FINANCIAL STATEMENTS OF SELECT HARVESTS LIMITED

QUESTION

1. Review current AASB framework which is also known as “Framework for the Preparation and Presentation of Financial Statements” and provide a critical analysis of different measurement bases.

1. B.    From a review of 2011 annual reports/financial statements of twoAustralian firms listed in ASX from different industries, identify and briefly discuss different measurement bases used by these firms and provide explanation about the implications of using these measurement bases.

1. C.    Explore the relationship between accounting information and market reaction with reference to measurement issuesby usingthe relevant research literature from refereed journals.

SOLUTION

1. A.    The AASB Framework or “Framework for the Preparation and Presentation of Financial Statements” provides the framework for defining different financial elements, measuring them and finally presenting them as financial statements. Measurement can be defined as the process of evaluating the value for the elements of financial statements to be reported in financial statements like balance sheet and income statement. There can be different ways of measuring the value depending on our assumptions. Hence, there are measurement bases. The different measurement bases included in the current AASB framework are described below:

Historical Cost: Very commonly used measurement basis, Historical cost assumes the cost of the initial transaction. Assets are calculated as the fair value of the consideration given to acquire them at the time of the initial transaction. Liabilities, on the other hand, are evaluated at the fair value of consideration received in exchange of considerations during the time they were incurred (AASB). Although the term ‘fair value’ may seem a bit confusing, the definition of historical cost also refers to “the amount of cash or cash equivalents given” in case of assets and “the amount of proceeds received” in case of liabilities. ‘To acquire’ an asset here means to encompass all possible means of asset acquisition (CASB). Also, the historical cost calculation assumes it to occur before any adjustments or amortization. In case of wanting to consider any adjustments, terms like ‘historical cost less adjustments’ is used.

Current Cost: The current cost measurement is done according to the amount that has to be paid if the same or similar asset is acquired at present. Similarly, for liabilities it refers to the undiscounted amount of cash or equivalent forms of cash that would be required to settle the obligation at present (AASB). The current cost thus captures the present market value of the same or equivalent asset or liability.

Realizable (settlement) value: According to the AASB definition, the settlement value of an asset is the value that can be obtained by selling the asset currently. The settlement value for a liability equals the undiscounted amounts of cash or cash equivalent expected to be paid to meet the liabilities. Thus, it gives the ‘net selling value’ or the ‘net market value’.  For an asset, it refers to the net market value on the date of measurement. For a liability, it refers to the estimated amount paid to be free from the liability on the measurement date plus the additional costs necessary to make that release possible.

Present Value: Present value considers the time-value of money. Thus assets are recorded by calculating the net cash inflows from their continuous use from now till its end and final disposal at the end of its life, and then discounting it with appropriate rate of return. Similarly, liabilities are evaluated at their today’s discounted value of cash outflows during the period of business operation that will be incurred if the liabilities are kept. The discounting is done with the help of rates that reflect the current risk free rate of investment and risks associated.

Fair Value: According to the IASB definition, “Fair value is the amount for which an asset or liability could be exchanged between knowledgeable and willing parties in an arm’s length transaction”. Although not explicitly mentioned about the market value, it is implicit that knowledgeable and willing parties will come to agree at the market value of the asset or liability.

The measurement basis mostly used is historical cost or its variations. Sometimes different measurement bases are combined together. For example, inventories are reported as the lower of cost and net realizable value. Some companies use current cost to deal with the changing prices of non-monetary assets. Different financial elements, thus, need to be addressed through different measurement bases. Property, plant and equipment should account for the depreciation, hence, historical cost less accumulated depreciation is used as a measurement basis for them.

1. B.    The two Australian firms selected for analysis are:

• Select Harvests Limited (SHV) in Food, Beverage & Tobacco industry
• Kresta Holdings Limited (KRS) in Consumer Durables and Apparels industry

The two companies operate in different industries, and hence have different assets and liabilities and have accordingly used different measurement bases for valuation of these assets and liabilities.Although historical cost is used by both of them, some of the assets have been handled differently. The implications can be studied by understanding how different assets have been valued due to assumption of different measurement bases.

Select Harvests Limited

Select Harvests Limited is into processing and marketing of almonds. It has been in operation for 30 years in Australia, and has well-established export networks (Select Harvests Company website).

The financial report for the Select Harvests follows the Australian Accounting Standards. The measurement bases used is different for different elements in accordance to the suitability of the basis for the element (Select Harvests Annual Report).

1. Inventories: Inventories are valued at the lower of cost and net realizable value. But almond stocks are valued at their fair value, less estimated cost to sell at the point of harvest (subsequently at Net Realizable value under AASB 102 Inventories). The cost is calculated by taking into account the FIFO historical cost of raw materials while for almonds it is the net market value.
2. Biological Assets: Almond trees are valued at the fair value.The process of discounted cash flow is used, thus, the economic life of the almond trees is taken into consideration. The growing almond crop is valued at the current selling prices of almonds minus the costs incurred in growing, transporting and selling it, followed by discounting the cost so obtained.
3. Derivatives: The valuation technique uses the fair value of derivations. The fair value depends on identifying whether the derivative is used for hedging, and what is the item it is used for hedging. Thus there are two types of designation for derivatives: hedges of the fair value of recognized assets or liabilities; and hedges of highly probable forecast transactions. Fair value is the measurement basis used.
4. Property, plant and equipment: These are evaluated at historical cost less adjustments like accumulated depreciation or impairments.

Kresta Holdings Limited

Kresta Holdings is a manufacturer, distributor and retailer of window treatments and components. The Company is present in Australia and New Zealandand has an export network in countries like Japan, USA, Canada, South-East Asia and England (Kresta Holdings Company website).

The financial report follows the AASB framework (Kresta Holdings Annual Report).

1. Inventories: Inventories here refers to both raw materials and finished goods. Inventories are valued at the lower of cost and settlement value. Costs considered for raw materials include FIFO historical cost, transport costs, and costs that are directly related to the raw materials. Finished goods costs include cost of labour, direct costs like materials etc. and some proportion of variable costs.
2. Derivatives: Derivatives used by the company are generally derivative instruments to hedge the associated risks with foreign exchange and interest rate fluctuations. These derivatives are initially recognized at the fair value of on which the derivative contract is entered into and subsequently re-measured to fair value.
3. Property, plant and equipment: These are evaluated at historical cost less adjustments like accumulated depreciation or impairments.
4. Goodwill and intangibles: Initial recognition of goodwill involves calculation of the combined business value minus the offering given.The treatment of goodwill takes into account impairment losses. Hence, it is calculated as fair value minus any impairment changes. Intangible assets acquired are evaluated at the fair value on the date of their acquisition.

1. C.    Financial reports help in the smooth running of capital markets by providing the investors with information for better decision-making (Kothari and Barone, 2010). The market reaction, to a large extent, is dependent on the financial reports of the companies. Thus, there are a large number of cases of manipulating accounting information by playing with measurement techniques to paint a rosy picture.

Window Dressing is presenting company accounts in such a way as to boost investor confidence by enhancing the financial position of the company (Averkamp). Some of the methods used for window dressing include ambiguity in capitalizing and revenue expenditure, changing depreciation policy, changing stock valuation, including intangible assets, sales and lease back etc.

With reference to the measurement bases discussed in the earlier answers, there can be manipulations too. For e.g. considering the historical cost for inventories can be misleading for inventories which have decayed since their initial acquisition. Suppose, the inventory was acquired 1 year back at 5000AUD. At present 50% of it has decayed, and the prices have fallen by 10% since. Thus the effective settlement value will be 2250AUD. However, the management sticks to the historical cost while presenting in the financial statements. This gives a wrong signal to the investor that the company has asset worth 5000AUD. The materiality of these figures can be very high with increasing monetary value. Market reaction is very much dependent on the facts presented on the financial reports, as most of the investors do not have inside sources or they do not consult analysts. Painting a rosy picture may lead to large buying of shares of the company, which will result in hike in stock prices and thus elevate a company’s trading status as well as market value.

The measurement bases used should satisfy the following criteria to be responsible for honest market reactions (AASB):

Understandability, Relevance, Reliability and Comparability

The measurement bases chosen should provide an accurate picture about the financial position of the company.

Materiality is an important criterion in deciding market reaction. Hiding of material information or manipulating material information may completely turn market reactions the other way.

Reporting standards provide anofficially accepted language that managers can use to convey information to shareholders (Healy and Palepu, 2001). According to research, most recent standards generate accounting information that is value relevant (Healy and Palepu, 2001). Exceptions do exist; inflation accounting has been found to have very little relation to stock prices. Timely availability of the information also goes a long way in assessing the market reaction.

The conclusion we can draw is that accounting information can greatly influence the market reaction and stock prices. Thus, it has a great role to play in the proper functioning of capital markets. Hence, proper measurement bases should be used and monitored through auditing to enforce a healthy capital market situation.

References:

AASB, ‘Framework for the preparation and presentation of financial statements’

Averkamp, H. ‘What is window dressing?’,  AccountingCoach, Accessed on 30April 2012, Available at http://blog.accountingcoach.com/window-dressing/

CASB, 2005, ‘Measurement Bases for Financial Accounting- Measurement on initial recognition’

Healy, P.M. and Palepu, K.G. 2001, ‘Information Asymmetry, corporate disclosure, and the capital markets: A review of the empirical disclosure literature’, Journal of Accounting & Economics, Accessed on 30 April 2012, available at http://tippieweb.iowa.uiowa.edu/accounting/mcgladrey/winterpapers/kothari1.pdf

Kothari, J. and Barone, E. 2010, ‘Conceptual Framework for financial reporting’, in Advanced Financial Accounting: An International Approach, Financial Times Press

Kresta Holdings Company Website, http://www.kresta.com.au

Kresta Holdings Annual Report, 2011, Available at http://www.kresta.com.au/wise.managed/pdfs/annual-reports/2011/kresta-2011-Annual-Report.pdf

Select Harvests Company Website, http://www.selectharvests.com.au/Home

Select Harvests Annual Report, 2011, Available at http://www.selectharvests.com.au/getattachment/2a245109-c2b2-4251-9581-c698c60e9349/2011-Annual-Report.aspx

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