Nanyang Technological University

Nanyang Business School

AC2101 – Accounting Recognition and Measurement

Semester 1, 2017-18

Outline for Seminar 6:

Leases III

Learning objectives

 Identify potential usage of leases in earnings management and the accounting implications

Required readings

 Per Seminars 4 and 5

 Imhoff, Lipe and Wright (1991), “Operating Leases: Impact of Constructive Capitalisation”
 IFRS (2016), “IFRS 16: Project Summary and Feedback Statement”
 FRS 116 Leases

Seminar questions:

Seminar Question 1

Discuss the key concerns and issues raised by Imhoff, Lipe and Wright (1991). Pay particular
attention to sections in the paper that highlight the impact of constructive capitalisation on the
balance sheet (Figure 1, p. 57) and income statement (Figure 2, p. 59) of firms that utilise
operating leases as opposed to finance leases.

Presentation questions:

Presentation Question on Measurement and Income – Project Team 1

For each of the following parts, the group is required to show workings clearly, where applicable,
in their presentation. When using animations in your presentations, please make sure the answers
are not “hidden by the animations” when printed out as hardcopies. Please ensure academic
integrity and cite sources of information, where necessary. These instructions are applicable to
ALL group presentations throughout the semester.

1
PART I

Explain clearly why the following statements are TRUE or FALSE:

(1) Under FRS 113 Fair Value Measurement, an entity shall use valuation techniques that are
appropriate in the circumstances and for which sufficient data are available to measure fair
value, maximizing the use of relevant unobservable inputs and minimizing the use of
observable inputs.

(2) According to the 2011 Conceptual Framework, “Timeliness” is the qualitative

characteristic of financial information that enables users of financial statements to generate
predictions about the future financial performance of a firm.

(3) Under FRS 113, when an asset is acquired or a liability assumed, the transaction price at
initial recognition may differ from fair value. In such a situation, depending on specific
reporting standards, a reporting entity may have to recognize a “day one” gain or loss in
the statement of profit or loss.

(4) In measuring the fair value of a liability, using the observed market price (without
adjustment) for (a) the sale of a corresponding identical asset in an active market, or (b) the
transfer of the identical liability in an active market will both result in a fair value input
hierarchy classification under Level 1.

PART II

Under ideal conditions with certainty, Ong Ltd commenced operations with $5,000 cash on 1
January 20x6. It used part of the cash to purchase a machine on the same day. The machine has
a 3-year useful life with zero residual value. It will generate cash inflows of $500 per year for
the next 3 years. Assume that (1) all cash inflows occur discretely at the end of each year, (2)
the interest rate is known and is a constant 10% per annum, (3) cash inflows generated by the
machine are all paid out as cash dividends at the end of each year.

Required

(a) What is Ong Ltd’s economic income (to the nearest dollar) for the year ended 31 December
20x7?

(b) What is Ong Ltd’s economic income (to the nearest dollar) for the year ended 31
December 20x7 if all assumptions remain the same except that no cash dividends are
paid at end of each year?

2
PART III

A Ltd is a listed entity that holds 150,000 shares that equals a 15% investment in B Ltd. The
shares are traded on a public stock exchange in an active market. B Ltd’s quoted price per share
is $5.30 at the measurement date on 31 December 20X3. A Ltd considers that it would be able
to sell its holding for $750,000 in a single transaction because of the size of its holding.

A Ltd also holds a 10% investment in unlisted C Ltd, which consists of 20,000 shares. A Ltd
uses a market multiple valuation technique (based on price to earnings ratio) to measure the
fair value of investment in C Ltd’s shares. Using publicly listed D Ltd as the comparable firm,
C Ltd’s share is valued at $2.10 each. A Ltd considers whether to adjust the $2.10 further
because of the illiquidity (i.e., lack of ready market) of C Ltd’s shares in comparison with D
Ltd’s shares. If a liquidity adjustment is made, C Ltd’s share will be valued at $1.90 each.

Required

Based on FRS 113, discuss and explain how A Ltd would measure the fair value of the share
investments in B Ltd and C Ltd.

PART IV

Mr Trump owned a large house on a sizeable piece of land. He sold the property to the Health
Group (HG) which was an association of doctors. The doctors wanted to use the house for their
medical practice. The house was surrounded by a large group of trees planted by the Trump
family over the years. The trees covered a large portion of the land.

HG did not want to make large alterations to the house as it was suitable for their use. However,
HG wanted to divide the land and sell a portion of it; the portion currently being covered in
trees. The land sold would be very suitable for up-market apartment complex.

One of the conditions of the sale of the property to HG was that, while Mr Trump remained
alive, the trees on the property could not be cut down. This clause in the contract would restrict
the building of the apartment complex. However, this restriction would not be enforceable on
subsequent buyers of the property if HG wanted to sell the property in the future. A further
issue that affected the building of the apartment complex was that across one part of the land
there was a gas pipeline that was a part of the city infrastructure for the supply of town gas.

Required

Based on FRS 113, discuss and explain how the restrictions will affect the fair value
measurement of the portion of land intended for sale by HG.

3
PART V

You are the Chief Accountant for Ace Ltd, a publicly listed company in Singapore which
recently acquired a new subsidiary. The subsidiary lacks proper personnel with the right
accounting background to advise its management on key accounting issues. While preparing
its financial statements for fiscal year ending 31 December 20x5, the General Manager (GM)
at the subsidiary approached you for advice on implementing FRS 113 Fair Value
Measurement for some of its assets

(1) The subsidiary has access to three markets for the sale of its vehicles and has done so
historically. As at the measurement date on 31 December 20x5, the subsidiary has 100
vehicles (same make, model and mileage). Volumes, prices and other information in the
markets on this date are as follows:

Market Sales Historical Total Transaction Transport Transport

Price – volume of market- cost per cost per cost per
per vehicles based vehicle as a vehicle to vehicle to
vehicle sold by volume of % of price to be paid by be paid by
$ the vehicles be paid by subsidiary the buyer to
subsidiary sold the to bring bring
subsidiary vehicle to vehicle its
the market location
$ $
A 30,000 55% 20% 15% 1,000 400
B 25,000 25% 65% 8% 200 700
C 20,000 20% 15% 12% 300 600

(2) The subsidiary owns a piece of freehold land acquired at a cost of $350,000. A factory to
produced vehicular spare parts was built on the land for $250,000 in January 20x1. Both
land and factory are recorded at costs with the factory having a carrying amount of
$125,000 on 31 December 20x5. The land is now considered as a prime residential site
given its river views and nearby new condominium developments.

A recent valuation of the land by a property valuation firm based on sales of residential
land in a nearby area showed that the land has a value of $1,000,000. Recent transactions
of land of similar size for industrial use located at a nearby district were made at $600,000.
It is estimated that the costs of building a brand new factory on the same site will be
$400,000. It will cost $100,000 to demolish the factory to make way for building of
residential units on the land.

4
Required

(a) The GM of the subsidiary would like to measure the vehicles, land and factory at fair
value on 31 December 20x5.

Advise the GM on the appropriate approach for fair value measurement of these assets
based on FRS 113 Fair Value Measurement.

(b) After listening to your advice, the GM made the following comment: “I doubt that an
asset measured on any other basis than its intended use will provide more useful
information to users of financial statements. The fact that a site used for production
would have a higher market value if it were redeveloped for residential purpose is not
relevant if the intention is to use site for production operations. The risk here is that the
fair value measure, as defined, results in irrelevant information.”

Discuss whether you agree or disagree with the GM’s comment.