Colored River Financial Issues - Case Study Example

Colored River Ltd financial reporting Name: University: Course: Tutor: Date: Introduction Coloured River Ltd has recently changed its status to a reporting entity. This will have implications on the preparation of financial statements so as to comply with the legal and regulatory requirements of a reporting entity. All financial statements must now be prepared in accordance with Australian Accounting Standards. This will mean that the company will have to observe more stringent reporting requirements as well as increased disclosures in the financial statements. All financial statements of Coloured River will now comply with the International Financial Reporting Standards. This will be achieved by complying with Australian Accounting Standards because the Australian Accounting Standards Board has adopted International Financial Reporting Standards. These standards are meant to improve the quality of financial reporting including increased comparability and fairness. These increased reporting requirements are meant to furnish persons interested in Coloured River financial information with true and fair financial reporting. These analyses will include financial reporting requirements excluding taxation effects in the three cases as we have been informed that a different consultant will handle taxation. Summary Guarantee The provision of the guarantee to Fly By Night should be accounted for depending on the nature of the agreement. Normally the probability of claims being raised against Coloured Waters should be assessed and a reasonable provision made. The management should make a reasonable estimate of the probability of cash outflow likely to be incurred in the settlement of this guarantee. If the cash outflow is determined to be probable, a provision will be required. If cash out flow is only possible, then a disclosure in the notes will suffice. This means that Coloured Waters may be required to recognize a liability in its financial statements. However, if the company chooses to treat this as an insurance contract it may account for it as such under the appropriate accounting standard. Costs of Training Local Communities The company should create a provision for these costs. This is because it has created a constructive obligation by creating an expectation on the community that it will train some locals. The company should present the provision in present value terms; this will involve using a discounting technique to find the present value. This will be presented in the financial statements as a liability to the company. The informal promise made to the elders is an obligating event since the company has announced its commitment to honor the agreement. A reliable estimate of expected cash outflow should be made before a provision can be made. These costs should not be capitalized since they are not capital expenditures and adding them to the cost of the property will contravene accounting standards. Stripping Costs The costs related to the removal of the overburden may be treated in several ways depending on the circumstances. If the overburden removed contains some minerals that may form part of the inventory, then these costs may be treated as costs of inventory. If the removal of the overburden is required to commence production, the costs should be capitalized and depreciated. Costs of removing the overburden as a regular cleaning exercise should be expensed when incurred. In the case of Coloured River the cost of stripping the overburden should be treated as a capital expense and capitalized over the useful life of the mine. The financial statements should at 30 June 2015, include the stripping costs of 10 million and the 10 million should be depreciated for an year of its useful life in line with the company policy. Detailed Accounting Treatment and Relevant Accounting Standards Guarantee The treatment of the guaranteed loan should be treated in accordance with AASB 137 Provisions, Contingent Liabilities and Contingent Assets, AASB 139 financial instruments; recognition and measurement, and AASB 4 Insurance Contracts. The guarantee should be recognized as an insurance contract if the company elects to treat it as such. This is done if the company believes or sees the guarantee as comprising of an insurance contract. If this election is made then the provisions of AASB 4 Insurance Contracts, should be followed. This guarantee may also be treated in accordance to AASB 139, Financial Instruments; Recognition and Measurement. This will involve the recognition of the guarantee as a financial liability at fair value. Subsequent amount to be included in the financial statements would be determined by referencing the rules of AASB 137 Provisions, Contingent Liabilities and Contingent Assets (Comlaw.gov, 2012). The guarantee by colored rivers meets the criteria for recognition of provisions as per AASB137. For a provision to be recognized, (a) an entity must Have a present obligation(legal/constructive) as a result of past event;(b)it must be probable that an outflow of economic benefits will be require to settle the obligation (c) it must be possible to make a reliable estimate of the obligation (Comlaw.gov, 2012). By becoming the guarantors of Fly by Night, Coloured Rivers has created a legal obligation. The estimation of the probability of a cash outflow is a matter of judgment and should be determined by the management. If it is possible to make a reliable estimate of the probable amount of cash flow required to settle the probable obligation the management should create a provision. If the expenditure is expected to occur after some years, the estimated cash outflow should be discounted to the present value using 13% as the discounting factor. The disclosure requirements of AASB 137 should be adhered to as part of conforming to the reporting standards. If the management determines that the probability of incurring cash outflow is only possible, and it is dependent on whether some uncertain future event occurs, it should disclose a contingent liability. It may also be possible that the management believes the company has a present obligation but cash outflow is not probable or the amount cannot be measured effectively. In this case, a contingent liability should be disclosed in the notes to financial statements (Comlaw.gov, 2012). Training of the Community The company should create a provision for the training costs and recognize an expense in the period that training costs is incurred. These training costs should meet all the required recognition criteria required under the accounting standard AASB 137 Provisions, Contingent Assets and Contingent Liabilities. The company has made a commitment to train 30 local individuals for a period of three years at the cost of 20,000 per person spread over three years. Despite this agreement not being legally binding, the management of Coloured Water has created a reasonable expectation that it will honor the agreements. According to AASB 137 this creates a constructive obligation. It is clear that to settle the obligation of training the individuals, an outflow of economic benefits will be required. It also seems that the managements are confident on the estimates of the training costs. With all these conditions the company should make a provision as per AASB 137. It may be seen as if committing to training and hiring the locals is pivotal to securing the operation of the mine field. This may seem to be a capital expenditure. Capital expenditures are those cost that enable an asset to generate revenue or improve revenue generating capacity to an asset (Comlaw.gov, 2012). One may argue that the training of local people should be included as part of the cost of the mine fields. This would require the training costs to be included in the value of the asset and depreciated over the useful life of the asset. This would be misleading and would be against the principles of AASB 116 Property, Plant And Equipment, which state that such training costs should be expensed (Charteredaccountants.com, 2012). These cash flows are expected to occur for the next three years and should therefore be discounted to a present value. Working with the managements estimates, a provision of $ 472,200 should be made. Costs per year per person = $20,000/3 Total cost per year = ($20,000/3)*30 = $200,000 per year for three years 3 year annuity factor of 13 %( from annuity factor tables) = 2.361 This is an annuity (constant cash flow over a number of years), therefore the present value can be derived by multiplying the annuity by the three year annuity factor at 13%. ($200,000*2.361=$472,200) The disclosure requirements of AASB 37 should also be observed. There are extensive disclosure requirements in this standard and they should be made as part of compliance with the financial reporting requirements of a reporting entity. These disclosures include; opening and closing balance, nature, timing, uncertainties, and additions among others (Charteredaccountants.com, 2012). The unwinding of the discount should also be disclosed for Coloured Rivers. Stripping Costs The treatment of the cost of unburdening is a complex issue and has been the subject of much debate. These costs may be treated in accordance with AASB 102 if the unburdening produces some output that form part of inventory. It may also be the case that mine stripping/unbundling costs are just but a routine cleanup activity that is not capital in nature. In this case the costs should be expensed. As In the case of Coloured River the stripping costs will help bring the mines into a revenue generating state. This expenditure is therefore capital in nature. Complexities arise where the mine unbundling costs comprises of the three possibilities above requiring the apportionment of the costs to each. According to AASB 116, An item of property, plant and equipment should initially be recorded at cost. Cost includes all expenditures necessary to bring the asset to working condition for its intended use. This would include not only its original purchase price but also costs of site preparation, delivery and handling (Charteredaccountants.com. 2012). Coloured River’s mine unbundling costs is a site preparation cost and should therefore be capitalized in line with this standard The costs that Coloured River incurred relating to mine stripping costs should be capitalized (added to the cost of the mine). This cost should then be depreciated over the useful life of the mine. Assuming that the mine will have a useful life of 10 years; $1 million depreciation will be recognized relating to the mine unbundling costs. Cost of the asset (mine) will be higher by $10 million. Net asset cost after depreciation will be $9 million. References Comlaw.gov. 2012.AASB 137 - Provisions, Contingent Liabilities and Contingent Assets.Online](updated 2012) Available at: http://www.comlaw.gov.au/Details/F2011C00042 [Accessed on 23 September 2012) Charteredaccountants.com. 2012. AASB 116 Property, plant and equipment [online](updated 2012) available at: http://www.charteredaccountants.com.au/Industry- [Accessed on 23 September 2012] Read More