Practice Question 3.3
4. Practice Question 3.7 (Part A only)

Chapter 4
5. Review Question 2
6. Case Study 2