Corporate Reporting Paper P2 (International) Course Notes ACP2CN07 (INT)
P2 Corporate Reporting (International) Study Programme
Page Introduction to the paper and the course............................................................................................................... (ii) 1 2 3 4 5 6
The financial reporting framework .............................................................................................................. 1.1 Professional and ethical duty of the accountant .......................................................................................... 2.1 Home study chapter: Environmental and social reporting ........................................................................... 3.1 Non-current assets ...................................................................................................................................... 4.1 Employee benefits....................................................................................................................................... 5.1 Income taxes ............................................................................................................................................... 6.1
End of Day 1 – refer to Course Companion for 7 8 9 10 11
Home Study Progress test 1
Financial instruments................................................................................................................................... 7.1 Share-based payment ................................................................................................................................. 8.1 Provisions, contingencies and events after the balance sheet date............................................................ 9.1 Related parties .......................................................................................................................................... 10.1 Leases....................................................................................................................................................... 11.1
End of Day 2 – refer to Course Companion for
Home Study Progress test 2
Course exam 1 12 13 14 15
Revision of basic groups ........................................................................................................................... 12.1 Complex groups ........................................................................................................................................ 13.1 Changes in group structures ..................................................................................................................... 14.1 Continuing and discontinued interests....................................................................................................... 15.1
End of Day 3 – refer to Course Companion for 16 17 18 19 20 21
Home Study Progress test 3
Foreign transactions and entities............................................................................................................... 16.1 Group cash flow statements...................................................................................................................... 17.1 Performance reporting............................................................................................................................... 18.1 Current developments ............................................................................................................................... 19.1 Reporting for specialised entities............................................................................................................... 20.1 Home study chapter: Implications of changes in accounting regulation on financial reporting ...................................................................................................................................... 21.1
End of Day 4 – refer to Course Companion for
Home Study Progress test 4
Course exam 2 22 23 24
Answers to Lecture Examples ................................................................................................................... 22.1 Question and Answer bank ....................................................................................................................... 23.1 Appendix: Pilot Paper questions................................................................................................................ 24.1 Don't forget to plan your revision phase!
• • • •
Revision of syllabus Testing of knowledge Question practice Exam technique practice
BPP provides revision courses, question days, mock days and specific material to assist you in this important phase of your studies.
(i)
INTRODUCTION
Introduction to Paper P2 Corporate Reporting (International) Overall aim of the syllabus To apply knowledge, skills and exercise professional judgement in the application and evaluation of financial reporting principles and practices in a range of business contexts and situations.
The syllabus The broad syllabus headings are: A B C D E F G H
The professional and ethical duty of the accountant The financial reporting framework Reporting the financial performance of entities Financial statements of groups of entities Specialised entities Implications of changes in accounting regulation on financial reporting The appraisal of financial performance and position of entities Current developments
Main capabilities On successful completion of this paper, candidates should be able to: • • • • • • • •
Discuss the professional and ethical duty of the accountant Evaluate the financial reporting framework Advise on and report the financial performance of entities Prepare the financial statements of groups of entities in accordance with relevant accounting standards Explain report issues relating to specialised entities Discuss the implications of changes in accounting regulation on financial reporting Appraise the financial performance and position of entities Evaluate current developments
Links with other papers Corporate Reporting (P2)
Advanced Audit & Assurance (P7)
Financial Reporting (F7)
Financial Accounting (F3) This diagram shows where direct (solid line arrows) and indirect (dashed line arrows) links exist between this paper and other papers that may precede or follow it. The financial reporting syllabus assumes knowledge acquired in paper F3 Financial Accounting and Paper F7 Financial Reporting and develops and applies this further and in greater depth.
(ii)
INTRODUCTION
Assessment methods and format of the exam Examiner: Graham Holt The examination is a three-hour paper. Requirements may ask for reports to be prepared, as well as for numbers to be calculated. Format of the Exam Section A
Marks
Compulsory
50
Section A will be scenario-based and will deal with the preparation of consolidated financial statements including group cash flow statements and ethical and social issues in financial reporting. Section B
Two from three 25-mark questions
50
Section B will normally comprise two questions which will be scenario or case study-based (covering a range of standards and syllabus topics) of which one question will usually be of an essay style, often encompassing current developments in corporate reporting. 100
(iii)
INTRODUCTION
Course Aims Achieving ACCA's Study Guide Outcomes A
The professional and ethical duty of the accountant
A1 Professional behaviour and compliance with accounting standards
Chapter 1
A2 Ethical requirements of corporate reporting and the consequences of unethical behaviour
Chapter 1
A3 Social responsibility
Chapter 1
B
The financial reporting framework
B1 The contribution and limitations of financial statements in meeting users' and capital markets' needs
Chapter 2
B2 The applications, strengths and weaknesses of an accounting framework
Chapter 2
B3 Critical evaluation of principles and practices
Chapter 2
C
Reporting the financial performance of entities
C1 Performance reporting
Chapter 19
C2 Non-current assets
Chapter 3
C3 Financial instruments
Chapter 6
C4 Leases
Chapter 10
C5 Segment reporting
Chapter 19
C6 Employee benefits
Chapter 4
C7 Income taxes
Chapter 5
C8 Provisions, contingencies and events after the balance sheet date
Chapter 8
C9 Related parties
Chapter 9
C10 Share-based payment
Chapter 7
D
Financial statements of groups of entities
D1 Group accounting including cash flow statements
Chapters 11-12, 16
D2 Continuing and discontinued interests
Chapter 14
D3 Changes in group structures
Chapter 13
D4 Foreign transactions and entities
Chapter 15
(iv)
INTRODUCTION
E
Specialised entities
E1
Financial reporting in specialised, not-for-profit and public sector entities
Chapter 20
E2
Reporting requirements for small- and medium-sized entities (SMEs)
Chapter 20
F
Implications of changes in accounting regulation on financial reporting
F1
The effect of changes in accounting standards on accounting systems
Chapter 21
F2
Proposed changes to accounting standards
Chapter 21
G
The appraisal of financial performance and position of entities
G1 The creation of suitable accounting policies
Chapter 19
G2 Analysis and interpretation of financial information and measurement of performance
Chapter 19
H
Current developments
H1 Environmental and social reporting
Chapter 17
H2 Convergence between national and international reporting standards
Chapter 18
H3 Comparison of national reporting requirements
Chapter 18
H4 Current reporting issues
Chapter 18
(v)
INTRODUCTION
Classroom tuition and Home study Your studies for BPP consist of two elements, classroom tuition and home study.
Classroom tuition In class we aim to cover the key areas of the syllabus. To ensure examination success you will to spend private study time reinforcing your classroom course with question practice and reviewing areas of the Course Notes and Study Text.
Home study To support you with your private study BPP provides you with a Course Companion which helps you to work at home and aims to ensure your private study time is effectively used. The Course Companion includes a Home Study section which breaks down your home study by days, one to be covered at the end of each day of the course. You will find clear guidance as to the time to spend on various activities and their importance. You are also provided with progress tests and two course exams which should be submitted for marking as they become due. These may include questions on topics covered in class and home study.
BPP Learn Online Come and visit the BPP Learn Online free at www.bpp.com/acca/learnonline for exam tips, FAQs and syllabus health check.
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Helpline If you have any queries during your private study simply contact your class tutor on the telephone number or e-mail address that they will supply. Alternatively, call +44 (0)20 8740 2222 (or your local training centre if outside the London area) and ask for a tutor for this paper to speak to you or to call you back within 24 hours.
Feedback The success of BPP's courses has been built on what you, the students tell us. At the end of the course for each subject, you will be given a feedback form to complete and return. If you have any issues or ideas before you are given the form to complete, please raise them with the course tutor or relevant head of centre. If this is not possible, please email
[email protected].
(vi)
INTRODUCTION
Key to icons
Question practice from the Study Text This is a question we recommend you attempt for home study.
Real world examples These can be found in the Course Companion.
Section reference in the Study Text Further reading is needed on this area to consolidate your knowledge.
(vii)
INTRODUCTION
(viii)
The financial reporting framework
Syllabus Guide Detailed Outcomes Having studied this chapter you will be able to: •
Evaluate the consistency and clarity of corporate reports.
•
Assess the insight into financial and operational risks provided by corporate reports.
•
Discuss the usefulness of corporate reports in making investment decisions
•
Evaluate the 'balance sheet' and 'fair value' models adopted by standard setters.
•
Discuss the use of an accounting framework in underpinning the production of accounting standards.
•
Assess the success of such a framework in introducing rigorous and consistent accounting standards.
•
Identify the relationship between accounting theory and practice.
•
Critically evaluate accounting principles and practices used in corporate reporting.
Exam Context In Section B of the exam there will always be a discussion question and this could be based on some of the topics covered in this chapter. The examiner could also ask you to discuss accounting treatments, or to criticise existing Standards in the light of the Framework in some of the more practical questions in this section.
Qualification Context The basic issues in this chapter, of accounting principles and the Framework were introduced in the Fundamentals level Paper F7 Financial Reporting. At this level you will be expected to have a greater depth of understanding of these areas.
Business Context The debates over the usefulness of corporate reports and the respective advantages and disadvantages of the balance sheet and fair value models are very much live arguments currently both within the standard-setting bodies and the wider business and investment community. The fair value model is particularly controversial, especially among smaller entities.
1.1
1: THE FINANCIAL REPORTING FRAMEWORK
Overview The financial reporting framework
Contribution and limitations of financial statements
Applications, strengths and weaknesses of an accounting framework
1.2
Revenue recognition
1: THE FINANCIAL REPORTING FRAMEWORK
1
Contribution and limitations of financial statements
Contributions 1.1
The usual definition of the role of financial statements is that they are designed to provide useful information for a range of users. The existence of accounting standards, and the increasing harmonisation of these standards internationally is seen as improving the consistency and clarity of financial statements. Clarity and usefulness of financial statements is considered to have improved due to: (a)
The growth in narrative reporting as discussed in Chapter 1, allowing users a greater insight into the risks faced by companies, both financial and operational, and the policies they are implementing to address these.
(b)
Increasing use of fair values in recent accounting standards. Fair values are generally seen as being more relevant than historical balance sheet values for investors assessing the position and performance of companies.
Limitations 1.2
Despite the improvements brought about by recent standards it can still be argued that there are limitations to the usefulness of financial statements. These include: (a)
All information within financial statements is historical.
(b)
All IASB standards are developed with the 'capital markets of the world' as the perceived primary user. This is seen as limiting their usefulness in the context of smaller entities.
(c)
There are arguments over the usefulness of fair values themselves. It is generally accepted that fair values that are based on market values of liquid assets are relevant and reliable. There is no such general acceptance of hypothetical calculations of fair values for assets where no actual market value exists. In these cases difficulties arise due to the variety of assumptions that can be used. The complexity of the models used for these valuations can also detract from the understandability of the resulting information.
(d)
Different users of financial statements will have different needs. Even within 'investors' it could be argued that a fixed income investor may be more interested in the proceeds that could realised from the sale of an asset, while an equity investor may be more interested in the cash spent on acquiring an asset in order to calculate return on capital invested.
Disclosures 1.3
One answer to the conflicting needs of users and other limitations in the usefulness of financial statements is to increase the amount of disclosure. For example, if management disclose all the assumptions and inputs into valuation models used investors can reassess the values independently.
1.3
1: THE FINANCIAL REPORTING FRAMEWORK
2 Chapter 1 Section 4.1-4.3
Application, strengths and weaknesses of an accounting framework
Fair presentation and compliance with IFRSs 2.1
'Fair presentation' is the term used in IAS 1 Presentation of Financial Statements equivalent to the concept of 'true and fair view'.
2.2
In order to achieve fair presentation, an entity must comply with: •
International Financial Reporting Standards. These comprise: – – –
•
International Financial Reporting Standards International Accounting Standards Interpretations originated by the IFRIC or the former SIC; and
The Framework for the Preparation and Presentation of Financial Statements.
The IASB's Framework 2.3
The Framework consists of seven sections: (a)
The objective of financial statements ‘To provide information about the financial position, performance and changes in financial position of an entity that is useful to a wide range of users in making economic decisions.’ This section discusses the ways financial statements provide information about the financial position, performance and changes in financial performance and why it is necessary.
(b)
Underlying assumptions Financial statements are prepared based on the following assumptions: (i) (ii)
(c)
Accruals basis Going concern.
Qualitative characteristics of financial statements The four principal qualitative characteristics are as follows: (i) (ii) (iii) (iv)
Understandability Relevance Reliability Comparability.
Within reliability, faithful representation, substance over form, neutrality, prudence and completeness should be followed. Materiality is detailed as being a factor in relevance.
1.4
1: THE FINANCIAL REPORTING FRAMEWORK (d)
The elements of financial statements Asset
A resource controlled by an entity as a result of past events and from which future economic benefits are expected to flow to the entity.
Liability
A present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits.
Equity
The residual interest in the assets of an entity after deducting all its liabilities.
Income
Increases in economic benefits during the accounting period in the form of inflows or enhancements of assets or decreases of liabilities that result in increases in equity, other than those relating to contributions from equity participants.
Expenses Decreases in economic benefits during the accounting period in the form of outflows or depletions of assets or increases of liabilities that result in decreases in equity, other than those relating to distributions to equity participants. (e)
Recognition of the elements of financial statements An item that meets the definition of an element should be recognised if: •
it is probable that any future economic benefit associated with the item will flow to or from the entity; and
•
the item has a cost or value that can be measured with reliability.
Consequently, in accordance with the Framework, in order for an item to be recognised in the financial statements, the following questions need to be answered: (1)
Is the item one of the elements of financial statements? ↓
(2)
Is it probable that economic benefits associated with the item will flow to or from the entity? ↓
(3) (f)
Can the item be measured with reliability?
Measurement of the elements of financial statements Defines different bases of measurement of the elements of the financial statements including specifically: (i) (ii) (iii) (iv)
historical cost; current cost: realisable value; and present value.
Historical cost is the basis most commonly used. (g)
Concepts of capital and capital maintenance Discusses alternative capital maintenance concepts and determination. 1.5
1: THE FINANCIAL REPORTING FRAMEWORK
Application of an accounting framework 2.4
Main uses • • •
Defines the concepts underpinning the production of new Standards Provides a common base for the evaluation of current Standards Source of accounting treatment where there is no Standard (IAS 8 – see Chapter 18)
Strengths and weaknesses of an accounting framework 2.5
Strengths • •
Allows Standards to be developed on a consistent basis Can protect Standard-setters from political interference
Weaknesses •
It is open to question whether a single framework can be appropriate to the needs of all users of financial statements
•
It is not clear that the existence of a framework makes the task of preparing and implementing standards any easier than it would be without a framework.
3
Revenue recognition (IAS 18)
3.1
Classes of revenue: • Sales of goods • Rendering of services • Interest • Royalties • Dividends.
Sales of goods 3.2
Criteria for revenue recognition: (a) Transfer to buyer of significant risks and rewards of ownership. (b) Entity retains no continuing managerial involvement nor effective control over the goods sold. (c) Revenue can be measured reliably. (d) Probable that the economic benefits associated with the transaction will flow to the seller. (e) Costs incurred in the transaction can be measured reliably.
Rendering of services 3.3
Criteria for revenue recognition: (c)-(e) as above + Stage of completion can be measured reliably
Measurement 3.4
Revenue recognised ⇒ Fair value of consideration received or receivable. Discount if material. 1.6
1: THE FINANCIAL REPORTING FRAMEWORK
Specific guidance 3.5
Type
Revenue recognised:
Consignment sales
• When goods are sold to third party
Sale and repurchase agreements
• Only when risks and rewards of ownership transferred (even though legal title may have been transferred)
Subscriptions to publications
• On a straight line basis over the period in which the items are despatched (when items are of similar value in each period) • On the basis of sales value despatched in relation to estimated total sales value of the subscription (when items vary in value)
Instalment sales (consideration receivable in instalments)
• Present value at date of sale. Interest element recognised as earned
Real estate sales
• Normally when legal title passes to the buyer • If the seller is obliged to perform any significant acts after transfer of title ⇒ as the acts are performed
Installation fees
• By reference to the stage of completion of the installation (unless incidental to sale of the product ⇒ when goods sold)
Servicing fees included in the price of the product
• Over period during which service is performed
Advertising commissions
• When advertisement or commercial appears before the public
Admission fees from artistic performances, banquets etc
• When event takes place
Initiation, entrance and membership fees
• If membership only ⇒ when no significant uncertainty as to collectability • If entitles member to services/publications etc ⇒ on basis that represents timing, nature and value of benefits provided
Fees from development of customised software
• By reference to stage of completion of development, including completion of services provided for postdelivery service support
Licence fees and royalties
• In accordance with the substance of the agreement, e.g. straight line over the life of the agreement • Immediately where the substance is a sale, e.g. a noncancellable contract where the licensee can exploit the rights freely 1.7
1: THE FINANCIAL REPORTING FRAMEWORK
Lecture example 1
(Each part) Exam standard for 3-4 marks
(a)
Realbuild operates in the house building sector and currently does not report under IFRS. In the market in which Realbuild operates, the custom is to sign a contract which includes a completion date when funds are transferred and the keys passed to the buyer. Realbuild's accounting policy is to recognise revenue on signing the contract. Where there is still building work to be completed, Realbuild delays revenue recognition until the completion of the work.
(b)
BCN Productions is a film production house. The company licences one of its new films to a distributor in a foreign country over which BCN Productions has no control. The film is expected to appear before the public over a period of six months and BCN Productions intends to recognise the revenue over this period.
(c)
KSoft is a start-up company that will develop bespoke software systems for corporate clients. The company's policy is to invoice fixed amounts which include the software development and fees for ongoing post-delivery support while the new software system is implemented. KSoft intends to recognise the revenue for both elements on installation of the software.
Required Advise the directors as to the acceptability of the above accounting policies for revenue recognition under IAS 18 Revenue.
Solution
1.8
1: THE FINANCIAL REPORTING FRAMEWORK
4
Chapter summary
4.1
Q11 Tree
Section
Topic
Summary
1
Contributions and limitations of financial statements
Financial statements are designed to provide clear and consistent information that is useful for a wide range of users. However, there are limitations to how useful the information can be to any one specific user.
2
Applications, strengths and weaknesses of an accounting framework
The Framework establishes the objectives and principles underlying financial statements and underlies the development of new Standards.
3
Revenue recognition (IAS 18)
Revenue recognition is also determined by the principle of substance. Revenue from sale of goods is recognised when criteria establishing whether the risks and rewards of ownership are transferred and the Framework recognition criteria are met. Revenue from services is recognised when the Framework recognition criteria are met by reference to the stage of completion of the service. Where the outcome cannot be estimated reliably, revenue is only recognised to the extent of expenses incurred expected to be recovered, consistent with the treatment of construction contract revenue.
1.9
1: THE FINANCIAL REPORTING FRAMEWORK
END OF CHAPTER 1.10
Professional and ethical duty of the accountant
Syllabus Guide Detailed Outcomes Having studied this chapter you will be able to: •
Appraise and discuss the ethical and professional issues in advising on corporate reporting.
•
Assess the relevance and importance of ethical and professional issues in complying with accounting standards.
•
Appraise the potential ethical implications of professional and managerial decisions in the preparation of corporate reports.
•
Assess the consequences of not upholding ethical principles in the preparation of corporate reports
•
Discuss the increased demand for transparency in corporate reports, and the emergence of non-financial reporting standards.
Exam Context The ethical topics will be examined as part of question 1, the 50-mark case study. The examiner has said that he is not going to take a 'rules-based' approach to these. He does not expect candidates to quote chunks of the ACCA or IFAC codes. His emphasis will be on professional skills, presenting problems and asking candidates to explain how they would deal with the practical issues involved. Current developments such as the increased demand for transparency in corporate reports and the emergence of nonfinancial reporting standards are more likely to appear in Section B of the exam, where they could form the basis of the essay question.
Qualification Context Ethical and professional issues are at the heart of the new ACCA qualification and feature in all of the papers at the professional stage.
Business Context The public reputation of the accounting and auditing profession was seriously damaged by the major corporate failures such as Enron and Worldcom. The role of accountants operating within these entities as directors, or associated with them as auditors has raised questions about the integrity of the profession. Globally, ethics in organisations have been subject to increased scrutiny and criticism from the media, regulators and public interest groups.
2.1
2: PROFESSIONAL AND ETHICAL DUTY OF THE ACCOUNTANT
Overview Professional and ethical duty of the accountant
Professional and ethical issues
Ethical principles in corporate reporting
Non-financial reporting standards
Complying with accounting standards
Transparency
Framework for decisions
2.2
Standards
2: PROFESSIONAL AND ETHICAL DUTY OF THE ACCOUNTANT
1
Professional and ethical issues
Ethical principles in corporate reporting 1.1 Chapter 2 Section 3
The ACCA Code of Ethics and Conduct identifies the fundamental principles most relevant to accountants in business involved in corporate reporting: •
Objectivity
•
Integrity
•
Professional competence and due care
•
Confidentiality
•
Professional behaviour.
Complying with accounting standards 1.2
In preparing financial statements or advising on corporate reporting, a variety of ethical problems may arise: (a)
Professional competence is clearly a key issue when decisions are made about accounting treatments and disclosures. Company directors and their advisers have a duty to keep up to date with developments in IFRS and other relevant regulations. Circumstances that may threaten the ability of accountants in these roles to perform their duties with the appropriate degree of professional competence and due care include:
(b)
•
Insufficient time
•
Incomplete, restricted or inadequate information
•
Insufficient experience, training or education
•
Inadequate resources
Objectivity and integrity may be threatened in a number of ways: • •
(c)
Financial interests, such as profit-related bonuses or share options Inducements to encourage unethical behaviour
ACCA's Code of Ethics and Conduct identifies that accountants may be pressurised, either externally or by the possibility of personal gain, to become associated with misleading information. The Code clearly states that members should not be associated with reports, returns, communications or other information where they believe that the information: •
Contains a materially misleading statement
•
Contains statements or information furnished recklessly
•
Has been prepared with bias, or
•
Omits or obscures information required to be included where such omission or obscurity would be misleading 2.3
2: PROFESSIONAL AND ETHICAL DUTY OF THE ACCOUNTANT
Framework for decisions 1.3
ACCA has developed an overall framework to help its members make ethical decisions in a wide range of circumstances: What is the real issue?
Are there threats to compliance with the fundamental principles?
Are the threats clearly significant?
Are there safeguards that will eliminate the threats or reduce them to an acceptable level?
Can you face yourself in the mirror?
Lecture example 1
Exam standard for 5 marks
You are the assistant group accountant of Bateleur Group. It is two weeks after the company's financial year-end and you are currently preparing the first draft of the statutory financial statements for the group. When the consolidation return was received from Eagle Corp, one of the major operating subsidiaries, it was apparent that Eagle's results fell well below what had been budgeted for the year. Your immediate line manager, the group accountant, has suggested that you contact the managers of Eagle to discuss the possibility of reassessing the estimates in relation to two substantial construction contracts. You are aware of the following: (a)
Your manager has suggested increasing the estimated proportion complete on the contracts. She has explained that it only amounts to recognising a portion of contract revenue that is expected to be certified as complete by surveyors within the next month and that this is immaterial in the context of a contract that extends over a period of two years.
(b)
Bateleur Group is planning to raise new capital in a rights issue shortly after the year-end.
2.4
2: PROFESSIONAL AND ETHICAL DUTY OF THE ACCOUNTANT (c)
Annual bonuses for all group staff, including those for you and the group accountant are linked to the total group profit as reported in the statutory financial statements.
Another operating subsidiary has been the subject of litigation relating to the safety of its products. The individual company accounts disclose a contingent liability relating to the litigation but the group accountant has instructed you to omit the disclosure from the group financial statements. Required Explain any ethical and professional issues arising in the above scenario and the appropriate action that you should take in response to your manager's request.
Solution
2.5
2: PROFESSIONAL AND ETHICAL DUTY OF THE ACCOUNTANT
2
Non-financial reporting standards
Transparency 2.1
The same reasons that led to the loss of confidence in financial information and the accounting profession have led stakeholders to demand greater transparency in the information provided by companies. This goes beyond the ever-increasing detail required to be disclosed under IFRS. Narrative information is now demanded on a wide range of areas such as: • • •
Trends and factors likely to affect the future development of the company Environmental, HR and social/community issues Policies and their effectiveness
Standards 2.2
In the last two decades businesses have come under increasing scrutiny in respect of their responsibilities towards all of their stakeholders and the environment and society in which they operate. Although the pace of development in reporting still varies widely around the world the types of issues now being reported include: • • • • • •
Governance Management systems Impact data Target setting Policy statements Values statements
2.3
Various guidance has been produced by national governments and non-governmental bodies but recent years have seen increasing moves towards global standardisation in this area.
2.4
The demand for more narrative reporting has led to the development of standards around the world. In the UK, guidance has existed for many years on best practice in preparing an Operating and Financial Review, while the US has long had a Management Discussion and Analysis requirement. The IASB have recently published an ED on the Management Commentary. These topics will be covered in more detail in Chapters 3 and 19.
2.6
2: PROFESSIONAL AND ETHICAL DUTY OF THE ACCOUNTANT
3
Chapter summary
3.1 Q1 Fundamental principles
Section
Topic
Summary
1
Professional and ethical issues
In all areas of professional work, whether in practice or in business, ACCA members and students must carry out their work with regard to the fundamental principles of professional ethics.
2
Non-financial reporting standards
There is an increasing demand by stakeholders for companies to produce more narrative information to supplement the financial statements. This is often in the form of a Management Commentary or Operating and Financial Review as well as reports about the company's interactions with society and the environment.
2.7
2: PROFESSIONAL AND ETHICAL DUTY OF THE ACCOUNTANT
END OF CHAPTER 2.8
Home study chapter – Environmental and social reporting
Syllabus Guide Detailed Outcomes Having studied this chapter you will be able to: •
Appraise the impact of environmental, social, and ethical factors on performance measurement.
•
Evaluate current reporting requirements in the area.
•
Discuss why entities might include disclosures relating to the environment and society.
•
Discuss the progress towards a framework for environmental and sustainability reporting.
Exam Context Environmental and social reporting could appear in either section of the paper, either as an 'add on' written part to the consolidation question in Section A, or as a full question or discrete part of a question in Section B.
Qualification Context Social and environmental matters are not restricted to Paper P2, as they are examined extensively as ethical issues in other papers such as in the context of the social and environmental effects of a business in Paper P1 Professional Accountant, in the context of corporate social responsibility in Paper P3 Business Analysis and from an audit angle in optional Paper P7 Advanced Audit and Assurance.
Business Context Environmental accounting has a business impact in that it reports how an entity interacts with its environment. Companies provide a wealth of information about environmental and sustainability accounting on their corporate websites, www.bp.com is a good example. Trucost (www.trucost.com) is an organisation which benchmarks companies' environmental disclosures.
3.1
3: HOME STUDY CHAPTER – ENVIRONMENTAL AND SOCIAL REPORTING
Overview Objectives
Benefits of environmental and social reporting
Environmental and social reporting
Human capital accounting
Current reporting requirements
IFRS requirements
National requirements
3.2
Voluntary disclosure
3: HOME STUDY CHAPTER – ENVIRONMENTAL AND SOCIAL REPORTING
1
Objectives
Environmental reporting Chapter 3 Section 1
1.1
The aim of environmental reporting is the disclosure of an organisation's corporate environmental responsibilities and the effects of its activities on its environment. The growing awareness within the general population of environmental issues plus pressure from non-governmental organisations (NGOs) has led to the expectation that quoted organisations will make these disclosures. External reporting is now seen as a key part of a company's dialogue with its stakeholders: General public and future population
Regulators and policy makers
Core values of a sustainable business
Banks and shareholders
Economic viability Environmental responsibility Social accountability
Employees
Local communities
Customers and suppliers
Social reporting Chapter 3 Section 3
1.2
The aim of social reporting is to measure and disclose the social impact of a business' activities: Examples of social measures include: • • • •
philanthropic donations, employee satisfaction levels and remuneration issues, community support, and stakeholder consultation information.
3.3
3: HOME STUDY CHAPTER – ENVIRONMENTAL AND SOCIAL REPORTING
2
Benefits of environmental and social reporting
2.1
Companies which voluntarily publish environmental and social reports have identified the following benefits: (a)
It demonstrates coherence of overall management strategy to important external stakeholders.
(b)
It strengthens stakeholder relations.
(c)
It increases competitive advantages (the 'first mover' effect).
(d)
Public recognition for corporate accountability and responsibility.
(e)
Target setting and external reporting drives continual environmental and social improvement.
(f)
Effective self-regulation minimises risk of regulatory intervention.
(g)
It may improve access to lists of 'preferred suppliers' of buyers with green procurement policies.
(h)
It reduces corporate risk, which may reduce financing costs and broaden the range of investors.
(i)
It enhances employee morale.
(j)
Improved profitability.
3.4
3: HOME STUDY CHAPTER – ENVIRONMENTAL AND SOCIAL REPORTING
3
Current reporting requirements
IFRS requirements 3.1
Under IFRS there are no required disclosure requirements for environmental and social matters.
3.2
However, environmental matters may be disclosed where they fall under specific accounting principles: •
Provisions for environmental damage are recognised and contingent liabilities are disclosed under IAS 37 Provisions, Contingent Liabilities and Contingent Assets.
•
IAS 1 Presentation of Financial Statements requires disclosure of facts material to a proper understanding of financial statements.
National requirements 3.3
Some countries require disclosure of environmental performance under national law. For example, the Netherlands, Denmark, Norway and Sweden have had required environmental reporting for a number of years.
3.4
The European Union's Business Review under the Account Modernisation Directive, which came into effect (through implementation in national law) in 2005 encourages the disclosure of key performance indicators ('KPIs') on environmental and employee matters.
Voluntary disclosure 3.5
Voluntary disclosure and the publication of environmental reports has now become the norm for quoted companies in certain countries as a result of pressure from stakeholder groups to give information about their environmental and social 'footprint'. The creation of ethical indices has added to this pressure for example, the FTSE4Good index in the UK, and the Dow Jones Sustainability Group Index in the US.
Sustainability reporting Chapter 3 Section 2
3.6
The initial disclosure of environmental matters has now expanded into sustainability reporting which integrates environmental, social and economic performance data and measures (including the economic element of sustainability such as wages, taxes and core financial statistics).
3.7
A number of guidelines for sustainability disclosure are available, but the most well known is the Global Reporting Initiative.
The Global Reporting Initiative (GRI) 3.8
The Global Reporting Initiative (GRI) (www.globalreporting.org) is a long-term, multistakeholder, international not-for-profit organisation whose mission is to develop and disseminate globally applicable Sustainability Reporting Guidelines for voluntary use by organisations.
3.5
3: HOME STUDY CHAPTER – ENVIRONMENTAL AND SOCIAL REPORTING The guidelines cover the reporting on the: • • •
economic, environmental, and social
dimensions of a business' activities, products and services. GRI Guidelines Shell
3.9
The GRI published revised Sustainability Reporting Guidelines ('G3') in 2006. The Guidelines set out the framework of a sustainability report. It consists of five sections: GRI Report content
Detail of GRI requirements
1
Strategy and Analysis
Provides a high-level, strategic view of the organisation's relationship to sustainability in order to provide context for subsequent and more detailed reporting, including a statement from the CEO.
2
Organisational Profile
The organisation's structure including brands, location of operations, geographical markets served and size of operations.
3
Report Parameters
The reporting period, materiality, report boundaries (e.g. countries), data measurement techniques and a GRI Content Index.
4
Governance, Commitments and Engagement
Governance structure of the organisation, commitments to external initiatives and how the organisation engages the stakeholders in its business.
5
Management Approach and Performance Indicators
Organised by economic, environmental, and social categories. Each category includes a Disclosure on Management Approach and a corresponding set of Core and Additional Performance Indicators.
3.6
3: HOME STUDY CHAPTER – ENVIRONMENTAL AND SOCIAL REPORTING Indicators in the GRI framework
Category
Aspect
Economic
Economic performance Market presence Indirect economic impacts
Environmental
Materials Energy Water Biodiversity Emissions, effluents, and waste Products and services Compliance Transport Overall
Environmental
Economic
3.10 GRI structures key performance indicators according to a hierarchy of category, aspect and indicator. Indicators are grouped in terms of the three dimensions of the conventional definition of sustainability – economic, environmental, and social.
Labour Practices and Decent Work Employment Labour/management relations Occupational health and safety Training and education Diversity and equal opportunity Investment and procurement practices Non-discrimination Freedom of association and collective bargaining Child labour Forced and compulsory labour Security practices Indigenous rights
Society
Community Corruption Public policy Anti-competitive behaviour Compliance
Product Responsibility
Customer health and safety Product and service labelling Marketing communications Customer privacy Compliance
Social
Human Rights
3.7
3: HOME STUDY CHAPTER – ENVIRONMENTAL AND SOCIAL REPORTING
4
Human capital accounting
4.1
Human capital accounting has at its core the principle that employees are assets. Competitive advantage is largely gained by effective use of people.
Implications of regarding people as organisational assets 4.2
(a)
People are a resource which needs to be carefully and efficiently managed with overriding concern for organisational objectives.
(b)
The organisation needs to protect its investment by retaining, safeguarding and developing its human assets.
(c)
Deterioration in the attitudes and motivation of employees, increases in labour turnover (followed by costs of hiring and training replacements) are costs to the company – even though a 'liquidation' of human assets, brought about by certain managerial styles, may produce short-term increases in profit.
(d)
A concept developed some time ago was that of human asset accounting (the inclusion of human assets in the financial reporting system of the organisation).
Intellectual assets 4.3
Because of the difficulties found in both theory and practice, the concept of human assets was broadened and became intellectual assets. Intellectual assets, or 'intellectual capital' as they are sometimes called can be divided into three main types: (a)
External assets. These include the reputation of brands and franchises and the strength of customer relationships.
(b)
Internal assets. These include patents, trademarks and information held in customer databases.
(c)
Competencies. These reflect the capabilities and skills of individuals.
4.4
'Intellectual assets' thus includes 'human assets'.
4.5
The value of intellectual assets will continue to rise and will represent an increasing proportion of the value of most companies. Whether or not traditional accounting will be able to measure them remains to be seen.
3.8
3: HOME STUDY CHAPTER – ENVIRONMENTAL AND SOCIAL REPORTING
5
Chapter summary
5.1 Section
Topic
Summary
1
Objectives
Both environmental and social disclosures aim to provide stakeholders with information about the impact of the business' activities.
2
Benefits of environmental and social reporting
Making environmental and social disclosures can actually benefit a company by improving credibility and making it aware of risks and costs.
3
Current reporting requirements
Reporting requirements come from three sources:
Human capital accounting
Views employees as assets of the business. As such they must be invested in, through training. Intellectual assets arise through employee work, but are not recognised in current financial statements as they do not meet the recognition criteria to be measured reliably.
5
• IFRS disclosures where covered by a standard • National/regional requirements to report environmental KPIs. • Voluntary disclosures, e.g. the GRI.
3.9
3: HOME STUDY CHAPTER – ENVIRONMENTAL AND SOCIAL REPORTING
END OF CHAPTER 3.10
Non-current assets
Syllabus Guide Detailed Outcomes Having studied this chapter you will be able to: •
Apply and discuss the timing of the recognition of non-current assets and the determination of their carrying amounts including impairments and revaluations.
•
Apply and discuss the accounting treatment of investment properties including classification, recognition and measurement issues.
•
Apply and discuss the accounting treatment of intangible assets including the criteria for recognition and measurement subsequent to acquisition and classification.
Exam Context It is unlikely that a full question would appear on any of the standards in this chapter (with the notable exception of impairment of assets). However, they are standards that appear frequently in the exam, and often more than once in any given paper, as part of scenario or multi-part questions.
Qualification Context All of these standards are also covered at Paper F7 Financial Reporting, although at a lower level, particularly in the case of impairments. Much of this chapter should therefore be revision.
Business Context Whether an asset is capitalised or not, the value attributed to it and how it is depreciated or not has a significant impact on the balance sheet, equity and profits of a company. These in turn affect analysts' measures of return and gearing, which are used as a basis for making investment decisions.
4.1
4: NON-CURRENT ASSETS
Overview Non-current assets
Intangible assets (IAS 38)
Property, plant and equipment (IAS 16)
Investment property (IAS 40)
Impairment of assets (IAS 36)
Government grants (IAS 20)
Borrowing costs (IAS 23)
4.2
4: NON-CURRENT ASSETS
1
Property, plant and equipment (IAS 16) Property, plant and equipment
Definition Tangible items that: (a) are held by an entity for use in the production or supply of goods or services, for rental to others, or for administrative purposes; and (b) are expected to be used during more than one period
Depreciation • • •
Recognition • •
•
Allocate depreciable amount (cost/ revalued amount less residual value) over UL Separate into depreciable parts Land normally has unlimited life - not depreciated At least annual review of UL and depreciation method
Probable that future economic benefits will flow to the entity Cost can be measured reliably
Measurement at recognition
Measurement after recognition
Purchase price • Import duties • Non-refundable purchase taxes + Directly attributable costs • Employee benefit costs • Site preparation • Initial delivery & handling costs • Installation & assembly costs • Professional fees • Costs of testing • Site restoration (IAS 37), where not included in cost of inventories produced + Finance costs • Capitalised for qualifying assets (IAS 23) + Subsequent costs • Capitalised when: - cost of replacing is incurred, and - recognition criteria met e.g. furnace relining
Cost model • Cost less accumulated depreciation/impairment losses Revaluation model • Revalued amount less subsequent accumulated depreciation/ impairment losses • Upward revaluation to R/S • Downward revaluation: - 1st to R/S - then in I/S • Valuation: - Sufficient regularity that does not differ materially from FV - volatile: annual - non-volatile: 3-5 years - L&B - MV by appraisal by professionally qualified valuers - P&E - MV by appraisal - So specialised that MV not available: income/ depreciated replacement cost approach - Revalue entire class • Reserves transfer: - Actual dep'n - HC dep'n - Optional
4.3
4: NON-CURRENT ASSETS
2
Intangible assets (IAS 38) Intangible assets
Definition •
'an identifiable asset without physical substance'
Amortisation/impairment tests Recognition • •
Probable future economic benefits Cost can be measured reliably
NOT CAPITALISED: Internally generated: • Brands • Mastheads • Publishing titles • Customer lists • Other similar items
Final useful life •
EXPENSED: • Start-up costs • Training • Advertising/promotion • Reoganisations/relocations
• • •
Cost model •
•
NOT amortised Review indefinite useful life assessment each period Impairment tests at least annually
Revaluation model •
Cost less accumulated amortisation/impairment losses
• • •
• Capitalised at cost • Include directly attributable costs
• •
Depreciate on systematic basis over useful life Begins when available for use Residual value normally assumed = 0 Review useful life and method at least each financial year-end
Measurement after recognition
Measurement at recognition
Separate acquisition
Indefinite useful life
Acquired in business combination
Government grant
• Capitalised at FV at date of acquisition (IFRS 3)
• Asset & grant at FV; or • Nominal amount + expenditure directly attributable to preparation for use
Exchanges of assets • Cost = normally FV of asset given up
To FV if active market: - homogenous items - willing buyers/sellers any time - prices available to the public No active market ⇒ cost model Revalue whole class Revalue regularly such that BV not materially diff to FV
Internally generated goodwill • NOT recognised
Research Phase
Development Phase
Recognise as expense when incurred • • •
4.4
Internally generated intangibles
• • •
Capitalise and amortise if following conditions are met: P robable future economic benefits I ntention to complete and use/sell R esources adequate to complete and use/sell A bility to use/sell T echnical feasibility E xpenditure can be measured reliably
4: NON-CURRENT ASSETS
3
Investment property (IAS 40)
Definition 3.1
Investment property (IAS 40) Investment property is property (land or building – or part of a building – or both) held (by the owner or by a lessee under a finance lease*) to earn rentals or for capital appreciation or both, rather than for: (a) (b) *
3.2 Chapter 4 Section 4.8
use in the production or supply of goods or services or for administrative purposes; or sale in the ordinary course of business. A property interest held under an operating lease may be accounted for as investment property if it otherwise meets the definition and the lessee uses the fair value model (for all investment property). This allows leased land (which is normally an operating lease) to be classified as investment property.
The following are not investment property. (a)
Property held for sale in the ordinary course of business or in the process of construction or development for such sale.
(b)
Property being constructed or developed on behalf of third parties.
(c)
Owner-occupied property, including property held for future use as owner-occupied property, property held for future development and subsequent use as owneroccupied property, property occupied by employees and owner-occupied property awaiting disposal.
(d)
Property that is being constructed or developed for future use as investment property.
Recognition 3.3
Investment property is recognised when it is probable that future economic benefits will flow to the entity and the cost can be measured reliably.
Measurement at recognition 3.4
Cost, including directly attributable expenditure and transaction costs.
Measurement after recognition 3.5
Fair value model:
• Any change in fair value reported in profit or loss • Not depreciated
Cost model:
• As cost model of IAS 16.
4.5
4: NON-CURRENT ASSETS
4
Impairment of assets (IAS 36)
Scope 4.1
IAS 36 applies to impairment of all assets other than: • • • • • • •
inventories deferred tax assets employee benefit assets financial assets investment property held under the fair value model biological assets held at fair value less estimated point-of-sale costs non-current assets held for sale.
Issue 4.2
Assets should be carried at no more that their recoverable amount. Recoverable Amount = Higher of
4.3
Fair value less costs to sell
Value In Use
Fair value less costs to sell 4.4
Best evidence is a binding sale agreement less incremental costs directly attributable to the asset's disposal. Otherwise, asset's market (bid) price (where there is an active market) or amount obtainable in an arm's length transaction, less costs of disposal in both cases. Fair value less costs to sell does not reflect a forced sale, unless management is compelled to sell immediately.
Value in use 4.5
Cash flow projections are based on the most recent management-approved budgets/forecasts. They should cover a maximum period of five years, unless a longer period can be justified.
4.6
The cash flows should include: (a)
projections of cash inflows from continuing use of the asset
(b)
projections of cash outflows necessarily incurred to generate the cash inflows from continuing use of the asset
(c)
net cash flows, if any, for the disposal of the asset at the end of its useful life
4.6
4: NON-CURRENT ASSETS (d) 4.7
future overheads that can be directly attributed, or allocated on a reasonable and consistent basis.
They should exclude: (a)
cash outflows relating to obligations already recognised as liabilities (to avoid double counting)
(b)
the effects of any future restructuring to which the entity is not yet committed
(c)
cash flows from financing activities or income tax receipts and payments.
Discount rate 4.8
The discount rate (or rates) should be a pre-tax rate (or rates) that reflect(s) current market assessments of: (a)
the time value of money; and
(b)
the risks specific to the asset for which future cash flow estimates have not been adjusted.
Lecture example 1
Exam standard for 4 marks
An entity has a single manufacturing plant which has a carrying value of $749,000. A new government elected in the country passes legislation significantly restricting exports of the product produced by the plant. As a result, and for the foreseeable future, the entity's production will be cut by 40%. Cash flow forecasts have been prepared derived from the most recent financial budgets/forecasts for the next five years approved by management (excluding the effects of general price inflation): Year Future cash flows
1 $'000 230
2 $'000 211
3 $'000 157
4 $'000 104
5 $'000 233 (including disposal proceeds)
If the plant was sold now it would realise $550,000, net of selling costs. The entity estimates that the pre-tax discount rate specific to the plant to be 15%, after taking into account the effects of general price inflation. Required Calculate the recoverable amount of the plant and any impairment loss. Note. PV factors at 15% are as follows. Year 1 2 3 4 5
PV factor @15% 0.86957 0.75614 0.65752 0.57175 0.49718
4.7
4: NON-CURRENT ASSETS
Solution
Impairment indicators 4.9
The entity should look for evidence of impairment at the end of each period and conduct an impairment review on any asset where there is evidence of impairment. The following are indicators of impairment: (a)
External (i)
Significant decline in market value of the asset below that expected due to normal passage of time or normal use
(ii)
Significant changes with an adverse effect on the entity in the – technological or market environment – economic or legal environment
(b)
(iii)
Increased market interest rates or other market rates of return affecting discount rates and thus reducing value in use
(iv)
Carrying amount of net assets of the entity exceeds market capitalisation.
Internal (i)
Evidence of obsolescence or physical damage
(ii)
Significant changes with an adverse effect on the entity*: – – – –
(iii)
the asset becomes idle plans to discontinue/ restructure the operation to which the asset belongs plans to dispose of an asset before the previously expected date reassessing an asset's useful life as finite rather than indefinite
Internal evidence available that asset performance will be worse than expected. 4.8
4: NON-CURRENT ASSETS * Once the asset meets the criteria to be classified as 'held for sale', it is excluded from the scope of IAS 36 and accounted for under IFRS 5 Non-current Assets Held for Sale and Discontinued Operations. 4.10 Annual impairment tests, irrespective of whether there are indications of impairment, are required for: • •
intangible assets with an indefinite useful life/ not yet available for use goodwill acquired in a business combination.
Cash-generating units 4.11 Where it is not possible to estimate the recoverable amount of an individual asset, the entity estimates the recoverable amount of the cash-generating unit to which it belongs. Chapter 4 Section 3.4
Definition 4.12
Cash-generating unit (IAS 36) A cash-generating unit is the smallest identifiable group of assets that generates cash inflows that are largely independent of the cash inflows from other assets or groups of assets. If an active market exists for the output produced by an asset or a group of assets, this group of assets should be identified as a CGU even if some or all of the output is used internally. If the cash inflows are affected by internal transfer pricing, management's best estimate of future prices that could be achieved in arm's length transactions are used in estimating the CGU's value in use.
Lecture example 2
Preparation question
Required Discuss whether the following items would be cash-generating units in their own right, or part of a larger cash-generating unit: (a)
A pizza oven in a pizza restaurant.
(b)
A branch of a pizza restaurant in Warsaw.
(c)
A monorail that takes fee paying visitors to a theme park from its car park.
(d)
A monorail that transports fee paying visitors from a suburban part of town to the centre of town.
(e)
The internal large telephone network of a country's railway system, although its use is currently not permitted to anybody other than railway workers.
4.9
4: NON-CURRENT ASSETS
Solution
Allocating goodwill to CGUs 4.13 Goodwill does not generate independent cash flows and therefore its recoverable amount as an individual asset cannot be determined. It is therefore allocated to the CGU to which it belongs and the CGU tested for impairment. Goodwill that cannot be allocated to a CGU on a non-arbitrary basis is allocated to the group of CGUs to which it relates. 4.14 Example: P
Goodwill on acquisition = $60m
Goodwill on acquisition = $50m
S2
S1
'Group of CGUs'
CGU1
CGU2
CGU3
CGU4
CGU5
Carrying value $140m
$160m
$180m
$220m
$260m
Allocated goodwill at acquisition
$20m
$22.5m
$17.5m
4.15 On acquisition of S1 the goodwill can be allocated on a non-arbitrary basis to the three acquired CGUs (in this case based on carrying value of the acquired assets). Each CGU is tested including the allocated goodwill. On acquisition of S2, the nature of the CGUs and their risks is different such that the goodwill cannot be allocated on a non-arbitrary basis. Instead, it is allocated to the group of CGUs to which it relates and is tested for impairment as part of that group of CGUs (here, S2). 4.10
4: NON-CURRENT ASSETS
Corporate assets 4.16 Corporate assets are treated in a similar way to goodwill. The CGU includes corporate assets (or a portion of them) that can be allocated to it on a 'reasonable and consistent basis'. Where not possible, the assets (or unallocated portion) are tested for impairment as part of the group of CGUs to which they can be allocated on a reasonable and consistent basis.
Recognition of impairment losses in financial statements 4.17 (a) (b)
Assets carried at historical cost – in the income statement. Revalued assets The impairment loss should be treated under the appropriate rules of the applicable IFRS. For example, property, plant and equipment first against any revaluation surplus relating to the asset and then to the income statement in accordance with IAS 16.
Allocation of impairment losses with a CGU 4.18 (a)
General rule The impairment should be allocated in the following order: (1) (2)
Goodwill allocated to the CGU Other assets on a pro-rata basis based on carrying value
The carrying amount of an asset should not be reduced below the higher of its recoverable amount (if determinable) and zero. The amount of the impairment loss that would otherwise have been allocated to the asset should be allocated to the other assets on a pro-rata basis. (b)
Allocation of loss with unallocated corporate assets or goodwill Where not all assets or goodwill will have been allocated to an individual CGU then different levels of impairment tests are performed to ensure the unallocated assets are tested: Test of individual CGUs (i)
Test the individual CGUs (including allocated goodwill and any portion of the carrying amount of corporate assets that can be allocated on a reasonable and consistent basis).
Test of group of CGUs (ii)
Test the smallest group of CGUs that includes the CGU under review and to which the goodwill can be allocated/ a portion of the carrying amount of corporate assets can be allocated on a reasonable and consistent basis.
4.11
4: NON-CURRENT ASSETS
Lecture example 3
Exam standard (for understanding to answer written questions)
Odourless Group has three divisions as a result of past 100% acquisitions: Personal Hygiene products (deodorants, soap, shower gel etc), Hair & Beauty products and Household Cleaning products. Odourless Group recently launched a new line of deodorants with a longer lasting effect. Unfortunately, the chemical in the deodorant was very strong and caused dermatitis in many users and sales of deodorants and other associated products dropped. Owing to consumer fears and the cross-brand marketing strategies adopted by Odourless, the Hair & Beauty division, and to a lesser extent the Household Cleaning division, were also affected. Odourless carried out an impairment review on its three divisions and found that the recoverable amount of all three divisions had fallen. The carrying values of allocated assets before the impairment review were:
Property, plant & equipment Goodwill Inventories Recoverable amount (after impairment review)
Personal Hygiene $m 240 6 120 366 348
Hair & Beauty $m 462 54 190 706 696
Household Cleaning $m 312 35 175 522
Treasury operations $m 174 – – 174
524
132
Goodwill re Total group of CGUs $m $m 1,188 – 20 115 – 485 20 1,788 –
1,700
The treasury operations department performs work on behalf of all the other divisions, but cannot be allocated on a reasonable and consistent basis between them and hence is to be treated as unallocated corporate assets. The smallest group of CGUs to which the treasury operations, assets and goodwill not allocated to individual CGUs can be allocated is the CGU of the whole entity itself. The value attributed to the treasury operations is its fair value less costs to sell as it is not a cashgenerating unit in its own right. Required Calculate the carrying values of the assets of Odourless Group after the impairment review and show the allocation of the impairment losses within each CGU.
4.12
4: NON-CURRENT ASSETS
Solution Test of individual CGUs Personal Hygiene $m
Hair & Beauty $m
Household Unallocated Goodwill re Cleaning corp assets group of CGUs $m $m $m
Personal Hygiene $m
Hair & Beauty $m
Household Cleaning $m
Personal Hygiene $m
Hair & Beauty $m
Household Unallocated Goodwill re Cleaning corp assets group of CGUs $m $m $m
Total $m
Property, plant & equipment Goodwill Inventories
Working 1
Allocation of impairment loss
Net carrying value Recoverable amount Impairment loss To be allocated against: Goodwill Other assets pro-rata
Test of group of CGUs
Property, plant & equipment Goodwill Inventories
Working 2
Allocation of impairment loss
$m
Net carrying value (after test of individual CGUs) Recoverable amount Impairment loss To be allocated against: Unallocated goodwill Other assets pro-rata
4.13
Total $m
4: NON-CURRENT ASSETS
After the impairment review 4.19 The depreciation/ amortisation should be adjusted in future periods to allocate the asset's revised carrying amount less its residual value on a systematic basis over its remaining useful life.
Treatment of the minority interest element of goodwill 4.20 Under current standards, the carrying value of a CGU comprises: (a) (b)
the parent and minority share of the identifiable net assets of the unit only the parent share of the goodwill.
Part of the calculation of the recoverable amount of the CGU relates to the unrecognised share in the goodwill. For the purpose of calculating the impairment loss, the carrying amount of the CGU is therefore notionally adjusted to include the minority share in the goodwill by grossing it up. The consequent impairment loss calculated is only recognised to the extent of the parent's share.
Lecture example 4
Exam standard for 2 marks (each part) as part of a consolidation question
Peter acquired 60% of Stewart on 1.1.20X1 for $450m recognising net assets of $600m, minority interest of $240m and goodwill of $90m. Stewart consists of a single cash-generating unit. Due to adverse publicity, the recoverable amount of Stewart had fallen by 31.12.20X1. The depreciated value of the net assets at that date was $550m (excluding goodwill). No impairment losses have yet been recognised relating to the goodwill. Required Show the allocation of the impairment losses: (a) (b)
if the recoverable amount was $510m at 31.12.20X1 if the recoverable amount was $570m at 31.12.20X1.
Solution
4.14
4: NON-CURRENT ASSETS
Reversal of past impairments 4.21 A reversal for a CGU is allocated to the assets of the CGU, except for goodwill, pro rata with the carrying amounts of those assets. Chapter 4 Section 3.12
4.22 However, the carrying amount of an asset is not increased above the lower of: (a) (b)
its recoverable amount (if determinable); and its depreciated carrying amount had no impairment loss originally been recognised.
Any amounts left unallocated are allocated to the other assets (except goodwill) pro-rata. 4.23 The reversal is recognised in the income statement, except where reversing a loss recognised on assets carried at revalued amounts, which are treated in accordance with the applicable IFRS. For example, an impairment loss reversal on property, plant and equipment reverses the loss recorded in the income statement and any remainder is credited to the revaluation surplus (IAS 16). Goodwill 4.24 Once recognised, impairment losses on goodwill are not reversed.
4.15
4: NON-CURRENT ASSETS
4.16
4: NON-CURRENT ASSETS
Additional Notes
4.17
4: NON-CURRENT ASSETS
5
Government grants (IAS 20)
IAS 20: Accounting for Government Grants and Disclosure of Government Assistance 5.1
(a)
Grants should not be recognised until there is reasonable assurance that the conditions will be complied with and the grants will be received.
(b)
Government grants should be recognised in the income statement so as to match them with the related costs they are intended to compensate on a systematic basis.
(c)
Government grants relating to assets should be presented either as deferred income or by deducting the grant in arriving at the carrying amount of the asset.
(d)
Grants relating to income may either be shown separately or as part of ‘other income' or alternatively deducted from the related expense.
(e)
A government grant that becomes repayable should be accounted for as a revision to an accounting estimate in accordance with IAS 8. Repayment of grants relating to income are taken first against any unamortised deferred credit and then as an expense. Repayments of grants relating to assets should be recorded by increasing the carrying value of the asset or reducing the deferred income balance. Any resultant cumulative extra depreciation should be shown as an expense immediately.
6
Borrowing costs (IAS 23)
6.1
Borrowing costs directly attributable to the acquisition, construction or production of a qualifying asset are capitalised as part of the cost of that asset. A qualifying asset is one that necessarily takes a substantial period of time to get ready for its intended use or sale. (a)
(b)
(c)
Borrowing costs eligible for capitalisation (i)
Funds borrowed specifically for a qualifying asset – capitalise actual borrowing costs incurred less investment income on temporary investment of the funds
(ii)
Funds borrowed generally – weighted average of borrowing costs outstanding during the period (excluding borrowings specifically for a qualifying asset) multiplied by expenditure on qualifying asset. The amount capitalised should not exceed total borrowing costs incurred in the period.
Commencement of capitalisation begins when: (i)
expenditures for the asset are being incurred;
(ii)
borrowing costs are being incurred; and
(iii)
activities that are necessary to prepare the asset for its intended use or sale are in progress
Capitalisation is suspended during extended periods when development is interrupted. 4.18
4: NON-CURRENT ASSETS (d) 6.2
Capitalisation ceases when substantially all the activities necessary to prepare the asset for its intended use or sale are complete.
The financial statements should disclose: •
the accounting policy adopted for borrowing costs,
•
amount of borrowing costs capitalised during the period, and
•
the capitalisation rate used to determine the amount of borrowings cost eligible for capitalisation.
Revision of IAS 23 (March 2007) 6.3
IAS 23 previously permitted expensing all borrowing costs. However, as part of the IASB's project to eliminate differences between IFRS and US GAAP, this option is no longer allowed, effective for accounting periods beginning on or after 1 January 2009, with earlier application encouraged.
4.19
4: NON-CURRENT ASSETS
7
Chapter summary
7.1 Q3 Acquirer
Section
Topic
Summary
1
Property, plant & equipment (IAS 16)
Property plant and equipment can be accounted for under the cost model (depreciated) or revaluation model (depreciated revalued amounts, gains reported in revaluation surplus).
2
Intangible assets (IAS 38)
Intangible assets can also be accounted for under the cost model or revaluation model, but only intangibles with an active market can be revalued. Intangible assets are amortised over their useful lives (normally to a zero residual value) unless they have an indefinite useful life (annual impairments tests required).
3
Investment property (IAS 40)
Investment property can be accounted for under the cost model or the fair value model (not depreciated, gains and losses reported in profit or loss).
4
Impairment of assets (IAS 36)
Impairment losses occur where the carrying value of an asset is above its recoverable amount. Impairment losses are charged first against any revaluation surplus and then in the income statement. Where cash flows cannot be measured separately, the impairment losses are calculated by reference to the cash-generating unit. Resulting impairment losses are allocated first against any goodwill and then pro-rata.
5
Government grants (IAS 20)
Government grants relating to income are recognised in profit or loss when the associated expense is recognised. Grants relating to assets can either be treated as deferred income or reduce the net book (depreciable) value of the asset.
6
Borrowing costs (IAS 23)
Borrowing costs relating to qualifying assets (those which necessarily take a substantial period of time to be ready for use/sale) must be capitalised. This includes both specific and general borrowings of the company.
END OF CHAPTER 4.20
Employee benefits
Syllabus Guide Detailed Outcomes Having studied this chapter you will be able to: •
Apply and discuss the accounting treatment of defined contribution and defined benefit plans.
•
Account for gains and losses on settlements and curtailments.
•
Account for the 'Asset Ceiling' test and the reporting of actuarial gains and losses.
Exam Context Pensions could appear as a full 25-mark question in Section B (which would be part written, part calculations). Pensions could also appear as short parts of other scenario questions and as an adjustment in the compulsory consolidation question.
Qualification Context Pensions accounting is only tested in ACCA Paper P2.
Business Context Pensions are often considered a 'time bomb', particularly for state pension schemes funded from current taxes where there are no allocated funds backing the payments. This creates an increasing burden as people live longer. For private companies with their own pension scheme, the actuarial valuation of the company's pension plan is often a deal-breaker in mergers and acquisitions, as any liability to pay future pensions will pass to the new owners in that any deficit will be charged to the company's future profits. The purpose of IAS 19 is to ensure that future liabilities to pay pensions are recognised on the balance sheet, less any funds specifically allocated to cover them, making the financial statements more transparent. Prior to the advent of IAS 19, such liabilities were off balance sheet.
5.1
5: EMPLOYEE BENEFITS
Overview Employee benefits
Post-employment benefits
Defined contribution schemes
Defined benefit schemes
Settlements & curtailments
Asset ceiling test
5.2
5: EMPLOYEE BENEFITS
1
Post-employment benefits
Introduction 1.1 EMPLOYEE BENEFITS
Short-term benefits
Post-employment benefits
Defined contribution schemes
Other long-term benefits
Termination benefits
Defined benefit schemes
1.2
IAS 19 Employee Benefits covers four distinct types of employee benefit. However, the examiner has confirmed that he will only examine post-employment benefits.
1.3
Post-employment benefits are employee benefits which are payable after the completion of employment. These can be in the form of: (a)
Defined contribution schemes: • •
(b)
Defined benefit schemes: • •
1.4
e.g. annual contribution = 5% salary future pension depends on the value of the fund. Final salary x years worked 60 future pension depends on final salary and years worked.
e.g. annual pension =
The accounting for the two different types of schemes are very different. It is important that you decide on the nature of the scheme before attempting to account for it.
5.3
5: EMPLOYEE BENEFITS 1.5
A pension scheme will normally be held in a form of trust separate from the sponsoring employer. Although the directors of the sponsoring company may also be trustees of the pension scheme, the sponsoring company and the pension scheme are separate legal entities that are accounted for separately. Sponsoring employer
Pays contributions The pension scheme (or plan/trust) is a separate fund from the company itself.
Pension scheme/plan
Pays pensions in future in accordance with the scheme's rules Pensioners
5.4
5: EMPLOYEE BENEFITS
Chapter 6 Section 3
2
Defined contribution schemes
2.1
The company's obligation is to pay an agreed amount into a plan on behalf of its employees.
Accounting treatment 2.2
The obligation for each year is shown as an expense for the period (disclosed in a note) and in the balance sheet to the extent that it has not been paid. These are easy to account for, as the cost of the pension contribution is always made under the control of the sponsoring employer.
Lecture example 1
Exam standard for 2 marks
Mouse Co agrees to contribute 5% of employees' total remuneration into a post-employment plan each period. In the year ended 31 December 20X9, the company paid total salaries of $10.5 million. A bonus of $3 million based on the income for the period was paid to the employees in March 20Y0. The company had paid $510,000 into the plan by 31 December 20X9. Required Calculate the total income statement expense for post-employment benefits for the year and the accrual which will appear in the balance sheet at 31 December 20X9.
Solution
5.5
5: EMPLOYEE BENEFITS
3
Defined benefit schemes
Introduction 3.1
A separate plan is established into which the company makes regular payments, as advised by an actuary. This fund needs to ensure that it has enough assets to pay future pensions to pensioners.
Measurement of plan obligation Projected unit credit method 3.2
IAS 19 requires the use of the projected unit credit method which sees each period of service as giving rise to an additional unit of benefit entitlement and measures each unit separately to build up the final liability (obligation).
Discounting – current service cost 3.3
The benefits earned must be discounted to arrive at the present value of the defined benefit obligation. The increase during the year in this obligation is called the current service cost which is shown as an expense in the income statement. In effect, the current service cost is the increase in total pensions payable as a result of continuing to employ your staff for another year.
3.4
The discount rate used should be related to market yields on high quality fixed-rate corporate debt, (or government debt if no market in corporate debt exists).
Compounding – interest cost 3.5
The obligation must be compounded back up each year reflecting the fact that the benefits are one period closer to settlement. This increase in the obligation is called interest cost and is also shown as an expense in the income statement. discount Current service cost Service performed Dr Current service cost (I/S) Cr PV obligation Now
Year end
Increase in annual pension payments Retirement
compound Dr Interest cost (I/S) Cr PV obligation
5.6
Death
5: EMPLOYEE BENEFITS 3.6
Illustration In 20X8, an employee leaves a company after working there for 24 years. The employee chooses to leave his accrued benefits in the pension scheme until he retires in seven years' time (he now works for another company). At the time of his departure, the actuary calculates that it is necessary at that date to have a fund of $296,000 to pay the expected pensions to the ex-employee when he retires. At the start of the year, the yield on high quality corporate debt was 8%, and remained the same in the following year. Year 1: Discounted cost b/d Interest cost (I/S) (8% x $296,000) Obligation c/d (B/S) Year 2: Interest cost (I/S)(8% x $319,680) Obligation c/d (B/S) .. etc
$ 296,000 23,680 319,680 25,574 345,254
Measurement of plan assets 3.7
The sponsoring employer needs to set aside investments during the accounting period to cover the pension liability. To meet the IAS 19 criteria (and protect the pensioners!) they must be held by an entity legally separate from the reporting entity. The value of the investments will increase over time. This is called the return on plan assets and is defined as interest, dividends and other revenue derived from plan assets together with realised and unrealised gains or losses on the plan assets, less any costs of administering the plan and less any tax payable by the plan itself. The expected return on plan assets is shown as income in the income statement. Any difference between that and the actual return is an actuarial gain or loss. Increase in annual pension payments
Service performed Now
Year end Dr FV plan assets Cr Company cash growth
Retirement
Dr FV plan assets Cr Expected return (I/S)
5.7
Death
5: EMPLOYEE BENEFITS
The role of the actuary 3.8
The actuary provides: • • • • •
the income statement charge for the year (current service cost) the rate for expected return on plan assets the discount factor for liabilities (interest cost) the contributions required, and a valuation of the assets and liabilities of the scheme on an annual basis.
Actuarial assumptions Chapter 6 Section 4.9
3.9
The actuarial assumptions must be: •
unbiased – neither imprudent not excessively conservative.
•
mutually compatible – reflecting relationships between inflation, rates of salary increase and returns on plan assets.
Actuarial gains and losses 3.10 Differences between the actuarial values of the asset and liability and the accounting values are called actuarial gains or losses. They are made up of: •
experience adjustments (the effects of differences between the previous actuarial assumptions and what has actually occurred), and
•
the effects of changes in actuarial assumptions.
3.11 IAS 19 allows a choice of accounting policy regarding recognition of actuarial gains and losses: •
in profit or loss either in the period in which they occur or deferred on a systematic basis
•
directly in retained earnings in the period in which they occur (and shown in the statement of recognised income and expense which becomes compulsory for entities that adopt this policy).
3.12 In the former case, IAS 19 requires (as a minimum) that the following actuarial gains and losses are recognised in profit or loss for the period: Net actuarial gains or losses brought forward outside 10% corridor Average remaining working lives of participating employees
The '10% corridor' limit is defined as the higher of 10% of b/d: (a) (b)
10% b/d present value of benefit obligations 10% b/d fair value of plan assets.
5.8
5: EMPLOYEE BENEFITS
Approach 3.13 The suggested approach to defined benefit schemes is to deal with the change in the obligation and asset in the following order, building up the disclosure notes: Step Item
Recognition
(1)
Record opening figures: • asset • obligation • any unrecognised gains and losses
(2)
Interest cost • Based on discount rate and PV obligation at start of period. • Should also reflect any changes in obligation during period, e.g. past service cost
(3)
Expected return on plan assets • Based on long-term expectations as advised by actuary and asset value at start of period. • Technically, the expected return is also time apportioned on contributions less benefits paid in the period.
(4)
(6)
Contributions
Dr Current service cost (I/S) Cr PV defined benefit obligation (B/S)
• Into the plan by the company • As advised by actuary.
Dr Plan assets (B/S) Cr Company cash
Benefits
Dr PV defined benefit obligation (B/S) Cr Plan assets (B/S)
• Actual pension payments made. (7)
Dr Plan assets (B/S) Cr Expected return on plan assets (I/S) (y% x b/d assets)
Current service cost • Increase in the present value of the obligation resulting from employee service in the current period.
(5)
Dr Interest cost (I/S) (x% x b/d obligation) Cr PV defined benefit obligation (B/S)
Past service cost • Increase in PV obligation as a result of the introduction or improvement of benefits. • Past service cost is vested when any minimum employment period has been completed.
5.9
Vested benefits: Dr Past service cost (I/S) Cr PV defined benefit obligation (B/S) Non-vested benefits: Dr Unrecognised past service cost (B/S) Cr PV defined benefit obligation (B/S) The unrecognised past service cost is amortised through profit or loss on a straight line basis over the average period until the minimum employment period is completed.
5: EMPLOYEE BENEFITS Step Item
Recognition
(8)
(a) (only If using corridor approach): recognise unrecognised gains/losses b/d outside 10% corridor in profit or loss over average remaining working lives of employees.
Actuarial gains and losses • Arising from annual valuations of obligation and assets. • On obligation, differences between actuarial assumptions and actual experience during the period, or changes in actuarial assumptions. • On assets, differences between expected and actual return.
(9)
Disclose in accordance with the Standard
(b) Calculate carried down actuarial gains/losses from balance sheet workings. Recognise in: – unrecognised gains/losses, or – profit or loss directly, or – retained earnings directly according to accounting policy. See Lecture example 2.
Lecture example 2
Exam standard for 20 marks
Lewis Co has a defined benefit plan for its employees. The present value of the future benefit obligations at 1 January 20X7 was $890m and fair value of the plan assets was $1,000 million. There were unrecognised actuarial gains of $120m at the same date (Lewis Co's accounting policy is to use the 10% corridor approach to recognition of actuarial gains and losses). Further data concerning the year ended 31 December 20X7 is as follows: $millions 127 150 104
Current service cost Benefits paid to former employees Contributions paid to plan Present value of benefit obligations at 31 December
1,100
Fair value of plan assets at 31 December
1,230
Interest cost (gross yield on 'blue chip' corporate bonds) Expected return on plan assets
As valued by professional actuaries
10% 12%
Existing employees participating in the plan have an average remaining working life of 10 years. This tends to remain static as employees leave and join the plan. On 1 January 20X7 the plan was amended to provide additional benefits with effect from that date subject to a minimum employment period of eight years. The present value of the additional benefits was calculated by actuaries at $10 million with respect to employees who had already completed the minimum service requirements and $20 million for employees who on average had worked for the company for three years.
5.10
5: EMPLOYEE BENEFITS Required Prepare the required notes to the income statement and balance sheet for the year ended 31 December 20X7. Assume the contributions and benefits were paid on 31 December 20X7.
Solution Income statement note Defined benefit expense recognised in profit or loss $m Current service cost Interest cost Expected return on plan assets Past service cost - vested benefits - non-vested benefits Net actuarial (gain)/loss recognised in year (Working) Balance sheet notes Net defined benefit liability recognised in the balance sheet $m Present value of defined benefit obligation Fair value of plan assets Unrecognised actuarial gains/(losses) (Working) Unrecognised past service cost Net liability Changes in the present value of the defined benefit obligation $m Opening defined benefit obligation
Closing defined benefit obligation
5.11
5: EMPLOYEE BENEFITS Changes in the fair value of plan assets $m Opening fair value of plan assets
Closing fair value of plan assets Working Recognised/unrecognised actuarial gains and losses $m
4
Settlements and curtailments
4.1
A settlement occurs when an entity enters into a transaction that eliminates all further legal or constructive obligations for part or all of the benefits provided under a defined benefit plan. Example: a lump-sum cash payment made in exchange for rights to receive postemployment benefits.
4.2
A curtailment occurs when an entity either: (a)
is demonstrably committed to make a material reduction in the number of employees covered by the plan; or
(b)
amends the terms of a defined benefit plan such that a material element of future service by current employees will no longer qualify for benefits, or will qualify only for reduced benefits.
5.12
5: EMPLOYEE BENEFITS Examples:
4.3
•
Discontinuance of an operation, so that employees' services are terminated earlier than expected.
•
A change to the plan rules where future service by current employees will qualify for less benefits.
The gain/loss on a settlement or curtailment is recognised in profit or loss. e.g. Dr PV obligation Cr FV plan assets Cr Unrecognised actuarial losses Cr Cash (for a settlement) Cr Income statement (difference)
X X X X X
With the changes as advised by the actuary
5
The 'Asset ceiling' test
5.1
Amounts recognised as a net pension asset in the balance sheet should not be stated at more than their recoverable amount. Consequently, IAS 19 requires any net pension asset to be measured at the lower of:
Chapter 6 Section 1.6
•
net reported asset, and
•
any cumulative unrecognised net actuarial losses and past service cost + present value of any refunds/reduction of future contributions available from the pension plan
5.2
The amount is charged immediately to profit or loss or to retained earnings depending on the entity's accounting policy for actuarial differences.
5.13
5: EMPLOYEE BENEFITS
6
Chapter summary
6.1 Q5 Radost
Section
Topic
Summary
1
Post-employment benefits
Post-employment benefits are the only type of employee benefit examinable. They are arrangements that provide for pensions on retirement. They can be divided into defined contribution and defined benefit schemes.
2
Defined contribution schemes
Also known as 'money purchase' schemes. The employer accounts for the agreed cost to the company on an accruals basis. The employee bears the risk of the pension's value.
3
Defined benefit schemes
Also known as 'final salary' schemes. The employee guarantees the employee an annual pension based on final salary and number of years worked. The projected unit credit method is used to accrue costs. Actuarial differences arising on differences between the year end value of the assets and liabilities and the book amounts can be accounted for in the income statement or in retained earnings.
4
Settlements and curtailments
The effects of settlements and curtailments are recognised in the income statement.
5
The 'asset ceiling' test
Defined benefit pension assets are limited to the lower of the net reported asset and [unrecognised gains and losses/past service costs + the present value of any refunds/contribution reductions available].
END OF CHAPTER 5.14
Income taxes
Syllabus Guide Detailed Outcomes Having studied this chapter you will be able to: •
Apply and discuss the recognition and measurement of deferred tax liabilities and deferred tax assets including the exceptions to recognition.
•
Determine the recognition of tax expense or income and its inclusion in the financial statements.
Exam Context Deferred tax is an important topic for this paper. It could appear as a 25-mark question in Section B of the paper. Fair value/group adjustments for deferred tax could also appear in Section A although this is less common. Deferred tax is very wide ranging, so a question on the topic could touch on virtually any area of the syllabus where there could be a difference between IFRS and tax accounting. A number of examples appear in this and other chapters (e.g. sharebased payment), but this is an area where past exam question practice is vital.
Qualification Context Deferred tax is also examined in Paper F7 Financial Reporting, however at a lower level. Any area of the syllabus could be examined from a deferred tax angle in this paper.
Business Context Deferred tax is an area which is widely misunderstood, but the idea behind deferred tax adjustments is so that the average investor does not need to worry about them, because they ensure the accruals concept is applied to tax relating to items recorded in the financial statements. This ensures the tax effect of changes in assets and liabilities in a given set of financial statements is recognised in the same period as the changes themselves to give a full picture of the business's activities, i.e. a true and fair view.
6.1
6: INCOME TAXES
Overview Current tax
Income taxes
Deferred tax
Temporary differences
Recognition
Taxable temporary differences
Deductible temporary differences
Measurement
6.2
Unused tax losses and credits
Presentation
6: INCOME TAXES
1
Current tax
1.1
Current tax is the amount of income taxes payable or recoverable in respect of taxable profit or loss for a period.
1.2
Current tax unpaid for current and prior periods should be recognised as a liability. Amounts paid in excess of amounts due are shown as an asset.
1.3
The benefit relating to a tax loss that can be carried back to recover current tax of a previous period should be recognised as an asset.
2
Deferred tax
Issue
Chapter 7 Section 2.3
2.1
The carrying value and tax base of an asset or a liability (i.e. period and manner in which a transaction is recognised in IFRS accounts and tax computation) may be quite different. Where the tax base materially differs to accounting treatment, that tax charge in the income statement may be misleading without some form of adjustment.
3
Temporary differences
3.1
Deferred tax is the tax attributable to temporary differences, which are differences between the carrying amount of an asset or liability in the balance sheet and its tax base. These can be either: (a)
taxable temporary differences – result in taxable amounts in determining taxable profit of future periods when the carrying amount of the asset or liability is recovered or settled; or
(b)
deductible temporary differences – result in amounts that are deductible in determining taxable profit of future periods when the carrying amount of the asset or liability or recovered or settled.
6.3
6: INCOME TAXES
Chapter 7 Sections 3 & 6.1.1
4
Taxable temporary differences
4.1
Taxable temporary differences generate a deferred tax liability in the balance sheet.
Types of taxable temporary difference 4.2
(a)
(b)
(c)
(d)
(e)
Accelerated capital allowances (accelerated tax depreciation) (i)
These recognise deferred tax when the allowances for the cost of a non-current asset are received before deductions for accounting depreciation are recognised in the balance sheet (accelerated capital allowances).
(ii)
The temporary difference is the difference between the carrying value of the asset at the balance sheet date and its tax depreciated value.
Interest revenue (i)
In some jurisdictions interest revenue may be included in the income statement on an accruals basis, but taxed when received.
(ii)
The temporary difference is equivalent to the income accrual at the balance sheet date as the tax base of the interest receivable is nil.
Development costs (i)
Development costs capitalised for accounting purposes in accordance with IAS 38 while being deducted from taxable profit in the period incurred.
(ii)
The temporary difference is equivalent to the amount capitalised at the balance sheet date as the tax base of the costs is nil since they have already been deducted from taxable profits.
Revaluations to fair value (i)
IFRS permits some assets to be revalued to fair value, e.g. property, plant and equipment under IAS 16 and investments in accordance with IAS 39.
(ii)
In some jurisdictions this will affect taxable profit in the current period in which case no temporary difference arises as the tax base is also adjusted.
(iii)
In others, the revaluation does not affect the tax base of the asset and hence a temporary difference occurs which should be provided for in full based on the difference between its carrying value and tax base.
(iv)
A deferred tax liability is created even if the entity does not intend to dispose of the asset as the revalued amount will be recovered through use which will generate taxable income in excess of the depreciation allowable for tax purposes in future periods.
Fair value adjustments on consolidation (i)
IFRS 3/ IAS 28 require assets acquired on acquisition of a subsidiary or associate to be brought in at their fair value rather than book value.
(ii)
In this case a temporary difference arises in the same way as above, but the deferred tax effect is a consolidation adjustment in the same way as the revaluation itself.
6.4
6: INCOME TAXES (f)
Undistributed profits of subsidiaries, branches, associates and joint ventures (i)
Chapter 7 Sections 4 & 6.1.2
Under IAS 12 a deferred tax liability is recognised unless: (1)
the parent, investor or venturer is able to control the timing of the reversal of the temporary difference (e.g. by determining dividend policy); and
(2)
it is probable that the temporary difference will not reverse in the foreseeable future.
5
Deductible temporary differences
5.1
Deductible temporary differences result in a deferred tax asset in the balance sheet.
Types of deductible temporary differences 5.2
(a)
Provisions (i)
(b)
Losses (i)
(c)
(d)
Chapter 7 Sections 3.5-3.6
The provision is recognised for accounting purposes when there is a present obligation, but may not be deductible for tax purposes until the expenditure is incurred. Current losses that can be carried forward to be offset against future taxable profits result in a deferred tax asset (see Section 9).
Fair value adjustments (i)
Liabilities recognised on business combinations result in a deferred tax asset where the expenditure is not deductible for tax purposes until a later period. A deferred tax asset also arises on downward revaluations where the fair value of the identifiable acquired asset is less than its tax base.
(ii)
In both cases the deferred tax asset decreases goodwill.
Unrealised profits on intragroup trading (i)
The profit is not realised from the group point of view until the items transferred are sold outside the group, but where the tax base is based on the cost to the individual receiving company and no equivalent adjustment for unrealised profits is made for tax purposes a temporary difference arises.
(ii)
Deferred tax is provided at the receiving company's tax rate.
6
Recognition
6.1
Under IAS 12 Income Taxes, a deferred tax liability or asset should be recognised for all taxable and deductible temporary differences, unless they arise from: (a)
the initial recognition of goodwill;
(b)
goodwill for which amortisation is not deductible for tax purposes; or
(c)
the initial recognition of an asset or liability in a transaction which (i) (ii)
is not a business combination at the time of the transaction, affects neither accounting profit nor taxable profit.
6.5
6: INCOME TAXES
Lecture example 1
Exam standard for 15 marks
Nyman Co has three 100% owned subsidiaries, Glass Co, Waddesdon Co, and Winsten SA, a foreign subsidiary. (a)
(b)
(c)
The following details relate to Glass Co: (i)
Nyman Co acquired its interest in Glass Co on 1 January 20X3. The fair values of the assets and liabilities acquired were considered to be equal to their carrying values, with the exception of freehold property which was considered to be $1m in excess of its book value. The directors have no intention of selling the property.
(ii)
Glass Co has sold goods at a price of $6 million to Nyman since acquisition and made a profit of $2 million on the transaction. The inventories of these goods recorded in Nyman's balance sheet at the year ended 30 September 20X3 was $3.6 million.
Waddesdon Co undertakes various projects from debt factoring to investing in property and commodities. The following details relate to Waddesdon Co for the year ended 30 September 20X3: (i)
Waddesdon has a portfolio of readily marketable government securities which are held as current assets for financial trading purposes. These investments are stated at market value in the balance sheet with any gain or loss taken to profit or loss. These gains and losses are taxed when the investments are sold. Currently the accumulated unrealised gains are $8 million.
(ii)
Waddeson has calculated it requires a general allowance of $2 million against its total loan portfolio. Tax relief is available when the specific loan is written off.
Winsten SA has unremitted earnings of €20 million which would give rise to additional tax payable of $2 million if remitted to Nyman's tax regime. Nyman intends to leave the earnings within Winsten for reinvestment.
Current tax is calculated based on the individual company's financial statements (adjusted for tax purposes) in the tax regime in which Nyman operates. Assume an income tax rate of 30% for Nyman and 25% for its subsidiaries. Required What are the deferred tax implications of the above information for the Nyman group of companies?
Solution
6.6
6: INCOME TAXES
7
Measurement
7.1
Deferred tax assets and liabilities are measured at the tax rates expected to apply to the period when the asset is realised or liability settled, based on tax rates (and tax laws) that have been enacted (or substantively enacted) by the balance sheet date.
7.2
Deferred tax assets and liabilities cannot be discounted.
7.3
Deferred tax assets are only recognised to the extent that it is probable that taxable profit will be available against which the deductible temporary difference can be utilised.
8
Presentation
8.1
Deferred tax assets and liabilities can only be offset if: (a)
the entity has a legally enforceable right to set off current tax assets against current tax liabilities; and
(b)
the deferred tax assets and liabilities relate to income taxes levied by the same taxation authority.
6.7
6: INCOME TAXES
9
Unused tax losses and unused tax credits
9.1
A deferred tax asset should be recognised for the carryforward of unused tax losses or credits to the extent that it is probable that future taxable profit will be available against which the unused tax losses and credits can be used.
9.2
Factors to consider include whether: (a)
the entity has sufficient taxable temporary differences which will result in taxable amounts against which the losses/credits can be used;
(b)
it is probable that the entity will have taxable profits before the losses/credits expire;
(c)
the unused tax losses result from identifiable causes which are unlikely to recur;
(d)
tax planning opportunities are available which will create taxable profits against which the losses/ credits can be used.
Lecture example 2
Technique demonstration
Barcino Co made tax losses of $230,000 in the year ended 31 December 20X1. Local tax rules state that losses can be carried forward for two calendar years to reduce future tax bills before they expire. Barcino recognised a deferred tax asset at 30% in 20X1 on the grounds that it was probable that the company would make sufficient taxable profits before the tax losses expired, and continued to hold this expectation at the 20X2 year end. No corporate income tax was payable in 20X1. In the accounting regime in which Barcino operates, taxable profits are measured based on profit before tax adjusted for disallowables. Results for the three years ended 31 December 20X3 were:
(Loss)/profit before tax Disallowable expenses Taxable (loss)/profit
20X1 $
20X2 $
20X3 $
(234,000) 4,000 (230,000)
47,000 3,000 50,000
135,500 4,500 140,000
Required Show relevant extracts from the financial statements of Barcino Co illustrating the effects of the tax losses over the three years ended 31 December 20X3. Notes to the financial statements are not required. Income tax rates of 30% apply throughout the three periods. There were no other temporary differences.
6.8
6: INCOME TAXES
Solution Income statement (extract)
20X1 $
20X2 $
20X3 $
20X1 $
20X2 $
20X3 $
(Loss)/profit before tax Current tax Deferred tax – origination/(reversal) of temporary differences – impairment of deferred tax asset (Loss)/profit for the period Balance sheet (extract)
Deferred tax asset
6.9
6: INCOME TAXES
10 Chapter summary 10.1 Q6 DT Group
Section
Topic
Summary
1
Current tax
Current tax is the tax charged by the tax authority. Unpaid amounts are shown as a liability. Any tax losses that can be carried back are shown as an asset.
2
Deferred tax
Deferred tax is the tax attributable to temporary differences, i.e. temporary differences in timing of recognition of income and expense between IFRS accounting and tax calculations.
3
Temporary differences Temporary differences are used to measure deferred tax from a balance sheet angle (consistent with the Framework). They are measured as the difference between the accounting carrying value of an asset or liability and its tax base (i.e. tax value).
4
Taxable temporary differences
Taxable temporary differences arise where the accounting carrying value exceeds the tax base. They result in deferred tax liabilities, representing the fact that current tax that will not be charged until the future, and so an accrual is made.
5
Deductible temporary differences
Deductible temporary differences arise when the accounting carrying value is less than the tax base. They result in deferred tax assets, representing the fact that the tax authorities will only give a tax deduction in the future (e.g. when a provision is paid). A deferred tax credit reduces the tax charge as the item has already been deducted for accounting purposes.
6
Recognition
Deferred tax is provided for under IAS 12 for all temporary differences (with limited exceptions).
7
Measurement
Deferred tax is measured at the tax rates expected to apply when the asset is realised or liability settled (based on rates enacted/substantively enacted by the balance sheet date).
8
Presentation
Deferred tax assets and liabilities are shown separately from each other (consistent with the IAS 1 'no offset' principle) unless the entity has a legally enforceable right to offset current tax assets and liabilities and the deferred tax assets and liabilities relate to the same taxation authority.
9
Unused tax losses A deferred tax asset is created for unused tax losses and and unused tax credits credits, providing it is probable that there will be future taxable profit against which they can be used.
END OF CHAPTER 6.10
Financial instruments
Syllabus Guide Detailed Outcomes Having studied this chapter you will be able to: •
Apply and discuss the recognition and derecognition of financial assets and financial liabilities.
•
Apply and discuss the classification of financial assets and financial liabilities and their measurement.
•
Apply and discuss the treatment of gains and losses arising on financial assets and financial liabilities.
•
Apply and discuss the treatment of impairments of financial assets.
•
Account for derivative financial instruments, and simple embedded derivatives.
•
Outline the principles of hedge accounting and account for fair value hedges and cash flow hedges including hedge effectiveness.
Exam Context Financial instruments is a a topic that could appear anywhere in the paper, and often more than once in any given paper. It could be an adjustment in the consolidation Q1 or appear as part or a full question in Section B. It is also still very much a current issue, which could be tested from an essay angle, e.g. about the increased use of fair values in financial reporting, in the final question on the paper.
Qualification Context Financial instruments are tested at an introductory level in Paper F7 Financial Reporting. Financial instrument valuation and risk management is included in the optional professional level paper P4 Advanced Financial Measurement syllabus.
Business Context Financial instruments are becoming increasingly common business transactions. In fact, all companies have financial instruments on their balance sheets given that receivables and cash are themselves financial instruments. At any point in time there are trillions of dollars of outstanding derivative financial instruments in the financial markets. Prior to the advent to IAS 39, many of these were off balance sheet until the gain or loss became a cash flow. The financial instruments standards enable the user of the financial statements to recognise the existence of financial instruments that could impact on future profits and liquidity and be aware of their risks.
7.1
7: FINANCIAL INSTRUMENTS
Overview
Financial assets
Financial liabilities
Derecognition (IAS 39)
Classification (IAS 32)
Recognition (IAS 39)
Financial instruments
Standards
Initial measurement
Measurement (IAS 39)
Subsequent measurement
Hedging (IAS 39)
Financial assets Impairment (IAS 39)
Embedded derivatives
7.2
Financial liabilities
7: FINANCIAL INSTRUMENTS
1
Standards
1.1
The dynamic nature of international financial markets has resulted in the widespread use of a variety of financial instruments. Prior to the issue of IAS 32, many financial instruments were 'off-balance-sheet', being neither recognised nor disclosed in the financial statements while still exposing the shareholders to significant risks.
1.2
The project to create a set of Standards for financial instruments was tackled in phases, followed by revisions by the IASB, resulting in three separate Standards: Accounting for financial instruments
IAS 32 Presentation (first issued 1995)
IAS 39 Recognition and Measurement (first issued 1998)
IFRS 7 Disclosures (first issued 2005)
1.3
The IASB has recently revised these Standards in order to improve them and make them easier to apply and plans further revisions in the future.
1.4
The examiner has confirmed that he will not test the disclosures of IFRS 7 and so they are not summarised in this chapter.
2
Classification (IAS 32)
2.1
In order to decide on whether a transaction is a financial instrument (and how to classify it if it is a financial instrument) it is important to have a good understanding of the instruments as defined by IAS 32: Financial instruments
Financial assets
Financial liabilities
Equity instruments
Compound instruments 7.3
7: FINANCIAL INSTRUMENTS
Definitions (simplified to Paper P2 level) 2.2
(a)
Financial instrument. Any contract that gives rise to both a financial asset of one entity and a financial liability or equity instrument of another entity.
(b)
Financial asset. Any asset that is: (i)
cash;
(ii)
an equity instrument of another entity;
(iii)
a contractual right: (1)
to receive cash or another financial asset from another entity; or
(2)
to exchange financial assets or financial liabilities with another entity under conditions that are potentially favourable to the entity.
Examples: • • • (c)
trade receivables; options; shares (as an investment).
Financial liability. Any liability that is: A contractual obligation: (i)
to deliver cash or another financial asset to another entity; or
(ii)
to exchange financial assets or financial liabilities with another entity under conditions that are potentially unfavourable to the entity.
Examples: • • • • (d)
trade payables; debenture loans (payable); mandatorily redeemable preference shares; forward contracts standing at a loss.
Equity instrument. Any contract that evidences a residual interest in the assets of an entity after deducting all of its liabilities. Examples: • • •
own ordinary shares; warrants; non-cumulative irredeemable preference shares.
7.4
7: FINANCIAL INSTRUMENTS
Compound instruments 2.3
Where a financial instrument contains some characteristics of equity and some of financial liability then its separate components need to be classified separately. Method: 1
Determine the carrying value of the liability component (by measuring the fair value of a similar liability that does not have an associated equity component);
2
Assign the residual amount to the equity component.
Lecture example 1
Revision question
Compound instruments and amortised cost Karaiskos SA issues 1,000 convertible bonds on 1 January 20X1 at par. The bond is redeemable in three years' time at its par value of $2,000 per bond. The bonds pay interest annually in arrears at an interest rate (based on nominal value) of 6%. Each bond can be converted at the maturity date into 125 $1 shares. The prevailing market interest rate for three-year bonds that have no right of conversion is 9% Required (a) (b)
Show the presentation of the compound instrument in the financial statements at inception. Show the presentation of the compound instrument at the period end, 31 December 20X1.
3-year discount factors: 6% 9%
Simple
Cumulative
0.840 0.772
2.673 2.531
Solution (a)
1 January 20X1
$ Non-current liabilities
Financial liability component of convertible bond (Working) Equity component of convertible bond
Equity
Working Fair value of equivalent non-convertible debt Present value of principal Present value of interest annuity
7.5
7: FINANCIAL INSTRUMENTS (b)
31 December 20X1
$ Non-current liabilities
Financial liability component of convertible bond Equity component of convertible bond
Equity
Working
3
Recognition (IAS 39)
3.1
IAS 39 states that financial instruments should be recognised on the balance sheet when the entity becomes a party to the contractual provisions of the instrument. Derivatives (e.g. a forward contract) are therefore recognised in the financial statements at inception even though there may have been no cash flow, and disclosures about them are made in accordance with IFRS 7.
3.2
The recognition criteria in IAS 39 differ from those in the Framework which states that items should be recognised when there is a probable inflow or outflow of resources and the item has a cost or value that can be measured reliably.
7.6
7: FINANCIAL INSTRUMENTS
Lecture example 2
Exam standard for 6 marks
Required Would the following be recognised under IAS 39? (a)
A guarantee to replace or repair goods sold by a business in the normal course of business
(b)
A firm commitment (order) to purchase a specific quantity of cocoa beans
(c)
A forward contract to purchase cocoa beans at a specified price and quantity on a specified date
Solution
4
Derecognition (IAS 39)
4.1
Derecognition happens: Financial assets:
–
when the contractual rights to the cash flows expire (e.g. because a customer has paid their debt or an option has expired worthless); or
–
the financial asset is transferred (e.g. sold), based on whether the entity has transferred substantially all the risks and rewards of ownership of the financial asset.
Chapter 8 Section 3.4
Financial liabilities: –
when the obligation is discharged (e.g. paid off), cancelled or expires.
Where a part of a financial instrument (or group of similar financial instruments) meets the criteria above, that part should be derecognised.
7.7
7: FINANCIAL INSTRUMENTS
Lecture example 3
Exam standard for 8 marks
Required Discuss whether the following financial instruments would be derecognised. (a)
AB Co sells an investment in shares, but retains a call option to repurchase those shares at any time at a price equal to their current market value at the date of repurchase.
(b)
CD Co sells an investment in shares and enters into a 'total return swap' with the buyer. Under a 'total return swap' arrangement, the buyer returns any increases in value to the seller, and the seller compensates the buyer for any decrease in value plus interest.
(c)
EF Co enters into a stocklending agreement where an investment is lent to a third party for a fixed period of time for a fee.
(d)
GH Co sells title to some of its receivables to a debt factor for an immediate cash payment of 90% of their value. The terms of the agreement are that GH Co has to compensate the factor for any amounts not recovered by the factor after six months.
Solution
7.8
7: FINANCIAL INSTRUMENTS
5
Measurement (IAS 39)
Initial measurement 5.1
Financial instruments are initially measured at: Fair value (normally the transaction price) +/– any transaction costs (for financial assets/ liabilities not held at fair value through profit or loss).
Subsequent measurement – financial assets 5.2
For the purposes of subsequent measurement, financial assets are divided into four categories by IAS 39:
* Interest/dividend income and changes in value due to exchange rates continue to be recognised in profit or loss in accordance with IAS 18/ IAS 21. Notes on category definitions (IAS 39 para 9) 5.3
Financial assets held to maturity: •
Chapter 8 Sections 4.2 & 4.4
Non-derivative financial assets with fixed/ determinable payments and fixed maturity that an entity has the positive intention and ability to hold to maturity eg. debentures in another company that the entity intends to hold until redemption.
Loans and receivables: •
Includes trade receivables and loans the entity itself has entered into or made to third parties. Also includes unquoted purchased receivables not 'held for trading' (see below).
7.9
7: FINANCIAL INSTRUMENTS Financial assets at fair value through profit or loss: •
'Held for trading' includes assets acquired for the purpose of selling in the near term, e.g. with the intention of taking profit from short term market fluctuations, and all derivatives that are not accounted for as hedging instruments.
•
Groups of financial assets (or of financial liabilities or both) must be both managed and their performance evaluated on a fair value basis in accordance with a documented risk management or investment strategy, with information provided internally to key management personnel.
Available-for-sale financial assets: •
Includes assets that the entity classes as being 'available-for-sale' (and therefore fair value gains/losses are held over in reserves until the asset is sold or impaired when they are recognised in the income statement) or any financial asset that does not fall into the other categories, e.g. shares held as an investment.
Subsequent measurement – financial liabilities 5.4
Notes on category definitions (IAS 39 para 9) 5.5
Financial liabilities at amortised cost: •
Financial liabilities that do not fall into the –'fair value through profit or loss' category are held at amortised cost.
Financial liabilities at fair value through profit or loss: •
Follows the same principles as financial assets in this category, i.e. they are 'held for trading'/ are derivatives or groups of financial liabilities (or of both financial assets and financial liabilities).
7.10
7: FINANCIAL INSTRUMENTS
Amortised cost 5.6
Amortised cost of a debt instrument is the amount at which the debt was initially recorded, less any principal repayments, plus the cumulative amortisation of the difference between the initial and maturity values. The difference is amortised using the effective interest rate of the debt instrument, i.e. the internal rate of return of the debt. It includes both nominal interest payments and any discounts on the debt on inception.
Calculation of fair value 5.7
Fair value is measured in the following order depending on information available: (1)
Quoted market price in an active market (where possible)
(2)
Most recent transaction price (where current prices unavailable/ market is not an active one) providing there has been no significant change in economic circumstances
(3)
Current fair value of similar instruments or those that are substantially the same
(4)
Discounted cash flow analysis or option pricing models.
5.8
Transaction costs to be incurred on sale/disposal are excluded – this is consistent with the treatment of property, plant and equipment and investment properties. Where a spread exists in market price, bid price should be used.
5.9
Investments in equity instruments that do not have a quoted price in an active market and whose fair value cannot be reliably measured are measured at cost.
Lecture example 4
Preparation question
Effect of fair value measurement Lulworth Co purchased a two year $20 million 6% debenture at par on 1 January 20X1 when the market rate of interest was 6%. Interest is paid annually on 31 December. The market rate of interest on debentures of equivalent term and risk changed to 7% on 31 December 20X1. Required Show the charge or credit to the income statements for the two years to 31 December 20X2 if the debentures are held: (a) (b) (c)
at amortised cost at fair value through profit or loss at fair value as an available-for-sale financial asset.
Fair value is to be calculated using discounted cash flow techniques.
7.11
7: FINANCIAL INSTRUMENTS
Solution (a) Amortised cost
(b) FV through P/L
20X1 $'000
20X1 $'000
Income statement Interest income Gain/(loss) due to change in fair value
Balance sheet Financial asset Reserves Gain/(loss) due to change in fair value Workings
7.12
20X2 $'000
20X2 $'000
(c) AFSFA 20X1 $'000
20X2 $'000
7: FINANCIAL INSTRUMENTS
Lecture example 5
Exam standard for 3 marks for each item
Greentree Co had the following financial instrument transactions affecting the year ended 31 December 20X2: (1)
Purchased 4% debentures in MT Co on 1 January 20X2 (their issue date) for $100,000 as an investment. Greentree intends to hold them until their redemption after six years at a premium of 17%. Transaction costs of $2,000 were incurred on purchase. The internal rate of return of the bond is 6.0%.
(2)
Entered into a speculative interest rate option costing $7,000 on 1 September 20X2 to borrow $5,000,000 from GF Bank commencing 31 March 20X3 for six months at 5.5%. Value of the option at 31 December 20X2 was $13,750.
(3)
Purchased 25,000 shares in EG Co in 20X1 for $2.00 each as an investment. Transaction costs on purchase or sale are 1% purchase/sale price. The share price on 31 December 20X1 was $2.25 – $2.28. Greentree sold the shares on 20 December 20X2 for $2.62 each.
(4)
Sold some shares in BW Co ‘short' (i.e. sold shares that were not yet owned) on 22 December 20X2 for $24,000 (the market price of the shares on that date) to be delivered on 10 January 20X3. The market price of the shares at 31 December 20X2 was $28,000.
Required Show the accounting treatment and relevant extracts from the financial statements for the year ended 31 December 20X2.
Solution Balance sheet extracts $ Financial assets: 4% debentures in MT Co (W1) Interest rate option (W2) Shares in EG Co (W3) Financial liabilities: Shares in BW Co sold ‘short' (W4) Income statement extracts $ Finance income: Effective interest on 4% debentures in MT Co (W1) Gain on interest rate option (W2) Gain on sale of shares in EG Co (W3) In the period Recycled from reserves
7.13
7: FINANCIAL INSTRUMENTS $ Finance costs: Loss on shares in BW Co sold ‘short' (W4) Workings
7.14
7: FINANCIAL INSTRUMENTS
Chapter 8 Section 1.3
6
Embedded derivatives
6.1
(a)
Some contracts (that may or may not be financial instruments themselves) may have derivatives embedded in them.
(b)
For example, an entity may issue a bond which is redeemable in five years' time with part of the redemption price being based on the increase in the FTSE 100 index.
(c)
'Host' contract
Bond
Embedded derivative
Option on equities
Accounted for as normal
Treat as derivative, i.e. remeasured to FV with changes recognised in I/S
IAS 39 requires that an embedded derivative be separated from its host contract and accounted for as a derivative when: (i)
the economic characteristics and risks of the embedded derivative are not closely related to the economic characteristics and risks of the host contract;
(ii)
a separate instrument with the same terms as the embedded derivative would meet the definition of a derivative; and
(iii)
the hybrid (combined) instrument is not measured at fair value with changes in fair value recognised in the profit or loss (a derivative embedded in a financial asset or financial liability need not be separated out if the entity holds the combined instrument at fair value through profit or loss).
7.15
7: FINANCIAL INSTRUMENTS
7.16
7: FINANCIAL INSTRUMENTS
Additional Notes
7.17
7: FINANCIAL INSTRUMENTS
7
Impairment of financial assets (IAS 39)
7.1
Where there is evidence of a financial asset being impaired then an impairment review must be undertaken. Examples of indications of impairment include: • • • •
financial difficulty of issuer breach of contract in repayments granting a concession to a borrower not normally given high probability of bankruptcy of borrower.
Loans and receivables and held-to-maturity investments 7.2
7.3
The impairment loss is calculated as the difference between: •
the asset's carrying value; and
•
the present value of future expected cash flows discounted using the asset's original effective interest rate.
The impairment loss is reported in profit or loss. The carrying amount of the asset is either reduced directly or through the use of an allowance account.
Available-for-sale financial assets 7.4
Where an available-for-sale financial asset suffers an impairment loss, the loss is charged first against any cumulative gains on fair value adjustments previously recognised in equity, and then to the income statement. If there are cumulative losses held in equity, they are recycled in the income statement in addition to the impairment loss.
Reversals 7.5
Where subsequent evidence shows part or all of an impairment loss to be unnecessary, the reversal is reported in profit or loss (except for equity instruments classified as availablefor-sale where it is reported in equity until disposal).
Lecture example 6
Exam standard for 4 marks
The company issuing the 4% debentures in Lecture example 5 gets into financial trouble at the end of the first year (31.12.X2 – all interest has been paid up to this date). On this date the liquidator of the company that issued the bond informs you that no further interest will be paid and only 75% of the maturity value will be repaid, on the original repayment date. The market interest rate on similar bonds is 7% on that date. Required How much is the impairment and how should it be reported in the financial statements?
7.18
7: FINANCIAL INSTRUMENTS
Solution
8
Hedging (IAS 39)
8.1
Companies enter into hedging transactions in order to reduce business risk. Where an item in the balance sheet or future cash flow is subject to potential fluctuations in value that could be detrimental to the business, a hedging transaction may be entered into. The aim is that where the item hedged makes a financial loss, the hedging instrument would make a gain and vice versa, reducing overall risk.
8.2
Adopting the hedge accounting provisions of IAS 39 is mandatory where a transaction qualifies as a hedge. To qualify the relationship needs to show:
Chapter 8 Section 5
(a)
It was designated at its inception as a hedge with full documentation of how this hedge fits into the company's strategy.
(b)
The hedge has been and is expected to be 'highly effective' (i.e. the ratio of the gain or loss on the hedging instrument compared to the loss or gain on item being hedged is within the ratio 80% to 125%).
(c)
The hedge effectiveness can be reliably measured.
Types of hedges 8.3
IAS 39 identifies different types of hedges which determines their accounting treatment. The hedges examinable are: • •
fair value hedges; and cash flow hedges.
Fair value hedges 8.4
These hedge the change in value of a recognised asset or liability (or unrecognised firm commitment) that could affect profit or loss, e.g. hedging the fair value of fixed rate debentures due to changes in interest rates. All gains and losses on both the hedged item and hedging instrument are recognised immediately in profit or loss. The gain or loss on the hedged item adjusts the carrying value of hedged item.
7.19
7: FINANCIAL INSTRUMENTS Cash flow hedges 8.5
These hedge the risk of change in value of future cash flows from a recognised asset or liability (or highly probable forecast transaction) that could affect profit or loss, e.g. hedging a variable rate interest income stream. The hedge is accounted for as follows: (a)
The gain or loss on the effective portion of the hedge (i.e. up to the value of the loss or gain on cash flow hedged) is recognised in reserves and transferred to the income statement when the hedged item is recognised in the income statement (e.g. by depreciation or sale).
(b)
Any excess is recognised immediately in profit or loss.
Lecture example 7
Exam standard for 6 marks
Bruntal is a manufacturer and retailer of gold jewellery. On 1 October 20X1, the cost of Bruntal's inventories of finished jewellery was $8.280 million with a gold content of 24,000 troy ounces. At that date their sales value was $9.938 million. The selling price of gold jewellery is heavily dependent on the current market price of gold (plus a standard percentage for design and production costs). Bruntal's management wished to reduce their business risk of fluctuations in future cash inflow from sale of the jewellery by hedging the value of the gold content of the jewellery. In the past this has proved to be an effective strategy. Therefore it sold futures contracts for 24,000 troy ounces of gold at $388 per troy ounce at 1 October 20X1. The contracts mature on 30 September 20X2. The jewellery was sold for $9.186m on 30 September 20X2 when the spot price of gold per troy ounce was $352. Required Discuss how the above transaction would be treated in the financial statements for the year ended 30 September 20X2.
7.20
7: FINANCIAL INSTRUMENTS
Solution
7.21
7: FINANCIAL INSTRUMENTS
9
Chapter summary
9.1 Q7 PQR Q8 Hedging
Section
Topic
Summary
1
Standards
Three standards: IAS 32: Presentation IAS 39: Recognition & Measurement IFRS 7: Disclosures
2
Classification (IAS 32)
Financial instruments are classified as debt or equity or divided into their component parts.
3
Recognition (IAS 39)
Financial instruments are recognised on the balance sheet when the entity becomes a party to the contractual provisions of the instrument.
4
Derecognition (IAS 39)
Financial assets are derecognised when the rights to the cash flow expire or are transferred (considering the risks and rewards of ownership). Financial liabilities are derecognised when the obligation is discharged, cancelled or expires.
5
Measurement (IAS 39)
Financial instruments are initially measured at fair value. Subsequent measurement is at amortised cost or fair value depending on the instrument's classification.
6
Embedded derivatives
Embedded derivatives are divided into their component parts unless certain criteria are met.
7
Impairment of financial assets (IAS 39)
Financial assets are written down to their recoverable amount where there is evidence of impairment. The recoverable amount of a debt instrument held at amortised cost is calculated by discounting the revised expected cash flows by the asset's original effective interest rate. The impairment loss is charged to the income statement (except for available for sale financial assets where there are special rules).
8
Hedging (IAS 39)
There are two examinable types of hedge: – Fair value hedge – Cash flow hedge Each has different accounting rules.
END OF CHAPTER 7.22
Share-based payment
Syllabus Guide Detailed Outcomes Having studied this chapter you will be able to: •
Apply and discuss the recognition and measurement criteria for share-based payment transactions.
•
Account for modifications, cancellations and settlements of share-based payment transactions.
Exam Context Share-based payment seems to be a favourite topic of the examiner and could appear as a 25-mark Section B question. More often, however, it appears as part of a multi-part question or in a scenario question, such as a deferred tax question.
Qualification Context Accounting for share-based payment is only tested in ACCA Paper P2. However, valuation of share options (share option pricing theory) is part of the syllabus of optional Paper P4 Advanced Financial Management.
Business Context IFRS 2 is a very controversial Standard. Prior to its existence, a cost was not recognised in the financial statements for many share-based payment transactions, and, where it was, it was recognised at the exercise, rather than over the vesting period of the options. Consequently, the Standard has been unpopular with businesses due to its negative impact on profits. The IASB issued a Discussion Paper twice before an Exposure Draft and then finally, a much simplified final Standard emerged.
8.1
8: SHARE-BASED PAYMENT
Overview Types of share-based payment
Vesting conditions
Recognition
Share-based payment Measurement Deferred tax implications
Modifications, cancellations settlements
Equity-settled
Cash-settled
8.2
Equity + cash alternative
8: SHARE-BASED PAYMENT
1
Types of share-based payment
Introduction 1.1
Chapter 15 Section 2.1
The use of share-based payment has increased in recent years. Until the issue of this Standard there was no IFRS on this topic, other than disclosures formerly required for 'equity compensation benefits' under IAS 19. Improvements in accounting treatment were called for. In particular, the omission of expenses arising from share-based payment transactions with employees was believed to cause economic distortions and corporate governance concerns.
Types of transaction 1.2
IFRS 2 applies to all share-based payment transactions: (a)
Equity-settled share-based payment The entity receives goods or services as consideration for equity instruments of the entity (including shares or share options)
(b)
Cash-settled share-based payment The entity acquires goods or services by incurring liabilities to the supplier of those goods or services for amounts that are based on the price (or value) of the entity's shares or other equity instruments
(c)
Transactions with a choice of settlement The entity receives or acquires goods or services and the terms of the arrangement provide either the entity or the supplier with a choice of whether the entity settles the transaction in cash or by issuing equity instruments.
2
Recognition
2.1
Dr
Expense Cr Cr
2.2
Equity (if equity-settled) Liability (if cash-settled).
Where performance by the counterparty is not immediate the expense is spread over the period until the counterparty becomes entitled to receive the share-based payment (the 'vesting' period). E.g: Employee services where a minimum period of service must be completed before entitlement to the share-based payment.
8.3
8: SHARE-BASED PAYMENT
3
Measurement
3.1
The entity measures the expense using the method that provides the most reliable information: (a)
Direct method Use the fair value of goods or services received.
(b)
Indirect method (often for employee services) By reference to the fair value of the equity instruments (e.g. options or share appreciation rights) granted: Equity-settled ⇒ use fair value at grant date and do not update for subsequent changes Cash-settled ⇒ update the fair value at each year end (changes recognised in profit or loss).
3.2
Any changes in estimates of expected number of employees being entitled to receive sharebased payment is treated as a change in accounting estimate and recognised in the period of the change.
Estimating the fair value of equity instruments granted 3.3
(a)
Shares – market price as at the grant date
(b)
Share options – market prices are usually not available for share options granted to employees – so fair value must be estimated using an option pricing model.
Risk free rate
Share price
Exercise price
Volatility
Option pricing model
Option valuation
8.4
Dividends
Option life
8: SHARE-BASED PAYMENT
Equity-settled share-based payment
Lecture example 1
(Each part) exam standard for 2 marks
An entity grants 100 share options on its $1 shares to each of its 500 employees on 1 January 20X5. Each grant is conditional upon the employee working for the entity over the next three years. The fair value of each share option as at 1 January 20X5 is $15. On the basis of a weighted average probability, the entity estimates on 1 January that 20% of employees will leave during the three-year period and therefore forfeit their rights to share options. Required Show the accounting entries which will be required over the three-year period in the event of the following: –
20 employees leave during 20X5 and the estimate of total employee departures over the three-year period is revised to 15% (75 employees)
–
22 employees leave during 20X6 and the estimate of total employee departures over the three-year period is revised to 12% (60 employees)
–
15 employees leave during 20X7, so a total of 57 employees left and forfeited their rights to share options. A total of 44,300 share options (443 employees x 100 options) are vested at the end of 20X7.
Solution
8.5
8: SHARE-BASED PAYMENT
Cash-settled share-based payment 3.4
(a)
This could arise where a company grants share appreciation rights to employees as part of their pay package. The employees will become entitled to a future cash payment based on the increase in the entity's share price from a specified level over a specified period of time.
(b)
The company must recognise the services received and the related liability as the services are rendered. The liability must be recognised at fair value using an option pricing model, with all changes in fair value being recognised in the income statement up to the date of settlement.
Lecture example 2
Exam standard for 4 marks
On 1 January 20X4 an entity grants 100 cash share appreciation rights (SARs) to each of its 500 employees on condition that the employees remain in its employ for the next two years. The SARs vest on 31 December 20X5 and may be exercised at any time up to 31 December 20X6. The fair value of each SAR at the grant date is $7.40. No. of employees exercising Outstanding Leavers rights SARs
Estimated further leavers
Intrinsic value* (i.e. cash paid) $
31 December 20X4
50
–
450
60
Fair value of SARs $ 8.00
31 December 20X5
50
100
300
–
8.50
8.10
31 December 20X6
–
300
–
–
–
9.00
Year ended
* Intrinsic value is the fair value of the shares less the exercise price Required Show the expense and liability which will appear in the financial statement in each of the three years.
Solution
8.6
8: SHARE-BASED PAYMENT
Share-based payment with a choice of settlement Entity has the choice 3.5 Is there a present obligation to settle in cash?
Yes
No
Treat as cash-settled transaction
Treat as equity-settled transaction
Counterparty has the choice 3.6 The entity has issued a compound financial instrument
Debt component
Equity component
As for cash-settled transaction
Measured as the residual fair value at grant date 8.7
8: SHARE-BASED PAYMENT
Lecture example 3
Exam standard for 5 marks
On 30 September 20X3, Saddler granted one of its directors the right to choose either 24,000 shares in Saddler or 20,000 'phantom' shares (a cash payment equal to the value of 20,000 shares) on the settlement date, 30 September 20X4. This right is not conditional on future employment. The company estimates that the fair value of the share alternative is $4·50 per share at 30 September 20X3 (taking into account a condition that they must be held for 2 years). Saddler's market share price was $5.20 per share on 30 September 20X3, and this rose to $5.40 by the date the financial statements were authorised for issue. Required Explain the accounting treatment of the above transaction for the year ended 30 September 20X3.
Solution
8.8
8: SHARE-BASED PAYMENT
4
Deferred tax implications
Issue 4.1
An entity may receive a tax deduction that differs from related cumulative remuneration expense, and may arise in a later accounting period. E.g: an entity recognises an expense for share options granted under IFRS 2, but does not receive a tax deduction until the options are exercised and receives the tax deduction at the share price on the exercise date.
Measurement 4.2
The deferred tax asset temporary difference is measured as: Carrying amount of share-based payment expense
4.3
0
Less: tax base of share-based payment expense (estimated amount tax authorities will permit as a deduction in future periods, based on year end information)
(X)
Temporary difference
(X)
Deferred tax asset at X%
X
If the amount of the tax deduction (or estimated future tax deduction) exceeds the amount of the related cumulative remuneration expense, this indicates that the tax deduction relates also to an equity item. The excess is therefore recognised directly in equity.
Lecture example 4
Exam standard for 4 marks
On 1 January 20X2, an entity granted 5,000 share options to an employee vesting two years later on 31 December 20X3. The fair value of each option measured at the grant date was $3. Tax law in the jurisdiction in which the entity operates allows a tax deduction of the intrinsic value of the options on exercise. The intrinsic value of the share options was $1.20 at 31 December 20X2 and $3.40 at 31 December 20X3 on which date the options were exercised. Assume a tax rate of 30%. Required Show the deferred tax accounting treatment of the above transaction at 31 December 20X2, 31 December 20X3 (before exercise), and on exercise.
8.9
8: SHARE-BASED PAYMENT
Solution
8.10
8: SHARE-BASED PAYMENT
Additional Notes
8.11
8: SHARE-BASED PAYMENT
5
Vesting conditions
Specified period of employee service 5.1
This is the typical scenario covered earlier in the chapter. The share-based payment is recognised over the required period of service.
Performance conditions (other than market conditions) 5.2
There may be performance conditions that must be satisfied before share-based payment vests, such as achieving a specific growth in profit or earnings per share. The amount recognised as share-based payment is based on the best available estimate of the number of equity instruments expected to vest (i.e. expectation of whether the profit target will be met), revised as necessary at each period end.
5.3
A vesting period may vary in length depending on whether a performance condition is satisfied, for example where different growth targets are set for different years, and if the first target is met, the instruments vest at the end of the first year, and if not the next target for the following year comes into play. In such circumstances, the share-based payment equity figure is accrued over the period based on the most likely outcome of which target will be met, revised at each period end.
Market conditions 5.4
Market conditions, such as vesting dependent on achieving a target share price, are not taken into consideration when calculating the number of equity instruments expected to vest. This is because market conditions are already taken into consideration when estimating the fair value of the equity instruments granted. Therefore an entity recognises share-based payment from a counterparty who satisfies all other vesting conditions (e.g. employee service period) irrespective of whether a target share price has been achieved.
8.12
8: SHARE-BASED PAYMENT
Lecture example 5
Exam standard for 6 marks
At the beginning of year 1, Kingsley grants 100 shares each to 500 employees, conditional upon the employees remaining in the entity's employ during the vesting period. The shares will vest at the end of year 1 if the entity's earnings increase by more than 18%; at the end of year 2 if the entity's earnings increase by more than an average of 13% per year over the two-year period; and at the end of year 3 if the entity's earnings increase by more than an average of 10% per year over the three-year period. The shares have a fair value of $30 per share at the start of year 1, which equals the share price at grant date. No dividends are expected to be paid over the three-year period. By the end of year 1, the entity's earnings have increased by 14%, and 30 employees have left. The entity expects that earnings will continue to increase at a similar rate in year 2, and therefore expects that the shares will vest at the end of year 2. The entity expects, on the basis of a weighted average probability, that a further 30 employees will leave during year 2, and therefore expects that 440 employees will vest in 100 shares at the end of year 2. By the end of year 2, the entity's earnings have increased by only 10% and therefore the shares do not vest at the end of year 2. 28 employees have left during the year. The entity expects that a further 25 employees will leave during year 3, and that the entity's earnings will increase by at least 6%, thereby achieving the average of 10% per year. By the end of year 3, 23 employees have left and the entity's earnings had increased by 8%, resulting in an average increase of 10.67% per year. Therefore 419 employees received 100 shares at the end of year 3. Required Show the expense and equity figures which will appear in the financial statements in each of the three years.
Solution
8.13
8: SHARE-BASED PAYMENT
6
Modifications, cancellations and settlements
Examples 6.1
The entity might: (a) (b)
reprice (modify) share options, or cancel or settle the options.
Modifications General rule 6.2
At the date of the modification, the entity must recognise, as a minimum, the services already received measured at the grant date fair value of the equity instruments granted, i.e. the normal IFRS 2 approach is followed up to the date of the modification. Any modifications that increase the total fair value of the share-based payment must be recognised over the remaining vesting period (i.e. as a change in accounting estimate).
6.3
For equity-settled share-based payment, the increase in total fair value is measured as: Fair value of modified equity instruments at the date of modification Less: Fair value of original equity instruments at the date of modification
X (X) X
This ensures that only the differential between the original and modified instrument is measured, rather than any increase in the fair value of the original instruments (which would be inconsistent with the principle of measuring equity-settled share based payment at grant date fair values). Illustrative example: Grant of share options that are subsequently repriced 6.4
Background At the beginning of year 1, an entity grants 100 share options to each of its 500 employees. Each grant is conditional upon the employee remaining in service over the next three years. The entity estimates that the fair value of each option is $15. On the basis of a weighted average probability, the entity estimates that 100 employees will leave during the three-year period and therefore forfeit their rights to the share options. Suppose that 40 employees leave during year 1. Also suppose that by the end of year 1, the entity's share price has dropped, and the entity reprices its share options, and that the repriced share options vest at the end of year 3. The entity estimates that a further 70 employees will leave during years 2 and 3, and hence the total expected employee departures over the three-year vesting period is 110 employees. During year 2 a further 35 employees leave, and the entity estimates that a further 30 employees will leave during year 3, to bring the total expected employee departures over the three-year vesting period to 105 employees. During year 3, a total of 28 employees leave, and hence a total of 103 employees ceased employment during the vesting period. For the remaining 397 employees, the share options vested at the end of year 3. 8.14
8: SHARE-BASED PAYMENT The entity estimates that, at the date of repricing, the fair value of each of the original share options granted (i.e. before taking into account the repricing) is $5 and that the fair value of each repriced share option is $8. Application The incremental value at the date of repricing is $3 per share option ($8 – $5). This amount is recognised over the remaining two years of the vesting period, along with remuneration expense based on the original option value of $15. The amounts recognised in years 1-3 are as follows: Year 1
$ Equity c/d [(500 – 110) × 100 × $15 × 1/3] Dr Expenses Cr Equity
2
$195,000 $195,000
Equity b/d ∴Income statement charge
Equity c/d [(500 – 105) × 100 × (($15 × 2/3) + ($3 × ½))] Dr Expenses Cr Equity 3
195,000 259,250 454,250
$259,250 $259,250
Equity b/d ∴Income statement charge Equity c/d [(500 – 103) × 100 × ($15 + $3)] Dr Expenses Cr Equity
195,000
454,250 260,350 714,600
$260,350 $260,350
Cancellation or settlement during the vesting period 6.5
Early cancellation is treated as an acceleration of vesting, meaning that the full amount that would have been recognised over the remainder of the period is expensed immediately.
6.6
If a payment (i.e. a settlement) is made to the employee on cancellation, it is treated as a deduction from (repurchase of) equity, with any excess over the fair value of equity instruments granted being recognised as an expense. If equity instruments are granted to the employee as a replacement for the cancelled instruments (and specifically identified as a replacement) this is treated as a modification of the original grant (as per 6.2-6.3). Applying this, the incremental fair value is measured as: Fair value of replacement instruments* Less: Net fair value of cancelled instruments
X (X) X
* FV immediately before cancellation less any payments to employee on cancellation
8.15
8: SHARE-BASED PAYMENT
Current developments: Amendment to IFRS 2: Vesting conditions and cancellations ED Overview 6.7
The proposals relate to two issues: (a) (b)
clarification of the term 'vesting conditions', and the treatment of cancellations.
Vesting conditions 6.8
The proposals would clarify that vesting conditions: (a)
include service conditions and performance conditions, and
(b)
exclude other features such as a requirement for employees to make regular contributions into a savings scheme.
Cancellations 6.9
Three types are identified: (a)
Cancellation by the entity (see 6.5)
(b)
Cancellations by the counterparty (e.g. the employee)
(c)
Cancellations by a third party (e.g. a shareholder)
all would be treated in the same way, i.e. as an acceleration of vesting (see 6.5)
Debate 6.10 There has been some debate over whether a cancellation by employees should be treated in the same way as a cancellation by the entity but the ED proposes this treatment for two reasons: (a) (b)
in the interests of international harmonisation, aligning IFRS with US GAAP to avoid potential abuse of the rules.
8.16
8: SHARE-BASED PAYMENT
7
Chapter summary
7.1 Q15 Share-based payment
Section
Topic
Summary
1
Types of share-based payment
Three types:
2
Recognition
Over the vesting period (i.e the period during which the counterparty becomes entitled to receive the payment).
3
Measurement
Based on the expected fair value of the payment, using year-end estimates of instruments expected to vest and fair values of instruments at grant date (equity-settled) and at year end (cash-settled).
4
Deferred tax implications
Since the accounting value of share-based payment is zero (it is expensed), any future tax deductions (e.g. if there is no tax deduction until the share-based payment vests) will generate a deferred tax asset.
5
Vesting conditions
Where there are performance conditions (other than market conditions which are already factored into the fair value of the instrument), an estimate is made of the number of instruments expected to vest, and revised at each year end.
6
Modifications, cancellations and settlements
The fair value of modifications is recognised over the remaining vesting period.
Equity-settled, e.g. share options Cash-settled, e.g. share appreciation rights Choice of settlement, by entity or by counterparty
When a cancellation/settlement occurs, the remaining share-based payment charge is immediately expensed (accelerated recognition).
8.17
8: SHARE-BASED PAYMENT
END OF CHAPTER 8.18
Provisions, contingencies and events after the balance sheet date
Syllabus Guide Detailed Outcomes Having studied this chapter you will be able to: •
Apply and discuss the recognition, derecognition and measurement of provisions, contingent liabilities and contingent assets including environmental provisions.
•
Calculate and discuss restructuring provisions.
•
Apply and discuss the accounting for events after the balance sheet date.
•
Determine and report going concern issues arising after the balance sheet date.
Exam Context As these topics are studied at lower levels, a full question is unlikely. However, these standards are likely to appear in almost every exam for a few marks within Section B scenario questions, and could be examined in more detail as a part of a multi-part question.
Qualification Context Both these topics are studied in Paper F3 Financial Accounting and Paper F7 Financial Reporting.
Business Context Accounting rules govern provisions to attempt to ensure that companies do not manipulate (or smooth) their profits by making unnecessary provisions when profits are higher which are released (unused) later. Disclosure of contingent liabilities and events after the balance sheet date provides an investor with important information he should be aware of in making an investment decision, up to the date the financial statements were authorised for issue.
9.1
9: PROVISIONS, CONTINGENCIES AND EVENTS AFTER THE BALANCE SHEET DATE
Overview Provisions, contingencies and events after the balance sheet date
Current developments
Provisions
Events after the balance sheet date
Contingent liabilities
Contingent assets
Specific types of provision
Future operating losses
Onerous contracts
9.2
Restructuring
9: PROVISIONS, CONTINGENCIES AND EVENTS AFTER THE BALANCE SHEET DATE
1
Provisions
Recognition 1.1
Chapter 9 Section 2.4
A provision is recognised when: (a)
an entity has a present obligation (legal or constructive) as a result of a past event,
(b)
it is probable that an outflow of resources embodying economic benefits will be required to settle the obligation, and
(b)
a reliable estimate can be made of the amount of the obligation.
Measurement of provisions General rule 1.2
The amount recognised should be the best estimate of the expenditure required to settle the present obligation at the balance sheet date.
Allowing for uncertainties 1.3 Chapter 9 Section 2.5.1
(a)
Where the provision being measured involves a large population of items ⇒ use expected values.
(b)
Where a single obligation is being measured ⇒ the individual most likely outcome may be the best estimate.
Discounting of provisions 1.4
Where the time value of money is material, the provision should be discounted. The discount rate should: • •
be a pre-tax rate appropriately reflect the risk associated with the cash flows.
Recognising an asset when creating a provision 1.5
An asset can only be recognised where the present obligation recognised as a provision gives access to future economic benefits (e.g. decommissioning costs could be an IAS 16 component of cost).
1.6
Changes in estimated outflow and discount rate are treated as follows (IFRIC 1): (a)
Assets held under cost model Adjusts carrying value of asset.
(b)
Assets held under revaluation model Increase in provision – first debited against any revaluation surplus re the asset, thereafter to income statement Decrease in provision – credited to revaluation surplus (unless reversing a revaluation deficit recognised in profit or loss).
1.7
The unwinding of the discount is recognised in profit or loss. 9.3
9: PROVISIONS, CONTINGENCIES AND EVENTS AFTER THE BALANCE SHEET DATE
Lecture example 1
Exam standard for 5 marks
A company is awarded a contract to build and operate a nuclear power station on 1 January 20X1. The power station comes into operation on 31 December 20X3 and the operating licence is for 30 years from that date. The construction cost of the power station was $450m. Part of the agreement for the contract was that in addition to building and operating the power station, the company is obliged to dismantle it at the end of its 30-year life and make the site safe for alternative use. At 31 December 20X3, the estimated cost of the obligation was $50m. An appropriate discount rate reflecting market assessments of the time value of money and risks specific to the power station is 8%. Required Explain the treatment of the cost of the Power station and obligation to dismantle it as at 31 December 20X3 and for the year ended 31 December 20X4. Work to the nearest $0.1m.
Solution
9.4
9: PROVISIONS, CONTINGENCIES AND EVENTS AFTER THE BALANCE SHEET DATE
2
Contingent liabilities
Definition 2.1
Contingent liability (IAS 37) A contingent liability is either: (a) a possible obligation arising from past events whose existence will be confirmed only by the occurrence of one or more uncertain future events not wholly within the control of the entity; or (b)
a present obligation that arises from past events but is not recognised because: (i)
it is not probable that an outflow of economic benefit will be required to settle the obligation; or
(ii)
the amount of the obligation cannot be measured with sufficient reliability.
Disclosure 2.2
Contingent liabilities are disclosed unless the possibility of an outflow of economic benefits is remote.
2.3
For each class of contingent liability, an entity should disclose the following: (a) (b) (c) (d)
3
the nature of the contingent liability an estimate of its financial effect an indication of the uncertainties relating to the amount or timing of any outflow the possibility of any reimbursement.
Contingent assets
Definition 3.1
Contingent asset (IAS 37) A contingent asset is a possible asset that arises from past events and whose existence will be confirmed by the occurrence of one or more uncertain future events not wholly within the entity's control.
3.2
A possible asset that arises from past events and whose existence will be confirmed by the occurrence of one or more uncertain future events not wholly within the entity's control.
Treatment 3.3
Disclose where an inflow of economic benefits is probable.
9.5
9: PROVISIONS, CONTINGENCIES AND EVENTS AFTER THE BALANCE SHEET DATE
4
Specific types of provision
4.1
Future operating losses Provisions should not be recognised for future operating losses.
4.2
Onerous contracts If an entity has a contract that is onerous, the present obligation under the contract should be recognised and measured as a provision.
4.3
Restructuring A constructive obligation to restructure arises only when an entity:
Chapter 9 Section 2.6.1
(i)
has a detailed formal plan for the restructuring; and
(ii)
has raised a valid expectation in those affected that it will carry out the restructuring by starting to implement that plan or announcing its main features to those affected by it.
A restructuring provision should include only the direct expenditures arising from the restructuring, which are those that are both: (a) (b)
5
necessarily entailed by the restructuring; and not associated with the ongoing activities of the entity.
IAS 10: Events after the balance sheet date
Summary diagram 5.1 1/1/X1
31/12/X1 Year end
31/3/X2 Transaction takes place here
Adjusting
30/4/X2 FS authorised for issue here
Non-adjusting - indicative of conditions that arose after the B/S date
- provide evidence of conditions that existed at the B/S date Going concern implications - adjust
9.6
No going concern implications - disclose if material uncertainty
9: PROVISIONS, CONTINGENCIES AND EVENTS AFTER THE BALANCE SHEET DATE
Disclosure 5.2
(a)
An entity discloses the date when the financial statements were authorised for issue and who gave the authorisation.
(b)
If non-adjusting events after the balance sheet date are material, non-disclosure could influence the decisions of users taken on the basis of the financial statements. Accordingly, the following is disclosed for each material category of non-adjusting event after the balance sheet date: – –
6
the nature of the event; and an estimate its financial effect, or statement that such an estimate cannot be made.
Current developments
Amendments to IAS 37 Exposure Draft (June 2005) Chapter 9 Section 3
Scope 6.1
The Standard would be renamed Non-financial Liabilities. Its scope would be extended to include all liabilities not covered by other standards. However, an entity would still be permitted to describe certain non-financial liabilities as provisions.
Probability criterion 6.2
The probability criterion is not included in the revised standard because under the Framework the definition of a liability does not include probability. Further, an unconditional obligation (which determines whether a provision is recognised) always meets the probability criterion (see below).
Contingent liabilities 6.3
The term 'contingent liability' would be eliminated because (under the Framework) liabilities arise only from unconditional (non-contingent) obligations. Instead, items previously described as contingent liabilities would be recognised based on their two elements: • •
an unconditional obligation (which establishes the existence of a liability) a conditional obligation (which affects the amount required to settle it).
The uncertainty would be factored into the amount required to settle the obligation. This aligns the treatment of contingent liabilities to that under IFRS 3 for business combinations. Contingent assets 6.4
The term 'contingent asset' would also be eliminated as assets arise only from unconditional (non-contingent) rights. 9.7
9: PROVISIONS, CONTINGENCIES AND EVENTS AFTER THE BALANCE SHEET DATE Those items previously described as contingent assets which meet the Framework definition of an asset would be recognised under IAS 38. Illustration: product warranty costs 6.5
Current IAS 37 •
A provision is recognised if it is probable that the cost will be in incurred.
•
The amount of the provision is based on expected cash flow (or as a result of past experience for groups of similar items).
IAS 37 ED •
A provision is always recognised as the obligation to 'stand ready to honour' warranty claims is unconditional.
•
The provision is measured based on the conditional obligation (expected outflow).
Measurement 6.6
Current IAS 37
IAS 37 Exposure draft
Best estimate of future discounted expenditure required to settle the obligation at the balance sheet date
The amount the entity would rationally pay to settle the obligation at the balance sheet date or transfer it to a third party
Large population of items: – expected values
Expected values
Single obligation – most likely outcome Restructuring provisions See 4.3 above
No special rules. To be recognised when definition of a liability met (consistent with other non-restructuring liabilities) ED provisions re costs associated with restructurings:
Recognised:
• Termination benefits
• Under IAS 19
• Term liabilities continuing to be incurred under a contract with no economic benefits
• When the entity ceases to use the rights conveyed by the contract
• Costs of terminating a contract before end of its term
• When the entity terminates the contract
9.8
9: PROVISIONS, CONTINGENCIES AND EVENTS AFTER THE BALANCE SHEET DATE Proposed effective date 6.7
The revised standard would be effective for annual periods beginning on or after 1 January 2009 (with earlier application encouraged providing the revised business combinations standards are also applied). The IASB announced in July 2006 that no new IFRSs would be effective until 1 January 2009 to provide four years of stability in the IFRS platform after the 2005 adoption and changes.
7
Chapter summary
7.1 Q9 Clean
Section
Topic
Summary
1
Provisions
Provisions are recognised when the Framework definition of a liability and recognition criteria are met.
2
Contingent liabilities
Contingent liabilities are not recognised because they are possible rather than present obligations, the outflow is not probable or the liability cannot be reliably measured. Contingent liabilities are disclosed.
3
Contingent assets
Contingent assets are disclosed, but only where an inflow of economic benefits is probable.
4
Specific types of provision
Provisions are not made for future operating losses as there is no obligation to incur them. Where a contract is onerous a provision is made for the unavoidable cost. Restructuring provisions are only recognised when certain criteria are met.
5
Events after the balance sheet date
Adjusting events are adjusted in the financial statements as they provide evidence of conditions existing at the balance sheet date. Non-adjusting events are disclosed if material, as, while important, they do not affect the financial statement figures.
6
Current developments
9.9
Proposal ED to treat all liabilities in the same way, i.e. recognise them, considering the probability of an outflow in their valuation.
9: PROVISIONS, CONTINGENCIES AND EVENTS AFTER THE BALANCE SHEET DATE
END OF CHAPTER 9.10
Related parties
Syllabus Guide Detailed Outcomes Having studied this chapter you will be able to: •
Determine the parties considered to be related to an entity.
•
Identify the implications of related party relationships and the need for disclosure.
Exam Context Related parties does seem to be a favourite of this examiner and could appear as a single topic question (part theoretical and part practical along the lines of Lecture example 1). More likely, however, is that the topic would appear as a discrete part of a multi-part Section B question.
Qualification Context Related parties are touched on from an interpretation angle, particularly in the context of groups in Paper F7 Financial Reporting. A higher level of detail, particularly in the identification of related parties, is required in this paper.
Business Context Disclosure of related parties is essential to a good understanding of a business's financial health and for investment decision-making. For example, if a group company is up for sale to a potential investor, trading with other group companies may stop, raw materials may be supplied at a higher price and so on. This could have a significant impact on the future bottom line and earnings per share.
10.1
10: RELATED PARTIES
Overview Related parties
Related parties
Disclosure
Not necessarily related parties
10.2
10: RELATED PARTIES
Chapter 15 Section 1-1.2
1
Related parties
1.1
Related party relationships and transactions are a normal feature of business, however, there is a general presumption that transactions reflected in financial statements have been carried out on an arm's length basis, unless disclosed otherwise.
Definition Related party (IAS 24)
1.2
A party is related to an entity if:
1.3
(a)
directly or indirectly, through one or more intermediaries, the party: (i) controls, or is controlled by, or is under common control with, the entity (this includes parents, subsidiaries and fellow subsidiaries); (ii) has an interest in the entity that gives it significant influence over the entity; (iii) has joint control over the entity;
(b)
the party is an associate of the entity;
(c)
the party is a joint venture in which the entity is a venturer;
(d)
the party is a member of key management personnel of the entity or its parent;
(e)
the party is a close member of the family of any individual referred to in (a) or (d);
(f)
the party is an entity that is controlled, jointly controlled or significantly influenced by, or for which significant voting power in such an entity resides with, directly or indirectly, any individual referred to in (d) or (e); or
(g)
the party is a post-employment benefit plan for the benefit of employees
Close members of the family of an individual are defined as 'those family members who may be expected to influence, or be influenced by, that individual in their dealings with the entity. They may include: • • •
an individual's spouse or domestic partner and children; children of the individual's domestic partner; and dependants of the individual or the individual's domestic partner.'
In considering each possible related party relationship, attention is directed to the substance of the relationship, and not merely the legal form.
10.3
10: RELATED PARTIES
2
Not necessarily related parties
2.1
The following are not necessarily related parties: (a)
Two entities simply because they have a director or other member of key management personnel in common, notwithstanding paragraphs (d) and (f) above;
(b)
Two venturers simply because they share joint control over a joint venture;
(c)
(i) (ii) (iii) (iv)
Providers of finance, Trade unions, Public utilities, and Government departments and agencies,
simply by virtue of their normal dealings with an entity (even though they may affect the freedom of action of an entity or participate in its decision-making process); and (d)
A customer, supplier, franchisor, distributor, or general agent with whom an entity transacts a significant volume of business, merely by virtue of the resulting economic dependence.
3
Disclosure
3.1
IAS 24 requires disclosure of the following. (a)
The name of the entity's parent and, if different, the ultimate controlling party irrespective of whether there have been any transactions.
(b)
Where there have been transactions between related parties: (i)
nature of the related party relationship
(ii)
information about the transactions and outstanding balances necessary for an understanding of the relationship on the financial statements. As a minimum, this includes:
(c)
amount
(2)
amount of outstanding balances (including terms and conditions and guarantees)
(3)
doubtful debt allowances re the outstanding balances
(4)
bad and doubtful debt expense re related parties in the period;
Key management personnel compensation broken down by: (i) (ii) (iii) (iv) (v)
3.2
(1)
short-term employee benefits post-employment benefits other long-term benefits termination benefits share-based payment.
No disclosure is required of intragroup related party transactions in the consolidated financial statements (since they are eliminated).
10.4
10: RELATED PARTIES 3.3
The disclosures should be made separately for each of the following categories: (a) (b) (c) (d) (e) (f) (g)
The parent; Entities with joint control or significant influence over the entity; Subsidiaries; Associates; Joint ventures in which the entity is a venturer; Key management personnel of the entity or its parent; and Other related parties.
Items of a similar nature may be disclosed in aggregate except where separate disclosure is necessary for understanding purposes.
Lecture example 1
Exam standard for 10 marks
Leoval is a private manufacturing company making car parts. It is 90% owned by Cavelli, a listed entity. Cavelli is a long-established company controlled by the Grassi family through an agreement which pools their voting rights. Leoval regularly provides parts at market price to another company in which Francesca Cincetti has a minority (23%) holding. Francesca Cincetti is the wife of Roberto Grassi, one of the key Grassi family shareholders that controls Cavelli. Leoval advances interest-free loans to its employees in order for them to purchase annual season tickets to get to work. The loan repayment is deducted in 12 instalments from the employees' salaries. Cavelli charges Leoval an annual management services fee of 20% of profit before tax (before accounting for the fee). 30% of Leoval's revenue comes from transactions with a major car maker, Piat. Leoval provides a defined benefit pension plan for its employees based on 2% of final salary for each year worked. The scheme is currently overfunded and so Leoval has not made any contributions during the current year. Required Explain whether disclosures are required for each of the above pieces of information by IAS 24 Related Party Disclosures.
Solution
10.5
10: RELATED PARTIES
4
Chapter summary
4.1 Q14 Ace
Section
Topic
Summary
1
Related parties
IAS 24 identifies parties as related where there is a close personal relationship to the entity or a control, joint control or significant influence relationship. In any case, the substance of the relationship is considered when deciding whether parties are related.
2
Not necessarily related parties
IAS 24 identifies parties which are not automatically related in their normal dealings with the entity.
3
Disclosure
Disclosure is important so the user can estimate the effects of related party transactions. IAS 24 requires disclosure of the entity's parent/ultimate parent, transactions with related parties and benefits earned by key management personnel.
END OF CHAPTER 10.6
Leases
Syllabus Guide Detailed Outcomes Having studied this chapter you will be able to: •
Apply and discuss the classification of leases and accounting for leases by lessors and lessees.
•
Account for and discuss sale and leaseback transactions.
Exam Context Leasing could appear as a single topic question in Section B, although a large part of such a question would be written, perhaps focusing on the current debate over accounting for leases. More likely is that leases and sale and leaseback would come up for a few marks in a scenario/ specialised industry question or as a discrete part of a multi-part question.
Qualification Context Lessee accounting is also covered in Paper F7 Financial Reporting. So the new areas in this paper are lessor accounting, the treatment of initial direct costs, and guaranteed and unguaranteed residual values. Lease versus buy scenarios are covered in Paper F9 Financial Management.
Business Context The classification of a lease as an operating lease or finance lease is fundamental when analysing a set of financial statements: this is because finance leases are reported as loans in the balance sheet (therefore increasing gearing and finance costs reported), whereas operating leases are treated as an ongoing expense.
11.1
11: LEASES
Overview Leases
Lessee accounting
Lessor accounting
Finance leases
Finance leases
Operating leases
Operating leases
11.2
Current developments
Sale and leaseback transactions
11: LEASES
1
Lessee accounting
Issue 1.1
IAS 17 Leases was the first standard to address the problem of substance over form. The correct treatment of the transaction in the financial statements of both the lessee and the lessor is determined by the commercial substance of the lease. The legal form of any lease is that the title to the asset remains with the lessor.
Overview 1.2
LESSEE ACCOUNTING
FINANCE LEASE
OPERATING LEASE
• A lease that transfers substantially all the risks and rewards incident to ownership of an asset to the lessee. Title may or may not eventually be transferred Accounting treatment • Capitalise asset and recognise liability at fair value of leased property or, if lower, present value of minimum lease payments • Depreciate asset over the shorter of the useful life and the lease term (useful life if reasonable certainty the lessee will obtain ownership) • Add initial direct costs (incremental costs directly attributable to negotiating and arranging a lease) to amount recognised as an asset • Apply finance charge so as to give a constant rate on the outstanding liability (using the interest rate implicit in the lease) • Rental payments are split between the finance charge element and the repayment of capital. 11.3
• A lease other than a finance lease
• Rentals are charged to profit or loss on a straight line basis over the lease term unless another systematic basis is representative of the user's benefit • Incentives to sign operating leases (and initial reverse premiums or rent-free periods) are spread over the life of the operating lease reducing the overall payments on the lease charged to profit or loss (SIC-15)
11: LEASES
Further definitions 1.3
1.4
IAS 17 identifies five situations which would normally lead to a lease being classified as a finance lease: (a)
The lease transfers ownership of the asset to the lessee at the end of the lease term;
(b)
The lessee has the option to purchase the asset at a price sufficiently below fair value at exercise date, that it is reasonably certain the option will be exercised;
(c)
The lease term is for a major part of the asset's economic life even if title is not transferred;
(d)
Present value of minimum lease payments amounts to substantially all of the asset's fair value at inception;
(e)
The leased asset is so specialised that it could only be used by the lessee without major modifications being made.
The lease term is the non-cancellable period for which the lessee has contracted to lease the asset together with any further terms for which the lessee has the option to continue to lease the asset, with or without further payment, when at the inception of the lease it is reasonably certain that the lessee will exercise the option. Minimum lease payments are the payments over the lease term that the lessee is, or can be required, to make (excluding contingent rent, costs for services and taxes to be paid by and reimbursed to the lessor) plus any amounts guaranteed by the lessee or by a party related to the lessee.
Disclosures Lufthansa
Leased assets 1.5
For each class of asset, the net carrying amount at the balance sheet date.
Finance lease liabilities 1.6
Give maturity analysis – two disclosures notes required – – –
not later than one year later than one year and not later than five years later than five years
Reconciliation of minimum lease payments and present value Within one year Later than one year and not later than five years Later than five years Less: future finance charges Present value of finance lease liabilities
11.4
$ 2,000 8,000 4,000 14,000 2,800 11,200
11: LEASES Present value of finance lease liabilities
$ 1,300 6,200 3,700 11,200
Within one year Later than one year and not later than five years Later than five years Operating leases 1.7
Disclose the future minimum lease payments under non-cancellable operating leases analysed as follows: Operating leases payments
$ X X X X
Within one year Later than one year and not later than five years Later than five years
Lecture example 1
Technique demonstration (exam standard)
A company leases an asset (as lessee) on 1 January 20X1. The terms of the lease are to pay: • •
a non-refundable deposit of $5,800 on inception six annual instalments of $16,000 payable in arrears.
The fair value of the asset (equivalent to the present value of minimum lease payments) on 1 January 20X1 is $80,000. Its useful life to the company is five years. As part of the lease agreement the company guaranteed to the lessor that the asset could be sold for $8,000 at the end of the lease term. It also incurred $2,000 of costs in setting up the lease agreement. The interest rate implicit in the lease has been calculated as 10.0%. Required (a)
Prepare the relevant extracts from the financial statements (excluding notes) in respect of the above lease for the year ended 31 December 20X1.
(b)
Explain what would happen at the end of the lease if the asset could be sold by the lessor: (i) (ii)
for $10,000 for only $6,000.
11.5
11: LEASES
Solution (a)
Financial statement extracts $ Income statement for the year ended 31 December 20X1 (extract) Depreciation Finance costs (Working) Balance sheet as at 31 December 20X1 (extract) Non-current assets Leased asset Non-current liabilities Finance lease liability (Working) Current liabilities Finance lease liability (Working) Working
(b)
Treatment of guaranteed residual value
11.6
11: LEASES
2
Lessor accounting
2.1
The approach to lessor accounting is very similar to that for lessee accounting, the key difference being the inclusion of 'unguaranteed residual value' (see below).
Overview 2.2
LESSOR ACCOUNTING
FINANCE LEASE
OPERATING LEASE
Substance • Risk and rewards with the lessee (or other third parties) Accounting treatment • Recognise a receivable equal to 'net investment in the lease'. This is minimum lease payments plus any unguaranteed residual value (see below) accruing to the lessor less unearned finance income (i.e. both discounted at the interest rate implicit in the lease) • Initial direct costs incurred by the lessor are not added separately to the net investment as they are already included in the discounted figures since they are included in the calculation of the interest rate implicit in the lease (reducing the return)
• Risks and rewards with the lessor • Asset retained in the books of the lessor and depreciated over its useful life • Rentals are credited to the income statement on a straight line basis over the lease term unless another systematic basis is more representative
• Finance income recognised reflecting constant periodic rate of return on the lessor's net investment outstanding
Unguaranteed residual value 2.3
The unguaranteed residual value is that portion of the residual value of the leased asset, the realisation of which by the lessor is not assured or is guaranteed solely by a party related to the lessor.
11.7
11: LEASES
Lecture example 2
Technique demonstration (exam standard)
A company leased an asset to another company on the following terms: Lease term Inception of lease Annual instalments in advance Residual value of asset as guaranteed by lessee Expected residual value at end of lease Fair value of the asset Initial direct costs incurred by the lessor Interest rate implicit in the lease
4 years 1.1.X1 $22,000 $10,000 $12,000 $82,966 $700 11%
Required (a)
Calculate the unguaranteed residual value and the net investment in the lease as at 1 January 20X1.
(b)
Prepare extracts from the financial statements of the lessor for the year ended 31.12.X1 (excluding notes).
Solution (a)
Unguaranteed residual value and net investment in the lease at 1 January 20X1. Gross investment $
Date
1.1.X1 1.1.X2 1.1.X3 1.1.X4 31.12.X4 31.12.X4 (b)
Instalment Instalment Instalment Instalment Guaranteed residual value Minimum lease payments Unguaranteed residual value Investment in the lease
Discount factor (11%)
Net investment $
1 0.901 0.812 0.731 0.659 0.659
Financial statement extracts $ Income statement for the year ended 31 December 20X1 (extract) Finance income (Working) Balance sheet as at 31 December 20X1 (extract) Non-current assets Net investment in finance lease (Working)
11.8
11: LEASES $ Current assets Net investment in finance lease (Working) Working – net investment in finance lease
Disclosure 2.4
Very similar disclosures are required for finance lease assets (in the lessor's books) as for finance lease liabilities (in the lessee's books) plus disclosure of unguaranteed residual value.
3
Sale and leaseback transactions
3.1
If the leaseback transaction is a finance lease, under IAS 17 there is not deemed to be a disposal so any excess of sales proceeds over carrying value should be deferred and amortised over the lease term. Consequently, the double entry is: Dr: Cash Cr: Finance lease liability with all cash received. Further entries are as per any finance lease.
3.2
If the leaseback transaction is an operating lease BV = book value, SP = sale proceeds, FV = fair value (a)
If SP = FV (i.e. an arm's length transaction) (i)
Recognise any profit/loss immediately.
11.9
11: LEASES (b)
If SP < FV (i)
(c)
Recognise any profit/loss immediately unless the apparent loss is compensated by future rentals at below market price, in which case defer and amortise over period asset is expected to be used.
If SP > FV (i)
Defer excess over fair value and amortise over period asset is expected to be used.
(ii)
In substance this excess is a loan which would be held at amortised cost in accordance with IAS 39. Consequently, the operating lease rentals would need to be split between the fair market rental and the repayment of the loan plus interest.
Note. In all cases, if FV < BV Recognise the loss of BV – FV immediately.
Lecture example 3
Exam standard for 2-3 marks (each part)
Rental enters into the following sale and leaseback agreements on 1 July 20X1. The lease agreements are operating leases for a three-year period in accordance with IAS 17. (i) $ 15,000 12,000 16,000 2,000
Book value Sale proceeds Fair value Rentals p.a. (payable in arrears)
(ii) $ 15,000 16,500 18,000 3,000
(iii) $ 15,000 17,500 16,000 4,000
Required Indicate how the above transactions would be reflected in the financial statements of Rental for the year ended 30 June 20X2. Interest rates are currently 10% and the annuity factor for three years at 10% is 2.487.
Solution
11.10
11: LEASES
4
Current developments
The issue 4.1
The distinction between classification of a lease as an operating or finance lease has a considerable impact on the financial statements, most notably on indebtedness, gearing ratios, ROCE and interest cover. It is argued that the current accounting treatment of operating leases is inconsistent with the definition of assets and liabilities in the IASB's Framework. There have therefore been calls for the capitalisation of non-cancellable operating leases on the balance sheet on the grounds that if non-cancellable, they meet the definitions of assets and liabilities, giving similar rights and obligations as finance leases over the period of the lease.
11.11
11: LEASES IASB response 4.2
Having been an agenda item for some time, the IASB decided in May 2003 to actively undertake a leasing project with the objective of developing a single method of accounting for leases that is consistent with the Framework. The single method would not rely on a distinction between operating and finance leases.
5
Chapter summary
5.1 Q10 Able
Section
Topic
Summary
1
Lessee accounting
Finance leases (where, in substance, the lessee has the risks and rewards of ownership) are capitalised in the lessee's books and shown as a liability. Operating leases are treated as rental expense. The effect of incentive payments received and rent free periods are both spread over the life of the lease.
2
Lessor accounting
Assets leased out under finance leases are derecognised from the lessor's books and replaced with a receivable, 'the net investment in the lease'. Assets leased under a operating lease remain in the lessee's books and rental income is shown.
3
Sale and leaseback transactions
Accounting for sale and leaseback transactions depends on whether in substance, the leaseback is a finance lease or an operating lease.
4
Current developments
The IASB is considering the capitalisation of all noncancellable leases as assets and liabilities, as they meet the Framework definitions. This means there would no longer be a distinction between operating and finance leases.
END OF CHAPTER 11.12
Revision of basic groups
Syllabus Guide Detailed Outcomes Having studied this chapter you will be able to: •
Apply the method of accounting for business combinations including complex group structures. (Complex structures covered in Chapter 13)
•
Apply the principles in determining the cost of a business combination.
•
Apply the recognition and measurement criteria for identifiable acquired assets and liabilities and goodwill including step acquisitions. (Step acquisitions covered in Chapter 13)
•
Apply and discuss the criteria used to identify a subsidiary and an associate.
•
Determine and apply appropriate procedures to be used in preparing group financial statements.
•
Apply the equity method of accounting for associates.
•
Outline and apply the key definitions and accounting methods which relate to interests in joint ventures.
Exam Context Compulsory question 1 for 50 marks in Section A of the Paper will be set in the context of group financial statements. This topic is therefore fundamental to passing Paper P2. However, there will be adjustments in the group financial statements from other areas of the syllabus and it is likely that part of the question will be written.
Qualification Context Group accounting is covered at a lower level in Paper F7 Financial Reporting. This chapter revises group knowledge brought forward from Paper F7, and also brings in joint ventures which are not examinable in that paper.
Business Context Most large quoted companies are in fact groups, made up of a plethora of interlinked companies rather than a single trading entity. In order to be able to understand, and therefore analyse, the financial statements of large companies, it is essential to understand the concepts of group accounting. If an investor were to use the separate financial statements of the parent to make investment decisions, all that would appear would be the carrying value of the investment in shares of the subsidiary and dividend income in the income statement. However, the group controls all of the subsidiaries' net assets and profits and this is only shown in the consolidated balance sheet and income statement.
12.1
12: REVISION OF BASIC GROUPS
Overview Approach
Current development
Basic groups
Goodwill
Cost of business combination
FV of assets acquired and liabilities assumed
Types of investment
Subsidiaries
Associates
Joint ventures
Jointly controlled entities
Jointly controlled operations & assets
Special purpose entities
12.2
12: REVISION OF BASIC GROUPS
1
Approach
Consolidation 1.1
Consolidation is the process of adjusting and combining financial information from the separate financial statements of a parent and its subsidiaries to prepare consolidated financial statements that present financial information for the group as a single economic entity.
Purchase method 1.2
All business combinations are accounted for using the purchase method. One party is identified as the acquirer (parent) and the other as the acquiree (subsidiary).
Consolidated balance sheet Overview 1.3
(a)
Purpose:
to show the assets and liabilities which it controls and the ownership of those assets and liabilities
(b)
Assets and liabilities:
always 100% P plus 100% of the book value of S providing P exercises control over S
(c)
Share capital:
P only
Reason:
simply reporting to the parent's shareholders in another form
Reserves:
100% P plus group share of post-acquisition retained earnings of S, plus/ less consolidation adjustments
Reason:
to show the extent to which the group actually owns assets and liabilities included in the consolidated balance sheet
Minority interest:
MI share of S's consolidated net assets (including fair value adjustments)
Reason:
to show the extent to which other parties own net assets under the control of the parent
(d)
(e)
Method 1.4
Step 1 Read the question and draw up the group structure (W1), highlighting useful information: – the % owned – acquisition date – pre-acquisition reserves. Step 2 Draw up the pro-forma taking into account the group structure identified – – – – –
leave out cost of investment put in a line for goodwill put in a line for investment in associate (where appropriate) remember to include minority interest leave some lines in case of any additions. 12.3
12: REVISION OF BASIC GROUPS Step 3 Aggregate the assets and liabilities – 100% of all assets and liabilities controlled at the balance sheet date – put in ordinary share capital and share premium – parent only. Step 4 Read through the additional notes and attempt the adjustments showing workings for all calculations. Do the double entry for the adjustments onto your answer or (where retained earnings is affected) onto the face of the question to remind you when calculating minority interest and retained earnings. Examples: – cancel any intragroup items e.g. current a/c balances, loans – adjust for unrealised profits: unrealised profit on intragroup sales % held @ y/e = Provision for unrealised profit (PUP) (adjust in company selling goods) –
X % X
Dr Cr
Retained earnings Group inventories
make fair value adjustments:
– – –
Inventories Depreciable non-current assets Non-depreciable non-current assets
Acq'n date X X X X
Movement
Goodwill
(X) (X) (X) (X) Ret'd earnings
B/S date X Put on TOP X half of B/S X X Minority interest
Step 5 Calculate goodwill Cost of business combination (= cost of investment in S) Less: – – – –
Net fair value of identifiable assets and liabilities acquired: Share capital Share premium Retained earnings @ acquisition Fair value adj @ acquisition (include contingent liabilities)
X X X X X X
× Group %
(X) X (X) X
Less: group impairment losses on goodwill to date Step 6 Calculate 'Investment in associate' (if appropriate) Cost of associate Share of post-acquisition retained reserves ((Y – X) × X%) Less: group impairment losses on associate to date
12.4
X X (X) X
12: REVISION OF BASIC GROUPS Step 7 Calculate minority interest in the subsidiary's net assets as consolidated S's net assets at balance sheet date per question Fair value adjustments Other adjustments, e.g. PUP on sales by S
X X (X) X
× MI %
X
Step 8 Calculate retained earnings Per question Adjustments Fair value adjustments movement Pre-acquisition retained earnings S - share of post acq'n ret'd earnings (A × %) A/JCE - share of post acq'n ret'd earnings (B × %) Less: all group impairment losses to date
Parent X X(X) – X X
Subsidiary X X(X) X/(X) (X) A
Assoc/JCE X X(X) X/(X) (X) B
X (X) X
Consolidated income statement Overview 1.5
The income statement shows a true and fair view of the group's activities since acquisition of any subsidiaries. (a)
The top part of the income statement shows the income, expenses and profit controlled by the group
(b)
The reconciliation at the bottom of the income statement shows the ownership of those profits.
Method 1.6
Step 1
Read the question and draw up the group structure and where subsidiaries/associates are acquired in the year identify the proportion to consolidate. A timeline may be useful.
Step 2
Draw up the pro-forma – remember the minority interest reconciliation at the foot of the statement
Step 3
Aggregate the income and expenses (time apportioned if appropriate) – exclude dividends receivable from subsidiary
Step 4
Go through question, calculating the necessary adjustments showing workings for all calculations, transfer the numbers to your proforma and mark the adjustments on the face of the question where the subsidiary's profit is affected to remind you when calculating minority interest.
12.5
12: REVISION OF BASIC GROUPS Step 5
Calculate 'Share of profit of associate' (where appropriate) A's profit for the period (PFP) × Group % Any group impairment loss recognised on the associate during the period
X (X) X
Shown before group profit before tax. Step 6
Calculate minority interest in subsidiary's PFP as consolidated S's PFP per question (time-apportioned if appropriate) +/- adjustments (e.g. PUP)
X × MI%
2
Types of investment
2.1
The three types of investment in the consolidated financial statements are each governed by their own Standard: • • •
Subsidiaries (IAS 27 Consolidated and Separate Financial Statements) Associates (IAS 28 Investments in Associates) Jointly controlled entities (IAS 31 Interests in Joint Ventures).
Accounting treatment in the separate financial statements of the investor 2.2
In all three cases, the investment should be shown in the investor's separate financial statements either: • •
3
at cost; or as an available-for-sale financial asset in accordance with IAS 39 Financial Instruments: Recognition and Measurement.
Subsidiaries
Definition 3.1
Subsidiary (IAS 27) A subsidiary is an entity, including an unincorporated entity such as a partnership, that is controlled by another entity (known as the parent).
3.2
Control is the power to govern the financial and operating policies of an entity or business so as to obtain benefits from its activities.
3.3
Control is presumed to exist where the acquirer acquires more than one-half of that other entity's voting rights (unless it can be demonstrated that such ownership does not constitute control). It also exists where, as a result of the combination, the acquirer obtains: (a)
power over more than one-half of the voting rights of the other entity by virtue of an agreement with other investors; or
12.6
12: REVISION OF BASIC GROUPS (b)
power to govern the financial and operating policies of the other entity under a statute or an agreement; or
(c)
power to appoint or remove the majority of the members of the board of directors or equivalent governing body of the other entity; or
(d)
power to cast the majority of votes at meetings of the board of directors or equivalent governing body of the other entity.
Consolidation procedures 3.4
The following should be noted: (a)
The financial statements of parents, subsidiaries, associates and jointly controlled entities should be prepared to the same reporting date. Where this is impracticable: •
the difference must be no greater than three months;
•
adjustments are made for the effects of significant transactions in the intervening period; and
•
the length of the reporting period and any difference in the reporting dates must be the same from period to period.
(b)
Uniform accounting policies are used.
(c)
Intragroup balances, transactions, income and expenses are eliminated in full for subsidiaries.
(d)
Unrealised profits on intragroup transactions are eliminated in full.
Special purpose entities (Quasi-subsidiaries) - SIC-12 3.5
A special purpose entity is a corporation, trust, partnership or unincorporated entity that is created for a specific purpose (e.g. to effect a lease or undertake research and development activities). Although a special purpose entity may not be owned by the reporting entity, it may be directly or indirectly controlled giving rise to benefits (and risks) for that entity that are in substance no different from those that would arise were the entity a normal subsidiary. SIC-12 requires consolidation of a special purpose entity where the substance of the relationship indicates that it is controlled by the reporting entity.
12.7
12: REVISION OF BASIC GROUPS
4
Associates
Definition 4.1
Associate (IAS 28) An associate is an entity (including an unincorporated entity such as a partnership) over which the investor has significant influence and that is neither a subsidiary nor an interest in a joint venture.
4.2
Significant influence is the power to participate in the financial and operating policy decisions of the investee but is not control or joint control over those policies. This could be shown by: (a) (b) (c) (d) (e)
representation on the board of directors participation in policy-making processes material transactions between the investor and investee interchange of managerial personnel provision of essential technical information.
Presumptions 4.3
If an investor holds, directly or indirectly: (a)
20% or more of voting power –
(b)
presumption of significant influence unless demonstrated otherwise.
< 20% of voting power –
presumption of no significant influence unless demonstrated otherwise
Intragroup transactions 4.4
Intragroup transactions and balances are not eliminated. However, the investor's share of unrealised profits or losses on intragroup transactions is eliminated.
12.8
12: REVISION OF BASIC GROUPS
Lecture example 1
Preparation question
Otway, a public limited company, acquired a subsidiary, Holgarth, on 1 July 20X2 and an associate, Batterbee, on 1 January 20X5. The details of the acquisitions at the respective dates are as follows: Investee
Holgarth Batterbee
Ordinary share capital of $1 $m 400 220
Reserves Retained Share earnings premium $m 160 269
$m 140 83
Fair value of net assets at acquisition $m 800 652
Cost of investment $m 765 203
Ordinary share capital acquired $m 320 55
The draft financial statements for the year ended 30 June 20X6 are: Balance sheets as at 30 June 20X6 Non-current assets Property, plant and equipment Intangible assets Investment in Holgarth Investment in Batterbee Current assets Inventories Trade receivables Cash and cash equivalents Equity Share capital Share premium Retained earnings Current liabilities Trade and other payables
12.9
Otway $m
Holgarth $m
Batterbee $m
1,012 – 765 203 1,980
920 350 – – 1,270
442 27 – – 469
620 950 900 2,470 4,450
1,460 529 510 2,499 3,769
214 330 45 589 1,058
1,000 200 1,370 2,570
400 140 929 1,469
220 83 361 664
1,880 4,450
2,300 3,769
394 1,058
12: REVISION OF BASIC GROUPS Income statements for the year ended 30 June 20X6
Otway $m 4,480 (2,690) 1,790 (620) (50) 260 1,380 (330) 1,050
Holgarth $m 4,200 (2,940) 1,260 (290) (80) 890 (274) 616
Dividends paid in the year
250
300
80
Retained earnings brought forward
570
613
293
Revenue Cost of sales Gross profit Distribution costs and administrative expenses Finance costs Dividend income (from Holgarth and Batterbee) Profit before tax Income tax expense Profit for the period
Batterbee $m 1,460 (1,020) 440 (196) (24) 220 (72) 148
Additional information: (1)
Neither Holgarth nor Batterbee had any reserves other than retained earnings and share premium at the date of acquisition. Neither issued new shares since acquisition.
(2)
The fair value difference on the subsidiary relates to property, plant and equipment being depreciated through cost of sales over a remaining useful life of 10 years from the acquisition date. The fair value difference on the associate relates to a piece of land (which has not been sold since acquisition).
(3)
Holgarth's intangible assets include $87 million of training and marketing expenditure incurred during the year ended 30 June 20X6. The directors of Holgarth believe that these should be capitalised as they relate to the start-up period of a new business venture in Scotland, and intend to amortise the balance over five years from 1 July 20X6.
(4)
During the year ended 30 June 20X6 Holgarth sold goods to Otway for $1,300 million. The company makes a profit of 30% on the selling price. $140 million of these goods were held by Otway on 30 June 20X6 ($60 million on 30 June 20X5).
(5)
Annual impairment tests have indicated impairment losses of $100m relating to the recognised goodwill of Holgarth including $25m in the current year. The Otway Group recognises impairment losses on goodwill in cost of sales. No impairment losses to date have been necessary for the investment in Batterbee.
Required Prepare the income statement for the year ended 30 June 20X6 for the Otway Group and a balance sheet at that date.
12.10
12: REVISION OF BASIC GROUPS
Solution Consolidated balance sheet as at 30 June 20X6 $m Non-current assets Property, plant and equipment Goodwill Other intangible assets Investment in associate Current assets Inventories Trade receivables Cash and cash equivalents
Equity attributable to equity holders of the parent Share capital Share premium Retained earnings Minority interest
Current liabilities Trade and other payables Consolidated income statement for the year ended 30 June 20X6 $m Revenue Cost of sales Gross profit Distribution costs and administrative expenses Finance costs Share of profit of associate Profit before tax Income tax expense Profit for the period Attributable to: Equity holders of the parent Minority interest
12.11
12: REVISION OF BASIC GROUPS
12.12
12: REVISION OF BASIC GROUPS
12.13
12: REVISION OF BASIC GROUPS
5
Joint ventures
Definitions 5.1
Joint venture (IAS 31) A joint venture is a contractual arrangement whereby two or more parties undertake an economic activity that is subject to joint control. Joint control is the contractually agreed sharing of control over an economic activity, and exists only when the strategic financial and operating decisions relating to the activity require the unanimous consent of the parties sharing the control (the venturers).
Types 5.2
Joint ventures can be: Jointly controlled entities ⇒ a separate entity created which needs to be consolidated Jointly controlled operations (e.g. to build a plane) Jointly controlled assets (e.g. an oil pipeline)
Chapter 17 Section 3.1-3.2
No separate entity is created. Accounted for in the investor's own books
Consolidating jointly controlled entities 5.3
Proportionate consolidation The venturer records its share of assets, liabilities, income and expenses in the consolidated financial statements IAS 31 allows a choice of: • •
combining items on a line-by-line basis, or including separate line items for each category of assets, liabilities, income and expenses.
Both reporting formats give the same overall results. 5.4
Equity method As an alternative, the equity method may be used in the same way as for associates.
Transactions between a venturer and a joint venture 5.5
In a similar way to the requirements for associates, IAS 31 states that the venturer's share of any unrealised gain or loss in transactions with the joint venture (either way) should be eliminated on consolidation (unless the unrealised loss represents a reduction in the net realisable value of current assets or an impairment loss). Additionally, where proportionate consolidation is used the venturer's share of intragroup transactions and balances is eliminated as similar principles apply to those used for consolidation of a subsidiary.
12.14
12: REVISION OF BASIC GROUPS
Lecture example 2
Preparation question
Parachute has a 50% interest in Jump, an entity set up and controlled jointly with a third party. The balance sheets of the two companies as at 31 December 20X5 are as follows: Parachute Group $'000 Non-current assets Property, plant and equipment Investment in Jump Current assets Inventories Others
Equity Share capital Retained earnings Current liabilities
Jump $'000
406 10 416
160
100 200 300
50 110 160
716
320
200 366 566
20 180 200
150 716
120 320
160
Their respective income statements for the year ended 31 December 20X5 are as follows: Parachute Group $'000 490 (280) 20 230 (100) 130
Revenue Cost of sales and expenses Dividend from Jump Profit before tax Income tax expense Profit for the period Dividends charged to retained earnings during the period:
60
Jump $'000 312 (200) – 112 (32) 80 40
During December 20X5 Parachute transferred goods to Jump for $50,000. Parachute sells goods at a mark-up of 25%. Jump had not paid Parachute's invoice or sold any of the goods to third parties by the year end. There was no goodwill arising on Parachute's original investment. No dividends from Jump are outstanding in the Parachute's books. Required Prepare a consolidated balance sheet and income statement as at 31 December 20X5 using: (a) (b)
proportionate consolidation (on a line by line basis) equity accounting. 12.15
12: REVISION OF BASIC GROUPS
Solution (a)
Parachute Group – Consolidated balance sheet as at 31 December 20X5 $'000 Non-current assets Property, plant and equipment Current assets Inventories Others
Equity attributable to equity holders of the parent Share capital Retained earnings Current liabilities Parachute Group – Consolidated income statement for the year ended 31 December 20X5 $'000
Revenue Cost of sales and expenses Profit before tax Income tax expense Profit for the period Workings 1
Group structure
2
Provision for unrealised profit on inventories
12.16
12: REVISION OF BASIC GROUPS 3
(b)
Consolidated retained earnings
Parachute Group – Consolidated balance sheet as at 31 December 20X5 $'000 Non-current assets Property, plant and equipment Investment in joint venture Current assets Inventories Others
Equity attributable to equity holders of the parent Share capital Retained earnings Current liabilities Parachute Group – Consolidated income statement for the year ended 31 December 20X5 $'000 Revenue Cost of sales and expenses Share of profit of joint venture Profit before tax Income tax expense Profit for the period Workings (cont'd) 4
Investment in joint venture
12.17
12: REVISION OF BASIC GROUPS
Jointly controlled operations and assets 5.6
Jointly controlled operations
The venturer recognises in its own books: • • •
Jointly controlled assets
the assets controlled liabilities and expenses incurred; and its share of income.
The venturer recognises in its own books: • •
any liabilities or expenses incurred; and its share of any joint assets, liabilities, income and expenses.
No adjustments are necessary on consolidation as the figures are already incorporated correctly into the investor's own financial statements.
12.18
12: REVISION OF BASIC GROUPS
Additional Notes
12.19
12: REVISION OF BASIC GROUPS
Chapter 16 Section 6
6
Goodwill (IFRS 3)
6.1
At the acquisition date, the acquirer: (a)
recognises goodwill acquired in the business combination as an asset;
(b)
initially measures it at its cost: Cost of the business combination
X
Less: Acquirer's interest in the net fair value of identifiable assets, liabilities and contingent liabilities recognised
(X) X
6.2
If the acquirer's interest in the net fair value of identifiable assets, liabilities and contingent liabilities exceeds the cost of the business combination (formerly 'negative' goodwill), the acquirer: (a)
reassesses the identification and measurement of the assets, liabilities and cost; and
(b)
recognises immediately in the income statement any excess remaining after the reassessment.
Cost of a business combination 6.3
6.4
The cost of the business combination is measured as: (a)
the fair values, at the date of exchange, of assets given, liabilities incurred or assumed, and equity instruments issued; plus
(b)
directly attributable costs.
Specifically: Item
Treatment
(a) Deferred consideration
– present value taking into account any premium or discount likely to be incurred in settlement
(b) Contingent consideration
– included if it is probable that a payment will be made and can be measured reliably
(c) Quoted equity instruments – normally published price at the date of the exchange transaction (d) Unquoted equity instruments
– fair value by reference to: (i) proportional interest in the fair value of acquirer, or (ii) proportional interest in the fair value of acquiree whichever is more clearly evident.
(e) Directly attributable costs
– includes professional fees paid to accountants, legal advisers and other consultants, but not general administrative costs and other costs that cannot be directly attributed NB: equity instrument issue costs reduce the proceeds of the issue in accordance with IAS 32. 12.20
12: REVISION OF BASIC GROUPS
Lecture example 3
Exam standard for 2 marks (as part of a consolidation question)
A Co acquired 80% of B Co on 31 December 20X8. The consideration was as follows: $1m cash paid on 31.12.X8 plus $1.5m payable on 31.12.X9 and a final payment of 2 × the 20X9 profits on 31.12.20Y0. The 20X9 profits are expected to be $0.8m. The company can borrow money at 10%. The discount factors for one year and two years are 0.909 and 0.826 respectively. Required Calculate (i) (ii) (iii)
the carrying value of the investment the interest to be charged to the income statement in each year the liability in the balance sheet at the end of each year
Solution
12.21
12: REVISION OF BASIC GROUPS
Fair value of the identifiable assets acquired and liabilities and contingent liabilities assumed Recognition 6.5
(a)
The acquiree's identifiable assets, liabilities and contingent liabilities are recognised when they meet the following criteria: (i)
Assets (other than intangibles)
– it is probable that associated future economic benefits will flow to the acquirer; and – fair value can be measured reliably
(ii)
Liabilities (other than contingent)
– it is probable that an outflow of resources embodying economic benefits will be required to settle the obligation; and – fair value can be measured reliably
(iii) (b)
(c)
Intangible assets and contingent liabilities
– fair value can be measured reliably
The acquirer recognises only the identifiable assets, liabilities and contingent liabilities that existed at the acquisition date. Consequently: (i)
Liabilities for terminating or reducing the activities of the acquiree are only recognised when an existing liability for restructuring is recognised in accordance with IAS 37 Provisions, Contingent Liabilities and Contingent Assets.
(ii)
Liabilities are not recognised for future losses or other costs expected to be incurred as a result of the business combination.
Non-current assets (or disposal groups) classified as held-for-sale are recognised at fair value less costs to sell in accordance with IFRS 5 Non-current Assets Held for Sale and Discontinued Operations. (see Chapter 14)
Measurement 6.6
The fair value is calculated as: Asset
Valuation basis
(a) Property, plant and equipment and financial instruments
– market value
(b) Receivables and payables
– present value
(c) Finished goods and work in progress
– selling price less costs to complete/dispose and reasonable profit margin
(d) Raw materials
– current replacement cost
(e) Intangible assets
– by reference to an active market or otherwise arm's length basis
12.22
12: REVISION OF BASIC GROUPS Asset
Valuation basis
(f) Financial instruments
– market value by reference to an active market – estimated values if none
(g) Tax assets and liabilities (including deferred tax)
– tax benefit re losses or tax payable on profit assessed from group perspective
(h) Contingent liabilities
– amount a third party would charge to assume the liability
Lecture example 4
Issue demonstration
P Co acquired 100% of S Co for $1,000. At the date of acquisition S Co had net assets of $500. However, S Co would need to spend $200 on restructuring as a result of the business combination. The income statement of P Co and its subsidiary in the first year following the business combination is as follows: P Co $ 700
Profit before restructuring costs Restructuring costs Profit before tax Income tax expense Profit for the period
700 200 500
S Co $ 400 200 200 70 130
Required Calculate goodwill and show the income statement for the year following the business combination. (a)
Assuming the provision for restructuring was as a result of a payment S Co is contractually required to make to its employees in the event that it is acquired in a business combination.
(b)
Assuming that the provision for restructuring was as a result of P Co's plans on acquisition of S.
12.23
12: REVISION OF BASIC GROUPS
Solution Goodwill (a) With provision $
(b) Without provision $
(a)
(b)
$
$
Cost of combination Net assets acquired Provision for restructuring Goodwill P Group – Consolidated income statement for the year
Profit before restructuring costs Restructuring costs Release provision Profit before tax Income tax expense Profit for the period
Initial accounting determined provisionally 6.7
Adjustments to provisional figures for the cost of the combination and fair value of assets, liabilities and contingent liabilities acquired may be made within 12 months of the acquisition date. Thereafter, adjustments to goodwill can only be made for: •
errors under IAS 8
•
unrecognised deferred tax assets subsequently realised
•
contingent consideration (which was either not probable or could not be measured reliably at the time of the combination).
12.24
12: REVISION OF BASIC GROUPS
7
Current developments
Changes to IFRS 3 Exposure Draft (June 2005) Scope 7.1
IFRS 3 would be extended to cover: • • •
acquisition of assets and liabilities of unincorporated businesses business combinations involving mutual entities business combinations by contract alone.
Overview 7.2
Accounting for business combinations would be simplified: all would be accounted for using the acquisition method (formerly the 'purchase' method). The whole acquired business would be measured at fair value, not just the assets and liabilities themselves.
Goodwill 7.3
Goodwill would be shown gross of non-controlling (formerly 'minority') interest and measured as: Fair value of 100% of the acquiree as a whole* Less: Fair value of net identifiable assets acquired and liabilities assumed
X (X) X
* measured using quoted price/ grossed up consideration (if representative) or market/income valuation techniques. This applies even with acquisitions < 100% and step by step (piecemeal) acquisitions. Fair value measurement 7.4
Assets acquired and liabilities assumed Currently IFRS 3 uses estimated fair values and some fair value principles inconsistent with the concept of fair value (e.g. measuring finished goods at selling price less costs of disposal and profit). The revised IFRS 3 would require all items to be measured at their fair value (in accordance with the guidance in the relevant standard), except: • • • • •
assets held for sale Measured in accordance with the deferred tax relevant standard to reduce cost of operating leases applying IFRS 3 employee benefit plans goodwill (measured as a residual under IFRS 3)
Contingencies would be treated as per IAS 37 revised. Intangible assets would measured separately from goodwill whenever they meet the IAS 38 definition (previously only if their fair value could be measured reliably).
12.25
12: REVISION OF BASIC GROUPS Acquisition costs would normally be treated as expenses rather than being treated as part of the consideration. The IASB is considering issuing a standalone Standard on fair value measurement before IFRS 3 is finalised (see Chapter 14). 7.5
Fair value of consideration The fair value of consideration transferred is calculated as the acquisition-date fair values of: (a) (b)
the assets transferred, liabilities assumed or equity interests issued by the acquirer any non-controlling interest owned immediately before the acquisition date.
Contingent consideration is treated as follows after the measurement period: • • 7.6
If accounted for as equity: not remeasured If accounted for as liabilities: remeasured per IAS 37/39 or other IFRS as appropriate.
If the consideration transferred < fair value of acquirer's interest in acquiree, after reassessing the fair values used, the excess is accounted for as follows: • •
first to reduce the goodwill recognised to zero; thereafter as a gain in the acquirer's income statement.
Such transactions are rare (e.g. if the seller is forced to sell), and are treated as a bargain purchase. Business combinations achieved in stages (Piecemeal acquisitions) 7.7
Where a non-controlling interest was held before control obtained A previously held non-controlling interest is remeasured to fair value (with changes recognised in profit or loss, recycling any gains/losses previously recognised in reserves), before applying para 7.3. Where control has previously been obtained Accounted for as equity transactions in accordance with IAS 27 – see Chapter 14 Section 5.2.
Proposed effective date 7.8
The revised Standard would be effective for annual periods beginning on or after 1 January 2009 (with earlier application encouraged providing revised IAS 27 (see Chapter 14) and revised IAS 37 (see Chapter 9) are also applied). The IASB announced in July 2006 that no new IFRSs would be effective until 1 January 2009 to provide four years of stability in the IFRS platform after the 2005 adoption and changes.
12.26
12: REVISION OF BASIC GROUPS
8
Chapter summary
8.1 Q16 Highland
Section
Topic
Summary
1
Approach
BPP recommends a methodical step by step approach to the consolidated balance sheet and income statement.
2
Types of investment
Investments in subsidiaries, associates or joint ventures are accounted for in the investor's own books at cost or at fair value (as an available-for-sale financial asset under IAS 39).
3
Subsidiaries
The definition is based on a control relationship. Subsidiaries are consolidated in full, but intragroup transactions, balances and unrealised profits are eliminated in full. Special purpose entities which are in substance quasi subsidiaries are consolidated as if they were a subsidiary.
4
Associates
Associates arise where the investor has significant influence. They are accounted for using the equity method as one line in the balance sheet and one line in the income statement. Intragroup transactions are not eliminated other than the investor's share of unrealised profits.
5
Joint ventures
There are three types of joint venture. Jointly controlled entities are consolidated using proportionate consolidation or the equity method. Jointly controlled assets and operations are accounted for in the investor's own financial statements.
6
Goodwill
IFRS 3 contains detailed rules on how to measure the cost of the business combination and the fair value of assets acquired and liabilities assumed to ensure the goodwill figure is accurate.
7
Current developments
A radical overhaul of IFRS 3 is planned. The fair value rules would be revised, and most significantly, goodwill would be measured gross of the minority share and a minority interest shown in it.
12.27
12: REVISION OF BASIC GROUPS
END OF CHAPTER 12.28
Complex groups
Syllabus Guide Detailed Outcomes Having studied this chapter you will be able to: •
Apply the method of accounting for business combinations including complex group structures.
•
Apply the recognition and measurement criteria for identifiable acquired assets and liabilities and goodwill including step acquisitions.
Exam Context Any of the topics covered in this chapter could appear as the compulsory consolidation question in Section A of the exam paper, combined with adjustments on other areas of the syllabus.
Qualification Context Accounting for complex groups is only tested in Paper P2.
Business Context Complex business structures are extremely common in the business world. In order to be able to understand, and therefore analyse, the financial statements of large companies, it is essential to understand how these structures have been accounted for.
13.1
13: COMPLEX GROUPS
Overview Complex groups
Issues
Calculations
Acquisition of sub-subsidiary pre acquisition
'D' shaped groups
Acquisition of sub-subsidiary post acquisition
13.2
13: COMPLEX GROUPS
1
Issues
1.1
So far we have only considered simple group structures e.g. P 80% S Here P has direct control of S its subsidiary.
Control 1.2
P must prepare group accounts including each subsidiary it controls whether directly or indirectly. Consider the following example: P 60% S1 60% S2 P controls S1, S1 controls S2; therefore P controls S2.
Ownership 1.3
As S2 held via a 60% owned subsidiary (S1) the ownership of S2 is 36% and the minority interest is 64%.
Consolidation technique 1.4
Assets and liabilities – show what group controls Equity section
– shows the ownership of the assets and liabilities included in the balance sheet – reserves, therefore, will be based on effective holdings.
13.3
13: COMPLEX GROUPS
2
Calculations
Goodwill and post acquisition profits 2.1
When calculating goodwill and post acquisition profits the date of the acquisition of the subsubsidiary by the intermediate parent needs to be considered carefully.
Acquisition of sub-subsidiary ‘pre acquisition' 2.2
e.g. P 1.1.X5 S1 1.1.X2 S2 In this case P is acquiring an interest in the S1 group. Goodwill arising on the acquisition by P will be calculated as one figure by comparing the cost of the combination to the consolidated identifiable assets, liabilities and contingent liabilities of S1.
Acquisition of sub-subsidiary ‘post acquisition' 2.3
e.g. P 1.1.X5 S1 1.1.X7 S2 In this case P is acquiring an interest in S1 only, an individual company, and goodwill should be calculated as such. When S1 acquires its interest in S2 further goodwill will arise. The full amount will be included in the consolidated balance sheet of P. The minority interest in S1 will include a share of this goodwill. Only the group share of any impairment losses on goodwill will affect retained earnings.
13.4
13: COMPLEX GROUPS
Lecture example 1
Preparation question
Ultimate
Share capital $ 100,000
Reserves 20X1 $ 500,000
20X4 $ 750,000
Superior
50,000
120,000
180,000
Inferior
20,000
65,000
95,000
Required Calculate goodwill arising in the consolidated balance sheet of Ultimate on the basis that: (a)
Ultimate acquired 80% of Superior in 20X4 for $220,000. Superior had acquired its 75% interest in Inferior in 20X1 for $87,000.
(b)
Ultimate acquired 80% of Superior in 20X1 for $160,000. Superior subsequently acquired its 75% interest in Inferior in 20X4 for $100,000.
Solution
13.5
13: COMPLEX GROUPS
Vertical groups
Lecture example 2
Preparation question
Below are the balance sheets of three companies, Alpha, Beta and Gamma as at 31 December 20X5: Alpha $'000 Investments 300,000 shares in Beta 240,000 shares in Gamma Current assets
Beta $'000
Gamma $'000
890
320 610
670
1,340
930
670
600 400 1,000 340 1,340
400 300 700 230 930
300 100 400 270 670
450
Share capital ($1 ordinary shares) Retained earnings Current liabilities (1)
Alpha acquired its interest in Beta on 1 January 20X3 when the balance on the retained earnings was $100,000.
(2)
Beta acquired its interest in Gamma on 1 January 20X2 when the balance on the retained earnings was $50,000. On 1 January 20X3 the balance was $60,000.
(3)
Beta and Gamma form a single cash-generating unit. An impairment review carried out at 31 December 20X5 revealed that the CGU had a recoverable amount of $840,000.
Required Prepare the consolidated balance sheet of Alpha and its subsidiary companies as at 31 December 20X5.
13.6
13: COMPLEX GROUPS
Solution Alpha Group Consolidated balance sheet as at 31 December 20X5 Goodwill (W2) Current assets Share capital Retained earnings (W4) Minority interest (W3) Current liabilities Workings 1
Group structure
2
Goodwill
3
Minority interest
13.7
$'000
13: COMPLEX GROUPS 4
Consolidated retained earnings
Lecture example 3
Preparation question
Continuing from Lecture example 2 above are the summarised income statements of Alpha, Beta and Gamma for the year ended 31 December 20X5. Alpha Beta Gamma $'000 $'000 $'000 Profit before tax 500 300 200 Income tax expense (300) (150) (150) Profit for the period 200 150 50 $18,000 of the impairment loss recognised in Lecture example 2 relates to the current period. Required Prepare the consolidated income statement of Alpha and its subsidiary companies for the year ended 31 December 20X5.
Solution Alpha Consolidated income statement for the year ended 31 December 20X5 $'000 Profit before tax Income tax expense Profit for the period Attributable to: Equity holders of the parent Minority interest (W1)
13.8
13: COMPLEX GROUPS Workings 1
Minority interest
3
‘D' shaped groups
Lecture example 4
Preparation question
Below are the balance sheets of Alpha, Beta and Gamma as at 31 December 20X5. Alpha $'000 Investments 300,000 shares in Beta 24,000 shares in Gamma 216,000 shares in Gamma
Beta $'000
Gamma $'000
450 35 315
Current assets
869 1,354
660 975
574 574
Share capital ($1 ordinary shares) Retained earnings
600 400 1,000 354 1,354
400 357 757 218 975
320 180 500 74 574
Current liabilities (1)
Alpha acquired its interest in Beta on 1 January 20X3 when the balance on the retained earnings was $140,000.
(2)
Alpha and Beta acquired their respective interests in Gamma on 1 January 20X4 when the balance on the retained earnings was $80,000.
(3)
Alpha, Beta and Gamma constitute separate cash-generating units. The year end impairment test revealed impairment losses of $10,000 re Gamma's recognised goodwill, but none of the other CGUs were affected.
Required Prepare the consolidated balance sheet as at 31 December 20X5.
13.9
13: COMPLEX GROUPS
Solution Alpha Consolidated balance sheet as at 31 December 20X5 $'000 Goodwill (W2) Current assets
Share capital Retained earnings (W4) Minority interest (W3) Current liabilities Workings 1
Group structure
2
Goodwill
13.10
13: COMPLEX GROUPS 3
Minority interest
4
Retained earnings
4
Chapter summary
4.1 Q19 Big Group
Section
Topic
Summary
1
Issues
A parent must consolidate all investments that meet the definition of a subsidiary, i.e. where there is control. Therefore, a sub-subsidiary controlled by a subsidiary is consolidated, even though the effective holding may be a minority one.
2
Calculations
The date of control determines the method for calculating goodwill and therefore the date that postacquisition profits are consolidated from.
3
'D' shaped groups
Control of a sub-subsidiary can be made up of both an indirect interest by the subsidiary and a direct interest by the parent. The approach to consolidation is the same where there is control.
13.11
13: COMPLEX GROUPS
END OF CHAPTER 13.12
Changes in group structures
Syllabus Guide Detailed Outcomes Having studied this chapter you will be able to: •
Prepare group financial statements where activities have been discontinued, or have been acquired or disposed of in the period. (Discontinued activities covered in Chapter 15)
•
Discuss the reasons behind a group reorganisation.
•
Evaluate and assess the principal terms of a proposed group reorganisation.
Exam Context Disposals are a commonly examined topic. It could appear as the compulsory consolidation question in Section A of the exam paper, combined with adjustments on other areas of the syllabus There is also scope for discussing or calculating disposal figures in Section B in a scenario/specialised industry question or as part of a multi-part question. IAS 27 Consolidated and Separate Financial Statements contains the principles for dealing with disposals in consolidated financial statements. In the parent's separate financial statements, a disposal is a sale of shares and so is accounted for in accordance with IAS 39 Financial Instruments: Recognition and Measurement.
Qualification Context Accounting for disposals is a topic specific to Paper P2. However, acquisitions, mergers and reorganisation strategies are explored further in optional Paper P4 Advanced Financial Management.
Business Context Disposals can cause significant cash flow and profit impacts in a group's financial statements. Understanding how the figures are calculated helps the analyst make judgements about the future impact of the disposal on the financial statements.
14.1
14: CHANGES IN GROUP STRUCTURES
Overview Current developments Changes in group structures
Types of disposal
Piecemeal (step) acquisitions
Internal group reorganisations
Full disposal
Subsidiary to subsidiary
Partial disposal
Subsidiary to associate
Subsidiary to investment Calculation of gain/loss
Parent's separate financial statements
14.2
Group financial statements
14: CHANGES IN GROUP STRUCTURES
1
Types of disposal
Full disposal 1.1
Income statement •
Consolidate results to date of disposal
•
Include group gain or loss in income statement as part of profit or loss for the period. Where significant, it should be disclosed separately.
Balance sheet •
There will be no consolidation and no minority interest as there is no subsidiary at the date the balance sheet is being prepared.
Partial disposals 1.2
(a)
Subsidiary to subsidiary Income statement (i)
Consolidate subsidiary in full for the whole period.
(ii)
Minority interest time apportioned based on percentage before and after disposal.
Balance sheet (i) (b)
Minority interest is based on year end percentage.
Subsidiary to associate Income statement (i)
Treat as subsidiary to date of disposal, i.e. consolidate for correct number of months and show minority interest for that period.
(ii)
Treat as associate thereafter.
Balance sheet • (c)
Equity valuation based on year-end holding.
Subsidiary to trade investment Income statement (i)
Consolidate as subsidiary to date of disposal
(ii)
Show dividend income only thereafter.
Balance sheet (i)
Equity valuation at date of disposal and then treat as an available-for-sale financial asset under IAS 39.
14.3
14: CHANGES IN GROUP STRUCTURES
2
Calculation of gain or loss
2.1
Parent's separate financial statements
$
Sale proceeds Less: Carrying value of investment (original cost in the exam) Profit/(loss) (probably taxable)
$ X (X) X/(X)
Group financial statements Sale proceeds Less: Net assets at disposal × share disposed share disposed Goodwill at disposal × share held before disposal
X X (X) X/(X)
Group profit/(loss) 2.2
$ X
Income tax is normally payable by reference to the parent's gain. This should only be accounted for in exams if requested by the examiner.
14.4
14: CHANGES IN GROUP STRUCTURES
Lecture example 1
Preparation question
Ted Co bought 240,000 shares in Bill (80% of Bill Co's share capital) for $950,000 on 1 October 20X1. At that date Bill Co's retained earnings stood at $510,000. Ted Co has several other subsidiaries, which are wholly owned. The balance sheets at 30 September 20X8 and the summarised income statements to that date are given below: Balance sheets
Property, plant and equipment Investment in Bill Co Current assets Share capital ($1 ordinary shares) Retained earnings Current liabilities
Ted Co Group $'000 2,050 950 2,700 5,700
Bill Co
2,000 2,500 4,500 1,200 5,700
300 1,100 1,400 500 1,900
$'000 1,400 (400) 1,000
$'000 180 (50) 130
$'000 1,500 1,000 2,500
$'000 970 130 1,100
$'000 600 – 1,300 1,900
Income statements Profit before interest and tax Income tax expense Profit for the period Statement of changes in equity (extract) Retained earnings at 30 September 20X7 Profit for the period Retained earnings at 30 September 20X8
No entries have been made in the accounts for any of the following transactions. Assume that profits accrue evenly throughout the year. To date no impairment losses on goodwill have been necessary. Ignore income taxes. Required Prepare the consolidated balance sheet, income statement and statement of changes in equity extract at 30 September 20X8 in each of the following circumstances: (a)
Ted Co sells all of its shares in Bill Co for $2,100,000 on 30 September 20X8.
(b)
Ted Co sells 60,000 shares in Bill Co for $380,000 on 30 June 20X8.
(c)
Ted Co sells 150,000 shares in Bill Co for $1,350,000 on 30 June 20X8, and the remaining holding is to be dealt with as an associate. 14.5
14: CHANGES IN GROUP STRUCTURES
Solution (a)
Full disposal at the year end Consolidated balance sheet as at 30 September 20X8
$'000
Property, plant and equipment Current assets Share capital ($1 ordinary shares) Retained earnings Current liabilities
Consolidated income statement for the year ended 30 September 20X8 $'000 Profit before interest and tax Profit on disposal of shares in subsidiary Profit before tax Income tax expense Profit for the period Attributable to: Equity holders of the parent Minority interest
Consolidated statement of changes in equity (extract) Retained earnings $'000 Balance at 30 September 20X7 Profit for the period Balance at 30 September 20X8
14.6
14: CHANGES IN GROUP STRUCTURES Workings
14.7
14: CHANGES IN GROUP STRUCTURES (b)
Partial disposal (subsidiary to subsidiary) mid year Consolidated balance sheet as at 30 September 20X8
$'000
Property, plant and equipment Goodwill Current assets Share capital ($1 ordinary shares) Retained earnings Minority interest Current liabilities
Consolidated income statement for the year ended 30 September 20X8 $'000 Profit before interest and tax Profit on disposal of shares in subsidiary Profit before tax Income tax expense Profit for the period Attributable to: Equity holders of the parent Minority interest
Consolidated statement of changes in equity (extract) $'000 Retained earnings Balance at 30 September 20X7 Profit for the period Balance at 30 September 20X8
14.8
14: CHANGES IN GROUP STRUCTURES Workings
14.9
14: CHANGES IN GROUP STRUCTURES (c)
Partial disposal (subsidiary to associate) mid year Consolidated balance sheet as at 30 September 20X8
$'000
Property, plant and equipment Investment in associate Current assets Share capital ($1 ordinary shares) Retained earnings Current liabilities
Consolidated income statement for the year ended 30 September 20X8 $'000 Profit before interest and tax Profit on disposal of shares in subsidiary Share of profit of associate Profit before tax Income tax expense Profit for the period Attributable to: Equity holders of the parent Minority interest
Consolidated statement of changes in equity (extract) Retained earnings $'000 Balance at 30 September 20X7 Profit for the period Balance at 30 September 20X8
14.10
14: CHANGES IN GROUP STRUCTURES Workings
14.11
14: CHANGES IN GROUP STRUCTURES
Additional Notes
14.12
14: CHANGES IN GROUP STRUCTURES
Dividends 2.3
(a)
Calculation of reserves The retained reserves/net assets at the date of disposal of the subsidiary should be calculated deducting only those dividends to which the parent is entitled i.e. dividends paid up to the date of disposal and dividends declared if the shares are sold ex-dividend.
(b)
Proforma calculation At the date of disposal would be as follows: Retained earnings brought forward Profit for period to date of disposal Dividends paid/declared at date of disposal
Lecture example 2
$ X X (X) X Preparation question
A Co acquires B Co in 20X1 on incorporation. On 30.6.X3 it disposes of its holding. The following are the results of B Co for the year ended 31.12.X3 $'000 $'000 Retained earnings b/d 4,000 Profit for the period 10,000 Dividends – interim (30/4) 2,000 – final 3,000 (5,000) Retained earnings c/d 9,000 Required Calculate retained earnings at the date of disposal.
Solution $'000 Retained earnings brought forward Profit for period to date of disposal Dividends paid/declared at date of disposal
14.13
14: CHANGES IN GROUP STRUCTURES
3
Internal group reorganisations
Illustrative example 3.1
A group may restructure itself internally to achieve a desired effect. For example: Before
After
Shareholders
Shareholders
P
P
S1 S1
S2
S2 Analysis 3.2
Reasons for such a reorganisation include: • • •
3.3
S1 can be sold off (perhaps to reduce group gearing) without selling off S2 potential tax advantages (e.g. loss relief) divisionalisation so that S1 and S2 report independently to P.
Such reorganisations (known as 'entities under common control') are excluded from the scope of IFRS 3 Business Combinations at the present time and so there are no specific accounting requirements. The substance of the transaction from the shareholders' point of view is that no sale has occurred as they own the same assets before and after the transaction (assuming ownership of each subsidiary is 100%). However, a gain or loss may be made in the separate financial statements of S1. This unrealised from the group point of view and would need to eliminated in the consolidated financial statements.
14.14
14: CHANGES IN GROUP STRUCTURES
4
Piecemeal (step) acquisitions
Issue 4.1
In practice, acquisitions may not take place all at once. It is possible that a controlling interest will be built up over a period of time.
4.2
There are two possible ways the subsidiary may have been treated in the consolidated accounts: (i)
As an IAS 39 investment until control is achieved (assuming there was no significant influence);
(ii)
If there was significant influence, equity accounted as an associate.
In both cases, goodwill is accounted for in the same way: each tranche is calculated separately on an incremental basis as at the date of each purchase, but it is only recognised from the date when either significant influence or control is achieved (i.e. in a single step for case (i), but in 2 steps for case (ii)).
Lecture example 3
Exam standard for 18 marks
Peace acquired 25% of Miel on 1.1.20X1 for $2,020,000 (equivalent to the fair value of $10.10 per share acquired on that date) when Miel's retained earnings were standing at $5,800,000. Miel had no other reserves. The fair value of Miel's identifiable assets and liabilities at that date was $7,200,000. Both Peace and Miel are stock market listed entities. A further 35% stake in Miel was acquired on 31.12.20X2 for $4,025,000 (equivalent to the fair value of $14.375 per share acquired on that date) giving Peace control over Miel. The fair value of Miel's identifiable assets and liabilities at that date was $9,400,000. Summarised balance sheets of the two companies at that date show: Non-current assets Property, plant and equipment Investment in Miel Current assets Equity attributable to equity holders of the parent Share capital Retained earnings Liabilities
Peace $'000
Miel $'000
38,650 6,900 45,550 12,700 58,250
7,500 – 7,500 2,200 9,700
10,200 40,600 50,800 7,450 58,250
800 7,800 8,600 1,100 9,700
The difference between the fair value of the identifiable assets and liabilities of Miel and their book value relates to the value of a plot of land. The land had not been sold by 31.12.20X2.
14.15
14: CHANGES IN GROUP STRUCTURES For consistency with the measurement of other shares, Peace holds all investments in subsidiaries and associates as available-for-sale financial assets in its separate financial statements as permitted by IAS 27. The investment in Miel figure at 31.12.20X2 is therefore made up of: Purchase of 25% stake at cost Fair value adjustments on 25% stake to 31.12.X2 [($14.375 - $10.10) x 20,000 shares] Purchase of 35% stake at cost
$'000 2,020 855 4,025 6,900
In accordance with IFRS 3, any adjustments to fair values relating to previously held interests at the time of subsequent acquisitions are accounted for as revaluations. No impairment losses on recognised goodwill have been necessary to date. Required Prepare the consolidated balance sheet of Peace Group as at 31.12.20X2 in the following circumstances: (a)
The 25% interest in Miel allowed Peace significant influence over the financial and operating policy decisions of Miel.
(b)
The other 75% of shares were held by a single shareholder and Peace was allowed no influence in the running of Miel until acquiring control.
Solution Consolidated balance sheet as at 31 December 20X2 $'000 Non-current assets Property, plant and equipment Goodwill Current assets Equity attributable to equity holders of the parent Share capital Retained earnings Revaluation surplus Minority interest Liabilities
14.16
14: CHANGES IN GROUP STRUCTURES Workings 1
Group structure
2
Fair value adjustments
3
Goodwill
4
Minority interest
5
Consolidated retained earnings
14.17
14: CHANGES IN GROUP STRUCTURES
5
Changes to IAS 27 Exposure Draft (June 2005)
Disposals 5.1
The revised IAS 27 would specify how to measure the income statement gain or loss, on loss of control of a subsidiary: Fair value of proceeds
X
+
Fair value of any investment remaining at date control lost
X
–
P's share of consolidated carrying value immediately before control lost
(X)
+/–
Gains/(losses) previously recognised in equity
X/(X) X
Changes in ownership without loss of control 5.2
Any changes in P's ownership that do not result in a loss of control (including piecemeal acquisitions, part disposals and 'deemed disposals') would be accounted for as transactions between equity holders (in their capacity as equity holders). No gain or loss would therefore be recognised in profit or loss. The change would be recognised in equity attributable to equity holders of the parent as follows: Fair value of consideration received/(paid)
X/(X)
Change in non-controlling interest in carrying value of net identifiable assets
(X)/X
Change in non-controlling interest in goodwill*
(X)/X X/(X)
*
Goodwill is reassigned between the equity holders of the parent and the noncontrolling interest based on the relative carrying values of goodwill allocated to each group. (This may not be equal to non-controlling interest multiplied by the amount recognised as goodwill if the parent had acquired an amount that exceeds the equity share of the subsidiary's fair value because the acquirer paid a premium for control.)
Summary of approach 5.3
Subsidiary to subsidiary (increase/decrease)
• No loss of control • Gain/loss to equity
Subsidiary to joint venture
• Gain/loss to income statement • Remeasured fair value is 'cost' • Held under IAS 31/28 from thereon
Subsidiary to associate Subsidiary to investment
• Gain/loss to income statement • Hold at fair value under IAS 39
14.18
14: CHANGES IN GROUP STRUCTURES
Proposed effective date 5.4
The revised standard would be effective for annual periods beginning on or after 1 January 2009 (with earlier application encouraged providing revised IFRS 3 (see Chapter 12) and revised IAS 37 (see Chapter 9) are also applied). The IASB announced in July 2006 that no new IFRSs would be effective until 1 January 2009 to provide four years of stability in the IFRS platform after the 2005 adoption and changes.
14.19
14: CHANGES IN GROUP STRUCTURES
6
Chapter summary
6.1 Q20 Murder, Mystery & Supense Q21 Holmes & Deakin
Section
Topic
Summary
1
Types of disposal
Disposals can be of a number of types: Subsidiary to subsidiary where control is not lost, but minority interest changes during the period. Subsidiary to associate where the investment is part consolidated, part equity accounted in the period. Subsidiary to investment where the subsidiary is consolidated to the point of sale and treated as an investment in shares thereafter.
2
Calculation of gain or loss
The gain or loss is different between the parent's separate financial statements and the group financial statements because the investment has a different carrying value in each set of books.
3
Internal reorganisations
Groups may restructure themselves internally for a number of reasons. Such reorganisations are outside the scope of IFRS 3. Any gains or losses in the separate financial statements of each company are unrealised from the group point of view and would need to be eliminated.
4
Piecemeal (step) acquisitions
Piecemeal (or 'step') acquisitions are where a controlling interest is built up in stages. Goodwill is calculated separately for each purchase at the date of each step based on figures at that date, and recognised from the date control is achieved.
5
Current developments: Changes to IAS 27 ED
An Exposure Draft proposes measuring the gain or loss on disposal of a subsidiary where control is lost as the difference between the sale proceeds plus the fair value of the remaining investment less the full consolidated value of the subsidiary before the disposal, not just the share disposed. Where control is not lost, or a piecemeal acquisition increases a controlling interest, the ED proposes recognition of the change in equity as a reallocation between parent and minority equity holders.
END OF CHAPTER 14.20
Continuing and discontinued interests
Syllabus Guide Detailed Outcomes Having studied this chapter you will be able to: •
Apply and discuss the treatment of non-current assets held for sale.
•
Prepare group financial statements where activities have been discontinued, or have been acquired or disposed of in the period.
•
Apply and discuss the treatment of a subsidiary which has been acquired exclusively with a view to subsequent disposal.
Exam Context This topic could appear as part of the compulsory groups question in Section A of the Paper. The requirements relating to discontinued operations generally and non-current assets held for sale could be examined as part of a scenario/ specialised industry question in Section B.
Qualification Context IFRS 5 is also covered in Paper F7 Financial Reporting. However, the group aspects are brought in only at this level.
Business Context Separate analysis of discontinued operations and of non-current assets held for sale allows the user of the accounts to make more accurate assessments about the business' prospects in the future, by being able to exclude these items.
15.1
15: CONTINUING AND DISCONTINUED INTERESTS
Overview Continuing and discontinued interests
Discontinued operations
Non-current assets/disposal groups held for sale
Non-current assets/ disposal groups to be abandoned
15.2
15: CONTINUING AND DISCONTINUED INTERESTS
1
IFRS 5: Non-current assets held for sale and discontinued operations
Introduction 1.1
The IFRS covers: •
measurement, presentation and disclosure of non-current assets and disposal groups of an entity; and
•
the presentation and disclosure of discontinued operations.
It was the first IFRS to be issued as a result of the 'Norwalk Agreement' which aims to work towards harmonisation of International and US GAAP.
Scope 1.2
The IFRS applies to all of an entity's recognised non-current assets and disposal groups (as defined below) with the following exceptions: • • • • • •
Deferred tax assets; Assets arising from employee benefits; Financial assets within the scope of IAS 39; Investment properties accounted for under the fair value model; Biological assets measured at fair value; and Rights under insurance contracts.
Disposal groups 1.3
Disposal group – definition (IFRS 5) A disposal group is a group of assets to be disposed of (by sale or otherwise) together as a group in a single transaction and liabilities directly associated with those assets that will be transferred in the transaction. The disposal group may be a group of CGUs (cash-generating units), a single CGU, or part of a CGU.
Classification of non-current assets (or disposal groups) as held for sale Chapter 19 Section 3.2
1.4
An entity shall classify a non-current asset (or disposal group) as held for sale if its carrying amount will be recovered principally through a sales transaction rather than through continuing use.
1.5
To be classified as 'held for sale', the following criteria must be met: (a)
The asset (or disposal group) must be available for immediate sale in its present condition, subject only to usual and customary sales terms; and
15.3
15: CONTINUING AND DISCONTINUED INTERESTS (b)
The sale must be highly probable. For this to be the case: –
P rice at which the asset (or disposal group) is actively marketed for sale must be reasonable in relation to its current fair value;
–
U nlikely that significant changes will be made to the plan or the plan withdrawn (indicated by actions required to complete the plan);
–
M anagement (at the appropriate level) must be committed to a plan to sell;
–
A ctive programme to locate a buyer and complete the plan must have been initiated;
–
S ale expected to qualify for recognition as a completed sale within one year from the date of classification as held for sale (subject to limited specified exceptions).
Measurement and presentation of non-current assets (or disposal groups) classified as held for sale Approach 1.6
Immediately before initial classification as held for sale, the asset (or disposal group) is measured in accordance with the applicable IFRS (eg. property, plant and equipment held under the IAS 16 revaluation model is revalued). Any impairment loss arising on reclassification is accounted for as normal (IAS 36). Classify non-current asset (or disposal group) as held for sale and measure at the lower of: • •
Carrying amount; and Fair value less costs to sell.
Non-current assets/disposal groups classified as held for sale are not depreciated/amortised. Subsequent changes in fair value less costs to sell Any subsequent changes in fair value less costs to sell are recognised as a further impairment loss (or reversal of an impairment loss) as normal (IAS 36). However, gains recognised cannot exceed cumulative impairment losses to date (whether under IAS 36 or IFRS 5). Disclosed: • as single amounts (of assets and liabilities); • on the face of the balance sheet; • separately from other assets and liabilities, and • normally as current assets and liabilities (not offset). 15.4
15: CONTINUING AND DISCONTINUED INTERESTS
Lecture example 1
Exam standard for 2 marks (each part)
On 1 July 20X2, an item of property, plant and equipment with a net book value of $200,000 at that date is classified as held for sale and was expected to be sold in March 20X3. Its fair value less costs to sell and market value on that date are $205,000 and $207,000 respectively. The asset had not been sold by the year end, 31 December 20X2. The asset's fair value less costs to sell at 31 December was $195,000. Required Explain the accounting treatment of the asset at initial classification as held for sale and at the year end 31 December 20X2 assuming: (a)
it was held under the cost model of IAS 16
(b)
it was held under the revaluation model of IAS 16 (cumulative previous revaluations amounted to $4,000, none of which had been treated as realised at 1 July 20X2).
Solution
No longer classified as held for sale 1.7
A non-current asset that ceases to be classified as held for sale (or ceases to be included in a disposal group classified as held for sale) is measured at the lower of: (a)
its carrying amount before the asset (or disposal group) was classified as held for sale, adjusted for any depreciation, amortisation or revaluations that would have been recognised had the asset (or disposal group) not been classified as held for sale; and
(b)
its recoverable amount at the date of the subsequent decision not to sell.
15.5
15: CONTINUING AND DISCONTINUED INTERESTS
2
Non-current assets to be abandoned
2.1
Non-current assets (or disposal groups) to be abandoned are not classified as held for sale, since their carrying amount will be recovered principally through continuing use. This includes non-current assets (or disposal groups) that are to be: • •
used to the end of their economic life; or closed rather than sold.
2.2
However, if the disposal group meets the definition of a discontinued operation (see 3.1), it is presented as such at the date it ceases to be used.
3
Discontinued operations
Definition 3.1
Discontinued operation (IFRS 5) A discontinued operation is a component of an entity that either has been disposed of or is classified as held for sale and: (a)
represents a separate major line of business or geographical area of operations, or
(b)
is part of a single coordinated plan to dispose of a separate major line of business or geographical area of operations, or is a subsidiary acquired exclusively with a view to resale.
(c)
A component of an entity is one that has operations and cash flows that can be clearly distinguished, operationally and for financial reporting purposes, from the rest of the entity.
Presentation and disclosure 3.2
The general requirement is that an entity shall present and disclose information that enables users of financial statements to evaluate the financial effects of discontinued operations and disposals of non-current assets and disposal groups. The following disclosures apply: Discontinued operations (a)
On the face of the income statement (i)
a single amount comprising the total of: (1)
the post-tax profit or loss of discontinued operations, and
(2)
the post-tax gain or loss recognised on the remeasurement to fair value less costs to sell or on the disposal of assets/disposal groups comprising the discontinued operation.
15.6
15: CONTINUING AND DISCONTINUED INTERESTS (b)
On the face of the income statement or in the notes (i)
the revenue, expenses, and pre-tax profit or loss of discontinued operations, and the related income tax expense;
(ii)
the gain or loss recognised on the measurement to fair value less costs to sell or on the disposal of assets/disposal groups comprising the discontinued operation and related income tax expense;
(iii)
the net cash flows attributable to the operating, investing, and financing activities of discontinued operations.
Non-current assets/disposal groups held for sale or sold (c)
In the notes (i)
a description of the non-current asset (or disposal group);
(ii)
a description of the facts and circumstances of the sale, or leading to the expected disposal, and the expected manner and timing of the disposal;
(iii)
the gain or loss recognised on assets classified as held for sale, and (if not separately disclosed on the face on the income statement) the caption which includes it;
(iv)
if applicable, the operating segment in which the non-current asset is presented in accordance with IFRS 8.
Proforma disclosure 3.3
XYZ Group – Income statement for the year ended 31 December 20X3 20X3 $'000
20X2 $'000
Continuing operations Revenue Cost of sales Gross profit Other income Distribution costs Administrative expenses Other expenses Finance costs Share of profit of associates Profit before tax Income tax expense Profit for the period from continuing operations
X (X) X X (X) (X) (X) (X) X X (X) X
X (X) X X (X) (X) (X) (X) X X (X) X
Discontinued operations Profit for the period from discontinued operations
X
X
Profit for the period
X
X
X X X
X X X
Attributable to: Equity holders of the parent Minority interest
15.7
15: CONTINUING AND DISCONTINUED INTERESTS
Lecture example 2
Exam standard for 25 marks
Balboa, a public limited company, has acquired two subsidiaries during the accounting period. The details of the acquisitions are as follows:
Company
Date of acquisition
Borbon Carbonell
1 May 20X4 1 October 20X4
Ordinary share capital of $1 $m 500 300
Reserves at acquisition $m 750 180
Fair value of net assets at acquisition $m 1,400 640
Cost of investment $m 1,332 476
Ordinary share capital of $1 acquired $m 450 210
The draft income statements for the year ended 31 December 20X4 are: Balboa $m 4,700 (3,700) 1,000 150 (270) (220) (110) 550 (180) 370
Revenue Cost of sales Gross profit Other income Distribution costs Administrative expenses Finance costs Profit before tax Income tax expense Profit for the period
Borbon $m 3,300 (2,400) 900 30 (210) (180) (60) 480 (150) 330
Carbonell $m 1,800 (1,400) 400 – (180) (80) (20) 120 (40) 80
The following information is relevant to the preparation of the group financial statements. (a)
The investment in Borbon was acquired as part of a growth strategy of the group. The difference between fair value and book value on acquisition relates to properties, with an average remaining useful life of 10 years at the date of acquisition. Borbon made a dividend payment of $50m on 20 October 20X4 out of post acquisition profits and this is included in Balboa's 'other income'.
(b)
Carbonell was acquired exclusively with a view to sale and at 31 December 20X4 meets the criteria of being a disposal group. The fair value of Carbonell at 31 December 20X4 is $710m and the estimated selling costs of the shareholding in Carbonell are $14m. The difference between fair value and book value at acquisition related to land held by Carbonell. Carbonell did not pay any dividends in the post-acquisition period.
(c)
At 1 January 20X4, Borbon held an investment in the quoted debenture loans of another company, correctly carried at $113m, which it intended to hold to its maturity date, 31 December 20X4, when they were to be redeemed at $115m. The debentures had an effective interest rate is 5.5%. On 1 January 20X4 the company received a letter indicating the investee was suffering financial difficulties and was expected to enter liquidation. The letter indicated that the bond would be repaid on its original repayment date 31 December 20X4, but that no further interest would be paid. This is indeed what happened. Other than recording the cash received on 31 December 20X4, no further adjustments have been made. The letter was not considered an adjusting event after the balance sheet date affecting the 20X3 financial statements. 15.8
15: CONTINUING AND DISCONTINUED INTERESTS (d)
No adjustments have yet been made for Balboa's defined benefit pension scheme, details as follows: $m Present value of obligation at 31 December 20X3 150 Fair value of plan assets at 31 December 20X3 160 Interest cost 4% Current service cost 12 Expected return on scheme assets 5% On 31 December 20X4, given the surplus on the scheme, the plan rules were changed to improve benefits. This resulted in an additional liability of $10m of which 40% related to vested benefits and 60% to benefits that will vest over the next six years from that date. Balboa's accounting policy is to recognised actuarial gains and losses immediately in retained earnings. The net pension cost is treated as a cost of sale.
(e)
Calculations conducted at the year end showed the recoverable amount (based on continuing use) of Borbon to be $1,660m and that of Carbonell was $690m at 31 December 20X4. Impairment losses on goodwill are charged to cost of sales.
(f)
Assume that profits accrue evenly throughout the year and ignore any taxation effects.
Required Prepare a consolidated income statement for the Balboa Group for the year ended 31 December 20X4 in accordance with International Financial Reporting Standards. Notes to the financial statements are not required.
Solution Balboa Group Consolidated income statement for the year ended 31 December 20X4 $m Continuing operations Revenue Cost of sales Gross profit Other income Distribution costs Administrative expenses Finance income Finance costs Profit before tax Income tax expense Profit for period from continuing operations
15.9
15: CONTINUING AND DISCONTINUED INTERESTS
Discontinued operations Profit for the period from discontinued operations Profit for the period Attributable to: Equity holders of the parent Minority interest Workings
15.10
$m
15: CONTINUING AND DISCONTINUED INTERESTS
15.11
15: CONTINUING AND DISCONTINUED INTERESTS
4
Chapter summary
4.1 Section
Topic
Summary
1
Non-current assets/ disposal groups held for sale
Non-current assets or groups of non-current assets (and associated liabilities) are classified as held for sale when certain criteria are met. Such assets are disclosed separately in the balance sheet and not depreciated.
2
Non-current assets/disposal groups to be abandoned
Non-current assets or disposal groups being abandoned are not classified as held for sale as they are not being sold. However, if they represent a big enough component to meet the discontinued operation definition, they are classified as such, but not until the period of discontinuance.
3
Discontinued operations
Discontinued operations are also disclosed separately. The minimum disclosure on the face of the income statement is the profit/loss on the discontinued operations and any gains or losses on sale or remeasurement if classified as held for sale.
END OF CHAPTER 15.12
Foreign transactions and entities
Syllabus Guide Detailed Outcomes Having studied this chapter you will be able to: •
Outline and apply the translation of foreign currency amounts and transactions into the functional currency and the presentation currency.
•
Account for the consolidation of foreign operations and their disposal.
•
Describe the principal objectives of establishing a standard for enterprises reporting in the currency of a hyperinflationary economy.
Exam Context A foreign subsidiary could form the basis of the group accounting question in Section A of the exam. Other aspects, such as accounting for a foreign currency transaction, the distinction between functional currency and presentation currency, a calculation of the gain or loss on disposal of a foreign operation or of goodwill on the acquisition of a foreign subsidiary, or dealing with the exchange differences on a loan financing a foreign operation could also appear in Section B of the paper.
Qualification Context Foreign currency accounting is only tested in Paper P2. Foreign currency risk management is included in the optional Professional Level Paper P4 Advanced Financial Measurement syllabus.
Business Context The rules in IAS 21 apply to any business which trades abroad or which has operations located abroad. Exchange differences, particularly those on the translation of the financial statements or a foreign operation, can be a very large figure in the financial statements. An analyst needs to understand the impact of such differences on past and future cash flows and profits.
16.1
16: FOREIGN TRANSACTIONS AND ENTITIES
Overview Foreign transactions and entities
Currency concepts
Functional currency
Hyperinflation
Presentation currency
Foreign operations
Monetary items forming part of net investment in foreign operation
16.2
16: FOREIGN TRANSACTIONS AND ENTITIES
1
Currency concepts
Objective 1.1
1.2
The translation of foreign currency transactions and financial statements should: (a)
produce results which are generally compatible with the effects of rate changes on a company's cash flows and its equity, and
(b)
ensure that the financial statements present a true and fair view of the results of management actions.
Two currency concepts
FUNCTIONAL CURRENCY
PRESENTATION CURRENCY
• Currency of the primary economic environment in which an entity operates • The currency used for measurement in the financial statements • Other currencies treated as a foreign currency
16.3
• Can be any currency • Special rules apply to translation from functional currency to presentation currency • Same rules used for translating foreign operations
16: FOREIGN TRANSACTIONS AND ENTITIES
2
Functional currency
Definition 2.1
Functional currency (IAS 21) The currency of the primary economic environment in which the entity operates. It is the currency in which the financial statement transactions are measured.
Determining an entity's functional currency 2.2
An entity considers the following factors in determining its functional currency: (a)
(b)
2.3
The currency: (i)
that mainly influences sales prices for goods and services (this will often be the currency in which sales prices for its goods and services are denominated and settled); and
(ii)
of the country whose competitive forces and regulations mainly determine the sales prices of its goods and services.
The currency that mainly influences labour, material and other costs of providing goods or services (this will often be the currency in which such costs are denominated and settled).
The following factors may also provide evidence of an entity's functional currency: (a) (b)
The currency in which funds from financing activities are generated. The currency in which receipts from operating activities are usually retained.
Reporting foreign currency transactions in the functional currency Initial recognition 2.4
Translate each transaction by applying the spot exchange rate between the functional currency and the foreign currency at the date of transaction (an average rate for a period may be used as an approximation if rates do not fluctuate significantly).
At subsequent balance sheet dates 2.5
(a)
Monetary assets and liabilities Restate at closing rate.
(b)
Non-monetary assets measured in terms of historical cost (e.g. non-current assets, inventories) Do not restate (i.e. they remain at historical rate).
(c)
Non-monetary assets measured at fair value Use exchange rate when fair value was determined.
16.4
16: FOREIGN TRANSACTIONS AND ENTITIES Recognition of exchange differences 2.6
Exchange differences are recognised as part of profit or loss for the period in which they arise. IAS 21 is not prescriptive about which caption the exchange difference would be included in. The following however is the generally accepted approach: Trading transactions – other income/expense Financing transactions – finance income/finance costs
Lecture example 1
Exam standard for 2 marks
San Francisco Co entered into the following foreign currency transaction: 31.10.X8 31.12.X8 31.01.X9
Purchased goods from Mexico SA for 129,000 Mexican pesos Payables have not yet been paid San Francisco Co paid its payables.
The exchange rates are as follows: 31.10.X8 31.12.X8 31.01.X9
Pesos to $1 9.5 10 9.7
Required How would this transaction be recorded in the books of San Francisco Co for the years ended 31 December 20X8 and 20X9?
Solution
16.5
16: FOREIGN TRANSACTIONS AND ENTITIES
Changes in the functional currency 2.7
An entity's functional currency reflects the underlying transactions, events and conditions that are relevant to it. Accordingly, once determined, the functional currency is not changed unless there is a change in those underlying transactions, events or conditions. Where there is a change in the functional currency, translation procedures applicable to the new functional currency are applied prospectively from the date of the change.
3
Presentation currency
Definition 3.1
Presentation currency (IAS 21) The currency in which the financial statements are presented. An entity may present its financial statements in any currency (or currencies).
Translation rules 3.2
The results and financial position of an entity whose functional currency is not the currency of a hyperinflationary economy are translated into a different presentation currency as follows: (a)
Assets and liabilities for each balance sheet presented (i.e. including comparatives) ⇒ translated at the closing rate at the date of that balance sheet;
(b)
Income and expenses for each income statement (i.e. including comparatives) ⇒ translated at actual exchange rates at the dates of the transactions (an average rate for the period may be used if exchange rates do not fluctuate significantly); and
(c)
All resulting exchange differences ⇒ are recognised as a separate component of equity (the translation reserve).
4
Foreign operations
Definition 4.1
Foreign operation (IAS 21) A foreign operation is an entity that is a subsidiary, associate, joint venture or branch of a reporting entity, the activities of which are based or conducted in a country or currency other than those of the reporting entity.
16.6
16: FOREIGN TRANSACTIONS AND ENTITIES
Translation method 4.2
The foreign operation determines its own functional currency and prepares its financial statements in that currency. Where different to the parent's functional currency, the financial statements need to be translated before consolidation. The financial statements are translated into the presentation currency (functional currency of the reporting entity) using the presentation currency rules outlined in Section 3. Any goodwill and fair value adjustments are treated as assets and liabilities of the foreign operation and are translated at the closing rate.
Determining a foreign operation's functional currency 4.3
The following additional factors are considered in determining the functional currency of a foreign operation, and whether its functional currency is the same as that of the reporting entity: (a)
Whether the activities of the foreign operation are carried out as an extension of the reporting entity, rather than being carried out with a significant degree of autonomy. An example of the former is when the foreign operation only sells goods imported from the reporting entity and remits the proceeds to it. An example of the latter is when the operation accumulates cash and other monetary items, incurs expenses, generates income and arranges borrowings, all substantially in its local currency.
(b)
Whether transactions with the reporting entity are a high or a low proportion of the foreign operation's activities.
(c)
Whether cash flows from the activities of the foreign operation directly affect the cash flows of the reporting entity and are readily available for remittance to it.
(d)
Whether cash flows from the activities of the foreign operation are sufficient to service existing and normally expected debt obligations without funds being made available by the reporting entity.
Exchange rates 4.4
In practical terms the following approach is used when translating the financial statements of a foreign operation for exam purposes: (a)
Balance sheet All assets and liabilities – @ CR Share capital and reserves: Share capital and pre-acquisition reserves – @ HR Post-acquisition reserves – Profit @ average rate (AR) for each year – Dividends @ actual rate Translation reserve – Balancing figure
16.7
16: FOREIGN TRANSACTIONS AND ENTITIES (b)
Income statement All items – @ actual rate or average rate (AR) as an approximation
Calculation of translation reserve/ exchange differences 4.5
4.6
The exchange differences result from: (a)
translating income and expenses at the exchange rates at the dates of the transactions and assets and liabilities at the closing rate;
(b)
translating the opening net assets at a closing rate that differs from the previous closing rate;
(c)
translating goodwill on consolidation at the closing rate at each year end.
You may be required to calculate exchange differences recognised in the year or total exchange differences recognised in the translation reserve. The exam approach to calculating them is the same for both: $ $ Exchange differences in the year/ in the translation reserve: On translation of net assets Closing net assets as translated Less: opening* net assets as translated at the time Less: retained profit as translated at the time
X (X) X (X) X/(X)
Group share %
X/(X)
On goodwill – see Lecture example 2 standard working * to calculate total exchange differences to date, substitute 'acquisition' for 'opening'.
16.8
X/(X) X/(X)
16: FOREIGN TRANSACTIONS AND ENTITIES
Lecture example 2
Exam standard for 20 marks (with adjustments removed)
Bennie Co acquired 80% of Jennie Co for $993,000 on 1 January 20X1. Jennie Co is a foreign operation whose functional currency is the Jen. Balance sheets at 31 December 20X2
Property, plant and equipment Cost of investment in Jennie Goodwill Current assets Share capital Pre-acquisition ret'd earnings Post-acquisition ret'd earnings Translation reserve
Bennie $'000
Jennie J'000
5,705 993 – 6,698 2,222 8,920
7,280 – – 7,280 5,600 12,880
1,700 5,185 – 6,885
1,200 5,280 2,400 – 8,880
2,035 8,920
4,000 12,880
Rate $
Jennie $'000
Consol $'000
Rate $
Jennie $'000
Consol $'000
Minority interest Current liabilities
Income statements for year ended 31 December 20X2
Revenue Cost of sales Gross profit Operating expenses Goodwill impairment loss Dividend from Jennie Profit before tax Income tax expense Profit for the period
Bennie $'000 9,840 (5,870) 3,970 (2,380)
Jennie J'000 14,620 (8,160) 6,460 (3,570)
112 1,702 (530) 1,172
2,890 (850) 2,040
Attributable to: Equity holders of the parent Minority interest
16.9
16: FOREIGN TRANSACTIONS AND ENTITIES Statement of changes in equity for the year (extract for retained earnings)
Balance at 31 December 20X1 Profit for the period Total recognised income and expense for the period Dividends paid Balance at 31 December 20X2
Bennie $'000 4,623 1,172 1,172 (610) 5,185
Jennie J'000 6,760 2,040 2,040 (1,120) 7,680
Jennie's balance sheets at acquisition and at 31 December 20X1 were as follows: 1.1.X1 J'000
31.12.X1 J'000
Property, plant and equipment Current assets
5,710 3,360 9,070
6,800 5,040 11,840
Share capital Retained earnings
1,200 5,280 6,480 2,590 9,070
1,200 6,760 7,960 3,880 11,840
Current liabilities Exchange rates were as follows 1 January 20X1 31 December 20X1 31 December 20X2 Weighted average rate for 20X1 Weighted average rate for 20X2
$1: 12 Jens $1: 10 Jens $1: 8 Jens $1: 11 Jens $1: 8.5 Jens
Required Prepare the consolidated balance sheet, income statement and statement of changes in equity extract for retained earnings and the translation reserve for the Bennie Group for the year ended 31 December 20X2. An impairment test conducted at the year end revealed impairment losses of 1,496,000 Jens on recognised goodwill. No impairment losses were necessary in the year ended 31 December 20X1. The balance brought forward on the translation reserve on consolidation at 1.1.20X2 was $217,800. Jennie pays its dividends on 31 December. A dividend of 1,160,000 Jens was paid on 31 December 20X1.
16.10
16: FOREIGN TRANSACTIONS AND ENTITIES
Solution Consolidated statement of changes in equity for year ended 31 December 20X2 (extracts) Retained earnings $'000 Balance at 31 December 20X1 Exchange differences on translating foreign operations Net income recognised directly in equity Profit for the period Total recognised income and expense for the period Dividends Balance at 31 December 20X2 Workings
16.11
Translation reserve $'000
16: FOREIGN TRANSACTIONS AND ENTITIES
Disposal of foreign operations 4.7
On disposal, the cumulative amount of the exchange differences recognised in equity relating to the foreign operation are recognised in ('recycled' through) profit or loss at the same time as the disposal gain/loss is recognised.
16.12
16: FOREIGN TRANSACTIONS AND ENTITIES
Additional Notes
16.13
16: FOREIGN TRANSACTIONS AND ENTITIES
5
Monetary items forming part of a net investment in a foreign operation
5.1
An entity may have a monetary item that is receivable from or payable to a foreign operation for which settlement is neither planned nor likely to occur in the foreseeable future. This may include a long-term receivable or loan. They do not include trade receivables or trade payables. In substance such items are part of the entity's net investment in a foreign operation. The amount could be due between the parent and the foreign operation, or a subsidiary and the foreign operation. Separate financial statements (a)
Where denominated in the functional currency of the reporting entity or foreign operation any exchange differences are recognised in profit or loss in the separate financial statements of the reporting entity or foreign operation as appropriate (as normal).
(b)
Where denominated in a currency other than the functional currency of the reporting entity or foreign operation, exchange differences will be recognised in profit or loss in the separate financial statements of both parties (as normal).
Consolidated financial statements (a)
Any exchange differences are recognised (reclassified) initially in a separate component of equity; and
(b)
Are recognised in ('recycled' through) profit or loss on disposal of the net investment.
Lecture example 3
Exam standard for 6 marks
On 1/1/X8 Gabby, a company reporting in dollars, bought a controlling interest in a Japanese company for ¥ 75,000,000. The company is run as an autonomous subsidiary. On the day of purchase a long-term loan was advanced to the subsidiary – value ¥ 5,000,000 (repayable in yen). On
1/1/X8 the exchange rate was $1: 150 ¥, 31/12/X8, $1: 130 ¥.
Required (a)
Explain the accounting treatment of the investment and loan in Gabby's separate financial statements at 31/12/X8.
(b)
Explain the effect in Gabby's consolidated financial statements at 31/12/X8.
(c)
Show the income statement effect in Gabby's consolidated financial statements if the subsidiary was sold on 30/6/X9 for $720,000 when the exchange rate was 120 ¥ to the dollar and the value of Japanese subsidiary's net assets and goodwill in the consolidated books was $660,000.
Assume that the investment is held in Gabby's separate financial statements using the cost option in IAS 27 and that cumulative exchange gains on translation of the financial statements of the 16.14
16: FOREIGN TRANSACTIONS AND ENTITIES foreign operation of $128,900 were recognised in the consolidated financial statements up to the date of disposal.
Solution
16.15
16: FOREIGN TRANSACTIONS AND ENTITIES
6 Chapter 20 Section 4
Hyperinflation
IAS 29: Financial reporting in hyperinflationary economies 6.1
IAS 29 defines a hyperinflationary economy as one where the inflation rate over three years has cumulatively exceeded 100% (simple or compound interest). In these circumstances, the 'current (general) purchasing power' approach of accounting for inflation is adopted by the reporting entity: (a)
Non-monetary assets and liabilities and income and expenses are restated to year end prices using a general prices index
(b)
Monetary items are not restated because their value is their face value, but a gain or loss on the net monetary position is included in profit or loss.
Translation into a different presentation currency 6.2
6.3
When an entity's functional currency is the currency of a hyperinflationary economy, and it chooses to present its financial statements in a different presentation currency, the entity must restate its financial statements in accordance with IAS 29 (as above) before translating as follows: (a)
All amounts (i.e. assets, liabilities, equity items, income and expenses, including comparatives) are translated at the closing rate at the date of the most recent balance sheet, with the exception outlined in (b).
(b)
When amounts are translated into the currency of a non-hyperinflationary economy, comparative amounts are those that were presented as current year amounts in the relevant prior year financial statements (i.e. not adjusted for subsequent changes in the price level or subsequent changes in exchange rates).
An entity cannot avoid restatement for hyperinflation under IAS 29 by, for example, adopting as its functional currency a currency other than the functional currency determined in accordance with IAS 21 (such as the functional currency of the parent).
16.16
16: FOREIGN TRANSACTIONS AND ENTITIES
7
Chapter summary
7.1 Q22 Harvard
Section
Topic
Summary
1
Currency concepts
IAS 21 introduces functional currency and presentation currency concepts.
2
Functional currency
Currency of the primary economic environment that entity faces. Measurements made in this currency.
3
Presentation currency
Can be any currency. Special translation rules.
4
Foreign operations
Translated using presentation currency rules where functional currency is different to the parent.
5
Monetary items forming part of a net investment in a foreign operation
In consolidated financial statements, exchange differences reclassified as equity.
6
Hyperinflation
Hyperinflation occurs where inflation over three years cumulatively exceeds 100%. Non-monetary assets and liabilities and profit or loss items are restated to year end prices using a general prices index. Where hyperinflationary accounts are translated into a different presentation currency, IAS 29 must be applied before translation. Then all amounts are translated at the closing rate.
16.17
16: FOREIGN TRANSACTIONS AND ENTITIES
END OF CHAPTER 16.18
Group cash flow statements
Syllabus Guide Detailed Outcomes Having studied this chapter you will be able to: •
Prepare and discuss group cash flow statements.
Exam Context Group cash flow statements could appear as the compulsory question in Section A of the paper. If this is the case, the examiner has stated it is likely that there would be some other aspect of consolidation tested in Section B.
Qualification Context Cash flow statements are also tested in both Paper F3 Financial Accounting and Paper F7 Financial Reporting. However, group and foreign currency aspects are only tested in this Paper.
Business Context A cash flow statement is very revealing because it provides 'raw' data about the underlying financial position of the company. For a company to stay afloat, it not only needs to be profitable, but also needs to have a healthy cash flow position. When a company goes bankrupt, the trigger is normally lack of cash to pay creditors who then force the company into liquidation. IAS 7 addresses these issues by showing cash generated (or used) by operating activities compared with the other activities of the entity and a disclosure note breaks down the quality of the entity's cash and cash equivalents at the beginning and end of the period.
17.1
17: GROUP CASH FLOW STATEMENTS
Overview Group cash flow statements
Formats
Definitions
Consolidated CFS
Approach to CFS questions
Interpretation of CFS
Foreign currency transactions
17.2
17: GROUP CASH FLOW STATEMENTS
1
Formats
1.1
Direct Method Cash Flow Statement 31.12.20X1 $'000 $'000 Cash flows from operating activities Cash receipts from customers Cash paid to suppliers and employees Cash generated from operations Interest paid Income taxes paid
30,150 (27,600) 2,550 (270) (900)
Net cash from operating activities
1,380
Cash flows from investing activities Acquisition of subsidiary X, net of cash acquired Purchase of property, plant and equipment Proceeds from sale of equipment Interest received Dividends received
(550) (350) 20 200 200
Net cash used in investing activities
(480)
Cash flows from financing activities Proceeds from issue of share capital Proceeds from long-term borrowings Payments of finance lease liabilities Dividends paid*
250 250 (90) (1,200)
Net cash used in financing activities
(790)
Net increase in cash and cash equivalents
110
Cash and cash equivalents at beginning of period
120
Cash and cash equivalents at end of period
230
17.3
17: GROUP CASH FLOW STATEMENTS 1.2
Indirect Method Cash Flow Statement 31.12.20X1 $'000 $'000 Cash flows from operating activities Profit before taxation Adjustment for: Depreciation Foreign exchange loss Investment income Interest expense
3,350
Increase in trade and other receivables Decrease in inventories Decrease in trade payables Cash generated from operations Interest paid Income taxes paid
450 40 (500) 400 3,740 (500) 1,050 (1,740) 2,550 (270) (900)
Net cash from operating activities Cash flows from investing activities Acquisition of subsidiary X net of cash acquired Purchase of property, plant and equipment Proceeds from sale of equipment Interest received Dividends received
1,380 (550) (350) 20 200 200
Net cash used in investing activities Cash flows from financing activities Proceeds from issue of share capital Proceeds from long-term borrowings Payments of finance lease liabilities Dividends paid*
(480) 250 250 (90) (1,200)
Net cash used in financing activities
(790)
Net increase in cash and cash equivalents
110
Cash and cash equivalents at beginning of period
120
Cash and cash equivalents at end of period
230
* This could also be shown as an operating cash flow.
17.4
17: GROUP CASH FLOW STATEMENTS
2
Definitions
Cash 2.1
Cash comprises cash on hand and demand deposits.
Cash equivalents Chapter 21 Section 2.4
2.2
Cash equivalents are short-term, highly liquid investments that are readily convertible into known amounts of cash and which are subject to an insignificant risk of changes in value.
Cash flows 2.3
Cash flows are inflows and outflows of cash and cash equivalents.
3
Consolidated cash flow statements
Issue 3.1
A group's cash flow statement should only deal with flows of cash external to the group. Additional considerations for a group cash flow include: • • • •
cash flows to the minority interest cash received from associates payments to acquire subsidiaries receipts from sale of subsidiaries
17.5
17: GROUP CASH FLOW STATEMENTS
Minority interest 3.2
Only the actual payment of cash, i.e. dividends, to minorities should be reflected in the cash flow statement. This is normally included under the 'Cash flows from financing' heading as a separate sub-heading.
Lecture example 1
Preparation question
Consolidated income statement for the year ended 31 December 20X2
$'000 30 (10) 20
Group profit before tax Income tax expense Profit for the period Attributable to: Equity holders of the parent Minority interest
15 5 20
Consolidated balance sheets as at 31 December 20X2 $'000 102
Minority interest
20X1 $'000 100
Required Calculate the dividend paid to minority interest.
Solution Minority interest $'000
17.6
$'000
17: GROUP CASH FLOW STATEMENTS
Associates 3.3
Dividends received from associates are normally included as a separate item in 'Cash flows from investing activities'.
Lecture example 2
Preparation question
Consolidated income statement for the year ended 31 December 20X2 Group profit from operations Share of profit of associates Profit before tax Income tax expense Profit for the period
$'000 50 10 60 (25) 35
Consolidated balance sheets as at 31 December 20X2 $'000 92
Investment in associates
20X1 $'000 88
Required Calculate the dividend received from associates.
Solution Investment in associate $'000
17.7
$'000
17: GROUP CASH FLOW STATEMENTS
Acquisition and disposal of subsidiaries 3.4
The acquisition or disposal of a subsidiary should be included under the heading 'Cash flows from investing activities' and show the cash flow net of any cash and cash equivalents acquired or disposed of.
Acquisitions and disposals of associates, joint ventures and trade investments 3.5
Receipts and payments of cash to acquire associates, joint ventures and trade investments should be included under the heading 'Cash flows from investing activities'. Cash flows from dividend income also shown (except where a jointly controlled entity is proportionately consolidated in which case the entity is proportionately consolidated into each line of the balance sheet and hence cash flow statement).
4
Approach to cash flow statement questions
4.1
1
Read the question and set up a proforma
2
Transfer balance sheet figures to face of cash flow statement or working
3
Transfer income statement figures to face of cash flow statement or working
4
Deal with additional information
5
Finish off workings and transfer figures to answer
6
Do additional workings for direct method (if required)
7
Finish off cash flow statement.
Lecture example 3
Exam standard for 12 marks
Acquisitions On 1.10.X8 P Co acquired 90% of S Co by issuing 100,000 shares at an agreed value of $1.60 per share and $140,000 in cash. At that time the balance sheet of S Co was as follows: Property, plant and equipment Inventories Trade receivables Cash and cash equivalents Trade payables
17.8
$'000 190 70 30 10 (40) 260
17: GROUP CASH FLOW STATEMENTS The consolidated balance sheets of P Co as at 31 December were as follows:
Non-current assets Property, plant and equipment Goodwill Current assets Inventories Trade receivables Cash and cash equivalents
Equity attributable to equity holders of the parent Share capital ($1 ordinary shares) Share premium account Retained earnings Minority interest Current liabilities Trade payables Income tax payable
20X8 $'000
20X7 $'000
2,500 66 2,566
2,300 – 2,300
1,450 1,370 16 2,836 5,402
1,200 1,100 50 2,350 4,650
1,150 590 1,791 3,531 31 3,562
1,000 500 1,530 3,030 – 3,030
1,690 150 1,840 5,402
1,520 100 1,620 4,650
The consolidated income statement for the year ended 31 December 20X8 was as follows: $'000 10,000 7,500 2,500 2,080 420 150 270
Revenue Cost of sales Gross profit Administrative expenses Profit before tax Income tax expense Profit for the period Attributable to: Equity holders of the parent Minority interest
261 9 270
You are also given the following information: 1 2 3 4
All other subsidiaries are wholly owned. Depreciation charged to the consolidated income statement amounted to $210,000. There were no disposals of property, plant and equipment during the year. No dividends were paid by the parent.
17.9
17: GROUP CASH FLOW STATEMENTS Required Prepare a cash flow statement for the year ended 31 December 20X8 under the indirect method in accordance with IAS 7. Notes to the cash flow statement are not required.
Solution Cash flow statement for the year ended 31 December 20X8 Cash flows from operating activities Profit before taxation Adjustments for: Depreciation Increase in trade and other receivables Increase in inventories Increase in trade payables Cash generated from operations Income taxes paid Net cash from operating activities Cash flows from investing activities Acquisition of subsidiary, net of cash acquired Purchase of property, plant & equipment Net cash used in investing activities Cash flows from financing activities Proceeds from issue of share capital Dividend paid to minority interest Net cash from financing activities Net decrease in cash and cash equivalents Cash and cash equivalents at the beginning of the period Cash and cash equivalents at the end of the period
17.10
$'000
$'000
17: GROUP CASH FLOW STATEMENTS Workings 1
Additions to property, plant and equipment Property, plant and equipment $'000
2
$'000
Impairment losses Goodwill $'000
3
$'000
Dividends paid to minority interest Minority interest $'000
4
$'000
Income taxes paid Income tax payable $'000
17.11
$'000
17: GROUP CASH FLOW STATEMENTS
Lecture example 4
Preparation question
Disposal Below is the consolidated balance sheet of Columbus Group as at 30 June 20X5 and the consolidated income statement for the year ended on that date: Consolidated balance sheet as at 30 June
Non-current assets Property, plant and equipment Current assets Inventories Receivables Cash and cash equivalents
Equity attributable to equity holders of the parent Share capital Retained earnings Minority interest Current liabilities Trade payables Income tax payable
Consolidated income statement for the year ended 30 June 20X5 Profit before interest and tax Profit on disposal of shares in subsidiary Profit before tax Income tax expense Profit for the period Attributable to: Equity holders of the parent Minority interest
20X5 $'000
20X4 $'000
4,067
3,950
736 605 294 1,635 5,702
535 417 238 1,190 5,140
1,000 3,637 4,637 482 5,119
1,000 3,118 4,118 512 4,630
380 203 583 5,702
408 102 510 5,140 $'000 878 34 912 290 622 519 103 622
You are given the following information: 1
Columbus Co sold its entire interest in New World Co on 31 March 20X5 for $400,000. Columbus Co acquired an 80% interest in New World on incorporation several years ago.
17.12
17: GROUP CASH FLOW STATEMENTS The net assets at the date of disposal were: $'000 390 50 39 20 (42) 457
Property, plant and equipment Inventories Receivables Cash and cash equivalents Trade payables 2
Depreciation charge for the year was $800,000. There were no disposals of non-current assets other than on the disposal of the subsidiary.
Required (to the nearest $'000s) (a)
How will the disposal appear in the cash flow statement?
(b)
What are the additions to property, plant and equipment?
(c)
What is the dividend paid to minority interest?
(d)
Prepare the reconciliation of profit before tax to cash generated from operations, as at the top of the indirect method cash flow statement.
Solution (a)
Cash flows from investing activities
$'000
Disposal of subsidiary net of cash disposed (b)
Cash flows from investing activities Purchase of property, plant and equipment (W1)
(c)
Cash flows from financing activities Dividend paid to minority interest (W2)
(d)
Cash flows from operating activities Profit before tax Adjustments for: Depreciation Profit on disposal of subsidiary Increase in receivables Increase in inventories Increase in payables Cash generated from operations
17.13
$'000
17: GROUP CASH FLOW STATEMENTS Workings 1
Additions to property, plant and equipment Property, plant and equipment $'000
2
$'000
Dividends paid to minority interest Minority interest $'000
17.14
$'000
17: GROUP CASH FLOW STATEMENTS
5
Interpretation of cash flow statements
Analysis points Chapter 21 Section 1
5.1
(a) (b) (c)
Overall increase/decrease in cash. What are the significant components in the cash flows? How do the cash flows compare to expectations? Operating activities – key inflow Investing activities – key outflow Financing activities – how the business has financed acquisitions/purchases of assets Cash generated from operations vs interest, income tax
(d)
Reconciliation of profit before tax to cash generated from operations – –
(e)
impact of accounting policies e.g. deferral of expenditure, recognition of income where no cash generated movements in working capital e.g. build up of inventories/receivables signs of over-trading
Ratio analysis (examples of ratios): –
Cash return on capital employed = Cash generated from operations x 100% Total assets less current liabilities
–
Cash generated from operations to total debt
= Cash generated from operations Total debt –
Net cash from operating activities to capital expenditure
= Net cash from operating activities x 100% Net capital expenditure
17.15
17: GROUP CASH FLOW STATEMENTS
Additional Notes
17.16
17: GROUP CASH FLOW STATEMENTS
6
Foreign currency transactions
Implications 6.1
The amounts to be included in the cash flow statement are the actual amounts paid or received, therefore use the rates ruling on the date of payment rather than the rates ruling at the original transaction. The exchange differences will be relevant in calculating the amount paid or received.
Lecture example 5
Exam standard for 10 marks
Below are the consolidated balance sheets for the years ended 31/12/X1 and 31/12/X2 and the consolidated income statement for the year ended 31/12/X2 for Piddly incorporating its 90% subsidiary Small. Small was owned throughout 20X1 and 20X2. Consolidated balance sheet
Property, plant and equipment Goodwill Inventories Trade receivables Cash and cash equivalents Share capital Reserves Minority interest Trade payables
20X2 $'000 25,020 1,300 2,680 6,280 2,310 37,590
20X1 $'000 23,600 1,400 2,300 5,700 2,200 35,200
2,000 30,400 500 32,900 4,690 37,590
2,000 28,250 450 30,700 4,500 35,200
Consolidated income statement for the year ended 31 December 20X2
Revenue Cost of sales Gross profit Operating expenses Profit before tax Income tax expense Profit for the period Attributable to: Equity holders of the parent Minority interest
$'000 52,300 (33,820) 18,480 (11,085) 7,395 (2,400) 4,995 4,755 240 4,995
17.17
17: GROUP CASH FLOW STATEMENTS
Small is a foreign operation. The following exchange gains and (losses) on translation for the period have been included in the consolidated reserves figure: $'000 Property, plant and equipment (1,080) Inventories (90) Trade receivables (270) Cash and cash equivalents (45) Trade payables 135 (1,350) Goodwill (65) (1,415) You are also given the following information: 1 2 3 4
Piddly has no other subsidiaries. There were no disposals of property, plant and equipment during the year. The depreciation charge for the year was $2,150,000. Dividends paid in the period by Piddly amounted to $1,190,000.
Required
Prepare the consolidated cash flow statement for the Piddly Group for the year ended 31 December 20X2 using the indirect method in accordance with IAS 7. Notes to the cash flow statement are not required.
Solution Cash flow statement for the year ended 31 December 20X2
$'000 Cash flows from operating activities Profit before taxation Adjustments for: Depreciation Impairment losses
Increase in trade receivables Increase in inventories Increase in trade payables Cash generated from operations Income taxes paid Net cash from operating activities Cash flows from investing activities Purchase of property, plant & equipment Net cash used in investing activities
17.18
$'000
17: GROUP CASH FLOW STATEMENTS Cash flows from financing activities Dividends paid Dividend paid to minority interest Net cash used in financing activities Net increase in cash and cash equivalents Cash and cash equivalents at the beginning of the period Effect of exchange rate changes Cash and cash equivalents as restated Cash and cash equivalents at the end of the period Workings
17.19
17: GROUP CASH FLOW STATEMENTS
7
Chapter summary
7.1 Q23 Tastydesserts
Section
Topic
Summary
1
Formats
The preferred method under IAS 7 is the direct method (as it shows information not available elsewhere in the financial statements). However, the indirect method is more common in exams.
2
Definitions
The IAS 7 cash flow statement is more of a funds flow statement as it reconciles to cash and cash equivalents which include short term liquid investments.
3
Consolidated cash flow statements
Additional considerations include: – dividends paid to minority shareholders – dividends received from associates – cash flows on acquisition/disposal of group entities.
4
Approach to cash flow statement questions
BPP recommends a methodical approach of working through the balance sheet, income statement then notes, thinking 'each figure goes somewhere: face or working (or both!)'.
5
Interpretation of cash flow statements
The cash flow statement itself can tell us useful information about the business' ability to generate cash and the source/use of cash. Ratio analysis can also assist in interpretation.
6
Foreign currency transactions
Unrealised foreign currency translation differences are not cash flows and must therefore be excluded from the cash flow figures.
END OF CHAPTER 17.20
Performance reporting
Syllabus Guide Detailed Outcomes Having studied this chapter you will be able to: •
Prepare reports relating to corporate performance for external stakeholders.
•
Evaluate proposed changes to reporting financial performance.
•
Determine business and geographical segments, and reportable segments.
•
Specify and discuss the nature of information to be disclosed.
•
Develop accounting policies for an entity which meet the entity's reporting requirements.
•
Identify accounting treatments adopted in financial statements and assess their suitability and acceptability.
•
Select and calculate relevant indicators of financial and non-financial performance.
•
Identify and evaluate significant features and issues in financial statements.
•
Highlight inconsistencies in financial information through analysis and application of knowledge.
•
Make inferences from the analysis of information taking into account the limitation of the information, the analytical methods used and the business environment in which the entity operates.
Exam Context The techniques developed in this chapter will be relevant throughout the paper as it contains 4-6 marks at each sitting for 'professional skills'. The technical content is particularly relevant to the essay question on current developments and any question which requires the preparation of a report. Segment reporting could be examined as a discrete part of a Section B question.
Qualification Context Report writing is tested in a number of ACCA Papers. Segment reporting is tested for the first time in this paper.
Business Context For large diverse companies, disclosure of accounting policies (especially where IFRS allows choices which are significantly different) and a breakdown of company figures into the different business segments they comprise, is vital to understanding of, and therefore analysis of, a company's performance. In the real world, report writing is an important business skill, and this is developed in the context of 'professional skills' in this ACCA Paper.
18.1
18: PERFORMANCE REPORTING
Overview Performance reporting
Reports about corporate performance
Current developments
Appraisal of financial performance and position of entities
Creation of suitable accounting policies (IAS 8)
Segment reporting
IFRS 8 Operating segments
Analysis and interpretation of financial information & measurement of performance
18.2
Analysis points
18: PERFORMANCE REPORTING
1
Appraisal of financial performance and position of entities
Creation of suitable accounting policies Definition 1.1
Accounting policies (IAS 8) Accounting policies are the specific principles, bases, conventions, rules and practices applied by an entity in preparing and presenting financial statements.
1.2
IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors requires that an entity selects its accounting policies by applying the relevant International Standard or Interpretation. Some Standards permit a choice of accounting policies (e.g. cost and revaluation models).
1.3
In the absence of a Standard or Interpretation covering a specific transaction, other event or condition, management uses its judgement to develop an accounting policy which results in information that is relevant in the economic decision-making needs of users and reliable, considering in the following order: (1)
Standards or Interpretations dealing with similar and related issues;
(2)
The Framework definitions elements of the financial statements and recognition criteria; and
(3)
The most recent pronouncements of other national GAAPs based on a similar conceptual framework and accepted industry practice (providing the treatment does not conflict with extant Standards, Interpretations or the Framework).
Changes in accounting policies 1.4
1.5
A change in accounting policy is only allowed if: •
required by a Standard or an Interpretation; or
•
it results in the financial statements providing reliable and more relevant information about the effects of transactions, other events or conditions on the entity's financial position, financial performance or cash flows.
Where the initial application of a Standard/Interpretation does not prescribe specific transitional provisions, changes in accounting policy are accounted for retrospectively by: •
adjusting the opening balance of each affected component of equity for the earliest prior period presented, and
•
adjusting comparative amounts for each prior period presented as if the accounting policy had always been applied.
18.3
18: PERFORMANCE REPORTING
Analysis and interpretation of financial information and measurement of performance 1.6
The examiner has stated that 'traditional ratio analysis will not be examined as such, but may be required in the evaluation of a company's performance.' Ratio analysis could therefore appear, for example, as part of a question on evaluating management commentary, segment disclosures or the effects of changes in accounting policies.
Performance indicators Chapter 12 Section 1
1.7
Financial A summary of financial accounting ratios that may be useful to you is included in the Additional Notes to this chapter. Non-financial There is an increasing demand for companies to provide non-financial performance measures such as carbon emissions, or staff retention rates. Further examples are included in Chapter 3 Environmental and Social Reporting.
Limitations of financial information 1.8
The usefulness of information and ratio analysis is limited by distorting factors. Distorting factors include: • • • • • • • •
2
historical or out of date financial information even at time of issue different accounting policies/classifications when comparing to different companies inflation when comparing to previous years window dressing, eg. posting invoices early in the previous period lack of information seasonality year end figures not representative related party transactions.
Reports about corporate performance
Report writing 2.1
Questions in Section B of the paper will often be in the form of a report and 'professional marks' will be available for the structure and style of the report.
Types of report 2.2
• •
Advice to directors in respect of accounting treatments or developments. Review of performance and financial status of a business.
18.4
18: PERFORMANCE REPORTING Structure of report 2.3
• • • •
Terms of reference/introduction Headings for key areas of report Conclusion with recommendations if appropriate Appendices.
•
Short paragraphs and sentences
•
Professional English
•
Language used should take account of the needs and presumed knowledge (or lack thereof) of the addressee.
Style 2.4
Approach 2.5
(1)
Understand the requirements • •
Identify the task(s) from the requirements Identify the user/addressee and consider their needs their existing knowledge
the type of business and/or the transactions in the scenario
the purpose of the report
(2)
Plan the structure of your answer and identify the headings to be used.
(3)
Use the scenario • •
(4)
to generate ideas to make the answer specific.
Write your answer in the appropriate style keeping your answer relevant to the scenario at all times and as precise as possible.
Professional skills 2.6
Marks will be awarded for professional skills in this paper. Between 4 and 6 marks will be available at each sitting.
2.7
Professional skills encompass the creation, analysis, evaluation and synthesis of information. The examiner has identified the following areas for which marks will be awarded: (a)
Developing information and ideas, and forming an opinion.
(b)
Developing an understanding of the implications for the entity of the information including the entity's operating environment.
(c)
Analysing information and ideas by identifying: (i) (ii)
the purpose of the analysis the limitations of given information 18.5
18: PERFORMANCE REPORTING (iii) (iv)
bias and underlying assumptions and their impact problems of liability and inconsistency
(d)
Identifying the purpose of a computation and whether it meets its purpose.
(e)
Analysing information, drawing conclusions and considerable implications, and any further action required.
(f)
Identifying appropriate action in response to the information/analysis including advice or amendments to the data.
(g)
Considering, discussing and combining ideas and information from diverse sources to arrive at a solution or a broader understanding of the issues.
(h)
Analysing the information in the context of the views and reactions of the stakeholders.
(i)
Identifying solutions to problems or ranking potential solutions, or ways to manage the problem, or recommending a course of action.
(j)
Exercising good judgement and an ethical approach to providing advice in line with: (i) (ii) (iii)
(k)
relevant standards stakeholders interests the stated objectives
Communicating effectively and efficiently in producing required documents including: (i) (ii) (iii) (iv) (v) (vi) (vii)
the intended purpose of the document its intended users and their needs the appropriate type of document logical and appropriate structure/format nature of background information and technical language detail required clear, concise and precise presentation
Note: not all skills discussed above will be required in each paper.
3
Current developments
3.1
The IASB is engaged in a joint project with the US's FASB with assistance from the 'Joint International Group on Performance Reporting' with the aim of revising the presentation standards to improve the usefulness of information. The project has been split into two segments, A and B. Segment A defines the revised full set of financial statements. Segment B will focus on a more fundamental reconsideration of presentation and display issues, including recycling, categorisation and disaggregation.
Amendments to IAS 1 Exposure Draft (March 2006): Segment A Complete set of financial statements 3.2
A complete set of financial statements should include the following: •
Statement of Financial Position at beginning and end of each period
showing assets, liabilities and equity (similar to the current balance sheet) three statements would be required including one at the beginning of the comparative period
18.6
18: PERFORMANCE REPORTING •
Statement of Recognised Income and Expense
showing all income and expenses (other than transactions with owners in their capacity as owners)
•
Statement of Changes in Equity
showing changes in equity arising from transactions with owners in their capacity as owners
•
Statement of Cash Flows
showing cash inflows and outflows
Each statement would be shown with equal prominence. Statement of Recognised Income and Expense (SORIE) 3.3
The SORIE would combine the current income statement and SORIE into a single statement of performance showing all income and expenses for the period divided between 'profit or loss for the period' (subtotalled) and 'other recognised income and expense'. 'Other recognised income and expense' would be made up of: • • • • •
changes in revaluation surplus translation differences on translation of foreign operations gains and loss on available-for-sale financial assets (IAS 39) the effective portion of gains and losses on cash flow hedges actuarial gains and losses on defined benefit plans.
All other income and expenses would be treated as part of profit or loss. 3.4
The ED allows the statement to be split into a separate statement of profit or loss shown immediately before the statement of recognised income and expense (the latter beginning with profit or loss for the period). This represents a significant change of approach by the IASB, who were previously advocating only a single statement.
Earnings per share, reclassifications, tax and dividends 3.5
Earnings per share would be based on the profit or loss for the period figure. Entities would also be permitted to disclose total recognised income and expense per share (as now) in the notes. Reclassifications between other recognised income and expense and profit or loss (i.e. 'recycling') would be disclosed separately. Tax effects of each component of other recognised income and expense would be disclosed separately (e.g. tax effects on foreign exchange gains on a foreign subsidiary). Dividends and dividends per share would be shown on the face of the statement of changes in equity rather than the face of the statement of recognised income and expense as they are transactions with owners.
18.7
18: PERFORMANCE REPORTING 3.6
XYZ Group – Income statement for the year ended 31 December 20X7
Revenue Cost of sales Gross profit Other income Distribution costs Administrative expenses Other expenses Finance costs Share of profit of associates Profit before tax Income tax expense Profit for the year from continuing operations Loss for the year from discontinued operations PROFIT FOR THE YEAR Exchange differences on translating foreign operations Available-for-sale financial assets Cash flow hedges Gains on property revaluation Actuarial gains (losses) on defined benefit pension plans Share of other recognised income and expense of associates Income tax relating to components of other recognised income and expense* Other recognised income and expense for the year, net of tax Total recognised income and expense for the year Profit attributable to: Equity holders of the parent Minority interest Total recognised income and expense attributable to: Equity holders of the parent Minority interest Earnings per share (in $): Basic Diluted
20X7 $000 X (X) X X (X) (X) (X) (X) X X (X) X – X X (X) X X X X
20X6 $000 X (X) X X (X) (X) (X) (X) X X (X) X (X) X (X) X (X) X (X) (X)
(X)
X
X
(X)
X
X
X X X
X X X
X X X
X X X
X X
X X
* A separate note would show the tax effect of each component of recognised income and expense.
18.8
18: PERFORMANCE REPORTING
Effective date 3.7
The Standard for Segment A would be effective for annual periods beginning on or after 1 January 2009, with earlier application encouraged. The IASB announced in July 2006 that no new IFRSs would be effective until 1 January 2009 to provide four years of stability in the IFRS platform after the 2005 adoption and changes.
4
Segment reporting
IFRS 8: Operating segments Introduction 4.1
In order to allow shareholders to fully understand the development of the company's business, certain entities are required to provide segment information which discloses revenues, profits and assets (amongst other items) by major business area. IFRS 8 is only compulsory for entities whose debt or equity instruments are traded in a public market (or entities filing or in the process of filing financial statements for the purpose of issuing instruments).
Definition 4.2
Operating segment (IFRS 8) An operating segment is a component of an entity: (a) that engages in business activities from which it may earn revenues and incur expenses (including revenues and expenses relating to transactions with other components of the same entity), (b) whose operating results are regularly reviewed by the entity's chief operating decision maker to make decisions about resources to be allocated to the segment and assess its performance, and (c) for which discrete financial information is available.
Aggregation 4.3
Two or more operating segments may be aggregated if the segments have similar economic characteristics, and the segments are similar in each of the following aspects: (a) (b) (c) (d) (e)
The nature of the products or services; The nature of the production process; The type or class of customer for their products or services; The methods used to distribute their products or provide their services; and If applicable, the nature of the regulatory environment.
18.9
18: PERFORMANCE REPORTING Determining reportable segments 4.4
An entity must report separate information about each operating segment that: (a)
has been identified as meeting the definition of an operating segment; and
(b)
segment total is 10% or more of total: – revenue (internal and external); or – all segments not reporting a loss (or all segments in loss if greater); or – assets.
4.5
At least 75% of total external revenue must be reported by operating segments. Where this is not the case, additional segments must be identified (even if they do not meet the 10% thresholds).
4.6
Two or more operating segments below the thresholds may be aggregated to produce a reportable segment if the segments have similar economic characteristics, and the segments are similar in a majority of the aggregation criteria above.
4.7
Operating segments that do not meet any of the quantitative thresholds may be reported separately if management believes that information about the segment would be useful to users of the financial statements.
Lecture example 1
Exam standard for 8 marks
Endeavour, a public limited company, trades in six business areas which are reported separately in its internal accounts provided to the chief operating decision maker. The operating segments have historically been Chemicals, Pharmaceuticals wholesale, Pharmaceuticals retail, Cosmetics, Hair care and Body care. Each operating segment constituted a 100% owned sub-group except for the Chemicals market which is made up of two sub-groups. The results of these segments for the year ended 31 December 20X5 before taking account of the information below are as follows. Operating segment information as at 31 December 20X5 before the sale of the body care operations
Chemicals: Europe Rest of world Pharmaceuticals wholesale Pharmaceuticals retail Cosmetics Hair care Body care
External $m 14 56 59 22 12 11 18 192
Revenue Internal $m 7 3 8 0 3 1 24 46
Total $m 21 59 67 22 15 12 42 238
Segment profit/(loss) $m 1 13 9 (2) 2 4 (6) 21
Segment assets $m 31 78 7 104 30 18 21 54 336
Segment liabilities $m 14 34 35 12 10 8 19 132
There were no significant intragroup balances in the segment assets and liabilities. All companies were originally set up by the Endeavour Group. Endeavour decided to sell off its Body care operations and the sale was completed on 31 December 20X5. On the same date the group acquired another group in the Hair care area. The fair values of the assets and liabilities of the new Hair care group were $32 million and $13 million respectively. The purpose of the purchase was to
18.10
18: PERFORMANCE REPORTING expand the group's presence by entering the Chinese market, with a subsidiary providing lower cost products for the mass retail markets. Until then, Hair care products had been 'high end' products sold mainly wholesale to hairdressing chains. The directors plan to report the new purchase as part of the Hair care segment. Required Which of the operating segments of Endeavour constitute a 'reportable' operating segment under IFRS 8 Operating Segments for the year ending 31 December 20X5?
Solution
18.11
18: PERFORMANCE REPORTING Disclosures 4.8
(a)
Factors used to identify the entity's reportable segments
(b)
Types of products and services from which each reportable segment derives its revenues
(c)
Reportable segment revenues, profit or loss, assets, liabilities and other material items:
InBev
External Revenue Inter-segment Interest revenue Interest expense Depreciation and amortisation Other material non-cash items Material income/expense (IAS 1) Profit, assets & liabilities
Share of profit of associates/joint ventures equity accounted Profit/loss (as reported to chief operating decision maker) Income tax expense Segment assets Investments in associates/ jointly controlled entities Expenditures for non-current assets (1) Segment liabilities
A reconciliation of the each of the above material items to the entity's reported figures is required. Reporting of a measure of profit or loss and total assets by segment is compulsory. Other items are disclosed if included in the figures reviewed by or regularly provided to the chief operating decision maker. (d)
External revenue by each product and service (if reported basis is not products and services)
18.12
18: PERFORMANCE REPORTING (e)
Geographical information: External revenue (2) Geographical areas
(f)
Non-current assets (1)
by: • entity's country of domicile, and • All foreign countries (subdivided if material)
Information about reliance on major customers (i.e. those who represent > 10% external revenue) (1)
excludes financial instruments, deferred tax assets, post-employment benefit assets, and rights under insurance contracts
(2)
allocated based on customer's location
Effective date 4.9
An entity shall apply IFRS 8 in its annual financial statements for periods beginning on or after 1 January 2009. Earlier application is encouraged. If an entity applies IFRS 8 before 1 January 2009, it should disclose that fact.
Key changes from IAS 14 Segment Reporting 4.10 (a)
IFRS 8 converges with US GAAP by adopting SFAS 131 Disclosures about Segments of an Enterprise and Related Information.
(b)
The FASB managerial approach to identifying segments based on an internal organisation structure is used rather than the IAS 14 risk and returns approach.
(c)
No primary and secondary (either business or geographical) segment disclosure hierarchy.
(d)
No requirement for more than 50% of revenue to be external for a segment to be reported separately.
(e)
Revenue, profit and assets for reportable segment testing no longer defined (depend on the information reported to the chief operating decision maker).
(f)
Lower level of compulsory segment disclosure as only profit or loss and total assets are required figures. Other items are only disclosed if included in the figures reviewed by or regularly provided to the chief operating decision maker.
(g)
Wider disclosures to include finance income, finance cost and income tax expense (if the specified amounts are included in the measure of segment profit or loss reviewed by the chief operating decision maker).
(h)
New disclosures on factors used to determine reportable segments and types of products and services.
(i)
Geographical disclosures required on a country by country basis if material.
(j)
No requirement to disclose capital expenditure on a geographical basis.
18.13
18: PERFORMANCE REPORTING Advantages and disadvantages of the old and new segment definition approaches 4.11
Advantages • The method helps to highlight 'Risks and the profitability, risks and Returns' approach returns of an identifiable (IAS 14) segment. • Investors focus on risks and
returns.
Disadvantages • Segment determination is the
responsibility of directors and is subjective. • Management may report
segments which are not consistent for internal reporting and control purposes making its usefulness questionable. • Additional costs are incurred to
generate the data • It is cost effective because the • Information broken down on a 'Managerial' marginal cost of reporting managerial decision-making approach (IFRS 8) segmental data will be low. basis may be commercially sensitive. • The information can be
reconciled to the financial statements. • Users can be sure that the
• The segments may include
operations with different risks and returns.
segment data reflects the operational strategy of the business.
Analysis points 4.12 The following points may be relevant when analysing segment data: •
Growing segments versus declining segments
•
Loss-making segments
•
Return (and other key indicators) analysed by segment
•
The proportion of costs or assets etc that have remained unallocated
•
Any additional segment information required.
18.14
18: PERFORMANCE REPORTING
Additional Notes
18.15
18: PERFORMANCE REPORTING
5
Summary of financial performance indicators
5.1
Profitability (a)
Return on assets (or ROCE) (i)
Profit before interest and tax % TALCL
alternatively (ii) (b)
Profit before interest and tax % Net assets
Asset turnover Revenue TALCL
Asset turnover = (c)
(d)
Profit margin Profit margin =
Profit before interest and tax % Revenue
NB: ROCE =
Profit before interest and tax Re venue × TALCL Revenue
Return on equity Return on equity =
5.2
Profit after tax and preference dividends % Ordinary share capital + reserves
Liquidity (a)
Current ratio Current ratio =
(b)
Current assets Current liabilitie s
Quick ratio Quick ratio (or acid test) =
CA - inventories * CL
* liquid assets only (c)
Average collection period Trade receivables × 365 days Credit turnover
(d)
Inventory turnover
Inventory turnover =
Cost of sales Inventories
18.16
18: PERFORMANCE REPORTING
Alternatively: Inventories × 365 days Cost of sales
Inventory days = (e)
Average payment period
Trade payables × 365 days Credit purchases 5.3
Gearing
(a)
Debt/equity
Debt/equity = or (b)
Interest bearing debt % Equity
Interest bearing debt % Debt + Equity
Interest cover
Interest cover = 5.4
Profit before interest and tax (including interest receivable) Interest payable
Investors' ratios
(a)
Earnings per share
Basic EPS =
Profit after tax, MI and preference dividends Weighted average number of shares outstanding during the period
Diluted EPS =
Diluted earnings Diluted weighted average number of shares
Diluted earnings = Basic earnings Interest saved on convertible debt (net of tax saving)
X X X
Diluted shares = Basic weighted average X Convertible debt: additional shares on conversion X Share options: potential shares less shares purchasable at FV X X (b)
Dividend yield
Dividend yield = (c)
Dividend per share Mid market price (MMP)
Dividend cover
Dividend cover = or
EPS Dividend per share
Profit after tax and preference dividends Dividend on ordinary shares
18.17
18: PERFORMANCE REPORTING
(d)
P/E ratio
P/E ratio = (e)
MMP EPS
Earnings yield
Earnings yield = (f)
EPS MMP
Net assets per share
Net assets per share = 5.5
Net assets No. of shares
Other financial performance measures
Companies are increasingly reporting new performance measures rather than 'text book' ratios. Examples are: (i) (ii) (iii)
6
EBITDA (earnings before interest, tax, depreciation and amortisation); adjusted earnings per share; free cash flow – see Chapter 17.
Chapter summary
6.1 Q13 Grow by acquisition
Section
Topic
Summary
1
Appraisal of financial performance and position of entities
An entity selects its accounting policies based on the options available in IFRS, but may design its own where IFRS is not specific providing they do not contradict the Framework. Performance can be measured both financially and through the use of non-financial measures.
2
Reports about corporate performance
Reports should have a clear structure and be tailored to the needs and knowledge of users. 4-6 marks will be awarded in each exam paper for 'professional skills'.
3
Current developments
The IASB plans to require three years of balance sheet data and combine the income statement and statement of recognised income and expense. This would be an alignment with US GAAP.
4
Segment reporting
IFRS 8 requires an entity to report its operating segments based on the data reported internally to management. The minimum disclosure is of profit/loss and assets by segment. Geographical disclosures of external revenue and non-current assets are also required.
18.18
18: PERFORMANCE REPORTING Section
Topic
Summary
5
Summary of financial performance indicators
A full 'interpretation of financial statements' question, would not be set, but these ratios are important for analysis or to highlight issues in the context of other questions.
18.19
18: PERFORMANCE REPORTING
END OF CHAPTER 18.20
Current developments
Syllabus Guide Detailed Outcomes Having studied this chapter you will be able to: •
Evaluate the implications of worldwide convergence with International Financial Reporting Standards.
•
Discuss the implementation issues arising from the convergence process.
•
Identify the reasons for major differences in accounting practices, including culture.
•
Discuss the influence of national regulators on international financial reporting.
•
Discuss current issues in corporate reporting.
Exam Context Current issues are important for this Paper. Often the topic of the 25-mark essay question in Section B will be a current issue. They may also be examined as part of a Section A or B question.
Qualification Context This topic is specific to this paper.
Business Context To be a good business adviser, it is not enough to know the contents of current standards. A good business adviser is aware of the weaknesses of current standards and can advise about plans to change them. This is drawn out in this area of the syllabus.
19.1
19: CURRENT DEVELOPMENTS
Overview
Current developments
International convergence
Influence of national reporting
19.2
Current projects
19: CURRENT DEVELOPMENTS
1
International convergence
The global move towards IFRS 1.1
The following table summarises the applicability of IFRS for selected countries: Not permitted
Permitted for domestic listed companies
Required for some domestic listed companies
Required for domestic listed companies
• Argentina • Colombia • Chile • Canada • India • Israel • Japan • Mexico • Pakistan • Moldova • United States
• Bermuda • Bolivia • Brunei Darussalam • Cayman Islands • El Salvador • Gibraltar • Laos • Macau • Sri Lanka • Switzerland • Turkey • Zimbabwe
• Brazil (Financial institutions from 2010) • China
• All EU/EEA member states (Consolidated FS*) • Australia • Costa Rica • Croatia • Ecuador • Egypt • Hong Kong • Jamaica • Jordon • Kenya • Kuwait • Lebanon • New Zealand (2007) • Peru • Russia • South Africa • Ukraine
* The EU Regulation which became effective for accounting periods beginning on or after 1 January 2005 requires all EU companies listed on a regulated market to prepare their consolidated financial statements in accordance with IFRS. It also gives each member state the option to require or permit the use of IFRSs for the separate financial statements of listed companies and for the separate and consolidated financial statements of non-listed companies. Of the 30 EU/EEA countries, 15 permit the use of IFRS for any company.
19.3
19: CURRENT DEVELOPMENTS
Convergence with US GAAP 1.2
In October 2002, the IASB reached an agreement with the US's FASB (Financial Accounting Standards Board) (the 'Norwalk' agreement) to undertake a short-term convergence project aimed at removing a variety of individual differences between US GAAP and International standards. The first standard resulting from this project was IFRS 5 Non-current Assets Held for Sale and Discontinued Operations (published March 2004).
1.3
In March 2003, an 'identical style and wording' approach was agreed for standards issued by FASB and the IASB on joint projects. FASB also recognised the need to follow a 'principles-based' approach to standard-setting (as the IASB has always done) in the light of recent corporate failures and scandals which have led to criticism of the 'rules-based' approach.
1.4
1.5
In October 2004 the IASB and FASB agreed to develop a common conceptual framework which would be a significant step towards harmonisation of future standards. The project has been divided into two phases: •
The initial focus is on particular aspects of the frameworks dealing with objectives, qualitative characteristics, elements, recognition, and measurement, giving priority to issues affecting projects for new/ revised Standards.
•
Later, they will consider the applicability of those concepts to other sectors, beginning with not-for-profit entities in the private sector.
In February 2006, the two Boards signed a 'Memorandum of Understanding'. This laid down a 'roadmap of convergence' between IFRS and US GAAP in the period 2006-2008. The aim is to remove by 2009 the requirement for foreign companies reporting under IFRS listed on a US stock exchange to have to prepare a reconciliation to US GAAP.
Dialogue with other key standard setters 1.6
The IASB maintains a policy of dialogue with other key standard setters around the world, in the interest of harmonising standards across the globe. Partner standard setters are often involved in the development of Discussion Papers and Exposure Drafts on new areas.
1.7
In February 2006, China officially released a new set of Chinese Accounting Standards (CASs) which are substantially converged with IFRSs, and reaffirmed its commitment to international convergence. In January 2005, the IASB and the Accounting Standards Board of Japan (ASBJ) announced a joint project to reduce differences between IFRSs and Japanese accounting standards, which is currently in progress.
19.4
19: CURRENT DEVELOPMENTS
2
Influence of national reporting
2.1
The IASB cannot mandate the use of IFRS, which is a national adoption or convergence issue. This often has implications.
Users 2.2
Different users of financial statements have different needs. For example: (a)
Mainland Europe Financial statements were often tax driven. Trial balances were maintained to a strict chart of accounts to ensure consistency.
(b)
United States The focus of reporting is for investment decision making. The traditional approach to standard setting was a 'rules-based' approach, which resulted in very detailed standards. However, this is now being dropped in favour of the IASB's 'principles-based' approach.
(c)
Japan Prior to a substantial revision in 2000, the focus was on individual company financial statements and these were used to calculate tax payable.
2.3
These 'legacy' systems have their influence on the countries' attitude to adoption/ convergence with IFRS. A survey of 200 first-time adopters of IFRS in Europe by KPMG indicated that legacy GAAP often dictated the presentation of financial statements where IFRS allows flexibility.
National law 2.4
In order for IFRSs to be applied, changes are often required to national/regional law. For example: •
The UK Companies Act had to be changed to allow redeemable preference shares to be classed as a liability.
•
The European Union accounting directives had to be revised to allow the wider use of fair values.
Tax law 2.5
Given that tax is payable on accounting profits adjusted for tax, difficult decisions need to be made about how to tax those profits and how to treat the increased use of fair values. For example, in the UK, the interest element of discounted revenue is taxed as interest income, whereas in some countries applying IFRS, it is still taxed as sales revenue.
19.5
19: CURRENT DEVELOPMENTS
3
Current projects
3.1
The following (examinable) current projects are being undertaken by the IASB: (i)
Joint IASB-FASB Conceptual Framework See below.
(ii)
Business Combinations project See Chapters 12 and 14.
(iii)
Provisions See Chapter 9.
(iv)
Fair value measurement See below.
(v)
Reporting performance See Chapter 18.
(vi)
Management commentary See below.
(vii)
SME standards See Chapter 20.
Discussion Paper: Preliminary Views on an Improved Conceptual Framework for Financial Reporting (July 2006) 3.2
This Discussion Paper is the first in a series of publications being developed jointly by FASB and the IASB as part of a joint project to develop a common Conceptual Framework for Financial Reporting. The aim is to provide the best common foundation for developing principles-based and converged standards.
3.3
The Paper covers the first two chapters of a proposed Conceptual Framework: • •
Chapter 1: The objective of financial reporting Chapter 2: Qualitative characteristics of decision-useful financial reporting information.
The Discussion also includes the Draft chapters themselves.
Objective 3.4
The proposed objective of general purpose external financial reporting is 'to provide information that is useful to present and potential investors and creditors and others in making investment, credit, and similar resource allocation decisions'. The focus therefore is on the capital markets.
19.6
19: CURRENT DEVELOPMENTS
Qualitative characteristics 3.5
Similar to the current Framework the proposed chapter considers the users of the financial statements in terms of their abilities and needs.
3.6
Proposed qualitative characteristics that make information useful and considerations in developing standards: (a)
Relevance: predictive value, confirmatory value, timeliness
(b)
Faithful representation: data must be verifiable, neutral and complete (replacing 'reliability')
(c)
Comparability (including consistency)
(d)
Understandability: for users who have a reasonable knowledge of business and economic activities and financial accounting
(e)
Constraints of financial reporting - Materiality (all material information included; not cluttered with immaterial information) - Benefits and costs (the benefits of financial information should justify the costs).
Discussion Paper: Fair Value Measurements (November 2006) 3.7
The Discussion Paper has arisen as a result of the Memorandum of Understanding between the IASB and FASB (February 2006) reaffirming their commitment to the convergence of IFRSs and US GAAP. The objective of the project is to codify, clarify and simplify existing guidance that is dispersed widely in IFRSs. The intention is not, therefore, to expand the use of fair value in financial reporting.
3.8
The Discussion Paper focuses on the recent US Statement of Financial Accounting Standards No. 157 Fair Value Measurements (SFAS 157) as a starting point, on which work was well advanced before the Memorandum of Understanding was published.
3.9
SFAS 157 defines fair value as 'the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.' The IFRS definition is generally 'the amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arm's length transaction'.
3.10 There are three key differences between the SFAS 157 and IFRS definitions: (a)
The SFAS definition is explicitly an exit (selling) price, whereas the IFRS definition is neither explicitly an exit price nor an entry (buying) price.
(b)
The SFAS definition refers explicitly to market participants, whereas the IFRS definition refers to knowledgeable, willing parties in an arm's length transaction.
(c)
For liabilities, the SFAS definition rests on the notion that the liability is transferred (the liability to the counterparty continues; it is not settled with the counterparty). The IFRS definition refers to the amount at which a liability could be settled between knowledgeable, willing parties in an arm's length transaction.
19.7
19: CURRENT DEVELOPMENTS 3.11 SFAS 157 establishes a three-level hierarchy for the inputs that valuation techniques use to measure fair value: Level 1 Quoted prices (unadjusted) in active markets for identical assets or liabilities that the reporting entity has the ability to access at the measurement date Level 2 Inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly, e.g. quoted prices for similar assets in active markets or for identical or similar assets in non active markets or use of quoted interest rates for valuation purposes Level 3 Unobservable inputs for the asset or liability, i.e. using the entity's own assumptions about market exit value. 3.12 The Discussion Paper analyses each of these principles in detail and provides a copy of the SFAS in order to seek a public opinion on this as a starting point for an IFRS ED to be published in early 2008.
Discussion Paper: Management Commentary (October 2005) Chapter 1 Section 2
Introduction 3.13 The Discussion Paper discusses the need for a management commentary accompanying the financial statements and concludes that it would be within the scope of the IASC Foundation's remit to develop such a standard. The Paper draws on existing examples of management commentary requirements from partner standards setters. The Paper highlights that requirements to produce management commentaries date back to the 1930s and there has been an EU requirement since 1978. Proposed definition 3.14 Management commentary is information that accompanies financial statements as part of an entity's financial reporting. It explains the main trends and factors underlying the development, performance and position of the entity's business during the period covered by the financial statements. It also explains the main trends and factors that are likely to affect the entity's future development, performance and position. Objectives of management commentary 3.15 The Discussion Paper highlights the following objectives of a management commentary standard: (a)
To interpret and assess the related financial statements in the context of the environment in which the entity operates;
(b)
To assess what management views as the most important issues facing the entity and how it intends to manage those issues; and
(c)
To assess the strategies adopted by the entity and the likelihood that those strategies will be successful.
19.8
19: CURRENT DEVELOPMENTS Characteristics of high quality management commentary 3.16 Management commentary should: (a) (b) (c)
supplement and complement financial statement information; provide an analysis of the entity through the eyes of management; and have an orientation to the future.
3.17 Management commentary should also possess the attributes that make information useful to investors, namely: • • • • •
Understandability Relevance Supportability Balance, and Comparability over time.
Management disclosure framework 3.18 The Discussion Paper states that to meet the objective of management commentary, an entity should disclose information on: (a) (b) (c) (d) (e)
the nature of its business; its objectives and strategies; its key resources, risks and relationships; its results and prospects; and its performance measures and indicators.
The Paper includes illustrative examples and a proposed Standard. The Paper/ Sample Standard do not propose a fixed format as the nature of management commentary would vary between entities. Development of a future standard 3.19 Four ways are proposed to proceed with the development of a Standard: (a)
Requirements within an existing IFRS, specifically IAS 1;
(b)
A standard with defined scope that is narrower than other IFRSs, e.g. the way IAS 14 Segment Reporting is written;
(c)
A Standard that sits outside the ‘core' set of IFRSs, but is available for adoption if a jurisdiction elects to make it mandatory or an entity elects to adopt it, in a similar way to the scope of IAS 34 Interim Financial Reporting; or
(d)
A separate strand of Standards aimed at management commentary, with a unique numbering system to distinguish them from IFRSs, similar to the UK ASB's approach to their Operating and Financial Review reporting standards.
Adoption hurdle 3.20 The Discussion Paper also highlights the adoption hurdle, i.e. that the perceived cost of applying IFRS might increase.
19.9
19: CURRENT DEVELOPMENTS This could dissuade jurisdictions/ countries not having adopted IFRS from requiring its adoption, especially where requirements differ significantly from existing national requirements.
4
Chapter summary
4.1 Section
Topic
Summary
1
International convergence
International convergence has gained pace recently with the EU adoption of IFRS for quoted companies. Now the IASB is working with FASB and other major accounting standard setters to work towards a harmonised global GAAP.
2
Influence of national reporting
National reporting has an influence on the adoption and application of IFRS, due to the needs and expectations of different users, interference of national law, and the need to change tax rules where IFRS is adopted.
3
Current projects
The IASB has a number of projects underway. These could form the basis of the essay question in Section B of the exam.
END OF CHAPTER 19.10
Reporting for specialised entities
Syllabus Guide Detailed Outcomes Having studied this chapter you will be able to: •
Apply knowledge from the syllabus to straightforward transactions and events arising in specialised, not-for-profit, and public sector entities.
•
Outline the principal considerations in developing a set of accounting standards for SMEs.
•
Discuss solutions to the problem of differential financial reporting.
Exam Context The examiner has stated that the exam will often include a 25-mark 'specialised industry' question in Section B. You are not required to have any specific knowledge of accounting practice in specialised industries, but, rather, be able to show that you can apply the accounting knowledge in the syllabus to more 'unusual' scenarios. This chapter demonstrates how to do this.
Qualification Context Specialised, not-for-profit and public sector entities are introduced at an introductory level at Paper F7 Financial Accounting. Applying accounting rules to specialised entities is unique to Paper P2.
Business Context The inclusion of this area in the ACCA syllabus recognises that an accountant is likely to come across companies in more specialist scenarios in the course of their career. Due to the volume and nature of the different derivative and nonderivative products it sells, more accountants are needed in the 'Back Office' of a bank than for a standard manufacturing company.
20.1
20: REPORTING FOR SPECIALISED ENTITIES
Overview Types of specialised entities
Reporting for specialised entities
Application of standards
Reporting requirements of SMEs
Specialist industry standards
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20: REPORTING FOR SPECIALISED ENTITIES
1
Types of specialised industry
1.1
The exam could include a full 25-mark Section B question in the context of virtually any specialised industry. You are not required to have any specific knowledge of specialised industries, but rather, be able to apply your accounting knowledge to specialised industry scenarios.
Profit-orientated specialised entities 1.2
Examples: • • • • • • • • • • •
Agriculture and farming Oil and gas exploration and refinery Pharmaceuticals companies Airlines Hotel industry Telecommunications and Internet provision Record and entertainment industry Football clubs Mining Construction Banking and insurance.
Not-for-profit organisations Chapter 22 Section 1
1.3
Not-for-profit organisations have objectives which are quite distinct in many respects. For example: -
1.4
they do not report to shareholders (but may have stakeholders) focus is often on cash flow and income generation rather than profit they do not normally pay dividends.
Examples of not-for-profit organisations: • • •
Charities Clubs and societies Non-governmental organisations ('NGOs').
Public sector entities Chapter 22 Sections 2-3
1.5
Traditionally, public sector entities' accounts were prepared on a cash basis, but, due to increased demands for accountability, many are now accounted for using the accruals concept. The stakeholders in public sector entities are often taxpayers, who ultimately fund them.
1.6
The International Federation of Accountants (IFAC) produces International Public Sector Accounting Standards (IPSASs), which have been based on their IAS/IFRS counterpart. However, the take-up of IPSASs has been slower than that of IFRSs (because the demand for international comparability is not so strong).
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20: REPORTING FOR SPECIALISED ENTITIES 1.7
Examples of public sector entities: • • •
2
National and local government departments and agencies State sponsored health care providers Education institutions.
Application of Standards to specialised industries
Application of relevant standards 2.1
Although an industry may be specialist, IFRSs are designed to apply to a wide-range of entities and scenarios (although admittedly the world's capital markets are identified as the primary user). The first step is to identify extant Standards relevant or that can be applied to a particular scenario.
Application of the Framework 2.2
Where there is no obvious Standard covering the accounting treatment of a particular area, IAS 8 requires us to look at the Framework definitions in order to determine an accounting treatment: Asset – – –
Resource controlled by the entity Past events Future economic benefits.
Liability – – –
Present obligation of the entity Past events Expected to result in an outflow of resources embodying economic benefits.
Income –
Increases in assets/decreases in liabilities (other than contributions from shareholders).
Expense –
Depletions of assets/incurrences of liabilities (other than distributions to shareholders).
The recognition criteria must also be met: – –
Probable inflow/outflow of future economic benefits Cost or value can be measured with reliability.
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20: REPORTING FOR SPECIALISED ENTITIES
Lecture example 1
Exam standard for 2 marks (each part) as part of a scenario question
Required Identify an appropriate Standard governing the following scenarios and an appropriate accounting treatment: (a)
A pharmaceuticals company incurs a large amount of research and development expenditure on a recurring basis. Some of the drugs never reach human trials, while others become market leaders.
(b)
A property constructor accepts non-refundable deposits from customers amounting to 10% of the price of the property under construction when the customer commits to purchase. The remaining 90% is payable on legal completion.
(c)
A clothes retailer has a policy of refunding customers for returns beyond the national legal requirement of replacement of faulty goods returned within 14 days with a valid proof of purchase. The retailer (which only sells own brand clothing) will make a refund in cash with proof of purchase, or a as a credit note without proof of purchase, providing the goods are returned in saleable condition and are still on sale in one of its stores.
(d)
A government agency operates a national pension scheme, based on earnings and credits for the number of years of social insurance contributions. Pension payments are funded from current taxes.
Marks & Spencer
Solution
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20: REPORTING FOR SPECIALISED ENTITIES
3
Specialist industry standards
3.1
Certain specialist industries have dedicated accounting standards due to their specialised nature. The number of such standards is likely to increase in the future.
3.2
In addition, some accounting regimes have voluntary standards for certain specialised/notprofit industries. For example, in the UK there are Statements of Recognised Practice (SORPs) for accounting for charities and pension schemes.
3.3
The examiner has confirmed that only an overview knowledge of such standards included in the examinable documents list is required.
IAS 11 Construction contracts 3.4
IAS 11 applies specifically to contracts 'specifically negotiated for the construction of an asset or a combination of assets that are closely interrelated or interdependent in terms of their design, technology and function or their ultimate purpose or use'.
3.5
IAS 11 applies similar rules to those in IAS 18 relating to revenue generally: construction revenue and costs are recognised by reference to the stage of completion of the contract (once the contract's outcome can be estimated reliably). However, any expected losses on contracts are recognised immediately on the grounds of prudence.
IAS 41 Agriculture 3.6
IAS 41 deals with biological assets (defined as 'living plants and animals') from the point of their planting/birth until their harvest/slaughter: IAS 41 Agriculture
IAS 2 Inventories
Biological transformation Planting/ birth
Harvest/ slaughter
Sale
Biological transformation includes: • growth • degeneration, and • procreation. 3.7
Biological assets are held at fair value less estimated point of sale costs (e.g. commissions to brokers and transfer taxes). Any change in fair value from period to period is reported in profit or loss.
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20: REPORTING FOR SPECIALISED ENTITIES
IFRS 4 Insurance 3.8
Insurers recognise premium income from insurance policies. Insurance claims are recognised as an expense. Expected/unpaid claims must also be recognised in order to apply to the accruals concept and are shown as a liability.
3.9
IFRS 4 is an interim limited improvements Standard. It allows insurers to continue following their current accounting policies. However, it requires insurers to carry out a liability adequacy test at each reporting date. If this shows the liability for claims to be inadequate, the deficit is recognised as an expense in profit or loss.
IFRS 6 Exploration for and Evaluation of Mineral Resources 3.10 Exploration for and evaluation of mineral resources is defined as 'the search for mineral resources, including minerals, oil, natural gas and similar non-regenerative resources after the entity has obtained legal rights to explore in a specific area, as well as the determination of the technical feasibility and commercial viability of extracting the mineral resource.' 3.11 IFRS 6 is also an interim limited improvements standard. It requires that an entity follows IAS 8 in order to determine its own detailed accounting policies (see Chapter 19). However, exploration and evaluation assets are required to be measured initially at cost (not fair value). IFRS 6 then allows an entity to adopt either the cost model or the revaluation model of IAS 16 Property, Plant and Equipment or IAS 38 Intangible Assets for measurement after recognition. The standard also requires an impairment test to be conducted on those assets if there are indications that they may be impaired.
Lecture example 2
Exam standard for 25 marks
Hanslufta is a successful established international airline, whose functional currency is the dollar. You have been asked to advise on the accounting treatment of the following matters relating to the year ending 31 December 20X3: (a)
During the year, Hanslufta set up a new 'low cost' airline subsidiary, operating under the name AirTwo. As a result of the set up, substantial set up costs were incurred. These included: Legal and formation expenses Marketing Development of a new website with online booking Leases of new planes (lease instalments under finance leases)
$7m $12m $3m $30m $52m
Hanslufta has indicated that it would like to capitalise as much of this cost as possible. The leases relate to five new Boeing 737 aircraft, leased from 1 January 20X3 under an 8-year finance lease agreement, each with payments of $6m annually on 31 December. The fair value of the planes on 1 January 20X3 was $60m each. The present value of minimum
20.7
20: REPORTING FOR SPECIALISED ENTITIES lease payments discounted at the interest rate implicit in the lease of 9.3% stated in the lease agreement was $32.8m at that date. (b)
Hanslufta had, until the current year, not operated a frequent traveller fidelity programme, using the fact that its flights were cheaper as a result as a marketing advantage. This is no longer the case and Hanslufta's new CEO decided to set up a programme called 'Miles & Miles', which came into operation at the beginning of 20X3, with free flights being available from 20X4. It has been very successful, and had approximately 800,000 members at the year end. The average balance on members' accounts was around 7,000 miles and free flights are available for an average of 20,000 miles. However, this masks the true situation that around 250,000 members had zero or very low balances, and are unlikely to earn a free flight before the miles expire, whereas the other 550,000 members had an average balance of around 10,000 miles and are likely to be able to spend their miles. The average cost of a seat to the company is $50, but Hanslufta estimates that the fair value of each award seat is $60 on average. Research conducted by other similar airlines indicates that only 70% of customers who earn free flights actually take them. Hanslufta wishes to follow IFRIC 13 Customer Loyalty Programmes which requires the fair value of the award to be separated from ticket sales revenue, and deferred until the award flight is taken and revenue earned. All tickets sold in the year have been recorded as revenue.
(c)
In addition to the aircraft leased for the low cost subsidiary, the airline decided to lease out some older aircraft on operating leases during the year. In order to encourage airlines to take out the leases, an incentive was offered: no payments in the first year, provided the aircraft are leased for five years, payments being made of $200,000 in the other years for each of 10 aircraft.
(d)
Hanslufta placed a substantial order during the year for four Airbus long-range A380s for delivery in four years' time amounting to €960m. Given the size of the commitment, and in order to have cash flow security, the company also entered into a forward contract to buy the appropriate amount of euros to pay for the aircraft. In order to accommodate these aircraft, new airbridges will need to be built at Hanslufta's home airport. Hanslufta has entered into an agreement with the airport operator to finance 50% of the cost of the construction which will take place as part of a redevelopment programme of the airport over the next five years. The airbridge will be 50% owned with the airport operator.
(e)
Hanslufta's functional currency is the dollar. However, as of this year, it has decided to also present its financial statements in yen, as it is planning to dual list on the Japanese Stock Exchange.
Required Write a report to the management of Hanslufta Group identifying the accounting issues above and explaining their accounting treatment in the group financial statements. Calculations should be to the nearest $0.1m as Hanslufta presents its financial statements rounded to $0.1m.
20.8
20: REPORTING FOR SPECIALISED ENTITIES
Solution
20.9
20: REPORTING FOR SPECIALISED ENTITIES
20.10
20: REPORTING FOR SPECIALISED ENTITIES
4
Reporting requirements of small and medium-sized entities
4.1
IFRSs are designed for entities quoted on the world's capital markets. There has been some debate for some time over whether the IASB should develop Standards specifically for small and medium-sized entities (SMEs).
Considerations in developing Standards for SMEs 4.2
(a)
Scope Which entities SME Standards should apply to and whether this should be based on a size test or some other basis.
(b)
Comparability with full IFRSs Whether the core IFRS principles should be retained or whether they could be changed if perceived necessary.
(c)
Accounting for areas not covered by an IFRS for SMEs Whether compulsory reversion to 'full' IFRSs should be required for such areas, and whether the entity would be required to then apply the full IFRS or just the part resolving the issue itself.
(d)
Presentation A separate single Standard versus a set of summarised IFRSs.
(e)
Enforceability SME Standards can only be enforced if adopted by national/regional bodies. The IASB must also rely on those bodies to 'police' the application of the IFRS for SMEs.
(f)
Adoption hurdle Making an IFRS for SMEs more onerous increases the perceived cost of applying it. This may discourage governments from adopting it, as well as companies who are allowed to choose between national GAAP and the IFRS for SMEs. This has to be balanced with the need for a rigorous comprehensive Standard.
Differential financing reporting 4.3
There are those that argue that developing a set of Standards for smaller entities is a step backwards on the following grounds: (a)
IFRSs for SMEs ('Little GAAP') may be perceived as lower quality than full IFRSs ('Big GAAP') limiting their credibility and discouraging investment.
(b)
This may detract from the perception of the quality of full IFRS.
(c)
Different sets of Standards limit comparability between smaller and larger companies.
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20: REPORTING FOR SPECIALISED ENTITIES
IASB Exposure Draft: IFRS for Small and Medium-sized Entities 4.4
The IASB issued an Exposure Draft of an IFRS on SMEs in February 2007 (following a Discussion Paper in June 2004). The Exposure Draft is in the form of a single IFRS, with sections for each topic. These sections are not numbered in the order of current IFRSs, but have been re-ordered into a logical format. The IASB followed an approach of extracting the core principles of existing IFRSs for inclusion in the IFRS for SMEs with a 'rebuttable presumption' of no changes being made to recognition and measurement principles.
4.5
The IASB approach is that the Standard would apply to entities publishing financial statements for external users without public accountability (i.e. those that do not issue instruments in a public market or hold assets in a fiduciary capacity for outsiders) where required by national law. There would be no size test, as this would be difficult to apply to companies operating under different legal frameworks.
4.6
The main differences between full IFRSs and the draft IFRS for SMEs are: (a)
Segment disclosures and earnings per share: not required
(b)
Financial instruments: 'non-derivative' debt & unquoted equity instruments whose fair value cannot be measured reliably held at amortised cost/cost; all others at fair value through profit or loss
(c)
Hedge accounting: limited to certain (stated) scenarios
(d)
Internally-generated intangible assets: can be expensed (rather than compulsorily being capitalised if they meet 'PIRATE' criteria)
(e)
Borrowing costs: can be expensed rather than capitalised
(f)
Impairment of non-financial assets: based on fair value less costs to sell (rather than recoverable amount which also requires value in use to be calculated)
(g)
Impairments: charged to profit or loss (rather than first against any revaluation surplus)
(h)
Government grants: recognised in profit or loss when any attached conditions met (rather than reducing the carrying value of the asset or as deferred income, both of which conflict with the Framework)
(i)
Sample financial statements in the ED: presented in current/non-current order rather than the other way round (although this would not be compulsory)
(j)
Income statement and retained earnings reconciliation: can be combined into one statement
(k)
Changes in accounting policy and discontinued operations: restatement of comparatives not required where impracticable (i.e. after 'every reasonable effort' made)
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20: REPORTING FOR SPECIALISED ENTITIES
5
(l)
Consolidated financial statements: associates and jointly controlled entities can be held at cost or equity or fair value through profit or loss (or proportionately consolidated in the case of jointly controlled entities)
(m)
Separate financial statements of investor: subsidiaries, associates and jointly controlled entities can be held at cost or fair value through profit or loss
(n)
Goodwill: impairment test required only when there are indications of impairment (rather than annually)
(o)
Employee benefits: all actuarial gains and losses recognised immediately in profit or loss
(p)
Agriculture: cost model can be used if fair value 'not readily determinable'.
Chapter summary
5.1 Section
Topic
Summary
1
Types of specialised industry
The exam could include a question in the context of virtually any specialised industry. You are not required to have any specific knowledge of specialised industries, but rather, be able to apply your accounting knowledge to specalised industry scenarios.
2
Application of standards
The key here is to think broadly about what standards are relevant to a given scenario. Revenue recognition, provisions and development expenditure accounting rules are likely to be ones that will appear often. If there is no particular standard, you should consider the Framework definitions (assets, liabilities, income and expenses) to determine a suggested accounting treatment.
3
Specialist industry standards
Some specialist industries (e.g. agriculture) do have their own standards. An overview knowledge (only) of these is required.
4
Reporting requirements of SMEs
SMEs are 'specialised' due to their smaller size. There are many considerations as to whether the same or a different set of IFRSs should apply to them. The IASB has issued an Exposure Draft of Standards for SMEs that would apply to companies without public accountability (rather than using a size test).
20.13
20: REPORTING FOR SPECIALISED ENTITIES
END OF CHAPTER 20.14
Home study chapter – Implications of changes in accounting regulation on financial reporting Syllabus Guide Detailed Outcomes Having studied this chapter you will be able to: •
Apply and discuss the accounting implications of the first time adoption of a body of new accounting standards.
•
Outline the issues in implementing a change to new accounting standards including organisational, behavioural, and procedural changes within the entity.
•
Identify issues and deficiencies which have led to a proposed change to an accounting standard.
•
Apply and discuss the implications of a proposed change to an accounting standard on the performance and balance sheet of an entity.
Exam Context The examiner is always interested in changes to accounting standards. Questions in Section B are likely to include requirements discussing proposed changes to accounting standards although there will never be a full question on a single exposure draft. Where the standard-setters have issued a proposal you need to know the main thrust of the proposals and be able to explain both why the change is being made and what its main effects would be in a given scenario. The topic of 'first time adoption' arises in relation to first time adoption of IFRSs. The examiner has said that this will only be examined in terms of the key areas of impact on the entity.
Qualification Context In the Paper P7 Financial Reporting you are expected to build up a reasonable knowledge of the accounting standards that are in issue. In this paper you are expected to extend this understanding by developing the ability to criticise existing standards and by learning about changes to standards right from the point where the standards setters issue them in Discussion Papers and Exposure Drafts.
Business Context In recent years the implications of changes in accounting standards has been a significant challenge for entities, particularly in the many countries that adopted IFRS instead of local accounting standards in 2005. Many proposals are currently in the pipeline (as outlined in Chapter 19) and all accountants involved in the preparation or audit of financial statements need to keep abreast of these changes.
21.1
21: HOME STUDY CHAPTER – IMPLICATIONS OF CHANGES IN ACCOUNTING REGULATION ON FINANCIAL REPORTING
Overview Implications of changes in accounting regulation on financial reporting
First time adoption of a body of new accounting standards
Changes in accounting standards
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21: HOME STUDY CHAPTER – IMPLICATIONS OF CHANGES IN ACCOUNTING REGULATION ON FINANCIAL REPORTING
1
First time adoption of a body of new accounting standards
1.1
The adoption of a new body of accounting standards will inevitably have a significant effect on the accounting treatments used by an entity and on the related systems and procedures. In 2005 many countries adopted IFRS for the first time and over the next few years other countries are likely to do the same.
1.2
IFRS 1 First-time Adoption of International Financial Reporting Standards was issued to ensure that an entity's first IFRS financial statements contain high quality information that: (a) (b) (c)
is transparent for users and comparable over all periods presented; provides a suitable starting point for accounting under IFRSs; and can be generated at a cost that does not exceed the benefits to users.
IFRS 1: First-time adoption of international financial reporting standards General principles 1.3
An entity applies IFRS 1 in its first IFRS financial statements. An entity's first IFRS financial statements are the first annual financial statements in which the entity adopts IFRS by an explicit and unreserved statement of compliance with IFRS. Any other financial statements (including fully compliant financial statements that did not state so) are not the first set of financial statements under IFRS.
Opening IFRS balance sheet 1.4
An entity prepares an opening IFRS balance sheet at the date of transition to IFRS as a starting point for IFRS accounting. Generally, this will be the beginning of the earliest comparative period shown (i.e. full retrospective application).
1.5
Illustration Comparative year 1.1.2005
1st year of adoption 31.12.2005
31.12.2006
Transition date Opening IFRS B/S 1.6
The opening balance sheet itself need not be presented.
1.7
Preparation of an opening IFRS balance sheet typically involves adjusting the amounts reported at the same date under previous GAAP. All adjustments are recognised directly in retained earnings (or, if appropriate, another category of equity) not in the income statement, i.e. full retrospective adjustment.
21.3
21: HOME STUDY CHAPTER – IMPLICATIONS OF CHANGES IN ACCOUNTING REGULATION ON FINANCIAL REPORTING Estimates 1.8
Estimates in the opening IFRS balance sheet must be consistent with estimates made at the same date under previous GAAP even if further information is now available (in order to comply with IAS 10).
Transition process 1.9
(a)
Accounting policies
The entity should select accounting policies that comply with IFRS effective at the reporting date. These accounting policies are used in the opening IFRS balance sheet and throughout all periods presented. The entity does not apply different versions of IFRS effective at earlier dates.
(b)
Derecognition of assets and liabilities
Previous GAAP balance sheet may contain items that do not qualify for recognition under IFRS. E.g. IFRS does not permit capitalisation of research, staff training and relocation costs.
(c)
Recognition of new assets and liabilities
New assets and liabilities may need to be recognised. E.g. deferred tax balances and certain provisions such as environmental and decommissioning costs.
(d)
Reclassification of assets and liabilities
E.g. compound financial instruments need to be split into their liability and equity components.
(e)
Measurement
Value at which asset or liability is measured may differ under IFRS. E.g. discounting of deferred tax assets/liabilities not allowed under IFRS.
Main exemptions from applying IFRS in the opening IFRS balance sheet 1.10 (a)
Property, plant and equipment, investment properties and intangible assets –
(b)
Fair value/previous GAAP revaluation may be used as a substitute for cost at transition date.
Business combinations For business combinations prior to the opening IFRS balance sheet: –
The same classification (acquisition or uniting of interests) is retained as under previous GAAP.
–
For items requiring a cost measure for IFRS, the carrying value at the date of the business combination is treated as deemed cost and IFRS rules are applied from thereon.
21.4
21: HOME STUDY CHAPTER – IMPLICATIONS OF CHANGES IN ACCOUNTING REGULATION ON FINANCIAL REPORTING
(c)
–
Items requiring a fair value measure for IFRS are revalued at the date of opening IFRS balance sheet.
–
The carrying value of goodwill at the date of the opening IFRS balance sheet is the amount as reported under previous GAAP.
Employee benefits –
(d)
Cumulative translation differences on foreign operations –
(e)
Unrecognised actuarial gains and losses can be deemed zero at the date of transition to IFRS. IAS 19 is applied from then on. Translation differences (which must be disclosed in a separate translation reserve under IFRS) may be deemed zero at the date of transition to IFRS. IAS 21 is applied from then on.
Adoption of IFRS by subsidiaries, associates and joint ventures If a subsidiary, associate or joint venture adopts IFRS later than its parent, it measures its assets and liabilities: –
Either: At the amount that would be included in the parent's financial statements, based on the parent's date of transition
–
Or:
At the amount based on the subsidiary (associate or joint venture)'s date of transition.
Disclosure 1.11 (a)
(b)
A reconciliation of previous GAAP equity to IFRSs is required at the date of transition to IFRSs and for the most recent financial statements presented under previous GAAP. A reconciliation of profit for the most recent financial statements presented under previous GAAP.
Organisational and procedural changes 1.12 The technical changes involved in adopting a new body of standards will provide a challenge to company management and their advisers. These are some of the key issues: (a)
Accurate assessment of the task involved. Underestimation or wishful thinking may hamper the effectiveness of the conversion and may ultimately prove inefficient.
(b)
Proper planning. This should take place at the overall project level, but a detailed task analysis could be drawn up to control work performed.
(c)
Human resource management. The project must be properly structured and staffed.
(d)
Training. Where there are skills gaps, remedial training should be provided.
(e)
Monitoring and accountability. A relaxed 'it will be all right on the night' attitude could spell danger. Implementation progress should be monitored and regular meetings set up so that participants can personally account for what they are doing as well as flag up any problems as early as possible. Project drift should be avoided.
21.5
21: HOME STUDY CHAPTER – IMPLICATIONS OF CHANGES IN ACCOUNTING REGULATION ON FINANCIAL REPORTING (f)
Achieving milestones. Successful completion of key steps and tasks should be appropriately acknowledged, i.e. what managers call 'celebrating success', so as to sustain motivation and performance.
(g)
Physical resources. The need for IT equipment and office space should be properly assessed.
(h)
Process review. Care should be taken not to perceive the conversion as a one-off quick fix. Any change in future systems and processes should be assessed and properly implemented.
(i)
Follow-up procedures. Good management practice dictates that follow-up procedures should be planned and in place to ensure that the transfer is effectively implemented and that any necessary changes are identified and implemented on a timely basis.
(j)
Contractual terms may be affected, such as covenants related to borrowing facilities based on balance sheet ratios. The potential effect of the new Standards on these measurements should be assessed and discussed with the lenders at an early stage.
Lecture example 1
Exam standard for 15 marks
Europa is a listed company incorporated in Molvania. It will adopt International Financial Reporting Standards (IFRSs) for the first time in its financial statements for the year ended 31 December 2006. The directors of Europa are unclear as to the impact of IFRS 1 First-time Adoption of International Financial Reporting Standards. Required Advise the directors of Europa on the following. (a)
The procedure for preparing IFRS financial statements for the first time (as required by IFRS 1).
(b)
The practical steps that the company should take in order to ensure an efficient transfer to accounting under IFRS.
(c)
In its previous financial statements for 31 December 2004 and 2005, which were prepared under local GAAP, the company: (i)
made a number of routine accounting estimates, including accrued expenses and provisions, and
(ii)
did not recognise a provision for a court case arising from events that occurred in September 2005. When the court case was concluded on 30 June 2006, Europa was required to pay $10 million and paid this on 10 July 2006, after the 2005 financial statements were authorised for issue.
In the opinion of the directors, the company's estimates of accrued expenses and provisions under local GAAP were made on a basis consistent with IFRSs. Required Discuss how the matters above should be dealt with in the financial statements of Europa for the year ended 31 December 2006.
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21: HOME STUDY CHAPTER – IMPLICATIONS OF CHANGES IN ACCOUNTING REGULATION ON FINANCIAL REPORTING
Solution
21.7
21: HOME STUDY CHAPTER – IMPLICATIONS OF CHANGES IN ACCOUNTING REGULATION ON FINANCIAL REPORTING
2 Chapter 24 Section 4
Changes in accounting standards
Transitional provisions 2.1
Changes in accounting standards normally contain transitional provisions for their first time application, e.g. goodwill was not subject to amortisation for annual periods beginning on or after 31 March 2004, and impairment tests applied thereafter. If the standard does not contain transitional provisions, the approach in IAS 8 applies, i.e. retrospective restatement by adjusting the appropriate opening balance of equity.
Effective date 2.2
The standards also contain an effective date (e.g. 'annual periods beginning on or after…..'. Most new standards also encourage earlier adoption. The IASB announced in July 2006 that no new IFRSs would be effective until 1 January 2009 to provide four years of stability in the IFRS platform after the 2005 adoption and changes.
3
Chapter summary
3.1 Section
Topic
Summary
1
First time adoption of a body of new accounting standards
IFRS 1 provides the accounting treatment on first time adoption of IFRS. All adjustments from previous GAAP are recognised in equity and certain exemptions are available where the cost of applying the requirements of IFRSs in full would exceed the benefits. Transition to a new accounting regime requires significant planning, resource allocation and system upgrades.
2
Changes in accounting standards
New accounting standards have their own transitional provisions and effective date. Earlier application is often encouraged.
END OF CHAPTER 21.8
Answers to Lecture Examples
22.1
22: ANSWERS TO LECTURE EXAMPLES
Chapter 1 Answer to Lecture Example 1 (a)
The general rule under IAS 18 Revenue is that revenue is recognised when the significant risks and rewards of ownership have been transferred and there is no continuing managerial involvement nor effective control. IAS 18 provides additional guidance re real estate sales and states that revenue is recognised when legal title is transferred, i.e. when the legal completion occurs and the keys are handed over. Realbuild's current policy recognises the revenue before this is the case. Where there is continuing building work to be undertaken, there is continuing involvement by the seller and revenue cannot be recognised until it is completed, regardless of whether the funds have been transferred, so Realbuild's policy is appropriate in that instance.
(b)
Licence fees (and royalty income) are normally recognised straight line over the life of the agreement. However, where the licensee has no remaining obligations to perform, or, as in this case, no control over the use of the images once licensed, the substance of the transaction is a sale, and revenue should be recognised at the time of sale, so BCN Productions' policy is not appropriate.
(c)
IAS 18 provides guidance on the recognition of revenue from the development of customised software: it should be recognised by reference to the stage of completion of the development including completion of the services provided for post-delivery support. Consequently, it is not appropriate to recognise the revenue on installation: it should be recognised over the period of development and support (although not necessarily straight line as can be matched to the level of work done in each period).
Chapter 2 Answer to Lecture Example 1 The ethical responsibilities of the accountant are clear in this scenario. Construction contracts Student members of ACCA should demonstrate professional competence at all times. The recognition of revenue and profit on the contracts should comply with IAS 11 Construction Contracts. Under IAS 11 the estimates of completion should be made as at the balance sheet date whereas here there is a suggestion that a certificate issued at a later date should be used hence anticipating profits not earned until the following financial year. This raises concerns in relation to objectivity and integrity. The accountant may feel pressurised, both as a result of the instruction from a more senior employee, and as a result of self-interest since any increase in profit will have an effect on the individual's annual bonus. Although there may be some suspicion that the group accountant's suggestion arises from either the company's situation with regard to the planned equity issue or from self-interest relating to the bonus calculation, it would be perfectly acceptable to discuss the contract estimates with the managers of the subsidiary. It may be that the figures included in the draft accounts are based on surveyors' certificates at a date earlier than the balance sheet date and it may be possible to recognise more profit and stay within the requirements of IAS 11. If recognition of any additional profit would contravene IAS 11, the individual should refuse to make any accounting adjustments. If the group accountant applies any undue pressure then the individual should consider reporting the issue to someone more senior within the company. Many companies now have
22.2
22: ANSWERS TO LECTURE EXAMPLES
formalised whistle-blowing arrangements so that any concerns of this nature can be raised confidentially. Another source of advice is the advisory service of the ACCA. Contingent liability The issues relating to the omission of the contingent liability are very similar to those relating to the construction contract. As a professional accountant, the individual should assess the need to disclose the provision with regard to IAS 37. If the amount is material in the context of the group accounts and the likelihood of an outflow of benefits is anything more than remote it should be disclosed. Information of this nature may be significant to existing shareholders in assessing the company's position when making their decisions over the rights issues as well as to other stakeholders. Again, the appropriate action for the accountant to take is to carry out their work in accordance with professional practice even where there may be pressure from a more senior employee.
Chapter 3 No Lecture examples
Chapter 4 Answer to Lecture Example 1 The fair value less costs to sell of the plant is below its carrying value so it may be impaired. It is now necessary to find the value in use in order to determine whether an impairment has occurred and to quantify any impairment loss. Year
Future cash flows
1 2 3 4 5
$'000 230 211 157 104 233
PV factor at 15% 0.86957 0.75614 0.65752 0.57175 0.49718
Discounted future cash flows $'000 200 160 103 59 116 638
To calculate the impairment loss, compare the carrying value of $749,000 with the higher of value in use ($638,000) and fair value less costs to sell ($550,000). The impairment loss is therefore $749,000 – $638,000 = $111,000.
22.3
22: ANSWERS TO LECTURE EXAMPLES
Answer to Lecture Example 2 The key issue is whether the cash generating unit produces cash flows which are independent of other assets or not. The CGUs which appear to have cash flows independent of the other assets (and can therefore be subject to reliable assessment of their recoverable value) are: (b) (d)
A branch of pizza restaurant in Warsaw A commuter monorail
(a) and (c) are not generators of independent cash flows and are therefore too small to be CGUs in their own right. In the case of (c) the CGU is the theme park as one entity. Additionally (e) is a CGU in its own right as there is an external active market for its services, even though these are not openly available. (paragraph 71, IAS 36).
Answer to Lecture Example 3 Test of individual CGUs Personal Hygiene
Hair & Beauty
Household Cleaning
Unall. corp assets
$m
$m
$m
$m
$m
462 44 190 696
312 35 175 522
174 – – 174
– 20 – 20
1,176 99 485 1,760
Personal Hygiene $m 366 348 18
Hair & Beauty $m 706 696 10
Household Cleaning $m 522 524 –
6 12
10 –
$m PPE Goodwill Inventories
240 – 12 (W1)228 6 – 6 (W1)
– 120 348
54 – 10 (W1)
Goodwill
Total
Workings 1
Allocation of impairment loss
Net carrying value Recoverable amount Impairment loss To be allocated against: Goodwill Other assets pro-rata
– –
Only the Personal Hygiene and Hair & Beauty divisions are specifically impaired. Inventories are outside the scope of IAS 36 and are therefore not adjusted (they are already held at the lower of cost and NRV under IAS 2). Hence the impairment loss of $12m in the Personal Hygiene division is allocated against the property, plant and equipment. Test of group of CGUs
PPE Goodwill Inventories
Personal Hygiene
Hair & Beauty
Household Cleaning
Unall. corp assets
Goodwill
$m
$m
$m
$m
$m
228 – 120
462 44 190
312 35 175
348
696
522
22.4
174 – 40 (W2)
134 – – 134
20 – 20 (W2)
Total $m
–– – –
1,136 79 485
–
1,700
22: ANSWERS TO LECTURE EXAMPLES
2
Allocation of impairment loss $m 1,760 1,700 60
Net carrying value (after test of individual CGUs) Recoverable amount Impairment loss To be allocated against: Unallocated goodwill Other assets pro-rata*
20 40
* Allocated to the unallocated corporate assets (the impaired CGUs have already been reduced to their recoverable amounts and cannot be reduced further).
Answer to Lecture Example 4
(a) $m 150 550 700
(b) $m 150 550 700
Recoverable amount
510
570
Impairment loss
190
130
$m 150 40 190
$m 130 130
$m – 510 510
$m 12 550 562
Notional goodwill (90 × 100/60) Carrying amount of net assets
Allocation of impairment loss: Goodwill Other assets pro-rata Carrying value after impairment: Goodwill (90 – (150 × 60/100))/(90 – (130 × 60/100)) Other net assets (550 – 40)/ -
Chapter 5 Answer to Lecture Example 1 Salaries Bonus Dr
I/S Cr Cr
$10,500,000 $ 3,000,000 $13,500,000 × 5% = $675,000 $675,000 Cash Accruals
$510,000 $165,000
22.5
22: ANSWERS TO LECTURE EXAMPLES
Answer to Lecture Example 2 Income statement note Defined benefit expense recognised in profit or loss Current service cost Interest cost [(890 × 10%) + (30 × 10%)] Expected return on plan assets (1,000 × 12%) Past service cost - vested benefits - non-vested benefits (20/(8 – 3 years)) Net actuarial (gains)/losses recognised in the year (Working)
$m 127 92 (120) 10 4 (2) 111
Balance sheet notes Net defined benefit liability recognised in the balance sheet Present value of defined benefit obligation Fair value of plan assets Unrecognised actuarial gains/(losses) (Working) Unrecognised past service cost [20 – (20/(8 – 3 years)] Net liability Changes in the present value of the defined benefit obligation Opening defined benefit obligation Interest cost [(890 × 10%) + (30 × 10%)] Current service cost Benefits paid Past service cost - vested - non-vested Actuarial (gain)/loss (balancing figure) Closing defined benefit obligation Changes in the fair value of plan assets Opening fair value of plan assets Expected return on plan assets (1,000 × 12%) Contributions Benefits paid Actuarial gain/(loss) (balancing figure) Closing fair value of plan assets
$m 1,100 (1,230) (130) 163 (16) 17 $m 890 92 127 (150) 10 20 111 1,100 $m 1,000 120 104 (150) 156 1,230
Working Recognised/unrecognised gains and losses
$m
Corridor limits, higher of: 10% b/d obligation 10% b/d assets Corridor limit
89 100 100
Unrecognised gains/(losses) b/d Gain recognised [(120–100)/10] Gain/(loss) on obligation in the year Gain/(loss) on assets in the year Unrecognised gains/(losses) c/d
120 (2) (111) 156 163
22.6
22: ANSWERS TO LECTURE EXAMPLES
Chapter 6 Answer to Lecture Example 1 (a)
(b)
(c)
(i)
Fair value adjustments are treated in a similar way to temporary differences on revaluations in the entity's own accounts. A deferred tax liability is recognised under IAS 12 even though the directors have no intention of selling the property as it will generate taxable income in excess of depreciation allowed for tax purposes. The deferred tax of $1m × 25% = $0.25m is debited to goodwill, reducing the fair value adjustments (and net assets at acquisition) and increasing goodwill.
(ii)
Provisions for unrealised profits are temporary differences which create deferred tax assets and the deferred tax is provided at the receiving company's rate of tax. A deferred tax asset would arise of (3.6 × 2/6 ) @ 30% = $360,000.
(i)
The unrealised gains are temporary differences which will reverse when the investments are sold therefore a deferred tax liability needs to be created of ($8m × 25%) = $2 million.
(ii)
The general provision is a temporary difference which will reverse when the currently unidentified loans go bad and the entity will then be entitled to tax relief. A deferred tax asset of ($2m at 25%) = $500,000 should be created.
No deferred tax liability is required for the additional tax payable of $2 million as Nyman controls the dividend policy of Winsten and does not intend to remit the earnings to its own tax regime in the foreseeable future.
Answer to Lecture Example 2 Income statement (extract):
(Loss)/profit before tax Current tax Deferred tax – origination/(reversal) of temporary differences (230 × 30%)/(50 × 30%)/(140 × 30%) – impairment of deferred tax asset ((230 – 50 – 140) × 30%) (Loss)/profit for the period Balance sheet (extract):
Deferred tax asset (230 × 30%)/((230 – 50) × 30%)
22.7
20X1 $
20X2 $
20X3 $
(234,000)
47,000
135,500
– 69,000
– (15,000)
– (42,000)
– 69,000
– (15,000)
(12,000) (54,000)
(165,000)
32,000
81,500
20X1 $
20X2 $
20X3 $
69,000
54,000
–
22: ANSWERS TO LECTURE EXAMPLES
Chapter 7 Answer to Lecture Example 1 (a)
At inception Presentation Non-current liabilities Financial liability component of convertible bond (Working) Equity Equity component of convertible bond (2,000,000 – (Working) 1,847,720) Working
$ 1,847,720 152,280 $
Fair value of equivalent non-convertible debt Present value of principal payable at end of 3 years (1,000 × $2,000 = $2m × 0.772) Present value of interest annuity payable annually in arrears for 3 years [(6% × $2m) × 2.531] (b)
1,544,000
303,720 1,847,720
At 31 December 20X1 Presentation Non-current liabilities Financial liability component of convertible bond Equity Equity component of convertible bond
$ 1,894,015 152,280
Working
$ 1,847,720 166,295 (120,000) 1,894,015
Proceeds of bond issue Effective interest at 9% Nominal coupon payment (6% × $2m) Carrying value at 31 December 20X1
Answer to Lecture Example 2 (a)
No. This would be covered by IAS 37.
(b)
No. This is a normal operating purchase which is not recognised until delivery when there is a contractual obligation on the part of the purchaser to pay for the cocoa beans.
(c)
Yes, if the contract is to be settled net in cash rather than by delivery of the cocoa beans. The contract is recognised on the commitment date rather than the closing date under IAS 39. No, if the contract is for the entity's expected usage of cocoa beans in their business (outside the scope of IAS 39, para 5). Would be accounted for as a normal purchase on delivery, as (b).
22.8
22: ANSWERS TO LECTURE EXAMPLES
Answer to Lecture Example 3 (a)
AB Co should derecognise the asset as it only has an option to purchase.
(b)
CD Co should not derecognise the asset as it has retained substantially all the risks and rewards of ownership.
(c)
EF Co should not derecognise the asset as it has retained substantially all the risks and rewards of ownership. The inventory should be retained in its books even though legal title is temporarily transferred.
(d)
GH Co has received 90% in cash, but this is dependent on the performance of the factor in recovering all of the debts and may have to be repaid. GH Co therefore retains the risks and rewards of 100% of the debt value and the debts should not be derecognised (IAS 39 para 16(b)). The cash received is treated as a loan. The additional 10% that GH Co may have to pay depending on the performance of the debts will be accrued in accordance with its substance, i.e. as interest over the six month period increasing the value of the loan. After six months, the debt can be derecognised by netting against it the amount of the loan that does not need to be repaid to the factor. The amount of debts remaining (i.e. equivalent to cash paid to the factor) are bad debts and are written off to the income statement. If there was any indication that the receivables were irrecoverable during the six months, the impairment loss would be recognised earlier.
Answer to Lecture Example 4 (a) Amortised cost
(c) AFSFA
20X1 $'000
20X2 $'000
20X1 $'000
20X2 $'000
20X1 $'000
20X2 $'000
1,200
1,200
1,200
1,387
1,200
1,387
– 1,200
– 1,200
(187) 1,013
– 1,387
– 1,200
(187)* 1,200
20,000
–
19,813
–
19,813
–
–
(187)
–
Income statement Interest income (W1)/(W2) Gain/(loss) due to change in FV (W2) Balance sheet Financial asset (W1)/(W2)
(b) FV through P/L
Reserves Gain/(loss) due to change in FV (W2)
–
–
–
* recycled from reserves on derecognition. Workings 1
Amortised cost Cash – 1.1.20X1 Effective interest at 6% (same as nominal as not issued at a discount) Coupon received (nominal interest 6% × 20m) At 31.12.20X1 Effective interest at 6% Coupon and capital received (( 6% × 20m) + 20m) At 31.12.20X2
22.9
$'000 20,000 1,200 (1,200) 20,000 1,200 (21,200) 0
22: ANSWERS TO LECTURE EXAMPLES
2
Fair value
$'000 20,000 1,200 (1,200) (187) 19,813 1,387 (21,200) 0
Cash Market interest at 6% (6% × 20,000) Coupon received (nominal interest 6% × 20m) Fair value loss β At 31.12.20X1 (W3) Market interest at 7% (7% × 19,813) Coupon and capital received (( 6% × 20m) + 20m) At 31.12.20X2 3
Fair value at 31.12.20X1
$'000 19,813
Interest and capital due on 31.12.20X2 (21.2m/1.07)
Answer to Lecture Example 5 Balance sheet extracts
$
Financial assets: 4% debentures in MT Co (W1) Interest rate option (W2) Shares in EG Co (W3)
104,120 13,750 0
Financial liabilities: Shares in BW Co sold 'short' (W4)
(28,000)
Income statement extracts
$
Finance income: Effective interest on 4% debentures in MT Co (W1) Gain on interest rate option (W2) Gain on sale of shares in EG Co (W3) In the period (14,345 – 5,750) Recycled from reserves
8,595 5,750
Finance costs: Loss on shares in BW Co sold 'short' (W4)
(4,000)
6,120 6,750
Workings 1
Debentures (Financial asset held-to-maturity) Cash paid on 1.1.20X2 (100,000 + 2,000) Effective interest income (102,000 × 6%) Coupon paid (100,000 × 4%) Amortised cost at 31.12.20X2
22.10
$ 102,000 6,120 (4,000) 104,120
22: ANSWERS TO LECTURE EXAMPLES
2
3
Option (Financial asset at fair value through profit or loss) 1.9.20X2 Dr Financial asset Cr Cash
$7,000 $7,000
31.12.20X2 Dr Financial asset ($13,750 – $7,000) Cr Income statement
$6,750 $6,750
Shares (Available-for-sale financial asset – recycling) 20X1 $ Purchase for cash ((25,000 × $2) + (1% × $50,000)) 50,500 Fair value gain at 31.12.20X1 ((25,000 × $2.25 bid price) – $50,500)) 5,750 Fair value at 31.12.20X1 56,250 20.12.20X2 Dr Cash ((25,000 × $2.62) – (1% × 65,500)) Dr Equity reserve Cr Financial asset Cr Income statement
4
reserves
$64,845 $5,750 $56,250 $14,345
Shares sold 'short' (Financial liability at fair value through profit or loss) 22.12.20X2 Dr Cash Cr Financial liability
$24,000 $24,000
31.12.20X2 Dr Income statement ($28,000 – $24,000) Cr Financial liability
$4,000 $4,000
Answer to Lecture Example 6 Recoverable amount at 31.12.20X2 = 75% × $117,000 ×
1 = $65,572. 1.065
The impairment of $38,548 ($104,120 – $65,572) should be recorded as: Dr Income statement Cr Financial asset
$38,548 $38,548.
Answer to Lecture Example 7 Given that Bruntal is hedging the volatility of the future cash inflow from selling the gold jewellery, the futures contracts can be accounted for as a cash flow hedge, providing the criteria (i.e. documentation at inception as a cash flow hedge, being a 'highly effective' hedge and ability to measure the effectiveness of the hedge) for hedge accounting are met. In order to decide whether hedge accounting can be used and how much of the gain/loss on the futures contracts is reported in reserves and how much in the income statement, a test of the effectiveness of the hedge must be undertaken: Fall in the selling price of the jewellery inventories ($9.938m – $9.186m)
$752,000
Gain on the fair value of the futures contracts over the period (($388 – $352) × 24,000 troy ounces)
$864,000
The effectiveness of the hedge is therefore $752,000/$864,000 = 87% or $864,000/$752,000 = 115%. This is within the 80% - 125% effective hedge range and so hedge accounting can be used.
22.11
22: ANSWERS TO LECTURE EXAMPLES
The effective portion of the $864,000 gain on the futures contract, i.e. the $752,000 which matches the fall in selling price of the jewellery inventories, is recognised initially in reserves. This is then transferred to the income statement when the hedged items affect profit or loss, i.e. when the gold jewellery is sold. In this example the jewellery is sold on the same day the futures contracts expire. The ineffective portion of the gain, i.e. $112,000 ($864,000 - $752,000) is credited immediately to the income statement. The effect on the income statement for the year ended 30 September 20X2 is as follows: Income statement (extract)
$'000
Revenue Cost of sales
$'000 9,186 (8,280) 906
Profit on futures contracts: Ineffective portion credited to income statement Effective portion transferred on sale from reserves
112 752 864 1,770
Without hedging the company would have reported a profit of only $906,000. Note: Bruntal could also have accounted for this transaction as a fair value hedge, if, at inception, its documented objective of the hedge had been to hedge the fair value of its inventories.
Chapter 8 Answer to Lecture Example 1 20X5 Equity c/d and expense ((500 – 75) × 100 × $15 × 1/3) Dr
Expenses Cr Equity
$ 212,500
$212,500 $212,500
20X6 Equity b/d ∴Income statement expense Equity c/d ((500 – 60) × 100 × $15 × 2/3) = Dr
Expenses Cr Equity
$ 212,500 227,500 440,000 $227,500 $227,500
20X7 Equity b/d ∴Income statement expense Equity c/d (443 × 100 × $15) = Dr
Expenses Cr Equity
$ 440,000 224,500 664,500 $224,500 $224,500
22.12
22: ANSWERS TO LECTURE EXAMPLES
Answer to Lecture Example 2 $ Year ended 31 December 20X4 Liability c/d and expense ((500 – 110) × 100 × $8.00 × ½)
156,000 $
Year ended 31 December 20X5 Liability b/d ∴Income statement expense Less: cash paid on exercise of SARs by employees (100 × 100 × $8.10) Liability c/d (300 × 100 × $8.50)
156,000 180,000 (81,000) 255,000 $
Year ended 31 December 20X6 Liability b/d ∴Income statement expense Less: cash paid on exercise of SARs by employees (300 × 100 × $9.00) Liability c/d
255,000 15,000 (270,000) –
Answer to Lecture Example 3 The right granted to the director represents share-based payment with a choice of settlement where the counterparty has the choice. Consequently, a compound financial instrument has in substance been issued and it needs to be broken down into its equity (equity-settled) and liability (cash-settled) components. The equity-settled component is measured as a residual, consistent with the definition of equity, by comparing, at grant date, the fair value of the shares alternative and the cash alternative. The accounting entry on the grant date (30 September 20X3) would therefore be as follows (all figures from W1): DR Income statement – remuneration expense CR Liability CR Equity
$000 108 104 4
The equity component is not subsequently revalued (consistent with the treatment of equity-settled sharebased payment), but the liability component will need to be adjusted for any changes in the fair value of the cash alternative up to the settlement date (30 September 20X4). The post year end change in the share price (which will affect the cash-settled share-based payment) is a non-adjusting event after the balance sheet date, as it relates to conditions that arose after the year end. The liability is not therefore adjusted for this, but the difference (20,000 x $0.20 = $4,000) would be disclosed if considered material. This is unlikely here, but may be considered material due to the fact that it is a transaction with a member of key management personnel. At the settlement date the liability element of the share-based payment will be re-measured to its fair value at that date and the method of settlement chosen by the director will then determine the accounting treatment (payment of the liability or transfer to share capital/share premium). Working 1
Fair value of equity component Fair value of the shares alternative at grant date (24,000 shares × $4.50) Fair value of the cash alternative at grant date (20,000 phantom shares × $5.20) ∴Fair value of the equity component of the compound instrument
22.13
$ 108,000 (104,000) 4,000
22: ANSWERS TO LECTURE EXAMPLES
It can be seen that where the right to the shares alternative is more valuable than the right to a cash alternative, at the grant date, and therefore the equity component has a value of the residual amount, not the full amount of the shares alternative, as the director must surrender the cash alternative in order to accept the shares alternative, he cannot accept both.
Answer to Lecture Example 4 31/12/20X2 31/12/20X3 before exercise Carrying amount of share-based payment expense 0 0 Less: Tax base of share-based payment expense (5,000 × $1.2 × ½)/(5,000 × $3.40) (3,000) (17,000) Temporary difference (3,000) (17,000) Deferred tax asset @ 30%
900
5,100
Deferred tax (Cr I/S) (5,100 – 900 – (Working) 600) Deferred tax (Cr Equity) (Working)
900 0
3,600 600
On exercise, the deferred tax asset is replaced by a current tax one. The double entry is: Dr deferred tax (I/S) 4,500 Dr deferred tax (equity) 600 Cr deferred tax asset 5,100 Dr current tax asset Cr current tax (I/S) Cr current tax (equity)
reversal
5,100 4,500 600
Working Accounting expense recognised (5,000 × $3 × ½)/(5,000 × $3) Tax deduction Excess temporary difference
7,500 15,000 (3,000) (17,000) (2,000) 0
Excess deferred tax asset to equity @ 30%
0
600
Answer to Lecture Example 5 Kingsley – performance condition Expense $ 660,000 174,000 423,000
Year 1 Year 2 Year 3
Equity (per balance sheet) $ 660,000 834,000 1,257,000
Workings 1
Year 1 Equity c/d and I/S expense [(500 – 30 – 30) × 100 × $30 × ½] (using original estimate of 2-year period)
2
Year 2
$660,000 $
Equity b/d ∴ I/S expense Equity c/d [(500 – 30 – 28 – 25) × 100 × $30 × 2/3] (using revised estimate of 3-year period)
22.14
660,000 174,000 834,000
22: ANSWERS TO LECTURE EXAMPLES
3
Year 3
$
Equity b/d ∴ I/S expense Equity c/d [(500 – 30 – 28 – 23) × 100 × $30]
834,000 423,000 1,257,000
Chapter 9 Answer to Lecture Example 1 At 31 December 20X3 The discounted amount of the provision would be included in the initial measurement of the cost of the power station as at 31 December 20X3: $m 450.0 5.0 455.0
Cost Provision ($50m × 1/1.0830) Year ended 31 December 20X4
The power plant would be depreciated over its 30 year life resulting in a charge of $455.0m/ 30 = $15.2m to the income statement and a net book value of $455m – $15.2m = $439.8m. The provision would begin to be compounded resulting in an interest charge of $5.0 × 8% = $0.4m in the income statement and an outstanding provision of $5.0 + $0.4 = $5.4m in the balance sheet. Any change in the expected present value of the provision would be made as an adjustment to the provision and to the asset value (affecting future depreciation charges).
Chapter 10 Answer to Lecture Example 1 Leoval must disclose its parent (Cavelli) and ultimate controlling party (the Grassi family). This is irrespective of whether transactions have occurred with these related parties during the period. The company in which Francesca Cincetti has a 23% shareholding is related to Leoval as it is significantly influenced by close family of a controlling party of Leoval. Consequently the sales, any outstanding balances and any bad or doubtful debts must be disclosed even though they are at market prices: Leoval might lose this business if Francesca's husband was not a shareholder and investors need to be aware of this. The interest-free loans, although a benefit, are not a related party transaction in themselves; they are part of the remuneration package of the employees and would be accounted for under IAS 19 Employee Benefits. However, if the employees include key management personnel the transaction and its cost must be disclosed as a related party transaction for them. The management service fee is a transaction with the controlling party, and must be disclosed in Leoval's own financial statements (but will be eliminated and not require disclosure in the group accounts); it will be particularly important information for the 10% minority interest shareholders in Leoval. Leoval is dependent on Piat in that it is a major customer, but this in itself, in the absence of any other information suggesting otherwise, is not a related party issue.
22.15
22: ANSWERS TO LECTURE EXAMPLES
Post-employment benefit plans are related parties under IAS 24. Leoval has had no transactions with the plan in the period requiring disclosure under IAS 24, but recognises other income and expenses relating to the plan in its financial statements. These are disclosed under IAS 19 Employee Benefits.
Chapter 11 Answer to Lecture Example 1 (a)
Financial statement extracts Income statement for the year ended 31 December 20X1 (extract) Depreciation [(80,000 + 2,000 – 8,000)/5)] Finance costs (Working)
$ 14,800 7,420
Balance sheet as at 31 December 20X1 (extract) $ Non-current assets Leased asset [(80,000 + 2,000) – ((80,000 + 2,000 – 8,000)/5)]
67,200
Non-current liabilities Finance lease liability (Working)
56,182
Current liabilities Finance lease liability (Working) (65,620 – 56,182)
9,438
Working $ Year ended 31 December 20X1: 1.1.X1 Asset at FV 1.1.X1 Non-refundable deposit 1.1.X1 – 31.12.X1 31.12.X1 Balance at 31.12.X1
Interest at 10% Instalment 1
Year ended 31 December 20X2: 1.1.X2 – 31.12.X2 Interest at 10% 31.12.X2 Instalment 2 Balance at 31.12.X2 (b)
80,000 (5,800) 74,200 7,420 (16,000) 65,620 6,562 (16,000) 56,182
Treatment of guaranteed residual value At the end of the lease, the lessee will have an asset at residual value of $8,000 in its balance sheet and a finance lease liability of $8,000 representing the residual value guarantee to the lessor. (i)
If the lessor is able to sell the asset for more than the value guaranteed by the lessee, the lessee has no further liability and derecognises the asset and lease liability: Dr Finance lease liability Cr Asset NBV
(ii)
$8,000 $8,000
If the lessor is unable to sell the asset for the value guaranteed by the lessee, the lessee has a liability to make up the difference of $8,000 – $6,000 = $2,000: Recognise impairment loss on asset (as soon as known during the lease term): Dr I/S Cr Asset NBV
$2,000 $2,000
22.16
22: ANSWERS TO LECTURE EXAMPLES
Make guarantee payment to lessor and derecognise the asset and lease liability: Dr Finance lease liability Cr Cash Cr Asset NBV
$8,000 $2,000 $6,000
Answer to Lecture Example 2 (a)
Unguaranteed residual value and net investment in the lease at 1 January 20X1 Date 1.1.X1 1.1.X2 1.1.X3 1.1.X4 31.12.X4 31.12.X4
(b)
Instalment Instalment Instalment Instalment Guaranteed residual value Minimum lease payments Unguaranteed residual value Investment in the lease
Gross investment $ 22,000 22,000 22,000 22,000 10,000 98,000 2,000 100,000
Discount factor (11%) 1 0.901 0.812 0.731 0.659 0.659
Net investment $ 22,000 19,822 17,864 16,082 6,590 82,358 1,318 83,676
Financial statement extracts Income statement for the year ended 31 December 20X1 (extract) Finance income (Working)
$ 6,783
Balance sheet as at 31 December 20X1 (extract) $ Non-current asset Net investment in finance lease (Working)
46,449
Current assets Net investment in finance lease (Working) (68,449 – 46,449)
22,000
Working – net investment in finance lease $ Year ended 31 December 20X1: 1.1.X1 Net investment 1.1.X1 Instalment 1 in advance 1.1.X1 – 31.12.X1 Balance at 31.12.X1
Interest income at 11%
Year ended 31 December 20X2: 1.1.X2 Instalment 2 in advance
22.17
83,666 (22,000) 61,666 6,783 68,449 (22,000) 46,449
Lessee's liability Lessor's asset
22: ANSWERS TO LECTURE EXAMPLES
Answer to Lecture Example 3 Operating leases (i)
Apparent loss on sale The apparent loss of $3,000 should be recognised immediately unless compensated by future rentals at below market price. If this is the case the loss of $3,000 will be deferred as a prepayment and amortised over the lease term, i.e. $1,000 p.a..
(ii)
Profit on sale but proceeds below fair value Recognise profit of $1,500 immediately. If the company has negotiated rentals at below market price (as a result of the proceeds, $16,500 being less than fair value, $18,000) then the benefit of the low rentals will be automatically spread over the term of the lease as each rental is expensed.
(iii)
Selling price above fair value Recognise profit of $1,000 immediately (FV – BV). The excess profit of $1,500 (SP – FV) will be 1,500 treated as a loan. The repayments of the loan including interest at 10% will be = 603 p.a. 2.487 Therefore charges to the I/S in the year to 30 June 20X2 will be: $ 3,397
Operating lease rental at fair value (4,000 – 603) Interest on loan 1,500 × 10%
150 3,547
The remaining portion of the “rental” will be treated at a repayment of capital $ 1,500
Initial loan Less: capital repayment (603 – 150) Outstanding at end of first year
(453) 1,047
22.18
22: ANSWERS TO LECTURE EXAMPLES
Chapter 12 Answer to Lecture Example 1 Consolidated balance sheet as at 30 June 20X6 Non-current assets Property, plant and equipment (1,012 + 920 + (W5) 60) Goodwill (W4) Other intangible assets (350 – (W3) 87) Investment in associate (W6) Current assets Inventories (620 + 1,460 – (W2) 42) Trade receivables (950 + 529) Cash and cash equivalents (900 + 510)
$m 1,992 25 263 226 2,506 2,038 1,479 1,410 4,927 7,433
Equity attributable to equity holders of the parent Share capital Share premium Retained earnings (W8) Minority interest (W7) Current liabilities Trade and other payables (1,880 + 2,300)
1,000 200 1,773 2,973 280 3,253 4,180 7,433
Consolidated income statement for the year ended 30 June 20X6 Revenue (4,480 + 4,200 – 1,300) Cost of sales (2,690 + 2,940 – 1,300 + (W2) 24 + (W5) 10 + 25) Gross profit Distribution costs and administrative expenses (620 + 290 + (W3) 87) Finance costs (50 + 80) Share of profit of associate (148 × 25%) Profit before tax Income tax expense (330 + 274) Profit for the period Attributable to: Equity holders of the parent Minority interest (W9)
$m 7,380 (4,389) 2,991 (997) (130) 37 1,901 (604) 1,297 1,198 99 1,297
22.19
22: ANSWERS TO LECTURE EXAMPLES
Workings 1
Group structure Otway 1.7.X2 (4 years ago) 320 = 80% 400
1.1.X5 (1½ years ago) 55 = 25% 220
Holgarth 2
Batterbee
Unrealised profit
$m 18 42 24
In opening inventories (60 × 30%) In closing inventories (140 × 30%) Increase (to cost of sales) 3
Start-up costs IAS 38 Intangible Assets states that start-up, training and promotional costs should all be written off as an expense as incurred as no intangible asset is created that can be recognised (the benefits cannot be sufficiently distinguished from internally generated goodwill, which is not recognised).
4
Goodwill $m Cost of combination Net assets acquired Share capital Share premium Retained earnings at acq'n ∴ fair value adjustment Total FV of net assets
Holgarth
400 140 160 100 800 × 80%
Less: cumulative impairment losses 5
Fair value – Holgarth
Difference at acquisition $m 100 100
Property, plant and equipment * Additional depreciation = 6
100
10
Additional depreciation* $m (40) (40)
$m 765
640 125 (100) 25 Difference at B/S date $m 60 60
= 10 per annum × 4 years = 40
Investment in associate Cost of associate Share of post acquisition retained reserves [(361 – 269) × 25%] Less: impairment losses on associate to date
22.20
$m 203 23 (0) 226
22: ANSWERS TO LECTURE EXAMPLES
7
Minority interest (balance sheet)
$m 1,469 (42) (87) 60 1,400
Holgarth's net assets per question PUP (W3) Start-up costs (W3) FV adj (W5)
280
× 20% = 8
Consolidated retained earnings c/f
Otway $m 1,370
Per question PUP (W2) Start up costs (W3) Depreciation on FV adj (W5) Less: Pre-acq'n Holgarth [600 × 80%] Batterbee [92 × 25%] Less: impairment losses on goodwill (per Q): Holgarth Less: impairment losses on associate Batterbee 9
Minority interest (income statement)
1,370 480 23
Holgarth $m 929 (42) (87) (40) (160) 600
Batterbee $m 361 (0) (269) 92
(100) (0) 1,773 $m 616 (24) (87) (10) 495
Holgarth's PFP per question Less: PUP (W2) Less: start-up costs (W3) Less: FV dep'n (W5)
99
× 20% =
22.21
22: ANSWERS TO LECTURE EXAMPLES
Answer to Lecture Example 2 (a)
Parachute Group – Consolidated balance sheet as at 31 December 20X5 $'000 Non-current assets Property, plant and equipment [406 + (160 × 50%)]
486
Current assets Inventories [100 + (50 × 50%) – (W2) 5] Others [200 + (110 × 50%) – (50 × 50%)]
120 230 350 836
Equity attributable to equity holders of the parent Share capital Retained earnings (W3)
200 451 651
CCurrent liabilities [150 + (120 × 50%) – (50 × 50%)]
185 836
Workings 1
Group structure Parachute 50% Jump Pre acq'n ret'd earnings $0 (set up by Parachute)
2
Provision for unrealised profit on inventories Investor's share of unrealised profit in inventories: $50,000 × 25%/125% × 50% = $5,000 ...
3
Dr Retained earnings $5,000 Cr Group inventories $5,000.
Consolidated retained earnings
Per question PUP (W2) Pre-acquisition retained earnings
Parachute $'000 366 (5)
Jump – share of post-acquisition earnings (180 × 50%)
361 90 451
Jump $'000 180 (0) 180
Parachute Group – Consolidated income statement for the year ended 31 December 20X5 Revenue [490 + ((312 × 50%) – (50 × 50%)] Cost of sales and expenses [280 + ((200 × 50%) – (50 × 50%)+ (W2) 5)] Profit before tax Income tax expense [100 + (32 × 50%)] Profit for the period
22.22
$'000 621 (360) 261 (116) 145
22: ANSWERS TO LECTURE EXAMPLES
(b)
Parachute Group – Consolidated balance sheet as at 31 December 20X5 $'000 Non current assets Property, plant and equipment Investment in joint venture (W4)
406 95 501
Current assets Inventories Others
100 200 300 801
Equity attributable to equity holders of the parent Share capital Retained earnings (W3) Current liabilities
200 451 651 150 801
Workings (cont'd) 4
Investment in Jump Cost of joint venture Add: post-acquisition retained reserves ((180 × 50%) Less: PUP (W2)*
$'000 10 90 (5) 95
* Adjusted against the joint venture rather than group inventories because in this scenario it is the joint venture that holds the inventories. The credit adjustment is made wherever the inventories are held under equity accounting. Parachute Group – Consolidated income statement for year ended 31 December 20X5 Revenue Cost of sales and expenses (280 + (W2) 5) Share of profit of joint venture (80 × 50%) Profit before tax Income tax expense Profit for the period
Answer to Lecture Example 3
$'000 490 (285) 40 245 (100) 145
$m 1.0 1.364
Cash now (31.12.X8) Deferred (31.12.X9) (1.5m × 0.909) Contingent (31.12.20Y0) (1.6m × 0.826)
1.322 3.686
22.23
22: ANSWERS TO LECTURE EXAMPLES
(i)
Carrying value
(ii)
Interest
(iii)
3.686
20X9
(1.364 + 1.322) × 10% =
0.269
20Y0
1.455 × 10% =
0.145
31.12.X9 31.12.Y0
(2.686 + 0.269 – 1.5) = (1.455 + 0.145 – 1.6) =
1.455 Nil
Answer to Lecture Example 4 In part (a), the contractual obligation is recognised as a liability in S's books when the business combination becomes probable and the liability can be measured reliably. It is a contingent liability until that time. In part (b), an acquiree's restructuring plan whose execution is conditional upon being acquired in a business combination is not, immediately before the business combination, a present obligation of the acquiree. Goodwill
Cost of combination Net assets acquired Provision for restructuring Goodwill
(a) With provision $ 1,000 500 (200) 700
(b) Without provision $ 1,000 500
With provision $ 1,100 (200) 200 1,100 (270) 830
Without provision $ 1,100 (200)
500
Income Statement
Profit before restructuring costs Restructuring costs Release provision Profit before tax Income tax expense Profit for the period
22.24
900 (270) 630
22: ANSWERS TO LECTURE EXAMPLES
Chapter 13 Answer to Lecture Example 1 (a)
Goodwill on Superior U 80% 20X4 S 75% 20X1 (effective interest 60%) I
$
Cost of combination Fair value of identifiable net assets acquired S Share capital Pre-acquisition reserves Investment in Inferior
I
(b)
50,000 180,000 (87,000) 143,000
Share capital Pre-acquisition reserves
20,000 95,000 115,000
$ 220,000
× 80% (114,400)
× 60% (69,000) 36,600
U 80% 20X1 S 75% 20X4 I
U in S $
Cost of combination FV of identifiable NA acquired Share capital Reserves
S in I $ 160,000
50,000 120,000 170,000
$
$ 100,000
20,000 95,000 115,000
× 80%
× 75% 136,000 24,000
86,250 13,750
Goodwill in Ultimate's books is recorded as $37,750 ($24,000 + $13,750) and minority interest is increased by 20% × $13,750
22.25
22: ANSWERS TO LECTURE EXAMPLES
Answer to Lecture Example 2 Alpha Group consolidated balance sheet as at 31 December 20X5
$'000 45 2,170 2,215
Goodwill (W2) Current assets (890 + 610 + 670) Share capital Retained earnings (W4)
600 520 1,120 255 1,375 840 2,215
Minority interest (W3) Current liabilities (340 + 230 + 270) Workings 1
Group structure Alpha 75% Beta
Minority interest
25%
80% Group effective interest (80% × 75%) ... Minority interest
Gamma
2
Goodwill
60% 40% 100%
$'000
Cost of combination Fair value of identifiable net assets acquired Beta Share capital Pre-acquisition retained earnings Investment in Gamma
Gamma Share capital Pre-acquisition retained earnings
400 100 (320) 180
× 75%
(135)
300 60 360
× 60%
(216) 99 (54) 45
Impairment losses (see below) Impairment losses
$'000 100
Goodwill (gross) (99 × 75 ) Net assets (700 – 320 + 400)
132 780 912 (840) 72
Recoverable amount ∴Impairment loss (gross) Impairment loss (net) (72 × 75%)
54
22.26
$'000 450
22: ANSWERS TO LECTURE EXAMPLES
3
Minority interest
Beta $'000 700 (320) 380
Net assets per question Less: cost of investment in Gamma Minority share
Gamma $'000 400 400
× 25% 95
× 40% 160 255
4
Consolidated retained earnings
Alpha $'000 400
Per question Retained earnings at acquisition Beta – share of post acquisition earnings (200 × 75%) Gamma – share of post acquisition earnings (40 × 60%) Goodwill impairment losses to date (W2)
Beta $'000 300 (100) 200
Gamma $'000 100 (60) 40
150 24 (54) 520
Answer to Lecture Example 3 Vertical Group income statement
$'000 982 (600) 382
Profit before tax (500 + 300 + 200 – 18) Income tax expense (300 + 150 + 150) Profit for the period Attributable to: Equity holders of the parent Minority interest (W1)
324.5 57.5 382
Working 1
Minority interest
$'000 37.5 20 57.5
Beta (150 × 25%) Gamma (50 × 40%)
22.27
22: ANSWERS TO LECTURE EXAMPLES
Answer to Lecture Example 4 Alpha consolidated balance sheet as at 31 December 20X5
$'000 65 2,103 2,168
Goodwill (W2) Current assets (869 + 660 + 574) Share capital Retained earnings (W4)
600 617 1,217 305 1,522 646 2,168
Minority interest (W3) Current liabilities (354 + 218 + 74) Workings 1
Group structure Alpha 75% Beta
8% 72%
Gamma Alpha's effective interest in Gamma [(75% x 72%) indirect + 8% direct] 62% ... Minority interest 38% 100% 2
Goodwill Cost of combination NA acquired SC Retained earnings Group share Impairment losses to date (10, ratio 27:3)
Alpha in Beta $'000 $'000 450 400 140 540
Beta in Gamma $'000 $'000 315 320 80 400
75%
Alpha in Gamma $'000 $'000 35 320 80 400
72%
8%
(405) 45
(288) 27
(32) 3
(0) 45
(9) 18
(1) 2
Consolidated goodwill $45,000 + $18,000 + $2,000 = $65,000
22.28
22: ANSWERS TO LECTURE EXAMPLES
3
Minority interest
Beta $'000 757 18 (315) 460
Net assets per question Goodwill (W2) Less: cost of investment in Gamma Minority share
Gamma $'000 500 500
× 25% 115
× 38% 190 305
4
Retained earnings Per question Retained earnings at acquisition Goodwill impairment losses to date (W2) Beta – share of post acquisition earnings (208 × 75%) Gamma – share of post acquisition earnings (100 × 62%)
Alpha $'000 400 (1)
Beta $'000 357 (140) (9) 208
Gamma $'000 180 (80) 100
156 62 617
Chapter 14 Answer to Lecture Example 1 (a)
Consolidated balance sheet as at 30 September 20X8 $'000 2,050 4,800 6,850
Property, plant and equipment Current assets (2,700 + 2,100) Share capital Retained earnings (2,500 + (W2) 1,150) Current liabilities
2,000 3,650 5,650 1,200 6,850
Consolidated income statement for the year ended 30 September 20X8 Profit before interest and tax (1,400 + 180) Profit on disposal of shares in subsidiary (W4) Profit before tax Income tax expense (400 + 50) Profit for the period Attributable to: Equity holders of the parent Minority interest (130 × 20%)
$'000 1,580 678 2,258 (450) 1,808 1,782 26 1,808
22.29
22: ANSWERS TO LECTURE EXAMPLES
Consolidated statement of changes in equity (extract) Retained earnings $'000 1,868 1,782 3,650
Balance at 30 September 20X7 (W5) Profit for the period Balance at 30 September 20X8 (per B/S) Workings 1
Timeline 1.10.X7
30.9.X8
I/S
Subsidiary – all year
Group gain on disposal Not sub at y/e 2
Profit on disposal of Bill in Ted's separate financial statements
$'000 2,100 (950) 1,150
Sale proceeds Less: cost of Bill Co 3
Goodwill on acquisition of Ted
$'000
Cost of combination Less: share of net assets acquired Share capital Retained earnings
300 510 810
Group share (80%) 4
(648) 302
Group profit on disposal of Bill
$'000
Sale proceeds Less: Net assets of Bill now sold (1,400 × 80%) Goodwill disposed (W3) 5
$'000 950
Retained earnings brought forward Per question Pre-acquisition retained earnings Bill – share of post acquisition earnings (460 × 80%)
22.30
1,120 302
Ted $'000 1,500 1,500 368 1,868
$'000 2,100 (1,422) 678 Bill $'000 970 (510) 460
22: ANSWERS TO LECTURE EXAMPLES
(b)
Consolidated balance sheet as at 30 September 20X8 $'000 2,650 226.5 2,876.5 4,380 7,256.5
Property, plant and equipment (2,050 + 600) Goodwill (W3) Current assets (2,700 + 1,300 + 380) Share capital Retained earnings (W4)
2,000 2,996.5 4,996.5 560 5,556.5 1,700 7,256.5
Minority interest (1,400 × 40%) Current liabilities (1,200 + 500) Consolidated income statement for the year ended 30 September 20X8 Profit before interest and tax (1,400 + 180) Profit on disposal of shares in subsidiary (W5) Profit before tax Income tax expense (400 + 50) Profit for the period
$'000
$'000 1,580 31 1,611 (450) 1,161
Attributable to: Equity holders of the parent
1,128.5
Minority interest [(130 ×
9 12
× 20%) + (130 ×
3
× 40%)]
32.5
12
1,161
Consolidated statement of changes in equity (extract) Retained earnings $'000 1,868 1,128.5 2,996.5
Balance at 30 September 20X7 (W6) Profit for the period Balance at 30 September 20X8 (W4) Workings 1
Timeline 1.10.X7 I/S
30.6.X8
30.9.X8
Subsidiary – all year 20% MI × 9/12
40% MI × 3/12 Sells 60,000 shares = 20% of Bill Group gain on disposal
22.31
Consol – 40% MI
22: ANSWERS TO LECTURE EXAMPLES
2
Profit on disposal of Bill in Ted's separate financial statements
$'000 380 (237.5) 142.5
Sale proceeds Less: cost of Bill Co (950 × 20%/80%) 3
Goodwill part (a) (W2)
$'000 302
20% = ¼ sold 80%
60% = ¾ retained 80% 226.5
75.5 4
Retained earnings carried forward Per question Add: profit on disposal in Ted Co books (W2) Pre-acquisition retained earnings Bill – share of post acquisition earnings (590 × 60%)
5
Group profit on disposal of Bill Co
Ted $'000 2,500 142.5 2,642.5 354 2,996.5 $'000
Sale proceeds Less: Net assets of Bill now sold [(1,400 – (130 × 123 )) × 20%] Goodwill disposed (W3) 6
Retained earnings brought forward Per question Pre-acquisition retained earnings Bill – share of post acquisition earnings (460 × 80%)
(c)
273.5 75.5
Ted $'000 1,500 1,500 368 1,868
Bill $'000 1,100 (510) 590
$'000 380
(349) 31 Bill $'000 970 (510) 460
Consolidated balance sheet as at 30 September 20X8 $'000 2,050 533.25 2,583.25 4,050 6,633.25
Property, plant and equipment Investment in associate (W3) Current assets (2,700 + 1,350) Share capital Retained earnings (W4)
2,000 3,433.25 5,433.25 1,200 6,633.25
Current liabilities
22.32
22: ANSWERS TO LECTURE EXAMPLES
Consolidated income statement for the year ended 30 September 20X8 $'000 1,535 477.5 9.75 2,022.25 (437.50) 1,584.75
Profit before interest and tax (1,400 + (180 × 9/12)) Profit on disposal of shares in subsidiary (W6) Share of profit of associate (130 × 3/12 × 30%) Profit before tax Income tax expense (400 + (50 × 9/12)) Profit for the period Attributable to: Equity holders of parent Minority interest (130 × 9/12 × 20%)
1,565.25 19.5 1,584.75
Consolidated statement of changes in equity (extract) Retained earnings $'000 1,868 1,565.25 3,433.25
Balance at 30 September 20X7 (W7) Profit for the period Balance at 30 September 20X8 (W4) Workings 1
Timeline 1.10.X7 I/S
30.6.X8 Subsidiary – 9/12
30.9.X8
Associate – 3/12 Sells 150,000 shares Equity account = 50% of Bill in B/S (30% share) Group gain on disposal
2
Profit on disposal of Bill in Ted's separate financial statements Sale proceeds Less: cost of Bill Co (950 x 50%/80%)
3
Investment in associate Cost of associate (950 × 30%/80%) Share of post acquisition retained reserves [(1,100 – 510) × 30%]
22.33
$'000 1,350 (593.75) 756.25 $'000 356.25 177 533.25
22: ANSWERS TO LECTURE EXAMPLES
4
Retained earnings carried forward
Ted $'000 2,500 756.25
Per question Add: profit on disposal in Ted Co books (W2) Retained earnings at acquisition
(510) 590
Bill – share of post acquisition earnings (590 × 30%) 5
Bill $'000 1,100
Goodwill part (a) (W3)
177 3,433.25 $'000 302
50% sold 80%
30% retained 80%
188.75
113.25 included in (950 × 30%/80%) in associate valuation
6
Group profit on disposal of Bill Co
$'000
Sale proceeds Less: Net assets of Bill now sold [(1,400 – (130 × 123 )) × 50%] Goodwill disposed (W5)
$'000 1,350
683.75 188.75 (872.5) 477.5
7
Retained earnings brought forward Per question Pre-acquisition retained earnings Bill – share of post acquisition earnings (460 × 80%)
Answer to Lecture Example 2
Ted $'000 1,500 1,500 368 1,868
Bill $'000 970 (510) 460
$'000 4,000 5,000
Retained earnings b/f Profit for period 10,000 × 126 Dividends paid Retained earnings at date of disposal
(2,000) 7,000
22.34
22: ANSWERS TO LECTURE EXAMPLES
Answer to Lecture Example 3 Parts (a) and (b) to the example would generate the same answer. In part (b), however, impairment tests on the goodwill would only be undertaken from 31.12.X2 onwards. Peace Group Consolidated balance sheet as at 31 December 20X2
$'000
Non-current assets Property, plant and equipment [38,650 + 7,500 + ((W2) 800 × 100%)] Goodwill (W3)
46,950 955 47,905
Current assets (12,700 + 2,200)
14,900 62,805
Equity attributable to equity holders of the parent Share capital Retained earnings (W5) Revaluation surplus (W2) [(800 – 600) × 25%]
10,200 40,245 50 50,495 3,760 54,255
Minority interest (W4) Liabilities (7,450 + 1,100)
8,550 62,805
Workings 1
Group structure Peace 1.1.X1 31.12.X2 25% + 35% = 60% ∴ Minority interest = 40% Miel
2
Fair value adjustments On acquisition of 25% stake
Land (7,200 – (800 + 5,800))
Acquisition 1.1.X1 $'000 600
Movement
Acquisition 31.12.X2 $'000 800
Movement
$'000 –
B/S date 31.12.X2 $'000 600
On acquisition of 35% stake
Land (9,400 – (800 + 7,800))
22.35
$'000 –
B/S date 31.12.X2 $'000 800
22: ANSWERS TO LECTURE EXAMPLES
3
Goodwill
1.1.X1 25% share $'000
Cost of combination Fair value of identifiable assets and liabilities acquired represented by: Share capital Retained earnings Fair value adjustments (W2)
800 5,800 600 7,200 × 25%
$'000 2,020
(1,800) 220
31.12.X2 35% share $'000
800 7,800 800 9,400 × 35%
$'000 4,025
(3,290) 735
Total goodwill $955,000 ($220,000 + $735,000) 4
5
Minority interest Net assets at B/S date Fair value adjustment (W2)
$'000 8,600 800 9,400
Minority share (40%)
3,760
Consolidated retained earnings
$'000 Peace
Per question Fair value movement – 20X1 acquisition (W2) Fair value movement – 20X2 acquisition (W2) Retained earnings at acquisition Share of post acquisition earnings Miel 25% (2,000 × 25%) Miel 35% (0 × 35%) Less: Fair value gain recognised in Peace's separate FS
40,600
$'000 Miel 25% 7,800 (0) (5,800) 2,000
$'000 Miel 35% 7,800 (0) (7,800) 0
500 0 (855) 40,245
Note (for information purposes only): The $855,000 fair value gain in Peace's separate financial statements is treated as follows in the group financial statements: $'000 $'000 Recognised as post acquisition earnings 500 Recognised as revaluation surplus 50 Unrecognised difference between: Fair value of shares (2,020 + 855) 2,875 Fair value of identifiable NA and goodwill (2,570) [($9,400,000 × 25%) + (W3) 220,000] 305 855
22.36
22: ANSWERS TO LECTURE EXAMPLES
Chapter 15 Answer to Lecture Example 1 (a)
At the date of classification, since the asset is held under the cost model at $200,000, it is not impaired and no adjustment to its carrying value is necessary. It is however, reclassified as a separate category 'Non-currents assets classified as held for sale' within current assets and not depreciated. At the year end, an impairment loss of $5,000 ($200,000 - $195,000) is recognised. This is recognised in the income statement since the asset is held under the cost model of IAS 16.
(b)
At the date of classification, the asset is first revalued to $207,000 under IAS 16, increasing the revaluation surplus to $11,000 ($4,000 + $7,000). IFRS 5 is then applied and an impairment loss of $2,000 ($207,000 - $205,000) is recognised reducing the asset value to $205,000; this is charged against the revaluation surplus reducing it to $9,000 ($11,000 - $2,000). The asset is reclassified as 'Non-currents assets classified as held for sale' under current assets and depreciation stops. At the year end, a further impairment loss of $10,000 ($205,000 - $195,000) is recognised, reducing the asset value to $195,000. $9,000 of this is charged to the revaluation surplus reducing it to zero and the remaining $1,000 is recognised in the income statement.
Answer to Lecture Example 2 Balboa Group Consolidated income statement for the year ended 31 December 20X4 $m Continuing operations Revenue (4,700 + (3,300 × 8/12)) Cost of sales (3,700 + (2,400 × 8/12) + (W4) 14 + (W5) 10 + (W7) 27) Gross profit Other income (150 + (30 × 8/12) – (W2) 45) Distribution costs (270 + (210 × 8/12)) Administrative expenses (220 + (180 × 8/12)) Finance income (W3) Finance costs (110 + (60 × 8/12) + (W3) 4) Profit before tax Income tax expense (180 + (150 × 8/12)) Profit for period from continuing operations Discontinued operations Profit for the period from discontinued operations (80 × 3/12) – (W7) 7) Profit for the period Attributable to: Equity holders of the parent Minority interest (W10)
66,900 (5,351) 1,549 125 (410) (340) 6 (154) 776 (280) 496 13 509 482 27 509
22.37
22: ANSWERS TO LECTURE EXAMPLES
Workings 1
Group structure Balboa 450 500
210
= 90%
300
Borbon
= 70% (owned for 3 months)
Carbonell
Carbonell is a discontinued operation (IFRS 5). Timeline 1.1.X4
1.5.X4
I/S
31.12.X4
Balboa (parent) – all year Borbon – owned for 8/12 of year Carbonell × 3/12 (discontinued)
2
Dividend payment by Borbon Amount received by Balboa = $50m × 90% = $45m. Not included in consolidated income statement.
3
Debenture loan asset held by Borbon Carrying value of loan at 1.1.20X4 (financial asset held to maturity) Impairment loss (balancing figure) Present value of expected future cash flows (115 × Effective interest income (109 × 5.5%) Coupon interest income received Capital repaid At 31.12.20X4
4
1 1.055
at 1.1.20X4)
$m 113 (4) 109 6 (115) -
Defined benefit pension scheme Amount to record in cost of sales: Interest cost ($150m × 4%) Current service cost Expected return on plan assets ($160m × 5%) Vested past service costs ($10m × 40%)
6 12 (8) 4 14
The past service cost relating to benefits not yet vested will be recognised at $10m/6 = $1m per year in the year commencing 31 December 20X5.
22.38
22: ANSWERS TO LECTURE EXAMPLES
5
Fair value – Borbon
Difference at acquisition $m 150 150
Properties (1,400 – 500 – 750) * Additional depreciation = 6
$150m
10
Borbon $m
Cost of business combination Group share (W1)
Carbonell $m 1,332
$m
1,400 90%
Impairment losses Notional goodwill ((W6)72 × 100/90) ((W6)28 × 100/70) Carrying amount of net assets (W8)/(W9) Recoverable amount Fair value less costs to sell (710 – (14 × 100/70))
8
770%
Borbon $m 80 1,610 1,690
(448) 28 Carbonell $m 40 660 700
(1,660) (690)
Impairment loss: gross
30
10
Impairment loss recognised: all allocated to goodwill (30 × 90%)/(10 × 70%)
27
7
Carrying amount of net assets at 31 December 20X4 (Borbon)
$m 1,400 220 (10) 1,610
Fair value of identifiable assets and liabilities acquired (1 April 20X4) Post acquisition profit (330 × 8/12) Less: depreciation of fair value adjustment (W5) 9
$m 476
640 (1,260) 72
7
Carrying amount of net assets at 31 December 20X4 (Carbonell)
$m 640 20 660
Fair value of net assets at acquisition (1 October 20X4) Post acquisition profit (80 × 3/12) 10
Difference at B/S date $m 140 140
= $15m per annum × 8/12 = $10m
Goodwill
Fair value of net assets at acq'n
Additional depreciation* $m (10) (10)
Minority interest Profit for period per question (330 × 8/12) (80 × 3/12) Less: fair value depreciation (W5)
Borbon $m 220
Carbonell $m 20
(10) 210
20
× 10% 21
× 30% 6 27
22.39
22: ANSWERS TO LECTURE EXAMPLES
Chapter 16 Answer to Lecture Example 1 31.10.X8 31.12.X8 31.01.X9
DR $ 13,579
Purchases (129,000 @ 9.50) Payables
CR $ 13,579
Payables (Working) Income statement – exchange gains Payables Income statement – exchange losses Cash (129,000 @ 9.7)
Working
679 679 12,900 399 13,299 $ 12,900 13,579 679
Payables as at 31.12.X8 (129,000 @10) Payables as previously recorded Exchange gain
Answer to Lecture Example 2 Bennie Group Consolidated balance sheet at 31 December 20X2 Property, plant and equipment (5,705 + (W2) 910) Goodwill (W5) Current assets (2,222 + (W2) 700) Share capital Retained earnings (W6) Translation reserve (W8)
$'000 6,615 654.5 7,269.5 2,922 10,191.5 1,700 5,177.2 557.3 7,434.5 222 7,656.5 2,535 10,191.5
Minority interest ((W2) 1,110 × 20%) Current liabilities (2,035 + (W2) 500)
22.40
22: ANSWERS TO LECTURE EXAMPLES
Consolidated income statement for year ended 31 December 20X2
$'000 11,560 (6,830) 4,730 (2,800) (187) 1,743 (630) 1,113
Revenue (9,840 + (W3) 1,720) Cost of sales (5,870 + (W3) 960) Gross profit Operating expenses (2,380 + (W3) 420) Goodwill impairment loss (W5) Profit before tax Income tax expense (530 + (W3) 100) Profit for the period Attributable to: Equity holders of the parent Minority interest ((W3) 240 × 20%)
1,065 48 1,113
Consolidated statement of changes in equity for year ended 31 December 20X2 Retained earnings (W6-7) $'000 4,722.2
Balance at 31 December 20X1 Exchange differences on translating foreign operations Net income recognised directly in equity Profit for the period Total recognised income and expense for the period Dividends Balance at 31 December 20X2
1,065 1,065 (610.0) 5,177.2
Translation reserve (W8-10) $'000 217.8 339.5 339.5 339.5 557.3
Workings 1
Group structure Jennie 1.1.X1
80% Pre-acquisition ret'd earnings 5,280,000 Jens Bennie
2
Translation of Jennie – Balance Sheet Property, plant and equipment Current assets Share capital Pre-acquisition reserves Post-acquisition reserves Translation reserve Current liabilities
22.41
J'000 7,280 5,600 12,880
@ 8 8
$'000 910 700 1,610
1,200 5,280 2,400 – 8,880 4,000 12,880
12 12 (W4) BAL
100 440 224 346 1,110 500 1,610
8
22: ANSWERS TO LECTURE EXAMPLES
3
Translation of Jennie – Income Statement Revenue Cost of sales Gross profit Operating expenses Profit before tax Income tax expense Profit for the period
4
J'000
@
$'000
14,620 (8,160) 6,460 (3,570) 2,890 (850) 2,040
8.5 8.5
1,720 (960) 760 (420) 340 (100) 240
J'000 2,640 (1,160) 1,480 2,040 (1,120) 920 2,400
@ 11 10
Translation of Jennie – Post-acquisition retained earnings 20X1 – Profit β – Dividends 20X2 – Profit – Dividends
5
J'000 Share capital Retained earnings
$ '000 240 (116) 124 240 (140) 100 224
8.5 8
J'000 11,916
Rate
$'000
1,200 5,280 6,480
Group share (80%)
(5,184) 6,732 (0)) 6,732 (1,496) 5,236
Impairment losses 20X1 Exchange gain/(loss) 20X1 At 31.12.X1 Impairment losses 20X2 Exchange gain/(loss) 20X2 At 31.12.X2 Consolidated retained earnings carried forward Bennie Add: post-acquisition retained earnings of Jennie ((W4) 224 × 80%) Less: goodwill impairment losses (W5) 7
8.5
Goodwill Cost of combination ($993,000 × 12)
6
8.5
Consolidated retained earnings brought forward Bennie Add: post-acquisition retained earnings of Jennie ((W4) 124 × 80%) Less: goodwill impairment losses (W5)
22.42
12 β 10 8 β 8
561 (0) 112.2 673.2 (187) 168.3 654.5 $'000 5,185 179.2 (187) 5,177.2 $'000 4,623 99.2 ( – ) 4,722.2
22: ANSWERS TO LECTURE EXAMPLES
8
Translation reserve carried forward $'000 Group share of exchange difference on translating financial statements ((W2) 346 × 80%) 276.8 Goodwill [(W5) 112.2 + 168.3] 280.5 557.3
9
Exchange differences arising during the year On translation of net assets of Jennie: Closing NA at CR (W2) Opening NA @ OR (7,960/10) Less: retained profit as translated ((W3) 240 – J1,120/8)
10
$'000
$'000
1,110 (796) 314 (100) 214
Group share recognised in translation reserve (80%)
171.2
On goodwill (W5)
168.3 339.5
Translation reserve brought forward (proof – figure given in question) $'000 Group share of exchange difference on translating financial statements [((W2) 346 – (W9) 214) × 80%] Goodwill (W5)
105.6 112.2 217.8
Answer to Lecture Example 3 (a)
Separate financial statements of Gabby The accounting treatment is as follows: At recognition: Investment
¥75,000,000 = $500,000 recorded at historical rate. 150
Loan asset
¥5,000,000 = $33,333 recorded at historical rate. 150
At the year end:
Investment in subsidiary remains at cost (Gabby's accounting policy). Loan asset retranslated
¥5,000,000 = $38,462 at closing rate. 130
A gain of $5,129 is recognised in the income statement. (b)
Consolidated financial statements
The subsidiary will be consolidated and shown at the translated value of its net assets and goodwill (both at the closing exchange rate). No exchange gain or loss on the loan payable occurs in the individual financial statements of the Japanese company as the loan is denominated in yen. IAS 21 requires the exchange difference on the retranslation of the loan in Gabby's books to be taken in full (reclassified) as a movement on reserves (as is the exchange difference on translation of the subsidiary). No I/S expense/income re the loan In reserves – $5,129 gain on loan.
22.43
22: ANSWERS TO LECTURE EXAMPLES
(c)
Consolidated financial statements – Income statement extracts Gain on sale of subsidiary
Sale proceeds
$ 720,000
Less: net assets and goodwill of Japanese company
(660,000)
Add: cumulative gain on retranslation of net assets and goodwill recycled from translation reserve
128,900
Add: gain on retranslation of loan: – in period (Working) – recycled from reserves
3,205 5,129 197,234
Working
Gain on loan in period ¥5,000,000 120
¥5,000,000 = $3,205 130
Chapter 17 Answer to Lecture Example 1 Minority interest $'000 MI paid c/d X2
b/d X1 MI (I/S)
3 102 105
$'000 100 5 105
Answer to Lecture Example 2 Investment in associate b/d 20X1
$'000
$'000 88 Cash received
Associate (I/S)
6
10 c/d 20X2 98
22.44
92 98
22: ANSWERS TO LECTURE EXAMPLES
Answer to Lecture Example 3 Cash flow statement for the year ended 31 December 20X8
$'000 Cash flows from operating activities Profit before taxation Adjustments for: Depreciation
$'000
420
Increase in trade receivables (1,370 – 1,100 – 30) Increase in inventories (1,450 – 1,200 – 70) Increase in trade payables (1,690 – 1,520 – 40) Cash generated from operations Income taxes paid (W4)
210 630 (240) (180) 130 340 (100) 240
Net cash from operating activities Cash flows from investing activities Acquisition of subsidiary net of cash acquired (140 – 10) Purchase of property, plant and equipment (W1)
(130) (220) (350)
Net cash used in investing activities Cash flows from financing activities Proceeds from issuance of share capital (1,150 + 590 – 1,000 – 500 – (100 × $1.60)) Dividend paid to minority interest (W3)
80 (4)
Net cash from financing activities
76
Net decrease in cash and cash equivalents Cash and cash equivalents at the beginning of the period Cash and cash equivalents at the end of the period
(34) 50 16
Workings
1
Additions to property, plant and equipment
b/d On acquisition ... Additions
2
Property, plant and equipment $'000 2,300 Depreciation 190 c/d 220 2,710
$'000 210 2,500 2,710
Impairment losses
b/d Additions [300 – (90% × 260)]
Goodwill $'000 – 66 ... Impairment losses c/d 66
22.45
$'000 0 66 66
22: ANSWERS TO LECTURE EXAMPLES
3
Dividends paid to minority interest
Minority interest $'000 4 b/d 31 Acquisition I/S 35
... Dividend c/d
4
$'000 – 26 9 35
Income taxes paid
Income tax payable $'000 b/d 100 I/S 150
∴ Income taxes paid c/d
250
$'000 100 150 250
Answer to Lecture Example 4 Disposal of subsidiary
(a)
Cash flows from investing activities
Disposal of subsidiary net of cash disposed (400 – 20) (b)
(1,307)
Cash flows from financing activities
Dividend paid to minority interest (W2) (d)
380
Cash flows from investing activities
Purchase of property, plant and equipment (W1) (c)
$'000
Cash flows from operating activities
Profit before tax Adjustments for: Depreciation Profit on disposal of subsidiary Increase in receivables (605 – 417 + 39) Increase in inventories (736 – 535 + 50) Increase in payables (380 – 408 + 42) Cash generated from operations
22.46
(42)
$'000 912 800 (34) 1,678 (227) (251) 14 1,214
22: ANSWERS TO LECTURE EXAMPLES
Workings
1
Additions to property, plant and equipment
Property, plant and equipment $'000 3,950 1,307
b/d additions
$'000 4,067 390 800 5,257
c/d on disposal depreciation
5,257 2
Dividends paid to minority interest
Minority interest $'000 482 b/d 91 I/S 42 615
c/d on disposal ∴ dividend
$'000 512 103 615
Answer to Lecture Example 5 Foreign currency Cash flow statement for the year ended 31 December 20X2
$'000 Cash flows from operating activities Profit before taxation Adjustments for: Depreciation Impairment losses (W2)
$'000
7,395
Increase in trade receivables (6,280 – 5,700 + (W4) 300) Increase in inventories (2,680 – 2,300 + (W4) 100) Increase in trade payables (4,690 – 4,500 + (W4) 150) Cash generated from operations Income taxes paid
2,150 35 9,580 (880) (480) 340 8,560 (2,400) 6,160
Net cash from operating activities Cash flows from investing activities Purchase of property, plant and equipment (W1)
(4,770) (4,770)
Net cash used in investing activities Cash flows from financing activities Dividends paid Dividend paid to minority interest (W3)
(1,190) (40) (1,230)
Net cash used in financing activities Net increase in cash and cash equivalents Cash and cash equivalents at beginning of period Effect of exchange rate changes (W4) Cash and cash equivalents at beginning of period as restated Cash and cash equivalents at end of period
22.47
160 2,200 (50) 2,150 2,310
22: ANSWERS TO LECTURE EXAMPLES
Workings
1
Additions to property, plant and equipment
Property, plant and equipment b/d ... Additions
$'000 23,600 4,770
$'000 2,150 1,200 25,020 28,370
Depreciation Exchange loss (W3) c/d
28,370 2
Impairment losses
Goodwill b/d
$'000 1,400
$'000 65 35 1,300 1,400
Exchange loss ... Impairment losses c/d
1,400 3
Dividend paid to minority interest
Minority interest ... Dividend Exchange losses (1,500 – 1,350) c/d 4
$'000 40 150 500 690
$'000 450 240
b/d I/S
690
Exchange gains and (losses)
$'000 Group share 90% (1,080) (90) (270) (45) 135 (1,350)
Property, plant and equipment Inventories Trade receivables Cash and cash equivalents Trade payables
$'000 Total share 100% (1,200) (100) (300) (50) 150 (1,500)
Goodwill does not need to be grossed up as only the group share is shown under current standards
Chapter 18 Answer to Lecture Example 1 IFRS 8 Operating Segments states that an operating segment is separately reportable if it has been identified as a separate operating segment meeting the operating segment definition, and: (a)
its reported revenue is 10% or more of the combined revenue (external and internal) of all operating segments, or
(b)
the absolute amount of its reported profit or loss is 10% or more of the greater of the combined profit of all operating segments that did not report a loss and the combined reported loss of all operating segments that reported a loss, or
22.48
22: ANSWERS TO LECTURE EXAMPLES
(c)
its assets are 10% or more of the combined assets of all operating segments.
At 31 December 20X2 four of the six operating segments are reportable operating segments: •
The Chemicals and Pharmaceuticals Wholesale segments meet the definition on all size criteria.
•
The Hair care segment is separately reported due to its profitability being greater than 10% of total segments in profit (4/29).
•
The Body care segment meets the size criteria, but was disposed of during the period. However, it still requires disclosure under IFRS 8 as it earned revenue and profits exceeding the size criteria in the year. Also note that the fact that it does not make a majority of its sales externally does not prevent separate disclosure under IFRS 8. The sale of the operations may meet the criteria to be reported as a discontinued operation under IFRS 5 which will require additional disclosures.
The Pharmaceuticals Retail segment represents 9.2% of revenue, the loss is 6.9% of the 'control number' of, in this case, operating segments in profit (2/29) and 8.9% of total assets (before the addition of the new Hair care operations/sale of the Body care segment, and 9.6% (30/314) after). Consequently, it is not separately reportable. Although it falls below the 10% thresholds it can still be reported as a separate operating segment if management believes that information about the segment would be useful to users of the financial statements. Alternatively, the group could consider amalgamating it with the Pharmaceuticals Wholesale segment, providing the two operating segments have similar economic characteristics and share a majority of the 'aggregation' criteria, which, excluding the type of customer, may be the case. Otherwise it would be disclosed in an 'All other segments' column. The Cosmetics segment represents 6.3% of revenue, 6.9% of operating segments in profit (2/29) and 5.4% of total assets (before the addition of the new Hair care operations/sale of the Body care segment, and 5.7% (18/314) after). It can also be reported separately if management believes the information would be useful to users. Alternatively the group may be able to amalgamate it with the Body care segment, providing the operating segments have similar economic characteristics and share a majority of the 'aggregation' criteria. Otherwise it would also be disclosed in an 'All other segments' column. After the sale of the Body care segment, the new Chinese business increases the size of the Hair care segment which still remains reportable. However, the business itself represents 10.2% of revised total operating segment assets (32/(336 – 54 + 32)), and may justify separate reporting as a different operating segment if management considers that the nature of its product type (mass market rather than 'high end') and distribution (retail versus wholesale) differ sufficiently from the 'traditional' Hair care products the group manufactures.
Chapter 19 No Lecture examples
Chapter 20 Answer to Lecture Example 1 (a)
The rules for recognising internally-generated intangibles in IAS 38 Intangible Assets are relevant here. The expenditure should only be recognised as an asset (for future amortisation) when there is evidence that the six criteria for capitalisation are all met. In any other circumstance, or if all six criteria are no longer met for a capitalised asset, the expenditure must be charged to profit or loss.
(b)
This is a revenue recognition issue and so IAS 18 Revenue provides guidance. The general rule is that revenue is not recognised until there is a transfer of the risks and rewards of ownership. The Application Guidance to IAS 18 clarifies that in real estate sales this occurs on transfer of legal title, so the 10% deposit is deferred and recognised as a liability until then.
22.49
22: ANSWERS TO LECTURE EXAMPLES
(c)
The company, through its public policy, has created itself a constructive obligation to make refunds. This creates a liability as there is a present (constructive) obligation as a result of past events (the sales), expected to result in an outflow of resources (the refunds). Based on past experience, the company can estimate the amount of the refunds and a provision (under IAS 37) should be made against the revenue, reducing it permanently for expected refunds, or deferring it in the case of credit notes.
(d)
This is an interesting scenario. Accruals accounting (and application of IAS 19 Employee Benefits), would require a liability to be recognised as this is a defined benefit pension scheme and the definition of a liability is once again met. However, governments often do not make provision for such liabilities as there is no fund to pay them and it would bankrupt them (hence they are paid from current taxes). This approach is a concern because the liability is growing as people live longer, which is a burden on future taxpayers. For this reason, many governments are advocating private pension schemes rather than reliance on a state scheme.
Answer to Lecture Example 2 REPORT
To: From: Subject: Date:
Management of Hanslufta A. N. Accountant Financial statements of Hanslufta for the year ended 31 December 20X3 January 20X4
Introduction and terms of reference
The purpose of this report is to advise on the accounting treatment of various matters that have been brought to our attention for comment by the management of Hanslufta in the preparation of the group financial statements for the year ended 31 December 20X3. New subsidiary – set-up and marketing costs
Under IAS 38 Intangible Assets, set-up costs (i.e. the legal and formation costs) and marketing costs are treated as expenses because they cannot be reliably attributed to the future economic benefits that they generate. Consequently, the $19m will need to be charged to profit or loss. New subsidiary – website development costs
The costs associated with the development of the website will generate future economic benefits in the form of online bookings, and these can be estimated from the company's budgets. Consequently they should be recognised as an asset as they meet the recognition criteria in the Framework for the Preparation and Presentation of Financial Statements. Because it is the website itself rather than the physical equipment which generates this return, this should be recognised as an intangible asset. The company has therefore developed an internally generated intangible asset and so all the six criteria of the IAS 38 for capitalisation must be met: • • • • • •
The development must be technically feasible There must be an intention to use the website There must be an ability to use the website Future economic benefits must be demonstrable Technical, financial and other resources must be available to complete the development The expenditure must be capable of reliable measurable during its development.
SIC-32 Intangible Assets – Website Costs gives additional guidance here, clarifying that these six criteria must be met in addition to the Framework recognition criteria (probable future economic benefits that can be measured reliably). It clarifies that planning costs are akin to research and must be expensed and only directly attributable expenditures can be capitalised.
22.50
22: ANSWERS TO LECTURE EXAMPLES
The $3m must therefore be analysed and only directly attributable expenditures of the website itself can be capitalised, and only if they meet all of the six criteria. New subsidiary – leased assets
The new aircraft are leased under finance leases. Consequently, as the economic ownership is attributable to the group they should be capitalised in the balance sheet as if they were owned assets. The amount capitalised is the lower of fair value of the asset ($60m per plane) and present value of minimum lease payments ($32.8m per plane). Consequently, $164m ($22.8m x 5) is initially recognised as an asset. The assets will be depreciated over the lease term (or useful life to the group if shorter), giving a net book value of $143.5m ($164m – $20.5m depreciation) at the balance sheet date (assuming useful life is the same as lease term of 8 years). The finance lease must be recognised as a liability in the balance sheet at the following amount: Lease liability at 1 January 20X3 ($32.8m x 5) 164.0 Interest at 9.3% 15.3 (30.0) 1st Lease instalment ($6m x 5) Lease liability at 31 December 20X3 149.3 Consequently, a lease liability of $149.3m is recognised in the balance sheet at the year end and $15.3m of interest and $20.5m of depreciation will be charged to profit or loss. The lease liability would be presented in the balance sheet split between its current and non-current elements. Fidelity programme
Part of the revenue that Hanslufta has recognised is attributable to flights that will be taken in the future as a result of 'air mile' awards, but has not yet been earned. This represents a liability to the company at the balance sheet date as there is a present obligation (the 'Miles and Miles' programme) as a result of past events (miles-earning tickets sold with miles claimed) that will result in an outflow of resources embodying economic benefits (the cost of providing a 'free' flight to the programme member). Consequently the revenue relating to the awards should be deferred as a liability. This is based on the fair value of the awards earned, reduced by award flights not expected to be taken, in accordance with IFRIC 13. Based on the data given, the deferred revenue would be calculated as follows: 550,000 x 70% x 10,000 = 3.85bn miles / 20,000 miles per average flight = 192,250 award seats x $60 fair value per award seat = $11.55m. Revenue should therefore be deferred and a liability recognised for approximately $11.6m: Dr Revenue Cr Deferred revenue (balance sheet)
$11.6m $11.6m
The deferred revenue will be recognised as revenue as the miles are redeemed. Aircraft hired out under operating leases
As these are leased out under short-term operating leases, they will remain as assets, depreciated in Hanslufta's balance sheet. However, the income should be recognised over life of the lease including the effect of the 'incentive' of one year's rent being 'free'. Such income is normally recognised straight line unless another systematic basis appears more appropriate. The amount to recognise in each year is therefore: $200,000 x 4 years x 10 aircraft / 5 years = $1.6m per annum. This is normally recorded as other income as it is not part of the airline's normal business. Commitment to purchase Airbus A380s
The commitment to purchase these assets must be disclosed as a capital commitment under IAS 16 Property, Plant and Equipment. They will not be recognised as assets until the purchase takes place.
22.51
22: ANSWERS TO LECTURE EXAMPLES
Forward contract
The forward contract must be accounted for under IAS 39 Financial Instruments: Recognition and Measurement. Providing it meets the strict criteria to be classed as a hedge, it will be treated as a cash flow hedge under IAS 39. This means that the forward contract will be re-measured to fair value at each reporting date. Any gain or loss will be reported in equity until the asset is recognised and depreciated, except that any 'ineffective' portion of the hedge (as determined under IAS 39) will be reported in the income statement. Airbridges
The commitment to finance part of the cost of the airbridge is also a capital commitment to be disclosed under IAS 16. Given that the airbridges will be owned jointly with the airport, once built they will be accounted for as jointly controlled assets under IAS 31 Interests in Joint Ventures, which means that a 50% share of the asset will be recognised in Hanslufta's balance sheet. Hanslufta will also be able to recognise a 50% share of any income generated by the airbridges being rented to other airlines. Presentation currency
Under IAS 21 The Effects of Changes in Foreign Exchange Rates, an entity can present its financial statements in any currency it chooses, providing measurement has taken place in its functional currency as determined following the IAS 21 rules. The translation rules require that assets and liabilities are translated at year end exchange rates and income and expenses at the rate when the transactions occurred (or at an average rate if exchange rates have not fluctuated significantly). All exchange differences as a result of this will be recognised in a separate translation reserve as part of equity, not in profit or loss. Conclusion
We hope you have found the information in this document useful. Should you require any further assistance or explanation, please contact us.
Chapter 21 Answer to Lecture Example 1 (a)
Europa's first IFRS financial statements will be for the year ended 31 December 2006. IFRS 1 requires that at least one year's comparative figures are presented and therefore the date of transition to IFRSs is the beginning of business on 1 January 2005 (or close of business on 31 December 2004). Therefore the procedure for adopting IFRSs is: (i)
Identify accounting policies that comply with IFRSs effective at 31 December 2006 (the reporting date for the first IFRS financial statements)
(ii)
Restate the opening balance sheet at 1 January 2005 (the date of transition) using these IFRSs retrospectively, by: (1)
Recognising all assets and liabilities whose recognition is required by IFRSs
(2)
Not recognising items as assets or liabilities if IFRSs do not permit such recognition
(3)
Reclassifying items that were recognised under previous GAAP as one type of asset, liability or component of equity, but are a different type of asset liability or component of equity under IFRSs
(4)
Measuring all recognised assets and liabilities in accordance with IFRSs.
22.52
22: ANSWERS TO LECTURE EXAMPLES
The company will almost certainly need to change some of its accounting policies and to adjust some of the amounts that it reported previously at the same dates using previous GAAP. It should recognise these adjustments directly in retained earnings (i.e. in equity). (iii)
Explain the effect of the transition from previous GAAP to IFRSs, by presenting: (1)
A reconciliation of equity reported under previous GAAP to equity under IFRSs at the date of transition and at the last previous GAAP balance sheet date; and
(2)
A reconciliation of the profit or loss reported under previous GAAP to profit or loss reported under IFRSs for the last period presented under previous GAAP.
If Europa presented a cash flow statement under previous GAAP, it should also explain any material adjustments to the cash flow statement. Although the general rule is that all IFRSs should be applied retrospectively, a number of exemptions are available. These are intended to cover cases in which the cost of complying fully with a particular requirement would outweigh the benefits to users of the financial statements. Europa may choose to take advantage of any or all of the exemptions. (b)
Changing from previous GAAP to IFRSs is likely to be a complex process and should be carefully planned. Although previous GAAP and IAS/IFRS may follow broadly the same principles there are still likely to be many important differences in the detailed requirements of individual standards. If Europa has foreign subsidiaries outside Molvania it will also need to ensure that they comply with any previous reporting requirements. This may mean that subsidiaries have to prepare two sets of financial statements: one using their previous GAAP; and one using IFRSs (for the consolidation). The process will be affected by the following: (i)
The differences between previous GAAP and IFRSs as they affect the group financial statements in practice. The company will need to carry out a detailed review of current accounting policies, paying particular attention to areas where there are significant differences between previous GAAP and IFRSs. These will probably include deferred tax, business combinations, employee benefits and foreign currency translation. It should be possible to estimate the effect of the change by preparing pro-forma financial statements using IFRSs.
(ii)
The level of knowledge of IFRSs of current finance staff (including internal auditors). It will probably be necessary to organise training and the company may need to recruit additional personnel.
(iii)
The group's accounting systems. Management will need to assess whether computerised accounting systems can produce the information required to report under IFRSs. They will also need to produce new consolidation packages and accounting manuals.
Lastly, the company should consider the impact of the change to IFRSs on investors and their advisers. For this reason management should try to quantify the effect of IFRSs on results and other key performance indicators as early as possible. (c)
(i)
Accounting estimates
Estimates under IFRSs at the date of transition must be consistent with those made at the same date under previous GAAP, (after adjustments to reflect any difference in accounting policies). The only exception to this is if the company has subsequently discovered that these estimates were in error. This is not the case here and therefore the estimates are not adjusted in the first IFRS financial statements. (ii)
Court case
The treatment of this depends on the reason why Europa did not recognise a provision under previous GAAP at 31 December 2005.
22.53
22: ANSWERS TO LECTURE EXAMPLES
If the requirements of previous GAAP were consistent with IAS 37 Provisions, Contingent Liabilities and Contingent Assets, presumably the directors concluded that an outflow of economic benefit was not probable and that the recognition criteria were not met. In this case, Europa's assumptions under IFRSs are consistent with its previous assumptions under previous GAAP. Europa does not recognise a provision at 31 December 2005 and accounts for the payment in the year ended 31 December 2006. If the requirements of previous GAAP were not consistent with IAS 37, Europa must determine whether it had a present obligation at 31 December 2005. The directors should take account of all available evidence, including any additional evidence provided by events after the balance sheet date up to the date the 2005 financial statements were authorised for issue in accordance with IAS 10 Events After the Balance Sheet Date. The outcome of the court case confirms that Europa had a liability in September 2005 (when the events that resulted in the case occurred), but this event occurred after the 2005 financial statements were authorised for issue. Based on this alone, the company would not recognise a provision at 31 December 2005 and the $10m cost of the court case would be recognised in the 2006 financial statements. If the company's lawyers had advised Europa that it was probable that they would be found guilty and suggested the expected settlement amount before the financial statements were authorised for issue, the provision would be recognised in the 2005 financial statements reporting under IFRS for that amount.
END OF ANSWERS TO LECTURE EXAMPLES
22.54
Question and Answer bank
23.1
Index to Question and Answer bank Page Questions 1 2 3 4 5 6 7 8 9 10 11 12 13 14
Greensmith................................................................................................................................23.3 Radost .......................................................................................................................................23.4 DT Group...................................................................................................................................23.5 PQR...........................................................................................................................................23.6 Hedging .....................................................................................................................................23.6 Share-based payment ...............................................................................................................23.7 Ace ............................................................................................................................................23.7 Able ...........................................................................................................................................23.8 Highland ....................................................................................................................................23.9 Armoury...................................................................................................................................23.10 Holmes & Deakin.....................................................................................................................23.11 Murder, Mystery and Suspense...............................................................................................23.12 Harvard....................................................................................................................................23.13 Tastydesserts ..........................................................................................................................23.15
23.2
Answers 23.17 23.19 23.21 23.22 23.24 23.25 23.26 23.28 23.30 23.33 23.35 23.38 23.41 23.44
23: QUESTION AND ANSWER BANK
Questions 1
Greensmith (Study Text Question 2) (a)
You have recently had a meeting with the finance director of a large company, Greensmith Co. He is concerned about a recent broker's circular which ranked his company as a 'sell'. The reasons for this were: – – –
low earnings per share; a poor return on capital employed; and a weak net assets per share figure.
He had identified various items of property, plant and equipment that he thinks could be revalued. He is reluctant to involve his auditor in preliminary discussions so has turned to you as an independent adviser. He wishes you to advise him on the following matters: –
Does he have to revalue the assets?
–
Can any of the revaluations be pooled or will they all be dealt with separately?
–
What are the accounting effects of any revaluations or devaluations?
–
What will be the effect on the income statement in the future when he sells revalued assets? and
–
What will be the effect of the revaluations on earnings per share, return on capital employed and net assets per share?
The assets in question are:
(b)
–
The company's head office in Conway Square, London. It has a book value (cost) of $4 million but is now estimated to be worth $3.3 million. They do not intend to sell the building and are sure property prices will recover in the longer term. The building is not depreciated as they argue that residual value is at least equal to book value.
–
The company has a residential training centre in Berkshire which it leases on a 20-year lease from the freeholder. It is at present in the books at a cost of $5 million less two years' amortisation. It is now felt to be worth $8 million.
The finance director is also unsure how to account for the following items: (i)
Last year Greensmith purchased a 15-year franchise for a tanning shop within the Berkshire training centre. The cost was $500,000.
(ii)
The training centre has been generating considerable income over the past few years and the finance director has been approached by a potential purchaser offering a price of $1,000,000 in excess of the fair value of the individual net assets. The company wishes to include this as a brand value in the balance sheet.
Required Prepare a memorandum for the finance director summarising your response to the questions he has raised, and indicate your recommended course of action. 20 marks
23.3
23: QUESTION AND ANSWER BANK
2
Radost (Study Text Question 5) Radost Co has a defined benefit pension scheme for its staff. Staff are eligible for an annual pension between the date of their retirement and the date of their death equal to: Annual pension = Final salary per year × Years' service. 50 You are given the following data relating to the year ended 31.12.20X3: •
Unrecognised actuarial gains at 1 February 20X3: $6 million
•
Yield on high quality corporate bonds: 10% pa.
•
Expected return on pension fund investments: 11% pa.
•
Contributions paid by Radost Co to pension plan: $12 million
•
Pensions paid to former employees: $8 million
•
Current service cost was $3.75 million
•
NPV of the pension obligation at: 1.1.X3 – $45 million 31.12.X3 – $44 million (as given by the actuary)
•
Fair value of the plan assets, as valued by the actuary: 1.1.X3 – $52 million 31.12.X3 – $64.17 million
•
The average remaining working life of employees who are members of the pension scheme is 20 years
Required (a)
Produce the notes to the balance sheet and income statement in accordance with IAS 19. 12 marks
(b)
Explain why the pension plan assets are recognised in the financial statements of Radost, even though they are held in a separate legal trust for Radost's employees. 5 marks
Notes: (1)
Work to the nearest $1,000 throughout.
(2)
You should assume contributions and benefits were paid on the last day of the year.
23.4
23: QUESTION AND ANSWER BANK
3
DT Group (Study Text Question 6) DT, a public limited company, has decided to adopt the provisions of IFRSs for the first time in its financial statements for the year ending 30 November 20X1. The amounts of deferred tax provided and unprovided as set out in the notes of the group financial statements for the year ending 30 November 20X0 were as follows:
Tax depreciation in excess of accounting depreciation Other temporary differences Liabilities for health care benefits Losses available for offset against future taxable profits Income tax on capital gains arising on the disposal of property which had been deferred Tax that would arise if properties were disposed of at their revalued amounts
Provided $m 38 11 (12) (34)
Unprovided $m 12 14 – (56)
–
165
– 3
140 275
The following notes are relevant to the calculation of the deferred tax liability as at 30 November 20X1: (i)
DT acquired a 100% holding in a foreign company on 30 November 20X1. The subsidiary does not plan to pay any dividends for the financial year to 30 November 20X1 or in the foreseeable future. The carrying amount in DT's consolidated financial statements of its investment in the subsidiary at 30 November 20X1 is made up as follows: $m 76 14 90
Carrying value of net assets acquired excluding deferred tax Goodwill (before deferred tax and impairment losses) Carrying amount/cost of investment
The tax base of the net assets of the subsidiary at acquisition was $60 million. No deduction is available in the subsidiary's tax jurisdiction for the cost of the goodwill. Immediately after acquisition on 30 November 20X1, DT had supplied the subsidiary with inventories amounting to $30 million at a profit of 20% on selling price. The inventories had not been sold by the year end and the tax rate applied to the subsidiary's profit is 25%. There was no significant difference between the fair values and carrying values on the acquisition of the subsidiary. (ii)
The carrying amount of the property, plant and equipment (excluding that of the subsidiary) is $2,600 million and their tax base is $1,920 million. The tax arising on the revaluation of properties, if disposed of at their revalued amounts, is the same at 30 November 20X1 as at the beginning of the year. The revaluation of the properties is included in the carrying amount above. Other taxable temporary differences (excluding the subsidiary) amount to $90 million as at 30 November 20X1.
(iii)
The liability for health care benefits in the balance sheet had risen to $100 million as at 30 November 20X1 and the tax base is zero. Health care benefits are deductible for tax purposes when payments are made to retirees. No payments were made during the year to 30 November 20X1.
(iv)
Under the tax law of the country, tax losses can be carried forward for three years only. The taxable profits for the years ending 30 November were anticipated to be as follows: 20X1 $m 110
20X2 $m 100
23.5
20X3 $m 130
23: QUESTION AND ANSWER BANK
The auditors are unsure about the availability of taxable profits in 20X3 as the amount is based upon the projected acquisition of a profitable company. It is anticipated that there will be no future reversals of existing taxable temporary differences until after 30 November 20X3. (v)
Income tax on the property disposed of becomes payable on 30 November 20X4 under the deferral relief provisions of the tax laws of the country. There had been no sales or revaluations of property during the year to 30 November 20X1.
(vi)
Income tax is assumed to be 30% for the foreseeable future in DT's jurisdiction and the company wishes to discount any deferred tax liabilities at a rate of 4% if allowed by IAS 12.
(vii)
There are no other temporary differences other than those set out above. The directors of DT have calculated the opening balance of deferred tax using IAS 12 to be $280 million and not the total of the provided and unprovided amounts of $278 million at the beginning of the year.
Required Calculate the liability for deferred tax required by the DT Group at 30 November 20X1 and the deferred tax expense in the income statement for the year ending 30 November 20X1 using IAS 12, commenting on the effect that the application of IAS 12 will have on the financial statements of the DT Group. 13 marks
4
PQR (Study Text Question 7) PQR has the following financial instruments in its financial statements for the year ended 31 December 20X5: •
An investment in the debentures of STU, nominal value $40,000, purchased on their issue on 1 January 20X5 at a discount of $6,000 and carrying a 4% coupon. PQR plans to hold these until their redemption on 31 December 20X8. The internal rate of return of the debentures is 8.6%.
•
A foreign currency forward contract purchased to hedge the commitment to purchase a machine in foreign currency six months after the year end.
•
100,000 redeemable preference shares issued in 20X0 at $1 per share with an annual dividend payment of 6 cents per share, redeemable in 20X8 at their nominal value.
Required Advise the directors (insofar as the information permits) about the accounting for the financial instruments stating the effect of each on the gearing of the company. Your answer should be accompanied by calculations where appropriate. 10 marks
5
Hedging (Study Text Question 8) A company owns 100,000 barrels of crude oil which were purchased on 1 July 20X2 at a cost of $26.00 per barrel. In order to hedge the fluctuation in the market value of the oil the company signs a futures contract on the same date to deliver 100,000 barrels of oil on 31 March 20X3 at a futures price of $27.50 per barrel. Due to unexpected increased production by OPEC, the market price of oil on 31 December 20X2 slumped to $22.50 per barrel and the futures price for delivery on 31 March 20X3 was $23.25 per barrel at that date Required Explain the impact of the transactions on the financial statements of the company for the year ended 31 December 20X2. 8 marks
23.6
23: QUESTION AND ANSWER BANK
6
Share-based payment (Study Text Question 15) J&B granted 200 options on its $1 ordinary shares to each of its 800 employees on 1 January 20X1. Each grant is conditional upon the employee being employed by J&B until 31 December 20X3. J&B estimated at 1 January 20X1 that: (i)
the fair value of each option was $4 (before adjustment for the possibility of forfeiture).
(ii)
approximately 50 employees would leave during 20X1, 40 during 20X2 and 30 during 20X3 thereby forfeiting their rights to receive the options. The departures were expected to be evenly spread within each year.
The exercise price of the options was $1.50 and the market value of a J&B share on 1 January 20X1 was $3. In the event, only 40 employees left during 20X1 (and the estimate of total departures was revised down to 95 at 31 December 20X1), 20 during 20X2 (and the estimate of total departures was revised to 70 at 31 December 20X2) and none during 20X3, spread evenly during each year. Required The directors of J&B have asked you to illustrate how the scheme is accounted for under IFRS 2 Sharebased Payment.
7
(a)
Show the double entries for the charge to the income statement for employee services over the three years and for the share issue, assuming all employees entitled to benefit from the scheme exercised their rights and the shares were issued on 31 December 20X3.
(b)
Explain how your solution would differ had J&B offered its employees cash based on the share value rather than share options. 6 marks
Ace (Study Text Question 14) On 1 April 20X1, Ace Co owned 75% of the equity share capital of Deuce Co and 80% of the equity share capital of Trey Co. On 1 April 20X2, Ace Co purchased the remaining 25% of the equity shares of Deuce Co. In the two years ended 31 March 20X3, the following transactions occurred between the three companies: (a)
On 30 June 20X1 Ace Co manufactured a machine for use by Deuce Co. The cost of manufacture was $20,000. The machine was delivered to Deuce Co for an invoiced price of $25,000. Deuce Co paid the invoice on 31 August 20X1. Deuce Co depreciated the machine over its anticipated useful life of five years, charging a full year's depreciation in the year of purchase.
(b)
On 30 September 20X2, Deuce Co sold some goods to Trey Co at an invoiced price of $15,000. Trey Co paid the invoice on 30 November 20X2. The goods had cost Deuce Co $12,000 to manufacture. By 31 March 20X3, Trey Co had sold all the goods outside the group.
(c)
For each of the two years ended 31 March 20X3, Ace Co provided management services to Deuce Co and Trey Co. Ace Co did not charge for these services in the year ended 31 March 20X2 but in the year ended 31 March 20X3 decided to impose a charge of $10,000 per annum to Trey Co. The amount of $10,000 is due to be paid by Trey Co on 31 May 20X3.
Required Summarise the related party disclosures which will be required in respect of transactions (a) to (c) above for both of the years ended 31 March 20X2 and 31 March 20X3 in the financial statements of Ace Co, Deuce Co and Trey Co. Note. You may assume that Ace Co presents consolidated financial statements for both of the years dealt with in the question. 8 marks
23.7
23: QUESTION AND ANSWER BANK
8
Able (Study Text Question 10) (a)
The development of conceptual frameworks for financial reporting by accounting standard setters could fundamentally change the way in which financial contracts such as leases are accounted for. These frameworks identify the basic elements of financial statements as assets, liabilities, equity, income and expenses and set down their recognition rules. In analysing the definitions of assets and liabilities one could conclude that most leases, including non-cancellable operating leases, qualify for recognition as assets and liabilities because the lessee is likely to enjoy the future economic benefits embodied in the leased asset and will have an unavoidable obligation that will result in an outflow of resources embodying economic benefits to the lessor. Because of the problems of accounting for leases, there have been calls for the capitalisation of all noncancellable operating leases so that the only problem would be the definition of the term 'noncancellable'. Required
(b)
(i)
Explain how leases are accounted for in the books of the lessee under IAS 17 Leases. 7 marks
(ii)
Discuss the current problems relating to the recognition and classification of leases in corporate financial statements. (Candidates should give examples where necessary). 8 marks
(i)
During the financial year to 31 May 20X8, Able a public limited liability company disposed of electrical distribution systems from its electrical power plants to Cain a public limited liability company for a consideration of $198m. At the same time Able entered into a longterm distribution agreement with Cain whereby the assets were leased back under a 10year operating lease. The fair value of the assets sold was $98m and the carrying value based on depreciated historic cost of the assets was $33m. The lease rentals were $24m per annum which represented twice the normal payment for leasing this type of asset. 5 marks
(ii)
Additionally on 1 June 20X7, Able sold plant with a book value of $100m to Esau a public limited liability company when there was a balance on the revaluation reserve of $30m which related to the plant. The fair value and selling price of the plant at that date was $152m. The plant was immediately leased back over a lease term of four years which is the asset's remaining useful life. The residual value at the end of the lease period is estimated to be a negligible amount. Able can purchase the plant at the end of the lease for a nominal sum of $1. The lease is non-cancellable and requires equal rental payments of $43.5m at the commencement of each financial year. Able has to pay all of the costs of maintaining and insuring the plant. The implicit interest rate in the lease is 10% per annum. The plant is depreciated on a straight-line basis. (The present value of an ordinary annuity of $1 per period for 3 years at 10% interest is $2.49.) 5 marks
Required Show and explain how the above transactions should be dealt with in the financial statements of Able for the year ending 31 May 20X8 in accordance with IAS 17 Leases and the Framework for the Preparation and Presentation of Financial Statements. Total: 25 marks
23.8
23: QUESTION AND ANSWER BANK
9
Highland (Study Text Question 16) Highland owns two subsidiaries acquired as follows: 1 July 20X1
80% of Aviemore for $5 million when the book value of the net assets of Aviemore was $4 million.
30 November 20X7
65% of Buchan for $2 million when the book value of the net assets of Buchan was $1.35 million.
The companies' income statements for the year ended 31 March 20X8 were: Highland $'000 5,000 (3,000) 2,000 (1,000) 230
Revenue Cost of sales Gross profit Administrative expenses Other income Finance costs Profit/(loss) before tax Income tax expense Profit/(loss) for the period
1,230 (300) 930
Dividends paid during the year
200
Aviemore $'000 3,000 (2,300) 700 (500) – (50) 150 (50) 100 50
Buchan $'000 2,910 (2,820) 90 (150) – (210) (270) – (270) –
Additional information (1)
On 1 April 20X7, Buchan issued $2.1 million 10% loan stock to Highland. Interest is payable twice yearly on 1 October and 1 April. Highland has accounted for the interest received on 1 October 20X7 only.
(2)
On 1 July 20X7, Aviemore sold a freehold property to Highland for $800,000 (land element – $300,000). The property originally cost $900,000 (land element – $100,000) on 1 July 20W7. The property's total useful life was 50 years on 1 July 20W7 and there has been no change in the useful life since. Aviemore has credited the profit on disposal to 'Administrative expenses'.
(3)
The property, plant and equipment of Buchan on 30 November 20X7 was valued at $500,000 (book value $350,000) and was acquired in April 20X7. The property, plant and equipment has a total useful life of ten years. Buchan has not adjusted its accounting records to reflect fair values.
(4)
All companies use the straight-line method of depreciation and charge a full year's depreciation in the year of acquisition and none in the year of disposal. Depreciation on fair value adjustments is time apportioned from the date of acquisition.
(5)
Highland charges Aviemore an annual fee of $85,000 for management services and this has been included in 'Other income'.
(6)
Highland has accounted for its dividend received from Aviemore in 'Other income'.
(7)
Impairment tests conducted at the year end revealed recoverable amounts of $7,040,000 for Aviemore and $4,674,000 for Buchan versus book values of net assets of $4,450,000 and $3,310,000 in the separate financial statements of Aviemore and Buchan respectively (adjusted for the effects of group fair value adjustments). No impairment losses had previously been recognised.
Required Prepare the consolidated income statement for Highland for the year ended 31 March 20X8.
23.9
16 marks
23: QUESTION AND ANSWER BANK
10 Armoury (Study Text Question 18) Bayonet Co purchased 6,000 shares in Rifle Co on 1 January 20X3 for $10,000. Rifle Co had purchased 4,000 shares in Pistol Co for $9,000 on 31 December 20X2. The balances on retained earnings of the acquired companies were $8,000 and $6,500 respectively. The balance sheets of the three companies as at 31 December 20X9 are as follows:
Non-current assets Property, plant and equipment Investment in Rifle Investment in Pistol Current assets Inventories Trade receivables Cash
Equity 50¢ ordinary shares Retained earnings Current liabilities
Bayonet Co $
Rifle Co $
Pistol Co $
14,500 10,000 – 24,500
12,140 – 9,000 21,140
17,500 – – 17,500
6,300 4,900 500 11,700 36,200
2,100 2,000 1,440 5,540 26,680
450 2,320 515 3,285 20,785
5,000 25,500 30,500
4,000 20,400 24,400
2,500 16,300 18,800
5,700 36,200
2,280 26,680
1,985 20,785
Required Prepare the consolidated balance sheet of Bayonet Co for the year ended 31 December 20X9. Impairment tests in previous years resulted in the write-off of all recognised goodwill. No other assets suffered impairment losses. Assume there was no movement in the reserves of Pistol between 31 December 20X2 and 1 January 20X3. 10 marks
23.10
23: QUESTION AND ANSWER BANK
11 Holmes & Deakin (Study Text Question 21) Holmes Co has owned 85% of the ordinary share capital of Deakin Co for some years. The shares were bought for $255,000 and Deakin Co's retained earnings at the time of purchase were $20,000. On 28.2.X3 Holmes Co sold 40,000 of the Deakin shares for $160,000. The only entry made in respect of this transaction has been the receipt of the cash, which was credited to the 'investment in subsidiary' account. No dividends were paid by either entity in the period. The following draft summarised financial statements are available: Income statements for the year to 31 May 20X3
Profit before tax Income tax expense Profit for the period
Holmes Co $'000 200 90 110
Deakin Co $'000 110 60 50
$'000
$'000
535 95 630
178 – 178
320 250 80 650 1,280
190 175 89 454 632
500 310 810
200 170 370
295 80 95 470 1,280
171 60 31 262 632
Balance sheets as at 31 May 20X3 Non-current assets Property, plant and equipment (NBV) Investment in Deakin Co Current assets Inventories Trade receivables Cash
Equity Share capital $1 ordinary shares Retained earnings Current liabilities Trade payables Income tax payable Provisions
No impairment losses have been necessary in the group financial statements to date. Assume that the capital gain will be subject to corporate income tax at 33%. Required Prepare: (a)
the income statement and a statement of changes in equity extract for retained earnings of Holmes Co for the year ended 31 May 20X3; 5 marks
(b)
the consolidated income statement of Holmes for the same period;
6 marks
(c)
a consolidated balance sheet as at 31 May 20X3; and
9 marks
(d)
a consolidated statement of changes in equity extract for the year ended 31 May 20X3 for retained earnings. 2 marks 22 marks
23.11
23: QUESTION AND ANSWER BANK
12 Murder, Mystery and Suspense (Study Text Question 20) On 1 January 20X3 Murder acquired 60% of Mystery. On 30 July 20X1 Murder acquired 10% of Suspense and on the same day Mystery acquired 80% of Suspense. The balance sheets of the three companies as at 31 December 20X7 are as follows:
Non-current assets Property, plant and equipment Investment in Mystery Investment in Suspense Current assets Inventories Trade receivables Cash
Equity Ordinary share capital Share premium Retained earnings Current liabilities Trade payables
Murder $'000
Mystery $'000
Suspense $'000
2,430 900 55 3,385
1,410 – 240 1,650
870 – – 870
450 610 240 1,300 4,685
200 365 95 660 2,310
260 139 116 515 1,385
500 250 2,805 3,555
200 120 1,580 1,900
100 50 851 1,001
1,130 4,685
410 2,310
384 1,385
During the year, Mystery sold goods to Suspense of $260,000 including a mark-up of 25%. All of these goods remain in inventories at the year end. The retained earnings of the three companies may be summarised as follows: 30.7.X1 $'000 1,610 700 46
Murder Mystery Suspense
1.1.X3 $'000 1,860 950 261
31.12.X7 $'000 2,805 1,580 851
No impairment losses have been necessary in the consolidated financial statements to date. Required Prepare the consolidated balance sheet of Murder group as at 31 December 20X7. 18 marks
23.12
23: QUESTION AND ANSWER BANK
13 Harvard (Study Text Question 22) The draft financial statements of Harvard and its subsidiary, Krakow sp. z o.o. are set out below. Balance sheets at 31 December 20X5 Non-current assets Property, plant and equipment Investment in Krakow Current assets Inventories Trade receivables Cash
Equity Share capital ($1/PLN1) Retained earnings Non-current liabilities Loans Current liabilities Trade payables
Harvard $ '000
Krakow PLN '000
2,870 840 3,710
4,860 – 4,860
1,990 1,630 240 3,860 7,570
8,316 4,572 2,016 14,904 19,764
118 502 620
1,348 14,060 15,408
1,920
–
5,030 7,570
4,356 19,764
40,425 (35,500) 4,925 (4,400) 718 1,243 (300) 943
97,125 77,550 19,575 (5,850) – 13,725 (4,725) 9,000
700
3,752
Income statements for the year ended 31 December 20X5 Revenue Cost of sales Gross profit Distribution and administrative expenses Investment income Profit before tax Income tax expense Profit for the period Dividends paid during the period The following additional information is given: (1)
Exchange rates Zloty (PLN) to $ 4.40 4.16 4.00 3.92 3.60 3.75
31 December 20X2 31 December 20X3 31 December 20X4 15 May 20X5 31 December 20X5 Average for 20X5
23.13
23: QUESTION AND ANSWER BANK
(2)
Harvard acquired 1,011,000 shares in Krakow for $840,000 on 31 December 20X2 when Krakow's retained earnings stood at PLN 2,876,000. Krakow operates as an autonomous subsidiary. Its functional currency is the Polish zloty.
(3)
Krakow paid an interim dividend of PLN 3,752,000 on 15 May 20X5. No other dividends were paid or declared in the period.
(4)
The translation differences (gross) in the consolidated financial statements at 31 December 20X4 relating to the translation of the financial statements of Krakow (excluding goodwill) were $208,000. Retained earnings of Krakow in Krakow's separate financial statements in the postacquisition period to 31 December 20X4 as translated amounted to $1,372,000.
(5)
No impairment losses were necessary in the consolidated financial statements by 31 December 20X5.
Required (a)
Prepare the consolidated balance sheet at 31 December 20X5.
6 marks
(b)
Prepare the consolidated income statement and an extract from the statement of changes in equity for retained earnings and translation reserve for the year ended 31 December 20X5. 12 marks 18 marks
23.14
23: QUESTION AND ANSWER BANK
14 Tastydesserts (Study Text Question 23) The following are extracts from the financial statements of Tastydesserts and one of its wholly owned subsidiaries, Custardpowders, the shares in which were acquired on 31 October 20X2. Balance sheets Tastydesserts and subsidiaries 31 December 31 December 20X2 20X1 $'000 $'000 Non-current assets Property, plant & equipment Goodwill Investment in associates Current assets Inventories Receivables Bank balances and cash
Equity Share capital Share premium Reserves Non-current liabilities Loans Deferred tax Current liabilities Payables Bank overdrafts Current tax payable
Custardpowders 31 October 20X2 $'000
4,764 42 2,195 7,001
3,685 – 2,175 5,860
694 – – 694
1,735 2,658 43 4,436 11,437
1,388 2,436 77 3,901 9,761
306 185 7 498 1,192
4,896 216 2,540 7,652
4,776 – 2,063 6,839
400 – 644 1,044
1,348 111 1,459
653 180 833
1,915 176 235 2,326 11,437
1,546 343 200 2,089 9,761
– – – 148 – – 148 1,192
Consolidated income statement for the year ended 31 December 20X2 $'000 546 – 120 666 126 540
Profit before interest and tax Finance costs Share of profit of associates Profit before tax Income tax expense Profit for the period Attributable to: Equity holders of the parent Minority interest
540 0 540
23.15
–
23: QUESTION AND ANSWER BANK
The following information is also given: (1)
The consolidated figures at 31 December 20X2 include Custardpowders.
(2)
The amount of depreciation on property, plant and equipment during the year was $78,000. There were no disposals.
(3)
The cost on 31 October 20X2 of the shares in Custardpowders was $1,086,000 comprising the issue of $695,000 unsecured loan stock at par, 120,000 ordinary shares of $1 each at a value of 280c and $55,000 in cash.
(4)
No write down of goodwill was required during the period.
(5)
Total dividends paid by Tastydesserts (parent) during the period amounted to $63,000.
Required Prepare a cash flow statement for Tastydesserts and subsidiaries for the year ended 31 December 20X2 using the indirect method. Notes to the cash flow statement are not required.
END OF QUESTION BANK
23.16
15 marks
23: QUESTION AND ANSWER BANK
Answers 1
Greensmith (Study Text Question 2) Memorandum The need for and impact of possible revaluations of assets by Greensmith Co To
:
From :
FD, Greensmith Co Accountant
For the private use of the company I have considered the issues you raised and would advise you of the following matters: (1)
(2)
(3)
Need to revalue •
IAS 36 Impairment of Assets indicates that impairments losses such as that for Conway Square must be reflected in the financial statements in the year that they occur.
•
There is no need to revalue the Berkshire Training Centre if you do not wish to, but if you were to revalue this asset, all assets of the same class would need to be revalued, per IAS 16 Property, Plant and Equipment. Furthermore, the revaluations need to be kept up to date so that the carrying amount is not materially different to the asset's fair value at the balance sheet date. IAS 16 suggests that every three to five years may be sufficient if prices are not too volatile.
Pooling/Accounting Treatment •
When you take account of the impairment of Conway Square and if you revalue the Training Centre they will have to be accounted for separately. You could not pool the net movement.
•
The fall in the value of Conway Square of $0.7 million would go through the income statement as it has not been previously revalued.
•
The $3.5 million increase in the Training Centre's value would go through the revaluation surplus and it would therefore be reflected in the Statement of Recognised Income and Expense.
Effect on the income statement of future disposals The reported profit sale would be lower if an upward revaluation had occurred as the profit on disposal is calculated as proceeds less book value as it must be calculated by reference to the new carrying value. The previously recognised revaluation surplus, would be credited directly to retained earnings. The profit on any disposal of Conway Square would conversely be higher (or any loss lower).
(4)
Effect on EPS, ROCE and NAPS (i)
EPS •
reflecting the impairment of Conway Square would almost certainly need to be disclosed (under IAS 1) given its size and would reduce earnings and therefore EPS.
23.17
23: QUESTION AND ANSWER BANK
•
Revaluing the Training Centre will lead to an increased amortisation charge $'000 – new
8m 18
444
per annum
– existing
5m 20
250
per annum
This will obviously lower EPS for the remainder of the lease term. (ii)
(iii)
ROCE •
The revaluation upwards would worsen ROCE by increasing capital employed. Additionally, the revaluation will increase the amortisation and thus reduce the return.
•
Reflecting the impairment of Conway Square would reduce the return in the year in question but would also reduce capital employed for the indefinite future.
NAPS • •
(5)
(6)
The revaluations upwards would strengthen NAPS. The impairment in Conway Square would weaken it.
Summary and recommendations •
Conway Square must be reduced in value to reflect its impairment in value. This will have the effect of making all of the measures of concern look worse this year. ROCE will be improved in the future.
•
The Training Centre should not be revalued upwards. It will reduce EPS for the next 18 years and worsen ROCE. The increase in NAPS does not seem a reasonable trade-off as it is likely to be the least used of the three measures.
Advice on accounting for franchise and brand valuation (i)
Purchase of a franchise IAS 38 Impairment of Assets states that an intangible asset acquired separately from a business should be capitalised at its cost, which in this case is $500,000. Given that the franchise is for a fixed period, it should be amortised on a systematic basis over its 15-year useful life.
(ii)
Brand value The Standard is clear on this area and states that internally generated brands should not be recognised as intangible assets. This is because expenditure on internally generated brands cannot be distinguished from the cost of developing the business as a whole. Costs of developing the business as a whole represent internally generated goodwill which is also not capitalised as it is not an identifiable resource that can be measured reliably at cost. The brand value cannot therefore be recognised in the balance sheet.
I hope this assists you in your decision taking. These are complex issues so please contact me if any points in my report need clarifying or if there is any other way I can help out. T. Brown 1 December 20X2
23.18
23: QUESTION AND ANSWER BANK
2
Radost (Study Text Question 5) (a)
Income statement note Defined benefit expense recognised in profit or loss
$'000 3,750 4,500 (5,720) (40) 2,490
Current service cost Interest cost (10% × 45,000) Expected return on plan assets (11% × 52,000) Recognised actuarial gains (W1) Income statement expense Balance sheet notes Net defined benefit asset recognised in the balance sheet
$'000 44,000 (64,170) (20,170) 9,660 (10,510)
Present value of defined benefit obligation Fair value of plan assets Unrecognised actuarial gains (W1) Net asset Changes in the present value of the benefit obligation
$'000 45,000 4,500 3,750 (8,000) (1,250) 44,000
Opening defined benefit obligation Interest cost (10% × 45,000) Current service cost Benefits paid Actuarial gain (balancing figure) Closing defined benefit obligation – per actuary Changes in the fair value of plan assets
$'000 52,000 5,720 12,000 (8,000) 2,450 64,170
Opening fair value of plan assets Expected return on plan assets (11% × 52,000) Contributions Benefits paid Actuarial gain (balancing figure) Closing fair value of plan assets – per actuary Working 1
Recognised/unrecognised gains and losses Corridor limits, higher of 10% of b/d obligation (10% × 45,000) 10% of b/d obligation assets (10% × 52,000) Corridor limit Unrecognised actuarial gains/losses b/d Gain recognised in income statement (6,000 – 5,200)/20 years Gain on obligation in the year Gain on assets in the year Unrecognised gains c/d
23.19
$'000
$'000
4,500 5,200 5,200 6,000 (40) 1,250 2,450 9,660
23: QUESTION AND ANSWER BANK
(b)
Legally the assets of the Radost pension scheme do not belong to Radost once the contributions are made. This is because to meet the definition of plan assets of a post-employment benefit scheme under IAS 19 Employee Benefits they must be held by an entity/fund that is legally separate from the reporting entity. This provides the employees with a measure of protection should the entity go bankrupt or should the directors fraudulently attempt to plunder the assets of the pension scheme. Nevertheless, the substance of the arrangement is that the assets are held exclusively to pay the company's future defined benefit obligation and it is therefore logical that they should be shown in the company's balance sheet reducing that liability. In the case of plan assets that exceed the value of the associated obligation (as in Radost's case), a net asset would normally be recognised in the company's balance sheet on the grounds that the definition of an asset ('a resource controlled by the entity as a result of past events and from which future economic benefits are expected to flow to the entity') is met. In this case the 'benefits' are reduced future contributions as the scheme is in surplus.
23.20
23: QUESTION AND ANSWER BANK
3
DT Group (Study Text Question 6) Calculation of deferred tax liability
Carrying amount $m 2,600
Property, plant and equipment Other temporary differences Subsidiary Inventories Property sold – tax due 30.11.20X4 (165/0.3) Liability for health care benefits Unrelieved tax losses Temporary differences Deferred tax liability Deferred tax liability Deferred tax asset
1,320 16 (200) (6) 1,130
76 24 100
at 30% at 25% at 30% at 25%
Less: opening deferred tax liability deferred tax attributable to subsidiary to goodwill (76-60) × 25% Deferred tax expense for the year
Tax base $m 1,920 60 30 – –
Temporary differences $m 680 90 16 (6) 550 (100) (100) 1,130 396 4 (60) (1.5) 338.5 (280) (4) 54.5
Notes 1
As no deduction is available for the cost of goodwill in the subsidiary's tax jurisdiction, then the tax base of goodwill is zero. Paragraph 15a of IAS 12, states that DT should not recognise a deferred tax liability of the temporary difference associated in B's jurisdiction with the goodwill. Goodwill will be increased by the amount of the deferred tax liability of the subsidiary i.e. $4 million.
2
The tax that would arise if the properties were disposed of at their revalued amounts which was provided at the beginning of the year will be included in the temporary difference arising on the property, plant and equipment at 30 November 20X1.
3
DT has unrelieved tax losses of ($34m + $56m)/0.3 i.e. $300m. This will be available for offset against current year's profits ($110m) and against profits for the year ending 30 November 20X2 ($100m). Because of the uncertainty about the availability of taxable profits in 2003, no deferred tax asset can be recognised for any losses which may be offset against this amount. Therefore, a deferred tax asset may be recognised for the losses to be offset against taxable profits in 20X2. That is $100m × 30% i.e. $30m.
4
Unrealised group profit eliminated on consolidation are provided for at the receiving company's rate of tax (i.e. at 25%).
Comment The deferred tax liability of DT will rise in total by $335.5 million ($338.5m – $3m), thus reducing net assets, distributable profits, and post-tax earnings. The profit for the period will be reduced by $54.5 million which would probably be substantially more under IAS 12 than the old method of accounting for deferred tax. A prior period adjustment will occur of $280m – $3m as IAS are being applied for the first time (IFRS 1) i.e. $277m. The borrowing position of the company may be affected and the directors may decide to cut dividend payments. However, the amount of any unprovided deferred tax, analysed into its major components, was required to be disclosed under the previous standard used. IAS 12 brings this liability onto the balance sheet but because the bulk of the liability has already been disclosed the impact on the share price should be minimal.
23.21
23: QUESTION AND ANSWER BANK
4
PQR (Study Text Question 7) Investment in debentures Given that these debentures are planned to be held until redemption, they would be classed as a financial asset – investment held to maturity – held at amortised cost. This means that they are initially shown at their cost (including any transaction costs) and their value increased over time to the redemption value by applying a constant effective interest rate which takes into account not only the annual income due from the coupon, but also amortisation of the redemption premium. Their value is reduced by distributions received, i.e. the coupon. Consequently the amortised cost valuation of these debentures at the year end would be: Cost (40,000 – 6,000) Effective interest at 8.6% Coupon received (4% x 40,000)
34,000 2,924 shown as finance income (1,600) debited to cash 35,324
The debentures are an asset belonging to the equity holders and so as the increase in value is recognised until redemption, the equity of the business will increase, marginally reducing gearing. Forward contract Providing the forward meets the following criteria it qualifies for hedge accounting: •
Designated as a hedge on entering into the contract (including documentation of company's strategy)
•
Expected to be "highly effective" during its whole life (i.e. gains/losses on the hedging instrument vs losses/gains on the hedged item or vice versa fall within the ratio 80% to 125% – this is likely to be the case with a foreign currency forward contract, IAS 39, para AG108)
•
The hedge effectiveness can be reliably measured.
A foreign currency forward contract can be argued to be either a hedge of the future cash flow or a hedge of the fair value of the machine to be purchased. IAS 39 Financial Instruments: Recognition and Measurement therefore allows foreign currency hedges of firm commitments to be classed as either a cash flow hedge or a fair value hedge. If the contract is classed as a cash flow hedge, given that the machine is not yet recognised in the books, any gain or loss on the hedging instrument is split into two components: •
The effective portion of the hedge (which matches the change in expected cash flow) is recognised initially in reserves. It is transferred out of reserves either when the asset is recognised (reducing the asset base and future depreciation) or when the cash flow is recognised in the income statement (e.g. by deprecation). Both options therefore apply the accruals concept.
•
The ineffective portion of the hedge is recognised in the income statement immediately as it has not hedged anything.
If the contract is classed as a fair value hedge, all gains and losses on the hedging instrument must be recognised immediately in the income statement. However, in order to match those against the asset hedged, the gain or loss on the fair value of the asset hedged is also recognised in the income statement (and as an asset or liability in the balance sheet). This is arguably less transparent as it results in part of the asset value (the change in fair value) being recognised in the balance sheet until the purchase actually occurs – consequently, IAS 39 allows the option to treat foreign currency forward contracts as a cash flow hedge. Gearing will be different depending on whether the forward contract is accounted for as a cash flow hedge or a fair value hedge (and whether a gain or loss on the hedging instrument occurs). Gearing will be less volatile if a fair value hedge is used as the change in fair value of the hedged asset is also
23.22
23: QUESTION AND ANSWER BANK
recognised offsetting gains or losses on the hedging instrument, whereas this is not the case until the asset is purchased (and recognised) for the cash flow hedge. Redeemable preference shares Redeemable preference shares, although called shares, are not, in substance, equity, they are a debt instrument, i.e. a loan made to the company which receives interest and is paid back at a later date. Consequently, IAS 32 requires them to be classed as such, i.e. as a non-current liability in the balance sheet. The 'dividends' paid will be shown in the income statement as finance costs and accrued at the end of the year if outstanding, whether declared or not. The shares are consequently a financial liability held at amortised cost. In this case, given that the shares are issued and redeemed at the same value, the effective interest rate and nominal coupon rate will be the same (6%) and each year $6,000 will be shown as a finance cost in the income statement and the balance outstanding under non-current liabilities at each year end will be $100,000 as follows: Cash received/ b/d value Effective interest at 6% Coupon paid (6% x 100,000)
100,000 6,000 shown as finance cost (6,000) credited to cash 100,000
In the financial statements for the year ending 31 December 20X7, the shares will need to be reclassified as a current liability given that they will be repaid within one year. Given that these shares are classed as a financial liability, gearing will be higher (as they are treated as debt) than if they were ordinary shares (which would be treated as equity).
23.23
23: QUESTION AND ANSWER BANK
5
Hedging (Study Text Question 8) The futures contract was entered into to protect the company from a fall in oil prices and hedge the value of the inventories. It is therefore a fair value hedge. The inventories are recorded at their cost of $2,600,000 (100,000 barrels at $26.00) on 1 July 20X2. The futures contract has a zero value at the date it is entered into and so no entry is made in the financial statements. Tutorial note: however, the existence of the contract and associated risk would be disclosed from that date in accordance with IFRS 7 (detail outside the scope of the syllabus). At the year end the inventories must be shown at the lower of cost and net realisable value. Hence they will be shown at $2,250,000 (100,000 barrels at $22.50) and a loss of $350,000 recognised in the income statement. However, a gain has been made on the futures contract: $ The company has a contract to sell on 31 March 20X3 at $27.50
2,750,000
A contract entered into at the year end would sell at $23.25 on 31 March 20X3
2,325,000
Gain (= the value the contract could be sold on for to a third party)
425,000
The gain on the futures contract is also recognised in the income statement: Dr Future contract asset Cr Income statement
$425,000 $425,000
The net effect on the income statement is a gain of $75,000 ($425,000 less $350,000) whereas without the hedging contract the whole loss of $350,000 would have been the only impact on the income statement. Note If the inventories had gained in value, this gain would also be recognised in the income statement as hedge accounting is being applied (normally gains on inventories are not recognised until sale). A loss would have occurred on the futures contract, which would also be recognised in the income statement.
23.24
23: QUESTION AND ANSWER BANK
6
Share-based payment (Study Text Question 15) (a)
Accounting entries 31.12.X1 Dr Cr
$
Income statement (Staff costs) Equity reserve ((800 – 95) × 200 × $4 × 1/3)
188,000 188,000
31.12.X2 Dr Cr
Income statement (Staff costs) (W1) Equity reserve
201,333 201,333
31.12.X3 Dr Cr
Income statement (Staff costs) (W2) Equity reserve
202,667 202,667
Issue of shares: Dr Dr
Cash (740 × 200 × $1.50) Equity reserve
222,000 592,000
Cr Cr
Share capital (740 × 200 × $1) Share premium (balancing figure)
148,000 666,000
Workings 1
Equity reserve at 31.12.X2 Equity b/d ∴ I/S charge Equity c/d ((800 – 70) × 200 × $4 × 2/3)
2
188,000 201,333 389,333
Equity reserve at 31.12.X3 Equity b/d ∴ I/S charge Equity c/d ((800 – 40 – 20) × 200 × $4 × 3/3)
(b)
389,333 202,667 592,000
Cash-settled share-based payment If J&B had offered cash payments based on the value of the shares at vesting date rather than options, in each of the three years an accrual would be shown in the balance sheet representing the expected amount payable based on the following: No of employees estimated at the year end to be entitled to rights at the vesting date
×
Number of rights each
×
Fair value of each right at year end
×
Cumulative proportion of vesting period elapsed
The movement in the accrual would be charged to the income statement representing further entitlements received during the year and adjustments to expectations accrued in previous years. The accrual would continue to be adjusted (resulting in an income statement charge) for changes in the fair value of the right over the period between when the rights become fully vested and are subsequently exercised. It would then be reduced for cash payments as the rights are exercised.
23.25
23: QUESTION AND ANSWER BANK
7
Ace (Study Text Question 14) Year ended 31 March 20X2 Relationship Ace Co has a 75% subsidiary (Deuce Co) and an 80% subsidiary (Trey Co). Ace is a related party of Deuce and Trey and vice versa. Deuce and Trey are also related parties because they are subject to 'common control'. Any transactions between Ace, Deuce and Trey need not be disclosed in Ace's consolidated accounts as they are eliminated. Disclosures Ace Co • Intragroup sale of machine for $25,000 at profit of $5,000. No balances outstanding. • Management services provided to Deuce (nil charge) and Trey (nil charge) No disclosure is required in the group accounts of Ace of these items as they are eliminated. Deuce •
Parent (and ultimate controlling party) is Ace Co
•
Machine purchased from parent $25,000 (original cost $20,000) and depreciation charge $5,000. No amounts outstanding at year end.
•
Purchase of management services from Ace (nil charge)
Trey • •
Parent (and ultimate controlling party) is Ace Co Purchase of management services from Ace (nil charge)
For all transactions the nature of the related party relationship (i.e. parent, subsidiary, fellow subsidiary) should be disclosed. Year ended 31 March 20X3 Relationship Ace Co has a 100% subsidiary (Deuce Co) and an 80% subsidiary (Trey Co). Ace is a related party of Deuce and Trey and vice versa. Deuce and Trey are related because they remain under common control. Any transactions between Ace, Deuce and Trey need not be disclosed in Ace's consolidated accounts as they are eliminated. Disclosures Ace Co •
Management services provided to Deuce (nil charge) and Trey ($10,000 outstanding)
No disclosure is required in the group accounts of Ace of these items as they are eliminated. Deuce •
Parent (and ultimate controlling party) is Ace Co
Disclosures of intragroup transactions is still required even though Deuce is a wholly-owned subsidiary: •
Sale of inventories to Trey for $15,000 (original cost $12,000) all sold on, no amounts outstanding at year end
•
Purchase of management services from Ace (nil charge)
23.26
23: QUESTION AND ANSWER BANK
Trey •
Parent (and ultimate controlling party) is Ace Co
•
Purchase of inventories from Deuce $15,000 (original cost $12,000) all sold, no amounts outstanding at year end
•
Purchase of management services from Ace costing $10,000. All outstanding at year end
For all transactions the nature of the related party relationship (i.e. parent, subsidiary, fellow subsidiary) should be disclosed.
23.27
23: QUESTION AND ANSWER BANK
8
Able (Study Text Question 10) (a)
(i)
IAS 17 Leases differentiates between operating and finance leases. A finance lease: (1)
Substantially transfers all of the risks and rewards incident to ownership of an asset to a lessee.
(2)
Should be capitalised in the accounts at the fair value of the leased asset or, if lower, the present value of minimum lease payments over the lease term using the interest rate implicit in the lease (otherwise the lessee's marginal borrowing rate may be used). Any residual payments guaranteed by the lessee should also be included.
(3)
The capitalised asset is depreciated over the shorter of the lease term or useful life.
(4)
Interest and principal components of each payment must be identified and allocated to accounting periods, thus reducing the lease liability.
(5)
Finance charges are calculated as the difference between the total of the minimum lease payments and value of the liability to the lessor. Finance charges are applied to produce a constant periodic rate of charge on the liability in the income statement.
An operating lease:
(ii)
(1)
Is any lease which is not a finance lease.
(2)
Lease rentals are charged to the income statement on a systematic basis which represents the pattern of the benefits derived by the users from the leased asset.
Current standards do not adequately deal with leases. The problems are as follows. (1)
The rights and obligations under operating leases are not recognised in the lessee's accounts. IAS 17 takes the view that if risks and rewards of ownership are not substantially transferred to a lessee then the lease is classified as an operating lease.
(2)
The issue lies with the definition of 'substantial', which has been judged against quantitative not qualitative factors. If a lease is non-cancellable and the present value of the minimum lease payments is greater than or substantially equal to the asset's fair value or the lease term covers the major part of the asset's life, then the lease is usually treated as a finance lease.
(3)
'Substantially equal' has been taken to be in excess of 90% of the fair value of the leased asset and the figure of 75% of the life has typically been used, but these terms are not defined in IAS 17.
(4)
However, many leases have been designed which are in substance finance leases but, when judged in quantitative terms, are classified as operating leases.
(5)
Factors such as relative responsibilities of lessor/lessee for maintenance, insurance and bearing losses have also blurred the distinction and classification of leases.
(6)
Long term finance leases have often been packaged as operating leases in order to represent a source of 'off balance sheet finance'.
(7)
Specific measures used to enable classification as operating leases include:
•
Contingent rentals which are excluded from the calculation of minimum lease payments
23.28
23: QUESTION AND ANSWER BANK
(b)
(i)
•
Making the implicit interest rate impossible to calculate, so the lessee uses an estimated rate which could reduce the present value of minimum lease payments
•
For leases of land and buildings, it is expected that the risks and rewards of ownership of land cannot pass without legal transfer of ownership. Companies may allocate as much as possible to the land element, thus ensuring the buildings element is also treated as an operating lease by reducing the present value of the minimum lease payments.
Electrical distribution system Where a lessee enters a sale and leaseback transaction resulting in an operating lease, then the original asset should be treated as sold. If the transaction is at fair value then immediate recognition of the profit/loss should occur. If the transaction is above fair value, then the profit based on fair value of $65m should be recognised. The balance in excess of fair value of $100m (198 – 98) should be deferred and amortised over the period for which the asset is expected to be used (10 years) i.e. $10m pa. If the sales value is not at fair value, the operating lease rentals of $24m are likely to have been adjusted for the excess price paid. For Able the sales value is more than twice the fair value and the use of the Framework and standards dictate the substance of a transaction is essentially one of sale and a loan back equal to the deferred income element. The entity may have shown the excess over fair value as a loan and part of the costs of the operating lease will essentially be repayment of capital and interest ($12m pa).
(ii)
Sale and leaseback of plant This appears to create a finance lease because the lease term is for the major part of the asset's remaining economic life and the present value of the minimum lease payments is substantially equal to the fair value ($43.5 + ($43.5m × 2.49))= $151.82m, compared to fair value $152m). The lease also contains a bargain purchase option. Able seems to enjoy all the risks and rewards of ownership. Under IAS 17, where a sale and leaseback transaction results in a finance lease, any excess of sale proceeds over the carrying amount should be deferred and recognised over the lease term. Therefore the excess proceeds over $100m ($52m) will be amortised over four years at $13m pa. The asset and the lease obligation are recorded at the sale value of $152m. Depreciation is charged on the new asset value and if the revaluation reserve is transferred to revenue reserves, this will also occur over the four year lease term.
23.29
23: QUESTION AND ANSWER BANK
9
Highland (Study Text Question 16) Highland Group Consolidated income statement for the year ended 31 March 20X8 Revenue (5,000 + 3,000 + (2,910 × 4 ))
$'000 8,970
Cost of sales (3,000 + 2,300 + (2,820 × 4 ))
(6,240)
Gross profit Administrative expenses (W5) Finance income (W6) Finance costs (50 + (210 × 4 ) – (W2) 70)
2,730 (1,672) 140 (50)
Profit before tax Income tax expense (300 + 50)
1,148 (350) 798
12
12
12
Attributable to: Equity holders of the parent Minority interest (W8)
824 (26) 798
Workings 1
Group Structure Highland
Aviemore 80% 2
Buchan 65% (owned for 4 months)
Interest 2,100,000 × 10%
=
210 ×
8
12
210
Pre = 140
Post-acquisition cancels with finance cost (210 × 4 12 ) = 70 in Buchan on consolidation.
Finance income 3
Unrealised profit on disposal of freehold property Land
Buildings
Proceeds Net book value Profit on disposal (in Aviemore) Proceeds (800 – 300) Net book value (800 × 40
)
50 Loss on disposal (in Aviemore) Proportion of loss depreciated (1/40)
23.30
$'000 300 (100)
$'000 200
500 (640) (140) 3.5 63.5
23: QUESTION AND ANSWER BANK
4
Fair value depreciation
At acquisition $'000 150 150
Property, plant and equipment (500 – 350)
Additional depreciation* $'000 (5) (5)
At B/S date $'000 145 145
4 = $5,000 * Additional depreciation = 150 10 = 15 per annum × 12
5
Administrative expenses
$'000
1,000 + 500 + ( 4 × 150)
1,550 63.5 138.5 (85) 5 1,672
12
Unrealised profit on disposal (W3) Impairment losses (W9) Less: management services Fair value depreciation (W4) 6
Other income
$'000 230 (85) (40) 105 (70) 140
Per income statement Less: management services Less: dividend from Aviemore (50 × 80%) Add: interest from Buchan not recorded ($210,000/2) Less: post acquisition element (W2) NB: becomes Finance income as only interest income from Buchan remains. 7
Goodwill Cost of combination FV net assets acquired: Net book value per question Fair value adjustment (W4) Group share
8
Aviemore $'000 $'000 5,000
Buchan $'000 $'000 2,000
4,000 4,000 × 80%
1,350 150 1,500 × 65%
Minority interest
(3,200) 1,800
(975) 1,025 $'000
Aviemore (100 – 63.5 profit on disposal ) × 20%
7.3 dr
Buchan [(270 loss × 4 ) + 5 (W4)] × 35% 12
33.25 cr 25.95 cr
Hence, rounding to nearest $'000, MI of $26,000 increases profit attributable to equity holders of the parent.
23.31
23: QUESTION AND ANSWER BANK
9
Impairment losses
Aviemore $'000 1,800
Buchan $'000 1,025
Notional goodwill (× 100/80) (× 100/65) Net assets at 31 December
2,250 4,450 6,700
1,577 3,310 4,887
Recoverable amount Impairment loss
7,040 0
4,674 213
Goodwill (W7)
Allocated to: Notional goodwill Other assets
– – 0
Recognised impairment loss: Recognised goodwill (213 × 65%) Other assets (100%)
– –
23.32
213 – 213 138.5 –
23: QUESTION AND ANSWER BANK
10 Armoury (Study Text Question 18) Consolidated balance sheet for the year ended 31 December 20X9
$
Non-current assets Property, plant and equipment (14,500 + 12,140 + 17,500)
44,140
Current assets Inventories (6,300 + 2,100 + 450) Trade receivables (4,900 + 2,000 + 2,320) Cash (500 + 1,440 + 515)
8,850 9,220 2,455 20,525 64,665
Equity attributable to equity holders of the parent Share capital – 50c ordinary shares Retained earnings (W4)
5,000 38,330 43,330 11,370 54,700
Minority interest (W3) Current liabilities (5,700 + 2,280 + 1,985)
9,965 64,665
Workings 1
Group structure B 1.1.X3 MI: 25%
2
B effectively owns 75% × 80% = 60% of Pistol
4,000 = 80% ∴ 5,000
M.I. in Pistol = 40% (20% direct and 25% × 80% = 20% indirect)
R
31.12.X2 MI: 20%
6,000 = 75% ∴ 8,000
P
Goodwill
$
Cost of combination Fair value of identifiable net assets acquired Rifle Share capital Pre-acquisition retained earnings Investment in Pistol Pistol
Share capital Pre-acquisition retained earnings
23.33
$ 10,000
4,000 8,000 (9,000) 3,000
× 75%
(2,250)
2,500 6,500 9,000
× 60%
(5,400) 2,350
23: QUESTION AND ANSWER BANK
3
Minority interest
Rifle $ 24,400 (9,000) 15,400
Net assets per question Less: cost of investment in Pistol Minority share
Pistol $ 18,800 18,800
× 25% 3,850
× 40% 7,520 11,370
4
Retained earnings
Bayonet $ 25,500
Per question Retained earnings at acquisition
25,500 Rifle Co – share of post acquisition earnings (12,400 × 75%) Pistol Co – share of post acquisition earnings (9,800 × 60%) Goodwill impairment losses to date (W2)
23.34
9,300 5,880 40,680 (2,350) 38,330
Rifle $ 20,400 (8,000) 12,400
Pistol $ 16,300 (6,500) 9,800
23: QUESTION AND ANSWER BANK
11 Holmes & Deakin (Study Text Question 21) (a)
(b)
Holmes Co Income statement for the year ended 31 May 20X3 Profit before gain on disposal of shares in subsidiary Gain on disposal of shares in subsidiary (W3) Profit before tax Income tax expense (90 + (W3) 33) Profit for the period
$'000 200 100 300 (123) 177
Statement of changes in equity (Extract) Retained earnings at 31.5.20X2 (310 – 110) Profit for the period Retained earnings at 31.5.20X3
$'000 200 177 377
Holmes Co Consolidated income statement for the year ended 31 May 20X3 Profit before gain on disposal of shares in subsidiary (200 + 110) Gain on disposal of shares in subsidiary (W3) Profit before tax Income tax expense (90 + 60 + (W3) 33) Profit for the period Attributable to: Equity holders of the parent Minority interest (50 ×
(c)
$'000 310 72.5 382.5 183.0 199.5 189.5
9
× 15%) + (50 × 3 × 35%) 12 12
Holmes Co Consolidated balance sheet as at 31.5.X3 Non-current assets Property, plant and equipment (535 + 178) Goodwill (W2) Current assets Inventories (320 + 190) Trade receivables (250 + 175) Cash (80 + 89)
10.0 199.5
$'000 713 52 765 510 425 169 1,104 1,869
Equity attributable to equity holders of the parent Share capital $1 ordinary shares Retained earnings (W5) Minority interest (370 × 35%)
23.35
500 474.5 974.5 129.5 1,104
23: QUESTION AND ANSWER BANK
$'000 Current liabilities Trade payables (295 + 171) Income tax payable (80 + 60 + (W3) 33) Provisions (95 + 31)
(d)
466 173 126 765 1,869
Statement of changes in equity (Extract)
$'000 285 189.5 474.5
Retained earnings at 31.5.20X2 (W4) Profit for the period Retained earnings at 31.5.20X3 (W5) Workings 1
Timeline 1.6.X2 I/S
28.2.X3
31.5.X3
Subsidiary – all year 35% MI × 3/12
15% MI × 9/12
Group gain on disposal 2
Goodwill
$'000
$'000 255
Cost of combination Fair value of identifiable net assets acquired: Share capital Pre-acquisition retained earnings
3
20 200 220
Consol – 35% MI
× 85%
Gain on disposal of shares
(187) 68 $'000
Gain in parent's separate financial statements Sale proceeds Less: original cost of shares (255 × 40/170) Parent gain Less: tax on capital gain (33%)
160 60 100 33
Gain in consolidated financial statements $'000 Sale proceeds Net assets at disposal Share capital Retained earnings b/f To disposal (50 × 9 ) 12
$'000 160
200 120 37.5 357.5 (71.5) (16) 72.5
× 20% Goodwill ((W2) 68 × 40/170)
23.36
23: QUESTION AND ANSWER BANK
4
Retained earnings brought forward
Holmes $'000 310 (110)
Per question (31.5.X3) Less: profit for the year Retained earnings at acquisition Deakin – share of post acquisition earnings (100 × 85%) 5
200 85 285
Deakin $'000 170 (50) (20) 100
Proof of retained earnings as at 31.5.X3 Holmes $'000 377
Per question (Holmes per part (a)) Retained earnings at acquisition Deakin – share of post acquisition earnings (150 × 65%)
23.37
377 97.5 474.5
Deakin $'000 170 (20) 150
23: QUESTION AND ANSWER BANK
12 Murder, Mystery and Suspense (Study Text Question 20) Murder Consolidated balance sheet as at 31 December 20X7 $'000 Non-current assets Property, plant and equipment (2,430 + 1,410 + 870) Goodwill (W3) Current assets Inventories (450 + 200 + 260 – (W2) 52) Trade receivables (610 + 365 + 139) Cash (240 + 95 + 116)
858 1,114 451 2,423 7,253.12
Equity attributable to equity holders of the parent Ordinary share capital Share premium Retained earnings (W5) Minority interest (W4) Current liabilities Trade payables (1,130 + 410 + 384)
Group structure Murder 1.1.X3
60% 30.7.X1 10%
Mystery 30.7.X1
80%
Suspense
2
Murder effectively owns 10% + (60% × 80%) = 58% of Suspense
Unrealised profit on inventories Mark-up =
500 250 3,515.5 4,265.5 1,063.62 5,329.12 1,924 7,253.12
Workings 1
4,710 120.12 4,830.12
25 × 260,000 = $52,000 125
23.38
23: QUESTION AND ANSWER BANK
3
Goodwill – Piecemeal acquisition Murder in Mystery group (1 January 20X3) $'000
$'000 900
Cost of combination Fair value of identifiable net assets acquired Mystery Share capital Share premium Pre-acquisition retained earnings (1.1.X3) Investment in Suspense Suspense Share capital Share premium Pre-acquisition retained earnings (1.1.X3)
200 120 950 (240) 1,030
× 60%
(618)
100 50 261 411
× 48%
(197.28) 84.72
Murder in Suspense (calculated as at 30 July 20X1) When Murder bought the 10% stake in Suspense, Suspense was neither a subsidiary nor an associate and no goodwill was calculated. Suspense becomes a subsidiary on 1 January 20X3 on the acquisition of Mystery Group. However, goodwill on the 10% stake is calculated using fair values as at 30 July 20X1 (IFRS 3 paras 58–60) and retained earnings are retrospectively consolidated from that date. $'000
$'000 55
Cost of combination Fair value of identifiable net assets acquired Share capital Share premium Retained earnings
100 50 46 196 (19.6) 35.4
× 10% Total goodwill 4
120.12
Minority interest Net assets per question PUP (W2) Less: cost of investment in Suspense Minority share
Mystery $'000 1,900 (52) (240) 1,608
Suspense $'000 1,001 1,001
× 40% 643.2 1,063.62
23.39
× 42% 420.42
23: QUESTION AND ANSWER BANK
5
Retained earnings
Per question Less: PUP (W2) Retained earnings at acq'n
Murder
Mystery
$'000 2,805
$'000 1,580 (52) (950) 578
2,805 Mystery – share of post acq'n earnings (578 × 60%) Suspense – share of post Acq'n earnings (590 × 48%) Suspense – share of post acq'n earnings (805 × 10%) Goodwill impairment losses to date
346.8 283.2 80.5 3,515.5 (0) 3,515.5
23.40
Suspense 48% $'000 851
Suspense 10% $'000 851
(261) 590
(46) 805
23: QUESTION AND ANSWER BANK
13 Harvard (Study Text Question 22) (a)
Consolidated balance sheet at 31 December 20X5 $'000 Non-current assets Property, plant and equipment (2,870 + (W2) 1,350) Goodwill (W4) Current assets Inventories (1,990 + (W2) 2,310) Trade receivables (1,630 + (W2) 1,270) Cash at bank and in hand (240 + (W2) 560)
Equity attributable to equity holders of the parent Share capital ($1) Retained earnings (W5) Translation reserve (W6) Minority interest ((W2) 4,280 × 25%) Non-current liabilities Loans
4,300 2,900 800 8,000 12,367 118 2,613 406 3,137 1,070 4,207 1,920
Current liabilities Trade payables (5,030 + (W2) 1,210) (b)
4,220 147 4,367
6,240 12,367
Consolidated income statement for year ended 31 December 20X5 Revenue (40,425 + (W3) 25,900) Cost of sales (35,500 + (W3) 20,680) Gross profit Distribution and administrative expenses (4,400 + (W3) 1,560) Profit before tax Income tax expense (300 + (W3) 1,260) Profit for the period Attributable to: Equity holders of the parent Minority interest ((W3) 2,400 × 25%)
$'000 66,325 (56,180) 10,145 (5,960) 4,185 (1,560) 2,625 2,025 600 2,625
Statement of changes in equity for the year ended 31 December 20X5 (extract) $'000 $'000 Translation Retained reserve earnings Balance at 31 December 20X4 (W6)/ (W5) 168 1,288 – 238 Currency translation differences [(W7) (297 × 75%) + (W4) 15)] Net income recognised directly in equity 238 – Profit for the period 2,025 Total recognised income and expense for the period 238 2,025 (700) Dividends Balance at 31 December 20X5 (W6)/ (W5) 406 2,613
23.41
23: QUESTION AND ANSWER BANK
Workings 1
Group structure Harvard 31.12.X2
1,011 = 75% 1,348 Pre-acq'n ret'd earnings = PLN 2,876,000 Krakow
2
Translation of Krakow – balance sheet Property, plant and equipment Inventories Trade receivables Cash Share capital Retained earnings – pre-acquisition – 20X3 – 20X4 (given) – 20X5 Profit – 20X5 Dividends Translation reserve (100%, excludes goodwill) – brought forward (given) – for year (W7) Trade payables
3
Translation of Krakow – income statement Revenue Cost of sales Gross profit Distribution and administrative expenses Profit before tax Income tax expense Profit for the period
23.42
PLN '000 4,860 8,316 4,572 2,016 19,764
Rate
$'000
3.6 3.6 3.6 3.6
1,350 2,310 1,270 560 5,490
1,348
4.4
306
2,876 5,936 9,000 (3,752) 14,060
4.4
654 1,372 2,400 (957) 3,469
– – 15,408 4,356 19,764 PLN '000 97,125 (77,550) 19,575 (5,850) 13,725 (4,725) 9,000
3.75 3.92
β or (W7) 3.6
208 297 4,280 1,210 5,490
Rate
$'000
3.75 3.75
25,900 (20,680) 5,220 (1,560) 3,660 (1,260) 2,400
3.75 3.75
23: QUESTION AND ANSWER BANK
4
Goodwill
PLN '000
Cost of combination (840 × 4.4) Less: Share of net assets acquired Share capital Retained earnings
(3,168) 528 528 528
Proof of retained earnings (i)
At 31 December 20X5 Per question/(W2) Less: retained earnings at acquisition (W2) Group share (75%) Goodwill impairment losses to date
(ii)
At 31 December 20X4 Harvard (502 – (943 – 700))/Krakow (W2) (654 + 1,372) Less: retained earnings at acquisition (W2) Group share (75%) Goodwill impairment losses to 31.12.X4
6
Translation reserve (i)
(i)
7
Rate
$'000
4.4 β 4.0 β 3.6
120 12 132 15 147
1,348 2,876 4,224
Group share (75%) Goodwill at acquisition Exchange gain 20X3 – 20X4 Goodwill at 31 December 20X4 Exchange gain 20X5 Goodwill at balance sheet date 5
PLN '000 3,696
$'000 Harvard 502
$'000 Krakow 3,469 (654) 2,815
2,111 (0) 2,613 $'000 Harvard 259
$'000 Krakow 2,026 (654) 1,372
1,029 (0) 1,288 $'000
At 31 December 20X5 Translation of Krakow ((208 + (W7) 297) × 75%) Translation of goodwill (12 + (W4) 15) At 31 December 20X4 Translation of Krakow (208 × 75%) Translation of goodwill (W4)
Exchange differences Net assets of Krakow at 31 December 20X5 Less: net assets of Krakow at 31 December 20X4 (15,408 – 9,000 + 3,752) @ 4.0 Increase over the year Less: retained profit for the year (W2) (2,400 – 957) Exchange differences Group share (75%)
379 27 406 156 12 168 $'000 4,280 (2,540) 1,740 (1,443) 297 223
23.43
23: QUESTION AND ANSWER BANK
14 Tastydesserts (Study Text Question 23) Cash flow statement for the year ended 31 December 20X2 Cash flows from operating activities Profit before taxation Adjustments for: Depreciation Share of profit of associates Interest expense
$'000
$'000
666 78 (120) – 624 (37) (41) 221 767 – (160)
Increase in receivables (2,658 – 2,436 – 185) Increase in inventories (1,735 – 1,388 – 306) Increase in payables (1,915 – 1,546 – 148) Cash generated from operations Interest paid Income taxes paid (W5) Net cash from operating activities
607
Cash flows from investing activities Acquisition of subsidiary Custardpowders net of cash acquired (55 – 7) Purchase of property, plant and equipment (W1) Dividends received from associates (W3) Net cash used in investing activities Cash flows from financing activities Dividends paid
(48) (463) 100 (411) (63)
Net cash used in financing activities
(63) 133
Net increase in cash and cash equivalents
(266)
Cash and cash equivalents at beginning of period
(133)
Cash and cash equivalents at end of period Workings 1
Purchase of property, plant and equipment Property, plant and equipment b/d Acquisition of Custardpowders ∴Cash additions
2
$'000 3,685 694 463 4,842
$'000 Depreciation c/d
78 4,764 4,842
Goodwill Goodwill b/d Acquisition of Custardpowders (1,086 – (1,044 × 100%))
$'000 42 42
23.44
$'000 ∴Impairment losses c/d
0 42 42
23: QUESTION AND ANSWER BANK
3
Dividends received from associates Investment in associate b/d Share of profit
$'000 2,175 120
$'000 ∴Dividends received c/d
2,295 4
100 2,195 2,295
Reconciliation of share capital $'000 4,776 336 5,112
Share capital plus premium b/d Issued to acquire sub (120,000 × $2.80) Share capital plus premium c/d (4,896 + 216) ∴ no shares have been issued for cash during the year. 5
Income taxes paid Income tax payable $'000 b/d ∴Cash paid c/d – current tax – deferred tax
160 235 111 506
23.45
I/S
– current tax – deferred tax
$'000 200 180 126
506
23: QUESTION AND ANSWER BANK
END OF ANSWER BANK
23.46
Pilot paper Questions
24.1
24.2
24: PILOT PAPER QUESTIONS
24.3
24: PILOT PAPER QUESTIONS
24.4
24: PILOT PAPER QUESTIONS
24.5
24: PILOT PAPER QUESTIONS
24.6
24: PILOT PAPER QUESTIONS
24.7
24: PILOT PAPER QUESTIONS
24.8
24: PILOT PAPER QUESTIONS
24.9
24: PILOT PAPER QUESTIONS
END OF PILOT PAPER QUESTIONS 24.10
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