ACCT2542 S2 2018

Topic 1 (Chapters 1, 2, 16 and 18)- Practice Questions with Solutions

Chapter 1: Accounting regulation and the conceptual framework

Comprehension questions

1. What are the key sources of regulation in Australia for a listed company?

The key sources of regulation for a listed company in Australia are:

The Corporations Act, which is administered by the Australian Securities and Investments
Commission
Australian Accounting Standards and the Conceptual Framework, issued by the Australian
Accounting Standards Board
Australian Securities Exchange Listing Rules.

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 objectives 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, 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; for example, government and other regulatory bodies,
customers, employees and their representatives, are not the focus of the objective.

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 ignored in the revised
conceptual framework.

16. Define ‘equity’ and explain why the conceptual framework does not prescribe any
recognition criteria for equity.

The conceptual framework 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.
Application and analysis exercises

Exercise 1.1

Relevant information

A year ago you bought shares in an investment company. The investment company in turn buys,
holds and sells shares of business enterprises. You want to use the financial statements of the
investment company to assess its performance over the past year.
1. What financial information about the investment company’s holdings would be most relevant
to you?
2. The investment company earns profits from appreciation of its investment securities and from
dividends received. How would the concepts of recognition in the conceptual framework
apply here?
(LO5 and LO8)

1. The performance of an investment company results from income earned on its investments
(dividends and interest) and changes in the fair values of its investments while they are held. I would
like to know:
Ÿ Fair values of the securities that the investment company holds.
Ÿ How those fair values changed during the year. It would not matter much to me whether the
investment company actually sold the investments (in which case they would have to replace
them with other investments) or held on to the investments. Either way, the fair value changes
represent gains and losses to the investment company and, therefore, to me as an investor in the
investment company.
Ÿ How the fair value changes of investments managed by this investment company compared to
changes in similar investments in the market as a whole.
Ÿ Turnover of the portfolio and related transaction costs such as commissions.
Ÿ Interest and dividends earned.
Ÿ Information about risks in the portfolio.
Ÿ Income taxes are usually only based on those fair value changes that have been ‘confirmed’ by a
sale transaction. If that is the case with this investment company, I might want to know how the
fair value changes were split between ‘realised’ (relating to investments that have been sold) and
‘unrealised’ (relating to investments that are still held). In many countries, investment companies
that distribute their earnings rapidly to the investors do not themselves pay taxes — only the
investors pay the taxes on realised gains and dividend and interest income.

2. Under the conceptual framework, an item that meets the definition of an asset, liability, income, or
expense should be recognised if:
(a) it is probable that any future economic benefit associated with the item will flow to or from
the entity; and
(b) the item has a cost or value that can be measured with reliability.

With respect to income, the conceptual framework states that income is recognised in the income
statement when an increase in future economic benefits related to an increase in an asset or a decrease
of a liability that results in increases in equity, other than those relating to contributions from equity
participants. Appreciation of the fair value of investment securities does represent an increase in an
asset. The appreciation of its investment securities means it is probable that future economic benefit
will flow to the entity and the fair value can be measured with reliability. Hence, it fulfils both of the
definition of income and the recognition criteria. As to dividends, when the investment company’s right
to receive payment is established, it can recognise dividends as revenue. Because fair value changes
and dividends are different in nature, they would be reported separately.
Exercise 1.4

Financial statements

An entity purchases a rental property for $10 000 000 as an investment. The building is fully
rented and is in a good area. At the end of the current year, the entity hires an appraiser who
reports that the fair value of the building is $15 000 000 plus or minus 10%. Depreciating the
building over 50 years would reduce the carrying amount to $9 800 000.
1. What are the relevance and faithful representation accounting considerations in deciding how
to measure the building in the entity’s financial statements?
2. Does the conceptual framework lead to measuring the building at $15 000 000? Or at $9 800
000? Or at some other amount?
(LO5 and LO9)

1. Is the fair value relevant to stakeholders’ decisions? Whether the stakeholders care about the fair
value of the building should be considered.

Relevance:
Ÿ Information in financial statements is relevant when it influences the economic decisions of
users. It can do that both by (a) helping them evaluate past, present, or future events relating to
an enterprise and by (b) confirming or correcting past evaluations they have made.
Ÿ Materiality is a component of relevance. Information is material if its omission or misstatement
could influence the economic decisions of users.
Ÿ Timeliness is another component of relevance. To be useful, information must be provided to
users within the time period in which it is most likely to bear on their decisions.

Faithful representation:
Ÿ Information in financial statements is a faithful representation if it is complete, neutral and free
from material error and bias and can be depended upon by users to represent events and
transactions faithfully. Information is not a faithful representation when it is purposely designed
to influence users’ decisions in a particular direction.
Ÿ There is sometimes a trade-off between relevance and faithful representation — and judgement
is required to provide the appropriate balance.
Ÿ Faithful representation is affected by the use of estimates and by uncertainties associated with
items recognised and measured in financial statements. These uncertainties are dealt with, in
part, by disclosure and, in part, by exercising prudence in preparing financial statements.
Prudence is the inclusion of a degree of caution in the exercise of the judgements needed in
making the estimates required under conditions of uncertainty, such that assets or income are
not overstated and liabilities or expenses are not understated. However, prudence can only be
exercised within the context of the other qualitative characteristics in the conceptual
framework, particularly relevance and the faithful representation of transactions in financial
statements. Prudence does not justify deliberate overstatement of liabilities or expenses or
deliberate understatement of assets or income, because the financial statements would not be
neutral and, therefore, not have the quality of reliability.
 Analysis:
Ÿ The fair value of the property is relevant to the investors in the enterprise. The enterprise —
and therefore its owners — are better off because the value of the property has gone up. Better
off means that their wealth increased.
Ÿ Is the fair value reported by the appraiser reliable? Certainly, appraisals involve judgements,
and different valuation methods and different assumptions can generate different valuations.
The objectivity and other qualifications of the appraiser should be considered. The conceptual
framework acknowledges that accounting information can be reliable even if it is not precise.
The appraiser acknowledged that there is a potential for error of plus or minus 10%. That does
not mean that the value information is not reliable.

2. The conceptual framework does not include concepts or principles for selecting which measurement
basis should be used for particular elements of financial statements or in particular circumstances.
The qualitative characteristics do provide some guidance, particularly the characteristics of
relevance and faithful representation.

Exercise 1.5

The conceptual framework versus interpretations

Applying the conceptual framework is subjective and requires judgement. Would the IASB be
better off to abandon the conceptual framework entirely and instead rely on a very active
interpretations committee that develops detailed guidance in response to requests from
constituents? (LO4, LO8 and LO9)

No. The fact that the conceptual framework involves judgement does not mean that it should be
abandoned.

The guidance developed by the interpretations committee would be ad hoc – that is, developed case by
case without the foundation of the framework to look to. The standards themselves would suffer from
the same problem if there were no framework.

The conceptual framework provides guidance and direction to the standard setters, and therefore will
lead to consistency among the standards.

But it is a set of concepts. It provides a boundary for the exercise of judgement by the standard setter
and the interpretive body.
Chapter 2: Application of accounting theory

Case study 2.1

Penny Ltd made the following disclosure in the notes to its financial statements about how it
accounts for insurance premiums:

Required
1. List the four components of an accounting policy decision.
2. Analyse Penny Ltd’s policy for accounting for the insurance premium in terms of each
component.

1. An accounting policy decision may comprise four components:

• definition, whether the transaction or event gives rise to an item that satisfies the definition of
an element of financial statements;
• recognition, whether or when it should be recognised;
• measurement, how it should be measured, which may include a decision about subsequent
measurement as well as initial measurement; and
• disclosure, that it, how information about the item should be presented and what information
should be disclosed.

2. The insurance policy is accounted for as an asset, namely prepaid insurance. This is appropriate
because it satisfies the definition of an asset. First, it is a resource controlled by Penny Ltd as a result
of a past event, being the payment of the insurance premium in accordance with the insurance policy
(the insurance contract). The other criterion, that future economic benefits are expected to flow to
Penny Ltd, is evident to the extent of the unexpired period of the insurance cover.

The insurance policy is recognised as an asset at the time of settlement, that is, when Penny Ltd pays
the insurance premium. It is subsequently expensed as the period of the insurance policy expires.

The prepaid insurance asset is initially measured at cost and amortised to expenses on a time
proportionate (straight-line) basis. Thus subsequent measurement of the prepaid insurance asset
reflects the cost of the unexpired portion of the insurance policy.

Penny Ltd includes the prepaid insurance asset in ‘other current assets’ in the statement of financial
position and discloses the carrying amount and the accounting policy in the notes to the financial
statements.
Chapter 16: Presentation of financial statements

Comprehension questions

2. Why is it important for entities to disclose the measurement bases used in preparing the
financial statements?

It is important for entities to disclose the measurement bases used in preparing the financial statements
because Accounting Standards permit alternatives – such as cost or fair value for property, plant and
equipment. Therefore users need to know which alternatives the entity has chosen so as to understand
how items are measured and for purposes of comparison with the financial statements of other entities.

8. Does the separate identification of profit and items of other comprehensive income provide a
meaningful distinction between the effects of different types of non-owner transactions and
events?

Whether an item of income or expense is included in profit or in other comprehensive income is

determined by the treatment of various gains and losses and other items of income or expense prescribed
by accounting standards. The distinction becomes blurred when similar items, such as the effects of an
asset revaluation under AASB 116/IAS 16, are included in profit (if a loss on revaluation) and in other
comprehensive income (if a gain on revaluation).

10. Why is a summary of accounting policies important to ensuring the understandability of

financial statements to users of general purpose financial statements?

Refer sections 16.6 and 16.6.2. A summary of accounting policies facilitates the understandability of
financial statements to users of general purpose financial statements for the following reasons:
• Various options exist in certain Australian Accounting Standards (such as the option to revalue
property, plant and equipment as an alternative to using historical cost) and therefore it is essential
that the summary of accounting policies identify which options have been adopted (where relevant).
• Under Australian Accounting Standards various assets of an entity (such as internally generally
brand names and self-generated goodwill) and rights and obligations (such as non-cancellable
operating leases) are not recognised in an entity’s statement of financial position. The summary of
accounting policies helps ensure users of financial statements are aware of these omissions.

11. Provide an example of a judgement made in preparing the financial statements that can lead
to estimation uncertainty at the end of the reporting period. Describe the disclosures that would
be required in the notes.

Refer section 16.6.2. Some of the more important judgements that can lead to uncertainty required in
the preparation of financial statements include:
• Useful life of plant and equipment for depreciation purposes;
• Residual value of plant and equipment;
• Useful life of intangible assets, including whether the assets have an indefinite life or a finite life;
• Assessment as to whether there is any indication that a non-current asset is impaired and, if so, the
measurement of the recoverable amount of the asset, including estimating future cash flows and the
appropriate discount rate for value in use measures;
• Estimation of the fair value of assets and liabilities acquired in a business combination;
• Estimation of the fair value of the consideration given in a transaction, particularly where the
consideration is in the form of non-current assets or equity instruments;
• Estimation of the expected outcome of construction contracts;
• Estimation of provisions such as provisions for long service leave and provisions for restructuring;
• Estimation of the realisable value of inventory.
Paragraph 125 of AASB 101/IAS 1 requires that the notes disclose information about the assumptions
made concerning the future and other major sources of estimation uncertainty at the end of the reporting
period, that have a significant risk of causing a material adjustment to the carrying amounts of assets
and liabilities within the next financial year (for example, assumptions used in performing significant
asset impairment tests). The entity should disclose the nature and carrying amount of the assets and
liabilities concerned.

Case study 16.3

Management judgements

Any judgements made by management when applying the entity’s accounting policies that have
significant effect on amounts recognised in the financial statements must also be disclosed. What
judgements do you think are made by management?

According to paragraph 122 of AASB 101, an entity must disclose in the notes the judgements, apart
from those involving estimates, made by management when applying the entity’s accounting policies
that have the most significant effect on the amounts recognised in the financial statements. These
judgements (as outlined in AASB 101 paragraph 123) may include:
(a) whether financial assets are held-to-maturity investments;
(b) whether substantially all the risks and rewards of ownership of an asset are transferred (a finance
lease) or whether the lease is an operating lease; and
(c) whether, in substance, particular sales of goods are financing arrangements and therefore do not
give rise to revenue.
Case study 16.4

Formats for statement of profit or loss and other comprehensive income

The accountant for Moonshine Ltd has heard that following recent changes to
accounting standards, the income statement now has a new title and companies now
have a choice regarding the presentation of income and expense items recognised in a
period. However, the accountant is unsure of the exact requirements following changes
to accounting standards.

Required
As you are a recent university accounting graduate, the accountant seeks your assistance and
requests that you provide information to Moonshine Ltd about this apparent presentation choice
and whether the income statement now has a new title.

The statement of profit or loss and other comprehensive income provides information regarding the
financial performance of the entity for the reporting period. Income, expenses and other comprehensive
income (e.g. movements in asset revaluation reserve) are summarised in the statement of profit or loss
and other comprehensive income to determine an entity’s total comprehensive income, the usual
measure of an entity’s financial performance.

According to paragraph 10A of AASB 101, an entity may present:

• a single statement of profit or loss and other comprehensive income with profit or loss and other
comprehensive income presented in two sections (the two sections are to be presented together with
the profit or loss section presented first followed directly by the other comprehensive income
section), or
• a separate statement of profit or loss immediately followed by a statement of comprehensive
income, which shall begin with profit or loss.

There appears to be no clear principles as to why income and expenses can be separated into two
statements.

While the income statement is now referred to as the statement of profit or loss and other
comprehensive income by AASB 101, according to paragraph 10 and entity may use another title
for the statement of profit or loss and other comprehensive income, e.g. statement of comprehensive
income.
Exercise 16.16

Presentation of items in the financial statements

Consider the following items for Cooper Ltd at 30 June 2019:

(a) contingent liabilities
(b) dividends paid
(c) cash and cash equivalents
(d) capital contributed during the year
(e) revaluation gain on land (not reversing any previous revaluation)
(f) judgements that management has made in classifying financial assets
(g) income tax expense
(h) provisions.

Required
State whether each item is reported:
1. in the statement of financial position
2. in profit or loss in the statement of profit or loss and other comprehensive income
3. in other comprehensive income in the statement of profit or loss and other comprehensive
income
4. in the statement of changes in equity
5. in the notes to the financial statements.
(LO2, LO3, LO4, LO5 and LO6)

(a) contingent liabilities 5. notes

(b) dividends paid 4. statement of changes in equity
(c) cash and cash equivalents 1. statement of financial position
(d) capital contributed during the year 4. statement of changes in equity
(e) revaluation gain on land (not reversing any 3. other comprehensive income in
previous revaluation) statement of profit or loss and other
comprehensive income
(f) judgements that management has made in 5. notes
classifying financial assets
(g) income tax expense 2. in profit or loss in the statement of
profit or loss and other comprehensive
income
(h) Provisions 1. statement of financial position
Chapter 18: Accounting policies and other disclosures

Exercise 18.3

Accounting estimates and errors

Young Ltd estimates its future liability for repairs to products sold with a 12-month warranty as
a percentage of its net credit sales. Warranty expense and actual repair costs for the last 2 years
ending 30 June were as follows.

Required
Comment on Young Ltd’s accounting method for warranty liabilities. What action should be
taken with respect to the accounting estimates? If an investigation during 2021–22 finds that the
figure for warranty expense was incorrectly calculated for 2020–21 and should have been $70 000,
what action is required under AASB 108/IAS 8? (LO2 and LO3)

The significant variances between the provision for warranty and the actual repairs in the two years
indicate that either the policy of using a percentage of net credit sales as a means of estimating warranty
costs is not appropriate, or the percentage used is not adequate. The company needs to look at changing
either its policy or perhaps simply increasing the percentage used. Past claims as a percentage of past
net credit sales should provide a reliable measure. If a new percentage is adopted it will be applied
prospectively (from 2021-22 on) according to AASB 108 paragraph 36.

If the variance for 2020-21 was due to an error in calculation then, providing it is material, the figures
for 2020-21 should be retrospectively corrected (according to AASB 108 paragraph 42) by the
following entry:
$ $
Retained earnings (1 July 2021) Dr 26 000
Provision for Warranty Cr 26 000

Such a correction would suggest that the variance between the warranties that would have been provided
for had the error not occurred ($70,000) and the actual warranties incurred ($73,000) were not material
(i.e. only $3,000 or only 4%) which indicates that the revised level of warranty provision is appropriate.
Exercise 18.4

Events after the reporting period

In relation to the operations of Cat Ltd. The following events took place after the end of the
reporting period, 30 June 2019, but before the date the accounts were authorised, 15 September
2019.

(a) On 17 July 2019, Cat Ltd’s main fishing fleet was sunk during a freak storm. Insurance will
cover the replacement of the vessels but lost sales representing $550 000 in profits are not
covered.
(b) On 19 July 2019 Cat Ltd took delivery of a fishing net for its prawn trawler. The net was
purchased from a UK manufacturer on delivered duty paid shipping terms and was in
transit at the end of the reporting period. An inspection of the net revealed significant
structural flaws and the net was returned to the supplier on 28 July 2019. Cat Ltd is to
receive a full refund of the $650 000 purchase price which had been paid in advance on 29
June 2019.
(c) On 29 August 2019 a lawsuit was lodged against the company by the families of crew
members drowned in the 17 July storm, alleging negligence, and claiming $4 million in
damages. No date has as yet been set for the court hearing.
(d) On 1 September 2019 the directors resolved to issue to the public 10 000 5% debentures of
$10 each, payable $5 on application and $5 on allotment.

Required
Classify the above events into adjusting and non-adjusting events after the end of the reporting
period, justifying your choice. (LO6)

Classification of after reporting period events

Assuming all events are material by reason of size and nature:

Date Classification Justification

17 July 2019 Non-Adjusting The storm which caused the loss of the fishing fleet and the
uninsured loss of profits occurred after the end of the
reporting period and impacts on future conditions.

19 July 2019 Adjusting The receipt and subsequent return of the fishing net provides
new information about the assets owned by Cat Ltd as at the
end of the reporting period.

29 August 2019 Non-Adjusting The lawsuit arose as a consequence of an event after the end
of the reporting period (the storm on 17 July) and it may have
material effects on future cash flows or operations if the
company has to pay the $4 million damages claim.

1 September 2019 Non-Adjusting The issue of $100 000 5% debentures to the public does not
relate to conditions existing at the end of the reporting period
but will have a material impact on future cash flows.
Exercise 18.10

Accounting policies, accounting estimates and errors

In order to comply with AASB 108/IAS 8, determine whether the following changes should be
accounted for prospectively or retrospectively.

1. A change in accounting estimate.

2. A voluntary change in an accounting policy.
3. A change in accounting policy required by a new or revised accounting standard.
4. An immaterial error discovered in the current year, relating to a transaction recorded three
years ago.
5. In the current year, a material error was discovered relating to a transaction recorded three
years ago. Management determines that retrospective application would cause undue cost
and effort.
(LO1, LO2 and LO4)

1. Prospective.

2. Retrospective.

3. As required by the transitional provisions of that Standard; if not specified then retrospective.

4. The amount is immaterial and so may either be ignored or corrected in the current year.

5. Retrospective application is required unless impracticable to do so, but the definition of

impracticable does not include undue cost and effort (AASB 108 paragraph 5).