Accounting and Decision Making Seminar exercise accounting principles

Week 2

Listed below are a range of different situations where the treatment of the item in the accounts might OR might not comply with GAAP or the IASB conceptual framework. See cheat notes at end of exercise as a reminder of key GAAP and IASB points. In each case, explain whether you believe (i) (ii) the issue has breached GAAP or the IASBs Conceptual Framework, stating the principle(s) or concept(s) most relevant to the situation described; and describe what action you would recommend to correct any errors, if required. Principle/concept/proposal
This is OK if the loan of the lorry was for a short period of time. However, if it was longer term, recognition should be made in the accounts. The lorry meets the classification of an asset (right to control, measurable amount, past event) and could be included in non-current assets at 15,000. If this is done, then the company would need to show a MATCHING loan to the sister company for 15,000. The FACT at 31st December was that the HISTORIC COST of the factory was 750,000, so the accounts are correct. However, immediately after year end there was a fire and this value is now under threat. More seriously, the manufacturing facility is damaged, and will take over 6 months before it is fully operational again. This could have a substantial negative impact on the companys Income Statement for the following year. So the information IS RELEVANT to the reader, and needs to be DISCLOSED. The accounts would not be COMPLETE without a detailed note to the accounts explaining the problems. The proper name for something like this is post balance sheet event. This is OK. The company has applied a MATCHING policy to show the gradual wear and tear on the computer over the 4 years of ownership. The FACT was that the HISTORIC COST of the inventory was 1,500. We should record assets at the lower of historic cost or realisable value. So it is not TRUE to include a valuation of 2,000 on the stock just because that was the normal price.

Issue
Company was given a lorry on loan from a sister company. The estimated market value of the lorry is 15,000. Company has not recorded any value for the lorry in the year end accounts. Company invested 750,000 in a brand new factory two years ago to manufacture its products. The financial year end is 31 st December and the factory was recorded in the books at historic cost of 750,000. On 28 th January there was a terrible fire and over 60% of the factory was destroyed. The companys insurance company has offered to pay for repairs but it is likely to take 6 months before it is fully operational again. The company is not sure how to deal with this issue in terms of reporting. Company bought a computer for 2,000. It estimates that it will last 4 years and be scrapped (for no money) at the end of that time. An amount of 500 has been included as depreciation in the accounts for the year. Company bought stock (inventory) in bulk at a big discount - 1,500 compared to the normal amount which would have been 2,000. The sales value of the stock is 3,000. Goods have been included in inventory at the normal purchase cost of 2,000.

Company sold some goods to a customer for 23,700. It has received 10,000 and the balance of 13,700 is shown in the SOFP as a receivable. The customer has now appointed liquidators (bankruptcy). The company has included the remaining 13,700 balance showing in its receivables at year end. Company has presented its SOFP in the following format: Current assets Current liabilities Non-current assets Total xx (xx) xx xx

This is a POTENTIAL overstatement of the asset value. We have reason to believe that the REALISABLE VALUE of the receivable is lower than the amounts shown in the accounts. Therefore to take a PRUDENT approach, since the company has gone into liquidation, would be to provide in full against the 13,700 as a potential bad debt. This is OK, permissible under the standards. However, one might question how USEFUL and easy to UNDERSTAND the layout is, depending on the circumstances of the company.

Non-current liabilities xx Equity share capital xx Reserves xx Total xx Company has just won a court case against a competitor. Last year the legal costs of fighting the case were 150,000, and were shown as legal expenses in the Income Statement. This year the company was awarded 75,000 in damages. Legal costs were shown as nil and the receipt of 75,000 damages was netted off (i.e. reduced the balance of) the total of 250,000 administration costs in the Income Statement.

Company just completed a full stock take and recorded the value of finished goods inventory at 2,450,780. Some months after the SOFP was prepared, a mistake was found and the stock value should have been 2,460,780. No change was made to the SOFP to reflect this new information. Company has recorded total costs of 12,000 for December, but invoices have not yet been received from all freelance workers for their December hours, estimated to be as much as 4,000. Accounts have been prepared for the year end including costs of 12,000 for December.

The FACTS are correct the company spent 150,000 last year, and received 75,000 this year. However, there is a CONSISTENCY problem with the presentation of the numbers. To reduce administration costs by the income of 75,000 shows administration costs as lower than they really are. Where total administration costs are only 250,000 in the first place, to show it as 175,000 represents a MATERIAL change in the implied level of costs under this category. It would be better and more COMPARABLE with prior years to show the 75,000 as a line item Other Income in the Income Statement, and to leave administration costs at 250,000. Technically the SOFP should include the correct figures, 10,000 more than currently shown. An increase in closing stock will increase profit for the year, so the company will also be showing 10,000 less profit that it actually achieved. However, in this instance, as the mistake was found quite late, you would argue that the MATERIALITY of the change is probably not worth worrying about - 10,000 as a % of 2,450,780 is less than % - the rule of thumb on materiality is 5%. Ensure the mistake is corrected in the next set of accounts Under the ACCRUALS principle, costs should be recorded in the accounts when they occur, not when cash is paid. A provision of 4,000 (this being the best guess of the relevant costs) should be included in the December costs to FAITHFULLY REPRESENT the cost of the company doing business in December.

Company has signed a two-year deal to licence a product range from an overseas manufacturer. The costs of negotiating the licence were 34,000 and the deal required a signing-on fee of 16,000, payable to the manufacturer. The company has included the total cost of in noncurrent assets under the heading intangible assets licences. Company is handling a long-term supply contract for electrical installation at an airport. Total contract value 135,000. Total cost of sales 105,000. The contract will last 3 years, with expected sales 50,000, 50,000 and 35,000. At the end of the first year the company has invoiced 60,000 because it is ahead of schedule. Costs recorded on the ledger total 35,000 but this is thought to be because some subcontractors havent charged in full yet. The contract manager believes he should be able to do the whole job for 100,000, saving 5,000 on the original forecast and wants to leave 35,000 as the costs for the year. The accountant says this is wrong and it would be more prudent to allow the equivalent proportion of costs (60,000/135,000 x 105,000) as a provision for the year, so that any profit can be shown at the end of the contract. What would you do? Company received a payment of 8,000 from a customer to book a holiday 3 months from now. Company has shown cash of 8,000 in the bank account as a current asset, but also an 8,000 balance in customer deposits as a current liability. Last year the company showed tools & consumables as inventory because they are fairly small items and tend to be renewed every year. After a review this year, where he noticed that most tools did in fact cost over 100 each but that many of the items supposed to be in stock were actually broken or no longer held, the accountant was worried inventory values were overstated so he moved the tools & consumables to noncurrent assets under the heading tools and equipment and depreciated them by 33% (3 years)

This is OK: the situation meets the criteria for recognition of an asset (monetary value, expected future benefit, as a result of past deal etc). However, company must follow the ACCRUALS accounting principle and depreciates the cost by 50% each year, so that its written down to NIL value by the end of Year 2. Under the MATCHING principle, revenues should be matched with RELEVANT costs. It would seem that 35,000 is not COMPLETE and is not the matching set of costs against the 60,000 revenue. The accountants suggestion is a PRUDENT one, matching expected costs and revenues. In taking the view that the possible 5,000 might not be saved, he is perhaps being a little too cautious. However, in his defence, there are two more years for the project to run, so it would be too early to make a judgement on a potential increase in profit until further into the project. On balance therefore, the accountant is correct.

This is correct. The company has received money in advance of providing a service, so it would not FAITHFULLY REPRESENT the situation to show it as owned by the company. It is correct to show a MATCHING liability until such time as the service is delivered. First, the DISCLOSURE of this item has not been CONSISTENT or COMPARABLE. Secondly, unless regular provisions are made against breakages, the inventory value at historic cost will exceed the realisable value of the remaining tools. It might be argued that a more RELEVANT category for this item would be an a expense category in the Income Statement small tools and consumables If the accountant insists they should remain as non-current assets, there is evidence that the lifespan of these tools is a year, not the 3 years given by the accountant in his depreciation calculations. So to be PRUDENT they should be depreciated in full over 1 year.

An employee is suing the company for unfair dismissal. The lawyers advising the company have said she has a 60% chance of winning her case and estimate the potential damages payable at 50,000. No provision is included in the year end accounts.

Company has been in existence since 1926 and sells products under a well known brand name. The CEO argues that the brand name has a value and should be recognised as an intangible asset. He suggests a value of 3m, as a rough estimate of what it might be worth. He says the accounts should include a non-current intangible asset of 3m.

A reputable firm of lawyers is saying that the company has a 60% chance of having to pay this money, so it is not COMPLETE or a FAITHFUL REPRESENTATION of the TRUE situation to ignore this in the accounts. The company should make a provision for an appropriate amount in the year end accounts. This would be shown as a LIABILITY (provisions). It is a matter of judgement whether the company allows a full 60,000 or another figure, but any alternative figure would need to be supported by a strong justification. This is not a NEUTRAL position, and there is no CONFIRMATORY value available for the brand name which can be included in the accounts. It is also very difficult to measure the monetary value of the brand so one of the KEY CRITERIA FOR RECOGNITION OF AN ASSET has not been met: the CEO has just picked a 3m figure out of the air. Some companies DO include a valuation on their brand names in their accounts, but this is either where they have acquired them in which case the cost of purchase is used as a guide, OR where an independent valuation has been carried out by an independent professional consultancy. Even then, it is a questionable practice.

GAAP key principles

IASB Conceptual
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Framework