ACCOUNTING OF FRESH MILK LTD.

QUESTION

ACC222 EXTERNAL REPORTING
Session 201230
Due 9
th

ASSIGNMENT TWO

May
Complete all 3 questions given below. A total of 45 marks are allocated to the questions
below, which will then be converted to 15% in total.
Question 1 [8 marks]
Revaluation of assets
Pepperoni Ltd has a financial year ends on 30 June. On 1 July 2011, the company acquired
two assets within the same class of plant and equipment. Information on these assets is given
below.

Cost Expected useful life
$ Years
Machine A 100,000 5
Machine B 60,000 3

At 30 June 2012, the fair value for machines A & B are $84,000 and $38,000 respectively.
There is no change in the expected useful lives of the machines. The machines are
depreciated using straight line method.
The management has decided to use the fair value basis for the measurement of its plant and
equipment. These machines are hard to obtain and has in fact increased in value over the
current period. The management is arguing that, as there has been no decline in fair value, no
depreciation should be charged on these pieces of equipment.
Required:

As an accountant of Pepperoni Ltd, prepare a memorandum to the management:

(a) Explain why the depreciation of the equipment should be imposed despite the increase
of their values; and
(b) Outline the journal entries for the financial periods ended 30 June 2012.
Source:
Leo, K., Hoggett, J., & Sweeting, J. (2008). Company Accounting (8th ed.). John Wiley & Sons, Milton, Queensland.

Page 1 of 3

Question 2 [15 marks]
Part A Cash-generating units (5 marks)
Fresh Milk Ltd owns a large number of dairy farms in Queensland. It has a number of
factories that are used to produce milk products that are then sent to other factories to be
converted into milk-based products such as yogurt and custard. In applying AASB136
Impartment of Assets, the accountant for Fresh Milk Ltd is concerned about correctly
identifying the cash-generating units (CGUs) for company, and has sought your advice on
such questions as to whether the milk production section is a separate CGU even though the
company does not sell milk directly to other parties, or whether it should be included in the
milk-based products CGU.
Required:
Write a report to the accountant of Fresh Milk Ltd, including the following:
1. Define a CGU.
2. Explain why impairment testing requires the use of CGUs, rather than being based on
single assets.
3. Explain the factors that the accountant should consider in determining the CGUs for
Fresh Milk Ltd.

Part B Computation of impairment losses (10 marks)

Green Miles Ltd has determined that its milk production division is a cash-generating unit. At
31 December 2011, the carrying amounts of the assets were:

$
Plant & machinery 300,000
Accumulated depreciation – plant & machinery (90,000)
Land 150,000
Inventory 60,000
Equipment 150,000
Accumulated depreciation – equipment (30,000)
The inventory’s fair value less costs to sell was equal to its carrying amount. Green Miles Ltd
calculated the value in use of the division to be $500,000.
Required:
Prepare the journal entries for Green Miles Ltd in relation to the impairment exercise for 31
December 2011, assuming the fair value less costs to sell of the land are:
(a) $130,000 and
(b) $145,000.
Explain and justify your answers, showing all necessary workings.
Source:
Leo, K., Hoggett, J., & Sweeting, J. (2008). Company Accounting (8th ed.). John Wiley & Sons, Milton, Queensland.
Page 2 of 3

Question 3 [22 marks]

Part A Finance lease vs operating leases (6 marks)

Kumara Ltd runs a successful chain of fashion boutiques, but has been experiencing
significant cash flow problems. The directors are examining a proposal made by an
accounting consultant that all the shops currently owned by the company be sold and either
leased back or the businesses moved to alternative leased shops. The directors are keen on the
plan but are puzzled by the consultant’s insistence that all lease agreements for the shops be
“operating” rather than “finance” lease.

Required:

1. Explain the difference between a finance and an operating lease.
2. Explain, by reference to the requirements of AASB117, why the consultant prefers
operating to finance leases.
3. Describe three disadvantages of entering into finance lease agreements.
Source:
Leo, K., Hoggett, J., & Sweeting, J. (2008). Company Accounting (8th ed.). John Wiley & Sons, Milton, Queensland.

Part B Accounting for leasing – by lessee (16 marks)
On 30 June 2011, Cherry Ltd leased equipment from Young Ltd. The crane cost Young Ltd
$3,700,000 (fair value). The lease agreement contained the following provisions:
Lease term 6 years
Estimated useful life of crane 8 years
Annual lease payment, payable on 30 June each year, with the first payment to be
made up front on 30 June 2011
$700,000
Estimated residual value of crane at end of lease term $613,711
Residual value guaranteed by Cherry Ltd $500,000
Interest rate implicit in lease 10%
The lease is cancellable only with the permission of the lessor. Both entities use straight line
depreciation for similar assets. The control of the leased asset reverts back to Young Ltd at
the end of the lease.
Required:
(a) Classify the lease for Cherry Ltd (the lessee) based on the guidance provided in AASB
117. Justify your answer.
(b) Prepare the lease payment schedules for both Cherry Ltd and Young Ltd (show all
workings).
(c) Prepare the necessary journal entries to account for the lease in the books of Cherry Ltd
and Young Ltd for the years ended 30 June 2011 and 2012. Narrations are not required.
Note: round all figures to the nearest dollar, and leave all percentages with one decimal
place. Show all workings clearly.
Page 3 of 3

SOLUTION

Answer1: a)depreciation deals with loss of value to degradation of physical condition wheras the concept of revaluation of assets takes into account the increase or decrease in the value of an asset due to the market condition in which the firm is operating. Since, the approach of the two concepts in recording  the fair value of assets in the books of accounts is conceptually distinct therefore it is imperative to disclose both the amounts i.e. amount of depreciation and the revaluation amount(profit or loss) separately in the books of accounts.

In the question, the arguments of the management of Pepperoni ltd that as there has been no decline in the fair value of the assets , no depreciation should be charged on them is conceptually incorrect as the treatment of the two amounts I.e. the depreciation amount and the increment in the value after revaluation is different. The former is treated as expense in profit and loss account and the latter is treated as surplus and shown under balance sheet as a part of owner’s equity. Therefore, offsetting the depreciation amount with the revaluation profit is not acceptable according to the AASB framework.

b) Accumulated Depriciation A/c Dr                   40,000

To  Machine A                                                                       20,000

To Machine B                                                                        20,000

Profit and Loss A/c                Dr                               40,000

To Accumulated Depriciation A/c                                       40,000

Machine A                            Dr                                      4000

To Revaluation Reserve                                                       4000

Revaluation Reserve A/c         Dr                            2000

Machine B                                                                                            2000

ANSWER 2:

PART A

a) “ Cash-generating units are assets held with the primary objective of generating a commercial return.”- AASB

“ Cash-generating unit is the smallest identifiable group of assets that generates cash inflows that are largely independent of the cash

inflows from other assets or groups of assets.”- IASB

“A portfolio of similar assets that are subject to the same economic and commercial influences.”- SAICA

b) In order to check whether an asset needs impairment or not , it is required to compute the following figures with respect to the asset

• Recoverable amount
• Value in use

According to the AASB framework, if it is not possible to estimate the recoverable amount of the individual asset, an entity shall determine the recoverable amount of the cash-generating unit to which the asset belongs (the asset’s cash-generating unit).

Under following circumstances impairment testing is carried out with respect to a CGU rather than an individual  asset:

• When an individual asset do not generate cash inflows that are largely independent of those from other assets.

• Furthermore, an individual asset’s value in use cannot be estimated as precisely as the amount of its fair value less cost to sell.

c) In identifying a cash-generating unit the entity is required to identify the lowest aggregation of assets that generate largely independent cash inflows. The following factors should be kept in mind by the accountant of  Fresh Milk Ltd while determining CGU:

• It should be the smallest identifiable group of assets
• It should generate cash inflows
• Independently from other assets or groups of assets
• The CGU has to be consistent with the organization of the  business. It could be based on factor like quality of product, type of area etc
• Should be meaningful to the users of the financial statements of the Fresh Milk Ltd
• Consider the degree of shared infrastructure required to obtain inflows .Certain specific assets like shared facilities should be assessed separately
• CGU needs to be defined consistently from period to period
• Corporate assets are allocated to CGU’s on the basis of relative weighted carrying amounts

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