ACC2001 Introductory Accounting

The following questions are unrelated except that they all apply to non-current assets and intangible assets:
1. The manager of Golf Gear often debits the cost of repair or maintenance of equipment to Plant and equipment. Is this a violation of accounting standards and accepted good practice Why would the manager do that.
2. The manager of Castle Industries often buys plant and equipment and debits the cost to Repairs and maintenance expense. Does this action violates accounting standards and accepted good practice Why would he do that.
3. Some people suggest that, since many intangible assets have no value except to the business that owns them, e.g. the website, they should be valued at $1.00 or zero on the balance sheet. Many accountants disagree with this view. Which view do you support Why.

 

On 1 March 2017, Hope Investments (HI) issued 7%, 20-year debentures with maturity value of $500 000. The debentures pay interest on 28 February and 31 August. HI amortizes debenture premium and discount by the straight-line method. The financial year ends on 31 December.
Requirements
1. If the market interest rate is 6.5% when HI issues its debentures, will the debentures be priced at maturity (par) value, at a premium or at a discount Explain
2. If the market interest rate is 8% when HI issues its debentures, will the debentures be priced at par, at a premium or at a discount Explain. 
3. Assume that the issue price of the debentures is 95. Journalise the following debenture transactions:
a) issue of the debentures on 1 March 2017
b) payment of interest and amortisation of discount on 31 August 2017
c) accrual of interest and amortisation of discount on 31 December 2017
d) payment of interest and amortisation of discount on 28 February 2018. 

• Debiting cost of repairs or maintenance of equipment to Plant and equipment is a violation of accounting standard AASB 116 “Property, Plant & Equipment” as it does not meet the recognition criteria of standard. Further, it is also a violation of accepted good practice as good practice is to follow the accounting standards and general industry practice is also aligned with accounting standards that is to charge off repairs and maintenance to P&L.

“As per AASB 116, the cost of an item of property, plant and equipment shall be recognized as an asset if, and only if:  (a) it is probable that future economic benefits associated with the item will flow to the entity; and (b) the cost of the item can be measured reliably.”

Since, repair and maintenance does not give any future benefits nor they increases the life or productivity of the assets and are required for upkeep and maintenance of the assets only, that’s why it should not be added to the cost of assets rather it should be charged off as an expense to the Statement of Profit and Loss account.

Manager might be of the view that since it relates to the assets so it should be added to the carrying value of the assets. That’s why he added the cost to the asset instead of charging it to the P&L. Secondly, by adding repairs and maintenance cost to the asset it will increase the carrying value of asset and increase in carrying value will increase the depreciation charged to P&L. Increase in depreciation will reduce the profit to that extent in current year as well as in years to come till the life of the asset. This reduced profit will consequently reduce the tax liability of the company.

• Purchasing Property, Plant & Equipment and debiting its cost to repairs and maintenance is a violation of accounting standard AASB 116 “Property, Plant & Equipment” as well as accepted good practice. As per the recognition Criteria of AASB 116:

“The cost of an item of property, plant and equipment shall be recognized as an asset if, and only if:  (a) it is probable that future economic benefits associated with the item will flow to the entity; and (b) the cost of the item can be measured reliably.”

As per AASB 116, any transaction that meets the recognition criteria should be classified as property, plant and equipment and should be depreciated over its life. Since, purchase of plant and equipment meets the recognition criteria and further it is having economic benefits associated with it so it should be classified as Property, Plant & Equipment.

Manager might have does so because he wants to reduce the profit for the year by charging the entire cost of assets to P&L. By reducing profit, he can reduce the tax liability, keeping the cash flow intact. This is a common practice used to window dressed the profits of the company.

• Every asset has a value. It is agreeable fact that many intangible assets have no value except to the business that owns them, but to create such assets, the business might have incurred some or other expenses. For example, for creating website, the business will have purchased the domain name, will have incurred expenses on its designing and all, etc. Only after incurring all these expenses, the business will be able to use that website. So, all these expenses associated with the intangibles should be recognized as intangible assets. Even the expenses incurred on research and development will also constitute the part of value of intangible assets.

Moreover, AASB 138 “Intangible Assets” also states that any intangible that has expected future economic benefits to the entity should be recognized as an asset and these types of intangibles should be recorded at cost. And if the asset is created or acquired at no cost or for a nominal cost, the asset should be recorded at fair value on the transaction date (i.e. acquisition date or its creation date).

So, the view that intangible assets should be recognized at $1 or $0 is not a valid view.

• If on the issue date, the market interest rate is 6.5% and the debentures are issued at 7% then the debentures will be priced at a premium. As in the market, the instruments are offering 6.5% and the debentures are offering 7%, i.e. greater than market price, the debentures will become more valuable and it will increase the price of debentures.
• If on the issue date, the market interest rate is 8% and the debentures are issued at 7% then the debentures will be priced at a discount. As in the market the instruments are offering 8% and the debentures are offering 7%, i.e. less than the market price, than the investors will be less interested in debentures as they are offering less amount of interest, whereas they can get more interest from other instruments available in the market. So, it will reduce the price of the debentures.

• Journal entries

Semi-annual interest payment = $500,000 x 7% / 2 = $17,500

The total discount of $25,000 is amortized over 20 years.  Since interest is paid twice a year, the amount of discount amortized at the time of each interest payment = $25,000 /(20*2)= $625.