Intermediate Financial Accounting Notes (Pre Mid Sem chapters) PDF

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Notes on first half of semester, prior to mid sem exam. ...

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Intermediate Financial Accounting Notes Chapter 3

Fair value: 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 measurement of fair value is based on a hypothetical transaction. The three key elements of fair value are: 1. it is a current exit price 2. the asset is sold, or the liability is transferred in an orderly transaction 3. the transaction is between market participants. Current exit price: The price that would be received to sell an asset or paid to transfer a liability. 

The exit price is based on expectations about the future cash flows that will be generated by the asset subsequent to the sale of the asset or transfer of the liability to an acquiring entity. These cash flows may be generated from use of the asset or from sale of the asset by the acquiring entity.

Orderly Transactions: The exit price is based on expectations about the future cash flows that will be generated by the asset subsequent to the sale of the asset or transfer of the liability to an acquiring entity. These cash flows may be generated from use of the asset or from sale of the asset by the acquiring entity. Market Participants: Buyers and sellers in the principal (or most advantageous) market for the asset or liability that have all of the following characteristics: (a) They are independent of each other, i.e. they are not related parties as defined in AASB 124 [Related Party Disclosures], although the price in a related party transaction may be used as an input to a fair value measurement if the entity has evidenced that the transaction was entered into at market terms. (b) They are knowledgeable, having a reasonable understanding about the asset or liability and the transaction using all available information, including information that might be obtained through due diligence efforts that are usual and customary. (c) They are able to enter into a transaction for the asset or liability. (d) They are willing to enter into a transaction for the asset or liability, i.e. they are motivated but not forced or otherwise compelled to do so.

Application to non-financial assets Step 1: What is the particular asset being measured? 

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What is the location of the asset? If the asset is located away from the market, it will need to be transported to the market and transport costs will be incurred. Time constraints or difficulties in transporting the asset may affect its fair value. What is the condition of the asset? Many of the factors that are considered in depreciating an asset are relevant to assessing the condition of an asset, such as remaining useful life, physical condition, expected usage, and technical or commercial obsolescence. Assets may be new or second-hand, and may be well or poorly maintained.

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Are there any restrictions on sale or use of the asset? There may be legal limits on the use of the asset; for example, patents, licences or expiry dates of related lease contracts. It may be illegal to sell certain assets in some countries. Is the asset a stand-alone asset or is it a group of assets? Where a fair value is being calculated for impairment purposes, the assets being valued may be a cash generating unit.

Step 2: What is the appropriate measurement valuation premise? The fair value of an asset is determined by considering what a market participant would pay to buy the asset. The market participant would determine this by considering the potential cash flows from the asset, whether from its sale or use. The market participant may have a number of alternative ways in which it can sell or use the asset. Fair value is measured by considering the highest and best use of the asset. According to paragraph 28 of AASB 13/IFRS 13, these uses must be: (a) physically possible, taking into account the physical characteristics of the asset (b) legally permissible, considering any legal restrictions (e.g. zoning regulations on the use of land) (c) financially feasible, in that the market participant must be able to make a return from the asset from using the asset. In-combination valuation premise: When a fair value is determined under the in-combination valuation premise, the highest and best use of the asset is where the market participants obtain maximum value principally through using the asset in combination with other assets as a group. Stand-alone valuation premise: The fair value of the asset is the price that would be received in a current transaction to sell the asset to market participants who would use the asset on a stand-alone basis; that is, not in combination with other assets or liabilities.

Step 3: What is the principal (or most advantageous market) for the asset? A fair value measurement assumes that the transaction to sell the asset takes place either: (a) in the principal market for the asset; or (b) in the absence of a principal market, in the most advantageous market for the asset. Principal Market: The market with the greatest volume and level of activity for the asset. Most advantageous market: The market that maximises the amount that would be received to sell the asset or minimises the amount that would be paid to transfer the liability, after taking into account transaction costs and transport costs.

Step 4: What is the appropriate valuation technique for the measurement of the asset? Market approach: involves direct observation of what is occurring in a market. Prices are obtained directly from information gathered from the activities in markets. Cost approach: based on the amount a market participant would pay to acquire or construct an asset that has the same qualities as the asset being valued. The cost may be that for the construction of an identical asset by the entity itself or by paying another entity to physically make the asset. Income approach: The fair value determined under the income approach is based upon market expectations about future cash flows, or income and expenses associated with that asset. Present value techniques are an example of techniques used in applying the income approach.

Chapter 7 – Impairment of Assets

When to undertake an impairment test: Paragraph 9 of AASB 136/IAS 36 states: An entity shall assess at the end of each reporting period whether there is any indication that an asset may be impaired. If any such indication exists, the entity shall estimate the recoverable amount of the asset. For most assets, the need for an impairment test can be assessed by analysing sources of evidence. However, paragraph 10 of AASB 136/IAS 36 specifies some assets for which an impairment test must be undertaken every year. These assets are: • • •

intangible assets with indefinite useful lives intangible assets not yet available for use (e.g. capitalised development outlays) goodwill acquired in a business combination.

Step 1: Determine the recoverable amount of an asset, which is done by considering the following three components defined in paragraph 6 of AASB 136/IAS 36. • •

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Fair value — 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. Costs of disposal — Incremental costs directly attributable to the disposal of an asset or cash-generating unit, excluding finance costs and income tax expense. Examples of such costs are legal costs, stamp duty and similar transaction taxes, costs of removing the asset, and direct incremental costs to bring the asset into condition for its sale. Value in use — The present value of the future cash flows expected to be derived from an asset or cash-generating unit. Paragraph 30 of AASB 136/IAS 36 notes that the following elements shall be reflected in the calculation of an asset’s value in use: (a) an estimate of the future cash flows the entity expects to derive from the asset; (b) expectations about possible variations in the amount or timing of those future cash flows; (c) the time value of money, represented by the current market risk-free rate of interest; (d) the price for bearing the uncertainty inherent in the asset; and

(e) other factors, such as illiquidity, that market participants would reflect in pricing the future cash flows the entity expects to derive from the asset.

Step 2: Compare the recoverable amount with the carrying amount of the asset as recorded by the entity. An impairment loss is the amount by which the carrying amount of an asset or CGU exceeds its recoverable amount. • •

If the recoverable amount is greater than the carrying amount, there is no impairment loss. If the recoverable amount is less than the carrying amount, an impairment loss has occurred.

Identifying a cash-generating unit Identification of a CGU requires judgement. The key is to determine the smallest identifiable group of assets that creates independent cash flows from continuing use. • • • • •

Consider how management monitors the entity’s operations (such as by product lines, businesses, individual locations, districts or regional areas). Consider how management makes decisions about continuing, or disposing of, the entity’s assets and operations. If an active market exists for the output of a group of assets, this group constitutes a CGU. Even if some of the output of a group is used internally, if the output could be sold externally, then these prices can be used to measure the value in use of the group of assets. CGUs should be identified consistently from period to period for the same group of assets.

Impairment loss for a CGU Having identified the CGU, at the end of a reporting period, management assess the sources of information determining whether there is an indication of impairment. If it is probable that the assets of the CGU are impaired, management then: • calculate the recoverable amount of the CGU • compare it with the total carrying amount of the assets of the CGU • determine whether an impairment loss exists.

If an impairment loss is identified, the loss must be written off against the assets of the CGU. The allocation process has two steps:

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Reduce the carrying amount of any goodwill allocated to the CGU Allocate any balance of impairment loss to the other assets of the CGU pro rata on the basis of the carrying amount of each asset in the CGU.

Reversal of an impairment loss A reversal would allow the entity to write the assets up, and recognise the increase as income. According to paragraph 110 of AASB 136/IAS 36: An entity shall assess at the end of each reporting period whether there is any indication that an impairment loss recognised in prior periods for an asset other than goodwill may no longer exist or may have been decreased. If any such indication exists, the entity shall estimate the recoverable amount of that asset.

Individual assets According to paragraph 117 of AASB 136/IAS 36: The increased carrying amount of an asset other than goodwill attributable to a reversal of an impairment loss shall not exceed the carrying amount that would have been determined (net of amortisation or depreciation) had no impairment loss been recognised for the asset in prior years. The reason for this restriction is the application of the historical cost model. To increase an asset above the carrying amount calculated using the historical model would effectively involve a revaluation of the asset. According to paragraph 119 of AASB 136/IAS 36: A reversal of an impairment loss for an asset other than goodwill shall be recognised immediately in profit or loss, unless the asset is carried at revalued amount in accordance with another Standard (e.g. the revaluation model in AASB 116 [IAS 16]). Any reversal of an impairment loss of a revalued asset shall be treated as a revaluation increase in accordance with that other Standard.

CGUs According to paragraph 122 of AASB 136/IAS 36: A reversal of an impairment loss for a cash-generating unit shall be allocated to the assets of the unit, except for good-will, pro rata with the carrying amounts of those assets. These increases in carrying amounts shall be treated as reversals of impairment losses for individual assets and recognised in accordance with paragraph 119. The accounting for the reversals for each asset is done as discussed earlier for reversals of individual assets. According to paragraph 123 of AASB 136/IAS 36: In allocating a reversal of an impairment loss for a cash-generating unit in accordance with paragraph 122, the carrying amount of an asset shall not be increased above the lower of:

(a) its recoverable amount (if determinable); and (b) the carrying amount that would have been determined (net of amortisation or depreciation) had no impairment loss been recognised for the asset in prior periods. The amount of the reversal of the impairment loss that would otherwise have been allocated to the asset shall be allocated pro rata to the other assets of the unit, except for goodwill....