CIMA REVISION CARDS Financial Analysis Catherine Gowthorpe Managerial Level Paper P8
AMSTERDAM l BOSTON PARIS l SAN DIEGO l
HEIDELBERG SAN FRANCISCO
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LONDON l SINGAPORE
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NEW YORK SYDNEY
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OXFORD TOKYO
Elsevier Butterworth-Heinemann Linacre House, Jordan Hill, Oxford OX2 8DP 30, Corporate Drive, Burlington, MA 01803 First published 2005 Copyright ß 2005, Elsevier Ltd. All rights reserved No part of this publication may be reproduced in any material form (including photocopying or storing in any medium by electronic means and whether or not transiently or incidentally to some other use of this publication) without the written permission of the copyright holders, except in accordance with the provisions of the Copyright, Designs and Patents Act 1988, or under the terms of a licence issued by the Copyright Licensing Agency Ltd, 90 Tottenham Court Road, London, England W1T 4LP. Applications for the copyright holder’s written permission to reproduce any part of this publication should be addressed to the publisher. Permissions may be sought directly from Elsevier’s Science & Technology Rights Department in Oxford, UK: phone: (+44) 1865 843830, fax: (+44) 1865 853333, e-mail:
[email protected]. You may also complete your request on-line via the Elsevier homepage (http://www.elsevier.com), by selecting ‘Customer Support’ and then ‘Obtaining Permissions’ British Library Cataloguing in Publication Data A catalogue record for this book is available from the British Library Library of Congress Cataloging in Publication Data A catalogue record for this book is available from the Library of Congress ISBN 07506 64886 For information on all Elsevier Butterworth-Heinemann publications visit our website at http://books.elsevier.com Printed and bound in Great Britain
Welcome to CIMA’s Official Revision Cards. These cards have been designed to:
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Save you time by summarising the syllabus in a concise form Jog your memory through the use of diagrams and bullet points Follow the structure of the CIMA Official Study Systems Refer to relevant questions found within the Preparing for the Examination section of the study system Provide you with plenty of exam tips and hints
Ensure exam success by revising with the only revision cards endorsed by CIMA.
TABLE OF CONTENTS 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14. 15. 16.
Financial reporting frameworks ..................................................... Consolidated balance sheet 1 ....................................................... Consolidated balance sheet 2 ....................................................... The consolidated income statement ................................................ Associates and joint ventures ....................................................... Complex group structures............................................................ Acquisitions in the accounting period .............................................. Disposals in the accounting period ................................................. Business reorganisations .............................................................. Foreign currency transactions ........................................................ Cash-flow statements ................................................................. Financial instruments 1 ............................................................... Financial instruments 2 ............................................................... Changing price levels.................................................................. Measurement of income and capital ................................................ Techniques of ratio analysis ..........................................................
1 7 13 19 23 29 33 39 45 51 59 63 69 75 81 87
17. 18. 19. 20. 21.
Interpretation of financial statements ............................................... 95 Earnings per share .................................................................... 101 Issues and problems in financial analysis ......................................... 105 Non-financial, environmental and social reporting ................................ 111 International financial reporting ..................................................... 117
Financial Reporting Frameworks Establishing the regulatory context of financial reporting
Topics
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The international standard setting structure Framework for the Preparation and Presentation of Financial Statements IAS 1 Presentation of Financial Statements Update on recent developments 1
Financial Reporting Frameworks
The international standard setting structure
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IASC Foundation 19 trustees, to appoint IASB, IFRIC and SAC. Review strategy, approve budget. Establish operating procedures. Approved amendments to constitution.
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Standards Advisory Council (SAC) Advise IASB on agenda decisions and priorities.
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––––––––––––––––––––––––––––––––––––– Financial Reporting Frameworks
The international standard setting structure
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International Financial Reporting Interpretations Committee (IFRIC) Consider issues lacking definitive guidance. Publish Interpretations. Report to IASB.
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International Accounting Standards Board (IASB) Publish high-quality, understandable and enforceable global standards. Promote application of standards. Bring about convergence.
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Financial Reporting Frameworks
The IASC’s Framework
Objective of financial statements. Underlying assumptions. Qualitative characteristics. Elements of financial statements. Recognition. Measurement. Concepts of capital and capital maintenance.
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Content
Remember The objective of financial statements: provide information useful to a wide range of users in making economic decisions.
Study tips Making relevant references to the Framework in written questions often gains marks. Make sure you fully understand and can apply the definitions of the elements. Memorise and understand the qualitative characteristics.
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––––––––––––––––––––––––––––––––––––– Financial Reporting Frameworks
IAS 1 Presentation of financial statements
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Key points Objective of fair presentation – normally achieved through following IFRSs. Departure from IFRSs permissible but extremely unusual. Complete set of financial statements to contain: Balance sheet. Income statement. Statement of changes in equity. Cash-flow statement. Accounting policies and explanatory notes.
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Financial Reporting Frameworks
Recent developments
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Improvements project To reduce choice of accounting treatments and to eliminate inconsistencies. Thirteen standards affected. IFRS 1 First time adoption of IFRS. IFRS 2 Share-based payment. IFRS 3 Business combinations. IFRS 4 Insurance contracts. IFRS 5 Non-current assets held for sale and discontinued operations. Amendments to IAS 32 and IAS 39.
Remember New versions of thirteen IASs were published in December 2003. Make sure you read the up to date version.
IFRS 3 Business combinations is very important for this paper. IFRS 2 Share-based payment is also examinable. The latest versions of IAS 32 and IAS 39 are referred to in chapters 12 and 13 of these revision cards.
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Consolidated Balance Sheet 1 Introducing the basic principles and preparing a simple consolidated balance sheet
Topics
Key Study System questions Objective test questions 1 & 3
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Theoretical and regulatory background Aggregation principle Calculating goodwill on acquisition Minority interests Intra-group balances 7
Consolidated Balance Sheet 1
Theoretical and regulatory background
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Concept of control Reporting entity – a cohesive economic unit. Parent entity – controls operating and financial policies of subsidiaries. Control typically via ownership of majority of voting shares. Parent entity must prepare consolidated statements, unless it is a wholly owned subsidiary itself, or there is no objection from the minority. Exclusion of subsidiaries from consolidation: only where investment held for resale and control is temporary (under 12 months). IAS 27 Consolidated and separate financial statements.
Definition IAS 27: ‘Control is the power to govern the financial and operating policies of an entity, so as to obtain benefits from its activities’.
Study tip Always look carefully at the facts in an example to determine whether genuine control exists. Ownership of >50% of the ordinary shares of another entity does not always result in control.
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–––––––––––––––––––––––––––––––––––––– Consolidated Balance Sheet 1
Aggregation principle Assets and liabilities A consolidated balance sheet is a single statement that shows all of the assets and liabilities over which the parent entity has control. 100% of the assets and liabilities of the parent and its subsidiaries are aggregated.
Remember Consolidated reserves comprise the reserves of the parent, plus its share of the post-acquisition reserves of its subsidiaries, less any amounts written off in respect of impairment.
Eliminated items Investments in subsidiaries are eliminated, because the assets and liabilities of the subsidiaries are included instead. Issued share capital and share premium of subsidiaries are eliminated. Pre-acquisition reserves of subsidiaries are eliminated.
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Consolidated Balance Sheet 1
Calculating goodwill on acquisition Goodwill on acquisition is the excess of the amount paid for an investment over the fair value of the net assets acquired. Goodwill on acquisition is carried as an asset in the consolidated balance sheet. The asset is written down only if there is subsequent evidence of impairment.
Remember The treatment of goodwill on consolidation is determined by IFRS 3 Business Combinations. Goodwill should be tested for impairment annually.
Minority interests Aggregation principle: show 100% of the assets and liabilities controlled by the parent in the consolidated balance sheet. BUT subsidiaries are not always 100% owned: the proportion not wholly owned ¼ minority interest. Minority share of the net assets is shown on one line in the consolidated balance sheet.
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–––––––––––––––––––––––––––––––––––––– Consolidated Balance Sheet 1
Intra-group balances
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Principles and practice Intra-group trading usually results in intra-group receivables and payables at the year end. The consolidated balance sheet shows the assets and liabilities of the group as a single economic entity. Intra-group items must therefore be eliminated. Net off intra-group receivables and payables. Sometimes, there is cash or inventory in transit. Recognise the in transit items and then complete elimination of intra-group balances.
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Consolidated Balance Sheet 2 Preparing more complex consolidated balance sheets
Topics
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Non-equity investments by parent Elimination of intra-group dividends and interest Elimination of unrealised intra-group profits Uniform accounting policies Introduction to adjustments for fair value 13
Consolidated Balance Sheet 2
Non-equity investments by parent
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Investments in preferred shares and/or loan instruments Investment by parent in a subsidiary’s loan instrument should be cancelled on consolidation (the parent’s asset cancels out the subsidiary’s liability). Investment by parent in preferred shares involves calculation of minority interest in two parts: minority share of net assets financed by preferred shares; and minority share of net assets financed by equity shares. Where amount paid for preferred shares exceeds their fair value, goodwill arises.
Remember The amount of a parent’s investment in the non-equity instruments of another entity is irrelevant for the purposes of determining control or percentage of equity ownership.
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–––––––––––––––––––––––––––––––––––––– Consolidated Balance Sheet 2
Elimination of intra-group dividends and interest Unpaid intra-group dividends and interest on the balance sheet date are recorded in the individual entity financial statements as payables and receivables. For example, a 75% owned subsidiary records a total dividend payable of $10,000 in its balance sheet. Upon consolidation, the proportion payable to the parent ($7,500) is eliminated against the dividend receivable of $7,500 in the parent’s own balance sheet. A balance of $2,500 remains in consolidated payables; this is the amount payable to the minority interest.
Study tip Sometimes, the balance sheets of the individual entities are given before adjustment for intra-group dividends and interest. It is best to adjust the individual financial statements before proceeding with the consolidation.
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Consolidated Balance Sheet 2
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Elimination of unrealised intra-group profits Profits on sales of inventory to other group entities cannot be recognised until the goods are sold outside the group. Until a third-party sale takes place, profits are treated as unrealised in the group. Intra-group profits must be eliminated with a debit to consolidated profits and a credit to the provision for unrealised profits (to be deducted from consolidated inventory). Where profit is recorded in a partly-owned subsidiary, minority interest should be charged with its share of the unrealised profit. Treatment of unrealised profit on intra-group sales of non-current assets is as above, BUT note that adjustments must be made in respect of depreciation in subsequent years.
Remember The provision for unrealised profit is carried forward to the next year. Where there are both opening and closing unrealised profits, only the movement on the provision is reflected in group profits for the year.
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–––––––––––––––––––––––––––––––––––––– Consolidated Balance Sheet 2
Uniform accounting policies The consolidated balance sheet is prepared from a ‘single entity’ perspective. Therefore, all entities in the group must adopt the same accounting policies. IAS 27 Consolidated and separate financial statements requires that, where group entities’ accounting policies differ, adjustments must be made on consolidation to achieve uniformity.
Adjustments for fair value IFRS 3 Business combinations requires that the net assets of a newly acquired subsidiary should be included at their fair values at the date of acquisition. Adjustments are therefore often required to increase or decrease the subsidiary’s assets and/or liabilities.
Study tip If any adjustments are required in order to achieve uniform accounting policies, these should be made before proceeding with the consolidation.
Definition Fair value is the amount of cash that would be paid or received in exchange for an asset in an arm’s-length transaction.
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The Consolidated Income Statement Preparing a consolidated income statement and statement of changes in equity
Key Study System questions
Topics
Question 5 Objective test questions 4, 8 and 9
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Basic principles Intra-group transactions 19
The Consolidated Income Statement
Basic principles
Remember The basic principles underlying the preparation of the consolidated income statement and statement of changes in equity, are the same as those underlying the preparation of the consolidated balance sheet.
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A consolidated income statement presents the results of all group entities. A consolidated statement of changes in equity presents the changes in equity for the group. The results of the parent and its subsidiaries are aggregated. Intra-group investment income is eliminated. Minority interests are shown on one line below profits after tax. The dividends figure in the statement of changes in equity is for the parent entity only. The statement of changes in equity comprises the parent’s changes in equity and the group share of the post-acquisition changes in equity of the subsidiaries.
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–––––––––––––––––––––––––––––––––– The Consolidated Income Statement
Intra-group transactions
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Non-equity investments Intra-group interest payable and receivable should be eliminated on consolidation. Minority interests, in respect of investments in preferred shares, should be aggregated with minority interests in respect of equity shares.
Remember Where the unrealised profit was made in a partly-owned subsidiary, the appropriate share of the adjustment must be made to minority interest.
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Intra-group trading Intra-group revenue must be eliminated IN FULL. Unrealised profit on intra-group revenue must be eliminated from profit via a deduction from group gross profit.
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Associates and Joint Ventures Explaining the conditions for classification of investments as associates or joint ventures, and their inclusion in group financial statements
Key Study System questions Question 4 Objective test questions 11, 12 and 13
Topics
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Investments in associates Interests in joint ventures The equity method of accounting The proportional consolidation method of accounting 23
Associates and Joint Ventures
Investments in associates
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An investment over which a parent entity exerts significant influence. This is the power to participate in the financial and operating policy decisions of the entity, evidenced in one or more of the following: Board representation. Participation in policy-making. Existence of material transactions between the group and the entity. Interchange of managerial personnel. Provision of essential technical information. A holding of more than 20%, but less than 50%, suggests (but does not ensure) that the investor exerts significant influence.
Definition IAS 28 Accounting for associates defines an associate as follows: ‘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’.
Remember Investments in associates are consolidated using the equity method of accounting.
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–––––––––––––––––––––––––––––––––––––– Associates and Joint Ventures
Interests in joint ventures Joint ventures involve two or more venturers bound by a contractual agreement. The nature of the agreement must be such that it establishes joint control of the operation.
IAS 31 Interests in joint ventures defines a joint venture as: ‘A contractual arrangement whereby two or more parties undertake an economic activity that is subject to joint control’.
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The accounting method varies depending on the nature of the joint venture: Jointly controlled operations: the individual financial statements of each venturer include assets and liabilities controlled, and share of income and expenses. Jointly controlled assets: share of jointly controlled assets and liabilities, share of income and expenses to be included. Jointly controlled entities: in group statements use either proportionate consolidation or the equity method of accounting.
Definition
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Associates and Joint Ventures
The equity method of accounting
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Key features Also referred to as ‘one-line’ consolidation. In the consolidated balance sheet, investments in associates comprise the group share of the associate’s assets and liabilities, plus any unimpaired goodwill. In the consolidated income statement, share of income from investments in associates is shown on one line, before tax. There is no elimination of intra-group balances between parent and associate. But adjustments for unrealised profit should be made, with the balance sheet adjustment to the one line ‘investment in associate.’
Study tip It is important to be able to compare and contrast the equity method of accounting with the acquisition method applied to subsidiaries. Written questions may be set in this area in the exam.
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–––––––––––––––––––––––––––––––––––––– Associates and Joint Ventures
The proportional consolidation method of accounting
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Key features Assets and liabilities of the joint venture are aggregated on a line-by-line basis with those of the parent entity and its subsidiaries. BUT, only the group share of the assets and liabilities is aggregated. Income and expenses are aggregated on a line-by-line basis with those of the parent entity and its subsidiaries. BUT, only the group share of the income and expenses is aggregated. No minority interest is accounted for (because only the group’s share is taken into account in the consolidation).
Study tips Written questions: be prepared for questions that require explanations of the proportional method of accounting contrasted with equity and acquisition methods. Limited applicability: proportional consolidation is used only in accounting for joint ventures. DO NOT consolidate associates or subsidiaries using this method.
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Complex Group Structures Preparing consolidated financial statements for more complex groups
Topics Key Study System questions Objective test question 14
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Accounting for sub-subsidiaries Mixed groups Indirect investments in associates or joint ventures 29
Complex Group Structures
Accounting for sub-subsidiaries Where a parent (entity A) has a subsidiary (entity B) that itself has a subsidiary (entity C), then C is a subsubsidiary of A. Because A controls B, and B controls C, then A controls C, and C must be line-by-line consolidated in the group financial statements. A’s interest in C is 75% x 80% ¼ 60%. The minority interest is 40%. NB: 1. Goodwill for C is calculated and then the portion representing the parent’s interest (80%) is included in the consolidated balance sheet. 2. Date of acquisition: C becomes a sub-subsidiary of A on the date A acquires B.
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–––––––––––––––––––––––––––––––––––––––– Complex Group Structures
Mixed groups Sometimes, a parent has both a direct and an indirect investment in a subsidiary. In this case, A’s interest in C is both direct and indirect: A holds 10% of C’s shares. Added to the indirect holding of 60% (75% x 80%), this gives A an interest of 70%. The minority interest is therefore 30%. Note that two stages will be involved in the calculation of goodwill on the acquisition of C: A’s share of the goodwill on the acquisition by B, and A’s goodwill in respect of its direct acquisition.
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Complex Group Structures
Indirect investments in associates or joint ventures Key points
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Where a partly-owned subsidiary has an interest in an associate: The minority interest in the subsidiary must be credited with their interest in the associate. Goodwill is calculated in the same way as for a sub-subsidiary, but in accordance with equity accounting principles, it is added to the group share of the net assets of the associate. The amount of retained profit recognised by the ultimate parent should represent its effective interest in the associate.
Note that the same points apply to a joint venture which is equity accounted.
But note that Where proportional consolidation is applied in respect of a joint venture interest owned by a subsidiary, it is important to use the correct percentage for the group interest. 32
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Acquisitions in the Accounting Period Preparing consolidated financial statements to reflect an acquisition in the period, and incorporating fair value adjustments
Topics Key Study System question Objective test question 17
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IFRS 3 Business combinations – requirements relating to fair value Acquisitions during the accounting period Piecemeal acquisitions 33
Acquisitions in the Accounting Period
IFRS 3 – Fair value requirements
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Principles Purchase consideration and the group share of net assets acquired must be measured at fair values. The difference between the two is goodwill. Assets and liabilities of the subsidiary at acquisition should be recognised separately if they satisfy the criteria of IFRS 3:
An asset is to be recognised if it is probable that future economic benefits will flow to the acquirer, and if its fair value can be measured reliably. A liability (other than a contingent liability) should be recognised if it meets IAS 37 criteria. A contingent liability should be recognised if its fair value can be measured reliably.
Note Normally, contingent liabilities are not recognised in financial statements (unless they meet IAS 37’s criteria for recognition). Note the different treatment required in respect of the fair value exercise upon acquisition.
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–––––––––––––––––––––––––––––––––– Acquisitions in the Accounting Period
IFRS 3 – Fair value requirements
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Specific assets and liabilities Consideration: where it comprises equity shares, fair value is the published price of the equity instruments. Fair value also includes any directly attributable costs. Property, plant and equipment: fair value is normally depreciated market value. Inventory: fair value is normally market value. Investments in listed financial instruments: normally the price quoted at the date of acquisition. Monetary assets and liabilities: amounts receivable or payable. Provisions for restructuring: no provisions can be made for future expected losses.
Note Normally, the fair value of monetary assets and liabilities is the same as recorded book value. However, in some cases – e.g., long-term borrowings – fair value (represented by discounted present value) is materially different from book value. In this case, discounted present value should be used.
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Acquisitions in the Accounting Period
Acquisitions during the accounting period
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Treatment of dividends paid by a new subsidiary entity
In the year of acquisition the subsidiary’s profit for the period must be split into pre- and post-acquisition amounts. A figure for total pre-acquisition reserves is required for the correct calculation of goodwill.
Note Unless otherwise stated in an examination question, it is safe to assume that profits accrue evenly over the accounting period.
Paid after the date of acquisition: the parent entity receives its share of the dividend, which is credited to income in its own financial statements. But note that a large dividend paid shortly after acquisition may be regarded as giving rise to a reduction in carrying value of the investment. Paid before the date of acquisition: the parent entity receives no part of the dividend.
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–––––––––––––––––––––––––––––––––– Acquisitions in the Accounting Period
Piecemeal acquisitions
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Sometimes, a subsidiary interest is acquired in stages rather than as one purchase. The following situations may arise, and are examinable: Increasing a stake in an entity that is already a subsidiary. Increasing a stake to take an associate to a subsidiary. Increasing a stake to take a trade investment to a subsidiary.
Study tip If the principles of consolidation have been thoroughly understood, piecemeal acquisitions should present no particular problems. The calculations, however, are likely to be a little more complex. Students should ensure that they present full workings for all consolidation questions as neatly and logically as possible.
In the first two cases, the goodwill calculation will be done in two stages. Time apportionment of profits in the year(s) of acquisition will be required. In the third case, the original trade investment stake would not have been consolidated, and the goodwill calculation will be based on the total cost of investment.
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Disposals in the Accounting Period Examining the impact of the disposal of all or part of an investment in a subsidiary
Topics Key Study System questions Questions 1 and 17
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Disposal of the Partial disposal Partial disposal Partial disposal
whole of an investment in a subsidiary leading to a reduced subsidiary interest leading to an investment in an associate leading to a trade investment 39
Disposals in the Accounting Period
Disposal of the whole investment
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Key points Where a subsidiary interest is disposed off completely, no balances relating to that subsidiary are included in the consolidated balance sheet. A consolidated profit or loss on disposal must be calculated. Sometimes it is also necessary to calculate the profit or loss on disposal in the parent’s own books, so as to calculate the tax charge or credit. Where the disposal has taken place part-way through the year, revenue and expenses of the subsidiary must be time-apportioned and the correct proportion included in the consolidated income statement.
Remember The consolidated gain or loss on disposal of a subsidiary is calculated as follows: $000 Sale proceeds
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Less: reduction in the carrying value of the identifiable net assets relating to the disposal
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Less: unimpaired goodwill on acquisition relating to the disposal Gain/loss on disposal before tax
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––––––––––––––––––––––––––––––––––– Disposals in the Accounting Period
Partial disposal – reduced subsidiary interest
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Key points Gain or loss on disposal is calculated as shown on previous card, but care is needed in calculating the net assets relating to the disposal. A subsidiary interest remains, and so the assets and liabilities of the subsidiary are consolidated 100% on a line-by-line basis at the period end. Note, however, that the minority interest proportion increases and unimpaired goodwill decreases. Revenue and expense items for the subsidiary are consolidated 100% on a line-by-line basis for the period. Note, however, that the minority interest proportion increases.
Remember The principles of consolidation. At the period end, the parent retains a controlling interest in the subsidiary, even though its ownership percentage is lower. Therefore, 100% consolidation of net assets is required.
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Disposals in the Accounting Period
Partial disposal – leading to investment in associate
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Key points Gain or loss on disposal is calculated as before, but care is needed in calculating the net assets relating to the disposal. By the period end, only an associate interest remains. This is shown on a single line in the consolidated balance sheet. Note that the investment in associate will include a proportion of the original unimpaired goodwill. The consolidated income statement will include revenue and expenses relating to the subsidiary, up till the date of disposal. Thereafter, the income from the investment will be shown on one line: ‘share of profits of associate’, in accordance with equity accounting principles.
Study tip Chapter 8 of the Study System contains a detailed example demonstrating the impacts of the various levels of disposals. If the principles are not yet clear, work through the example again.
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––––––––––––––––––––––––––––––––––– Disposals in the Accounting Period
Partial disposal – leading to a trade investment
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Key points Trade investments are normally shown at cost. However, where a trade investment is a residual following disposal, it is often calculated on an equity basis; i.e., the sum of the residual share of net assets at the date of disposal, plus any unimpaired goodwill relating to the shares retained. The revenue and expenses of the subsidiary, up to the date of the partial disposal, must be included in the consolidated income statement, followed by the appropriate deduction in respect of the minority interests.
Remember By the period end, there is no longer an investment in a subsidiary, and so the assets and liabilities are not consolidated on either an acquisition or equity basis.
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Business Reorganisations Explaining the principles involved in accounting for a capital reconstruction scheme
Topics Key Study System questions Question 7
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Reorganisations – principal features Current and future developments Examples of intra-group reorganisation schemes 45
Business Reorganisations
Reorganisations – principal features
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Reorganisations commonly take place in the following circumstances: Debit balance on reserves. Reorganisation forced by a group of stakeholders. A haphazardly constituted group requires an improved ownership structure. To facilitate flotation. To facilitate disposal of an investment. Hiving off part of a business into a separate group (demerger).
Note In many jurisdictions, entities are permitted to reduce their share capital, enter into a scheme of arrangement with their stakeholders, transfer business to a new entity, and purchase their own shares. These mechanisms can help to facilitate reorganisation schemes.
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–––––––––––––––––––––––––––––––––––––––– Business Reorganisations
Current and future developments Currently: there is little regulatory guidance in this area. IFRS 3 briefly discusses reverse acquisitions. Note that application of substance over form may help in determining the acquirer in reverse acquisitions. Future developments: the IASB continues to work on phase 2 of its business combinations project. Some issues relating to reconstructions and demergers are likely to be covered in a future accounting standard. Note the possibility of ‘fresh start’ accounting for business combinations. Guidance is required on such issues as business combinations achieved by contractual arrangements.
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Business Reorganisations
Intra-group reorganisation schemes I Transfer a shareholding in a subsidiary from one group entity to another
BEFORE
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Likely to be effected by transferring the investment from one group entity to another, in exchange for a transfer of shares. May be appropriate where management wishes to reconstruct the group in a more ‘hierarchical’ style. Or where management wishes to hive off a sub-group (demerger).
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–––––––––––––––––––––––––––––––––––––––– Business Reorganisations
Intra-group reorganisation schemes II
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Moving a subsidiary upwards in the group hierarchy Prior to reorganisation, entity D has a subsidiary and a sub-subsidiary. The reorganisation involves transferring the subsidiary’s holding in the sub-subsidiary to its parent, D. This creates a ‘flatter’ group structure, which may be more desirable where greater direct control by the parent’s management is required.
BEFORE D 100% E 75% F
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Foreign Currency Transactions Explaining the principles of foreign currency transaction
Topics
Key Study System questions Questions 2, 19 and 20
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IAS 21 The effects of changes in foreign exchange rates Functional and presentation currencies Single transactions in foreign currencies Translating foreign operations Hedging 51
Foreign Currency Transactions
IAS 21 The effects of changes in foreign exchange rates Note: this IAS was extensively revised in December 2003 as part of the IASB’s improvements project. IAS 21’s objective is: ‘to prescribe how to include foreign currency transactions and foreign operations in the financial statements of an entity, and how to translate financial statements into a presentation currency. Two distinct types of foreign activities are covered: 1. Single transactions in foreign currencies 2. The translation of foreign operations.
Definitions Functional currency – the currency of the primary economic environment in which the entity operates. Presentation currency – the currency in which the financial statements are presented.
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––––––––––––––––––––––––––––––––––––– Foreign Currency Transactions
Functional currency
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What is the functional currency of an entity? Which currency influences selling prices? Which country’s competitive forces and regulations determine selling prices? In which currency are funds for financing generated? In which currency are receipts from operations kept? Which currency influences labour, material and other costs?
Note The functional currency of an entity is a matter of fact, although it may be difficult to identify.
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Foreign Currency Transactions
Presentation currency
Note The presentation currency of an entity is a matter of management choice.
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Presentation currency may not be the same as functional currency. Management may choose a different presentation currency because: The entity’s functional currency is relatively obscure and it may be more sensible to report in, e.g., US dollars or Euros. The entity’s principal investors function in another currency.
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––––––––––––––––––––––––––––––––––––– Foreign Currency Transactions
Single transactions in foreign currencies IAS 21 requires that the transaction should be recorded, by translating the foreign currency amount into the entity’s functional currency, by using the spot exchange rate at the date of the transaction.
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Year end translation of assets and liabilities in foreign currencies Non-monetary items remain at the value at which they were originally recorded on the date of the transaction. Monetary items (e.g., liabilities denominated in a foreign currency) should be translated using the closing rate at the entity’s year end. Any gain or loss on exchange is recognised in the income statement for the year.
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Foreign Currency Transactions
Translating foreign operations Assets and liabilities of foreign operations, such as subsidiaries, branches, associates and joint ventures, must be translated into the presentation currency of the reporting entity.
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Method Assets and liabilities should be translated using the closing rate at the balance sheet date. Income and expenses should be translated at the exchange rates in force at the dates of the transactions (or at a representative average rate). All resulting exchange differences are recognised as movements in equity.
Note: goodwill on consolidation should be translated at the closing rate.
Remember Consolidation techniques are the same for foreign operations as for any other business combination. The requirements of IFRS 3, IAS 28, IAS 31 and IAS 27 apply.
Study tip Chapter 10 in the Study System includes a detailed worked example of foreign operation translation. If this aspect of the syllabus is still unclear, revise the example carefully.
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––––––––––––––––––––––––––––––––––––– Foreign Currency Transactions
Hedging
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Sometimes, a foreign currency investment is hedged by a liability in the same currency. A hedging relationship involves a hedged item and a hedging instrument. The hedged item in this context is the investment in the foreign operation. The hedging instrument is a financial liability, whose cash flows are expected to offset cash flows of the hedged item.
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Effects of hedging
Remember If the hedging relationship were not recognised, gains and losses on the hedged item would be recognised in equity, but gains and losses on the hedging instrument would be recognised in the income statement. Hedging allows for recognition of the substance of the relationship between the investment and the loan that finances it.
Gains or losses on the hedged item can be offset against the gains or losses on the hedging instrument.
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Cash-flow Statements Preparing a cash-flow statement for a group of entities
Topics Key Study System questions Objective test questions 17 and 18
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IAS 7 Cash-flow statements Minority interests and associates Acquisitions and disposals in the year 59
Cash-flow Statements
IAS 7 Cash-flow statements Cash flow is defined as inflows and outflows of cash and cash equivalents. A cash-flow statement should be presented using the standard headings specified in IAS 7, and should contain, as a note, a reconciliation between operating profit and net cash inflow or outflow from operating activities.
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Standard headings Cash flow from operating activities. Cash flow from investing activities, returns on investments and servicing of finance. Cash flow from financing activities. Net change in cash and cash equivalents for the period.
Definitions Cash – cash on hand and available upon demand Cash equivalents – short-term, highly liquid, investments that are readily convertible to known amounts of cash and that are subject to an insignificant risk of changes in value.
Remember A group cash-flow statement should report only cash flows that are external to the group. This is in line with the general principles of consolidation covered in previous chapters.
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–––––––––––––––––––––––––––––––––––––––––– Cash-flow Statements
Minority interests One hundred per cent of the cash flows of all subsidiaries that are line-by-line consolidated should be included in the consolidated cash-flow statement. Dividends paid to minority shareholders are cash outflows from the group, and they should be shown as such in the cash flow statement.
Study tip Note that the minority interest and income from associates included in the income statement are not cash flows. The only cash flows involved are in respect of dividends.
Associates The only time that cash flows of the group are affected by investments that are equity accounted is when the investee entity makes a dividend payment. Dividends received from associates should be included as a cash inflow, under ‘cash flow from investing activities’.
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Cash-flow Statements
Acquisitions and disposals in the year
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Key points If a newly acquired investment is to be line-by-line consolidated, cash flows arising in the subsidiary should be included from the date of acquisition. The cash paid to acquire the investment, net of cash or overdrafts brought into the group, should be shown as an outflow of cash under the heading ‘investing activities’. The treatment of disposals in the cash-flow statements is the mirror image of acquisitions. Proceeds from the sale of an investment should be shown as a cash inflow.
Remember Part of the net movement in working capital items may be attributable to acquisitions or disposals. Do not double count working capital movements when an investment is acquired or disposed of during the year.
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Financial Instruments 1 Explaining the disclosure and presentation requirements of IAS 32, showing the possible treatments of financial instruments in the issuer’s financial statements
Topics Key Study System question Objective test question 24
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IAS 32 Financial instruments: disclosure and presentation Debt or equity? Correct classification Complex financial instruments Hybrid financial instruments 63
Financial Instruments 1
IAS 32 Financial instruments: disclosure and presentation
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A financial asset is any of the following: Cash. Contractual right to receive cash. Contractual right to exchange financial instruments on favourable terms. An equity instrument of another entity.
Definition A financial instrument is any contract that gives rise to both a financial asset of one entity and a financial liability or equity instrument of another entity.
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A financial liability is a contractual obligation to either: Deliver cash or another financial asset. Exchange financial instruments under potentially unfavourable conditions. NB: some kinds of financial instrument fall outside the scope of the standard (e.g., interests in subsidiaries, joint ventures and associates).
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––––––––––––––––––––––––––––––––––––––––– Financial Instruments 1
Debt or equity?
Definition Gearing is the relationship between an entity’s borrowings, which includes both prior charge capital and long-term debt, and its shareholders’ funds (ordinary share capital plus reserves).
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The relationship between debt and equity is expressed by the gearing ratio. This is an important measure of an entity’s risk and stability. Therefore, the classification of instruments as debt or equity is very important. Gearing can be manipulated by incorrect classification, e.g.: Employing off-balance sheet financing, or a SPE. Using operating rather than finance leases. Repackaging debt as a sale and purchase agreement. Splitting one transaction into several smaller ones to lessen the impact. Window dressing.
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Financial Instruments 1
Correct classification
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IAS 32 requirements The substance of a financial instrument governs its classification. A contractual obligation to deliver cash or another financial asset to the holder of an instrument, means that the instrument is a financial liability. Where there is no contractual obligation under potentially unfavourable conditions, the instrument is classified as equity. Where there is a requirement for mandatory redemption of the instrument at a fixed or determinable future date, the instrument is a financial liability.
Remember To consider the key accounting principle of substance over form when determining the classification of financial instruments.
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––––––––––––––––––––––––––––––––––––––––– Financial Instruments 1
Complex financial instruments
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Examples Warrants and options giving the holder a right to subscribe for equity shares at a specified price at a specified time. Perpetual debt, providing the holder with the right to receive interest at fixed rates into the indefinite future. Redeemable preference shares, carrying a fixed rate of return. Non-redeemable preference shares. Convertible securities with options to convert at some future date into equity. Financial instruments with contingent settlement. Zero-coupon bonds.
Study tip Examination questions in this area may ask for a decision on the classification of financial instruments as equity or debt, together with explanations for the decision.
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Financial Instruments 1
Hybrid instruments Are those that have characteristics of both debt and equity. The most common example is convertible debt. IAS 32 takes the view that this type of financial instrument creates both debt and equity interests, and that each component should be classified separately. The liability element is valued by reference to the discounted present value of the principal and interest, using a prevailing market interest rate. The equity element is the balancing figure between the total value of the debt issue and the liability element.
Study tip Question 4 on the Pilot Paper for Financial Analysis requires, for 10 marks, the calculation of the liability and equity elements of a hybrid instrument.
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Financial Instruments 2 Identifying circumstances in which amortised cost, fair value and hedge accounting are appropriate for financial instruments
Topics Key Study System questions Questions 18 and 20 Objective test question 25
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IAS 39 Financial instruments: recognition and measurement Initial classification of financial instruments Measurement principles and subsequent measurement Derivatives Hedging 69
Financial Instruments 2
IAS 39 Financial instruments: recognition and measurement Financial assets and financial liabilities are defined in the standard in exactly the same way as in IAS 32. They include items such as deposit available on demand or after the lapse of time, commercial debt, loans receivable and payable, asset backed securities and derivatives such as forward contract and futures contracts.
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A financial asset or liability should be recognised once the entity becomes party to the contractual provisions of the instruments. All financial assets and liabilities should be recognised on an entity’s balance sheet. This includes derivative financial instruments.
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Recognition
Most national accounting systems have not so far required recognition and measurement of derivatives, so this new requirement in IAS 39 is highly significant.
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––––––––––––––––––––––––––––––––––––––––– Financial Instruments 2
Initial classification of financial instruments
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Financial assets should be classified initially as one of the following: Financial assets held for trading. Loans and receivables. Held-to-maturity investments. Available-for-sale financial assets.
Financial instruments that do not fall into one of the first three categories are classified normally as ‘available-for-sale’. Classification is important, because it determines the valuation principles that are applicable to the financial instrument.
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Financial Instruments 2
Measurement principles
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Subsequent measurement Financial assets held for trading – fair value. Loans and receivables – amortised cost, using the effective interest rate method. Held-to-maturity investments – amortised cost, using the effective interest rate method. Available-for-sale financial assets – fair value. Financial liabilities should be measured at amortised cost, using the effective interest rate method.
Remember That fair value accounting will give rise to gains and losses; these should be taken to the income statement, except in the case of available-for-sale, where gains and losses go to the statement of changes in equity.
Initial measurement should be at fair value. This is likely to be quoted market price, where available. Otherwise, a valuation technique based on market conditions should be used. If no market value is available, and no fair value can be estimated, the financial instrument should be measured at cost less any impairment.
And also IAS 39 allows entities to opt to account for any financial asset at fair value.
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––––––––––––––––––––––––––––––––––––––––– Financial Instruments 2
Derivatives
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A derivative has all three of the following characteristics: Its value changes in response to a change in a specified price or rate. It requires no initial net investment. It is settled at a future date.
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Examples of derivatives: Forward contracts for commodities or foreign currencies. Options to buy (call option) or to sell (put option) a specified quantity of a financial instrument, commodity or currency at a specified price.
Remember The intention of IAS 39 is that users of financial statements should be given enough information to be able to assess the performance of management in setting up and handling this type of transaction. Therefore, derivatives should be recognised and should be measured at fair value.
Derivatives must be valued at fair value.
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Financial Instruments 2
Hedging Hedging is part of management’s strategy to reduce risk and volatility in managing assets and liabilities. IAS 39 permits hedge accounting.
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Key points Hedging permits the offset of gains and losses on the hedging item and its hedging instrument. Hedging relationships must be designated, so as to avoid manipulation of reported profits and losses. Hedge effectiveness must be assessed. If the hedge is proved to be ineffective, hedge accounting must be discontinued.
Remember Hedging establishes a relationship between a hedging instrument and a hedged item.
Definitions A hedged item is an asset, liability, or commitment that exposes the entity to risk of changes in fair value or future cash flows. A hedging instrument is a designated financial asset or liability, whose fair value or cash flows are expected to offset changes in the fair value or cash flows of a designated hedged item.
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Changing Price Levels Examining measures to reduce distortion in financial statements when price levels change
Topics Key Study System questions Questions 14 and 16 Objective test question 22
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Defects of historical cost accounting Maintenance of capital Entry and exit value accounting Current cost accounting Current purchasing power accounting 75
Changing Price Levels
Defects of historical cost accounting
Remember Financial statements are intended to provide information useful to a wide range of users in making economic decisions. It is questionable whether historical cost accounting is capable of producing reliable financial statements, especially when price levels are changing rapidly.
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Historical cost accounting is defective, especially in times of rapid price level increases: Current revenue values are matched with costs incurred at an earlier date. Cost of sales is likely to be understated. The book value of assets may bear no relationship to the current value of the asset. In consequence, measurements of return on capital employed are likely to be unrealistically positive. Comparison of financial statements over time will be unreliable. Holding gains and losses are not recognised. Depreciation tends to be unrealistically low, so that profits may be overstated.
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–––––––––––––––––––––––––––––––––––––––––– Changing Price Levels
Maintenance of capital Where price levels change, there is a risk that entities will fail to maintain their capital. To ensure that an entity is as well off at the end of a period as it was at the beginning (i.e. its capital is maintained), some allowance should be made for diminution in the value of money during the period. Otherwise, there is a risk of making distributions out of capital. Maintenance of physical capital: profit is earned only if the physical productive capacity of the entity at the end of the period exceeds that at the beginning, after excluding distributions to, and contributions from, owners. Maintenance of financial capital: profit is earned only if the financial amount of the net assets at the end of the period exceeds the financial amount of the net assets at the beginning, after excluding distributions to, and contributions from, owners.
Note In times of changing price levels, financial statements prepared under the historical cost accounting convention may appear to maintain capital, but, in real terms, it may be diminishing rapidly.
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Changing Price Levels
Entry and exit values Financial statements could be prepared using either entry or exit values (or a combination). Entry values are also known as replacement costs. Using replacement costs instead of historical costs in times of rising prices, tends to result in higher asset values, higher depreciation and revaluation surpluses (holding gains). Entry value (replacement cost) accounting separates holding gains from operating profits, and allows for clear identification of distributable profits. Exit values are also known as realisable values. Using realisable values in a balance sheet provides information relevant to investors and lenders (allowing the latter to judge the extent to which their lending is covered by assets at realisable values).
Definition Replacement cost is ‘the price at which identical goods or capital equipment could be purchased at the date of valuation’.
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–––––––––––––––––––––––––––––––––––––––––– Changing Price Levels
Current cost accounting (CCA)
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Features Adopts the principle of Value to the Business, which is the lower of replacement cost and recoverable amount. Balance sheet values can be a mixture of net realisable values, replacement costs, and value in use. The CCA income statement adjusts historical cost profit, using up to four adjustments: the cost of sales adjustment (COSA), the depreciation adjustment, the monetary working capital adjustment (MWCA) and the gearing adjustment. CCA is based on the concept of physical capital maintenance.
Study tips Ensure that you are able to identify the advantages and disadvantages of the CCA system. Be aware of the purpose and nature of each of the principal income statement adjustments.
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Changing Price Levels
Current purchasing power accounting (CPP)
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Features Movements in a general price index are used to adjust non-monetary items in the balance sheet. Revenue and expense items are adjusted so that they are expressed in comparable terms. A gain or loss on holding monetary items is recognised in the CPP income statement. CPP is based on the concept of financial capital maintenance.
Study tips Ensure that you are able to identify the advantages and disadvantages of the CPP system. Examination questions will test understanding of the concepts underpinning the various methods of accounting for changing price levels, and may require interpretation of financial statements adjusted for price changes. However, there will be no requirement to prepare a set of adjusted statements.
Remember The ‘real terms’ system incorporates elements of the CCA and CPP systems. 80 —————————————————————————————————————————
Measurement of Income and Capital Explaining topics including the application of the substance over form principle and accounting for employee benefits
Topics Key Study System questions Questions 9, 15, 18 and 19 Objective test questions 20 and 23
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IAS 19 Accounting for employee benefits Defined benefit plan accounting Substance over form IAS 18 Revenue 81
Measurement of Income and Capital
IAS 19 Accounting for employee benefits
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Objectives The cost of providing employee benefits should be matched as far as possible with the benefit derived from employees’ service. The employer should recognise the costs of employee benefits on a systematic and rational basis.
Definitions A defined benefit plan is one in which the rules specify the benefits to be paid. A defined contribution plan is one in which the benefits are directly determined by the value of contributions paid in respect of each member.
Defined contribution plan: pension costs payable should be charged against the profits of the period. Defined benefit plan: accounting and estimation techniques involved are much more complex. See next card.
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–––––––––––––––––––––––––––––––––– Measurement of Income and Capital
Defined benefit plan accounting
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The steps involved Use actuarial techniques to estimate the amount of benefit earned by employees in the period. Discount the benefit to determine the present value of the obligation and current service cost. Current service cost and interest cost to be charged in the income statement. Determine fair value of plan assets. Calculate the expected rate of return on opening fund assets and use to reduce charge to income statement. Determine actuarial gains and losses. Use 10% ‘corridor’ rule to determine charge/credit to income statement.
Study tip Be prepared to answer both calculation based questions and discussion type questions on this topic. It is possible that one question could involve both calculation and explanation.
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Measurement of Income and Capital
Substance over form There is no separate standard on this topic, although IAS 1 sets out the general principle of substance over form, and IASs 18 and 39 are also of relevance.
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Substance over form issues Consignment stock. Factoring of receivables. Derecognition of financial assets and liabilities. Off-balance sheet financing arrangements, including quasi-subsidiaries. Special purpose entities (SPEs).
Note The SIC’s guidance: an SPE should be consolidated when the substance of the relationship between an entity and the SPE indicates control.
SIC-12 Consolidation: special purpose entities is relevant.
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–––––––––––––––––––––––––––––––––– Measurement of Income and Capital
IAS 18 Revenue Revenue from sale of goods
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Revenue should be recognised: Provided that the significant risks and rewards of ownership have been transferred to the buyer, and the entity retains no significant involvement. If it can be measured reliably. It is probable that economic benefits will flow to the entity. The transaction costs can be measured reliably.
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Revenue from sale of services Revenue should be recognised by reference to the state of completion of the transaction.
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Techniques of Ratio Analysis Calculating a full range of accounting ratios
Topics
Key Study System questions Objective test questions 26 and 27
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Identifying the users of financial statements Performance ratios Liquidity ratios Analysis of capital structure Valuation and investor ratios Cash-flow statement analysis 87
Techniques of Ratio Analysis
Identifying the users It is important to be aware of the needs of the various groups of users of financial statements. The analysis of financial statements may vary, depending upon the perspective of the user.
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User groups
Study tip Examination questions often ask for an analysis prepared for a specific type of user. It is important to be selective in calculating ratios, in order to gear the analysis towards specific user needs.
Present and potential investors. Lenders and potential lenders. Suppliers and creditors. Employees. Customers. Governments and their agencies. The general public.
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–––––––––––––––––––––––––––––––––––––– Techniques of Ratio Analysis
Performance ratios
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Profitability ratios Gross profit margin. Operating profit margin. Net profit margin. EBITDA.
Study tip It is important to be able to calculate ratios quickly under examination conditions; therefore, ensure that you know the formulae thoroughly.
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Activity ratios Asset turnover. Inventory turnover.
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Return on capital ratios Return on capital employed. Return on assets. Return on shareholders’ funds. 89 —————————————————————————————————————————
Techniques of Ratio Analysis
Liquidity ratios
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Working capital analysis Current ratio. Quick or acid-test ratio. The working capital cycle. Receivables days. Payables days.
Also, the analysis of an entity’s liquidity could commence with a review of the cash position. Has there been a significant increase or decrease in bank balances? Is the overdraft near to its permitted limit? Analysis of the cash flow statement can yield further useful information about the entity’s liquidity position.
Remember There are no ‘ideal’ ratio numbers. Much depends upon norms and expectations in the industrial sector in which the entity operates, and upon the stage the entity has reached in the business cycle.
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–––––––––––––––––––––––––––––––––––––– Techniques of Ratio Analysis
Analysis of capital structure The gearing ratio is an important measure of risk. It is likely to be of particular interest to the investor and lender groups. Increasing levels of debt tend to increase risk for long-term creditors, who may demand higher rewards, thus decreasing resources available for shareholders. But, appropriate use of debt capital can assist in increasing rewards available to shareholders.
Remember Not to assume automatically that debt capital is a problem. Sensible levels of gearing can increase returns to investors.
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Relevant ratios Gearing. Interest cover.
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Techniques of Ratio Analysis
Valuation and investor ratios
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Useful ratios Earnings per share. Price earnings (P/E) ratio. Profit retention ratio. Dividend payout ratio. Dividend yield. Dividend cover. Book value per share.
Remember That all ratios must be interpreted with care. In an examination question try to link the analysis to the business circumstances sketched out in the scenario.
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–––––––––––––––––––––––––––––––––––––– Techniques of Ratio Analysis
Cash-flow statement analysis
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Useful analysis techniques Comparison of subtotals for cash flows from operating activities, investing activities and financing activities over time. Cash return on capital employed. Cash generated from operations compared to total debt. Net cash from operating activities compared to capital expenditure.
Study tip In most questions relatively few marks are awarded for pure calculation of ratios. Do not, therefore, spend most of the allotted time on calculation. In most questions the quality of the written analysis earns the most marks.
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Interpretation of Financial Statements Analysing financial statements and preparing a concise report
Topics Key Study System questions Questions 10, 11 and 13
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Horizontal, vertical and common size analysis Addressing examination questions Types of interpretation and analysis questions Segment analysis 95
Interpretation of Financial Statements
Horizontal, vertical and common size analysis Horizontal analysis examines the changes between two or more sets of figures (e.g., increases/decreases in revenue figures over time). Where several years’ figures are available, horizontal analysis can reveal trends over time. Vertical analysis involves expressing each of the figures in a primary financial statement (usually income statement and/or balance sheet) as a percentage of one key figure. The key figure used in the income statement is usually revenue and, in the balance sheet, total assets. Common size analysis extends vertical analysis over several periods. This can be a very useful technique in tracking trends.
Study tip Time and space constraints limit the amount of data that can be provided in an examination question, so it is unlikely that extensive horizontal or common size analysis would be required. However, the techniques may be applicable to specific income statement or balance sheet items.
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–––––––––––––––––––––––––––––––––– Interpretation of Financial Statements
Addressing examination questions
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Key points Often a specific type of user will be addressed in an analysis of financial statements. Ratios should be carefully selected to suit the circumstances. It is likely that some calculations will be required. These should usually be placed in an appendix. Unless the question clearly indicates that a large number of marks is to be awarded for calculation (unusual), time spent on this exercise should be restricted. The report or summary of analysis should be written in an appropriate style and should be well-organised.
Study tip Two 25 mark analysis and interpretation questions were included in the Pilot Paper for Financial Analysis. These are good examples of the type of longer questions that will be set in this area.
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Interpretation of Financial Statements
Types of interpretation and analysis question Study tip It is quite possible that short questions on interpretation and analysis will be set in Section A of the paper for 2-4 marks, or in Section B for 10 marks (see question 2 of the Pilot Paper for example).
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Note: this is not an exhaustive list! Other types of questions may be set. Report on a given extract from a set of financial statements. Typically, an income statement or balance sheet or cash flow statement will be provided. Report on a set of ratios provided in the question. This type of question would probably require no further calculations. Make adjustments to a set of financial statements and compare ratios before and after the adjustments. Report on segment information. Calculation of earnings per share and comment on the results of the calculation.
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–––––––––––––––––––––––––––––––––– Interpretation of Financial Statements
Segment analysis The scope of IAS 14 Segment reporting is limited to those entities that have publicly traded securities.
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Key points Each reporting entity must select a primary and secondary segment reporting format. There is a materiality test in relation to reportable segments. Disclosures for the primary format include: segment revenue, segment result, total segment assets, segment liabilities, cost of acquiring non-current assets in the period, total depreciation and amortisation expense, total of significant other non-cash expenses, aggregate of results of associates and joint ventures.
Remember The choice of reporting formats lies between geographical segments and business segments.
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Earnings Per Share Calculating and interpreting this key accounting ratio
Key Study System questions
Topics
Questions 12 and 19 Objective test questions 28, 29 and 30.
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IAS 33 Earnings per share Effect of share issues in the period Diluted earnings per share 101
Earnings Per Share
IAS 33 Earnings per share Earnings per share is the only accounting ratio whose method of calculation is prescribed in an accounting standard.
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Key points The scope of the IAS is restricted to those entities whose ordinary shares or potential ordinary shares are publicly traded. Basic earnings per share is calculated by dividing net profit attributable to ordinary shareholders by the weighted average of the ordinary shares in issue. The weighted average of the ordinary shares in issue is calculated on a time basis, and reflects issues and repurchases of shares during the accounting period.
Definitions Net profit attributable to ordinary shareholders: consolidated profit or loss for the year after tax, minority interests, preferred share dividends and extraordinary items. Ordinary shares: ‘an ordinary share is an equity instrument that is subordinate to all other classes of equity instruments’.
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––––––––––––––––––––––––––––––––––––––––––– Earnings Per Share
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Issue at full market price: cash or other assets flow into the entity that will generate additional earnings. Earnings are apportioned over the weighted average of shares in issue in the period. Bonus issue: no further resources flow into the entity. The effect is simply to spread the same earnings over a greater number of shares. The bonus fraction is used to calculate the increased number of shares in issue, irrespective of the date of issue. Eps for comparative periods is recalculated on the same basis. Rights issue: some new resources flow into the entity, but there is also a bonus element to the issue.
Remember
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Effect of share issues in the period
The formula for the bonus fraction used to adjust the weighted average of shares in issue in respect of a rights issue: Fair value before the exercise of rights Theoretical ex-rights price
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Earnings Per Share
Diluted earnings per share
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Remember The formula for the diluted eps ratio: Basic earnings þ adjustment for dilutive shares No. of ordinary shares þ adjustment for dilutive shares
Study tip Question 2 in the Pilot Paper for Financial Analysis tests knowledge of diluted earnings per share.
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Issues and Problems in Financial Analysis Explaining the limitations of accounting ratio analysis
Topics
Key Study System questions Question 13
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Limitations of financial reporting information Limitations of accounting ratio analysis Creative accounting methods Motivation to use creative accounting Analysing financial obligations 105
Issues and Problems in Financial Analysis
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Limitations of financial reporting information Orientation towards events in the past. Timeliness – reports may be out of date. Comparisons over time may be invalid because of changes to the business. Comparability over time is often threatened by price inflation. Changes in accounting policies and practice may invalidate comparisons. A business may not be comparable with another, even if they are both in the same sector. The financial statements of two or more businesses with different year ends may not be comparable.
Study tips Examination questions on the interpretation of financial statements often contain a requirement to comment on the limitations of the analysis. Question 7 of the Pilot Paper for Financial Analysis tests the ability to discuss limitations.
And also Financial reporting information may be affected by creative accounting practices.
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––––––––––––––––––––––––––––––– Issues and Problems in Financial Analysis
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Limitations of accounting ratio analysis Except for earnings per share, the calculation of accounting ratios is not prescribed. Care must be taken to ensure that like is compared with like (i.e., the same method has been used). Many accounting ratios are calculated using an average of opening and closing figures. However, these figures may not truly represent the average throughout the period. Ratios may be calculated incorrectly. For example, it is incorrect to include cash sales in calculating the receivables days ratio. Ratio calculations do not supply all the answers. Often, they simply lead to more questions.
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Issues and Problems in Financial Analysis
Creative accounting methods
Note It can be very difficult to draw a distinction between the aggressive use of the options offered by regulation and outright fraud.
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Creative accounting is often intended to mislead the user of financial statements and it may be very difficult to detect, even by an expert. Methods include: Altering the timing of genuine transactions. Exploiting the element of choice permitted by accounting standards. Incorrect capitalisation of expenses. Exclusion of liabilities (via SPEs or other off-balance sheet strategies). Inappropriate revenue recognition. Managing market expectations about forthcoming results.
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––––––––––––––––––––––––––––––– Issues and Problems in Financial Analysis
Motivation to use creative accounting
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Significant factors include: Tax avoidance. Increasing shareholder confidence, so as to avoid share price volatility. Personal gain through, for example, profit-related bonuses. Indirect personal gain via the market for management expertise. Following industry practice. Meeting the conditions of lending covenants.
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Issues and Problems in Financial Analysis
Analysing financial obligations Study tip Wider reading of the financial press and the chapter 19 bibliography is recommended, in order to achieve a good grasp of the issues featured in this section of the syllabus.
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The analyst must be aware of the implications of certain types of financial obligation. These include the following: Redeemable debt. Analysts must take redemption dates into account; a business that is short of liquid funds or already highly geared may find redemption problematical. Contingent liabilities. Provisions are made, under IAS 37, where there is a greater than 50% probability of an obligation occurring. Possible obligations are noted. Earn out arrangements. This is a special type of contingency that may arise upon acquisition of a subsidiary. There may be a contractual obligation to make additional payments if profits exceed a certain level. It is important to read the notes to the financial statements carefully to be aware of these items.
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Non-financial, Environmental and Social Reporting Examining various aspects of non-financial reporting
Topics
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The Operating and Financial Review Social accounting and reporting Reporting financial information relating to the environment Human resource issues The Global Reporting Initiative 111
Non-financial, Environmental and Social Reporting
The Operating and Financial Review (OFR) The UK Accounting Standards Board has issued guidance on the OFR. Inclusion of an OFR is becoming more frequent, both in the UK and internationally.
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Key principles of the OFR Purpose: to assist users, primarily investors, in assessing likely future performance of the business. Time-frame: it should identify factors relevant for assessing future performance. Reliability: it should be free from bias. Comparability: users should be able to use it to make valid comparisons. Measures: it should use widely accepted measures.
Study tip The best way to become familiar with the typical features of an OFR statement is to read some examples. The example of Novartis is used in the Study System, but many other listed entities produce OFRs.
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––––––––––––––––––––––––––– Non-financial, Environmental and Social Reporting
Social accounting and reporting
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Traditional financial reports have failed to deal with interactions with: The natural environment. The sociological environment.
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Social accounting might include: Reporting the environmental impact of the entity’s policies. Measuring and reporting the impact of future obligations to rectify environmental damage. Measuring and reporting the value of human assets. Reporting employment policies. Reporting on intellectual capital. Reporting the entity’s ethical stance.
Study tip Use the end of chapter readings in the Study System to deepen your knowledge and understanding of social accounting and reporting. Also, look out for relevant material in the business press.
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Non-financial, Environmental and Social Reporting
Reporting financial information relating to the environment
Remember Accounting for the costs of environmental impacts is not a theoretical proposition; many entities are affected by the need to make provisions under IAS 37.
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Some examples of possible financial reporting implications: Taxation charges relating to the climate change levy, landfill tax and capital allowances for environmentally friendly investment. Rectification expenditure relating to the pollution of sites by, for example, extractive activities. Provisions for environmental damage. These should be recognised or noted in accordance with IAS 37 requirements. Contingent environmental liabilities.
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––––––––––––––––––––––––––– Non-financial, Environmental and Social Reporting
Human resource issues
Note the problems associated with human asset accounting, bearing in mind the definition of an asset in the IASC’s framework. IAS 38 does not permit the recognition of human assets in the financial statements.
Remember
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Reporting of financial and non-financial social reporting issues could take many forms. Some examples: Employment report. Value-added statements. Quantitative disclosures about, for example, number of fatalities and injuries sustained by the workforce, gender diversity and union membership. Intellectual capital reports. Human asset accounting.
The case of Skandia’s reporting of intellectual capital, which is discussed in the readings at the end of Chapter 20 in the Study System.
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Non-financial, Environmental and Social Reporting
The Global Reporting Initiative (GRI)
Launched in 1997 as a joint initiative of CERES and the UN. Voluntary guidelines for entities wishing to report on sustainability issues. GRI report would be set out under headings:
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Key points
Study tip Keep up to date with GRI developments via the website at www.globalreporting.org
Vision and strategy. Profile. Governance structure. GRI content index. Performance indicators.
GRI performance indicators are grouped into three dimensions: economic, environmental and social.
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International Financial Reporting Identifying cultural influences on financial reporting, and major differences between IFRS and US GAAP
Topics
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Influences on financial reporting Classification systems Harmonisation Convergence between IFRS and US GAAP 117
International Financial Reporting
Influences on financial reporting
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Important influences include: Variations in prevailing methods of providing capital – lending or investment via a stock market. Regulatory systems (which reflect cultural differences). Contrast between common law and legal code systems. Political systems, including the influence of colonial government and geographical proximity. Typical levels of inflation. Language and culture. The relationship between tax and accounting.
Study tip Exam questions in this area might require discussion of the key influences on international accounting variations. Background reading in the recommended textbooks would help to consolidate the Study System coverage.
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Classification systems
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The ‘Anglo-Saxon’ system Common law, with strong accounting profession and large stock exchange. Fair presentation, shareholder orientation, separate tax and accounting rules, substance over form. UK, Australia, Canada, Ireland, the Netherlands.
Study tip Be prepared to contrast these two classification systems, and to discuss in the context of recent developments in international standard setting.
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The ‘Continental’ system Roman law, weak accounting profession, and small stock exchange. Creditor orientation, close tax/accounting link, form over substance. France, Germany, Italy, Japan, Sweden.
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International Financial Reporting
Harmonisation
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Advantages Cost reduction and efficiency increases for multi-nationals. Increased comparability between financial statements. Increased competition and efficiency in capital markets.
And also Note the progress that has been made recently towards international harmonisation via the implementation of International Accounting Standards.
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Barriers to harmonisation Resistance at a national level. Robustness of existing traditions.
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Convergence between IFRS and US GAAP
Remember This is an area of rapid development. It is possible to impress an examiner with up-to-date knowledge. Consult the IASB’s website at regular intervals to keep track of current developments.
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Differences remain between US GAAP and IFRS. But note the convergence project (Norwalk Agreement) launched in Sept. 2002. Examples of work to date: IFRS dealing with disposal of non-current assets and presentation of discontinued operations – to bring international practice into line with US GAAP. Current projects on reducing differences in: Accounting for research and development. Income taxes. Interim reporting.
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