ACCA
Paper F7 (INT)
Financial Reporting
Essential text
British library cataloguing­in­publication data
A catalogue record for this book is available from the British Library.
Published by:
Kaplan Publishing UK
Unit 2 The Business Centre
Molly Millars Lane
Wokingham
Berkshire
RG41 2QZ
ISBN 978 1 84710 543 1
© Kaplan Financial Limited, 2008
Printed and bound in Great Britain.
Acknowledgements
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Management Accountants for permisssion to reproduce past examination questions. The answers
have been prepared by Kaplan Publishing.
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Contents
Page
Chapter 1
The regulatory framework
1
Chapter 2
A conceptual framework
25
Chapter 3
Accounting concepts and policies
37
Chapter 4
Principles of consolidated financial statements
53
Chapter 5
Consolidated statement of financial position
61
Chapter 6
Consolidated income statement
93
Chapter 7
Associates
109
Chapter 8
Tangible non­current assets
125
Chapter 9
Intangible assets
145
Chapter 10
Impairment of assets
159
Chapter 11
Inventories and construction contracts
169
Chapter 12
Financial assets and financial liabilities
181
Chapter 13
Leases
201
Chapter 14
Substance over form
217
Chapter 15
Provisions, contingent liabilities and contingent
assets
231
Chapter 16
Taxation
247
Chapter 17
Reporting financial performance
259
Chapter 18
Earnings per share
275
Chapter 19
Interpretation of financial statements
293
Chapter 20
Statement of cash flows
323
Chapter 21
Questions & Answers
337
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iii
iv
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chapter
Intro
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v
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chapter
1
The regulatory framework
Chapter learning objectives
Upon completion of this chapter you will be able to:
•
•
explain why a regulatory framework is necessary
•
distinguish between a principles­based and a rules­based
framework
•
discuss whether a principles­based framework and a rules­
based framework can be complementary
•
describe the structure and objectives of the International
Accounting Standards Committee (IASC) Foundation, the
International Accounting Standards Board (IASB), the Standards
Advisory Council (SAC) and the International Financial Reporting
Interpretations Committee (IFRIC)
•
describe the IASB’s standard­setting process including revisions
to and interpretations of standards
•
explain the relationship between national standard setters and
the IASB in respect of the standard­setting process
•
describe the structure (format) and content of financial
statements presented under International Financial Reporting
Standards (IFRS)
•
prepare an entity’s financial statements in accordance with
prescribed structure and content
•
distinguish between the primary aims of not­for­profit and public
sector entities and those of profit­orientated entities
•
discuss the extent to which IFRS are relevant to specialised, not­
for­ profit and public sector entities.
explain why accounting standards on their own are not a
complete regulatory framework
1
The regulatory framework
1 The regulatory system
Structure of the international regulatory system
International Accounting Standards Committee (IASC) Foundation
The IASC Foundation:
•
•
•
is the supervisory body for the new structure
has 22 trustees
is responsible for governance issues and ensuring each body is
properly funded.
The objectives of the IASC Foundation are to:
•
2
develop a set of global accounting standards which are of high quality,
are understandable and are enforceable
KAPLAN PUBLISHING
chapter 1
•
which require high quality, transparent and comparable information in
financial statements to help those in the world’s capital markets and
other users make economic decisions
•
•
promote using and applying these standards
bring about the convergence of national and international accounting
standards.
International Accounting Standards Board (IASB)
The IASB:
•
is solely responsible for issuing International Accounting Standards
(IASs)
•
standards now called International Financial Reporting Standards
(IFRSs)
•
•
is made up of 14 members
has the same objectives as the IASC Foundation.
Expandable text
International Financial Reporting Interpretations Committee (IFRIC)
The IFRIC:
•
issues rapid guidance on accounting matters where divergent
interpretations of IFRSs have arisen
•
issues interpretations called IFRIC 1, IFRIC 2, etc.
Expandable text ­ Compliance with IFRSs
Standards Advisory Council (SAC)
The SAC provides a forum for a range of experts from different countries
and different business sectors to offer advice to the IASB when drawing up
new standards.
The development of an IFRS
The procedure for the development of an IFRS is as follows:
•
The IASB identifies a subject and appoints an advisory committee to
advise on the issues.
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3
The regulatory framework
•
The IASB publishes an exposure draft for public comment, being a draft
version of the intended standard.
•
Following the consideration of comments received on the draft, the
IASB publishes the final text of the IFRS.
•
At any stage the IASB may issue a discussion paper to encourage
comment.
•
The publication of an IFRS, exposure draft or IFRIC interpretation
requires the votes of at least eight of the 14 IASB members.
Expandable text ­ Status of IFRSs
Benchmark treatment and allowed alternative treatment
Some older IASs have two choices of treatment of items in the financial
statements:
•
•
the benchmark treatment, and
the allowed alternative treatment.
In future IFRSs:
•
•
If different treatments are allowed they will be given equal status.
No treatment will be designated as the benchmark treatment.
This is the case in IFRS 3 (revised), issued in 2008, which provides a
choice of treatment with regard to goodwill.
The IASB and national standard setters
The intentions of the IASB are:
•
to develop a single set of understandable and enforceable high quality
worldwide accounting standards, however
•
•
the IASB cannot enforce compliance with its standards, therefore
it needs the co­operation of national standard setters.
In order to achieve this the IASB works in partnership with the major national
standard­setting bodies:
•
4
All the most important national standard setters are represented on the
IASB and their views are taken into account so that a consensus can be
reached.
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chapter 1
•
All national standard setters can issue IASB discussion papers and
exposure drafts for comment in their own countries, so that the views of
all preparers and users of financial statements can be represented.
•
Each major national standard setter ‘leads’ certain international
standard­setting projects.
Expandable text
Test your understanding 1
What would be the advantages of international harmonisation of
accounting standards for investors and potential investors?
The regulatory framework
The regulatory framework of accounting in each country which uses IFRS is
affected by a number of legislative and quasi­legislative influences as well
as IFRS:
•
•
•
national company law
EU directives
security exchange rules.
Why a regulatory framework is necessary
A regulatory framework for the preparation of financial statements is
necessary for the following reasons:
•
Financial statements are used by a wide range of users – investors,
lenders, customers, etc.
•
•
•
•
They need to be useful to these users.
•
They regulate the behaviour of companies towards their investors.
They need to be comparable.
They need to provide at the least some basic information.
They increase users’ understanding of, and confidence in, financial
statements.
Accounting standards on their own would not be a complete regulatory
framework. In order to fully regulate the preparation of financial statements
and the obligations of companies and directors, legal and market
regulations are also required.
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5
The regulatory framework
Principles­based and rules­based framework
Principles­based framework:
•
•
based upon a conceptual framework such as the IASB's Framework
accounting standards are set on the basis of the conceptual framework.
Rules­based framework:
•
•
‘Cookbook’ approach
accounting standards are a set of rules which companies must follow.
In the UK there is a principles­based framework in terms of the Statement of
Principles and accounting standards and a rules­based framework in terms
of the Companies Acts, EU directives and stock exchange rulings.
Test your understanding 2
What are the objectives of the IASC Foundation?
2 Preparation of financial statements for companies
IAS 1 Presentation of financial statements
In most jurisdictions the structure and content of financial statements are
defined by local law. IASs are, however, designed to work in any jurisdiction
and therefore require their own set of requirements for presentation of
financial statements. This is provided in IAS 1, revised 2007.
A complete set of financial statements comprises:
•
•
a statement of financial position
either
– a statement of comprehensive income, or
–
•
•
•
an income statement plus a statement showing other
comprehensive income
a statement of changes in equity
a statement of cash flows
accounting policies and explanatory notes.
IAS 1 (revised) does not require the above titles to be used by companies. It
is likely in practice that many companies will continue to use the previous
terms of balance sheet rather than statement of financial position and cash
flow statement rather than statement of cash flows.
6
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chapter 1
The statement of financial position
A recommended format is as follows:
XYZ Group Statement of Financial Position as at 31 December 20X2
Assets
Non­current assets:
Property, plant and equipment
Goodwill
Other intangible assets
$
$
X
X
X
–––
X
Current assets:
Inventories
Trade receivables
Cash and cash equivalents
X
X
X
–––
X
––
X
–––
Total assets
Equity and liabilities
Capital and reserves:
Share capital
Retained earnings
Other components of equity
Total equity
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X
X
X
––
X
––
X
––
7
The regulatory framework
Non­current liabilities:
Long­term borrowings
Deferred tax
Current liabilities:
Trade and other payables
Short­term borrowings
Current tax payable
Short­term provisions
X
X
––
X
X
X
X
––
X
––
X
––
Total equity and liabilities
•
•
X
it will be settled within 12 months of the reporting date, or
it is part of the entity's normal operating cycle.
Within the capital and reserves section of the statement of financial position,
other components of equity include:
•
•
revaluation reserve
general reserve.
Statement of changes in equity
The statement of changes in equity provides a summary of all changes in
equity arising from transactions with owners in their capacity as owners.
This includes the effect of share issues and dividends.
Other non­owner changes in equity are disclosed in aggregate only.
8
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chapter 1
XYZ Group
Statement of changes in equity for the year ended 31 December
20X2
Share
Share Revaluation Retained Total
capital premium
surplus
earnings equity
Balance at 31
December 20X1
Change in
accounting policy
Restated balance
Dividends
Issue of share
capital
Total
comprehensive
income for the year
Transfer to
retained earnings
Balance at 31
December 20X2
$
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
Statement of comprehensive income
Total comprehensive income is the realised profit or loss for the period,
plus other comprehensive income.
Other comprehensive income is income and expenses that are not
recognised in profit or loss (i.e. they are recorded in reserves rather than as
an element of the realised profit for the period). For the purposes of F7,
other comprehensive income includes any change in the revaluation surplus.
IAS 1 allows a choice of two presentations of comprehensive income:
(1) A statement of comprehensive income showing total comprehensive
income , or
(2) An income statement showing the realised profit or loss for the period
PLUS a statement showing other comprehensive income.
Throughout this text, other than where indicated, the second approach will
be adopted.
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9
The regulatory framework
Statement of comprehensive income
A recommended format is as follows:
XYZ Group : Statement of comprehensive income for the year ended
31 December 20X2
$
Revenue
X
Cost of sales
(X)
––
Gross profit
X
Distribution costs
Administrative expenses
Profit from operations
Finance costs
Profit before tax
Income tax expense
Profit for the year
Other comprehensive income
Gain on property revaluation
X
Income tax relating to components of other comprehensive income
(X)
––
Other comprehensive income for the year, net of tax
X
––
X
––
Total comprehensive income for the year
10
(X)
(X)
––
X
(X)
––
X
(X)
––
X
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chapter 1
Income statement plus statement of comprehensive income
A recommended format for the income statement is as follows:
XYZ Group
Income statement for the year ended 31 December 20X2
Revenue
Cost of sales
Gross profit
Distribution costs
Administrative expenses
Profit from operations
Finance costs
Profit before tax
Income tax expense
Net profit for the period
$
X
(X)
––
X
(X)
(X)
––
X
(X)
––
X
(X)
––
X
A recommended format for the presentation of other comprehensive income
is:
XYZ Group
Other comprehensive income for the year ended 31 December 20X2
$
Profit for the year
X
Other comprehensive income
Gain on property revaluation
Income tax relating to components of other Comprehensive income
Other comprehensive income for the year, net of tax
Total comprehensive income for the year
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X
(X)
––
X
––
X
––
11
The regulatory framework
Test your understanding 3
Slamometer, which has traded for many years, has an authorised and
issued capital of 60,000 5.6% redeemable preference shares of $1 and
140,000 ordinary shares of $1. The ordinary shares are fully paid and
qualify as equity shares. The redeemable preference shares qualify as a
liability and are to be treated as such. It also has in issue $20,000 9%
loan notes redeemable on 31 December 20X9.
The income statement for the year ended 31 March 20X4 has been
drafted:
$
Profit on trading
Interest received
Less: Interest on loan notes
Income taxes under ­provided for previous year
$
71,570
910
––––––
72,480
1,800
870
––––––
2,670
––––––
69,810
––––––
The following further information is relevant:
(a) Total sales revenue for the year was $1,013,000.
12
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chapter 1
(b) Profit on trading is calculated after charging:
$
Distribution costs
152,571
Raw materials
366,238
Manufacturing overheads
159,302
Wages of production employees
98,789
Salaries of sales staff
56,400
Depreciation of factory
4,000
Depreciation on plant and machinery
7,300
Office rent
2,300
Management remuneration
91,100
Auditors’ remuneration
1,500
Legal and accounting charges
620
Interest on bank overdraft
1,310
(c) Management remuneration is to be allocated as follows:
Cost of sales
Distribution costs
Administrative expenses
$12,300
$15,300
$63,500
(d) The loan note interest was paid on 31 March 20X4.
(e) Income tax on the profits of the year ended 31 March 20X4 is
estimated at $32,000, based on a rate of 25%.
(f)
The $3,360 dividend for the year on the redeemable preference
shares has been paid and is treated as a finance cost.
(g) The balances on the company’s retained earnings at 1 April 20X3
was $51,700
(h) An ordinary dividend of $18,360 in respect of the year ended 31
March 20X3 was paid during the year.
(i) Slalometer revalued land during the year by $200,000. The tax effect
is a debit of $60,000.
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13
The regulatory framework
Prepare the income statement and statement showing other
comprehensive income of Slamometer Limited for the year ended
31 March 20X4.
Test your understanding 4
The following trial balance has been extracted from the books of Arran
as at 31 March 20X7:
Accounts office rent
Audit fee
Salaries
Irrecoverable debts
General administration
General distribution
Distribution centre storage costs
Advertising
Share capital (all ordinary shares of $1 each)
Share premium
Revaluation reserve
Dividend
Cash at bank and in hand
Receivables
Non­current asset investments
Interest paid
Dividends received
Interest received
Land and buildings at cost (land 100, buildings 100)
Land and buildings: accumulated depreciation
Plant and machinery at cost
Plant and machinery: accumulated depreciation
Retained earnings account (at 1 April 20X6)
Purchases
Sales
Inventory at 1 April 20X6
Trade payables
Bank loan
14
$000 $000
98
22
150
27
125
23
110
40
270
80
20
27
3
233
280
25
15
1
200
30
400
170
235
1,210
2,165
140
27
100
––––– –––––
3,113 3,113
––––– –––––
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chapter 1
Additional information
(1) Inventory at 31 March 20X7 had a cost of $85,000.
(2) Depreciation for the year to 31 March 20X7 is to be charged
against cost of sales as follows:
Buildings
5% on cost (straight line)
Plant and machinery
balance)
30% on carrying value (CV) (reducing
(3) Income tax of $165,000 is to be provided for the year to 31 March
20X7. A dividend of 10c per share was paid. The loan is repayable
in five years.
(4) Non­current asset investments are to be revalued up by $100,000.
(5) Salaries are to be apportioned equally between cost of sales,
administration expenses and distribution costs.
Prepare the statement of comprehensive income, statement of
changes in equity and statement of financial position for year
ended 31 March 20X7.
Note: Show all workings but notes are not required.
3 Not­for­profit and public sector entities
Comparison of aims
The main aims of not­for­profit and public sector entities are very different to
those of profit­orientated entities:
Profit­orientated sector
Not­for­profit/public sector
Financial aim is to make profit
Financial aim is to achieve value for
and increase shareholder wealth. money/provide service.
Directors are accountable to
shareholders.
Managers are accountable to
trustees/government/public.
External finance freely available in Finance limited to donations/
the form of loans and share
government subsidies.
capital.
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The regulatory framework
Accounting standards and not­for­profit and public sector entities
Accounting standards are designed to:
•
•
•
measure financial performance accurately and consistently
report the financial position accurately and consistently
account for the directors' stewardship of the resources and assets.
Not­for­profit and public sector organisations:
•
do not aim to achieve a profit but will have to account for their income
and costs
•
•
will have to account for their effectiveness, economy and efficiency
do not have to produce financial statements for the public (but in many
cases may do so).
Some measurement accounting standards will be relevant such as those
relating to inventory, non­current assets, leasing, etc. Others relating purely
to reporting such as earnings per share (EPS) will not be so relevant.
16
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chapter 1
Chapter summary
KAPLAN PUBLISHING
17
The regulatory framework
Test your understanding answers
Test your understanding 1
Investors increasingly make investment decisions on a worldwide basis,
because businesses progressively operate across national boundaries.
Therefore investors need to compare the financial statements of
companies operating in different countries.
At present most non­domestic investments are made by public
investment companies and unit trusts which employ analysts skilled in
the examination of financial statements from different countries. An
individual investor would have difficulty making an informed investment
decision with the present differences in international financial reporting.
Test your understanding 2
The objectives of the IASC Foundation are to:
(a) develop a set of global accounting standards which are of high
quality, are understandable and are enforceable
(b) require high quality, transparent and comparable information in
financial statements to help those in the world’s capital markets and
other users make economic decisions
(c) promote using and applying these standards
(d) bring about the convergence of national and international accounting
standards.
18
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chapter 1
Test your understanding 3
Slamometer: Income statement for the year ended 31 March 20X4
$
$
Sales revenue
1,013,000
Cost of sales (W2)
(647,929)
––––––––
Gross profit
365,071
Distribution costs (W2)
224,271
Administrative expenses (W2)
67,920
––––––––
(292,191)
––––––––
Profit from operations
72,880
Interest receivable
910
Finance cost $(1,800 + 1,310 + 3,360)
(6,470)
––––––––
(5,560)
––––––––
Profit before tax
67,320
Income tax expense (W1)
(32,870)
––––––––
Profit for the year
34,450
––––––––
Slalometer ­ Other comprehensive income for the year
ended 31 March 20X4
Profit for the year
Other comprehensive income
Gain on property revaluation
Income tax relating to components of other Comprehensive
income
Other comprehensive income for the year, net of tax
Total comprehensive income for the year
KAPLAN PUBLISHING
$
34,450
200
(60)
–––––
140
–––––
34,590
–––––
19
The regulatory framework
Workings
(W1) Taxation
$
32,000
870
––––––––
32,870
––––––––
Income tax at 25%
Tax under­provided in previous year
(W2) Classification of expenses
Cost of Distribution Administrative
sales
costs
expenses
$
$
$
Expenses per note (b)
Distribution costs
Raw materials
Manufacturing overheads
Staff costs
Directors
Depreciation $(4,000 + 7,300)
Office rent
Audit
Legal and accountancy
152,571
366,238
159,302
98,789
12,300
11,300
––––––––
647,929
––––––––
56,400
15,300
63,500
––––––––
224,271
––––––––
2,300
1,500
620
––––––––
67,920
––––––––
Note:
20
•
Ordinary dividends declared/paid in the year are included in the
statement of changes in equity, not the income statement or
statement of comprehensive income.
•
Dividends on redeemable preference shares are always treated as
a finance cost. This is covered in further detail in chapter 12.
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chapter 1
Test your understanding 4
Statement of comprehensive income for the year ended 31 March
20X7
$000
2,165
(1,389)
––––––
776
(295)
(250)
––––––
231
(25)
1
15
––––––
222
(165)
––––––
57
––––––
Revenue
Cost of sales (W1)
Gross profit
Administration (W1)
Distribution (W1)
Operating profit
Finance cost
Interest receivable
Investment income
Profit before tax
Income tax expense
Profit for the year
Other comprehensive income
Gain on property revaluation
100
–––––
157
––––––
Total comprehensive income for the year
Statement of changes in equity
B/f
Total
comprehensive
income for the
year
Dividends
C/f
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Share Share Revaluation Retained Total
capital premium
surplus
earnings equity
$000
$000
$000
$000
$000
270
80
20
235
605
100
57
157
–––
270
–––
80
–––
120
(27)
–––
265
(27)
–––
735
21
The regulatory framework
Statement of financial position as at 31 March 20X7
$000
Non­current assets:
Property, plant and equipment (W2)
Investment (280 + 100)
Current assets:
Inventory
Receivables
Bank
Share capital
Share premium
Revaluation reserve
Retained earnings
Non­current liabilities
Current liabilities ($27 + $165)
22
326
380
85
233
3
–––
321
––––
1,027
––––
270
80
120
265
––––
735
100
192
––––
1,027
––––
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chapter 1
Workings
(W1) Costs
Cost of
sales
$000
Accounts office rent
Audit fee
Salaries
Irrecoverable debts
General administration
General distribution
Distribution centre
Advertising
Purchase
Opening inventory
Closing inventory
Depreciation (5% × 100) + (400 –
170) × 30%
Distribution Admin
$000
50
50
27
$000
98
22
50
125
23
110
40
1,210
140
(85)
74
–––––
1,389
–––––
Total
––––– –––––
250
295
––––– –––––
(W2) Tangible non­current assets
Land and buildings Plant and machinery Total
CV b/f
Depreciation
charge
CV c/f
KAPLAN PUBLISHING
$000
170
(5)
$000
230
(69)
$000
400
(74)
–––––
165
–––––
161
––––
326
23
The regulatory framework
24
KAPLAN PUBLISHING
chapter
2
A conceptual framework
Chapter learning objectives
Upon completion of this chapter you will be able to:
•
•
•
describe what is meant by a conceptual framework
•
explain what is meant by understandability in relation to the
provision of financial information
•
•
•
•
define the qualitative characteristics of relevance and reliability
•
•
•
•
•
•
define recognition in financial statements
•
indicate when income and expense recognition should occur
under the financial position approach.
discuss whether a conceptual framework is necessary
discuss what an alternative system to a conceptual framework
might be
describe the qualities that enhance these two characteristics
define the characteristic of comparability
discuss the importance of comparability to users of financial
statements
explain the recognition criteria in financial statements
apply the recognition criteria to assets
apply the recognition criteria to liabilities
apply the recognition criteria to income and expenses
discuss what is meant by the financial position approach to
recognition
25
A conceptual framework
1 The meaning of a conceptual framework
Introduction
There are two main approaches to accounting:
•
A principles­based or conceptual framework approach such as that
used by the IASB.
•
A rules­based approach such as that used in the US.
What is a conceptual framework?
A conceptual framework is:
•
•
a coherent system of interrelated objectives and fundamental principles
a framework which prescribes the nature, function and limits of financial
accounting and financial statements.
Expandable text ­ Reasons for conceptual framework
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chapter 2
Purpose of the Framework
The conceptual framework published by the IASB is called the Framework. It
includes guidance with regard to
•
•
•
the qualitative characteristics of financial information
the elements of financial statements
recognition of the elements of financial statements.
The purpose of the Framework is to:
•
help the IASB in their role of developing future accounting standards
and in reviewing existing IFRSs
•
help the IASB by providing a basis for reducing the number of
alternative accounting treatments permitted by IFRSs
•
•
help national standard­setting bodies in developing national standards
•
help auditors when they are forming an opinion as to whether financial
statements conform with IFRSs
•
help users of financial statements when they are trying to interpret the
information in financial statements which have been prepared in
accordance with IFRSs
•
provide information to other parties that are interested in the work of the
IASB.
help those preparing financial statements to apply IFRSs and also to
deal with areas where there is no relevant standard
2 Qualitative characteristics of financial information
Introduction
Qualitative characteristics are the attributes that make information provided
in financial statements useful to others.
The Framework identifies four qualitative characteristics:
•
•
•
•
relevance
reliability
comparability
understandability.
All are subject to a threshold quality of materiality.
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A conceptual framework
Materiality
A threshold quality is:
•
one that needs to be studied before considering the other qualities of
that information
•
a cut­off point – if any information does not pass the test of the threshold
quality, it is not material and does not need to be considered further.
Information is material if its omission or misstatement could influence the
economic decisions of users taken on the basis of the financial statements.
This depends on the size of the item or error judged in the particular
circumstances of its omission or misstatement.
Understandability
Understandability depends on:
•
•
the way in which information is presented
the capabilities of users.
It is assumed that users:
•
•
have a reasonable knowledge of business and economic activities
are willing to study the information provided with reasonable diligence.
For information to be understandable users need to be able to perceive its
significance.
Information that is relevant and reliable should not be excluded from the
financial statements simply because it is difficult for some users to
understand.
Relevance
Information is relevant if:
•
•
28
it has the ability to influence the economic decisions of users, and
is provided in time to influence those decisions.
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chapter 2
Qualities of relevance
Information provided by financial statements needs to be relevant.
Information that is relevant has predictive, or confirmatory, value.
•
Predictive value enables users to evaluate or assess past, present or
future events.
•
Confirmatory value helps users to confirm or correct past evaluations
and assessments.
Where choices have to be made between mutually­exclusive options, the
option selected should be the one that results in the relevance of the
information being maximised – in other words, the one that would be of
most use in taking economic decisions.
Expandable text­ Relevance
Illustration 1 ­ Relevance
A business is a going concern with no intentions to reduce or curtail its
operations. Which would be the most relevant valuation for its machinery
– the net realisable value of the machinery or its depreciated cost?
Expandable Text ­ Solution
Reliability
Reliable information can be depended upon to present a faithful
representation and is neutral, error free, complete and prudent.
Qualities of reliability
Information is reliable when:
•
it can be depended upon by users to represent faithfully what it either
purports to represent or could reasonably be expected to represent
•
•
•
it is free from material error
it is free from deliberate or systematic bias (i.e. it is neutral).
It is complete within the bounds of materiality
KAPLAN PUBLISHING
29
A conceptual framework
•
in conditions of uncertainty, a degree of caution (i.e. prudence) has
been applied in exercising judgement and making the necessary
estimates.
Expandable text ­ Qualities of reliability
Test your understanding 1
A business is facing legal proceedings which may result in a potential
liability. At the time of producing the financial statements no realistic
estimate can be made of the possible amount of any damages.
How would the characteristics of relevance and reliability be
applied to this situation?
Comparability
Users must be able to:
•
compare the financial statements of an entity over time to identify trends
in its financial position and performance
•
compare the financial statements of different entities to evaluate their
relative financial performance and financial position.
For this to be the case there must be:
•
•
consistency and
disclosure.
Expandable text ­ Comparability
3 Elements of the financial statements
Assets
Assets are:
•
•
•
30
resources controlled by the entity
as a result of past events
from which future economic benefits are expected to flow to the entity.
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chapter 2
Liabilities
Liabilities are:
•
•
•
an entity’s obligations
to transfer economic benefits
as a result of past transactions or events.
Equity interest
Equity interest is the residual amount found by deducting all liabilities of
the entity from all of the entity’s assets.
Expandable text ­ Assets, liabilities and equity interest
Income
Income is:
•
an increase in economic benefits during the accounting period in the
form of inflows or enhancements of assets or decreases in liabilities
•
transactions that result in increases in equity, other than those relating
to contributions from equity participants.
Expenses
Expenses are:
•
decreases in economic benefits during the accounting period in the
form of outflows or depletions of assets or incurrences of liabilities
•
transactions that result in decreases in equity, other than those relating
to distributions to equity participants.
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A conceptual framework
4 Recognition of assets, liabilities, income and expenses
Recognition
Recognition is:
•
•
•
the depiction of an element
in words and by monetary amount
in the financial statements.
Recognition of assets
An asset will only be recognised if:
•
it gives rights or other access to future economic benefits controlled by
an entity as a result of past transactions or events
•
•
it can be measured with sufficient reliability
there is sufficient evidence of its existence.
Recognition of liabilities
A liability will only be recognised if:
•
there is an obligation to transfer economic benefits as a result of past
transactions or events
•
•
it can be measured with sufficient reliability
there is sufficient evidence of its existence.
Illustration 2 – Assets, liabilities, income and expenses
Below are listed four situations.
(1) M has paid $3 million towards the cost of a new hospital in the
nearby town, on condition that the hospital agrees to give priority
treatment to its employees if they are injured at work.
(2) N is the freehold legal owner of a waste disposal tip. It has charged
customers for the right to dispose of their waste for many years. The
tip is now full, and heavily polluted with chemicals. If cleaned up,
which would cost $8 million, the site of the tip could be sold for
housing purposes for $6 million.
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chapter 2
(3) P has signed a contract to pay its finance director $300,000 pa for
the next five years. He has agreed to work full time for the firm over
that period.
(4) Q has paid $25,000 to buy a patent right, giving the right to sole use,
for 8 years, of a manufacturing method which saves costs.
For each situation, state whether an asset or a liability is created.
Expandable text ­ Solution
Recognition of income
Income is recognised in the income statement when:
•
an increase in future economic benefits arises from an increase in an
asset (or a reduction in a liability), and
•
the increase can be measured reliably.
Recognition of expenses
Expenses are recognised in the income statement when:
•
a decrease in future economic benefits arises from a decrease in an
asset or an increase in a liability, and
•
can be measured reliably.
Financial position approach to recognition
It can be seen therefore that:
•
•
income is an increase in an asset/decrease in a liability
expenses are an increase in a liability/decrease in an asset.
As income and expenses are therefore recognised on the basis of changes
in assets and liabilities this is known as a financial position (or balance
sheet) approach to recognition.
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A conceptual framework
Chapter summary
34
KAPLAN PUBLISHING
chapter 2
Test your understanding answers
Test your understanding 1
It is likely that the existence of the court case will be highly relevant to
users of the financial statements, however at the current time there is no
reliable estimate of the amount of any possible damages.
As the case is relevant, the facts of it should be disclosed, even if the
amounts are not quantified due to lack of reliability.
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35
A conceptual framework
36
KAPLAN PUBLISHING
chapter
3
Accounting concepts and
policies
Chapter learning objectives
Upon completion of this chapter you will be able to:
•
distinguish between an accounting policy and an accounting
estimate
•
distinguish between a change in accounting policy and a change
in accounting estimate
•
describe how IAS 8 applies the principle of comparability where
an entity changes its accounting policies
•
•
•
•
account for a change in accounting policy
•
•
•
•
•
•
•
•
•
define historical cost
•
discuss whether the use of current value accounting overcomes
the problems of historical cost accounting
recognise a prior period error
account for a prior period adjustment
describe the underlying assumptions of financial statements – the
accruals concept and going concern
compute an asset value using historical cost
define fair value/current value
compute fair value/current value
define net realisable value (NRV)
compute the NRV of an asset
define present value (PV) of future cash flows
compute the PV of future cash flows
describe the advantages and disadvantages of historical cost
accounting
37
Accounting concepts and policies
38
•
describe the concepts of financial and physical capital
maintenance
•
explain how the use of financial or physical capital maintenance
affects the determination of profits
•
describe what is meant by financial statements achieving a
faithful representation
•
discuss whether faithful representation constitutes more than
compliance with accounting standards
•
•
list the circumstances where a true and fair override may apply
explain the disclosures required where a true and fair override
applies.
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chapter 3
1 IAS 8 Accounting policies, changes in accounting estimates and
errors
Introduction
IAS 8 governs the following topics:
•
•
•
•
selection of accounting policies
changes in accounting policies
changes in accounting estimates
correction of prior period errors.
Accounting policies
Accounting policies are the principles, bases, conventions, rules and
practices applied by an entity which specify how the effects of transactions
and other events are reflected in the financial statements.
IAS 8 requires an entity to select and apply appropriate accounting policies
complying with International Financial Reporting Standards (IFRSs) and
Interpretations to ensure that the financial statements provide information
that is:
•
•
relevant to the decision­making needs of users
reliable in that they:
– represent faithfully the results and financial position of the entity
–
reflect the economic substance of events and transactions and not
merely the legal form
–
are neutral, i.e. free from bias
–
are prudent
–
are complete in all material respects.
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Accounting concepts and policies
Changing accounting policies
The general rule is that accounting policies are normally kept the same from
period to period to ensure comparability of financial statements over time.
IAS 8 requires accounting policies to be changed only if the change:
•
•
is required by IFRSs or
will result in a reliable and more relevant presentation of events or
transactions.
A change in accounting policy occurs if there has been a change in:
•
•
recognition, e.g. an expense is now recognised rather than an asset
•
measurement basis, e.g. stating assets at replacement cost rather than
historical cost.
presentation, e.g. depreciation is now included in cost of sales rather
than administrative expenses, or
Accounting for a change in accounting policy
The required accounting treatment is that:
•
the change should be applied retrospectively, with an adjustment to the
opening balance of retained earnings in the statement of changes in
equity
•
comparative information should be restated unless it is impracticable to
do so
•
if the adjustment to opening retained earnings cannot be reasonably
determined, the change should be adjusted prospectively, i.e. included
in the current period’s income statement.
Disclosure
When a change in accounting policy has a material effect on the current
period or any prior period presented, or may have a material effect in
subsequent periods, the following disclosures should be made:
40
•
•
the reasons for the change
•
the amount of the adjustment relating to periods prior to those included
in the financial statements.
the amounts of the adjustments recognised in the current period and the
previous period presented (i.e. the comparative figures)
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chapter 3
Accounting estimates
An accounting estimate is a method adopted by an entity to arrive at
estimated amounts for the financial statements.
Most figures in the financial statements require some estimation:
•
the exercise of judgement based on the latest information available at
the time
•
at a later date, estimates may have to be revised as a result of the
availability of new information, more experience or subsequent
developments.
Ilustration 1 ­ Accounting estimates
If a non­current asset has a depreciable amount of $5,000 to be written
off over five years, different depreciation methods such as straight line,
reducing balance, sum of the digits, etc. all represent different estimation
techniques.
The choice of method of depreciation would be the estimation technique
whereas the policy of writing off the cost of non­current assets over their
useful lives would be the accounting policy.
Estimation techniques therefore implement the measurement aspects of
accounting policies.
Changes in accounting estimates
The requirements of IAS 8 are:
•
The effects of a change in accounting estimate should be included in
the income statement in the period of the change and, if subsequent
periods are affected, in those subsequent periods.
•
The effects of the change should be included in the same income or
expense classification as was used for the original estimate.
•
If the effect of the change is material, its nature and amount must be
disclosed.
Examples of changes in accounting estimates are changes in:
•
•
•
the useful lives of non­current assets
the residual values of non­current assets
the method of depreciating non­current assets
KAPLAN PUBLISHING
41
Accounting concepts and policies
•
warranty provisions, based upon more up­to­date information about
claims frequency.
Test your understanding 1
Which of the following is a change in accounting policy as
opposed to a change in estimation technique?
(1) An entity has previously charged interest incurred in connection with
the construction of tangible non­current assets to the income
statement. Following the revision of IAS 23, and in accordance with
the revised requirements of that standard, it now capitalises this
interest.
(2) An entity has previously depreciated vehicles using the reducing
balance method at 40% pa. It now uses the straight­line method
over a period of five years.
(3) An entity has previously shown certain overheads within cost of
sales. It now shows those overheads within administrative
expenses.
(4) An entity has previously measured inventory at weighted average
cost. It now measures inventory using the first in first out (FIFO)
method.
Prior period errors
Prior period errors are omissions from, and misstatements in, the financial
statements for one or more prior periods arising from a failure to use
information that:
•
was available when the financial statements for those periods were
authorised for issue and
•
could reasonably be expected to have been taken into account in
preparing those financial statements.
Such errors include mathematical mistakes, mistakes in applying
accounting policies, oversights and fraud.
Current period errors that are discovered in that period should be corrected
before the financial statements are authorised for issue.
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KAPLAN PUBLISHING
chapter 3
Correction of prior period errors
Prior period errors are dealt with by:
•
restating the opening balance of assets, liabilities and equity as if the
error had never occurred, and presenting the necessary adjustment to
the opening balance of retained earnings in the statement of changes in
equity
•
restating the comparative figures presented, as if the error had never
occurred
•
disclosing within the accounts a statement of financial position at the
beginning of the earliest comparative period. In effect this means that
three statements of financial position will be presented within a set of
financial statements:
– at the end of the current year
–
at the end of the previous year
–
at the beginning of the previous year.
Illustration 2 – Prior period errors
During 20X1 a company discovered that certain items had been
included in inventory at 31 December 20X0 at a value of $2.5 million but
they had in fact been sold before the year end.
The original figures reported for the year ending 31 December 20X0
and the figures the current year 20X1 are given below:
Sales
Cost of sales
Gross profit
Tax
Net profit
20X1
$000
52,100
(33,500)
_______
18,600
(4,600)
_______
14,000
20X0
$000
48,300
(30,200)
_______
18,100
(4,300)
_______
13,800
The cost of goods sold in 20X1 includes the $2.5 million error in opening
inventory. The retained earnings at 1 January 20X0 were $11.2 million.
(Assume that the adjustment will have no effect on the tax charge.)
Show the 20X1 income statement with comparative figures and the
retained earnings for each year. Disclosure of other comprehensive
income is not required.
KAPLAN PUBLISHING
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Accounting concepts and policies
Expandable text ­ Solution
Expandable text ­ Disclosure
Illustration 3 ­ Prior period errors
During 20X2 a company discovered that certain items of research
expenditure had been incorrectly capitalised as development
expenditure at 31 December 20X1. The amount of expenditure
capitalised was $4 million. This research expenditure should have been
included in cost of sales.
The original figures reported for year ending 31 December 20X1 and
the figures the current year 20X2 are given below:
Sales
Cost of sales
Gross profit
Tax
Net profit
20X2
$000
60,000
(40,000)
______
20,000
(5,000)
______
15,000
______
20X1
$000
50,000
(32,000)
______
18,000
(4,000)
______
14,000
______
The opening retained earnings at 1 January 20X1 were $50 million. The
adjustment has no effect on the tax for the year.
Show the 20X2 income statement with comparative figures and
the retained profits for each year.
44
KAPLAN PUBLISHING
chapter 3
Solution
Income statement for the year ended 31 December 20X2
Sales
Cost of sales (32,000 + 4,000)
Gross profit
Tax
Net profit
Retained profits
Retained profits b/f
As previously reported (50,000 +
14,000)
Prior period adjustment
As restated
Profit for the year
Retained profits c/f
20X2
$000
60,000
(40,000)
––––––
20,000
(5,000)
––––––
15,000
––––––
20X1
$000
50,000
(36,000)
––––––
14,000
(4,000)
––––––
10,000
––––––
64,000
50,000
(4,000)
––––––
60,000
15,000
––––––
75,000
––––––
­
––––––
50,000
10,000
––––––
60,000
––––––
Underlying assumptions
The Framework identifies the underlying assumptions governing financial
statements – the accruals basis of accounting and going concern.
•
The accruals basis of accounting means that the effects of transactions
and other events are recognised as they occur and not as cash or its
equivalent is received or paid.
•
The going concern basis assumes that the entity has neither the need
nor the intention to liquidate or curtail materially the scale of its
operations.
These must be taken into account by an entity when deciding on accounting
policies and estimates.
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Accounting concepts and policies
2 Measurement in financial statements
Expandable text ­ Historical cost
Expandable text ­ Fair value
Illustration 4 ­ Fair value
•
If the item is quoted on an active market, then its fair value is its
market value on that market. For example, the shares in large public
companies are quoted on stock exchanges. The fair value of 1,000
shares in Company AB quoted at $2 each would be $2,000.
•
If the item is not quoted on an active market, but similar items are,
then the item’s fair value should be determined by reference to
these similar items. For example, a company might own 1,000
shares in an unquoted company CD. If CD is identical in every way
to the quoted company AB which has a share price of $2 each, then
perhaps the fair value of the shares held in CD is $2,000.
•
If the item is not quoted on an active market, and no similar items
can be identified that are quoted, then the fair value must be
estimated using a valuation model. For example, a shareholding in
an unquoted company may be valued using a variety of techniques
such as a dividend model.
Expandable text ­ Further illustration: fair value
Expandable text ­ Other asset values
Illustration 5 ­ Other asset values
A company owns a machine which it purchased four years ago for
$100,000. The accumulated depreciation on the machine to date is
$40,000. The machine could be sold to another manufacturer for
$50,000 but there would be dismantling costs of $5,000. To replace the
machine with a new version would cost $110,000. The cash flows from
the existing machine are estimated to be $25,000 for the next two years
followed by $20,000 per year for the remaining four years of the
machine's life.
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chapter 3
The relevant discount rate for this company is 10% and the discount
factors are:
Year 1
Year 2
Years 3­6 inclusive
0.909
0.826
2.619 (annuity rate)
Calculate the following values for the machine:
(a) Historical cost
(b) NRV
(c) Replacement cost
(d) Economic value
Solution
a. Historical cost
Cost
Less: depreciation
$
100,000
(40,000)
______
60,000
______
b. NRV
Selling price
Less: costs to sell
$
50,000
(5,000)
______
45,000
______
c. Replacement cost
Replacement cost for new asset
Less: 4 years’ depreciation
(4 × 10% × $110,000)
$
110,000
(44,000)
______
66,000
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Accounting concepts and policies
d. Economic value
$
22,725
20,650
52,380
______
95,755
______
$25,000 × 0.909
$25,000 × 0.826
$20,000 × 2.619
Expandable Text­ Historical cost accounting
Illustration 6 ­ Deficiencies of historical cost accounts
Company A acquires a new machine in 20X4. This machine costs
$50,000 and has an estimated useful life of ten years.
Company B acquires an identical one­year old machine in 20X5. The
cost of the machine is $48,000 and it has an estimated useful life of nine
years.
Depreciation charges (straight­line basis) in 20X5 are as follows.
Company A
Company B
CVs at the end of 20X5 are:
Company A
Company B
$50,000/10
$48,000/9
= $5,000
= $5,333
$50,000 – (2 × $5,000) = $40,000
$48,000 – $5,333 = $42,667
Both companies are using identical machines during 20X5, but the
income statements will show quite different profit figures because of
adherence to historical cost. Is the comparison of financial statements
for the two companies in 20X5 meaningful?
Expandable text ­ Alternatives to historical cost accounting
Expandable text ­ Constant purchasing power accounting
Expandable text ­ Advantages and disadvantages of CPP
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Expandable text ­ Current cost accounting
Expandable text ­ Advantages and disadvantages of CCA
Illustration 7 ­ Current cost accounting
Describe the types of business that would be most heavily affected by
the replacement of historical cost accounting with a system based on
current values.
Expandable text ­ Solution
Expandable text ­ Capital maintenance
Expandable text ­ Fair presentation
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Accounting concepts and policies
Chapter summary
50
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chapter 3
Test your understanding answers
Test your understanding 1
For each of the items, ask whether this involves a change to:
•
•
•
recognition
presentation
measurement basis.
If the answer to any of these is yes, the change is a change in accounting
policy.
(1) This is a change in recognition and presentation. Therefore this is a
change in accounting policy.
(2) The answer to all three questions is no. This is only a change in
estimation technique.
(3) This is a change in presentation and therefore a change in
accounting policy.
(4) This is a change in measurement basis and therefore a change in
accounting policy.
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Accounting concepts and policies
52
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chapter
4
Principles of consolidated
financial statements
Chapter learning objectives
Upon completion of this chapter you will be able to:
•
•
•
•
•
•
describe the concept of a group as a single economic unit
•
explain the need for using coterminous year ends and uniform
accounting policies when preparing consolidated financial
statements
•
•
explain why it is necessary to eliminate intra­group transactions
explain the objective of consolidated financial statements
explain the definition of a subsidiary according to IAS 27
apply the IAS 27 definition of a subsidiary
explain why directors may not wish to consolidate a subsidiary
list the circumstances where it is permitted not to consolidate a
subsidiary
identify the effect that the related party relationship between a
parent and subsidiary may have on the subsidiary’s entity
statements and the consolidated financial statements.
53
Principles of consolidated financial statements
1 The concept of group accounts
What is a group?
If one company owns more than 50% of the ordinary shares of another
company:
•
•
this will usually give the first company ‘control’ of the second company
•
P is, in effect, able to manage S as if it were merely a department of P,
rather than a separate entity
•
in strict legal terms P and S remain distinct, but in economic substance
they can be regarded as a single unit (a ‘group’).
the first company (the parent company, P) has enough voting power to
appoint all the directors of the second company (the subsidiary
company, S)
Expandable text
Group accounts
The key principle underlying group accounts is the need to reflect the
economic substance of the relationship.
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chapter 4
•
•
P is an individual legal entity.
S is an individual legal entity.
P controls S and therefore they form a single economic entity – the Group.
The objective of the consolidated financial statements is to show the
position of the group as if it were a single economic entity, therefore:
•
all of the assets and liabilities of P and S are included in the
consolidated statement of financial position
•
all of the income and expenses of P and S are included in the
consolidated income statement
•
all of the other comprehensive income of P and S is included in the
consolidated statement showing other comprehensive income.
Expandable text
Expandable text ­ The single economic unit concept
Expandable text
2 Definitions
IAS 27 Consolidated and Separate Financial Statements uses the following
definitions:
•
subsidiary – an entity that is controlled by another entity (known as the
parent)
•
control – the power to govern the financial and operating policies of an
entity so as to obtain benefits from its activities.
Control is usually based on ownership of more than 50% of voting power,
but other forms of control are possible.
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Principles of consolidated financial statements
Expandable text ­ Other forms of control
Test your understanding 1
Hercules is considering an investment in Samson, the capital structure of
which is as follows: 10,000 A voting ordinary shares 10,000 B non­voting
ordinary shares. Both classes of shares have the same dividend rights.
Describe the appropriate group accounting for Samson if:
(i) Hercules purchases 6,000 A ordinary shares.
(ii) Hercules purchases 10,000 B and 4,000 A ordinary shares.
Expandable text ­ Excluded subsidiaries
Expandable text ­ Excluded subsidiaries: further detail
Illustration 1 ­ Excluded subsidiaries
Hobart Group owns 90% of the voting ordinary shares of Storey.
Consider the following statements:
(i) Storey is a foreign subsidiary.
(ii) Storey operates a very different business to Hobart.
(iii) Storey was acquired with another subsidiary and has always been
intended to be sold.
Discuss how each of the above statements could affect how
Hobart accounts for Storey in the group.
Expandable text ­ Solution
Expandable Text ­ reasons for wanting to exclude a subsidiary
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Expandable text
Expandable text ­ Principles of consolidation
Illustration 2 ­ Intragroup transactions
If intra­group transactions were not eliminated before consolidation, a
group could buy an item of inventory, sell it to another member of the
group (at a profit), who in turn could sell it to another member of the
group and so on.
•
The result would be that each member of the group would make a
profit which would then be combined to form a large group profit.
•
This would be ‘balanced’ by an over­inflated inventory value in the
statement of financial position.
Such accounting would not show a fair presentation.
Expandable text ­ Related parties
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Principles of consolidated financial statements
Chapter summary
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Test your understanding answers
Test your understanding 1
(i) Hercules has purchased 6,000 of the 10,000 voting A shares but no
non­voting B shares.
It is the voting shares that give Hercules the influence in Samson.
With 60% of the voting shares Hercules should control Samson.
Samson should therefore be treated as a subsidiary.
(ii) Hercules has purchased 4,000 of the 10,000 voting A shares and
10,000 non­voting B shares.
As Hercules has less than 50% of the voting share this time it
probably will not be able to control Samson. Samson will not be a
subsidiary.
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Principles of consolidated financial statements
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chapter
5
Consolidated statement of
financial position
Chapter learning objectives
Upon completion of this chapter you will be able to:
•
prepare a consolidated statement of financial position for a
simple group (parent and one subsidiary)
•
•
•
deal with pre­ and post­acquisition profits
•
•
•
apply the required accounting treatment of consolidated goodwill
•
•
account for the consolidation of other reserves
•
explain why it is necessary to use fair values when preparing
consolidated financial statements
•
account for the effects of fair value adjustments (including the
effect of consolidated goodwill) to:
deal with non­controlling interests
describe the required accounting treatment of consolidated
goodwill
account for impairment of goodwill
explain the consolidation of other reserves (e.g. share premium
and revaluation)
account for the effects of intra­group trading in the statement of
financial position
(i) depreciating and non­depreciating non­current assets
(ii) inventory
(iii) monetary liabilities
(iv) assets and liabilities not included in the subsidiary’s own
statement of financial position including contingent assets
and liabilities.
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Consolidated statement of financial position
1 Principles of the consolidated statement of financial position
Basic principle
The basic principle of a consolidated statement of financial position is that it
shows all assets and liabilities of the parent and subsidiary.
Intra­group items are excluded, e.g. receivables and payables shown in the
consolidated statement of financial position only include amounts owed
from/to third parties.
Method of preparing a consolidated statement of financial position
(1) The investment in the subsidiary (S) shown in the parent’s (P’s)
statement of financial position is replaced by the net assets of S.
(2) The cost of the investment in S is effectively cancelled with the ordinary
share capital and reserves of the subsidiary
This leaves a consolidated statement of financial position showing:
62
•
•
the net assets of the whole group (P + S)
•
the retained profits, comprising profits made by the group (i.e. all of P’s
historical profits + profits made by S post­acquisition).
the share capital of the group which always equals the share capital of
P only and
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Illustration 1 – Principles of the consolidated SFP
Statements of financial position at 31 December 20X4
Non­current assets
Investment in S at cost
Current assets
Ordinary share capital ($1 shares)
Retained earnings
Current liabilities
P
S
$000
60
50
40
___
150
___
100
30
20
___
150
___
$000
50
40
___
90
___
40
10
40
___
90
___
P acquired all the shares in S on 31 December 20X4 for a cost of
$50,000.
Prepare the consolidated statement of financial position at 31
December 20X4.
Expandable text ­ Solution
Goodwill on acquisition
In the previous illustration, the cost of the shares in S was $50,000. Equally
the net assets of S were $50,000. This is not always the case.
The value of a company will normally exceed the value of its net assets. The
difference is goodwill. This goodwill represents assets not shown in the
statement of financial position of the acquired company such as the
reputation of the business.
Goodwill on acquisition is calculated by comparing the value of the
subsidiary acquired to its net assets.
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Consolidated statement of financial position
Where 100% of the subsidiary is acquired, the calculation is therefore:
Cost of investment (= value of the
subsidiary)
Net assets of subsidiary
Goodwill
$
X
(X)
___
X
Where less than 100% of the subsidiary is acquired, the value of the
subsidiary comprises two elements:
•
•
The value of the part acquired by the parent
The value of the part not acquired by the parent, known as the non­
controlling interest
There are 2 methods in which Goodwill may now be calculated following the
update to IFRS3.
(i) Partial Goodwill
(ii) Full goodwill
Partial Goodwill (old method)
Cost of Investment
For:
Parents share of sub's NA @Acq
Goodwill on consolidation
(parent's share)
$000
X
(X)
—
X
—
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Full Goodwill (new method)
$000
Cost of Investment
$000
X
For:
Parents share of sub's NA @ Acq
(X)
—
Goodwill ­ parents share
F.V of NCI at acquisition
X
X
Less:
NCI share of NA @ Acq
(X)
—
Goodwill ­ NCI share
X
—
Total Goodwill
X
══
This method is referred to as the full goodwill method, as it results in 100%
of the goodwill being shown in the group statement of financial position –
that belonging to the shareholders of the parent and that belonging to the
non­ controlling interest.
An alternative presentation of the full goodwill method as allowed by the
standard is shown below:
$
Cost of investment(value of acquired part)
X
Non­ controlling invest (value of part not acquired)
X
—
X
Net assets of subsidiary
(X)
—
Goodwill
X
—
Positive goodwill is presented as a non­current asset on the face of the
consolidated statement of financial position and is subject to impairment
reviews to assess whether its value has fallen.
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Consolidated statement of financial position
Test your understanding 1
Daniel acquired 80% of the ordinary share capital of Craig on 31
December 20X6 for $78,000. At this date the net assets of Craig were
$85,000.
What goodwill arises on the acquisition
(i) if the NCI is valued using the proportion of net assets method
(ii) if the NCI is valued using the full goodwill method and the fair value of
the NCI on the acquisition date is $21,000?
The mechanics of consolidation
A standard group accounting question will provide the accounts of P and the
accounts of S and will require the preparation of consolidated accounts.
The best approach is to use a set of standard workings.
(W1) Establish the group structure
(W2) Net assets of subsidiary
Share capital
Reserves:
Retained earnings
66
At date of acquisition
$
X
At the reporting date
$
X
X
––
X
––
X
––
X
––
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(W3) Goodwill
­ Proportion of net Assets method (old) method)
Purchase consideration
X
for:
Parents % of sub's Net assets @ Acquisition
(X)
—
Goodwill on acquisition
X
Less:
Impairments to date
(X)
—
Carrying Goodwill
═
or:
­ Fair value method (new method)
Purchase consideration
X
for:
Parents % of sub's NA @ Acq
(X)
—
Goodwill on acquisition­ parents share
FV of NCI @ Acq
X
X
Less:
NCI % of subs NA @ Acq
(X)
—
Goodwill ­ NCI share.
X
—
X
(W4) Non­ controlling interest (NCI) (Old method)
M1 % of subsidiarys net assets at
at reporting date(W2)
(W4) Non­ controlling interest (NCI) (New method)
X
M1 % of subsidiarys net assets
at reporting date(W2)
X
NCI share of goodwill (W3)
X
—
X
—
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Consolidated statement of financial position
(W5) Group retained earnings
$
P's retained earnings (100%)
X
S:group share of post­acquisition retained earnings
Less: Goodwill impairments to date(W3)
X
(X)
—
X
—
Illustration 2– Principles of the consolidated SFP
Consolidated statement of financial position
Austin buys all of the share capital of Reed on 31 December 20X7.
The SFPs of the two companies at 31 December 20X7, are as follows:
Austin
Non­current assets:
Tangible
Investments
Shares in Reed
Current assets
Capital and reserves:
Share capital
Retained earnings
Current liabilities:
68
Reed
$
$
80,000
8,000
17,000
______
97,000
198,000
______
295,000
______
24,000
______
32,000
______
100,000
30,000
––––––
130,000
––––––
165,000
––––––
295,000
––––––
10,000
5,000
––––––
15,000
––––––
17,000
––––––
32,000
––––––
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chapter 5
There has been no impairment in the value of goodwill.
Prepare the consolidated statement of financial position of Austin as at
31 December 20X7.
Expandable text ­ Solution
2 Pre­acquisition profits and group reserves
Pre­ and post­acquisition profits
Pre­acquisition profits are the reserves which exist in a subsidiary
company at the date when it is acquired.
They are capitalised at the date of acquisition by including them in the
goodwill calculation.
Post­acquisition profits are profits made and included in the retained
earnings of the subsidiary company since acquisition.
They are included in group reserves.
Group reserves
When looking at the reserves of S at the year end, e.g revaluation reserve, a
distinction must be made between:
•
those reserves of S which existed at the date of acquisition by P (pre­
acquisition reserves) and
•
the increase in the reserves of S which arose after acquisition by P
(post­acquisition reserves).
As with retained earnings, only the group share of post­acquisition reserves
of S is included in the group statement of financial position.
Expandable text ­ Illustration: pre and post­acquisition profits
3 Non­controlling interests
What is a non­controlling interest?
In some situations a parent may not own all of the shares in the subsidiary,
e.g. if P owns only 80% of the ordinary shares of S, there is a non­controlling
interest of 20%.
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Consolidated statement of financial position
Note, however, that P still controls S.
Accounting treatment of a non­controlling interest
As P controls S:
•
in the consolidated statement of financial position, include all of the net
assets of S
•
‘give back’ the net assets of S which belong to the non­controlling
interest within the capital and reserves section of the consolidated
statement of financial position (calculated in W4).Where the full goodwill
method is used to value the NCI, a proportion of goodwill on acquisition
is also 'given back' to the NCI.
Expandable text
Illustration 3 – Non­controlling interests
Draft SFPs of Piper and Swans on 31 December 20X1 are as follows.
Piper
Swans
$000
$000
Non­current assets
90
100
Investment in Swans at cost
110
Current assets
50
30
––––
––––
250
130
––––
––––
Equity and liabilities
Capital and reserves
Ordinary share capital $1
100
100
Retained earnings
120
20
–––
–––
220
120
–––
–––
Current liabilities
30
10
–––
–––
250
130
–––
–––
Piper had bought 80% of the ordinary shares of Swans on 1 January
20X1 when the retained profits of Swans were $10,000. No impairment
of goodwill has occurred to date.
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Prepare a consolidated statement of financial position as at 31
December 20X1, assuming that the Piper group values the non­
controlling interest using the proportion of net assets method.
Expandable text ­ Solution
Test your understanding 2
The following SFPs have been prepared at 31 December 20X8.
Dickens
Non­current assets:
Tangible assets
Investments
Shares in Jones
Current assets
Capital and reserves:
Called­up share capital
Share premium
Retained earnings
Current liabilities
Jones
$
$
85,000
18,000
60,000
––––––
145,000
160,000
––––––
305,000
––––––
84,000
––––––
102,000
––––––
65,000
35,000
70,000
––––––
170,000
135,000
––––––
305,000
––––––
20,000
10,000
25,000
––––––
55,000
47,000
––––––
102,000
––––––
Dickens acquired its 80% holding in Jones on 1 January 20X8, when
Jones’ retained earnings stood at $20,000.On this date, the fair value of
the 20% non­controlling shareholding in Jones was $12,500.
There has been no impairment of goodwill since acquisition.
The Dickens Group uses the full goodwill method to value the non­
controlling interest.
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Consolidated statement of financial position
Prepare the consolidated statement of financial position of
Dickens as at 31 December 20X8.
4 Intra­group trading
Types of intra­group trading
P and S may well trade with each other leading to the following potential
problem areas:
•
•
•
•
•
current accounts between P and S
unrealised profits on sales of inventory (see below)
unrealised profits on sales of non­current assets (see below)
loan stock held by one company in the other
dividends and loan interest.
Current accounts
If P and S trade with each other then this will probably be done on credit
leading to:
•
•
a receivables (current) account in one company’s SFP
a payables (current) account in the other company’s SFP.
These are amounts owing within the group rather than outside the group and
therefore they must not appear in the consolidated statement of financial
position.
They are therefore cancelled (contra’d) against each other on consolidation.
Cash/goods in transit
At the year end, current accounts may not agree, owing to the existence of
in­transit items such as goods or cash.
The usual rules are as follows:
–
If the goods or cash are in transit between P and S, make the
adjusting entry to the statement of financial position of the recipient:
–
cash in transit adjusting entry is:
– Dr Cash in transit
–
72
Cr Receivables current account
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chapter 5
–
goods in transit adjusting entry is:
– Dr Inventory
–
Cr Payables current account
this adjustment is for the purpose of consolidation only.
•
Once in agreement, the current accounts may be contra’d and
cancelled as part of the process of cross casting the assets and
liabilities.
•
This means that reconciled current account balance amounts are
removed from both receivables and payables in the consolidated
statement of financial position .
Illustration 4 – Intra­group trading
Current accounts and cash in transit
Draft SFPs of Plant and Shrub on 31 March 20X7 are as follows.
Tangible non­current assets
Investment in S at cost
Current assets
Inventory
Trade receivables
Cash
Equity and liabilities
Capital and reserves:
Share capital: Ordinary $1 shares
Share premium
Retained earnings
Non­current liabilities:
10% loan notes
Current liabilities
KAPLAN PUBLISHING
Plant
$000
100
180
Shrub
$000
140
30
20
10
___
340
35
10
5
___
190
250
–
–
___
250
100
30
20
___
150
65
25
___
340
–
40
___
190
73
Consolidated statement of financial position
Notes:
•
Plant bought 80,000 shares in Shrub in 20X1 when Shrub’s
reserves included a share premium of $30,000 and retained profits
of $5,000.
•
Plant's accounts show $6,000 owing to Shrub; Shrub's accounts
show $8,000 owed by Plant. The difference is explained as cash in
transit.
•
•
No impairment of goodwill has occurred to date.
Plant uses the proportion of net assets method to value the non­
controlling interest.
Prepare a consolidated statement of financial position as at 31 March
20X7.
Expandable text ­ Solution
5 Goodwill
IFRS 3 Business combinations
IFRS 3 revised governs accounting for all business combinations other than
joint ventures and a number of other unusual arrangements not included in
this syllabus. The definition of goodwill is:
Goodwill is an asset representing the future economic benefits arising from
other assets acquired in a business combination that are not individually
identified and separately recognised.
Goodwill is calculated as the excess of the consideration transferred and
amount of any non­controlling interest over the net of the acquisition date
identifiable assets acquired and liabilities assumed.
Treatment of goodwill
Positive goodwill
• Capitalised as an intangible non­current asset.
•
•
Tested annually for possible impairments.
Amortisation of goodwill is not permitted by the standard.
Expandable text
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Negative goodwill
•
Arises where the cost of the investment is less that the value of net
assets purchased.
•
IFRS 3 does not refer to this as negative goodwill, however this is the
commonly used term.
•
Most likely reason for this to arise is a misstatement of the fair values of
assets and liabilities and accordingly the standard requires that the
calculation is reviewed.
•
After such a review, any negative goodwill remaining is credited directly
to the income statement.
Expandable text ­ Illustration: Goodwill
6 Fair values
Fair value of consideration and net assets
To ensure that an accurate figure is calculated for goodwill:
•
the consideration paid for a subsidiary must be accounted for at fair
value
•
the subsidiary’s identifiable assets and liabilities acquired must be
accounted for at their fair values.
The fair value of assets and liabilities is defined in IFRS 3 (and several
other IFRSs) as ‘the amount for which an asset could be exchanged or a
liability settled between knowledgeable, willing parties in an arm’s length
transaction’.
Expandable text
Calculation of cost of investment
The cost of acquisition includes the following elements:
•
•
cash paid
fair value of any other consideration
Incidental costs of acquisition such as legal, accounting, valuation and other
professional fees should be expensed as incurred. The issue costs of debt
or equity associated with the acquisition should be recognised in
accordance with IAS 39 (see chapter 12).
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Consolidated statement of financial position
Deferred and contingent consideration
In some situations not all of the purchase consideration is paid at the date of
the acquisition, instead a part of the payment is deferred until a later date –
deferred consideration.
•
Deferred consideration should be measured at fair value at the date of
the acquisition.
•
Any contingent consideration should always be included as long as it
can be measured reliably.This will be indicated where relevant in an
exam question.
Where contingent consideration involves the issue of shares, there is no
liability (obligation to transfer economic benefits). This should be
recognised as part of shareholders' funds under a separate caption
representing shares to be issued.
Subsequent changes
If the cost of acquisition changes subsequently as the result of a different
outcome of a contingency, the change should generally be recognised in
income statement. Goodwill is therefore not reinstated.
Subsequent changes to contingent consideration classified as equity are,
however, not remeasured.
If the cost of acquisition changes within 12 months as the result of new
information about fair values of consideration at the acquisition date then
the change should be recorded and goodwill reinstated.
Illustration 5 – Fair values
Jack acquires 24 million $1 shares (80% ) of the ordinary shares of
Becky by offering a share­for­share exchange of two shares for every
three shares acquired in Becky and a cash payment of $1 per share
payable three years later. The current market value of a Jack’s share is
$2.
There are two ways to discount the deferred amount to fair value at
acquisition date:
(1) The examiner gives you the present value of the payment based on
a cost of capital (10%). In this example it is $0.75.
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(2) Use the interest rate given and apply the discount fraction where r is
the interest rate and n the number of years to settlement
1
––––––
(1 + r ) n
(i) Calculate the cost of investment and show the journals to record
it in Jack's accounts.
(ii) Show how the discount would be unwound.
Expandable text ­ Solution
Fair value of net assets acquired
IFRS 3 revised requires that the subsidiary’s assets and liabilities are
recorded at their fair value for the purposes of the calculation of goodwill
and production of consolidated accounts.
Adjustments will therefore be required where the subsidiary’s accounts
themselves do not reflect fair value.
Expandable text ­ Illustration: Fair value of net assets acquired
Expandable text
How to include fair values in consolidation workings
(1) Adjust both columns of W2to bring the net assets to fair value at
acquisition and reporting date.
This will ensure that the fair value of net assets is carried through to the
goodwill and non­controlling interest calculations.
At acquisition At reporting date
$000
$000
Ordinary share capital + Reserves
X
X
Fair value adjustments
X
X
X
X
___
___
(2) At the reporting date make the adjustment on the face of the SFP when
adding across assets and liabilities.
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Consolidated statement of financial position
Expandable text ­ Uniform accounting policies
7 Unrealised profit
Profits made by members of a group on transactions with other group
members are:
•
•
recognised in the accounts of the individual companies concerned, but
in terms of the group as a whole, such profits are unrealised and must
be eliminated from the consolidated accounts.
Unrealised profit may arise within a group scenario on:
•
•
inventory where companies trade with each other
non­current assets where one group company has transferred an asset
to another.
Intra­group trading and unrealised profit in inventory
When one group company sells goods to another a number of adjustments
may be needed.
•
•
Current accounts must be cancelled (see earlier in this chapter).
•
Inventory must be included at original cost to the group (i.e. cost to the
company which then sold it).
Where goods are still held by a group company, any unrealised profit
must be cancelled.
Expandable text
Adjustments for unrealised profit in inventory
The process to adjust is:
(1) Determine the value of closing inventory included in an individual
company’s accounts which has been purchased from another company
in the group.
(2) Use mark­up or margin to calculate how much of that value represents
profit earned by the selling company.
(3) Make the adjustments. These will depend on who the seller is.
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If the seller is the parent company, the profit element is included in
the holding company’s accounts and relates entirely to the group.
Adjustment required:
Dr Group retained earnings (deduct the profit in W5)
Cr Group inventory (deduct the profit when adding P’s inventory + S’s
inventory on the face of the consolidated SFP.
If the seller is the subsidiary, the profit element is included in the
subsidiary company’s accounts and relates partly to the group, partly to
non­controlling interests (if any).
Adjustment required:
Dr Subsidiary retained earnings (deduct the profit in W2)
Cr Group inventory (deduct the profit when adding P’s inventory
+ S’s inventory on the face of the consolidated SFP).
Expandable text
Illustration 6 – Unrealised profit
Health (H) bought 90% of the equity share capital of Safety (S), two
years ago on 1 January 20X2 when the retained earnings of Safety
stood at $5,000. Statements of financial position at the year end of 31
December 20X3 are as follows:
H
$000
Non­current assets:
Property,plans+equipment
Investment
KAPLAN PUBLISHING
S
$000
100
34
––––
134
$000
$000
30
79
Consolidated statement of financial position
Current assets:
Inventory
Receivables
Bank
90
110
10
––––
Share capital
Retained earnings
Non­current liabilities
Current liabilities
20
25
5
––––
210
––––
344
15
159
174
50
––––
80
5
31
36
120
50
––––
344
––––
28
16
––––
80
––––
S transferred goods to H at a transfer price of $18,000 and a mark­up of
50%. Two­thirds remained in inventory at the year end. The current
account in parent and subsidiary stood at $22,000 on that day. Goodwill
has suffered an impairment of $10,000.
Prepare the CSFP at 31/12/X3.
Note: the non­controlling interest is valued using the proportion of net
assets method.
Expandable text
Non­current assets
If one group member sells non­current assets to another group member
adjustments must be made to recreate the situation that would have existed
if the sale had not occurred:
•
•
There would have been no profit on the sale.
Depreciation would have been based on the original cost of the asset
to the group.
Expandable text
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Adjustments for unrealised profit in non­current assets
The easiest way to calculate the adjustment required is to compare the
carrying value (CV) of the asset now with the CV that it would have been
held at had the transfer never occurred:
CV at reporting date
CV at reporting date if intra­group transfer had not occurred
Adjustment required
X
(X)
–––
X
The calculated amount should be:
(1) deducted when adding across P’s non­current assets + S’s non­current
assets
(2) deducted in the retained earnings of the seller (W2 if the seller is the
subsidiary; W5 if it is the parent company).
Illustration 7 ­ Non­current asset PURP
Unrealised profit in non­current assets
Parent company (P) transfers an item of plant to subsidiary (S) for
$6,000 at the start of the 20X1. The plant originally cost P $10,000 and
has been depreciated at the group depreciation rate of 20% since
acquisition 3 years ago. What is the unrealised profit on the transaction
at the end of the year of transfer?
Expandable text ­ Solution
Test your understanding 3
H owns 80% of S. In separate years transfers are:
(1) From H to S, $20,000, mark­up 25%, half in inventory.
(2) From S to H, $150,000, mark­up 50%, 20% in inventory.
(3) From H to S, $120,000, mark­up one third, third in inventory.
(4) From S to H, $65,000, mark­up 30%, third in inventory.
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Consolidated statement of financial position
(5) H sold goods to S at a price of $12 million. These goods cost H $9
million. During the year S sold $10 million (at the cost to S) of these
goods for $15 million.
(6) S sold a machine with a book value of $100,000 to H at a transfer
price of $120,000 at the year start. Group policy dictates that the
machine is depreciated over its remaining life of five years.
(7) H sold an item of plant to S for $240,000. The transfer had a mark
up of 20%. S charged $24,000 in depreciation.
Calculate the provision for unrealised profit in each case.
8 Mid­year acquisitions
Calculation of reserves at date of acquisition
If a parent company acquires a subsidiary mid­year, the net assets at the
date of acquisition must be calculated based on the net assets at the start of
the subsidiary's financial year plus the profits of up to the date of acquisition.
To calculate this it is normally assumed that S’s profit after tax accrues
evenly over time.
Expandable text ­ Illustration: Mid­year acquisitions
Test your understanding 4
Hazelnut acquired 80% of the share capital of Peppermint two years
ago, when the reserves of Peppermint stood at $125,000. Hazelnut paid
initial cash consideration of $1 million. Additionally Hazelnut issued
200,000 shares with a nominal value of $1 and a current market value of
$1.80. It was also agreed that Hazelnut would pay a further $500,000 in
three years’ time. Current interest rates are 10% pa. The appropriate
discount factor for $1 receivable three years from now is 0.751. The
shares and contingent consideration have not yet been recorded.
82
KAPLAN PUBLISHING
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Below are the statements of financial position of Hazelnut and
Peppermint as at 31 December 20X4:
Hazelnut
Peppermint
$000
$000
Investment in Peppermint at cost
1,000
Non­current assets
5,500
1,500
Current assets:
Inventory
550
100
Receivables
400
200
Cash
200
50
–––––
–––––
7,650
1,850
–––––
–––––
Share capital
2,000
500
Retained earnings
1,400
300
–––––
–––––
3,400
800
Non­current liabilities
3,000
400
Current liabilities
1,250
650
–––––
–––––
7,650
1,850
–––––
–––––
At acquisition the fair values of Peppermint’s non­current assets
exceeded their book value by $200,000. They had a remaining useful life
of five years at this date. The consolidated goodwill has been impaired
by one fifth of its value.
The Hazelnut Group values the non­controlling interest using the full
goodwill method. At the date of acquisition the fair value of the 20% non­
controlling interest was $380,000
Prepare the consolidated statement of financial position as at 31
December 20X4.
KAPLAN PUBLISHING
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Consolidated statement of financial position
Chapter summary
84
KAPLAN PUBLISHING
chapter 5
Test your understanding answers
Test your understanding 1
(ii)
Cost of investment
for:
80% of NA @ acquisition
(80% × $85,000(W2))
Goodwill ­ parents share
f.V of NCI @ acquisition
NCI in NA @ acquisition
(20% × $85,000)
Goodwill ­ NCI
Total Goodwill
$
78,000
(68,000)
————
10,000
21,000
(17,000)
———
4,000
———
14,000
———
Test your understanding 2
Dickens consolidated statement of financial position as at 31
December 20X8
Non­current assets:
Goodwill (W3)
Tangible $(85,000 + 18,000)
Current assets $(160,000 + 84,000)
Share capital
Share premium
Retained earnings (W5)
Non­controlling interest (W4)
Current liabilities $(135,000 + 47,000)
KAPLAN PUBLISHING
$000
22.5
103
244
___
369.5
___
65
35
74
13.5
___
187.5
182
___
369.5
___
85
Consolidated statement of financial position
(W1) Group structure
(W2) Net assets of Jones
At date of acquisition
Share capital
Share premium
Retained earnings
Net assets
At reporting date
$
20,000
10,000
20,000
______
50,000
______
$
20,000
10,000
25,000
______
55,000
______
(W3) Goodwill
$000
Cost of Investment
Less:
80% of NA @ acquisition
(80% × $50,000 (W2) )
Goodwill ­ parents share
f.v of NCI at acquisition
Less:
20% of NA @ acq
(20% × $50,000(W2))
NCI shareof goodwill
Total Goodwill
86
$000
60,000
(40,000)
———
20,000
12,500
10,000
———
2,500
———
22,500
═════
KAPLAN PUBLISHING
chapter 5
(W4) NCI
20% of NA @ reporting date
(20% × $55,000 (W2))
NCI share of goodwill (W3)
11,000
2,500
———
13,500
———
Test your understanding 3
(1)
(2)
(3)
(4)
(5)
(6)
(7)
$2,000
$10,000
$10,000
$5,000
$500,000
$16,000
$36,000
[(20) × (25/125) × (½)]
[(150) × (50/150) × (20%)]
[(120) × (33/133) × (1/3)]
[(65) × (30/130) × (1/3)]
[(12,000 – 9,000) × (2/12)]
[(4/5) × (120 – 100)]
[240 × (20/120) × (1 – 24/240)]
Test your understanding 4
Hazelnut consolidated statement of financial position at 31
December 20X4
Goodwill (W3)
Non­current assets (5.5m + 1.5m + 200,000 ­ 80,000)
Current assets:
Inventory $(550,000 + 100,000)
Receivables $(400,000 + 200,000)
Cash $(200,000 + 50,000)
KAPLAN PUBLISHING
$000
1,033
7,120
650
600
250
–––––
9,653
–––––
87
Consolidated statement of financial position
Share capital $(2m + 200,000)
Share premium $(0 + 160,000)
Retained earnings (W5)
2,200
160
1,191
–––––
3,551
347
–––––
3,898
–––––
3,400
1,900
455
–––––
9,653
–––––
Non­controlling interest (W4)
Non­current liabilities $(3m + 400,000)
Current liabilities $(1.25m + 650,000)
Deferred consideration $(376,000 + 79,000)
Workings
(W1) Group structure
(W2) Net assets of Peppermint
At date of
acquisition
Share capital
Retained earnings
Fair value adjustment
Depreciation adjustment (200 ×
2/5)
88
At reporting
date
$000
500
125
200
$000
500
300
200
(80)
___
825
___
___
920
___
KAPLAN PUBLISHING
chapter 5
Note: the cost of the investment in Hazelnut’s SFP is $1 million, i.e. the
cash consideration paid. Hazelnut has:
Dr
Cr
Investment
Bank
$1 million
$1 million
Hazelnut has not yet recorded the share consideration or the deferred
consideration. The journals required to record these are:
and
Dr
Cr
Cr
Dr
Cr
Investment
Share capital
Share premium
Investment
Deferred consideration
$360,000
$200,000
$160,000
$376,000
$376,000
In the CSFP, since the cost of the investment does not appear there is
no need to worry about the debit side of the entries. The credit entries
do, however, need recording.
(W3) Goodwill
$000
$000
Cost of investment
1,000
•
Cash
•
Shares (200 × $1.80)
360
•
Deferred consideration (500 × 0.751 )
376
_____
1,736
For:
80% of NA @ Acquisition
(80% × $825(W2))
Goodwill­ parents share
F.V of NCI @ Acquisition
KAPLAN PUBLISHING
(660)
———
1,076
380
89
Consolidated statement of financial position
Less:
20% of NA @ Acquisition
(20% x $ 825 (W2))
(165)
——
Goodwill­ NCI share
Total Goodwill @ Acquisition
Impairment
Carrying Goodwill
215
———
1,291
(258)
———
1,033
———
(W4) Non­ controlling interest
20% of NA @ reporting date
(20% × $920 (W2))
NCI share of Goodwill (W3)
NCI share of impairment
184
215
(52)
——
347
——
(W5) Group retained earnings
Hazelnut (1,400 – 79) (W6)
Peppermint (80% × (920 – 825))
Impairment of goodwill (W3)
$000
1,321
76
(206)
_____
1,191
_____
(W6) Unwinding of discount
Present value of deferred consideration at acquisition
Present value of deferred consideration at reporting date
90
$000
376
455
___
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KAPLAN PUBLISHING
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At acquisition, Hazelnut should record a liability of 376, being the
present value of the future cash flow at that date.
The reporting date is two years’ liability and there is only one year to go
until the deferred consideration will be paid. Therefore the liability in
Hazelnut’s SFP at this date is 376 × 1.102.
So, Hazelnut needs to:
Dr Income statement
Cr Deferred consideration liability
KAPLAN PUBLISHING
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79
91
Consolidated statement of financial position
92
KAPLAN PUBLISHING
chapter
6
Consolidated income
statement
Chapter learning objectives
Upon completion of this chapter you will be able to:
•
prepare a consolidated income statement for a simple group and
a non­controlling interest
•
account for the effects of intra­group trading in the income
statement
•
prepare a consolidated income statement for a simple group with
an acquisition in the period and non­controlling interest
•
account for impairment of goodwill.
93
Consolidated income statement
1 Principles of the consolidated income statement
Basic principle
The consolidated income statement shows the profit generated by all
resources disclosed in the related consolidated statement of financial
position, i.e. the net assets of the parent company (P) and its subsidiaries
(Ss).
The consolidated income statement follows these basic principles:
•
From revenue to profit after tax include all of P’s income and expenses
plus all of S’s income and expenses (reflectingcontrol of S).
•
After profit after tax deduct share of profits due to the non­controlling
interest (to reflect ownership).
Expandable text ­ Basic principle
The mechanics of consolidation
As with the statement of financial position, it is common to use standard
workings when producing a consolidated income statement:
•
•
•
94
consolidation schedule (see below)
group structure diagram
net assets of subsidiary at acquisition (required for goodwill calculation)
KAPLAN PUBLISHING
chapter 6
•
goodwill calculation (required where an impairment is to be charged to
profits (see below))
•
non­controlling interest (NCI) (see below).
Consolidation schedule
This schedule is used as a tool to add together P's and S’s income and
expenses and make any necessary adjustments. It includes:
•
•
100% of P's income and expenses
100% of S's income and expenses (unless a mid­year acquisition has
occurred in which case this is time apportioned).
P
S
Adj Total
Time apportion if mid­year
Revenue
X
X
(X)
X
Cost of sales
(X)
(X)
X
(X)
Operating expenses
(X)
(X)
(X) (X)
Finance cost
(X)
(X)
(X)
Income taxes
(X)
(X)
(X)
–––
–––
Profit after tax
X
X
Impairment of goodwill
Once any impairment has been identified during the year, the charge for the
year will be passed through the consolidated income statement. This will
usually be through operating expenses, however always follow instructions
from the examiner.
Total impairment to date is an adjustment in retained earnings in the
consolidated statement of financial position.
Non­controlling interest
This is calculated as: NCI% × subsidiary’s profit after tax (taken from S’s
column of consolidation schedule).
KAPLAN PUBLISHING
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Consolidated income statement
Illustration 1 – Basic consolidated income statement
Poplin acquired, several years ago, 80% of the ordinary share capital of
Silk. Their results for the year ended 30 November 20X4 were as
follows:
P
S
$000
$000
Sales revenue
8,500
2,200
Cost of sales and expenses
(7,650)
(1,980)
______
______
Trading profit before tax
850
220
Income taxes
(400)
(100)
______
______
450
120
______
______
Prepare the consolidated income statement for the year ended 30
November 20X4.
Expandable text ­ Solution
Dividends
A payment of a dividend by S to P will need to be cancelled. The effect of
this on the consolidated income statement is:
•
only dividends paid by P to its own shareholders appear in the
consolidated financial statements. These are shown within the
consolidated statement of changes in equity which you will not be
required to prepare for the F7 examination.
•
any dividend income shown in the consolidated income statement must
arise from investments other than those in subsidiaries or associates
(covered in chapter 7).
Expandable Text ­ NCI dividend
Fair values
If a depreciating non­current asset of the subsidiary has been revalued as
part of a fair value exercise when calculating goodwill, this will result in an
adjustment to the consolidated income statement.
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KAPLAN PUBLISHING
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The subsidiary's own income statement will include depreciation based on
the value the asset is held at in the subsidiary's own SFP.
The consolidated income statement must include a depreciation charge
based on the fair value of the asset, included in the consolidated SFP.
Extra depreciation must therefore be calculated and charged to an
appropriate cost category within the consolidation schedule.
Test your understanding 1
The income statements for Paddle and Skip for the year ended 31
August 20X4 are shown below. Paddle acquired 75% of the ordinary
share capital of Skip several years ago.
Sales revenue
Cost of sales and expenses
Trading profit
Investment income:
Dividend received from Skip
Profit before tax
Tax
Profit for the year
Paddle
Skip
$
2,400,000
(2,160,000)
––––––––
240,000
$
800,000
(720,000)
–––––––
80,000
1,500
––––––––
241,500
(115,000)
––––––––
126,500
–––––––
80,000
(38,000)
–––––––
42,000
Prepare the consolidated income statement for the year. Ignore
goodwill.
2 Sales, purchases and inventories
The effect of intra­group trading must be eliminated from the consolidated
income statement.
Sales and purchases
Such trading will be included in the sales revenue of one group company
and the purchases of another.
•
Consolidated sales revenue = P’s revenue + S’s revenue – intra­group
sales.
•
Consolidated cost of sales = P’s COS + S’s COS – intra­group sales.
KAPLAN PUBLISHING
97
Consolidated income statement
The deduction of the intra­group sales in both cases should be shown in the
adjustments column of the consolidation schedule.
Inventory
If any goods sold intra­group are included in closing inventory, their value
must be adjusted to the lower of cost and net realisable value (NRV) to the
group (as in the CSFP).
The adjustment for unrealised profit should be shown as an increase to cost
of sales in the seller’s column in the consolidation schedule.
Expandable text ­ Unrealised profit in inventory
Illustration 2 – Sales, purchases and inventories
Given below are the income statements for Paris and its subsidiary
London for the year ended 31 December 20X5.
Sales revenue
Cost of sales
Gross profit
Distribution costs
Administrative expenses
Investment income
Taxation
Net profit for the year
Paris
$000
3,200
(2,200)
–––––
1,000
(160)
(400)
–––––
440
160
–––––
600
(400)
–––––
200
London
$000
2,560
(1,480)
–––––
1,080
(120)
(80)
–––––
880
–
–––––
880
(480)
–––––
400
Additional information:
98
•
Paris paid $1.5 million on 31 December 20X1 for 80% of London’s
ordinary share capital of $800,000. The balance on London’s
retained earnings was $600,000 at that time.
•
Goodwill impairments at 1 January 20X5 amounted to $152,000. A
further impairment of $38,000 was found to be necessary at the year
end. Impairments are included within administrative expenses.
KAPLAN PUBLISHING
chapter 6
•
Paris made sales to London, at a selling price of $600,000 during
the year. Not all of the goods had been sold externally by the year
end. The profit element included in London’s closing inventory was
$30,000.
•
The figure for investment income in Paris’s income statement
comprises the parent company’s share of the subsidiary’s total
dividend for the year.
Prepare a consolidated income statement for the year ended 31
December 20X5 for the Paris group.
Expandable text ­ Solution
Test your understanding 2
On 1 January 20X9 Zebedee acquired 60% of the ordinary shares of
Xavier.
The following income statements have been produced by Zebedee and
Xavier for the year ended 31 December 20X9.
Sales revenue
Cost of sales
Gross profit
Distribution costs
Administration expenses
Profit from operations
Investment income from Xavier
Profit before taxation
Taxation
Profit after taxation
Zebedee
$000
1,260
(420)
–––––
840
(180)
(120)
–––––
540
36
–––––
576
(130)
–––––
446
Xavier
$000
520
(210)
–––––
310
(60)
(90)
–––––
160
–––––
160
(26)
–––––
134
During the year ended 31 December 20X9 Zebedee had sold $84,000
worth of goods to Xavier. These goods had cost Zebedee $56,000. On
31 December 20X9 Xavier still had $36,000 worth of these goods in
inventories (held at cost to Xavier).
KAPLAN PUBLISHING
99
Consolidated income statement
Prepare the consolidated income statement to incorporate
Zebedee and Xavier for the year ended 31 December 20X9.
Note: Goodwill on consolidation has not been impaired.
Interest
If loans are outstanding between group companies, intra­group loan interest
will be paid and received.
Both the loan and loan interest must be excluded from the consolidated
results.
The relevant amount of interest should be deducted from group investment
income and group finance costs through the adjustments column of the
consolidation schedule.
Transfers of non­current assets
If one group company sells a non­current asset to another group company
the following adjustments are needed in the income statement.
•
Any profit or loss arising on the transfer must be deducted from the
appropriate category within the seller’s column in the consolidation
schedule.
•
The depreciation charge must be adjusted (again in the seller’s column
of the schedule) so that it is based on the cost of the asset to the group.
Expandable text ­ Unrealised profit on non­current assets
3 Mid­year acquisitions
Mid­year acquisition procedure
If a subsidiary is acquired part way through the year, then the subsidiary’s
results should only be consolidated from the date of acquisition, i.e. the date
on which control is obtained.
In practice this will require:
100
•
Identification of the net assets of S at the date of acquisition in order to
calculate goodwill.
•
Time apportionment of the results of S in the year of acquisition.For this
purpose, unless indicated otherwise, assume that revenue and
expenses accrue evenly.
KAPLAN PUBLISHING
chapter 6
•
After time­apportioning S’s results, deduction of post acquisition intra­
group items as normal.
Expandable text ­ Illustration: Mid­year acquisition
Expandable text
Test your understanding 3
Set out below are the draft income statements of Smiths and its
subsidiary company Flowers for the year ended 31 December 20X7.
On 1 January 20X6 Smiths purchased 75,000 ordinary shares in
Flowers at a cost of $170,000. The issued share capital of Flowers is
100,000 $1 ordinary shares. At that date the income statement of
Flowers showed a credit balance of $60,000.
Income statements for the year ended 31 December 20X7
Smiths
Flowers
$000
$000
Sales revenue
600
300
Cost of sales
(360)
(140)
––––
––––
Gross profit
240
160
Operating costs
(93)
(45)
––––
––––
Operating profit
Interest payable
Profit before tax
Tax
Profit for the year
147
––––
147
(50)
––––
97
115
(3)
––––
112
(32)
––––
80
The following additional information is relevant.
(1) During the year Flowers sold goods to Smiths for $20,000, making
a mark­up of one third. Only 20% of these goods were sold before
the end of the year, the rest were still in inventory.
KAPLAN PUBLISHING
101
Consolidated income statement
(2) Goodwill has been subject to an impairment review at the end of
each year since acquisition. The first review at the end of last year
revealed an impairment of $5,000 and the review at the end of this
year revealed another impairment of $5,000. The current
impairment is to be recognised as an operating cost.
Prepare for presentation to members the consolidated income
statement account for the year ended 31 December 20X7.
102
KAPLAN PUBLISHING
chapter 6
Chapter summary
KAPLAN PUBLISHING
103
Consolidated income statement
Test your understanding answers
Test your understanding 1
Paddle consolidated income statement for year ended31 August
20X4
Sales revenue
Cost of sales and expenses
Group profit before tax
Tax
Profit for the year
Attributable to:
Group (167,000 – NCI)
Non­controlling interest ( W1)
Consolidation schedule
Revenue
Cost of sales and expenses
Income taxes
Profit after tax
$
3,200,000
(2,880,000)
––––––––
320,000
(153,000)
––––––––
167,000
156,500
10,500
P
S
Adj
$000
$000 $000
2,400
800
(2,160)
(720)
(115)
(38)
–––––
42
Total
$000
3,200
(2,880)
(153)
–––––
167
(W1) Non­controlling interest
25% × $42,000 = $10,500
104
KAPLAN PUBLISHING
chapter 6
Test your understanding 2
Zebedee consolidated income statement for the year ended 31
December 20X9
$000
1,696
(558)
–––––
1,138
(240)
(210)
–––––
688
(156)
–––––
532
Sales revenue
Cost of sales
Gross profit
Distribution costs
Administrative expenses
Operating profit
Taxation
Profit after tax
Amount attributable to:
Equity holders of the parent (532 – NCI)
Non­controlling interests (W3)
478.4
53.6
Workings
Consolidation schedule
Z
X
Adj
Total
$000 $000 $000
$000
Turnover
1,260
Cost of sales
(420) (210)
PURP (W2)
520
(12)
(84) 1,696
84
(558)
Distribution costs
(180)
(60)
(240)
Administrative expenses
(120)
(90)
(210)
Tax
(130)
(26)
(156)
–––
–––––
134
532
Profit after tax
KAPLAN PUBLISHING
105
Consolidated income statement
(W1) Group structure
(W2) Unrealised profit in inventory
$000
84
(56)
–––
28
–––
Selling price
Cost
Total profit
The profit mark­up is therefore one third of the selling price
28
––
84
=
1
––
3
Since closing inventory at selling price is $36,000 the unrealised profit is
1
––
3
x $36,000
= $12,000
(W3) Non­controlling interest
NCI share of subsidiary’s profit after tax 40% × $134,000
106
$000
53.6
KAPLAN PUBLISHING
chapter 6
Test your understanding 3
Smiths consolidated income statement for the year ended 31
December 20X7
$000
880
(484)
–––––
396
(143)
–––––
253
(3)
–––––
250
(82)
–––––
168
Sales revenue
Cost of sales
Gross profit
Operating costs
Profit from operations
Interest payable
Profit before tax
Tax
Profit for the year
Attributable to
Non­controlling interest (W3)
Group (168 – 19)
19
149
Workings
Consolidation schedule
Sales revenue
Cost of sales
PURP (W4)
Operating costs
Finance cost
Income taxes
Profit after tax
KAPLAN PUBLISHING
S
$000
600
(360)
(93)
(50)
F
$000
300
(140)
(4)
(45)
(3)
(32)
––––
76
Adj
$000
(20)
20
(5) G’will
Total
$000
880
(484)
(143)
(3)
(82)
––––
168
107
Consolidated income statement
(W1) Group structure
(W2) Unrealised profit
(80% × 20,000) × 33/133 = 4
Seller = subsidiary
(W3) Non­controlling interest
NCI share of subsidiary’s PAT from consolidation schedule
25% × 76 = 19
108
KAPLAN PUBLISHING
chapter
7
Associates
Chapter learning objectives
Upon completion of this chapter you will be able to:
•
•
define an associate
•
prepare a consolidated statement of financial position to include
a single subsidiary and an associate
•
prepare a consolidated income statement to include a single
subsidiary and an associate.
explain the principles and reasoning for the use of equity
accounting
109
Associates
1 IAS 28 Investments in associates
Definition of an associate
IAS 28 defines an associate as:
An entity over which the investor has significant influence and that is neither
a subsidiary nor an interest in joint venture.
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.
Significant influence is assumed with a shareholding of 20% to 50%.
110
KAPLAN PUBLISHING
chapter 7
Principles of equity accounting and reasoning behind it
Equity accounting is a method of accounting that brings an associate
investment into the parent company’s financial statements initially at cost.
The carrying amount of the investment is then adjusted in each period by the
group share of the profit of the associate less any impairment losses.
The investment in the associate is therefore stated at:
•
•
•
cost plus
group share of retained post­acquisition profits; less
amounts written off (i.e. impairment losses).
The effect of this is that the consolidated statement of financial position
includes:
•
100% of the assets and liabilities of the parent and subsidiary company
on a line by line basis
•
an ‘investments in associates’ line within non­current assets which
includes the group share of the assets and liabilities of any associate.
The consolidated income statement includes:
•
100% of the income and expenses of the parent and subsidiary
company on a line by line basis
•
one line ‘share of profit of associates’ which includes the group share of
any associate’s profit after tax.
Note that in order to equity account, the parent company must already be
producing consolidated financial statements (i.e. it must already have at
least one subsidiary).
Expandable text ­ IAS 28 Investments in Associates
2 Associates in the consolidated statement of financial position
Preparing the CSFP including an associate
The CSFP is prepared on a normal line­by­line basis following the
acquisition method for the parent and subsidiary.
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Associates
The associate is included as a non­current asset investment calculated as:
Cost of investment
Share of post acquisition profits
Less: impairment losses
$000
X
X
(X)
___
X
___
The group share of the associate’s post acquisition profits or losses and the
impairment of goodwill will also be included in the group retained earnings
calculation.
01;
$000
Parents share of associates net assets at reporting date (W2)
Carrying Goodwill/Premium (W3)
X
X
——
X
——
Standard workings
The calculations for an associate (A) can be incorporated into standard
CSFP workings as follows.
(W1) Group structure
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(W2) Net assets of S
Share capital
Retained earnings
At date of acquisition
At the reporting date
$
X
X
___
X
___
$
X
X
___
X
___
At date of acquisition
$
X
X
___
X
___
At the reporting date
$
X
X
___
X
___
Net assets of A
Share capital
Retained earnings
W3 Goodwill – S
Proportion of net assets (old method)
Purchase consideration
For:
Parents share of subs net assets at acquisition
Goodwill on acquisition
Less: Impairment
Carrying Goodwill
x
(x)
—
x
(x)
—
x
—
or;
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Associates
Fair value method (new method)
Purchase Consideration
For:
Parents share of subs net assets at acquisition
Goodwill ­ Parents share
F.V of NCI @ acquisition
Less:
NCI % of subs net assets at acquisition
Goodwill ­ NCI share
Total Goodwill on acquisition
Less impairment
Carrying Goodwill
W4 Non Controlling Interest (old method)
Parents share of subs net assets at reporting date
or;
Non­ controlling interest (new method)
Parents share of subs net assets at reporting date
NCI share of Goodwill
$000 $000
(x)
—
x
x
(x)
—
x
—
x
(x)
—
x
—
x
x
x
—
x
—
(W5) Group retained earning
$
Preserve (100%)
S – group share of post­acquisition reserves
A – group share of post­acquisition reserves
Less: Impairment losses to date (S + A) (W3)
114
X
X
X
X
—
X
—
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chapter 7
(W6) Investment in associated company
$
X
X
X
—
X
—
Cost of investment
Post­acquisition profits (W5)
Less impairment
or:
Parents share of Assets NA @ reporting date
Carrying Goodwill
X
X
—
X
—
Illustration 1 ­ Associates in the SCFP
Below are the statements of financial position of three companies
as at 31 December 20X9.
Non­current assets:
Tangible assets
Investments
672,000 shares in LaaLaa
168,000 shares in Po
Current assets:
Inventory
Receivables
Cash
KAPLAN PUBLISHING
Dipsy
$000
LaaLaa
$000
Po
$000
1,120
980
840
644
224
–––––––
1,988
­
­
–––––––
980
­
­
–––––––
840
380
190
35
–––––––
605
–––––––
2,593
–––––––
640
310
58
–––––––
1,008
–––––––
1,988
–––––––
190
100
46
–––––––
336
–––––––
1,176
–––––––
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Associates
Equity and liabilities
Capital and reserves
$1 ordinary shares
Retained earnings
Current liabilities:
Trade payables
Taxation
1,120
1,232
–––––––
2,352
840
602
–––––––
1,442
560
448
–––––––
1,008
150
91
–––––––
241
–––––––
2,593
–––––––
480
66
–––––––
546
–––––––
1,988
–––––––
136
32
–––––––
168
–––––––
1,176
–––––––
You are also given the following information:
(1) Dipsy acquired its shares in LaaLaa on 1 January 20X9 when
LaaLaa had retained losses of $56,000.
(2) Dipsy acquired its shares in Po on 1 January 20X9 when Po had
retained earnings of $140,000.
(3) An impairment test at the year end shows that goodwill for LaaLaa
remains unimpaired and the investment in Po by $2,800.
(4) The Dipsy Group values the non­controlling interest at full value. The
fair value on 1 January 20X9 was $157,000.
Prepare the consolidated statement of financial position for the year
ended 31 December 20X9 for Dipsy and its subsidiary, incorporating its
associated company in accordance with IAS 28.
Expandable text­ Solution
Fair values and the associate
If the fair value of the associate’s net assets at acquisition are materially
different from their book value the net assets should be adjusted in the same
way as for a subsidiary.
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Balances with the associate
Generally the associate is considered to be outside the group. Therefore
balances between group companies and the associate will remain in the
consolidated statement of financial position.
If a group company trades with the associate, the resulting payables and
receivables will remain in the consolidated statement of financial position.
Unrealised profit in inventory
Adjustment must be made for unrealised profit in inventory as follows.
(1) Determine the value of closing inventory which is the result of a sale to
or from the associate.
(2) Use mark­up/margin to calculate the profit earned by the selling
company.
(3) Make the required adjustments. These will depend upon who the seller
is:
Parent company selling to associate — the profit element is
included in the parent company’s accounts.
Dr Group retained earnings
Cr Investment in associate
Associate selling to parent company— the profit element is
included in the associate company’s accounts.
Dr Group retained earnings
Cr Group inventory
3 Associates in the consolidated income statement
Equity accounting
The equity method of accounting requires that the consolidated income
statement:
•
•
does not include dividends from the associate
instead includes group share of the associate’s profit after tax less any
impairment of the associate in the year.
Expandable Text ­ Proforma consolidated income statement
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Associates
Trading with the associate
Generally the associate is considered to be outside the group.
Therefore any sales or purchases between group companies and the
associate are not normally eliminated and will remain part of the
consolidated figures in the income statement.
It is normal practice to instead adjust for the unrealised profit in inventory.
The following illustration will explain this in more detail.
Illustration 2 – Associates in the consolidated income statement
Below are the income statements of the Barbie group and its associated
companies, as at 31 December 20X8.
Sales revenue
Cost of sales
Gross profit
Operating expenses
Profit before tax
Tax
Profit after tax
Barbie
$000
385
(185)
___
200
(50)
___
150
(50)
___
100
Ken
$000
100
(60)
___
40
(15)
___
25
(12)
___
13
Shelly
$000
60
(20)
___
40
(10)
___
30
(10)
___
20
You are also given the following information.
(1) Barbie acquired 60,000 ordinary shares in Shelly for $80,000 when
that company had a credit balance on its retained earnings of
$50,000 a number of years ago. Shelly has 200,000 $1 ordinary
shares.
(2) Barbie acquired 45,000 ordinary shares in Ken , a number of years
ago, for $70,000 when retained earnings were $20,000. Ken has
50,000 $1 ordinary shares.
(3) During the year Shelly sold goods to Barbie for $28,000. None of
these goods were in inventory at the year end
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(4) Goodwill and the investment in the associate were impaired for the
first time during the year as follows:
Shelly $2,000
Ken $3,000
Impairment of the subsidiary’s goodwill should be charged to
operating expenses.
Prepare the consolidated income statement for Barbie including the
results of its associated company.
Expandable text ­ Solution
Dividends from associates
Dividends from associates are excluded from the consolidated income
statement; the group share of the associate’s profit is included instead.
Test your understanding 1
The following are the summarised accounts of Alecia (A), Devina (D)
and Gertrude (G) for the year ended 31 December 20X4.
Income statement
A
Sales revenue
Operating costs
Operating profit
Interest payable
Dividend income from D
Dividend income from G
Dividend income from other sources
Profit before tax
Tax
Profit for the financial year
KAPLAN PUBLISHING
$
573,600
(300,000)
_______
273,600
(20,000)
14,400
4,000
10,000
_______
282,000
(72,000)
_______
210,000
_______
D
G
$
$
314,000 150,000
(200,000) (90,000)
_______ _______
114,000 60,000
(14,000) (8,000)
_______
100,000
(30,000)
_______
70,000
_______
_______
52,000
(16,000)
_______
36,000
_______
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Associates
Statements of financial position
Investment in D Ltd (60%)
Investment in G Ltd (25%)
Other assets
Ordinary shares
Retained earnings
Current liabilities
A
$
60,000
50,000
300,000
_______
410,000
_______
D
$
G
$
120,000
_______
120,000
_______
100,000
_______
100,000
_______
$
20,000
330,000
60,000
_______
410,000
_______
$
30,000
66,000
24,000
_______
120,000
_______
$
10,000
70,000
20,000
_______
100,000
_______
The shares in Devina and Gertrude were acquired on 1 January 20X4,
when the balances of gthe retained earnings accounts were:
Devina
$20,000
Gertrude $50,000
Goodwill in the subsidiary has suffered an impairment of 20% of its
value, and the associate has suffered an impairment of $7,000.
Subsidiary goodwill impairment is recognised in operating costs and
impairment of the associate is charged against associate profits. Alecia
has accounted for the dividends from subsidiary and associate.
The Alecia group values the non­controlling interest at its proportionate
share of the fair value of the subsidiary's identifiable net assets.
Prepare the consolidated income statement for the year ended 31
December 20X4 and consolidated statement of financial position
as at 31 December 20X4.
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Chapter summary
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121
Associates
Test your understanding answers
Test your understanding 1
Alecia: consolidated statement of financial position as at 31
December 20X4
Goodwill (W3)
Investment in associate (W6)
Other assets (300 + 120)
Share capital
Retained earnings (W5)
Non­controlling interest (W4)
Current liabilities (60 + 24)
$000
24
48
420
–––
492
–––
20
349.6
38.4
84
–––
492
–––
Alecia: consolidated income statement for the year ended 31
December 20X4
Sales revenue (573.6 + 314)
Operating costs (300 + 200 + 6)
Operating profit
Interest payable (20 + 14)
Investment income
Share of profits of associate (25% × 36) – 7
Profit before tax
Tax (72 + 30)
Profit for the year
Attributable profit
NCI (W4)
Profit attributable to members of Alecia
122
$000
887.6
(506)
–––
381.6
(34)
10
2
–––
359.6
(102)
–––
257.6
28
229.6
KAPLAN PUBLISHING
chapter 7
(W1) Group structure
(W2) Net assets: Devina
Share capital
Retained earnings
Net assets: Gertrude
Share capital
Retained earnings
At date of acquisition At reporting date
$
$
30,000
30,000
20,000
66,000
––––––
––––––
50,000
96,000
At date of acquisition At reporting date
$
$
10,000
10,000
50,000
70,000
––––––
––––––
60,000
80,000
(W3) Goodwill – Devina
$000
Cost of Investment
$000
60,000
For:
60% net assets @ acquisition
(60% × $50,000 (W2) )
(30,000)
———
Goodwill
30000
Less: impairment
(20% × $30,000)
(6,000)
———
24,000
———
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Associates
W4) Non­controlling interest
Income statement
SFP
NCI share of Devina’s profit after
tax (40% × 70,000)
NCI share of Devina’s net
assets at reporting date (40% ×
96,000)
$ 28,000
$38,400
(W5) Group reserves c/f
Alecia (100%)
Devina – group share of post acquisition retained earnings
60% × $(66,000 – 20,000)
Gertrude – group share of post acquisition retained earnings
25% × $(70,000 – 50,000)
Less impairment
$
330,000
27,600
5,000
(13,000)
––––––
349,600
––––––
(W6) Investment in associate
Cost of investment
Post acquisition profits (W6)
Less impairment
124
$
50,000
5,000
(7,000)
––––––
48,000
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8
Tangible non­current assets
Chapter learning objectives
Upon completion of this chapter you will be able to:
•
•
•
define the cost of a non­current asset
•
•
•
•
distinguish between capital and revenue expenditure
•
•
•
•
•
account for revaluation of non­current assets
•
apply the provisions of IAS 20 in relation to accounting for
government grants
•
•
define investment properties
•
apply the requirements of IAS 40 for investment properties.
calculate the initial cost measurement of a non­current asset
calculate the initial cost measurement of a self­constructed non­
current asset
identify the subsequent expenditure that may be capitalised
explain the treatment of borrowing costs
explain the requirements of IAS 16 in relation to the revaluation of
non­current assets
account for gains and losses on disposal of non­current assets
calculate depreciation based on the cost model
calculate depreciation based on the revaluation model
calculate depreciation on assets that have two or more
significant parts (complex assets)
discuss why the treatment of investment properties should differ
from other properties
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Tangible non-current assets
1 IAS 16 Property, plant and equipment
Property, plant and equipment
Property, plant and equipment are tangible assets held by an entity for
more than one accounting period for use in the production or supply of
goods or services, for rental to others, or for administrative purposes.
Recognition
An item of property, plant and equipment should be recognised as an asset
when:
126
•
it is probable that future economic benefits associated with the asset
will flow to the entity; and
•
the cost of the asset can be measured reliably.
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chapter 8
Initial measurement
An item of property, plant and equipment should initially be measured at its
cost:
•
•
include all costs involved in bringing the asset into working condition
•
revenue costs should be written off as incurred.
include in this initial cost capital costs such as the cost of site
preparation, delivery costs, installation costs
Expandable text ­ Construction costs
Expandable text ­ Illustration: initial measurement
Expandable text ­ Further illustration: initial measurement
Subsequent expenditure
Subsequent expenditure on property, plant and equipment should only be
capitalised if it results in the total economic benefits expected from the
asset to increase above those expected on original recognition, e.g. the
cost of an extension to a building should be capitalised (capital expenditure)
as economic benefits will increase with greater space.
All other subsequent expenditure should be recognised in the income
statement, because it merely maintains the economic benefits originally
expected e.g. the cost of general repairs should be written off immediately
(revenue expenditure).
Expandable Text­ Illustration: subsequent expenditure
Test your understanding 1
In each of the following cases justify whether or not the
expenditure should be capitalised:
(a) A new engine is fitted to a machine which will increase its
production capacity from 100,000 units a year to 140,000 units
a year.
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Tangible non-current assets
(b) Replacement of rotting windows in the head office.
(c) Replacement of an aircraft engine every five years.
2 Depreciation
Definitions
Depreciable amount is the cost of an asset, or other amount substituted
for cost in the financial statements, less its residual value.
Depreciation is the systematic allocation of the depreciable amount of an
asset over its useful life.
Expandable Text ­Illustration: depreciable amount
Commencement of depreciation
Depreciation must be charged from the date the asset is available for use,
i.e. it is capable of operating in the manner intended by management.
This may be earlier than the date it is actually brought into use, for example
when staff need to be trained to use it. Depreciation is continued even if the
asset is idle.
Change in method of depreciation
The depreciation method used should reflect as fairly as possible the
pattern in which the asset’s economic benefits are consumed by the entity.
Possible methods include:
•
•
•
straight line
reducing balance
machine hours.
A change from one method of providing depreciation to another:
•
is permissible only on the grounds that the new method will give a fairer
presentation of the results and of the financial position
•
•
does not constitute a change of accounting policy
is a change in accounting estimate.
The carrying amount should be written off over the remaining useful life,
commencing with the period in which the change is made.
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Review of useful lives and residual values
Useful life and residual value should be reviewed at the end of each
reporting period and revised if expectations are significantly different from
previous estimates.
The carrying amount of the asset at the date of revision less any residual
value should be depreciated over the revised remaining useful life.
Expandable text ­ Revision of useful lives
Illustration 1 – Depreciation
Revision of useful life
An asset was purchased for $100,000 on 1 January 20X5 and straight­
line depreciation of $20,000 pa is being charged (five­year life, no
residual value). The annual review of asset lives is undertaken and for
this particular asset, the remaining useful life as at 1 January 20X7 is
eight years.
The financial statements for the year ended 31 December 20X7 are
being prepared. What is the depreciation charge for the year ended 31
December 20X7?
Expandable text ­ Solution
Separate components
A complex asset is an asset that may be thought of as having separate
components within a single asset, e.g. an engine within a piece of plant.
Each separate part of the asset should be depreciated over their useful life.
Major inspection or overhaul costs
Inspection and overhaul costs are generally expensed as they are incurred.
They are, however, capitalised as a non­current asset to the extent that they
satisfy the IAS 16 rules for separate components.
Where this is the case they are then depreciated over their useful lives.
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Tangible non-current assets
Illustration 2 – Depreciation
Overhaul costs
An entity purchases an aircraft that has an expected useful life of 20
years with no residual value. The aircraft requires substantial overhaul at
the end of years 5, 10 and 15. The aircraft cost $25 million and $5
million of this figure is estimated to be attributable to the economic
benefits that are restored by the overhauls.
Calculate the annual depreciation charge for the years 1­5 and years 6­
10.
Expandable text ­ Solution
Expandable Text­ Further illustration :overhaul costs
3 Revaluation of non­current assets
IAS 16 treatments
IAS 16 allows a choice of accounting treatment for property, plant and
equipment:
•
•
the cost model
the revaluation model.
The cost model
Property, plant and equipment should be valued at cost less accumulated
depreciation.
The revaluation model
Property, plant and equipment may be carried at a revalued amount less
any subsequent accumulated depreciation.
If the revaluation alternative is adopted, two conditions must be complied
with:
•
130
Revaluations must subsequently be made with sufficient regularity to
ensure that the carrying amount does not differ materially from the fair
value at each reporting date.
KAPLAN PUBLISHING
chapter 8
•
When an item of property, plant and equipment is revalued, the entire
class of assets to which the item belongs must be revalued.
Accounting for a revaluation
Steps:
(1) Restate asset from cost to valuation.
(2) Remove any existing accumulated depreciation provision.
(3) Include increase in carrying value in revaluation reserve (part of other
components of equity within the statement of financial position).
Journal:
$
Dr
Dr
Cr
Non­current assets cost/valuation
(revalued amount – cost)
Accumulated depreciation
(eliminate all of existing provision)
Revaluation reserve
(valuation less previous CV)
$
X
X
X
Recognising revaluation gains and losses
Revaluation gains are recorded in the revaluation reserve and reported as a
component of other comprehensive income either within the statement of
comprehensive income or in a separate statement.
Revaluation losses which represent an impairment are recognised in the
income statement.
Expandable text ­ The revaluation model
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Tangible non-current assets
Illustration 3 – Revaluation of non­current assets
Recognition of revaluation gain
A company revalues its buildings and decides to incorporate the
revaluation into its financial statements.
Extract from the statement of financial position at
31 December 20X7:
Buildings:
Cost
Depreciation
$000
1,200
(144)
–––––
1,056
–––––
The building is revalued at 1 January 20X8 at $1,400,000. Its useful life
is 40 years at that date.
Show the relevant extracts from the final accounts at 31 December
20X8.
Expandable text ­ Solution
Depreciation of revalued asset
Once an asset has been revalued the following treatment is required.
132
•
Depreciation must be charged, based on valuation less residual value,
over remaining useful life.
•
•
The whole charge must go to the income statement for the year.
An annual reserves transfer may be made (revaluation reserve to
retained earnings) for extra depreciation on the revalued amount
compared to cost.
KAPLAN PUBLISHING
chapter 8
Journals
Dr
Cr
Income statement depreciation charge
Accumulated depreciation
X
X
Revaluation reserve (depreciation on
valuation – depreciation on original cost)
Retained earnings
X
And:
Dr
Cr
X
Expandable text ­ Depreciation of revalued asset
Test your understanding 2
A company revalued its land and buildings at the start of the year to $10
million ($4 million for the land). The property cost $5 million ($1 million
for the land) ten years prior to the revaluation. The total expected useful
life of 50 years is unchanged. The company's policy is to make an
annual transfer of realised amounts to retained earnings.
Show the effects of the above on the financial statements for the
year.
Disposal of revalued non­current assets
The profit or loss on disposal of a revalued non­current asset should be
calculated as the difference between the net sale proceeds and the carrying
amount.
It should be accounted for in the income statement of the period in which the
disposal occurs.
The remainder of the revaluation reserve relating to this asset should now
be transferred to retained earnings.
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Tangible non-current assets
Illustration 4 – Revaluation of non­current assets
Disposal of revalued non­current assets
A property costing $750,000 was purchased on 1 January 20X4 and is
being depreciated over its useful life of 10 years. It has no residual value.
At 31 December 20X4 the property was valued at $810,000. There was
no change to its useful life.
On 31 December 20X6 the property was sold for $900,000.
What is the profit or loss on disposal?
Expandable text ­ Solution
Expandable text ­ Key disclosures
4 IAS 20 Accounting for government grants and disclosure of
government assistance
Introduction
Governments often provide money or incentives to companies to export or
promote local employment.
Government grants could be:
•
•
revenue grants, e.g. money towards wages
capital grants, e.g. money towards purchase of non­current assets.
General principles
IAS 20 follows two general principles when determining the treatment of
grants:
Prudence: grants should not be recognised until the conditions for receipt
have been complied with and there is reasonable assurance the grant will
be received.
Accruals: grants should be matched with the expenditure towards which
they were intended to contribute.
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Expandable text ­ IAS 20 definitions
Revenue grants
The recognition of the grant will depend upon the circumstances.
•
If the grant is paid when evidence is produced that certain expenditure
has been incurred, the grant should be matched with that expenditure.
•
If the grant is paid on a different basis, e.g. achievement of a non­
financial objective, such as the creation of a specified number of new
jobs, the grant should be matched with the identifiable costs of
achieving that objective.
Presentation of revenue grants
IAS 20 allows such grants to either:
•
•
be presented as a credit in the income statement, or
deducted from the related expense.
Expandable text
Capital grants
IAS 20 permits two treatments:
•
Write off the grant against the cost of the non­current asset and
depreciate the reduced cost.
•
Treat the grant as a deferred credit and transfer a portion to revenue
each year, so offsetting the higher depreciation charge on the original
cost.
Expandable text
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Tangible non-current assets
Illustration 5 – IAS 20 Accounting for government grants
Capital grants
An entity opens a new factory and receives a government grant of
$15,000 in respect of capital equipment costing $100,000. It
depreciates all plant and machinery at 20% pa straight­line. Show the
statement of financial position extracts in respect of the grant in the first
year under both methods.
Expandable text ­ Solution
Test your understanding 3
Europe buys a building for a total cost of $200,000. It receives a
European Union grant of $60,000 towards the cost and pays the net of
$140,000 by cheque. The useful life of the building is estimated at 50
years. The deferred income method is to be used for the grant.
Show the movement in tangible non­current assets and deferred
grant income in the first year.
Repayment of grants
In some cases grants may need to be repaid if the conditions of the grant
are breached.
If there is an obligation to repay the grant and the repayment is probable,
then it should be provided for in accordance with the requirements of IAS 37
(see chapter 15).
Expandable text ­ Government assistance
Expandable text ­ IAS 20 disclosure requirements
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5 IAS 23 Borrowing costs
IAS 23 treatment
IAS 23 Borrowing costs regulates the extent to which entities are allowed to
capitalise borrowing costs incurred on money borrowed to finance the
acquisition of certain assets.
•
Borrowing costs must be capitalised as part of the cost of an asset, if
that asset is one which necessarily takes a substantial time to get ready
for its intended use or sale.
The rate of interest to be taken
Where borrowings are made specifically to acquire a qualifying asset:
•
Borrowing costs which may be capitalised are those actually incurred,
less any investment income on the temporary investment of the
borrowings.
Where funds for the project are taken from general borrowings:
•
The weighted average cost of general borrowings is taken. This
excludes borrowings with specific functions.
Commencement of capitalisation
Capitalisation of borrowing costs should commence when all of the following
conditions are met:
•
•
•
expenditure for the asset is being incurred.
borrowing costs are being incurred.
activities that are necessary to prepare the asset for its intended use or
sale are in progress.
Cessation of capitalisation
Capitalisation of borrowing costs should cease when either:
•
substantially all the activities necessary to prepare the qualifying asset
for its intended use or sale are complete, or
•
construction is suspended, e.g. due to industrial disputes.
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Tangible non-current assets
Illustration 6 – IAS 23 Borrowing costs
On 1 January 20X5, Sainsco began to construct a supermarket which
had an estimated useful life of 40 years. It purchased a leasehold
interest in the site for $25 million. The construction of the building cost $9
million and the fixtures and fittings cost $6 million. The construction of the
supermarket was completed on 30 September 20X5 and it was brought
into use on 1 January 20X6.
Sainsco borrowed $40 million on 1 January 20X5 in order to finance this
project. The loan carried interest at 10% pa. It was repaid on 30 June
20X6.
Calculate the total amount to be included at cost in property, plant and
equipment in respect of the development at 31 December 20X5.
Expandable text ­ Solution
Disclosures
The disclosures required by IAS 23 are:
•
•
•
the accounting policy adopted for borrowing costs
the amount of borrowing costs capitalised during the period
the capitalisation rate used.
Test your understanding 4
A retailer, Lewis John constructed a new store at a cost of $50 million
over six months from 1 January to 30 June 20X9. To assist the financing
of the project the company raised a $40 million 10% loan on 1 January.
The loan was repaid on 30 September. The store did not open until the
following year.
Calculate the initial cost valuation of the store.
6 IAS 40 Investment properties
IAS 40 Definition
Investment property is land or a building held to earn rentals, or for capital
appreciation or both, rather than for use in the entity or for sale in the
ordinary course of business.
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Owner­occupied property is excluded from the definition of investment
property.
Accounting treatment
Investment properties should initially be measured at cost.
IAS 40 then gives a choice between following:
•
•
a cost model
a fair value model.
Once the model is chosen it should be used for all investment properties
Expandable text
Cost model
Under the cost model the asset should be accounted for in line with the cost
model laid out in IAS 16.
•
The property will be shown in the statement of financial position at cost
less accumulated depreciation.
Fair value model
Under the fair value model:
•
•
•
the asset is revalued to fair value at the end of each year
the gain or loss is shown directly in the income statement
no depreciation is charged on the asset.
Fair value is normally established by reference to current prices on an active
market for properties of in the same location and condition.
Expandable text ­ Establishing fair value
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Tangible non-current assets
Illustration 7 – IAS 40 Investment properties
Celine, a manufacturing company, purchases a property for $1 million on
1 January 20X1 for its investment potential. The land element of the cost
is believed to be $400,000, and the buildings element is expected to
have a useful life of 50 years. At 31 December 20X1, local property
indices suggest that the fair value of the property has risen to $1.1
million. Show how the property would be presented in the financial
statements as at 31 December 20X1 if Celine adopts:
(a) the cost model
(b) the fair value model.
Expandable text ­ Solution
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Chapter summary
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Tangible non-current assets
Test your understanding answers
Test your understanding 1
(a) This expenditure enhances the economic benefits of the machine by
increasing its productivity and therefore would be capitalised
subsequent expenditure.
(b) It would be difficult to argue that the replacement of the windows
enhanced the economic benefits of the head office and therefore
this would be treated as revenue expenditure and written off to the
income statement as incurred.
(c) The engine of an aircraft is likely to be a separate component asset
of the aircraft as its economic life will be substantially less than that
of the aircraft itself. The engine will be depreciated over a five year
period and the cost of the replacement engine will then be
capitalised every five years.
Test your understanding 2
PPE Note
Land and buildings (CV)
B/f (5m ­ (10/50 x 4m))
Revaluation (β)
Valuation
Depreciation (6m/40years)
C/f
$000
4,200
5,800
–––––
10,000
(150)
–––––
9,850
–––––
Other comprehensive income ­ extract
Gain on property revaluation
Statement of changes in equity
B/f
Comprehensive income for year
Transfer to retained earnings (150 – 4m/50)
C/f
142
$000
5,800
Revaluation surplus
$000
0
5,800
(70)
–––––
5,730
–––––
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Test your understanding 3
Building
$
Cost
B/f
Addition
Nil
200,000
–––––––
200,000
–––––––
C/f
Depreciation
B/f
Charge (200,000/50)
Nil
4,000
–––––––
4,000
–––––––
196,000
–––––––
C/f
CV Cf
Grant
$
Nil
60,000
(1,200)
–––––––
58,800
–––––––
B/f
Granted
Income (60,000/50)
C/f
Test your understanding 4
Interest to be capitalised = $40m × 10% × 6/12 = $2m.
Initial cost:
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$50m + $2m = $52m.
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Tangible non-current assets
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chapter
9
Intangible assets
Chapter learning objectives
Upon completion of this chapter you will be able to:
•
explain the nature of internally­generated and purchased
intangibles
•
explain the accounting treatment of internally­generated and
purchased intangibles
•
•
•
distinguish between goodwill and other intangible assets
•
•
•
explain the subsequent accounting treatment of goodwill
•
•
explain how this difference should be accounted for
•
explain the accounting requirements of IAS 38 for research
expenditure and development expenditure
•
account for research expenditure and development expenditure.
describe the criteria for the initial recognition of intangible assets
describe the criteria for the initial measurement of intangible
assets
explain the principle of impairment tests in relation to goodwill
explain why the value of the purchase consideration for an
investment may be less than the value of the acquired net assets
define research expenditure and development expenditure
according to IAS 38
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Intangible assets
1 Intangible assets
Introduction
Many businesses invest significant amounts with the intention of obtaining
future value on areas such as:
•
•
•
•
•
•
scientific/technical knowledge
design of new processes and systems
licences and quotas
intellectual property, e.g. patents and copyrights
market knowledge, e.g. customer lists, relationships and loyalty
trade marks.
All of these expenses may result in future benefits to the business, but not all
can be recognised as assets.
Objective of IAS 38 Intangible assets
The objective of IAS 38 is to prescribe the specific criteria that must be met
before an intangible asset can be recognised in the accounts.
Definition
An intangible asset is an identifiable non­monetary asset without physical
substance.
To meet the definition the asset must be identifiable, i.e. separable from the
rest of the business or arising from legal rights.
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It must also meet the normal definition of an asset:
•
controlled by the entity as a result of past events (normally by
enforceable legal rights)
•
a resource from which future economic benefits are expected to flow
(either from revenue or cost saving).
Recognition
To be recognised in the financial statements, an intangible asset must:
•
•
meet the definition of an intangible asset, and
meet the recognition criteria of the framework:
– it is probable that future economic benefits attributable to the asset
will flow to the entity
–
the cost of the asset can be measured reliably.
If these criteria are met, the asset should be initially recognised at cost.
Internally­generated intangibles
The following internally­generated items may never be recognised:
•
•
•
•
•
goodwill
brands
mastheads
publishing titles
customer lists.
Expandable text ­ Purchased and internally generated intangibles
Test your understanding 1
How should the following intangible assets be treated in the
financial statements?
•
•
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A publishing title acquired as part of a subsidiary company.
A licence purchased in order to market a new product.
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Intangible assets
Measurement after initial recognition
There is a choice between:
•
•
the cost model
the revaluation model.
The cost model
• The intangible asset should be carried at cost less amortisation and
any impairment losses.
•
This model is more commonly used in practice.
The revaluation model
• The intangible asset may be revalued to a carrying value of fair value
less subsequent amortisation and impairment losses.
•
Fair value should be determined by reference to an active market.
Features of an active market are that:
–
the items traded within the market are homogeneous
–
willing buyers and sellers can normally be found at any time
–
prices are available to the public.
In practice such markets are rare.
Expandable text ­ Revaluation model
Amortisation
An intangible asset with a finite useful life must be amortised over that life,
normally using the straight­line method with a zero residual value.
An intangible asset with an indefinite useful life:
•
•
should not be amortised
should be tested for impairment annually, and more often if there is an
actual indication of possible impairment.
Expandable text ­ Amortisation
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Expandable text ­ Impairment losses
Test your understanding 2
What is the accounting treatment of a recognised intangible asset
with an indefinite useful life?
Key disclosures
The financial statements should disclose the following for each class of
intangible assets, distinguishing between internally­generated intangible
assets and other intangible assets:
•
•
•
whether the useful lives are finite or indefinite
the useful lives or the amortisation rates used for assets with finite lives
the amortisation methods used for assets with finite lives.
2 Goodwill
The nature of goodwill
Goodwill is the difference between the value of a business as a whole and
the aggregate of the fair values of its separable net assets.
Separable net assets are those assets (and liabilities) which can be
identified and sold off separately without necessarily disposing of the
business as a whole. They include identifiable intangibles such as patents,
licences and trade marks.
Fair value is the amount at which an asset or liability could be exchanged in
an arm’s length transaction between informed and willing parties, other than
in a forced or liquidation sale.
Goodwill may exist because of any combination of a number of possible
factors:
•
•
•
•
reputation for quality or service
technical expertise
possession of favourable contracts
good management and staff.
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Intangible assets
Purchased and non­purchased goodwill
Purchased goodwill:
•
•
arises when one business acquires another as a going concern
•
will be recognised in the financial statements as its value at a particular
point in time is certain.
includes goodwill arising on the consolidation of a subsidiary or
associated company
Non­purchased goodwill:
•
•
•
is also known as inherent goodwill
has no identifiable value
is not recognised in the financial statements.
IFRS 3 revised Business combinations
IFRS 3 revised governs accounting for all business combinations and deals
with the accounting treatment of goodwill.
Goodwill is defined in IFRS 3 as an asset representing the future economic
benefits arising from assets acquired in a business combination that are not
individually identified and separately recognised.
Goodwill is calculated at the acquisition date as:
Fair value of consideration paid (shares issued plus cash paid plus
direct costs)
Non­controlling interest
(valued either at fair value or as a proportion of net assets)
Fair value of net assets of acquiree
$
X
X
___
X
(X)
___
X
Accounting treatment of goodwill
Purchased goodwill:
•
•
•
150
should be capitalised as an intangible non­current asset
should not be amortised
must be tested for impairment annually in accordance with IAS 36, or
more frequently if circumstances indicate that it might be impaired.
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Expandable text ­ Purchased and non­purchased goodwill
Test your understanding 3
An entity acquires 75% of the share capital of another entity, JKL. The
consideration for the purchase was shares with a fair value of $800,000
and cash of $200,000. There were direct costs involved in the takeover
of $20,000 .The non­controlling interest is valued using the proportion of
net assets method.The carrying amounts and fair values of JKL assets
and liabilities at the date of acquisition were as follows:
Tangible non­current assets
Current assets
Current liabilities
Carrying value
$000
700
400
(200)
–––––
900
Fair value
$000
950
350
(200)
–––––
1,100
What is the amount of goodwill be recognised on acquisition?
Expandable text ­ Bargain purchases
Test your understanding 4
What are the main characteristics of goodwill which distinguish it
from other intangible assets?
State your reasons.
3 Research and development expenditure
Definitions
Research is original and planned investigation undertaken with the
prospect of gaining new scientific knowledge and understanding.
Development is the application of research findings or other knowledge to
a plan or design for the production of new or substantially improved
materials, devices, products, processes, systems or services before the
start of commercial production or use.
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Intangible assets
Accounting treatment
Research expenditure: write off as incurred to the income statement
Development expenditure: recognise as an intangible asset if, and only if,
an entity can demonstrate all of the following:
•
the technical feasibility of completing the intangible asset so that it will
be available for use or sale
•
•
•
its intention to complete the intangible asset and use or sell it
•
the availability of adequate technical, financial and other resources to
complete the development and to use or sell the intangible asset
•
its ability to reliably measure the expenditure attributable to the
intangible asset during its development.
its ability to use or sell the intangible asset
how the intangible asset will generate probable future economic
benefits. Among other things, the entity should demonstrate the
existence of a market for the output of the intangible asset or the
intangible asset itself or, if it is to be used internally, the usefulness of
the intangible asset
Expandable text
Test your understanding 5
An entity has incurred the following expenditure during the current year:
(a) $100,000 spent on the design of a new product ­ it is anticipated
that this design will be taken forward over the next two year period to
be developed and tested with a view to production in three years
time.
(b) $500,000 spent on the testing of a new production system which
has been designed internally and which will be in operation during
the following accounting year. This new system should reduce the
costs of production by 20%.
How should each of these costs be treated in the financial
statements of the entity?
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Amortisation
Development expenditure should be amortised over its useful life.
Illustration 1 – Research and development expenditure
Amortisation of development expenditure
Improve has deferred development expenditure of $600,000 relating to
the development of New Miracle Brand X. It is expected that the demand
for the product will stay at a high level for the next three years. Annual
sales of 400,000, 300,000 and 200,000 units respectively are expected
over this period. Brand X sells for $10.
How should the development expenditure be amortised?
Expandable text ­ Solution
Disclosure
The key disclosures required for development costs are:
•
•
•
the useful lives or the amortisation rates used for assets with finite lives
the amortisation methods used for assets with finite lives
the gross carrying amount and the accumulated amortisation
(aggregated with accumulated impairment losses) at the beginning and
end of the period.
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Intangible assets
Test your understanding 6
D&E are both development projects. Both projects are anticipated to be
successful. They have clearly­defined parameters. The project
expenditure is carefully controlled. The prototypes proved successful.
The budgets show sales well in excess of total costs. Finance is readily
available. Project D has commenced production and the revenues have
started to flow in.
Project Project
D
E
Costs accumulated to 1.1.X5 (and meeting
capitalisation criteria)
Costs incurred during the year
Total anticipated net revenues
Net revenues during the year
$000
400
$000
350
600
250
30,000 15,000
6,000
nil
The company has also invested $340,000 in development project F but
the tests are at present inconclusive.
Describe with reasons the accounting for the above issues.
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Chapter summary
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Intangible assets
Test your understanding answers
Test your understanding 1
•
The answer depends on whether the asset can be valued reliably. If
this is possible, the title will be recognised at its fair value, otherwise
it will be treated as part of goodwill on acquisition of the subsidiary.
•
As the licence has been purchased separately from a business, it
should be capitalised at cost.
Test your understanding 2
An intangible asset with an indefinite useful life:
•
•
should not be amortised
should be tested for impairment annually, and more often if there is
an actual indication of possible impairment.
Test your understanding 3
$000
Fair value of consideration
Shares
Cash
800
200
–––––
1,000
Non­controlling interest (1,100 x 25%)
275
–––––
1,275
(1,100)
Net assets of acquiree
Goodwill
175
–––––
Note: IFRS 3 revised requires acquisition costs to be expensed as
incurred. They do not form part of the cost of acquisition.
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Test your understanding 4
Characteristics
•
It is a ‘balancing figure’. Goodwill itself is not valued but a
comparison is made between the fair value of the whole business
and the fair value of the separable net assets of the business. It
cannot be valued on its own.
•
•
Goodwill cannot be disposed of as a separate asset.
•
The value of goodwill is volatile – it can only be given a numerical
value at the time of acquisition of the whole business.
The factors contributing to the value of goodwill cannot be valued,
e.g. how can one value the benefit of an experienced workforce?
Test your understanding 5
(a) These are research costs as they are only in the early design stage
and therefore should be written off as part of profit and loss for the
period.
(b) These would appear to be development stage costs as the new
production system is due to be in place fairly soon and will produce
economic benefits in the shape of reduced costs. Therefore these
should be capitalised as development costs.
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Intangible assets
Test your understanding 6
As tests are inconclusive in project F, its costs must be expensed to the
income statement.
Projects D and E are both examples of development spend which meets
the capitalisation critera and as such the relevant costs are shown as
assets on the statement of financial position.
Project D has commenced production and so requires amortisation.
Development expenditure
B/f
Capitalised
Amortised (6/30 × 1,000)
C/f
Intangible non­current assets (Note)
Development expenditure
as at 1.1.X5
Costs deferred
Released to the Income statement
as at 31.12.X5
158
D
400
600
(200)
––––
800
E
350
250
Nil
––––
600
Total
750
850
(200)
––––
1,400
$000
750
850
(200)
–––––
1,400
–––––
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chapter
10
Impairment of assets
Chapter learning objectives
Upon completion of this chapter you will be able to:
•
•
•
•
define an impairment loss
•
allocate an impairment loss to the assets of a CGU.
list the circumstances which may indicate impairments to assets
describe a cash generating unit (CGU)
explain the basis on which impairment losses should be
allocated
159
Impairment of assets
1 Impairment of individual assets
Objective of IAS 36 impairment of assets
The objective is to set rules to ensure that the assets of an entity are carried
at no more than their recoverable amount (i.e. value to the business).
Expandable text ­ Excluded assets
Impairment
An asset is impaired if its recoverable amount is below the value currently
shown on the statement of financial position – the asset’s current carrying
value (CV).
Recoverable amount is taken as the higher of:
•
•
160
fair value less costs to sell (net selling price), and
value in use.
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An impairment exists if:
Expandable text ­ Measurement of recoverable amount
Illustration 1 – Impairment of individual assets
Recoverable amount
A company owns a car that was involved in an accident at the year end.
It is barely useable, so the value in use is estimated at $1,000. However,
the car is a classic and there is a demand for the parts. This results in a
net realisable value of $3,000. The opening carrying value was $8,000
and the car was estimated to have a life of eight years from the start of
the year.
Identify the recoverable amount of the car.
Expandable text ­ Solution
Test your understanding 1
The following information relates to three assets:
Carrying value
Net realisable value
Value in use
A
$000
100
110
120
B
$000
150
125
130
C
$000
120
100
90
What is the recoverable amount of each asset?
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Impairment of assets
Calculate the impairment loss for each of the three assets.
Expandable Text­ Illustration : recoverable amount
Indications of impairment
IAS 36 requires that at each reporting date, an entity must assess whether
there are indications of impairment.
Indications may be derived from within the entity itself (internal sources) or
the external market (external sources).
External sources of information
• The asset’s market value has declined more than expected.
•
Changes in the technological, market, economic or legal environment
have had an adverse effect on the entity.
•
Interest rates have changed, thus increasing the discount rate used in
calculating the asset’s value in use.
Internal sources of information
• There is evidence of obsolescence of or damage to the asset.
•
•
Changes in the way the asset is used have occurred or are imminent.
Evidence is available from internal reporting indicating that the
economic performance of an asset is, or will be, worse than expected.
Expandable text ­ Annual impairment reviews
Recognition and measurement of an impairment
Where there is an indication of impairment, an impairment review should be
carried out:
•
•
•
the recoverable amount should be calculated
the asset should be written down to recoverable amount and
the impairment loss should be immediately recognised in the income
statement.
The only exception to this is if the impairment reverses a previous gain
taken to the revaluation reserve.
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In this case, the impairment will be taken first to the revaluation reserve (and
so disclosed as other comprehensive income) until the revaluation gain is
reversed and then to the income statement.
Test your understanding 2
An entity owns a property which was originally purchased for $300,000.
The property has been revalued to $500,000 with the revaluation of
$200,000 being recognised as other comprehensive income and
recorded in the revaluation reserve. The property has a current carrying
value of $460,000 but the recoverable amount of the property has just
been estimated at only $200,000.
What is the amount of impairment and how should this be treated
in the financial statements?
Expandable text ­ Reversal of impairment losses
2 Cash generating units (CGUs)
What is a CGU?
When assessing the impairment of assets it will not always be possible to
base the impairment review on individual assets.
•
The value in use calculation will be impossible on a single asset
because the asset does not generate distinguishable cash flows.
•
In this case, the impairment calculation should be based on a CGU.
Definition of a CGU
A CGU is defined as the smallest identifiable group of assets which
generates cash inflows independent of those of other assets.
Expandable text ­ Illustration ­ CGUs
Expandable text ­ Goodwill and CGUs
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Impairment of assets
The impairment calculation
The impairment calculation is done by:
•
•
assuming the cash generating unit is one asset
comparing the carrying value of the CGU to the recoverable amount of
the CGU.
As previously, an impairment exists where the carrying value exceeds the
recoverable amount.
Impairment of a CGU
If a CGU is impaired the assets must be written down in a strict order:
(1) any obviously impaired asset
(2) goodwill allocated to the CGU (both recognised goodwill and , where
the proportion of net assets method is used to value the NCI, notional
goodwill attributed to the NCI)
(3) other assets (pro rata according to carrying value).
Note: No individual asset should be written down below recoverable
amount.
Test your understanding 3
A company runs a unit that suffers a massive drop in income due to the
failure of its technology on 1 January 20X8. The following carrying values
were recorded in the books immediately prior to the impairment:
Goodwill
Technology
Brands
Land
Buildings
Other net assets
164
$m
20
5
10
50
30
40
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The recoverable value of the unit is estimated at $85 million. The
technology is worthless, following its complete failure. The other net
assets include inventory, receivables and payables. It is considered that
the book value of other net assets is a reasonable representation of its
net realisable value.
Show the impact of the impairment on 1 January.
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Impairment of assets
Chapter summary
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Test your understanding answers
Test your understanding 1
The recoverable amounts for each asset are as follows:
A: $120,000
B: $130,000
C: $100,000
The impairment loss for each asset is as follows:
A: Nil
B: $20,000
C: $20,000
Test your understanding 2
Impairment = $460,000 – 200,000 = $260,000
Of this $200,000 is debited to the revaluation reserve to reverse the
previous upwards revaluation (and recorded as other comprehensive
income) and the remaining $60,000 is charged to the income statement.
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Impairment of assets
Test your understanding 3
•
•
•
Carrying value is $155 million.
Recoverable value is $85 million.
Therefore an impairment of $70 million is required.
Carrying value
Goodwill
Impairment
Impaired value
20
(20)
0
5
(5)
0
Brands
10
(5)
5
Land
50
(25)
25
Buildings
30
(15)
15
Other
40
(0)
40
CGU
155
(70)
85
Technology
Working
Total impairment:
Allocated
– Goodwill
– Technology
Remaining
Prorate based on carrying value:
Brands
Land
Buildings
168
$m
70
(20)
(5)
–––
45
45 × 10/(10 + 50 + 30) =
45 × 50/(10 + 50 + 30) =
45 × 30/(10 + 50 + 30) =
5
25
15
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chapter
11
Inventories and construction
contracts
Chapter learning objectives
Upon completion of this chapter you will be able to:
•
explain the principles of IAS 2 with regard to the valuation of
inventory
•
apply the principles of IAS 2 with regard to the valuation of
inventory
•
•
define a construction contract
•
explain the acceptable methods of determining the stage (%) of
completion of a construction contract
•
prepare financial statement extracts for construction contracts.
explain how accounting concepts affect the recognition of profit
on construction contracts
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Inventories and construction contracts
1 Accounting for inventory
IAS 2 inventory valuation
Inventories are valued at the lower of cost and net realisable value (NRV).
Definition of cost
Cost is the cost of bringing items of inventory to their present location and
condition (including cost of purchase and costs of conversion).
Expandable text ­ Definition of cost
Expandable text ­ Definition of NRV
Expandable text ­ Inventory valuation methods
Expandable text ­ Disclosure requirements
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Test your understanding 1
Value the following items of inventory.
(a) Materials costing $12,000 bought for processing and assembly for
a profitable special order. Since buying these items, the cost price
has fallen to $10,000.
(b) Equipment constructed for a customer for an agreed price of
$18,000. This has recently been completed at a cost of $16,800. It
has now been discovered that, in order to meet certain regulations,
conversion with an extra cost of $4,200 will be required. The
customer has accepted partial responsibility and agreed to meet
half the extra cost.
2 IAS 11 Construction contracts
Definition of a construction contract
A construction contract is a contract 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.
Accounting problem of construction contracts
Construction contracts cause special problems as they are often of such a
length that they span more than one accounting period.
Therefore, some prescribed method of recording turnover, cost of sales and
profit over the life of the contract is needed.
Expandable text ­ Illustration :construction contracts
Expandable text ­ Contract revenue and costs
Recognition of contract revenue and expenses
Recognition depends upon whether the outcome of a contract can be
measured reliably
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Inventories and construction contracts
Where the outcome of a contract can be estimated reliably
If the expected outcome is a profit:
•
revenue and costs should be recognised according to the stage of
completion of the contract.
If the expected outcome is a loss:
•
the whole loss to completion should be recognised immediately.
Where the outcome of a construction contract cannot be estimated
reliably
•
Revenue should be recognised only to the extent of contract costs
incurred that it is probable will be recoverable.
•
Contract costs should be recognised as an expense in the period in
which they are incurred.
An expected loss on such a construction contract should be recognised as
an expense immediately.
Test your understanding 2
The following information relates to a construction contract:
Estimated contract revenue
Costs to date
Estimated costs to complete
Estimated stage of completion
$800,000
$320,000
$280,000
60%
(a) What amounts of revenue, costs and profit should be recognised in
the income statement?
(b) Take the same contract but now assume that the business is not
able to reliably estimate the outcome of the contract although it is
believed that all costs incurred will be recoverable from the
customer. What amounts should be recognised for revenue, costs
and profit in the income statement?
Expandable text ­ Reliable estimate of contract outcome
172
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Summary of recognition rules
Expandable text
Determining the stage of completion of a contract
IAS 11 indicates several ways in which the percentage of completion of a
contract may be arrived at:
•
the proportion that contract costs incurred for work performed to date
bear to the estimated total contract costs
(Costs to date/ Total costs) × 100% = % complete
•
surveys of work performed
(Work certified/Contract price) × 100% = % complete
•
completion of a physical proportion of the contract work (given as a
percentage).
Presentation in financial statements
Income statement
The following will appear in the income statement for construction contracts:
•
•
•
revenue
costs
profit or loss.
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Inventories and construction contracts
Calculated according to the rules given above.
Statement of financial position
The following figures may appear in the statement of financial position:
•
•
gross amount due from customers – asset
gross amount due to customers – liability.
The calculation (which may result in an asset or liability) is:
$
X
X
(X)
(X)
–––
X
––––
Costs incurred
Add: recognised profit
Less: recognised losses
Less: progress billings
Gross amounts due to/from customers
Expandable text ­ Asset and Liability
Expandable text ­ Disclosure requirements
Illustration 1 – IAS 11 Construction contracts
Softfloor House Limited make café bars. The projects generally take a
number of months to complete. The company has three contracts in
progress at the year ended 30 April.
A
B
C
$000
$000
$000
Costs incurred to date
200
90
600
Costs to complete
200
110
200
Contract price
600
300
750
40
70
630
Progress billings
Softfloor calculates the percentage of completion by using the costs
incurred compared to the total costs.
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Calculate the effects of the above contracts upon the financial
statements.
Expandable text ­ Solution
Test your understanding 3
Hardfloor House fits out nightclubs. The projects generally take a number
of months to complete. The company has three contracts in progress at
the year ended 30 April:
Costs incurred to date
Costs to complete
Contract price
Work certified to date
Received
J
$000
320
40
416
312
250
K
$000
540
90
684
456
350
L
$000
260
120
300
200
230
Hardfloor accrues profit on its construction contracts using the
percentage of completion derived from the sales earned as work
certified compared to the total sales value.
Calculate the effects of the above contracts upon the financial
statements.
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Inventories and construction contracts
Chapter summary
176
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Test your understanding answers
Test your understanding 1
(a) Value at $12,000. $10,000 is irrelevant. The rule is lower of cost or
NRV, not lower of cost or replacement cost. Since the special order
is known to be profitable, the NRV will be above cost.
(b) Value at NRV, i.e. $15,900, as this is below cost
(NRV = contract price, $18,000 – company’s share of modification
cost, $2,100).
Test your understanding 2
(a) Revenue ($800,000 × 60%)
Costs ((320,000 + 280,000) × 60%)
Profit
(b) Revenue (same as costs )
Costs
Profit
KAPLAN PUBLISHING
$480,000
$360,000
–––––
$120,000
$320,000
$320,000
–––––
Nil
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Inventories and construction contracts
Test your understanding 3
(1) Total profit
Revenue
Total costs
Total profit
J
$000
416
(360)
––––
56
––––
(2) Attributable profit
Contract % complete calculated
as:
Work certified
––––––––––––––
Contract price
J
312/416 = 75%
K
456/684 = 66.67%
L
200/300 = 66.67%
3.
L
$000
300
(380)
––––
(80)
––––
Profit/loss
75% × $56,000 = $42,000
66.67% × $54,000 = $36,000
Recognise loss in full, i.e.
$80,000
Income statement
Sales (work certified)
Costs (balancing figure)
Gross profit
178
K
$000
684
(630)
––––
54
––––
A
B
C
Total
$000 $000 $000 $000
312
456
200
968
(270) (420) (280) (970)
–––– –––– –––– ––––
42
36
(80)
(2)
–––– –––– –––– ––––
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4. Statement of financial position
Costs incurred
Profits recognised
Loss recognised
Less: progress payments
Balance
Total asset (112 + 226):
Total liability:
A
B
C
$000 $000 $000
320
540
260
42
36
–
–
–
(80)
(250) (350) (230)
–––– –––– ––––
112
226
(50)
$338,000
$50,000
Total asset: $338,000
Total liability: $50,000
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chapter
12
Financial assets and
financial liabilities
Chapter learning objectives
Upon completion of this chapter you will be able to:
•
explain the need for an accounting standard on financial
instruments
•
define financial instruments in terms of financial assets and
financial liabilities
•
•
distinguish between the four categories of financial instruments
•
explain how held­to­maturity financial assets should be measured
and how any gains/losses from subsequent measurement should
be treated in the financial statements
•
explain how available­for­sale financial assets should be
measured and how any gains/losses from subsequent
measurement should be treated in the financial statements
•
explain how loans and receivables should be measured and how
any gains/losses from subsequent measurement should be
treated in the financial statements
•
•
distinguish between debt and equity capital
•
account for the issue of redeemable preference shares and
payment of preference share dividends
•
account for the issue of debt instruments with no conversion
rights and the payment of interest.
explain how fair value through profit and loss financial instruments
should be measured and how any gains/losses from subsequent
measurement should be treated in the financial statements
account for the issue of equity shares and the payment of equity
dividends
181
Financial assets and financial liabilities
1 Financial instruments
Introduction
A financial instrument is any contract that gives rise to a financial asset of
one entity and a financial liability or equity instrument of another entity.
Expandable text ­ Need for accounting standards
Financial assets
A financial asset is any asset that is:
•
•
cash
•
a contractual right to exchange financial assets/liabilities with another
entity under conditions that are potentially favourable
•
•
a contract that will or may be settled in the entity’s own equity instrument
a contractual right to receive cash or another financial asset from
another entity
an equity instrument of another entity.
Examples of financial assets include:
•
•
•
182
trade receivables
options
investment in equity shares.
KAPLAN PUBLISHING
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Financial liabilities
A financial liability is any liability that is a contractual obligation:
•
•
to deliver cash or another financial asset to another entity, or
•
that will or may be settled in the entity’s own equity instruments.
to exchange financial assets/liabilities with another entity under
conditions that are potentially unfavourable, or
Examples of financial liabilities include:
•
•
•
trade payables
debenture loans
redeemable preference shares.
Test your understanding 1
Identify which of the following are financial instruments:
(a) inventories
(b) investment in ordinary shares
(c) prepayments for goods or services
(d) liability for income taxes
(e) a share option (an entity’s obligation to issue its own shares).
Expandable text ­ Classification, recognition and derecognition
Expandable text ­ Fair value through profit or loss financial
Expandable text ­ Held­to­maturity financial assets
Expandable text ­ Available­for­sale financial assets
Expandable text ­ Loans and receivables
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Financial assets and financial liabilities
Test your understanding 2
(1) A company invests $5,000 in 10% debentures. The debentures are
repayable at a premium after 3 years. The effective rate of interest
is 12%.
What amounts will be shown in the income statement and Statement
of Financial Position for the financial asset for years 1­3?
(2) A company invested in 10,000 shares of a listed company in
November 2007 at a cost of $4.20 per share. At 31 December
2007 the shares have a market value of $4.90. The company are
planning on selling these shares in April 2008.
Prepare extracts from the income statement for the year ended 31
December 2007 and a Statement of Financial Position as at that
date.
(3) A company invested in 20,000 shares of a listed company in
October 2007 at a cost of $3.80 per share. At 31 December 2007
the shares have a market value of $3.40. The company are not
planning on selling these shares in the short term.
Prepare extracts from the income statement for the year ended 31
December 2007 and a Statement of Financial Position as at that
date.
Expandable text ­ Impairment of financial assets
Expandable text ­ Measurement of financial liabilities
Test your understanding 3
(1) A company issues 5% loan notes at their nominal value of $20,000.
The loan notes are repayable at par after 4 years.
What amount will be recorded as a financial liability when the loan
notes are issued?
What amounts will be shown in the income statement and
Statement of Financial Position for years 1 ­4?
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(2) A company issues 0% loan notes at their nominal value of $40,000.
The loan notes are repayable at a premium of $11,800 after 3
years. The effective rate of interest is 9%.
What amount will be recorded as a financial liability when the loan
notes are issued?
What amounts will be shown in the income statement and
Statement of Financial Position for years 1­3?
(3) A company issues 5% redeemable preference shares at their
nominal value of $10,000. The shares are redeemable at a
premium of $1,760 after 5 years. The effective rate of interest is
8%.
What amounts will be shown in the income statement and
Statement of Financial Position for years 1­5?
(4) A company issues 4% loan notes with a nominal value of $20,000.
The loan notes are issued at a discount of 2.5% and $534 of issue
costs are incurred.
The loan notes will be repayable at a premium of 10% after 5 years.
The effective rate of interest is 7%.
What amount will be recorded as a financial liability when the loan
notes are issued?
What amounts will be shown in the income statement and
Statement of Financial Position for years 1­5?
(5) A company issues 3% bonds with a nominal value of $150,000.
The loan notes are issued at a discount of 10% and issue costs of
$11,455 are incurred.
The loan notes will be repayable at a premium of $10,000 after 4
years. The effective rate of interest is 10%.
What amount will be recorded as a financial liability when the loan
notes are issued?
What amounts will be shown in the income statement and
Statement of Financial Position for years 1­4?
Exandable text ­ Illustration: Measurement of financial liabilities
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Financial assets and financial liabilities
2 Equity and liabilities
Introduction
IAS 32 requires the classification of a financial liability, or its component
parts, as a liability or as equity according to the substance of the contractual
arrangement.
An equity instrument is any contract that evidences a residual interest in
the assets of an entity after deducting all of its liabilities.
Expandable text ­ Classification as liability or equity
Compound instruments
A compound instrument is one which has both a liability and an equity
component.
For example, a convertible bond:
•
the value of a convertible bond consists of a liability component – the
bond – and
•
an equity component – the value of the right to convert in due course to
equity.
The two elements must be separately recognised in the statement of
financial position:
•
•
the liability element
the equity element.
The economic effect of issuing convertible bonds is substantially the same
as the simultaneous issue of a debt instrument with an early settlement
provision and warrants to purchase shares.
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Illustration 1 – Equity and liabilities
Compound instruments
Convert issues a convertible loan that attracts interest of 2%. The market
rate is 8%, being the interest rate for an equivalent debt without the
conversion option. The loan of $5 million is repayable in full after three
years or convertible to equity. Discount factors are as follows:
Year
1
2
3
Discount factor at 8%
0.923
0.857
0.794
Required:
Split the loan between debt and equity at inception and calculate the
finance change for each year until conversion/redemption.
Test your understanding 4
(1) A company issues 2% convertible bonds at their nominal value of
$36,000.
The bonds are convertible at any time up to maturity into 120
ordinary shares for each $100 of bond. Alternatively the bonds will
be redeemed at par after 3 years.
Similar non­convertible bonds would carry an interest rate of 9%.
The present value of $1 payable at the end of year, based on rates
of 2% and 9% are as follows:
End of year
1
2
3
2%
0.98
0.96
0.94
9%
0.92
0.84
0.77
What amounts will be shown as a financial liability and as
equity when the convertible bonds are issued?
What amounts will be shown in the income statement and
Statement of Financial Position for years 1­3?
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Financial assets and financial liabilities
(2) A company issues 4% convertible bonds at their nominal value of $5
million.
Each bond is convertible at any time up to maturity into 400 ordinary
shares. Alternatively the bonds will be redeemed at par after 3
years.
The market rate applicable to non­convertible bonds is 6%.
The present value of $1 payable at the end of year, based on rates
of 4% and 6% are as follows:
End of year
1
2
3
4%
0.96
0.92
0.89
6%
0.94
0.89
0.84
What amounts will be shown as a financial liability and as
equity when the convertible bonds are issued?
What amounts will be shown in the income statement and
Statement of Financial Position for years 1­3?
Expandable text ­ Solution
Exandable text ­ Further illustration
Preference shares
If preference shares are irredeemable:
•
they are classified as equity.
If preference shares are redeemable:
•
188
they are classified as a financial liability.
KAPLAN PUBLISHING
chapter 12
Test your understanding 5
On 1 October 20X4, a company issued 50,000 redeemable preference
shares with a par value of $100 each to investors at $55. The shares are
redeemable at par on 30 September 20X9 and have a coupon rate of
2%. The effective rate of interest is 15.62%.
How would these redeemable preference shares appear in the
financial statements for the years ending 30 September 20X5 and
30 September 20X6?
Expandable text
Test your understanding 6
Why are redeemable preference shares treated as liabilities?
Expandable text ­ Preference share dividends
Interest and dividends
The accounting treatment of interest and dividends depends upon the
accounting treatment of the underlying instrument itself:
•
•
equity dividends declared are reported directly in equity
dividends on redeemable preference shares classified as a liability are
an expense in the income statement.
Offsetting financial assets and financial liabilities
In common with all IFRS rules on offsetting, a financial asset and a financial
liability may only be offset in very limited circumstances. The net amount
may only be presented in the statement of financial position when the entity:
•
•
has a legally enforceable right to set off the amounts, and
intends either to settle on a net basis or to realise the asset and settle
the liability simultaneously.
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Financial assets and financial liabilities
Chapter summary
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chapter 12
Test your understanding answers
Test your understanding 1
(a) Inventory (or any other physical asset such as non­current assets) is
not a financial instrument since there is no present contractual right
to receive cash or other financial instruments.
(b) An investment in ordinary shares is a financial asset since it is an
equity instrument of another entity.
(c) Prepayments for goods or services are not financial instruments
since the future economic benefit will be the receipt of goods or
services rather than a financial asset.
(d) A liability for income taxes is not a financial instrument since the
obligation is statutory rather than contractual.
(e) A share option is a financial instrument since a contractual
obligation does exist to deliver an equity instrument. Note, however,
that an option to buy or sell an asset other than a financial instrument
(e.g. a commodity) would not qualify as a financial instrument.
Test your understanding 2
(1) When the loan notes are issued:
Dr Bank $20,000
Cr Loan $20,000
notes
Income statement
Finance costs
1
2
3
4
(1,000) (1,000) (1,000) (1,000)
Statement of Financial Position
Non­current liabilities
Current liabilities
KAPLAN PUBLISHING
1
2
20,000 20,000
3
4
20,000 0
191
Financial assets and financial liabilities
Workings
Year
1
2
3
4
Opening
20,000
20,000
20,000
20,000
Finance costs 5%
1,000
1,000
1,000
1,000
Cash paid 5%
(1,000)
(1,000)
(1,000)
(1,000)
(20,000)*
Closing
20,000
20,000
20,000
0
*The loan notes are repaid at par i.e $20,000 at the end of year 4
(2) When the loan notes are issued:
Dr
$40,000
Bank
Cr Loan $40,000
notes
Income Statement
Finance Costs
1
2
3
(3,600) (3,924) (4,276)
Statement of Financial Position
Non­current liabilities
Current liabilities
1
43,600
2
3
47,524
0
Workings
Year
1
2
3
Opening
40,000
43,600
47,524
Finance costs 9%
3,600
3,924
4,276
Cash paid 0%
(0)
(0)
(0)
(51,800)
Closing
43,600
47,524
0
The loan notes are repaid at par i.e. $40,000, plus a premium of
$11,800 at the end of year 3
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(3)
Finance costs
1
2
3
4
5
(800) (824) (850) (878) (908)
Statement of Financial Position
1
10,300
Non­current liabilities
Current liabilities
2
10,624
3
10,974
4
5
11.352
0
Workings
Year
1
2
3
4
5
Opening
10,000
10,300
10,624
10,974
11,352
Finance costs 8%
800
824
850
878
908
Cash paid 5%
(500)
(500)
(500)
(500)
(500)
(11,760)
Closing
10.300
10,624
10,974
11,352
0
(4) When the loan notes are issued:
Dr Bank
$18,966
Cr loan notes
$18,966
Working
Nominal value
Discount 2.5%
Issue costs
20,000
(500)
(534)
_____
18,966
Income statement
Finance cost
KAPLAN PUBLISHING
1
(1,328)
2
(1,365)
3
(1,404)
4
1,446)
5
(1,491)
193
Financial assets and financial liabilities
Statement of Financial Position
1
19,494
Non­current liabilities
Current liabilities
2
20,059
3
20,663
4
5
21,309 0
Workings
Year
1
2
3
4
5
Opening
18,966
19,494
20,059
20,663
21,309
Finance costs 7%
1,328
1,365
1,404
1,446
1,491
Cash paid 4%
(800)
(800)
(800)
(800)
(800)
(22,000)
Closing
19,494
20,059
20,663
21,309
0
(5) When the loan notes are issued:
Dr $123,545
Bank
Cr $123,545
Loan
notes
Working
Nominal value
10% discount
Issue costs
150,000
(15,000)
(11,455)
_______
123,545
Income statement
Finance costs
194
1
(12,355)
2
(13,140)
3
(14,004)
4
(14,956)
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chapter 12
Statement of Financial Position
1
131,400
Non­current liabilities
Current liabilities
2
140,040
3
4
149,544
0
Workings
Year
1
2
3
4
Opening
123,545
131,400
140,040
149,544
Finance costs 10%
12,355
13,140
14,004
14,956
Cash paid 3%
(4,500)
(4,500)
(4,500)
(4,500)
(160,000)
Closing
131,400
140,040
149,544
0
Test your understanding 3
(1) When the convertible bonds are issed:
Dr Bank
$36,000
Cr Financial
Liability
$29,542
Cr Equity
$6,458
Year
1
2
3
Cash flow
720
720
36,720
Discount factor 9%
0.92
0.84
0.77
Present value
662.4
604.8
28,274.4
_________
29,541.6
_________
cash flow= 2% x 36,000 = 720
Income Statement
Finance costs
KAPLAN PUBLISHING
1
(2,659)
2
(2,833)
3
(3,023)
195
Financial assets and financial liabilities
Statement of Financial Position
Equity
Equity option
Non­current liabilities
Current liabilities
1
2
3
6,458
31,481
6,458
6,458
33,594
0
Workings
Year
1
2
3
Opening
29,542
31,481
33,594
Finance costs 9%
2,659
2,833
3,023
Cash paid 2%
(720)
(720)
(720)
(36,000)
Closing
31,481
33,594
0
(2) When the convertible bonds are issued:
Dr Bank
$5,000,000
Cr Financial
Liability
$4,734,000
Cr Equity
$266,000
Year
1
2
3
Cash flow
200,000
200,000
5,200,000
Discount factor
0.94
0.89
0.84
Present Value
188,000
178,000
4,368,000
__________
4,734,000
__________
Cash flow = 4% x 5,000,000 = $200,000
Income statement
Finance costs
196
1
(284,040)
2
(289,082)
3
(294,428)
KAPLAN PUBLISHING
chapter 12
Statement of Financial Position
Equity
Equity option
Non­current liabilities
Current liabilities
1
2
3
266,000
4,818,040
266,000
266,000
4,907,122
0
Workings
Year Opening
1
4,734,000
2
4,818,040
3
4,907,122
Finance costs 6%
284,040
289,082
294,428
Cash paid 4%
(200,000)
(200,000)
(200,000)
(5,000,000)
Closing
4,818,040
4,907,122
0
Test your understanding 4
(1) Assumed Held to maturity
Investment Income
1
600
2
612
3
625
Statement of Financial Position
1
2
3
5,100
5,212
0
Non­current assests
Investments
Working
Year
1
2
3
KAPLAN PUBLISHING
Opening Investment Income 12% Cash received 10% Closing
5,000
600
(500)
5,100
5,100
612
(500)
5,212
5,212
625
(500)
(5,837)
0
197
Financial assets and financial liabilities
(2) This is a fair value through profit or loss asset as it is held for sale in
the short term. It must therefore be revalued at the year end with
changes in value being recognised in the income statement.
Income statement
Investment Income (10,000 × (4.90­4.20))
7,000
Statement of Financial Position
Current Assets
Investments (10,000 × 4.90)
49,000
(3) This is an available for sale investment. It cannot be classified as
held to maturity or loans and receivables as it does not have fixed or
determinable payments.
Income statement
Investment Income
0
Statement of Financial Position
Non­current Assets
Investments (20,000 × 3.40)
Equity
Retained earnings (b/f–8,000 + PAT – Div's
198
68,000
X
KAPLAN PUBLISHING
chapter 12
There is a loss of $8,000 on the shares i.e. 20,000 × (3.80–3.40). This
will be recorded within reserves.
Test your understanding 5
Proceeds of issue = 50,000 × $55
Annual payment
Period ended
30 Sept
20X5
20X6
= $2,750,000
= 50,000 × $100 × 2% = $100,000
Opening Finance costs Cash paid Closing
balance
@ 15.62%
@ 2%
balance
$000
$000
$000
$000
2,750
430
(100)
3,080
3,080
481
(100)
3,461
Year ended 30 September 20X5:
SFP liability value for preference shares
$3,080,000
Interest charged in income statement
$430,000
Year ended 30 September 20X6:
SFP liability value for preference shares
$3,461,000
Interest charged in income statement
$481,000
Test your understanding 6
When a preference share provides for mandatory redemption by the
issuer for a fixed or determinable amount at a fixed or determinable
future date, or gives the holder the right to require the issuer to redeem
the share at or after a particular date for a fixed or determinable amount,
the instrument meets the definition of a financial liability and is classified
as such.
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Financial assets and financial liabilities
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13
Leases
Chapter learning objectives
Upon completion of this chapter you will be able to:
•
explain why recording the legal form of a finance lease can be
misleading to users making reference to the commercial
substance of such leases
•
•
define a finance lease and an operating lease
•
•
•
account for finance lease assets in the records of the lessee
determine whether a lease is a finance lease or an operating
lease
account for operating lease assets in the records of the lessee
explain the effect on the financial statements of a finance lease
being incorrectly treated as an operating lease.
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Leases
1 Finance leases and operating leases
What is a leasing agreement?
A leasing agreement is an agreement whereby one party, the lessee, pays
lease rentals to another party, the lessor in order to gain the use of an asset
over a period of time.
IAS 17 Leases defines a lease as an agreement whereby the lessor
conveys to the lessee, in return for a payment or series of payments, the
right to use an asset for an agreed period of time.
Types of lease
There are two types of lease:
•
•
202
a finance lease
an operating lease.
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A finance lease is a lease that transfers substantially all the risks and
rewards incidental to ownership of an asset to the lessee.
An operating lease is any lease other than a finance lease.
Classification of leases
To decide whether a lease is finance or operating, the first step is to assess
whether the risks and rewards of ownership have transferred to the lessee.
If this is inconclusive, IAS 17 provides additional guidance.
Risks and rewards
Risks and rewards of ownership include:
Risks
•
lessee carries out repairs and
maintenance
•
•
lessee insures asset
•
lessee runs the risk of
technological obsolescence
Rewards
•
lessee has right to use asset for
most or all of its useful life
lessee runs the risk of losses
from idle capacity
IAS 17 guidance
IAS 17 provides guidance as to the classification of leases as finance
leases or operating leases. It gives the following list of situations in which a
lease would normally be classified as a finance lease:
•
The lease transfers ownership of the asset to the lessee by the end of
the lease term (thus hire­purchase transactions qualify).
•
The lessee has the option to buy the asset at a price expected to be
lower than fair value at the time the option is exercised.
•
The lease term is for the major part of the economic life of the asset
even if title is not transferred.
•
At the beginning of the lease, the present value of the minimum lease
payments is approximately equal to the fair value of the asset.
•
The leased assets are of a specialised nature so that only the lessee
can use them without major modification.
•
If the lease gives the lessee the right to cancel the lease, the lessor’s
losses associated with the cancellation are borne by the lessee.
•
Gains or losses from fluctuations in fair value are borne by the lessee.
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•
The lessee has the ability to continue the lease for a secondary period
at a rent below the market rent.
Test your understanding 1
A company has entered into a four­year lease for a machine, with lease
rentals of $150,000 payable annually in advance, and with an optional
secondary period of three years at rentals of 80%, 60% and 40% of the
annual rental in the primary period. It is agreed that these rentals
represent a fair commercial rate. The machine has a useful life of eight
years and a cash value of $600,000.
Would this lease agreement be a finance lease or an operating
lease?
2 Substance over form
The meaning of substance over form
In many types of transactions there is a difference between the commercial
substance and the legal form:
•
•
Commercial substance reflects the financial reality of the transaction.
Legal form is the legal reality of the transaction.
Accounts are generally required to reflect commercial substance rather than
legal form.
Expandable text ­ Substance over form
Accounting treatment of the commercial substance of a lease
As the commercial substance of finance leases is that the lessee is the
effective owner of the asset the required accounting treatment is to:
•
record the asset as a non­current asset in the lessee’s statement of
financial position
•
record a liability for the lease payments payable to the lessor.
Expandable text ­ Leases and the definition of an asset
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3 Accounting for finance leases
Initial recording
At the start of the lease:
•
the fair value (or, if lower, the present value of the MLPs) should be
included as a non­current asset, subject to depreciation
•
the same amount (being the obligation to pay rentals) should be
included as a loan, i.e. a liability.
In practice, the fair value of the asset or its cash price will often be a
sufficiently close approximation to the present value of the MLPs and
therefore can be used instead.
Depreciation
The non­current asset should be depreciated over the shorter of:
•
•
the useful life of the asset (as in IAS 16)
the lease term.
The lease term is essentially the period over which the lessee has the use of
the asset. It includes:
•
•
the primary (non­cancellable) period
any secondary periods during which the lessee has the option to
continue to lease the asset, provided that it is reasonably certain at the
outset that this option will be exercised.
Payment of rentals and allocation of finance charge
Each individual rental payment should be split between:
•
•
finance charge (an expense in the income statement)
repayment of obligation to pay rentals (a reduction in the liability).
The finance charge should be allocated to each accounting period so as to
produce a constant periodic rate of interest on the remaining balance of the
liability.
There are two main methods of allocating the finance charge each period:
•
•
actuarial method
sum of the digits method.
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Leases
The examiner has confirmed that he will not examiner the sum of digits
method of allocating the finance charge. Therefore we will concentrate on
the actuarial method.
Firstly, however, for simplicity and illustration purposes, the following
example assumes that the finance charge is allocated on a straight line.
This method is not acceptable within the examination or in practice unless
amounts are immaterial.
Illustration 1 ­ Accounting for finance leases
Payment of rentals and allocation of finance charge
An entity leases an asset with three annual payments in arrears of $200
each. The fair value of the asset is $450. The asset has a useful life of
three years.
In this simple example the finance charge is to be allocated on the
straight­line basis.
Solution
$
600
(450)
––––
150
Lease payments (3 × $200)
Fair value
Total finance charge
On the straight­line basis this will be allocated to the income statement
at $50 ($150/3 years) pa.
The payables balance for the lease can be calculated using a standard
table:
Year
1
2
3
206
Balance b/f
$
450
300
150
Interest
$
50
50
50
Cash
$
(200)
(200)
(200)
Balance c/f
$
300
150
0
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The financial statements at the end of year 1 will show the following
amounts:
Income statement
Finance charge
Depreciation (450/3 years)
Statement of financial position
Non­current asset (450 – 150)
Current liabilities: payable (200 – 50)
Non­current liabilities: payables
$
50
150
300
150
150
At the end of year one, the payable table shows a carried forward
balance of $300. This must be split between a current and non­current
amount.
The easiest way to do this is to:
(1) identify the non­current liability as being the figure immediately
after the last repayment of the following year (in this case $150)
(2) calculate the current liability as being the total liability less the non­
current liability.
This method of splitting the liability will work whether payments are made
in advance or arrears.
The actuarial method
The actuarial method allocates interest to each period:
•
•
at a constant rate on the outstanding amount
using the interest rate implicit in the lease (you will be given this figure).
Illustration 2 – Accounting for finance leases
Actuarial method of allocating finance charge
A company has two options. It can buy an asset for cash at a cost of
$5,710 or it can lease it by way of a finance lease. The terms of the
lease are as follows.
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Leases
(1) Primary period is for four years from 1 January 20X2 with a rental of
$2,000 pa payable on 31 December each year.
(2) The lessee has the right to continue to lease the asset after the end
of the primary period for an indefinite period, subject only to a
nominal rent.
(3) The lessee is required to pay all repair, maintenance and insurance
costs as they arise.
(4) The interest rate implicit in the lease is 15%.
The lessee estimates the useful life of the asset to be eight years.
Depreciation is provided on a straight­line basis.
What figures will be shown in the financial statements in each of the
years ended 31 December 20X2­20X9 assuming the finance lease
option is taken.
Expandable text ­ Solution
Test your understanding 2
P Limited entered into a four­year lease on 1 January 20X3 for a
machine with a fair value of $69,738. Rentals are $20,000 pa payable in
advance. P Limited is responsible for insurance and maintenance
costs. The rate of interest implicit in the lease is 10%.
Show the allocation of the finance charges over the lease term on
an actuarial basis and calculate the non­current liability for
finance leases at 31 December 20X3.
Summary of accounting entries
(1) At the inception of the lease:
Dr Non­current assets: Cost
Cr Lease payable
with the present value of the minimum lease payments/fair value of the
leased asset.
(2) At the end of each period of the lease:
Dr Depreciation expense (income statement)
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Cr Non­current assets: accumulated depreciation
with the depreciation charge for the period.
(3) As each rental is paid:
Dr Lease creditor
Cr Cash
with the rental paid.
Dr Interest expense (income statement)
Cr Lease creditor
with the finance charge.
Expandable text ­ Disclosure: finance leases
Test your understanding 3
On 1 January 20X7 Jones plc acquired the use of a major piece of
heavy agricultural plant, the Vinnie, under a finance lease. The machinery
has a useful life of eight years with nil residual value. The cost of the
Vinnie would be $600,000 if it were bought for cash. The lease term for
the Vinnie is an eight years, with lease rentals of $110,000 payable
annually in advance. The interest rate implicit in the lease is 12.8%.
Show the amounts to be included in the statement of financial
position of Jones Ltd at 31 December 20X7 and the amounts to
appear in the income statement for that year.
4 Accounting for operating leases
Accounting treatment
Operating lease assets are very different in nature from finance lease
assets as the risks and rewards of ownership are not transferred to the
lessee.
Therefore the accounting treatment is also very different.
•
An asset is not recognised in the statement of financial position.
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Leases
•
Instead, rentals under operating leases are charged to the income
statement on a straight­line basis over the term of the lease, unless
another systematic and rational basis is more appropriate.
•
Any difference between amounts charged and amounts paid will be
prepayments or accruals.
Test your understanding 4
A company is leasing an asset under an operating lease. The initial
deposit is $1,000 on 1 January of year 1 followed by 3 annual payments
in arrears of $1,000 each on 31 December of years 1, 2 and 3.
What is the charge to the income statement and any amount to appear in
the statement of financial position at the end of year 1 of the lease?
Expandable text ­ Disclosure: operating leases
5 Finance lease or operating lease?
Significance
The significance of the accounting treatment of leased assets is heightened
by the difference between the accounting treatment of finance leases and
that of operating leases:
Finance lease
Operating lease
Asset capitalised
No asset
Liability recognised
No liability
Finance charge
Full rental charge
Depreciation charge
No depreciation
Finance lease treated as an operating lease
If a finance lease asset is incorrectly treated as an operating lease it will
have the following effects on the financial statements:
•
•
•
210
assets understated and so ROCE overstated
liabilities understated and so gearing understated
little effect on income statement.
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Expandable text ­ Effect of incorrect classification
Test your understanding 5
Wrighty acquired use of plant over three years by way of a lease.
Instalments of $700,000, are paid six­monthly in arrears on 30 June and
31 December. Delivery of the plant was on 1 January 20X0 so the first
payment of $700,000 was on 30 June 20X0. The present value of
minimum lease payment is $3,000,000. The interest implicit in the above
is 10% per six months. The plant would normally be expected to last
three years. Wrighty is required to insure the plant and cannot return it to
the lessor without severe penalties.
(a) Describe whether the above lease should be classified as an
operating or finance lease.
(b) Calculate the effect of the above on the income statement and
statement of financial position for the year ended 31
December 20X0.
(c) Why might Wrighty deliberately choose to report the lease as
an operating lease?
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Chapter summary
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Test your understanding answers
Test your understanding 1
The contracted lease term is only for half of the useful life of the machine
and there is no strong likelihood that the company will exercise the
option in four years' time, because the option is priced at fair value, not a
discount. Thus the risks and rewards of ownership have not passed to
the lessee and this lease should be treated as an operating lease.
Test your understanding 2
Year
20X3
20X4
20X5
20X6
Capital b/f
$
69,738
54,712
38,183
20,000
Lease
Capital
Finance Capital at
payment outstanding charge at year end
10%
$
$
$
$
(20,000)
49,738
4,974
54,712
(20,000)
34,712
3,471
38,183
(20,000)
18,183
1,818
20,000
(20,000)
–
–
–
Non­current liability at 31 December 20X3
Amounts due under finance lease (54,712 – 20,000)
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34,712
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Leases
Test your understanding 3
Statement of financial position
$
Non­current assets
Leased property under finance leases:
Cost
Depreciation 600,000 ÷ 8
Current liabilities
Current obligations under finance leases (W)
Non­current liabilities
Non­current obligation under finance leases (W)
Income statement
Depreciation on plant held under finance leases
Finance charges on finance leases (W)
600,000
75,000
110,000
442,720
75,000
62,720
Workings
Lease table
Year Capital
b/f
$
20X7 600,000
20X8 552,720
Lease
payment
Capital
outstanding
$
(110,000)
(110,000)
$
490,000
442,720
Finance
charge at
12.8%
$
62,720
56,668
Capital at
year end
$
552,720
499,388
For leases with annual payments in advance the current liability is the full
amount of the next payment due and the non­current liability is the
remainder of the capital at the year end.
Test your understanding 4
Income statement
Statement of financial position
214
= $1,333 ($4,000/3 years)
= Payment $2,000 – charge $1,333
= Prepayment of $667
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Test your understanding 5
(a) Risks and rewards of ownership of the machine are with Wrighty,
therefore this is a finance lease.
(b)
Period
Capitalb/f
Interest (10%)
Payment
Capital c/f
$000
$000
$000
$000
1
3,000
300
(700)
2,600
2
2,600
260
(700)
2,160
3
2,160
216
(700)
1,676
4
1,676
168
(700)
1,144
Income statement for year ended 31 December 20X0
$000
Depreciation (1/3 × $3m)
1,000
Finance charge (300 + 260)
$560
Statement of financial position at 31 December 20X0
$000
Non­current assets (2/3 × $3m)
2,000
Current liabilities
Obligations under finance leases (2,160 – 1,144)
1,016
Non­current liabilities
Obligations under finance leases
1,144
(c) In order to avoid showing the liability within the financial statements
and so achieve ‘off balance sheet finance’.
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Substance over form
Chapter learning objectives
Upon completion of this chapter you will be able to:
•
explain and demonstrate the importance of recording the
commercial substance rather than the legal form of transactions
•
•
list examples of previous abuses in this area
•
apply the principle of substance over form to recognition and
derecognition of assets and liabilities
•
•
•
•
•
account for goods sold on sale or return/consignment stock
describe the features which may indicate that the substance of
transactions differs from their legal form
account for sale and repurchase
account for sale and leaseback
account for factoring of receivables
demonstrate the role of the principle of substance over form for
recognising sales revenue.
217
Substance over form
1 Reporting the substance of transactions
Introduction
IAS 1 requires that financial statements:
•
•
must represent faithfully the transactions that have been carried out
must reflect the economic substance of events and transactions and not
merely their legal form.
Examples of accounts reflecting economic or commercial substance which
we have already met are:
•
•
the production of consolidated accounts (chapter 4)
the capitalisation of a finance lease (chapter 13).
Expandable text ­ The historical problem
Expandable Text ­ Illustration
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Determining the substance of a transaction
Common features of transactions whose substance is not readily apparent
are:
•
the legal title to an asset may be separated from the principal benefits
and risks associated with the asset (such as is the case with finance
leases)
•
a transaction may be linked with other transactions which means that
the commercial effect of the individual transaction cannot be
understood without an understanding of all of the transactions
•
options may be included in a transaction where the terms of the option
make it highly likely that the option will be exercised.
Identifying assets and liabilities
Key to determining the substance of a transaction is to identify whether
assets and liabilities arise subsequent to that transaction by considering:
•
•
who enjoys the benefits of any asset
who is exposed to the principal risks of any asset.
Assets are defined in the Framework as resources controlled by the entity
as a result of past events and from which future economic benefits are
expected to flow to the entity.
Liabilities are defined in the Framework as present obligations of the entity
arising from past events, the settlement of which is expected to result in an
outflow of resources from the entity.
Expandable text
Recognition and derecognition of assets and liabilities
Assets and liabilities should be recognised in the statement of financial
position where:
•
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.
When either of these criteria are not met the item should be derecognised.
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Substance over form
Disclosure
Disclosure of a transaction should be sufficiently detailed to enable the user
of the financial statements to evaluate the financial position, performance
and changes in financial position of the entity.
Expandable text
2 Examples where substance and form may differ
Introduction
Examples of areas where substance and form may differ include:
•
•
•
•
consignment inventory and goods on sale­or­return
sale and repurchase agreements
sale and leaseback agreements
factoring of receivables.
Consignment inventory
Consignment inventory is inventory which:
•
•
is legally owned by one party
is held by another party, on terms which give the holder the right to sell
the inventory in the normal course of business or, at the holder’s option,
to return it to the legal owner.
This type of arrangement is common in the motor trade.
Accounting for consignment inventory
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Key question:
In which company’s statement of financial position should the car appear as
inventory between 1 May 20X9 and 30 June 20X9?
Factors to consider are:
•
•
Who bears the risks of the inventory?
Who has the benefits or rewards of the inventory?
Whoever bears the risks of the inventory should recognise it in the statement
of financial position.
Expandable text
Expandable Text­ Illustration: Consignment inventory
Test your understanding 1
Carmart, a car dealer, obtains stock from Zippy, its manufacturer, on a
consignment basis. The purchase price is set at delivery and is
calculated to include an element of finance. Usually, Carmart pays Zippy
for the car the day after Carmart sells to a customer. However, if the car
remains unsold after six months then Carmart is obliged to purchase the
car. There is no right of return. Further, Carmart is responsible for
insurance and maintenance from delivery.
Describe how Carmart should account for the above
transactions.
Sale and repurchase agreements
Introduction
Sale and repurchase agreements are situations where an asset is sold by
one party to another. The terms of the sale provide for the seller to
repurchase the asset in certain circumstances at some point in the future.
Sale and repurchase agreements are common in property developments
and in maturing whisky stocks.
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Substance over form
Accounting for sale and repurchase agreements
Key question:
Is the commercial effect of the transaction that of a sale or of a secured
loan?
Factors to consider, whether
•
the seller will secure access to all future benefits inherent in the asset,
often through call options (a right to buy).
•
the buyer will secure adequate return on the purchase and appropriate
protection against loss in value of the asset bought, often through put
options (a right to sell).
Expandable text
Exandable text ­ Illustration: Sale and repurchase
Test your understanding 2
Xavier sells its head office, which cost $10 million, to Yorrick, a bank, for
$10 million on 1 January. Xavier has the option to repurchase the
property on 31 December, four years later at $12 million. Xavier will
continue to use the property as normal throughout the period and so is
responsible for the maintenance and insurance. The head office was
valued at transfer on 1 January at $18 million and is expected to rise in
value throughout the four­year period.
Giving reasons, show how Xavier should record the above during
the first year following transfer.
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Sale and leaseback
Introduction
A sale and repurchase agreement can be in the form of a sale and
leaseback.
The agreement may be:
•
•
a sale and finance leaseback
a sale and operating leaseback.
Accounting for sale and leaseback
Sale and finance leaseback:
•
•
no sale is recorded
the forwarded funds are treated as a loan secured on the leased asset.
Sale and operating leaseback:
•
a sale is normally recorded.
Expandable text
Exandable text ­ Illustration: Sale and leaseback
Factoring of receivables
Introduction
Factoring of receivables is where a company transfers its receivables
balances to another organisation (a factor) for management and collection
and receives an advance on the value of those receivables in return.
Accounting for the factoring of receivables
Key question:
Is the seller in substance receiving a loan on the security of his receivables,
or are the receipts an actual sale of those receivable balances?
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Substance over form
Factors to consider:
•
who bears the risk (of slow payment and irrecoverable debts).
Expandable text
Exandable text ­ Illustration: Factoring of receivables
Test your understanding 3
An entity has an outstanding receivables balance with a major customer
amounting to $12 million and this was factored to FinanceCo on 1
September 20X7. The terms of the factoring were:
FinanceCo will pay 80% of the gross receivable outstanding account to
the entity immediately.
•
The balance will be paid (less the charges below) when the debt is
collected in full. Any amount of the debt outstanding after four
months will be transferred back to the entity at its full book value.
•
FinanceCo will charge 1.0% per month of the net amount owing
from the entity at the beginning of each month. FinanceCo had not
collected any of the factored receivable amount by the year­end.
•
the entity debited the cash from FinanceCo to its bank account and
removed the receivable from its accounts. It has prudently charged
the difference as an administration cost.
What are the correct accounting entries for this arrangement?
3 IAS 18 Revenue
What is revenue?
Revenue is the gross inflow of economic benefits during the period arising
in the course of the ordinary activities of an entity.
Revenue is measured by the fair value of the consideration received or
receivable.
Expandable text ­ Measurement of revenue
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Traditional approaches to revenue recognition
Traditionally, two conditions must be met before revenue can be
recognised:
•
The revenue must be earned, i.e. the activities undertaken to create the
revenue must be substantially completed.
•
The revenue must be realised, i.e. an event has occurred which
significantly increases the likelihood of conversion into cash. This also
means that the revenue must be capable of being verifiably
measured.
In most cases, realisation is deemed to occur on the date of sale. Thus, the
date of the sale transaction is the moment that the revenue is recognised in
the financial statements.
Exandable text ­ Illustration: Traditional approach
Revenue from the sale of goods
According to IAS 18 Revenue, the following conditions must be satisfied
before the revenue from the sale of goods should be recognised.
•
The seller has transferred the significant risks and rewards of
ownership to the buyer.
•
The seller does not retain continuing managerial involvement to the
degree usually associated with ownership and does not have effective
control over the goods sold.
•
•
The amount of revenue can be measured reliably.
•
The costs incurred or to be incurred in respect of the transaction can be
measured reliably.
It is probable that the economic benefits associated with the transaction
will flow to the seller.
Expandable text
Revenue from services
Revenue from services should be recognised, according to the stage of
completion at the reporting date, when all the following conditions are met.
•
The amount of revenue can be measured reliably.
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Substance over form
•
It is probable that the economic benefits associated with the transaction
will flow to the entity.
•
The stage of completion of the transaction at the reporting date can be
measured reliably.
•
The costs incurred for the transaction and the costs to complete the
transaction can be measured reliably.
If these conditions are not met, revenue should be recognised only to the
extent of the expenses recognised that are recoverable.
Illustration 1 ­ Revenue from services
Revenue from services
On 1 July 20X3, Company A signs a contract with a customer under
which Company A delivers an 'off­the­shelf' IT system on that date and
then provides support services for the next three years.
The contract price is $740,000. The cost of the support services is
estimated at $60,000 pa and Company A normally makes a profit
margin of 25% on such work. Company A makes up financial
statements to 31 December each year.
What revenue should be recognised in the financial statements for the
year ended 31 December 20X3?
Expandable text ­ Solution
Test your understanding 4
A company is a retailer of washing machines. The company sells 100
washing machines for $500 each during the first week of the year. Each
deal includes one year’s free credit, valued at $25 per machine and a
three­year free parts warranty valued at $10 per machine per year.
Describe how the above revenue would be recognised in the year
of sale.
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Chapter summary
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Substance over form
Test your understanding answers
Test your understanding 1
•
Dealer faces the risk of slow movement as it is obliged to purchase
the car and has no right of return.
•
•
•
Dealer insures and maintains the cars.
Dealer faces risk of theft.
Dealer can sell the cars to the public.
Recognise the cars on dealer’s statement of financial position at
delivery.
Test your understanding 2
•
•
•
•
Xavier faces the risk of falling property prices.
Xavier continues to insure and maintain the property.
Xavier will benefit from a rising property price.
Xavier has the benefit of use of the property.
Xavier should continue to recognise the head office as an asset in the
statement of financial position. This is a secured loan with effective
interest of $2 million ($12 million – $10 million) over the four­year period.
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Test your understanding 3
As the entity still bears the risk of slow payment and irrecoverable debts,
the substance of the factoring is that of a loan on which finance charges
will be made. The receivable should not have been derecognised nor
should all of the difference between the gross receivable and the amount
received from the factor have been treated as an administration cost.
The required adjustments can be summarised as follows:
Receivables
Loan from factor
Administration $(12,000 – 9,600)
Finance costs: accrued interest ($9.6 million 1.0%)
Accruals
Dr
Cr
$000
$000
12,000
9,600
2,400
96
96
–––––– ––––––
12,096 12,096
–––––– ––––––
Test your understanding 4
Washing machine revenue 100 × (500 – 30 – 25)
Warranty revenue (100 × $10)
Interest income (100 × $25)
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$
44,500
1,000
2,500
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Substance over form
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chapter
15
Provisions, contingent
liabilities and contingent
assets
Chapter learning objectives
Upon completion of this chapter you will be able to:
•
•
•
•
•
•
•
•
explain why an accounting standard on provisions is necessary
•
•
•
•
identify and account for warranties/guarantees
distinguish between legal and constructive obligations
explain in what circumstances a provision may be made
explain in what circumstances a provision may not be made
show how provisions are accounted for
explain how provisions should be measured
define contingent liabilities and contingent assets
explain the accounting treatment of contingent liabilities and
contingent assets
identify and account for onerous contracts
identify and account for environmental and similar provisions
identify and account for provisions for future repairs and
refurbishments.
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Provisions, contingent liabilities and contingent assets
1 Provisions
The problem
Until the issue of IAS 37 Provisions, contingent liabilities and contingent
assets, there was no accounting standard covering the general topic of
provisions. This led to various problems.
•
Provisions were often recognised as a result of an intention to make
expenditure, rather than an obligation to do so.
•
Several items could be aggregated into one large provision that was
reported as an exceptional item (the ‘big bath’).
•
Inadequate disclosure meant that in some cases it was difficult to
ascertain the significance of the provisions and any movements in the
year.
Expandable Text ­ Illustration
Expandable text ­ The historical problem of provisioning
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Objective of IAS 37
The objective of IAS 37 Provisions, contingent liabilities and contingent
assets is to ensure that:
•
appropriate recognition criteria and measurement bases are applied to
provisions, contingent liabilities and contingent assets
•
sufficient information is disclosed in the notes to the financial
statements to enable users to understand their nature, timing and
amount.
What is a provision?
A provision is a liability of uncertain timing or amount.
A liability is 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.
Recognition of a provision
A provision should be recognised when:
•
an entity has a present obligation (legal or constructive) as a result of a
past event
•
it is probable that an outflow of resources embodying economic
benefits will be required to settle the obligation, and
•
a reliable estimate can be made of the amount of the obligation.
If any one of these conditions is not met, no provision may be recognised.
Expandable text ­ Recognition
Obligations
A provision may be necessary as a result of
•
•
a legal or
a constructive obligation.
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Provisions, contingent liabilities and contingent assets
Legal obligation
A legal obligation is an obligation that derives from:
•
•
•
a contract
legislation
other operation of law.
Constructive obligation
A constructive obligation is an obligation that derives from an entity’s
actions where:
•
by an established pattern of past practice, published policies or a
sufficiently specific current statement, the entity has indicated to other
parties that it will accept certain responsibilities, and
•
as a result, the entity has created a valid expectation on the part of
those other parties that it will discharge those responsibilities.
Test your understanding 1
A retail store has a policy of refunding purchases by dissatisfied
customers, even though it is under no legal obligation to do so. Its policy
of making refunds is generally known.
Should a provision be made at the year end?
Measuring provisions
The amount recognised as a provision should be:
•
•
a realistic estimate
•
discounted whenever the effect of this is material.
a prudent estimate of the expenditure needed to settle the obligation
existing at the reporting date
Expandable text ­ Measurement
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Methods of measuring uncertainties
Methods of measuring uncertainties include:
•
weighting the cost of all probable outcomes according to their
probabilities (‘expected value’)
•
considering a range of possible outcomes.
Illustration 1 Expected values
An entity sells goods with a warranty covering customers for the cost of
repairs of any defects that are discovered within the first two months
after purchase. Past experience suggests that 88% of the goods sold
will have no defects, 7% will have minor defects and 5% will have major
defects. If minor defects were detected in all products sold, the cost of
repairs would be $24,000; if major defects were detected in all products
sold, the cost would be $200,000.
What amount of provision should be made?
Expandable text ­ Solution
Illustration 2 Best estimate
An entity has to rectify a serious fault in an item of plant that it has
constructed for a customer. The most likely outcome is that the repair will
succeed at the first attempt at a cost of $400,000, but there is a
significant chance that a further attempt will be necessary, increasing the
total cost to $500,000.
What amount of provision should be recognised?
Expandable text ­ Solution
Expandable text ­ Disclosure
Expandable text ­ Specific scenarios: warranty provisions
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Provisions, contingent liabilities and contingent assets
Exandable text­ Illustration: warranty provisions
Expandable text ­ Further illustration: warranty provisions
Expandable text ­ Specific scenarios: guarantees
Exandable text ­ Illustration: Guarantees
Future operating losses
No provision may be made for future operating losses because they arise in
the future and therefore do not meet the criterion of a liability.
Onerous contracts
An onerous contract is a contract in which the unavoidable costs of
meeting the obligations under the contract exceed the economic benefits
expected to be received under it.
Expandable text ­ Onerous lease
Illustration 3 – Specific scenarios : onerous contract
A company has ten years left to run on the lease of a property that is
currently unoccupied. The present value of the future rentals at the
reporting date is $50,000. Subletting possibilities are limited but the
directors feel that likely future subletting rentals could have a present
value of $10,000.
What is the accounting treatment?
Expandable text ­ Solution
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Test your understanding 2
During December 20X8 a division of a company moved from
Buckingham to Sunderland in order to take advantage of regional
development grants. It holds its main premises in Buckingham under an
operating lease, which runs until 31 March 20Y1. Annual rentals under
the lease are $10 million. The company is unable to cancel the lease, but
it has let some of the premises to a charitable organisation at a nominal
rent. The company is attempting to rent the remainder of the premises at
a commercial rent, but the directors have been advised that the chances
of achieving this are less than 50%.
What is the accounting treatment required?
Environmental provisions
A provision will be made for future environmental costs if there is either a
legal or constructive obligation to carry out the work
This will be discounted to present value at a pre­tax market rate.
Illustration 4 – Specific scenarios : Environmental provision
Environmental provision
Rowsley is a company that carries out many different activities. It is
proud of its reputation as a ‘caring’ organisation and has adopted
various ethical policies towards its employees and the wider community
in which it operates. As part of its annual financial statements, the
company publishes details of its environmental policies, which include
setting performance targets for activities such as recycling, controlling
emissions of noxious substances and limiting use of non­renewable
resources.
The company has an overseas operation that is involved in mining
precious metals. These activities cause significant damage to the
environment, including deforestation. The company expects to abandon
the mine in eight years' time. The mine is situated in a country where
there is no environmental legislation obliging companies to rectify
environmental damage and it is very unlikely that any such legislation will
be enacted within the next eight years. It has been estimated that the
cost of cleaning the site and re­planting the trees will be $25 million if the
replanting were successful at the first attempt, but it will probably be
necessary to make a further attempt, which will increase the cost by a
further $5 million.
Should a provision for costs of cleaning the site be made?
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Provisions, contingent liabilities and contingent assets
Expandable text ­ Solution
Test your understanding 3
Laws have been passed that require an entity to fit certain health and
safety features in its factories by 30 June 20X2. At 31 December 20X1
(the reporting date) the entity has not yet fitted the health and safety
features.
How should this be accounted for in the financial statements?
Restructuring provisions
A restructuring is a programme that is planned and controlled by
management, and materially changes either:
•
•
the scope of a business undertaken by an entity, or
the manner in which that business is conducted.
A provision may only be made if:
•
•
a detailed, formal and approved plan exists
the plan has been announced to those affected.
The provision should:
•
•
include direct expenditure arising from restructuring
exclude costs associated with ongoing activities.
Expandable text
Illustration 5 – Specific scenarios : Restructuring provisions
Restructuring provisions
On 14 June 20X5 a decision was made by the board of an entity to
close down a division. The decision was not communicated at that time
to any of those affected and no other steps were taken to implement the
decision by the year end of 30 June 20X5. The division was closed in
September 20X5.
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Should a provision be made at 30 June 20X5 for the cost of closing
down the division?
Expandable text ­ Solution
Exandable text ­ Illustration: Restructuring provisions
Expandable text ­ Future repairs and refurbishments
Expandable text ­ Reorganisations
2 Contingent liabilities and contingent assets
Expandable text ­ Objective of IAS 37
Contingent liabilities
A contingent liability is:
•
a possible obligation that arises from past events and whose existence
will be confirmed only by the occurrence or non­occurrence of one or
more uncertain future events not wholly within the control of the entity, or
•
a present obligation that arises from past events but is not recognised
because:
– it is not probable that an outflow of resources embodying economic
benefits will be required to settle the obligation, or
–
the amount of the obligation cannot be measured with sufficient
reliability.
Contingent assets
A contingent asset is a possible asset that arises from past events and
whose existence will be confirmed only by the occurrence or non­occurrence
of one or more uncertain future events not wholly within the control of the
entity.
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Provisions, contingent liabilities and contingent assets
Exandable text ­ Contingencies example
Accounting for contingent liabilities
Contingent liabilities:
•
•
should not be recognised in the statement of financial position itself
should be disclosed in a note unless the possibility of a transfer of
economic benefits is remote.
Accounting for contingent assets
Contingent assets should not generally be recognised, but if the possibility
of inflows of economic benefits is probable, they should be disclosed.
If a gain is virtually certain, it falls within the definition of an asset and should
be recognised as such, not as a contingent asset.
Summary
The accounting treatment can be summarised in a table:
Degree of probability of an
outflow/inflow of resources
Liability
Asset
Virtually certain
Provide
Recognise
Probable
Provide
Disclose by
note
Possible
Disclose by
note
No disclosure
Remote
No disclosure No disclosure
Expandable text ­ Reimbursements
Disclosure of contingencies
The principal disclosure requirements regarding contingencies are:
•
•
•
240
the nature of the contingency
the uncertainties expected to affect the ultimate outcome
an estimate of the potential financial effect.
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chapter 15
Test your understanding 4
During the year to 31 March 20X9, a customer started legal proceedings
against a company, claiming that one of the food products that it
manufactures had caused several members of his family to become
seriously ill. The company’s lawyers have advised that this action will
probably not succeed.
Should the company disclose this in its financial statements?
3 IAS 10 Events after the reporting period
Events after the reporting period
Events after the reporting period are those events, both favourable and
unfavourable, which occur between the reporting date and the date on which
the financial statements are approved for issue by the board of directors.
Adjusting and non­adjusting events
Adjusting events are events after the reporting date which provide
additional evidence of conditions existing at the reporting date.
Non­adjusting events are events after the reporting date which concern
conditions that arose after the reporting date.
Adjusting events
Examples of adjusting events include:
•
irrecoverable debts arising after the reporting date, which may help to
quantify the allowance for receivables as at the reporting date
•
•
allowances for inventories due to evidence of net realisable value
•
the discovery of fraud or errors.
amounts received or receivable in respect of insurance claims which
were being negotiated at the reporting date
Non­adjusting events
Examples of non­adjusting events include:
•
•
a major business combination after the reporting date
the destruction of a major production plant by a fire after the reporting
date
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Provisions, contingent liabilities and contingent assets
•
abnormally large changes after the reporting date in asset prices or
foreign exchange rates.
Accounting for adjusting and non­adjusting events
Adjusting events require the adjustment of amounts recognised in the
financial statements.
Non­adjusting events should be disclosed by note if they are of such
importance that non­disclosure would affect the ability of the users of the
financial statements to make proper evaluations and decisions.
The note should disclose the nature of the event and an estimate of the
financial effect, or a statement that such an estimate cannot be made.
Expandable text ­ Non­adjusting events
Illustration 6 – IAS 10 Events after the reporting period
Shortly after the reporting date a major credit customer of a company
went into liquidation because of heavy trading losses and it is expected
that little or none of the $12,500 debt will be recoverable. $10,000 of the
debt relates to sales made prior to the year end; $2,500 relates to sales
made in the first two days of the new financial year.
In the 20X1 financial statements the whole debt has been written off, but
one of the directors has pointed out that, as the liquidation is an event
after the reporting date, the debt should not in fact be written off but
disclosure should be made by note to this year’s financial statements,
and the debt written off in the 20X2 financial statements.
Advise whether the director is correct.
Expandable text ­ Solution
Proposed dividends
Equity dividends proposed before but declared after the reporting date may
not be included as liabilities at the reporting date.
The liability arises at the declaration date so they are non­adjusting events
after the reporting date and must be disclosed by note as required by IAS 1.
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Chapter summary
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Provisions, contingent liabilities and contingent assets
Test your understanding answers
Test your understanding 1
•
•
•
•
The policy is well known and creates a valid expectation.
There is a constructive obligation.
It is probable some refunds will be made.
These can be measured using expected values.
Conclusion: A provision is required.
Test your understanding 2
244
•
The lease contract appears to be an onerous contract as defined by
IAS 37 (i.e. the unavoidable costs of meeting the obligations under it
exceed the economic benefits expected to be received under it).
•
Because the company has signed the lease contract, there is a
clear legal obligation and the company will have to transfer
economic benefits (pay the lease rentals) in settlement.
•
Therefore the company should recognise a provision for the
remaining lease payments.
•
The company may recognise a corresponding asset in relation to
the nominal rentals currently being received, if these are virtually
certain to continue. (In practice, it is unlikely that this amount is
material.)
•
As the chances of renting the premises at a commercial rent are
less than 50%, no further potential rent receivable may be taken into
account.
•
The financial statements should disclose the carrying amount of the
provision at the reporting date, a description of the nature of the
obligation and the expected timing of the lease payments, and the
amount of any expected rentals receivable from subletting. If an
asset is recognised in respect of any rentals receivable, this should
also be disclosed.
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Test your understanding 3
Present obligation? No. The obligating event would be either the fitting
of the health and safety features (which has not happened) or the illegal
operation of the factory without the features (which has not happened
because the features are not yet legally required).
Conclusion: Do not recognise a provision.
Test your understanding 4
•
•
Legal advice is that the claim is unlikely to succeed.
•
•
There is, however, a contingent liability.
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It is unlikely that the company has a present obligation to
compensate the customer and therefore no provision should be
recognised.
Unless the possibility of a transfer of economic benefits is remote,
the financial statements should disclose a brief description of the
nature of the contingent liability, an estimate of its financial effect
and an indication of the uncertainties relating to the amount or timing
of any outflow.
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Provisions, contingent liabilities and contingent assets
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chapter
16
Taxation
Chapter learning objectives
Upon completion of this chapter you will be able to:
•
•
•
account for income taxes in accordance with IAS 12
•
•
calculate deferred tax amounts
record entries relating to income taxes in the accounting records
explain the effect of taxable temporary differences on accounting
and taxable profit
record deferred tax in the financial statements.
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Taxation
1 IAS 12 income taxes
Expandable text ­ Current tax ­ general principles
Expandable Text ­ Accounting entries for income tax
Illustration 1 – IAS 12 Income taxes
Under and over ­ provisions for tax
Income tax provision at 31 May 20X5
Income tax paid on 28 February 20X6
Income tax charge at 30% for year ended 31 May 20X6
$
316,000
263,000
383,500
Show the entries in the income tax account and the income statement for
the year 31 May 20X6
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Expandable text ­ Solution
Test your understanding 1
Simple has estimated its income tax liability for the year ended 31
December 20X8 at $180,000, based on taxable profits of $600,000.
The tax rate is 30%.
Extract from the trial balance as at 31 December 20X8
Dr
Cr
$
$
Sales
1,500,000
Cost of sales, distribution and
administration expenses
900,000
Income tax
3,000
Show the income statement for the year ended 31 December
20X8 and the liability for income taxes in the statement of financial
position at that date.
Expandable text ­ Sales tax
Expandable text ­ Accounting for sales tax
Expandable Text­ Illustration: sales tax
Expandable text ­ Further illustration: sales tax
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Taxation
2 Deferred tax
What is deferred tax?
Deferred tax is:
•
the estimated future tax consequences of transactions and events
recognised in the financial statements of the current and previous
periods.
Deferred taxation is a basis of allocating tax charges to particular
accounting periods. The key to deferred taxation lies in the two quite
different concepts of profit:
•
the accounting profit (or the reported profit), which is the figure of
profit before tax, reported to the shareholders in the published accounts
•
the taxable profit, which is the figure of profit on which the taxation
authorities base their tax calculations.
Accounting profit and taxable profit
The difference between accounting profit and taxable profit is caused by:
•
•
permanent differences
temporary differences.
Permanent differences
Permanent differences are:
•
one­off differences between accounting and taxable profits caused by
certain items not being taxable/allowable
•
•
differences which only impact on the tax computation of one period
differences which have no deferred tax consequences whatever.
An example of a permanent difference is client entertaining expenses.
Temporary differences
Temporary differences are differences between the carrying amount of an
asset or liability in the statement of financial position and its tax base (the
amount attributed to that asset or liability for tax purposes).
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Examples of temporary differences include:
•
certain types of income and expenditure that are taxed on a cash, rather
than on an accruals basis, e.g.certain provisions
•
the difference between the depreciation charged on a non­current asset
that qualifies for tax allowances and the actual allowances (tax
depreciation) given (the most common practical example of a
temporary difference).
For your examination non­current assets are the important examples of
temporary differences.
Expandable text ­ The accounting problem
Illustration 2 – Deferred tax
An entity has annual profits of $1,000 (before depreciation) and on 1
January, Year 1 has purchased a non­current asset for $400 which has a
two­year useful life. Tax is at the rate of 30% and the company can claim
a 100% tax depreciation on the non­current asset.
Accounting profit – without deferred tax
Profits
Depreciation ($400/2)
Profit before tax
Tax – current (W1)
Profit after tax
Working 1
Taxable profit
Profit (before depreciation)
Tax depreciation
Taxable profit
Tax at 30%
Year 1 Year 2
$
$
1,000 1,000
(200)
(200)
––––
––––
800
800
––––
––––
(180)
(300)
––––
––––
620
500
1,000
(400)
––––
600
180
1,000
(–)
––––
1,000
300
Even though the same profit (before depreciation) was made each year
there is a very different profit after tax figure due to the tax depreciation.
This has meant that lower tax is paid in Year 1 but then higher tax in Year
2.
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Taxation
Deferred tax can eliminate the effect of this timing difference and ensure
that the tax charge is in direct relation to the reported profit.
Show the effect on the income statement of accounting for the deferred
taxation.
Expandable text ­ Solution
Expandable text ­ Reasons for recognising deferred tax
Exandable text ­ Illustration : reasons for deferred tax
Expandable text ­ IAS 12 and deferred tax
Exandable text ­ Illustration : IAS 12 and deferred tax
Test your understanding 2
As at 30 September, Grace has non­current assets with a carrying value
of $1,100,000 but a tax written down value of $700,000.
The brought forward balance on the deferred tax account is $300,000.
Assume a tax rate of 30%.
Compute the effect of deferred tax on the financial statements for
the year end 30 September.
Deferred tax liabilities
IAS 12 requires:
252
•
a deferred tax liability to be recognised for all taxable temporary
differences, with minor exceptions
•
a taxable temporary difference arises where the carrying value of an
asset is greater than its tax base
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chapter 16
•
•
the liability to be calculated using full provision
no discounting of the liability.
Deferred tax assets
IAS 12 requires that:
•
deferred tax assets should be recognised for all deductible temporary
differences
•
a deductible temporary difference arises where the tax base of an
asset exceeds its carrying value
•
to the extent that it is probable that taxable profit will be available
against which the deductible temporary difference can be utilised
•
no discounting is permitted.
Test your understanding 3
Richard of York is a Shakespearean costumier company. The following
is an extract from the trial balance of the above at 31 December 20X5:
Dr
$
Sales
Operating costs
Dividends received
Deferred tax
Corporation tax (over­provision from prior year)
Cr
$
100,000
55,000
8,000
19,000
4,000
A taxable temporary difference of $125,000 has accumulated at the year
end. Income tax at 20% is estimated at $30,000.
(a) Prepare the deferred tax note.
(b) Prepare the income statement and tax note.
Application to scenarios
Revaluation of non­current assets
Deferred tax should be recognised on revaluation gains even where there is
no intention to sell the asset or rollover relief is available on the gain.
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Taxation
The revaluation of non­current assets results in taxable temporary
differences, and so a liability. This is charged as a component of other
comprehensive income (alongside the revaluation gain itself). It is therefore
disclosed either in the statement of comprehensive income or in a separate
statement showing other comprehensive income.
Tax losses
Where unused tax losses are carried forward, a deferred tax asset can be
recognised to the extent that taxable profits will be available in the future to
set the losses against.
If an entity does not expect to have taxable profits in the future it cannot
recognise the asset in its own accounts.
If, however, the entity is part of a group and may surrender tax losses to
other group companies, a deferred tax asset may be recognised in the
consolidated accounts.
The asset is equal to the tax losses expected to be utilised multiplied by the
tax rate.
Disclosure requirements
The main disclosures are:
•
the tax expense (income) should be presented on the face of the
income statement
•
the major components of tax expense (income) should be disclosed
separately in a note
•
•
current and deferred tax charged / credited directly to equity
•
an explanation of the relationship between tax expense (income) and
accounting profit in either or both of the following forms:
– a numerical reconciliation between tax expense (income) and the
product of accounting profit multiplied by the applicable tax rate(s),
disclosing also the basis on which the applicable tax rate(s) is (are)
computed.
the amount of income tax relating to each component of other
comprehensive income
–
a numerical reconciliation between the average effective tax rate
and the applicable tax rate, disclosing also the basis on which the
applicable tax rate is computed.
Expandable text
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Chapter summary
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Taxation
Test your understanding answers
Test your understanding 1
Income statement for the year ended 31 December 20X8
$
$
Revenue
1,500,000
Costs
(900,000)
–––––––
Profit before tax
600,000
Income tax:
Income tax for the year
180,000
Over­provision in prior year
(3,000)
–––––––
177,000
–––––––
Profit after tax
423,000
–––––––
SFP as at 31 December 20X8
$
Current liabilities
Income tax
180,000
Test your understanding 2
Opening balance
Decrease (balancing figure)
Closing balance ((1,100 – 700) × 30%)
$000
300
(180)
––––
120
––––
The double entry will be:
Dr Deferred tax $180,000
Cr IS (tax charge) $180,000
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Test your understanding 3
a. Deferred tax
Opening balance
Increase
Closing balance (125,000 × 20%)
$000
19
6
–––
25
–––
b. Income statement
Revenue
Operating costs
Operating profit
Investment income
Profit before tax
Tax
Profit after tax
$000
100
(55)
–––
45
8
–––
53
(32)
–––
21
–––
Tax
Income tax
Over­provision in previous year
Deferred tax
KAPLAN PUBLISHING
$000
30
(4)
6
–––
32
–––
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Taxation
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chapter
17
Reporting financial
performance
Chapter learning objectives
Upon completion of this chapter you will be able to:
•
describe the structure (format) and content of financial
statements presented under International Financial Reporting
Standards (IFRS)
•
prepare an entity’s financial statements in accordance with the
prescribed structure and content
•
explain the importance of identifying and reporting the results of
continuing and discontinued operations
•
•
•
•
•
define non­current assets held for sale
•
explain the contents and purpose of the statement of changes in
equity
•
•
describe a statement of changes in equity
account for non­current assets held for sale
define discontinued operations
account for discontinued operations
identify circumstances where separate disclosure of material
items of income and expense is required
prepare a statement of changes in equity.
259
Reporting financial performance
1 Income statement, statement showing other comprehensive
income and statement of changes in equity
Income statement and statement showing other comprehensive
income
The IAS 1 requirements for an income statement and statement of other
comprehensive income were considered in detail in an earlier chapter.
260
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Illustration 1 – Income statement & statement showing other
XYZ Group
Income statement for the year ended 31 December 20X2
Revenue
Cost of sales
Gross profit
Distribution costs
Administrative expenses
Profit from operations
Finance costs
Profit before tax
Income tax expense
Net profit for the period
$
X
(X)
–––––
X
–––––
(X)
(X)
–––––
X
(X)
–––––
X
(X)
–––––
X
–––––
XYZ Group
Other comprehensive income for the year ended 31 December
20X2
Profit for the year
Other comprehensive income
Gain on property revaluation
Income tax relating to components of other comprehensive
income
Other comprehensive income for the year, net of tax
Total comprehensive income for the year
$
X
X
(X)
–––––
X
–––––
X
–––––
Exceptional items
Exceptional items is the name often given to material items of income and
expense of such size, nature or incidence that disclosure is necessary in
order to explain the performance of the entity.
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Reporting financial performance
The accounting treatment is to:
•
•
include the item in the standard income statement line
disclose the nature and amount in notes.
In some cases it may be more appropriate to show the item separately on
the face of the income statement.
Examples include:
•
•
•
•
•
•
•
write down of inventories to net realisable value (NRV)
write down of property, plant and equipment to recoverable amount
restructuring
gains/losses on disposal of non­current assets
discontinued operations
litigation settlements
reversals of provisions.
Statement of changes in equity
The statement of changes in equity provides a summary of transactions with
owners, such as share issues and dividends. Non­owner changes in equity
(such as revaluation gains) are reported in aggregate, but not presented
separately.
Illustration 2 – Statement of changes in equity
XYZ Group
Statement of changes in equity for the year ended 31 December
20X2
Balance at 31
December 20X1
Change in
accounting policy
Restated balance
262
Share Share Revaluation Retained Total
capital premium
surplus
earnings equity
$
$
$
$
$
X
X
X
X
X
––
X
––
––
X
––
––
X
––
(X)
(X)
––
X
––
––
X
––
KAPLAN PUBLISHING
chapter 17
Total
comprehensive
income for the
year
Dividends
Issue of share
capital
Balance at 31
December 20X2
X
X
X
––
X
––
X
––
X
X
X
(X)
(X)
X
––
X
––
X
Notes
•
The statement technically covers two years, so that comparative
figures are available. In an examination question it is likely that only
one year’s figures would be required.
•
Adjustments to the opening figures for changes in accounting policy
appear first. The correction of a prior period error would appear in
the same position.
Test your understanding 1
St Martin had the following opening capital and reserves as at 1 October
20X5.
Called­up share capital
Revaluation reserve
Retained earnings
$000
200
450
560
_____
1,210
_____
The profit after tax was $135,000 for the year to 30 September 20X6,
out of which a total of $40,000 dividends were paid.
During the year the head office was revalued at $340,000 above its
carrying value and this is to be incorporated into the accounts. Further,
the company issued 100,000 $1 ordinary shares at $5 each.
A prior period adjustment is required following the change of an
accounting policy. Retained earnings at 1 October 20X5 must be
adjusted downwards by $45,000.
Draft the statement of changes in equity.
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Reporting financial performance
2 IFRS 5 Non­current assets held for sale and discontinued
operations
Objective
The objectives of IFRS 5 are to set out:
•
requirements for the classification, measurement and presentation of
non­current assets held for sale, in particular requiring that such assets
should be presented separately on the face of the statement of financial
position
•
updated rules for the presentation of discontinued operations, in
particular requiring that the results of discontinued operations should be
presented separately in the income statement.
Classification as held for sale
A non­current asset should be classified as ‘held for sale’ if its carrying
amount will be recovered principally through a sale transaction rather than
through continuing use.
For this to be the case, the following conditions must apply:
•
•
the asset must be available for immediate sale in its present condition
the sale must be highly probable, meaning that:
– management are committed to a plan to sell the asset
–
there is an active programme to locate a buyer, and
–
the asset is being actively marketed
•
the sale is expected to be completed within 12 months of its
classification as held for sale
•
it is unlikely that the plan will be significantly changed or will be
withdrawn.
Expandable text
Measurement of non­current assets held for sale
Non­current assets that qualify as held for sale should be measured at the
lower of:
•
264
their carrying amount and
KAPLAN PUBLISHING
chapter 17
•
fair value less costs to sell.
Held for sale non­current assets should be:
•
•
presented separately on the face of the statement of financial position
not depreciated.
Expandable text
Expandable text ­ Statement of financial position proforma
Illustration 3 – Measurement of Non­current assets held for sale
On 1 January 20X1, Michelle Co bought a chicken­processing machine
for $20,000. It has an expected useful life of 10 years and a nil residual
value. On 31 December 20X2, after two years of using the asset,
Michelle Co decides to sell the machine and starts actions to locate a
buyer. The machines are in short supply, so Michelle Co is confident that
the machine will be sold fairly quickly. Its current market value is $15,000
and it will cost $500 to dismantle the machine and make it available to
the purchaser.
At what value should the machine be stated in Michelle Co’s statement
of financial position at 31 December 20X2?
Expandable text ­ Solution
Expandable Text ­Further illustration
Discontinued operations
A discontinued operation is a component of an entity that has either been
disposed of, or is classified as held for sale, and:
•
represents a separate major line of business or geographical area of
operations
•
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.
KAPLAN PUBLISHING
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Reporting financial performance
Discontinued operations are required to be shown separately in order to
help users to predict future performance, i.e. based upon continuing
operations.
Presentation in the income statement
An entity must disclose a single amount on the face of the income
statement, comprising the total of:
•
•
the post­tax profit or loss of discontinued operations, and
the post­tax gain or loss recognised on the measurement to fair value
less costs to sell, or on the disposal, of the assets constituting the
discontinued operation.
An analysis of this single amount must be presented, either in the notes or
on the face of the income statement.
The analysis must disclose:
•
the revenue, expenses and pre­tax profit or loss of discontinued
operations
•
•
the related income tax expense
•
the related income tax expense.
the gain or loss recognised on the measurement to fair value less costs
to sell, or on the disposal, of the assets constituting the discontinued
operation
Illustration 4 – Discontinued operations
Income statement presentation
20X2
$
Continuing operations:
Revenue
Cost of sales
Gross profit
Distribution costs
Administration expenses
Profit from operations
Finance costs
266
X
(X)
––
X
(X)
(X)
––
X
(X)
––
KAPLAN PUBLISHING
chapter 17
Profit before tax
Income tax expenses
X
(X)
––
X
Profit for the period from continuing operations
Discontinued operations:
Profit for the period from discontinued operations*
X
––
X
––
Total profit for the period
*The
analysis of this single amount would be given in the notes.
Alternatively the analysis could be given on the face of the income
statement, with separate columns for continuing operations,
discontinued operations, and total.
An alternative method of presenting discontinued operations in the income
statement:
X Co
Income statement for the year ended 31 October 20X4
Continuing Acquired Discontinued Total
operations operations operations
$000
$000
$000
$000
550
50
175
775
(415)
(40)
(165)
(620)
–––
–––
–––
–––
Gross
profit
135
10
10
155
Distribution
costs
(35)
(4)
(8)
(47)
Administrative
expenses
(50)
(7)
(57)
Sales
revenue
Cost of
sales
–––
–––
–––
–––
Profit on
operations
50
6
(5)
51
Profit on
sale of
properties
22
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267
Reporting financial performance
Loss on
sale of
discontinued
operations
–––
Profit
before
interest
72
–––
6
(15)
(10)
(10)
–––
–––
63
Finance
cost
(18)
–––
Profit
before
taxation
45
Income tax
expense
(16)
–––
Profit for
the year
29
Test your understanding 2
St. Valentine produced cards and sold roses. However, half way through
the year ended 31 March 20X6, the rose business was closed and the
assets sold off, incurring losses on the disposal of non­current assets of
$76,000 and redundancy costs of $37,000. The directors reorganised
the continuing business at a cost of $98,000.
Trading results may be summarised as follows:
Turnover
Cost of sales
Administration
Distribution
268
Cards
Roses
$000
650
320
120
60
$000
320
150
110
90
KAPLAN PUBLISHING
chapter 17
Other trading information is as follows:
Interest payable
Tax
Totals
$000
17
31
Draft the income statement for the year ended 31 March 20X6.
KAPLAN PUBLISHING
269
Reporting financial performance
Chapter summary
270
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chapter 17
Test your understanding answers
Test your understanding 1
Statement of changes in equity
Share
Share Revaluation Retained Total
capital premium surplus
earnings equity
Opening
$000
$000
$000
200
0
450
Prior
period
adj.
$000
$000
560 1,210
(45)
(45)
––––
––––
Restated
515 1,165
Dividends
(40)
Share
issue
100
400
(40)
500
(100,000 (100,000
× $1)
× $4)
Total
comprehensive
340
135
475
income
for the
year
Closing
KAPLAN PUBLISHING
––––
––––
––––
300
400
790
––––
––––
––––
–––– –––––
610
2100
–––– –––––
271
Reporting financial performance
Test your understanding 2
Income statement for St Valentine for the year ended 31 March
20X6
$000
Continuing operations:
Revenue
Cost of sales
Gross profit
Administration costs
Distribution costs
Operating profit
Reorganisation costs
Finance costs
Profit before tax
Income taxes
Profit for period from continuing operations
Discontinued operations:
Loss for period from discontinued operations
Loss for period from total operations
272
650
(320)
–––
330
(120)
(60)
–––
150
(98)
–––
52
(17)
–––
35
(31)
–––
4
(143)
–––
(139)
–––
KAPLAN PUBLISHING
chapter 17
In the notes to the accounts disclose analysis of the discontinued
operations figure:
Revenue
Cost of sales
Gross profit
Administration costs
Distribution costs
Operating loss
Loss on disposal
Redundancy costs
Overall loss
KAPLAN PUBLISHING
$000
320
(150)
–––
170
(110)
( 90)
–––
(30)
( 76)
( 37)
–––
(143)
–––
273
Reporting financial performance
274
KAPLAN PUBLISHING
chapter
18
Earnings per share
Chapter learning objectives
Upon completion of this chapter you will be able to:
•
•
•
•
•
•
•
•
•
define basic earnings per share (EPS)
•
explain the limitations of EPS as a performance measure.
calculate EPS with a bonus issue during the year
calculate EPS with an issue at full market value during the year
calculate EPS with a rights issue during the year
explain the relevance of diluted EPS (DEPS)
calculate DEPS involving convertible debt
calculate DEPS involving share options (warrants)
explain the importance of EPS as a stock market indicator
explain why the trend in EPS may be a more accurate indicator
of performance than a company’s profit trend
275
Earnings per share
1 Introduction
Earnings per share (EPS) is widely regarded as the most important
indicator of a company’s performance. It is important that users of the
financial statements:
•
•
are able to compare the EPS of different entities and
are able to compare the EPS of the same entity in different accounting
periods.
IAS 33 achieves comparability by:
276
•
•
defining earnings
•
requiring standard presentation and disclosures.
prescribing methods for determining the number of shares to be
included in the calculation of EPS
KAPLAN PUBLISHING
chapter 18
Expandable text ­The scope of IAS 33
Basic EPS
The basic EPS calculation is simply:
Earnings
–––––––––
Shares
This should be expressed as cents per share to 1 decimal place.
•
Earnings: group profit after tax, less non­controlling interests and
irredeemable preference share dividends.
•
Shares: weighted average number of ordinary shares outstanding
during the period.
Expandable text
Expandable text ­ IAS 33 definitions
Issue of shares at full market price
Earnings should be apportioned over the weighted average equity share
capital (i.e. taking account of the date any new shares are issued during the
year).
Expandable Text­ Illustration :calculation of EPS
Test your understanding 1
Gerard's earnings for the year ended 31 December 20X4 are
$2,208,000. On 1 January 20X4, the issued share capital of Gerard was
9,200,000 6% preference shares of $1 each and 8,280,000 ordinary
shares of $1 each. The company issued 3,312,000 shares at full market
value on 30 June 20X4.
Calculate the EPS for Gerard for 20X4
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Earnings per share
Bonus issue
A bonus issue (or capitalisation issue or scrip issue):
•
•
does not provide additional resources to the issuer
means that the shareholder owns the same proportion of the business
before and after the issue.
In the calculation of EPS:
•
the bonus shares are deemed to have been issued at the start of the
year
•
comparative figures are restated to allow for the proportional increase
in share capital caused by the bonus issue.
Expandable text
Exandable text ­Illustration: Bonus issue
Test your understanding 2
Dorabella had the following capital and reserves on 1 April 20X1:
Share capital ($1 ordinary shares)
Share premium
Revaluation reserve
Retained earnings
Shareholders’ funds
$000
7,000
900
500
9,000
––––––
17,400
Dorabella makes a bonus issue, of one share for every seven held, on
31 August 20X2.
278
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chapter 18
Dorabella plc’s results are as follows:
Profit after tax and NCI
20X3
$000
1,150
––––––
20X2
$000
750
––––––
Calculate EPS for the year ending 31 March 20X3, together with
the comparative EPS for 20X2 that would be presented in the
20X3 accounts.
Rights issue
Rights issues present special problems:
•
•
they contribute additional resources
they are normally priced below full market price.
Therefore they combine the characteristics of issues at full market price and
bonus issues.
Determining the weighted average capital, therefore, involves two steps as
follows:
(1) adjust for bonus element in rights issue, by multiplying capital in issue
before the rights issue by the following fraction:
Actual cum rights price
––––––––––––––––––––
Theoretical ex rights price
(2) calculate the weighted average capital in the issue as above.
Expandable Text­ Illustration : Rights issue
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Earnings per share
Test your understanding 3
On 31 December 20X1, the issued share capital consisted of 4,000,000
ordinary shares of 25c each, and the shares were quoted at $1. On 1
July 20X2 the company made a rights issue in the proportion of 1 for 4 at
50c per share. Its trading results for the last two years were as follows:
Year ended 31 December
Profit after tax
20X1
20X2
$
$
320,000
425,000
Show the calculation of basic EPS to be presented in the financial
statements for the year ended 31 December 20X2 (including the
comparative figure).
2 Diluted earnings per share (DEPS)
Introduction
Equity share capital may change in the future owing to circumstances which
exist now – known as dilution. The provision of a diluted EPS figure
attempts to alert shareholders to the potential impact on EPS.
Examples of dilutive factors are:
•
•
•
the conversion terms for convertible bonds
the conversion terms for convertible preference shares
the exercise price for options and the subscription price for warrants.
Basic principles of calculation
To deal with potential ordinary shares, adjust basic earnings and number of
shares assuming convertibles, options, etc. had converted to equity shares
on the first day of the accounting period, or on the date of issue, if later.
DEPS is calculated as follows:
Earnings + notional extra earnings
–––––––––––––––––––––––––––––––
Number of shares + notional extra shares
280
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chapter 18
Expandable text ­ Importance of DEPS
Convertibles
The principles of convertible bonds and convertible preference shares are
similar and will be dealt with together.
If the convertible bonds/preference shares had been converted:
•
the interest/dividend would be saved therefore earnings would be
higher
•
the number of shares would increase.
Exandable text ­ Illustration: DEPS
Test your understanding 4
A company had 8.28 million shares in issue at the start of the year and
made no new issue of shares during the year ended 31 December
20X4, but on that date it had in issue $2,300,000 10% convertible loan
stock 20X6­20X9. Assume a corporation tax rate of 30%.The earnings
for the year were $2,208,000.
This loan stock will be convertible into ordinary $1 shares as follows.
20X6
90 $1 shares for $100 nominal value loan stock
20X7
85 $1 shares for $100 nominal value loan stock
20X8
80 $1 shares for $100 nominal value loan stock
20X9
75 $1 shares for $100 nominal value loan stock
Calculate the fully DEPS for the year ended 31 December 20X4.
Options and warrants to subscribe for shares
An option or warrant gives the holder the right to buy shares at some time in
the future at a predetermined price.
Cash does enter the entity at the time the option is exercised, and the
DEPS calculation must allow for this.
KAPLAN PUBLISHING
281
Earnings per share
The total number of shares issued on the exercise of the option or warrant
is split into two:
•
the number of shares that would have been issued if the cash received
had been used to buy shares at fair value (using the average price of
the shares during the period)
•
the remainder, which are treated like a bonus issue (i.e. as having
been issued for no consideration).
The number of shares issued for no consideration is added to the number of
shares when calculating the DEPS.
Exandable text ­ Illustration: Options
Test your understanding 5
A company had 8.28 million shares in issue at the start of the year
and made no issue of shares during the year ended 31 December
20X4, but on that date there were outstanding options to purchase
920,000 ordinary $1 shares at $1.70 per share. The average fair value
of ordinary shares was $1.80. Earnings for the year ended 31
December 20X4 were $2,208,000.
Calculate the fully DEPS for the year ended 31 December 20X4.
Expandable text ­ Disclosure of EPS
3 The importance of EPS
Price earnings ratio
The figure EPS is used to compute the major stock market indicator of
performance, the price earnings ratio (P/E ratio). The calculation is as
follows:
P/E ratio =
282
Market value of share
––––––––
EPS
KAPLAN PUBLISHING
chapter 18
Trend in EPS
Although EPS is based on profit on ordinary activities after taxation, the
trend in EPS may be a more accurate performance indicator than the trend
in profit,
EPS:
•
measures performance from the perspective of investors and potential
investors
•
shows the amount of earnings available to each ordinary shareholder,
so that it indicates the potential return on individual investments.
Expandable text
Importance of DEPS
DEPS is important for the following reasons:
•
it shows what the current year’s EPS would be if all the dilutive potential
ordinary shares in issue had been converted
•
•
it can be used to assess trends in past performance
in theory, it serves as a warning to equity shareholders that the return on
their investment may fall in future periods.
Limitations of EPS
Although EPS is believed to have a real influence on the market price of
shares, it has several important limitations as a performance measure:
•
It does not take account of inflation. Apparent growth in earnings may
not be real.
•
It is based on historic information and therefore it does not necessarily
have predictive value.
•
An entity’s earnings are affected by the choice of its accounting
policies. Therefore it may not always be appropriate to compare the
EPS of different companies.
•
DEPS is only an additional measure of past performance despite
looking at future potential shares.
Expandable text
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283
Earnings per share
Test your understanding 6
On 1 January the issued share capital of Pillbox was 12 million
preference shares of $1 each and 10 million ordinary shares of $1 each.
Assume where appropriate that the income tax rate is 30%. The
earnings for the year ended 31 December were $5,950,000.
Calculate the EPS separately in respect of the year ended 31
December for each of the following circumstances (a)­(f), on the basis
that:
(a) there was no change in the issued share capital of the company
during the year ended 31 December
(b) the company made a bonus issue on 1 October of one ordinary
share for every four shares in issue at 30 September
(c) the company issued 1 share for every 10 on 1 August at full market
value of $4
(d) the company made a rights issue of $1 ordinary shares on 1
October in the proportion of 1 of every 3 shares held, at a price of
$3. The middle market price for the shares on the last day of
quotation cum rights was $4 per share
(e) the company made no new issue of shares during the year ended
31 December, but on that date it had in issue $2,600,000 10%
convertible bonds. These bonds will be convertible into ordinary $1
shares as follows:
20X6
20X7
20X8
20X9
(f)
284
90
85
80
75
$1 shares for $100 nominal value bonds
$1 shares for $100 nominal value bonds
$1 shares for $100 nominal value bonds
$1 shares for $100 nominal value bonds
the company made no issue of shares during the year ended 31
December, but on that date there were outstanding options to
purchase 74,000 ordinary $1 shares at $2.50 per share. Share
price during the year was $4.
KAPLAN PUBLISHING
chapter 18
Chapter summary
KAPLAN PUBLISHING
285
Earnings per share
Test your understanding answers
Test your understanding 1
Issue at full market price
Date
Actual number of Fraction of
Total
shares
year
1 January 20X4
8,280,000
6/12
4,140,000
11,592,000 (W1)
30 June 20X4
6/12
5,796,000
–––––––
Number of shares in EPS
9,936,000
calculation
–––––––
(W1) New number of shares
Original number
New issue
New number
8,280,000
3,312,000
–––––––––
11,592,000
The earnings per share for 20X4 would now be calculated as:
$2,208,000
–––––––––––––––––––––––––––––
9,936,000
= 22.2c
Test your understanding 2
The number of shares to be used in the EPS calculation for both years is
7,000,000 + 1,000,000 = 8,000,000.
The EPS for 20X2 is 750,000 / 8,000,000 × 100 c = 9.4c
The EPS for 20X3 is 1,150,000 / 8,000,000 × 100 c = 14.4c
Alternatively adjust last year’s EPS
20X2 750,000/7,000,000 × 7/8 = 9.4c.
286
KAPLAN PUBLISHING
chapter 18
Test your understanding 3
20X2 EPS
EPS =
$425,000
––––––––
4,722,222
= 9c per share
20X1 EPS
Applying correction factor to calculate adjusted comparative figure of
EPS:
8c ×
Theoretical ex rights price
––––––––––––––––––––
Actual cum rights price
90c
= 8c × –––– = 7.2c per share
100c
W1 Current year weighted average number of shares
Number of shares 1 July 20X1 to 31 December 20X1 (as adjusted):
4,000,000 ×
Actual cum rights price
––––––––––––––––––––
Theoretical cum rights price
100
4,000,000 × –––
90
KAPLAN PUBLISHING
×
6 months
––––
12 months
6
× –– = 2,222,222 shares
12
287
Earnings per share
Number of shares 1 January 20X2 to 30 June 20X2 (actual):
6
–––
12
×
5,000,000
= 2,500,000 shares
Total adjusted shares for year 4,722,222
W2 Theoretical ex rights price
Because the rights issue contains a bonus element, the past EPS
figures should be adjusted by the factor:
Theoretical ex rights price
––––––––––––––––––––
Actual cum rights price
Prior to rights issue
Taking up rights
4 shares
1 share
––
5
––
worth 4 × $1 =
cost 50c =
$
4.00
0.50
––––
4.50
––––
i.e. theoretical ex rights price of each share is $4.50 ÷ 5 = 90c
W3 Prior year EPS
Last year, reported EPS were $320,000 ÷ 4,000,000 = 8c
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KAPLAN PUBLISHING
chapter 18
Test your understanding 4
If this loan stock was converted to shares the impact on earnings would
be as follows.
$
Basic earnings
Add notional interest saved
($2,300,000 × 10%)
Less tax relief $230,000 × 30%
$
2,208,000
230,000
(69,000)
––––––
161,000
–––––––––
2,369,000
–––––––––
Revised earnings
Number of shares if loan
converted
Basic number of shares
Notional extra shares under the most
dilution possible
2,300,000 ×
8,280,000
90
–––
100
2,070,000
–––––––––
Revised number of shares
DEPS =
KAPLAN PUBLISHING
10,350,000
–––––––––
$2,369,000
–––––––––
10,350,000
=
22.9c
289
Earnings per share
Test your understanding 5
$
2,208,000
–––––––––
Earnings
Number of shares
Basic
Options (W1)
8,280,000
51,111
–––––––––
8,331,111
–––––––––
$2,208,000
The DEPS is therefore
–––––––––––
8,331,111
(W1) Number of shares at option price
Options
=
=
At fair value:
Number issued free
290
=
920,000 ×
$1,564,000
$1,564,000
–––––––––
$1.80
920,000 – 868,889
= 26.5c
$1.70
= 868,889
= 51,111
KAPLAN PUBLISHING
chapter 18
Test your understanding 6
(a) EPS (basic) = 59.5c
Earnings $(6.95m – 500,000 – 500,000)
Shares
EPS
(b) EPS (basic) = 47.6c
Earnings
Shares (10m × 5/4)
EPS
(c) EPS (basic) = 57.1c
Earnings
Shares
EPS
Pre (7/12 ×10m)
Post (5/12 ×10m ×11/10)
(d) EPS (basic) = 52.5c
Earnings
Shares
EPS
Pre (9/12 × 10m × 4.00/3.75)
Post (3/12 × 10m × 4/3)
Actual cum rights price
TERP (1@300 +3@400)/4
(e) EPS (basic) = 59.5c
EPS (fully diluted) = 49.7c
Earnings (5.95m + (10% × 2.6m × 70%))
Shares (10m + (90/100 × 2.6m))
EPS
KAPLAN PUBLISHING
000
$5,950
10,000
––––––
59.5c
––––––
000
$5,950
12,500
––––––
47.6c
––––––
000
$5,950
10,416
––––––
57.1c
––––––
$5,833
$4,583
000
$5,950
11,333
––––––
52.5c
––––––
$8,000
$3,333
$400
$375
000
$6,132
12,340
––––––
49.7c
––––––
291
Earnings per share
(f)
EPS (basic) = 59.5c
EPS (fully diluted) = 59.3c
Earnings
Shares (10m + (150/400× 74)
EPS
292
000
$5,950
10,028
––––––
59.3c
––––––
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19
Interpretation of financial
statements
Chapter learning objectives
Upon completion of this chapter you will be able to:
•
list the problems of using historic information to predict future
performance and trends
•
explain how financial statements may be manipulated to produce
a desired effect (creative accounting, window dressing)
•
recognise how related party relationships have the potential to
mislead users
•
explain why figures in the statement of financial position may not
be representative of average values throughout the period
•
•
define and compute relevant financial ratios
•
analyse and interpret ratios to give an assessment of an entity’s
performance and financial position in comparison with an entity’s
previous period financial statements
•
analyse and interpret ratios to give an assessment of an entity’s
performance and financial position in comparison with another
similar entity for the same period
•
analyse and interpret ratios to give an assessment of an entity’s
performance and financial position in comparison with industry
average ratios
•
interpret an entity’s financial statements to give advice from the
perspective of different stakeholders
•
explain how the interpretation of current value based financial
statements would differ from those using historical cost based
accounts
explain what aspects of performance specific ratios are intended
to assess
293
Interpretation of financial statements
294
•
explain the limitations in the use of ratio analysis for assessing
corporate performance
•
explain the effect that changes in accounting policies or the use
of different accounting policies between entities can have on the
ability to interpret performance
•
indicate other information, including non­financial information,
that may be of relevance to the assessment of an entity’s
performance
•
explain the different approaches that may be required when
assessing the performance of specialised not­for­profit and
public sector organisations.
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1 Interpreting financial information
Introduction
Financial statements on their own are of limited use. In this chapter we will
consider how to interpret them and gain additional useful information from
them.
Users of financial statements
When interpreting financial statements it is important to ascertain who are
the users of accounts and what information they need:
•
shareholders and potential investors – primarily concerned with
receiving an adequate return on their investment, but it must at least
provide security and liquidity
•
•
suppliers and lenders – concerned with the security of their debt or loan
management – concerned with the trend and level of profits, since this
is the main measure of their success.
Other potential users include:
•
•
•
•
•
bank managers
financial institutions
employees
professional advisors to investors
financial journalists and commentators.
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Interpretation of financial statements
Ratio analysis
A number of ratios can be calculated to help interpret the financial
statements.
In an examination question you will not have time to calculate all of the ratios
presented in this chapter so you must make a choice:
•
•
•
choose those relevant to the situation
choose those relevant to the party you are analysing for
make use of any additional information given in question to help your
choice.
Expandable text
Commenting on ratios
Ratios are of limited use on their own, thus most of the marks in an
examination question will be available for sensible, well­explained and
accurate comments on the key ratios.
If you doubt that you have anything to say, the following points should serve
as a useful checklist:
•
•
•
•
What does the ratio literally mean?
What does a change in the ratio mean?
What is the norm?
What are the limitations of the ratio?
2 Profitability ratios
Gross profit margin
Gross profit margin or percentage is:
Gross profit
––––––––––––
Sales revenue
296
x 100%
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This is the margin that the company makes on its sales, and would be
expected to remain reasonably constant.
Since the ratio is affected by only a small number of variables, a change
may be traced to a change in:
•
selling prices – normally deliberate though sometimes unavoidable, e.g.
because of increased competition
•
•
•
•
sales mix – often deliberate
purchase cost – including carriage or discounts
production cost – materials, labour or production overheads
inventory – errors in counting, valuing or cut­off, inventory shortages.
Expandable text ­ Comparison of gross profit margins
Net profit margin
The net profit margin or operating profit margin is calculated as:
PBIT
––––––––––––
Sales revenue
x 100%
Any changes in net profit margin should be considered further:
•
•
•
Are they in line with changes in gross profit margin?
•
Look for individual cost categories that have increased/decreased
significantly.
Are they in line with changes in sales revenue?
As many costs are fixed they need not necessarily increase/decrease
with a change in revenue.
Expandable text
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Interpretation of financial statements
ROCE
Profit
––––––––––––
Capital employed
ROCE =
x 100%
Profit is measured as:
•
•
operating (trading) profit, or
the PBIT, i.e. the profit before taking account of any returns paid to the
providers of long­term finance.
Capital employed is measured as:
•
equity, plus interest­bearing finance, less cash balances, i.e. the long­
term finance supporting the business.
ROCE for the current year should be compared to:
•
•
•
•
the prior year ROCE
a target ROCE
the cost of borrowing
other companies’ ROCE in the same industry.
Expandable text
Net asset turnover
The net asset turnover is:
Sales revenue
––––––––––––
Capital employed (net assets)
298
= times pa
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It measures management’s efficiency in generating revenue from the net
assets at its disposal:
•
the higher, the more efficient.
Note that this can be further subdivided into:
•
non­current asset turnover (by making non­current assets the
denominator) and
•
working capital turnover (by making net current assets the
denominator).
Relationship between ratios
ROCE can be subdivided into profit margin and asset turnover.
Profit margin
PBIT
––––––––––––
Sales revenue
×
Asset turnover
×
Sales revenue
––––––––––––
Capital employed
=
ROCE
=
PBIT
––––––––––––
Capital employed
Profit margin is often seen as an indication of the quality of products or
services supplied (top­of­range products usually have higher margins).
Asset turnover is often seen as a measure of how intensively the assets are
worked.
A trade­off may exist between margin and asset turnover.
•
Low­margin businesses (e.g. food retailers) usually have a high asset
turnover.
•
Capital­intensive manufacturing industries usually have relatively low
asset turnover but higher margins (e.g. electrical equipment
manufacturers).
Two completely different strategies can achieve the same ROCE.
•
Sell goods at a high profit margin with sales volume remaining low (e.g.
designer dress shop).
•
Sell goods at a low profit margin with very high sales volume (e.g.
discount clothes store).
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3 Liquidity and working capital ratios
Working capital ratios
There are two ratios used to measure overall working capital:
•
•
the current ratio
the quick or acid test ratio.
Current ratio
Current or working capital ratio:
Current assets
––––––––––––
Current liabilities
:1
The current ratio measures the adequacy of current assets to meet the
liabilities as they fall due.
A high or increasing figure may appear safe but should be regarded with
suspicion as it may be due to:
•
high levels of inventory and receivables (check working capital
management ratios)
•
high cash levels which could be put to better use (e.g. by investing in
non­current assets).
Expandable text
Quick ratio
Quick ratio (also known as the liquidity and acid test) ratio:
Quick ratio =
300
Current assets – Inventory
––––––––––––
Current liabilities
:1
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The quick ratio is also known as the acid test ratio because by eliminating
inventory from current assets it provides the acid test of whether the
company has sufficient liquid resources (receivables and cash) to settle its
liabilities.
Expandable text
Inventory turnover
Inventory turnover is defined as:
Cost of sales
––––––––––––
Inventories
= times pa
This is normally expressed as a multiple, say 10 times pa.
An alternative is to express the inventory turnover as so many days'
inventory:
Inventory
––––––––––––
Cost of sales
× 365 days
An increasing number of days (or a diminishing multiple) implies that
inventory is turning over less quickly which is regarded as a bad sign as it
may indicate:
•
•
•
lack of demand for the goods
poor inventory control
an increase in costs (storage, obsolescence, insurance, damage).
However, it may not necessarily be bad where management are:
•
buying inventory in larger quantities to take advantage of trade
discounts, or
•
increasing inventory levels to avoid stockouts.
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Interpretation of financial statements
Expandable text
Receivables collection period
This is normally expressed as a number of days:
Trade receivables
––––––––––––
Credit sales
× 365 days
The collection period should be compared with:
•
•
the stated credit policy
previous period figures.
Increasing accounts receivables collection period is usually a bad sign
suggesting lack of proper credit control which may lead to irrecoverable
debts.
It may, however, be due to:
•
•
a deliberate policy to attract more trade, or
a major new customer being allowed different terms.
Falling receivables days is usually a good sign, though it could indicae that
the company is suffering a cash shortage.
Expandable text
Payables payment period
This is usually expressed as:
Trade payables
––––––––––––
Credit purchases
302
× 365 days
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This represents the credit period taken by the company from its suppliers.
The ratio is always compared to previous years:
•
A long credit period may be good as it represents a source of free
finance.
•
A long credit period may indicate that the company is unable to pay
more quickly because of liquidity problems.
If the credit period is long:
•
the company may develop a poor reputation as a slow payer and may
not be able to find new suppliers
•
•
existing suppliers may decide to discontinue supplies
the company may be losing out on worthwhile cash discounts.
In most sets of financial statements (in practice and in examinations) the
figure for purchases will not be available therefore cost of sales is normally
used as an approximation in the calculation of the accounts payable
payment period.
4 Long­term financial stability
Introduction
The main points to consider when assessing the longer­term financial
position are:
•
•
gearing
overtrading.
Gearing
Gearing ratios indicate:
•
•
the degree of risk attached to the company and
the sensitivity of earnings and dividends to changes in profitability and
activity level.
Preference share capital is usually counted as part of debt rather than equity
since it carries the right to a fixed rate of dividend which is payable before
the ordinary shareholders have any right to a dividend.
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Interpretation of financial statements
High and low gearing
In highly geared businesses:
•
•
•
a large proportion of fixed­return capital is used
there is a greater risk of insolvency
returns to shareholders will grow proportionately more if profits are
growing.
Low­geared businesses:
•
provide scope to increase borrowings when potentially profitable
projects are available
•
can usually borrow more easily.
Expandable text
Measuring gearing
There are two methods commonly used to express gearing as follows.
Debt/equity ratio:
Loans + Preference share capital
––––––––––––––––––––––––––––––––––––––––
Ordinary share capital + Reserves + Non­controlling interest
Percentage of capital employed represented by borrowings:
Loans + Preference share capital
–––––––––––––––––––––––––––––––––––––––––
Ordinary share capital + Reserves + Non­controlling interest + Loans +
Preference share capital
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Interest cover
Interest cover =
PBIT
––––––––––––
Interest payable
Interest cover indicates the ability of a company to pay interest out of profits
generated:
•
low interest cover indicates to shareholders that their dividends are at
risk (because most profits are eaten up by interest payments) and
•
•
the company may have difficulty financing its debts if its profits fall
interest cover of less than two is usually considered unsatisfactory.
Expandable text
Overtrading
Overtrading arises where a company expands its sales revenue fairly
rapidly without securing additional long­term capital adequate for its needs.
The symptoms of overtrading are:
•
•
•
•
inventory increasing, possibly more than proportionately to revenue
receivables increasing, possibly more than proportionately to revenue
cash and liquid assets declining at a fairly alarming rate
trade payables increasing rapidly.
Expandable text
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Interpretation of financial statements
Illustration 1 – Interpretation of accounts
Statements of financial position and income statements for Ocean
Motors are set out below.
Statement of financial position for Ocean Motors
20X2
$000 $000
20X1
$000 $000
1,600
(200)
––––
1,450
(150)
––––
Non­current assets:
Land and buildings
Cost
Depreciation
1,400
Plant and machinery:
Cost
Depreciation
600
(120)
––––
1,300
400
(100)
––––
480
––––
1,880
Current assets:
Inventory
Receivables
Total assets
Capital and reserves:
Share capital – $1 ordinary shares
Retained earnings
306
300
400
––––
300
––––
1,600
100
100
––––
700
––––
2,580
200
––––
1,800
1,200
310
––––
1,510
––––
1,200
220
––––
1,420
––––
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Current liabilities:
Bank overdraft
Payables and accruals
Taxation liability
590
370
110
––––
210
70
100
––––
1,070
––––
2,580
––––
380
––––
1,800
––––
Income statements for Ocean Motors
Sales revenue
Cost of sales
Gross profit
Administration and distribution expenses
Net profit before tax
Income tax expense
Net profit after tax
20X2
$000
1,500
(700)
––––
800
(400)
––––
400
(200)
––––
200
20X1
$000
1,000
(300)
––––
700
(360)
––––
340
(170)
––––
170
The dividend for 20X1 was $100,000 and for 20X2 was $110,000.
Calculate the following ratios for Ocean Motors and briefly comment
upon what they indicate:
Profitability ratios:
•
•
•
•
KAPLAN PUBLISHING
gross profit margin
net profit margin
ROCE
net asset turnover.
307
Interpretation of financial statements
Liquidity and working capital ratios:
•
•
•
•
•
current ratio
quick ratio
inventory turnover
accounts receivable collection period
accounts payable payment period IS.
Expandable text ­ Solution
Test your understanding 1
Two very small specialist manufacturers make the same product,
although they do not compete as they operate in different parts of the
same country. The financial statements of the two manufacturing
companies are shown below:
Income statements
T
$
Revenue
Cost of sales
Gross profit
Selling expenses
Administrative expenses
Operating expenses
Operating profit
Interest payable
Profit before tax
Tax
Profit after tax
308
Y
$
150,000
(60,000)
––––––
90,000
13,500
15,000
––––––
$
$
700,000
(210,000)
––––––
490,000
84,000
35,000
––––––
(28,500)
––––––
61,500
(3,000)
––––––
58,500
(13,605)
––––––
44,895
––––––
(119,000)
––––––
371,000
(32,000)
––––––
339,000
(68,170)
––––––
270,830
––––––
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T paid dividends of $20,000 during the year and Y paid dividends of
$110,000 during the year.
Statements of financial position
Non­current
assets:
$
Property
Machinery
Current assets:
Inventory
Receivables
Bank
$
$
–
190,000
––––––
190,000
12,000
37,500
500
––––––
$
500,000
280,000
––––––
780,000
26,250
105,000
22,000
––––––
50,000
–––––––
240,000
–––––––
153,250
–––––––
933,250
–––––––
10,000
Nil
100,000
50,000
77,395
295,580
–––––––
87,395
–––––––
445,580
130,000
370,000
10,605
10,000
2,000
–––––––
240,000
–––––––
67,670
Nil
50,000
–––––––
933,250
–––––––
Equity:
Revaluation
reserve
Retained
earnings
Non­current liabilities:
Loan
Current
liabilities:
Trade payables
Overdraft
Tax
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Interpretation of financial statements
For each company calculate the following ratios and briefly
comment on your results:
Profitability ratios:
•
•
•
•
gross profit margin
net profit margin
ROCE
asset turnover.
Liquidity and working capital ratios:
•
•
•
•
•
current ratio
quick ratio
inventory turnover
receivables collection period
payables payment period.
Gearing ratios:
•
•
gearing ratio
interest cover.
5 Investor ratios
EPS
The calculation of EPS was covered in an earlier chapter.
Expandable text ­ Limitations of EPS
P/E ratio
P/E ratio =
310
Current share price
––––––––––––
Latest EPS
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•
•
Represents the market’s view of the future prospects of the share.
High P/E suggests that high growth is expected.
Expandable text
Dividend yield
Dividend yield =
Dividend per share
–––––––––––––––
Current share price
•
can be compared to the yields available on other investment
possibilities
•
the lower the dividend yield, the more the market is expecting future
growth in the dividend, and vice versa.
Dividend cover
Dividend cover =
Profit after tax
–––––––––––––––
Dividends
•
This is the relationship between available profits and the dividends
payable out of the profits.
•
The higher the dividend cover, the more likely it is that the current
dividend level can be sustained in the future.
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Interpretation of financial statements
Illustration 2 – Investor ratios
Given below are the income statements for Pacific Motors for the last
two years.
Income statements
Sales revenue
Cost of sales
Gross profit
Administration and distribution expenses
Net profit before tax
Income tax expense
Net profit after tax
20X2
$000
1,500
(700)
––––
800
(400)
––––
400
(200)
––––
200
20X1
$000
1,000
(300)
––––
700
(360)
––––
340
(170)
––––
170
In 20X1 dividends were $100,000 and in 20X2 they were $110,000.
The company is financed by 1,200,000 $1 ordinary shares and let us
suppose that the market price of each share was $1.64 at 31 December
20X2 and $1.53 at 31 December 20X1.
For each year calculate the following ratios and comment on them
briefly:
•
•
•
•
EPS
P/E ratio
dividend yield
dividend cover.
Expandable text ­ Solution
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6 Limitations of financial statements and ratio analysis
Historical cost accounts
Ratios are a tool to assist analysis.
•
They help to focus attention systematically on important areas and
summarise information in an understandable form.
•
They assist in identifying trends and relationships.
However ratios are not predictive if they are based on historical information.
•
•
•
They ignore future action by management .
They can be manipulated by window dressing or creative accounting.
They may be distorted by differences in accounting policies.
Expandable text ­ Window dressing
Exandable text ­ Illustration: window dressing
Change in accounting policies
It is necessary to be able to assess the impact of accounting policies on the
calculation of ratios. Comparison between businesses that follow different
policies becomes a major issue if accounting standards give either choice
or judgement to companies.
Examples of standards giving choice and judgement include:
Choice
IFRS 3 Choise over method of valuing the non­controlling interest, and so
choise to recognise partial or full goodwill.
IAS 16 Choice over whether to revalue tangible non­current assets.
Judgement
IAS 16 Depreciation rate to use.
IAS 38 Amortisation rate to use for intangible assets.
IAS 2 The net realisable value of inventory.
IAS 37 The likelihood of the pay­out on contingent liabilities and
provisions.
Expandable text
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Interpretation of financial statements
Test your understanding 2
A company has revalued its non­current assets during the most
recent accounting period. How will this affect the calculation of
ROCE?
Expandable text ­ Limitations of ratio analysis
Test your understanding 3
What are the main limitations of financial ratio analysis?
Additional information
In practice and in examinations it is likely that the information available in the
financial statements may not be enough to make a thorough analysis.
You may require additional financial information such as:
•
•
•
•
•
budgeted figures
other management information
industry averages
figures for a similar business
figures for the business over a period of time.
You may also require other non­financial information such as:
•
•
•
•
•
•
market share
key employee information
sales mix information
product range information
the size of the order book
the long­term plans of management.
Test your understanding 4
Explain why trends in accounting ratios may provide a more
useful insight into an entity’s financial performance and position
than the latest financial statements taken on their own.
314
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Specialised, not­for­profit and public sector organisations
The main financial aim of specialised, not­for­profit and public sector
organisations is not to achieve a profit or return on capital but to achieve
value for money.
Value for money is achieved by a combination of the three Es:
•
Effectiveness – success in achieving its objectives/providing its
service.
•
•
Efficiency – how well its resources are used.
Economy – keeping cost of inputs low.
As profit and return are not so meaningful, many ratios will have little
importance in these organisations, for example:
•
•
•
ROCE
gearing
investor ratios in general.
However such organisations must also keep control of income and costs
therefore other ratios will still be important such as working capital ratios.
As the main aim of these organisations is to achieve value for money, other,
non­financial ratios take on added significance:
•
measures of effectiveness such as the time scale within which out­
patients are treated in a hospital
•
•
measures of efficiency such as the pupil­to­teacher ratio in a school
measures of economy such as the teaching time of cheaper classroom
assistants in a school as opposed to more expensive qualified
teachers.
7 Interpreting current cost and current purchasing power
accounts
Problems with historical cost accounts
The figures used to prepare historical cost financial statements will tend to
be out of date. This has the following effects:
•
assets will be understated:
– this will overstate ROCE and understate gearing
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Interpretation of financial statements
•
profits will be overstated:
– this will overstate ROCE and overstate EPS .
Expandable text ­ Current cost and current purchasing power
8 Related parties
Definition of a related party
Two parties are considered to be related if one party has the ability to
control the other party or exercise significant influence over the other party,
or the parties are under common control.
Distortion of financial statements
A related party relationship can affect the financial position and operating
results of an entity in a number of ways.
•
Transactions are entered into with a related party which may not have
occurred without the relationship existing.
•
Transactions may be entered into on terms different to those with an
unrelated party.
•
Transactions with third parties may be affected by the existence of the
related party relationship.
Expandable text
Exandable text ­ Illustration: related parties
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Chapter summary
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Interpretation of financial statements
Test your understanding answers
Test your understanding 1
Profitability ratios:
Gross profit margin
Net profit margin
ROCE
Asset turnover
T
90/150 × 100
= 60%
61.5/150 × 100
= 41%
61.5/ (87.395
+ 130) × 100
= 28.3%
150/(87.395 + 130)
= 0.69
Y
490/700 × 100
= 70%
371/700 × 100
= 53%
371/(445.58 + 370)
× 100
= 45.5%
700/(445.58 + 370)
= 0.86
Comment
Overall, from the profitability angle Y would appear to be the better
company:
•
•
Y has a higher gross profit margin.
Y has a higher net profit margin.
It must also be noted that Y is a much larger company that T and
therefore may be benefiting from discounts from suppliers that are not
available to T and economies of scale.
•
Y has a higher ROCE caused by the better net profit margin and
higher asset turnover indicating a more efficient use of assets.
Liquidity and working capital ratios:
T
Current ratio
Quick ratio
Inventory turnover
Accounts receivable
318
50,000/22,605
= 2.21: 1
38,000/22,605
= 1.68 : 1
60,000/12,000
= 5 times
37,500/150,000
Y
153,250/117,670
= 1.30 : 1
127,000/117,670
1.08 : 1
210,000/26,250
8 times
105,000/700,000
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Collection period
Accounts payable
payment period
× 365
= 91 days
10,605/60,000 × 365
= 64 days
× 365
= 55 days
67,670/210,000 × 365
= 118 days
Comment
Again, as with profitability, Y would appear to be the stronger company
with regard to working capital control:
•
both companies have quite high current and quick ratios which may
be the norm in this business but T’s do appear to be very high
possibly indicating that best use is not being made of the assets of
the company
•
T holds its inventory for considerably longer than Y which may
indicate excessive capital being tied up in inventory holding
•
T’s accounts receivables collection period is seemingly long at 91
days and compared both with Y’s collection period of just 55 days
and also T’s accounts payable payment period of just 64 days. T is
paying its accounts payable considerably faster than it is receiving
money from its trade receivables
•
Y’s accounts payable payment period does appear long at 118
days but this may be due to the negotiating power of a much larger
business.
Gearing ratios
T
Y
Gearing can be measured in two
ways:
Compared to total capital
130,000/217,395 370,000/815,580
× 100
× 100
= 60%
= 45%
Compared to just equity capital
130,000/87,395 370,000/445,580
× 100
× 100
= 149%
= 83%
Interest cover
61,500/3,000
371,000/32,000
= 20.5 times
11.6 times
Comment
Both companies have fairly high levels of gearing and the following
specifics could be noted:
•
KAPLAN PUBLISHING
although the gearing levels appear quite high so does the interest
cover in each company indicating that there is no problem with
servicing the debt finance
319
Interpretation of financial statements
•
on the face of it T has a much higher interest cover than Y despite
being more highly geared
•
however the interest rate that T appears to have paid is only 2.3%
(3,000/130,000 × 100) which would indicate that T has only recently
taken out the loan finance
•
Y’s effective interest rate is a much more realistic 8.6%
(32,000/370,000 × 100).
Test your understanding 2
Any upward revaluation of non­current assets causes a reduction in
ROCE by:
•
•
increasing the capital employed, and
decreasing profits by a higher depreciation charge.
Test your understanding 3
The chief limitations of the usefulness of ratio analysis are as follows:
320
•
•
no rules as to what is an ideal ratio
•
statement of financial position figures may not necessarily be
representative
•
ratios based upon historical cost information ignore inflation and
distort trends
•
•
ratios only reflect monetary transactions
no definitions of ratios in accounting standards so comparison could
be misleading
changes/differences in accounting policies affect ratios.
KAPLAN PUBLISHING
chapter 19
Test your understanding 4
Comparative figures for several years provide information about the way
in which the performance and financial position of a business has
changed over a period. For example, if a company has low liquidity
ratios for a particular year, this would normally indicate liquidity
problems. However, if low liquidity ratios are viewed in the context of a
steadily improving trend, the picture is very different: the company is able
to survive at this level, is overcoming its problems and is unlikely to go
into receivership in the near future.
Trends in accounting ratios may provide information from which future
performance can be predicted, particularly if the figures are very stable.
The extent to which amounts and ratios are stable or volatile can reveal a
great deal. Ratios which are very volatile, or sudden changes in trends,
may indicate that the company will experience problems in the future,
even if performance is apparently improving.
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Interpretation of financial statements
322
KAPLAN PUBLISHING
chapter
20
Statement of cash flows
Chapter learning objectives
Upon completion of this chapter you will be able to:
•
prepare a statement of cash flows for a single entity using the
direct method in accordance with IAS 7
•
prepare a statement of cash flows for a single entity using the
indirect method in accordance with IAS 7
•
compare the usefulness of cash flow information with that of an
income statement
•
interpret a statement of cash flows to assess the performance
and financial position of an entity
•
indicate other information, including non­financial information,
that may be of relevance to the assessment of an entity’s
performance
323
Statement of cash flows
1 IAS 7 Statement of cash flows
Objective of the statement of cash flows
The objective of IAS 7 Statement of cash flows is:
•
to ensure that all entities provide information about the historical
changes in cash and cash equivalents by means of a statement of cash
flows
•
to classify cash flows (i.e. inflows and outflows of cash and cash
equivalents) during the period between those arising from operating,
investing and financing activities.
Expandable text
Definitions
Cash: cash on hand (including overdrafts) and on demand deposits.
Cash equivalents: short­term, highly liquid investments that are readily
convertible into known amounts of cash and are subject to an insignificant
risk of changes in value.
324
KAPLAN PUBLISHING
chapter 20
Expandable text
Proforma statement of cash flows
$
Cash flows from operating activities:
Net profit before tax
Adjustments for:
Interest expense
Depreciation
Profit on sale of non­current assets
Provisions
Government grants
Investment income
Operating profit before working capital changes
Increase/decrease in inventories
Increase/decrease in trade receivables
Increase/decrease in trade payables
Cash generated from operations
Interest paid
Income taxes paid
Net cash from operating activities
Cash flows from investing activities:
Purchases of property, plant and equipment
Proceeds of sale of property, plant and equipment
Interest received
Dividends received
Net cash used in investing activities
KAPLAN PUBLISHING
$
X
X
X
(X)
(X)
X
(X)
––––
X
(X)/X
(X)/X
X/(X)
––––
X
(X)
(X)
––––
X
(X)
X
X
X
––––
(X)
325
Statement of cash flows
Cash flows from financing activities:
Proceeds from issue of shares
X
Proceeds from long­term borrowings
X
Payment of finance lease liabilities
(X)
Dividends paid
(X)
––––
Net cash used in financing activities
(X)
Net increase in cash and cash equivalents
X
Cash and cash equivalents at beginning of the period
X
––––
Cash and cash equivalents at end of the period
X
––––
Analysis of cash and cash equivalents:
This year Last year
$
$
Cash on hand and balances with banks
X
X
Short­term investments
X
X
––––
––––
X
X
––––
––––
Cash and cash equivalents
Indirect method
The indirect method used above:
•
•
•
•
begins with profit before tax from the income statement
adjusts for interest to get back to profit from operations
adjusts for non­cash items
adjusts for increases and decreases in working capital.
Calculation of net cash flow from operating activities
There is a difference between profit and cash flow.
326
•
•
Profit before tax is computed using the accruals concept.
•
Adjustments are required to get from profit before tax back to cash flow.
Net cash flow from operating activities only records the cash inflows
and outflows arising out of trading.
KAPLAN PUBLISHING
chapter 20
Expandable text ­ Adjustments to profit before tax
Expandable text ­ Working capital changes
Expandable text ­ Interest and income taxes
Investing activities
Investing cash flows include:
•
cash paid for property, plant and equipment and other non­current
assets
•
cash received on the sale of property, plant and equipment and other
non­current assets
•
•
cash paid for investments in or loans to other entities
dividends received on investments.
Financing activities
Financing cash flows comprise receipts or repayments of principal from or
to external providers of finance including:
•
•
receipts from issuing shares or other equity instruments
•
•
repayments of amounts borrowed (other than overdrafts)
receipts from issuing debentures, loans, notes and bonds and from
other long­term and short­term borrowings (other than overdrafts, which
are normally included in cash and cash equivalents)
the capital element of finance lease rental payments.
Expandable Text­ Illustration : statement of cash flows
KAPLAN PUBLISHING
327
Statement of cash flows
Test your understanding 1
The financial statements of Hollywood are given below.
Statements of financial position at: 30 September 30 September
Non­current tangible assets:
Current assets:
Inventory
Trade receivables
Interest receivable
Investments
Cash in bank
Cash in hand
Total assets
Capital and reserves:
Ordinary shares $0.50 each
Share premium
Revaluation reserve
Retained profits
20X3
20X2
$000 $000 $000 $000
634
510
420
390
4
50
75
7
––––
460
320
9
0
0
5
––––
946
–––––
1,580
–––––
363
89
50
63
––––
794
–––––
1,304
–––––
300
92
0
(70)
––––
565
322
Non­current liabilities:
10% loan notes
5% loan notes
0
329
––––
40
349
––––
329
328
389
KAPLAN PUBLISHING
chapter 20
Current liabilities:
Bank overdraft
Trade payables
Income tax
Accruals
0
550
100
36
––––
70
400
90
33
––––
686
––––
1,580
––––
593
––––
1,304
––––
Income statement for the year to 30 September 20X3
$000
Revenue
Cost of sales
Gross profit
Administrative expenses
Distribution costs
Profit from operations
Income from investments
Finance cost
Profit before tax
Income tax expense
Net profit for the period
KAPLAN PUBLISHING
$000
2,900
(1,734)
–––––
1,166
342
520
–––––
(862)
––––
304
5
(19)
––––
(14)
––––
290
(104)
––––
186
––––
329
Statement of cash flows
Hollywood ­ Other comprehensive income for the year
ended 30 September 20X3
$000
186
Profit for the year
Other comprehensive income
Gain on property revaluation
50
–––
236
–––
Total comprehensive income for the year
Additional information:
(1) On 1 October 20X2, Hollywood issued 60,000 $0.50 ordinary
shares at a premium of 100%. The proceeds were used to finance
the purchase and cancellation of all its 10% loan notes and some of
its 5% loan notes, both at par. A bonus issue of one for ten shares
held was made on 1 November 20X2; all shares in issue qualified
for the bonus.
(2) The current asset investment was a 30­day government bond.
(3) Non­current tangible assets include certain properties which were
revalued in the year.
(4) Non­current tangible assets disposed of in the year had a carrying
value of $75,000; cash received on disposal was $98,000.
(5) Depreciation charged for the year was $87,000.
(6) The accruals balance includes interest payable of $33,000 at 30
September 20X2 and $6,000 at 30 September 20X3.
(7) Interim dividends paid during the year were $53,000.
Prepare, for the year ended 30 September 20X3, a statement of
cash flows using the indirect method and an analysis of cash and
cash equivalents.
Expandable text ­ Direct method
Exandable text ­ Direct vs indirect method
Expandable text ­ Advantages and disadvantages of each
330
KAPLAN PUBLISHING
chapter 20
2 Comparison of the statement of cash flows and income
statement
Advantages of the statement of cash flows
•
It may assist users of financial statements in making judgements on the
amount, timing and degree of certainty of future cash flows.
•
It gives an indication of the relationship between profitability and cash­
generating ability, and thus of the quality of the profit earned.
•
Analysts and other users of financial information often, formally or
informally, develop models to assess and compare the present value of
the future cash flow of entities. Historical cash flow information could be
useful to check the accuracy of past assessments.
•
A statement of cash flows in conjunction with a statement of financial
position provides information on liquidity, viability and adaptability. The
statement of financial position is often used to obtain information on
liquidity, but the information is incomplete for this purpose as the
statement of financial position is drawn up at a particular point in time.
•
Cash flows cannot be manipulated easily and are not affected by
judgement or by accounting policies.
Limitations of the statement of cash flows
•
Statements of cash flows are based on historical information and
therefore do not provide complete information for assessing future cash
flows.
•
There is some scope for manipulation of cash flows, e.g. a business
may delay paying suppliers until after the year end.
•
Cash flow is necessary for survival in the short­term, but in order to
survive in the long­term a business must be profitable. It is often
necessary to sacrifice cash flow in the short­term in order to generate
profits in the long­term (e.g. by investment in non­current assets). A
huge cash balance is not a sign of good management if the cash could
be invested elsewhere to generate profit.
Expandable text
3 Interpretation of statements of cash flow
The statement of cash flows should be reviewed after preparation. In
particular, cash flows in the following areas should be reviewed:
•
•
•
cash generation from trading operations
dividend and interest payments
capital expenditure
KAPLAN PUBLISHING
331
Statement of cash flows
•
•
•
financial investment
management of financing
net cash flow.
Expandable text
Illustration 1 – Interpretation of statements of cash flows
Look at the answer to the cash flow for Hollywood – what can we see?
Expandable text ­ Solution
Expandable Text­ Additional illustration: interpretation
332
KAPLAN PUBLISHING
chapter 20
Chapter summary
KAPLAN PUBLISHING
333
Statement of cash flows
Test your understanding answers
Test your understanding 1
Statement of cash flows for Hollywood for the year ended 30
September 20X3
$000 $000
Cash flows from operating activities:
Profit before tax
Adjustments for:
Depreciation
Profit on disposal of non­current asset (98 – 75)
Income from investments
Interest expense
Operating profit before working capital changes
Decreases in inventories
Increase in trade receivables
Increase in trade payables
Increase in sundry accruals (W1)
Cash generated from operations
Interest paid (W2)
Income taxes paid (W3)
Net cash from operating activities
Cash flows from investing activities:
Purchase of tangible non­current assets (W4)
Proceeds from sale of non­current assets
Interest received (W5)
Net cash used in investing activities
334
290
87
(23)
(5)
19
–––
368
40
(70)
150
30
–––
518
(46)
(94)
–––
378
(236)
98
10
–––
(128)
KAPLAN PUBLISHING
chapter 20
Cash flows from financing activities:
Proceeds from issue of share capital (60 × $1)
Redemption of 10% loan notes
Redemption of 5% loan notes
Dividends paid
60
(40)
(20)
(53)
–––
Net cash used in financing activities
Net increase in cash and cash equivalents
Cash and cash equivalents at 1 October 20X2 (5 – 70)
Cash and cash equivalents at 30 September 20X3
(50 + 75 + 7 – 0)
(53)
–––
197
(65)
–––
132
–––
Tutorial note: IAS 7 alternatively permits ‘dividends paid’ to be
presented as an operating cash flow, so that presentation would be
equally acceptable.
(ii) Analysis of cash and cash equivalents
30 Sept 20X3 30 Sept 20X2
$000
$000
Cash in bank
75
0
Cash in hand
7
5
Short­term investments
50
0
Bank overdraft
(0)
(70)
––––
––––
Total cash and cash equivalents
132
(65)
––––
––––
Workings
(W1) Movement in sundry accruals excluding interest payable
$000
Accruals c/f (36 – 6)
30
Accruals b/f (33 – 33)
0
––
Therefore ­ Increase in accruals
30
––
KAPLAN PUBLISHING
335
Statement of cash flows
(W2) Interest paid
$000
Paid (balancing figure)
Balance c/f
$000
46
Balance b/f
33
6
Income statement
19
–––
–––
52
52
(W3) Income taxes paid
$000
Therefore ­ Paid (bal fig)
Bal c/f
$000
94
Bal b/f
90
100
Income statement
104
–––
–––
194
194
–––
–––
(W4) Tangible non­current assets at CV
$000
Bal b/f
Revaluation
Therefore ­ Paid (bal fig)
$000
510
Disposal
75
50
Depreciation
87
236
Bal c/f
634
–––
–––
796
796
–––
–––
(W5) Interest received
$000
336
$000
Balance b/f
9
Received (balancing figure)
10
Income statement
5
Bal c/f
4
–––
–––
14
14
–––
–––
KAPLAN PUBLISHING
chapter
21
Questions & Answers
337
Questions & Answers
Chapter 1: The regulatory framework
There are no Questions in this Chapter.
Chaptert 2: A conceptual framework
There are no Questions in this Chapter.
Chapter 3: Accounting concepts and policies
Test your understanding 1 ­ Recost
Question 1
For over 20 years the accounting profession in many countries has
attempted to formulate a method of preparing financial statements that
takes account of the effects of price increases (inflation). It seems that
no proposed method of reflecting the effects of changing prices has
gained international acceptance. The decision of the IASB, and the
accounting standard setters in many countries, is that no form of
accounting for price changes should be made compulsory, but entities
are encouraged to present such information.
There have been two main methods put forward by various accounting
standard bodies for reporting the effects of price changes. One method
is based on the movements in general price inflation and is referred to
as a General (or Current) Purchasing Power Approach, the other
method is based on specific price changes of goods and assets and is
generally referred to as a Current Cost Approach. Some bodies have
also suggested an approach which combines features of each method.
Required:
(a) Explain the limitations of (pure) historic cost accounts when used as
a basis for assessing the performance of an entity. You should give
an example of how each of three different user groups may be
misled by such information.
(10 marks)
(b) Describe the advantages and criticisms of General Purchasing
Power and Current Cost Accounting.
(8 marks)
(Total: 18 marks)
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KAPLAN PUBLISHING
chapter 21
Chapter 4: Principles of consolidated financial statements
Test your understanding 2 ­ Hepburn and Salter
Question 1
Hepburn has a subsidiary Salter. At the same date as Hepburn made
the share exchange for Salter’s shares, it also acquired 6,000 ‘A’ shares
in Woodbridge for a cash payment of $20,000. The share capital of
Woodbridge is made up of:
Equity voting A shares
Equity non­voting B shares
10,000
14,000
All of Woodbridge’s equity shares are entitled to the same dividend
rights; however during the year to 31 March 20X0 Woodbridge made
substantial losses and did not pay any dividends.
Hepburn has treated its investment in Woodbridge as an ordinary long­
term investment on the basis that:
•
•
•
it is only entitled to 25% of any dividends that Woodbridge may pay
it does not have any directors on the Board of Woodbridge; and
it does not exert any influence over the operating policies or
management of Woodbridge.
Required:
Comment on the accounting treatment of Woodbridge by Hepburn’s
directors and state how you believe the investment should be accounted
for.
(5 marks)
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339
Questions & Answers
Chapter 5: Consolidated statement of financial position
Test your understanding 3 ­ Hanford & Stopple
Question 1
Hanford acquired six million of Stopple’s ordinary shares on 1 April
20X1 for an agreed consideration of $24.85 million.
The consideration was settled by a share exchange of five new shares in
Hanford for every three shares acquired in Stopple, and a cash payment
of $4.85 million. The cash transaction has been recorded, but the share
exchange has not.
The draft statements of financial position of the two companies at 30
September 20X1 are:
Hanford
$000
$000
Assets
Non­current assets
Property, plant and equipment
Investment in Stopple
Current assets
Inventory
Accounts receivable
Cash and bank
78,690
4,850
–––––
83,540
7,450
12,960
nil
–––––
Total assets
Equity and liabilities
Equity
Ordinary shares of $1 each
Reserves
Share premium
Retained earnings:
At 1 October 20X0
For the year to 30 September
20X1
20,410
–––––
103,950
–––––
27,180
nil
–––––
27,180
4,310
4,330
520
–––––
20,000
2,000
51,260
12,000
6,000
8,000
73,260
–––––
93,260
9,160
–––––
36,340
8,000
10,000
–––––
340
Stopple
$000
$000
–––––
16,000
–––––
24,000
KAPLAN PUBLISHING
chapter 21
Non­current liabilities
8% Loan notes 20X4
Current liabilities
Accounts payable and
accruals
Bank overdraft
Provision for taxation
Total equity and liabilities
nil
6,000
5,920
4,160
1,700
3,070
nil
2,180
10,690
––––– –––––
103,950
–––––
6,340
–––––
–––––
36,340
–––––––
The following information is relevant:
(i) The fair value of Stopple’s land at the date of acquisition was $4
million in excess of its carrying value. Stopple’s financial statements
contain a note of a contingent asset for an insurance claim of
$800,000 relating to some inventory that was damaged by a flood
on 5 March 20X1.
The insurance company is disputing the claim. Hanford has taken
legal advice on the claim and believes that it is highly likely that the
insurance company will settle it in full in the near future. The fair value
of Stopple’s other net assets approximated to their carrying values.
(ii) At the date of acquisition Hanford sold an item of plant that had cost
$2 million to Stopple for $2.4 million. Stopple has charged
depreciation of $240,000 on this plant since it was acquired.
(iii) Hanford’s current account debit balance of $820,000 with Stopple
does not agree with the corresponding balance in Stopple’s books.
Investigations revealed that on 26 September 20X1 Hanford billed
Stopple $200,000 for its share of central administration costs.
Stopple has not yet recorded this invoice. Inter company current
accounts are included in accounts receivable or payable as
appropriate.
(iv) It is group policy to value the non­controlling interest at its
proportionate share of the fair value of the subsidiary's identifiable
net assets.
KAPLAN PUBLISHING
341
Questions & Answers
Required:
(a) Prepare the consolidated statement of financial position of Hanford
at 30 September 20X1.
(20 marks)
(b) Suggest reasons why a parent company may not wish to
consolidate a subsidiary company, and describe the circumstances
in which non­consolidation of subsidiaries is permitted by
International Accounting Standards.
(5 marks)
(Total: 25 marks)
Chapter 6: Consolidated income statement
Test your understanding 4 ­ Hepburn and Salter
Question 1
On 1 October 19X9 Hepburn acquired 80% of the equity share capital of
Salter by way of a share exchange. Hepburn issued five of its own
shares for every two shares it acquired in Salter. The market value of
Hepburn’s shares on 1 October 19X9 was $3 each. The share issue has
not yet been recorded in Hepburn’s books. The summarised financial
statements of both companies are:
Income statements: Year to 31 March 20X0
Sales revenues
Cost of sales
Gross profit
Operating expenses
Debenture interest
Profit before tax
Income tax expense
Profit for the year
342
Hepburn
$000
1,200
(650)
––––
550
(120)
nil
––––
430
(100)
––––
330
Salter
$000
1,000
(660)
––––
340
(88)
(12)
––––
240
(40)
––––
200
KAPLAN PUBLISHING
chapter 21
Statements of financial position: as at 31 March 20X0
Hepburn
$000
$000
Non­current assets
Property, plant and
equipment
Investments
Current assets
Inventory
Accounts receivable
Bank
240
170
20
––––
Total assets
Equity and liabilities
Equity shares of $1 each
Retained earnings
Non­current liabilities
8% Debentures
Current liabilities
Trade accounts payable
Taxation
Salter
$000
$000
620
660
20
––––
640
10
––––
670
430
––––
1,070
––––
Total equity and liabilities
530
––––
1,200
––––
400
410
––––
810
150
700
––––
850
nil
150
210
50
––––
––––
280
210
40
––––
155
45
––––
260
––––
1,070
––––
––––
200
––––
1,200
––––
The following information is relevant:
(i) The fair values of Salter’s assets were equal to their book values
with the exception of its land, which had a fair value of $125,000 in
excess of its book value at the date of acquisition.
(ii) In the post acquisition period Hepburn sold goods to Salter at a
price of $100,000, this was calculated to give a mark­up on cost of
25% to Hepburn. Salter had half of these goods in inventory at the
year end.
KAPLAN PUBLISHING
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Questions & Answers
(iii) The current accounts of the two companies disagreed due to a cash
remittance of $20,000 to Hepburn on 26 March 20X0 not being
received until after the year end. Before adjusting for this, Salter’s
debit balance in Hepburn’s books was $56,000.
(iv) It is group policy to value the non­controlling interest using the full
method. The fair value of the non­controlling interest in Salter on 1
October 19X9 was $230,000.
Required:
Prepare a consolidated income statement and statement of financial
position for Hepburn for the year to 31 March 20X0.
(20 marks)
Test your understanding 5 ­ Holding
Question 2
Holding acquired 18 million of Subside’s equity shares on 1 January
20X9 at a cost of $174million. Holding’s accounting year end is 30
September; the year end of Subside prior to its acquisition had been 30
June. In order to facilitate the consolidation process Subside has
changed its year end to 30 September and prepared its financial
statements for the 15 months period to 30 September 20X9. The
following are the income statements of both companies:
Sales revenue
Cost of sales
Gross profit
Operating expenses
Interest payable
Profit before tax
Income tax expense
Profit for the year
344
Holding 12
Subside 15 months
months to 30
to 30 September
September 20X9
20X9
$m
$m
350
280
(200)
(170)
––––
––––
150
110
(72)
(35)
(10)
(5)
––––
––––
68
70
(22)
(10)
––––
––––
46
60
––––
––––
KAPLAN PUBLISHING
chapter 21
The share capital and reserves of Subside at 30 June 20X8 were:
$m
Equity shares of $1 each
Reserves:
Retained earnings
Revaluation reserve
64
20
––––
$m
24
84
––––
108
––––
The following information is relevant:
(i) In the post acquisition period Holding sold goods to Subside at a
price of $30 million. Holding had marked up the cost of these goods
by 25%. One third of these goods were still held in inventory by
Subside at 30 September 20X9.
(ii) The revaluation reserve of Subside relates to a property carried at
its fair value. It was last revalued on 30 June 20X8. At the date of
acquisition the value of the property had increased by a further $4
million.
(iii) The only other fair value adjustment that is required in respect of the
acquisition is in relation to the plant and equipment of Subside. The
details of this are:
Book value at 30 June 20X8
$m
Cost on 1 July 20X6
100
Depreciation (2 years)
(40)
–––
Carrying value
60
–––
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The plant is being depreciated over a five­year life using the
straight­line method. This is in line with group policy. The cost of
sales expense of Subside contains an amount of $25 million in
respect of depreciation on the plant for the 15 months to 30
September 20X9. The replacement cost of the type of plant used by
Subside has increased dramatically since it was acquired and
Holding estimated that the fair value of Subside’s plant at the date of
acquisition was $90 million. The estimate of its remaining life was
unaltered.
(iv) Subside’s business activities are not seasonal in nature and
therefore it can be assumed that profits accrued evenly throughout
the 15­month period to 30 September 20X9.
Required:
(a) Calculate the consolidated goodwill in respect of the acquisition of
Subside, assuming that the non­controlling interest is valued at its
proportionate share of the fair value of the subsidiary's net assets.
(8 marks)
(b) Prepare the consolidated income statement of Holding for the year
to 30 September 20X9.
(17 marks)
(Total: 25 marks)
Chapter 7: Associates
Test your understanding 6 ­ Bacup, Townley and Rishworth
Question 1
The summarised statements of financial position of Bacup, Townley and
Rishworth as at 31 March 20X7 are as follows:
Bacup Townley Rishworth
$000
$000
$000
Non­current assets:
Tangible assets
Development expenditure
Investments
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3,820
–
1,600
–––––
5,420
4,425
200
–
–––––
4,625
500
–
–
–––––
500
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Current assets:
Inventory
Receivables
Cash at bank
Total assets
Equity:
Ordinary shares of 25 cents each
Reserves:
Share premium
Retained earnings at 31 March 20X6
Retained for year
Current liabilities:
Trade payables
Bank overdraft
Taxation
Total equity and liabilities
2,740
1,960
1,260
–––––
5,960
–––––
11,380
–––––
1,280
980
–
–––––
2,260
–––––
6,885
–––––
250
164
86
–––––
500
–––––
1,000
–––––
4,000
500
200
800
2,300
1,760
–––––
8,860
–––––
125
380
400
–––––
1,405
–––––
450
150
–––––
800
–––––
2,120
–
400
–––––
2,520
–––––
11,380
–––––
3,070
2,260
150
–––––
5,480
–––––
6,885
–––––
142
–
58
–––––
200
–––––
1,000
–––––
The following information is relevant:
(i) Investments
Bacup acquired 1.6 million shares in Townley on 1 April 20X6
paying 75 cents per share. On 1 October 20X6 Bacup acquired
40% of the share capital of Rishworth for $400,000.
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(ii) Group accounting policies
Development expenditure
Development expenditure is to be written off as incurred as it does
not meet the criteria for capitalisation in IAS 38. The development
expenditure in the statement of financial position of Townley relates
to a project that was commenced on 1 April 20X5. At the date of
acquisition the value of the capitalised expenditure was $80,000.
No development expenditure of Townley has yet been depreciated.
(iii) Intra­group trading
The inventory of Bacup includes goods at a transfer price of
$200,000 purchased from Townley after the acquisition. The
inventory of Rishworth includes goods at a transfer price of
$125,000 purchased from Bacup. All transfers were at cost plus
25%.
The receivables of Bacup include an amount owing from Townley of
$250,000. This does not agree with the corresponding amount in
the books of Townley due to a cash payment of $50,000 made on
29 March 20X7, which had not been received by Bacup at the year
end.
(iv) Share premium
The share premium account of Townley arose prior to the
acquisition by Bacup.
(v) It is group policy to value the non­controlling interest at its
proportionate share of the fair values of the subsidiary's identifiable
net assets.
Required:
(a) A consolidated statement of financial position of the Bacup group
as at 31 March 20X7.
(18 marks)
(b) Norden Manufacturing has been approached by Mr Long, a
representative of Townley. Mr Long is negotiating for Norden to
supply Townley with goods on six­month credit. Mr Long has pointed
out that Townley is part of the Bacup group and provides the
consolidated statement of financial position to support the credit
request.
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Required:
Briefly discuss the usefulness of the group statement of financial
position for assessing the creditworthiness of Townley and describe
the further investigations you would advise Norden Manufacturing to
make.
(7 marks)
(Total: 25 marks)
Test your understanding 7 ­ Harden
Question 2
Harden acquired 800,000 of Solder’s $1 equity shares on 1 October
20X0 for $2.5 million. One year later, on 1 October 20X1, Harden
acquired 200,000 $1 equity shares in Active for $800,000. The
statements of financial position of the three companies at 30 September
20X2 are shown below:
Harden
$000 $000
Non­current assets
Property, plant and
equipment
Patents
Investments – in Solder
– in Active
– in others
Current assets
Inventories
Trade receivables
Bank
Total assets
Solder
$000 $000
Active
$000 $000
3,980
2,300
1,340
250
420
nil
2,500
800
150 3,450
––––– –––––
7,680
–––––
200
–––––
2,920
–––––
60
–––––
1,400
–––––
570
400
300
420
380
400
nil
990
150
930
120
820
––––– ––––– ––––– ––––– ––––– –––––
8,670
3,850
2,220
–––––
–––––
–––––
Equity and liabilities
Equity:
Equity shares of $1
each
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2,000
1,000
500
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Questions & Answers
Reserves:
Share premium
Retained earnings
Non­current liabilities
Deferred tax
Current liabilities
Trade payables
Taxation
Overdraft
Total equity and
liabilities
1,000
500
4,500 5,500 1,900
––––– ––––– –––––
7,500
–––––
200
100
2,400 1,200 1,300
––––– ––––– –––––
3,400
1,800
–––––
–––––
nil
80
750
450
280
140
nil
60
80
970
nil
450
nil
340
––––– ––––– ––––– ––––– ––––– –––––
8,670
3,850
2,220
–––––
–––––
–––––
The following information is relevant:
(i) The balances of the retained earnings of the three companies were:
Harden
Solder
Active
$000
$000
$000
at 1 October
2,000
1,200
500
20X0
at 1 October
3,000
1,500
800
20X1
(ii) At the date of its acquisition the fair values of Solder’s net assets
were equal to their book values with the exception of a plot of land
that had a fair value of $200,000 in excess of its book value.
(iii) On 26 September 20X2 Harden processed an invoice for $50,000
in respect of an agreed allocation of central overhead expenses to
Solder. At the 30 September 20X2 Solder had not accounted for
this transaction. Prior to this the current accounts between the two
companies had been agreed at Solder owing $70,000 to Harden
(included in trade receivables and trade payables respectively).
(iv) During the year Active sold goods to Harden at a selling price of
$140,000 which gave Active a profit of 40% on cost. Harden had
half of these goods in inventory at 30 September 20X2.
(v) It is group policy to value non­controlling interests at full value. The
fair value of the non­controlling interest in Solder was as follows:
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1 October 20X0
$600,000
30 September 20X2
$675,000
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Required:
(a) Prepare the consolidated statement of financial position of Harden
as at 30 September 20X2.
(20 marks)
Chapter 8: Tangible non­current assets
Test your understanding 8 ­ Simpkins
Question 1
During the preparation of the draft financial statements of Simpkins for
the year to 30 September 20X1 the following problem area has arisen:
Simpkins has three long leasehold properties in different regional areas.
The original costs, accumulated depreciation and book (carrying) values
of them at 1 October 20X0 are shown below.
The accompanying ‘change’ column is the estimated percentage
change from their book value, at 1 October 20X0, as provided by an
independent surveyor on that date:
Cost
Property in the South
Property in Midlands
Property in the North
$000
4,000
2,500
2,000
Depreciation
(1 Oct 20X0)
$000
800
1,000
1,200
Book
value
$000
3,200
1,500
800
Change
value
%
+40
Nil
­ 20
The leaseholds were for a period of 50 years when they were acquired
and the company policy is to depreciate them over their life on a straight­
line basis. None of the leaseholds are investment properties.
As can be seen from the ‘change’ column the value of the leasehold in
the South has increased significantly. In its financial statements for the
year to 30 September 20X1, the directors of Simpkins are proposing to
adopt the current value (as from 1 October 20X0) of the leasehold in the
South, but to leave the remaining leaseholds at their original depreciated
cost. In the case of the leasehold in the North, the directors justified this,
on the basis that a recovery in the market value of the leasehold property
was expected within the next few years.
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Questions & Answers
Required:
Assuming the directors are committed to using current value for the
property in the South, advise the directors as to the acceptability of their
proposal; and calculate the income statement charges and the non­
current asset statement of financial position extracts relating to all the
properties for the year to 30 September 20X1 in accordance with the
requirements of IAS 16 Property, Plant and Equipment.
(5 marks)
Test your understanding 9 ­ Myriad
Question 2
Myriad owns several properties which are revalued each year. Three of
its properties are rented out under annual contracts. Details of these
properties and their valuations are:
Property
A
B
C
Type/life
freehold 50
years
freehold 50
years
freehold 15
years
Cost
$000
150
Value 30
Value 30
September September20X1
20X0
$000
$000
240
200
120
180
145
120
140
150
All three properties were acquired on 1 October 19W9. The valuations of
the properties are based on their age at the date of valuation. Myriad’s
policy is to carry all non­investment properties at cost. Annual
amortisation, where appropriate, is based on the carrying value of
assets at the beginning of the relevant period.
Property A is let to a subsidiary of Myriad on normal commercial terms.
The other properties are let on normal commercial terms to companies
not related to Myriad.
Myriad adopts the fair value model of accounting for investment
properties in IAS 40 Investment Property, and the cost model for owner­
occupied properties in IAS 16 Property, Plant and Equipment.
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Required:
(i) Describe the possible accounting treatments for investment
properties under IAS 40 and explain why they may require a
different accounting treatment to owner­occupied properties.
(4 marks)
(ii) Prepare extracts of the consolidated financial statements of Myriad
for the year to 30 September 20X1 in respect of the above
properties assuming the company adopts the fair value method in
IAS 40.
(6 marks)
(Total: 10 marks)
Chapter 9: Intangible assets
Test your understanding 10 ­ Dexterity
Question 1
(a) During the last decade it has not been unusual for the premium paid
to acquire control of a business to be greater than the fair value of
its tangible net assets. This increase in the relative SFP proportions
of intangible assets has made the accounting practices for them all
the more important. During the same period many companies have
spent a great deal of money internally developing new intangible
assets such as software and brands. IAS 38 Intangible Assets
was issued in September 1998 and prescribes the accounting
treatment for intangible assets.
Required:
In accordance with IAS 38, discuss whether intangible assets should
be recognised, and if so how they should be initially recorded and
subsequently amortised in the following circumstances:
–
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When they are purchased separately from other assets.
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Questions & Answers
–
When they are obtained as part of acquiring the whole of a
business, and
–
When they are developed internally.
(10 marks)
Note: your answer should consider goodwill separately from other
intangibles.
(b) Dexterity is a public listed company. It has been considering the
accounting treatment of its intangible assets and has asked for your
opinion on how the matters below should be treated in its financial
statements for the year to 31 March 20X4.
(i) On 1 October 20X3 Dexterity acquired the whole of the share
capital of Temerity, a small company that specialises in
pharmaceutical drug research and development. The purchase
consideration was by way of a share exchange and valued at $35
million. The fair value of Temerity’s net assets was $15 million
(excluding any items referred to below).
Temerity owns a patent for an established successful drug that has
a remaining life of eight years. A firm of specialist advisors,
Leadbrand, has estimated the current value of this patent to be $10
million, however the company is awaiting the outcome of clinical
trials where the drug has been tested to treat a different illness. If the
trials are successful, the value of the patent is then estimated to be
$15 million. Also included in the company’s statement of financial
position is $2 million for medical research that has been conducted
on behalf of a client.
(4 marks)
(ii) Dexterity has developed and patented a new drug which has been
approved for clinical use. The costs of developing the drug were
$12 million. Based on early assessments of its sales success,
Leadbrand have estimated its market value at $20 million.
(3 marks)
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(iii) Dexterity’s manufacturing facilities have recently received a
favourable inspection by government medical scientists. As a result
of this the company has been granted an exclusive five­year licence
to manufacture and distribute a new vaccine. Although the licence
had no direct cost to Dexterity, its directors feel its granting is a
reflection of the company’s standing and have asked Leadbrand to
value the licence. Accordingly they have placed a value of $10
million on it.
(3 marks)
(iv) In the current accounting period, Dexterity has spent $3 million
sending its staff on specialist training courses. Whilst these courses
have been expensive, they have led to a marked improvement in
production quality and staff now need less supervision. This in turn
has led to an increase in revenue and cost reductions. The directors
of Dexterity believe these benefits will continue for at least three
years and wish to treat the training costs as an assets.
(2 marks)
(v) In December 20X3, Dexterity paid $5 million for a television
advertising campaign for its products that will run for six months from
1 January 20X4 to 30 June 20X4. The directors believe that
increased sales as a result of the publicity will continue for two years
from the start of the advertisements.
(3 marks)
Required:
Explain how the directors of Dexterity should treat the above items in the
financial statements for the year to 31 March 20X4.
(15 marks as indicated)
Note: The values given by Leadbrand can be taken as being reliable
measurements. You are not required to consider depreciation aspects.
(Total: 25 marks)
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Questions & Answers
Chapter 10: Impairment of assets
Test your understanding 11 ­ Shiplake
Question 1
It is generally recognised in practice that non­current assets should not
be carried in a statement of financial position at values that are greater
than they are ‘worth’. There has been little guidance on this with the result
that impairment losses were not recognised on a consistent or timely
basis or were not recognised at all. IAS 36 Impairment of Assets was
issued in June 1998 on this topic and revised in March 2004.
Required:
(a) (i) Define an impairment loss and explain when companies should
carry out a review for impairment of assets.
(3 marks)
(ii) Describe the circumstances that may indicate that a company’s
assets may have become impaired.
(7 marks)
(b) Shiplake is preparing its financial statements to 31 March 20X2.
The following situations have been identified by an impairment
review team:
(i) On 1 April 20X1 Shiplake acquired the whole share capital of
two subsidiary companies, Halyard and Mainstay, in separate
acquisitions. Consolidated goodwill was calculated as:
Purchase consideration
Estimated fair value of net assets
Consolidated goodwill
356
Halyard
$000
12,000
(8,000)
–––––
4,000
–––––
Mainstay
$000
4,500
(3,000)
–––––
1,500
–––––
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A review of the fair value of each subsidiary’s net assets was
undertaken in March 20X2. Unfortunately both companies’ net
assets had declined in value. The estimated value of Halyard’s net
assets as at 1 April 20X1 was now only $7 million. This was due to
more detailed information becoming available about the market
value of its specialised properties. Mainstay’s net assets were
estimated to have a fair value of $500,000 less than their carrying
value. This fall was due to some physical damage occurring to its
plant and machinery.
(3 marks)
(ii) Shiplake has an item of earth­moving plant, which is hired out to
companies on short­term contracts. Its carrying value, based on
depreciated historical cost, is $400,000. The estimated selling
price of this asset is only $250,000, with associated selling
expenses of $5,000. A recent review of its value in use based
on its forecast future cash flows was estimated at $500,000.
Since this review was undertaken there has been a dramatic
increase in interest rates that has significantly increased the
cost of capital used by Shiplake to discount the future cash
flows of the plant.
(6 marks)
(iii) Shiplake is engaged in a research and development project to
produce a new product. In the year to 31 March 20X1 the
company spent $120,000 on research that concluded that there
were sufficient grounds to carry the project on to its
development stage and a further $75,000 had been spent on
development. At that date management had decided that they
were not sufficiently confident in the ultimate profitability of the
project and wrote off all the expenditure to date to the income
statement. In the current year further direct development costs
have been incurred of $80,000 and the development work is
now almost complete with only an estimated $10,000 of costs
to be incurred in the future. Production is expected to
commence within the next few months. Unfortunately the total
trading profit from sales of the new product is not expected to
be as good as market research data originally forecast and is
estimated at only $150,000. As the future benefits are greater
than the remaining future costs, the project will be completed,
but due to the overall deficit expected, the directors have again
decided to write off all the development expenditure.
(4 marks)
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Questions & Answers
Required:
Explain, with numerical illustrations where possible, how the information
in (i) to (iv) above would affect the preparation of Shiplake’s
consolidated financial statements to 31 March 20X2.
(Total: 25 marks)
Test your understanding 12 ­ Multiplex
Question 2
On 1 January 20X0 Multiplex acquired the whole of Steamdays, a
company that operates a scenic railway along the coast of a popular
tourist area. The summarised statement of financial position at fair
values of Steamdays on 1 January 20X0, reflecting the terms of the
acquisition was:
Goodwill
Operating licence
Property ­ train stations and land
Rail track and coaches
Two steam engines
Purchase consideration
$000
200
1,200
300
300
1,000
–––––
3,000
–––––
The operating licence is for ten years. It was renewed on 1 January
20X0 by the transport authority and is stated at the cost of its renewal.
Carrying values of the property, rail track and coaches are based on
their value in use. Engines are valued at their net selling prices.
On 1 February 20X0 the boiler of one of the steam engines exploded,
completely destroying the whole engine. Fortunately no one was injured,
but the engine was beyond repair. Due to its age a replacement could
not be obtained. Because of the reduced passenger capacity the
estimated value in use of the whole of the business after the accident
was assessed at $2 million.
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Passenger numbers after the accident were below expectations even
after allowing for the reduced capacity. A market research report
concluded that tourists were not using the railway because of their fear of
a similar accident occurring to the remaining engine. In the light of this
the value in use of the business was re­assessed on 31 March 20X0 at
$1.8 million. On this date Multiplex received an offer of $900,000 in
respect of the operating licence (it is transferable). The realisable value
of the other net assets has not changed significantly.
Required:
Calculate the carrying value of the assets of Steamdays (in Multiplex’s
consolidated statement of financial position) at 1 February 20X0 and 31
March 20X0 after recognising the impairment losses.
(6 marks)
Chapter 11: Inventories and construction contracts
Test your understanding 13 ­ Merryview
Question 1
Merryview specialises in construction contracts. One of its contracts,
with Better Homes, is to build a complex of luxury flats. The price agreed
for the contract is $40 million and its scheduled date of completion is 31
December 20X2. Details of the contract to 31 March 20X1 are:
Commencement date
Contract costs:
Architects’ and surveyors’ fees
Materials delivered to site
Direct labour costs
Overheads are apportioned at 40% of direct
labour costs
Estimated cost to complete (excluding
depreciation – see below)
1 July 20X0
$000
500
3,100
3,500
14,800
Plant and machinery used exclusively on the contract cost $3,600,000 on
1 July 20X0. At the end of the contract it is expected to be transferred to
a different contract at a value of $600,000. Depreciation is to be based
on a time apportioned basis. Inventory of materials on site at 31 March
20X1 is $300,000. Better Homes paid a progress payment of
$12,800,000 to Merryview on 31 March 20X1.
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Questions & Answers
At 31 March 20X2 the details for the construction contract have been
summarised as:
Contract costs to date (i.e. since the start of the
contract) excluding all depreciation
Estimated cost to complete (excluding
depreciation)
$000
20,400
6,600
A further progress payment of $16,200,000 was received on 31 March
20X2. Merryview accrues profit on its construction contracts using the
percentage of completion basis as measured by the percentage of the
cost to date compared to the total estimated contract cost.
Required:
(a) Prepare extracts of the financial statements of Merryview for the
construction contract with Better Homes for:
(i) the year to 31 March 20X1
(8 marks)
(ii) the year to 31 March 20X2.
(7 marks)
(Total: 15 marks)
Test your understanding 14 ­ Multiplex
Question 2
Multiplex is in the intermediate stage of a construction contract for the
building of a new privately owned road bridge over a river estuary. The
original details of the contract are:
Approximate duration of contract:
Date of commencement:
Total contract price:
Estimated total cost:
360
3 years
1 October 19W8
$40 million
$28 million
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An independent surveyor certified the value of the work in progress as
follows:
– on 31 March 19W9
– on 31 March 20X0
Total costs incurred at:
– 31 March 19W9
– 31 March 20X0
$12 million
$30 million (including the $12 million in
19W9)
$9 million
$28.5 million (including the $9 million in
19W9)
Progress billings at 31 March 20X0 were $25 million
On 1 April 19W9 Multiplex agreed to a contract variation that would
involve an additional fee of $5 million with associated additional
estimated costs of $2 million.
The costs incurred during the year to 31 March 20X0 include $2.5 million
relating to the replacement of some bolts which had been made from
material that had been incorrectly specified by the firm of civil engineers
who were contracted by Multiplex to design the bridge. These costs
were not included in the original estimates, but Multiplex is hopeful that
they can be recovered from the firm of civil engineers.
Multiplex calculates profit on construction contracts using the percentage
of completion method. The percentage of completion of the contract is
based on the value of the work certified to date compared to the total
contract price.
Required:
Prepare the income statement and statement of financial position
extracts in respect of the contract for the year to 31 March 20X0 only.
(9 marks)
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Questions & Answers
Chapter 12: Financial assets and financial liabilities
Test your understanding 15 ­ Multicolour
Question 1
On 1 April 19X9 Multicolour issued $80 million 8% convertible loan stock
at par. The stock is convertible into equity shares, or redeemable at par,
on 31 March 20X4, at the option of the stockholders. The terms of
conversion are that each $100 of loan stock will be convertible into 50
equity shares of Multicolour. A finance consultant has advised that if the
option to convert to equity had not been included in the terms of the
issue, then a coupon (interest) rate of 12% would have been required to
attract subscribers for the stock.
The value of $1 receivable at the end of each year at a discount rate of
12% are:
Year
1
2
3
4
5
$
0.89
0.80
0.71
0.64
0.57
Required:
Calculate the income statement finance charge for the year to 31 March
20X0 and the statement of financial position extracts at 31 March 20X0
in respect of the issue of the convertible loan stock.
(5 marks)
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Chapter 13: Leases
Test your understanding 16 ­ Deltoid
Question 1
The following statement of financial position has been extracted from the
draft financial statements of Deltoid for the year to 31 March 20X2:
Statement of financial position as at 31 March 20X2
Non­current assets
Property, plant and equipment
Current assets
Inventory
Trade accounts receivable
Bank
$000
3,850
2,450
250
––––––
Total assets
Equity and liabilities
Equity:
Ordinary shares of 50 cents each
Reserves
Share premium
Revaluation reserve
Retained earnings b/f at 1 April 20X1
Profit after tax for year to 31 March 20X2
Total equity and liabilities
KAPLAN PUBLISHING
6,550
––––––
18,660
––––––
2,000
1,000
3,000
3,700
2,000
––––––
Non­current liabilities
6% loan note
Current liabilities
Trade accounts payable
Taxation
$000
12,110
5,700
––––––
11,700
3,000
2,820
1,140
––––––
3,960
––––––
18,660
––––––
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Questions & Answers
The following additional information is available:
(1) The financial statements include an item of plant based on its
treatment in the company’s management accounts where plant is
depreciated on a machine hour use basis. The details of this item of
plant are:
Cost (1 April 20X0)
Estimated residual value
Estimated machine hour life
Measured usage in year to:
31 March 20X1
31 March 20X2
$250,000
$50,000
8,000 hours
2,000 hours
800 hours
In the financial statements the company policy is that plant and
machinery should be written off at 20% per annum on the reducing
balance basis.
(2) The income statement includes a charge of $150,000 being the first
two of ten payments of $75,000 each in respect of a five­year lease
of an item of plant. The payments were made on 1 April 20X1 and 1
October 20X1.
The fair value of this plant at the date it was leased was $600,000.
Information obtained from the finance department confirms that this
is a finance lease and an appropriate periodic rate of interest is
10% per annum.
Deltoid has treated the lease as an operating lease in the above
financial statements. The company depreciates plant used under
finance leases on a straight­line basis over the life of the lease.
(3) Deltoid made a 1 for 4 bonus issue of shares on 1 March 20X2
utilising the revaluation reserve. This has not yet been recorded in
the above financial statements.
Required:
Redraft the statement of financial position of Deltoid as at 31 March
20X2 making appropriate adjustments for the items in (1) to (3) above.
(20 marks)
Note: work to the nearest $000 and show separately your working for
the retained earnings included in the statement of financial position.
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KAPLAN PUBLISHING
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Test your understanding 17 ­ Bowtock
Question 2
Bowtock has leased an item of plant under the following terms:
•
•
•
•
•
Commencement of the lease was 1 January 20X2.
Term of lease five years.
Annual payments in advance $12,000.
Cash price and fair value of the asset – $52,000 at 1 January 20X2
Implicit interest rate within the lease (as supplied by the lessor) 8%
per annum (to be apportioned on a time basis where relevant).
The company’s depreciation policy for this type of plant is 20% per
annum on cost (apportioned on a time basis where relevant).
Required:
Prepare extracts of the income statement and statement of financial
position for Bowtock for the year to 30 September 20X3 for the above
lease.
(5 marks)
Chapter 14: Substance over form
Test your understanding 18 ­ Atkins
Question 1
The principle of recording the substance or economic reality of
transactions rather than their legal form lies at the heart of the
Framework for the Preparation and Presentation of Financial
Statements (Framework) and several International Accounting
Standards.
The development of this principle was partly in reaction to a minority of
public interest companies entering into certain complex transactions.
These transactions sometimes led to accusations that company
directors were involved in ‘creative accounting’.
KAPLAN PUBLISHING
365
Questions & Answers
Required:
(a) (i) Explain, with relevant examples, what is generally meant by the
term ‘creative accounting’.
(5 marks)
(ii) Explain why it is important to record the substance rather than
the legal form of transactions and describe the features that
may indicate that the substance of a transaction is different from
its legal form.
(5 marks)
(b) (i) Atkins’s operations involve selling cars to the public through a
chain of retail car showrooms. It buys most of its new vehicles
directly from the manufacturer on these terms:
–
Atkins will pay the manufacturer for the cars on the date
they are sold to a customer or six months after they are
delivered to its showrooms whichever is the sooner.
–
The price paid will be 80% of the retail list price as set by
the manufacturer at the date that the goods are delivered.
–
Atkins will pay the manufacturer 1.5% per month (of the
cost price to Atkins) as a ‘display charge’ until the goods
are paid for.
–
Atkins may return the cars to the manufacturer any time up
until the date the cars are due to be paid for. Atkins will
incur the freight cost of any such returns. Atkins has never
taken advantage of this right of return.
–
The manufacturer can recall the cars or request them to be
transferred to another retailer any time up until the time they
are paid for by Atkins.
Required:
Discuss which party bears the risks and rewards in the above
arrangement and come to a conclusion on how the transactions
should be treated by each party.
(6 marks)
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KAPLAN PUBLISHING
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(ii) Atkins bought five identical plots of development land for $2
million in 19W9. On 1 October 20X1 Atkins sold three of the
plots of land to an investment company, Landbank, for a total of
$2.4 million. This price was based on 75% of the fair market
value of $3.2 million as determined by an independent surveyor
at the date of sale. The terms of the sale contained two clauses:
–
Atkins can re­purchase the plots of land for the full fair value
of $3.2 million (the value determined at the date of sale)
any time until 30 September 20X4, and
–
On 1 October 20X4, Landbank has the option to require
Atkins to re­purchase the properties for $3.2 million. You
may assume that Landbank seeks a return on its
investments of 10% per annum.
Required:
Discuss the substance of the above transactions.
(3 marks)
Prepare extracts of the income statement and statement of financial
position (ignore cash) of Atkins for the year to 30 September 20X2:
–
if the plots of land are considered as sold to Landbank
(2 marks)
–
reflecting the substance of the above transactions.
(4 marks)
(Total: 25 marks)
Test your understanding 19 ­ Jenson
Question 2
Jenson has entered into the following transactions/agreements in the
year to 31 March 20X0:
(i) Goods, which had a cost of $20,000, were sold to Wholesaler for
$35,000 on 1 July 19W9. Jenson has an option to repurchase the
goods from Wholesaler at any time within the next two years. The
repurchase price will be $35,000 plus interest charged at 12% per
annum from the date of sale to the date of repurchase. It is expected
that Jenson will repurchase the goods.
KAPLAN PUBLISHING
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Questions & Answers
(ii) Jenson owns the rights to a fast food franchise. On 1 April 19W9 it
sold the right to open a new outlet to Mr Cody. The franchise is for
five years. Jenson received an initial fee of $50,000 for the first year
and will receive $5,000 per annum thereafter. Jenson has continuing
service obligations on its franchise for advertising and product
development that amount to approximately $8,000 per annum per
franchised outlet. A reasonable profit margin on the provision of the
continuing services is deemed to be 20% of revenues received.
(iii) On 1 September 19W9 Jenson received total subscriptions in
advance of $240,000. The subscriptions are for 24 monthly
publications of a magazine produced by Jenson. At the year end
Jenson had produced and despatched six of the 24 publications.
The total cost of producing the magazine is estimated at $192,000
with each publication costing a broadly similar amount.
Required:
Describe how Jenson should treat each of the above examples in its
financial statements in the year to 31 March 20X0.
(8 marks)
Chapter 15: Provisions, contingent liabilities and contingent assets
Test your understanding 20 ­ Bodyline
Question 1
IAS 37 Provisions, Contingent Liabilities and Contingent Assets
was issued in 1998. The Standard sets out the principles of accounting
for these items and clarifies when provisions should and should not be
made. Prior to its issue, the inappropriate use of provisions had been an
area where companies had been accused of manipulating the financial
statements and of creative accounting.
Required:
(a) Describe the nature of provisions and the accounting requirements
for them contained in IAS 37.
(6 marks)
(b) Explain why there is a need for an accounting standard in this area.
Illustrate your answer with three practical examples of how the
standard addresses controversial issues.
(6 marks)
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KAPLAN PUBLISHING
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(c) Bodyline sells sports goods and clothing through a chain of retail
outlets. It offers customers a full refund facility for any goods returned
within 28 days of their purchase provided they are unused and in
their original packaging. In addition, all goods carry a warranty
against manufacturing defects for 12 months from their date of
purchase. For most goods the manufacturer underwrites this
warranty such that Bodyline is credited with the cost of the goods
that are returned as faulty. Goods purchased from one manufacturer,
Header, are sold to Bodyline at a negotiated discount which is
designed to compensate Bodyline for manufacturing defects. No
refunds are given by Header, thus Bodyline has to bear the cost of
any manufacturing faults of these goods.
Bodyline makes a uniform mark up on cost of 25% on all goods it
sells, except for those supplied from Header on which it makes a
mark up on cost of 40%. Sales of goods manufactured by Header
consistently account for 20% of all Bodyline’s sales.
Sales in the last 28 days of the trading year to 30 September 20X3
were $1,750,000. Past trends reliably indicate that 10% of all goods
are returned under the 28­day return facility. These are not faulty
goods. Of these 70% are later resold at the normal selling price and
the remaining 30% are sold as ‘sale’ items at half the normal retail
price.
In addition to the above expected returns, an estimated $160,000
(at selling price) of the goods sold during the year will have
manufacturing defects and have yet to be returned by customers.
Goods returned as faulty have no resale value.
Required:
Describe the nature of the above warranty/return facilities and
calculate the provision Bodyline is required to make at 30
September 20X3:
(i) for goods subject to the 28 day returns policy, and
(ii) for goods that are likely to be faulty.
(8 marks)
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Questions & Answers
(d) Rockbuster has recently purchased an item of earth moving plant at
a total cost of $24 million. The plant has an estimated life of 10
years with no residual value, however its engine will need replacing
after every 5,000 hours of use at an estimated cost of $7.5 million.
The directors of Rockbuster intend to depreciate the plant at $2.4
million ($24 million/10 years) per annum and make a provision of
$1,500 ($7.5 million/5,000 hours) per hour of use for the
replacement of the engine.
Required:
Explain how the plant should be treated in accordance with
International Accounting Standards and comment on the Directors’
proposed treatment.
(5 marks)
(Total: 25 marks)
Chapter 16: Taxation
Test your understanding 21 ­ Energiser
Question 1
The following extracted balances relate to Energiser at 31 December
20X4:
$000
Ordinary shares of 20c each
Retained profits 1 January 2004
6% redeemable preference shares
Trade payables
Income tax
Deferred tax – 1 January 2004
Land and buildings – cost
Plant and equipment ­ cost
Depreciation 1 January 2004 – land and
buildings
Depreciation 1 January 2004 – plant and
equipment
Trade receivables
Inventory – 1 January 2004
Bank
revenue
370
$000
100,000
128,400
60,000
73,800
4,200
29,400
300,000
217,200
18,000
49,200
62,400
51,300
7,400
600,000
KAPLAN PUBLISHING
chapter 21
Purchases
Distribution expenses
Administration expenses
Preference dividend
Interim ordinary dividend
316,900
52,800
46,400
3,600
5,000
––––––––– –––––––––
1,063,000 1,063,000
––––––––– –––––––––
Additional information
(1) Revenue includes $100 million for an item of plant sold on 1
September 20X4. The plant had a book value of $80 million at the
date of its sale, which was charged to cost of sales. On the same
date, Energiser entered into an agreement to lease back the plant
for the next five years (being the estimated remaining life of the
plant). Energiser has negotiated extended credit so that the first
instalment of capital and interest on the lease falls after 31
December 2005, more than one year from the year end. An
arrangement of this type is deemed to have financing cost of 12%
per annum. No depreciation has been charged on the item of plant
in the current year.
(2) The inventory at 31 December 20X4 was valued at cost of $57
million. This includes $9 million of slow moving goods. Energiser
believes that it will be able to sell these goods for only $4 million.
(3) The land and buildings cost of $300 million includes land at a cost of
$60 million. The remaining life of the building as at 1 January 20X4
was estimated at 40 years.
(4) Plant and equipment (other than that referred to in note 1 above) is
depreciated at 20% per annum on the reducing balance basis. All
depreciation is to be charged to cost of sales.
(5) The balance on the income tax account in the trial balance is the
result of the settlement of the previous year’s tax charge. The
directors have estimated the provision for income tax for the year to
31 December 20X4 at $18.4 million. For the deferred tax provision,
the only temporary differences are accelerated capital allowances.
At 31 December 20X4 these temporary differences were $91
million. Assume an income tax rate of 30%.
(6) On 1 January 20X4 Energiser issued a loan note, the details of
which are:
KAPLAN PUBLISHING
Nominal value issued
$60 million
Discount on issue
6%
Nominal interest rate
8%
371
Questions & Answers
The loan note is redeemable on 31 December 20X7 at a premium
of 10%. Interest is payable annually on 31 December. Energiser has
not yet made any entries in respect of this loan note.
(7) The outstanding receivable balance of a major customer amounting
to $12 million was factored to Debtco on 1 December 20X4. The
terms of the factoring were:
–
Debtco will pay 80% of the gross debtor outstanding to
Energiser immediately.
–
The balance will be paid (less the charges below) when the
trade receivable is collected in full. Any amount of the debt
outstanding after four months will be transferred back to
Energiser at its full book value.
–
Debtco will charge 1% per month on the net amount owing from
Energiser at the beginning of each month. Debtco had not
collected any of the factored debtor by the year­end.
–
Energiser debited the cash received from Debtco to its bank
account and removed the debtor from its sales ledger. It has
prudently charged the difference as an administration cost.
(8) The directors do not wish to propose a final ordinary dividend.
Required:
Prepare Energiser’s income statement for the year ended 31 December
20X4 and its statement of financial position at that date. These should
be in a form suitable for publication.
(25 marks)
All workings must be clearly shown.
Test your understanding 22 ­ Telenorth
Question 2
The following trial balance relates to Telenorth at 30 September 20X1:
$000
Sales
Inventory 1 October 20X0
Purchases
Distribution expenses
Administration expenses
Loan note interest paid
372
$000
283,460
12,400
147,200
22,300
34,440
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KAPLAN PUBLISHING
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Interim dividends
­ ordinary
­ preference
Investment income
25 year leasehold building– cost
Plant and equipment – cost
Computer system – cost
Investments – at valuation
Depreciation 1 October 20X0 (note 2)
­ leasehold
­ plant and equipment
­ computer system
Trade receivables (note 3)
Bank overdraft
Trade payables
Deferred tax (note 4)
Ordinary shares of $1 each
Suspense account (note 5)
6% Loan notes (issued 1 October 20X0)
8% Preference shares (qualifying as equity shares)
Revaluation reserve (note 4)
Retained earnings 1 October 20X0
2,000
480
1,500
56,250
55,000
35,000
34,500
18,000
12,800
9,600
35,700
1,680
17,770
5,200
20,000
26,000
10,000
12,000
3,400
14,160
––––––– –––––––
435,570 435,570
––––––– –––––––
The following notes are relevant:
(1) Counting of inventory could not be conducted by Telenorth until 4
October 20X1 due to operational reasons. The value of the inventory
on the premises at this date was $16 million at cost. Between the
year­end and the inventory count the following transactions have
been identified:
Normal sales at a mark up on cost of 40%
$1,400,000
Sales on a sale or return basis at a mark
up on cost of 30%
$650,000
Goods received at cost
$820,000
All sales and purchases had been correctly recorded in the period in
which they occurred.
KAPLAN PUBLISHING
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Questions & Answers
(2) Telenorth has the following depreciation policy:
–
Leasehold – straight­line.
–
Plant and equipment – five years straight line with residual
values estimated at $5,000,000.
–
Computer system – 40% per annum reducing balance.
Depreciation of the leasehold and plant is treated as cost of
sales; depreciation of the computer system is an administration
expense.
(3) The outstanding balance (receivable) of a major customer
amounting to $12 million was factored to Kwikfinance on 1
September 20X1. The terms of the factoring were:
–
Kwikfinance will pay 80% of the gross balance receivable to
Telenorth immediately.
–
The balance will be paid (less the charges below) when the
receivable is collected in full. Any amount of the debt
outstanding after four months will be transferred back to
Telenorth at its full book value.
–
Kwikfinance will charge 1.0% per month of the net amount
owing from Telenorth at the beginning of each month.
Kwikfinance had not collected any of the factored receivable
balance by the year­end.
Telenorth debited the cash from Kwikfinance to its bank
account and removed the receivable balance from its sales
ledger. It has prudently charged the difference as an
administration cost.
(4) A provision for tax, excluding the amount of any withholding taxes, of
$23.4 million for the year to 30 September 20X1 is required. The
deferred tax liability is to be increased by $2.2 million, of which $1
million relates to other comprehensive income and is to be charged
direct to the revaluation reserve.
(5) The suspense account contains the proceeds of two share issues:
374
–
The exercise of all the outstanding directors’ share options of
four million shares on 1 October 20X0 at $2 each.
–
A fully subscribed rights issue on 1 July 20X1 of 1 for 4 held at a
price of $3 each. The stock market price of Telenorth’s shares
immediately before the rights issue was $4.
KAPLAN PUBLISHING
chapter 21
Required:
(a) (i) prepare the income statement of Telenorth for the year to 30
September 20X1, and
(9 marks)
(ii) prepare a statement of financial position as at 30 September
20X1 in accordance with current International Accounting
Standards as far as the information permits.
(11 marks)
(Total: 20 marks)
Notes to the financial statements are not required.
Test your understanding 23 ­ Picklette
Question 3
The following information has been extracted from the books of Picklette
for the year to 31 March 20X9.
Administrative expenses
Interest paid
Called up share capital (ordinary shares of
$1 each)
Dividend
Cash at bank and in hand
Income tax (remaining balance from
previous year)
Warranty provision
Distribution costs
Land and buildings:
at cost
accumulated depreciation (at 1 April 20X8)
KAPLAN PUBLISHING
Dr
$000
170
5
Cr
$000
200
6
9
10
90
240
210
48
375
Questions & Answers
Plant and machinery:
at cost
accumulated depreciation (at 1 April 20X8)
Retained earnings (at 1 April 20X8)
Loan
Purchases
Sales
Inventory (at 1 April 20X8)
Trade payables
Trade receivables
125
75
270
80
470
1,300
150
60
728
–––––
2,123
–––––
–––––
2,123
–––––
Additional information
(1) Inventory at 31 March 20X9 was valued at $250,000.
(2) Buildings and plant and machinery are depreciated on a straight­
line basis (assuming no residual value) at the following rates:
On cost:
Buildings
Plant and machinery
5%
20%
(3) Land at cost was $110,000. Land is not depreciated.
(4) There were no purchases or sales of non­current assets during the
year to 31 March 20X9.
(5) The depreciation charges for the year to 31 March 20X9 are to be
apportioned as follows:
Cost of sales
Distribution costs
Administrative expenses
60%
20%
20%
(6) Income taxes is for the year to 31 March 20X9 (at a rate of 30%) are
estimated to be $135,000.
(7) The directors paid a dividend of 3p per share. The loan is repayable
in five years.
(8) The year end provision for warranty claims has been estimated at
£75,000. Warranty costs are charged to administrative expenses.
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KAPLAN PUBLISHING
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Required:
Insofar as the information permits, prepare Picklette plc’s income
statement for the year to 31 March 20X9 and a statement of financial
position as at that date without accompanying notes.
(15 marks)
Chapter 17: Reporting financial performance
Test your understanding 24 ­ Mrs Harper
Question 1
You are a partner in a small audit and accounting practice. You have just
completed the audit and finalised the financial statements of a small
family owned company in discussion with its managing director Mrs
Harper. After the meeting Mrs Harper has asked for your help. She has
obtained the published financial statements of several quoted
companies in which she is considering buying some shares as a
personal investment. She presents you with the following information:
(a) In the year to 30 September 20X2, two companies, Gamma and
Toga, reported identical profits before tax of $100 million.
Information in the Chairmen’s reports said both companies also
expected profits from their core activities (to be interpreted as from
continuing operations) to grow by 10% in the following year. Mrs
Harper has extracted information from the income statements and
made the following summary:
Gamma
Toga
$ million
$ million
Operating profit:
Continuing activities
70
90
Acquisitions
nil
50
Discontinued activities
30
(40)
––––
––––
100
100
––––
––––
A note to the financial statements of Toga said that both the
discontinuation and acquisition occurred on 1 April 20X2 and were
part of an overall plan to focus on its traditional core activities after
incurring large losses on a new foreign venture.
KAPLAN PUBLISHING
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Questions & Answers
Required:
(i) Briefly explain to Mrs Harper why information on discontinued
operations is useful.
(3 marks)
(ii) Calculate the expected operating profit for both companies for
the year to 30 September 20X3 (assuming the Chairmen’s
growth forecasts are correct):
–
in the absence of information of the discontinued
operations, and
–
based on the information provided above.
(4 marks)
(b) Mrs Harper has noticed that the tax charge for a company called
Stepper is $5 million on profits before tax of $35 million. This is an
effective rate of tax of 14.3%. Another company Jenni has an
income tax charge of $10 million on profit before tax of $30 million.
This is an effective rate of tax of 33.3% yet both companies state the
rate of income tax applicable to them is 25%. Mrs Harper has also
noticed that in the statements of cash flows each company has paid
the same amount of tax of $8 million.
Required:
Advise Mrs Harper of the possible reasons why the income tax
charge in the financial statements as a percentage of the profit
before tax may not be the same as the applicable income tax rate,
and why the tax paid in the statement of cash flows may not be the
same as the tax charge in the income statement.
(6 marks)
(Total: 13 marks)
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chapter 21
Test your understanding 25 ­ Bewley
Question 2
On 1 January 20X0 the Board of Bewley approved a resolution to close
the whole of its loss­making engineering operation. A binding
agreement to dispose of the assets was signed shortly afterwards. The
sale will be completed on 10 June 20X0 at an agreed value of $30
million. The costs of the closure are estimated at:
•
•
•
•
$2 million for redundancy/retrenchment.
•
Operating losses for the period from 1 April 20X0 to the date of sale
are estimated at $4.5 million.
$3 million in penalty costs for non­completion of contracted orders.
$1.5 million for associated professional costs.
Losses on the sale of the net assets and liabilities, whose book
value at 31 March 20X0 was $66 million and $20 million
respectively.
Bewley accounts for its various operations on a divisional basis.
Required:
Advise the directors on the correct treatment of the closure of the
engineering division for the year ended 31 March 20X0.
(5 marks)
Chapter 18: Earnings per share
Test your understanding 26 ­ Rodney Miller
Question 1
A client, Rodney Miller has obtained the published financial statements
of several quoted companies in which he is considering buying some
shares as a personal investment.
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Questions & Answers
He has obtained the following information from the published financial
statements of one of the companies, Taylor:
Earnings per share:
Year to 30 September
Basic earnings per share
20X2
20X1
25 cents
20 cents
The earnings per share is based on attributable earnings of $50 million
($30 million in 20X1) and 200 million ordinary shares in issue throughout
the year (150 million weighted average number of ordinary shares in
20X1).
SFP extracts:
8% Convertible loan stock
20X2
$ million
200
20X1
$ million
200
The loan stock is convertible to ordinary shares in 20X4 on the basis of
70 new shares for each $100 of loan stock.
Note to the financial statements:
There are directors’ share options (in issue since 19W9) that allow
Taylor’s directors to subscribe for a total of 50 million new ordinary
shares at a price of $1.50 each.
(Assume the current rate of income tax for Taylor is 25% and the market
price of its ordinary shares throughout the year has been $2.50)
Rodney Miller has read that the trend of the earnings per share is a
reliable measure of a company’s profit trend. He cannot understand why
the increase in profits is 67% ($30 million to $50 million), but the
increase in the earnings per share is only 25% (20 cents to 25 cents).
He is also confused by the company also quoting a diluted earnings per
share figure, which is lower than the basic earnings per share.
Required:
(i) Explain why the trend of earnings per share may be different from
the trend of the reported profit, and which is the more useful
measure of performance.
(3 marks)
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KAPLAN PUBLISHING
chapter 21
(ii) Calculate the diluted earnings per share for Taylor based on the
effect of the convertible loan stock and the directors’ share options
for the year to 30 September 20X2 (ignore comparatives).
(5 marks)
(iii) Explain the relevance of the diluted earnings per share measure.
(4 marks)
(Total: 12 marks)
Test your understanding 27 ­ Niagara’s
Question 2
Extracts of Niagara’s consolidated income statement for the year to 31
March 20X3 are:
Sales
Cost of sales
Gross profit
Other operating expenses
Finance costs
Impairment of non­current assets
Income from associates
Profit before tax
Taxation
Profit for the period
KAPLAN PUBLISHING
$000
36,000
(21,000)
––––––
15,000
(6,200)
(800)
(4,000)
1,500
––––––
5,500
(2,800)
––––––
2,700
––––––
381
Questions & Answers
Attributable to:
Shareholders of the parent
Non­controlling interests
2,585
115
––––––
2,700
––––––
The impairment of non­current assets attracted tax relief of $1 million
which has been included in the tax charge.
Niagara paid an interim ordinary dividend of 3c per share in June 20X2
and declared a final dividend on 25 March 20X3 of 6c per share.
The issued share capital of Niagara on 1 April 20X2 was:
Ordinary shares of 25c each
8% Preference shares
$3 million
$1 million
The preference shares are non­redeemable.
The company also had in issue $2 million 7% convertible loan stock
dated 20X5. The loan stock will be redeemed at par in 20X5 or
converted to ordinary shares on the basis of 40 new shares for each
$100 of loan stock at the option of the stockholders. Niagara’s income
tax rate is 30%.
There are also in existence directors’ share warrants (issued in 20X1)
which entitle the directors to receive 750,000 new shares in total in 20X5
at no cost to the directors.
382
KAPLAN PUBLISHING
chapter 21
The following share issues took place during the year to 31 March 20X3:
•
1 July 20X2; a rights issue of 1 new share at $1.50 for every 5
shares held. The market price of Niagara’s shares the day before
the rights was $2.40.
•
1 October 20X2; an issue of $1 million 6% non­redeemable
preference shares at par.
Both issues were fully subscribed.
Niagara’s basic earnings per share in the year to 31 March 20X2 was
correctly disclosed as 24c.
Required:
Calculate for Niagara for the year to 31 March 20X3:
(i) the basic earnings per share including the comparative
(4 marks)
(ii) the fully diluted earnings per share (ignore comparative); and advise
a prospective investor of the significance of the diluted earnings per
share figure.
(6 marks)
(Total: 10 marks)
KAPLAN PUBLISHING
383
Questions & Answers
Chapter 19: Interpretation of financial statements
Test your understanding 28 ­ Webster
Question 1
Webster is a diversified holding company that is looking to acquire an
engineering company. Two private limited engineering companies, Cole
and Darwin, are available for sale. The summarised financial statements
for the year to 31 March 20X0 of both companies are as follows:
Income statements:
Cole
$000
Sales revenues (note 1)
Opening inventory
Purchases (note 2)
Closing inventory
Gross profit
Operating expenses
Debenture interest
Overdraft interest (note
5)
450
2,030
–––––
2,480
(540)
–––––
$000
3,000
(1,940)
–––––
1,060
480
80
nil
–––––
Net profit
384
Darwin
$000
$000
4,400
720
3,080
–––––
3,800
(850) (2,950)
–––––
–––––
1,450
964
nil
10
–––––
(560)
–––––
500
–––––
(974)
–––––
476
–––––
KAPLAN PUBLISHING
chapter 21
Statements of financial position:
Cole
$000
Non­current assets
Property (note 3)
Plant (note 4)
Current assets
Inventory
Accounts receivable
Bank
Non­current liabilities
10% Debenture
Current liabilities
Accounts payable
Overdraft
Total equity and liabilities
KAPLAN PUBLISHING
$000
$000
1,140
1,200
–––––
2,340
540
522
20
–––––
Total assets
Equity and liabilities:
Equity shares of $1 each
Reserves:
Revaluation reserve
Retained earnings 1 April
19X9
Profit for year to 31 March
20X0
Darwin
1,082
–––––
3,422
–––––
$000
1,900
1,200
–––––
3,100
850
750
nil
–––––
1,600
–––––
4,700
–––––
1,000
500
nil
700
684
1,912
500
1,184
476
2,388
–––––
–––––
2,184
–––––
–––––
3,588
800
438
nil
–––––
438
–––––
3,422
–––––
nil
562
550
–––––
1,112
–––––
4,700
–––––
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Questions & Answers
Webster bases its preliminary assessment of target companies on
certain key ratios. These are listed below with the relevant figures for
Cole and Darwin calculated from the above financial statements:
Cole
ROCE
500 + 80
–––––––––––
2,184 + 80
476
–––––––––––
3,588
Asset turnover
(3,000/2,984)
(4,400/3,588)
Gross profit margin
Net profit margin
Accounts receivable
collection period
Accounts payable
payment period
× 100
× 100
Darwin
19.4%
13.3%
1.01
35.3%
16.7%
64 days
1.23
33.0%
10.8%
62 days
79 days
67 days
Note: capital employed is defined as shareholders’ funds plus long­term
debt at the year end; asset turnover is sales revenues divided by gross
assets less current liabilities.
The following additional information has been obtained:
(1) Cole is part of the Velox Group. On 1 March 20X0 it was permitted
by its holding company to sell goods at a price of $500,000 to
Brander, a fellow subsidiary. Cole’s normal selling price for these
goods would have been $375,000. In addition Brander was
instructed to pay for the goods immediately. Cole normally allows a
three month payment period to customers.
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(2) On 1 January 20X0 Cole purchased $275,000 (cost price to Cole)
of its materials from Advent, another member of the Velox Group.
Advent was also instructed to depart from its normal trading terms
that would have resulted in a charge of $300,000 to Cole for these
goods. The Group’s finance director also authorised a four­month
payment period on this sale. Normal payment terms in this industry
would be to receive two months’ credit from suppliers. Cole had
sold all of these goods at the year­end.
(3) Non­current assets:
Details relating to the two companies’ non­current assets at 31
March 20X0 are:
Depreciation
Book value
– property
– plant
Cost/
revaluation
$000
3,000
6,000
$000
1,860
4,800
Darwin – property
– plant
2,000
3,000
100
1,800
$000
1,140
1,200
–––––
2,340
–––––
1,900
1,200
–––––
3,100
–––––
Cole
Both companies own very similar properties. Darwin’s property was
revalued to $2,000,000 at the beginning of the current year (i.e. 1
April 19W9). On this date Cole’s property, which is carried at cost
less depreciation, had a book value of $1,200,000. Its current value
(on the same basis as Darwin’s property) was also $2,000,000. On
this date (1 April 19W9) both properties had the same remaining life
of 20 years.
(4) Darwin purchased new plant costing $600,000 in February 20X0. In
line with company policy a full year’s depreciation at 20% per annum
has been charged on all plant owned at the year­end. The plant is
still being tested and will not come on­stream until next year. The
purchase of the plant was largely financed by an overdraft facility
that resulted in the interest cost shown in the income statement.
Both companies depreciate plant over a five­year life.
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Questions & Answers
(5) The bank overdraft that would have been required but for the
favourable treatment towards Cole in respect of the items in (1) and
(2) above, would have attracted interest of $15,000 in the year to 31
March 20X0.
Required:
(a) Restate the financial statements of Cole and Darwin for the year to
31 March 20X0 in order that they may be considered comparable
for decision making purposes. State any assumptions you make
(10 marks)
(b) Recalculate the key ratios used by Webster and, together with any
other relevant points, comment on how the revised ratios may affect
the relative assessment of the two companies.
(10 marks)
(Total: 20 marks)
Test your understanding 29 ­ Judicious
Question 2
You are the assistant financial controller of Judicious. One of your
company’s credit controllers has asked you to consider the account
balance of one of your customers, Breadline. He is concerned at the
pattern of payments and increasing size and age of the account balance.
As part of company policy he has obtained the most recently filed
financial statements of Breadline and these are summarised below. A
note to the financial statements of Breadline states that it is a wholly
owned subsidiary of Wheatmaster, and its main activities are the
production and distribution of bakery products to wholesalers. By
coincidence your company’s Chief Executive has been made aware that
Breadline may be available for sale. She has asked for your opinion on
whether Breadline would make a suitable addition to the group’s
portfolio.
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Breadline
Income statement year to:
Sales revenue
Cost of sales
Gross profit
Operating expenses
Finance costs – loan note
– overdraft
Profit before tax
Taxation
Profit for the
year
31 December
20X1
$000
$000
8,500
(5,950)
––––––
2,550
(560)
10
10
(20)
–––––– ––––––
1,970
(470)
––––––
1,500
31 December
20X0
$000
$000
6,500
(4,810)
––––––
1,690
(660)
nil
5
(5)
–––––– ––––––
1,025
(175)
––––––
850
Breadline paid no dividend in 20X0 but paid a dividend of $900,000 for
the year ending 31 December 20X1.
Statements of financial position as at:
Non­current
31 December 20X1
31 December
assets
20X0
Freehold premises
nil
1,250
at valuation
Leasehold
2,500
nil
premises
Plant
1,620
750
––––––
––––––
4,120
2,000
Current assets
Inventory
370
240
Accounts receivable
960
600
Bank
nil
1,330
250
1,090
––––––
–––––– –––––– ––––––
Total assets
5,450
3,090
______
––––––
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Questions & Answers
Equity and
liabilities
Equity:
Ordinary shares of $1
each
Reserves:
Share premium
Revaluation reserve
(re freehold
premises)
Retained earnings
Non­current
liabilities
2% Loan note
Current liabilities
Accounts payable
Overdraft
Total equity and
liabilities
500
200
nil
3,000
––––––
100
nil
700
3,200
––––––
3,700
1,700
––––––
500
1,030
220
––––––
1,250
––––––
5,450
––––––
2,400
––––––
2,500
nil
590
nil
––––––
590
––––––
3,090
––––––
From your company’s own records you have ascertained that sales to
Breadline for the year to 20X1 and 20X0 were $1,200,000 and
$800,000 respectively and the year­end accounts receivable balances
were $340,000 and $100,000 respectively. Normal credit terms, which
should apply to Breadline, are that payment is due 30 days after the end
of the month of sale. You are also aware that the company has not
changed its address and is trading from the same premises. A note to
Breadline’s financial statements says that the profit on the disposal of
the freehold premises has been included in cost of sales as this is where
the depreciation on the freehold was charged.
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Note: a commercial rate of interest on the loan note of Breadline would
be 8% per annum.
Required:
(a) Describe the matters that may be relevant when entity financial
statements are used to assess the performance of a company that
is a wholly owned subsidiary.
(5 marks)
Note: your answer should give attention to related party issues.
(b) From the information above and with the aid of suitable ratios,
prepare a report for your Chief Executive on the overall financial
position of Breadline. Your answer should include reference to
matters in the financial statements of Breadline that may give you
cause for concern or require further investigation.
(20 marks)
(Total: 25 marks)
Chapter 20: Cash flow statements
Test your understanding 30 ­ Placid
Question 1
The following are the financial statements, with an extract from the notes,
of Placid.
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Questions & Answers
Placid income statement for the year ended 31 March 2006
$ million
Sales
1,162
Cost of sales
(866)
––––
Gross profit
296
Distribution costs
(47)
Administrative expenses
(110)
––––
139
79
(55)
––––
163
(24)
––––
139
––––
Operating profit
Interest received
Interest paid
Profit before taxation
Taxation
Profit for the financial year
Placid statement of financial position as at 31 March
2006
$m
$m
$m
Non­current assets
Intangible assets
277
Tangible assets
1,023
Investments
69
–––––
1,369
Current assets
Inventory
Trade receivables
Investments
Cash at bank and in hand
246
460
­
250
–––––
234
600
68
–––––
902
128
353
20
124
–––––
956
–––––
2,325
–––––
392
2005
$m
625
–––––
1,527
–––––
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chapter 21
Equity
Called up share capital
Share premium
Revaluation reserve
Retained profits
Non­current liabilities
Debenture stock
Deferred taxation
Current liabilities
Overdrafts
Trade payables
Taxation
29
447
251
165
–––––
892
24
377
­
48
–––––
449
755
4
555
2
388
244
42
–––––
185
311
25
–––––
674
–––––
2,325
–––––
521
–––––
1,527
–––––
Notes:
(1) The non­current asset investments relate to the shares held by
Placid in a competitor company.
(2) The intangible assets are patents used in production.
(3) The current asset investments were shares in Sparks and Fencer
plc, held for a short­term gain. The sale of the current asset
investments realised $25 million. The gain on the disposal has been
subsumed into interest received.
(4) The trading profit is after charging depreciation on the tangible
assets of $22 million and amortisation on the intangible assets of $7
million. The revaluation reserve relates wholly to tangible assets.
(5) During the year ended 31 March 2006, plant and machinery, costing
$1,464 million, written down to $244 million at 31 March 2005, was
sold for $250 million. The profit on disposal has been subsumed
into cost of sales.
(6) A proportion of the debenture stock was issued at par for oil used in
production, the remaining $130m was issued for cash.
(7) During the year ended 31 March 2006 25 million 20p shares were
issued at a premium of $2.80.
(8) During the year ended 31 March 2006 an equity dividend of $22
million was paid.
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Questions & Answers
Required:
(a) Prepare a statement of cash flows of Placid for the year ended 31
March 2006.
(18 marks)
(b) Comment on the working capital and cash flow of Placid.
(7 marks)
(Total: 25 marks)
Test your understanding 31 ­ Nedberg
Question 2
The financial statements of Nedberg for the year to 30 September 20X2,
together with the comparative statement of financial position for the year
to 30 September 20X1 are shown below:
Income statement – year to 30 September 20X2
Sales revenue
Cost of sales (note 1)
Gross profit for period
Operating expenses (note 1)
Interest – Loan note
Profit before tax
Taxation
Net profit for the period
394
$m
3,820
(2,620)
–––––
1,200
(280)
–––––
920
(30)
–––––
890
(270)
–––––
620
–––––
KAPLAN PUBLISHING
chapter 21
Statements of financial position as at 30 September:
20X2
Non­current assets
$m
Property, plant and
equipment
Intangible assets (note 2)
20X1
$m
1,890
$m
670
–––––
2,560
$m
1,830
300
–––––
2,130
Current assets
Inventory
Accounts receivable
Cash
1,420
990
70
–––––
Total assets
Equity and liabilities
Ordinary shares of $1 each
Reserves
Share premium
Revaluation
Retained earnings
Non­current liabilities (note
3)
Current liabilities (note 4)
Total equity and liabilities
2,480
–––––
5,040
–––––
940
680
nil
–––––
1,620
–––––
3,750
–––––
750
500
350
140
1,910
–––––
3,150
870
100
nil
1,600
–––––
2,200
540
1,020
–––––
5,040
–––––
1,010
–––––
3,750
–––––
Notes to the financial statements:
(1) Cost of sales includes depreciation of property, plant and
equipment of $320 million and a loss on the sale of plant of $50
million. It also includes a credit for the amortisation of government
grants.
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Questions & Answers
(2) Intangible non­current assets:
1
Deferred development expenditure
Goodwill
3.
4.
5.
396
Non­current liabilities:
10% loan note
Government grants
Deferred tax
20X2
20X1
$m
470
200
–––––
670
–––––
$m
100
200
–––––
300
–––––
300
260
310
–––––
870
–––––
100
300
140
–––––
540
–––––
Current liabilities:
Accounts payable
Bank overdraft
Accrued loan interest
Taxation
875
730
nil
115
15
5
130
160
–––––
–––––
1,020
1,010
–––––
–––––
Extract from statement of changes in equity – Movement on
retained earnings:
Opening balance
1,600
1,000
Total comprehensive income for the 620
800
year
Dividends – interim
(320)
(200)
Transfer from revaluation reserve
10
–––––
–––––
Closing balance
1,910
1,600
–––––
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The following additional information is relevant:
(i) Intangible non­current assets:
The company successfully completed the development of a new
product during the current year, capitalising a further $500 million
before amortisation charges for the period.
(ii) Property, plant and equipment/revaluation reserve:
–
The company revalued its buildings by $200 million on 1
October 20X1. The surplus was recorded as other
comprehensive income and credited to a revaluation reserve.
–
New plant was acquired during the year at a cost of $250
million and a government grant of $50 million was received for
this plant.
–
On 1 October 20X1 a bonus issue of 1 new share for every 10
held was made from the revaluation reserve.
–
$10 million has been transferred from the revaluation reserve to
realised profits as a year­end adjustment in respect of the
additional depreciation created by the revaluation.
–
The remaining movement on property, plant and equipment was
due to the disposal of obsolete plant.
(iii) Share issues:
In addition to the bonus issue referred to above Nedberg made a
further issue of ordinary shares for cash.
Required:
(a) A statement of cash flows for Nedberg for the year to 30 September
20X2 prepared in accordance with IAS 7 Statement of Cash
Flows.
(20 marks)
(b) Comment briefly on the financial position of Nedberg as portrayed
by the information in your statement of cash flows.
(5 marks)
(Total: 25 marks)
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Questions & Answers
Test your understanding answers
Test your understanding 1 ­ Recost
Answer 1
(a) The main drawback of the use of historic cost accounts for
assessing the performance of a business is that they do not take
into account the current values of assets and, to a lesser extent,
liabilities. This can become a serious problem and give misleading
information when either specific or general price inflation rates are
considered to be high. The effect is that many of the values of the
assets in the statement of financial position are understated, and,
partly because of related depreciation, profits tend to be overstated.
More detailed criticisms of historic cost accounts during a period of
rising prices are:
Effects on the statement of financial position
(i) Most non­current assets can be considerably understated in
terms of their current worth. The most affected assets tend to be
land and buildings, investments and some plant.
(ii) In general net current assets tend not to be affected by inflation
mainly because they are monetary in nature. The possible
exception is trading inventories.
(iii) Liabilities tend to be ignored when current values are
discussed. This may be an error because, for example, a long
term loan carrying a fixed rate of interest, may have a current
value that is considerably different to when it was taken out
(ignoring the possibility of any repayments). This is because
current interest rates may have changed (often as a reaction to
levels of inflation) since the loan was originally taken out.
(iv) The accounting equation dictates that if the net assets are
understated, then so too are shareholders’ funds.
Effects on the income statement
Many costs tend to be understated in terms of their current value.
Where this occurs it means the profit is overstated in as much as the
use of lower costs leads to a higher profit. Many commentators
argue that pure historical cost profits are made up of a current
operating profit (see below) plus inflationary gains relating to the:
–
398
Costs of goods sold (both purchased and manufactured). This
can be mitigated, but not completely removed, by the use of
LIFO, however this is not common practice in many countries
and is now prohibited by IAS 2 Inventories.
KAPLAN PUBLISHING
chapter 21
–
Depreciation charges for non­current assets. In historic cost
accounts these are based on historical values rather than
current values, and therefore understate the values of the assets
that have been used (consumed) during the period.
–
Some methods of accounting for inflation include monetary
working capital and/or ‘gearing’ adjustments to historical cost
profits. These are intended to reflect the inflation effects of
holding net monetary working capital and debt.
The above combined effects lead to the following criticisms and
limitations of the use of historic cost accounts to assess a
business’s performance:
Lack of comparability
It may be invalid to compare the results of two companies. One
company may have assets that are relatively old (and of lower cost)
whereas another company may have similar, but more recently
purchased (and of higher cost) assets. In effect such companies
would have a similar operating capacity, but it would be recorded at
different values. This situation can also be found within a single
company that has operating divisions with similar characteristics to
the above scenario. Management may assess their relative
performance using historical costs (which would be an invalid basis)
to make decisions relating to future investment or even closure.
There is also a lack of comparability between a company’s current
year’s results and those of previous years i.e. trend analysis may be
distorted.
Conceptual inconsistency
Accounting theorists sometimes argue that historic cost accounts
are not internally consistent because they are in fact ‘mixed value’
accounts. This means that some historical costs are at current
values, whereas other historical costs are at out­of­date values.
Thus current values, of say sales revenues, are being matched with
out­of­date values such as depreciation relating to older assets.
Many important ratios which are calculated as a basis for
interpreting and assessing company performance can be distorted
by inflation. Important examples are: return on capital employed,
profit margins, many asset turnover ratios, gearing levels and
earnings per share.
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Questions & Answers
The misleading effects of the above on different users
Investors may find it difficult to compare the results of different
companies as a basis for investment decisions. A shareholder may
be tempted to accept a low bid for his/her shares if weight is given
to the asset backing, based on book values, of the shares.
Dividends may seem low in relation to reported profits, this may be
because management is recommending dividends based on a
current operating profit.
Employees may make high wage demands based on reported
profit rather than current operating profits.
Governments generally tax reported profits which means companies
pay tax on higher, inflation boosted, profits.
(b) The advantages and criticisms of General (Current) Purchasing
Power and Current Cost Accounting are set out below:
General (Current) Purchasing Power Accounts
It is claimed that general purchasing power (GPP) accounts retain
many of the advantages of historic cost accounts and overcome
some of their deficiencies. Like historic cost accounts GPP
accounts are transaction based, and are therefore objective and
verifiable. This is because they are a restatement of historic cost
accounts (which possess the above qualities) adjusted for the
movement in an inflation index, usually published by the government.
Because the income statement and the statement of financial
position are adjusted for price movements over time, GPP accounts
are said to be comparable between companies and over time. This
overcomes many of the difficulties of historic cost accounts.
If the index used to adjust the historic cost accounts is a consumer
based index (as it usually is), then they are more appropriate to
shareholders because this index is well understood by them and
more appropriate to their spending patterns. The figure for
shareholders funds is said to be a measure of the spending power
(or consumption) that is being forgone in making (or holding) the
investment in the company, and can be judged in those terms.
Opponents or critics of GPP accounting argue that many of the
claimed advantages may not be true. GPP accounts suffer from
some practical as well as theoretical problems:
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(i) GPP values are not real values, current or otherwise; they are
the result of statistical calculations. For many companies the
GPP values of their non­current assets will only be similar to
their real (current) values if the movement of the specific price
indexes relating to those assets is similar to that of the General
Price Index. An extreme case of this problem would occur
where there was general (retail) price inflation, but the company
trades in an activity where the prices of the goods they
manufacture and supply are falling. Hi­fi, video and computer
equipment may be examples of this. Average measures of
inflation, particularly if they are measures of consumer inflation,
are not usually appropriate to account for specific price inflation
experienced by companies, which differs from company to
company.
(ii) Most items in the income statement are adjusted by the
average inflation factor for the period. During periods of inflation
this is greater than one and can give the general effect of
increased profits. Although this effect is mitigated by higher
depreciation charges, GPP profits for profitable companies can
be higher than their historic cost profits. A major criticism of
historic cost accounts is that they overstate operating profits,
GPP accounts can worsen this problem rather than solve it.
Highly geared companies tend to show even greater GPP
profits (due to gains on net monetary liabilities), and such
companies are more vulnerable when inflation is high. This is
because interest rates are often increased by Governments in
an attempt to control inflation. This has a detrimental effect on
companies with high variable rate borrowings.
Current Cost Accounting
Current cost accounting (CCA) principles, from a conceptual point
of view, are more soundly based and therefore more difficult to
criticise than GPP accounts. They correct most of the limitations of
historic cost accounts that are due to increased price levels. They
reflect the current values of a company’s specific assets although
this is not necessarily the current cost of those assets. The reported
current operating profit is considered to be more relevant to many
decisions such as dividend distribution, employee wage claims and
even as a basis for taxation.
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Questions & Answers
The problems of CCA lie in their preparation and understanding. In
practical terms it can be very difficult to determine the current value
of assets, and many alternative forms of current value exist e.g.
replacement cost, realisable value and value in use. Methods of
determining current costs include the use of manufacturers’ price
lists for plant and inventory, professional revaluation of assets e.g.
land and buildings and the use of specific price indexes published
by government agencies. Whatever method is used it is often
subjective and sometimes complex. This makes the cost of the
preparation and audit of current cost accounts expensive.
An interesting point arising from the past use of CCA in some
countries is that when current cost results of companies were
published there was no significant differential change in share
prices relating to the current cost information. The Efficient Market
Hypothesis would suggest that if CCA provided ‘new’ information
then market prices would react. An interpretation of the above
observation is that the information revealed by CCA was already
‘known’ by the market makers and imputed into share prices. Thus
many feel that the expense of producing CCA gives no benefit to
users. This perhaps explains why historic cost accounts are still
dominant in financial reporting.
Test your understanding 2 ­ Hepburn and Salter
Answer 1
The directors do appear to be misunderstanding the basis of
determining subsidiary company status. IAS 27 Consolidated and
Separate Financial Statements bases its definition of a subsidiary on
control rather than ownership. In the case of Woodbridge, Hepburn in
fact owns 6,000 of the 10,000 voting shares, and, in the absence of any
other information, this would constitute control of Woodbridge by virtue of
its 60% of voting rights. Therefore Woodbridge’s results should be
consolidated by Hepburn from the date of its acquisition.
It may be that the motive for the directors’ position is that they wish to
improve group profits by avoiding consolidation of Woodbridge’s
losses. This is, however, not a valid reason for exclusion from
consolidation.
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Test your understanding 3 ­ Hanford & Stopple
Answer 1
(a) Hanford consolidated statement of financial position at 30
September 20X1
Non­current assets
$000
Property, plant and equipment (W8)
Goodwill (W3)
$000
109,510
6,850
–––––––
116,360
Current assets
Inventory (7,450 + 4,310)
Accounts receivable (12,960 + 4,330 – 820
(W7))
Bank
Equity and liabilities
Equity attributable to the equity holders of the
parent:
Ordinary shares of $1 each (20,000 +10,000
(W6))
Reserves:
Share premium (10,000 + 10,000 (W6))
Retained earnings (W5)
11,760
16,470
520
–––––––
28,750
–––––––
145,110
–––––––
30,000
20,000
65,750
–––––––
Non­controlling interests (W4)
85,750
–––––––
115,750
6,950
–––––––
122,700
Non­current liabilities
8% Loan notes 20X4
Current liabilities
Trade accounts payable (5,920 + 4,160 – 620
(W7))
Bank overdraft
Provision for taxation (3,070 + 2,180)
6,000
9,460
1,700
5,250
–––––––
Total equity and liabilities
KAPLAN PUBLISHING
16,410
–––––––
145,110
403
Questions & Answers
Workings (all figures in $000)
(W1) Group Structure
Hanford
|
75% 6m/8m
Stopple
Note: the unrealised profit on the sale of the plant was initially $400,000,
of this 10% i.e. $40,000 has been realised via Stopple's depreciation
charge, giving a net adjustment of $360,000 to both Hanford's profits
(W5) and the carrying value of the plant.
(W2) Net assets in subsidiary
Share capital
Share premium
Retained earnings (6,000 + 4,000)
Fair value adjustment
Administration charges
At
acquisition
$000
8,000
2,000
10,000
4,000
––––––
24,000
––––––
At reporting
date
$000
8,000
2,000
14,000
4,000
(200)
––––––
27,800
––––––
Fair value adjustments
The insurance claim is a contingent asset and cannot be recognised by
Stopple. IFRS revised requires Hanford to make an assessment of all
assets, liabilities and contingent liabilities of Stopple at the date of
acquisition. Contingent assets can only be recognised if they are virtually
certain, the receipt of the claim is merely ‘highly likely’. Therefore it is not
recognised by the group at the date of acquisition.
Therefore the fair value adjustment is only for the land.
404
KAPLAN PUBLISHING
chapter 21
(W3) Goodwill ­ Proportionate share method
$000
24,850
(18,000)
______
6,850
______
Cost of investment
For 75% Net assets at acq (75% × 24,000)
Goodwill
(W4) Non­controlling interest
25% × 27,800 (W2) =
6,950
(W5) Consolidated retained earnings
Hanford
Profit on sale of plant (see below)
Stopple Group share post acquisition profits
(27,800 ­ 24,000) ×
75%
$000
63,260
(360)
2,850
––––––
65,750
––––––
(W6) Share exchange
Hanford acquired six million shares in Stopple. On the basis of an
exchange of five for three, Hanford would issue 10 million new shares.
The total value of the consideration is $24.85 million of which $4.85
million was for cash, therefore the value of the 10 million shares would
be $20 million, or $2 each i.e. they were issued at a premium of $1
each.
KAPLAN PUBLISHING
405
Questions & Answers
(W7) Elimination of current accounts
The difference on the current accounts is due to the invoice for central
administration of $200,000. A summary of the intra­group
adjustment/cancellation is:
Dr
Hanford’s overdraft
Accounts payable
Accounts receivable
Cr
200
620
––––
820
––––
820
––––
820
––––
(W8) Property, plant and equipment
Amount from question – Hanford
– Stopple
Fair value adjustment
Unrealised profit in transfer of plant
78,690
27,180
4,000
(360)
–––––––
109,510
–––––––
Note: the unrealised profit on the sale of the plant was initially $400,000,
of this 10% i.e. $40,000 has been realised via Stopple's depreciation
charge, giving a net adjustment of $360,000 to both Hanford's profits
(W5) and the carrying value of the plant.
(b) The reasons why a parent company may not wish to consolidate a
subsidiary can be broken down into two broad groups; (i) to improve
the reported position of the group financial statements; and (ii)
where consolidating a subsidiary might not give a fair presentation
of the performance and position of the group.
Improvement of the financial position
The financial statements of a subsidiary could show any of the
following:
406
–
substantial operating losses
–
a poor liquidity position, or
–
high levels of borrowing (high gearing).
KAPLAN PUBLISHING
chapter 21
If a parent were to consolidate such a subsidiary, it would
proportionately worsen the group position in the above areas. Thus
a parent may prefer not to consolidate poorly performing
subsidiaries.
Fair presentation
There is a case for excluding subsidiaries from a parent’s
consolidated financial statements for the following reasons:
–
The subsidiary operates under severe long­term restrictions. In
effect the parent does not have full control (particularly over the
ability to transfer funds to the parent) over the subsidiary,
–
Control is intended to be temporary because the investment is
held exclusively with a view to its subsequent resale.
It is apparent that the first group of reasons for non­consolidation is
not permitted by International Accounting Standards, whereas in
theory the latter group might be.
In addition, subsidiaries may sometimes be excluded on the basis
of differing activities. Companies that have adopted this approach
argue that to add together the assets and liabilities of companies
whose activities differ greatly could lead to consolidated financial
statements that give a misleading impression (or not provide fair
presentation). IAS 27 has never permitted exclusion on these
grounds because it feels that ‘differing activity’ problems are
overcome by the provision of segmental information.
The revised version of IAS 27 Consolidated and Separate
Financial Statements does not allow any exclusions from
consolidation; all subsidiaries must be consolidated. However, IAS
27 requires disclosure of the nature and extent of any significant
restrictions on the ability of a subsidiary to transfer funds to the
parent. Where a subsidiary is held exclusively with a view to
subsequent resale (provided it has not previously been
consolidated) IFRS 5 Non­current Assets Held for Sale and
Discontinued Operations requires that it is presented separately
in the statement of financial position and that other information is
disclosed, so that users of the financial statements are made aware
that control is only intended to be temporary.
KAPLAN PUBLISHING
407
Questions & Answers
Test your understanding 4 ­ Hepburn and Salter
Answer 1
Hepburn Consolidated income statement year to 31 March 20X0
$000
Sale revenue (1,200 + 500 – 100 intra­group sales)
1,600
Cost of sales (W7)
(890)
–––––
Gross profit
710
Operating expenses (120 + 44)
(164)
Finance costs (12 x 6/12)
(6)
–––––
Profit before tax
540
Income tax expense (100 + 20)
(120)
–––––
Profit for the period
420
–––––
Attributable to:
Equity holders of the parent
400
Non­controlling interests (200 x 20% × 6/12)
20
–––––
420
–––––
Consolidated statement of financial position
at 31 March 20X0
Non­current assets
$000
Property, plant and equipment (620 + 660 +
125)
Intangible: Goodwill (W3)
Investments (20 + 10)
Current assets
Inventory (240 + 280 – 10) [W1]
Accounts receivable (170 + 210 – 56 (W6))
Bank (20 + 40 + 20 (W5))
Total assets
408
$000
1,405
255
30
–––––
1,690
510
324
80
–––––
914
–––––
2,604
–––––
KAPLAN PUBLISHING
chapter 21
Equity and liabilities:
Equity shares of $1 each (400 + 300 (W3))
Reserves:
Share premium (W3)
Retained earnings (W6)
700
600
480
–––––
Non­controlling interest (W4)
1,080
–––––
1,780
250
–––––
2,030
Non­current liabilities
8% Debentures
Current liabilities
Trade payables (210 + 155 – 36 (W6))
Taxation (50 + 45)
150
329
95
–––––
424
–––––
2,604
–––––
Workings
(W1) Group Structure
Hepburn
80%
Salter
The unrealised profit (URP) in inventory is calculated as:
Intra­group sales of $100,000 of which one half is in inventory at the year
end = $50,000.
This has been sold at a mark­up of 25% on cost, therefore the URP in
inventory is $50,000 × 25%/125% = $10,000.
KAPLAN PUBLISHING
409
Questions & Answers
(W2) Net Assets ­ Salter
Share Capital
retained earnings (500 +
(200x6/12))
Book Value
Fair Value adjustment
Land
Fair value
at date of
acquisition
$000
150
600
at reporting
date
$000
150
700
____
750
____
850
125
____
875
125
____
975
(W3) Goodwill ­ Fair Value (full goodwill method)
Hepburn issued five shares for every two shares it acquired in Salter.
Therefore Hepburn issued ((150,000/2 x 5) x 80%) = 300,000 shares at
a value of $3 each for a total consideration of $900,000.
This would be recorded in Hepburn’s books as equity share capital of
$300,000 and share premium of $600,000.
$000
Investment at cost (300 × $3)
For 80% (875)
Parent shares of goodwill
FV of NCI
NCI in net assets at date of acq
(875 x 20%)
Total Goodwill
410
$000
900
(700)
____
200
230
175
——
55
––––
255
––––
KAPLAN PUBLISHING
chapter 21
(W4) Non­controlling interest (Minority Interest)
$000
195
20% 975
NCI in goodwill
55
____
250
––––
(W5) Consolidated reserves
$000
410
80
Hepburn’s reserves
Share of Salter’s post acquisition profits
(200 x 6/12 x 80%)
URP in inventory
(10)
––––
480
––––
(W6) Elimination of current accounts
The difference on the current accounts is due to cash in transit of
$20,000. A summary of the intra­group cancellations is:
Cash/bank
Accounts payable
Accounts receivable
$000
20
36
––––
56
––––
KAPLAN PUBLISHING
$000
56
––––
56
––––
411
Questions & Answers
(W7) Cost of sales
$000
650
330
(100)
10
––––
890
––––
Hepburn
Salter (660 × 6/12)
Intra­group sales
URP in inventory (below)
Test your understanding 5 ­ Holding
Answer 2
Holding has acquired 18 million of Subside’s 24 million equity shares
which represents 75% ownership.
(a) Goodwill
$m
Cost of investment
Non­controlling interest
Share capital
Revaluation reserve (W1)
Profit and loss reserve (W2)
Net assets of subsidiary at acquisition date
Goodwill
412
24
64
88
––––
25%x
176
$m
174
44
___
218
(176)
––––
42
––––
KAPLAN PUBLISHING
chapter 21
Workings
(W1) Fair value gains/revaluation reserve
Property
– at 30 June 20X8
– increase up to 1 January 20X9
Plant:
Net book value 30 June 20X8
Depreciation 6 months to date of acquisition (20 × 6/12)
Net book value at date of acquisition
Fair value at date of acquisition
Fair value increase
Total revaluation gains (24 + 40)
$m
20
4
––––
24
––––
60
(10)
––––
50
(90)
––––
40
––––
64
––––
(W2) Pre­acquisition profits
Retained earnings at 30 June 20X8
Retained profit for period (6/15m × $60m)
Total pre­acquisition profits
KAPLAN PUBLISHING
64
24
––––
88
––––
413
Questions & Answers
(b) Consolidated income statement of Holding for the year to 30
September 20X9
Sales revenue (W1)
Cost of sales (W2)
Gross profit
Operating expenses (W3)
Interest payable (10 + (9/12m × 5))
Profit before tax
Income tax expense (22 + (9/12m × 10))
Profit for the period
Attributable to:
Equity holders of the parent
Non­controlling interest (W4)
$ million
488
(286)
––––
202
(93)
(13)
––––
96
(28)
––––
68
––––
62
6
––––
68
––––
Workings: ($ million)
(W1)
Most of the figures in the consolidated income statement are based on
the whole of the holding company’s figures plus the post acquisition
figures of the subsidiary. The results of the subsidiary are for a 15 month
period, of which nine months is post acquisition. Thus the post
acquisition results would be 9/15 or 60% of Subside’s relevant figures.
Sales revenue
Holding
Subside (9/12 × 280)
Intra­group sales
414
$m
350
168
(30)
––––
488
––––
KAPLAN PUBLISHING
chapter 21
(W2) Cost of sales
Holding
Subside (9/12 × 170)
Intra­group sales
Unrealised profit in inventory (see below)
Additional depreciation (see below)
$m
200
102
(30)
2
12
––––
286
––––
Unrealised profit
A mark­up of 25% on cost is equivalent to 20% of the selling price.
Holding has $10 million ($30 m x 1/3) of inventories at the transfer price,
thus the unrealised profit is ($10 m x 20%) $2 million.
Additional depreciation (plant of Subside)
At the date of the acquisition (1 January 20X9) the plant is two and a half
years old and has a remaining life also of two and a half years. Therefore
the revaluation gain of $40 million will be amortised at $16 million per
annum ($40 m/2.5). The post acquisition period is 9 months and would
thus require additional depreciation of $12 million (9/12 × $16m).
(W3) Operating expenses
$m
Holding
72
Subside (9/12% × 35)
21
––––
93
––––
(W4) Non­controlling interest
The profit after tax of Subside is $60 million of which $36 million (9/15) is
post acquisition. The depreciation adjustment of $12 million (see W4
above) is deducted from this to give an adjusted figure of $24 million.
The NCI has a 25% interest in this profit = $6 million.
KAPLAN PUBLISHING
415
Questions & Answers
Test your understanding 6 ­ Bacup, Townley and Rishworth
Answer 1
(a) Bacup
Consolidated statement of financial position as at 31 March 20X7
$000
$000
Non­current assets:
Tangible assets (3,820 + 4,425)
8,245
Goodwill (W3)
460
Investment in associate (W6)
420
–––––
9,125
Current assets:
Inventory (2,740 + 1,280 – 40)
3,980
Receivables (1,960 + 980 – 250)
2,690
Bank (1,260 + 50 cash in transit)
1,310
–––––
7,980
–––––
Total assets
17,105
–––––
Ordinary shares of 25 cents each
4,000
Reserves:
Share premium
800
Retained earnings (W5)
4,272
–––––
5,072
–––––
9,072
Non­controlling interest (W4)
233
–––––
Equity
9,305
Current liabilities:
Trade payables (2,120 + 3,070 — 200)
4,990
Bank overdraft
2,260
Taxation (400 + 150)
550
–––––
7,800
–––––
Total equity and liabilities
17,105
–––––
416
KAPLAN PUBLISHING
chapter 21
Workings
(W1) Net assets in subsidiary
Share capital
Share premium
Retained earnings (W2)
At acquisition
$000
500
125
300
––––
925
At reporting date
$000
500
125
540
––––
1,165
Net assets in associate
At acquisition
At reporting date
$000
$000
Share capital
200
200
Retained earnings
525
600
––––
––––
725
800
Pre/post acquisition reserves of Townley
Pre Post
(W2)
$000 $000
Retained earnings
380 400
Development expenditure
(80) (120)
Inventory URP
– (40)
–––– ––––
300 240
–––– ––––
Townley
Goodwill
(W3)
$000
Cost of investment (0.75 × 1,600)
1,200
Non­controlling interest (20% x 925)
185
–––––
1,385
Net assets of Townley at acquisition
(925)
____
460
––––
Non­controlling interest
(W4)
$000
Share of net assets (20% × 1,165)
233
KAPLAN PUBLISHING
417
Questions & Answers
(W5)
Retained earnings
Bacup
Unrealised profit on inventory
Townley (540 – 300) × 80%
Rishworth (600 – 525) × 40%
$000
4,060
(10)
192
30
–––––
4,272
–––––
Note: inventory URP (unrealised profit in inventories):
–
Sold by Bacup to Rishworth, group share only as it is an
associate, 40% of (125 × 25/125) = 10;
–
Sold by Townley to Bacup, total profit as it is a subsidiary, 200
× 25/125 = 40.
(W6) Associate – Rishworth
Carrying value in the statement of financial position at 31 March
20X7
Cost
Share of post acquisition profits (40% x (600­525))
PURP
$000
400
30
(10)
––––
420
(b) The group statement of financial position is of little use in assessing
the liquidity of any member of the group. It must be appreciated that
the group does not exist as a legal entity; it is an economic reporting
entity. For example it is not possible to sue a group, one would have
to sue the relevant member of the group.
Even if the liquidity position shown by calculations using the group
statement of financial position is favourable (for the statement of
financial position in the answer to (a) they are not good at all), it
implies nothing about the individual members of the group. A
criticism often levelled at group statement of financial position is that
they can give the impression that all of the group’s assets are
available to meet all of the group’s liabilities. The reality is that only
the assets of an individual member of the group are available to
discharge the liabilities of that individual member.
418
KAPLAN PUBLISHING
chapter 21
Occasionally some lenders, usually banks, will obtain guarantees
from the holding company when advancing loans or overdrafts to
subsidiaries. When this occurs it contradicts the above paragraph.
Sometimes a holding company will support a subsidiary that is in
financial difficulties when it has no legal obligation to do so. It does
this to preserve the value, reputation and goodwill of the group.
Further investigation
(i) The management of Norden Manufacturing must obtain the
separate financial statements of Townley in order to calculate
appropriate liquidity ratios. From the information in the question
Townley’s liquidity position is a cause of serious concern.
However, the usefulness of this could be questioned even if the
liquidity position was more favourable. This is due to the
limitations of such ratios e.g. they are open to ‘window
dressing’ and ‘creative accounting’ techniques.
(ii) The above should be supplemented by the use of a credit
reference agency to obtain a report on the position of Townley.
(iii) Discreet enquiries should be made with existing customers and
suppliers to see if they have had any unsatisfactory dealings
with Townley.
(iv) It is always worth trying to get the holding company, i.e. Bacup,
to guarantee any liability that Townley may incur to Norden
Manufacturing.
(v) As a further precaution Norden Manufacturing could sell goods
‘subject to reservation of title’.
Test your understanding 7 ­ Harden
Answer 2
(a) Consolidated statement of financial position of Harden as at
30 September 20X2
$000
$000
Non­current assets
Property, plant and equipment (W8)
Patents (250 + 420)
Consolidated goodwill (W3)
KAPLAN PUBLISHING
6,480
670
200
–––––
870
419
Questions & Answers
Investments
Associated company (W9)
Others (150 + 200)
Current assets
Inventories (W6)
Trade receivables (420 + 380 – 70 – 50)
(W7)
Bank
960
350
–––––
962
680
150
–––––
Total assets
Equity attributable to equity holders of the parent
Equity shares of $1 each
2,000
Reserves
Share premium
1,000
Retained earnings (W5)
5,172
–––––
Non­controlling interest (W4)
Non­current liabilities
Deferred tax
Current liabilities
Trade payables (750 + 450 – 70) (W7)
Taxation
Overdraft
Total equity and liabilities
420
1,310
–––––
8,660
1,792
–––––
10,452
8,172
730
–––––
8,902
200
1,130
140
80
–––––
1,350
–––––
10,452
KAPLAN PUBLISHING
chapter 21
Workings ($000)
(W1) Group Structure
Harden
80%
40%
active
Solder
(W2) Net assets in subsidiary
Share capital
Share premium
Retained earnings
Fair value adjustment
At acquisition
$000
1,000
500
1,200
200
–––––
2,900
At reporting date
$000
1,000
500
1,900
200
–––––
3,600
Net assets in associate
At acquisition
Share capital
Share premium
Retained earnings
KAPLAN PUBLISHING
$000
500
100
800
–––––
1,400
_____
At reporting date
$000
500
100
1,200
–––––
1,800
_____
421
Questions & Answers
(W3) Goodwill ­ Fair value (full goodwill) method
Cost of investment
For 80% Net assets acquired
(80% (2,900))
Goodwill ­ parents share
FV of NCI 600
NCI in Net assets at date of acq (580)
Total Goodwill
Solder
$000
2,500
(2,320)
_____
180
20
_____
200
–––––
(W4) Non­controlling interest
Fair value at acquisition
Share of post acquisition profits (20% x(3,600­
2,900) ­ 50)
$000
600
130
___
730
(W5) Retained earnings
Harden
Solder – group share post acquisition 80% ×
((1,900 – 50) – 1,200)
Active – group share post acquisition 40% × (1,200
– 800)
Less: unrealised profit (W6)
422
$000
4,500
520
160
(8)
–––––
5,172
–––––
KAPLAN PUBLISHING
chapter 21
(W6) Inventories
Amounts per question (570 + 400)
Group share of unrealised profit (140 x 40/140 x ½ x 40%)
$000
970
(8)
––––
962
––––
(W7) Elimination of current accounts
The current accounts of Harden and Solder were agreed at $70,000
before the charge for the allocation of central overheads. When Harden
processed this transaction it would have debited Solder’s current
account to give a balance of $120,000 which must be eliminated. The
corresponding adjustments are to eliminate $70,000 from Solder’s trade
payables and debit $50,000 to the retained earnings of Solder.
In summary:
Trade payables (elimination of intra­group
creditor)
Retained earnings of Solder reflecting the
charge
Trade receivables (elimination of intra­group
debtor)
Dr
70
Cr
50
120
––––
120
––––
––––
120
––––
(W8) Tangible non­current assets
Balance from question
– Harden
– Solder
Land fair value
increase
$000
3,980
2,300
200
–––––
6,480
–––––
KAPLAN PUBLISHING
423
Questions & Answers
(W9) Associated company – carrying value in consolidated
statement of financial position
$000
800
160
––––
960
––––
Investment at cost
Post acquisition profits (40% × (1,200 – 800))
Test your understanding 8 ­ Simpkins
Answer 1
IAS 16 Property, Plant and Equipment does not allow companies to
carry out selective revaluations of non­current assets (sometimes
referred to as ‘cherry picking’). Where a company decides to revalue a
non­current asset, it must be consistent and revalue all assets of the
same class. Furthermore where a class of non­current assets has been
revalued its carrying values must be kept up to date. Thus the proposal
of the directors of Simpkins would fall foul of IAS 16. Either all of the
properties must be revalued, thus recognising the loss on the property in
the North, or none of them should be revalued. The non­recognition of a
fall in an asset’s market value can no longer be justified on the basis that
a recovery in market prices is expected in the near future.
Income statement:
Property in the South:
Depreciation ($3.2 million x 140%)/40 years
In the Midlands:
Depreciation ($1.5 million/30 years)
In the North:
Loss on revaluation (20% x $800,000)
Depreciation (800,000 x 160,000)/20 years
424
$000
$000
112
50
160
32
––––
192
––––
354
––––
KAPLAN PUBLISHING
chapter 21
At 1 October 20X0 the accumulated depreciation of the property in the
South is $800,000. This represents ten years’ depreciation charges
leaving a remaining life of 40 years. Similar calculations for the
properties in the Midlands and the North give remaining lives of 30 and
20 years respectively. In the absence of a previous revaluation surplus
on the property in the North, the loss on its revaluation in the current year
must be charged to the income statement; it cannot be offset against a
surplus on a different asset.
Statement of financial position:
Property in the South
Property in the Midlands
Property in the North
KAPLAN PUBLISHING
Revaluation
$000
4,480
1,500
640
–––––
6,620
–––––
Depreciation
$000
112
50
32
––––
194
–––––
Book value
$000
4,368
1,450
608
––––
6,426
–––––
425
Questions & Answers
Test your understanding 9 ­ Myriad
Answer 2
(i) It is argued that the principal reasons for holding investment
properties are that the owner expects to receive rental income from
them and benefit from capital appreciation. They are not held for
‘consumption’ in the normal course of business i.e. they are not
used as part of a company’s operations in the production or supply
of goods and services or administrative purposes. As they are held
as an investment for (eventual) disposal, it is often considered that it
is the current values of the investments and the changes in them that
are more important than their original costs. IAS 40 Investment
Property takes this into account by permitting a choice of either a
‘cost’ model of a ‘fair value’ model on which the accounting
treatment of investment properties must be based.
Cost model
Under the cost model (as in IAS 16 Property, Plant and Equipment)
investment properties are measured at depreciated historic cost
(less any impairments). In effect this treats investment properties in
a similar manner to owner­occupied properties. Where the cost
model is adopted, the fair values of investment properties must be
disclosed.
Fair value model
This requires investment properties to be measured at their fair
values on the statement of financial position with changes in fair
values being recognised in income. This differs from a revaluation
model that requires (with certain exceptions) revaluation surpluses
to be recognised as changes in equity (reserve movements), not as
income. In the introduction to the Standard the IASB makes it clear
that they consider the fair value model to be desirable, although they
point out that it is an evolutionary step forward and therefore stop
short, at this stage, of making it a requirement.
(ii) Consolidated statement of financial position extractsas at 30
September 20X1
Non­current assets
Property, plant and
equipment
Investment properties
426
Cost/ Accumulated Carrying
valuation depreciation value
–A
$000
150
$000
6 (2 years)
$000
144
–B
–C
145
150
Nil
Nil
145
150
KAPLAN PUBLISHING
chapter 21
Consolidated income statement extracts year to 30 September
20X1
Depreciation: Property A (150/50 years)
Deficit in fair value of investment property B (180 – 145)
Surplus in fair value of investment property C (140 – 150)
$000
3
(35)
10
Note: property A is let to a subsidiary of Myriad, therefore in Myriad’s
entity and consolidated financial statements it would be treated as an
owner­occupier property (cost model in IAS 16).
Test your understanding 10 ­ Dexterity
Answer 1
Dexterity
(a) Goodwill:
International Accounting Standards state that goodwill is the
difference between the purchase consideration and value of the NCI
and the fair value of the acquired business’s identifiable (separable)
net assets. Identifiable assets and liabilities are those that are
capable of being sold or settled separately, i.e. without selling the
business as a whole. Purchased goodwill should be recognised in
the statement of financial position at this value and it should not be
amortised. However it should be tested at least annually for
impairment.
Other intangibles:
Where an intangible asset other than goodwill is acquired as a
separate transaction, the treatment is relatively straightforward. It
should be capitalised at cost and amortised over its estimated
useful life if it has a finite life, and not amortised if it has an indefinite
life. The fair value of the purchase consideration paid to acquire an
intangible is deemed to be its cost.
Intangibles purchased as part of the acquisition of a business
should be recognised separately to goodwill if they can be
measured reliably. Reliable measurement does not have to be at
market value, techniques such as valuations based on multiples of
revenue or notional royalties are acceptable. This test is not meant
to be overly restrictive and is likely to be met in valuing intangibles
such as brands, publishing titles, patents etc. Any intangible not
capable of reliable measurement will be subsumed within goodwill.
KAPLAN PUBLISHING
427
Questions & Answers
Recognition of internally developed intangibles is much more
restrictive. IAS 38 states that internally generated brands,
mastheads, publishing titles, customer lists and similar items should
not be recognised as intangible assets as these items cannot be
distinguished from the cost of developing the business as a whole.
The Standard does require development costs to be capitalised if
they meet detailed recognition criteria.
(i) The purchase consideration of $35 million should be allocated
as:
Net tangible assets
Work in progress
Patent
Goodwill
$m
15
2
10
8
–––
35
–––
The difficulty here is the potential value of the patent if the trials are
successful. In effect this is a contingent asset. There is insufficient
information to make a judgment of the fair value of the contingent
asset and in these circumstances it would be prudent to value the
patent at $10 million. The additional $5 million is an example of
where an intangible cannot be measured reliably and thus it should
be subsumed within goodwill. The other issue is that although
research cannot normally be treated as an asset, in this case the
research is being done for another company and is in fact work in
progress and should be recognised as such.
(ii) This is an example of an internally developed intangible asset
and although the circumstances of its valuation are similar to the
patent acquired above it cannot be recognised at Leadbrand’s
valuation. Internally generated intangibles can only be
recognised if they meet the definition of development costs in
IAS 38. Internally generated intangibles are permitted to be
carried at a revalued amount (under the allowed alternative
treatment) but only where there is an active market of
homogeneous assets with prices that are available to the
public. By their very nature drug patents are unique (even for
similar types of drugs) therefore they cannot be part of a
homogeneous population. Therefore the drug would be
recorded at its development cost of $12 million.
428
KAPLAN PUBLISHING
chapter 21
(iii) This is an example of a ‘granted’ asset. It is neither an internally
developed asset nor a purchased asset. In one sense it is
recognition of the standing of the company that is part of the
company’s goodwill. IAS 38’s general requirement requires
intangible assets to be initially recorded at cost and specifically
mentions granted assets. IAS 38 also refers to IAS 20
Accounting for Government Grants and Disclosure of
Government Assistance in this situation. This standard says
that both the asset and the grant can be recognised at fair value
initially (in this case they would be at the same amount). If fair
values are not used for the asset it should be valued at the
amount of any directly attributable expenditure (in this case this
is zero). It is unclear whether IAS 38’s general restrictive
requirements on the revaluation of intangibles as referred to
above (i.e. the allowed alternative treatment) are intended to
cover granted assets under IAS 20.
(iv) There is no doubt that a skilled workforce is of great benefit to a
company. In this case there is an enhancement of revenues and a
reduction in costs and if resources had been spent on a tangible
non­current asset that resulted in similar benefits they would be
eligible for capitalisation. However the Standard specifically
excludes this type of expenditure from being recognised as an
intangible asset and such highly trained staff can be described as
‘pseudo­assets’. The main reason is the issue of control (through
custody or legal rights). Part of the definition of any asset is the
ability to control it. In the case of employees (or, as in this case,
training costs of employees) the company cannot claim to control
them, as it is quite possible that employees may leave the company
and work elsewhere.
(v) The benefits of effective advertising are often given as an example
of goodwill (or an enhancement of it). If this view is accepted then
such expenditures are really internally generated goodwill which
cannot be recognised. In this particular case it would be reasonable
to treat the unexpired element of the expenditure as a prepayment
(in current assets); this would amount to 3/6 of $5 million i.e. $2.5
million. This represents the cost of the advertising that has been
paid for, but not yet taken place. In the past some companies have
treated anticipated continued benefits as deferred revenue
expenditure, but this is no longer permitted as it does not meet the
Standard’s recognition criteria for an asset.
KAPLAN PUBLISHING
429
Questions & Answers
Test your understanding 11 ­ Shiplake
Answer 1
Shiplake
a.
(i) An impairment loss arises where the carrying value of an asset, or
group of assets, is higher than their recoverable amounts. In effect
the Standard requires that assets should not appear in a statement
of financial position at a value which is higher than they are ‘worth’.
The recoverable amount of an asset is defined as the higher of its
net realisable value (i.e. the amount at which it can be sold for net of
direct selling expenses) or its value in use (i.e. its estimated future
net cash flows discounted to a present value). IAS 36 Impairment
of Assets recognises that many assets do not produce
independent cash flows and therefore the value in use may have to
be calculated for a group of assets – a cash­generating unit.
The Standard recognises that it would be too onerous for
companies to have to test for impaired assets every year and
therefore only requires impairment reviews when there is some
indication that an impairment has occurred. The exception to this
general principle is where an intangible asset has an indefinite
useful life or is not yet available for use, in which case an impairment
review is required at least annually. This also applies to goodwill
acquired in a business combination.
430
KAPLAN PUBLISHING
chapter 21
(ii) Impairments generally arise where there has been an event or
change in circumstances. It may be that something has happened to
the assets themselves (e.g. physical damage) or there has been a
change in the economic environment relating to the assets (e.g. new
regulations may have come into force).
The Standard gives several examples of indicators of impairment,
which may be available from internal or external sources:
KAPLAN PUBLISHING
–
Poor operating results. This could be a current operating loss or
a low profit. One year’s losses in itself does not necessarily
mean there has been an impairment, but if this is coupled with
previous losses or expected future losses then this is an
indication of impairment.
–
A significant decline in an asset’s market value (in excess of
normal depreciation through use or the passage of time) or
evidence of obsolescence (through market changes or
technology) or physical damage.
–
Evidence of a reduction in the useful economic life or estimated
residual value of assets.
–
Adverse changes in the market or economy such as the
entrance of a major competitor, new statutory or regulatory rules
or any indicator of value that has been used to value an asset
(e.g. on acquisition a brand may have been valued on a
‘multiple of sales revenues’. If subsequent sales were below
expectations this may indicate an impairment).
–
A commitment to a significant reorganisation or restructuring of
the business.
–
Loss of key employees or major customers.
–
Increases in long­term interest rates (this could materially
impact on value in use calculations thus affecting the
recoverable amounts of assets).
–
Where the carrying amount of an entity’s net assets is more
than its market capitalisation.
431
Questions & Answers
b.
(i) On the acquisition of a subsidiary, the purchase consideration must
be allocated to the fair value of its net assets with the residue being
classed as goodwill (or 'negative goodwill' if the assets have a
greater fair value than the purchase consideration). IFRS 3 revised
Business Combinations recognises that it is not always possible
to accurately determine the value of some assets at the date of
acquisition and therefore allows a measurement period’ up to the
end of the first full reporting period following the period of
acquisition. As the revision to the value of Halyard’s assets was due
to more detailed information becoming available, the fall in its asset
values should be treated as an adjustment to provisional valuations
made at the time of acquisition. In effect the net assets and goodwill
should be restated to $7 million and $5 million respectively; the fall
of $1 million is not an impairment loss and should not be charged to
the income statement. The above assumes that the recoverable
value of the company as a whole is greater than $12 million.
The fall in value of Mainstay’s assets is the result of events that
occurred after the acquisition (i.e. physical damage to the plant) and
this does constitute an impairment loss. The plant and machinery
should be written down to its recoverable amount and the loss
charged to the income statement. On the assumption that the
recoverable value of the company as a whole has not fallen, goodwill
will not be affected.
(ii) On the basis of the original estimates, Shiplake’s earth­moving plant
was not impaired, the value in use of $500,000 being greater than
its carrying value. However due to the ‘dramatic’ increase in interest
rates causing Shiplake’s cost of capital to increase, the value in use
of the plant will have to be recalculated. As the discount rate has
risen this will cause the value in use to fall. There is insufficient
information to be able to quantify this fall. If the new discounted value
is above the carrying value of $400,000 there is still no impairment.
If it is between $245,000 and $400,000, this will be the recoverable
amount of the plant and it should be written down to this value. As
the plant can be sold for $250,000 less selling costs of $5,000,
$245,000 is the least amount that the plant should be written down
to even if its revised value in use is below this figure.
432
KAPLAN PUBLISHING
chapter 21
(iii) The treatment of the research and development costs in the year to
31 March 20X1 was correct due to the element of uncertainty at the
date. The development costs of $75,000 written off in that same
period should not be capitalised at a later date even if the
uncertainties leading to its original write off are favourably resolved.
The treatment of the development costs in the year to 31 March
20X2 is incorrect. The directors’ decision to continue the
development is logical as (at the time of the decision) the future
costs are estimated at only $10,000 and the future revenues are
expected to be $150,000. It is also true that the project is now
expected to lead to an overall deficit of $135,000 (120 + 75 + 80 +
10 – 150 (in $000)). However, at 31 March 20X2 the unexpensed
development costs of $80,000 are expected to be recovered.
Provided the criteria in IAS 38 Intangible Assets are met these
costs of $80,000 should be recognised as an asset in the statement
of financial position and ‘matched’ to the future earnings of the new
product. Thus the directors’ logic of writing off the $80,000
development cost at 31 March 20X2 because of an expected
overall loss is flawed. The directors do not have the choice to write
off the development expenditure.
Test your understanding 12 ­ Multiplex
Answer 2
Notes
Goodwill
Operating licence
Property – train
stations/land
Rail track and
coaches
Steam engines
KAPLAN PUBLISHING
Assets: First Revised Second Revised
1 Jan impair assets: impairment assets:
20X0 ­ment 1 Feb
31 Mar
20X0
20X0
$000 $000
$000
$000
$000
200 (200)
nil
nil
1,200 (200)
1,000
(100)
900
300
(50)
250
(50)
200
300
(50)
250
1,000 (500)
––––– –––––
3,000 (1,000)
––––– –––––
500
–––––
2,000
–––––
(50)
200
–––––
(200)
–––––
500
–––––
1,800
–––––
433
Questions & Answers
The first impairment loss of $1 million:
•
$500,000 must be written off the engines as one of them no longer
exists and is no longer part of the cash­generating unit
•
•
the goodwill of $200,000 must be eliminated; and
the balance of $300,000 is allocated pro rata to the remaining net
assets other than the engine which must not be reduced below its
net selling price of $500,000
The second impairment loss of $200,000:
•
the first $100,000 is applied to the licence to write it down to its net
selling price
•
the balance is applied pro rata to assets carried at other than their
net selling prices, i.e. $50,000 to both the property and the rail track
and coaches.
Test your understanding 13 ­ Merryview
Answer 1
(i) Merryview – Income statement (extracts) – year to 31 March
20X1
$000
Sales revenue (40,000 x 35% (W1))
14,000
Cost of sales (W1)
(9,100)
––––––
Profit on contract
4,900
––––––
Statement of financial position (extracts) as at 31 March 20X1
Non­current assets
Plant and machinery (3,600 – 900 (W2))
Current assets
Amount due from customer (W3)
2,700
1,500
(ii) Merryview – Income statement (extracts) – year to 31 March
20X2
Sales revenue (40,000 x 75% – 14,000 (W1))
Cost of sales (22,500 – 9,100 (W1))
Profit on contract
434
$000
16,000
(13,400)
––––––
2,600
KAPLAN PUBLISHING
chapter 21
Statement of financial position (extracts) as at 31 March 20X2
Non­current assets
Plant and machinery (3,600 – 900 – 1,200 (W2))
Current assets
Amount due from customer (W3)
1,500
1,000
Workings (all figures $000):
(W1) Contract costs as at 31 March 20X1:
Architects’ and surveyors’ fees
Materials used (3,100 – 300 inventory)
Direct labour costs
Overheads (40% of 3,500)
Plant depreciation (9 months (W2))
Cost at 31 March 20X1
Estimated cost to complete:
Excluding depreciation
Plant depreciation (3,600 – 600 – 900)
500
2,800
3,500
1,400
900
––––––
9,100
14,800
2,100
––––––
Estimated total costs on completion
Percentage of completion at 31 March
20X1 (9,100/26,000)
Contract costs as at 31 March 20X2:
Summarised costs excluding depreciation
Plant depreciation (21 months at $100 per
month)
Cost to date
Estimated cost to complete:
Excluding depreciation
Plant depreciation (9 months)
Estimated total costs on completion
Percentage of completion at 31 March
20X2 (22,500/30,000)
KAPLAN PUBLISHING
16,900
––––––
26,000
––––––
= 35%
20,400
2,100
––––––
22,500
6,600
900
––––––
7,500
––––––
30,000
––––––
= 75%
435
Questions & Answers
(W2) The plant has a depreciable amount of $3,000k (3,600 – 600
residual value). Its estimated life on this contract is 30 months (1 July
20X0 to 31 December 20X2). Depreciation would be $10k per month
i.e. $900k for the period to 31 March 20X1; $1,200k for the period to 31
March 20X2; and a further $900k to completion.
(W3) Amount due from customer at 31 March 20X1:
Contract costs incurred (9,100 + 300
material inventory)
Recognised profit
9,400
4,900
––––––
14,300
(12,800)
––––––
1,500
––––––
Cash received at 31 March 20X1
Amount due at 31 March 20X1
Amount due from customer at 31 March 20X2:
Contract costs incurred
Recognised profit (4,900 + 2,600)
Cash received – 31 March 20X1
– 31 March 20X2
22,500
7,500
30,000
(12,800)
(16,200)
––––––
Amount due at 31 March 20X2
(29,000)
––––––
1,000
––––––
Test your understanding 14 ­ Multiplex
Answer 2
Income statement year to 31 March 20X0
Contract revenue (W2)
Contract costs recognised (balancing figure)
Contract profit (W3)
Statement of financial position extracts as at 31
March 20X0
Current assets
Gross amounts due from customers (W5)
436
$m
18.0
(14.1)
–––––
3.9
–––––
$m
11.0
KAPLAN PUBLISHING
chapter 21
Note to the financial statements
Contingent asset
The company is in the process of attempting to recover $2.5 million from
a firm of civil engineers. The engineers were contracted to design the
structure of a road bridge to be built by Multiplex. The engineers
incorrectly specified certain materials to be used on the contract, which
had to be replaced at a later date. The company’s lawyers have advised
that there is a good prospect of a successful recovery of these costs.
Workings
(W1) The percentage completion is
calculated as:
at 31 March 19W9
Work certified
–––––––
$12 million
––––––––––
Contract price
$30 million
at 31 March
20X0
$30 million
=
–––––––– = 66.7% (or
30%
2/3)
$45 million
(W2) The figure for 20X0 includes the variation to the contract.
The accumulated contract revenues at 31 March 20X0 would be
$30 million (2/3 x $45 million). The contract revenue to be reported
in 20X0 would be $18 million i.e. accumulated revenue of $30
million less the contract revenue of $12 million reported in the
previous year.
(W3) The accumulated profit at 31 March 20X0 would have been 2/3 of
the revised estimated total profit of $15 million ($45 million contract
price less $30 million costs).
However the cost of the rectification work of $2.5 million must be
charged to the year in which it occurs (i.e. the year to 31 March
20X0).
This gives a reported profit for the year of $3.9 million ($10 million
– $3.6 million in 19W9 – $2.5 million rectification work).
KAPLAN PUBLISHING
437
Questions & Answers
(W4) The income statement for the year to 31 March 19W9 would be:
$m
Contract revenue
12.0
Contract costs incurred (balancing figure)
(8.4)
––––
Profit ((40 – 28) x 30%)
3.6
––––
(W5) The gross amount due from customers is made up of:
costs incurred to date
plus recognised profits (3.6 + 3.9)
less progress billings
28.5
7.5
(25.0)
––––
11.0
––––
Test your understanding 15 ­ Multicolour
Answer 1
Income statement extracts:
$000
Loan stock interest paid ($80 million x 8%)
Required accrual of finance cost
Total finance cost for loan stock
($68,704,000 x 12%)
$000
6,400
1,844
–––––
8,244
–––––
Statement of financial position extracts:
Non­current liabilities
8% loan stock 20X4
Accrual of finance costs
Equity and liabilities
Share options
438
68,704
1,844
–––––
70,548
–––––
11,296
KAPLAN PUBLISHING
chapter 21
Workings
IAS 32 and 39, dealing with financial instruments, require compound or
hybrid financial instruments such as convertible loan stock to be treated
under the substance of the contractual agreement. For this type of
instrument this means that its equity element and liability (debt) element
must be separately identified and presented as such in the statement of
financial position. In practice there are several methods of calculating the
split between the two elements. For example there are several option
pricing models. However, given the limited information in the question,
the split can only be calculated by a ‘residual value of equity’ approach.
This involves calculating the present value of the cash flows attributable
to a ‘pure’ debt instrument and treating the difference between this and
the issue proceeds (the residue) as the equity component.
Cash flow
Year 1 interest
Year 2 interest
Year 3 interest
Year 4 interest
Year 5 interest and capital
Residual equity element (share
options)
Proceeds of issue
KAPLAN PUBLISHING
$m
6.4
6.4
6.4
6.4
86.4
Factor
Discounted
cash flow
$000
x 0.89
5,696
x 0.80
5,120
x 0.71
4,544
x 0.64
4,096
x 0.57
49,248
–––––––
68,704
11,296
–––––––
80,000
–––––––
439
Questions & Answers
Test your understanding 16 ­ Deltoid
Answer 1
Statement of financial position of Deltoid as at 31 March 20X2
Non­current assets
$000
$000
Property, plant and equipment (12,110 + 600
– 20 (W1) – 120 (W3))
Current assets
Inventory
Trade accounts receivable
Bank
12,570
3,850
2,450
250
––––––
Total assets
Equity and liabilities:
Equity
Ordinary shares of 50c each (2,000 + 500
bonus issue)
Reserves
Share premium
Revaluation reserve (3,000 – 500 bonus
issue)
Retained earnings (W1)
6,550
––––––
19,120
––––––
2,500
1,000
2,500
5,660
––––––
9,160
––––––
11,660
Non­current liabilities
Finance lease (W3)
6% loan note
Current liabilities
Trade accounts payable
Accrued interest (W3)
Finance lease (W3)
Taxation
Total equity and liabilities
440
371
3,000
––––––
2,820
24
105
1,140
––––––
3,371
4,089
––––––
19,120
––––––
KAPLAN PUBLISHING
chapter 21
Workings
(W1) Recalculation of retained earnings
Retained profit for year to 31 March 20X2 from question
Additional depreciation of:
plant (W2)
(20)
leased plant
(120)
(W3)
––––
Add back: lease rentals (W3)
Additional finance costs:
leased plant
(W3)
2,000
(140)
150
(50)
––––
1,960
3,700
Restated retained profit for year
Retained profit b/f at 1 April 20X1
from question
Current
policy
50
–––––
5,660
–––––
Group
policy
(250 x 20%) 50
20
(200 x 20%) 40
Retained earnings
(W2)
Change of
depreciation policy
Year to 31 March 20X1
((250 – 50) x
2,000/8,000)
Year to 31 March 20X2
((250 –50) x 800/8,000)
The net effect of this is an increase in the depreciation charge of
$20,000 for the current year only.
(W3) Leased plant – this has been treated as an operating lease
whereas it should be treated as a finance lease:
$000
Fair value/cost
1st payment 1 April 20X1
Interest to 30 September 20X1 (10% for 6 months)
2nd payment 1 October 20X1
KAPLAN PUBLISHING
600
(75)
––––
525
26
––––
551
(75)
441
Questions & Answers
Capital outstanding at 31 March 20X2
Accrued interest to 31 March 20X2
Total outstanding at 31 March 20X2
3rd payment due 1 April 20X2
Interest to 30 September 20X2 (10% for 6 months)
4th payment 1 October 20X2
Capital outstanding at 31 March 20X3
476
24
––––
500
(75)
––––
425
21
––––
446
(75)
––––
371
––––
Summarising:
•
The lease payments of $150,000 should be eliminated from
expenses and replaced with a depreciation charge of $120,000
($600,000 x 20% pa).
•
Interest of $50,000 ($26,000 paid, $24,000 accrued) should be
included as a finance cost.
•
Current liabilities are $24,000 for accrued interest and $105,000
($476,000 – $371,000) for the capital element of the finance lease.
•
Non­current liabilities are $371,000 for the capital element of the
finance lease.
Test your understanding 17 ­ Bowtock
Answer 2
$
Income statement extracts year to 30 September 20X3
Depreciation of leased asset (W1)
Lease interest expense (W2)
442
10,400
2,672
KAPLAN PUBLISHING
chapter 21
Statement of financial position extracts as at 30 September 20X3
$
Leased asset at cost
52,000
Accumulated depreciation (7,800 + 10,400 (W1))
18,200
______
Carrying value
33,800
Non­current liabilities
Obligations under finance leases (W2)
21,696
Current liabilities
Accrued lease interest (W2)
1,872
Obligations under finance leases (W2)
9,504
Workings
(W1) Depreciation for the year ended 30 September 20X2 would be
$7,800 ($52,000 x 20% x 9/12). Depreciation for the year ended 30
September 20X3 would be $10,400 ($52,000 x 20%)
(W2)
The lease obligations are calculated as follows:
Cash price/fair value
Rental 1 January 20X2
Interest to 30 September 20X2 (40,000 x 8% x 9/12)
Interest to 1 January 20X3 (40,000 x 8% x 3/12)
Rental 1 January 20X3
Capital outstanding 1 January 20X3
Interest to 30 September 20X3 (31,200 x 8% x 9/12)
Interest to 1 January 20X4 (31,200 x 8% x 3/12)
KAPLAN PUBLISHING
$
52,000
(12,000)
––––––
40,000
2,400
800
––––––
43,200
(12,000)
––––––
31,200
1,872
624
––––––
33,696
––––––
443
Questions & Answers
The lease interest expense for the year to 20 September 20X3 is
$2,672 (800 + 1,872 from above), of which $1,872 is a current liability.
The total capital amount outstanding at 30 September 20X3 is $31,200
(the same as at 1 January 20X3 as no further payments have been
made). This must be split between current and non­current liabilities.
Next year’s payment will be $12,000 of which $2,496 (1,872 + 624) is
interest. Therefore capital repaid in the next year will be $9,504 (12,000
– 2,496). This leaves capital of $21,696 (31,200 – 9,504) as a non­
current liability.
Test your understanding 18 ­ Atkins
Answer 1
Atkins
a.
(i) Creative accounting is a term in general use to describe the
practice of applying inappropriate accounting policies or
entering into complex or ‘special purpose’ transactions with the
objective of making a company’s financial statements appear to
disclose a more favourable position, particularly in relation to
the calculation of certain ‘key’ ratios, than would otherwise be
the case. Most commentators believe creative accounting stops
short of deliberate fraud, but is nonetheless undesirable as it is
intended to mislead users of financial statements.
Probably the most criticised area of creative accounting relates
to off balance sheet financing. This occurs where a company
has financial obligations that are not recorded in its statement
of financial position. There have been several examples of this
in the past:
–
Finance leases treated as operating leases.
–
Borrowings (usually convertible loan stock) being classified
as equity.
–
Secured loans being treated as ‘sales’ (sale and
repurchase agreements).
–
The non­consolidation of ‘special purpose vehicles’ (quasi
subsidiaries) that have been used to raise finance.
–
Offsetting liabilities against assets (certain types of
accounts receivable factoring).
The other main area of creative accounting is that of
increasing or smoothing profits. Examples of this are:
444
KAPLAN PUBLISHING
chapter 21
–
The use of inappropriate provisions (this reduces profit in
good years and increases them in poor years).
–
Not providing for liabilities, either at all or not in full, as they
arise. This is often related to environmental provisions,
decommissioning costs and constructive obligations.
–
Restructuring costs not being charged to income (often
related to a newly acquired subsidiary – the costs are
effectively added to goodwill).
It should be noted that recent International Accounting Standards
have now prevented many of the above past abuses, however more
recent examples of creative accounting are in use by some of the
new Internet/Dot.com companies. Most of these companies do not
(yet) make any profit so other performance criteria such as site
‘hits’, conversion rates (browsers turning into buyers), burn periods
(the length of time cash resources are expected to last) and even
sales revenues are massaged to give a more favourable
impression.
(ii) One of the primary characteristics of financial statements is
reliability i.e. they must faithfully represent the transactions and
other events that have occurred. It can be possible for the
economic substance of a transaction (effectively its commercial
intention) to be different from its strict legal position or ‘form’.
Thus financial statements can only give a faithful representation
of a company’s performance if the substance of its transactions
is reported. It is worth stressing that there will be very few
transactions where their substance is different from their legal
form, but for those where it is, they are usually very important.
This is because they are material in terms of their size or
incidence, or because they may be intended to mislead.
Common features which may indicate that the substance of a
transaction (or series of connected transactions) is different
from its legal form are:
KAPLAN PUBLISHING
–
Where the ownership of an asset does not rest with the
party that is expected to experience the risks and rewards
relating to it (i.e. equivalent to control of the asset).
–
Where a transaction is linked with other related
transactions. It is necessary to assess the substance of the
series of connected transactions as a whole.
–
The use of options within contracts. It may be that options
are either almost certain to be (or not to be) exercised. In
such cases these are not really options at all and should be
ignored in determining commercial substance.
445
Questions & Answers
–
Where assets are sold at values that differ from their fair
values (either above or below fair values).
Many complex transactions often contain several of the
above features. Determining the true substance of
transactions can be a difficult and sometimes subjective
procedure.
b.
(i) This is an example of consignment inventory. From Atkins’s
point of view the main issue is whether or at what point in time
the goods have been purchased and should therefore be
recognised. As is often the case in these types of agreement
there is conflicting evidence as to which party bears the risks
and rewards relating to the vehicles. The manufacturer retains
the legal right of ownership until the goods are paid for by
Atkins. Consistent with this the manufacturer also has the right
to have the goods returned or passed on to another supplier.
The fact that Atkins may choose to return the goods to the
manufacturer is also indicative that the manufacturer is exposed
to the risk of obsolescence or falling values. These factors
would seem to suggest that the vehicles have not been sold and
should therefore remain in the inventory of the manufacturer and
not be recognised in the accounting records of Atkins.
There are, however, some contrary indications to this view. The
price for the goods is fixed as of the date of transfer, not the
date that they are deemed ‘sold’. This means that Atkins is
protected from any price increases by the manufacturer. The
1.5% paid to the manufacturer appears to be in substance a
finance charge, despite it being described as a ‘display
charge’. A finance charge indicates that Atkins must have a
liability to the manufacturer; in effect this liability is the amount
payable in respect of the cost of the vehicles. Although Atkins
has a right of return, it cannot exercise this without a cost. There
is an explicit freight cost, but this may not be the only cost. It
could well be that Atkins may suffer poor future supplies from
the manufacturer if it does return goods. The question says that
Atkins has never taken advantage of this option, which would
seem to suggest that it should be ignored.
446
KAPLAN PUBLISHING
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Conclusion
The substance of this transaction appears to suggest that the goods
have been purchased by Atkins and the company is paying a
finance cost. Therefore the vehicles should be recognised in
Atkins’s statement of financial position, together with the respective
liability. It would seem logical that if Atkins considers the goods as
purchased, then the manufacturer should consider them as sold. The
problem is that prudence may prevent the manufacturer from
recognising the profit on the sale, as the period for the right to return
the goods has not expired. Therefore, either the sales are not
recognised by the manufacturer (the goods would remain in its
inventory), or if they are, an allowance should be made in respect of
the unrealised profits.
This could lead to the unusual situation that the goods may appear
in both companies’ statement of financial position.
(ii) Although the question says that Atkins has sold the land to
Landbank and even though there will be a legal transfer of the land,
the substance of this transaction is that of a secured loan. The two
clauses in combination mean that in practice Atkins will repurchase
the land on or before 1 October 20X4. This is because if its value is
above $3.2 million Atkins will exercise its option to purchase,
conversely if the value is below $3.2 million Landbank will exercise
its option to require a repurchase. Either way Atkins will repurchase
the land. When this is understood it becomes clear that the
difference between the ‘sale’ price of $2.4 million and the
repurchase price of $3.2 million represents a finance charge on a
secured loan.
KAPLAN PUBLISHING
447
Questions & Answers
Under the assumption that the land is sold:
Income statement – year to 30 September 20X2
$
2,400,000
(1,200,000)
–––––––––
1,200,000
–––––––––
$
Sales
Cost of sales (3 /5 x $2 million)
Profit on sale of land
Statment of financial position as at 30 September
20X2
Non­current assets
Development land ($2 million – $1.2 million
800,000
above)
Under the assumption that the arrangement is a secured loan:
Income statement – year to 30 September 20X2
$
Interest on loan
(240,000)
(10% of in substance loan of $2.4 million)
Statement of financial position as at 30
September 20X2
Non­current assets
Development land at cost
Non­current liabilities
Secured loan
Accrued interest
448
$
$
2,000,000
2,400,000
240,000
––––––––
(2,640,000)
––––––––
KAPLAN PUBLISHING
chapter 21
Test your understanding 19 ­ Jenson
Answer 2
(i) Although this agreement may be worded as a sale, and even if the
title to the goods passes to Wholesaler, it seems clear that this is
not a sale ­ it is a secured loan. Therefore Jenson should not treat
the income from Wholesaler as revenue, but instead as a loan in its
statement of financial position. The goods should continue to be
recognised as inventory in the statment of financial position, and
accrued interest of $3,150 ($35,000 x 12% x 9/12) should be
provided for in the income statement.
(ii) It appears that the ongoing fees after the first initial payment are
insufficient to cover Jenson’s servicing cost and provide a
reasonable profit. In these circumstances IAS 18 Revenue requires
part of the initial fee of $50,000 to be deferred and recognised in
future periods as the servicing costs are incurred. As there is a
requirement to earn a (reasonable) profit of 20% on revenues, with
ongoing servicing costs of $8,000, revenues of $10,000 would need
to be recognised in the next four years. The actual fees receivable
are $5,000, therefore Jenson will have to defer $20,000 ($5,000 x 4
years) of the initial fee. Thus in the year to 31 March 20X0 Jenson
would recognise $30,000 ($50,000 – $20,000) of the initial
franchise fee.
(iii) An accruals/matching approach to this problem would be to say that
the profit on each publication would be $2,000 (($240,000 –
$192,000)/24). In the year to 31 March 20X0, as six of the 24
publications have been produced and delivered, the income
statement would be:
Sales (6 x 240,000/24)
Cost of sales (6 x 192,000/24)
Profit
$
60,000
(48,000)
–––––––
12,000
–––––––
Deferred income on the statement of financial position would be
$180,000 ($240,000 – $60,000).
KAPLAN PUBLISHING
449
Questions & Answers
Test your understanding 20 ­ Bodyline
Answer 1
Bodyline
(a) IAS 37 Provisions, Contingent Liabilities and Contingent
Assets only deals with those provisions that are regarded as
liabilities. The term provision is also used in some countries to
describe those amounts set aside to write down the value of assets
such as depreciation charges and provisions for diminution in value
(e.g. provision to write down the value of damaged or slow moving
inventory). The definition of a provision in the Standard is quite
simple; provisions are liabilities of uncertain timing or amount. If
there is reasonable certainty over these two aspects the liability is
not to be presented as a provision on the statement of finacial
position. There is clearly an overlap between provisions and
contingencies. Because of the ‘uncertainty’ aspects of the definition,
it can be argued that to some extent all provisions have an element
of contingency. The IASB distinguishes between the two by stating
that a contingency is not recognised as a liability if it is either only
possible and therefore yet to be confirmed as a liability, or where
there is a liability but it cannot be measured with sufficient reliability.
The IASB notes the latter should be rare.
The IASB intends that only those liabilities that meet the
characteristics of a liability in its Framework for the Preparation
and Presentation of Financial Statements should be reported in
the statement of financial position. IAS 37 summarises the above by
requiring provisions to satisfy all of the following three recognition
criteria:
–
There is a present obligation (legal or constructive) as a result
of a past event.
–
It is probable that a transfer of economic benefits will be
required to settle the obligation.
–
The obligation can be estimated reliably.
A provision is triggered by an obligating event. This must have
already occurred, future events cannot create current liabilities.
The first of the criteria refers to legal or constructive obligations.
A legal obligation is straightforward and uncontroversial, but
constructive obligations are a relatively new concept. These
arise where a company creates an expectation that it will meet
certain obligations that it is not legally bound to meet. These
may arise due to a published statement or even by a pattern of
past practice. In reality constructive obligations are usually
accepted because the alternative action is unattractive or may
damage the reputation of the company.
450
KAPLAN PUBLISHING
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The most commonly quoted example of such is a commitment to
pay for environmental damage caused by the company, even where
there is no legal obligation to do so.
To summarise: a company must provide for a liability where the
three defining criteria of a provision are met, but conversely a
company cannot provide for a liability where they are not met. The
latter part of the above may seem obvious, but it is an area where
there has been some past abuse of provisioning as is referred to in
(b).
(b) The main need for an accounting standard in this area is to clarify
and regulate when provisions should and should not be made. Many
controversial areas including the possible abuse of provisioning are
based on contravening aspects of the above definitions. One of the
most controversial examples of provisioning is in relation to future
restructuring or reorganisation costs (often as part of an
acquisition). This is sometimes extended to providing for future
operating losses. The attraction of providing for this type of
expense/loss is that once the provision has been made, the future
costs are then charged to the provision such that they bypass the
income statement (of the period when they occur). Such provisions
can be glossed over by management as ‘exceptional items’, which
analysts are expected to disregard when assessing the company’s
future prospects. If this type of provision were to be incorporated as
a liability as part of a subsidiary’s net assets at the date of
acquisition, the provision itself would not be charged to the income
statement. IAS 37 now prevents this practice as future costs and
operating losses (unless they are for an onerous contract) do not
constitute past events.
Another important change initiated by IAS 37 is the way in which
environmental provisions must be treated. Practice in this area has
differed considerably. Some companies did not provide for such
costs and those that did often accrued for them on an annual basis.
If say a company expected environmental site restoration cost of
$10 million in 10 years time, it might argue that this is not a liability
until the restoration is needed or it may accrue $1 million per annum
for 10 years (ignoring discounting). Somewhat controversially this
practice is no longer possible. IAS 37 requires that if the
environmental costs are a liability (legal or constructive), then the
whole of the costs must be provided for immediately. That has led to
large liabilities appearing in some companies’ statements of
financial position.
A third example of bad practice is the use of ‘big bath’ provisions
and over­provisioning. In its simplest form this occurs where a
company makes a large provision, often for non­specific future
expenses, or as part of an overall restructuring package.
KAPLAN PUBLISHING
451
Questions & Answers
If the provision is deliberately overprovided, then its later release will
improve future profits. Alternatively the company could charge to the
provision a different cost than the one it was originally created for.
IAS 37 addresses this practice in two ways: by not allowing
provisions to be created if they do not meet the definition of an
obligation; and specifically preventing a provision made for one
expense to be used for a different expense. Under IAS 37 the
original provision would have to be reversed and a new one would
be created with appropriate disclosures. Whilst this treatment does
not affect overall profits, it does enhance transparency.
Note: other examples would be acceptable.
(c) Guarantees or warranties appear to have the attributes of contingent
liabilities. If the goods are sold faulty or develop a fault within the
guarantee period there will be a liability, if not there will be no
liability. The IASB view this problem as two separate situations.
Where there is a single item warranty, it is considered in isolation
and often leads to a disclosable contingent liability unless the
chances of a claim are thought to be negligible. Where there are a
number of similar items, they should be considered as a whole. This
may mean that whilst the chances of a claim arising on an individual
item may be small, when taken as a whole, it should be possible to
estimate the number of claims from past experience. Where this is
the case, the estimated liability is not considered contingent and it
must be provided for.
(i) Bodyline’s 28­day refund policy is a constructive obligation. The
company probably has notices in its shops informing customers
of this policy. This would create an expectation that the
company will honour its policy. The liability that this creates is
rather tricky. The company will expect to give customers refunds
of $175,000 ($1,750,000 x 10%). This is not the liability. 70% of
these will be resold at the normal selling price, so the effect of
the refund policy for these goods is that the profit on their sale
must be deferred. The easiest way to account for this is to
make a provision for the unrealised profit. This has to be
calculated for two different profit margins:
Goods manufactured by Header (at a mark up of 40% on cost):
$24,500 ($175,000 x 70% x 20%) x 40/140 = $7,000.
Goods from other manufacturers (at a mark up of 25% on cost).
$98,000 ($175,000 x 70% x 80%) x 25/125 = $19,600.
452
KAPLAN PUBLISHING
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The sale of the remaining 30% at half the normal selling price will
create a loss. Again this must be calculated for both group of sales:
Goods manufactured by Header were originally sold for $10,500
(175,000 x 30% x 20%). These will be resold (at a loss) for half this
amount i.e. $5,250. Thus a provision of $5,250 is required.
Goods manufactured by other manufacturers were originally sold for
$42,000 (175,000 x 30% x 80%). These will be resold (at a loss) for
half this amount, i.e. $21,000. Thus a provision of $21,000 is
required.
The total provision in respect of the 28­day return facility will be
$52,850 (7,000 + 19,600 + 5,250 + 21,000).
(d) (i) Goods likely to be returned because they are faulty require a
different treatment. These are effectively sales returns. Normally
the manufacturer will reimburse the cost of the faulty goods. The
effect of this is that Bodyline will not have made the profit
originally recorded on their sale. This applies to all goods other
than those supplied by Header. Thus these sales returns would
be $128,000 (160,000 x 80%) and the credit due from the
manufacturer would be $102,400 (128,000 x 100/125 removal
of profit margin). The overall effect is that Bodyline would have
to remove profits of $25,600 from its financial statements.
For those goods supplied by Header, Bodyline must suffer the
whole loss as this is reflected in the negotiated discount. Thus
the provision required for these goods is $32,000 (160,000 x
20%), giving a total provision of $57,600 (25,600 + 32,000).
(e) The Directors’ proposed treatment is incorrect. The replacement of
the engine is an example of what has been described as cyclic
repairs or replacement. Whilst it may seem logical and prudent to
accrue for the cost of a replacement engine as the old one is being
worn out, such practice leads to double counting. Under the
Directors’ proposals the cost of the engine is being depreciated as
part of the cost of the asset, albeit over an incorrect time period. The
solution to this problem lies in IAS 16 Property, Plant and
Equipment. The plant constitutes a ‘complex’ asset i.e. one that
may be thought of as having separate components within a single
asset. Thus part of the plant $16.5 million (total cost of $24 million
less $7.5 assumed cost of the engine) should be depreciated at
$1.65 million per annum over a 10­year life and the engine should
be depreciated at $1,500 per hour of use (assuming machine hour
depreciation is the most appropriate method). If a further provision
of $1,500 per machine hour is made, there would be a double
charge against profit for the cost of the engine.
KAPLAN PUBLISHING
453
Questions & Answers
IAS 37 also refers to this type of provision and says that the future
replacement of the engine is not a liability. The reasoning is that the
replacement could be avoided if, for example, the company chose
to sell the asset before replacement was due. If an item does not
meet the definition of a liability it cannot be provided for.
Test your understanding 21 ­ Energiser
Answer 1
Income statement for the year ended 31 December 20X4
Revenue (600,000 – 100,000)
Cost of sales (W1)
Gross profit
Distribution costs
Administrative expenses (46,400 – 2,400)
Operating profit
Interest payable (4,000 (W3) + 7,200 (W5)+ 96 (W6) +
3,600 (prefs))
$000
500,000
(291,800)
–––––––
208,200
(52,800)
(44,000)
–––––––
111,400
(14,896)
–––––––
96,504
(12,100)
–––––––
84,404
–––––––
Profit before taxation
Taxation ( – 4,200 + 18,400 – 2,100) (W4)
Profit after taxation
Statement of financial position as at 31 December 20X4
$000
Non­current assets
Land and buildings (W2)
Plant and equipment (W2)
454
$000
276,000
198,400
––––––
474,400
KAPLAN PUBLISHING
chapter 21
Current assets
Inventory (57,000 – (9,000 – 4,000))
Trade receivables (62,400+12,000)
Bank (7,400 –100,000 + 100,000 + 56,400 – 4,800 –
9,600 + 9,600)
52,000
74,400
59,000
––––– 185,400
––––––
659,800
––––––
Equity
Ordinary share capital
Retained earnings (W7)
Non­current liabilities
6% redeemable preference shares
Lease creditor (100,000+4,000) (W3)
Loan note (56,400 + 7,200 – 4,800) (W5)
Deferred Tax (W4)
Current liabilities
Trade payables
Income tax
Debt factor loan (9,600 + 96)
KAPLAN PUBLISHING
100,000
207,804
––––––
307,804
60,000
104,000
58,800
27,300
––––––
73,800
18,400
9,696
––––––
––––––
250,100
––––––
101,896
––––––
659,800
––––––
455
Questions & Answers
Workings
(W1)
Cost of sales
Opening inventory
Purchases
Sale and leaseback error
Closing inventory (57,000 – 5,000)
Dep’n buildings
Dep’n plant
Dep’n plant
(W2)
Cost per TB
Sale and leaseback correction
Dep’n per TB
Charge (300,000 – 60,000)/40
years
80,000/5 years
(217,200 – 49,200) x 20%
Carrying value
$000
51,300
316,900
(80,000)
(52,000)
6,000
16,000
33,600
–––––––
291,800
–––––––
Buildings Fixtures and
fittings
$000
$000
300,000
217,200
80,000
–––––––
–––––––
300,000
297,200
–––––––
–––––––
18,000
49,200
6,000
–––––––
24,000
–––––––
276,000
–––––––
16,000
33,600
–––––––
98,800
–––––––
198,400
–––––––
(W3) Note 1
Energiser has recorded sale of plant by making the following double
entries:
Dr
Cr
Dr
Cr
456
Bank
Revenue
Cost of Sales
Non­current assets
100 million
100 million
80 million
80 million
KAPLAN PUBLISHING
chapter 21
These double entries should now be reversed since the transaction
has been accounted for incorrectly.
In substance, this is a loan of the sale proceeds of £100 million and
the plant should remain in fixed assets at $80 million. The loan
carries interest at 12% per annum. Note that only four months’ worth
of interest is charged in the year ended 31 December 20X4 since
the transaction took place on 1 September 20X4.
The following double entries should now be recorded:
Dr
Cr
Dr
Cr
Bank
Lease creditor
Income statement – interest
Lease creditor
100 million
100 million
4 million
4 million
(W4) Deferred tax
1 January
Decrease (balance)
31 December (91,000 x 30%)
$000
29,400
(2,100)
–––––––
27,300
–––––––
(W5) Loan note
Proceeds
Issue costs – discount at 6%
Net proceeds
KAPLAN PUBLISHING
$000
60,000
(3,600)
–––––––
56,400
–––––––
457
Questions & Answers
Repayments
Loan note
Premium at 10%
Interest (60,000 x 8% x 4 years)
Net proceeds
Finance costs
60,000
6,000
19,200
–––––––
85,200
(56,400)
–––––––
28,800
–––––––
Annual finance cost to Income statement
= $28,800,000/4 yrs = $7,200,000
Double entries:
Dr
Cr
Dr
Cr
Dr
Cr
Bank
Loan note
Interest payable
Loan note
Loan note
Bank
56.4m
56.4m
7.2m
7.2m
4.8m
4.8m
(8% interest paid on 31 December 20X4)
(W6) Factored debt
Energiser has
Dr
Dr
Cr
Bank (80% x 12 million)
Admin expenses
Trade receviables
9.6 million
2.4 million
12 million
The terms indicate that Energiser still faces all of the risks and rewards
attaching to the $12 million trade receivable. Therefore in substance the
$12 million is a short­term loan for four months with interest at 1% per
month.
458
KAPLAN PUBLISHING
chapter 21
Therefore, the above double entry should be reversed and the following
double entry made:
Dr
Cr
Dr
Cr
Bank
Short­term loan
Interest (1% x 9.6 million)
Short­term loan
9.6 million
9.6 million
96,000
96,000
(W7) Retained earnings
$000
84,404
5,000
–––––––
79,404
128,400
–––––––
207,804
Profit for the year
Dividends
Retained earnings for the year
Retained earnings b/f
Retained earnings c/f
Test your understanding 22 ­ Telenorth
Answer 2
a.
(i) Telenorth
Income statement for year to 30 September 20X1
$000
Sales revenue
Cost of sales (W1)
Gross profit
Distribution expenses
Administration expenses (W1)
KAPLAN PUBLISHING
(22,300)
(42,200)
––––––––
$000
283,460
(155,170)
––––––––
128,290
(64,500)
––––––––
63,790
459
Questions & Answers
Financing cost (96 + 600)
(W3)
Investment income
(696)
1,500
––––––––
804
––––––––
64,594
(24,600)
––––––––
39,994
––––––––
Profit before tax
Income tax (23,400 + 1,200)
Net profit for the period
(ii) Telenorth
Statement of financial position as at 30 September 20X1
Assets
Non­current assets
Property, plant and equipment (W2)
Investments
Current assets
Inventory (W4)
Trade accounts receivable (35,700 + 12,000)
(W3)
$000
16,680
47,700
$000
83,440
34,500
––––––––
117,940
64,380
–––––––– ––––––––
182,320
––––––––
Equity and liabilities
Equity:
Ordinary shares of $1 each (20,000 + 4,000 +
6,000)(W6)
8% Preference shares
Reserves:
Revaluation (3,400 – 1,000 deferred tax)
Share premium (4,000 + 12,000)(W6)
Retained earnings (W6)
460
30,000
12,000
––––––––
42,000
2,400
16,000
51,194
69,594
–––––––– ––––––––
111,594
KAPLAN PUBLISHING
chapter 21
Non­current liabilities
6% Loan notes
Deferred tax (5,200 + 1,200 + 1,000)
Current liabilities
Trade and other payables (W5)
Loan from Kwikfinance (9,600 + 96) (W3)
Provision for income tax
Dividends (W5)
Overdraft
Total equity and liabilities
10,000
7,400
––––––––
18,070
9,696
23,400
480
1,680
––––––––
17,400
53,326
––––––––
182,320
––––––––
Workings (all figures in $000)
(W1) Cost of sales:
Opening inventory
Purchases
Depreciation (W2)
Closing inventory (W4)
Administration:
Per question
Incorrect factoring charge (W3)
Depreciation of computer system (W2)
KAPLAN PUBLISHING
12,400
147,200
12,250
–––––––
171,850
(16,680)
–––––––
155,170
–––––––
34,440
(2,400)
10,160
–––––––
42,200
–––––––
461
Questions & Answers
(W2) Property, plant and
equipment
Leasehold
Plant and equipment
Computer system
Cost
Depreciation Carrying
value
56,250 20,250 (18,000
+ 2,250)
55,000 22,800 (12,800
+ 10,000)
35,000 19,760 (9,600 +
10,160)
36,000
32,200
15,240
––––––
83,440
––––––
Depreciation for year:
Leasehold (56,250/25 years)
Plant (55,000 – 5,000/5­year
life)
2,250
10,000
–––––––
12,250
–––––––
Charged to cost of sales
Computer system charged to
administration
(35,000 – 9,600) x 40%)
10,160
–––––––
(W3) Accounts receivable/factoring
As Telenorth still bears the risk of slow payment and bad debts, the
substance of the factoring is that of a loan on which finance charges will
be made. The amount receivable from the customer should not have
been derecognised (removed from the SFP) nor should all of the
difference between the amount due from the customer and the amount
received from the factor have been treated as an administration cost.
The required adjustments are as follows:
Accounts receivable
Loan from factor
Administration (12,000 – 9,600)
Finance costs: accrued interest ($9.6 million x
1.0%)
Accruals
Dr
12,000
9,600
2,400
96
––––––
12,096
––––––
462
Cr
96
––––––
12,096
––––––
KAPLAN PUBLISHING
chapter 21
There would also be loan note interest of $600,000 charged for the year
($300,000 paid + $300,000 accrued).
(W4) Closing inventory
As this was not counted at the year­end, the actual value counted needs
to be adjusted for movements in the period between the year­end and
the date of the count:
Balance on 4 October 20X1
Add goods sold at cost: normal sales (1,400/140 x 100)
sale or return (650/130 x 100)
Less goods received at cost
Adjusted value
16,000
1,000
500
(820)
––––––
16,680
––––––
(W5) Current liabilities
Trade and other payables:
Accounts payable from question
Accrued loan note interest (W3)
17,770
300
––––––
18,070
––––––
480
––––––
Dividends
(W6) Share capital/retained earnings/suspense account:
The elimination of the suspense account is as follows:
Suspense account (per trial balance)
Directors’ options: share capital (4 million at $1)
share premium (4 million at $1)
Rights issue: share capital (20 million + 4
million)/4)
share premium (6 million at $2)
Dr
26,000
4,000
4,000
6,000
––––––
26,000
––––––
KAPLAN PUBLISHING
Cr
12,000
––––––
26,000
––––––
463
Questions & Answers
Retained earnings:
Balance 1 October 20X0
Net profit for the period
Dividends – Preference (8% x 12,000)
Ordinary
Balance 30 September 20X1
14,160
39,994
960
2,000
––––––
(2,960)
––––––
51,194
––––––
Test your understanding 23 ­ Picklette
Answer 3
Picklette income statement
Revenue
Cost of sales (470 + 150 – 250 + (60% × 30))
Gross profit
Distribution ((20% x 30) + 240)
Administration ((20% x 30) + 170 ­ 15)
Operating profit
Finance costs
Profit before tax
Income Tax (135 + 10)
Profit for the period
464
$000
1,300
(388)
–––––
912
(246)
(161)
–––––
505
(5)
–––––
500
(145)
–––––
355
–––––
KAPLAN PUBLISHING
chapter 21
Statement of financial position
$000
Non current assets
Tangible (W1)
Current assets
Inventory
Receivables
Bank
$000
182
250
728
9
–––––
987
–––––
1,169
–––––
Share capital
Retained earnings (W2)
200
619
–––––
819
Non­current liabilities
Loan
Provision for warranties
Current liabilities (60 + 135)
KAPLAN PUBLISHING
80
75
–––––
155
195
–––––
1,169
–––––
465
Questions & Answers
Working 1
Cost
b/f
Depreciation
b/f
Charge
c/f
Carrying value
c/f
Land and
buildings
$000
Plant and
machinery
$000
Total
210
––––
125
––––
335
––––
48
5
––––
53
––––
75
25
––––
100
––––
123
30
––––
153
––––
157
––––
25
––––
182
––––
$000
Working 2
Profit for the year
Dividends
Retained earnings b/f
Retained earnings c/f
$000
355
(6)
––––
349
270
––––
619
––––
Test your understanding 24 ­ Mrs Harper
Answer 1
a.
(i) The requirement in IFRS 5 Non­current Assets Held for Sale
and Discontinued Operations to provide an analysis
between continuing and discontinued operations is intended to
improve the predictive usefulness of financial statements.
466
KAPLAN PUBLISHING
chapter 21
In essence there can be no more important information when trying
to assess the future performance of a company than to know which
parts of it are continuing their operations and those which have
ceased or been sold or are about to be in the near future. Only the
results of continuing operations should be used in forecasting future
results; profits or losses from discontinued operations will not be
repeated.
Information on discontinued operations can also help to assess
management’s strategy. One would expect loss­making activities to
be sold or closed down, but selling a profitable activity may indicate
that a company has liquidity or debt problems.
(ii) If no information on continuing and discontinued activities were
available then the best estimate of the future profit of both
companies would be $110 million (i.e. $100 million × 110%).
Utilising the available information, a very different picture emerges:
Gamma
Toga
$ million
$ million
Forecast profit
77
209
Gamma’s forecast is based on profit from continuing activities of
$70 million increasing by 10% to $77 million.
Toga’s forecast is also based on its continuing activities, but it is in
two parts. The ‘existing’ activities that made profits of $90 million
would be expected to produce profits of $99 million in 20X3. Its
newly acquired activities would be expected to produce profits of
$110 million. The latter figure is based on the $50 million profit in
20X2 being for only six months, a full year would have presumably
yielded $100 million. In 20X3 this would increase by 10% to $110
million.
KAPLAN PUBLISHING
467
Questions & Answers
(b) There are two main reasons why the income tax charge in the
financial statements is not at the same rate as the stated
percentage. The first reason is that tax is payable on the taxable
profits of a company, which may differ considerably from the
accounting profit. Such differences may be because some items of
income or expenditure included in the financial statements may be
disallowable for tax purposes (or allowed in a different accounting
period) and some taxation allowances (e.g. tax depreciation
allowances) are not included in the accounting profit. These
differences may be mitigated by deferred tax on temporary
differences. The second reason for differences is that the income
tax charge does not usually consist solely of the charge on the
current year’s profit. Commonly the tax charge also includes an
element of deferred tax (this may be a debit or credit) and possibly
an adjustment to the previous year’s tax provision (due to it being
settled at an amount different to the provision). Other more complex
items such as withholding taxes on income and double (dual)
taxation relief may also be included in the tax charge.
The main reason why the income tax charge in the income
statement differs to that in the statement of cash flows is that the tax
charge in the financial statements is a provision for tax that is
normally settled in the following period. This means that the cash
flow figure for tax actually paid is the amount needed to settle the
previous year’s tax liability. Other differences may be due to items
referred to above such as deferred tax movements that are not cash
flows.
Test your understanding 25 ­ Bewley
Answer 2
Under IFRS 5 Non­current Assets Held for Sale and Discontinued
Operations the engineering division meets the definition of a disposal
group which must be treated in the financial statements in the same way
as an asset ‘held for sale’. As the division was not sold until after the
year end then the directors must include it in the statement of financial
position at the lower of the carrying amount and the fair value less costs
to sell.
The current carrying value of the division is $46m ($66m – $20m) and
the fair value less costs to sell is the agreed value of $30m. Therefore
the division should appear in the statement of financial position at 31
March 20X0 at a value of $30m quite separate from Bewley’s other non­
current assets. The impairment of $16m ($46m – $30m) must be
recognised in the income statement.
468
KAPLAN PUBLISHING
chapter 21
As the division is classified as ‘held for sale’, it represents a separate
major line of business and it is part of a single co­ordinated plant to
dispose of this separate major line, then it meets the IFRS 5 definition of
discontinued operations. Therefore in the income statement there should
be a single amount comprising the total post­tax profit or loss of the
division and the $16m impairment required to measure the division at
fair value less costs to sell.
As the company is committed to the closure it should also recognise a
provision for the cost of the closure (as required by IAS 37). The total
provision should be made up of the following amounts:
Redundancies
Professional costs
Penalty costs
$m
2.0
1.5
3.0
–––
6.5
–––
The operating losses of $4.5 million in the period from 1 April 20X0 until
the date of closure can no longer be provided for at the date the closure
is announced. IAS 37 Provisions, Contingent Liabilities and
Contingent Assets now prohibits this type of provision unless it relates
to losses on ‘onerous contracts’. There is no indication in the question
that these future losses relate to onerous contracts.
KAPLAN PUBLISHING
469
Questions & Answers
Test your understanding 26 ­ Rodney Miller
Answer 1
(i) The trend shown by a comparison of a company’s profits over time
is rather a ‘raw’ measure of performance and can be misleading
without careful interpretation of all the events that the company has
experienced. In the year to 30 September 20X2, Taylor’s eps has
increased by 25% (from 20 cents to 25 cents), whereas its profit has
increased by a massive 67% (from $30 to $50 million). It is not
possible to determine exactly what has caused the difference
between the percentage increase in the eps and the percentage
increase in the reported profit of Taylor, but a simpler example may
illustrate a possible explanation. Assume company A acquired
company B by way of a share exchange. Both companies had the
same market value and the same profits. A comparison of A’s post
combination profits with its pre­combination profits would be very
misleading. They would have appeared to double. This is because
the post combination figures incorporate both companies’ results,
whereas the pre­combination profits would be those of company A
alone. The trend shown by the earnings per share goes some way to
addressing such distortion. In the above the increase in post
combination profit would also be accompanied by an increase in the
issued share capital (due to the share exchange) thus the reported
eps of company A would not be distorted by its acquisitive growth. It
can therefore be argued that the trend of a company’s eps is a more
reliable measure of its earnings performance than the trend shown
by its reported profits.
(ii) Both the convertible loan stock and the directors’ share options will
give rise to dilution:
8% Loan stock – on conversion there will be 140 million new shares
(200 million x 70/100).
The interest saved, net of tax at 25%, will be $12 million ($200
million x 8% x 75%).
The directors’ share options will yield income of $75 million (50
million x $1.50). At the market price of $2.50 this would be sufficient
to purchase 30 million shares. As the options are for 50 million
shares the dilutive effect of the options is 20 million shares.
470
KAPLAN PUBLISHING
chapter 21
Diluted EPS year to 30 September 20X2:
Earnings
Number of
shares
$62
million
360
million
(basic $50 million + $12 million re loan stock)
(basic 200 million + 140 million re loan stock +
20 million re options)
Diluted eps
17.2
cents
(iii) The relevance of the diluted earnings per share measure is that it
highlights the problem of relying too heavily on a company’s basic
eps when trying to predict future performance. There can exist
certain circumstances which may cause future eps to be lower than
current levels irrespective of future profit performance. These are
said to cause a dilution of the eps. Common examples of diluting
circumstances are the existence of convertible loan stock or share
options that may cause an increase in the future number of shares
without being accompanied by a proportionate increase in earnings.
It is important to realise that a diluted eps figure is not a prediction
of what the future eps will be, but it is a ‘warning’ to shareholders
that, based on the current level of earnings, the basic reported eps
would be lower if the diluting circumstances had crystallised. Clearly
future eps will be based on future profits and the number of shares in
issue.
Test your understanding 27 ­ Niagara’s
Answer 2
(i) All items in arriving at the profit for the financial year are included in
the calculation of the earnings per share.
Earnings attributable to the ordinary shares are after the deduction
of the following dividends on the non­redeemable preference
shares:
8% on $1 million for full year
new issue 6% on $1 million for six months
Preference dividends
Earnings attributable to ordinary shares (2,585,000
– 110,000)
$
80,000
30,000
––––––––
110,000
––––––––
$2,475,000
––––––––
KAPLAN PUBLISHING
471
Questions & Answers
Weighted average number of shares in issue:
Calculation of theoretical ex­rights price:
100 shares at $2.40 would be worth
rights to 20 shares at $1.50 each costing
$
240
30
––––
270
––––
120 shares now worth
This gives a theoretical ex­rights value of $2.25 per share ($270/120).
Weighted average calculation:
12,000,000 x $2.4/$2.25 x 3/12
14,400,000 (12 million x 1.2) x 9/12
Weighted average number
3,200,000
10,800,000
––––––––––
14,000,000
––––––––––
Earnings per share is 1 7.7c ($2,475,000/14,000,000 x 100).
Restated earnings per share for the year to 31 March 20X2 is 22.5c (24
x 2.25/2.40).
(ii) Fully diluted earnings per share
On conversion the loan stock would create an extra 800,000 new
shares ($2 million x 40/$100). The effect on earnings would be a
saving of interest of $140,000 ($2 million x 7%) before tax and
$98,000 after tax (140,000 x (100% – 30%)).
The directors’ warrants would create an additional 750,000 new
shares without any effect on earnings. Fully diluted earnings per
share is 16.5c ((2,475,000 + 98,000)/(14,000,000 + 800,000 +
750,000)).
472
KAPLAN PUBLISHING
chapter 21
The basic earnings per share is a measure of past performance.
The diluted earnings per share figure is more forward looking and is
intended to act as a warning to existing and prospective
shareholders. Although it is still based on past performance, it does
give effect to potential ordinary shares outstanding during the
period. Its disclosure is required where circumstances exist that
would cause the eps to be lower if those circumstances had
crystallised. It is not a prediction of the future earnings per share
figures, as these will be based on the future profits and the number
of shares in issue in the future.
The diluted EPS is more a ‘theoretical’ value, as it is unlikely that the
profit in the period when the circumstances crystallise will be the
same as the current year’s profit. The convertible loan stock in the
question is a good example of diluting circumstance. On conversion
the share entitlement will cause the number of shares in issue in the
future to be greater than the present (assuming loan stockholders
opt for conversion). There will be a compensating increase in profit
as a result of the non­payment of interest but overall the expected
conversion will cause a dilution.
Test your understanding 28 ­ Webster
Answer 1
Income statements to 31 March 20X0
Cole
Darwin
$000
$000
$000
$000
Sales (3,000 – 125 W1)
2,875
4,400
Opening inventory
450
720
Purchases (W2)
2,055
3,080
–––––
–––––
2,505
3,800
Closing inventory
(540)
(1,965)
(850)
(2,950)
–––––
–––––
–––––
–––––
Gross profit
910
1,450
Operating expenses
480
964
Depreciation
40
(W3) (120)
adjustment
Debenture interest
80
nil
Overdraft interest
15
(615) ((W4) nil
(844)
–––––
–––––
–––––
–––––
Net profit
295
606
–––––
–––––
KAPLAN PUBLISHING
473
Questions & Answers
Statements of financial position as at 31 March 20X0
Cole
Darwin
Non­current assets
Property (W3)
Plant
Current assets
Inventory
Accounts receivable
(522 + 375 W1)
Bank (W4)
1,900
1,200
–––––
3,100
1,900
(W3) 720
–––––
2,620
540
850
897
nil
–––––
750
1,437 (W4) 60
––––– –––––
4,537
–––––
Total assets
Equity and liabilities
Equity shares of $1 each
Reserves:
Revaluation reserve (W3)
Retained earnings (684 + 295
+ 40)
1,000
1,660
–––––
4,280
–––––
500
760 (1,912 +
1,019
606)
700
2,518
–––––
2,779
–––––
3,718
800
nil
Non­current liabilities
10% Debentures
Current liabilities
Trade accounts payable (438
– 275 W2)
Overdraft (W4)
Total equity and liabilities
163
795
–––––
562
958
–––––
4,537
–––––
nil
–––––
562
–––––
4,280
–––––
Workings: all figures in $000
(W1) If the sale to Brander of $500 had been on normal commercial
terms it would have been $375. Applying this would cause a
reduction in sales of $125. The effect of applying normal credit
arrangements would be that the revised sales figure of $375 would
still be in accounts receivable and the original sale proceeds of
$500 would not have been received and thus increase Cole’s
overdraft (see W4).
474
KAPLAN PUBLISHING
chapter 21
(W2) The purchase from Advent under normal trading terms would have
resulted in an increase in cost of sales of $25. Applying a normal
two­month credit period would mean that the goods would have
been paid for by the year­end thus increasing the overdraft by a
further $300, and accounts payable would be reduced by the
original value of the transaction of $275.
(W3) Non­current assets/depreciation
Cole – property
Depreciation for the year to 31 March 20X0 based on the revalued
amount would be the same as Darwin’s, $100 (2,000/20 years), this
would give Cole an additional depreciation charge of $40 (100 ×
60). The revaluation of Cole’s property would lead to a revaluation
reserve of $800. An amount equal to the excess depreciation of $40
is normally transferred from the revaluation reserve to retained
earnings.
Darwin – plant
As the plant acquired in February 20X0 has not yet contributed to
the operations of Darwin, then, for comparability purposes, it could
be logical to ignore its acquisition. The effects of this are:
–
cost of plant would be reduced by $600. This would also affect
the bank balance – see (W4) below.
–
depreciation of $120 (600 x 20%) would be reversed.
The overall effect of depreciation in the income statements would
be:
Original depreciation on property (1,200
– 1,140)
Depreciation on revalued amount
Reversal of depreciation on new plant
Net depreciation adjustment
KAPLAN PUBLISHING
Cole
$000
(60)
Darwin
$000
100
––––
debit 40
––––
(120)
––––
credit (120)
––––
475
Questions & Answers
Summary of non­current assets:
Cost/ revaluation
Depreciation
$000
$000
Carrying
value
$000
2,000
100
1,900
6,000
4,800
1,200
–––––
3,100
–––––
2,000
2,400 (3,000 –
600)
100
1,680 (1,800 –
120)
1,900
720
Cole
– property
– plant
(unchanged)
Darwin
– property
– plant
–––––
2,620
–––––
(W4) Bank balances
– balance b/f
– reversal of sale proceeds
– payment for increased purchases
– payment for plant reversed
– payment/saving of overdraft interest
– balance c/f
Cole
$000
20
(500)
(300)
(15)
––––
(795)
––––
Darwin
$000
(550)
600
10
––––
60
––––
(b) Ratios from question:
Return on capital employed
Asset turnover
Gross profit margin
Net profit margin
Accounts receivable collection period
Accounts payable payment period
476
Cole
19.4%
1.01 times
35.3%
16.7%
64 days
79 days
Darwin
13.3%
1.23 times
33.0%
10.8%
62 days
67 days
KAPLAN PUBLISHING
chapter 21
Ratios from restated financial statements:
Return on capital
employed
Cole
10.5%
(295 + 80)/(2779 +
800) x 100
Asset turnover
(2875/3,579)
0.80 times
Gross profit margin
(910/2875) x 100
31.7%
Net profit margin
(295/2,875) x 100
10.3%
Accounts receivable
collection period
(897/2875) x 365
114 days
Accounts payable
payment period
(163/2055) x 365
29 days
Drawin
16.3%
(606/3,718) x
100
(4,400/3,718) 1.18 times
33.0%
(606/4,400) x 13.8%
100
62 days
67 days
Note: the figures without workings have not changed.
Comments:
An assessment of the performance of the two companies based on
the unadjusted ratios would favour Cole as most of its ‘key’ ratios
are better than Darwin’s. Cole’s overall profitability as measured by
the ROCE is higher. This is due to higher profit margins as Darwin’s
asset turnover is in fact higher than Cole’s. A point of note is that
both companies have rather poor asset turnovers, implying
inefficient use of assets.
The management of working capital of the two companies is rather
similar with the exception that Cole is obtaining (or taking) a slightly
longer credit period from its suppliers. Webster may be better
advised to calculate liquidity ratios as well as working capital ratios.
This would show that Cole’s liquidity ratios are a healthy 2.5
(1,082/438) and 1.23 (542/438) for the current and quick ratios
(acid test) respectively, whereas Darwin’s figures are only 1.4
(1,600/1,112) and 0.7 (750/1,112) which are a cause for concern
and further investigation.
KAPLAN PUBLISHING
477
Questions & Answers
When the above ratios are recalculated on the adjusted financial
statements, the relative position is very much reversed. The
favourable trading terms and conditions that have been orchestrated
by Cole’s parent company have favourably distorted its financial
statements. Equally, due to the limitations of traditional ratio
analysis, Darwin’s ratios are unfavourably affected by its policy of
revaluing property, and acquiring additional plant just before the
year­end.
The revised ratios show Darwin is much more profitable than Cole
with better margins and more efficient use of assets. Further Cole’s
‘true’ liquidity position is not impressive; a current ratio of 1.5
(1,437/958) and a quick ratio of 0.93 (897/ 958). The management
of working capital figures show poor credit control of accounts
receivable (114 days) and, despite the question saying Cole
normally takes two months credit, there is very early payment of
suppliers. This may be due to suppliers imposing strict terms as a
result of past experiences, or Cole may have a poor credit rating. It
can also be seen that Darwin’s poor liquidity ratios are in the main
due to financing the acquisition of the new plant from overdraft
facilities. Darwin may be advised to re­finance this plant from
medium term borrowings (say a five­year debenture).
In coming to a decision about which company Webster should
purchase there are many other factors that should be considered, as
examples:
(i) What is the asking price of the companies? If Cole is priced
cheaply, reflecting its problems, and Darwin is expensive clearly
this will be critical in any decision to purchase.
(c) (ii) It must be remembered that Webster will be buying the future
profits/cash flows of a company and past financial statements
may be misleading in this respect. For example the new plant
coming on stream will affect Darwin’s future profits. Another
aspect relating to this point is that other information (which may
not be available to Webster) may be very useful e.g. profit and
cash flow forecasts. Also non­financial information can be very
important, for example, has either company got a full or an
empty order book? Does either company have a history of
good or poor labour relations?
(iii) It may be that neither company would be a good purchase and
other potential acquisitions should be considered.
(d) Information in the notes:
Assuming that financial statements are prepared in accordance with
International Accounting Standards and are publicly available, most
of the information in notes (1) to (5) of the question would have to be
disclosed in the financial statements.
478
KAPLAN PUBLISHING
chapter 21
Specifically:
(1) and (2) This information concerns related party transactions. IAS
24 Related Party Disclosures specifically says the following must
be disclosed:
–
the nature of related party transactions including:
– the volume of transactions
–
outstanding items
–
any other elements necessary for an understanding of the
financial statements (this may include disclosure of the
details of profit margins and credit terms).
(3) IAS 16 Property, Plant and Equipment requires that where a
company adopts revalued amounts for its properties these
values would be included in the statement of financial position
with various supporting information. IAS 16 also encourages the
disclosure of the ‘fair value’ (which is probably similar to the
market value) of property, plant and equipment where this is
materially different from its carrying amount. If Cole has
responded to this encouragement the market value of its
property would be disclosed. However even if the fair value has
not been disclosed, an informed ‘user’ of financial statements
may have a shrewd idea of its value as a result of a knowledge
of property market conditions in general.
(4) Although the acquisition of the plant would be detailed as part of
the movement in non­current assets, the exact date of purchase
and the manner of its financing would not usually be available.
(5) In the absence of the information in respect of notes (1) and (2)
it would be impossible to calculate the effect they would have on
Cole’s overdraft and on its interest cost. Even where such
transactions have to be disclosed it is unlikely that they would
extend to the specific disclosure of an implied interest cost.
Tutorial note: Journal entries for the adjustments in part (a)
$000
Cole
(i)
(ii)
KAPLAN PUBLISHING
Dr Sales
Dr Accounts receivable
Cr Bank
Dr Purchases
Dr Trade accounts payable
Cr Bank
$000
125
375
500
25
275
300
479
Questions & Answers
(iii)
(v)
Dr Property (SFP carrying value)
Cr Revaluation reserve
Dr Depreciation (income statement) 40
Cr Property (SFP carrying value)
Dr Overdraft interest
15
Cr Bank
800
Dr Bank
Cr Plant
Dr Plant
Cr Depreciation (income statement)
Dr Bank
Cr Overdraft interest
600
800
40
15
Darwin
(iv)
600
120
120
10
10
Test your understanding 29 ­ Judicious
Answer 2
(a) A company that is a wholly owned subsidiary is a related party of its
parent company. This means that the financial statements may have
been affected by related party transactions. Such transactions may
or may not be at ‘arm’s length’ i.e. on normal commercial terms.
Even where related party transactions are at arm’s length, it is still
important to realise that they are related party transactions. This is
because it is quite possible that they would not have occurred but for
the relationship. For example a parent company may purchase all of
its motor vehicle fleet requirements from one of its subsidiaries on
normal commercial terms. Whilst this may appear perfectly proper, it
may mean that, but for the custom of its parent, the subsidiary’s
sales and profits would have been much less. The types of
transaction that may occur between related parties are:
480
–
purchases and sales, possibly at favourable prices or
advantageous settlement terms; provision of finance, again
possibly at artificially low (favourable) rates of interest
–
equipment or other property may be provided under favourable
terms
–
favourable agency arrangements
–
provision of services, such as sharing technical knowledge from
research and development activities or allowing patented
goods to be produced under licence, and
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chapter 21
–
guarantees for loans or overdrafts.
All of the above would mean that there is hardly any area of financial
reporting that could not be influenced by the presence of related
party transactions with the possibility that this may cause severe
distortion of the financial statements.
Although there is a requirement to disclose related party
relationships and transactions, many related party transactions may
not be disclosed.
Apart from related party issues, a common error when dealing with
individual subsidiaries is to assume that the liabilities of an
individual subsidiary may be ‘covered’ by assets owned by other
members of the group, or that the parent company will guarantee a
subsidiary’s liabilities. This is not usually the case.
(b) Report on the Financial Position of Breadline
Introduction
The following report is based on the available financial statements
of Breadline for the year to 31 December 20X1, which include
comparative figures for the year 20X0. The comments have been
based on taking the financial statements at face value. Towards the
end of the report under ‘causes of concern’ I have expressed
matters that could seriously affect the position of Breadline as
portrayed in its financial statements.
Profitability
Breadline’s overall profitability has shown a creditable improvement
from a ROCE of 41% to 47.1%. Calculation of the asset turnover
and profit margins reveal that this improvement has arisen from
increased profit margins (at both the gross and net level) as the
asset turnover of Breadline has declined from 2.6 to 2.0 times.
Liquidity
This is an area of concern as both the current ratio and the quick
ratio (acid test) have deteriorated considerably from normal and
acceptable positions in 20X0 to worryingly low levels of 1.1:1
(current) and 0.77:1 (quick) in 20X1.
Looking in more depth at the composition of these ratios:
Inventory holding has gone from 18 days to 23 days. In general
these are relatively low levels, but given the trade of Breadline
(bakery), large inventory holdings would not be expected.
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Questions & Answers
The accounts receivable collection period shows a modest decline
from 34 days in 20X0 to 41 days in 20X1; despite the worsening of
this ratio it is still an efficient collection period.
The accounts payable period: two figures have been calculated for
this ratio. The figure for the payment of our own balance shows a
very serious worsening of the payment period from 46 days (which
was in line with our credit terms) in 20X0 to an unacceptable period
of 103 days for 20X1. The payment period when our own balance is
excluded also shows an increasing payment period from 45 days in
20X0 to 53 days in 20X1, however this is nothing like the increase
for our own account.
Although the increasing payment period is partly responsible for the
worsening of the liquidity ratios of Breadline, it is the deterioration in
the cash position that is the main cause. It has gone from a balance
in hand of $250,000 in 20X0 to an overdraft of $220,000 in 20X1.
Further evidence of a deteriorating cash flow position is the
company having to raise a loan (of $500,000) in the current year.
Gearing and financing
Gearing is not a significant issue for Breadline. The company had nil
gearing in 20X0 and the issue of the loan note (at the beginning of
the current year) has created modest gearing of 12%.
The company appears to have made an issue of shares during the
year to the amount of $600,000 cash ($400,000 capital + $200,000
premium – see below). This is a significant amount representing
17% of net assets at the end of 20X0.
It would appear the composition of the retained earnings at 31
December 20X1 is made up of a brought forward balance of
$1,700,000 plus $600,000 retained profit for the current year (after a
dividend of $900,000) and the transfer of the revaluation reserve of
$700,000 to realised profits (as the company’s freehold has now
been sold). Thus it must be a cash issue of shares that has caused
the increase in share capital and share premium.
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chapter 21
Causes of concern/further investigations
Sale of property
The company appears to have sold its freehold premises and
leased it back as a leasehold property. The main reason for this
conclusion is that our company is aware that Breadline traded from
the same business address in both 20X0 and 20X1. There is no
indication of how long the lease is, but even if it is for a long period,
its cost ($2.5 million) is likely to have been less than the freehold
was sold for as even a long lease would be worth less than the
freehold. Therefore there must have been a large profit on the sale
of at least $1,250,000. This should be $2,500,000 (minimum value
of the freehold) less $1,250,000 (the carrying value of the freehold).
This profit has been included in the income statement as a reduction
of the cost of sales. This profit seems to be largely responsible for
the improvement in Breadline’s margins and overall profitability. If
the ROCE is calculated excluding this profit it would be 17.4%
[(1,970 +10 – 1,250)/(3,700 + 500) × 100)], which is much worse
than the previous year’s 41%. Normally this type and size of profit is
separately disclosed either on the face of the income statement or
in a note to the financial statements. It should not be considered as
a reduction of the cost of sales. Clearly any prospective purchaser
of Breadline cannot expect to repeat this type of profit in future
periods.
Issue of Loan note/Share capital
The most striking feature of the issue of the loan note is the interest
rate it carries. At only 2% this is well below the commercial rate of
8%. It is possible that the loan note has been issued to Breadline’s
parent company, and the low interest rate is a feature of the related
party relationship. If it is not a related party transaction, it may be
that the low interest is compensated for by high premium on its
redemption. If this is so the premium should be amortised over the
life of the loan note to give a higher finance charge. One way or
another it appears that the issue of the loan note has led to an
artificially low finance cost and is another example of flattering
profitability.
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Questions & Answers
The issue of the shares is even more perplexing. As Breadline is a
100% owned subsidiary of Wheatmaster, the shares must have
been issued to Wheatmaster. It is not immediately obvious why this
share issue occurred. The practical effect of the issue is that
Breadline received $600,000 from its parent. What is interesting is
that Breadline paid a dividend of $900,000 to its parent company
during the year. Given the size of Breadline’s overdraft, it may have
had insufficient cash to pay the dividend without the receipt from the
proceeds of the share issue. Thus the issue may have been a
mechanism to enable Breadline to transfer some of its profits to its
parent company.
Conclusion
The apparent improvement in Breadline’s profitability seems largely
due to related party issues and the sale and leaseback of the
freehold property. Thus it is illusory rather than a genuine
commercial improvement. The company’s liquidity is also poor and
its most valuable asset (the freehold property) has now been
replaced by a leasehold property of unknown duration. All of these
may be symptoms of the parent company preparing to sell the
business and attempting to improve the financial position of
Breadline. There is insufficient information to conclude whether
Breadline would be a good (or poor) acquisition, but it is important
that such an evaluation is made based on ‘non­manipulated’
information.
A more immediate concern is the deterioration in the payment
period to our company. Breadline must be contacted immediately to
find out why the account is so late in being paid. It would not be
advisable to allow any further trading on credit until the account is
within the stated credit terms. Enquiries should be made as to why
our internal credit control procedures have allowed the situation to
develop this far.
D E Franks
Assistant Financial Controller
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chapter 21
Appendix
Performance ratios
20X1
Return on capital employed
47.1%
(1,970 + 10)/ (3,700 + 500) x
100
Net assets turnover
2.0 times
(8,500/4,200)
Gross profit margin (see
30%
below) (2,550/8,500) x 100
Net profit (after tax) margin
17.6%
(1,500/8,500) x 100
Current ratio (1,330/1,250)
1.1:1
Quick ratio (960/1,250)
0.77:1
Inventory holding period
23 days
(370/5,950) x 365
Accounts receivable collection 41 days
period (960/8,500) x 365
Accounts payable payment
53 days
period (see below) (excluding
Judicious) (1,030 – 340)/
(5,950 – 1,200)) x 365
Judicious payment period
103 days
(340/1,200) x 365
Gearing (500/4,200) x 100
12%
20X0
(1,025/2,500) x 41.0%
100
(6,500/2,500)
2.6 times
(1,690/6,500) x
100
(850/6,500) x
100
(1,090/590)
(850/590)
(240/4,810) x
365
(600/6,500) x
365
(590 – 100)/
(4,810 – 800) x
365
26%
13.1%
1.8:1
1.4:1
18 days
34 days
45 days
(100/800) x 365 46 days
The 2% loan note has been treated as a financing item in calculating
the net asset turnover.
The accounts payable payment period is based on the cost of sales
as the purchases figure is not available.
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Questions & Answers
Test your understanding 30 ­ Placid
Answer 1
a.
Statement of cash flows
Operating profit
Depreciation
Inventory increase
Trade receivables increase
Trade payables decrease
Amortisation
Profit on disposal of FA
Non cash purchase
Cash generated from operations
Interest received (79 – 5)
Interest paid
Taxation
Investing activities
Sale of tangible non­current assets
Acquisition of intangible assets
Acquisition of tangible non­current assets
Acquisition of Investments.
Sale of current asset investments
Financing activities
Debenture Issue
Share Issue (70 S/P + 5 S/C)
Equity dividend paid
Cash flow
486
$m
139
22
(118)
(107)
(67)
7
(6)
70
––––
(60)
74
(55)
(5)
––––
(46)
250
(50)
(438)
(1)
25
––––
(214)
130
75
(22)
––––
183
––––
(77)
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chapter 21
(b) Cash flow interpretation
(1) Statement of cash flows
–
Cash generated from operations is negative which is
worrying as it indicates that cash may not be available to
finance mandatory cash outflows such as tax in the future.
Further investigation, however reveals that this is largely
due to the very poor management of working capital.
Assuming that working capital management can be
improved in the near future, the outflow of cash from
operations should be able to be reversed.
–
The level of expenditure on non­current assets is very high
and far exceeds the proceeds of the sale of non­current
assets plus depreciation. This suggests that the company
is not only replacing those assets that it disposed of in the
year, but also investing to increase its non­current asset
base and so achieve growth.
–
The majority of the cash to finance this expansion has been
raised through the issue of debentures and shares.
(2) Working capital management
–
Placid is building up inventory and appears to be giving
extended credit to its customers. Both of these activities
mean that cash is tied up in working capital. Despite this
trade payables are decreasing, suggesting that they are
being paid quickly – possibly earlier than required. This
mis­management of working capital is resulting in an
unhealthy statement of cash flows.
Conclusion
Placid itself is financially healthy, as indicated by the income statement
and statement of financial position:
•
•
It shows a good operating profit.
It is able to issue shares which suggests that the market is confident
of its prospects.
The management of working capital is, however, a key area for
improvement.
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Questions & Answers
Recommendations
•
•
•
•
•
•
Review management decisions.
Sweep up overdraft.
Achieve control of inventory by selling it.
Tighten up the credit control function
Use the credit facilities extended by suppliers.
Delay further non­current asset investment.
Test your understanding 31 ­ Nedberg
Answer 2
(a) Statement of cash flows of Nedberg for the Year to 30
September 20X2
$m
Cash flows from operating activities
Net profit before interest and tax
Adjustments for:
Amortisation – development expenditure (W1)
Depreciation – property, plant and equipment
Amortisation of government grant (W2)
Loss on sale of plant
Increase in inventory (1,420 – 940)
Increase in accounts receivable (990 – 680)
Increase in accounts payable (875 – 730)
Cash generated from operations
Interest paid (30 – (15 – 5 accrual
adjustments))
Income tax paid (W3)
Net cash from operating activities
Cash flows from investing activities
Purchase of property, plant and equipment
(W4)
Capitalised development costs (W1)
Receipt of government grant
Proceeds of sale of plant (W4)
488
$m
920
130
320
(90)
50
(480)
(310)
145
––––
685
(20)
(130)
535
(250)
(500)
50
20
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chapter 21
Net cash used in investing activities
Cash flows from financing activities
Issue of ordinary shares (W5)
Issue of loan notes (300 – 100)
Dividends paid
Net cash from financing activities
Net increase in cash and cash equivalents
Cash and cash equivalents at beginning of
period
Cash and cash equivalents at end of period
(680)
450
200
(320)
––––
330
––––
185
(115)
––––
70
––––
Workings
(W1) Development expenditure
Balance b/f
Amount capitalised
Amortisation – balancing figure
Balance c/f
$m
100
511100
(130)
––––
470
––––
(W2) Government grant
Balance b/f
Cash received
Amortisation
Balance c/f
KAPLAN PUBLISHING
$m
300
50
(90)
––––
260
––––
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Questions & Answers
(W3) Income tax
Tax provision b/f
Deferred tax b/f
Charged to income statement
Tax provision c/f
Deferred tax c/f
Difference cash paid
$m
160
140
270
(130)
(310)
––––
130
––––
(W4) Property, plant and equipment
Balance b/f
Revaluation surplus
Plant acquired
Depreciation
Disposal at net book value – balancing figure
Balance c/f
Disposal of plant:
Net book value from above
Loss on sale (from question)
Difference is sale proceeds
490
$m
1,830
200
250
(320)
(70)
––––
1,890
––––
70
(50)
––––
20
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(W5) Share capital
Ordinary shares b/f
Bonus issue 1 for 10 (from revaluation reserve)
Ordinary shares c/f
Difference issue for cash
Plus increase in share premium (350 – 100)
Total cash proceeds of issue of ordinary shares
$m
(500)
(50)
750
––––
200
250
––––
450
––––
(W6) Reconciliation of reserve movements
Revaluation reserve:
Balance b/f
Revaluation of buildings
Bonus issue
Transfer to realised profits
Balance c/f
KAPLAN PUBLISHING
$m
Nil
200
(50)
(10)
––––
140
––––
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Questions & Answers
(b) The cash flows generated from operations of $685 million are
relatively healthy and more than adequate to pay the interest costs
and taxation, but not as large as the equivalent profit figure. For
most companies the operating cash flows tend to be higher than the
profit before interest and tax due to the effects of
depreciation/amortisation (which are not cash flows). In the case of
Nedberg the depreciation/amortisation effect has been more than
offset by a much higher investment in working capital of $645
million. Inventory has increased by over 50% and accounts
receivable by 45%. This may be an indication of expanding activity,
but it could also be an indication of poor inventory management
policy and poor credit control, or even the presence of some
obsolete inventory or unprovided bad accounts receivable.
A cause of concern is the size of the dividends, at $320 million they
represent 52% of the profit for the period. This is a very high
distribution ratio, and it seems curious that the company is returning
such large amounts to shareholders at the same time as they are
raising finance. $450 million has been received from the issue of
new shares and $200 million from a further issue of loan notes.
The company has invested considerably in new plant ($250 million)
and even more so in development expenditure ($500 million). If
management has properly applied the capitalisation criteria in IAS
38 Intangible Assets, then this indicates that they expect good future
returns from the investment in new products or processes. The net
investment in non­current assets is $680 million which closely
correlates to the proceeds from financing of $650 million. In general
it is acceptable to finance increases in the capacity of non­current
assets by raising additional finance, however operating cash flows
should finance replacement of consumed non­current assets.
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