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ACCT3321 Financial Accounting Theory and Practice

Loftus 2022 (4th ed) Chapter 1: Accounting regulation and the conceptual framework

Comprehension questions: 7,11,12,15

Exercises: 1.12, 1.13, 1.18

Comprehension questions 

7.Specify the objectives of general purpose financial reporting, the nature of users and the information to be provided to users to achieve the objectives as provided in the Conceptual Framework.

The Conceptual Framework specifies the objective of general purpose financial reporting as providing financial information about the reporting entity that is useful to existing and potential investors, lenders and other creditors in making decisions about providing resources to the entity. It adopts the ‘entity perspective’; that is, the entity is the object of general purpose financial reporting, not its owners and others having an interest in it. 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 lenders or creditors. Both present and potential shareholders, 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; for example, government and other regulatory bodies, customers, employees and their representatives, are not the focus of financial reporting. It 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 still ignored in the revised Conceptual Framework. However, this omission may not be important as currently shareholders themselves are interested in environmental and social issues and that provides incentives to entities to provide further information related to those issues.

11. Discuss the essential characteristics of an asset as described in the Conceptual Framework.

An asset is defined in paragraph 4.3 of the Conceptual Framework as ‘a present economic resource controlled by the entity as a result of past events’. Paragraph 4.4 defines an economic resource as ‘a right that has the potential to produce economic benefits’.

As such, the essential characteristics of an asset are:

Ÿ it is a right – the potential to produce the economic benefits for the entity and to be controlled by the entity (paragraph 4.9)

Ÿ it has potential to produce economic benefits – the potential does not need to be certain, or even likely. It is only necessary that the right already exists and that, in at least one circumstance, it would produce for the entity economic benefits beyond those available to all other parties (paragraph 4.14)

Ÿ it is controlled by the entity – the entity has the present ability to direct the use of the economic resource and obtain the economic benefits that may flow from it (paragraph 4.20).

12.Discuss the essential characteristics of a liability as described in the Conceptual Framework.

A liability is defined in the current Conceptual Framework as ‘a present obligation of the entity to transfer an economic resource as a result of past event’.

The important aspects of this definition are:

· the entity has an obligation – which is a duty or responsibility of the entity to act or perform in a certain way. The entity has little, if any, discretion in avoiding this obligation.

· the obligation is to transfer an economic resource. This transfer is to take place in the future and may be required on demand, at a specified date, or on the occurrence of a specified event.

· the obligation is a present obligation that exists as a result of past events. For example, wages to be paid to staff for work they will do in the future is not a liability as there is no past event and no present obligation.

15. Define ‘equity’, and explain why the Conceptual Framework does not prescribe any recognition criteria for equity.

The Conceptual Framework paragraph 4.2 defines equity as ‘the residual interest in the assets of the entity after deducting all its liabilities’. Equity cannot be identified independently of the other elements in the statement of financial position/balance sheet.

The characteristics of equity are that equity is a residual, i.e. something left over after the entity has determined its assets and liabilities. In other words:

Equity = Assets – Liabilities.

There is no need for recognition criteria for equity as it is a residual, determined after recognition criteria are applied to the other elements.

Exercise 1.12

Definition of elements

Explain how Beachside Ltd should account for the following items/situations, justifying your answer by reference to the Conceptual Framework’s definitions and recognition criteria.

1. Receipt of artwork of sentimental value only.

2. Beachside Ltd receives 5 000 shares in Monty Ltd, trading at $6 each, as a gift from a grateful client.

3. The panoramic view of the coast from Beachside Ltd’s café windows, which you are convinced attracts customers to the café.

4. The court has ordered Beachside Ltd to repair the environmental damage it caused to the local river system. You have no idea how much this repair work will cost.

(LO7 and LO8)

1. Trinket of sentimental value:

· Fails the paragraph 4.3 asset definition as it does not constitute a present economic resource controlled by the entity. Furthermore, it does constitute a right that has the potential to produce economic benefits (paragraph 4.4).

· Recognition criteria are irrelevant, as there is no asset to recognise.

2. Receipt of 5 000 shares in Monty Ltd, trading at $6 each, as a gift from a grateful client.

· The receipt of the shares meets the asset definition: (1) present economic resource (via future sales or dividend stream); (2) controlled by Beachside Ltd (only Beachside Ltd can benefit from either selling them or receiving dividends); (3) past event (their receipt).

· They also meet the asset recognition criteria: relevant and faithfully represented (via sale or dividend stream, trading at $6 each).

· The shares also meet the income definition and recognition criteria. Definition: (1) increase in assets — Beachside Ltd now owns 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 assets has arisen, as Beachside Ltd now owns the shares (asset). The shares’ value is known and so can be faithfully represented.

3. Café’s panoramic view.

· The view fails the definition as the entity does not control the economic resources that are expected to produce economic benefits — the entity cannot deny or regulate access by others to the view.

· Recognition criteria are irrelevant, as there is no asset to recognise.

4. 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) legal obligation; (2) obligation to transfer economic resources — future payment for repair of damage (3) past event — order has been made;

· 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.

· However, if you know a minimum amount that Beachside Ltd 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 Beachside Ltd has been ordered by the court) that Beachside Ltd 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.

Exercise 1.13

Definition and recognition criteria

Explain how Simpkins Ltd should account for the following items, justifying your answer by reference to the definitions and recognition criteria in the Conceptual Framework. Also. state, where appropriate, which ledger accounts should be debited and credited.

Required

1. Photographs of the company’s founders, which are of great sentimental and historical value.

2. (a) Simpkins Ltd has been sued for negligence — likely it will lose the case.

(b) Simpkins Ltd has been sued for negligence — likely it will win the case.

3. Obsolete machinery now retired from use.

4. Simpkins Ltd receives a donation of $5 000.

(LO7 and LO8)

1. Photographs of the company’s founders, which are of great sentimental value.

· The asset definition criteria are not met, as the photographs do not represent future economic benefits (paragraph 4.5). Future economic benefits constitute the potential to contribute, directly or indirectly, to the flow of cash and cash equivalents to an entity.

· Recognition criteria are thus irrelevant, as there is no asset to recognise.

2(a) Simpkins Ltd has been sued for negligence — likely it will lose the case. Assume that the amount Simpkins Ltd has to pay is at least $20 000.

Ÿ The liability definition (paragraph 4.27) is met as all 3 characteristics are present.

- Past event: The act of negligence or the act of being sued.

- An obligation: paragraph 4.29 states that an obligation is a duty or responsibility to act or perform in a certain way and there is no practical ability to avoid the obligation. The key question here is whether there is an obligation. The obligation is a present obligation that exists as a result of a past event i.e. the lawsuit (arising from being sued) gives rise to a present obligation because Simpkins Ltd may have to transfer an economic resource that it would not otherwise have had to transfer.

- Transfer an economic resource: If a present obligation is accepted as existing, its settlement will involve the outflow of economic benefits, namely cash.

· The liability recognition criteria (paragraph 5.7) are met, as it is relevant (cash will be paid), and the amount can be faithfully represented.

· Therefore, at this stage a liability must be recognised. If the damages firm up to another amount as the case progresses, the amount must be adjusted.

· The expense definition (paragraph 4.69) is met as all 3 characteristics are present.

- Decrease in economic benefits during the period: The loss represents a decrease in economic benefits and Simpkins Ltd was sued during the period.

- In the form of a liability increase: See above liability discussion — Simpkins Ltd now owes at least $20 000.

- Results in a decrease in equity: If liabilities increase and assets remain unchanged, equity decreases.

· The expense recognition criteria (paragraph 5.7) are met. It is relevant, as Simpkins Ltd now owes $20 000 minimum, and the amount ($20 000 minimum) can be faithfully represented.

· Therefore, at this stage an expense of $20 000 must also be recognised. If the damages firm up to another amount as the case progresses, the amount must be adjusted accordingly.

· Note that in this case the recognition of a liability has resulted in the simultaneous recognition of an expense.

2(b) Simpkins Ltd has been sued for negligence — likely it will win the case.

· The liability definition (paragraph 4.27) is met as all 3 characteristics are present. See discussion in (b)(i) above.

· However, the liability probability recognition criterion (paragraph 5.12) is failed, as it is not probable that an outflow of economic benefits will result from settling the liability. As Simpkins Ltd is likely to win the case, it is unlikely that it will have to pay damages.

· Therefore, the liability cannot be recognised. However, if material, the lawsuit should be disclosed in the notes.

3. Obsolete machinery now retired from use.

· The asset definition is failed as the plant no longer represents future economic resources (paragraph 4.3).

· The machinery must now be written off from the accounts.

· Recognition criteria are thus irrelevant, as there is no asset to recognise.

4. Donation of $5 000 received.

· The asset definition (paragraph 4.5) is met as all 3 characteristics are present.

- Past event: The receipt of the donation.

- Present economic resource: The donation represents an inflow of $5 000 cash into Simpkins Ltd.

- Controlled by the entity: Simpkins Ltd will benefit from this $5 000 cash inflow and can deny or regulate the access of others to this cash inflow.

· The asset recognition criteria (paragraph 5.7) are met, as it is probable (actually, it is certain) that an inflow of economic benefits (cash) will flow to the entity, and the amount ($5 000) can be faithfully represented as it is known.

· Therefore, an asset of $5 000 must be recognised.

· The income definition (paragraph 4.68) is met as all characteristics are present.

- Increase in assets during the period: The inflow of $5 000 cash represents an increase in economic benefits, and Simpkins Ltd received and cleared the donation during this period.

- Results in an increase in equity: If assets increase and liabilities remain unchanged, equity increases.

· The income recognition criteria are met, as the increase in economic resources is relevant (as Simpkins Ltd now has additional cash), and the amount ($5 000) is known.

· Therefore, income of $5 000 must also be recognised.

· Note that in this case the recognition of an asset has resulted in the simultaneous recognition of income.

Exercise 1.18

Asset definition and recognition

A retail store of Savemart Ltd was broke in and $21 000 was stolen from night safe. Explain how Savemart should account for this event, justifying your answer by reference to relevant Conceptual Framework definitions and recognition criteria. (LO7 and LO8)

The Conceptual Framework defines expenses as decreases in assets, or increases in liabilities, that result in decreases in equity, other than those relating to distributions to holders of equity claims. The theft of the $21 000 cash satisfies the expense definition as:

· it is a decrease in assets during the period, as cash (economic benefits) has decreased; and

· it has resulted in a decrease in equity, as assets have decreased and liabilities have not changed.

In accordance with the Conceptual Framework an expense must be recognised when:

· a decrease in economic resources related to an asset decrease or a liability increase is relevant (has arisen); and

· the decrease can be faithfully represented (reliably measured).

The theft of the cash satisfies both recognition criteria as:

· the decrease in economic benefits related to an asset decrease (a decrease in cash) has occurred; and

· the decrease can be faithfully represented, as the amount of cash lost is known (i.e. $21 000).

Accordingly, an expense (Dr) and asset decrease (Cr) of $21 000 must be recognised.