AF210 Tutorial 2

1. Discuss the importance of the going concern assumptions to the practice of

accounting.

Financial statements are prepared under the assumption that an entity will continue to operate
in the foreseeable future. This going concern assumption is important as it may be used to
justify the use of historical costs in accounting for liabilities and assets and, in the case of non-
current assets, for the systematic allocation of their costs to depreciation expense over their
useful lives. As such the assumption is made that current market values of assets are sometimes
of little importance. It also ensures that the financial statements are not prepared on the basis
of expected liquidation or forced sale values.

Exercise 1.6

The Conceptual Framework versus interpretations

Applying the Conceptual Framework is subjective and requires judgement. Would the
IASB be better off to abandon the Conceptual Framework entirely and instead rely on a
very active interpretations committee that develops detailed guidance in response to
requests from constituents? (LO3, LO4, LO8 and LO9)

The fact that the Conceptual Framework involves judgement does not mean that it should be
abandoned. The guidance developed by the interpretations committee would be ad hoc – that
is, developed case by case without the foundation of the framework to look to. The standards
themselves would suffer from the same problem if there were no framework.

The Conceptual Framework provides guidance and direction to the standard setters, and
therefore will lead to consistency among the standards. But it is a set of concepts. It provides a
boundary for the exercise of judgement by the standard setter and the interpretive body.

Exercise 1.7

Meaning of ‘decision useful’

What is meant by saying that accounting information should be ‘decision useful’? Provide
examples. (LO5)

The Conceptual Framework identifies the principal classes of users of general purpose
financial statements as the existing and potential investors, lenders and other creditors.

All of these categories of users rely on financial statements to help them in making various
kinds of decisions. Investors need to decide whether to buy, sell, or hold shares. Lenders need
to decide whether to lend and at what price. Suppliers need to decide whether to extend credit.
Information is decision-useful if it helps these people make their decisions.

Existing and potential investors, lenders and other creditors have the most critical and
immediate need for the information in financial reports and many cannot require the entity to
provide the information to them directly.
The general purpose financial statements shall focus on the needs of participants in capital
markets, which include not only existing investors but also potential investors and existing and
potential lenders and other creditors.

Information that meets the needs of the specified primary users is likely to meet the needs of
users both in jurisdictions with a corporate governance model defined in the context of
shareholders and those with a corporate governance model defined in the context of all types
of stakeholders.

Individual primary users have different, and possibly conflicting, information needs and
desires. Reporting entities shall seek to provide the information set that will meet the needs of
the maximum number of primary users. However, focusing on common information needs does
not prevent the reporting entity from including additional information that is most useful to a
particular subset of primary users.

The Conceptual Framework notes that financial statements cannot provide all the information
that users may need to make economic decisions. In developing financial reporting
requirements that meet the objective of financial reporting, reporting entities shall rely on the
qualitative characteristics of, and the cost constraint on, useful financial information to avoid
providing too much information.

While the concepts in the Conceptual Framework are likely to lead to information that is useful
to the management of a business enterprise in running the business, the Conceptual Framework
does not purport to address their information needs. The same can be said for the regulators
and fiscal-policy decision makers.

Exercise 1.8

Performance of a business entity

A financial analyst said:

I advise my clients to invest for the long term. Buy good shares and hang onto
them. Therefore, I am interested in a company’s long-term earning power.
Accounting standards that result in earnings volatility obscure long-term earning
power. Accounting should report earning power by deferring and amortising costs
and revenues.

Is this analyst’s view consistent with the fundamental characteristics of financial

information established in the Conceptual Framework? (LO5)

Accounting standards should help provide relevant and faithfully represented financial
information. Companies that operate in risky business environments or that enter into risky
kinds of transactions are likely to experience real ups and downs in their performance. In such
cases, volatility of reported earnings results from the real transactions and activities of the
company. In other words, the statement of profit or loss and other comprehensive income
reflects the underlying risks. It is not the role of financial accounting and reporting to try to
smooth the company’s earnings by, say, deferring profits in good years and deferring expenses
in bad years. The amounts reported in the financial statements would not be faithfully
represented because they do not reflect real phenomena.
Exercise 1.11

Definition of elements

Explain how Beachside Ltd should account for the following items/situations, justifying
your answer by reference to the Conceptual Framework’s definitions and recognition
criteria.
1. Receipt of artwork of sentimental value only.
2. Beachside Ltd is the guarantor for an employee’s bank loan:
(a) You have no reason to believe the employee will default on the loan.
(b) As the employee is in serious financial difficulties, you think it likely that he will
default on the loan.
3. Beachside Ltd receives 5 000 shares in Monty Ltd, trading at $6 each, as a gift from a
grateful client.
4. The panoramic view of the coast from Beachside Ltd’s café windows, which you are
convinced attracts customers to the café.
5. The court has ordered Beachside Ltd to repair the environmental damage it caused
to the local river system. You have no idea how much this repair work will cost.
(LO7 and LO8)

1. Trinket of sentimental value:

 Fails the paragraph 4.3 asset definition as it does not constitute a present economic
resource controlled by the entity. Furthermore, it does constitute a right that has the
potential to produce economic benefits (paragraph 4.4).
 Recognition criteria are irrelevant, as there is no asset to recognise.

2. Guarantor for an employee’s loan.

(i) Employee unlikely to default on his/her loan
 Meets the paragraph 4.27 liability definition: (1) present obligation — legal
obligation via the guarantor contract; (2) transfer an economic resource — payment
of the guarantee; (3) past event — signing the guarantor contract.
 Fails probability recognition criterion, as it is not likely that Beachside Ltd will be
required to pay on the guarantee. No liability can be recognised as it will not result
in relevant and faithful represented information. However, note disclosure of the
guarantee may be warranted.
(ii) Employee likely to default on his loan.
 Again, meets the liability definition as per (i) above.
 Meets both recognition criteria — relevant and can be faithfully represented.
Hence, a liability should be recognised.
 Also meets the expense definition and recognition criteria. Definition: (1) an
increase in a liability — Beachside Ltd now owes the amount of the employee’s
loan; (2) during period — the liability increase arose during period; (3) results in
equity decrease — if liabilities increase and assets do not change, equity decreases.
Recognition criteria: The decrease in future economic benefits has arisen, as
Beachside Ltd now owes the amount of the employee’s loan. The bank can advise
exactly how much the employee owes and so it can be reliably measured.

3. Receipt of 5 000 shares in Monty Ltd, trading at $6 each, as a gift from a grateful client.
 The receipt of the shares meets the asset definition: (1) present economic
resource (via future sales or dividend stream); (2) controlled by Beachside Ltd
 (only Beachside Ltd can benefit from either selling them or receiving
dividends); (3) past event (their receipt).
 They also meet the asset recognition criteria: relevant and faithfully represented
(via sale or dividend stream, trading at $6 each).
 The shares also meet the income definition and recognition criteria. Definition:
(1) increase in assets — Beachside Ltd now owns the shares; (2) during period
— the shares were received during period; (3) results in equity increase — if
assets increase and liabilities do not change, equity increases. Recognition
criteria: The increase in assets has arisen, as Beachside Ltd now owns the shares
(asset). The shares’ value is known and so can be faithfully represented.

4. Café’s panoramic view.

 The view fails the definition as the entity does not control the economic
resources that are expected to produce economic benefits — the entity cannot
deny or regulate access by others to the view.
 Recognition criteria are irrelevant, as there is no asset to recognise.

5. Court order to repair environmental damage caused to the local river system. You have
no idea how much this repair work will cost.
 The court order meets the liability definition: (1) legal obligation; (2) obligation
to transfer economic resources — future payment for repair of damage (3) past
event — order has been made;
 Fails reliable measurement recognition criterion, as you have no idea as yet how
much the repair work will cost. Hence, no liability can be recognised. However,
note disclosure of the court order may be warranted.
 However, if you know a minimum amount that Beachside Ltd will have to pay,
then the reliable measurement criterion is met for this amount. The probability
criterion is met as it is certain (given that Beachside Ltd has been ordered by
the court) that Beachside Ltd will have to pay the repair cost. Again, note
disclosure may still be warranted advising that the cost may be well in excess
of this amount.