FR Course notes
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Syllabus A: THE CONCEPTUAL AND REGULATORY FRAMEWORK
3
Syllabus A1. The Need For A Conceptual Framework
3
Syllabus A2. Recognition And Measurement
14
Syllabus A3. Regulatory Framework
23
Syllabus A4. The Concept Of A Group
30
Syllabus B: ACCOUNTING FOR TRANSACTIONS IN FINANCIAL STATEMENTS
45
Syllabus B1. Tangible non-current assets
45
Syllabus B2. Intangible non current assets
66
Syllabus B3. Impairment of assets
76
Syllabus B4. Inventory and biological assets
83
Syllabus B5. Financial instruments
86
Syllabus B6. Leasing
107
Syllabus B7. Provisions and events after the reporting period
120
Syllabus B8. Taxation
128
Syllabus B9. Reporting financial performance
133
Syllabus B10. Revenue
154
Syllabus B11. Government grants
167
Syllabus B12. Foreign currency transactions
169
Syllabus C: ANALYSING AND INTERPRETING THE FINANCIAL STATEMENTS
173
Syllabus C1. Limitations of financial statements
173
Syllabus C2. Interpretation of accounting ratios
179
Syllabus C3. Limitations of interpretation techniques
188
Syllabus C4. Specialised, not-for-profit and public sector entities
191
Syllabus D: PREPARATION OF FINANCIAL STATEMENTS
192
Syllabus D1. CF - Approach to the Question
192
Syllabus D2. Preparing group SFP
207
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Syllabus A: THE CONCEPTUAL AND
REGULATORY FRAMEWORK
Syllabus A1. The Need For A Conceptual Framework
Syllabus A1a) Describe what is meant by a conceptual framework for financial reporting.
Accounting standards need to be built on a reliable set of
concepts
The Conceptual framework is:
•
a framework for setting accounting standards
•
a basis for resolving accounting disputes
•
fundamental principles which then do not have to be repeated in accounting
standards
•
a theoretical basis for determining how transactions should be measured
(historical value or current value) and reported
•
a statement of generally accepted accounting principles (GAAP) for evaluating
existing practices and developing new ones
Who else is the framework useful to?
1
Auditors
2
Users of accounts
3
Anyone interested in how IFRS's are formulated
The Framework is NOT an accounting standard, and if there's a conflict between the two then
the IFRS wins.
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Syllabus A1b)
Discuss whether a conceptual framework is necessary and what an alternative system might be.
Is there an alternative system?
Simply, Yes. A rules-based system
WITHOUT a principles based conceptual framework
The following happens..
1
Inconsistent standards
2
Standards produced on a "fire fighting" basis
(Being reactive rather than proactive)
3
Standard setting bodies are biased in their membership
4
Same theoretical issues are repeated each time a problem comes up
Having no framework leads to ‘rules- based’ accounting systems
Such a system is very prescriptive and inflexible, though also the accounts are then more
comparable and consistent.
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Syllabus A1cd)
c) Discuss what is meant by relevance and faithful representation and describe the qualities that
enhance these characteristics.
d) Discuss whether faithful representation constitutes more than compliance with accounting
standards.
Faithful Representation
Accounts must represent faithfully the phenomena it purports to represent
Faithful Representation means..
1
Substance over form
Faithful representation means capturing the real substance of the matter.
2
Represents the economic phenomena
Faithful means an agreement between the accounting treatment and the economic
phenomena they represent.
The accounts are verifiable and neutral.
3
Completeness, Neutrality & Verifiability
Examples
Sell and buy back = Loan
An entity may sell some inventory to a finance house and later buy it back at a price based on
the original selling price plus a pre-determined percentage. Such a transaction is really a
secured loan plus interest. To show it as a sale would not be a faithful representation of the
transaction.
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Convertible Loans
Another example is that an entity may issue convertible loan notes. Management may argue
that, as they expect the loan note to be converted into equity, the loan should be treated as
equity. They would try to argue this as their gearing ratio would then improve. However, it is
recorded as a loan as primarily this is what it is.
As noted previously, simply following rules in accounting standards can provide for treatment
which is essentially form over substance. Whereas, users of accounts want the substance
over form.
The concept behind faithful representation should enable creators of financial statements to
faithfully represent everything through measures and descriptions above and beyond that in
the accounting standard if necessary.
Limitations to Faithful Representation
1
Inherent uncertainties
2
Estimates
3
Assumptions
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Syllabus A1c)
Discuss what is meant by relevance and faithful representation and describe the qualities that
enhance these characteristics.
Relevance
Relevant information influences the economic decisions of the user
Has Predictive value and/or Confirmatory value
So users can assess the entity ability to..
1
Take advantage of opportunities
2
React to adverse situations
3
eg. Discontinued operations separated from continuing on the income statement
Materiality
This is not a matter to be considered by standard-setters but by preparers of accounts and their
auditors.
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Syllabus A1c)
Discuss what is meant by relevance and faithful representation and describe the qualities that
enhance these characteristics.
What is meant by relevance and faithful representation?
The Framework differentiates between fundamental and enhancing
information characteristics
Woah! What?!
Fundamental qualitative characteristics
For information to be useful, it must be both relevant and faithfully represented
1
Relevance
2
Faithful representation
Enhancing qualitative characteristics
1
Comparability (including consistency)
2
Timeliness
3
Verifiability
4
Understandability
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Syllabus A1c)
Discuss what is meant by relevance and faithful representation and describe the qualities that
enhance these characteristics.
Faithful and Reliable accounts
Accounts should show a faithful and reliable representation
To do this sometimes you need to show the substance of a transaction rather than its legal form.
For example, if you ‘sell’ an asset but still enjoy its benefits, then this probably isn't a true sale in
reality (in all probability this is a loan - see later).
How do you know if substance is not the same as form?
Well it usually is - but look for..
• Where control differs from ownership of an asset
• Where items are sold at NOT fair value
• Where there's an extra "option" in the agreement
• Where this is any "extra" attachment to an agreement
• This is called a linked transaction
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Consignment Stock
Also known as goods on sale or return basis
The issue here is who CONTROLS the stock in substance - you need to know whose stock it is.
Find out who takes the majority of the following risks..
• If the stock becomes obsolete
• If stock is slow to sell
Illustration
You sell goods to me.
If I don't sell the goods I return them to you for a refund.
Solution
The stock is yours because you take the risks:
Obsolescence - If they don't sell I send them back to you for a refund
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Factoring of Receivables
Here we sell our debtors to a factor in return for cash
But again we need to look to see whose debtors they really are (have i really sold them in
substance) by looking at who keeps the majority of the risks…
Receivables Risks
• Risk of bad debt
• Risk of slow paying debtors
Illustration
You sell me your debtors but we have the following agreement:
• If the debts go bad - I return them to you for a refund
• You pay me 2% interest a month on all debtors who don't pay me immediately
Solution
You have not sold the debtors because you keep both the bad debt risk and slow paying risk (you
pay me interest on o/S debtors).
Therefore you do not have a sale you have a payable loan to me.
This loan gets repaid as the debtors pay me.
Sale and Buy back
For a sale of goods you need to have transferred the majority of the risks and rewards.
Here look at the rewards.. who gets the majority of the benefits of the asset
If you make this sale and then buy it back - then you have probably kept the majority of the
rewards and so not sold the asset.
Instead, again, it is a loan
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Syllabus A1e)
Discuss what is meant by understandability and verifiability in relation to the provision of financial
information.
Verifiability, Timeliness & Understandability
These should be maximised both individually and in combination
Let's look in more detail..
Verifiable
This allows independent observers to agree that a transaction is faithfully represented.
Timely
Timeliness means that information is available to decision-makers in time to be capable of
influencing their decisions.
Understandable
Understandability is enhanced when the information is:
1. classified
2. characterised
3. presented clearly and concisely
Complex info is not left out just because it is hard to understand.
If it is relevant..it's relevant!
Financial reports are prepared for users who have a reasonable knowledge of business and
economic activities and who review and analyse the information with diligence.
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Syllabus A1f)
Discuss the importance of comparability and timeliness to users of financial statements.
Comparability
Comparability is fundamental to assessing the performance of an entity
Analysing trends needs the accounts to have been prepared on a comparable (consistent) basis.
Comparability is improved by:
Consistent accounting policies
Different policies may be necessary though to be more relevant and reliable.
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Syllabus A2. Recognition And Measurement
Syllabus A2ab)
a) Define what is meant by ‘recognition’ in financial statements and discuss the recognition criteria.
b) Apply the recognition criteria to:
i) assets and liabilities.
ii) income and expenses.
Recognition and recognition criteria
Recognition and measurement
Recognition
Please remember this!!!
For an item to be recognised in the accounts it must pass three tests:
1.
Meet the definition of an asset/liability or income/expense or equity
2.
Be probable
3.
Be reliably measurable
Definitions
• Asset
An asset is a resource controlled by the enterprise as a result of past events and from which
future economic benefits are expected to flow to the enterprise.
• Liability
A liability is a present obligation of the enterprise arising from past events, the settlement of
which is expected to result in an outflow from the enterprise of resources embodying economic
benefits.
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• Equity
Equity is the residual interest in the assets of the enterprise after deducting all its liabilities.
• Income
Income is increases in assets (or decreases of liabilities) that result in increases in equity, other
than contributions from equity participants.
• Expense
Expenses are decreases in assets or (incurrences of liabilities) that result in decreases in equity,
other than distributions to equity participants.
How this is applied in specific cases?
1.
Factoring of receivables
Where debts are factored, the firm sells its debts to the factor. This may be a true sale or just a
means of getting cash in and so in effect a loan.
It all depends on whether the debtors sold are still an asset to the company.
The definition of an asset refers to economic benefits so whoever receives those benefits should
hold the debtors as an asset.
• Example
RCA (that fine academy) sells some of its debtors to a factor. The terms of the arrangement are as
follows:
Factor charges 5% Interest on all outstanding debts every month.
Any bad debts are transferred back to RCA for a refund.
• Solution
The best way to view this is by looking at who takes the risks. The risk of a debtor is that they pay
slowly and/or go bad.
The 5% interest charge means that if the debtor is a slow payer, RCA pays 5% so takes the risk.
Equally if the debt goes bad RCA takes the risk. So they remain RCA debtors. The money from
the so called sale is treated as a loan. As the debtors pay the factor that is the loan being paid off.
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2.
Consignment Stock
This is where inventories are held by one party but are owned by another (for example a
manufacturer and car dealer arrangement)
Often used in a ‘sale or return’ basis.
• Issue
The issue is - to whom does the stock belong? Not the legal form but the substance. Again look
at who is taking most of the risks and it is they who should have the stock on their SFP.
• Risks
Who takes the risk of obsolescence?
Who takes the risk of the sell on price falling?
Who takes the risk of the stock taking a long time to sell?
Example
Here’s an agreement between a car manufacturer (m) and a car dealer (d)
The price of vehicles is fixed at the date of transfer. (Price fall risk taken by d)
D has no right to return unsold cars (obsolescence risk taken by d)
D pays m 2% a month on all unsold cars. (slow moving stock risk taken by d)
Therefore the cars should be on D’s statement of financial position.
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Syllabus A2c)
Explain and compute amounts using the following measures:
i) historical cost
ii) current cost
iii) value in use
iv) fair value
Measurement
Different measures
Historic Cost
The amount paid or fair value of the consideration given.
(eg. Cost – Accumulated Depreciation)
Fair Value
IFRS 13 defines fair value as “the price that would be received to sell an asset or paid to transfer a
liability in an orderly transaction between market participants at the measurement date”.
Current Cost
The amount that would have to be paid if the same or an equivalent asset was acquired currently.
Net realisable value
The amount that could currently be obtained by selling the asset, net of the estimated selling and
completion costs.
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Present value of future cash flows
The present discounted value of the future net cash inflows that the item is expected to generate
Example
A company owns a machine which was purchased last year for $280,000.
Depreciation is provided at 25% straight line.
It is estimated that this machine could be sold second hand for $88,000 although the company
would have to spend about $500 in advertising costs to do so.
If replaced, the machine would cost $360,000, although this current model is 20% more efficient.
The machine is expected to generate net cash inflows of $40,000 for the next 5 years after which
time it will be scrapped.
The company’s cost of borrowing is 6%.
The discount factors at 6% at the end of:
Year 1 0.943
Year 2 0.890
Year 3 0.840
Year 4 0.792
Year 5 0.747
What is the value of the following asset using:
a) Historical Cost
b) Fair Value
c) Current Cost
d) Net Realisable Value
e) Present Value of Future Cashflows
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Solution
• Historical Cost
Cost – Accumulated Depreciation
280,000 – 70,000 = $210,000
(Accumulated dep'n = 0.25 x 280,000)
• Fair Value
$88,000
• Current cost
360,000 x 100/120 = 300,000 – 75,000(dep'n) = $225,000
• Net realisable Value
88,000 – 500 = $87,500
• Present Value of Future Cashflows
40,000 x 4.212 = $168,480
(0.943 + 0.890 + 0.840 + 0.792 + 0.747 = 4.212)
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Syllabus A2d)
Discuss the advantages and disadvantages of historical cost accounting.
Advantages and disadvantages of historical cost
accounting
Advantages of Historical Cost Accounting
Advantages
1.
Cost is known and can be checked to an invoice
2.
Enhances comparability
3.
Leads to stable, non-volatile pricing
Disadvantages of Historical Cost Accounting
Disadvantage
1.
Non-current asset values become quickly out of date
2.
Depreciation charge is unrealistically low
3.
Lower costs lead to higher profits - which may lead to too high dividends in
real terms
4.
Comparisons over time are impossible
5.
Users are often interested in current values not past e.g. security on loan
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Syllabus A2e)
Discuss whether the use of current value accounting overcomes the problems of historical cost
accounting.
Current Cost accounting
Provides more realistic book values by valuing assets at current replacement
cost
It is usually calculated by adjusting the historical cost for inflation.
The 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.
The problems that current cost accounting (and other approaches to accounting for inflation)
attempt to solve are obviously linked to inflation.
In practical terms, it can be very difficult to determine the current value of assets. It is often
subjective and complex.
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Syllabus A2f)
Describe the concept of financial and physical capital maintenance and how this affects the
determination of profits.
Financial and Physical capital maintenance
These 2 look at maintaining financial or operating balances
Financial capital maintenance
Profit is when..
1.
Money net assets at end > Money net assets at start
2.
Can be measured using purchasing power
3.
Takes into account inflation
Physical capital maintenance
Profit is when..
1.
Physical operating capability at end > Physical operating capability at start
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Syllabus A3. Regulatory Framework
Syllabus A3a)
Explain why a regulatory framework is needed including the advantages and disadvantages of IFRS
over a national regulatory framework.
Why regulation is needed
A regulatory framework is needed to ensure relevant and reliable information
is given to users
A regulatory framework regulates the behaviour of companies towards their investors.
They increase users’ understanding of, and their confidence, in financial statements.
Benefits of adopting IFRS
• They are high-quality and transparent global standards that are intended to achieve
consistency and comparability
• Companies that use IFRS and have their financial statements audited in accordance with
International Standards on Auditing (ISA) will have an enhanced status and reputation
• The International Organisation of Securities Commissions (IOSCO) recognise IFRS for listing
purposes
• Thus companies that use IFRS need produce only one set of financial statements for any
securities listing for countries that are members of IOSCO.
• Companies that own foreign subsidiaries will find the process of consolidation simplified if all
their subsidiaries use IFRS
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• Companies that use IFRS will find their results are more easily compared with those of other
companies that use IFRS
This would help the company to better assess and rank prospective investments in its foreign
trading partners
What are the challenges of adopting IFRS to national standards?
1.
Laws and regulations
2.
IFRS training to finance staff and regulators
3.
Greater complexity in the financial reporting process
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Syllabus A3b)
Explain why accounting standards on their own are not a complete regulatory framework
Accounting standards
Accounting standards on their own are not a complete regulatory framework
Legal and market regulations are also required to regulate the preparation and presentation of
financial statements.
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Syllabus A3c)
Distinguish between a principles based and a rules based framework and discuss whether they can
be complementary
Principles-based and a rules-based framework
Principles-based Framework
• Principles which reflect the initial objectives of financial statements are set.
All accounting standards then follow these principles.
• Therefore, a principles-based framework is based upon a conceptual framework.
Rules-based Framework
• Rules are laid out as events arise, designed to cover all eventualities.
• Therefore, accounting standards are a set of rules which companies must follow.
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Syllabus A3d)
Describe the IASB’s Standard setting process including revisions to and interpretations of Standards.
Standard Setting Process
International Financial Reporting Standards (IFRSs) are developed through
an international consultation process, the "due process”.
The due process comprises six stages:
1
Setting the agenda
The IASB identifies a subject (mainly by reference to the needs of the
investors)
2
Planning the project
After considering the nature of the issues and the level of interest among
constituents, the IASB may establish a working group at this stage
3
Developing and publishing the discussion paper
4
Developing and publishing the exposure draft
for public comment, which is a draft version of the intended standard
5
Developing and publishing the standard
6
After the standard is issued, the staff and the IASB members hold regular
meetings with interested parties, to help understand unanticipated
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issues related to the practical implementation and potential impact of its
proposals
The IFRS Interpretations Committee
It has the following roles:
1
Interpret the application of IFRSs
2
Provide timely guidance on financial reporting issues not specifically
addressed in IFRSs
3
Publish draft Interpretations for public comment
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Syllabus A3d)
Explain the relationship of national standard setters to the IASB in respect of the standard setting
process.
National standard setters and the IASB
The IASB works in partnership with the major national standard-setting
bodies
They do this by:
• Co-ordinating each others work plans
• Review each others standards
• National standard setters can issue IASB discussion papers and exposure draft for comments
in their own countries
• National standard setters may include more guidance in their exposure drafts on relevant
issues to them
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Syllabus A4. The Concept Of A Group
Syllabus A4a) Describe the concept of a group as a single economic unit.
A single economic unit
Parent and Sub are deemed to be parts of the SAME company from a group
perspective
However LEGALLY each member is a separate legal entity and therefore the group itself IS NOT a
separate legal entity
This focuses on a criticism of group accounts where the assets and liabilities of P and S are added
together
This can give the impression that all of the group’s assets would be available to discharge all of the
group’s liabilities
This is not the case
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Syllabus A4b)
Explain and apply the definition of a subsidiary within relevant accounting standards.
Definition of a subsidiary
Group Accounting
According to IAS 1 accounts must distinguish between:
1
Profit or Loss for the period
2
Other gains or losses not reported in profits above (Other Comprehensive Income)
3
Equity transactions (share issues and dividends)
Here's some key definitions:
Consolidated financial statements:
The financial statements of a group presented as those of a single economic entity.
Subsidiary: an entity that is controlled by another entity (known as the parent)
Parent: an entity that has one or more subsidiaries
Control: the power to govern the financial and operating policies of an entity so as to obtain
benefits from its activities
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Identification of subsidiaries
Control is presumed when the parent has 50% + voting rights of the entity.
Even when less than 50%, control may be evidenced by power..
•
Getting the 50%+ by an arrangement with other investors
•
Governing the financial and operating policies
•
Appointing the majority of the board of directors
•
Casting the majority of votes
It could also come from the parent controlling one subsidiary, which in turn controls another.
The parent then controls both subsidiaries
Power
• So a parent needs the power to affect the subsidiary and as we said before this is normally
given by owning more than 50% of the voting rights
• It might also come from complex contractual arrangements
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Syllabus A4b)
Explain and apply the definition of a subsidiary within relevant accounting standards.
Group accounts principles
Some more definitions
Consolidated financial statements
Where assets, liabilities, equity, income, expenses and cash flows of the parent and its subs are
presented as those of a single economic entity
Control of an investee
An investor controls an investee when the investor is exposed, or has rights, to the variable returns
of the investee
Also it has the ability to affect those returns through its power
Parent
An entity that controls one or more entities
Power
Existing rights that give the current ability to direct the relevant activities
Protective rights
Rights designed to protect rather than control
Relevant activities
Activities of the investee that significantly affect the investee's returns
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What is CONTROL exactly?
Firstly as an investor you need to decide if you are a PARENT or not..
This means do you control the investment or not
An investor controls when it is exposed, or has rights, to variable returns from its involvement with
the investee (investment) and has the ability to affect those returns through its power eg….
•
Existing rights give the ability to direct the relevant activities
•
Exposure, or rights, to variable returns from its involvement with the investee
•
Ability to use power over the investee to affect the amount of the it's return
Rights to variable returns
•
Through straightforward voting rights
•
Can't be just protective rights
•
Rights to make decisions over the investment (not on behalf of someone else
though)
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Syllabus A4c)
Using accounting standards and other regulation, identify and outline the circumstances in which a
group is required to prepare consolidated financial statements.
When is a group required to prepare consolidated financial
statements
IAS 27 outlines the circumstances in which a group is required to prepare
consolidated FS
Consolidated financial statements should be prepared when the parent company has control over
the subsidiary. Control is usually based on ownership of more than 50% of voting power.
However, IAS 27 lists the following situations where control exists, even when the parent
owns only 50% or less of the voting power of an enterprise
•
The parent has power over more than 50% of the voting rights by virtue of
agreement with other investments
•
The parent has power to govern the financial and operating policies of the
enterprise by statute or under an agreement
•
The parent has the power to appoint or remove a majority of members of the board
of directors (or equivalent governing body)
•
The parent has power to cast a majority of votes at meetings of the board of
directors
As per IFRS 10, “an investor controls an investee if and only if the investor has all of the
following elements:
•
power over the investee i.e. the investor has existing rights that give it the ability to
direct the relevant activities (the activities that significantly affect the investee’s
returns)
•
exposure, or rights to variable returns from its involvement with the investee
•
the ability to use its power over the investee to affect the amount of the investor’s
returns.”
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Syllabus A4d)
Describe the circumstances when a group may claim exemption from the preparation of
consolidated financial statements.
Exemptions from the preparation of consolidated
accounts?
Always produce group accounts...unless
Exceptions
1
The parent is itself a 100% subsidiary
2
The parent isn't a 100% sub but the other owners don't mind the parent not
preparing group accounts
3
The parent's loans or shares are not traded in a public market
4
The parent didn't file its accounts with a stock exchange (in order to issue shares)
5
The ultimate parent already produces group accounts
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Syllabus A4e)
Explain why directors may not wish to consolidate a subsidiary and when this is permitted by
accounting standards and other applicable regulation.
Why directors may not wish to consolidate a subsidiary
The directors of a parent company may not wish to consolidate some
subsidiaries due to:
•
Poor performance of the subsidiary
•
Poor financial position of the subsidiary
•
Differing activities (nature) of the subsidiary from the rest of the group
These reasons are not permitted according to IFRSs.
As already mentioned, consolidated financial statements should include all subsidiaries of the
parent.
IFRS 3 requires exclusion from consolidation only if the parent has lost control over its investment.
An entity loses control when it loses the power to govern its financial and operating policies. This
could occur, for e.g., where a subsidiary becomes subject to the control of the government, a
regulator, a court of law, or as a result of a contractual agreement.
If a parent loses control of a subsidiary, the parent:
•
de-recognises the assets and liabilities of the former subsidiary from the
consolidated SF
•
recognises any investment retained in the former subsidiary at its fair value
•
recognises the gain or loss associated with the loss of control attributable to the
former controlling interest.
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If, on acquisition, a subsidiary meets the criteria to be classified as ‘held for sale’ in accordance
with IFRS 5 (i.e. there should be evidence that the subsidiary has been acquired with the intention
to dispose of it within 12 months, and that management is actively seeking a buyer), then it must
still be included in the consolidation but accounted for in accordance with that standard.
The parent’s interest will be presented separately as a single figure on the face of the consolidated
SFP, rather than being consolidated like any other subsidiary.
This will be described in more detail when we do IFRS 3.
This might occur when a parent has acquired a group with one or more subsidiaries that do not fit
into its long-term strategic plans are therefore likely to be sold.
A subsidiary that has previously been excluded from consolidation and is not disposed of within the
12 month period must be consolidated from the date of acquisition.
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Syllabus A4f)
Explain the need for using coterminous year ends and uniform accounting polices when preparing
consolidated financial statements.
Co-terminous Year-ends and Accounting policies
Ideally P and S should have the same year end and accounting policies
The accounts of the parent and its subsidiaries (used for the group accounts) should all have the
same reporting date, unless it is impracticable to do so.
If it is impracticable, adjustments must be made for the effects of significant transactions or events
that occur between the dates of the subsidiary's and the parent's year end.
The difference must never be more than three months.
Consolidated financial statements must be prepared using uniform accounting polices for like
transactions and other events in similar circumstances.
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Syllabus A4g)
Explain why it is necessary to eliminate intra group transactions.
Intra-group transactions
Intra-group balances, transactions should be eliminated in full
Intra-group balances, transactions, income, and expenses should be eliminated in full.
Intra-group losses may indicate that an impairment loss on the related asset should be recognised.
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Syllabus A4h)
Explain the objective of consolidated financial statements.
Objective of consolidated financial statements
The objective of the consolidated financial statements is to show the position
of the group as if it were a single economic entity, therefore:
1
Assets and liabilities of P and S are included in the consolidated statement of
financial position
2
Income and expenses of P and S are included in the consolidated statement of
profit or loss.
3
All the other comprehensive income of P and S is included in the consolidated
statement of profit or loss and other comprehensive income showing other
comprehensive income.
4
Intra-group balances are eliminated
5
The parent’s investment in each subsidiary is offset against the parent’s portion of
equity of each subsidiary.
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Syllabus A4i)
Explain why it is necessary to use fair values for the consideration for an investment in a subsidiary
together with the fair values of a subsidiary’s identifiable assets and liabilities when preparing
consolidated financial statements.
Why use Fair values when calculating goodwill?
This is to ensure goodwill is calculated correctly
If a company has net assets of 100 in its accounts - these aren't necessarily at FV.
Lets say the FV is actually 120.
Now someone buys this company for 150 - how much is goodwill?
If FV of assets is used then it is 30 (this is the correct figure).
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Syllabus A4j)
Define an associate and explain the principles and reasoning for the use of equity accounting.
Associates
Associates
An associate is an entity over which the group has significant influence, but not control.
Significant influence
Significant influence is normally said to occur when you own between 20-50% of the shares in a
company but is usually evidenced in one or more of the following ways:
•
representation on the board of directors
•
participation in the policy-making process
•
material transactions between the investor and the investee
•
interchange of managerial personnel; or
•
provision of essential technical information
Accounting treatment
An associate is not a group company and so is not consolidated. Instead it is accounted for using
the equity method. Inter-company balances are not cancelled.
Statement of Financial Position
There is just one line only “investment in Associate” that goes into the consolidated SFP (under the
Non-current Assets section).
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It is calculated as follows:
Consolidated income statement
Again just one line in the consolidated income statement:
Include share of PAT less any impairment for that year in associate.
Do not include dividend received from A.
What’s important to notice is that you do NOT add across the associate’s Assets and Liabilities or
Income and expenses into the group totals of the consolidated accounts. Just simply place one line
in the SFP and one line in the Income Statement.
Unrealised profits for an associate
1
Only account for the parent’s share (eg 40%).
This is because we only ever place in the consolidated accounts P’s share of A’s
profits so any adjustment also has to be only P’s share.
2
Adjust earnings of the seller
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Syllabus B: ACCOUNTING FOR TRANSACTIONS
IN FINANCIAL STATEMENTS
Syllabus B1. Tangible non-current assets
Syllabus B1a) Define and compute the initial measurement of a non-current asset (including
borrowing costs and an asset that has been self-constructed).
Initial Recognition of PPE
When should we bring PPE into the accounts?
When the following 3 tests are passed:
1
When we control the asset
2
When it’s probable that we will get future economic benefits
3
When the asset’s cost can be measured reliably
What gets included in ‘Cost'
1
Directly attributable costs to get it to work and where it needs to be
eg. site preparation, delivery and handling, installation, related professional fees for
architects and engineers.
2
Estimated cost of dismantling and removing the asset and restoring the site.
This is:
Dr PPE
Cr Liability
All at present value
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This will need discounting and the discount unwound:
Dr interest (with unwinding of discount)
Cr liability
3
Borrowing costs
If it is an asset that takes a while to construct.
Interest at a market rate must be recognised or imputed.
Let's look at the Future obligated costs in detail..
Future obligated costs
Dr PPE
Cr Liability
at present value
•
The present value is calculated by discounting down at the rate given in the exam
eg. 100 in 2 years time at 10% = 100/1.10/1.10 = 82.6
•
So the double entry would be:
Dr PPE 82.6
Cr Liability 82.6
However the LIABILITY needs unwinding..
•
Unwinding of discount
Dr Interest
Cr Liability
Use the original discount rate (so here 10%)
10% x 82.6 = 8.26
Dr Interest 8.26
Cr Liability 8.26
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Syllabus B1a) Define and compute the initial measurement of a non-current asset (including
borrowing costs and an asset that has been self-constructed).
Borrowing Costs
Let’s say you need to get a loan to construct the asset of your dreams - well the interest on the
loan then is a directly attributable cost.
So instead of taking interest to the I/S as an expense you add it to the cost of the asset.
(in other words - you capitalise it)
There are 2 scenarios here to worry about:
1. You use current borrowings to pay for the asset
2. You get a specific loan for the asset
1) Use current borrowings
This is looking at the scenario where we use funds we have already borrowed from different
sources.
So, if the funds are borrowed generally – we need to calculate the weighted average cost of all the
loans we have generally.
(I know you're thinking - how the cowing'eck do I work out the weighted average of borrowings...
aaarrgghh!).
Well relax my little monkey armpit - here's how you do it:
•
•
•
•
Calculate the total amount of borrowings
Calculate the interest payable on these in total
Weighted average of borrowing costs = Divide the interest by the borrowing - et voila!
We then take this weighted average of borrowing costs and multiply it by any expenditure on the
asset.
The amount capitalised should not exceed total borrowing costs incurred in the period.
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Illustration
5% Overdraft 1,000
8% Loan 3,000
10% Loan 2,000
We buy an asset with a cost of 5,000 and it takes one year to build - how much interest goes
to the cost of the asset?
Solution
Calculate the WA cost of the borrowings:
• Total Borrowing = (1,000+3,000+2,000) = 6,000
• Interest payable = (50+240+200) = 490
490/6,000 = 8.17%
• So the total interest to be added to the asset is 8.17% x 5,000 = 408
2) Get a specific loan
Ok well you would think this is easy - just the interest paid, surely?! But it’s not quite that easy…
It is the actual borrowing costs less investment income on any temporary investment of the funds
So what does this mean exactly?
Well imagine you need 10,000 to build something over 3 years. You borrow 10,000 at the start but
dont need it all straight away.
So the bit you dont need you leave in the bank to gain interest
So, the amount you could capitalise would be the interest paid on the 10,000 less the interest
received on the amount not used and left in the bank (or reinvested elsewhere)
Steps:
1. Calculate the interest paid on the specific loan
2. Calculate any interest received on loans proceeds not used
3. Add the net of these 2 to 'cost of the asset'
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Illustration
Buy asset for 2,000 - takes 2 years to build.
Get a 2,000 10% loan.
We reinvest any money not used in an 8% deposit account.
In year 1 we spend 1,200.
How much interest is added to the cost of the asset?
• Interest Paid = 2,000 x 10% = 200
• Interest received = ((2,000-1,200) x 8%) = 64
• Dr PPE Cost (200-64) = 136
Cr Interest Accrual
Basic Idea
Borrowing costs that are directly attributable to the acquisition, construction or production of a
qualifying asset form part of the cost of that asset.
Other borrowing costs are recognised as an expense.
So what is a “Qualifying asset?”
It is one which needs a substantial amount of time to get ready for use or sale.
This means it can’t be anything that is available for use when you buy it.
It has to take quite a while to build (PPE, Investment Properties, Inventories and Intangibles).
You don’t have to add the interest to the cost of the following assets:
• Assets measured at fair value,
• Inventories that are manufactured or produced in large quantities on a repetitive basis even if
they take a substantial period of time to get ready for use or sale.
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When should we start adding the interest to the cost of the asset?
Capitalisation starts when all three of the following conditions are met:
• Expenditure begins for the asset
• Borrowing costs begin on the loan
• Activities begin on building the asset e.g. Plans drawn up, getting planning etc.
So just having an asset for development without anything happening is not enough to qualify for
capitalisation
Are borrowing costs just interest?
It’s actually any costs that an entity incurs in connection with the borrowing of funds.
So it includes:
• Interest expense calculated using the effective interest method.
• Finance charges in respect of finance leases
What about if the activities stop temporarily?
Well you should stop capitalising when activities stop for an extended period
During this time borrowing costs go to the profit or loss.
Be careful though - If the temporary delay is a necessary part of the construction process then you
can still capitalise, e.g. Bank holidays etc.
When will capitalisation stop?
Well, when virtually all the activities work is complete.
This means up to the point when just the finalising touches are left.
NB
• Stop capitalising when AVAILABLE for use. This tends to be when the construction is finished
• If the asset is completed in parts then the interest capitalisation is stopped on the completion of
each part
• If the part can only be sold when all the other parts have been completed, then stop capitalising
when the last part is completed
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Syllabus B1b)
Identify subsequent expenditure that may be capitalised, distinguishing between capital and revenue
items.
Capital and revenue items
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Capital expenditure results in the appearance of a non-current asset in the statement of financial
position of the business.
Revenue expenditure results in an expense in the statement of profit or loss.
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Syllabus B1cd)
c) Discuss the requirements of relevant accounting standards in relation to the revaluation of noncurrent assets.
d) Account for revaluation and disposal gains and losses for non-current assets.
PPE - After Initial recognition
After the initial recognition there are 2 choices:
Cost model
•
Cost less accumulated depreciation and impairment
•
Depreciation should begin when ready for use not wait until actually used
Revaluation model
Fair value at the date of revaluation less depreciation
•
If we follow the revaluation model - how often should we revalue?
Revaluations should be carried out regularly
For volatile items this will be annually, for others between 3-5 years or less if
deemed necessary.
•
Ok and which assets get revalued?
If an item is revalued, its entire class of assets should be revalued
•
And to what value?
Market value normally is fair value.
Specialised properties will be revalued to their depreciated replacement cost.
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Accounting treatment of a Revaluation
If you revalue the asset UP ("Revaluation Gain")
Any increase is credited to equity under the heading "revaluation surplus" (and shown in the OCI "Revaluation gain”)
•
DR Asset
•
CR equity (Reserve) - “Revaluation Surplus”
If you revalue the asset DOWN ("Impairment loss")
is taken to the income statement.
•
DR I/S ("Impairment loss")
•
CR Assets
If you revalue the asset UP and then DOWN ("Revaluation loss")
Any decrease down is taken to the revaluation reserve (and OCI) as a debit.
•
DR equity (Reserve) - “revaluation loss”
•
CR Assets
If you revalue the asset DOWN and then UP ("Reversal of Impairment")
Any decrease below depreciated historic cost is debited to the income statement
•
DR Assets
•
CR Income statement ("Reversal of impairment”)
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Disposal of a Revalued Asset
The revaluation surplus in equity - IS NOT transferred to the income statement - it just drops into
RE.
It will, therefore, only show up in the statement of changes in equity.
Let´s make no mistake about this - the revaluation adjustments can be very tricky.
when you revalue upwards:
1
the asset will increase .... therefore
2
the depreciation will increase ... and hence
3
the expenses will increase ...
4
This means smaller profits and smaller retained earnings just because of the
revaluation!
Shareholders will not be impressed by this as retained earnings are where they are legally allowed
to get their dividends from.
Because of this, a transfer is made out of the revaluation reserve and into retained earnings every
year with the extra depreciation caused by the previous revaluation.
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Syllabus B1e)
Compute depreciation based on the cost and revaluation models and on assets that have two or
more significant parts (complex assets).
Depreciation
Where assets held by an enterprise have a limited useful life, it is necessary to apportion the value
of an asset used in a period against the revenue it has helped to create.
Therefore, with the exception of land held on freehold or very long leasehold, every non-current
asset has to be depreciated.
A charge is made in the income statement to reflect the use that is made of the asset by the
business.
This charge is called depreciation.
The need to depreciate non-current assets arises from the accrual assumption.
If money is spent on an asset, then the amount must be charged against profits.
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Some key terms are:
•
Depreciation
the allocation of the depreciable amount of an asset over its estimated useful life.
•
Useful life
the period over which a depreciable asset is expected to be used by the enterprise;
or the number of production or similar units expected to be obtained from the asset
by the enterprise.
•
Depreciable amount
cost/revalued amount less residual value
•
Residual value
the amount the asset is expected to be sold for at the end of its useful life. It is also
known as scrap value
2 Methods of Depreciation
1
Straight line method
2
Reducing balance method
1) Straight line method
The depreciation charge is the same every year.
•
Formula
(Cost of asset - residual value) / expected useful life of asset
OR
(Cost - Residual value) × %
This method is suitable for assets which are used up evenly over their useful life, e.g. fixtures and
fittings in the accounts department.
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Illustration
A non-current asset costing $60,000 has an estimated life of 5 years and a residual value of
$7,000.
Required:
(a) Calculate the annual depreciation charge.
(b) Calculate the cost, accumulated depreciation and net book value (NBV) for each year of the
assets life.
•
a) ($60,000 - $7,000) / 5 years = $10,600 depreciation charge per year
•
b)
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2) Reducing balance method
This method is suitable for those assets which generate more revenue in earlier years than in later
years; for example machinery in a factory where productivity falls as the machine gets older.
Under this method the depreciation charge will be higher in the earlier years and reduce over time.
•
Formula:
Depreciation rate (%) × Net Book Value (NBV)
Net book value (NBV) = cost - accumulated depreciation to date
This method ignores residual value.
Illustration
A business buys a lorry costing $17,000.
After 5 years, it is expected to be sold for scrap for $2,000.
The depreciation rate is 35% on a reducing balance basis.
Required:
Calculate depreciation expense, accumulated depreciation and net book value of the machine for
these five years using the reducing balance basis.
•
Solution
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Double-Entry for Depreciation
Depreciation has a dual effect which needs to be accounted for:
1
It reduces the value of the asset in the statement of financial position.
2
It is an expense in the income statement.
The double-entry for depreciation is:
•
Dr Depreciation expense (I/S)
Cr Accumulated Depreciation (SFP)
with the depreciation charge for the period.
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Syllabus B1e)
Compute depreciation based on the cost and revaluation models and on assets that have two or
more significant parts (complex assets).
Components
Various components of an asset to be identified and depreciated separately
if they have differing patterns of benefits.
If a significant component is expected to wear out quicker than the overall asset, it is depreciated
over a shorter period.
Then any restoring or replacing is capitalised.
This approach means different depreciation periods for different components.
Examples are land, roof, walls, boilers and lifts.
So the depreciation reflects the effect of a future restoration or replacement.
A challenging process
due to..
•
Difficulties valuing components
because it is unusual for the various component parts to be valued, so..
1
Involve company personnel in the analysis
2
Applying component accounting to all assets
3
How far the asset should be broken down into components
4
Any measure used to determine components is subjective
5
Asset registers may need to be rewritten
6
Breaking down assets needs ‘materiality', setting a de minimis limit
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•
When a component is replaced or restored
The old component is de-recognised to avoid double-counting and the new
component recognised.
•
Where it is not possible to determine the carrying amount of the replaced part
of an item of PPE
Best estimates are required.
A possibility is:
◦
Use the replacement cost of the component, adjusted for any subsequent
depreciation and impairment
•
A revaluation
Apportion over the significant components.
•
When a component is replaced
1
The carrying value of the component replaced should be charged to the
income statement
2
The cost of the new component recognised in the statement of financial
position
Transition to IFRS
Use the ‘fair value as deemed cost’ for the asset:
•
The fair value is then allocated to the different significant parts of the asset
Componentisation adds to subjectivity.
The additional depreciation charge can be significant.
Accountants and other professionals must use their professional judgment when establishing
significance levels, assessing the useful lives of components and apportioning asset values over
recognised components.
Discussions with external auditors will be key one during this process.
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Syllabus B1fg)
f) Discuss why the treatment of investment properties should differ from other properties.
g) Apply the requirements of relevant accounting standards to an investment property.
IAS 40 Investment property
A building (or land) owned but not used - just an investment
The building is not used it just makes cash by:
1
its FV going up (capital appreciation) or
2
from rental income
It might not even belong to the entity it could even be just on an operating lease.
This is still an IP (if the FV model is used).
This allows leased land (which is normally an operating lease) to be classified as investment
property.
Land held for indeterminate future use is an investment property where the entity has not decided
that it will use the land as owner occupied or for short-term sale.
Accounting treatment for the Rental Income
1
Add it to the income statement
2
Easy! (Even for a gonk like you!) :p
Accounting treatment for the FV increase
•
The difference in FV each year goes to the I/S
•
Double easy - double gonky
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No depreciation is needed because it's not used :)
Give me examples of what can be Investment Properties cowy.
ok you asked for it:
1
Land held for long-term capital appreciation rather than short-term sale
2
Land held for a currently undetermined future use
This basically means they haven't yet decided what to do with the land
3
A building owned but leased to a third party under an operating lease
4
A building which is vacant but is held to be leased out under an operating lease
5
Property being constructed or developed for future use as an investment property
Ok smarty pants - what ISN'T an Investment property?
•
Property intended for sale in the ordinary course of business
(It's stock!)
•
Owner-occupied property
•
Property leased to another entity under a finance lease
•
Property being constructed for third parties
Parts of property
These can be investment properties if the different sections can be sold or leased separately.
Mais oui, monsier/madame
For example, company owns a building and uses 4 floors and rents out 1. The latter
can be an IP while the rest is treated as normal PPE.
Can it still be an IAS 40 Investment property if we are involved in the building still by giving
services to it?
Si Claro hombre/mujer - It´’s still an IAS 40 Investment property if the supply is small and
insignificant.
If it’s a significant part of the deal with the tenant then the property becomes an IAS
16 property.
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What if my subsidiary uses it but I don’t?
Right ok - now your questions are getting on my nerves… but still - it’s an IAS 40 Investment
property in your own individual accounts - because you personally are not using it.
However, in the group accounts it´s an IAS 16 property because someone in the group is using it.
..now enough of the questions already.. get back to facebook ..
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Syllabus B2. Intangible non current assets
Syllabus B2a) Discuss the nature and accounting treatment of internally generated and purchased
intangibles.
Syllabus B2c) Describe the criteria for the initial recognition and measurement of intangible assets.
IAS 38 Intangible asset
What is an Intangible asset?
Well, according to IAS 38, it’s an identifiable non-monetary asset without physical substance,
such as a licence, patent or trademark.
The three critical attributes of an intangible asset are:
1
Identifiability
2
Control (power to obtain benefits from the asset)
3
Future economic benefits
Whooah there partner, what´s identifiable mean??
Well it just means the asset is one of 2 things:
1
It is SEPARABLE, meaning it can be sold or rented to another party on its own
(rather than as part of a business) or
2
It arises from contractual or other legal rights.
It is the lack of identifiability which prevents internally generated goodwill being recognised. It is not
separable and does not arise from contractual or other legal rights.
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Examples
•
Employees can never be recognised as an asset; they are not under the control of
the employer, are not separable and do not arise from legal rights
•
A taxi licence can be an intangible asset as they are controlled, can be sold/
exchanged/transferred and arise from a legal right
(The intangible doesn’t have to be separable AND arise from a legal right, just one
or the other is enough).
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Syllabus B2b)
Distinguish between goodwill and other intangible assets.
When can you recognise an IA and for how much?
Well it's the old reliably measurable and probable again!
In posher terms…
1
When it is probable that future economic benefits attributable to the asset will flow to
the entity
2
The cost of the asset can be measured reliably
So at how much should we show the asset at initially?
Well thick pants - it’s obviously brought in at cost!! Aaarh but what is cost I hear you whisper in my
big floppy cow-like ears.. well it’s
Purchase price plus directly attributable costs
Remember that directly attributable means costs which otherwise would not have been paid, so
often staff costs are excluded.
Let’s now look at some specific issues that come up often in the exam:
•
IA acquired as part of a business combination
Well this time, the intangible asset (other than goodwill ) should initially be
recognised at its fair value.
If the FV cannot be ascertained then it is not reliably measurable and so cannot be
shown in the accounts.
In this case by not showing it, this means that goodwill becomes higher.
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•
Research and Development Costs
Research costs are always expensed in the income statement.
Development costs are capitalised only after technical and commercial feasibility of
the asset for sale or use have been established.
This means that the enterprise must intend and be able to complete the intangible
asset and either use it or sell it and be able to demonstrate how the asset will
generate future economic benefits.
If entity cannot distinguish between research and development - treat as research
and expense.
•
Research and Development Acquired in a Business Combination
Recognised as an asset at cost, even if a component is research.
Subsequent expenditure on that project is accounted for as any other research and
development cost.
•
Internally Generated Brands, Mastheads, Titles, Lists
Should not be recognised as assets - expense them as there is no reliable measure
•
Computer Software
If purchased: capitalise as an IA
Operating system for hardware: include in hardware cost
If internally developed: charge to expense until technological feasibility, probable
future benefits, intent and ability to use or sell the software, resources to complete
the software, and ability to measure cost.
Always expense the following:
1
Internally generated goodwill
2
Start-up, pre-opening, and pre-operating costs
3
Training cost
4
Advertising and promotional cost, including mail order catalogues
5
Relocation costs
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Syllabus B2b)
Distinguish between goodwill and other intangible assets.
Goodwill v Other intangibles
Goodwill is calculated as follows:
Goodwill may be due to:
•
Reputation for quality or service
•
Technical expertise
•
Possession of favourable contracts
•
Good management and staff
Negative goodwill
If the difference above is negative, the resulting gain is recognised as a bargain purchase in the
statement of profit or loss
Goodwill v Other intangibles
Main differences
•
It cannot be valued on its own
•
Goodwill cannot be disposed of as a separate asset
•
The factors contributing to the value of goodwill cannot be valued
•
The value of goodwill is volatile
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Syllabus B2de)
d) Describe the subsequent accounting treatment, including the principle of impairment tests in
relation to goodwill.
e) Indicate why the value of purchase consideration for an investment may be less than the value of
the acquired identifiable net assets and how the difference should be accounted for.
Impairment of Goodwill
Goodwill is reviewed for impairment not amortised
An impairment occurs when the subs recoverable amount is less than the subs carrying value +
goodwill.
How this works in practice depends on how NCI is measured - Proportionate or Fair Value method.
Proportionate NCI
Here, NCI only receives % of S's net assets.
NCI DOES NOT have any share of the goodwill.
1
Compare the recoverable amount of S (100%) to..
2
NET ASSETS of S (100%) + Goodwill (100%)
3
The problem is that goodwill on the SFP is for the parent only - so this needs
grossing up first
4
Then find the difference - this is the impairment - but only show the parent % of the
impairment
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Example
H owns 80% of S. Proportionate NCI
Goodwill is 80 and NA are 200
Recoverable amount is 240
How much is the impairment?
Solution
RA = 240
NA = 200 + G/W (80 x 100/80) = 100 = 300
Impairment is therefore 60.
The impairment shown in the accounts though is 80% x 60 = 48.
This is because the goodwill in the proportionate method is parent goodwill only. Therefore only
parent impairment is shown.
Fair Value NCI
Here, NCI receives % of S's net assets AND goodwill.
NCI DOES now own some goodwill.
1
Compare the recoverable amount of S (100%) to..
2
NET ASSETS of S (100%) + Goodwill (100%)
3
As, here, goodwill on the SFP is 100% (parent & NCI) - so NO grossing up needed
4
Then find the difference - this is the impairment - this is split between the parent and
NCI share
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Example
H owns 80% of S. Fair Value NCI
Goodwill is 80 and NA are 200
Recoverable amount is 240
How much is the impairment?
Solution
RA = 240
NA = 200 + G/W 80 = 280
Impairment is therefore 40.
The impairment shown in P's RE as 80% x 40 = 32.
The impairment shown in NCI is 20% x 40 = 8.
Impairment adjustment on the Income Statement
1
Proportionate NCI
Add it to P's expenses.
2
Fair Value NCI
Add it to S's expenses
(this reduces S's PAT so reduces NCI when it takes its share of S's PAT).
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Syllabus B2f)
Describe and apply the requirements of relevant accounting standards to research and development
expenditure.
Research and development
Research is expensed, Development is often an asset.
Research
Research is investigation to get new knowledge and understanding
All goes to I/S
Development
Under IAS 38, an intangible asset must demonstrate all of the following criteria:
(use pirate as a memory jogger)
1
Probable future economic benefits
2
Intention to complete and use or sell the asset
3
Resources (technical, financial and other resources) are adequate and available
to complete and use the asset
4
Ability to use or sell the asset
5
Technical feasibility of completing the intangible asset (so that it will be available
for use or sale)
6
Expenditure can be measured reliably
Once capitalised they should be amortised.
Amortisation begins when commercial production has commenced.
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Once capitalised they should be amortised
The cost of the development expenditure should be amortised over the useful life.
Therefore, the cost of the development expenditure is matched against the revenue it produces.
Amortisation must only begin when the asset is available for use (hence matching the income and
expenditure to the period in which it relates).
It is an expense in the income statement:
•
Dr Amortisation expense (I/S)
•
Cr Accumulated amortisation (SFP)
It must be reviewed at the year-end to check it still is an asset and not an expense.
If the criteria are no longer met, then the previously capitalised costs must be written off to the
statement of profit or loss immediately.
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Syllabus B3. Impairment of assets
Syllabus B3a) Define, calculate and account for an impairment loss.
Syllabus B3b) Account for the reversal of an impairment loss on an individual asset.
Syllabus B3c) Identify the circumstances that may indicate impairments to assets.
IAS 36 Impairments
A company cannot show anything in its accounts higher than what they’re
actually worth
“What they’re actually worth” is called the “Recoverable Amount”.
So no asset can be in the accounts at MORE than the recoverable amount.
Less is fine, just not more.
So, assets need to be checked that their NBV is not greater than the RA.
If it is then it must be impaired down to the RA.
So how do you calculate a Recoverable Amount?
There are 2 things an entity can do with an asset
1
Sell it or
2
Use it
It will obviously choose the one which is most beneficial.
So, you'll choose the higher of the following
•
FV-CTS
(Fair value less costs to sell)
•
VIU
(Value in use)
So the higher of the FV - CTS and VIU is called the Recoverable amount.
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Illustration
In the accounts an item of PPE is carried at 100.
It’s FV-CTS is 90 and its VIU is 80.
•
This means the recoverable amount is 90 (higher of FV-CTS and VIU)
•
And that the PPE (100) is being carried at higher than the RA, which is not allowed,
and so an impairment of 10 down to the RA is required in the accounts (100 - 90)
Recognition of an Impairment Loss
An impairment loss should be recognised whenever RA is below carrying amount.
The impairment loss is an expense in the income statement
Adjust depreciation for future periods.
Here's some boring definitions for you:
•
Fair value
The amount obtainable from the sale of an asset in a bargained transaction
between knowledgeable, willing parties.
•
Value in use
The discounted present value of estimated future cash flows expected to arise from:
- the continuing use of an asset, and from
- its disposal at the end of its useful life
Recoverable Amount in more detail
Fair Value Less Costs to Sell
•
If there is a binding sale agreement, use the price under that agreement less costs
of disposal
•
If there is an active market for that type of asset, use market price less costs of
disposal.
Market price means current bid price if available, otherwise the price in the most
recent transaction
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•
If there is no active market, use the best estimate of the asset's selling price less
costs of disposal (direct added costs only (not existing costs or overhead))
Let's look at VIU in more detail..
The future cash flows:
•
Must be based on reasonable and supportable assumptions
(the most recent budgets and forecasts)
•
Budgets and forecasts should not go beyond five years
•
The cashflows should relate to the asset in its current condition
– future restructuring to which the entity is not committed and expenditures to
improve the asset's performance should not be anticipated
•
The cashflows should not include cash from financing activities, or income tax
•
The discount rate used should be the pre-tax rate that reflects current market
assessments of the time value of money and the risks specific to the asset
Identifying an Asset That May Be Impaired
At each balance sheet date, review all assets to look for any indication that an asset may be
impaired.
If there is an indication that an asset may be impaired, then you must calculate the asset’s
recoverable amount... to see if it is below carrying value
if it is - then you must impair it
Illustration
Asset has carrying value of 100
It has a FV-CTS of 90
It has a VIU of 95
It's recoverable amount is therefore the higher of the 2 = 95 and this is below the carrying value in
the books (100) and so needs impairment of 5.
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What are the indicators of impairment?
1
Losses / worse economic performance
2
Market value declines
3
Obsolescence or physical damage
4
Changes in technology, markets, economy, or laws
5
Increases in market interest rates
6
Loss of key employees
7
Restructuring / re-organisation
Just to confuse you a little bit more, we do not JUST check for impairment when there has been an
indicator (listed above).
We also check the following ANNUALLY regardless of whether there has been an
impairment indicator or not:
1
an intangible asset with an indefinite useful life
2
an intangible asset not yet available for use
3
goodwill acquired in a business combination
Reversal of an Impairment Loss
First of all you need to think about WHY the impairment has been reversed..
1
Discount Rate Changes
Here, no reversal is allowed. So if the discount rate lowers and thus improves the
VIU, this is not considered to be a reversal of an impairment.
2
Other
The increased carrying amount due to reversal should not be more than what the
depreciated historical cost would have been if the impairment had not been
recognised
3
Accounting treatment
Reversal of an impairment loss is consistent with the original treatment of the
impairment in terms of whether recognised as income in the income statement or
OCI.
Reversal of an impairment loss for goodwill is prohibited.
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Syllabus B3de)
d) Describe what is meant by a cash generating unit.
e) State the basis on which impairment losses should be allocated, and allocate an impairment loss
to the assets of a cash generating unit.
Cash Generating Units
Sometimes individual assets do not generate cash inflows so the calculation
of VIU is impossible
In such a case then the asset will belong to a larger group that does generate cash.
This is called a cash generating unit (CGU) and it is the carrying value of this which is then tested
for impairment.
Recoverable amount should then be determined for the asset's cash-generating unit (CGU).
CGU - A restaurant
For example, the tables in a restaurant do not generate cash.
They do belong to a larger CGU though (the restaurant itself).
It is the restaurant that is then tested for impairment.
The carrying amount of the CGU is made up of the carrying amounts of all the assets directly
attributed to it.
Added to this will be assets that are not directly attributed such as head office and a portion of
goodwill.
Illustration
A subsidiary was acquired, which included 3 cash generating units and the goodwill for the whole
subsidiary was 40m.
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Each CGU would be allocated part of the 40 according to the carrying amount of the assets in each
CGU as follows:
A CGU to which goodwill has been allocated (like the 3 above) shall then be tested for impairment
at least annually by comparing the carrying amount of the unit, including the goodwill, with the
recoverable amount of the CGU.
If the carrying amount of the unit exceeds the recoverable amount of the unit, the entity must
recognise an impairment loss (down to the unit’s RA).
Order of Impairment
But the problem is what do you impair first - the assets or the goodwill in the unit?
The impairment loss is allocated in the following order:
1
Reduce any goodwill allocated to the CGU
2
Reduce the assets of the unit pro rata
Note: The carrying amount of an asset should not be reduced below its own recoverable
amount.
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Illustration
The following carrying amounts were recorded in the books of a restaurant immediately prior to the
impairment:
The fair value less costs to sell of these assets is $260m whereas the value in use is $270m.
Required: Show the impact of the impairment
Solution
Recoverable amount is 270 - so the CV of the CGU needs to be reduced from 300 to 270 = 30
This 30 reduces goodwill down to 70.
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Syllabus B4. Inventory and biological assets
Syllabus B4a) Describe and apply the principles of inventory valuation.
Basic Inventory
Inventories should be measured at the lower of cost and net realisable value.
What goes into ‘cost'?
1
Purchase price
2
Conversion costs
3
Costs to bring into current location & condition
What does NOT go into ‘cost'
•
Abnormal amounts
•
Storage costs
•
Administration overheads
•
Selling costs
Illustration
Item A has the following costs:
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What is the ‘cost'
Solution
328
Include everything except admin costs
Net Realisable Value
The net realisable value of an item is essentially its net selling proceeds after all costs have been
deducted.
It is calculated as follows..
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Syllabus B4b)
Apply the requirements of relevant accounting standards for biological assets.
Accounting for Biological Assets
Learn by Doing!
Try our revolutionary new technique - where you literally learn by doing :)
No teaching, nada.
Just follow these simple steps:
1
Do the Quiz now
Try and get as many right as possible - read the questions and explanations
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2
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You should feel comfortable with Agriculture IAS 41 - and who would have thought that half an hour
ago? ;)
Good luck!
Here is a link to the quiz
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Syllabus B5. Financial instruments
Syllabus B5a) Explain the need for an accounting standard on financial instruments.
Syllabus B5b) Define financial instruments in terms of financial assets and financial liabilities.
Syllabus B5e) Distinguish between debt and equity capital.
Financial Instruments - Introduction
Ok, ok, relax at the back - this is not as bad as it seems… trust me
Definition
•
First of all it must be a contract
•
Then it must create a financial asset in one entity and a financial liability or equity
instrument in another.
•
Examples:
An obvious example is a trade receivable. There is a contract, one company has the
debt as a financial asset and the other as a liability
•
Other examples:
Cash, investments, trade payables and loans….
And the trickier stuff…..
It also applies to derivatives financial such as call and put options, forwards, futures, and swaps.
And the just plain weird….
It also applies to some contracts that do not meet the definition of a financial instrument, but have
characteristics similar to derivative financial instruments.
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Such as precious metals at a future date when the following applies:
1
The contract is subject to possible settlement in cash NET rather than by
delivering the precious metal
2
The purchase of the precious metal was not normal for the entity
The trick in the exam is to look for contracts which state “will NOT be delivered” or “can be settled
net” - these are almost always financial instruments.
The following are NOT financial instruments:
Anything without a contract, e.g. Prepayments
Anything not involving the transfer of a financial asset, e.g. Deferred income and Warranties
Recognition
The important thing to understand here is that you bring a FI into the accounts when you enter into
the contract NOT when the contract is settled. Therefore derivatives are recognised initially even if
nothing is paid for it initially.
Substance over form
Form (legally) means a preference share is a share and so part of equity. HOWEVER, a substance
over form model is applied to debt/equity classification. Any item with an obligation, such as
redeemable preference shares, will be shown as liabilities.
De-recognition
This basically means when to get rid of it / take it out of the accounts
•
So you should do this when:
◦
The contractual rights you used to have have expired/gone
•
For Example
◦
You sell an asset and its benefits now go to someone else (no conditions attached)
•
You DONT de-recognise when..
◦
You sell an asset but agree to buy it back later (this means you still have an interest
in the risk and rewards later)
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The difference between equity and liabilities
IAS 32 Financial Instruments: Presentation
establishes principles for presenting financial instruments as liabilities or equity.
•
IAS 32 does not classify a financial instrument as equity or financial liability on the
basis of its legal form but the substance of the transaction.
The key feature of a financial liability
1
is that the issuer is obliged to deliver either cash or another financial asset to the
holder.
2
An obligation may arise from a requirement to repay principal or interest or
dividends.
The key feature of an Equity
has a residual interest in the entity’s assets after deducting all of its liabilities.
•
An equity instrument includes no obligation to deliver cash or another financial asset
to another entity.
•
A contract which will be settled by the entity receiving or delivering a fixed number of
its own equity instruments in exchange for a fixed amount of cash or another
financial asset is an equity instrument.
•
However, if there is any variability in the amount of cash or own equity instruments
which will be delivered or received, then such a contract is a financial asset or
liability as applicable.
An accounting treatment of the contingent payments on acquisition of the NCI in a
subsidiary
•
IAS 32 states that a contingent obligation to pay cash which is outside the control of
both parties to a contract meets the definition of a financial liability which shall be
initially measured at fair value.
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Syllabus B5d)
Indicate for the following categories of financial instruments how they should be measured and how
any gains and losses from subsequent measurement should be treated in the financial statements:
i) amortised cost
ii) fair value through other comprehensive income (including where an irrevocable election has been
made for equity instruments that are not held for trading)
iii) fair value through profit or loss
Financial Assets - Initial Measurement
There are 3 categories to remember:
Financial assets that are Equity Instruments
e.g. Shares in another company
These are easy - Just 2 categories
•
FVTPL
FVTPL = Fair Value through Profit & Loss
These are Equity instruments (shares) Held for trading
Normally, equity investments (shares in another company) are measured at FV in
the SFP, with value changes recognised in P&L
Except for those equity investments for which the entity has elected to report value
changes in OCI.
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•
FVTOCI
FVTOCI = Fair Value through Other Comprehensive Income
These are Equity instruments (shares) Held for longer term.
•
NB. The choice of these 2 is made at the beginning and cannot be changed
afterwards.
There is NO reclassification on de-recognition.
Financial Assets that are Receivable Loans
There are basically 3 types:
1
Fair Value Through Profit & Loss (FVTPL)
A receivable loan where capital and interest aren’t the only cashflows
2
FVTOCI
Receivable loans where the cashflows are capital and interest only BUT the
business model is also to sell these loans
3
Amortised Cost
A financial asset that meets the following two conditions can be measured at amortised
cost:
1
Business model test:
Do we normally keep our receivable loans until the end rather than sell them on?
2
Cashflows test
The contractual terms of the financial asset give rise on specified dates to cash
flows that are solely payments of principal and interest on the principal outstanding.
In other words:
Are the ONLY cashflows coming in capital and interest?
So what sort of things go into the FVTPL category?
•
If one of the tests above are not passed then they are deemed to fall into the FVTPL
category.
This will include anything held for trading and derivatives.
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INITIAL measurement
•
Good news! Initially both are measured at FV.
Easy peasy to remember.
The FV is calculated, as usual, as all cash inflows discounted down at the market
rate.
FVTPL can be:
1
Equity items held for trading purposes
2
Equity items not held for trading (but OCI option not chosen)
3
A receivable loan where capital and interest aren’t the only cashflows
Derivative assets are always treated as held for trading.
Initial recognition of trade receivables
1
Trade receivables without a significant financing component
Use the transaction price from IFRS 15
2
Trade receivables with a significant financing component
IFRS 9 does not exempt a trade receivable with a significant financing component
from being measured at fair value on initial recognition.
Therefore, differences may arise between the initial amount of revenue recognised
in accordance with IFRS 15 – and the fair value needed here in IFRS 9
Any difference is presented as an expense.
FVTOCI - Receivable loans held for cash and selling
Interest revenue, credit impairment and foreign exchange gain or loss recognised in P&L (in the
same manner as for amortised cost assets).
Other gains and losses recognised in OCI.
On de-recognition, the cumulative gain or loss previously recognised in OCI is reclassified from
equity to profit or loss.
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Syllabus B5d)
Indicate for the following categories of financial instruments how they should be measured and how
any gains and losses from subsequent measurement should be treated in the financial statements:
i) amortised cost
ii) fair value through other comprehensive income (including where an irrevocable election has been
made for equity instruments that are not held for trading)
iii) fair value through profit or loss
Financial assets - Accounting Treatment
So we have these 3 categories..
Initially both are measured at FV.
Now let's look at what happens at the year-end..
FVTPL accounting treatment
1
Revalue to FV
2
Difference to I/S
FVTOCI accounting treatment
1
Revalue to FV
2
Difference to OCI
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Amortised cost accounting treatment
1
Re-calculate using the amortised cost table
(see below)
An Example:
8% 100 receivable loan (effective rate 10% due to a premium on redemption)
Amortised Cost Table
The interest (10) is always the effective rate and this is the figure that goes to the income
statement.
The receipt (8) is always the cash received and this is not shown in the income statement - it just
decreases the carrying amount.
Any expected credit losses and forex gains/losses all go to I/S.
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Syllabus B5d)
Indicate for the following categories of financial instruments how they should be measured and how
any gains and losses from subsequent measurement should be treated in the financial statements:
i) amortised cost
ii) fair value through other comprehensive income (including where an irrevocable election has been
made for equity instruments that are not held for trading)
iii) fair value through profit or loss
Financial liabilities - Categories
There's only 2 categories, FVTPL and Amortised cost.. Yay!
Right-y-o, we’ve looked at recognising (bring into the accounts for those of you who are a
sandwich short of a picnic*) - now we want to look at HOW MUCH to bring the liabilities in at.
*A quaint old English saying - meaning you're an idiot :p
We already dealt with this on a tricky convertible loan.
Trust me this section is much easier.
Basically there are 2 categories of Financial Liability…
1
Fair Value Through Profit and Loss (FVTPL)
This includes financial liabilities incurred for trading purposes and also derivatives.
2
Amortised Cost
If financial liabilities are not measured at FVTPL, they are measured at amortised
cost.
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The good news is that whatever the category the financial liability falls into - we always recognise it
at Fair Value INITIALLY.
It is how we treat them afterwards where the category matters (and remember here we are just
dealing with the initial measurement).
Accounting Treatment of Financial Liabilities (Overview)
So - the question is - how do you measure the FV of a loan??
Well again the answer is simple - and you’ve done it already with compound instruments. All you
do is those 2 steps:
If the market rate is the same as the rate you actually pay (effective rate) then this is no problem
and you don’t really have to follow those 2 steps as you will just come back to the capital
amount…let me explain.
10% 1,000 Payable Loan 3 years
Capital 1,000 x 0.751 = 751
Interest 100
Total
x 2.486 = 249
1,000
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So the conclusion is - WHERE THE EFFECTIVE RATE YOU PAY (10%) IS THE SAME AS THE
MARKET RATE (10%) THEN THE FV IS THE PRINCIPAL - so no need to do the 2 steps.
Always presume the market rate is the same as the effective rate you’re paying unless told
otherwise by El Examinero.
Possible Naughty Bits
Premium on redemption
This is just another way of paying interest. Except you pay it at the end (on redemption).
e.g. 4% 1,000 payable loan - with a 10% premium on redemption.
This means that the EFFECTIVE interest rate (the rate we actually pay) is more than 4% - because
we haven’t yet taken into account the extra 100 (10% x 1,000) payable at the end. So the
examiner will tell you what the effective rate actually is - let’s say 8%.
The crucial point here is that you presume the effective rate (e.g. 8%) is the same as the market
rate (8%) so the initial FV is still 1,000.
Discount on Issue
Exactly the same as above - it is just another way of paying interest - except this time you pay it
at the start.
e.g. 4% 1,000 payable loan with a 5% discount on issue.
So again the interest rate is not 4%, because it ignores the extra interest you pay at the beginning
of 50 (5% x 1,000). So the effective rate (the rate you actually pay) is let’s say 7% (will be given in
the exam).
The crucial point here is that the discount is paid immediately. So, although you presume that the
effective rate (7%) is the same as the market rate (7% say), the INITIAL FV of the loan was 1,000
but is immediately reduced by the 50 discount - so is actually 950.
NB You still pay interest of 4% x 1,000 not 4% x 950
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Syllabus B5d)
Indicate for the following categories of financial instruments how they should be measured and how
any gains and losses from subsequent measurement should be treated in the financial statements:
i) amortised cost
ii) fair value through other comprehensive income (including where an irrevocable election has been
made for equity instruments that are not held for trading)
iii) fair value through profit or loss
Financial Liabilities - Amortised Cost
So, we’ve just looked at initial measurement (at FV) Now let’s look at how we
measure it from then onwards….
This is where the categories of financial liabilities are important - so let’s remind ourselves what
they are:
So you only have 2 rules to remember - cool…
1
FVTPL
- simple just keep the item at its FV (remember this is those 2 steps) and put the
difference to the income statement
2
Amortised Cost
- Amortised Cost is the measurement once the initial measurement at FV is done
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Amortised Cost
This is simply spreading ALL interest over the length of the loan by charging the effective interest
rate to the income statement each year.
If there’s nothing strange (premiums etc) then this is simple. For example
10% 1,000 Payable Loan
Now let’s make it trickier
10% 1,000 Loan with a 10% premium on redemption . Effective rate is 12%
So in year 1 the income statement would show an interest charge of 120 and the loan would be
under liabilities on the SFP at 1,020. This SFP figure will keep on increasing until the end of the
loan where it will equal the Loan + premium on redemption.
And trickier still…
10% 1,000 loan with a 10% discount on issue. Effective rate is 12%
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IFRS 9 requires FVTPL gains and losses on financial liabilities to be split into:
1
The gain/loss attributable to changes in the credit risk of the liability (to be placed in
OCI)
2
The remaining amount of change in the fair value of the liability which shall be
presented in profit or loss.
The new guidance allows the recognition of the full amount of change in the FVTPL only if the
recognition of changes in the liability's credit risk in OCI would create or enlarge an accounting
mismatch in P&L.
Amounts presented in OCI shall not be subsequently transferred to P&L, the entity may only
transfer the cumulative gain or loss within equity.
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Syllabus B5f)
Apply the requirements of relevant accounting standards to the issue and finance costs of:
i) equity
ii) redeemable preference shares and debt instruments with no conversion rights (principle of
amortised cost)
iii) convertible debt
Financial Instruments - Transactions costs
Transaction Costs
There will usually be brokers’ fees etc to pay and how you deal with these depends on the
category of the financial instrument…
For FVTPL - these go to the income statement
For everything else they get added/deducted to the opening balance.
So if it is an asset - it will increase the opening balance.
If it is a liability - it will decrease the opening balance.
Nb. If a company issues its own shares, the transaction costs are debited to share premium.
Illustration 1
A debt security that is held for trading is purchased for 10,000. Transaction costs are 500.
•
The initial value is 10,000 and the transaction costs of 500 are expensed.
Illustration 2
A receivable bond is purchased for £10,000 and transaction costs are £500.
•
The initial carrying amount is £10,500.
Illustration 3
A payable bond is issued for £10,000 and transaction costs are £500.
•
The initial carrying amount is £9,500.
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Note: With the amortised cost categories, the transaction costs are effectively being spread over
the length of the loan by using an effective interest rate which INCLUDES these transaction costs
Illustration: Transaction costs
An entity acquires a financial asset for its offer price of £100 (bid price £98)
IFRS 9 treats the bid-offer spread as a transaction cost:
1
If the asset is FVTPL
The transaction cost of £2 is recognised as an expense in profit or loss and the
financial asset initially recognised at the bid price of £98.
2
If the asset is classified as amortised cost
The transaction cost should be added to the fair value and the financial asset
initially recognised at the offer price (the price actually paid) of £100.
Treasury shares
It is becoming increasingly popular for companies to buy back shares as another way of giving a
dividend. Such shares are then called treasury shares.
Accounting Treatment
1
Deduct from equity
2
No gain or loss shown, even on subsequent sale
3
Consideration paid or received goes to equity
Illustration
Company buys back 10,000 (£1) shares for £2 per share. They were originally issued for £1.20
•
Dr RE 20,000 Cr Cash 20,000
The original share capital and share premium stays the same, just as it would have
done if they had been bought by a different third party.
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Syllabus B5d)
Indicate for the following categories of financial instruments how they should be measured and how
any gains and losses from subsequent measurement should be treated in the financial statements:
i) amortised cost
ii) fair value through other comprehensive income (including where an irrevocable election has been
made for equity instruments that are not held for trading)
iii) fair value through profit or loss
Financial Liabilities - convertible loans
When we recognise a financial instruments we look at substance rather than
form.
Anything with an obligation is a liability (debt).
However we now have a problem when we consider convertible payable loans. The ‘convertible’ bit
means that the company may not have to pay the bank back with cash, but perhaps shares.
So is this an obligation to pay cash (debt) or an equity instrument?
In fact it is both! It is therefore called a Compound Instrument.
Convertible Payable Loans
These contain both a liability and an equity component so each has to be shown separately.
•
This is best shown by example:
2% Convertible Payable Loan €1,000
•
This basically means the company has offered the bank the option to convert the
loan at the end into shares instead of simply taking €1,000
•
The important thing to notice is that that the bank has the option to do this.
•
Should the share price not prove favourable then it will simply take the €1,000 as
normal.
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Features of a convertible payable loan
1
Better Interest rate
The bank likes to have the option. Therefore, in return, it will offer the company a
favourable interest rate compared to normal loans.
2
Higher Fair Value of loan
This lower interest rate has effectively increased the fair value of the loan to the
company (we all like to pay less interest ;-))
We need to show all payable loans at their fair value at the beginning.
3
Lower loan figure in SFP
Important: If the fair value of a liability has increased the amount payable (liability)
shown in the accounts will be lower.
After all, fair value increases are good news and we all prefer lower liabilities!
How to Calculate the Fair Value of a Loan
So how is this new fair value, that we need at the start of the loan, calculated?
Well it is basically the present value of its future cashflows…
•
Step 1: Take what is actually paid (The actual cashflows):
Capital €1,000
Interest (2%) €20 pa.
Now let’s suppose this is a 4 year loan and that normal (non-convertible) loans carry
an interest rate of 5%.
•
Step 2: Discount the payments in step 1 at the market rate for normal loans
(Get the cashflows PV)
Take what the company pays and discount them using the figures above as follows:
Capital €1,000 discounted @ 5% (4 years SINGLE discount figure) = 1,000 x 0.823
= 823
Interest €20 discounted @ 5% (4 years CUMULATIVE)= 20 x 3.465 = 69
Total = 892
This €892 represents the fair value of the loan and this is the figure we use in the
balance sheet initially.
The remaining €108 (1,000-892) goes to equity.
Dr Cash 1,000
Cr Loan 892
Cr Equity 108
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•
Next we need to perform amortised cost on the loan (the equity is left untouched
throughout the rest of the loan period).
The interest figure in the amortised cost table will be the normal non-convertible rate
and the paid will the amounts actually paid.
The closing figure is the SFP figure each year
Now at the end of the loan, the bank decide whether they should take the shares or receive
1,000 cash…
Option 1: Take Shares (lets say 400 ($1) shares with a MV of $3)
Dr Loan 1,000
Dr Equity 108
Cr Share Capital 400
Cr Share premium 708 (balancing figure)
Option 2: Take the Cash
Dr Loan 1,000
Cr Cash 1,000
Dr Equity 108
Cr Income Statement 108
Conclusion
•
•
•
•
When you see a convertible loan all you need to do is take the capital and interest PAYABLE.
Then discount these figures down at the rate used for other non convertible loans.
The resulting figure is the fair value of the convertible loan and the remainder sits in equity.
You then perform amortised cost on the opening figure of the loan. Nothing happens to the figure
in equity.
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Convertible Payable Loan with transaction costs - eek!
Ok well remember our 2 step process for dealing with a normal convertible loan? No?? Well you’re
an idiot. However, luckily for you, I’m not so I will remind you :p
Step 1) Write down the capital and interest to be PAID
Step 2) Discount these down at the interest rate for a normal non-convertible loan
Then the total will be the FV of the loan and the remainder just goes to equity. Remember we do
this at the start of the loan ONLY.
Right then let’s now deal with transaction or issue costs.
These are paid at the start.
Normally you simply just reduce the Loan amount with the full transaction costs.
However, here we will have a loan and equity - so we split the transaction costs pro-rata
I know, I know - you want an example…. boy, you’re slow - lucky you’re gorgeous
eg 4% 1,000 3 yr Convertible Loan.
Transaction costs of £100 also to be paid.
Non convertible loan rate 10%
Step 1 and 2
Capital 1,000 x 0.751 = 751
Interest 40 x 2.486 = 99 (ish)
Total = 850
So FV of loan = 850, Equity = 150 (1,000-850)
Now the transaction costs (100) need to be deducted from these amounts pro-rata
So Loan = (850-85) = 765
Equity (150-15) = 135
And relax….
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Syllabus B5e)
Distinguish between debt and equity capital.
Debt and Equity
Loans go to debt (liabilities); ordinary shares go to equity. Why?
It is back to the conceptual framework again and also to the important concept of substance over
form.
The definition of liability includes the need for a present obligation.
As interest MUST be paid but dividends may not, only loans have this obligation and so go to
liabilities.
Normal Payable loans
These have an obligation to pay interest and capital
•
Debt
Redeemable Preference shares
These have an obligation to pay dividends and capital
•
Debt
Irredeemable Preference shares
These do NOT have an obligation to pay dividends and capital
•
Equity
Our own shares
These do NOT have an obligation to pay dividends or capital
•
Equity
Convertible loans
These do have an obligation but are also potential shares
•
Debt and Equity
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Syllabus B6. Leasing
Syllabus B6a) Account for right of use assets and lease liabilities in the records of the lessee.
Leases - definition
Leases - Definition
IFRS 16 gets rid of the Operating lease (which showed no liability on the SFP).
So, every lease now shows a liability!
Therefore the definition of what is a lease is super important (as it affects the amount of debt
shown on the SFP).
Here is that definition:
A contract that gives the right to use an asset for a period of time in exchange for
consideration.
So let's dig deeper
There's 3 tests to see if the contract is a lease..
1
The asset must be identifiable
This can be explicitly - it's in the contract
Or implicitly - the contract only makes sense by using this asset
(There is no identifiable asset if the supplier can substitute the asset (and would
benefit from doing so))
2
The customer must be able to get substantially all the benefits while it uses it
3
The customer must be able to direct how and for what the asset is used
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Example
A contract gives you exclusive use of a specific car
You can decide when to use it and for what
The car supplier cannot substitute / change the car
So does the contract contain a lease?
Does it pass the 3 tests?
1
Is there an Identifiable asset?
Yes the car is explicitly referred to and the supplier cannot substitute the car
2
Does the customer have substantially all benefits during the period?
Yes
3
Does the customer direct the use?
Yes he/she can use it for whatever and whenever they choose
So, yes this contract contains a lease because it's...
A contract that gives the right to use an asset for a period of time in exchange for
consideration.
Example
A contract gives you exclusive use of a specific airplane
You can decide when it flies and what you fly (passengers, cargo etc)
The airplane supplier though operates it using its own staff
The airplane supplier can substitute the airplane for another but it must meet specific conditions
and would, in practice, cost a lot to do so
So does the contract contain a lease?
Does it pass the 3 tests?
1
Is there an Identifiable asset?
Yes the airplane is explicitly referred to and the substitution right is not substantive
as they would incur significant costs
2
Does the customer have substantially all benefits during the period?
Yes it has exclusive use
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3
Does the customer direct the use?
Yes the customer decides where and when the airplane will fly
So, yes this contract contains a lease because it's...
A contract that gives the right to use an asset for a period of time in exchange for
consideration
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Syllabus B6a)
Account for right of use assets and lease liabilities in the records of the lessee.
Lessee Accounting
Basic Rule
Lessees recognise a right to use asset and associated liability on its SFP for most leases.
How to Value the Liability
Present value of the lease payments
where the lease payments are:
1
Fixed Payments
2
Variable Payments (if they depend on an index / rate)
3
Residual Value Guarantees
4
Probable purchase Options
5
Termination Penalties
How to Value the Right of Use asset?
Includes the following:
1
The Lease Liability (PV of payments)
2
Any lease payments made before the lease started
3
Any Restoration costs (Dr Asset Cr Provision)
4
All initial direct costs
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After the initial Measurement - Asset
•
Cost - depreciation (normally straight line) less any impairments
•
Any subsequent re-measurements of the liability
After the initial Measurement - Liability
•
Effective interest rate method (amortised cost)
•
Any re-measurements (e.g. residual value guarantee changes)
Example
3 year lease term
Annual lease payments in arrears 5,000
Rate implicit in lease: 12.04%
PV of lease payments: 12,000
Answer
The lease liability is initially the PV of future lease payments - given here to be 12,000
Double entry: Dr Asset 12,000 Cr Lease Liability 12,000
The Asset is then depreciated by 4,000pa (12,000 / 3)
The lease liability uses amortised cost:
Example - Variable lease payments (included in Lease Liability)
(Remember only include those linked to a rate or index)
So the lease contract says you have to pay more lease payments of 5% of the sales in the shop
you're leasing - should you include this potential variable lease payment in your lease liability?
Answer
No - because it is not based on a rate or index
(They are just put to the Income statement when they occur)
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Syllabus B6a)
Account for right of use assets and lease liabilities in the records of the lessee.
Lease Accounting Example
Variable Lease payments example
10 year Lease contract:
500 payable at the start of every year
Increased payments every 2 years to reflect the change in the consumer price index
The consumer price index was 125 at the start of year 1
The consumer price index was 130 at the start of year 2
The consumer price index was 135 at the start of year 3
(so these are variable payments based upon an index / rate)
ANSWER (IGNORING DISCOUNTING)
Start of year 1:
Dr Asset 500 Cr Cash 500
Dr Asset 4500 Cr Lease Liability 4500 (9 x 500)
End of year 2:
Asset will be 5,000 - 1,000 (straight line depreciation) = 4,000
Lease liability will be 8 x 500 = 4,000
End of year 3:
Lease payments are now different - 500 x 135/125 = 540
So the lease liability will be 7 x 540 = 3,780
Asset will be 4,000 - 500 (depreciation) + 280 (re-measurement of Liability) = 3,780
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(Please note that this example ignored discounting - which would normally happen as the liability is
measured as the PV of future payments)
Variable payments that are really fixed payments
These are included in the liability as they're pretty much fixed and not variable
e.g. Payments made if the asset actually operates
(well it will operate of course and so this is effectively a fixed payment and not a variable one)
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Syllabus B6b)
Explain the exemption from the recognition criteria for leases in the records of the lessee.
Leases - Exemptions
Exemptions to Leases treatment
So now we know that all lease contracts mean we have to show
1
A right to use Asset
2
A Liability
So remember we said there was no longer a concept of operating leases - all lease contracts mean
we need to show a right to use asset and its associated liability
Well.. there are some exemptions..
Exemption 1 - Short Term Leases
These are less than 12 months contracts (unless there's an option to extend that you'll probably
take or an option to purchase)
1
Treat them like operating leases
Just expense to the Income Statement (on a straight line / systematic basis)
2
Each class of asset must have the same treatment
3
This exemption ONLY applies to Lessees
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Exemption 2: Low Value Assets
e.g. IT equipment, office furniture with a value of less than $5,000
1
Treat them like operating leases
Just expense to the Income Statement (on a straight line basis)
2
Choice is made on a lease by lease basis
3
This exemption ONLY applies to Lessees
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Syllabus B6b)
Explain the exemption from the recognition criteria for leases in the records of the lessee.
Leases - Measurement Exemptions
Measurement Exemptions
Exemption 1: Investment Property
(if it uses the FV model in IAS 40)
•
Measure the property each year at Fair Value
Exemption 2 - PPE
(if revaluation model is used)
•
Use revalued amount for asset
Exemption 3: Portfolio Approach
(Portfolio of leases with SIMILAR characteristics)
•
Use same treatment for all leases in the portfolio
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Syllabus B6c)
Account for sale and leaseback agreements.
Sale and leaseback
Sale and leaseback
Let’s have a little ponder over this before we dive into the details…
So - the seller makes a sale (easy) BUT remember also leases it back - so the seller becomes the
lessee always, and the buyer becomes the lessor always
Seller = Lessee (after)
Buyer = Lessor (after)
However, If we sell an item and lease it back - have we actually sold it? Have we got rid of the risk
and rewards?
So the first question is..
Have we sold it according to IFRS 15? (revenue from contracts with customers)
Option 1: Yes - we have sold it under IFRS 15
This means the control has passed to the buyer (lessor now)
But remember we (the seller / lessee) have a lease - and so need to show a right to use asset and
a lease liability
Step 1: Take the asset (PPE) out
Dr Cash
Cr Asset
Cr Initial Gain on sale
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Step 2: Bring the right to use asset in
Dr Right to use asset
Cr Finance Lease / Liability
Dr/Cr Gain on sale (balancing figure)
•
How much do we show the Right to Use asset at?
The proportion (how much right of use we keep) of our old carrying amount
The PV of lease payments / FV of the asset x Carrying amount before sale
•
How much do we show the finance liability at?
The PV of lease payments
Example
A seller-lessee sells a building for 2,000. Its carrying amount at that time was 1,000 and FV 1,800
The seller-lessee then leases back the building for 18 years, for 120 p.a in arrears.
The interest rate implicit in the lease is 4.5%, which results in a present value of the annual
payments of 1,459
The transfer of the asset to the buyer-lessor has been assessed as meeting the definition of a sale
under IFRS 15.
Answer
Notice first that the seller received 200 more than its FV - this is treated as a financing transaction:
Dr Cash 200
Cr Financial Liability 200
Now onto the sale and leaseback..
Step1: Recognise the right-of-use asset - at the proportion (how much right of use we keep) of
our old carrying amount
Old carrying amount = 1,000
How much right we keep = 1,259 / 1,800 (The 1,259 is the 1,459 we actually pay - 200 which was
for the financing)
So, 1,259 / 1,800 x 1,000 = 699
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Step 2: Calculate Finance Liability - PV of the lease payments
Given - 1,259
So the full double entry is:
Dr Cash 2,000
Cr Asset 1,000
Cr Finance Liability 200
Cr Gain On Sale 800
Dr Right to use asset 699
Cr Finance lease / liability 1,259
Dr Gain on sale 560 (balance)
Option 2: It's not a sale under IFRS 15
So the buyer-lessor does not get control of the asset
Therefore the seller-lessee leaves the asset in their accounts and accounts for the cash received
as a financial liability.
The buyer-lessor simply accounts for the cash paid as a financial asset (receivable).
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Syllabus B7. Provisions and events after the reporting period
Syllabus B7a) Explain why an accounting standard on provisions is necessary.
Syllabus B7b) Distinguish between legal and constructive obligations.
Syllabus B7c) State when provisions may and may not be made and demonstrate how they should
be accounted for.
Syllabus B7d) Explain how provisions should be measured.
Syllabus B7e) Define contingent assets and liabilities and describe their accounting treatment and
required disclosures.
Provisions
A provision is a liability of uncertain timing or amount
Double entry
•
Dr Expense
Cr Provision (Liability SFP)
If it is part of a cost of an asset (e.g. Decommissioning costs)
•
Dr Asset
Cr Provision (Liability SFP)
Recognise when
1
There is an obligation (constructive or legal)
2
There is a probable outflow
3
It is reliably measurable
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At how much?
The best estimate of the expenditure
1
Large Population of Items..
use expected values.
2
Single Item...
the individual most likely outcome may be the best estimate.
Discounting of provisions
•
Provisions should be discounted
Eg. A future liability of 1,000 in 2 years time (discount rate 10%)
1,000 x 1/1.10 x 1/1.10 = 826
Dr Expense 826
Cr Provision 826
•
Then the discount unwound
Year 1
826 x 10% = 83
Dr Interest
83
Cr Provision 83
Year 2
(826+83) x 10% = 91
Dr Interest
91
Cr Provision 91
Measurement of a Provision
The amount recognised as a provision should be the best estimate of the expenditure required to
settle the present obligation at the end of the reporting period.
•
Provisions for one-off events
E.g. restructuring, environmental clean-up, settlement of a lawsuit
Measured at the most likely amount
•
Large populations of events
E.g. warranties, customer refunds
Measured at a probability-weighted expected value
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A company sells goods with a warranty for the cost of repairs required in the first 2 months after
purchase.
Past experience suggests:
88% of the goods sold will have no defects
7% will have minor defects
5% will have major defects
If minor defects were detected in all products sold, the cost of repairs will 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?
(88% x 0) + (7% x 24,000) + (5% x 200,000) = $11,680
Contingent Liabilities
•
These are simply a disclosure in the accounts
•
They occur when a potential liability is not probable but only possible
(Also occurs when not reliably measurable)
Contingent Assets
Here, it is not a potential liability, but a potential asset.
The principle of PRUDENCE is important here, it must be harder to show a potential asset in your
accounts than it is a potential liability.
This is achieved by changing the probability test.
For a potential (contingent) asset - it needs to be virtually certain (rather than just probable).
Probability test for Contingent Liabilities
•
Remote chance of paying out - Do nothing
•
Possible chance of paying out - Disclosure
•
Probable chance of paying out - Create a provision
Probability test for Contingent Assets
•
Remote chance of receiving - Do nothing
•
Possible chance of receiving - Do nothing
•
Probable chance of receiving - Disclosure
•
Virtually certain of receiving - create an asset in the accounts
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Syllabus B7f)
Identify and account for:
i) warranties/guarantees
ii) onerous contracts
iii) environmental and similar provisions
iv) provisions for future repairs or refurbishments
Some typical examples
Specific types of provision
•
Future operating losses
Provisions are not recognised for future operating losses (no obligation)
•
Onerous contracts
Recognised and measured as a provision (as there is a contract and so a legal
obligation)
•
Restructuring
Restructuring - Create a provision when:
1
There is a detailed formal plan for the restructuring; and
2
There is a valid expectation in those affected that it will carry out the restructuring by
starting to implement that plan or announcing its main features to those affected by
it (this creates a constructive obligation)
Provide only for costs that are:
•
(a) necessarily entailed by the restructuring; and
•
(b) not associated with the ongoing activities of the entity
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Possible Exam Scenarios
•
Warranties
Yes there is a legal obligation so provide. The amount is based on the class as a
whole rather than individual claims. Use expected values
•
Major Repairs
These are not provided for. Instead they are treated as replacement non current
assets. See that chapter
•
Self Insurance
This is trying to provide for potential future fires etc. Clearly no provision as no
obligation to pay until fire actually occurs
•
Environmental Contamination Clearance
Yes provide if legally required to do so or other parties would expect the company to
do so as it is its known policy
•
Decommissioning Costs
All costs are provided for. The debit would be to the asset itself rather than the
income statement
•
Restructuring
Provide if there is a detailed formal plan and all parties affected expect it to happen.
Only include costs necessary caused by it and nothing to do with the normal
ongoing activities of the company (e.g. don’t provide for training, marketing etc)
•
Reimbursements
This is when some or all of the costs will be paid for by a different party.
This asset can only be recognised if the reimbursement is virtually certain, and the
expense can still be shown separately in the income statement
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Syllabus B7g) Events after the reporting period:
i) distinguish between and account for adjusting and non-adjusting events after the reporting period
ii) Identify items requiring separate disclosure, including their accounting treatment and required
disclosures
IAS 10 Events After The Reporting Period
Events can be adjusting or non-adjusting.
We are looking at transactions that happen in this period, and whether we should go back
and adjust our accounts for the year end or not adjust and just put into next year’s accounts.
If the event gives us more information about the condition at the year-end then we adjust.
If not then we don’t.
When is the "After the Reporting date" period?
It is anytime between period end and the date the accounts are authorised for issue.
•
After the SFP date = Between period end and date authorised for issue
Ok and why is it important?
Well it may well be that many of the figures in the accounts are estimates at the period end.
However, what if we get more information about these estimates etc afterwards, but before the
accounts are authorised and published.. should we change the accounts or not?
The most important thing to remember is that the accounts are prepared to the SFP date. Not
afterwards.
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So we are trying to show what the situation at the SFP date was. However, it may be that more
information ABOUT the conditions at the SFP date have come about afterwards and so we should
adjust the accounts.
Sometimes we do not adjust though…
Adjusting Events
Here we adjust the accounts if:
The event provides evidence of conditions that existed at the period end
Examples are..
1
Debtor goes bad 5 days after SFP date
(This is evidence that debtor was bad at SFP date also)
2
Stock is sold at a loss 2 weeks after SFP date
3
Property gets impaired 3 weeks after SFP date
(This implies that the property was impaired at the SFP date also)
4
The result of a court case confirming the company did have a present obligation at
the year end
5
The settling of a purchase price for an asset that was bought before the year end
but the price was not finalised
6
The discovery of fraud or error in the year
Non-Adjusting Events - these are disclosed only
These are events (after the SFP date) that occurred which do not give evidence of conditions at
the year end, rather they are indicative of conditions AFTER the SFP date
1
Stock is sold at a loss because they were damaged post year-end
(This is evidence that they were fine at the year-end - so no adjustment)
2
Property impaired due to a fall in market values generally post year end
(This is evidence that the property value was fine at the year end - so no adjustment
required).
3
The acquisition or disposal of a subsidiary post year end
4
A formal plan issued post year end to discontinue a major operation
5
The destruction of an asset by fire or similar post year end
6
Dividends declared after the year end
Non-adjusting event which affects Going Concern
Adjust the accounts to a break up basis regardless if the event was a non-adjusting event.
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Syllabus B8. Taxation
Syllabus B8a) Account for current taxation in accordance with relevant accounting standards.
Current Tax
This is a simple tax payable
Dr Tax (I/S)
Cr Tax payable (SFP)
Let's say we did this - and the amount was 100
This is paid after the year end, however there were adjustments still to be made and we ended up
paying 110
The problem is that the accounts have already been published
So the extra 10 has to go in the following year
This is an UNDER provision of tax
Under Provisions look like this on the trial balance in question 2
Over Provisions look like this on the trial balance in question 2
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How to deal with an under provision
in the trial balance
•
Add it to tax on I/S
How to deal with an over provision
in the trial balance
•
Take it away from tax on I/S
How do you deal with the tax payable for the year
•
Add it to tax on (I/S)
•
Create a tax payable (SFP)
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Syllabus B8abc)
a) Account for current taxation in accordance with relevant accounting standards.
b) Explain the effect of taxable temporary differences on accounting and taxable profits.
c) Compute and record deferred tax amounts in the financial statements.
Income Tax
Current tax
The amount of income taxes payable or receivable in a period.
Any tax loss that can be carried back to recover current tax of a previous period is shown as an
asset.
If the gain or loss went to the OCI, then the related tax goes there too.
Deferred Tax
This is basically the matching concept.
Let´s say we have credit sales of 100 (but not paid until next year).
There are no costs.
The tax man taxes us on the cash basis (i.e. next year).
The Income statement would look like this:
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This is how it should look.
The tax is brought in this year even though it´s not payable until next year, it´s just a temporary
timing difference.
Illustration
•
Tax Base
Let’s presume in one country’s tax law, royalties receivable are only taxed when
they are received
•
IFRS
IFRS, on the other hand, recognises them when they are receivable
Now let’s say in year 1, there are 1,000 royalties receivable but not received until year 2.
The Income statement would show:
Royalties Receivable 1000
Tax
(0) (They are taxed when received in yr 2)
This does not give a faithful representation as we have shown the income but not the related tax
expense.
Therefore, IFRS actually states that matching should occur so the tax needs to be brought into
year 1.
Dr Tax (I/S)
Cr Deferred Tax (SFP provision)
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Deferred tax on a revaluation
Deferred tax is caused by a temporary difference between accounts rules and tax rules.
One of those is a revaluation:
Accounting rules bring it in now.
Tax rules ignore the gain until it is sold.
So the accounting rules will be showing more assets and more gain so we need to match with the
temporarily missing tax.
Illustration
A company revalues its assets upwards making a 100 gain as follows:
This is how it should look.
The tax is brought in this year even though it´s not payable until sold, it´s just a temporary timing
difference.
Notice the tax matches where the gain has gone to.
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Syllabus B9. Reporting financial performance
Syllabus B9a) Discuss the importance of identifying and reporting the results of discontinued
operations.
Discontinued Operation
An analysis between continuing and discontinuing operations improves the
usefulness of financial statements.
When forecasting ONLY the results of continuing operations should be used.
Because discontinued operations profits or losses will not be repeated.
What is a discontinued operation?
1
A separate major line of business or geographical area
or..
2
is part of a single co-ordinated plan to dispose of a separate major line of
business or geographical area
or..
3
is a subsidiary acquired exclusively with a view to resale
How is it shown on the Income Statement?
The PAT and any gain/loss on disposal
•
A single line in I/S
How is it shown on the SFP?
If not already disposed of yet?
•
Held for sale disposal group
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How is it shown on the cash-flow statement?
•
Separately presented
•
in all 3 areas - operating; investing and financing
No Retroactive Classification
IFRS 5 prohibits the retroactive classification as a discontinued operation, when the discontinued
criteria are met after the end of the reporting period
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Syllabus B9b)
Define and account for non-current assets held for sale and discontinued operations.
Assets Held for Sale
How do we deal with items in our accounts which we are no longer going to
use, instead we are going to sell them
So, think about this for a moment.. Why does this matter to users?
Well, the accounts show the business performance and position, and you expect to see assets in
there that they actually are looking to continue using.
Therefore their values do not have to be shown at their market value necessarily (as your intention
is not to sell them)
Here, though, everything changes… we are going to sell them.
So maybe market value is a better value to use, but they haven’t been sold yet, so showing them
at MV might still not be appropriate as this value has not yet been achieved
So these are the issues that IFRS 5 tried, in part, to deal with and came up with the following
solution..
Accounting Treatment
1
Step 1 - Calculate the Carrying Amount...
Bring everything up to date when we decide to sell
This means:
- charge the depreciation as we would normally up to that date or
- revalue it at that date (if following the revaluation policy)
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2
Step 2 - Calculate FV - CTS
Now we can get on with putting the new value on the asset to be sold..
Measure it at Fair Value less costs to sell (FV-cts).
This is because, if you think about it, this is the what the company will receive.
HOWEVER, the company hasn’t actually made this sale yet and so to revalue it now
to this amount would be showing a profit that has not yet happened
3
Step 3 - Value the Assets held for sale
IFRS 5 says the new value should actually be…
...The lower of carrying amount (step 1) and FV-CTS (step 2)
4
Step 4 - Check for an Impairment
Revaluing to this amount might mean an impairment (revaluation downwards) is
needed.
This must be recognised in profit or loss, even for assets previously carried at
revalued amounts.
Also, any assets under the revaluation policy will have been revalued to FV under step 1
Then in step 2, it will be revalued downwards to FV-cts.
Therefore, revalued assets will need to deduct costs to sell from their fair value and this will result
in an immediate charge to profit or loss.
Subsequent increase in Fair Value?
•
This basically happens at the year-end if the asset still has not been sold
A gain is recognised in the p&l up to the amount of all previous impairment losses.
Non-depreciation
Non-current assets or disposal groups that are classified as held for sale shall not be depreciated.
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When is an asset recognised as held for sale?
•
Management is committed to a plan to sell
•
The asset is available for immediate sale
•
An active programme to locate a buyer is initiated
•
The sale is highly probable, within 12 months of classification as held for sale
•
The asset is being actively marketed for sale at a sales price reasonable in
relation to its fair value
Abandoned Assets
The assets need to be disposed of through sale. Therefore, operations that are expected to be
wound down or abandoned would not meet the definition. Therefore assets to be abandoned would
still be depreciated.
Balance sheet presentation
Presented separately on the face of the balance sheet in current assets
•
Subsidiaries Held for Disposal
IFRS 5 applies to accounting for an investment in a subsidiary held only with a view
to its subsequent disposal in the near future.
•
Subsidiaries already consolidated now held for sale
The parent must continue to consolidate such a subsidiary until it is actually
disposed of. It is not excluded from consolidation and is reported as an asset held
for sale under IFRS 5.
So subsidiaries held for sale are accounted for initially and subsequently at FV-CTS
of all the net assets not just the amount to be disposed of.
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Syllabus B9c)
Indicate the circumstances where separate disclosure of material items of income and expense is
required.
Separate disclosure of material items
Exceptional items get disclosed separately
This is where disclosure is necessary in order to explain the performance of the entity better
The NORMAL accounting treatment is to:
•
Show in the standard line in the I/S
•
Disclose the nature and amount in notes
EXCEPTIONS such as these can have their own I/S line:
•
Write down of inventories to net realisable value (NRV)
•
Write down of property, plant and equipment to recoverable amount
•
Restructuring costs
•
Gains/losses on disposal of non-current assets
•
Discontinued operations profits / losses
•
Litigation settlements
•
Reversals of provisions
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Syllabus A1g/B9d
g) Discuss the principle of comparability in accounting for changes in accounting policies.
d) Account for changes in accounting estimates, changes in accounting policy and correction of prior
period errors.
IAS 8 Changes in accounting policies and accounting
estimates
Comparatives are changed for accounting POLICY changes only
Changes in accounting estimates have no effect on the comparative
Changes in accounting policy means we must change the comparative too to ensure we keep the
accounts comparable for trend analysis
Accounting Policy
Definition
“the specific principles, bases, conventions, rules and practices applied by an entity in preparing
and presenting the financial statements”
An entity should follow accounting standards when deciding its accounting policies
If there is no guidance in the standards, management should use the most relevant and reliable
policy
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Changes to Accounting Policy
These are only made if:
- It is required by a Standard or Interpretation; or
- It would give more relevant and reliable information
1
Adjust the comparative amounts for the affected item
(as if the policy had always been applied)
2
Adjust Opening retained earnings
(Show this in statement of changes in Equity too)
Accounting Estimates
Definition
“an adjustment of the carrying amount of an asset or liability, or related expense, resulting from
reassessing the expected future benefits and obligations associated with that asset or liability”
Examples
Allowances for doubtful debts;
Inventory obsolescence;
A change in the estimate of the useful economic life of property, plant and equipment
Changes in Accounting Estimate
1
Simply change the current year
2
No change to comparatives
Prior Period Errors
These are accounted for in the same way as changes in accounting policy
Accounting treatment
1
Adjust the comparative amounts for the affected item
2
Adjust Opening retained earnings
(Show this in statement of changes in Equity too)
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Syllabus B9e)
Earnings per share (eps)
i) calculate the eps in accordance with relevant accounting standards (dealing with bonus issues, full
market value issues and rights issues)
ii) explain the relevance of the diluted eps and calculate the diluted eps involving convertible debt and
share options (warrants)
IAS 33 EPS Introduction
EPS is a much used PERFORMANCE appraisal measure
It is calculated as:
PAT - Preference dividends / Number of shares
It is not only an important measure in its own right but also as a component in the price earnings
(P/E) ratio (see below)
Diluted EPS
This is saying that the basic EPS might get worse due to things that are ALREADY in issue such
as:
•
Convertible Loan
This will mean more shares when converted
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•
Share options
This will mean more shares when exercised
Who has to report an EPS?
•
PLCs
•
Group accounts where the parent has shares similarly traded/being issued
EPS to be presented in the income statement.
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Syllabus B9e)
Earnings per share (eps)
i) calculate the eps in accordance with relevant accounting standards (dealing with bonus issues, full
market value issues and rights issues)
ii) explain the relevance of the diluted eps and calculate the diluted eps involving convertible debt and
share options (warrants)
IAS 33 EPS - earnings figure
This is basically Profit after Tax
less preference dividends
*Be careful of the type of preference share though…
Redeemable preference shares
These are actually liabilities and their finance charge isn’t a dividend in the accounts but interest.
•
Do not adjust for these dividends.
Irredeemable preference shares
These are equity and the finance charge is dividends
•
Do adjust for these dividends
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Syllabus B9e)
Earnings per share (eps)
i) calculate the eps in accordance with relevant accounting standards (dealing with bonus issues, full
market value issues and rights issues)
ii) explain the relevance of the diluted eps and calculate the diluted eps involving convertible debt and
share options (warrants)
IAS 33 EPS - Number of shares
Calculating the weighted average number of ordinary shares
The number of shares given in the SFP at the year-end - may not be the number of shares in issue
ALL year.
So we need to know how many we had in issue on AVERAGE instead of at the end.
Well if there were no additional shares in the year then obviously the weighted average is the same
as the year end - so no problem!
However, if additional shares have been issued we’ve got some work to do as follows (depending
on how those shares were issued):
Full Market Price issue of shares
No problem here as the new shares came with the right amount of new resources so the company
should be able to use those new resources to maintain the EPS
•
No adjustment needed (apart from time)
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Bonus & Rights Issue of shares
More problematic, as the share were issued for cheaper (rights) than usual or for free (bonus).
In both cases the company has not been given enough new resource to expect the EPS to be
maintained.
This causes comparison to last year problems.
•
Adjust for these (Bonus fraction)
•
Pretend they were in issue ALL year
•
Change comparative (Pretend they were in last year too)
So, how to calculate it is best explained by example:
1st January 100 shares in issue
1st May Full market price issue of 400 shares
1st July 1 for 5 bonus issue
Solution
Draw up a table like this:
Now fill in the first 2 columns:
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Notice how this shows the TOTAL shares. Now fill in the timing of how long these TOTALS lasted
for in the year.
Finally look for any bonus issues and pretend that they happened at the start of the year. We do
this by applying the bonus fraction to all entries BEFORE the actual bonus or rights issue.
In this case the bonus fraction would be 6/5 - so apply this to everything before the actual bonus
issue:
Finally, multiply through and calculate the weighted average:
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Syllabus B9e)
Earnings per share (eps)
i) calculate the eps in accordance with relevant accounting standards (dealing with bonus issues, full
market value issues and rights issues)
ii) explain the relevance of the diluted eps and calculate the diluted eps involving convertible debt and
share options (warrants)
IAS 33 Bonus issue
Additional shares are issued to the ordinary equity holders in proportion to their current
shareholding, for example 1 new share for every 2 shares already owned.
No cash is received for these shares.
Double Entry
•
Dr Reserves or Share premium
•
Cr Share Capital
IAS 33 pretends that the bonus issue has been in place all year - regardless of when it was
actually made.
We do this by multiplying the totals before the issue by a “bonus fraction”.
Bonus Fraction Calculation - Bonus issue
1 for 2 bonus issue - means we’ve now got 3 where we used to have 2 = 3/2
2 for 5 - now got 7 used to have 5 = 7/5
3 for 4 - now got 7 used to have 4 = 7/4
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Example
1st Jan 100 shares in issue
1st July 1 for 2 bonus issue (i.e. 50 more shares)
•
Weighted Average number of shares
100 x 6/12 (we had a total of 100 for 6 months) = 50 x 3/2 (bonus fraction) = 75
150 x 6/12 (we had a total of 150 for 6 months) = 75
Total = 150
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Syllabus B9e)
Earnings per share (eps)
i) calculate the eps in accordance with relevant accounting standards (dealing with bonus issues, full
market value issues and rights issues)
ii) explain the relevance of the diluted eps and calculate the diluted eps involving convertible debt and
share options (warrants)
IAS 33 Rights Issue
Rights issue
A rights issue is:
•
An issue of shares for cash to the existing ordinary equity holders in proportion to
their current shareholdings.
•
At a discount to the current market price. It is, in fact, a mixture of a full price and
bonus issue.
So again we do the same as in the bonus issue - we pretend it happened all year
and to do this we multiply the previous totals by the bonus fraction.
The problem is - calculating the bonus fraction for a rights issue is slightly different:
Example
2 for 5 offered at £4 when the market value is £10
So we are being offered 2 @ £4 = £8
For every 5 which cost us £10 each = £50
So we now have 7 at a cost of £58 = 8.29
This is what we call the TERP (theoretical ex-rights price).
The bonus fraction is the current MV / TERP = 10 / 8.29
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Syllabus B9e)
Earnings per share (eps)
i) calculate the eps in accordance with relevant accounting standards (dealing with bonus issues, full
market value issues and rights issues)
ii) explain the relevance of the diluted eps and calculate the diluted eps involving convertible debt and
share options (warrants)
IAS 33 Basic EPS putting it all together
IAS 33 Basic EPS putting it all together
1
Step 1: Calculate the EARNINGS (PAT - irredeemable pref. shares)
2
Step 2: Calculate Weighted average NUMBER OF SHARES
3
Divide one by the other!
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Syllabus B9e)
Earnings per share (eps)
ii) explain the relevance of the diluted eps and calculate the diluted eps involving convertible debt and
share options (warrants)
IAS 33 Diluted EPS
This is the basic EPS adjusted for the potential effects of a convertible loan
(currently in the SFP) being converted and options (currently in issue) being
exercised.
This is because these things will possibly increase the number of shares in the future and thus
dilute EPS.
This is how these items affect the Basic Earnings and Shares.
Earnings
The convertible loan will (once converted) increase earnings as interest will no longer have to be
paid.
So increase the basic earnings with a tax adjusted interest savings.
Shares
•
Simply add the shares which will result from the convertible loan
•
Also add the “free” shares from a share option
Convertible loan
•
Add the interest saved (after tax) to the EARNINGS from basic EPS
•
Add the extra shares convertible to the SHARES from basic EPS
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Options
Step 1 : Calculate the money the options will bring in
Step 2 : Calculate how many shares this would normally buy
Step 3 : Look at the number of shares given away in the option, compare it to those in step 2 and
these are the “free shares”
We add the free shares to the SHARES figure from basic EPS.
Illustration
5% 800 convertible loan - each 100 can be converted into 20 shares (tax 30%)
100 share options @ $2 (MV $5)
How to calculate Interest Saved
5% x 800 = 40 x 70% (tax adjusted) = 28
How to calculate the extra convertible shares
800/100 x 20 = 160
How to calculate the free shares in share options
Cash in from option $200, this would normally mean the company issuing (200/5) 40 shares
instead of the 100, so there has effectively been 60 shares issued for ‘free’. We use this figure in
the diluted eps calculation.
An alternative calculation is:
100 x (5-2) / 5 = 60
Solution
Basic EPS
Convertible Loan
E 100
+ 28
S 50
+ 160
Share options
+ 60
Diluted EPS = 128 / 270 = 0.47
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Syllabus B9e)
Earnings per share (eps)
i) calculate the eps in accordance with relevant accounting standards (dealing with bonus issues, full
market value issues and rights issues)
ii) explain the relevance of the diluted eps and calculate the diluted eps involving convertible debt and
share options (warrants)
EPS as a performance measure
EPS is better than PAT as an earnings performance indicator
Profit after tax gives an absolute figure
An increase in PAT does not show the whole picture about a company's profitability
Some profit growth may come from acquiring other companies
If the acquisition was funded by new shares then profit will grow but not necessarily EPS
So EPS trends show a better picture of profitability than PAT
Simply looking at PAT growth ignores any increases in the resources used to earn them
The diluted EPS is useful as it alerts existing shareholders to the fact that future EPS may be
reduced as a result of share capital changes
Where the finance cost per potential new share is less than the basic EPS, there will be a dilution
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Syllabus B10. Revenue
Syllabus B10a) Explain and apply the principles of recognition of revenue:
(i) Identification of contracts
(ii) Identification of performance obligations
(iii) Determination of transaction price
(iv) Allocation of the price to performance obligations
(v) Recognition of revenue when/as performance obligations are satisfied.
Revenue Recognition - IFRS 15 - introduction
Revenue Recognition - IFRS 15
When & how much to Recognise Revenue?
Here you need to go through the 5 step process…
1
Identify the contract(s) with a customer
2
Identify the performance obligations in the contract
3
Determine the transaction price
4
Allocate the transaction price to the performance obligations in the contract
5
Recognise revenue when (or as) the entity satisfies a performance obligation
Before we do that though, let’s get some key definitions out of the way..
Key definitions
•
Contract
An agreement between two or more parties that creates enforceable rights and
obligations.
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•
Income
Increases in economic benefits during the accounting period in the form of
increasing assets or decreasing liabilities
•
Performance obligation
A promise in a contract to transfer to the customer either:
- a good or service that is distinct; or
- a series of distinct goods or services that are substantially the same and that have
the same pattern of transfer to the customer.
•
Revenue
Income arising in the course of an entity’s ordinary activities.
•
Transaction price
The amount of consideration to which an entity expects to be entitled in exchange
for transferring promised goods or services to a customer.
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Syllabus B10abcd)
a) Explain and apply the principles of recognition of revenue:
(i) Identification of contracts
(ii) Identification of performance obligations
(iii) Determination of transaction price
(iv) Allocation of the price to performance obligations
(v) Recognition of revenue when/as performance obligations are satisfied.
b) Explain and apply the criteria for recognising revenue generated from contracts where performance
obligations are satisfied over time or at a point in time.
c) Describe the acceptable methods for measuring progress towards complete satisfaction of a
performance obligation.
d) Explain and apply the criteria for the recognition of contract costs.
Revenue Recognition - IFRS 15 - 5 steps
Revenue Recognition - IFRS 15 - 5 steps
Ok let’s now get into a bit more detail…
Step 1: Identify the contract(s) with a customer
•
The contract must be approved by all involved
•
Everyone’s rights can be identified
•
It must have commercial substance
•
The consideration will probably be paid
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Step 2: Identify the separate performance obligations in the contract
This will be goods or services promised to the customer
These goods / services need to be distinct and create a separately identifiable obligation
•
Distinct means:
The customer can benefit from the goods/service on its own AND
The promise to give the goods/services is separately identifiable (from other
promises)
•
Separately identifiable means:
No significant integrating of the goods/service with others promised in the contract
The goods/service doesn’t significantly modify another good or service promised in
the contract.
The goods/service is not highly related/dependent on other goods or services
promised in the contract.
Step 3: Determine the transaction price
How much the entity expects, considering past customary business practices
•
Variable Consideration
If the price may vary (eg. possible refunds, rebates, discounts, bonuses, contingent
consideration etc) - then estimate the amount expected
•
However variable consideration is only included if it’s highly probable there won’t
need to be a significant revenue reversal in the future (when the uncertainty has
been subsequently resolved)
•
However, for royalties from licensing intellectual property - recognise only when the
usage occurs
Step 4: Allocate the transaction price to the separate performance obligations
If there’s multiple performance obligations, split the transaction price by using their standalone
selling prices. (Estimate if not readily available)
•
How to estimate a selling Price
- Adjusted market assessment approach
- Expected cost plus a margin approach
- Residual approach (only permissible in limited circumstances).
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•
If paid in advance, discount down if it’s significant (>12m)
Step 5: Recognise revenue when (or as) the entity satisfies a performance obligation
Revenue is recognised as control is passed, over time or at a point in time.
•
What is Control
It’s the ability to direct the use of and get almost all of the benefits from the asset.
This includes the ability to prevent others from directing the use of and obtaining the
benefits from the asset.
•
Benefits could be:
- Direct or indirect cash flows that may be obtained directly or indirectly
- Using the asset to enhance the value of other assets;
- Pledging the asset to secure a loan
- Holding the asset.
•
So remember we recognise revenue as asset control is passed (obligations
satisfied) to the customer
This could be over time or at a specific point in time.
Examples (of factors to consider) of a specific point in time:
1
The entity now has a present right to receive payment for the asset;
2
The customer has legal title to the asset;
3
The entity has transferred physical possession of the asset;
4
The customer has the significant risks and rewards related to the ownership of the
asset; and
5
The customer has accepted the asset.
Contract costs - that the entity can get back from the customer
These must be recognised as an asset (unless the subsequent amortisation would be less 12m),
but must be directly related to the contract (e.g. ‘success fees’ paid to agents).
Examples would be direct labour, materials, and the allocation of overheads - this asset is then
amortised
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Syllabus B10e)
Apply the principles of recognition of revenue, and specifically account for the following types of
transaction:
(i) principal versus agent
(ii) repurchase agreements
(iii) bill and hold arrangements
(iv) consignments
Exam Standard Illustrations
Illustration 1 - Agent or not?
An entity negotiates with major airlines to purchase tickets at reduced rates
It agrees to buy a specific number of tickets and must pay even if unable to resell them.
The entity then sets the price for these ticket for its own customers and receives cash immediately
on purchase
The entity also assists the customers in resolving complaints with the service provided by airlines.
However, each airline is responsible for fulfilling obligations associated with the ticket, including
remedies to a customer for dissatisfaction with the service.
How would this be dealt with under IFRS 15?
1
Step 1: Identify the contract(s) with a customer
This is clear here when the ticket is purchased
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2
Step 2: Identify the performance obligations in the contract
This is tricky - is it to arrange for another party provide a flight ticket - or is it - to
provide the flight ticket themselves?
Well - look at the risks involved. If the flight is cancelled the airline pays to
reimburse
If the ticket doesn't get sold - the entity loses out
Look at the rewards - the entity can set its own price and thus rewards
On balance therefore the entity takes most of the risks and rewards here and thus
controls the ticket - thus they have the obligation to provide the right to fly ticket
3
Step 3: Determine the transaction price
This is set by the entity
4
Step 4: Allocate the transaction price to the performance obligations in the
contract
The price here is the GROSS amount of the ticket price (they sell it for)
5
Step 5: Recognise revenue when (or as) the entity satisfies a performance
obligation
Recognise the revenue once the flight has occurred
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Illustration 2 - Loyalty discounts
An entity has a customer loyalty programme that rewards a customer with one customer loyalty
point for every $10 of purchases.
Each point is redeemable for a $1 discount on any future purchases
Customers purchase products for $100,000 and earn 10,000 points
The entity expects 9,500 points to be redeemed, so they have a stand-alone selling price $9,500
How would this be dealt with under IFRS 15?
1
Step 1: Identify the contract(s) with a customer
This is when goods are purchased
2
Step 2: Identify the performance obligations in the contract
The promise to provide points to the customer is a performance obligation along
with, of course, the obligation to provide the goods initially purchased
3
Step 3: Determine the transaction price
$100,000
4
Step 4: Allocate the transaction price to the performance obligations in the
contract
The entity allocates the $100,000 to the product and the points on a relative standalone selling price basis as follows:
So the standalone selling price total is 100,000 + 9,500 = 109,500
Now we split this according to their own standalone prices pro-rata
Product $91,324 [100,000 x (100,000 / 109,500]
Points $8,676 [100,000 x 9,500 /109,500]
5
Step 5: Recognise revenue when (or as) the entity satisfies a performance
obligation
Of course the products get recognised immediately on purchase but now lets look at
the points..
Let’s say at the end of the first reporting period, 4,500 points (out of the 9,500) have
been redeemed
The entity recognises revenue of $4,110 [(4,500 points ÷ 9,500 points) × $8,676]
and recognises a contract liability of $4,566 (8,676 – 4,110) for the unredeemed
points
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Syllabus B10f)
Prepare financial statement extracts for contracts where performance obligations are satisfied over
time.
Revenues - Presentation in financial statements
Presentation in financial statements
Show in the SFP as a contract liability, asset, or a receivable, depending on when paid and
performed
i.e.. Paid upfront but not yet performed would be a contract liability
Performed but not paid would be a contract receivable or asset
1
A contract asset if the payment is conditional (on something other than time)
2
A receivable if the payment is unconditional
Contract assets and receivables shall be accounted for in accordance with IFRS 9.
Disclosures
All qualitative and quantitative information about:
•
its contracts with customers;
•
the significant judgments in applying the guidance to those contracts; and
•
any assets recognised from the costs to fulfil a contract with a customer.
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Syllabus B10b)
Explain and apply the criteria for recognising revenue generated from contracts where performance
obligations are satisfied over time or at a point in time.
Accrued and deferred Income
An entity will accrue income when it has earned the income during the period but it has not yet
been invoiced or received. This will increase income in the statement of profit or loss and be shown
as a receivable in the statement of financial position at year end.
Accounting Treatment: Accrued Income
Dr Accrued income (SOFP)
Cr Income Account (I/S)
When an entity has received income in advance of it being earned, it should be deferred to the
following period. This will reduce income in the statement of profit or loss and be shown as a
payable in the statement of financial position at the year end.
Accounting Treatment: Deferred Income
Dr Income Account (I/S)
Cr Deferred Income (SOFP)
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Syllabus B11a)
Apply the provisions of relevant accounting standards in relation to accounting for government
grants.
Government Grants Part 1
Government grants are a form of government assistance.
When can you recognise a government grant?
When there is reasonable assurance that:
•
The entity will comply with any conditions attached to the grant and
•
the grant will be received
However, IAS 20 does not apply to the following situations:
1
Tax breaks from the government
2
Government acting as part-owner of the entity
3
Free technical or marketing advice
Accounting treatment of government grants
Dr Cash
The debit is always cash so we only have to know where we put the credit..
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There are 2 approaches - depending on what the grant is given for:
•
Capital Grant approach:
(Given for Assets - For NCA such as machines and buildings)
Recognise the grant outside profit or loss initially:
Dr Cash
Cr Cost of asset or
Cr Deferred Income
•
Income Grant approach:
(Given for expenses - For I/S items such as wages etc)
Recognise the grant in profit or loss
Dr Cash
Cr Other income (or expense)
Capital Grant approach - accounting for as "Cr Cost of asset”
•
Dr Cash Cr Cost of asset
This will have the effect of reducing depreciation on the income statement and the
asset on the SFP
•
An Example
Asset $100 with 10yrs estimated useful life
Received grant of $50
Accounting for a grant received:
DR Cash $50
CR Asset $50
At the Y/E
Depreciation charge:
DR Depreciation expense (I/S) (100-50)/10yrs = $5
CR Accumulate depreciation $5
Capital Grant approach - accounting for as "Cr Deferred Income”
•
Dr Cash
Cr Deferred Income
This will have the effect of keeping full depreciation on the income statement and
the full asset and liability on the SFP
Then...
Dr Deferred Income
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Cr Income statement (over life of asset)
This will have the effect of reducing the liability and the expense on the income
statement
•
An Example
Asset $100 with 10yrs estimated useful life
Received grant of $50
Accounting for a grant received:
DR Cash $50
CR Deferred income $50
At the Y/E
Depreciation charge:
DR Depreciation expense (I/S) 100/10yrs = $10
CR Accumulate depreciation $10
Release of deferred income:
DR Deferred income 50/10yrs =$5
CR I/S $5
That's all I'll say here as it is best seen visually and practically in the video :)
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Syllabus B11. Government grants
Syllabus B11a) Apply the provisions of relevant accounting standards in relation to accounting for
government grants.
Government Grants Part 2
Government grants Part 2
Conditions
These may help the company decide the periods over which the grant will be earned.
It may be that the grant needs to be split up and taken to the income statement on different bases.
Compensation
The grant may be for compensation on expenses already spent.
Or it might be just for financial support with no actual related future costs.
Whatever the situation, the grant should be recognised in profit or loss when it becomes
receivable.
NB
If a condition might not be met then a contingent liability should be disclosed in the notes. Similarly
if it has already not been met then a provision is required.
Non-monetary government grants
Think here, for example, of the government giving you some land (ie not cash).
To put a value on it - we use the Fair Value. Alternatively, both may be valued at a nominal
amount.
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Repayment of government grants
This means when we are not allowed the grant anymore and so have to repay it back.
This would be a change in accounting estimate (IAS 8) and so you do not change past periods just
the current one.
•
Accounting treatment (capital grant repayment):
• Dr Any deferred Income Balance or Dr Cost of asset
• Dr Income statement with any balance
and CR cash with the amount repaid
The extra depreciation to date that would have been recognised had the grant not
been netted off against cost should be recognised immediately as an expense.
•
Accounting treatment - Income Grant Repayment
Dr Income statement
Cr Cash
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Syllabus B12. Foreign currency transactions
Syllabus B12a) Explain the difference between functional and presentation currency and explain why
adjustments for foreign currency transactions are necessary.
Foreign currency - extras
Foreign Currency - Examinable Narrative & Miscellaneous points
Functional Currency
Every entity has its own functional currency and measures its results in that currency
Functional currency is the one that
influences sales price
the one used in the country where most competitors are and where regulations are made and
the one that influences labour and material costs
If functional currency changes then all items are translated at the exchange rate at the date of
change
Presentation Currency
An entity can present in any currency it chooses.
The foreign sub (with a foreign functional currency) will present normally in the parents
presentation currency and hence the need for foreign sub translation rules!
Foreign currency dealings between H and S
There is often a loan between H and a foreign sub. If the loan is in a foreign currency don’t forget
that this will need retranslating in H’s or S’s (depending on who has the ‘foreign’ loan) own
accounts with the difference going to its income statement.
If H sells foreign S, any exchange differences (from translating that sub) in equity are taken to the
income statement (and out of the OCI).
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Deferred tax
There are deferred tax consequences of foreign exchange gains (see tax chapter). This is because
the gains and losses are recognised by H now but will not be dealt with by the taxman until S is
eventually sold.
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Syllabus B12b)
Account for the translation of foreign currency transactions and monetary/non-monetary foreign
currency items at the reporting date.
Foreign Exchange Single company
Foreign Exchange Single company
Transactions in a single company
This is where a company simples deals with companies abroad (who have a different currency).
The key thing to remember is that…
ALL EXCHANGE DIFFERENCES TO INCOME STATEMENT
So - a company will buy on credit (or sell) and then pay or receive later. The problem is that the
exchange rate will have moved and caused an exchange difference.
Step 1: Translate at spot rate
Step 2: If there is a creditor/debtor @ y/e - retranslate it (exch gain/loss to I/S)
Step 3: Pay off creditor - exchange gain/loss to I/S
Illustration 1
On 1 July an entity purchased goods from a foreign country for Y$10,000.
On 1 September the goods were paid in full.
The exchange rates were:
1 July $1 = Y$10
1 September $1 = Y$9
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Calculate the exchange difference to be included in profit or loss according to IAS 21 The
Effects of Changes in Foreign Exchange Rates.
Solution
Account for Payables on 1 July: Y$10,000/10 = 1,000
Payment performed on 1 September: Y$10,000 / 9 = 1,111
The Exchange difference: 1,000 - 1,111 = 111 loss
Illustration 2
Maltese Co. buys £100 goods on 1st June (£1:€1.2)
Year End (31/12) payable still outstanding (£1:€1.1)
5th January £100 paid (£1:€1.05)
Solution
Initial Transaction
Dr Purchases 120
Cr Payables 120
Year End
Dr Payables 10
Cr I/S Ex gain 10
On payment
Dr Payables 110
Cr I/S Ex gain 5
Cr Cash 105
Also items revalued to Fair Value will be retranslated at the date of revaluation and the exchange
gain/loss to Income statement.
All foreign monetary balances are also translated at the year end and the differences taken to the
income statement.
This would include receivables, payables, loans etc.
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Syllabus C: ANALYSING AND INTERPRETING
THE FINANCIAL STATEMENTS
Syllabus C1. Limitations of financial statements
Syllabus C1a) Indicate the problems of using historic information to predict future performance and
trends.
Problems Using Historic Information To Predict Future
Historic info gets out of date
especially in times of rising prices
Effect on Predicting Future
1
Cost of replacing asset (in the future) MUCH higher than NBV of asset currently
2
This means higher future depreciation (and interest if a loan is needed)
3
Cost of Sales are understated (if using FIFO) - yet sales revenue keeps up to date thus overstating profit trends
Also, the low depreciation and interest etc could have led to too many profits being distributed thus
meaning more loans needed in the future potentially
So profits are overstated and assets understated - making ROCE seem higher compared to those
in the future
The ‘overstated’ profit means more tax payable and maybe even employees want more wages
The understatement of assets can depress a company’s share price and may make it vulnerable to
a takeover bid.
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These problems can be overcome by introducing current values by following a policy of
revaluations. Also IFRS's are now using Fair (current) Values more eg. Investment Properties and
FVTPL items
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Syllabus C1b)
Discuss how financial statements may be manipulated to produce a desired effect (creative
accounting, window dressing).
Manipulating Financial Statements
Creative Accounting
Example 1 - Using Provisions
•
Create an unnecessary provision in good times (this reduces profits)
•
Release this provision in bad times (this increases profits)
The effect of this is a smoother profitability rather than big up and down swings (which investors
don't like)
Window Dressing
Cash Postpone paying suppliers, so Y/E cashbooks good
Receivables Record an unusually low bad debt provision
Revenue Offer early shipment discounts to get revenues in current year
Expenses Withhold supplier payments, so that they are recorded in a later period.
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Syllabus C1c)
Explain why figures in a statement of financial position may not be representative of average values
throughout the period for example, due to:
i) seasonal trading
ii) major asset acquisitions near the end of the accounting period.
When The Financial Position May Not Be Representative
Seasonal Trading
This is best explained by an example:
Imagine a company who has highly seasonal trading.
Their year end may be immediately after this high trading period
Therefore, they will probably have higher than normal levels of cash and receivables and lower
than normal levels of payables
Major Asset Acquisitions Near The Year-End
This has the effect of:
Higher Assets (and maybe loans) but...
No related Income (as it was just before the year end)
This makes ROCE look worse
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Syllabus C1d)
Explain how the use of consolidated financial statements might limit interpretation techniques.
Consolidated Financial Statements Might Limit
Interpretation
The main problem comes from mid year acquisitions / disposals
Problems include:
1
Income statement includes only half the returns (if mid-year acq)
But the SFP includes all the assets (capital employed)
Thus distorting ROCE
2
Synergies can take a while to come in and so return is artificially low
3
Subs are acquired at FV
This generally increases asset values
Meaning a deterioration in ROCE and Asset Turnover
4
Goodwill is now recognised whereas before it wasn't
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Syllabus C1)
Ratio limitations
Ratio limitations
Ratios aren't always comparable
Factors affecting comparability
1
Different accounting policies
Eg One company may revalue its property; this will increase its capital employed
and (probably) lower its ROCE
Others may carry their property at historical cost
2
Different accounting dates
Eg One company has a year ended 30 June, whereas another has 30 September
If the sector is exposed to seasonal trading, this could have a significant impact on
many ratios.
3
Different ratio definitions
Eg This may be a particular problem with ratios like ROCE as there is no universally
accepted definition
4
Comparing to averages
Sector averages are just that: averages
Many of the companies included in the sector may not be a good match to the type
of business being compared
Some companies go for high mark-ups, but usually lower inventory turnover,
whereas others go for selling more with lower margins
5
Possible deliberate manipulation (creative accounting)
6
Different managerial policies
e.g. different companies offer customers different payment terms
Compare ratios with
1
Industry averages
2
Other businesses in the same business
3
With prior year information
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Syllabus C2. Interpretation of accounting ratios
Syllabus C2abcd)
a) Define and compute relevant financial ratios
b) Explain what aspects of performance specific ratios are intended to assess.
c) Analyse and interpret ratios to give an assessment of an entity’s/group’s performance and financial
position in comparison with:
i) previous period’s financial statements
ii) another similar entity/group for the same reporting period
iii) industry average ratios.
d) Interpret financial statements to give advice from the perspectives of different stakeholders.
Profitability
Return on Capital Employed
ROCE
This is a measure of management’s overall efficiency in using the finance/assets
•
is affected by the carrying amount of PPE
•
So old plant will give a higher than usual ROCE
•
Revaluations upwards will give a lower than usual ROCE
ROCE can be broken down (explained by) 2 more ratios:
Operating Margin
Asset Turnover
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So if operating margin goes up and ROCE goes down - you know that ROCE is going down due to
a poor Net asset turnover.
The assets aren't producing the amount of sales they used to
Operating Margin
= Operating profit (PBIT) / Sales
Asset Turnover
= Sales / Capital Employed
Gross Margin
This is affected by..
An increase in gross profit doesn't necessarily mean an increase in the margin
This is because Gross profit is also affected by the volume of sales (not just the margin made on
each one)
•
Opening and closing inventory measured at different costs
•
Inventory write downs due to damage/obsolescence
•
A change in the sales mix
eg. from higher to lower margin sales
•
New (different margin) products
•
New suppliers with different costs
•
Selling prices change
eg. discounts offered
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•
More or less Import duties
•
Exchange rate fluctuations
•
Change in cost classification:
eg. Some costs included as operating expenses now in cost of sales
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Syllabus C2abcd)
a) Define and compute relevant financial ratios
b) Explain what aspects of performance specific ratios are intended to assess.
c) Analyse and interpret ratios to give an assessment of an entity’s/group’s performance and financial
position in comparison with:
i) previous period’s financial statements
ii) another similar entity/group for the same reporting period
iii) industry average ratios.
d) Interpret financial statements to give advice from the perspectives of different stakeholders.
Gearing
Financial Gearing
This could also be calculated as:
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Interest Cover
Points to notice about LOW interest cover
Low interest cover is a direct consequence of high gearing and . For example,
•
It makes profits vulnerable to relatively small changes in operating activity
•
So small reductions in sales / margins or small increases in expenses may mean
interest can't be paid
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Syllabus C2abcd)
a) Define and compute relevant financial ratios
b) Explain what aspects of performance specific ratios are intended to assess.
c) Analyse and interpret ratios to give an assessment of an entity’s/group’s performance and financial
position in comparison with:
i) previous period’s financial statements
ii) another similar entity/group for the same reporting period
iii) industry average ratios.
d) Interpret financial statements to give advice from the perspectives of different stakeholders.
Liquidity
Current ratio
Quick Ratio
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Bank Account / Overdraft
Don't forget the obvious and look at the movement on this
•
Look for why it has increased or decreased
•
If money is spent on assets thats normally a good thing
•
If money is spent on high dividends (with little cash) thats a bad thing
•
If a loan is paid off - that's normally a bad idea (as the company should be
able to make a better return)
Working Capital Cycle
This is made up of
The difference between being paid needs to be funded (often by an overdraft)
1
Inventory Days + (ideally these are low)
2
Receivable days - (ideally these are low)
3
Payable days (ideally these are high)
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Indicators of deteriorating liquidity
•
Cash balances falling
•
New share / loan issues with no respective increase in assets
•
Sale and leaseback of assets
•
Payables days getting longer
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Syllabus C2e)
Discuss how the interpretation of current value based financial statements would differ from those
using historical cost based accounts.
Interpretation Of Current V Historic Value Based Financial
Statements
ROCE is affected because
•
HC Capital Employed is understated compared to using CV
•
HC profits are overstated in comparison to CV
•
Both of the above have the effect of overstating ROCE
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Syllabus C3. Limitations of interpretation techniques
Syllabus C3abcdef)
a) Discuss the limitations in the use of ratio analysis for assessing corporate performance.
b) Discuss the effect that changes in accounting policies or the use of different accounting polices
between entities can have on the ability to interpret performance.
c) Indicate other information, including non- financial information, that may be of relevance to the
assessment of an entity’s performance.
d) Compare the usefulness of cash flow information with that of a statement of profit or loss or a
statement of profit or loss and other comprehensive income.
e) Interpret a statement of cash flows (together with other financial information) to assess the
performance and financial position of an entity.
f) i) explain why the trend of eps may be a more accurate indicator of performance than a company’s
profit trend and the importance of eps as a stock market indicator
ii) discuss the limitations of using eps as a performance measure.
Other relevant information
When buying a company
•
Audited financial statements
•
Forward looking information
Eg. Profit and financial position forecasts
Capital expenditure budgets and
Cash budgets and
Order levels
•
Current (fair) values of assets being acquired
•
Level of business risk
Highly profitable companies may also be highly risky, whereas a less profitable
company may have more stable ‘quality’ earnings
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•
Expected price to acquire a company
It may be that a poorer performing business may be a more
attractive purchase because it has higher potential for growth
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Syllabus C3c)
Indicate other information, including non- financial information, that may be of relevance to the
assessment of an entity’s performance.
Other Helpful Information
Other helpful Information includes..
1
Order Books
2
Loan Repayment Dates
3
Age of Company
4
Asset Replacement Dates
5
Management Skills
6
Potential Synergies
7
FV of Assets
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Syllabus C4. Specialised, not-for-profit and public sector
entities
Syllabus C4a) Explain how the interpretation of the financial statement of a specialised, not-for-profit or
public sector organisations might differ from that of a profit making entity by reference to the different
aims, objectives and reporting requirements.
Not for Profit sector
Getting a Loan
Similar criteria as would be used for profit-orientated entities
•
How secure is the loan?
Here use the capital gearing ratio:
Long-term loans to net assets
Clearly if this ratio is high, further borrowing would be at an increased risk
•
Ability to repay the interest & capital
Interest cover should be calculated
PBIT / Interest
The higher this ratio the less risk of interest default
Look for trends indicating a deterioration in this ratio
•
Nature and trend of income
Are the sources of income increasing or decreasing
Does the reported income contain ‘one-off’ donations (which may not be recurring)
etc?
•
Other matters
Market value of, and prior charges against, any assets used as loan security
Any (perhaps the trustees) personal guarantees for the loan
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Syllabus D: PREPARATION OF FINANCIAL
STATEMENTS
Syllabus D1. CF - Approach to the Question
Syllabus D1c) Prepare a statement of cash flows for a single entity (not a group) in accordance with
relevant accounting standards using the indirect method.
Cashflow statements - Step 1
Cash flow statements - Step 1
Indirect method
The idea here is simply to get to the profit from operating activities as a starting point - nothing
more!
So IAS tells us that although we need to get to the operating profit figure we must start with Profit
before tax (PBT) and reconcile this to the operating profit figure.
Operating Profit
Before we do this let’s remind ourselves what “Operating profit” is.
Operating Profit is:
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Illustration
tart with the profit before tax figure and then reconcile to the operating profit figure.
Operating profit would be:
o, let’s start reconciling…
Then fill in the reconciling figures between them (income is a negative and expense a positive
here). This is because we are going upwards on the income statement, rather than the normal
downwards.
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So this is the final answer to step 1:
You place this in the “Cashflow from Operating Activities” part of the cash-flow statement.
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Syllabus D1c)
Prepare a statement of cash flows for a single entity (not a group) in accordance with relevant
accounting standards using the indirect method.
Cashflow statements - Step 2
Cash flow statements - Step 2
Now we have the operating profit figure we need to get to the cash.
We do this by taking the profit figure (calculated and reconciled to in step 1) and adding back all
the non-cash items (we get to the cash therefore indirectly).
Key point to remember here
The non-cash items we add back are ONLY those in operating profit (Sales, COS, admin and distr.
costs).
For example:
Depreciation, amortisation, impairments, profit on sale, receivables, payables and inventory
There could be more - it depends on the question - but dealing with these will ensure you pass.
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So the operating activities part of the cash flow will now look like this:
Ensure you get the signs the right way around!
For example an increase in stock means less cash so (x).
Notice we added back receivables / payables & Inventory.
This is because credit sales, stock and credit payables are not cash and are in the operating profit
figure.
You just need to be careful that you get the signs the right way around as with these we just
account for the movement in them.
Think of it like this:
•
Increase in Inventory - means less cash - so show as a negative
•
Increase in receivables - means less cash now - so show as a negative
•
Increase in payables - means don’t have to pay people just yet so an increase in
cash - so show as a positive
We have now dealt with the first part of the income statement - Sales, COS, administration
expenses and distribution costs. We have indirectly got the cash from these figures by adding back
all the non-cash items that may have been in there (as above).
All of this happens in the “Cashflow from Operating Activities” part of the cash-flow
statement.
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Syllabus D1c)
Prepare a statement of cash flows for a single entity (not a group) in accordance with relevant
accounting standards using the indirect method.
Cashflow statements - Step 3
Cash flow statements - Step 3
So far we have got the cash (indirectly) from operating profit. This means we have the cash from
Sales, COS, admin and distribution costs. What we now do is look at what’s left in the income
statement and try to find the cash.
(In our example in step 1, we would have to deal with IP income, finance costs and tax).
So we are looking at the other parts of the income statement (after operating profit) and finding the
cash and putting this directly into the cash-flow statement.
Direct method
We do this by using a different method to the one in step 2 as we are now looking to put the cash
in directly to the cash-flow statement (rather than taking a profit figure and adding back the noncash items to indirectly arrive at cash).
So how do we do this?
Let’s say you owed somebody 100, then bought 20 more in the year - you should therefore owe
them 120 right?
However you look at your books at the year end and you see you only owe them 70
Therefore, you must have paid cash to them of 50 - this is the figure we then put in our cash-flow
statement.
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To show this differently (and how the examiner often shows it):
We use this format for the rest of the cashflow question - though it may need adjusting slightly
(PPE is calculated differently).
We will now go on to look at the different items that you may find in the income statement and how
we deal with them in the cash-flow statement using this method.
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Syllabus D1c)
Prepare a statement of cash flows for a single entity (not a group) in accordance with relevant
accounting standards using the indirect method.
Cashflow statement - finance costs
Finance Costs - Illustration of Step 3
Solution
Finance costs of 120 paid go to the operating activities section of the cashflow statement.
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Syllabus D1c)
Prepare a statement of cash flows for a single entity (not a group) in accordance with relevant
accounting standards using the indirect method.
Cashflow statement - taxation
Taxation - Illustration of Step 3
Solution
Taxation costs of 150 paid go to the operating activities section of the cashflow statement.
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Syllabus D1c)
Prepare a statement of cash flows for a single entity (not a group) in accordance with relevant
accounting standards using the indirect method.
Cashflow statement - Investment property
Investment Property Income - Illustration of Step 3
There were no purchases of IP in the year.
Solution
Investment property income of 20 (rent received probably) goes to the investing activities
section of the cashflow statement.
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Syllabus D1c)
Prepare a statement of cash flows for a single entity (not a group) in accordance with relevant
accounting standards using the indirect method.
Cashflow statements - Step 4
Cash flow statements - Step 4
So in the first 3 steps, we have turned the Income statement into cash and placed it into the cashflow statement. We now need to do the same with the S - remember much of it we have already
dealt with (e.g. receivables, inventory, payables, investment
Property, interest and tax payable
So let’s begin with…
PPE
We deal with this slightly differently to the income statement items in step 3:
Process to follow
Here’s the process to follow:
Write down the PPE figures per the accounts
Work out the cash element of each item (if any)
Illustration
Notes:
Depreciation in year = 50
Revaluation = 100
Disposal = Asset sold for 100 making 20 profit
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Solution
The key here is to try and find the balancing figure (per the accounts) which will be additions in the
year.
Note: we are dealing with NBVs.
Write down the PPE figures per the accounts.
The balancing figure is 90 and this is additions.
Work out the cash element of each item (if any):
All PPE items go the investing activities section of the cashflow statement.
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Syllabus D1c)
Prepare a statement of cash flows for a single entity (not a group) in accordance with relevant
accounting standards using the indirect method.
Cashflow statements - Step 5 - Loans
Cashflow statements - Step 5 - Loans
Let’s now look at another one of the items that would still be left on the SFP, that we need to find
the cash and take to the cash-flow statement - Loans
Illustration
Follow same techniques as before..
Solution
Loan repayments of 40 go to the financing activities section of the cashflow statement.
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Syllabus D1c)
Prepare a statement of cash flows for a single entity (not a group) in accordance with relevant
accounting standards using the indirect method.
Cashflow statements - Step 5 - Shares
Cashflow statements - Step 5 - Shares
So in steps 1-3 we looked at how we got the cash from the income statement and into the
statement of cash flows.
In step 4 we looked at getting the cash flows from PPE.
So now in our final step we look at getting cash from what’s left in the SFP… starting with shares.
Share issues
Again let’s look at this by illustration and we are using virtually the same technique as step 3 as
you will see..
Solution
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Share Proceeds goes to the financing activities section of the cashflow statement.
Effect of Bonus Issue
If there’s been a bonus issue, you need to be careful.
You need to look at where the debit went - share premium or retained earnings:
If share premium - ignore the bonus issue and the answer calculated above is still correct
If Retained earnings - reduce the cash by the amount of the bonus issue
See the quizzes for examples of this.
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Syllabus D2. Preparing group SFP
Syllabus D2a) Prepare a consolidated statement of financial position for a simple group (parent and
one subsidiary and associate) dealing with pre and post acquisition profits, non-controlling interests
and consolidated goodwill.
Business Combinations - Basics
The purpose of consolidated accounts is to show the group as a single
economic entity.
So first of all - what is a business combination?
•
Well my little calf, it’s an event where the acquirer obtains control of another
business.
•
Let me explain, let’s say we are the Parent acquiring the subsidiary.
We must prepare our own accounts AND those of us and the sub put together
(called “consolidated accounts”)
This is to show our shareholders what we CONTROL.
Basic principles
The accounts show all that is controlled by the parent, this means:
1
All assets and liabilities of a subsidiary are included
2
All income and expenses of the subsidiary are included
Non controlling Interest (NCI)
However the parent does not always own all of the above.
So the % that is not owned by the parent is called the “non-controlling interest”.
•
A line is included in equity called non-controlling interests. This accounts for their
share of the assets and liabilities on the SFP.
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•
A line is also included on the income statement which accounts for the NCI’s share
of the income and expenses.
One Thing you must understand before we go on
Forgive me if this is basic, but hey, sometimes it’s good to be sure.
Notice if you add the assets together and take away the liabilities for H - it comes to 400
(500+200+100-100-300)
There are 2 things to understand about this figure:
1
It is NOT the true/fair value of the company
2
It is equal to the equity section of the SFP
•
This shows you how the net assets figure has come about. The share capital is the
Equity
capital introduced from the owners (as is share premium).
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•
The reserves are all the accumulated profits/losses/gains less dividends since the
business started. Here the figure is 400 for H.
Notice it is equal to the net assets
Acquisition costs
•
Where there’s an acquisition there’s probably some of the costs eg legal fees etc
Costs directly attributable to the acquisition are expensed to the income statement.
•
Be careful though, any costs which are just for the parent (acquirer) issuing its own
debt or shares are deducted from the debt or equity itself (often share premium).
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Syllabus D2a)
Prepare a consolidated statement of financial position for a simple group (parent and one subsidiary
and associate) dealing with pre and post acquisition profits, non-controlling interests and
consolidated goodwill.
Simple Goodwill
Simple Goodwill
Goodwill
•
When a company buys another - it is not often that it does so at the fair value of the
net assets only.
This is because most businesses are more than just the sum total of their ‘net
assets’ on the SFP.
Customer base, reputation, workforce etc. are all part of the value of the company
that is not reflected in the accounts.
This is called “goodwill”
•
Goodwill only occurs on a business combination. Individual companies cannot show
their individual goodwill on their SFPs.
This is because they cannot get a reliable measure, This is because nobody has
purchased the company to value the goodwill appropriately.
On a business combination the acquirer (Parent) purchases the subsidiary normally at an amount higher than the FV of the net assets on the SFP, they buy it
at a figure that effectively includes goodwill.
Therefore the goodwill can now be measured and so does show in the group
accounts.
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How is goodwill calculated?
On a basic level - I hope you can see - that it is the amount paid by the parent less the FV of the
subs assets on their SFP.
Let me explain..
In this example S’s Net assets are 900 (same as their equity remember).
This is just the ‘book value’ of the net assets.
The Fair Value of the net assets may be, say, 1,000.
However a company may buy the company for 1.200. So, Goodwill would be 200.
The goodwill represents the reputation etc. of a company and can only be reliably measured when
the company is bought out.
Here it was bought for 1,200. Therefore, as the FV of the net assets of S was only 1,000 - the extra
200 is deemed to be for goodwill.
The increase from book value 900 to FV 1,000 is what we call a Fair Value adjustment.
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Bargain Purchase
This is where the parent and NCI paid less at acquisition than the FV of S’s net assets. This is
obviously very rare and means a bargain was acquired
So rare in fact that the standard suggests you look closely again at your calculation of S’s net
assets value because it is strange that you got such a bargain and perhaps your original
calculations of their FV were wrong
However, if the calculations are all correct and you have indeed got a bargain then this is
NOT shown on the SFP rather it is shown as:
•
Income on the income statement in the year of acquisition
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Syllabus D2a)
Prepare a consolidated statement of financial position for a simple group (parent and one subsidiary
and associate) dealing with pre and post acquisition profits, non-controlling interests and
consolidated goodwill.
NCI in the Goodwill calculation
NCI in the Goodwill calculation
So far we have presumed that the company has been 100% purchased when calculating goodwill.
Our calculation has been this:
Non-controlling Interests
Let’s now take into account what happens when we do not buy all of S. (eg. 80%)
This means we now have some non-controlling interests (NCI) at 20%
The formula changes to this:
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This NCI can be calculated in 2 ways:
1
Proportion of FV of S’s Net Assets
2
FV of NCI itself
Proportion of FV of S’s Net Assets method
This is very straight forward. All we do is give the NCI their share of FV of S’s Net Assets..Consider
this:
P buys 80% S for 1,000. The FV of S’s Net assets were 1,100.
How much is goodwill?
The NCI is calculated as 20% of FV of S’s NA of 1,100 = 220
“Fair Value Method” of Calculating NCI in Goodwill
•
So in the previous example NCI was just given their share of S’s Net assets.
They were not given any of their reputation etc.
In other words, NCI were not given any goodwill.
•
I repeat, under the proportionate method, NCI is NOT given any goodwill.
Under the FV method, they are given some goodwill.
•
This is because NCI is not just given their share of S’s NA but actually the FV of
their 20% as a whole (ie NA + Goodwill).
This FV figure is either given in the exam or can be calculated by looking at the
share price.
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P buys 80% S for 1,000. The FV of S’s Net assets were 1,100. The FV of NCI at this date was
250.
How much is goodwill?
Notice how goodwill is now 30 more than in the proportionate example. This is the goodwill
attributable to NCI.
NCI goodwill = FV of NCI - their share of FV of S’s NA
Remember
Under the proportionate method NCI does not get any of S’s Goodwill (only their share of S’s NA).
Under the FV method, NCI gets given their share of S’s NA AND their share of S’s goodwill.
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Syllabus D2a)
Prepare a consolidated statement of financial position for a simple group (parent and one subsidiary
and associate) dealing with pre and post acquisition profits, non-controlling interests and
consolidated goodwill.
Equity Table
Equity Table
S’s Equity Table
As you will see when we get on to doing bigger questions, this is always our first working.
This is because it helps all the other workings.
Remember that Equity = Net assets
Equity is made up of:
1
Share Capital
2
Share Premium
3
Retained Earnings
4
Revaluation Reserve
5
Any other ‘reserve’!
If any of the above is mentioned in the question for S, then they must go into this equity table
working.
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What does the table look like?
Remember that any other reserve would also go in here.
So how do we fill in this table?
1
Enter the "Year end" figures straight from the SFP
2
Enter the "At acquisition" figures from looking at the information given normally in
note 1 of the question.
Please note you can presume the share capital and share premium is the same as
the year-end figures, so you're only looking for the at acquisition reserves figures
3
Enter "Post Acquisition" figures simply by taking away the "At acquisition" figures
away from the "Year end" figures
(ie. Y/E - Acquisition = Post acquisition)
So let's try a simple example.. (although this is given in a different format to the actual exam let's
do it this way to start with).
A company has share capital of 200, share premium of 100 and total reserves at acquisition of 100
at acquisition and have made profits since of 400. There have been no issues of shares since
acquisition and no dividends paid out.
Show the Equity table to calculate the net assets now at the year end, at acquisition and
post-acquisition
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Solution
Fair Value Adjustments
Ok the next step is to also place into the Equity table any Fair Value adjustments
When a subsidiary is purchased - it is purchased at FAIR VALUE at acquisition.
Using the figures above, if I were to tell you that the FV of the sub at acquisition was 480.
Hopefully you can see we would need to make an adjustment of 80 (let’s say that this was because
Land had a FV 80 higher than in the books):
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Now as land doesn’t depreciate - it would still now be at 80 - so the table changes to this:
If instead the FV adjustment was due to PPE with a 10 year useful economic life left - and lets say
acquisition was 2 years ago, the table would look like this:
The -16 in the post acquisition column is the depreciation on the FV adjustment. (80 / 10 years x 2
years).
This makes the now column 64 (80 at acquisition - 16 depreciation post acquisition).
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Syllabus D2a)
Prepare a consolidated statement of financial position for a simple group (parent and one subsidiary
and associate) dealing with pre and post acquisition profits, non-controlling interests and
consolidated goodwill.
NCI on the SFP
Non-Controlling Interests
So far we have looked at goodwill and the effect of NCI on this.. Now let’s look at NCI in a bit more
detail (don’t worry we will pull all this together into a bigger question later).
If you remember there are 2 methods of measuring NCI at acquisition:
1
Proportionate method
This is the NCI % of FV of S’s Net assets at acquisition.
2
FV Method
This is the FV of the NCI shares at acquisition (given mostly in the question).
This choice is made at the beginning.
Obviously, S will make profits/losses after acquisition and the NCI deserve their share of these.
Therefore the formula to calculate NCI on the SFP is as follows:
* This figure depends on the option chosen at acquisition (Proportionate or FV method).
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Impairment
S may become impaired over time. If it does, it is S’s goodwill which will be reduced in value first. If
this happens it only affects NCI if you are using the FV method.
This is because the proportionate method only gives NCI their share of S’s Net assets and none of
the goodwill.
Whereas, when using the FV method, NCI at acquisition is given a share of S’s NA and a share of
the goodwill.
NCI on the SFP Formula revised
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Syllabus D2a)
Prepare a consolidated statement of financial position for a simple group (parent and one subsidiary
and associate) dealing with pre and post acquisition profits, non-controlling interests and
consolidated goodwill.
Basic groups - Simple Question 1
Basic groups - Simple Question 1
Have a look at this question and solution below and see if you can work out where all the figures in
the solution have come from.
Make sure to check out the videos too as these explain numbers questions such as these far better
than words can..
P acquired 80% S when S’s reserves were 80.
Prepare the Consolidated SFP, assuming P uses the proportionate method for measuring
NCI at acquisition.
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Goodwill
NCI
Reserves
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Group SFP
Notice
1) Share Capital (and share premium) is always just the holding company
2) All P + S assets are just added together
3) “Investment in S”..becomes “Goodwill” in the consolidated SFP
4) NCI is an extra line in the equity section of consolidated SFP
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Syllabus D2a)
Prepare a consolidated statement of financial position for a simple group (parent and one subsidiary
and associate) dealing with pre and post acquisition profits, non-controlling interests and
consolidated goodwill.
Basic groups - Simple Question 2
Basic groups - Simple Question 2
P acquired 80% S when S’s Reserves were 40.
At that date the FV of S’s NA was 150.
Difference is due to Land.
There have been no issues of shares since acquisition.
P uses the FV of NCI method at acquisition, and at acquisition the FV of NCI was 35. No
impairment of goodwill.
Prepare the consolidated set of accounts.
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Step 1: Prepare S’s Equity Table
Now the extra 10 FV adjustment now must be added to the PPE when we come to do the SFP at
the end.
Step 2: Goodwill
Step 3: Do any adjustments in the question
: NONE
Step 4: NCI
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Step 5: Reserves
Step 6: Prepare the final SFP (with all adjustments included)
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Syllabus D2a)
Prepare a consolidated statement of financial position for a simple group (parent and one subsidiary
and associate) dealing with pre and post acquisition profits, non-controlling interests and
consolidated goodwill.
Associates
An associate is an entity over which the group has significant influence, but not control.
Significant influence
Significant influence is normally said to occur when you own between 20-50% of the shares in a
company but is usually evidenced in one or more of the following ways:
•
representation on the board of directors
•
participation in the policy-making process
•
material transactions between the investor and the investee
•
interchange of managerial personnel; or
•
provision of essential technical information
Accounting treatment
An associate is not a group company and so is not consolidated. Instead it is accounted for using
the equity method. Inter-company balances are not cancelled.
Statement of Financial Position
There is just one line only “investment in Associate” that goes into the consolidated SFP (under the
Non-current Assets section).
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It is calculated as follows:
Consolidated income statement
Again just one line in the consolidated income statement:
Include share of PAT less any impairment for that year in associate.
Do not include dividend received from A.
What’s important to notice is that you do NOT add across the associate’s Assets and Liabilities or
Income and expenses into the group totals of the consolidated accounts. Just simply place one line
in the SFP and one line in the Income Statement.
Unrealised profits for an associate
1
Only account for the parent’s share (eg 40%).
This is because we only ever place in the consolidated accounts P’s share of A’s
profits so any adjustment also has to be only P’s share.
2
Adjust earnings of the seller
Adjustments required on Income Statement
•
If A is the seller - reduce the line “share of A’s PAT”
•
If P is the seller - increase P’s COS
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Adjustments required on SFP
•
If A is the seller - reduce A’s Retained earnings and P’s Inventory
•
If P is the seller - reduce P’s Retained Earnings and the “Investment in Associate”
line
Illustration
P sells goods to A (a 30% associate) for 1,000; making a 400 profit. 3/4 of the goods have been
sold to 3rd parties by A.
What entries are required in the group accounts?
Profit = 400; Unrealised (still in stock) 1/4 - so unrealised profit = 400 x 1/4 = 100. As this is an
associate we take the parents share of this (30%). So an adjustment of 100 x 30% = 30 is needed.
Adjustment required on the Income statement
P is the seller - so increase their COS by 30.
Adjustment required on the group SFP
P is the seller - so reduce their retained earnings and the line “Investment in Associate” by 30.
The retained earnings of S and A were £70,000 and £30,000 respectively when they were acquired
8 years ago.
There have been no issues of shares since then, and no FV adjustments required.
The group use the proportionate method for valuing NCI at acquisition.
Prepare the consolidated SFP
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Solution
Step 1: Equity Table
Step 2: Goodwill
H owns 18,000 of S’s share capital of 30,000 so 60%.
Step 3: NCI
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Step 4: Retained Earnings
Step 5: Investment in Associate
Final answer - Goodwill
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Syllabus D2b)
Prepare a consolidated statement of profit or loss and consolidated statement of profit or loss and
other comprehensive income for a simple group dealing with an acquisition in the period and noncontrolling interest.
Group Income Statement
Group Income Statement
Rule 1 - Add Across 100%
Like with the SFP, P and S are both added together. All the items from revenue down to Profit after
tax; except for:
1) Dividends from Subsidiaries
2) Dividends from Associates
Rule 2 - NCI
This is an extra line added into the consolidated income statement at the end. It is calculated as
NCI% x S’s PAT.
The reason for this is because we add across all of S (see rule 1) even if we only own 80% of S.
We therefore owe NCI 20% of this which we show at the bottom of the income statement.
Rule 3 - Associates
Simply show one line (so never add across an associate).
The line is called “Share in Associates’ Profit after tax”.
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Rule 4 - Depreciation from the Equity table working
Remember this working from when we looked at group SFP’s?
The -10 from the FV adjustment is a group adjustment. So needs to be altered on the group
income statement. It represents depreciation, so simply put it to admin expenses (or wherever the
examiner tells you), be careful though to only out in THE CURRENT YEAR depreciation charge.
Rule 5 - Time Apportioning
This isn’t difficult but can be awkward/tricky. Basically all you need to remember is the group only
shows POST -ACQUISITION profits. i.e. Profits made SINCE we bought the sub or associate.
If the sub or associate was bought many years ago this is not a problem in this year’s income
statement as it has been a sub or assoc. all year.
The problem arises when we acquire the sub or the associate mid year. Just remember to only add
across profits made after acquisition. The same applies to NCI (as after all this just a share of S’s
PAT).
For example if our year end is 31/12 and we buy the sub or assoc. on 31/3. We only add across
9/12 of the subs figures and NCI is % x S’s PAT x 9/12.
One final point to remember here is adjustments such as unrealised profits / depreciation on FV
adjustments are entirely post - acquisition and so are NEVER time apportioned.
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Rule 6 - Unrealised Profit
You will remember this table I hope
Well the idea stays the same - it’s just how we alter the accounts that changes, because this is an
income statement after all and not an SFP. So the table you need to remember becomes:
Notice how we do not need to make an adjustment to reduce the value of inventory. This is
because we have increased cost of sales (to reduce profits), but we do this by actually reducing
the value of the closing stock.
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Syllabus D2cd)
c) Explain and account for other reserves (e.g. share premium and revaluation surplus).
d) Account for the effects in the financial statements of intra-group trading.
Unrealised Profit
Unrealised Profit
The key to understanding this - is the fact that when we make group accounts - we are pretending
P & S are the same entity.
Therefore you cannot make a profit by selling to yourself!
So any profits made between two group companies (and still in group inventory) need removing this is what we call ‘unrealised profit’.
Unrealised profit - more detail
Profit is only ‘unrealised’ if it remains within the group. If the stock leaves the group it has become
realised.
So ‘Unrealised profit” is profit made between group companies and REMAINS IN STOCK.
Example
P buys goods for 100 and sells them to S for 150. S has sold 2/5 of this stock.
The Unrealised Profit is: Profit between group companies 50 x 3/5 (what remains in stock) = 30.
How do we then deal with Unrealised Profit
If P buys goods for 100 and sells them to S for 150.
Thereby making a profit of 50 by selling to another group company.
S sells 4/5 of them to 3rd parties.
Unrealised profit is 50 x 1/5 = 10
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So why do we reduce inventory as well as profit?
Well let’s say that S buys goods for 100 and sells them to P for 150 and P still has them in stock.
How much did the stock actually cost the group?
The answer is 100, as they are still in the group.
However P will now have them in their stock at 150.
So we need to reduce stock/inventory also with any unrealised profit.
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Syllabus D2cd)
c) Explain and account for other reserves (e.g. share premium and revaluation surplus).
d) Account for the effects in the financial statements of intra-group trading.
Intra-Group Balances & In-transit Items
Inter-group company balances
As with Unrealised Profit - this occurs because group companies are considered to be the same
entity in the group accounts.
Therefore you cannot owe or be owed by yourself.
So if P owes S - it means P has a payable with S, and S has a receivable from P in their
INDIVIDUAL accounts.
In the group accounts, you cannot owe/be owed by yourself - so simply cancel these out:
Dr Payable (in P)
Cr Receivable (in S)
The only time this wouldn’t work is if the amounts didn’t balance, and the only way this could
happen is because something was still in transit at the year end. This could be stock or cash.
You always alter the receiving company. What I mean is - if the item is in transit, then the receiving
company has not received it yet - so simply make the RECEIVING company receive it as follows:
Stock in transit
In the RECEIVING company’s books:
Dr Inventory
Cr Payable
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Cash in transit
In the RECEIVING company’s books:
Dr Cash
Cr Receivable
Having dealt with the amounts in transit - the inter group balances (receivables/payables) will
balance so again you simply:
Dr Payable
Cr Receivable
Intra-group dividends
eliminate all dividends paid/payable to other entities within the group, and all intragroup dividends
received/receivable from other entities within the group.
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Syllabus D2cd)
c) Explain and account for other reserves (e.g. share premium and revaluation surplus).
d) Account for the effects in the financial statements of intra-group trading.
Share for Share Exchanges
Share for share exchanges
These can form part, or all, of the cost of investment which is used in the goodwill
calculation.
Under normal circumstances, P acquires S’s shares by giving them cash, so the double entry is
Dr Cost of Investment
Cr Cash
However this time, P does not give cash, but instead gives some of its own shares
If this exchange has yet to be accounted for, the double entry is always:
Dr Cost of Investment
Cr Share capital (with the nominal value of P shares given out)
Cr Share premium (with the premium)
Illustration
P acquired 80% of S shares via a 2 for 1 share exchange.
At the date of acquisition, the following balances were in the books of P and S:
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The share price of P was $2 at the date of acquisition. This has not been accounted for.
Show the accounting treatment required to account for the share exchange.
P acquired 80% of S’s shares.
The shares had a value of $400 but a nominal value of $0.50.
This means S has 800 shares in total. P acquired 80% x 800 = 640 shares
The share for share deal was 2 for 1.
So P gives 1,280 of its shares in return for 640 of S’s shares.
P’s shares have a MV of $2 at this date so the “cost of investment is 1,280 x 2 = 2,560
Double entry
Dr Cost of Investment 2,560
Cr Share Capital (P) 1,280
Cr Share Premium (P) 1,280
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Syllabus D2efg)
e) Account for the effects of fair value adjustments (including their effect on consolidated goodwill) to:
i) depreciating and non-depreciating non-current 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
f) Account for goodwill impairment.
g) Describe and apply the required accounting treatment of consolidated goodwill.
Basic Goodwill Calculation
This is calculated on the date of acquisition of the sub
It represents the intangible reputation / customer base etc of the sub.
It is calculated as follows:
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Syllabus D2efg)
e) Account for the effects of fair value adjustments (including their effect on consolidated goodwill) to:
i) depreciating and non-depreciating non-current 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
f) Account for goodwill impairment.
g) Describe and apply the required accounting treatment of consolidated goodwill.
Make sure you use FV of Consideration
Consideration is simply what the Parent pays for the sub.
It is the first line in the goodwill working as follows:
Normal Consideration
This is straightforward. It is simply:
Dr Investment in S
Cr Cash
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Future Consideration
This is a little more tricky but not much. Here, the payment is not made immediately but in the
future. So the credit is not to cash but is a liability.
Dr Investment in S
Cr Liability
The only difficulty is with the amount.
As the payment is in the future we need to discount it down to the present value at the date of
acquisition.
Illustration
P agrees to pay S 1,000 in 3 years time (discount rate 10%).
Dr Investment in S 751
Cr Liability 751 (1,000 / 1.10^3)
As this is a discounted liability, we must unwind this discount over the 3 years to get it back to
1,000. We do this as follows:
Contingent Consideration
This is when P MAY OR MAY NOT have to pay an amount in the future (depending on, say, S’s
subsequent profits etc.). We deal with this as follows:
Dr Investment in S
Cr Liability
All at fair value
You will notice that this is exactly the same double entry as the future consideration (not surprising
as this is a possible future payment!).
The only difference is with the amount.
Instead of only discounting, we also take into account the probability of the payment actually being
made.
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Doing this is easy in the exam - all you do is value it at the FV
(this will be given in the exam you’ll be pleased to know).
Illustration
1/1/x7 H acquired 100% S when it’s NA had a FV of £25m. H paid 4m of its own shares (mv at
acquisition £6) and cash of £6m on 1/1/x9 if profits hit a certain target.
At 1/1/x7 the probability of the target being hit was such that the FV of the consideration was now
only £2m. Discount rate of 8% was used.
At 31/12/x7 the probability was the same as at acquisition.
At 31/12/x8 it was clear that S would beat the target.
Show the double entry
Contingent consideration should always be brought in at FV. Any subsequent changes to this FV
post acquisition should go through the income statement.
Any discounting should always require an winding of the discount through interest on the income
statement
Double entry - Parent Company
1/1/x7
Dr Investment in S (4m x £6) + £2 = 26
Cr Share Capital 4
Cr Share premium 20
Cr Liability 2
31/12/x7
Dr interest 0.16
Cr Liability 0.16
31/12/x8
Dr Income statement 4 (6-2)
Dr Liability 2
Cr Cash 6
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Syllabus D2efg)
e) Account for the effects of fair value adjustments (including their effect on consolidated goodwill) to:
i) depreciating and non-depreciating non-current 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
f) Account for goodwill impairment.
g) Describe and apply the required accounting treatment of consolidated goodwill.
Use either proportionate or FV NCI
NCI can be valued using the PROPORTIONATE method or the FAIR VALUE
method
Proportionate method
Here NCI gets its % of S's NA
1
% of S's NA (at fair value)
2
No goodwill in S is given to NCI
Let's say the parent acquires 80% of a subsidiary with net assets of 100.
NCI would receive 20 at acquisition
The goodwill calculation would look like this…
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Fair Value
Here NCI get their % of NA AND goodwill
1
% of S's NA (at fair value)
2
% of S's Goodwill
Let's say the parent acquires 80% of a subsidiary with net assets of 100.
NCI would receive the FV of its holding at acquisition
This would be given in the exam or calculated as NCI shares x share price
Let's say this is 28
The goodwill calculation would look like this…
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Syllabus D2efg)
e) Account for the effects of fair value adjustments (including their effect on consolidated goodwill) to:
i) depreciating and non-depreciating non-current 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
f) Account for goodwill impairment.
g) Describe and apply the required accounting treatment of consolidated goodwill.
Impairment of Goodwill
Goodwill is reviewed for impairment not amortised
An impairment occurs when the subs recoverable amount is less than the subs carrying value +
goodwill.
How this works in practice depends on how NCI is measured - Proportionate or Fair Value method.
Proportionate NCI
Here, NCI only receives % of S's net assets.
NCI DOES NOT have any share of the goodwill.
1
Compare the recoverable amount of S (100%) to..
2
NET ASSETS of S (100%) +
Goodwill (100%)
3
The problem is that goodwill on the SFP is for the parent only - so this needs
grossing up first
4
Then find the difference - this is the impairment - but only show the parent % of the
impairment
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Example
H owns 80% of S. Proportionate NCI
Goodwill is 80 and NA are 200
Recoverable amount is 240
How much is the impairment?
Solution
RA = 240
NA = 200 + G/W (80 x 100/80) = 100 = 300
Impairment is therefore 60.
The impairment shown in the accounts though is 80% x 60 = 48.
This is because the goodwill in the proportionate method is parent goodwill only. Therefore only
parent impairment is shown.
Fair Value NCI
Here, NCI receives % of S's net assets AND goodwill.
NCI DOES now own some goodwill.
1
Compare the recoverable amount of S (100%) to..
2
NET ASSETS of S (100%) +
Goodwill (100%)
3
As, here, goodwill on the SFP is 100% (parent & NCI) - so NO grossing up needed
4
Then find the difference - this is the impairment - this is split between the parent and
NCI share
Example
H owns 80% of S. Fair Value NCI
Goodwill is 80 and NA are 200
Recoverable amount is 240
How much is the impairment?
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Solution
RA = 240
NA = 200 + G/W 80 = 280
Impairment is therefore 40.
The impairment shown in P's RE as 80% x 40 = 32.
The impairment shown in NCI is 20% x 40 = 8.
Impairment adjustment on the Income Statement
1
Proportionate NCI
Add it to P's expenses.
2
Fair Value NCI
Add it to S's expenses
(this reduces S's PAT so reduces NCI when it takes its share of S's PAT).
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Syllabus D2efg)
e) Account for the effects of fair value adjustments (including their effect on consolidated goodwill) to:
i) depreciating and non-depreciating non-current 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
f) Account for goodwill impairment.
g) Describe and apply the required accounting treatment of consolidated goodwill.
Make sure you use FV of Net Assets Acquired
A subsidiary is brought into group accounts at FAIR value at acquisition
Here's a subsidiary at Book Value
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The FAIR Values of the above net assets were the same as their book value with the exception of
PPE which had a FV $3000 in excess of the book value
Here's the subsidiary at FAIR Value
Once the FV of the NA has been calculated, the total goes into the goodwill calculation as follows:
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Syllabus D2h)
h) Explain and illustrate the effect of the disposal of a parent’s investment in a subsidiary in the
parent’s individual financial statements and/or those of the group (restricted to disposals of the
parent’s entire investment in the subsidiary).
Full Disposal
Full Disposal
This is when we lose control, so we go from owning a % above 50 to one below 50 (eg 80% to
30%).
In this case we have effectively disposed of the subsidiary (and possibly created a new associate).
As the sub has been disposed of - then any gain or loss goes to the INCOME STATEMENT (and
hence retained earnings).
Also, the old Subs assets and liabilities no longer get added across, there will be no goodwill or
NCI for it either.
How do you calculate this gain or loss?
What’s the effect on the Income Statement?
Consolidated until sale; Then treat as Associate (if we have significant influence) otherwise a
FVTPL investment.
Show profit on disposal (see above).
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