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GDX Retail Ltd - Self-insurance against flood damage


GDX Retail Ltd operates two retail stores in Brisbane. GDX Retail Ltd owns the land and buildings for both retail stores which are located near the Brisbane river. Because the Brisbane river is prone to flooding, there has been a significant increase in recent years in the premiums for flood insurance. Because of the increased expense in obtaining flood insurance, GDX Retail Ltd has opted to not purchase flood insurance on its two buildings. Instead, GDX Retail Ltd intends to ‘self-insure’ against flood damage. GDX Retail Ltd can estimate reliably the statistical probability of the occurrence and amount of expected flood losses which are about $500,000 once every ten years. GDX Retail Ltd proposes to recognise a liability of $50,000 and related expense each year for the next ten years to reflect its expected loss. To justify this, GDX Retail Ltd argues that the flood loss is highly probable, the amount of the flood loss can be measured reliably, and if it had purchased flood insurance it would recognise an expense in each reporting period.

Able Ltd sells products on consignment from Baker Ltd. The products that are to be sold on consignment are transported from Baker Ltd’s (the consignor) warehouse to Able Ltd’s (the consignee) retail shop with the cost of transportation being paid by Baker Ltd. Ownership (legal title) of the products on consignment remains with Baker Ltd. Once Able Ltd sells the products, it remits the cash received from the customer (less a 10% commission) to Baker Ltd. The accountant for Able Ltd intends to include the products on consignment in Able Ltd’s inventory account which will be disclosed as a current asset in Able Ltd’s financial statements. The accountant’s justification for this is that ownership is not a necessary characteristic of an asset and that some items, for example, leased vehicles and machines, satisfy the definition of an asset even though the entity does not own them.

On 1 July 2018, Rickson Ltd paid $8 million to purchase ‘The Triumph of Death’ which was painted circa 1562 by the renowned Dutch artist Pieter Bruegel the Elder. Rickson Ltd considers the painting to be an investment as it is expected that the painting will appreciate in value over time. Currently, the painting is not on display and it is being kept in a secure art storage vault maintained by Axis Fine Art Installation Ltd. However, management of Rickson Ltd is considering a long-term loan of the painting to a reputable art gallery. The accountant of Rickson Ltd intends to include the painting as an asset in their financial statements.

On 1 February 2018, Wattle Ltd signed a contract with Cygnet Ltd to purchase an item of plant equipment for $500,000. The terms of the contract require Wattle Ltd to pay a non-refundable deposit of

$150,000 on 10 February 2018. It is expected that the plant equipment will be shipped in early April 2018 and legal title will transfer from Cygnet Ltd to Wattle Ltd on delivery of the plant equipment. Once the plant equipment has been delivered, Cygnet Ltd will invoice Wattle Ltd for the remaining $350,000. The accountant of Wattle Ltd intends to record the payment of the deposit on 10 February 2018 with a debit to the asset account ‘Plant equipment’ and a credit to the ‘Cash at bank’ account.

Able Ltd - Recognition of consignment sales as inventory

Use the AASB’s Framework for the Preparation and Presentation of Financial Statements to identify and apply the relevant requirements relating to the definitions and recognition criteria of the elements that comprise financial statements to each of the four scenarios. More specifically, you should address the following:

  • Scenario 1: Is it appropriate for GDX Retail Ltd to recognise the expense and liability for the flood insurance?
  • Scenario 2: Is it appropriate for the products on consignment to be recognised as an asset in Able Ltd’s financial statements?
  • Scenario 3: Is it appropriate for Rickson Ltd to recognise the painting as an asset in their financial statements?
  • Scenario 4: Is a journal entry necessary on 10 February 2018 and, if so, what account should be debited? 

Question 2

Celeste Ltd is a manufacturing company that manufactures a range of commercial electrical products. The time taken to manufacture products is, on average, five months after the necessary raw materials have been purchased. The finished goods then spend, on average, two months in inventory before they are sold. Sales are on credit and, once the sale is made, the average time taken to receive the cash from the customer is one month.

You have been asked to assist Celeste Ltd in preparing its financial statements for the year ending 30 June 2018 and the following information has been provided to you.

Celeste Ltd

Trial Balance extract

30 June 2018

Item

Debit

Credit

Notes

($’000)

($’000)

Cash and cash equivalents

$9,000

Inventories

15,000

1

Trade and other receivables

8,500

Property, Plant and Equipment

58,000

Investment properties

4,000

Lease receivable

5,000

2

Available-for-sale financial assets

5,500

3

Other financial assets

2,000

4

Intangible assets

13,000

Trade and other payables

$7,000

Borrowings

36,000

5

Provisions

5,000

6

Current tax liabilities

2,500

7

Deferred income

2,000

8

Retirement benefit obligation

7,000

9

Other financial liabilities

6,500

10

Other non-current liabilities

4,000

11

Share capital

30,000

Other components of equity

5,000

Retained Earnings

15,000

Total

120,000

120,000

Notes:

1. This comprises: $4,000 of raw materials inventory; $6,000 of work-in-process inventory; and $5,000 of finished goods inventory.

2. $2,000 will be received before 30 June 2019; the remainder will be received after 30 June 2019.

3. Management expects to sell these before 30 June 2019.

4. These are long-term and management does not expect to sell these before 30 June 2019.

5. $12,000 will be paid before 30 June 2019; the remainder will be paid after 30 June 2019.

6. $1,500 will be paid before 30 June 2019; the remainder will be paid after 30 June2019.

7. This is expected to be paid in October 2018.

8. This is expected to be earned before 31 December 2018.

9. This will be paid after 30 June 2019.

10.This is due to be repaid in November 2018. However, Celeste Ltd expects, and has the discretion, to refinance this obligation for at least twelve months after the reporting period under the existing loan facility.

11.This will be paid after 30 June 2019.

Required

1. Define ‘operating cycle’ and explain the importance of the operating cycle in the preparation of the Statement of financial position. What is Celeste Ltd’s operating cycle? 

2. Prepare the Statement of financial position for Celeste Ltd for the year ended 30 June 2018 in accordance with the requirements of AASB 101 Presentation of Financial Statements. Comparative figures for the preceding year (ending 30 June 2017) have been omitted.

Question 3

Fabulous Furniture Ltd operates a chain of retail stores across Australia that sells a wide range of inexpensive home furniture. Although most sales are for cash, a significant proportion are on credit.

Fabulous Furniture Ltd is currently preparing its financial statements for the year ended 30 June 2018. Note 1 to the financial statements identifies the principal accounting policies adopted by Fabulous Furniture Ltd. The following disclosure about trade receivables (which has not changed since Fabulous Furniture Ltd started offering credit sales eight years ago) will again be included in Note 1.

Since 1 July 2010, Fabulous Furniture Ltd has used the percentage of sales method to estimate the amount of the impairment loss (bad debts) recognised as an expense in profit or loss. With this method, an estimate is made, on the basis of past experience and other relevant factors such as changes in credit policy and general economic indicators, of the percentage of net credit sales that are likely to be written off as uncollectible. This percentage figure is then multiplied by net credit sales for the year to calculate the amount of the expense.

Since 30 June 2011, the percentage figure used by Fabulous Furniture Ltd has been unchanged at 5%. On 30 June 2017, an analysis revealed that actual bad debts written off over the past seven years were between 4.5% and 5.5% of net credit sales. On this basis, the impairment loss for the year ending 30 June 2017 was estimated to be $15,000 which was calculated as 5% of the net credit sales for the year of $300,000.

However, in the year ending 30 June 2018, the number of customers unable to pay their accounts increased significantly to $40,000 meaning that the balance in the allowance account (provision for impairment of trade receivables) as at 30 June 2017 was understated by $10,000.

Net credit sales for the year ending 30 June 2018 are $250,000.

The movements in the allowance for doubtful debts for the years ending 30 June 2017 and 2018 are:

  Year ending 30 June 2018

Year ending 30 June 2017

Balance at the beginning of the year 30000 $25,000
Provision for imapairment (bad debts) recognised during the year ? 15000
Receivables written off during the year uncollectable -40000 -10000
Balance at the end of the year ? 30000

Required

Interpret and apply the requirements of AASB 108 Accounting Policies, Changes in Accounting Estimates and Errors to each of the of the following independent scenarios to explain the appropriate accounting treatment:

The accountant decides to change the percentage used to estimate bad debts expense for the year ending 30 June 2018 from 5% of net credit sales to 6% of net credit sales. The accountant also intends to treat the understatement from the previous year as a prior-period error and correct this by adjusting the opening balance of Retained earnings.

The accountant decides to change the method used to calculate bad and doubtful debts from the percentage of credit sales method to the ageing of accounts receivable method.

An investigation by the accountant reveals that the provision recognised for the year ending 30 June 2017 ($15,000) was incorrectly calculated. Net credit sales for the year ending 30 June 2017 were $600,000 and not $300,000. The accountant decides to continue to use 5% of net credit sales to estimate bad debts expense for the year ending 30 June 2018. 

GDX Retail Ltd - Self-insurance against flood damage

According to the conceptual framework, an expense consists of losses and expenses that occur in the ordinary course of business activities in the enterprise(Tent, 2015). Losses on the other hand characterises items that meet the definition of the expenses and may or may not arise in the ordinary course of business activities( Dichev, 2017). Losses represents decrease in economic benefits and hence are similar to that of other  expenses. Losses comprise of those  items that result from natural disaster like fire and flood as well as those arising on the disposal of non current assets(Tent, 2015). When losses are recognised in the income statement, they are usually displayed separately because they having knowledge of this aspect is useful for the purpose of making financial decisions( Dichev, 2017).

In this case GDX retail has done its due diligence in estimating the degree of certainty of probable loss and measuring  the amount of flood loss reliably . Since flood is a common phenomenon in the area of business, it is very reasonable to assume that the cost of flood insurance forms a part of normal activities of the business .It is therefore construed to be an expense in the ordinary course of business activities. So it is appropriate for GDX retail to recognise the flood insurance as an expense and a liability.

According to the conceptual framework, an asset is recognised in the financial statement as soon as it is possible that the upcoming monetary benefits will flow to the entity and that it has a cost that can be measured dependably(Lo et al., 2017). It is  not recognised in the statement of financial position when the expenditure has been incurred for which the economic benefits will flow beyond the present accounting year(Khamis, 2016).

In this case Able Ltd can  recognise the goods sold on consignment basis as an asset  when he transfers control of his goods to Baker ltd. A product that has been brought to another party may be tied up in a consignment procedure if that other party has not attained control of the mentioned product(Khamis, 2016). Since the title of ownership has been legally transferred to Baker Ltd, the company. In a few of these contracts control is reassigned when the product is carried to the location of the customer or at the moment when that  product is shipped. This depends upon the terms of the contract(Lo et al., 2017). In this case the goods have been safely transported to the warehouse of Baker Ltd. Hence Able ltd is well within its rights to recognise the goods sold on consignment basis as an asset in his books.

According to the conceptual framework, an asset is  a resource measured by the entity due to which the economic benefits  are ecpected to flow to the entity in the future(Basnan et al., 2017). This definition identifies its crucial features but however do not certify the standards that are required  to be met previously  recognised in the statement of financial position. In particular, the most important criteria that needs to  be met is the probability that  upcoming economic benefits must flow to the entity before recognising it is an asset(Basnan et al., 2017).

Able Ltd - Recognition of consignment sales as inventory

The above painting is a collector’s item and a historical treasure. Rickson Ltd plans to use this artwork to donate to a reputable art gallery. Collection items  are mostly held for long periods of time and are rarely sold .They are categorized as assets and continue providing economic benefit  through their usage.( Ellwood & Greenwood, 2016).  If the collection item is properly capitalized , it can be recognized as an asset. Hence in this case Rickson Ltd can recognize the painting as an asset, as long as it properly capitalizes the gallery collections on a retrospective basis or a prospective basis.

A property , plant and equipment item  that has been recognised as an asset shall be measured at its cost. The cost compromises of its purchase price, plus import duties and non-refundable purchase taxes , minus discounts and rebates(Petrovic,  Manson & Coakley, 2016). The non-refundable deposit of $ 150,000  forms a part of the cost of the equipment and is hence incorporated in the total cost of the asset. The cost of this asset is the cash price, $ 500,000 which is inclusive of the security deposit paid earlier.

Since the cost of the asset is recognised as soon as the item is shipped, therefore a journal entry is required as soon as the cost of the asset is recognised(Swink & Schoenherr,2015). In the corresponding journal entry, plant and equipment will be debited by $500, 000 while the corresponding cash at bank would be credited by the same amount. The asset is created in the book sand is hence debited, while cash is used to acquire the asset which implies there is an outflow of cash, Hence cash is credited.

The operating cycle of an organization is the average lenghth of time period that is needed by a business to make a preliminary amount of cash for production processes, then selling it and receiving cash  in exchange for the goods that are being provided. This is suitable for assessing the extent of working capital that is useful in the preparation of financial statements. It focuses on the purchase and sell of assets(Michalski, 2016). It also helps the users of financial statements in seeing  what assets will be used and what liabilities will become due in the current year.

Operating cycle can also be determined by summing up raw material conversion period, finished goods conversion period and debtors collection period . In the case of Celeste Company, the  operating cycle is

Operating cycle- RMCP +FGCP +DCP

  • 5 + 2 + 1= 8 months    

Statement of Financial position of Celeste Ltd as on 30th June,2018

ASSETS

      $

Financial assets

Cash and cash equivalents

9000

Trade and other receivables

8500

Total Financial assets

17500

Non-financial assets

Property, plant and equipment

58000

Inventory

15000

Investment properties

4000

Intangible assets

13,000

Accrued lease income

5000

Accrued income for available for sale financial assets

5500

Accrued income for other financial assets

2000

Total non-financial assets

102500

Total assets

1,20,000

Liabilities

Payables

Suppliers

7000

Total payables

7000

Interest Bearing Liabilities

Outstanding Borrowings

36000

Outstanding Current tax liabilities

2,500

Outstanding deferred income

2000

Outstanding Retirement benefit obligation

7,000

Outstanding other financial liabilities

6500

Outstanding Other non-current liabilities

4000

Total interest bearing liabilities

58000

Provisions

Other

5000

Total provisions

5000

Total liabilities

70000

Net assets

50,000

Equity

Share capital

30,000

Other components of equity

5,000

Retained earnings

15000

Total equity

50,000

Accounting estimates are approximate values that is assigned by the management of a company to various accounting variables, whose measurement cannot be reliably measured, for example, determining useful life of an asset or measuring bad debts provision (Bauman & Shaw, 2014). A change in accounting estimate makes changes in current and future periods only and not in past periods. The changes are either definite or variable in nature. The nature of accounting information is reliable when it is definite(Bauman & Shaw, 2014). However only passage of time can prove whether the changes in accounting estimates are definite or not. More often than not a balance is needed to be maintained between relevance and reliability.

Rickson Ltd - Inclusion of painting as an asset

  In the following scenario, the accountant wants to change the percentage of accounting estimate of estimating bad debts from five per cent to six per cent of net credit sales and also wants to make this understatement  from the previous year  as a prior period error and correct this by adjusting the opening balance of retained earnings. He can change the accounting estimate from five per cent to six per cent , if he feels it better warrants a more reliable and relevant data. However he cannot adjust the item as a prior period error because the change in estimate only incorporates that changes can be made to present and future periods, and not in past periods.

A change in accounting policy makes the financial statements reliable and relevant. The entity shall incorporate such a change in accounting policy that results from the preliminary application of an Australian Accounting Standard in agreement with the precise transitional provisions, if any (Christensen et al.,2015).

In this case the accountant decides to change the calculation of bad and doubtful debts estimate from a more traditional percentage of credit sales method to a less followed ageing of accounts receivable method. This involves a change in accounting policy(Christensen et al.,2015). The percentage of credit sales method estimates the amount of uncollectible amounts from the credit sales of a given period where the amount of bad debts expense is equal to net credit sales multiplied by the percentage estimated as uncollectable. The ageing off accounts receivable method involves classifying accounts receivable based on age , which actually gives a better basis for estimating the total amount of uncollected accounts. It considers experience as h basis by which they estimate how much of the accounts receivable would be uncollectible. This is a better basis of calculating total amount of bad and doubtful debts as it provides a better and more reliable display of financial information.

Errors can take place in reverence of recognising or measurement of elements of financial statements. Material errors, that is errors of significant amounts need to be corrected before the financial statements make its way to the public(Chan & Vasarhelyi, 2018). However material errors are not found out until the following period . These prior period errors need to be adjusted. An entity needs to  retrospectively adjust the material errors  in the financial statements(Chan & Vasarhelyi, 2018).

In this case the accountant made a material error in calculating the provision of bad debts. Instead of calculating the provision of bad debts on the amount of $ 600,000 , it is calculating the amount on  $ 300,000.It has understated the amount of provision of bad and doubtful debts. It needs to retrospectively correct this error in the end of the financial year 2018 to account for the material difference by restating the  balance of credit sales for the earliest prior period presented.

References:

Basnan, N., Salleh, M. F. M., Ahmad, A., Harun, A. M., & Upawi, I. (2017). Challenges in accounting for heritage assets and the way forward: Towards implementing accrual accounting in Malaysia. Geografia-Malaysian Journal of Society and Space, 11(11).

Bauman, M. P., & Shaw, K. W. (2014). An analysis of critical accounting estimate disclosures of pension assumptions. Accounting Horizons, 28(4), 819-845.

Chan, D. Y., & Vasarhelyi, M. A. (2018). Innovation and practice of continuous auditing. In Continuous Auditing: Theory and Application (pp. 271-283). Emerald Publishing Limited.

Christensen, H. B., Lee, E., Walker, M., & Zeng, C. (2015). Incentives or standards: What determines accounting quality changes around IFRS adoption?. European Accounting Review, 24(1), 31-61.

Dichev, I. D. (2017). On the conceptual foundations of financial reporting. Accounting and Business Research, 47(6), 617-632.

Ellwood, S., & Greenwood, M. (2016). Accounting for heritage assets: Does measuring economic value ‘kill the cat’?. Critical Perspectives on Accounting, 38, 1-13.

Khamis, A. M. (2016). Perception of Preparers and Auditors on New Revenue Recognition Standard (IFRS 15): Evidence From Egypt. Jurnal Dinamika Akuntansi dan Bisnis, 3(2), 1-18.

Lo, K., Fisher, G., Tsang, D., & Trottier, K. (2017). Intermediate Accounting. Pearson Canada Incorporated.

Michalski, G. (2016). Full operating cycle influence on the food and beverages processing firms characteristics. Agricultural Economics/Zemedelska Ekonomika, 62(2).

Petrovic, N., Manson, S., & Coakley, J. (2016). Changes in Non?current Assets and in Property, Plant and Equipment and Future Stock Returns: The UK Evidence. Journal of Business Finance & Accounting, 43(9-10), 1142-1196.

Swink, M., & Schoenherr, T. (2015). The effects of cross?functional integration on profitability, process efficiency, and asset productivity. Journal of Business Logistics, 36(1), 69-87.

Tent, S. I. (2015). Revenue Recognition–Milestone Method (Topic 605) 2010 Amendment: From the R&D Industry Perspective.

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