Background and assessment criteria
This assignment is designed to expose students to the sorts of applied research problems that financial accountants would expect in the workplace. You need to identify what the specific problems are, identify which rules apply, then apply them correctly. As is often the case in the real world, the information below is incomplete and can be interpreted in different ways. If you come to the situation where you are not sure which rule to apply, or how to apply a particular rule, you need to state this and justify the option you selected. Please note that some interpretations will not be acceptable.
Please also note that much of the material you learned in Accounting Systems and Practices is irrelevant and wrong for the purposes of this assignment, as it has been superseded (replaced with a new rule or rules). Students who apply the wrong rules will be given 0 for that part of the question. In the real world, they would often be sacked. This assignment requires you to deal with AASB 15 Revenue from Contracts with Customers. In addition, you will need to deal with other accounting rules. You will discover which rules these are, as you work through the questions asked. You can assume that the current versions of these rules are the version you need to apply. (Your questions are set in 2019 and beyond. If you discover that you need to apply AASB XXX, you need to apply the current version of that rule, not projected versions.)
Question 3 requires you to use AASB 9 Financial Instruments.
Marks will be allocated for correctly identifying the specific rules to apply and then applying them appropriately. Where you are asked to state an opinion, such as which option is preferred, or what were the standard setters worried about, you will be marked on your ability to express yourself and your ability to link the your response to the question asked. If you give me a fluffy answer that does not address the question directly, you will be lucky to get more than 10% of the marks allocated to that question.
Unless told otherwise, the first year in all questions refers to the year ending on 31/12/19. You can assume that AASB 15 commenced on 1/1/19 and that your company is a reporting entity. You can ignore GST.
Your manager is a paranoid little wretch. He nearly lost his job a while ago because he relied on the advice of a graduate. Fortunately for him, he was able to sack the graduate, and keep his own job. In all questions, unless told specifically otherwise, you must identify the reference for your journal entries. The reference may be to the standard or to other relevantprimary documents. Please note, textbooks and journal articles are not primary documents for the purposes of this assignment.
You only need to discuss your choice of reference if you feel the information is ambiguous or the reference material provides alternatives and you wish to justify your choice of treatment. Please note, failure to reference your journal entries, or failure to identify the appropriate reference material will result in substantial penalties (50% to 100% for each incorrect entry). If alternative interpretations are reasonable, and you have argued your case well, and applied the interpretation correctly, there will be minimal penalties, if any.
The manager expects the journals to look something like this.
Dr account name $xx
Cr account name $xx
(Ref – xxxxx para y)
Question 1 40 marks
Your manager has been very stressed lately, as the company’s profits are not looking very good and he wants to increase them without breaking the law or accounting rules. He is focused on profits, rather than cash flows, as the former is one of his KPIs[i]. Your company sells computer hardware and uses the perpetual inventory system. Recently sales growth has been flat. In order to increase revenues, the company has started offering incentives and creative arrangements to customers. It is currently in negotiations with Fleabag Ltd, a merchant bank and a long-time customer. The companies are negotiating the sale of some hardware that cost $210,000 to build and normally sells for $400,000. Your company’s borrowing rate is 8.55% which is typical for a company of this risk profile.
Your manager is considering two ways of structuring the transaction with Fleabag. The first is to sell the system for $400,000 and at the same time, your company will sell Fleabag a put option for $15,000. This option will allow Fleabag to require your company to buy back the hardware at the end of year 4 (31/12/2022) for $50,000. The FV of the option on 1/1/19 is $36,012. The consensus opinion among the sales staff is that the fair value of the hardware in 4 years’ time would be $30,000. It has an expected useful life of 5 years. Fleabag does not have to pay upfront; instead it will pay $115,646 at the end of each year for 4 years.
The alternative is to sell the hardware for $400,000, as well as an option for $15,000. This time the option allows Fleabag Ltd to require your company for buy back the asset on 31/12/2020 for $130,000, the estimated fair value of that asset at that time. The FV of this option on 1/1/19 is $110,327. In this option, Fleabag will pay the $415,000 on 1/1/19.
You have to prepare a briefing paper for your manager stating which option would be more attractive for your manager and specify why. You can assume the transactions commence on 1/1/19. Your response will not be confined to AASB 15.
Your response will present all relevant journal entries under both scenarios, assuming Fleabag accepted the offer at the start of the current year (1/1/19). The journal entries will cover the current year and the next 3 years (4 years in total). Remember, your response must specifically identify any assumptions you make and refer to specific rules and relevant evidence.
Your briefing paper will follow this general structure
Alternative 1 journal entries
Alternative 2 journal entries
As part of your answer ensure you deal with the situation where the option is exercised by Fleabag, as well as the entries if the option was not exercised.
Conclusion – state which option is preferred and clearly explain why. Please ignore the impact of the extra $20,000 in the first alternative.
(30 marks for the journal entries 10 marks for the conclusion and explanation)
Question 2 30 marks
This is the first year your company has been in business. All sales in this question were for cash. Customers had arranged their own financing, by borrowing money from their banks. Your company sells cars and offers a variety of warranties to customers. First, there is the basic, mandatory, warranty (W1) which states the cars will perform normally for 12 months. These warranties are standard on all base model cars sold by the company.
The company also offers a number of types of extended warranties. Extended warranties (W2) for normal performance are included in the cost of mid-level cars. These warranties run for 5 years.
In relation to their most expensive cars, the company includes extended (5 year) warranties for normal performance and servicing for the same period (W3).
Both extended warranties (W2 and W3) can be purchased separately by customers, even if the customers did not buy the more expensive models of cars.
During the year the company sold 2,000 base model cars for an average price of $15,000 each. The company estimates it will incur warranty costs of 5% of sales in relation to these sales.
The company also sold 1,800 mid-level cars for an average price of $25,000 each. The company estimates it will incur warranty costs of 7% in relation to these sales.
The company sold 1,500 luxury cars for an average price of $60,000 each and estimates it will incur warranty costs of 10% in relation to these sales.
In addition, the company sold 800 W2 at $1,000 each and 900 W3 at $2,000 each in the current year to customers who wished to upgrade the warranty cover for the cars they bought in the year.
In relation to the warranties sold with the cars, by the end of the first year the company had paid $750,000 under W1, $360,000 for W2, and $675,000 for W3.
In relation to the warranties sold separately, the company had paid $160,000 for W2 and $405,000 for W3.
Prepare all the relevant journal entries for the first year based on this information. Your company uses the perpetual inventory system. For the purposes of this question, you can ignore the COGS entries. Your manager is particularly concerned how you deal with the information relating to the warranties. Remember, your response must specifically identify any assumptions you make and refer to specific rules.
Question 3 30 marks
On 1/1/19 your company received $1,000,000 cash when it issued debentures with a face value of $1,000,000. These instruments have a life of 4 years and pay a coupon payment of 8% of the face amount annually on 31/12. These instruments are classified as Fair Value Through the Profit or Loss (FVTPL).
Your dearly beloved manager told you that changes in the credit risk of these debentures will not be offset in the Profit or Loss account by other financial instruments. You nodded politely and looked intelligent, wondering what the fool was rabbiting on about.
Your company only uses the London Interbank Offered Rate (LIBOR) as a proxy for market risk. Your company does not use other metrics to evaluate market risk.
The table below shows the LIBOR rates and market rates of interest for the life of the debentures.
Dates LIBOR rates Market rates
1/01/2019 5% 8%
31/12/2019 4.75% 7.60%
31/12/2020 4.65% 7.80%
31/12/2021 4.75% 7.90%
31/12/2022 4.50% 8.20%
a) Prepare all the relevant journal entries relating to these debentures. Your entries will cover the entire life-cycle of these instruments. You must reference your journal entries. 15 marks
b) Why would the standard setters require this accounting treatment? What were they worried about? Comment on the quality of this accounting treatment. When discussing the quality of this rule, you need to have a strong reference point. How can you determine whether this is a ‘good’ or ‘bad’ or ‘useless’ accounting rule? 15 marks
[i] Key performance indicator