Week 4

ACTL1122 Week 4
Issues in Financial Reporting

Week 4 Outline:
1. Accounting for Non-Cash Adjustments
2. Gearing
3. Case Study Application

1 / 16

Week 4

Topic Objectives and Learning Approach

I

Recognise key accounting adjustments such as

depreciation/amortisation and impairment of assets and their
purpose in reporting more relevant asset values

Understand the basics of asset valuation using discounted cash

flow models

Recognise the impact of asset impairment and company gearing

Understand the importance of gearing in context of the current
economic situation
See how the accounting concepts learnt may be integrated into a
company case study

2 / 16

Week 4

This Weeks Readings

I

I
I

2010 Transfield Services Infrastructure Fund Full-Year Financial

Results Presentation
Transfield Services Infrastructure Fund Rights Issue Booklet
Transfield Services Infrastructure Fund Case Study Reading
The material provided in these readings provide you with a more
big picture view of how companies manage their risks and
capital. Do not try to read the Rights Issue Booklet in its entirety,
but rather focus on the Chairmans Address and the Company
Presentation. The Case Study Reading provides a helicopter
view of the Capital Structure Review and company background

3 / 16

Accounting for Non-Cash Adjustments

Overview
I

Fair valuation accounting means financial statements should

ideally report values in such a way it is relevant to the current
market
Historical cost accounting and the modified version of it states
values are recorded as at transaction, with adjustments
Adjustments may be made to assets or liabilities over time to
reflect market movements, even if transactions do not occur
I

Such adjustments have no cash consequences (value change, but

no cash inflow/outflow)
Profits and losses are booked, but they are not realised until a
transaction occurs

Such adjustments ideally improve relevance, usefulness and

aims to give a true and fair view

Compromises on reliability and conservatism, however

4 / 16

Accounting for Non-Cash Adjustments

Examples of Accounting Adjustments

I

Depreciation of non-current assets :

I

Revaluation of non-current assets :

I

Appreciation of land or other assets due to economic changes

Amortisation of intangible assets :

I

Reflect estimated market value due to wear and tear or technical

obsolescence

Reflect reduced ability for such assets to provide economic benefits

(brand name, mines with depleted resources)

Impairment of non-current assets :

I

Reflect the current value of assets which can no longer be

expected to deliver future revenue at the level implied by the book
value (previous over-valuation)

5 / 16

Accounting for Non-Cash Adjustments

Depreciation and Amortisation

I

I
I

Non-current assets are recorded at transaction value, under

historical cost accounting
Ideally financial statements should reflect fair value
Non-current assets may have limited useful life, after which it is
either replaced or disposed of
Earnings will be volatile if these asset values are updated at the
end of useful life
To reconcile, periodic adjustments may be made to perishable
non-current assets :
I
I

Wear and tear through continual use

Technical obsolescence or the assets capability being surpassed
by new innovations

Recognised as an expense
6 / 16

Accounting for Non-Cash Adjustments

Discussion Question 1

Explain how the following non-current assets with limited useful lives
may decline in value gradually, thus justifying the need to recognise
their depreciation on a periodic basis :
(a) A supercomputer holding vast volumes of data for a bank, kept
inside an air-conditioned warehouse
(b) An investment property in the form of a 10 storey apartment block
(c) A coal mine with an estimated reserve of 60 million tonnes which
is under operation

7 / 16

Accounting for Non-Cash Adjustments

Re-valuation of Assets

Assets with unlimited useful life may be subject to appreciation

due to increase demand, especially land
Re-valuation of assets may be arguably recognised as a profit
under fair-valuation accounting :
I

Increase in fair value reflects recognition of increase in future

economic benefit
However, some argue this is not appropriate because this is not
realised in a transaction
Left to subjective interpretation in practice conservatism vs
following the revenue recognition principle

8 / 16

Accounting for Non-Cash Adjustments

Impairment of Assets
I

Assets may be recorded in the books at a higher value than their

current market value

When periodic review is conducted, assets may be found to be

worth substantially less :
I

Business operations have proven to consistently be below target as

implied in book value
Economic outlook becoming negative, thus affecting assets ability
to generate future economic benefits as it had in the past
The asset value has dropped because it is no longer as well
regarded by investors (especially with property, development
projects, etc.)

Impairment is recognised as a expense, similar to depreciation

and amortisation :
I

Future economic benefits are no longer recognised at the same

level as what was paid
9 / 16

Accounting for Non-Cash Adjustments

Asset Valuation Discounted Cash Flow Method

I

Assets may be viewed as Cash Generating Units (CGU)

Current value is the present value of expected future cash flow

generated :
I

Distinct from profits, since profits contain accounting adjustments

such as depreciation, amortisation etc.
Future economic benefits is in terms of cash

DCF method is like valuing net present value of annuities :

I
I

Review of ACTL1101 and FINS1613 concepts

Keep it simple for this course, but note in practice you need to
remove accounting adjustments from the NPV calculation

10 / 16

Gearing

What is Gearing?
I

Gearing can be measured as the how much of the companys

equity is supporting its borrowings and loans
Good measure of solvency position for the company :
I

Find an optimal gearing range to balance stability and capitalising

on risk

Gearing ratio is popularly used :

Net debt
Net debt + Shareholders equity

11 / 16

Gearing

Company Gearing and Decision-Making

I

Company operational and strategic decisions :

I
I
I

Expand or contract operations to ensure suitable capital structure

Repay borrowings to improve company stability
Raise further equity or debt capital for expansion or to manage
capital

Lending banks and decision to seek company actions to

reassure them of their solvency :
I
I

Loans may have clauses on maximum level of gearing

Where company is getting close to breaching the gearing
covenant, the banks may request company act urgently (sell off
assets or raise equity capital)
Banks may recall the loan where there is significant risks of
financial distress (do not want to be the last in case the cupboard is
bare)

12 / 16

Gearing

Asset Values, Impairments and Gearing

I

Asset values as recorded in the company financial statements

affect gearing levels :
I

Borrowings do not reduce when assets are written off as they are
contractual obligations
When assets are written down in value, the shareholders take the
full amount of the writedown (maybe net of taxes depending on
what type of assets being written off)

Gearing levels can increase dramatically in a significant asset

writedown :
I

Previously purchased investments have been reviewed to reflect a

lower market value
Previously acquired businesses had been overpaid so the goodwill
is written off
Research or development projects have delivered negative or less
positive results, resulting in lower market value due to delay in
realising benefits
13 / 16

Case Study Application

Transfield Services Infrastructure Fund Capital

Structure Review
I
I

Commenced in June 2009, completed in May 2010

Rationale was to ensure the fund had the right capital structure
to conduct business going forward :
I
I

A sustainable gearing level to ensure company financial stability

Review its portfolio of assets to determine their suitability to the
companys strategy
Propose possible actions such as managing debt levels, asset
trades and equity issue

On completion of the Capital Structure Review, the Board

recommended :
I
I
I

Sale of Mount Millar Wind Farm for $191 million

Fully underwritten equity issue of $110 million
Refinancing of existing bank loans with $263 million repayment
($728 million to $465 million)
14 / 16

Case Study Application

Discussion Questions
Refer to the presentation of the Transfield Services Infrastructure
Fund Equity Issue Booklet to answer the following questions :
(a) What types of information have been presented in the
presentation? What are the purposes of that information?
(b) What decisions have been made in relation to the companys
strategy?
(c) How do the decisions impact on the companys financial position,
in particular on their solvency position?
(d) If you were an existing shareholder faced with the decision of
whether to participate in this equity issue, what types of factors
would you consider and what would you do?
(e) With the benefit of hindsight, how effective was the Capital
Structure Review? What information would you use to evaluate
that?
15 / 16

Summary

Summary
I

Take time to reflect on the following :

I

What tension exists in the application of accounting theory and

relevant reporting for non-current assets?
How does depreciation, amortisation and impairment of assets
help companies report more relevant information? To what extent
is it of limited use?
What are the advantages and disadvantages of a business
borrowing money to operate?
What are the reasons for a company needing to monitor its gearing
ratio?
How do the aspects of financial reporting this week all link up
together?

16 / 16