Week 4

ACTL1122 Week 4Issues in Financial Reporting

Week 4 Outline:1. Accounting for Non-Cash Adjustments2. Gearing3. Case Study Application

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Week 4

Topic Objectives and Learning Approach

I Recognise key accounting adjustments such asdepreciation/amortisation and impairment of assets and theirpurpose in reporting more relevant asset values

I Understand the basics of asset valuation using discounted cashflow models

I Recognise the impact of asset impairment and company gearingI Understand the importance of gearing in context of the current

economic situationI See how the accounting concepts learnt may be integrated into a

company case study

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Week 4

This Weeks Readings

I 2010 Transfield Services Infrastructure Fund Full-Year FinancialResults Presentation

I Transfield Services Infrastructure Fund Rights Issue BookletI Transfield Services Infrastructure Fund Case Study Reading

The material provided in these readings provide you with a morebig picture view of how companies manage their risks andcapital. Do not try to read the Rights Issue Booklet in its entirety,but rather focus on the Chairmans Address and the CompanyPresentation. The Case Study Reading provides a helicopterview of the Capital Structure Review and company background

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Accounting for Non-Cash Adjustments

OverviewI Fair valuation accounting means financial statements should

ideally report values in such a way it is relevant to the currentmarket

I Historical cost accounting and the modified version of it statesvalues are recorded as at transaction, with adjustments

I Adjustments may be made to assets or liabilities over time toreflect market movements, even if transactions do not occurI Such adjustments have no cash consequences (value change, but

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

transaction occurs

I Such adjustments ideally improve relevance, usefulness andaims to give a true and fair view

I Compromises on reliability and conservatism, however

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Accounting for Non-Cash Adjustments

Examples of Accounting Adjustments

I Depreciation of non-current assets :I Reflect estimated market value due to wear and tear or technical

obsolescence

I Revaluation of non-current assets :I Appreciation of land or other assets due to economic changes

I Amortisation of intangible assets :I Reflect reduced ability for such assets to provide economic benefits

(brand name, mines with depleted resources)

I 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 bookvalue (previous over-valuation)

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Accounting for Non-Cash Adjustments

Depreciation and Amortisation

I Non-current assets are recorded at transaction value, underhistorical cost accounting

I Ideally financial statements should reflect fair valueI Non-current assets may have limited useful life, after which it is

either replaced or disposed ofI Earnings will be volatile if these asset values are updated at the

end of useful lifeI To reconcile, periodic adjustments may be made to perishable

non-current assets :I Wear and tear through continual useI Technical obsolescence or the assets capability being surpassed

by new innovations

I Recognised as an expense

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Accounting for Non-Cash Adjustments

Discussion Question 1

Explain how the following non-current assets with limited useful livesmay decline in value gradually, thus justifying the need to recognisetheir depreciation on a periodic basis :

(a) A supercomputer holding vast volumes of data for a bank, keptinside 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

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Accounting for Non-Cash Adjustments

Re-valuation of Assets

I Assets with unlimited useful life may be subject to appreciationdue to increase demand, especially land

I Re-valuation of assets may be arguably recognised as a profitunder fair-valuation accounting :I Increase in fair value reflects recognition of increase in future

economic benefitI However, some argue this is not appropriate because this is not

realised in a transactionI Left to subjective interpretation in practice conservatism vs

following the revenue recognition principle

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Accounting for Non-Cash Adjustments

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

current market valueI 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 valueI Economic outlook becoming negative, thus affecting assets ability

to generate future economic benefits as it had in the pastI The asset value has dropped because it is no longer as well

regarded by investors (especially with property, developmentprojects, etc.)

I Impairment is recognised as a expense, similar to depreciationand amortisation :I Future economic benefits are no longer recognised at the same

level as what was paid

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Accounting for Non-Cash Adjustments

Asset Valuation Discounted Cash Flow Method

I Assets may be viewed as Cash Generating Units (CGU)I 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.I Future economic benefits is in terms of cash

I DCF method is like valuing net present value of annuities :I Review of ACTL1101 and FINS1613 conceptsI Keep it simple for this course, but note in practice you need to

remove accounting adjustments from the NPV calculation

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Gearing

What is Gearing?

I Gearing can be measured as the how much of the companysequity is supporting its borrowings and loans

I Good measure of solvency position for the company :I Find an optimal gearing range to balance stability and capitalising

on risk

I Gearing ratio is popularly used :

Net debtNet debt+ Shareholders equity

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Gearing

Company Gearing and Decision-Making

I Company operational and strategic decisions :I Expand or contract operations to ensure suitable capital structureI Repay borrowings to improve company stabilityI Raise further equity or debt capital for expansion or to manage

capital

I Lending banks and decision to seek company actions toreassure them of their solvency :I Loans may have clauses on maximum level of gearingI Where company is getting close to breaching the gearing

covenant, the banks may request company act urgently (sell offassets or raise equity capital)

I Banks may recall the loan where there is significant risks offinancial distress (do not want to be the last in case the cupboard isbare)

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Gearing

Asset Values, Impairments and GearingI 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 obligationsI When assets are written down in value, the shareholders take the

full amount of the writedown (maybe net of taxes depending onwhat type of assets being written off)

I Gearing levels can increase dramatically in a significant assetwritedown :I Previously purchased investments have been reviewed to reflect a

lower market valueI Previously acquired businesses had been overpaid so the goodwill

is written offI Research or development projects have delivered negative or less

positive results, resulting in lower market value due to delay inrealising benefits

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Case Study Application

Transfield Services Infrastructure Fund CapitalStructure Review

I Commenced in June 2009, completed in May 2010I Rationale was to ensure the fund had the right capital structure

to conduct business going forward :I A sustainable gearing level to ensure company financial stabilityI Review its portfolio of assets to determine their suitability to the

companys strategyI Propose possible actions such as managing debt levels, asset

trades and equity issue

I On completion of the Capital Structure Review, the Boardrecommended :I Sale of Mount Millar Wind Farm for $191 millionI Fully underwritten equity issue of $110 millionI Refinancing of existing bank loans with $263 million repayment

($728 million to $465 million)

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Case Study Application

Discussion QuestionsRefer to the presentation of the Transfield Services InfrastructureFund Equity Issue Booklet to answer the following questions :

(a) What types of information have been presented in thepresentation? What are the purposes of that information?

(b) What decisions have been made in relation to the companysstrategy?

(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 ofwhether to participate in this equity issue, what types of factorswould you consider and what would you do?

(e) With the benefit of hindsight, how effective was the CapitalStructure Review? What information would you use to evaluatethat?

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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?I How does depreciation, amortisation and impairment of assets

help companies report more relevant information? To what extentis it of limited use?

I What are the advantages and disadvantages of a businessborrowing money to operate?

I What are the reasons for a company needing to monitor its gearingratio?

I How do the aspects of financial reporting this week all link uptogether?

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