Accounting in

Organisations and Society

Module 3 – Financial Accounting
Topic 2: General purpose financial statements – further consideration of the balance sheet

Learning Notes

Topic 2: General purpose financial statements -

further consideration of the balance sheet.

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Accounting in Organisations and Society
Topic 3: What do we provide an ‘account’ of, and why?
 Accounting in Organisations and Society

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Table of Contents
Overview of this topic .................................................................................................. 1
The balance sheet ....................................................................................................... 1
Current assets ............................................................................................................. 2
Non-current assets ...................................................................................................... 3
Why do we want to differentiate current and non-current assets? ........................... 3
The measurement of assets .................................................................................... 3
Some measurement bases ...................................................................................... 4
Prepayments ............................................................................................................ 4
Property, plant and equipment (P,P& E) .................................................................. 5
Measurement of P, P & E ........................................................................................ 5
Depreciation of P, P & E .......................................................................................... 8
Marketable securities ............................................................................................. 10
Intangible assets .................................................................................................... 10
Measurement of intangible assets ......................................................................... 11
Leased assets ........................................................................................................ 11
A summary of some of the different asset measurement rules ............................. 11
Current liabilities ........................................................................................................ 12
Non-current liabilities ................................................................................................. 13
Why do we want to differentiate current and non-current assets? ......................... 13
The measurement of liabilities ............................................................................... 13
Measurement bases .............................................................................................. 13
General principle for liability measurement ............................................................ 14
Contingent liabilities .................................................................................................. 15
Equity ........................................................................................................................ 16
Further reflections about the balance sheet .............................................................. 17
References ................................................................................................................ 24

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Overview of this topic

• Provide a more in-depth review of the balance sheet, including an investigation of;
– Measurement requirements for particular classes of assets, including:
• Cash at bank
• Inventory
• Accounts receivable
• Prepayments
• Property, plant and equipment,
• Marketable securities
• Intangible assets
• Leased assets
– Measurement requirements for particular classes of liabilities, including:
• Bank overdraft
• Provisions
• Bonds
• Contingent liabilities
– An analysis of components of equity, including:
• Share capital
• Retained earnings
• Various ‘reserves’

The balance sheet

• Also known as the statement of financial position.
• Provides details of the assets, liabilities and equity of an organisation at a point in time.
• Because it is ‘at a point in time’ its relevance can decrease with the passing of time.
• Based around the accounting equation of A = L + OE
• Often presented in the form A – L = OE
• Prepared at least once a year, but can be prepared more often if required.

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Current assets
• For balance sheet purposes, assets are generally subdivided into current and non-
current assets.
– An organisation does not have to classify its assets into current and non-current, but
this is normal practice.
– An alternative presentation format is to present assets on the basis of their order of
liquidity (how quickly the assets can be turned into cash).
• Banks often use this approach.
• Current assets are expected to be sold, consumed or otherwise used to create income
within one year of the date of the balance sheet, or within the current operating cycle of
the business.
• A common definition of current assets is:
– assets that, in the ordinary course of business, would be consumed or converted into
cash within 12 months after the end of the financial period (the ‘12-month test’). This
is what is often taught in introductory courses in financial accounting.
• However, a more ‘technically correct’ definition requires us to consider an entity’s
normal operating cycle when determining whether assets (and liabilities) should be
classified as current or non-current for the purposes of presentation in the statement of
financial position balance sheet. According to accounting standards, the operating cycle
of an entity is the time between the acquisition of assets for processing and their
realisation in cash or cash equivalents.
• When the entity’s normal operating cycle is not clearly identifiable, its duration is
assumed to be 12 months.
• As an entity’s ‘operating cycle’ might be greater than 12 months, assets that might not
be realised or converted to cash for a period in excess of 12 months can still be
considered ‘current’ within such entities.
• According to accounting standards, an entity shall classify an asset as current when:
1. it expects to realise the asset, or intends to sell or consume it, in its normal operating
cycle;
2. it holds the asset primarily for the purpose of trading;
3. it expects to realise the asset within twelve months after the reporting period;
4. or the asset is cash or a cash equivalent. An entity shall classify all other assets as
non-current.
• Current assets are separated from other assets because an organisation generally relies
on its current assets to fund ongoing operations. Examples of current assets on a typical
balance sheet would include:
Cash,
Accounts receivable,

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Inventory,
Prepaid expenses, and;
Investments expected to be sold.
• As an example of an organisation that might have an operating cycle greater than one
year, we can consider a ship builder. Such an organisation might have an operating
cycle longer than a year because it takes more time to build a ship (cash expenditures)
and, subsequently, to sell it (cash receipt). In such cases, the current versus non-current
classification will be based on a period longer than a year after the balance sheet date.

Non-current assets
• An asset that is not classified as current will be classified as non-current

Why do we want to differentiate current and non-current assets?

• Current assets are more likely to be used to generate cash in the short run and hence
they provide some indication of future cash flows.
• By classifying some assets as ‘current’ we are able to identify which of those we’re able
to sell or liquidate easier.
• This helps us to assess some aspects of the risk of the organisation, particularly when
we compare the current assets with the current liabilities.

The measurement of assets

• Whilst we know the definition of assets, and we know when they should be recognised
(on the basis of measurability and probability), the next step is to determine the amount
to be assigned to the asset.
• This can be called ‘measurement’.
• Not all assets are measured on the same basis – this might seem odd, but it is the case!
• And this creates what we might refer to as an ‘additivity problem’ (we add up all the
assets to calculate a total figure but the values of these assets are not on the same
base).
• Some assets might be measured at face value, whilst others might be measured at net
realisable value, present value, or fair value.
• This is called a ‘mixed measurement’ approach.
• This means we must be careful when interpreting the total: namely “total assets”.

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Some measurement bases

• Cash
– Measured at ‘face value’
– Face value is the value shown on the face of a security certificate, including currency.
• Debtors (Accounts receivable)
– At face value, less an allowance for doubtful debts
– Because, it would be unrealistic to believe that all debtors will pay. It is normal
practice to recognise that a certain percentage will not ultimately pay.
– For example, if an organisation has $1m in outstanding debtors and past practice
indicates that 5% of debtors typically don’t pay, then the debtors would be disclosed
as follows:
Debtors $1,000,000
Less allowance for doubtful debts $50,000
Net debtors $950,000
• Inventory (also known as stock) can be defined as assets:
– Held for sale in the ordinary course of business.
– In the process of production for sale.
– In the form of materials or supplies to be consumed in the production process or in
the rendering of services.
• Inventory shall be measured at the lower of cost and net realisable value
– Cost is to include
• Cost of purchase.
• Cost of conversion, and;
• Other costs incurred in bringing to inventories to their present location and
condition.
– Net realisable value is the estimated proceeds of sale less costs to completion and
costs to sell.

Prepayments
• Prepayments (and accrued expenses) are adjustments that we make to ensure that
expenses and income are recognised in the correct accounting period.
• According to the accruals concept, expenses should be recognised in the period they are
incurred rather than the period when they are recorded/paid, and income should be
recognised in the period it is earned, not the period it is recorded/received.

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• It is common to pay certain expenses in advance (that is, prepay them), for example rent,
insurance and various service contracts.
• We record the asset at the amount that relates to future services to be provided.
– Remember our definition of an asset.

Example of a prepayment
Mack Tavish Ltd pays 12 months’ rent in advance, $120,000, on 1 April
2017. The financial period for this business ends on 30 June 2017.
What is the amount that would be shown as a prepayment (prepaid
rent) at 30 June 2017?
Explain why prepaid rent is an asset?

Property, plant and equipment (P,P& E)

Property, plant and equipment are tangible items that:
a) Are held for use in the production or supply of goods or services, for rental to others, or
for administrative purposes; and
b) Are expected to be used during more than one period.

Measurement of P, P & E
• Strangely (perhaps) reporting entities have a choice between using the ‘cost model’ and
the ‘revaluation model’ to measure property, plant and equipment.
• If the cost model is used, then an item of property, plant and equipment shall be carried
at its cost, less any accumulated depreciation and any accumulated impairment losses.
• If the revaluation model is used then an item of property, plant and equipment shall be
measured at its fair value at the date of revaluation less any subsequent accumulated
depreciation and subsequent accumulated impairment losses.
– Fair value is defined in accounting standards as the price that would be received to
sell an asset, or paid to transfer a liability, in an orderly transaction between market
participants at the measurement date.
– The carrying amount refers to the amounts that the company has on its books for
an asset or a liability.
– Recoverable amount: the higher of an asset's fair value less costs of disposal*
(sometimes called net selling price) and its value in use.
– Value-in-use is the net present value (NPV) of a cash flow or other benefits that an
asset generates for a specific owner under a specific use.

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Illustration of the cost model

Acquisition of an asset
Eagle Ltd acquires production machinery. The total cost of this machine is
$55 000.
Assume this machine can be used for 10 years and will have no residual
value at the end.
The annual depreciation expense is $55 000/10=$5 500
After one year the machinery carrying amount is $55 000 - $5 500 = $49
500
However, the recoverable value of this machinery is only $47 500, which
is $2000 less than its carrying amount, the impairment loss of for this
machine will be $2000. The new carrying amount of this machine will be
$47 500 after taking into account the impairment loss.
Illustration of the revaluation model
Assume ABC Ltd owns a machine with a carrying amount of $8000 (cost
$10000 – accumulated depreciation $2000). ABC Ltd decides to revalue
the machine to its fair value of $13000. The value of the machine will
increase $5000 and the revaluation surplus will increase $5000 as well.
The new carrying amount of machine will be its fair value of $13000.
Implications of choosing between cost and fair value
Selected Balance
measurement sheet
Item basis Fair value Cost value
Land - Coogee Cost $1.2m $300,000 $300,000
Land - Maroubra Fair value $1.8m $1m $1.8m
Land - Clovely Cost $1.0m $400,000 $400,000
Land Bronte Cost $1.5m $1m $1.0m
Land - Tamarama Fair value $2.5m $700,000 $2.5m
$8.0m $3.4m $6.0m

Reflection
According to the JB Hi-Fi annual report, 2016, note 9, plant and
equipment and leasehold improvement are recorded at cost less
accumulated depreciation and any impairment. JB Hi-Fi has chosen the
cost method rather than fair value.
Please see the link below for details in JB Hi-Fi annual report 2016 p.70 :
https://www.jbhifi.com.au/Documents/2016%20JB%20Hi-
Fi%20Annual%20Report_ASX.pdf
Based on the Harvey Norman annual report 2016 note 13, land and
buildings are recorded at fair value at the date of revaluation.

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Please see the link below for details in Harvey Norman annual report
2016, p.99 :
http://www.harveynormanholdings.com.au/pdf_files/2016-Annual-
Report.pdf

Reflection
Fair value accounting, the practice of market-based measurement of
assets and liabilities, has been extensively used in recent decades. As
this accounting method is argued to provide more relevant accounting
information compared to the tradition historical cost (Ramanna 2013)
The fair value accounting news can be accessed via the following link:
https://hbr.org/2013/03/why-fair-value-is-the-rule
Required
• Can you list the main advantage of fair value accounting?
• Despite the advantage, fair value accounting has also been
questioned by scholars and practitioners. Explain the reason.

Reflection
The newly drafted accounting standards make not-for-profits
organisations record their assets at fair value. Australia Accounting
Standards Board (AASB) believe the new requirements could reduce
these organisations’ preparation and audit costs, but many of them
believe the new changes could cause more reporting obligations (AFR
2016).
The news can be addressed via the following link:
http://www.afr.com/business/accounting/new-accounting-standards-could-
hit-local-sporting-clubs-for-six-20161017-gs430a

Required
Identify non-profit organisations that have been mentioned in the news.
Demonstrate how these non-profit organisations will be influenced by the
new accounting standards.

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Depreciation of P, P & E
• For most items of property, plant and equipment there is an expectation that their useful
life – and related economic benefits - is not indefinite (other than land).
• From an accountant’s perspective, depreciation is the allocation of the cost of an asset
(or its re-valued amount) over the periods in which benefits are expected to be generated
by the asset.
• In calculating depreciation we must make judgements about:
• The depreciable base,
• The asset’s useful life,
• Appropriate method of cost apportionment.

Reducing
balance
Straight-line method method Units of production

Allow the depreciation cost to be A fixed The calculation of depreciation

charged evenly throughout the percentage is expense is based on the
useful life of the asset applied to the productive capacity and actual use
written-down of the asset.
value of the
𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 𝑒𝑥𝑝𝑒𝑛𝑠𝑒 𝑝𝑒𝑟 𝑎𝑛𝑛𝑢𝑚
𝑫𝒆𝒑𝒓𝒆𝒄𝒊𝒂𝒕𝒊𝒐𝒏 𝒆𝒙𝒑𝒆𝒏𝒔𝒆 𝒑𝒆𝒓 𝒂𝒏𝒏𝒖𝒎 asset. 𝐶𝑜𝑠𝑡 − 𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑅𝑒𝑠𝑖𝑑𝑢𝑎𝑙 𝑉𝑎𝑙𝑢𝑒
𝑪𝒐𝒔𝒕 − 𝑬𝒙𝒑𝒆𝒄𝒕𝒆𝒅 𝑹𝒆𝒔𝒊𝒅𝒖𝒂𝒍 𝑽𝒂𝒍𝒖𝒆 =
= 𝑇𝑜𝑡𝑎𝑙 𝑒𝑠𝑡𝑖𝑚𝑎𝑡𝑒𝑑 𝑢𝑛𝑖𝑡𝑠
𝑬𝒙𝒑𝒆𝒄𝒕𝒆𝒅 𝑼𝒔𝒆𝒇𝒖𝒍 𝑳𝒊𝒇𝒆 𝒐𝒇 𝒕𝒉𝒆 𝑨𝒔𝒔𝒆𝒕
×𝑢𝑛𝑖𝑡𝑠 𝑢𝑠𝑒𝑑 𝑖𝑛 𝑡ℎ𝑒 𝑝𝑒𝑟𝑖𝑜𝑑

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Guided activity: Straight-line depreciation

• XYZ Ltd paid $40 000 for a piece of machinery.
• The estimated useful life for this machinery is 3 years with $4 000
residual value. The depreciable amount is $36,000 (Cost of $40,000
minus residual value $4,000 which is the money the organisation will
receive when the machinery’s useful life is over. The $4,000 could be
the value of useable parts left in the machine).
• If XYZ Ltd uses the straight-line method for this machinery, how much
would be recognised in the income statement for each of the next
three reporting periods?
• The annual depreciation expense will be: ($40 000 – 4 000) / 3years =
$12 000.
Year 1 Year 2 Year 3
Carrying amount at start of year 40 000 28 000 16 000
Annual depreciation expense (12 000) (12 000) (12 000)
Carrying amount at end of year 28 000 16 000 4 000

Guided activity: Diminishing balance depreciation

Follow the previous example, and assume the asset is depreciated
using a 50 per cent diminishing balance.
Calculate the depreciation expense for each year
• Depreciation expense for year 1:
$40 000 * 50% = $20,000
• Depreciation expense for year 2:
($40 000 - $20 000) * 50% = $10,000
• Depreciation expense for year 3:
($40 000 - $20 000 - $10 000) * 50% = $5,000
Year 1 Year 2 Year 3
Carrying value at start of year 40 000 20 000 10 000
1
Annual depreciation expense (20 000) (10 000) (6 000)
Asset carrying value at end of year 20 000 10 000 4 000
1
The annual depreciation will be adjusted to $6,000 so as to arrive at the estimated
amount of residual value of machinery. The carrying amount at the end of the year
should be equal to the residual value of the asset.

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Guided activity: Units of production depreciation

Following the previous example, assume the useful life of the machinery
is 100 000 units of production. The equipment produces 50 000, 30 000
and 20 000 units in three years respectively.
Calculate the depreciation expense for each year.
Annual depreciation Calculation
Year 1 $18 000 ($40 000-$4 000)/100 000*50 000
Year 2 $10 800 ($40 000-$4 000)/100 000*30 000
Year 3 $7 200 ($40 000-$4 000)/100 000*20 000

Year 1 Year 2 Year 3

Carrying value at start of year 40 000 22 000 11 200
Annual depreciation expense (18 000) (10 800) (7 200)
Carrying value at end of year 22 000 11 200 4 000

Marketable securities
• For example, an organisation might have acquired shares in other companies for the
purpose of generating dividend income and capital appreciation.
• The general practice is to measure such investments at their fair value with this amount
being updated at the end of each reporting period.
Intangible assets
• Non-monetary assets without physical substance.
• Would include copyrights, patents, brand names, goodwill, research and development.
• A significant amount of a firm’s ‘value’ can be linked to its intangible assets.
• Intangible assets are required to be separately disclosed from other assets.
– Why might this be the case?
• Some examples of Intangible assets (AASB138)
– (a) brand names;
– (b) mastheads and publishing titles;
– (c) computer software;
– (d) licences and franchises;
– (e) copyrights, patents and other industrial property rights, service and operating
rights;
– (f) recipes, formulae, models, designs and prototypes; and
– (g) Intangible assets under development.

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Measurement of intangible assets

• Generally speaking, only externally acquired, (purchased) intangible assets can be
recognised for balance sheet purposes.
– Exception being, development expenditure as part of R & D.
• The implication of this is that most intangible assets do not appear on balance sheets.
• Also, there is a general prohibition on revaluing most externally acquired intangible
assets (that is, those that are allowed to be recognised).

Reflection
Based on the above information, how useful is the balance sheet in
demonstrating accountability, as it pertains to intangible assets?

Leased assets
• Many organisations lease some of their assets, rather than buying them.
• A lease is an agreement conveying the right from a lessor (typically the legal owner) to a
lessee to use property for a stated period of time in return for a series of payments.
• If we lease an item of property, plant and equipment – rather than owning it – should we
recognise it as an asset? The answer is ‘Yes’.
– Remember our definition of assets, which relies upon ‘control’ rather than legal
ownership.
• Leased assets (and the lease liability), are required by accounting standards to be
measured at the present value of the future lease payments.

A summary of some of the different asset measurement rules

Asset Measurement rule

Cash Face value

Debtors Face value less an allowance for doubtful debts

Inventory Lower of cost and net realisable value

Prepayments Amortised cost (valued at cost which is reduced as it is

used)

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Property, plant and equipment At cost or fair value

Marketable securities Fair value

Intangible assets Generally only externally acquired intangible assets can

be recognised. Recognition is generally at cost given
restrictions on revaluations

Leased assets At the present value of the future lease payments

So what does the total, ‘total assets’ actually represent?

Do we need to be careful with how we interpret and use this number?

Online resources
JB Hi-Fi’s 2016 annual report can be accessed via the following link:
https://www.jbhifi.com.au/Documents/2016%20JB%20Hi-
Fi%20Annual%20Report_ASX.pdf
Balance sheet is available on p.57 and notes about basis of preparation
of financial statements is available from p.60 to p.90.

Current liabilities
• As with assets, for balance sheet purposes, liabilities are generally subdivided into
current and non-current liabilities.
– An organisation does not have to classify its liabilities into current and non-current,
but this is normal practice.
– An alternative presentation format is to present assets on the basis of their order of
liquidity.
• Current liabilities are all liabilities of the organisation that are to be settled in cash within
12 months or the normal operating cycle of a given firm, whichever period is longer.
• According to accounting standards, an entity shall classify liability as current when:
1. it expects to settle the liability, in its normal operating cycle;
2. it holds the liability primarily for the purpose of trading;
3. The liability is due to be settled within twelve months after the reporting period;

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4. Or it does not have an unconditional right to defer settlement of the liability for at
least 12 months after the reporting period.
• As we already know, an entity’s ‘operating cycle’ might be greater than 12 months, so
liabilities that might not be settled for a period in excess of 12 months can be considered
‘current’ within such entities.
• Examples of current liabilities on a typical balance sheet would include bank overdraft,
accounts payable, accrued expenses, dividends payable and short term loans.

Non-current liabilities
Why do we want to differentiate current and non-current assets?
• Knowing which liabilities might have to be paid within one year, or in the normal
operating cycle of the organisation, is important to lenders, financial analysts, owners,
and managers of the organisation particularly when compared with current assets.

The measurement of liabilities

• Whilst we know the definition of liabilities, and we know when they should be recognised
(on the basis of measurability and probability), the next step is to determine the amount
to be assigned to the liability.
• Some liabilities might be measured at face value, whilst others might be measured at
expected value or present value.
• As we know, this is called a ‘mixed measurement’ approach.

Measurement bases
• Bank overdraft.
– Is a line of credit designed to cover short-term cash flow shortfalls and occurs when
money is withdrawn from a bank account and the available balance goes below zero.
Will typically attract an interest expense.
– Bank overdraft is a current liability measured at face value.
• Accounts payable.
– Is typically presented as a current liability which is measured at its face value
• Provisions
– The term ‘provision’ is used in relation to liabilities where there is some uncertainty
about the timing or amount of the future expenditure.

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– For example, provision for warranty repairs, provision for long service leave and
provision for site remediation. The entity is providing funds to pay for these future
expenses by creating a provision liability.
– The amount to be recognised shall be the best estimate of the expenditure required
to settle the present obligation at the end of the reporting period.
– Where a provision is not expected to be settled for more than a year then it will
typically be discounted to its present value.
– The interest rate to be used will take into account the time value of money and risks
specific to the particular liability.
• Bonds
– Larger organisations will, from time to time, issue corporate bonds meaning that the
organisation borrows funds (a loan) and then is obliged to pay the bondholder
interest on a periodic basis and also repay the principal at a later date, often referred
to as the maturity date.
– Bonds will be measured at their present value with the interest rate being the rate
that the market expects to receive on such securities.

General principle for liability measurement

• As a general principle, liabilities due for settlement beyond 12 months will be reported at
their present value, otherwise they will be reported at their face value.

Online resources
JB Hi-Fi 2016 annual report has stated their liability recognition and
measurement in note 12, p. 72-73. The annual report can be accessed
via the following link:
https://www.jbhifi.com.au/Documents/2016%20JB%20Hi-
Fi%20Annual%20Report_ASX.pdf
Required:
Discuss how JB Hi-Fi classified and measured employee benefits.

• A liability that is not classified as current will be classified as non-current

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Reflection
In 2016, the International Accounting Standards Board (IASB) issued a
new lease accounting standard: IFRS 16 Leases, which essentially
presents dramatic changes to companies’ balance sheets. For example,
Qantas has net debt of $2.5 billion on its balance sheet in 2015, and its
liability will increase to $3.7 billion. BHP Billiton could potentially increase
its liabilities up to US$2.36 billion when the new accounting standard is
implemented (King, 2016).
Why would it be necessary to change the accounting rules which
measure the value of liabilities?
Was the value of leases true and fair in 2015?

Contingent liabilities
• When an obligation is dependent upon a future event (for example, a company has
guaranteed the debts of another company if that other company is unable to pay its
debts) or where the obligation cannot be measured reliably at a given point in time (for
example, a company has been given a notice to remove contaminants from some land
but cannot reliably measure how much it will cost to clean the land) then the associated
obligation is referred to as a ‘contingent liability’.
• Does not satisfy the definition or recognition criteria for being a ‘liability’.
• To the extent that if the amount associated with the contingent liability is large enough
(material enough), then information about the contingent liability is required to be
disclosed in the notes to the financial statements.
• Financial statement readers should be diligent and know to look through the notes to see
if there are some reported contingent liabilities. Again, they will not be recorded within
the balance sheet.

Example of a ‘real-life’ contingent liability

Harvey Norman’s 2016 annual report explains treatment of contingent
liability in note 34, p.116. Please see the link below for annual report:
http://www.harveynormanholdings.com.au/pdf_files/2016-Annual-
Report.pdf
BHP Billiton’s disclosure and treatment of contingent liabilities appear on
p. 168 and p.203 of their 2016 annual report. Please see the link below
for annual report:
http://www.bhpbilliton.com/-/media/bhp/documents/investors/annual-
reports/2016/bhpbillitonannualreport2016_interactive.pdf?la=en

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Required:
• Identify contingent liabilities disclosed in notes of Harvey Norman and
BHP Billiton’s 2016 annual report.
• Explain why contingent liabilities are not recognised in the balance
sheet.

Equity
• As we know, equity is the residual interest in the assets of the entity after deducting its
liabilities.
• In organisations, total equity might be comprised of a number of accounts.
• For a company, equity might be made up of number of components, for example:
– Share capital
– Retained earnings
– Reserves
• Share capital
– This is the amount attributable to the amount paid by shareholders, to the company,
for their shares.
• Retained earnings
– This is the accumulation of past profits (and losses), less aggregated dividends, and
less transfers of retained earnings to reserves.
• Reserves
– Companies can have numerous types of equity reserves. For example, from time to
time a company might transfer amounts out of retained earnings and into reserves to
cover future expansion plans.

Online resources
Equity section in JB Hi Fi’s 2016 report disclosed on p.57 can be
accessed via the following link:
https://www.jbhifi.com.au/Documents/2016%20JB%20Hi-
Fi%20Annual%20Report_ASX.pdf
• Identify JB Hi-Fi’s equity accounts.
• Explain what is contributed equity and how is it distinct from retained
earnings.

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Reflection
1. The accounting equation which must be satisfied with every
transaction is
Equity = Assets less Liabilities
Does the total of equity in a company balance sheet equate to the
amount that shareholders might expect to receive in total, if all the
assets of the entity were sold and all the debts were paid?
If not, why not?
2. Would you expect that shareholders would receive more than the
reported amount of equity, if the organisation was sold in full, to new
owners?

Further reflections about the balance sheet

• So, even if we do not become accountants, we will nevertheless be exposed to balance
sheets in our work, or by way of the news and media.
– The language of accounting is everywhere!
• We should now be able to understand that reported ‘total assets’ – a fairly central
number for financial accounting purposes – does not represent the fair value of all the
assets, or the cost, or replacement value of them. Rather it is the sum of various different
measurement bases.
• Therefore, ‘total assets’ needs to be reviewed/used with much care.
• As we should also appreciate, ‘total assets’ does not include many valuable assets. For
example, most internally generated intangible assets – which might have great value –
are not recognised within financial accounting (the accounting standards prohibit their
recognition), and hence do not appear on the balance sheet.
• Also, many other key resources of the organisation – such as its labour force, key
intellectual capital, valuable customer and supplier networks and so forth are not
reported on the balance sheet.
• Therefore, the total ‘resources’ of the organisation, and its reported ‘total assets’ (as
determined by the financial accountants) can be quite different.
– Nevertheless, the accounting standard setters must believe that the balance sheet
provides information that satisfies the objective of financial reporting, which is “to
provide financial information about the reporting entity that is useful to existing and
potential investors, lenders and other creditors in making decisions about providing
resources to the entity” (Conceptual Framework, paragraph OB1).
• So be careful with how you use financial accounting reports such as balance sheets.
• If we do not understand the rules of financial accounting (including knowledge about
what assets do not appear, and the mixed measurement requirements for different

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categories of assets) the balance sheet can actually be a rather mis-leading, and
perhaps dangerous, document to deal with!!!
– For example, uninformed users of financial statements might incorrectly believe that
‘total assets’ reflects the current fair value of all assets held by the organisation.
– You should reflect on how you would have previously interpreted the meaning of
‘total assets’.

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Case Study: DC Surf Co.

Download Video:
https://smoovivideov1.s3.amazonaws.com/11fce144-8af0-
e234_7452.mp4

Background:
De and Claire studied a business course together 5 year ago. De majored
in Marketing and Claire majored in International Business. They met
through the University Surfing Club.
De works full-time as a marketing Assistant for a major retailer. On the
weekends he shapes surfboards in his shed. It started out as a hobby but
he has now started selling his boards in a few local surf shops. Claire
works part-time for a graphic design firm. She also designs her own t-
shirts and sells them online. She currently ships her t-shirts to 7 different
countries throughout South East Asia as well as the US.
De and Claire surf together a couple of times a month and often talk
about starting a business together. Finally, they have decided to take the
plunge and have set up ‘DC Surf Co’ with the vision of supplying high
quality surfing equipment and apparel. They have decided to start small
but have plans to grow quickly. For now, they are operating from a small
home office in De’s lounge room.
De and Claire decided to set up their business as a partnership. They
employed De’s neighbour Johnny on a part-time basis to assist with
setting up the website and other administrative tasks so that De and
Claire can focus on growing the business. De already had a relationship
with a few of the local surf shops and they have agreed to stock the full
range of DC Surf Co boards and apparel. They have also started selling
their goods online through their website. They have made a few bulk
purchases of materials (fibreglass, cotton, fabric) and are storing these in
De’s lounge room. They realise that they are quickly running out of space
and expect to either rent or purchase commercial premises within the next
6 months.
De and Claire considered restructuring the business from a partnership to
a company. They initially set up the business as a partnership because it
seemed to be the easiest and least expensive option but they then
wondered if perhaps they made the decision in haste and should have
researched business structures more thoroughly before making their
choice. After further consideration, they restructured the partnership into a
company.

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A large surfboard manufacturer has recently received negative media

attention for importing their surfboards into Australia from China where the
workers are subject to unsafe working and poor wage conditions. DC Surf
Co have noticed that a lot of potential customers are now enquiring as to
how and where DC Surf Co makes their boards. De is still manufacturing
his boards locally and has now employed one experienced staff member
and one trainee to assist him. Prior to the recent media attention, no-one
really asked about the origins of the boards and De has never made an
effort to voluntarily provide this information.
De decided to label his locally made boards with a sticker which says
“designed and made locally in Australia”. Since promoting his boards as
locally made, De has noticed a significant increase in sales but is finding
that most of this extra money is being used to purchase materials and pay
staff wages. De isn’t sure how well the business is performing and how he
should best go about improving the performance of the business. He came
across this article about how to make a living as a surfboard maker and has
decided that he and Claire should develop a business plan for their
business. De also thinks that they should hire an accountant to assist them
in their business but Claire isn’t convinced that this is necessary and is
worried about the extra cost. They decide on a compromise which is to
advertise a position for a part-time accountant to work in the business 2-3
days per week. Congratulations, you got the job!
With your help De and Claire have prepared and implemented a business
plan which they hope will increase sales, reduce costs and help their
business to perform better overall. Their vision is to become an emerging
leader in the surfing industry with a reputation for high quality products and
great service. It has now been six months since the plan was put into place
and from De and Claire’s perspective, the business seems to be going well.
DC Surf Co’s surfboards are currently stocked by 22 different surf shops. In
order to keep up with the demand, De and Claire have hired an additional
two trainees and one experienced staff member to assist with the surfboard
manufacturing. A great deal of time has gone into training the new trainees
and while they were learning they made some mistakes in the
manufacturing process that were not detected until the boards were
purchased and used by customers. In total, out of 192 board produced, 16
boards were returned to DC Surf Co. The business replaced 12 of these
boards and issued refunds for the remaining 4 boards. DC Surf Co.
retained the faulty boards so that the current and any future trainees could
use these boards to practice their board shaping skills.

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The apparel line is also growing. The business produces t-shirt which are
also stocked by the 22 surf-shops and are sold online both in Australia and
overseas. A celebrity was recently photographed in one of the t-shirts and
since then the t-shirts sales have tripled and the business has temporarily
sold out of some of the most popular styles and has been unable to fulfil
some customer orders. Whilst customer reviews on Facebook initially
spiked at 4.8 stars, since running out of stock, some customers have
become frustrated and their current rating has decreased to 4.1.
In order to leverage from the popularity of their t-shirts, De is keen to add
board shorts to their apparel line. Claire is not convinced that this is a good
idea and is concerned that board shorts are a very seasonal item and that
people do not buy shorts all year round. T-shirts on the other hand are
purchased by customers even during the winter time to wear underneath
warmer clothing. Before taking a risk on the new board short line, De and
Claire want to have a clear understanding of how the business is currently
performing.
With your help De and Claire make the decision to proceed with the board
short line and it is a huge success. It is now 3 years on and the business
now stocks a full range of both men’s and women’s apparel including
hoodies, tracksuit pants and hats. They have also decided to expand their
line into beach towels which they will manufacture themselves.
After preparing an analysing a number of budgets, De and Claire
discovered that they would be unable to continue growing at such a rapid
rate without obtaining the additional funds necessary to expand. They
considered borrowing funds from the bank but did not feel comfortable
taking on such a substantial amount of debt. Instead, they decide to list DC
Surf Co on the Australian Stock Exchange. They are now a publicly listed
company and have raised several million dollars through the initial public
offering (IPO) in order to further expand the business.
During the month of April 2017 they DC Surf Co experienced the following
transactions and events:

3 April 2017 DC Surf Co paid staff wages of $13,000

5 April 2017 DC Surf Co purchased $18,000 of materials to manufacture

their beach towels. Payment is not due for 14 days.

7 April 2017 Johnny resigned from DC Surf Co in order to take up a new

job opportunity in Canada. His final day will be 21 April 2017.
Due to operating efficiencies, De and Claire decided that they
will not need to replace Johnny and so expect to save $36,000
in wages per year.

13 April 2017 DC Surf Co made a large sale worth $85,000 to a new retailer
who has agreed to stock their entire range. This new customer

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is required to make payment in 14 days.

19 April 2017 DC Surf Co make the payment of $18,000 related to the

materials purchase on 5 April 2017.

19 April 2017 De discovers that the one of the surfboard shapers has been
incorrectly disposing of potentially hazardous waste. The
employee has been storing the waste behind an old shed and
after recent storms, much of this waste has been washed into
the nearby waterways and estuaries.

24 April 2017 DC Surf Co was named in a damaging post on Facebook and

had to apply to Facebook to have the review removed. On 26
April the post was removed. During the period 24 April -26
April, 3 retailers contacted DC Surf Co to advise that they will
not purchase any further goods from the company. These lost
future sales are estimated to total $100,000 per year.

26 April 2017 DC Surf Co is temporarily running low on cash and takes out a
small bank loan of $30,000 in order to pay the warehouse rent
for the month.

26 April 2017 Claire decides to switch cotton suppliers after learning that the
offshore supplier they had been using was not providing safe
working conditions for staff. It has been reported that 3 cotton-
pickers died from heat exhaustion in the past 4 weeks.

27 April 2017 DC Surf Co receive the $85,000 from the sale made on 13
April 2017. They use $30,000 of this money in order to pay
back their bank loan.

Additional Information:
De and Claire have decided to purchase new equipment that will allow
them to manufacture surfboards more efficiently and with fewer faults. The
equipment cost $180,000 with a further $15,000 of installation costs. It was
fully installed and ready to use on 1 July 2017. The useful life of the
equipment is 10 years with a residual value of $25,000.

Activity 1:
De and Claire are have asked you about the impact that the new
equipment purchase will have on the balance sheet in future years.
Determine the carrying value of the new surfboard making equipment at 30
June 2018 and 30 June 2019 using the straight-line method.

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Activity 2:
a. Based on your knowledge of DC Surf Co and the surfing industry
generally, identify 3 assets that might appear on the balance sheet of
DC Surf Co. For each asset, advise whether it should be categorised as
a current or a non-current asset and which basis for measurement is
most appropriate.
b. Based on your knowledge of DC Surf Co and the surfing industry
generally, identify 3 specific resources of DC Surf Co that will not be
reported on the balance sheet of DC Surf Co.

Activity 3:
Identify any transactions or events during the month of April 2017 that DC
Surf Co should consider as having the potential to give rise to a contingent
liability? Explain why the transaction or event may give rise to a contingent
liability and advise how and where such contingent liabilities should be
reported

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References

ANZ 2016, Annual report, ANZ, viewed 9 March 2017,

<https://www.shareholder.anz.com/sites/default/files/anz_-
_annual_report_2016.pdf>.
BDO Australia 2016, viewed on 7 Mar 2017, <http://www.bdo.com.au/en-
au/accounting-news/accounting-news-february-2016/new-leases-standard>.
BHP 2016, Annual Report, BHP, viewed 9 March 2017,
<http://www.bhpbilliton.com/-/media/bhp/documents/investors/annual-
reports/2016/bhpbillitonannualreport2016_interactive.pdf?la=en>.
Deegan, C, 2016, Financial Accounting, McGraw-Hill Education (Australia):
North Ryde, Australia.
Harvey Norman 2016, Annual Report, Harvey Norman, viewed 9 March 2017,
<http://www.harveynormanholdings.com.au/pdf_files/2016-Annual-Report.pdf>
Holland D 2016, New accounting standards could hit local sporting clubs for six,
Financial Review News,18 Oct, viewed on 7 Mar 2017.
JB Hi-Fi 2016, Annual Report, JB Hi-Fi, viewed 9 March 2017,<
https://www.jbhifi.com.au/Documents/2016%20JB%20Hi-
Fi%20Annual%20Report_ASX.pdf>.
King A 2016, Lease accounting standards will shift debt back to companies,
Financial Review News, 14 Jan, viewed on 7 Mar 2017.
KPMG 2016, viewed on 7 Mar 2017, <
https://home.kpmg.com/xx/en/home/insights/2016/01/leases-new-standard-
balance-sheet-transparency-slideshare-first-impressions-ifrs16-130116.html>.

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