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Question 1: Accounting Treatment of TDM Ltd's Assets and Liabilities

Question 1:

TDM Ltd is a manufacturing business at Mudjimba on the Sunshine Coast. You are the accountant for the company and the following items/issues relate to the financial year ending 30th June, 2016:

  1. Photographs of the company’s founders and original buildings, which are of great sentimental and historical value only.
  2. TDM Ltd is being sued for negligence by Zero Ltd and the legal advice is that it is likely the company will losethe case in court.
  3. TDM Ltd is being sued for negligence by Badger Ltd and the legal advice is that it is likely the company will winthe case in court.
  4. Obsolete plant and equipment is now (as at 30 June 2016) retired from use by the company.
  5. TDM Ltd has received a donation of $20,000.

Required:

Explain how TDM Ltd should account for each of the above items. You must justify your answer by reference to the AASB Conceptual Framework’s definitions and recognition criteria for assets, liabilities, income and/or expenses as applicable. You must also state which General Ledger accounts are to be debited and credited.

On 1st July, 2016, SC Airlines Ltd acquired a new aeroplane for a total cost of $10 million dollars. The following breakdown of the costs to build the aeroplane was given by the manufacturers.

Aircraft body

$3,000,000

Engines (2)

$4,000,000

Fitting out of aircraft:

       Seats

$1,000,000

       Carpets

$ 50,000

Electrical equipment:

       Passenger seats

$ 200,000

       Cockpit

$1,500,000

Food preparation equipment

$ 250,000

All costs include installation and labour costs associated with the relevant part.

It is expected that the aircraft will be kept for 10 years and then sold. The main value of the aircraft at that stage will be the body and the engines. The expected selling price is $2.1 million, with the body and engines retaining the existing proportionate value.

Costs in relation to the aircraft over the next 10 years are expected to be as follows:

Aircraft body: This requires an inspection every 2 years for cracks and wear and tear, at a cost of $10,000.

Engines: Each engine has an expected life of 4 years before being sold for scrap. It is expected that the engines will be replaced in 2020 for $4.5 million and again in 2024 for $6 million. These engines are expected to incur annual maintenance costs of $300,000. The manufacturer has informed SC Airlines that a new prototype engine with an extra 10% capacity should be on the market in 2022, and that existing engines could be upgraded at a cost of $1 million.

Fittings: Seats are replaced every 3 years. Expected replacement costs are $1.2 million in 2019 and $1.5 million in 2025. The repair of torn seats and faulty mechanisms is expected to cost $100,000 per annum. Carpets are replaced every 5 years. They will be replaced in 2022 at an expected cost of $65,000, but will not be replaced again before the aircraft is sold in 2026. Cleaning costs amount to $10,000 per annum. The electrical equipment (such as the TV) for each seat has an annual repair cost of $15,000. It is expected that, with the improvements in technology, the equipment will be totally replaced in 2022 by substantially better equipment at a cost of $350,000. The electrical equipment in the cockpit is tested frequently at an expected annual cost of $250,000. Major upgrades to the equipment are expected every 2 years at expected costs of $250,000 (in 2015), $300,000 (in 2017), $345,000 (in 2019), and $410,000 (in 2024). The upgrades will take into effect the expected changes in technology.

Food preparation equipment: This incurs annual costs for repair and maintenance of $20,000. The equipment is expected to be totally replaced in 2022.

Required:

Start by establish the issues for your analysis by addressing the following:

    1. the advantages of a components approach versus a simple depreciation of the $10 million dollars over the 10-year period.
    2. Since AASB 116 requires initial recognition at cost and then provides a choice between either the cost model (impairment) or the revaluation model (increment and/or decrement) – discuss the advantages and/or disadvantages in applying either model to the aeroplane as a whole – indicating which would be the most appropriate as a result or if treated as components then which would be most applicable to the components you have identified.  
    3. Basis for selecting the method of depreciation according to AASB 116.

Discuss how the costs relating to the aircraft should be accounted for (treated) with respect to:

    1. Aircraft body;
    2. Engines;
    3. Fittings;
    4. Food preparation equipment.
    5. Where relevant consider/discuss issues such as:
    6. the treatment of the upgrades of cockpit equipment.
    7. accounting for inspections.

Determine the expenses to be recognised for the financial year 1stJuly 2016 to 30th June 2017.

    1. Aircraft body;
    2. Engines;
    3. Fittings;
    4. Food preparation equipment;
    5. Total Expenses.

In the discussion by Upton (2001, 71) regarding the lives of intangible assets it is noted that the formula for Coca-Cola has grown more valuable over time, not less, and that Sir David Tweedie, former chairman of the IASB, jokes that the brand name of his favourite Scotch whisky is older than the United States of America — and, in Sir David’s view, the formula for Scotch whisky has contributed more to the sum of human happiness.

Required:

Outline the accounting treatment for brands under AASB 138/IAS 38, and discuss the difficulties for standard setters in allowing the recognition of all brands and formulas on statements of financial position.

Provisions are recognised as a liability in the statement of financial position whereas contingent liabilities are not recognised in the financial statements but disclosed in the notes to financial statements. Paragraph 12 of AASB 137/IAS 37 Provisions, Contingent Liabilities and Contingent Assets states that ‘in a general sense, all provisions are contingent because they are uncertain in timing or amount’.

Required:

  1. Discuss possible reasons as to why provisions are recognised in the financial statements whilst contingent liabilities are not.
  2. Determine whether the following items would be classified and recoded as liabilities or not (provide a brief explanation for your decision):
    1. Provision for long-service-leave;
    2. Dividends payable;
    3. Preference shares.
Question 1: Accounting Treatment of TDM Ltd's Assets and Liabilities

TDM Ltd holds photographs of company’s founders and original buildings which are considered to be of historical value. As per the guidelines of conceptual framework prescribed by Australian Accounting Standard Board, asset is an item that an entity controls as the result of events happened in the past and from that item the entity expects to get economic benefits in future (AASB, 2015). The photographs can be regarded as asset because TDM Ltd controls them as a result of past events. If a monetary value could be assigned to these items, the entity should recognize them as asset in the books. The photographs should be recognized as non-current asset by debiting non-current asset account and crediting the asset revaluation account under shareholder’s equity (Dagwell, Wines, & Lambert, 2015).

In this case, there is legal suit pending against TDM Ltd and the probability in respect of this suit is that the company may lose. In the company loses the suit, it will have to pay compensation to the party. The conceptual framework defines liability as the present obligation of the entity that will result in an outflow of the economic resources. Further, the provisions of AASB 137 state that an entity should recognize provision in the books when the liability is to crystallize in future and the amount of liability is not finalized (AASB 137, 2010). Therefore, considering these provisions TDM Ltd should make provision for the amount that it will have to pay as compensation to Zero Ltd. The provision should be credited and profit and loss account should be debited.

The AASB 137 states that when it appears that the probability of outflow of economic resource is remote, the entity should recognize a contingent liability (AASB 137, 2010). In those situations present obligation can not be established and hence no liability (provision) can be recognized, but contingent liability should be shown in the notes to accounts without giving any effect the balance sheet or income statement. In this case, TDM Ltd is facing a law suit however it is assessed that the probability of wining the law suit is more than losing it. Thus, the company should recognize a contingent liability in notes to account.     

The retirement of obsolete plant would require the company to debit the accumulated depreciation and credit the plant and equipment account. Thus, the value of total assets is to be reduced by the book value of obsolete plant and equipment and the accumulated depreciation would be reduced from the liabilities side (Whittington & Delaney, 2007).

Accounting for receipt of donation would depend upon the circumstances of the case. In some cases, the donation received forms part of corpus of equity holders while in others it may be shown as liability or as reduction from particular asset if donation is attached to an asset. It would be required to debit the cash and credit the equity, liability account, or specific asset account (Epstein & Jermakowicz, 2008).

a)

The accounting principles generally require that the items of fixed assets are to be depreciated on an individual basis. Further, in special circumstances like aircraft, various parts or components of the item of fixed asset (aircraft) could be clubbed together for depreciation purposes (Benesh & Bryant, 2017). However, it is always prudential to depreciate the components or parts of an item of fixed asset like aircraft separately if the cost of a component is significant, its useful life differs from the aircraft as a whole and it can be used in isolation (separate from function of aircraft as a whole).

Question 2: Accounting Treatment of SC Airlines Ltd's Aircraft Costs

The primary advantage of applying component approach is that it results in increase in depreciation which provides tax savings to the company. Further, it is flexible to applying revaluation model in component depreciation approach because component wise fair values can be determined with more precision as compared to fair value of an item of fixed asset as a whole (Benesh & Bryant, 2017).

b)

As per the provisions contained in AASB 116, an item of property plant and equipment is to be recognized at cost when it considered for recognition in the books for the first time. Further, the standard permits an entity to adopt either the historical cost model or revaluation model to account for the fixed assets (AASB 116, 2010). The primary advantage of revaluation model is that it provides fair valuation of the asset and helps in presenting true financial picture. However, there are difficulties in applying the revaluation model. The biggest difficulty is faced in regards to determination of fair value of the items of fixed assets. In case SC Airlines Ltd depreciates the aircraft as a whole, it would be difficult to determine the fair value. Therefore, in such a situation, it is preferable to apply cost model.

However, in case the company follows component approach in depreciating the aircraft, it would be preferable to apply revaluation model. The fair value of components of aircraft such as engine, seats, carpets, etc. can be determined with ease (Cope, 2015).     

c)

The AASB 116 states that the method of depreciation should be such that reflects the pattern of economic benefits to be received from the use of asset. The depreciation is a charge against the profits of the business and it should match with the benefits derived from the use of asset. An entity could choose a method of depreciation such as straight line, reducing down value, production unit method or any other method (AASB 116, 2010).

Aircraft body

The cost of aircraft body is $3 million which can be considered to be significant looking at the overall cost of aircraft. Further, it is expected to be used for more than one accounting period; hence, the cost of aircraft body should be capitalized.   

Engines

The cost of engine is $4 million which is also significant looking at the overall cost of the aircraft. Further, the engine to be used for 4 years thus, the cost of engine should also be capitalized.

Fittings

The cost of fittings is $1.50 million and the fittings are expected to be used for more than one accounting. It is necessary to capitalize in the books.

Food preparation equipment

The company is expected to realize benefits from the use of food preparation equipment for more than one accounting period and hence the same should be capitalized.   

Treatment of the upgrades of cockpit equipment

The major upgrades to the cockpit equipment are expected to enhance the capacity of cockpit therefore it should be capitalized.

Accounting for inspections

The inspection is the routine part of activities and thus, the same should be charged to the statement of profit and loss account.

Question 3: Accounting Treatment for Brands under AASB 138/IAS38

Aircraft body

There would be a depreciation charge of $300,000 [($300,000-0)/10].

Engines

The depreciation expense to be charged to the statement of profit and loss would be $1,000,000 [($4,000,000-0)/4]

Fittings

The following expenses are to be charged to the profit and loss account:

Amount ($)

Depreciation on seat

(1,000,000-0)/3

  333,333.33

Repair and maintenance expense of seats

  100,000.00

Depreciation on carpet

(50,000-0)/5

    10,000.00

Cleaning cost

    10,000.00

Electric equipment repair

    15,000.00

Total

  468,333.33

Food preparation equipment

The depreciation expense would be $50,000 [(250000-0)/5] and repair and maintenance expense would be $20,000.

Total Expenses

The total expense for the year would be $1,838,333.33 (300000+1000000+468333.33+50000+20000)

AASB 138 contains the provisions related to recognition and measurement of intangible assets such as goodwill, trademark, copyright, brand and formulas. The provisions prescribe that the internally generated brand, formulas, and meatheads are not to be recognized in the books of accounts. This is because the expenditure incurred on generating brand value can not be separated from developing the business as a whole. However, an entity is allowed to recognize the brand if it was purchased from other entity. Lack of concrete measurement base for valuation of brand is the main issue that warrants non recognition of the brand (AASB 138, 2015).

The accounting standard setters face major problem in regards to valuation of brand value for recognition in the books of accounts. Since, the brand is an intangible asset therefore it can not be sold or bought in a definite market. The determination of fair value of brand on an arbitrary basis is difficult. Further, it is considered that brand can not generate economic benefit separate from other assets thus, recognition of brand as separate asset is not legitimate (Wasserman, 2015).

The provision reflects present obligation on the entity to pay while a contingent liability does not reflect such obligation (AASB 137, 2010). However, the liability in respect of provision depends upon happening or non-happening of a future event but it is probable that the outflow of economic resources would take place. On the other hand, in case of contingent liability the probability of outflow of economic resource remote or very low. Thus, it is the difference in probability of outflow of economic resource that separates a provision from contingent liability. When it is likely that the entity would end up paying compensation in regards to an item, a provision is recognized whereas when it is established beyond all doubts that entity would not be required to pay, a contingent liability is shown in notes to accounts (AASB 137, 2010).    

Provision for long service depicts a present obligation on the entity, thus, it is necessary to recognize it as liability in the books of accounts. The entity would be required to pay to the employees upon satisfaction of the conditions of leaves policy (Stickney et al., 2009).

b.)

The dividend when declared by the company in the annual general meeting creates obligation on the company to pay to the shareholders. Thus, it should be recognized as liability in the balance sheet by making adequate provision (Stickney et al., 2009).

c.)

The preference shares are issued to raise capital thus these can not be classified as liability. The preferences shares will form part of shareholder’s equity (Stickney et al., 2009).

Reference List:

AASB 137. 2010. Provisions, Contingent Liabilities and Contingent Assets. Retrieved June 10, 2017, from https://www.aasb.gov.au/admin/file/content105/c9/AASB137_07-04_COMPoct10_01-11.pdf

Stickney, C.P., Weil, R.L., Schipper, K., & Francis, J. 2009. Financial Accounting: An Introduction to Concepts, Methods and Uses. Cengage Learning.

Dagwell, R., Wines, G., & Lambert, C. 2015. Corporate Accounting in Australia. Pearson Higher Education AU.

Whittington, O.R. & Delaney, P.R. 2007. Wiley CPA Exam Review 2008: Auditing and Attestation. John Wiley & Sons.

AASB. 2015. Conceptual Framework for Financial Reporting. Retrieved June 10, 2017, from https://www.aasb.gov.au/admin/file/content105/c9/ACCED264_06-15.pdf

AASB 137. 2010. Provisions, Contingent Liabilities and Contingent Assets. Retrieved June 10, 2017, from https://www.aasb.gov.au/admin/file/content105/c9/AASB137_07-04_COMPoct10_01-11.pdf

AASB 116. 2010. Property plant and equipment. Retrieved June 10, 2017, from https://www.aasb.gov.au/admin/file/content102/c3/AASB116_07-04_ERDRjun10_07-09.pdf

Benesh, B.K. & Bryant, M.K. 2017. Depreciation Handbook. LexisNexis.

Cope, A.T. 2015. International Financial Statement Analysis. John Wiley & Sons.

AASB 138. 2015. Intangible assets. Retrieved June 10, 2017, from https://www.aasb.gov.au/admin/file/content105/c9/AASB138_08-15_COMPoct15_01-18.pdf

Wasserman, B. 2015. Valuation of Intangible Assets: Should Brand Equity Be Accounted for on the Balance Sheet? Retrieved June 10, 2017, from https://digitalcommons.uconn.edu/cgi/viewcontent.cgi?article=1448&context=srhonors_theses

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