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In analyzing any company, we want to know the kind of assets it owned, the value of the assets and the level of the uncertainty about those values. Accounting reports makes a fairly good job of classifying the assets owned by a company, a job part of the assessment of the value of these assets, and a poor job of reporting uncertainty about asset values. In the question state that” conceptually, you might have thought that all assets should be measured in the same way, for example. At fair value or at cost, but this is not the case as measurement rules vary depending upon the type of asset”. In this section, we will start by looking at the basic principles of accounting classification and measurement of assets and limitations of financial statements to provide relevant information about
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In modern times a huge challenge for companies is to be able to measure the values of all the various types of investment i.e. plant, equipment, lands and inventories. The problem arises when different types of investments are measured using the same method. In Framework 2010 there is some discussion of measurement but it does no more than identify alternative bases of measurement. Those bases of measurement are historical cost, current cost, realisable value and present value. Each of these accounting measurement systems can result in a different measure of profit and equity. Consider the alternative base of measurement identified by the IASB and applies them to measuring the elements of financial statement. To achieve the objective of financial reporting, measurement should contribute to faithfully representing relevant information about recognised assets, liabilities income and expense, and about how efficiently and effectively the entity’s management and governing board have discharged their responsibilities to use the entity’s resources. In our report we are going to choose Wesfarmers Ltd. which is one of the biggest company in the Australia. Now we are analysing their annual report 2014 to know how they use different asset measurement model to measure their asset according to the AASB standards.
The definition of fair value focuses on assets because they are a major topic of accounting measurement. In addition, this standard applies to own equity instruments an entity to measure the fair value. Fair value is the amount for which an asset could be exchanged between knowledgeable, willing parties in an arm’s length transaction (i.e. exit price at the measurement date from the perspective of a market participant that holds the asset owed).
Fair value is not the market price only. There are other markets where prices are not included in the definition of fair value. Some existing standards also using fair value less costs to sell for impairment adjustment or value plus transaction costs equal to the initial measurement of assets (less any transaction costs for Initial measurement of liabilities). For some commodities market have different immigration, IASB may consider using an entity would have to pay the price to acquire an asset or received to assume or take responsibility.
Alternative measurement approaches:
Historical cost -the measurement of historical cost is relevant to the stewardship objective of financial reporting but it is probably of less relevant for the decision-usefulness objective of financial reporting. However, there is some doubt about whether it is more reliable than other measures. The relative importance attached to the stewardship objective of general purpose financial reporting is crucial to deciding the appropriateness of measuring historical cost. If stewardship is relegated to a relatively minor role, then the measurement of historical cost is also likely to be less.
Current cost- the amount of cash or cash equivalents that would have to be paid if the same or an equivalent asset were acquired at the end of the reporting period. Reliability must be considered in conjunction with relevance. It is possible that current cost provides a more relevant measure of an asset than some other more reliable measures.
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Fair value and Market value- This again is a different form of value measurement. In this case the market value is the price at which a certain asset can be sold. Market value is crucial because it indicates how well a company can adapt to changing environment. Therefore if a company wants to sell its assets and can only recover a small portion of the cost of the asset then it is bad for the company. It makes the company less adaptable and flexible. Therefore shareholders would prefer to know the market value of the assets in the company. Some time we can also say Marker value is Fair value but most of the time Marker value different from market to marker.
Most recently, since the adoption of Australian equivalents to IASB, there are two interrelated standards dealing with asset revaluations:
- AASB 116’ Property, Plant and Equipment’ and AASB 136 ‘Impairments of Asset’.
- AASB 102 Inventories
AASB 116 required that, items of property, plant and equipment must be measured using either the cost model or the revaluation model (p29). Entities must choose the basis on which property, plant and equipment will be measured subsequent to initial recognition.
- All assets in the same class of property, plant and equipment must be measured on the same basis (AASB 116, p29)
- A change between the cost model and the revaluation model may be made only if the change results in financial information that is more relevant and reliable. AASB 116 does not provide comment on the ability of an entity to change the measurement model of a class of assets.
Paragraphs 31 to 57 plus the appendices to AASB 136 provide further guidance on estimating the future cash and appropriate discount rate. In additional consideration is whether the asset has been measured using the revaluation model in accordance with the requirements of AASB 116 ‘property, Plant and Equipment’. If the revaluation model is used, AASB 116 required that assets are to be carried at their revalued amount- that is, fair value at the date of the revaluation. Fair value does not take account of the costs of disposal, which means that disposal cost are the only difference between fair value( required by AASB 116) and fair value less costs of disposal( required by AASB 136).
AASB 102 Inventories - The objective of this Standard is to prescribe the accounting treatment for different types of inventories. A primary issue in accounting for inventories is the amount of cost to be recognised as an asset and carried forward until the related revenues are recognised. This Standard provides guidance on the determination of cost and its subsequent recognition as an expense, including any write-down to net realisable value. It also provides guidance on the cost formulas that are used to assign costs to inventories. ('AASB 102 Inventories', 2009)
We know that inventory is initially recorded at original cost (the cost at which the inventory was acquired). However, the historical cost principle is pushed aside if inventory declines in value below its original cost, thus causing impairment of its value. The reason for such a decline could be among many including obsolescence, damaged inventory, inventory destroyed by natural disaster/fire/earthquake, price-level changes, etc. If any of these factors occur, then the general rule is that the historical cost principle is adjusted when the asset’s future utility (its ability to generate future cash flows) is no longer as great as its original cost. (Accountingscholar.com, 2014)
With everything mentioned above the significance of measuring different types of assets using different standard of measurement is quite clear. AASB is the main body that is instrumental in establishing the rules and regulation regarding measurements.. At the same time value of short term assets like inventories are not depreciated. They are measured at historical cost unless their market realisable value is lower in which case this is the value that is reported in the financial statements. Usually companies prepare different financial reports each using a different measurement method to give the stakeholders a more complete view of the company’s performance.
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“As we mention before our chosen company is Wesfarmers Ltd (WES). Now we are going to look at some specific parts of their annual financial report for the year 2014. Under “Notes to the financial statements” part 6(Inventories) and 7(property, plant and equipment) in particular are relevant to the discussion.
The company Wesfarmers mentions it in their report that they value the inventories at the lower of cost and net realisable value. Costs incurred in bringing each product to its present location and condition is accounted for as follows:
- Raw materials: Purchase cost on a weighted average basis.
- Manufactured finished goods and work in progress: Based on cost of Direct
Material and Labour. A proportion of manufacturing overheads based on normal operating capacity, but excluding borrowing costs.
- Retail and wholesale merchandise finished goods: purchase cost on a weighted average basis.
Therefore they claim that they are in compliance with the accounting standards set out by AASB 102. The report mentions that they had to write-down the inventory for a total worth of $19 million dollars so far in the year 2014. Therefore their inventories have been recorded at net realisable value. In year 2013 the write- down inventory was $51 million. Compare to the 2013 the write-down inventor is less $32 million in 2014 but still is so high and it is put huge effect on financial statement for materiality purpose. This is crucial in the creation of financial reports since without writing off this amount the value of assets would be overstated and therefore it would not be an accurate representation of their financial position.
For the sake of the sake of clarifying a point let’s assume Wesfarmers recorded their inventory at original cost and did not write down their inventory by 19 million. As a result the cost would be recorded at historical cost and therefore the profit would be overstated but on the flip side the liquidity risky will be higher. Shareholder and creditors who are willing to invest in the company would see this as a risk to their investment. Unadjusted price means that not only the historical price is misleading for the stakeholders but also that they do not know just how big the difference between the historical price and realisable value actually is. This is a big uncertainty. At the same time the assets of the company would be overstated which is a positive thing for the company but in reality most companies operate with a significant amount of liability and therefore the liquidity risk is ever present and cannot be ignored.
Therefore the standard set out by AASB 102 is absolutely crucial for any business and must be followed by Wesfarmers in regards to their inventory.” (Ltd, 2014) (AASB, 2014)
Property, Plant and Equipment
“Property, plants and equipment are long term assets and as such they have to be depreciated each accounting period which standards set out by AASB116.The financial report by Wesfarmers mentions that property, plant and equipment are valued according to cost model such as the cost of the asset, minus depreciation and impairment loss. The cost of the asset also includes the cost of replacing parts that are eligible for capitalisation, and the cost of major inspections. According to the report the total cost is $ 16018 million and total amount written off is$ 6066 million and therefore the adjusted fair value is $9952 million. Now if we assume that there is no depreciation and the assets are recorded at the historical cost each year then this would significantly overstate the value of the assets by $6066 million. It would be impossible to sell the assets at the historical price after years of use. Shareholders will know and understand this. They will not want to buy shares in a company who would purposefully mislead the stakeholders just to make a profit. Even if the balance sheet looks good it still would not change the fact there is a significant liquidity risk. To avoid this kind of risk the estimations of useful lives, residual value and amortisation methods require significant management judgement and are reviewed annually. These changes are limited to specific assets and any reasonably possible change in the estimate is unlikely to have a material impact. Therefore if Wesfarmers does not depreciate some of their major assets each financial year and suddenly those assets stop working towards the end of the useful life, there would be a huge expense on the balance sheet all of a sudden. This would create a sharp drop in the profit margin a particular year. But shareholders want to see that a company is going steady and these types of huge changes would raise difficult questions for the directors. They could always resort to creative accounting but the use of such methods is best kept to a minimum.
Therefore it is quite clear that the standards set out by AASB116 should be followed at all times to make a fair and true financial statement for users.” (Ltd, 2014) (AASB, AASB 116, 2014)
“The fair value of an asset is a necessary object for every business organization; if these methods would not be applied the financial report of company would overstate or understate the net-assets which will cause misleading and falsified disclosure to the users. A Conceptual Framework should incorporate a measurement objective. That measurement objective should be selecting those measurement alternatives that represent and reflect most fairly financial condition and capacity of an entity for decision making purposes. The two Accounting standard measurement models mansion and discussed in the Framework we think financial capacity would be best reflected by a fair value model. When the preferred measurement model is not practicable of faithful representation of a financial statement then the most relevant substitute model which is practicable faithful of representation could be adopt by the entity. At the end we can say, as a one of the large company in Australia Wesfarmers Ltd should choose the best asset measurement model for their each asset which model fairly represents true value of this particular asset.” (Henderson, 2014)
AASB. (2014, 05 10). AASB 102. Retrieved from http://www.aasb.gov.au/admin/file/content105/c9/AASB102_07-04_COMPjun09_01-09.pdf: http://www.aasb.gov.au/admin/file/content105/c9/AASB102_07-04_COMPjun09_01-09.pdf
AASB. (2014, 05 20). AASB 116. Retrieved from http://www.aasb.gov.au/admin/file/content102/c3/AASB116_07-04_ERDRjun10_07-09.pdf: http://www.aasb.gov.au/admin/file/content102/c3/AASB116_07-04_ERDRjun10_07-09.pdf
Henderson, P. H. (2014). Issues in Financial Accounting. (15th, Ed.) sydney: pearson.
Ltd, W. (2014, 05 10). Annual report 2014. Retrieved from http://www.wesfarmers.com.au/annualreport2014/files/inc/9f77606bdd.pdf: http://www.wesfarmers.com.au/annualreport2014/files/inc/9f77606bdd.pdf