Issues in financial accounting (15/e): Part 2

Part 2 ebook “Issues in financial accounting” has contents: the statement of comprehensive income and further financial reporting issues, industry accounting standards, international accounting, accounting and the community.

The statement of comprehensive income

and further financial

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LEARNING OBJECTIVES

After studying this chapter you should be able to:

1 understand different approaches to profit measurement;

2 understand the approach adopted in Australia;

3 apply the requirements for the preparation of a statement of comprehensive income in AASB 101 ‘Presentation of

Financial Statements’;

4 apply the requirements of AASB 118 ‘Revenue’ for the recognition and measurement of revenue in the statement of

comprehensive income;

5 calculate interest revenue using the effective interest method;

6 apply the requirements of AASB 101 ‘Presentation of Financial Statements’ for the classification of expenses; and

7 understand the required treatment of unusual items in AASB 101 ‘Presentation of Financial Statements’

16.3.3 Classification of expenses16.3.4 Unusual items

16.1 Introduction

The statement of profit or loss and other comprehensive income is one of four financial statements

that comprise the components of a complete set of financial statements (AASB 101, para 10)

The other three are the statement of financial position, the statement of changes in equity and the

statement of cash flows, discussed in Chapters 6, 15 and 17, respectively In Australia, the financial

statement that reports the profit or loss for a reporting period was originally called the ‘profit

and loss statement’ However, over the years, other titles have been employed, including the

‘statement of financial performance’ and the ‘income statement’ As part of the process of issuing

Australian Accounting Standards equivalent to the International Accounting Standards Board (IASB)

Accounting Standards, the AASB has issued AASB 101 ‘Presentation of Financial Statements’ In the

most recent version of the Standard, the title of the performance statement is ‘statement of profit or

loss and other comprehensive income’ However, paragraph 10 of AASB 101 provides that ‘an entity

may use titles for the statements other than those used in this Standard For example, an entity may

use the title ‘statement of comprehensive income’ instead of ‘statement of profit or loss and other

comprehensive income’ As a result of the choice allowed in paragraph 10, we have chosen to use

the title ‘statement of comprehensive income’ because of its relative brevity Note, however, that both

the titles referred to in paragraph 10, like a number of their predecessors, remain inconsistent with

the title used in the Corporations Act 2001 – ‘the profit and loss statement’.

This chapter discusses the form and content of the statement of comprehensive income It reviews

the background to the statement and considers the requirements of the accounting standards that

affect it

16.2 Measurement of profit

There is little doubt that many financial statement preparers and users regard the statement of

comprehensive income as the most important of the four financial statements Profit is the overriding

goal of business entities and it is the reported profit figure that generally attracts the most attention

It is hardly surprising, therefore, that accounting standard setters have tended to concentrate

their attention on improving the measurement and reporting of profit In many cases, however,

these ‘improvements’ have been achieved at the expense of the statement of financial position For

example, tax-effect accounting was originally introduced to give a more relevant profit figure, but it

resulted in statement of financial position items of doubtful validity

Traditionally, profit measurement has been a process of matching the revenues for a period with

the expenses incurred in earning those revenues Revenues for a period were identified, the expenses

incurred in generating those revenues were then identified and the two were matched to measure

profit This characterisation is no longer appropriate, for the following reasons

1 Changes in the categorisation and labelling of financial statement elements The Conceptual

Framework for Financial Reporting 2010 (Framework 2010) identifies the two financial

statement elements related to the measurement of profit as income and expenses This is more

than a simple change in labelling, as Framework 2010 notes that both income and expenses

consist of two components Income is made up of revenues and gains Revenues arise in the

course of the ordinary activities of the entity, whereas gains may be within or outside the

ordinary activities of the entity and are often reported net of related expenses For example,

statement of profit

or loss and other comprehensive income

A financial statement that reports all components of income and expense recognised during a reporting period.

revenue

A component

of income that represents the gross inflow of economic benefits during the period arising in the course of the ordinary activities of an entity.

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when property is disposed of, if the proceeds of sale exceed the carrying amount of the property, the net difference would be recognised as ‘gain on disposal of property’ Likewise,

expenses consist of expenses and losses Expenses arise in the course of the ordinary activities

of the entity, whereas losses may be within or outside the ordinary activities of the entity and are often reported net of related income Framework 2010 notes that ‘distinguishing between items of income and expense and combining them in different ways also permits several measures of entity performance to be displayed These have different degrees of inclusiveness’

(para 4.28)

2 Reduced emphasis on matching With the development and adoption of Framework 2010, less

reliance is placed on matching as a basis for periodic profit measurement Instead, accounting problems relating to the measurement of profit are resolved by reference to the definitions

of, and recognition criteria for, income and expenses Framework 2010 does not require

an association of particular expenses with particular items of income Periodic income and expenses are identified and recognised independently Profit is then measured as the difference between the income and expenses for the reporting period

Accounting standards have used several different approaches to the definition and measurement

of profit and hence to the content of the statement of comprehensive income This raises the issue of how we should evaluate possible approaches to periodic profit measurement According

to SAC 2 ‘Objective of General Purpose Financial Reporting’, the objective of general purpose

financial statements is to ‘provide information useful to users for making and evaluating decisions about the allocation of scarce resources’ (para 43) Framework 2010 outlines two fundamental qualitative characteristics (para QC5) that make information useful to users – relevance and faithful representation – and four enhancing qualitative characteristic (para QC19) that enhance the usefulness of information that is relevant and faithfully represented – comparability, verifiability, timeliness and understandability We use these characteristics to assess three possible approaches

to measuring periodic profit – the operating-profit approach, the all-inclusive approach and the comprehensive income approach

Under the operating-profit approach , profit is measured as income from operations minus

expenses from operations Profit is the result of ‘ordinary’ operations for the reporting period This approach excludes income and expenses that relate to prior periods (such as corrections of prior-period errors or revisions to accounting estimates) and those resulting from events outside ‘ordinary’

operations, such as the effects of extraordinary transactions and events, and changes in accounting policy Non-operating items bypass the statement of comprehensive income and are reported in the statement of changes in equity (see section 15.3)

The operating-profit approach is supported by arguments that report users require a profit figure that can be used as a basis for predicting future profits – that is, the most relevant measure

of profit focuses on income and expenses that are related to the ordinary operations of the reporting period and are likely to recur The inclusion of other income and expenses could distort the results of ordinary operations, which are the ‘best’ basis for assessing the current period’s performance and predicting future performance Furthermore, it is argued that the inclusion of items that are outside ordinary operations in the measurement of profit may destroy the utility of inter-period and inter-firm comparisons The inclusion of these other items could materially affect the results of some entities in some periods, making inter-period and inter-firm comparisons difficult

Against the operating-profit approach it is argued that allowing many items to bypass the

statement of comprehensive income may lead to profit manipulation and profit ‘smoothing’ For

example, management may have incentives to classify some income items as within opera tions

(operating) but some expense items as outside of operations (non-operating), with a resulting

overstatement of reported profit If the distinction between ‘operating’ and ‘non-operating’ is vague,

then reported operating profit could be manipulated in any year or smoothed over time by the

judicious classification of income and expense items The operating-profit approach arguably results

in information that is not a faithful representation of the transaction

It has also been asserted that non-operating expenses are, over several years, likely to exceed

non-operating income If this is correct, even with no deliberate manipulation, reported profits

would be consistently higher from the use of the operating-profit approach

Under the all-inclusive approach , profit for the period is measured as the result of ordinary

operations plus income and expenses relating to prior periods, the effects of some accounting

policy changes and the result of extraordinary transactions and events The all-inclusive approach

is broader than the operating-profit approach, but still allows certain items to bypass the statement

of comprehensive income For example, upward asset revaluations arguably satisfy the definition

and recognition criteria for income but bypass the statement of comprehensive income and are

recognised in the statement of changes in equity The all-inclusive approach is supported on

several grounds

The all-inclusive approach restricts opportunities for profit manipulation and/or profit

smoothing because, compared to the operating-profit approach, fewer items bypass the statement of

comprehensive income Hence, this approach arguably produces more relevant information An

all-inclusive statement of comprehensive income is easier to prepare because it avoids the need for an

accountant to exercise judgement in deciding whether an item is ‘operating’ or ‘non-operating’ In

some cases, the need to make a choice between operating and non-operating income and expenses

may lead to disputes among management, accountants, auditors and regulators If allitems for a

reporting period are included in the calculation of profit, this classification difficulty is avoided

Against the all-inclusive approach, it is argued that some items still bypass the statement of

comprehensive income, indicating that the potential for profit manipulation still exists Further, in

an effort to increase comparability, the all-inclusive approach may result in the labelling of certain

included items as extraordinary or unusual This process may also be open to manipulation

Under the comprehensive income approach,1 profit for the period includes allincome and

expenses as defined in Framework 2010 Allchanges in net assets or equity, other than transactions

with owners, are included in the measurement of profit The comprehensive income approach

requires that all recognised changes in the carrying amount of assets and liabilities be included

in the measurement of profit Under the comprehensive income approach, no income or expense

items bypass the statement of comprehensive income The comprehensive income approach

has some benefits First, the contents of the statement of comprehensive income are determined

conceptually, not arbitrarily Second, no items that satisfy the definition and recognition criteria for

income or expenses bypass the statement of comprehensive income Taken together, this reduces

the potential for manipulation and bias in reporting periodic profit, and may result in a more faithful

representation of the information

The problem with this approach is that many income and expense items included in the

statement of comprehensive income may arise from non-operating activities – that is, activities that

all-inclusive approach

An approach to periodic profit measurement in which profit for the period is measured

as the result of ordinary operations plus income and expenses relating

to prior periods, the effects of some accounting policy changes and the result of extraordinary transactions and events.

comprehensive income approach

An approach to periodic profit measurement in which profit for the period includes all income and expenses as defined

in Framework 2010 All changes in net assets or equity, other than transactions with owners, are included

in the measurement

of profit.

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are unusual and outside the entity’s ordinary activities and hence do not provide a good basis for predicting future profits A further problem is that some items of income and expense included in comprehensive income, such as non-current asset revaluation increments and decrements, may not yet be confirmed by an arm’s-length transaction between independent parties This may result in a profit figure of lower verifiability under the comprehensive income approach

The comprehensive income approach is consistent with Framework 2010 definitions of the elements of financial statements, but its use in practice is relatively recent In June 1997 the Financial

Accounting Standards Board (FASB) in the US issued Statement of Financial Accounting Standards

No 130 (SFAS 130) ‘Reporting Comprehensive Income’ The Standard requires the disclosure of

all components of comprehensive income As a result, US companies have to disclose two profit figures First is the profit or loss after tax, as would be calculated and displayed after applying allother accounting standards Second is the comprehensive income figure, which includes income and expenses that have previously bypassed the calculation of profit or loss after tax and have been taken directly to equity

As we outline in section 16.3.1, the current accounting standard governing the preparation

of the performance statement (AASB 101) adopts the title ‘statement of profit or loss and other

comprehensive income’, which seems to clearly indicate adoption of a comprehensive income

approach AASB 101 contains provisions similar to those of SFAS 130 in that items of other

comprehensive income, such as changes in asset revaluation surplus, remeasurement of defined benefit superannuation plans, and gains and losses arising from translating the financial statements

of a foreign operation are included in the statement of comprehensive income and the reported total comprehensive income for the period In the past, under operating-profit or all-inclusive approaches, such items would have bypassed the performance statement Further evidence in support of the use

of a comprehensive income approach is that AASB 101 forbids use of the term ‘extraordinary’ to

describe items of income or expense that arise outside ordinary activities (para 87)

Despite the apparent adoption of the comprehensive income approach, some issues and

uncertainties remain AASB 101 endorses the provisions of AASB 108 ‘Accounting Policies, Changes

in Accounting Estimates and Errors’ for the retrospective treatment of the effects of errors and changes in accounting policies The income and expense effects of such items are to be included in the statement of changes in equity and bypass the statement of comprehensive income This seems

inconsistent with the comprehensive income approach in which the effects of all recognised changes

in net assets (other than transactions with owners as owners) are to be included in the statement of comprehensive income This treatment is apparently justified by the definition of total comprehensive

income in AASB 101 as ‘the change in equity during a period resulting from transactions and other

events, other than those changes resulting from transactions with owners in their capacity as owners’

(para 7, emphasis added) As the income and expense effects of errors and changes in accounting policies relate to earlier periods, they are not part of total comprehensive income of this period (as defined in the Standard) Nevertheless, such prior-period effects are, arguably, part of comprehensive income in the comprehensive income approach outlined earlier in this section

A further uncertainty is that AASB 101 currently allows preparers the option of preparing a

single statement of comprehensive income or preparing two statements – a statement displaying components of profit or loss for the period, and a statement displaying components of other comprehensive income This second option seems somewhat inconsistent with a comprehensive

income approach However, if the proposals contained in the IASB Discussion Paper ‘Preliminary

Views on Financial Statement Presentation’ issued in October 2008 are adopted, this second

option will be removed The Discussion Paper proposes fundamental changes in the presentation of

published financial statements in that the structure of each of the statements of financial position,

comprehensive income and cash flows will be aligned so that they contain the same categories,

line items and order of presentation The Discussion Paper proposes the presentation of a single

statement of comprehensive income that would include a subtotal for profit or loss and a total for

comprehensive income It is for this reason that the analysis of Australian Accounting Standards

on the performance statement in section 16.3.1 concentrates on the option of presenting a single

statement of comprehensive income

The measurement of total comprehensive income can be summarised as follows:

Statement of comprehensive income

Income

Less: Expenses

= Profit or loss for the period

+/– Items of other comprehensive income

= Total comprehensive income for the period

16.3 Accounting standards

16.3.1 The form and content of the performance statement

The form and content of the performance statement is specified in AASB 101, the most recent version

of which is compiled to September 2011 and applies to reporting periods commencing on or after

1 July 2012 but before 1 January 2013.2 Paragraph 10A provides an option for an entity to either:

◆ present a single statement of comprehensive income with profit or loss and other

comprehensive income presented in two sections, where profit or loss is presented first

followed by components of other comprehensive income; or

◆ present the profit or loss section in a separate statement of profit or loss to be followed by a

statement of comprehensive income which shall begin with profit or loss

The approach to profit measurement adopted in AASB 101 is indicated in paragraph 88, which

requires that ‘an entity shall recognise all items of income and expense in a period in profit or loss

unless an Australian Accounting Standard requires or permits otherwise’ Paragraph 89 identifies

correction of prior-period errors and the effects of changes in accounting policies as two circumstances

in which particular items are recognised outside profit or loss in the current period (AASB 108) This

paragraph also refers to components of other comprehensive income that meet Framework 2010

definitions of income and expense but are required by other Australian Accounting Standards to

be excluded from profit or loss Paragraph 87 prohibits the presentation of any item of income or

expense in the statement of comprehensive income as an extraordinary item

AASB 101 also specifies the information that must be contained in the statement of

compre-hensive income

Paragraph 81B states that an entity shall present the following items, in addition to the profit or

loss and other comprehensive income sections, as allocation of profit or loss and other comprehensive

income for the period:

Apply the requirements for the preparation

of a statement of comprehensive income in

AASB 101

‘Presentation

of Financial Statements’.

LEARNING OBJECTIVE 3

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(a) profit or loss for the period attributable to:

(i) non-controlling interest, and (ii) owners of the parent.

(b) comprehensive income for the period attributable to:

(i) non-controlling interest, and (ii) owners of the parent.

If an entity presents profit or loss in a separate statement it shall present (a) in that statement

Paragraph 82 states that, in addition to items required by other Australian Accounting Standards, the profit or loss section shall include line items that present the following amounts for the period:

(a) revenue;

(aa) gains and losses arising from the recognition of financial assets measured at amortised cost;

(b) finance costs;

(c) share of the profit or loss of associates and joint ventures accounted for using the equity method;

(ca) if a financial asset is reclassified so that it is measured at fair value, any gain or loss arising from a difference between the previous carrying amount and its fair value at the reclassification date (as

defined in AASB 9);

(d) tax expense;

(e) [deleted by the IASB];

(ea) a single amount for the total discontinued operations (see AASB 5);

(f) – (i) [deleted by the IASB].

Paragraph 82A goes on to indicate the information to be presented in the other comprehensive income section and states that an entity ‘shall present line items for amounts of other comprehensive income in the period, classified by nature (including share of the other comprehensive income of associates and joint ventures accounted for using the equity method) and grouped into those that,

in accordance with other Australian Accounting Standards:

(a) will not be reclassified subsequently to profit or loss; and(b) will be reclassified subsequently to profit or loss when specific conditions are met.’

A simplified example of how a statement of comprehensive income might appear under

AASB 101 is shown opposite.

The item ‘other comprehensive income’ requires explanation Paragraph 7 of AASB 101 defines

it as follows:

Other comprehensive income comprises items of income and expense (including reclassification

adjustments) that are not recognised in profit or loss as required or permitted by other Australian Accounting Standards

The components of other comprehensive income include:

(a) changes in revaluation surplus (see AASB 116 ‘Property, Plant and Equipment’ and AASB 138

‘Intangible Assets’);

(b) remeasurement of defined benefit plans (see AASB 119 ‘Employee Benefits’);

(c) gains and losses arising from translating the financial statements of a foreign operation (see

AASB 121 ‘The Effects of Changes in Foreign Exchange Rates’);

(d) gains and losses from investments in equity instruments measured at fair value through other

comprehensive income in accordance with paragraph 5.7.5 of AASB 9 ‘Financial Instruments’

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(e) the effective portion of gains and losses on hedging instruments in a cash flow hedge (see AASB 9

‘Financial Instruments’); and

(f) for particular liabilities designated as at fair value through profit or loss, the amount of the

change in fair value that is attributable to changes in the liability’s credit risk (see para 5.7.7 of

AASB 9).

These items had previously bypassed the performance statement but, under the current standard,

they must be included in the other comprehensive income component of the performance statement

Paragraphs 90 and 91 require the entity to disclose the amount of income tax relating to each item

of other comprehensive income either in the statement of comprehensive income or in the notes

The inclusion of these items of other comprehensive income in the statement of comprehensive

income raises the potential for double counting, as other Australian Accounting Standards specify

whether and when items previously recognised in other comprehensive income are reclassified to

profit or loss When reclassification adjustments arise, paragraph 92 requires that they be disclosed

and paragraph 94 allows them to be presented either in the statement of comprehensive income or

in the notes

Paragraph 95 notes that reclassification adjustments arise in relation to the disposal of foreign

operations (AASB 121) and when a cash flow hedged forecast transaction affects profit or loss

(AASB 9) However, paragraph 96 notes that reclassification adjustments do not arise in relation to

changes in revaluation surpluses (AASB 116, AASB 138) or on remeasurements of defined benefits

plans (AASB 119).

Henson Ltd

Statement of Comprehensive Income for year ended

30 June 30 June

2012 2011

$000 $000

Share of profit of associates – –

Profit before income tax 2 211 1 740 Income tax expense (642) (509)

Profit from continuing operations 1 569 1 231 Profit (loss) from discontinued operations – –

Profit for the period 1 569 1 231 Profit attributable to non-controlling interests – –

Profit attributable to owners of the parent 1 569 1 231 Other comprehensive income Increase in revaluation surplus 480 –

Share of other comprehensive income of associates – –

Total other comprehensive income for the period 480 –

Other comprehensive income attributable to non-controlling interests – –

Total comprehensive income attributable to owners of the parent 480 –

Total comprehensive income for the period 2 049 1 231

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We now turn to the general format of the statement of comprehensive income and to specific

disclosures required by AASB 101 The simplified example of a statement of comprehensive income

presented on page 509 included only those line items mandated by paragraphs 81A, 81B, 82 and 82A

of AASB 101 Paragraph 85 requires entities to present additional line items, headings and subtotals

‘when such presentation is relevant to an understanding of the entity’s financial performance’ This

is a vague instruction However, paragraph 86 provides additional explanation that focuses on the users’ need for information to assist in understanding the entity’s current financial performance and

in making projections of its future performance Preparers are urged to consider materiality and the nature and function of items in deciding on additional line items, headings and subtotals While the sentiment is clear, these requirements have little operational content

A more specific requirement is contained in paragraph 97 of AASB 101 ‘When items of income or

expense are material, an entity shall disclose their nature and amount separately.’ The term ‘material’

is defined in AASB 101 as follows:

Omissions or misstatements of items are material if they could, individually or collectively, influence the economic decisions that users make on the basis of the financial statements Materiality depends on the size and nature of the omission or misstatement judged in the surrounding circumstances The size or nature of the item, or a combination of both, could be the determining factor (para 7)

Paragraph 98 of AASB 101 provides examples of circumstances that are considered to result in

items requiring separate disclosure:

(a) write-downs of inventories to net realisable value or of property, plant and equipment to recoverable amount, as well as reversals of such write-downs;

(b) restructurings of the activities of an entity and reversals of any provisions for the costs of restructuring;

(c) disposals of items of property, plant and equipment;

(d) disposals of investments;

(e) discontinued operations;

(f) litigation settlements; and (g) other reversals of provisions.

A further specific requirement is contained in paragraph 99 of AASB 101 ‘An entity shall present

an analysis of expenses recognised in profit or loss using a classification based on either their nature

or their function within the entity, whichever provides information that is reliable and more relevant.’

This requirement is discussed in section 16.3.3

Aspects of the statement of comprehensive income that warrant further comment are as follows:

1 revenue;

2 classification of expenses; and

3 treatment of unusual items

16.3.2 RevenueRevenue is a subset of income and is an important component of profit measurement in the statement

of comprehensive income The treatment of revenue in the statement of comprehensive income is

dealt with in AASB 118 ‘Revenue’, the most recent version of which is compiled to October 2010

AASB 118 defines revenue as follows:

Revenue is the gross inflow of economic benefits during the period arising in the course of the ordinary

activities of an entity when those inflows result in increases in equity, other than increases relating to

contributions from equity participants (para 7)

Comparing this definition with the definition of income in Framework 2010, the following

differences between income and revenue are apparent

1 Revenue is a gross inflow These words are not used in the definition of income, reflecting the fact

that some components of income (gains) may be measured net of related expenses Paragraph

8 of AASB 118 also points out that the focus on gross flows means that amounts collected on

behalf of third parties (such as sales taxes, goods and services taxes, and value added taxes) are

excluded from revenue

2 Arising in the course of the ordinary activities of an entity These words are also not used in the

definition of income, as income may arise from either within or outside ordinary activities

The usefulness of this distinction is limited by the lack of a definition or any discussion of the

term ‘ordinary activities’ However, this term has been extensively used in previous Australian

Accounting Standards Thus, AASB 1018 ‘Statement of Financial Performance’ defined ‘ordinary

activities’ as ‘activities that are undertaken by an entity as part of its business or to meet its

objectives and related activities in which the entity engages in furtherance of, incidental to, or

arising from activities undertaken to meet its objectives’ (para 8.1) This is an extremely broad

definition and it is unclear whether such a broad definition is intended in AASB 118 Hence,

distinguishing between gains and revenues is very difficult, especially as gains may also be

either within or outside ordinary activities

However, AASB 118 resolves this issue by confining itself to revenue arising from:

(a) the sale of goods;

(b) the rendering of services; and

(c) the use by others of the entity’s assets yielding interest, royalties and dividends (para 1)

Categories of revenue dealt with by the previous standard (AASB 1004 ‘Revenue’) but not by the

current standard include disposal of assets other than goods, contributions of assets, forgiveness of

liabilities and any other source (AASB 1004, para 2.1).

AASB 118 does not apply to some revenues, including those arising from:

◆ leases (AASB 117 ‘Leases’);

◆ dividends from an associate accounted for in accordance with AASB 128 ‘Investments in

Associates and Joint Ventures’;

◆ insurance contracts (AASB 4 ‘Insurance Contracts’);

◆ changes in the fair value of financial assets and financial liabilities or their disposal (AASB 9

‘Financial Instruments’); and

◆ initial recognition, and from changes in the fair value of biological assets (AASB 141

‘Agriculture’) (para 6)

AASB 118 deals with two issues:

1 the recognition and measurement of revenue; and

2 the disclosure of revenue in the statement of comprehensive income

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Recognition and measurement of revenue

Logically, measurement of revenue follows the decision to recognise revenue However, in AASB

118, measurement of revenue is discussed first and then specific conditions for recognition of

each of the three categories of revenue (sale of goods, rendering of services, and interest, royalties

and dividends) are outlined We follow the presentation in the Standard AASB 118 specifies the following requirement for the measurement of revenue:

Revenue shall be measured at the fair value of the consideration received or receivable (para 9)

In most cases, revenue will be in the form of cash (or cash equivalents), and the amount of revenue will be the cash (or cash equivalents) received or receivable However, if receipt of the cash

is delayed, the fair value of the revenue may be less than the nominal amount of the cash receivable

This would be the case if, for example, the entity provided interest-free credit to the purchaser If the arrangement is, in substance, a financing transaction, then the fair value of the consideration

is determined by discounting allfuture receipts using an imputed rate of interest (para 11) The

‘imputed rate of interest’ is the more clearly determinable of either:

(a) the prevailing rate for a similar instrument of an issuer with a similar credit rating; or (b) a rate of interest that discounts the nominal amount of the instrument to the current cash sales price of the goods or services (para 11)

The difference between the fair value and the nominal amount receivable is recognised as interest

revenue in accordance with AASB 9 (para 11).

Say, for example, a customer purchases a lounge suite from Harvey Norman for $3000 under an

850 days interest-free offer Assuming the customer pays $150 per month for 20 months to complete the transaction and that the appropriate imputed interest rate is 1% per month, the amount of sales revenue is determined as the present value of the 20 future monthly payments of $150 This is determined mathematically as:

Sales revenue: $150

0.01  (1 – 1

(1 + 0.01) 20 ) = $2706.83The difference between this amount ($2706.83) and the nominal sum receivable ($3000) is recognised as interest revenue:

Interest revenue: $3000 – $2706.83 = $293.17

In some cases, entities may enter into barter transactions in which the entities exchange goods

or services For such exchanges, paragraph 12 indicates that, when goods or services are exchanged

or swapped for goods or services of a similar nature and value, the exchange is not regarded as a transaction that gives rise to revenue For example, if two motor dealers swapped motor vehicles that were identical apart from their colour, with no cash payment, then neither dealer would record revenue However, if the swap involves the exchange of dissimilar goods and services, then revenue

is recognised and is measured as the fair value of the goods and services received For example, if two motor dealers exchange a second-hand car with a fair value of $5000 and cash of $15 000 for

a new car, the vendor of the new car would record revenue of $20 000 because this is the value of the consideration received The general journal entry to record revenue by the vendor of the new car would be as follows:

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Cash at bank Dr $15 000

The conditions necessary for the recognition of revenue vary according to the category of revenue

As a minimum, Framework 2010 recognition criteria for income must be satisfied before revenue

can be recognised – that is, the amount of the revenue can be measured reliably, and it is probable

that the economic benefits associated with the transaction will flow to the entity

We now discuss any additional recognition requirements for each of the three categories of

revenue identified in paragraph 1 of AASB 118.

1 Where the revenues arise from the sale of goods, the revenues are recognised only if the

following three additional requirements are satisfied:

(a) the entity has transferred to the buyer the significant risks and rewards of ownership of the goods;

(b) the entity retains neither continuing managerial involvement to the degree usually associated with ownership nor effective control over the goods sold;

(c) .

(d) .

(e) the costs incurred or to be incurred in respect of the transaction can be measured reliably

(para 14)

The three additional recognition requirements represent a substantial change from AASB

1004, which previously required, in addition to reliable measurement and probable occurrence,

that control of the goods had passed to the purchaser We now discuss these additional

requirements in more detail

Paragraphs 15 and 16 of AASB 118 indicate that, in most cases, passing of the risks and

rewards of ownership coincides with the transfer of legal title or the passing of possession to

the buyer An entity may retain significant risks of ownership in a number of circumstances

Paragraph 16 discusses several of these An example of such a circumstance is when the

receipt of revenue from a sale is contingent on the ability of the buyer to on-sell the goods The

intention of this requirement is to ensure that revenue is not recognised unless a genuine sale

has taken place However, this provision is inconsistent with Framework 2010, which defines

assets in terms of control, not ownership

The requirement that revenue cannot be recognised unless the costs incurred can be

reliably measured is discussed in paragraph 19 of AASB 118 This requirement is justified

on the basis of matching – that is, revenues and expenses that relate to the same transaction

are recognised simultaneously Thus, if the expenses cannot be measured reliably, the related

revenue also cannot be recognised Again, this requirement is contrary to Framework 2010

The definition and recognition of income require no link to expenses The existence and

recognition of income do not rely on the existence and recognition of expenses

2 Where the revenues arise from providing services, they should be recognised in accordance

with the stage of completion of the transaction, provided, in addition to the requirements for

reliable measurement and probable occurrence, that:

(a) .

(b) .

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(c) the stage of completion of the transaction at the reporting date can be measured reliably;

and (d) the costs incurred for the transaction and the costs to complete the transaction can be measured reliably (para 20)

AASB 118 requires the use of the stage-of-completion method for revenue arising from

the provision of services This method is also required for long-term construction contracts

under AASB 111 ‘Construction Contracts’ (discussed in Chapter 21) The ability to reliably

measure the stage of completion is a necessary condition to recognising revenue from services

Paragraph 24 of AASB 118 identifies possible methods for estimating the stage of completion

These include surveys of work performed, the services performed as a proportion of the total services to be performed or the costs incurred as a proportion of total costs If the outcome of a contract cannot be reliably estimated, then revenue must be recognised only to the extent that expenses recognised are recoverable (para 26)

3 Paragraphs 29–34 of AASB 118 consider the accounting procedures for recognising revenue from interest, royalties and dividends In general, these revenue items are to be recognised only if

it is probable that the revenue will flow to the entity and its amount can be measured reliably (para 29)

Interest revenue must be recognised ‘using the effective interest method as set out in AASB 9’

(para 30(a)) The effective interest rate is the rate that equates the expected stream of future cash receipts to the net carrying amount of the asset The effective interest method allocates interest revenue over the relevant period, as shown in Example 16.1

The effective interest method

On 1 July 2012, Troilus Ltd invested in 100 debentures issued by Cressida Ltd The five-year debentures each had a face value of $1000, with interest at 4.56% payable on 30 June each year The debentures were acquired at a discount of 10%

The effective interest rate on the investment by Troilus in the debentures is found by solving for i in

the following equation:

an addition to the principal In the first year, the general journal entry to record interest revenue would

Royalties must be recognised on an accrual basis in accordance with the substance of the relevant

agreement (para 30(b)), and dividends must be recognised when the shareholders’ right to receive

payment is established (para 30(c)) In the case of dividends, it is argued that, if a final dividend

has to be approved at a meeting of shareholders, the entity will not control the right to the dividend

until it is approved Note that, if the collectability of an amount already included in revenue ceases

to be probable, the amount is recognised as an expense rather than as an adjustment to revenue

(para 34)

Additional guidance can be found in the illustrative examples accompanying AASB 118, which

focus on particular aspects of a transaction for each category of revenue (sale of goods, rendering of

services and interest, royalties and dividends) identified in section 16.3.2

Disclosure of revenue

AASB 118 requires the disclosure of information about revenue It requires the disclosure of

the accounting policies adopted for revenue recognition and, in particular, the method used to

determine the stage of completion of transactions involving the rendering of services (para 35(a))

This information would be included in the accounting policies note to the financial statements

Paragraph 35(b) of AASB 118 also requires disclosure of each significant category of revenue

recognised arising from:

(i) the sale of goods;

(ii) the rendering of services;

(iii) interest;

(iv) royalties; and

(v) dividends

Principal at Year ended beginning Interest Cash Addition to

30 June of year revenue inflow principal

The balance in the investment account would now be $100 000 and the following general journal

entry would be passed to record receipt of the principal:

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Paragraph 35(c) requires the disclosure of the revenue arising from exchanges of goods or services included in each significant category of revenue

In addition to the requirements of AASB 118, AASB 101 requires the disclosure of revenue on the

face of the statement of comprehensive income (para 82(a))

16.3.3 Classification of expenses

AASB 101 requires that expenses (other than finance costs, which are required to be classified by

nature) be ‘classified’ according to either their nature or their function An analysis of expenses based

on one of these classifications must be presented (para 99) Paragraph 100 encourages companies

to present this analysis on the face of the statement of comprehensive income

The terms ‘nature’ and ‘function’ are not defined Paragraph 102 discusses and illustrates a classification based on nature Classification by nature might involve expense categories such as depreciation, purchases of raw materials and employee benefits These would not be reallocated across the various functions within the entity The benefit of this method is that it is simple and does not require arbitrary allocations of expenses An example of a classification using the nature-of-expense method is given in paragraph 102:

Classification by function-of-expense or cost-of-sales method might involve expense categories such as cost of sales, cost of distribution and cost of administration At a minimum, an entity selling goods that uses a functional classification would disclose the cost of sales separately from other expenses Functional classification can provide more relevant information, but may require arbitrary allocations of expenses across functional categories An example of a classification using the function-of-expense method is given in paragraph 103:

Companies adopting a functional classification are also required to disclose additional information

on the nature of expenses, including depreciation and amortisation expense and employee benefits expense (para 104)

Companies are required to choose the basis of classification that is reliable and more relevant

(para 105) Typically, what is ‘more relevant’ will depend on historical and industry factors as well

as the nature of the entity

16.3.4 Unusual items

It is argued in section 16.2 that one advantage of the operating-profit approach is that it identifies

(and excludes from profit measurement) items of income and expense that are ‘unusual’ It is claimed

that this allows for more accurate evaluation of current performance and more accurate forecasting

of future performance Current Australian Accounting Standards do not identify any categories of

‘unusual’ items for special disclosure in the statement of comprehensive income This is a departure

from previous practice In the past, one or more categories of unusual items have been identified

in the relevant standards We briefly review the past treatment of extraordinary items to illustrate

the issues

AASB 1018 ‘Statement of Financial Performance’ defined extraordinary items as ‘items of revenue

and expense that are attributable to transactions or other events of a type that are outside the ordinary

activities of the entity and are not of a recurring nature’ (para 8.1) The definition of extraordinary

items in AASB 1018 specified two conditions that must be satisfied if an item is to be considered

extraordinary These conditions were that transactions must:

1 Be outside the ordinary activities of the entity: as we note earlier, the definition of ordinary

activities in AASB 1018 is extremely broad As a result, virtually allitems of revenue and

expense arise in the course of ordinary activities of the entity Hence, items will rarely satisfy

the definition of extraordinary items Possible examples of extraordinary items include:

◆ the expropriation of assets in an environment where expropriation is rare; and

◆ an earthquake or other natural disaster, provided the entity does not operate in a region

that is prone to such disasters

2 Not be of a recurring nature: an event that is outside ordinary activities but is likely to recur is

not extraordinary

Where an item was classified as extraordinary, it was required to be separately disclosed, showing

the nature of the extraordinary item and its amount, both before and after associated tax

The benefit of separate disclosure of extraordinary items is that it allows for more accurate

evaluation of current performance and more accurate forecasting of future performance The cost is

the potential for manipulation There is evidence that some financial statement preparers deliberately

classified ordinary operating losses and expense items as ‘extraordinary’ in order to present a more

optimistic picture to statement users about the reporting entity’s profit As an entity’s operating

performance is generally judged on the basis of its profit from ordinary activities, there may have

been some perceived advantage from the misclassification of expense items as extraordinary The

use of extraordinary items in this way was investigated by Craig and Walsh, who concluded that

‘strong substantive evidence … was found to support assertions and anecdotal inferences that large

listed Australian companies are actively engaged in profit smoothing’.3 Hoffman and Zimmer found

that managers whose remuneration was high relative to the entity’s profits were more likely to

classify gains as operating items and losses as extraordinary items.4 This suggests that managers’

remuneration schemes may provide financial incentives for managers to misclassify expenses as

extraordinary

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Accounting standard setters responded to the perceived creative use of extraordinary items They progressively narrowed the definition of extraordinary items to the point where the current standard

(AASB 101) prohibits any entity from presenting any item of income or expense as ‘extraordinary’.

Extraordinary items were not the only category of ‘unusual’ items Earlier versions of AASB 1018

contained requirements for the separate disclosure of ‘abnormal items’ and subsequently ‘significant

items’ Neither of these categories is included in AASB 101 As noted before, there are no requirements for disclosure of specific categories of unusual items in the current standard However, AASB 101

does have requirements for the identification and disclosure of important items of income and expense Paragraph 97 requires that ‘when items of income and expense are material, an entity shall disclose their nature and amount separately’ Paragraph 98 identifies some examples of circumstances where separate disclosure would be required They include write-downs of inventory

or property, plant and equipment; restructuring of the activities of the entity; disposal of property, plant and equipment; discontinued operations; and litigation settlements Some of these could be regarded as ‘unusual’ items

An outcome of restricting the use of special categories of items is that companies report not only statutory profit measured in accordance with Australian Accounting Standards but other measures

of profit The Accounting in Focus box below provides some background and examples of the use of

a measure of profit frequently referred to as ‘underlying profit’

The practice of presenting a profit figure that is different from statutory profit is pervasive and accepted

in the business community and financial markets This is evident in the results from KPMG’s 2011 survey of the non-statutory reporting practices of the ASX100 companies.5 The survey shows 82% of those companies reporting non-statutory profit when reporting their 2011 result However, there has been much debate about the reporting of underlying profit and the prominence given to underlying profit number reported in financial reports and other company announcements Critics argue that the prominence given to reporting non-audited profit figures can be misleading to report users

In March 2011, the Australian Securities and Investments Commission (ASIC) issued Consultation Paper

150 ‘Disclosing financial information other than in accordance with accounting standards’ (CP150)

In CP150, ASIC proposes to restrict the use of non-AASB financials in corporate documents including annual reports In the consultation paper, ASIC indicates that: ‘Alternative profit information presented

to the market often excludes particular expenses, such as impairment losses, and has sometimes been used with an objective of removing “bad news” rather than providing meaningful information to the market paragraph’ (CP150, para RG000.25) In a review of 250 financial reports over three years (2009–2011), ASIC identified that 60% of companies’ practices do not substantially comply with the guidelines in the draft regulatory guide

In December 2011, after receiving responses on CP150, ASIC released Regulatory Guide 230 ‘Disclosing non-IFRS financial information’ (RG230), which is effective from 31 December 2011 RG230 provides regulatory guidance on disclosing non-International Financial Reporting Standard (IFRS) information, including underlying profit or non-statutory profit figures The purpose of RG230 is to:

• promote more meaningful communication of non-IFRS financial information to investors and other users of financial reports;

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• assist directors in ensuring that the information is not misleading; and

• provide greater certainty in the market as to ASIC’s view on disclosure of the information

In ASIC media release (11-287MR), Commissioner Michael Dwyer said: ‘Non-IFRS information can

provide useful information to investors and other users of financial reports However, it is important that

information is not misleading This ASIC guidance will be useful to stakeholders by providing guidance to

assist in reducing the risk that information is misleading.’ Guidance provided in RG230 includes:

• giving equal or greater prominence to IFRS financial information;

• explaining the non-IFRS information and reconciling it to the IFRS financial information;

• calculating the information consistently from period to period; and

• not using information to remove ‘bad news’

The findings from the KPMG 2011 survey of ASX100 companies indicate that RG230 will have a

significant impact because many companies will need to change their current disclosure practices The

findings highlight a number of current reporting practices that will need to change to be consistent with

RG230 These include:

• the location for reporting underlying income (cannot be on the face of the statement of

comprehensive income) and the use of different underlying profit and segment performance measures;

• the prominence given to underlying profit measures in management discussion and analysis, and the

use of underlying profit as the headline measure in other company documents;

• the practice of changing the comparative underlying profit numbers without explanation; and

• the absence of an explicit statement about whether underlying profit has been audited or reviewed

The following example illustrates the use of underlying profit by Campbell Brothers Limited in its Annual

Report 2012

Campbell Brothers Limited and its Subsidiaries

Directors’ Report For the year ended 31 March 2012

4 REVIEW AND RESULTS OF OPERATIONS Net profit

Directors are pleased to report that the Group achieved a record financial result in the year

to March 2012 Net profit after tax attributable to equity holders of the Company was

$222.4 million (refer to summary below) Underlying net profit after tax (attributable to equity holders of the Company and excluding unusual items) was also $222.4 million for the year in line with recent guidance provided to the market The result was up 68.2% on the previous year and was generated from revenue of $1 405.6 million (up 26.8% on the year to March 2011).

All divisions within the ALS testing and inspection services business recorded increased profit contributions and margins over the previous year (refer Divisional contributions below) In particular, strong growth in global mineral exploration activity lifted demand for the analytical testing services provided by ALS Minerals division Increased sample flow, combined with earnings generated by Ammtec (acquired November 2010) and Stewart Group (acquired July 2011) served to deliver a 92% increase in segment profit contribution when compared to the March 2011 year ALS Life Sciences division (formerly known as ALS Environmental) delivered strong gains in revenue and profit contribution, particularly within the Australian and North American regions.

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ALS Energy (formerly known as ALS Coal) and ALS Industrial divisions all recorded solid growth

in earnings contribution compared with the previous year Campbell Chemical delivered an improved profit result on lower revenue and the Reward Distribution hospitality supplies division returned to profitability during the year.

The translation of foreign earnings was impacted by a stronger Australian dollar during the year The average exchange rate against the US dollar was USD1.05 for the March 2012 year (2011: USD0.95).

Directors have declared a final partly franked (50%) dividend for the year of $1.30 per share (2011: 75 cents partly franked) bringing the total partly franked (50%) dividend for the year

to $2.25 per share (2011: $1.40 partly franked) The Company has re-instated its dividend reinvestment plan – a 5.0% discount to market price will apply for shares issued in relation to the 2012 final dividend.

Underlying profit before financing costs,

Income tax expense relating to underlying profit

Underlying profit before unusual items 224 687 132 144 Net profit/(loss) attibutable to non-controlling

Underlying profit before unusual items attibutable to equity holders of the Company 222 413 132 208 Unusual items net of income tax attibutable to

Gain on sale of chemical and cleaning

Write-down to recoverable amount goodwill and inventories in Reward Distribution segment – (9 405)

Profit attributable to equity holders of the Company 222 413 132 354

(Underlying profit is a non-IFRS disclosure and has been presented to assist in the assessment of the relative performance of the Group, from year to year.)

Source: Extract from Campbell Brothers, Annual Report 2012, pp 31–2 © ALS Limited (formerly Campbell Brothers Limited).

Bearing in mind that the RG230 requirements became effective from 31 December 2011, it is doubtful that the above disclosures would satisfy all of the guidance recommended in RG230 For example, whilst Campbell Brothers does not promote underlying profit over statutory profit or record underlying profit

in its statement of comprehensive income and does provide a basic reconciliation to statutory profit, the note does not provide an explicit statement about whether the underlying profit information has been audited or reviewed

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Selected references

Australian Securities and Investments Commission (ASIC), Consultation Paper 150, ‘Disclosing financial information other

than in accordance with accounting standards’, March 2011

Australian Securities and Investments Commission (ASIC), Regulation Guide 230, ‘Disclosing non-IRFS financial information’,

December 2011

Australian Securities and Investments Commission, 11-287MR ASIC release guide on using non-IFRS financial information,

9 December 2011.

Bamber, L.S., J.X Jiang, K.R Petroni and I.Y Wang, ‘Comprehensive Income: Who’s Afraid of Performance Reporting?’,

The Accounting Review, January 2010, pp 97–126.

Bernstein, L.A., Accounting for Extraordinary Gains and Losses, Ronald Press, New York, 1967.

Bernstein, L.A., ‘Extraordinary Gains and Losses – Their Significance to the Financial Analyst’, Financial Analysts Journal,

November–December 1972, pp 49–52, 88–90.

Buzby, S.L., ‘Nature of Adequate Disclosure’, Journal of Accountancy, April 1974, pp 38–47.

Craig, R and P Walsh, ‘Adjustments for “Extraordinary Items” in Smoothing Reported Profits of Listed Australian

Companies: Some Empirical Evidence’, Journal of Business Finance and Accounting, Spring 1989, pp 229–45.

Goncharov, I., and A Hodgson, ‘Measuring and Reporting Income in Europe’, Journal of International Accounting Research,

Spring 2011, pp 27–59.

Houghton, K., ‘AASB 1018 and Its Extraordinary Effect’, Charter, March 1994, pp 60–2.

Kanagaretnam, K., R Mathieu and M Shehata, ‘Usefulness of Comprehensive Income Reporting in Canada’, Journal of

Accounting and Public Policy, July–August 2009, pp 349–65.

KPMG, ‘Underlying Profit Report 2011’, December 2011, available at: <www.kpmg.com/au/en/issuesandinsights/

articlespublications/underlying-profits-report/pages/underlying-profits-report-2011.aspx>.

Walsh, P., R Craig and F Clarke, ‘“Big Bath Accounting” Using Extraordinary Items Adjustments: Australian Empirical

Evidence’, Journal of Business Finance and Accounting, January 1991, pp 173–89.

Questions

1 ‘It is clear that the matching concept is no longer pre-eminent in the measurement of profit.’ Discuss.

2 What criteria would you use to evaluate possible approaches to periodic profit measurement? Explain.

3 Distinguish between the operating-profit, all-inclusive and comprehensive income approaches to profit measurement.

4 What are the arguments for and against the all-inclusive approach to profit measurement?

5 Outline arguments against an operating-profit approach to periodic profit measurement.

6 It seems apparent that national and international accounting standard setters have opted for a comprehensive

income approach to periodic profit measurement Why? Explain why you agree or disagree with their choice.

7 Based on the requirements of AASB 101, what approach to profit measurement has been adopted by Australian

Accounting Standard setters? Explain.

8 Under AASB 101, identify items of income and expense that bypass the statement of comprehensive income Is this

consistent with the comprehensive income approach to measuring periodic profit? Outline the arguments for and against their exclusion in the calculation of profit.

9 AASB 101 currently offers preparers a choice in the way they report periodic profit Outline the available options.

10 Define and give examples of other comprehensive income.

11 What is a reclassification adjustment? Give an example Why is it that reclassification adjustments are necessary for

some items of other comprehensive income but not others?

12 Distinguish between and give examples of:

(a) revenues and gains; and (b) expenses and losses.

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13 Define revenue and explain how it differs from income.

14 Revenue is said to arise in the course of the ordinary activities of the entity Explain the meaning of the term

‘ordinary activities’, as used in AASB 118.

15 Explain how revenue is to be measured under AASB 118.

16 Outline the AASB 118 requirements governing the recognition of revenue from sale of goods Are these

requirements consistent with the Framework 2010 definition of, and recognition criteria for, income?

17 In light of the Framework 2010 definition of income and the matching concept, comment on the AASB 118

requirements for the recognition of revenue from the sale of goods.

18 Outline the AASB 118 requirements for the recognition of revenue from the provision of services.

19 Distinguish between the classification of expenses based on nature and the classification of expenses based on

function How are entities expected to choose between these alternative bases of classification?

20 Outline the AASB 101 requirements for classification of expenses in the statement of comprehensive income.

21 Outline the arguments for and against the identification and disclosure of ‘unusual’ items in the statement of

comprehensive income.

22 Explain why AASB 101 prohibits any item of income or expense from being labelled as ‘extraordinary’ Would

an item which was previously defined as ‘extraordinary’ (based on the AASB 1018 definition) be disclosed in the

financial statements? Explain.

23 The usefulness of reporting comprehensive income has been the subject of research in various countries A number

of research papers explore various aspects of reporting comprehensive income, including measurement, level of aggregation and the location of reporting components.

Required

(a) Explain briefly what Bamber, Jiang, Petroni and Wang find, for their sample of US companies, in their research paper entitled ‘Comprehensive Income: Who’s Afraid of Performance Reporting?’ Would the evidence provided by

Bamber et al be relevant to Australian listed companies? Give reasons

(b) Explain briefly what Goncharov and Hodgson find in their review of measuring and reporting income in 16 European countries.

(c) Explain briefly what Kanagaretnam, Mathieu and Shehata find in their investigation of the usefulness of comprehensive income reporting in Canada

(d) Based on your analysis in parts (a) to (c), prepare a letter to the AASB on the implications of the research evidence

relating to comprehensive income for the reporting requirements of AASB 101 Justify your decision, including any

caveats you may have.

(Note: Full references for these articles can be found in the selected references list on page 521.)

Problems

1 (Knowledge of the treatment of errors and changes in accounting policy is necessary to complete this problem.) Ian

Gerry Ltd is a retailer, selling goods under its own brand from stores owned and operated by the company Ian Gerry Ltd

is also a franchiser who supplies goods to independently owned, franchised stores trading under the Ian Gerry name

The terms of supply to franchised stores indicate that the goods may be returned by the franchisee to Ian Gerry Ltd at any time prior to their sale to external customers However, 95% of sales to franchisees are not returned, but are sold to external customers Ian Gerry Ltd adopts a policy of recognising revenue from sales to franchisees at the time the goods are delivered to the franchisees Sales to franchisees represent 30% of total Ian Gerry Ltd sales.

Required

(a) Analyse the Ian Gerry Ltd policy on recognising revenue on sales to franchisees in light of AASB 118.

(b) Based on your analysis in (a), would changing/correcting the policy be a change in accounting estimate, a change

in accounting policy or an error? Give reasons for your opinion

(c) Based on your analysis in (b), outline how Ian Gerry Ltd should treat the change/error in the current period.

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2 A junior accountant at Mammoth Enterprises has prepared the following draft statement of comprehensive income

for the year ended 30 June 2013:

Other comprehensive income

Adjustments for correction of errors

Required

(a) Identify departures from the requirements of AASB 101 in this draft statement.

(b) Prepare a statement of comprehensive income and a statement of changes in equity in accordance with

Extraordinary items

The statement of changes in equity of ABC Company Ltd for the year ended 30 June 2013 showed the following:

* A note explained prior-period adjustments as follows:

Understatement in 2005, 2006 and 2007 of depreciation on plant and equipment $140 000

Legal expenses for claims against the builder of premises erected in 2005 $131 000

Required

Indicate departures in these statements from the provisions of AASB 101.

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4 (Knowledge of tax-effect accounting is required to complete this problem.) Triple F Ltd is a fast-food chain operating a

number of vans beside major Victorian roads It employs casual staff to sell products such as hamburgers, doughnuts, hot dogs and ice creams Relevant data extracted from the (partially) adjusted trial balance for the year ended 30 June 2013 are detailed below:

(b) During the year, Triple F introduced a breakfast menu To encourage commuters to use this service, a credit facility was offered for regular orders There were no bad debts during the year and, at the end of the year, Triple F provided for bad debts at 1% of outstanding accounts receivable There had been no accounts receivable prior to this.

(c) After working for Triple F for many years, Freddy took long-service leave from January to March 2013 This amounted

to $7500 and was paid from the pre-existing provision for long-service leave account.

(d) Two grateful breakfast customers purchased a Lotto ticket for Triple F It won $905 000 Lottery winnings are not taxable.

(e) Depreciation on vans deductible for tax purposes amounted to $27 000 The tax base of the vans at the beginning

of the reporting period was $145 000.

(f) The company tax rate for the 2013 year was 30% In the May 2013 budget the treasurer announced that the tax rate would be raised to 38% from 1 July 2013.

5 The statement of comprehensive income for Wallingford Ltd for the year ended 30 June 2013 shows the following

information.

Wallingford Ltd Statement of Comprehensive Income for year ended 30 June 2013

Extraordinary items

Foreign currency losses on translation of overseas operations (300 000) (900 000)

Other information

(a) The income tax expense is $2 281 250.

(b) The company’s sales revenue amounted to $23 million; cost of goods sold was $12 million.

(c) The following expenses were incurred by Wallingford Ltd:

Prepare a statement of comprehensive income that complies with Australian Accounting Standards.

6 Cubic Ltd, a transport company, generated revenues from the provision of services for the financial year ended 30 June

2013 of $3.5 million In addition, the following transactions and events occurred during the year.

(a) Plant and equipment was purchased for $600 000.

(b) Depreciation using the straight-line method was $400 000.

(c) On 31 August 2011, the company entered into a non-cancellable finance lease agreement with A–Z Ltd to acquire

a number of additional trucks For 2012/2013 the total monthly lease payments, which are made in advance, amounted to $100 000 The lease agreement was for a period of five years and the implicit rate of interest was 1.6% per month There is no residual value.

(d) On 1 April 2013, Cubic purchased, for $1 million, a small transport company with net assets (including $26 000 goodwill) that had a book value of $700 000 and a fair market value of $826 000.

(e) The company’s bad debt expense for 2012/2013 was $260 000.

(f) Other expenses were as follows:

(g) During the year the company sold, at a non-taxable profit of $1 million, land no longer required for business operations.

(h) On 1 January 2013, the company revalued its buildings by $600 000.

(i) Dividends paid on 1 April 2013 were $800 000.

(j) Income tax expense for the year ended 30 June 2013 was $394 276.

(k) Balance of retained earnings on 1 July 2011 was $1 301 577.

Required

Prepare a statement of comprehensive income and statement of changes in equity for Cubic for the year ended 30 June

2013 in accordance with accounting standards Explain any assumptions you make and show all calculations.

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7 XYZ Ltd reported sales revenue of $16 million for the year ended 30 June 2013 In preparing the financial statements the

following matters were considered:

(a) Income tax expense for the year ended 30 June 2013 was $218 640.

(b) Financial restructuring has resulted in the disposal of land, bought in 2002 for future expansion, for a profit of

$200 000.

(c) A dividend of $26 000 has been received from a subsidiary company.

(d) Other expenses incurred:

(e) On 10 October 2012, plant with a carrying amount of $320 000 was destroyed by an earthquake.

(f) During the period, non-current assets were revalued upwards by a net $120 000.

(g) The foreign currency translation reserve fell by $60 000 as a result of translating the financial statements of a foreign operation.

(h) Balance of retained earnings as at 1 July 2012 was $567 040.

Required

Prepare a statement of comprehensive income in accordance with the requirements of AASB 101.

8 The following draft statement of comprehensive income was prepared by the trainee accountant of Black Ltd, which is a

diversified services company with its head office in Melbourne.

Black Ltd Statement of Comprehensive Income for year ended 30 June 2013

Revenue

Less: Expenses

Other comprehensive income

Retroactive settlement of company income tax for 2006 and 2007 346 000

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(i) Outline the correct treatment of sales tax under AASB 118.

(ii) Prepare the note disclosure required for revenue under AASB 118.

(iii) Distinguish between gains (losses) and revenues (expenses) Which items in the data above are gains/losses?

Are they required to be reported on a gross or net basis?

(b) Classification of expenses:

(i) Outline the requirements of AASB 101 for the classification of expenses.

(ii) What basis of classification would you adopt for Black Ltd? Give reasons.

(iii) Assuming expenses are classified on the face of the statement of comprehensive income, prepare a pro-forma

statement of comprehensive income showing the classification of expenses (actual numbers are not required).

(c) Outline the requirements of AASB 101 for the treatment of material ‘unusual’ items and prior-period errors.

9 The following letter appeared in the South Gippsland Sentinel-Times on 18 February 2003.

Point of View Fundamental error?

I have before me the Bass Coast Shire Council statement of financial performance for the year ended June 30, 2002

Comparative figures for the year 2000/2001 are also shown

Included in the revenue for that year is an item which, I believe, has caused some controversy As revenue, we are presented with ‘correction of fundamental error $15,704,000’

I have been a chartered accountant for over 60 years and have had occasion to peruse, prepare and audit numerous revenue statements I cannot recall such a strange item appearing as revenue I understand that this represents an extensive identification and valuation of the council’s assets including roads, streets, bridges and plant and equipment carried out during the 1999/2000 year I am not addressing the validity of the book entry

I do wish to state emphatically that I consider that the item has been wrongly shown in the shire accounts.

How can its inclusion as revenue from ordinary activities be justified? It does not even relate to the year in question, but

is an adjustment covering past financial years.

It is clear that this item should appear below as a ‘results from extraordinary items’.

I believe that this incorrect presentation has real importance because it obscures the fact that, in 2000/2001, the Bass Coast incurred a deficit in its revenue from ordinary items of $2,573,000.

The presentation claiming a profit of $13,130,000 as a result of ordinary activities is bizarre.

If true, as this amount exceeds a year’s rate revenue, the shire could have declared a ratepayers’ holiday for the ensuing year We know what really happened, don’t we?

I fail to see how the shire can deny that a deficit of $2,573,000 was the true result from ordinary activities.

This reflects badly on the financial administration of the shire and should concern ratepayers Rate hikes of 7.5% and 12% occurred in the two ensuing years.

The above, in my view, adds weight to the already strong case for an independent and comprehensive review of the Bass Coast Shire.

Source: William T Hopkins, South Gippsland Sentinel-Times, 18 February 2003.

The statement of financial performance (statement of comprehensive income) for the Bass Coast Shire for 2002 is reproduced on the following page.

PART 3 THE STATEMENT OF COMPREHENSIVE INCOME AND FURTHER FINANCIAL REPORTING ISSUES

Expenses Expenses from ordinary activities

Share of net profits/(losses) of associates accounted

Net result for reporting period 415 13 131

Increase in accumulated surplus as a result of a change in accounting policy 0 0

Total movements directly recognised as equity 0 0 Total changes in equity for the year 415 13 131 The accompanying notes form part of this financial report.

Source: Bass Coast Shire Council, Financial Report 2001/2002

(b) Respond to the following argument by Mr Hopkins: ‘It is clear that this item should appear below as a “results from extraordinary items”.’

10 Travel Centre Ltd conducts business as an airline booking agent Its main source of revenue is commission received from

airlines Following the terrorist attacks of 11 September 2001, international airline bookings dropped 50% and were still down 20% at the end of Travel Centre’s financial year (31 March 2002) The collapse of Ansett Airlines resulted in

Copyright © Pearson Australia (a division of Pearson Australia Group Pty Ltd) 2013 – 9781442561175 - Henderson/Issues in Financial Accounting 15e

a 30% fall in domestic airline bookings Travel Centre management states that commission revenues are down 25%

on the previous financial year and down 40% on budget The CEO of Travel Centre is reported as saying, ‘The recent extraordinary events affecting airline travel will have a devastating effect on this year’s bottom line.’

Required

Using relevant current accounting standards, explain how these events should be presented in Travel Centre’s statement

of comprehensive income for the year ended 31 March 2002.

11 On 1 July 2012, Lancer Ltd purchased 1000 debentures with a face value of $100 each for a price of $107 985 The

debentures were issued by Evo Ltd and pay interest on 30 June each year at a nominal rate of 10% per annum, while the effective interest implied by Lancer’s purchase price is 8% per annum The debentures mature and will be repaid on

12 Myer Holdings Limited and David Jones Limited have department stores that are direct competitors in the retail sector

Given their similar business models, you have decided to compare how each entity has applied the provisions of

AASB 101 and AASB 118 in relation to their performance statement

Required

Download the 2011 annual reports for Myer Holdings Limited and David Jones Limited from the respective websites (or ASX Announcements website) Compare and contrast their performance reports and related notes with the disclosure

requirements in AASB 101 and AASB 118 You should consider format, reporting choice, and any differences in the

disclosure of revenues and expenses.

13 Download the 2012 annual report for Origin Energy Limited from the company’s website (or ASX Announcements

website) Review the disclosures provided in relation to the underlying profit Do you consider the disclosures provided to

be consistent with the requirements of ASIC’s Regulatory Guide 230 ‘Disclosing non-IFRS financial information’? Explain.

Notes

1 The comprehensive income approach was developed in the US, where the term ‘profit’ is seldom used in an accounting

context The term ‘income’ is usually substituted for ‘profit’.

2 There have been subsequent amendments to AASB 101 The amendments are included in: AASB 2010-2 ‘Amendments

to Australian Accounting Standards arising from Reduced Disclosure Requirements’, June 2010; AASB 2010-7

‘Amendments to Australian Accounting Standards arising from AASB 9’, December 2010; AASB 2011-2 ‘Amendments

to Australian Accounting Standards arising from the Trans-Tasman Convergence Project – Reduced Disclosure

Requirements’, May 2011; AASB 2011-7 ‘Amendments to Australian Accounting Standards arising from the Consolidation and Joint Arrangements Standard’, August 2011; AASB 2011-8 ‘Amendments to Australian Accounting Standards arising from AASB 13’, September 2011; and AASB 2011-10 ‘Amendments to Australian Accounting Standards arising from AASB 119’, September 2011

3 R Craig and P Walsh, ‘Adjustments for “Extraordinary Items” in Smoothing Reported Profits of Listed Australian

Companies: Some Empirical Evidence’, Journal of Business Finance and Accounting, Spring 1989, p 243.

4 T Hoffman and I Zimmer, ‘Managerial Remuneration and Accounting for Recurring Extraordinary Items’, Accounting

and Finance, November 1994, pp 35–47.

5 KPMG, ‘Underlying Profit Report 2011’, December 2011 Available at: <www.kpmg.com/au/en/issuesandinsights/

articlespublications/underlying-profits-report/pages/underlying-profits-report-2011.aspx>

LEARNING OBJECTIVES

After studying this chapter you should be able to:

1 understand the background to the requirement to prepare a statement of cash flows;

2 identify reasons for preparing a statement of cash flows;

3 define and distinguish between three concepts of funds: cash, working capital and total resources;

4 understand the requirements of AASB 107 ‘Statement of Cash Flows’;

5 prepare a statement of cash flows in accordance with the requirements of AASB 107 ‘Statement of Cash Flows’;

6 distinguish between the direct and indirect methods of calculating cash flows from operating activities; and

7 distinguish between net cash flows and gross cash flows

17.1 Introduction

17.2 Development of the statement of cash

flows 17.3 Meaning of funds

17.4 The advantages of reporting cash flow

17.1 Introduction

This chapter discusses the statement of cash flows, which complements the statement of

comprehensive income and the statement of financial position by providing information about an

entity’s cash flows from operating, investing and financing activities Before the introduction of a

requirement to prepare a statement of cash flows, there was a requirement to prepare a statement of

funds flows In the first part of the chapter, therefore, we review the background to the requirement

to prepare a statement of cash flows We then discuss the accounting standards governing the

statement of cash flows

17.2 Development of the statement of cash flows

Early in the 20th century it was realised that the statement of financial position and statement of

comprehensive income did not present a complete picture of an entity’s economic activities While

the statement of comprehensive income summarised the entity’s operating transactions and the

statement of financial position summarised its financial position, there was no summary of investing

and financing transactions Information about important events, such as new share issues, new

borrowings, loan repayments, and the acquisition and disposition of non-current assets, was not

readily available to the users of financial statements The best that could be done was to glean some

of the data from a careful study of successive statements of financial position, and perhaps the notes

to the financial statements

To overcome this perceived deficiency, an additional financial statement was developed to

summarise investing and financing transactions For example, Cole, writing in 1908, discussed

the ‘Summary of Financial Transactions for the Year’ or the ‘where-got-where-gone’ statements that

were published by American railway companies.1 Increasingly, financial statements of this type were

published

The first accounting standard on the preparation of such a statement was issued in the US in

1963 when the American Institute of Certified Public Accountants issued Opinion No 3,2which

recommended that an optional, unaudited statement showing the sources and uses of funds should

be prepared In 1971, Opinion No 3 was replaced by Opinion No 19,3 which made the publication

of a funds statement mandatory and subject to audit The concept of funds used in the preparation

of this version of a funds statement was working capital, which measures changes in current assets

and current liabilities

The need to publish a funds statement was slower to gain acceptance in Australia For example,

a survey of reporting practices in 1968 found that only 30% of the companies surveyed included a

funds statement in their published financial statements.4 In 1972 the Australian Securities Exchange

(ASX) required listed companies to include a funds statement in their financial statements.5 Another

survey of reporting practices showed that, by 1979, 96% of the 250 surveyed companies presented a

funds statement.6 However, there was a marked lack of uniformity in the concept of funds employed

and in the method of presentation Ultimately, an Australian Accounting Standard was issued in

1983 that required the use of the total resources concept of funds in compiling a statement of

sources and applications of funds.7

In July 1986, as a result of suggestions that the Standard was deficient because it failed to require

the disclosure of cash flow information, the accounting standard setters issued an Invitation to

Understand the background to the requirement

to prepare a statement of cash flows.

LEARNING OBJECTIVE 1

PART 3 THE STATEMENT OF COMPREHENSIVE INCOME AND FURTHER FINANCIAL REPORTING ISSUES

532

Comment on a proposal to require the disclosure of ‘cash flow from operations’ as a note to the funds statement.8 The majority of respondents did not support the proposal because they did not believe that the disclosure of this information would be useful to financial statement users in the form proposed As a result, the Standard was not amended

During 1990 the disclosure of cash flow information was again discussed in Australia in light

of the failure of a number of high-profile companies It was asserted that the disclosure of cash flow information would have provided early warning of the difficulties faced by these companies

In addition, a proposal to require the publication of a statement of cash flows was contained in an ASX discussion paper.9 Given the likelihood, therefore, that the ASX would require publication

of a statement of cash flows, the accounting standard setters began work on the preparation of an

accounting standard on that topic The accounting standard AASB 1026 was issued in December

1991 More recently, AASB 1026 has been replaced by AASB 107 ‘Statement of Cash Flows’ as part of

the program to issue Australian Accounting Standards that are equivalent to International Financial Reporting Standards (IFRS)

The rationale for preparing a statement of cash flows is explained in AASB 107 (objective) as

follows:

Information about the cash flows of an entity is useful in providing users of financial statements with

a basis to assess the ability of the entity to generate cash and cash equivalents and the needs of the entity to utilise those cash flows The economic decisions that are taken by users require an evaluation

of the ability of an entity to generate cash and cash equivalents and the timing and certainty of their generation.

17.3 Meaning of funds

A funds statement shows sources and uses of funds, where an increase in funds is a ‘source’ and a decrease in funds is a ‘use’ Funds can be defined in a number of ways and the selected definition will have an important influence on the form and content of the funds statement The three principal interpretations of funds are cash, working capital and total resources.10

There is empirical evidence to support the usefulness of reporting cash flows, and this is discussed in section 17.4.1

However, while there is agreement that cash flow data are of great interest to both management and financial statement users, there is also fairly general agreement that statements of cash flows are not consistent with the purpose of funds statements Earlier we suggest that the main purpose

of a funds statement is to provide a summary of the funds flow effects of the investing and financing transactions of an entity If the funds statement summarises only transactions with

and investing cash

inflows and cash

immediate effects on cash, many important transactions would be omitted For example, credit

sales or purchases, the acquisition of assets in exchange for shares or on extended payment terms,

exchanges of non-cash assets and the refinancing of loans are important transactions that would

not be included in a statement of cash flows The omission of transactions such as these would

reduce the comprehensiveness, and therefore the usefulness, of a funds statement based solely

on cash flows

It has also been argued that showing only transactions with an immediate effect on cash is

inconsistent with the accrual basis of accounting, which is an integral part of the accounting

information system Internal consistency suggests that all financial statements should be based on

the accrual basis of accounting, which was developed to overcome the perceived deficiencies of

a cash-based system.11 Furthermore, ‘the flow of cash and the amount on hand at any time are

the result of decisions relating to matters in which management has numerous options and

wide-ranging discretion’.12

Working capital

Working capital was a widely used interpretation of funds, particularly in the US Working capital is

usually measured as current assets less current liabilities An increase in working capital (source of

funds) occurs when there is an increase in total current assets without a corresponding increase in

total current liabilities (e.g an issue of shares for cash) or a decrease in total current liabilities without

a corresponding decrease in current assets (e.g refinancing a short-term loan with a long-term

loan) A decrease in working capital (application of funds) occurs in the opposite circumstances

In total, the difference between sources and uses of working capital will be equal to the change in

working capital between successive statements of financial position

The use of working capital as the basis for the preparation of a funds statement is related

to liquidity considerations Additions to working capital presumably increase liquidity, and

reductions in working capital reduce liquidity Clift has suggested that the working capital concept

was ‘widely adopted in the USA because of pressure from the banking industry and other grantors

of credit’.13

Funds statements that show movements in working capital suffer from a similar defect to

statements of cash flows They omit the effects of some transactions that may be very important

These omissions are of two types The first is intra-working capital transactions that affect

components of working capital but leave total working capital unchanged Transactions of this

type include the purchase of inventory, the receipt of cash from debtors, the payment of cash to

creditors, the use of cash to settle a short-term loan and the short-term investment of cash in

marketable securities All these transactions leave working capital unchanged and are, therefore,

not disclosed in the working capital funds statement The implicit assumption in this treatment is

that the composition of working capital is unimportant All that matters is total working capital In

fact, of course, the components of working capital are often as important as the total For example,

other things being equal, the use of cash to purchase inventory, while leaving working capital

unchanged, could represent a significant decline in short-term liquidity Any funds statement that

does not disclose changes in the composition of working capital is depriving statement users of

data that may be useful

The second type of omission from working-capital-based funds statements is transactions that

have no effect on the components of working capital Transactions of this type include refinancing

working capital

Current assets less current liabilities.

PART 3 THE STATEMENT OF COMPREHENSIVE INCOME AND FURTHER FINANCIAL REPORTING ISSUES

534

of long-term loans, the acquisition of assets in exchange for shares or on long-term credit, the exchange of non-current assets, and the conversion to equity capital of a convertible note issue

A working-capital-based funds statement omits so many transactions that could be important

to users for decision making that it is not considered to be a satisfactory summary of the funds flow effects of an entity’s investing and financing transactions

Total resources

The total resources concept of funds is based on an interpretation of the statement of financial position as a statement that shows the sources of an entity’s resources and how those resources have been used The obligations side of the statement of financial position is a summary of the financial resources that have been entrusted to the entity by lenders and shareholders The assets side of the statement of financial position shows how these financial resources have been used Some financial resources have been used to acquire assets, some have been used to provide credit and some remain

as cash This interpretation of the statement of financial position is consistent with a stewardship notion of accounting The statement shows how management has used the financial resources entrusted to it by outsiders Any transaction that increases liabilities or equity is a source of funds

Conversely, any transaction that reduces liabilities or equity is a use of funds Any transaction that increases assets is a use of funds, and any transaction that reduces assets is a source of funds that are now ‘free’ for some new use Since all transactions affect the statement of financial position, a total resources funds statement summarises all transactions

It should be noted that funds are provided or used only when outsiders are involved Internal transactions, which Goldberg14 describes as ‘happenings within the undertaking not affecting relations with other persons’, neither provide nor use funds

Of the three concepts of funds that we have considered, only the total resources approach is consistent with the notion of a funds statement as a summary of all the transactions of an entity

17.4 The advantages of reporting cash flow information

The first Australian Accounting Standard on the preparation of a funds statement required

the preparation of one based on the total resources concept of funds As AASB 1026 and then, more recently, AASB 107 have replaced that Standard, accounting standard setters presumably

believed that cash flow information is more relevant to external users than total resources funds

flow information In particular, AASB 107 justifies cash flow reporting on the following grounds

(para 4):

A statement of cash flows when used in conjunction with the rest of the financial statements provides information that enables users to evaluate the change in net assets of an entity, its financial structure (including its liquidity and solvency) and its ability to affect the amounts and timing of cash flows in order to adapt to changing cirumstances and opportunities Cash flow information is useful in assessing the ability of the entity to generate cash and cash equivalents and enables users to develop models to assess and compare the present value of the future cash flows of different entities.

By disaggregating cash flows into operating cash flows and other categories, such as those from

investing and financing activities, AASB 107 endeavours to improve the decisions of the users of

and shareholders) and

how those resources

have been used

(i.e assets).

cash flows

Inflows and outflows

of cash and cash

equivalents.

Copyright © Pearson Australia (a division of Pearson Australia Group Pty Ltd) 2013 – 9781442561175 - Henderson/Issues in Financial Accounting 15e

financial statements To illustrate, Centuria Capital Ltd, which is an Australian diversified funds

management company, reports in its Annual Report 2012 (<www.centuria.com.au> a profit after

tax in its statement of comprehensive income, but net cash outflows from operations in its statement

of cash flows Such cash flow information is useful to investors in highlighting potential problems

that a company may have in generating sufficient funds to maintain its operating capability

17.4.1 Empirical evidence

Early studies examined the relative importance of various measures of cash flows These studies

examined, inter alia, the time-series properties of cash flows and profits as well as the effect on share

market returns of the announcement of cash and profit information A summary of these studies is

included in Brown.15

Using US data, Bowen, Burgstahler and Daley studied the time-series correlations of profit and

various cash flow calculations.16 Six variables (profit and five cash flow calculations) were examined

for 324 firms over a 10-year period ending in 1981 The cash flow measures were calculated using

the indirect method Bowen, Burgstahler and Daley found that time-series correlations became less

significant as more adjustments were made to profit to derive the cash flow measures Given the

nature and size of some of the adjustments made to profit, this result was not unexpected The

authors also found that profit did not allow accurate forecasts of future cash flows

Percy and Stokes replicated the Bowen, Burgstahler and Daley study using Australian data for

99 companies (in 23 industries) over the 10-year period ending in 1985.17 Their analysis also found

low correlations between profit and refined cash flow measures In other words, cash flow data

appear to be different from profit data

Whether these differences are important to users is a moot point Wilson examined the impact

on US share-market returns of cash flow and profit announcements.18 He found that the cash flow

from operations made a significant contribution to explaining abnormal share returns around the

cash flow publication date Flanagan and Whittred conducted a fairly general ‘financial autopsy’

of a large Australian listed company.19 They found that traditional financial ratios of liquidity,

solvency and profitability were poor predictors of failure On the other hand, cash flows from

operations provided an early indication of impending distress Furthermore, the company’s

share price seemed to track cash flows rather than profit measures in the years preceding

its collapse

Another stream of research has investigated the relative ability of components of cash flows

and accounting earnings to reflect stock returns – that is, to recognise value-relevant events in

a timely manner Using US data over several time periods, commencing in 1960 and ending in

1989, Dechow found that cash flows suffer from measurement errors to a greater extent than

earnings.20 She argued that, over the short term, the evidence was consistent with current accruals

playing a dominant role in reducing the timing and matching problems associated with cash

flows On this basis, Dechow argued that earnings were a superior measure of firm performance

Cotter considered this issue using Australian data over the same time period as Percy and

Stokes.21 Similarly, Cotter found that, on average, disaggregated earnings are better able to reflect

value-relevant events than disaggregated cash flows over return intervals of one to 10 years

However, her results also suggest that cash from operations recognises value-relevant events in a

timely manner

PART 3 THE STATEMENT OF COMPREHENSIVE INCOME AND FURTHER FINANCIAL REPORTING ISSUES

536

More recently, Orpurt and Zang investigated whether cash flow disclosures could be used

to predict future performance using a sample of US companies over the period 1989 to 2002

They found evidence that disclosures in statements of cash flows (in the format required by

AASB 107) enhanced forecasts of cash flows from operations and earnings, reflected more future

performance in current stock returns, and reduced articulation errors that arise because line items, such as cash received from customers, cannot be accurately estimated using other financial statements, such as the statement of comprehensive income.22 More recently, investigators have focused on the issue of the usefulness of aggregated cash flow information versus components

of cash flow to statement users For example, Clinch, Sidhu and Sin investigated the ability of components of disclosed operating cash flow and indirect accruals to explain annual returns for a sample of Australian companies over the period 1992–1997.23 They found evidence of significant explanatory power for disclosed operating cash flow components beyond aggregate operating cash flows, and beyond estimates of the components (based on other financial statement disclosures) for companies with large differences between disclosed and estimated components

Similarly, using a sample of US companies over the period 1988 to 2004, Cheng and Hollie investigated the usefulness of disclosure of cash flow components for predicting future cash flows.24

They differentiate between core cash flows or items that are closely related to operations such as cash flows related to sales, cost of goods sold and operating expenses, and non-core cash flows that are related to interest, taxes and owners’ equity They found evidence that core cash flows all have similar persistence and persist more than components of non-core cash flows

Adopting a different approach to assessing the usefulness of reporting cash flow data, Jones, Romano and Smyrnios surveyed 210 statement preparers from listed Australian companies.25

Respondents perceived the statement of cash flows to be relevant across a wide range of decision contexts, including liquidity and solvency evaluation, monitoring and prediction functions, strategic decision making and performance-evaluation tasks A follow-on study by Jones and Ratnatunga supported these findings.26

In summary, although the evidence on the usefulness of cash flow data has been collected from several different perspectives, on balance there appears to be a case for the reporting of cash flow data to complement the statement of comprehensive income and statement of financial position

That is, cash flow information is useful information for users of financial statements

17.5 Accounting standards

AASB 107 ‘Statement of Cash Flows’ has been issued and variously amended by the Australian

Accounting Standards Board (AASB) so that entities complying with AASB 107 will simultaneously

be in compliance with the International Accounting Standard IAS 7 ‘Statement of Cash Flows’

This reflects the AASB’s program of issuing Australian Accounting Standards that are equivalent

to IFRS

AASB 107 requires that entities prepare a statement of cash flows and present it as an integral

part of their financial statements (para 1) Guidance on an appropriate format is contained in

the illustrative appendices to AASB 107, which show a statement of cash flows that discloses the

amounts of cash at the beginning and end of each financial year, and adds (subtracts) the net increase (decrease) in cash and cash equivalents for the period Paragraph 10 requires that cash

flows arising during the period are classified as arising from operating, investing and financing

activities

Cash flows include inflows and outflows of cash and cash equivalents Paragraph 6 of AASB 107

defines cash as ‘cash on hand and demand deposits’ – that is, notes and coins held, and deposits

held at call with a financial institution Cash equivalents are defined as:

short-term, highly liquid investments that are readily convertible to known amounts of cash and which

are subject to an insignificant risk of changes in value (para 6)

Paragraph 7 elaborates on this definition It suggests that a ‘short period to maturity’ means three

months or less For a borrowing to be classified as cash it must not be subject to any term facility

but rather be ‘repayable on demand’ (para 8) Bank overdrafts that are repayable by an entity on

demand would meet the definition of cash Short-term money market investments that are repayable

on demand either at the investor’s option or at the purchaser’s option also meet the definition of cash

equivalents Suppose, for example, that a company had cash on hand of $100 000, liquid investments

of $200 000 maturing in two months and a bank overdraft of $50 000 Its cash would comprise:

The requirement for an entity to present its cash flows from operating, investing and financing

activities is based on the assumption that it allows users to assess ‘the impact of those activities on

the financial position of the entity and the amount of its cash and cash equivalents’ (para 11) That

is, disclosure of amounts of cash flows arising from an entity’s operating activities provides insights

into the extent to which sufficient funds are generated to repay loans, pay dividends and make

new investments without using external financing sources, as well as assisting in forecasting future

operating cash flows (para 13) Disclosure of cash flows arising from investing activities highlights

the extent to which investments in resources have been made to generate future cash flows (para

16) Finally, disclosure of cash flows from financing activities assists in predicting claims on future

cash flows by providers of external capital (para 17)

To illustrate, the Accounting in Focus box on the following page contains an extract from the

2011 financial statements of BHP Billiton Ltd The statement of cash flows reveals an increase

in cash flows from operating activities that was used in two share buy-back schemes, to pay

dividends and to reduce debt (disclosed as part of financing cash flows), and invest in capital

projects, intangible assets, financial assets and exploration programs (disclosed as part of investing

cash flows)

Paragraph 6 of AASB 107 defines operating activities as:

the principal revenue-producing activities of the entity and other activities that are not investing or

financing activities

Cash flows from operating activities generally result from transactions and other events that are

included in the measurement of profit or loss in the statement of comprehensive income (para 14)

Paragraphs 14 and 15 of AASB 107 provide some examples of operating activities They include

to an insignificant risk of changes

in value.

investment

Assets that are held

with the expectation

of generating periodic revenues and/or a gain when they are eventually sold.

PART 3 THE STATEMENT OF COMPREHENSIVE INCOME AND FURTHER FINANCIAL REPORTING ISSUES

538

BHP Billiton Annual Report 2011

Consolidated Cash Flow Statement for the year ended 30 June 2011

Impairments of property, plant and equipment, financial assets and intangibles 74 35

Changes in assets and liabilities:

Investment in subsidiaries, operations and jointly controlled entities, net of their cash (4 807) (508)

Proceeds from sale or partial sale of subsidiaries, operations and jointly controlled entities,

Financing activities

Purchase of shares by Employee Share Ownership Plan (ESOP) Trusts (469) (274)

Cash and cash equivalents, net of overdrafts, at the beginning of financial year 12 455 10 831

Effect of foreign currency exchange rate changes on cash and cash equivalents 27 26

Cash and cash equivalents, net of overdrafts, at the end of the financial year 23 10 080 12 455

Source: Extract from BHP Billiton, Annual Report 2011, p 164.

Copyright © Pearson Australia (a division of Pearson Australia Group Pty Ltd) 2013 – 9781442561175 - Henderson/Issues in Financial Accounting 15e

payments to suppliers for goods and services, payments to employees, receipts from the sale of

goods and the provision of services, receipts from royalties, fees and commissions, cash flows from

payments or refunds of income tax, cash flows from contracts held for ‘dealing or trading purposes’,

and cash flows from securities or loans held for ‘dealing or trading purposes’ Also, the cash payments

and receipts of an insurance entity for premiums and claims, annuities and other policy benefits are

included in operating activities Although the sale of an item of plant may give rise to a gain or loss

included in the statement of comprehensive income, the cash flows relating to the transaction are

classified as cash flows from investing activities (para 14)

Paragraph 6 of AASB 107 defines investing activities as ‘the acquisition and disposal of long-term

assets and other investments not included in cash equivalents’

Paragraph 16 requires that only ‘expenditures that result in a recognised asset in the statement

of financial position are eligible for classification as investing activities’ Examples provided in

paragraph 16 include payments to acquire property, plant and equipment, intangibles and other

long-term assets; proceeds from the sale of property, plant and equipment, intangibles and other

long-term assets; payments to acquire equity or debt instruments of other entities and interests in

joint ventures; and receipts from the sale of equity or debt instruments of other entities and interests

in joint ventures Additionally, cash advances and loans made to other entities, receipts from the

repayments of loans and advances, and cash payments and receipts from futures contracts, forward

contracts, option contracts and swap contracts are included in investing activities

Paragraph 6 of AASB 107 defines financing activities as:

activities that result in changes in the size and composition of the contributed capital and borrowings

of the entity.

Paragraph 17 provides some examples of cash flows arising from financing activities They include

the proceeds from issuing shares or equity instruments, cash outlays to buy back such instruments,

proceeds from issuing debentures, loans, notes, bonds, mortgages and other borrowings, cash

repayments of amounts borrowed, and cash payments by a lessee for reduction of the outstanding

principal on a finance lease

Of course, the only cash inflows and outflows that the statement of cash flows shows are those

from transactions with entities external to the reporting entity

There are some issues in preparing a statement of cash flows and its presentation that warrant

discussion:

1 the format of a statement of cash flows;

2 the presentation of cash flows from operating activities; and

3 the treatment of offsetting cash flows

17.5.1 Format of the statement of cash flows

The format of a statement of cash flows for Magnolia Ltd prepared in accordance with AASB 107 is

shown on the following page A difficulty with this format is that some cash inflows and outflows

may have characteristics of more than one category of cash flows In addition, the categories are not

mutually exclusive so that it will be a matter of judgement as to which category is appropriate for a

particular transaction involving cash flows

investing activities

Activities related to the purchase

or disposal of non-current assets.

financing activities

Activities that result

in changes in the size and composition of the contributed equity and borrowings of the entity.

Prepare a statement of cash flows in accordance with the requirements

of AASB 107

‘Statement of Cash Flows’.

LEARNING OBJECTIVE 5

PART 3 THE STATEMENT OF COMPREHENSIVE INCOME AND FURTHER FINANCIAL REPORTING ISSUES

540

For example, the payment of interest to a lender can be viewed as:

◆ an operating transaction – that is, as part of the cash management function associated with

operating activities; or

◆ a financing transaction – that is, as part of the return to the providers of interest-bearing debt.27

The Standard requires interest and dividends received (para 31), interest and dividends paid (para 31) and income taxes paid (para 35) to be disclosed separately Cash flows arising from taxes

on income are to be classified as part of operating activities unless they can be specifically identified with financing and investing activities (para 35) Dividends paid may be classified as either (i) a financing cash flow since they are a cost of obtaining financial resources, or (ii) an operating cash flow to assist users in determining the ability of an entity to pay dividends (para 34) Of the remaining items, it is not necessary to classify interest paid, interest received and dividends received in a particular way, as long as it is consistent from period to period (para 31) Note,

however, that the illustrative examples in AASB 107 show interest paid as part of operating

activities, interest received as part of investing activities, and dividends received as part of investing activities

Magnolia Ltd

Statement of Cash Flows for year ended 30 June 2014

Cash flows from operating activities

Cash flows from investing activities

Cash flows from financing activities

Net increase in cash and cash equivalents 410

Cash and cash equivalents at the beginning of the period 190

Cash and cash equivalents at the end of the period $600

17.5.2 Presentation of cash flows from operating activities

There are two methods for presenting cash flows from operating activities First, there is the direct

method which involves reporting the major classes of gross operating cash receipts and gross

operating cash payments (para 18(a)) An example of this approach is shown on the following page