ACCY111 – Week 3 Solutions

Chapter 10: Regulation and the Conceptual

Framework
Discussion questions
1. Outline the regulatory process in Australia in relation to accounting standard
setting and discuss the influence of international bodies in the standard-
setting process.

The answer to this question requires a full coverage of the material covered in
Learning Objective 1 of the chapter. Regarding international influence, refer to the
discussion of the roles played by the IASB and the FASB. See also discussion of the
Asian–Oceanian Standard Setters Group.

4. Briefly explain the nature of the Conceptual Framework for Financial Reporting,
and discuss the perceived advantages and disadvantages of having a conceptual
framework.

A conceptual framework of accounting theory should enable standard setters to

develop standards which are consistent and logically formulated, provide guidance to
accountants in areas of accounting where standards have not been established, and
enable standard users to better understand standards and proposed standards.

The IASB and FASB are currently undertaking a joint project to amend the
conceptual framework. The overall objective of this joint project is to develop a
common conceptual framework that is both complete and internally consistent. The
Boards want to develop a framework which will provide a sound foundation for
developing future accounting standards that are principles-based, internally consistent,
internationally converged, and that lead to financial reporting which provides the
information needed for investment, credit, and similar decisions. That framework,
which will deal with a wide range of issues, will build on the existing IASB and
FASB frameworks.

Are there any disadvantages in having a conceptual framework? Consider the cost of
developing the framework versus the benefits. Also, since it is not compulsory for
standard setters to follow the conclusions of the conceptual framework, will it be
ignored?

6. From the current Conceptual Framework, outline the qualitative

characteristics of financial information to be included in general purpose
financial reports.

The Conceptual Framework 2010, issued by the IASB and the FASB, has divided
qualitative characteristics into two categories, namely, fundamental characteristics
(relevance and faithful representation) and enhancing characteristics (comparability,
understandability, verifiability and timeliness). See Learning objective 5 in the
chapter for a discussion of each characteristic.
ACCY111 – Week 3 Solutions

8. ‘To determine whether an entity should classify its costs either as an

asset or an expense, accounting standards must contain definitions of
these terms.’

With reference to the above statement, discuss the concept of an asset

and an expense provided in the Conceptual Framework. Provide also a
discussion of the IASB’s and FASB’s alternative suggestion for amending
the definition of an asset. Do you agree with the above statement? Why
or why not?

An asset is defined in the current Framework as ‘a resource controlled by the entity as

a result of past events and from which future economic benefits are expected to flow
to the entity’. Expenses are defined in the Framework as ‘decreases in economic
benefits during the accounting period in the form of outflows or depletions of assets
or incurrences of liabilities that result in decreases in equity, other than those relating
to distributions to equity participants’. Note that the definition of an expense is driven
by the definitions of assets and liabilities.

For a cost incurred to qualify as an asset, the cost must result in future economic
benefits which the entity controls. If this is not the case, then the cost automatically
qualifies as an expense, as there is a reduction in an asset or an increase in a liability
which has the effect of decreasing the entity’s equity. The purchase of an asset does
not decrease equity and therefore does not create an expense. An expense also arises
whenever the economic benefits in the asset are consumed, expired or lost.

The proposed definition of an asset in the Framework is that ‘an asset of an entity is a
present economic resource to which the entity has a right or other access that others
do not have.’ This means that when a cost is incurred, the questions to be asked will
be, has a present economic resource come into existence? and does the entity have
rights to that resource that others do not have?

It is important that accounting standards contain definitions of assets and expenses in

order to provide a mechanism by which preparers of financial statements can
determine which costs are assets and which are expenses.

9. Outline the definitions of a liability and equity as provided in the current

Conceptual Framework. Provide and discuss examples of situations where
there is confusion in determining whether a liability exists as opposed to
equity.

A liability is defined in the current Framework as ‘a present obligation of the entity

arising from past events, the settlement of which is expected to result in an outflow
from the entity of resources embodying economic benefits’. Important aspects of this
definition are below.

A legal debt constitutes a liability, but a liability is not restricted to being a legal debt.
Its essential characteristic is the existence of a present obligation, being a duty or
responsibility of the entity to act or perform in a certain way. A present obligation
may arise as a legal obligation and also as an obligation imposed by custom or normal
business practices (referred to as a ‘constructive’ obligation). For example, an entity

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may decide as a matter of normal business policy to rectify faults in its products even
after the warranty period has expired. Hence, the amounts that are expected to be
spent in respect of goods already sold are liabilities.

A present obligation needs to be distinguished from a future commitment. A decision

by management to buy an asset in the future does not give rise to a present obligation.

A liability must result in the giving up of resources embodying economic benefits

which requires settlement in the future. The entity has little, if any, discretion in
avoiding this sacrifice. This settlement in the future may be required on demand, at a
specified date, or on the occurrence of a specified event.

A liability is that it must have resulted from a past event. For example, wages to be
paid to staff for work they will do in the future is not a liability as there is no past
event and no present obligation.

The current Framework defines equity as ‘the residual interest in the assets of the
entity after deducting all its liabilities’. Equity cannot be identified independently of
the other elements in the statement of financial position/balance sheet. The
characteristics of equity are that equity is a residual, i.e. something left over after the
entity has determined its assets and liabilities. In other words:

Equity = Assets – Liabilities.

The IASB and FASB have proposed to change the definition of a liability by focusing
on a liability as a ‘present economic obligation’ rather than an expected future
sacrifice of economic benefits. Furthermore, the reference to past events is to be
replaced by a focus on the present. A further essential attribute in the proposed
definition is that the entity is the ‘obligor’. An entity is the obligor if the entity is
required to bear the economic obligation and its requirement to bear the economic
obligation is enforceable by legal or equivalent means.

Examples of items which cause problems in determining whether they are liabilities
or equity are financial instruments such as:
 convertible debt
 redeemable preference shares.

Discussion Question – Chapter 2

1. Explain the basic differences between a sole trader (or single proprietorship),
a partnership and a company. Discuss the factors that need to be considered
in selecting an appropriate structure for Cynthia’s Beauty Services business.

The three basic business structures are:

Sole traders are where individuals conduct business in their own capacity. They
would be contributing their own capital or equity to the business and would be
borrowing money in the name of the business in their own name. They would be
liable to repay the outstanding debt of the business and, if unable to repay, the
bank, would have access to their own personal assets to repay the outstanding

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debt. This business structure is suitable for small operations with small staff and
turnover. The sole trader has sole responsibility and control for the business
operations and activities. This structure is suitable for small businesses which
require minimal capital to set up and have relatively low running costs and risk.
A partnership is two or more persons in business together, operating under a
partnership agreement which may or may not be a formally written document.
Partnerships have the advantage over sole traders in that they have a larger base
for capital contribution and are able to share the risks and responsibilities
associated with running a business. The partnership is treated as a separate entity
for accounting purposes but is not a separate legal entity. This means that the
underlying assets and liabilities of a partnership belong to the individual partners
in the proportion agreed upon as part of the partnership agreement. Therefore if
the business activities prove to be unsuccessful, creditors have the right to access
the personal assets of the individual partners in the event the business is unable to
repay any outstanding debt. For this reason, the partnership structure is usually
used where there is a low element of risk to the business or where the law dictates
that the business entity must be run by the individuals providing the service. For
example, work completed by professionals including accountants and lawyers.
The company is a separate legal entity with ownership of a company attributed to
shares held. The owners of the company are known as shareholders. The
advantage of this business structure is that, as a separate legal entity, the assets
and liabilities belong to the company. In the event the business is unable to repay
its debt, the creditors only have access to company assets for repayment of the
debt. The investment in the company by its shareholders is limited only to the
shareholders’ capital contribution, i.e. what the shareholder pays for the shares.
This business structure is more appropriate for entities requiring larger capital
contribution, which have a large number of overheads and employees and has a
higher business risk. The disadvantages include higher set up and ongoing costs
and possible reduction in control over the business operations where shareholders
are not directly involved in the business operations.

Factors that Cynthia needs to consider in selecting an appropriate structure for her
business include:
 Simplicity in setting up the business: sole traders and small partnerships are
easier to set up compared to companies.
 Establishment costs: companies are more expensive to establish compared to sole
traders and partnerships.
 Liability issues: sole traders and partnerships have unlimited liability, which
means owners and partners are personally liable for their business’ debts,
including those resulting from lawsuits or the actions of other partners. If
unlimited liability is a concern, then Cynthia may want to consider setting up a
company instead of being a sole trader or partnership.
 Tax: tax reporting requirements for companies are far greater than for sole traders
and partnerships.
 Control of the business: as an owner of a sole trader, Cynthia would have a
complete control over her business. If she chooses to partner with someone
through a partnership, she will need to discuss business matters with her partner.
If Cynthia decides to set up a company and employs a management team, she
may not have as much control in running the business as it will be the
responsibility of the management team.

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 Access to capital: the access to finance for a sole trader is limited to the owner’s
resources. On the other hand, a partnership has greater access to capital from
resources of all partners, and a company has even far greater access to capital
from various shareholders.

10. Discuss the significance of the following assumptions in the preparation

of an entity’s financial statements:
(a) Entity assumption
(b) Accrual basis assumption
(c) Going concern assumption
(d) Period assumption

(a) Entity assumption:

If the transactions of an entity are to be recorded, classified and summarised into

financial statements, the accountant must be able to identify clearly the boundaries of
the entity being accounted for. Under the accounting entity assumption, the entity is
considered a separate entity distinguishable from its owner and from all other entities.
It is assumed that each entity controls its assets and incurs its liabilities. The records
of assets, liabilities and business activities of the entity are kept completely separate
from those of the owner of the entity as well as from those of other entities.

The accounting entity assumption is important since it leads to the derivation of the
accounting equation.

(b) The accrual basis assumption:

Under the accrual basis of accounting, the effects of transactions and events are
recognised in accounting records when they occur, and not when the cash is received
or paid. Hence, financial statements report not only on cash transactions but also on
obligations to pay cash in the future and on resources that represent receivables of
cash in future. It is argued in the Conceptual Framework that accounting on an
accrual basis provides significantly better information about the transactions and other
events for the purpose of decision making by users of financial statements than does
the cash basis.

(c) The going concern assumption:

According to the Conceptual Framework, financial statements are prepared on the

assumption that the existing entity is expected to continue operating into the future. It
is assumed that the assets of the entity will not be sold off and that the entity will
continue its activities; hence, liquidation values (prices in a forced sale) of the entity’s
assets are not generally reported in financial statements, as this assumes that an entity
is to be wound up.

When management plans the sale or liquidation of the entity, the going concern
assumption is then set aside and the financial statements are prepared on the basis of
estimated sales or liquidation values. The significance of the going concern
assumption is in the valuation placed on the assets of an entity in the entity’s financial

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statements. The statements should identify clearly the basis upon which asset values
are determined — going concern? Or liquidation?

(d) The period assumption:

For financial reporting purposes, it is assumed that the total life of an entity can be
divided into equal time intervals. Hence, the financial performance of the entity can
be determined for a given time period, and the financial position of the entity can be
determined on the last day of that reporting period.

As a result of this assumption, profit determination involves a process of recognising

the income for a period and deducting the expenses incurred for that same period.
Together, the period assumption and accrual basis assumption lead to the requirement
for making end-of-period adjustments on the last day of the reporting period. These
adjustments will be considered in chapter 4.

Exercises
Exercise 10.10

Assets and asset recognition

For several seasons, Megan Gale and Jennifer Hawkins have been employed by
David Jones Limited and Myer Limited respectively in order to attract more
fashion-conscious customers to their stores. This strategy has met with some
success and their continued employment at fashion events in the future for their
respective companies appears assured.

Required
(a) Discuss whether Megan Gale and Jennifer Hawkins should be regarded as
assets of David Jones Limited and Myer Limited respectively. Discuss also
whether they should have been recognised on the statement of financial
position/balance sheet of the respective companies as assets.
(LO6 and LO7)

(a) An asset is defined in the current Framework as ‘a resource controlled by the

entity as a result of past events and from which future economic benefits are expected
to flow to the entity’.

It is proposed to amend the definition of an asset to the following.

 An asset of an entity is a present economic resource to which, through an

enforceable right or other means, the entity has access or can limit the
access of others.

Do Megan Gale and Jennifer Hawkins satisfy the definition of an asset? Under their
contracts, they are both being paid over $1 million cash, plus share options. Are they
both ‘resources’ containing future economic benefits to the respective companies? If

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you believe so, are those resources ‘controlled’ by the entities concerned, as a result
of past events? This is doubtful.

After they have performed their modelling duties for each company, do the future
economic benefits ‘linger on’? Or do the remunerations paid to them merely represent
part of advertising expenses?

Under the ‘proposed’ definition of an asset, do the two models represent present
economic resources to the two companies, over which they currently have rights that
others do not have? Whether the two entities have rights to the exclusion of others is
doubtful.

If you believe they are assets of the two companies, can they be recognised as such in
financial statements?

Recognition criteria for an asset are:

 it is probable that the future economic benefits will flow to the entity and the asset
has a cost or other value that can be measured reliably.

Hence, is it ‘probable’ that benefits will flow to the entity? Can the cost or other value
be measured reliably. What cost/value do you place on share options given to the two
models?