In: Accounting
The following extract is taken from an announcement released to
the Australian Securities Exchange by the Australian Agricultural
Company:
AACo announced today its trading results for the three months to 30
September 2003 (Q1 FY04) in which unaudited revenue was $22.1
million from cattle sales equivalent to 12.6 million kilograms.
Compared to the same period in 2002, revenue decreased 14%, while
sales volume increased 21%. Earnings before interest and tax (EBIT)
for the three months to 30 September 2003 was ($3.2) million and
compares with $7.7 million in the previous corresponding
period.
The decrease in earnings was primarily due to there being no
mark-to- market cattle value appreciation during the quarter
compared to the previous corresponding period which saw a mark to
market increase to trading cattle of 7.5%.
The lack of early spring rain saw many Queensland producers
increase supplies of cattle to market during the quarter with the
resulting downward pressure on prices as at 30 September 2003
impacting on the valuation of AACo cattle at that date. This trend
has reversed in October, with prices rising in some categories in
the order of 10%. Chief Executive Officer of AACO, Mr Peter Holmes
à Court said 'We sold a high volume of cattle during the quarter,
although the impact of last year's drought meant that they were
generally at lighter weights. Prices, however, have subsequently
risen due to the short supply of quality, finished cattle.'
Source: ASX Press Release, 30 October 2003, AACo First Quarter
FY04 Briefing.
Required
(a) Explain what is meant by 'mark-to-market cattle value
appreciation' in the context of AASB 141 'Agriculture'.
(b) Explain why no appreciation in the market value of cattle for the quarter ending 30 September 2003 resulted in a loss of $3.2 million compared to a profit of $7.7 million in the previous corresponding period.
(c) The volatile market conditions which had an impact on the Australian Agricultural Company serve to illustrate the principal difficulty of using fair value less costs to sell for biological assets.' Critically evaluate this comment.
(a) Explain what is meant by 'mark-to-market cattle value appreciation' in the context of AASB 141 'Agriculture'.
As per para 4 of AASB 141 "Dairy cattle" is a "Biological assets". As per para 5 "A biological asset is a living animal or plant." As per para 12 "A biological asset shall be measured on initial recognition and at the end of each reporting period at its fair value less costs to sell, except for the case described in paragraph 30 where the fair value cannot be measured reliably."
Australian Agricultural Company generate revenue through cattle sales. AASB 141 is an accounting standard which deals in accounting treatment of "biological assets, except for bearer plants and agricultural produce at the point of harvest". As per AASB 141, cattle is a biological asset therefore the recognition of cattle would be covered by this standard. As discussed above in para 12, a biological asset i.e. Cattle in the current case would initially and subsequently be measured at fair value. This means that at initial recognition of cattle, the inventory of cattle would be recognised at fair value. At every reporting period, the fair value of closing inventory of cattle would be determined and it would be recognised at the fair value at every reporting period.
The difference between the fair value at the end of reporting period and recognised value would be included in profit or loss and if this results in an increase, it would be called as mark-to-market cattle value appreciation.
For example
10 Cattles are recognised on 1 March 2020 with a total fair value of $10,000. At the ending of reporting period on 31 March 2020, these 10 cattles are unsold. Hence as per AASB 141, the fair value of the cattles have to be determined which comes a total fair value of $15,000. Hence, these 10 cattles would be recognised on 31 March 2020 at $15,000 with mark-to-market cattle value appreciation of $5,000 (i.e. $15,000-$10,000). For simplicity costs to sell is assumed as zero
(b) Explain why no appreciation in the market value of cattle for the quarter ending 30 September 2003 resulted in a loss of $3.2 million compared to a profit of $7.7 million in the previous corresponding period.
As per the question the lack of early spring rain saw many Queensland producers increase supplies of cattle to market during the quarter with the resulting downward pressure on prices as at 30 September 2003 impacting on the valuation of AACo cattle at that date. This implies that value of the inventory of cattle was lower at the quarter ending 30 September 2003 as compared to previous corresponding period. Further, the question has mentioned that Compared to the same period in 2002, revenue decreased 14%, while sales volume increased 21%. This implies that depsite increase in sales volume the revenue has declined. The decrease in earnings was primarily due to there being no mark-to- market cattle value appreciation during the quarter compared to the previous corresponding period which saw a mark to market increase to trading cattle of 7.5%.
The reason for loss as comparison to previous corresponding period can be because of the following reasons-
a) As discussed in 'a' above, the cattle being a biological asset would be recognised at fair value at the end of reporting period. Hence, the value of the opening inventory of the quarter ending as at 30 September 2003, would be higher than the sales price of the cattle during the year. The sales price would be lower because as mentioned in the question "increase supplies of cattle to market during the quarter with the resulting downward pressure on prices as at 30 September 2003". Thus resulting into a loss.
b) Another reason for the loss is that the opening inventory which remains unsold as at 30 September 2003 would have a decline in the fair value as compared to the carrying value, resulting into a loss
For example
Situation in current period
10 Cattles value of inventory on 30 June 2003 is $15,000. Suppose at the end of the quarter 30 September 2003 per cattle price is $1,100. Suppose during the year 2 cattles are sold at $1,200 each. For simplicity costs to sell is assumed as zero
The loss during the 30 September 2003:
Loss on sale of 2 cattles $ 600 ((1500-1200)*2)
Plus loss on closing inventory $3,200 ((1500-1100)*8)
Total loss $3,800 (600+3200)
Situation in previous corresponding period
10 Cattles value of inventory on 30 June 2002 is $15,000. Suppose at the end of the quarter 30 September 2002 per cattle price is $1,612.5 (1500*7.5%+1500). Suppose during the year 2 cattles are sold at $1,600 each. For simplicity costs to sell is assumed as zero
The profit during the 30 September 2002:
Profit on sale of 2 cattles $ 100 ((1600-1500)*2)
Plus mark to mark appreciation on closing inventory $900 ((1612.5-1500)*8)
Total profit $1,000 (100+900)
This type of situation has resulted in loss as at 30 September 2003. However as per the question, in previous corresponding period there was a mark to market increase to trading cattle of 7.5% which resulted in a profit during that period basis the discussion done in point 'a'.
(c) The volatile market conditions which had an impact on the Australian Agricultural Company serve to illustrate the principal difficulty of using fair value less costs to sell for biological assets.' Critically evaluate this comment.
The normal inventories are recognised at lower of cost or net realisable value. However, biological assets are recognised at its fair value less costs to sell irrespective of the cost. Leading to the biggest challenge for the Companies in this industry for determining the fair value. As it is known in general parlance, the price of biological assets and agriculture produce varies significantly demanding of the demand and supply situation. Being a permissible and essential item, the value is very sensitive to the cultivation/supply in comparison to the demand. The price will not be the same in every season or even for the same season in comparison to the previous corresponding period. The same is demostrated in the above question. Depsite increase in sales volume the revenue has declined in the current period in comparison to corresponding pervious year. The decrease in earnings was primarily due to there being no mark-to- market cattle value appreciation during the quarter compared to the previous corresponding period which saw a mark to market increase to trading cattle of 7.5%. This implies that decrease in earning was not due to decrease in the sales volume rather just because of fall in the price becuase of excess supply. Hence, using fair value to recognise the biological asset would result in huge fluctuation in the financial statement. In the lien period there would be a significant loss in comparison to exponential gain in peak season. This would make the financial statement volatile and non-comparable.