ACCOUTING THEORY OF CONSTRUCTIVE LIABILITY

QUESTION

ACCG923 Accounting Standards and Practice
Session 1, 2012
Assignment Instructions:
 Assessment percentage: 15%
 Mark allocation: This assignment will account for 15% of the total marks towards
your final assessment. Your lecturers will mark the technical component of the
assignment, and this will be marked out of 10. Centre for Macquarie English (CME)
will assess your writing skills. This component will be marked out of 5.
 Due: Week 7 classes (Starting from 23
rd
April, 2012)
 You must submit two hard copies of your assignments (with completed and signed
cover sheets and your originality report from TURNITIN attached to both copies) to
your lecturer during your class time only.
 The instructions on how to register, submit your assignment and prepare the
originality report will be available on iLearn under the assignment folder.
 You must clearly state your lecturer’s name and the time and day of your lecture.
Clearly mark COPY 1 and COPY 2 on each assignment.
 Format requirements: “Times New Roman”, size 12 with 1.5 line spacing
 If students are unable to submit the assignment on time due to illness or misadventure,
then they should contact the Unit Convenor prior to the due date and hand in the
appropriate absence form. It is important for students to provide proof of such
circumstance (eg. Medical certificate covering absence date and subsequent days until
submission). No penalty will apply if the evidence provided is approved by the Unit
Convenor and covers the entire period prior to submission.
 No extension will be granted for students who are enrolled late in this subject.
 Any submission after your class is considered as late assignment and it will not be
accepted by your lecturer. For example, if students submit the assignment after their
class time, but still within the same day, they will also be penalized for late
submission. For late assignment, students must submit at BEGC (E4A Level 2). Late
submission will be penalized at the rate of 10% of the maximum marks per day or
part thereof.
 The policy statement on cheating and plagiarism is a cornerstone of academic
integrity at Macquarie University. All students are responsible for familiarizing
themselves with the policy, seeking further advice if necessary and complying with it
at all times. If you use any material, for example textbooks, journal articles, etc, to
support your answer, you are to use the Harvard Style of referencing in your answer
for both in-text and bibliography referencing.
 Assignments not in accordance with ALL of the above instructions MAY NOT be
marked.

Background Information
You are a CPA working for an accounting firm called AccPlus. One of your clients is Cairns
Ltd. James Manning is the Managing Director of Cairns Ltd. He often contacts you for
accounting issues, which he cannot understand. Currently he has expressed some concerns
over a couple of accounting issues as shown in the memo below and he is seeking for your
professional advice.

To:  AccPlus
From:  James Manning
Manager Director—Cairns Ltd
455 Smith Street, Notsureville, NSW, 2555
Date:  10 April, 2012
Re:  Accounting Issues

1. I have been told by a colleague who is studying accounting that our current
accounting policy in relation to dividend may not be correct or in accordance with
accounting standards. My colleague stated that many public companies have dividend
policies, which have been communicated to shareholders as to the amount of the fully
franked distribution, which will be paid to shareholders. It may be argued that such a
policy provides the company with a constructive liability to pay the dividend.
Currently, the dividend is not treated as constructive liability in Cairns Ltd. Could you
please advise whether the constructive liability should arise?

2. Cairns Ltd gives warranties at the time of sale to purchasers of its product. Under the
terms of the contract for sale, the company undertakes to remedy, by repair or
replacement, manufacturing defects that become apparent within three years from the
date of sale. As this is the first year that the warranty has been available to Product X,
there is no data from the firm to indicate whether there will be claims under the
warranties. However, industry research suggests that it is likely that such claims will
be forthcoming. Should a provision be recognized in accordance with accounting
standards?

3. I am very concerned about the depreciation charges being made in relation to the
company’s equipment. In particular, I believe that the depreciation charges are not
high enough in relation to the factory machines because new technology applied in
that area is rapidly making the machines obsolete. In addition, the machines will have
to be replaced in the near future and, with the low depreciation charges, the fund will
not be sufficient to pay for the replacement machines. However, my colleague
suggested that I should not worry about the depreciation charges due to the nature of
depreciation. Could you please advise me on this matter?

4. Currently, all non-current assets, including Land and Buildings, Motor Vehicles and
Furniture and Fixtures are reported in the Statement of Financial Position at historical
cost. I would like to provide more relevant information to the users of our financial
statements, so I am considering whether to revalue the non-current assets. But I have a
problem that one of the buildings is a heritage listed building which would be
extremely difficult to value.
Can you please advise whether my proposed accounting treatment regarding the
revaluation is acceptable? If yes, how can I solve the difficulty with the heritage listed
building? What are the disclosure requirements for this change? If not, please explain
the reasons. I would like to see appropriate references to support your advice.

Kind Regards
James Manning
PS. Your written advice regarding these issues should be appreciated.

Required:
Write a business letter giving advice to James Manning, providing clear answers and
explanations to each of the four accounting issues he stated in the memo. Each accounting
issue will be marked out of ten and equal mark will be allocated to each accounting issue.
Your total marks will be prorated to a mark out of ten.

SOLUTION

Acc Plus

XXXXX

XXXXX

Date: 20th April, 2012

Dear Mr James Manning

Subject: Addressing your concerns related to certain accounting issues.

After the analysis of the problems being encountered by Mr James Manning, the following solutions have been suggested in light of the specific accounting difficulties of the organization.

1. Constructive Liability Treatment of Dividends

Firstly, the firm is encountering certain accounting difficulties in view of the dividend policy adopted by the organization. It is firstly important to understand dividends and the distribution of dividends to the shareholders. Dividends can be defined as the proportion of profits distributed among the shareholders. In other words dividends can be known as the reward for investment in an organization.

Therefore, it is extremely essential that the organizations have a clear and pre-determined dividend policy to satisfy the interests of the shareholders and maintain their confidence in the organization. The dividend policy is subjective to every organization. The business firstly has to ensure that the investors earn appropriately on the shares of the organization. Dividend is paid above the earning of the share. Companies may choose to pay dividends annually, bi-annually or not pay at all. Paying dividends is a prerogative of the organization.

Thus the decision of the firm to pay dividends depends upon Firstly the firm’s financial performance only a financially sound firm is able to pay dividends. Secondly it depends upon the long term goals and the future planning of the firm. The firm on some occasions may not choose to pay out dividends and invest and retain the entire amount for the growth and expansion of the business. This however is subjective to the firm another view that arises it is inappropriate to not reward investors as it creates distrust in the image and profitability of the firm. Thus timely reward is essential. The firm should be able to make a balance in between to achieve its long term goals and satisfying its investors ( Kapoor , 2006).

Any measurable economic benefit that accrues to the shareholders of the firm can be called a dividend. Any benefit declared to the shareholders of the firm can be called as a dividend for tax purposes even as it may be not formally declared or designated as a dividend. Such a benefit may not satisfy the legal requirements of a dividend such a benefit is known as constructive dividend. Thus in the case of Mr Mannings firm a constructive liability dividend policy may be followed only to avail certain tax relief and benefits.

The accounting treatment of both the constructive and the actual dividend is the same. But a constructive dividend is taxable only to a certain extent which enables the organization to avail a greater profit after the distribution of dividends and well improves the cash flow of the organization. Constructive dividends are often described as disguised dividends used to achieve high profits in the financial statements as well reduce the burden of the dividends to satisfy shareholders on an organization. Listed below are some examples of the constructive dividend

  • Shareholder use of corporate property, the shareholders may use the property of the corporation for their personal benefit and use these can be regarded as a dividend to the shareholder.
  • Payment to personally benefit the shareholder can be treated as a constructive dividend.
  • Any unaccounted or unreasonable compensation to the shareholder can be treated as a constructive.

(Hoffman et al, 2008)

Therefore the main use of the constructive dividend policy is to plan initiate the process of tax planning .The corporations aims at the minimization of their tax liability owning to such strategic accounting measures adoption.

 

2. Provision for Warranties

 

Secondly, issue that is of concern to Cairn ltd is the warranty and replacement valid for 3 years on sales provided by the company to the customers.  Currently the company is has received no claims for replacement or repair in the past one year, but internal research has proven that such claims are likely to arise. Therefore in such a situation if the product is replaced it will firstly be accounted as sales returns. Eventually prove to be a loss of revenue as well as imposing an additional cost on the business. Even the repairs are likely to increase costs and the expertise would require to repair the defects for this the firm would have set up additional funds required to enable the working of the system.

Therefore considering all the factors it and potential risk of loss that it imposes to the organization it is advisable that a provision for warranty and replacement be set up. A provision is set up in the recognition of the potential costs arising out the operations in the business. Setting up a provision highlights the business alertness and responsiveness to respond to any unprecedented situation. In this case the potential costs that have been recognised as firstly the cost of replacement of the product and secondly repair costs and the technical expertise required to repair the product.

Some liabilities may arise from the transactions of the firm in the future they are known as contingent liabilities. In this case a provision similar to a contingent reserve needs to be set up to provide for the potential loss that may occur in the future (Warren, 2008).

The most important factor in setting up of a contingent reserve is the amount of fund that needs to be put aside for the reserve is crucial. Since the loss is estimated in the future its valuation in the current terms is often difficult to estimate. Let us illustrate the creation of  provision by the with a help of an example : Suppose Cairn ltd sells a particular product X at $ 30000 and includes a 3 years warranty and repair on the product and 5% average cost on warranty is assumed then the transaction will be recorded as.

Particulars Amount Amount
Product  Warranty Expense

To Product Warranty Payable

1500 1500

 

Now in case the Warranty Expense become payable within the time period of the purchase and $200 becomes payable as replacement and repair expense then the transaction will be recorded as:

Particulars Amount Amount
Product Warranty Payable

To Supplies

200 200

 

(Warren et al, 2008)

Professional judgement is essential to distinguish between contingent and liabilities and the making of the contingency reserves. Therefore it is important to analyse the extent of loss and the risk expected due to warranty claims in the future and then appropriately form the required reserve and give it the accounting treatment required.

3. Depreciation Treatment

 

The third concern in relation to the depreciation charges being incurred upon the firm. The concern of the obsolete machinery and the depreciation charges is extremely appropriate. The organization should appropriately provide for depreciation. There are a wide variety of depreciation methods and techniques that can be considered by the organization to provide for depreciation.

One of the depreciation treatments that can be provided is the ‘Straight Line Depreciation Method’. Under the straight line depreciation method implies a certain rate of depreciation is fixed for the asset and each year the asset is depreciated by the value pre-determined. This method is however to simplistic and often in the real world is used more often to justify the life or the value of the asset in the long run. Thus, the method which is more practically used to realise the life and the value of the asset is the ‘Diminishing Balance Method’. Under the Diminishing balance method a higher rate of depreciation is provided for the early years of the life of the asset and for latter years a lower rate of depreciation is assumed. Let us illustrate the straight-line method method with the help of an example: Suppose Cairn ltd buys equipment for $860,000 and the asset has a life of 20 years.

Therefore

  Asset Value Life of Asset Depreciation
Equipment $860,000 20 years $43,000

 

And the accounting treatment that is to be given to the depreciation charge is as follows:

Particulars Amount Amount
Depreciation A/c

To Accumulated Depreciation

$43000 $43000

 

The accumulated depreciation would be reflected in the Non-current Asset groups in the balance sheet and would be deducted from the value of the asset.

(Kieso, 2008)

Thus the only component which needs to considered while evaluation and accounting for depreciation is assumption of the current life of the asset, It is the life of the asset which determines the appropriate depreciation figure for the asset.

4. Revaluation of the Heritage Building

 

The new accounting standards have made it essential to value the non-current assets like property, plant and equipment and the fair value. It is equally essential to revalue the non-current assets appropriately so that the investors have served with updated values and have faith in the profitability of the company. The fair value of the fixed assets is determined on the market evidence of set by appropriate people of skill. Changes in the fair value of the assets is dependent upon the market conditions, therefore it is advisable to revalue assets in a period of 3-5 years to remain in line with the market prices and conditions (The Institute of Chartered Accountants of India –accessed on 20/4/2012)

Regardless of the building being a heritage the building is first re-valued at the current market price. Even though the building is a heritage building the accounting treatment applied in the revaluation would be the same since the building is in use but the economic benefits of the value of the building would be realised in the future, according to the prevailing market prices and conditions (Australian Government, Australian Accounting Standards Board, 2008).

Hope the letter addresses all the concerns of Cairn limited related to the relevant accounting issues.

Thank you

Yours Truly

AccPlus

 

5. References

 

  • Hoffman, William H., William A. Raabe, James E. Smith, and David M. Maloney. West federal taxation 2007: Corporations, partnerships, estates & trusts. 2007 ed. Australia: Thomson/South-Western College, 2007. Print.
  • Kapoor, S. “IMPACT OF DIVIDEND POLICY ON SHAREHOLDERS’ VALUE: A STUDY OF INDIAN FIRMS.” Jaipee Institute of Information Technology University 1.1 (2006): 1-38. Print
  • Warren, Carl S. , James M. Reeve, and Jonnathan Duchac. Financial Managerial Accounting . Mason: South Western Cengage Learning, 2008. Print.
  • Kieso, Donald E., and Jerry J. Weygandt. Intermediate accounting. Hoboken, NJ: Wiley, 2011. Print.
  • Institute of Chartered Accountants India. “ACCOUNTING STANDARD FOR LOCAL BODIES (ASLB) 5 Property, Plant and Equipment.” The Institute of Chartered Accountants of India 1.1 (2008): 1. Print.
  • “Property, Plant and Equipment.” aasb.gov.au. N.p., 7 Nov. 2008. Web. 20 Apr. 2012. <http://www.aasb.gov.au>.

KB71

“The presented piece of writing is a good example how the academic paper should be written. However, the text can’t be used as a part of your own and submitted to your professor – it will be considered as plagiarism.

But you can order it from our service and receive complete high-quality custom paper.  Our service offers Accounting  essay sample that was written by professional writer. If you like one, you have an opportunity to buy a similar paper. Any of the academic papers will be written from scratch, according to all customers’ specifications, expectations and highest standards.”

Please  Click on the  below links to Chat Now  or fill the Order Form !

 

order-now-new                          chat-new (1)