Topic 2: Understanding the annual report I

Onerous contracts

AASB 137 defines an onerous contract as one under which the entity's unavoidable costs of meeting its obligations under the relevant contract exceed the economic benefits estimated to be received under it. An example of an onerous contract is a lease of a building that a company has decided to vacate part-way during the lease. If the lease is not cancellable, or the company is not otherwise able to sublet the building, the lease would be considered an onerous contract and a provision would be raised for the company's obligation for the remainder of the lease.

Production overhead Absorption costing

Absorption costing includes raw materials, direct labour, and variable and fixed production overheads in the cost of inventory. This results in a higher inventory value than variable costing. Production overheads (both variable and fixed) are included in the cost of inventory by dividing the estimated overhead costs for the year by the estimated production. This gives the amount of overhead costs to be added to the cost of each inventory item. Naturally, the actual overhead costs and the level of production will not be exactly as estimated. Adjustments should be made in the statement of financial position when the actual situation is significantly different from the estimates. Variable costing, which excludes fixed production overheads, results in a lower inventory valuation than absorption costing. AASB 102 'Inventories' and income tax legislation require absorption costing to be used in financial statements and income tax returns. However, some entities might use variable costing for internal management accounts.

Current assets

An asset is classified as current when it satisfies any of the following criteria: • it is expected to be realised in, or is intended for sale or consumption in, the entity's normal operating cycle • it is held primarily for the purpose of being traded (e.g., investments held for short-term profit) • it is expected to be realised within 12 months after the reporting date (e.g. surplus property or plant and equipment expected to be sold within the next 12 months) or • it is cash or a cash equivalent, unless it is restricted from being exchanged or used to settle a liability which is, at least, 12 months after the reporting date. All other assets are, by default, classified as non-current. The following rules are used in accounting standards to determine the length of the operating cycle: • a 12-month period is used as the operating cycle where an entity has no single, clearly identifiable operating cycle (e.g. because it is involved in a range of businesses with varying operating cycles) • a 12-month period is also used where an entity has an operating cycle of less than 12 months (e.g. most retailers with a very short operating cycle) • a period greater than 12 months is used as the operating cycle where an entity has a single, clearly identifiable operating cycle that extends over more than 12 months. For example, entities in the construction, property development and agricultural industries may have a single, clearly identifiable operating cycle that extends beyond 12 months. In this case, assets and liabilities that form part of working capital would be classified as 'current' even where they involve a period extending beyond 12 months from the reporting date. This is not common.

Equity accounted investments

An associate relationship exists where an investor can significantly influence an investee. Significant influence means the capacity to affect substantially (but not control) either, or both, of the financial and operating policies (e.g. dividend decisions, and decisions on major acquisitions or the appointment of key personnel) of another entity. Commonly, investments in associates arise where the investor holds between 20% and 50% of the voting power of another entity. In addition, the investor may have representation on the board of directors of the investee (e.g. two director appointments out of five possible director appointments). Investments in associates are accounted for using the equity method of accounting. Under the equity method, the investment in an associate is initially brought to account at its cost to the investor. Subsequently, this cost is adjusted by the investor's share of post-acquisition profits (or losses) of the associate as well as for changes in other equity reserves of the associate. The post-acquisition movements are also reflected in the investor's statement of profit and loss and comprehensive income as revenue (see Topic 3). The equity method of accounting is sometimes also referred to as 'one-line consolidation'. This reflects the fact that an investor's investment in an associate, as shown in the statement of financial position, only represents the investor's share of the net assets of the associate. Some argue that the failure of the equity method to include the investor's share of the gross assets and liabilities of the associate (as well as the investor's share of the gross revenues and expenses) can distort ratio analysis. For example, return on assets (ROA) can be overstated, as the gross assets used to generate the investor's share of an associate's profit are excluded from the investor's statement of financial position. Its share of profit would be reflected as an item of revenue in the investor's statement of comprehensive income.

Intangible assets

An intangible asset is an identifiable non-monetary asset without physical substance. Common examples of intangible assets are copyrights, trademarks, patents, franchises and brand names. Unlike assets such as property, plant and equipment, intangibles cannot be touched, weighed or physically measured. Their worth is very much a reflection of the assessor's perception. Entities must show intangible assets separately from other non-current assets in the statement of financial position by grouping them into a class called intangible assets.

Revaluation model (fair value basis)

An item of property, plant and equipment whose fair value can be measured reliably, can be carried at a revalued amount, being its fair value at the date of the revaluation less any subsequent accumulated depreciation and subsequent accumulated impairment losses. The fair value of land and buildings as well as plant and equipment is usually determined from market-based evidence, such as the price paid for similar items in an arm's length transaction. If there is no market-based evidence of fair value because of the specialised nature of the item of property, plant and equipment, then an entity may need to estimate its fair value using an accepted valuation technique. The frequency with which revaluations are necessary will depend on the nature of the asset. Some assets may require revaluations each year, while for other assets a revaluation every three years may be sufficient. The rules covering the treatment of such revaluations are: • revaluation increases relating to an item of property, plant and equipment must be credited directly to an asset revaluation reserve (this reserve appears as an equity item in the statement of financial position). However, to the extent that the increase reverses a previous revaluation decrease which was previously recognised in profit or loss in respect of that same asset, it must be recognised as revenue in profit or loss • revaluation decreases relating to an item of property, plant and equipment must be recognised as an expense in profit or loss except that, to the extent that a previous revaluation increase still exists in the asset revaluation reserve in respect of that same asset, the revaluation decrease must be taken against the asset revaluation reserve.

Assets

Assets are those valuable resources, controlled by an entity, which are expected to provide future economic benefits. Examples of assets include inventories, prepayments, property, machinery, investments, financial assets (such as cash, receivables and derivatives) and intangible assets (such as brand names and licences). The key to identifying something as an asset is its ability to deliver expected future economic benefits.

Current liabilities

Current liabilities are the obligations owed by an entity, which arise and are expected to be settled in the normal course of the entity's operating cycle, at-call, due or expected to be settled within 12 months of the reporting date. As for current assets, a period greater than 12 months is used as the operating cycle where an entity has a single, clearly identifiable operating cycle that extends over more than 12 months from the reporting date. Some analysts may adjust current liabilities, as reported on the statement of financial position, for some items currently reported 'off-balance sheet'. Examples include future rental payments under non-cancellable operating leases and certain contingent liabilities for which an outflow of resources is judged as probable, or commitments for expenditure. Such adjustments recognise the reduction in the entity's working capital, which may flow from these items.

Trade receivables less provision for doubtful debts

Directors are required to ensure that all current assets, in this case trade receivables, are stated at no more than the amount of cash that is ultimately expected to be collected from these assets. Hence, entities make provision for this by estimating doubtful debts and reducing trade receivables accordingly. It is important that Tesmer has objective evidence that its receivables are impaired, such as default or delinquency in interest or principal payments by its debtors. In making a provision, Tesmer does not actually put cash into an account or reserve, but reduces the value of trade receivables to reflect its best estimate of the cash that it expects to collect. In this sense, the provision for doubtful debts represents an adjustment to the gross carrying-amount of its receivables rather than a liability. In addition to making a provision for doubtful debts, companies may also be required to recognise an expense for bad debts. Whereas doubtful debts involve amounts that are not expected to be collected in cash, bad debts involve amounts owed by customers who cannot or will not pay (for instance, companies in administration or liquidation).

Equity

Equity is the difference between assets and liabilities. There are two components of equity — contributions made by shareholders (e.g. paying cash to subscribe to shares) and gains or losses made by the entity and kept by the entity (e.g. annual profit remaining after dividends, and gains from revaluing a property). In successful companies, equity tends to grow over time, with the growth being a mixture of further contributions from owners and 'self-generating' equity (i.e. the gains and profits generated by the entity and retained in the entity).

FIFO inventory valuation

First-in-first-out (FIFO): This method assumes that goods that were bought or manufactured first, in other words, the oldest goods in the inventory, are the ones that are sold out first. As such, the ending inventory is left with goods that were bought or manufactured last and therefore are valued at the latest costs. When prices are rising, FIFO will: • maximise the valuation of inventory reported in the statement of financial position, as the inventory will be valued at the later higher costs • minimise the cost of goods sold expense, as this will be charged at the earlier lower price • result in a higher reported profit than if the weighted average cost method had been used. Conversely, if prices are falling, the cost of inventory and profit will be lower using the FIFO method than if the average cost method had been used

Foreign currency translation reserve

Functional currency is the currency of the primary economic environment in which the entity operates. For example, the functional currency of some Australian companies (or subsidiaries thereof), that deal in the sale of commodities internationally, may be US dollars or another foreign currency rather than Australian dollars, as is the case with most of Tesmer's operations. Each entity is required to determine its functional currency and measure its results and financial position in that currency. Presentation currency is the currency in which the financial report is presented. Each entity (whether a group or individual entity) is permitted to present its financial report in any currency or currencies that it chooses. This has proven to be a controversial requirement in the eyes of some commentators who believe that Australian domiciled entities should continue to provide financial reports in Australian currency. An explanation must be provided if Australian dollars are not used as the presentation currency. In June 20X0, Tesmer announced that, commencing with the 20X0/X1 financial year, it would present its financial statements in US dollars rather than Australian dollars. Under AASB 121 the financial statements of an entity with a functional currency that is different to the group's presentation currency, need to be translated to the group's presentation currency. Any exchange gains/losses arising from this translation are recognised directly in equity, in a reserve such as an exchange fluctuations reserve.

Goodwill

Goodwill is an asset acquired in a business combination, representing a payment made by the acquirer in anticipation of future economic benefits from assets that are not capable of being individually identified and separately recognised. Examples of unidentifiable assets that may comprise goodwill include market penetration, effective advertising, good labour relations and a superior operating team. Goodwill is initially measured at its cost, being the excess of the cost of the business combination over the acquirer's interest in the net fair value of the identifiable assets, liabilities and contingent liabilities recognised. To test whether goodwill is impaired, an entity must allocate goodwill to the cash-generating unit expected to benefit from the goodwill. A cash-generating unit is the smallest identifiable group of assets, such as a business unit, that generates cash inflows that are largely independent of the cash inflows from other assets or groups of assets. The carrying amount of the cash-generating unit is then compared to its recoverable amount. If the recoverable amount is less than the carrying amount, an impairment loss exists.

Interest bearing liabilities

Interest bearing liabilities represent liabilities on which interest expense is being charged. Prior to AASB 101, interest-bearing liabilities were described as 'borrowings'. Current interest bearing liabilities include amounts borrowed from financial institutions or capital markets which must be paid within 12 months from the reporting date (assuming the entity's operating cycle does not exceed 12 months).

Classes of inventory

Inventory can be classified as merchandise, manufacturing or miscellaneous inventory. Merchandise inventory comprises goods that have been purchased for resale in their existing form. The inventory of retail companies such as Woolworths would fall into this category. Manufacturing inventory consists of inventory in each of the three stages of processing: raw materials, work in progress and finished goods. Inventory at each stage is valued and the total amount represents the inventory valuation. The third category, miscellaneous inventory, consists of items held for use in routine non-manufacturing operations and would include items such as office supplies. Miscellaneous inventory is usually not important in the analysis of a company's financial performance.

Liabilities

Liabilities represent the obligations of an entity to make repayments in cash or in kind and are, normally, settled through payment. Examples include payables, accruals, dividends payable, income tax payable, employee entitlements and borrowings. Cash (or other assets that can be converted into cash) is used to pay these liabilities.

Non-current assets

Non-current assets are assets which the entity intends to keep for longer than a year, or which will bring future economic benefits to the business over a period of more than one year. Unlike current assets, which may be converted relatively easily into cash, the value to an entity of most non-current assets lies in their use in producing goods and services for sale. Non-current assets are not intended to be sold in the short-term.

Topic learning outcomes

On completing this topic, students should be able to: • outline the different classes of assets, liabilities and equity, as well as the order in which they appear in the statement of financial position • describe how specific assets and liabilities are recorded in the statement of financial position • state the classification, description and valuation of the different classes of liabilities • distinguish the major components of equity and how they are recorded.

Prepayments

Prepayments (or prepaid expenses) represent amounts paid in advance for a service. For example, rents, rates and insurance premiums are generally, paid in advance. In other words, the services have been fully paid for but the benefit has not been fully received by the entity as at the reporting date. Since these prepaid expenses eliminate the need to pay cash for services in the future (i.e. they are savings in a future 'outflow'), they are the equivalent of an asset. Therefore, when a prepayment is made, it is recorded initially as an asset and is reduced over time so that each future period receives its fair share of the cost. This is consistent with the matching principle discussed in Topic 1. Prepayments are usually a small proportion of a company's assets and therefore do not usually warrant much attention in analysing a company. They are more reflective of the way a business is run than its underlying trading activities.

Property, plant and equipment

Property, plant and equipment are also referred to as fixed assets. 'Property' generally refers to land and buildings. 'Plant and equipment' are essentially the long-term infrastructure used by an entity over several years and includes items, such as machinery, office furniture, computers etc. The proportion of fixed assets to total assets of an entity varies depending on the nature of the business. The fixed assets of a transport entity are likely to form a large part of the total assets and could include vehicles, depots, servicing equipment and offices. On the other hand, a professional services entity typically only requires rented offices and so the fixed assets will be a much smaller proportion of the total assets. In accordance with AASB 116 'Property, Plant and Equipment', each item of property, plant and equipment is initially brought to account at cost, that is, the fair value of the consideration (e.g. cash, equity securities) offered by the acquirer. Subsequently, each class of non-current asset within property, plant and equipment is measured on either the cost model or the revaluation model (i.e. fair value basis), as discussed below. Property, plant and equipment is derecognised (i.e. removed) from the balance sheet when it is disposed of. The loss or gain that results from the disposal of the asset should be included in the statement of profit or loss and other comprehensive income.

Provisions (under liabilities)

Provisions are liabilities for which the amount or timing of the future sacrifice of economic benefits, that will be made, is uncertain. AASB 137 'Provisions, Contingent Liabilities and Contingent Assets' includes specific rules regarding when provisions should be recognised and how they should be measured. Sometimes provisions may be used to reduce reported profits. In a good year, an entity may over provide, thus creating a cushion that can then be used in a bad year to absorb any fall in profits. However, AASB 137 now makes it harder for companies to use provisions in this way to 'smooth' reported profits.

Impairment

Regardless of whether property, plant and equipment is measured using the cost model or revaluation model, AASB 136 'Impairment of Assets' requires that the carrying amount of such assets must not exceed their recoverable amount. Recoverable amount is the higher of the following amounts: • fair value less cost to sell — this is the amount that could be obtained from selling of an asset in an arm's length transaction between knowledgeable, willing parties, less the costs of disposal • value in use — this is the present-value of the future cash flows expected to be derived from an asset. The impairment rules prescribe a two-step impairment test. Step 1: Determine whether there is any indication that the carrying amount of an asset (or group of assets) is impaired. One such indication may be from internal sources of information — for example, net cash inflows or operating profit resulting from an asset are significantly lower than budgeted. Another indication may be from external sources of information — for example, significant changes with an adverse effect on the entity have taken place during the period, or are expected to take place in the near future, with respect to the technological, market, economic or legal environment in which the entity operates. Step 2: If any indication of impairment exists, then the recoverable amount of the asset (or group of assets) must be determined. If the recoverable amount is less than the carrying amount, then the asset is impaired and must be written down to its recoverable amount. Assets carried at cost are more susceptible to impairment write-downs than assets carried at fair value.

Reserves

Reserves represent that part of shareholders' equity that is not issued and paid-up shares or retained profits. The amounts can come from many sources and usually, the title of the reserve reveals the source. For example, an entity's reserves may include the asset realisation reserve (which arises from capital reserve on the sale of major assets such as property) and the asset revaluation reserve (which arises from gains on revaluing non-current assets). Retained profits are a form of reserve; however, these are listed separately. The use of the term 'reserves' can be potentially misleading in that it can be taken to mean that the company has set aside liquid assets (e.g. cash) equivalent to the amount of the reserves. This is not the case. A reserve simply denotes the extent to which limits have been placed on the ability of directors to make distributions of assets (e.g. in the form of dividends) to owners. These restrictions may arise due to statutory requirements, contractual requirements or Accounting Standards requirements. Reserves may also arise because management has voluntarily decided to set aside certain retained profits in a special reserve. Reserves created at the discretion of management can be removed later, if management decides to do so, for example by transferring the balance of the reserve to retained profits.

Reserves versus provisions

Reserves should not be confused with provisions. As previously noted, provisions are either liabilities for which the amount or timing of the future sacrifice of economic benefits that will be required is uncertain (e.g. provision for warranties) or reductions in the value of assets (e.g. provision for doubtful debts would be deducted from gross debtors, rather than disclosed as a liability). They are best estimates of anticipated amounts to be paid in the future or losses in value. Reserves represent increases in shareholders' equity arising from owners' contributions or from gains or losses in the entity's activities not included in retained profits. In essence, retained profits are a type of reserve.

Restructuring provisions

Restructuring provisions cover costs associated with a planned change in the nature of the activities undertaken by an entity or the manner in which those activities are conducted. Examples of events involving a restructuring include the sale or termination of a line of business, the closure of operations in a particular country or region and changes in management structure. Prior to AASB 137, analysts were wary of the creation of substantial restructuring provisions by companies. The concern was that restructuring provisions may be used by some companies as 'hollow logs', that is, the provisions were either not justified because they did not relate to a present obligation of the entity or they were recognised in excess of what was genuinely needed for the restructuring. Excess restructuring provisions could later be reversed thereby giving rise to an item of income. Despite the tightening of the rules for recognising provisions under AASB 137, analysts should still look carefully at such provisions to ensure that they remain appropriate.

Specific identification inventory valuation

Specific identification: This means that specific costs are attributed to 'identified' items of inventory. This is used where the goods sold are not ordinarily interchangeable and the goods or services are produced and segregated for specific projects. For example, specific identification may be used when the goods are large or valuable, such as cars or quality jewellery.

Standard costs

Standard costs are often used by manufacturers to determine the cost of inventory. Under this system, predetermined product costs that would be incurred under efficient operating conditions, are determined. When actual costs incurred vary from standard costs, the treatment of the variances depends on the nature and cause of the variances: • if variances are due to temporary factors, and standards have been properly set and maintained, the variances from standards are accounted for as a revenue or expense in the reporting period in which they arise • if significant variances occur arising from changes in any of the factors on which the standards are based (e.g. prices of materials, labour rates, manufacturing expenses or operating conditions), and without the standard cost being amended, the variances from standard are adjusted against inventories. This may require the variances to be apportioned between the cost of inventory sold during the reporting period and the cost of inventory on hand at the end of the reporting period. To be acceptable for inventory measurement, standard costs should take into account normal levels of materials and supplies, labour, efficiency and capacity utilisation. The standard costs must be regularly reviewed and, if necessary, revised in the light of current conditions.

Other receivables

Tesmer has other receivables of $16.0 million (refer to note 6) from transactions outside the usual trading activities of Tesmer Group. This could be money owing from other asset sales or the current portion of monies owing by employees of Tesmer under schemes that provide financial assistance to enable employees to purchase shares and for other purposes approved by shareholders. As noted above, trade receivables will be of more interest than other loans and receivables in analysing a company, since the former reflects sales from the entity's core activities. It is important to examine the amount of receivables in relation to the amount of sales. When receivables become an increasing proportion of sales, it can indicate more generous credit policies are being employed which, if not managed properly, may result in higher than normal doubtful or bad debts.

Inventory measurement

The basic principle of inventory valuation is that inventory is valued either at cost or net realisable value (NRV), whichever is the lowest, on an item-by-item basis. NRV is the estimated proceeds of sale less any costs it expects to incur in marketing, selling and distributing them. Where it is impracticable to measure items of inventory separately because there is a large number of homogenous items of inventory each having an insignificant cost, the basic principle of inventory valuation is applied to groups of such items. Financial statements are generally prepared using the historical cost convention. This means that inventory items are valued at their original cost, which is the amount paid for inventory or, in the case of a manufacturer, the cost of making these items. Some inventory may be old, out-of-date or in bad condition and an entity may have to sell it at a price lower than the original cost. Such inventory is valued not at cost but at NRV. The practice of writing inventories down below cost to NRV is consistent with the view that assets must not be carried in excess of the amount expected to be realised from their sale or use. Hence, for any particular inventory, it may reasonably be expected that the majority of the inventory value to be at cost, and for some of it to be at NRV.

Internally generated intangible assets

The capitalisation of 'internally generated' intangible assets is a controversial area of debate due to concerns about whether there is a discernible relationship between the expenditure giving rise to such assets and subsequent economic benefits. As noted above, Australian Accounting Standards specifically prohibit the recognition of internally generated goodwill. In practice, the distinction between internally generated intangible assets and internally generated goodwill may not be readily apparent in many cases. Credit analysts typically omit intangible assets when they assess the net worth of an entity. Despite this, intangible assets can be an important source of revenue generation for entities, particularly those in knowledge-based and service industries. The value of intangibles is perhaps more important in their contribution to earnings than the amount ascribed to them on the statement of financial position.

Other financial assets

The class 'other financial assets' includes all financial assets other than cash assets, receivables and equity accounted investments.

Inventory

The next class of assets shown under current assets is inventory, sometimes called 'stock'. For most retailers, wholesalers and manufacturing entities, inventory is a major asset. For a manufacturer, the associated cost of goods sold is usually the largest single expense, commonly between 60% and 70% of sales revenue. Therefore, companies should carefully manage inventory levels as excessive inventories can utilise significant amounts of cash or require substantial borrowings to finance them. The valuation placed on inventory has a significant influence on the reported profit. Valuation is not a precise exercise. Management must use judgment to choose an appropriate basis of valuation from a number of available alternatives. In an analysis of the stock (inventory) figure, the statement of accounting policies and other notes should be studied to find the principles and methods used in the valuation of inventory and to detect any changes

Diminishing value depreciation

The reducing balance or diminishing value method of depreciation involves expensing, in each period, a fixed percentage of the value of the asset shown in the statement of financial position. It results in a higher depreciation charge in the early years of the life of the asset. The diminishing value rate is normally one and a half times the straight-line rate. In the example of the photocopier detailed above, the diminishing value rate would be 15%. The reducing balance method would be used where the future economic benefits are expected to be consumed by an entity more heavily in the earlier years of the useful life of an asset than the later years. The depreciation method chosen by management should reflect the use of the asset. Depreciation is a cost of daily business, in the same way as salaries, and is therefore treated as an operating expense and charged against revenue. Depreciation follows the principle of matching — outlined in Topic 1. Depreciation recognises the relevant portion of service potential embodied in an asset that was 'consumed' during a period in the process of producing goods or services. This consumption of service potential is recorded as an expense (depreciation) in the statement of comprehensive income. Note: This operating expense is a non-cash expense because there is no outflow of cash. The cash was paid or perhaps borrowed at the time of obtaining the asset.

Retail inventory method

The retail inventory method is often employed by merchandising businesses to determine the cost of inventories. This method attempts to overcome the practical difficulties encountered by such businesses whose inventory comprises of a large number of items with a high rate of turnover and the cost of individual items is not readily obtainable. The retail inventory method can only be used to determine the cost of inventories where it results in an amount reasonably approximating the lower of cost and net realisable value (NRV). The retail inventory method involves discounting the selling value of the total inventory in a merchandise department (or classification) by the current average mark-up in that department (or classification) expressed as a percentage of the selling price. Problems may be encountered with the retail inventory method where inventory contains seasonal and slow-moving items, which are not expected to be sold at their original selling price, and their price has therefore been marked down. The application of the retail inventory method in these circumstances could result in the particular items being valued at less than cost.

Straight-line depreciation

The straight-line method spreads the original cost ($10,000) evenly over the 10 years so that the photocopier depreciates by $1,000 a year. Depreciation will be treated as an operating expense and each year charged through the statement of comprehensive income. The value of the asset shown on the statement of financial position will decrease accordingly. The straight-line method would be used where an asset is expected to contribute economic benefits to an entity on a more or less consistent basis from year to year.

Amended accounting standard for depreciation and amortisation

Under AASB 2014-4 Amendments to Australian Accounting Standards - Clarification of Acceptable Methods of Depreciation and Amortisation, AASB 116 has been amended to prohibit the use of a revenue-based depreciation method for property, plant and equipment. Additionally, the amendments provide guidance in the application of the diminishing balance method for property, plant and equipment. AASB 138 has also been amended to present a rebuttable presumption that a revenue-based amortisation method for intangible assets is inappropriate. This rebuttable presumption can be overcome (i.e. a revenue-based amortisation method might be appropriate) only in two (2) circumstances: • the intangible asset is expressed as a measure of revenue; for example, when the predominant limiting factor inherent in an intangible asset is the achievement of a revenue threshold (for instance, the right to operate a toll road could be based on a fixed total amount of revenue to be generated from cumulative tolls charged) or • when it can be demonstrated that revenue and the consumption of the economic benefits of the intangible asset are highly correlated. AASB 2014-4 is applicable to annual reporting periods beginning on or after 1 January 2016.

Cost model

Under the cost model, the relevant class of property, plant and equipment is carried, at its cost, to the entity less any accumulated depreciation and any accumulated impairment losses. The concepts of depreciation and impairment are considered in further detail below. Cost is the amount of cash or cash equivalents paid or the fair value of the other consideration, such as an entity's own shares given to acquire an asset at the time of its acquisition. While cost may be regarded as an objective and reliable basis of measurement, because it represents the amount paid by an entity to acquire an asset, a criticism of cost is that it may not give an accurate indication of the current worth of an asset. Indeed, with the passage of time, costs can become outdated and of limited usefulness for decision-making. As a result, some commentators advocate that assets be measured using a more up-to-date value such as fair value.

Production overhead variable costing

Variable costing (also known as direct costing) includes only raw materials, direct labour and variable production overheads in the cost of inventory. The fixed overheads are charged to the statement of comprehensive income as they are incurred.

Weighted average cost inventory valuation

Weighted average cost: Under this method, the cost of each item of inventory is determined by dividing the total cost of goods available for sale (beginning inventory + purchases) by the total quantity of inventory available for sale. Assumptions must be made when inventory purchased goes into bulk storage and it is not possible or is too costly to identify individual batches. The average cost method values inventory batches purchased or manufactured by calculating an average (mean) cost per unit. The average (mean) cost is updated each time a new batch of goods is received into inventory. This method smoothes out fluctuations in the cost of the goods — arising from changes in purchase price and manufacturing costs.

The rules covering the treatment of such revaluations are: • revaluation increases relating to an item of property, plant and equipment must be credited directly to an asset revaluation reserve (this reserve appears as an equity item in the statement of financial position). However, to the extent that the increase reverses a previous revaluation decrease which was previously recognised in profit or loss in respect of that same asset, it must be recognised as revenue in profit or loss • revaluation decreases relating to an item of property, plant and equipment must be recognised as an expense in profit or loss except that, to the extent that a previous revaluation increase still exists in the asset revaluation reserve in respect of that same asset, the revaluation decrease must be taken against the asset revaluation reserve.

With the exception of land, fixed assets wear out over time or otherwise become technically or commercially obsolete. Between the time an asset is acquired and when it is no longer economically useful, a decrease in its value takes place. Depreciation is a means of recognising this consumption of future economic benefits (embodied in the photocopier in the above example) by apportioning, as an expense, the original cost (or other revalued amount substituted for such cost) over its useful life. This is done after allowing for the net amount expected to be recovered on disposal of the item at the end of its useful life. This residual amount, referred to as 'residual value', would be subtracted from the original cost of the photocopier or other revalued amount, in determining the amount of depreciation expense.

Production overheads

overheads are a major element affecting the cost of inventory. They apply to entities which produce inventory, such as manufacturing or mining. It is only the production overheads that are allocated to the cost of inventory. All other overheads such as distribution, selling and administration are deducted from the statement of comprehensive income after the gross profit level. Examples of production overheads include factory rent, electricity, and factory insurance. Production overheads are unavoidable and are often very expensive. Accountants divide production overheads into two categories: • fixed production overheads — the costs are assumed the same regardless of the volume of production (e.g. rental cost of a factory) • variable production overheads — the costs are assumed to vary in accordance with the quantity manufactured (e.g. electricity used in operating machinery).

Deferred tax asset Assessable temporary difference

this means that when the carrying amount of an asset is recovered in the future, or a liability settled in the future, the entity will be subject to higher future tax payments as a result. For example, an entity that depreciates its plant and equipment at a faster rate for tax purposes than accounting purposes, will give rise to an assessable temporary difference since, in the latter years of the useful life of the plant and equipment, the entity would have exhausted most of its tax deductions. In turn, this gives rise to a deferred tax expense and a corresponding deferred tax liability.

Deferred tax asset Deductible temporary difference

— this means that when the carrying amount of an asset is recovered in the future, or a liability settled in the future, the entity will be subject to lower future tax payments as a result. For example, most provisions recognised for accounting purposes now (e.g. provision for long service leave) but deductible for tax later (e.g. when an employee takes the long service leave) will give rise to a deductible temporary difference. In turn, this gives rise to deferred tax 'income' and a corresponding deferred tax asset.