ACCOUNTING Financial and Organisational Decision Making

ACCOUNTINGFinancial and Organisational Decision Making Chapter 15 Assets and Expenses Slides written and designed by Tony Van Eekelen

Learning Objectives • In this chapter you will be introduced to : • The nature of assets • the nature of expenses • the difference between assets and expenses • the criteria for the recognition of assets and expenses • the influence of conservatism in accounting for assets and expenses

Learning Objectives • the allocation problems in asset and expense determination, especially in cases of inventories, marketable securities, depreciable assets and intangible assets • the lack of precision generally in accounting for assets and expenses

Introduction • Within the accounting system there exists certain elements which constitute the financial statements. • These elements are assets, liabilities, expenses and revenues. • How are these elements defined and when are they recognised?

Definition & Recognition • Definition: the identification of the attributes the elements should possess to be identified as such • Recognition: the determination process which decides whether an element should be report or accounted for in the financial statements.

Conservatism • Due to very nature of business and its reporting, uncertainty exists. • Due to this uncertainty, accounting has a assumption of conservatism in what is reported. • Conservatism means caution or prudence.

Conservatism • Accountants • anticipate losses • never anticipate gains • choice of value for asset is always the lowest • liabilities are never understated. • Makes reports more reliable. • Conservative approach to historical cost is to value at lower of original cost or recoverable amount.

The definition and recognition of assets and expenses • The basis for the definition and recognition criteria is based upon the International Accounting standards (IAS) and the Australian statements of accounting concepts (SACs)

Assets • An asset must have the following characteristics: • a resource offering future economic benefit through use or exchange • controlled by the entity • must have been derived by a past external transaction • Measurement in $A and at original cost unless net realisable value is lower.

Expenses • An expense must have the following characteristics: • some economic benefit has been consumed or lost during the period • the benefit must have been derived from a past external transaction • withdrawals are not expenses but reductions in capital

Stability of asset definitions • As the business world is dynamic is nature, the elements within the financial statements must also evolve. • In 1922, Paton defined assets as: • any consideration, materials or otherwise, owned by a specific business enterprise and of value to that enterprise

Stability of assets definitions • Based upon ownership not just control. • Must have some value, thus economic benefit. • Past definitions looked at the process not the properties. • Recently, this has changed, due to the resurgence of the balance sheet as important.

Properties of assets and expenses and their recognition • IASC • a resource controlled by the enterprise as a result of past events and from which future economic benefits are expected to flow to the enterprise • SAC 4 • future economic benefits controlled by an entity as a result of past transaction or other past events.

Three main characteristics Future Economic benefit Control Past event or transaction

Future economic benefit • IASC • ……is the potential to contribute, directly or indirectly, to the flow of cash and cash equivalents to the enterprise. ……it may be a productive one that is part of the operating activities of the enterprise. It may also take the form of convertibility into cash or cash equivalents or a capability to reduce cash outflows, ...

Future economic benefit • Assets are used to provide goods and services in exchange for net cash inflows. • For not-for-profit entities • benefits the entities by enabling them to meet their objectives of providing needed services

Control • The capacity of the entity to benefit from the asset and to deny or regulate the access of others to that benefit. • Ownership is not essential to control asset. • lease of motor vehicle no ownership but has control over its use.

Occurrence of past transaction or other event • An event or transaction must be evident giving the control of the asset to the entity. • Via cash, credit or barter • Or via discovery - mining • Event or transaction must be past, not future.

Recognition of assets • IASC framework specifies: • …an element should be recognised if: • it is probable that any future economic benefit associated with the time will flow to or from the enterprise; and • the item has a cost or value that can be measured with reliability

Recognition • Recognised if, and only if, it is “probable” • Probable means that it is more than likely, ie greater than 50% chance

Expenses • IASC framework defines expenses as: • Expenses are decreases in economic benefits during the accounting period in the form of outflows or depletion of assets or incurrences of liabilities that result in decreases in equity, other than those relating to distributions to equity participants

Expenses • SAC 4 • Expenses are consumptions or losses of future economic benefits in the form of reductions in assets or increases in liabilities of the entity, other than those relating to distribution to owners, that result in a decrease in equity during the reporting period • Major emphasis is on losses

Recognition of expenses • IASC framework recognises expenses as “.. decrease in future economic benefits related to a decrease in an asset or an increase in a liability has arisen that can be measured reliably”(para. 94) • Problem: to determine the amount of expired economic benefit for the period?

Allocation Problem • To decide the amount to be appropriated to an expense or to an asset is not a simple task. • The problem stems from the concepts of accounting period, continuity and capital maintenance. • Problems in all areas especially inventories, marketable securities, depreciable and intangible assets Expenses

Inventory • Inventory accounting relates to what is on hand and the calculation of the cost of sales. • In chapter 5, we covered the two methods of recording inventory transactions [physical & perpetual] now how do we value inventory.

Inventory • To achieve the matching of inventory costs under the historical cost system, two conditions are necessary: • all units of the same type of inventory purchased over the life of the firm are purchased at the same price • the purchase price of each individual item of inventory can be identified with certainty.

Inventory • First condition is unlikely to hold • Thus there is a need to identify the cost at purchase and transfer it a sale. • This method can be time consuming and in some cases to difficult. • Alternative approaches are available based upon assumption about the order in which the goods are sold.

Inventory cost allocation methods • Two methods methods exist • FIFO - first in, first out • assumes that the goods first received into inventory are sold first • LIFO - last in, first out • assumes that the goods most recently received into inventory are the first to be sold

Example of FIFO & LIFO • Purchases: Date Number Cost Total June 12 250 0.40 100 June 18 150 0.50 75 June 25 400 0.60 240 Total 800 • Sales June 19 200 June 27 250 Total 450

FIFO Cost of goods soldUnits Unit cost $ Total Cost $ 250 0.40 100 150 0.50 75 50 0.60 30 Total units sold 450 205 Cost of inventory on hand350 0.60 210 Total units available 800 415

LIFO Cost of goods sold Units Unit cost $ Total Cost $ June 19 150 0.50 75 50 0.40 20 June 27 250 0.60 150 Total units sold 450 245 Cost of inventory on hand 150 0.60 90 200 0.40 80 Inventory on hand 350170 Total units available 800 415

Comparison of FIFO & LIFO FIFO LIFO Cost of goods sold $205 $245 Ending Inventory $210 $170 Total available for sale $415 $415

Comparison • Inflationary times cost of goods sold for LIFO is generally larger. • In US can use LIFO thus reducing taxation payments. (inflationary times) • LIFO is inconsistent with historical cost • IASC allows LIFO, but in Australia LIFO is not allowed for taxation purposes and by the standards

Weighted Average Cost • The cost of inventory is determined by applying the weighted average cost of all inventory at the time of sale. • Under the perpetual recording system, the cost of inventory will need to be recalculate after each purchase.

Using previous example Cost of goods sold Unit sold WAC Total cost June 19 200 87.50 June 28 250136.46 450 223.96 Inventory on hand 350 0.54583 191.04 Total units available 800 415.00

Lower of cost or net realisable value • IAS2 states that inventories should be measured at the lower of cost and net realisable value. • This is consistent with the measurement rule that assets should be valued based upon their future economic benefits to the entity.

Marketable securities • Marketable securities are all investments in securities which can be traded through an exchange or other organised market. • Due to the changing price of the security, a problem arises. • The lower of cost or net realisable value approach is used. • In US can use the portfolio approach

Depreciating assets • Depreciation is the process of allocating the cost of a non-current asset over its life. • The more economic benefits used to generate revenue, the larger the depreciation charge.

Depreciating assets • Factors which determine the level of economic benefit consumed are • usage, • obsolescence, • indirect relationship with products • the pattern of benefits are not easily identified • taxation requirements • time

Profit or loss on sale • It is not the same as profit from operations but a prior-period adjustment made necessary by the understandable inability of the entity to predict accurately the actual scrap value of the asset or its actual useful life. • Usually the profit/loss on sale is determined by the difference between the book value and the proceeds from sale, however, this becomes ‘cloudy’ when a trade-in is involved.

What costs to include? • When determining the cost of an asset it must be recorded at the original cost. • In some cases there are additional costs which have been incurred to acquire the asset. • The definition of an asset and an expense gives us five (5) general rules when determining the cost of an asset.

5 rules of asset cost 1. Installation costs: • The cost of an assets includes all costs necessary to render an asset suitable for its intended use. 2. Group asset costs: • Where a group of assets is acquired for the purpose of acquiring only one of the assets, the entire purchase price relates to the desired asset.

5 rules of asset cost 3. Maintenance vs. improvements: • Any cost incurred to obtain the benefits initially expected from an asset is a maintenance expense of the current period. Any cost incurred to increase lifetime benefits beyond the original expectation gives rise to an additional asset for improvement.

5 rules of asset cost 4. The unit being accounted for: • Where objects associated with the costs arising out of a related set of transactions have either different life expectancies or different identities, the firm may choose to recognise more than one asset.

5 rules of asset cost 5. Replacement vs maintenance: • Where the expenditure results in the replacement of an entire asset, the old asset is removed from the accounts and the cost of the new asset is capitalised. • Where the expenditure results in the replacement of only part of an asset, it is treated as a maintenance expense of the period, unless the expenditure is expected to increase materially the asset’s condition and potential.

Major overhauls • A major overhaul differs from maintenance expense in that it extends the useful life of the asset, increases its productive capacity or reduces the operating costs. • Thus it has the characteristics of an asset and it should be included in the cost of the asset and depreciation should be adjusted for the remaining life of the asset.

Intangible and other non-current assets • Two types: • unidentifiable - goodwill • purchased or self developed • different methods off treatment • stay on balance sheet as asset • write off in year of acquisition • amortise over number of years. • Preferred method is amortisation over 5 years with a maximum of 20 years. • Identifiable - patents; • at lower cost and amortised

Research and development costs • Research is original and planned investigation undertaken with the prospect of gaining new scientific or technical knowledge and understanding • Development is the application of research findings or other knowledge to a plan or design for the production of new or substantially improved materials,….

Research and development costs • Asset determination will depend upon the asset recognition test. • Uncertainty, requires all research costs to be expensed. • AASB1011 requires that R&D costs be carried forward as assets to the extent that such costs, together with unamortised deferred costs in relation to that project, are expected beyond any reasonable doubt to be recoverable.

ACCOUNTING Financial and Organisational Decision Making