INSTITUTE OF CHARTERED
SECRETARIES
AND ADMINISTRATORS IN ZIMBABWE
ADVANCED ACCOUNTING AND FINANCIAL
REPORTING
(Volume 1)
By Patrick M. Paradza
BSc(Econ)
M.Acc
ACIS
RPAcc(ZIM)
PATRICK M. PARADZA.
Is the author, university lecturer and financial adviser holding the following
qualifications:
BSc(Econ); M.Acc; ACIS; RPAcc(Zim)
II
Published by the Institute of Chartered Secretaries &
Administrators in Zimbabwe, (ICSAZ)
P.O. Box CY 172,
Causeway,
Harare.
©: ICSAZ 2016
All rights reserved. No part of this publication may be reproduced, stored in a retrieval
system, or transmitted, in any form, or by any means, electronic, mechanical,
photocopying, recording or otherwise, without prior permission, in writing, from the
publisher.
Typeset by Online Electronic Publishing, Harare, Zimbabwe
ISBN 978-0-7974-3370-0
The study material in this book has been compiled from International Accounting
Standards, International Financial Reporting Interpretations published by the
International Accounting Standards Board. Other sources have been duly acknowledged.
III
CONTENTS
Unit
Page
1
The Theoretical Framework of Accounting
1
2
The Regulatory Framework of Accounting
14
3
First – time Adoption of International Financial Reporting Standards
19
4
Presentation of Financial Statements
31
5
Consolidation Financial Statements
62
6
Group Statement of Cash flows
207
7
Fair Value Measurement
223
8
Regulatory Deferral Accounts
239
9
Income Taxes
247
10
Share-Based Payment
272
11
Service Concession Arrangements
283
12
Property, Plant & Equipment
289
13
Non-Current Assets Held for Sale and Discontinued Operations
300
14
The Valuation of Shares and other Business Interests
313
15
Capital Re-organization and Reconstructions
335
16
Advanced Interpretation of Financial Statements
355
17
Earnings per Share
369
18
Intangible Assets
381
19
Leasing
398
20
Impairment of Assets
415
21
Employee Benefits
435
Subject Index
457
IV
UNIT ONE
THEORETICAL FRAMEWORK OF ACCOUNTING
COURSE OUTLINE
1.0 Introduction……………………………………………………………………………. 1
1.1 Objectives…………………………………………………………………………….... 2
1.2 Definition and scope of financial accounting theory………………………………….. 2
1.3 Approaches to the development of financial accounting theory………………………. 3
1.4 Purpose and status of the IASB conceptual framework……………………………….. 4
1.5 Objectives of financial statements……………………………………………………... 4
1.6 Qualitative characteristics of accounting information…………………………………. 6
1.6.1 Fundamental qualitative characteristics…………………………………………….... 7
1.6.2 Enhancing qualitative characteristics………………………………………………… 8
1.7 The elements of financial statements…………………………………………………... 9
1.7.1 Guidelines for the recognition of individual elements of financial statements…….... 11
1.7.2 Measurement of the elements of financial statements……………………………….. 11
1.8 Concepts of capital and capital maintenance…………………………………………... 12
1.9 Summary……………………………………………………………………………….. 13
1.10 References…………………………………………………………………………….. 13
UNIT TWO
THE REGULATORY FRAMEWORK OF ACCOUNTING
2.0 Introduction……………………………………………………………………………. 14
2.1 Objectives…………………………………………………………………………….... 14
2.2 Regulation of financial accounting information……………………………………….. 14
2.3 Objectives of the International Accounting Standards Board…………………………. 15
2.4 The IASB standard-setting process (also known as the due process)…………………. 16
2.5 The IFRS standard interpretation process……………………………………………... 17
2.6 Functions of the Zimbabwe Public Accountants and Auditors Board (PAAB)……….. 17
2.7 Harmonization of National Accounting Standards…………………………………….. 18
2.8 Summary……………………………………………………………………………….. 18
2.9 References……………………………………………………………………………… 18
UNIT THREE
FIRST-TIME ADOPTION OF INTERNATIONAL FINANCIAL
REPORTING STANDARDS (IFRS 1)
3.0 Introduction……………………………………………………………………………. 19
3.1 Objectives…………………………………………………………………………….... 19
3.2 Examples of IFRS financial statements………………………………………………... 20
3.3 Steps in preparation of an entity’s opening statement of financial position…………… 20
3.4 Accounting treatment arising from specific application of
IFRSs…………………………………………………………………………………... 21
3.4.1 IAS 10 (Events after the reporting period)…………………………………………... 22
3.4.2 IFRS 1 Requirements………………………………………………………………… 22
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V
3.4.3 IAS 12 (Income Tax)………………………………………………………………… 23
3.4.4 IAS 16 (Property, Plant and Equipment)…………………………………………….. 23
3.4.5 IAS 19 (Employee Benefits)…………………………………………………………. 23
3.5 The IFRS 3 exemption…………………………………………………………………. 24
3.6 Presentation and disclosure……………………………………………………………. 29
3.7 Summary……………………………………………………………………………….. 30
3.8 References……………………………………………………………………………… 30
UNIT FOUR
PRESENTATION OF FINANCIAL STATEMENTS (IAS 1)
4.0 Introduction……………………………………………………………………………. 31
4.1 Objectives……………………………………………………………………………… 31
4.2 Terminology…………………………………………………………………………… 32
4.3 Financial statements…………………………………………………………………… 32
4.3.1 Definition and purpose of financial statements……………………………………… 32
4.3.2 Complete set of financial statements/Components of financial statements…………. 32
4.4 General aspects of IFRSs……………………………………………………………… 33
4.4.1 Fair presentation and compliance with IFRSs………………………………………. 33
4.4.2 Departure from applicable IFRSs…………………………………………………..... 34
4.4.3 Going concern……………………………………………………………………….. 35
4.4.4 Accrual basis………………………………………………………………………… 35
4.4.5 Materiality and aggregation…………………………………………………………. 35
4.4.6 Offsetting……………………………………………………………………………. 35
4.4.7 Frequency of reporting………………………………………………………………. 36
4.4.8 Comparative information……………………………………………………………. 36
4.5 Structure and content of financial statements…………………………………………. 36
4.5.1 Identification of financial statements………………………………………………... 36
4.5.2 Information to be presented in the statement of financial position………………….. 37
4.5.3 Classification of statement of financial position elements…………………………... 38
4.5.3.1 Information to be presented either in the statement of financial position or
in the notes…………………………………………………………………………. 39
4.5.3.2 Information to be presented either in the statement of financial position or
the statement of changes in equity or in the notes…………………………………. 39
4.5.3.3 Overall presentation of the statement of financial position………………………... 40
4.5.4 The Statement of profit or loss and other comprehensive income…………………... 41
4.5.5 Information to be presented in the statement of profit or loss and other
comprehensive income…………………………………………………………….. 41
4.5.5.1 Profit or loss for the period………………………………………………………... 42
4.5.5.2 Other comprehensive income for the period………………………………………. 42
4.5.5.3 Information to be presented in the statement of profit or loss and other
comprehensive income or in the notes…………………………………………….. 43
4.5.6 Presentation of statement of profit or loss and other comprehensive income……….. 43
4.5.7 Overall presentation of statement of profit or loss and other comprehensive income..46
4.5.7.1 Function of expense method……………………………………………………….. 47
4.5.7.2 Nature of expense method…………………………………………………………. 48
4.5.7.3 Presentation of the statement of changes in equity………………………………... 53
4.6 Determination of reclassification adjustment…………………………………………. 56
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VI
4.7 Notes to the financial statements……………………………………………………… 57
4.7.1 Disclosure of accounting policies…………………………………………………… 58
4.7.2 Sources of estimation uncertainty…………………………………………………… 58
4.8 Summary………………………………………………………………………………. 61
4.9 References ……………………………………………………………………………... 61
UNIT FIVE
CONSOLIDATED FINANCIAL STATEMENTS
5.0 Introduction……………………………………………………………………………. 62
5.1 Objectives……………………………………………………………………………… 62
5.2 International financial reporting standards (IFRSs) that relate to consolidated
financial statements……………………………………………………………………. 63
5.3 Legal provisions……………………………………………………………………….. 64
5.4 Levels of ownership…………………………………………………………………… 65
5.5 Crossing the accounting boundary…………………………………………………….. 66
5.6 Acquisition method of accounting…………………………………………………….. 67
5.6.1 Identifying the acquirer……………………………………………………………… 68
5.6.1.1 Reverse acquisitions/takeover……………………………………………………... 69
5.6.2 Determining the acquisition date…………………………………………………….. 69
5.6.3 Recognising and measuring the identifiable assets acquired, the liabilities
assumed and any non-controlling interest in the acquire……………………………... 70
5.6.3.1 Fair valuation………………………………………………………………………. 72
5.6.3.2 Other issues to be aware of on recognising and measuring the identifiable
assets acquired…………………………………………………………………........... 74
5.6.4 Recognising and measuring goodwill or a gain from a bargain purchase…………… 76
5.6.4.1 Goodwill…………………………………………………………………………… 76
5.6.4.2 Bargain purchase gain (gain on bargain purchase)………………………………… 89
5.7. Basic consolidation procedure………………………………………………………… 90
5.7.1 Intra-company indebtedness…………………………………………………………. 90
5.7.2 Items in transit……………………………………………………………………….. 90
5.7.3 Bank balances………………………………………………………………………... 92
5.7.4 Unrealised profit in inventories……………………………………………………… 92
5.7.5 Intra group sales and purchases……………………………………………………… 94
5.7.6 Dividends declared out of pre-acquisition profits…………………………………… 94
5.7.7 Pre-acquisition losses………………………………………………………………… 94
5.7.8 Preference shares…………………………………………………………………….. 95
5.7.9 Intra-group profit on non-depreciable property, plant and equipment………………. 95
5.7.10 Intra-group profit on depreciable property, plant and equipment………………….. 95
5.8 Presentation of group financial statements……………………………………………. 95
5.9 Simple/trade investment (IFRS 9)……………………………………………………... 95
5.10 Simple group (IFRS 3 and IAS 27 revised)………………………………………….. 98
5.10.1 Wholly owned subsidiary (100%) ………………………………………………… 98
5.10.2 Consolidation of a fully/wholly owned subsidiary at acquisition date…………….. 98
5.10.3 Consolidation of a fully/wholly owned subsidiary post acquisition……………….. 100
5.10.4 Partial acquisitions (partly owned subsidiary)……………………………………… 103
5.10.5 Consolidation of a partly owned subsidiary at acquisition date……………………. 106
5.11 Horizontal group (IFRS 3 and IAS 27 revised)………………………………………. 122
5.12 Vertical group (IFRS 3 and IAS 27 revised)…………………………………………. 127
ICSAZ - P.M. PARADZA
VII
5.13 Complex group (IFRS 3 and IAS 27 revised)………………………………………… 140
5.14 Investment in associate and joint ventures (IAS 28)…………………………………. 147
5.14.1 Treatment of losses in associates…………………………………………………… 151
5.15 Joint arrangements (IFRS 11)……………………………………………………........ 159
5.16 Crossing the boundary accounting (IFRS 3 and IAS 27 revised)……………………. 162
5.16.1 From associate to subsidiary ………………………………………………………. 163
5.16.2 Trade/simple investment to subsidiary…………………………………………….. 173
5.16.3 From subsidiary to subsidiary (controlling interest increased)…………………….. 174
5.16.4 Full disposal of subsidiary (no crossing of boundary) and partial disposal
(subsidiary to associate/subsidiary to subsidiary)…………………………………... 179
5.16.5 Partial disposal (subsidiary to trade/simple investment)…………………………… 190
5.17 Use of a presentation currency other than the functional (IAS 21)…………………... 190
5.17.1 Translation into the presentation currency…………………………………………. 191
5.17.2 Translation of a foreign operation …………………………………………………. 191
5.17.3 Disposal of a foreign operation…………………………………………………….. 201
5.19 Worksheet approach to consolidation questions [IFRS 3 (2004)]…………………… 201
5.20 Consolidation disclosures …………………………………………………………… 204
5.20.1 IFRS 12 – group disclosure requirements…………………………………………. 204
5.20.2 IAS 21 – consolidation disclosures………………………………………………… 205
5.21 Summary……………………………………………………………………………... 206
5.22 References…………………………………………………………………………… 206
UNIT SIX
GROUP STATEMENT OF CASHFLOWS (IAS 7)
6.0 Introduction……………………………………………………………………………. 207
6.1 Objectives……………………………………………………………………………… 207
6.2 Classification of cash flows…………………………………………………………… 207
6.2.1 Different types of cash flows………………………………………………………... 208
6.2.2 Treatment of group cash flows………………………………………………………. 208
6.3 Preparation and presentation of group statement of cash flows ………………………. 208
6.3.1 Direct approach……………………………………………………………………… 209
6.3.2 Indirect approach…………………………………………………………………….. 211
6.4 Foreign currency cash flows…………………………………………………………… 212
6.5 Summary………………………………………………………………………………. 222
6.6 References …………………………………………………………………………….. 222
UNIT SEVEN
FAIR VALUE MEASUREMENT (IFRS 13)
7.0 Introduction……………………………………………………………………………. 223
7.1 Objectives……………………………………………………………………………… 223
7.2 Terminology.………………………………………………………………………….. 223
7.3 The essentials of a fair value measurement…………………………………………… 224
7.4 Key features of fair value measurement………………………………………………. 224
7.5 Application to specific categories of assets and liabilities……………………………. 226
7.5.1Highest and best use of non-financial assets………………………………………… 226
7.5.2 The valuation basis for non-financial assets ……………………………………….. 227
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VIII
7.5.3 General principles applicable to liabilities and an entity’s own equity instruments... 228
7.5.4 Liabilities and equity instruments held by other parties as assets…………………… 228
7.5.5 Liabilities and equity instruments held by other parties as assets………………….... 229
7.5.6 Non-performance risk……………………………………………………………….. 230
7.5.7 The offsetting of positions in market risks or counterparty credit risk……………… 231
7.6. Valuation techniques………………………………………………………………….. 231
7.6.1 Inputs to valuation techniques………………………………………………………. 232
7.6.2 Valuation techniques ………………………………………………………………... 234
7.6.3 The components of a present value measurement…………………………………… 235
7.6.4 Overview of the fair value framework………………………………………………. 237
7.7 Summary………………………………………………………………………………. 238
7.8 References …………………………………………………………………………….. 238
UNIT EIGHT
REGULATORY DEFERRAL ACCOUNTS (IFRS 14)
8.0 Introduction……………………………………………………………………………. 239
8.1 Objectives……………………………………………………………………………… 239
8.2 Definitions………………………………………………………………………………239
8.3 Conditions of use………………………………………………………………………. 241
8.4 Key provisions related to recognition, measurement, impairment and
derecognition issues…………………………………………………………………… 241
8.5.1 Application of IAS 10 Events after the Reporting period…………………………… 242
8.5.2 Application of IAS 12 Income Taxes………………………………………………... 243
8.5.3 Application of Earnings per Share…………………………………………………… 243
8.5.4 Application of IAS 36 Impairment of Assets………………………………………... 244
8.5.5Application of IFRS 3 Business Combinations………………………………………. 244
8.5.6 Application of IFRS 5 Non-current Assets Held for Sale and
Discontinued Operations…………………………………………………………….. 244
8.5.7 Application of IFRS 10 Consolidated Financial Statements and IAS 28
Investments in Associates and Joint Ventures………………………………………. 245
8.5.8 Application of IFRS 12 Disclosure of Interests in Other Entities…………………… 245
8.6. Summary……………………………………………………………………………… 246
8.7 References……………………………………………………………………………... 246
UNIT NINE
INCOME TAXES (IAS 12)
9.0 Introduction……………………………………………………………………………. 247
9.1 Objectives……………………………………………………………………………… 247
9.2 Legal provisions……………………………………………………………………….. 248
9.3 Corporate tax………………………………………………………………………….. 248
9.4 Current tax…………………………………………………………………………….. 249
9.5 Tax base……………………………………………………………………………….. 254
9.6 Deferred tax…………………………………………………………………………… 255
9.6.1 Taxable temporary differences (individual firm scenario)………………………….. 256
9.6.1.1 Definition………………………………………………………………………….. 256
9.6.1.2 Sources…………………………………………………………………………….. 256
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IX
9.6.3 Taxable temporary differences (group scenario)……………………………………. 261
9.6.4 Deductable temporary differences (individual firm scenario)……………………… 262
9.6.5 Deductable temporary differences (group scenario)………………………………… 263
9.7 Methods of accounting for deferred tax……………………………………………….. 265
9.8 Bases for accounting for deferred tax………………………………………………….. 266
9.8.1 Nil provision or flow through approach………………………………………………266
9.8.2 Full provision or comprehensive allocation approach………………………………. 266
9.8.3 Partial provision approach…………………………………………………………... 267
9.9 Deferred tax and non-current asset revaluations (IAS 16)……………………………. 267
9.10 Disclosure requirements……………………………………………………………... 268
9.11 Summary…………………………………………………………………………….. 271
9.12 Reference……………………………………………………………………………. 271
UNIT TEN
SHARE- BASED PAYMENT (IFRS 2)
10.0 Introduction…………………………………………………………………………… 272
10.1 Objectives……………………………………………………………………………. 272
10.2 Scope…………………………………………………………………………………. 272
10.3 Key definitions……………………………………………………………………….. 273
10.4 Recognition criteria…………………………………………………………………... 273
10.5 Equity-settled share-based payment transactions……………………………………. 274
10.6 Cash-settled share-based payment transactions……………………………………… 277
10.7 Disclosure requirements……………………………………………………………... 280
10.8 Summary…………………………………………………………………………….. 281
10.9 References…………………………………………………………………………… 282
UNIT ELEVEN
SERVICE CONCESSION ARRANGEMENTS (IFRIC 12 – SIC 29)
11.0 Introduction…………………………………………………………………………... 283
11.1 Objectives…………………………………………………………………………….. 283
11.2 Key definition………………………………………………………………………… 283
11.3 Types of service concession arrangements…………………………………………… 284
11.3.1 Granting of a financial asset………………………………………………………... 284
11.3.2 Granting of an intangible asset……………………………………………………... 284
11.3.3 Combined arrangement…………………………………………………………….. 284
11.4 Accounting for service concession arrangements……………………………………. 284
11.4.1 Financial asset model………………………………………………………………. 284
11.4.2 Intangible asset model……………………………………………………………… 284
11.4.3 Operating revenue………………………………………………………………….. 284
11.4.4 Accounting by the government (grantor)…………………………………………... 285
11.5 Disclosures…………………………………………………………………………… 288
11.6 Summary……………………………………………………………………………… 288
11.6 References……………………………………………………………………………. 288
ICSAZ - P.M. PARADZA
X
UNIT TWELVE
PROPERTY, PLANT AND EQUIPMENT (IAS 16)
12.0 Introduction………………………………………………………………………….. 289
12.1 Objectives……………………………………………………………………………. 289
12.2 Key definitions………………………………………………………………………. 289
12.3 Elements of cost……………………………………………………………………… 290
12.4. Recognition criteria…………………………………………………………………. 291
12.4.1 Initial costs………………………………………………………………………… 291
12.4.2 Subsequent costs…………………………………………………………………... 291
12.4.3 Determination of cost……………………………………………………………… 291
12.5 Measurement after initial recognition…………………………………………….…. 292
12.5.1 The cost model…………………………………………………………………….. 292
12.5.2 The revaluation model…………………………………………………….……….. 292
12.6 Depreciation principles………………………………………………………………. 293
12.7 Accounting for depreciation-practical aspects……………………………………….. 294
2.8 Impairment of assets…………………………………………………………………… 297
12.9 Disclosure requirements……………………………………………………………… 298
12.10 Summary……………………………………………………………………………. 299
12.11 References…………………………………………………………………………… 299
UNIT THIRTEEN
NON-CURRENT ASSETS HELD FOR SALE AND DISCONTINUED
OPERATIONS (IFRS 5)
13.0 Introduction………………………………………………………………………….. 300
13.1 Objectives……………………………………………………………………………. 300
13.2 Key definitions………………………………………………………………………. 300
13.3 Classification of non-current assets (or disposal groups) as held for sale…………… 301
13.4 Measurement principles……………………………………………………………… 301
13.4.1 At the time of classification as held-for-sale………………………………………. 301
13.4.2 After classification as held-for-sale……………………………………………….. 301
13.4.3 Impairment………………………………………………………………………… 301
13.4.3.1 At the time of classification as held for sale…………………………………….. 301
13.4.3.2 After classification as held-for-sale……………………………………………… 302
13.4.4 Impairment reversal (subsequent increases in fair value)…………………………. 302
13.4.5 Disclosures………………………………………………………………………… 302
13.5 Declassification of an assets held for sale or disposal group……………………....... 309
13.5.1 Declassification of an asset held for sale………………………………………….. 309
13.5.2 Declassification of an asset held for sale in a disposal group…………………….. 310
13.6 Discontinued operations…………………………………………………………….. 311
13.6.1 Definition………………………………………………………………………….. 311
13.6.2 Presentation and disclosure………………………………………………………… 311
13.7 Summary……………………………………………………………………………... 312
13.8 References……………………………………………………………………………. 312
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XI
UNIT FOURTEEN
THE VALUATION OF SHARES AND OTHER BUSINESS INTERESTS
14.0 Introduction…………………………………………………………………………... 313
14.1 Objectives……………………………………………………………………………. 313
14.2 Sources and types of value…………………………………………………………… 313
14.3 Determinants of valuations where there shares are not dealt with on a
stock exchange……………………………………………………………………….. 314
14.4 Methods of valuing shares……………………………………………………………. 315
14.4.1 Earnings basis (also known as net income basis or earnings capacity basis)………. 315
14.4.2 Net assets basis (also known as the equity basis)…………………………………... 317
14.4.3 Valuation of various sources of capital…………………………………………….. 319
14.5 Super profits and the valuation of goodwill …………………………………………. 326
14.5.1 Placing a value on super profits……………………………………………………. 326
14.6 Valuation based on market price…………………………………………………….. 331
14.7 The value of control of a business…………………………………………………… 333
14.7.1 Perspective of an investor without control………………………………………… 333
14.8 Summary…………………………………………………………………………….. 333
14.9 References…………………………………………………………………………… 334
UNIT FIFTEEN
CAPITAL REORGANISATION AND RECONSTRUCTIONS
15.0 Introduction…………………………………………………………………………... 335
15.1 Objectives……………………………………………………………………………. 335
15.2 Legal provisions……………………………………………………………………… 336
15.2.1 Reorganization……………………………………………………………………… 336
15.2.2 Reconstruction……………………………………………………………………… 336
15.2.3 Capital reduction…………………………………………………………………… 337
15.2.4 Power of a company to alter share capital (section 87)……………………………. 337
15.2.5 Winding up………………………………………………………………………… 338
15.2.5.1 Liabilities of members on winding up…………………………………………… 338
15.2.5.2 Consequences of voluntary winding up (section 256)…………………………… 338
15.2.5.3 Distribution of proceeds on a company`s winding up…………………………… 339
15.3 Accounting entries for reconstruction schemes……………………………………… 339
15.4 Self design of capital reconstruction schemes ………………………………………. 345
15.5 Summary……………………………………………………………………………... 354
15.6 References……………………………………………………………………………. 354
UNIT SIXTEEN
ADVANCED INTERPRETATION OF FINANCIAL STATEMENTS
16.0 Introduction…………………………………………………………………………... 355
16.1 Objectives……………………………………………………………………………. 355
16.2 Uses of ratio analysis………………………………………………………………… 355
16.4 Common size statements ……………………………………………………………. 359
16.5 Relationships among ratios………………………………………………………….. 364
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XII
16.6. The prediction of company failure………………………………………………….. 367
16.6.1 The use of Z-Scores ……………………………………………………………..… 367
16.7 Summary…………………………………………………………………………….. 368
16.8 References…………………………………………………………………………… 368
UNIT SEVENTEEN
EARNINGS PER SHARE
17.0 Introduction…………………………………………………………………………... 369
17.1 Objectives…………………………………………………………………………….. 369
17.2 Definition of earnings per share……………………………………………………… 369
17.3 The meaning of earnings per share…………………………………………………... 370
17.4 The dilution of earnings……………………………………………………………… 371
17.5 Calculation of earnings per share…………………………………………………….. 371
17.6 Convertible securities……………………………………………………………….... 377
17.7 Options, warrants and their equivalents…………………………………………….... 378
17.8 Contingently issuable shares…………………………………………………………. 379
17.9 Contracts that may be settled in ordinary shares or cash…………………………….. 379
17.10 Written put options…………………………………………………………………. 379
17.11 Presentation of earnings per share information…………………………………….. 379
17.12 Disclosure requirements……………………………………………………………. 380
17.14 Summary…………………………………………………………………………… 380
17.15 References………………………………………………………………………….. 380
UNIT EIGHTEEN
INTANGIBLE ASSETS (IAS 38)
18.0 Introduction………………………………………………………………………….. 381
18.1 Objectives……………………………………………………………………………. 381
18.2 Key definitions……………………………………………………………………….. 381
18.3 Exclusions……………………………………………………………………………. 382
18.4 Recognition and measurement of intangible assets………………………………….. 382
18.5 Acquisition …………………………………………………………………………... 383
18.5.1 Separate acquisition of intangible assets…………………………………………… 383
18.5.2 Acquisition as part of a business combination……………………………………... 384
18.5.3 Acquisition by way of a government grant……………………………………….... 385
18.5.4 Exchange of assets…………………………………………………………………. 385
18.6 Internally-generated goodwill ……………………………………………………….. 386
18.7 Internally-generated intangible assets………………………………………………... 386
18.7.1 Research phase……………………………………………………………………... 387
18.7.2. Development phase………………………………………………………………... 387
18.7.3 Prohibition to recognise certain items as intangible assets………………………… 388
18.7.4 Initial cost of an internally-generated asset ………………………………………... 388
18.8 Recognition of expenses related to intangible items ………………………………… 389
18.9 Alternative bases of measurement after initial recognition………………………….. 390
18.9.1 Accounting treatment of accumulated amortization………………………………. 390
18.9.2 Other revaluation guidelines………………………………………………………. 392
18.10 Estimating the useful life of an intangible asset……………………………………. 393
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XIII
18.11 Intangible assets with finite useful lives……………………………………………. 394
18.12 Residual value………………………………………………………………………. 394
18.13 Review of amortisation period and amortisation method…………………………... 394
18.14 Intangible assets with indefinite useful lives……………………………………….. 395
18.15 Retirements and disposals………………………………………………………….. 395
18.16 Disclosure requirements……………………………………………………………. 395
18.17 Summary…………………………………………………………………………… 397
18.18 References………………………………………………………………………….. 397
UNIT NINETEEN
LEASING (IAS 17)
19.0 Introduction………………………………………………………………………….. 398
19.1 Objectives……………………………………………………………………………. 398
19.2 Key definitions………………………………………………………………………. 398
19.3 Guaranteed residual value…………………………………………………………… 399
19.3.1 Classification of leases…………………………………………………………….. 399
19.3.2 Prima facie proof of a finance lease……………………………………………….. 400
19.4. Accounting for leases in the financial statements of lessees………………………... 401
19.4.1 Operating leases…………………………………………………………………… 401
19.5 Accounting for leases in the financial statements of lessors………………………… 405
19.5.1 Disclosure requirements for leases………………………………………………… 409
19.6. Changes in interest rates…………………………………………………………….. 409
19.7. Sale and leaseback transactions…………………………………………………….. 412
19.7.1 Finance lease………………………………………………………………………. 412
19.7.2 Operating lease……………………………………………………………………. 412
19.8 Disclosure requirements for lessors…………………………………………………. 413
19.8.1 Finance leases……………………………………………………………………… 413
19.8.2 Operating leases……………………………………………………………………. 413
19.9 Summary……………………………………………………………………………... 414
19.10 References…………………………………………………………………………... 414
UNIT TWENTY
IMPAIRMENT OF ASSETS (IAS 36)
20.0 Introduction………………………………………………………………………….. 415
20.1 Objectives……………………………………………………………………………. 415
20.2 Key definitions………………………………………………………………………. 415
20.3 Identifying impaired assets………………………………………………………….. 416
20.4 Measuring recoverable amount……………………………………………………… 417
20.5 Measuring fair value less costs to sell………………………………………………. 418
20.6 Measuring value in use……………………………………………………………… 419
20.7 Recognising and measuring an impairment loss……………………………………. 420
20.8 Identifying the cash-generating unit to which an asset belongs…………………….. 421
20.9 Recoverable amount and carrying amount of a cash-generating unit………………. 423
20.10 Allocating goodwill to cash-generating units……………………………………… 423
20.11 Testing cash-generating units with goodwill for impairment……………………… 425
20.11.1 Testing cash-generating units for impairment with no goodwill
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attached to them…………………………………………………………………. 425
20.12 Corporate assets……………………………………………………………………. 427
20.13 Recognition of impairment loss for a cash-generating unit………………………… 427
20.14 Reversal of impairment losses ……………………………………………………… 430
20.14.1 Guidelines for reversing an impairment loss for individual assets……………….. 431
20.14.2 Guidelines for reversing an impairment loss for a cash-generating unit…………. 431
20.15 Disclosure requirements……………………………………………………………. 433
20.16 Summary………………………………………………………………………….... 434
20.17 References………………………………………………………………………….. 434
UNIT TWENTY-ONE
EMPLOYEE BENEFITS (IAS 19 – Revised [2014])
21.0 Introduction………………………………………………………………………….. 435
21.1 Objectives……………………………………………………………………………. 435
21.2 Changes to the old IASs 19 (IFRS update, 2014: Ernst & young)…………………... 435
21.3 Classification of employee benefits…………………………………………………. 438
21.3.1 Short-term benefits………………………………………………………………… 438
21.3.2 Post-employment benefits…………………………………………………………. 440
21.3.3 Termination benefits (lump sum payments)……………………………………….. 440
21.3.4 Other long-term benefits…………………………………………………………… 440
21.4 Practice question and suggested solution on some of the key definitions…………… 441
21.5 Application of the projected unit credit method……………………………………... 443
21.6 Post-employment benefits…………………………………………………………… 445
21.6.1 Accounting for defined contribution schemes…………………………………….. 445
21.6.2 Accounting for defined benefit plans……………………………………………… 446
21.7 Examples of actuarial assumptions………………………………………………...... 451
21.8 Disclosures…………………………………………………………………………… 451
21.8.1 For a defined contribution plan…………………………………………………….. 451
21.8.2 For a defined benefit plan………………………………………………………….. 451
21.9 Corporate Secretaryship and pension funds…………………………………………. 452
21.10 General knowledge…………………………………………………………………. 453
21.11 Summary……………………………………………………………………………. 456
21. 12 References………………………………………………………………………….. 456
Subject Index……………………………………………………………………………… 457
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UNIT ONE
THEORETICAL FRAMEWORK OF ACCOUNTING
1.0 INTRODUCTION
You have reached the third and final stage of your Financial Accounting course. Well done.
This volume is the first of the two volumes that shall guide you through this final hurdle in
your accounting studies. It is the Institute’s belief that you would have developed into a fullyfledged accounting professional at completion of your studies. You shall notice that Group
Accounting is a major part of your Advanced Accounting course, however, all other areas carry
equal importance. To start with the theoretical framework of accounting is covered in this Unit.
Financial accounting is one of the most dynamic and controversial disciplines related to
business activities. The dynamism arises from the fact that financial accounting is a service
function which operates in a constantly changing environment, yet it is supposed to be firmly
rooted in its own fundamental principles. At the most basic level, the simplicity of this
discipline belies its critical role in society. We all know that the necessity for accounting is
related to the need by those entrusted with financial and other resources to be accountable for
those resources. However, the real importance of the accounting function can only be
appreciated by imagining for a moment a world where there is no accounting at all. In such a
world, chaos would be the order of the day in households, business organizations, government
departments, etc. For example, investors who put their money in limited liability companies
would not have any way of ensuring that the money is put to good use, and that the annual
reports produced by such companies are factual.
The controversy surrounding Financial Accounting results from the fact that not everybody is
convinced about its usefulness. Some sceptics allege that since it is mainly a historical record
of events which occur during a given period, hence Financial Accounting cannot be used for
decision making, a process which requires making forecasts about the future. Because there
was no all-embracing theoretical framework for a long time, this discipline developed in a
piecemeal manner to meet new situations as they arose. This problem-solving approach was
used to deal with consolidations, leases, mergers and acquisitions, research and development,
inflation, oil exploration costs etc. Almost 80 years ago, Canning expressed his frustration on
the weakness of Financial Accounting as follows:
“What is set out as a measure of net income can never be supposed to be a fact in any sense at
all, except that it is the figure that results when the accountant has finished applying the
procedures which he adopts.”
A strong statement indeed, but where does it leave us? Some would respond that, despite all
its alleged weaknesses, including lack of comparability between and within periods and poor
timeliness, Financial Accounting is the major source of information for most investors. Critics
may be pleased to note that theorists and practitioners are now working closely together in
order to address the challenges being faced by this discipline.
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1.1 OBJECTIVES
By the end of this Unit you should be able to:
•
Define financial accounting theory and explain its scope
•
Explain the process of financial accounting theory construction and verification
•
Outline the objectives of financial statements
•
State and explain the qualitative characteristics of financial accounting information
•
Explain the issues which are considered in the recognition of financial statement items
•
Explain the various concepts of capital and capital maintenance
1.2 DEFINITION AND SCOPE OF FINANCIAL ACCOUNTING THEORY
According to Hendriksen (1982) “Accounting theory may be defined as logical reasoning in
the form of a set of broad principles that (1) provide a general frame of reference by which
accounting practice can be evaluated (2) guide the development of new practices and
procedures. Accounting theory may also be used to explain the existing practices to obtain a
better understanding of them. But the most important goal of accounting theory should be to
provide a coherent set of logical principles that form the general frame of reference for the
evaluation and development of sound accounting practices.”
The scope of theory in Financial Accounting is much wider than in the natural sciences, where
theories are based on the empirical observation of physical phenomena. The core of Financial
Accounting theory consists of generally accepted accounting principles. These principles refer
to the consensus among accounting practitioners, academics and users of accounting
information about what should be regarded as income and expenses, assets and liabilities, as
well as changes in these and other accounting variables. The consensus results from the similar
training received by those who consider Financial Accounting to be their profession, whether
they are working as preparers of financial statements, auditors, tax experts or in some other
capacity. This common training is an important source of the development of Financial
Accounting theory. This is because working in different areas will cause such professionals to
have divergent viewpoints on the treatment of particular issues, for example, whether deferred
tax should be recorded as a liability or not. Academics have also contributed greatly to theory
development through authoritative research, which is often incorporated into official
pronouncements by professional accounting bodies.
1.3 APPROACHES TO THE DEVELOPMENT OF FINANCIAL ACCOUNTING
THEORY
i) Descriptive Approach
This approach to accounting theory development is mainly concerned with observing what
accountants do. The approach involves a process of inductive reasoning, which consists of
making generalized conclusions from specific observations. The purpose of observing
accounting practices is to look for similarity of instances, and to identify a sufficient number
of such instances to permit the required degree of assurance in the development of the proposed
theory. The descriptive approach is associated with the positive theory of accounting, which
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explains what accountants do and enables predictions to be made about how a particular
accounting item will be treated.
ii) Normative General Approach
In the early years of accounting theory development, proponents of this approach argued that
accountants did not seem to have any complete system of thought about their discipline. In a
publication entitled 'Blueprint for a Theory of Accounting,' Chambers (1955) stated that
accounting theory and research should be less concerned with describing current practices, but
be more involved with the development of better accounting practices.
According to the normative approach, it is feasible and desirable to develop theories of
accounting which are independent of current practice. It is necessary to develop normative
theories, which impose theoretical standards on the quality of information and check the
relevance of conventional accounting systems. Such theories depend on deductive reasoning,
which outlines a basic set of propositions about the issue under consideration. This type of
reasoning first makes general statements and then moves to more specific assertions.
iii) Empirical Approach
This approach to accounting theory development seeks to make accounting research more
rigorous, and to improve the reliability of results obtained by using increasingly sophisticated
analytical methods. Supporters of this approach argue that the normative general approach has
failed to produce a single comprehensive framework for solving accounting problems.
Empirical studies use the scientific method of inquiry to ascertain the value of accounting
information for decision-making purposes and other uses.
iv) Normative Specific Approach
This approach focuses on models which should be used by decision-makers in order to
maximize their decisions. These models generally require predictions of independent variables,
which impact on the issues of concern (dependent variables). The validity of the model depends
on the accuracy of the following:
a) Predictions of future events or states of nature or the probability of distributions
b) Predictions of alternative courses of action
c) Predictions of outcomes or pay-offs that will occur given the future event and the future
action
Theory is a coherent group of assumptions put forth to explain the relationship between two
or more observable facts and to provide a sound basis for predicting future events.
The Committee on Accounting Theory and Verification (USA-1971) defined accounting
theory as those substantive propositions that relate accounting measurements to decision
models and decision making. The Committee's report made the following observations on the
predictive power of decision models:
i.
it is not clear how the relative predictive power of any two models should be
assessed
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ii.
it is not possible to absolutely verify (prove) a theory
iii.
measurement error may cause researchers to wrongly conclude that the model is not
an adequate description of reality
iv.
it is difficult to specify the relevant prediction and decision models
v.
there is a possibility that results will be biased in favour of the existing model
1.4 PURPOSE AND STATUS OF THE IASB CONCEPTUAL FRAMEWORK
The purpose is stated in the framework as:
i)
To assist the IASB in the development of future IFRSs and in reviewing existing
IFRSs.
ii)
To assist the IASB in promotion of harmonisation of regulations, accounting
standards and procedures relating to the presentation of financial statements. The
conceptual framework reduces the number of alternative accounting treatments
permitted by IFRSs.
iii)
To assist national standard-setting bodies such as the Zimbabwe Accounting
Practices Board (ZAPB) in developing Zimbabwean accounting standards (ZAS).
You shall see in your Corporate Governance module that, for instance, the
Commonwealth Association of Corporate Governance guidelines (CACG) are in a
similar way that the framework is, a basis for the development of national corporate
governance codes.
iv)
To assist preparers of financial statements in the application of IFRSs.
v)
To assist auditors in forming an opinion as to whether financial statements comply
with IFRSs. This is how they pass an unqualified opinion (provided national
regulations also are complied with).
vi)
To assist users of financial statements in interpreting financial statement
information that is prepared in compliance with IFRSs.
vii)
To indicate to interested parties the work of the IASB as to its approach to the
formulation of IFRSs.
The status of the IASB Conceptual Framework is that it is not an IFRS. It however, informs
IFRSs or provides the foundation upon which they are built/developed.
1.5 OBJECTIVES OF FINANCIAL STATEMENTS
According to the International Accounting Standards Board Conceptual Framework for the
preparation and presentation of financial statements, financial statements are prepared for the
benefit of external users to enable them to:
a) decide when to buy, hold or sell equity investments
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b) assess the stewardship or accountability of management
c) assess the ability of the entity to pay and provide other benefits to its employees
d) assess the security for amounts lent to the entity
e) determine taxation policies
f) determine distributable profits and dividends
g) prepare and use national income statistics
h) regulate the activities of entities
Financial statements prepared for external use are often referred to as general-purpose financial
statements because they cannot be expected to meet the needs of particular user groups. The
Corporate Report (U.K. 1975) explained the rights of users/stakeholders to receive accounting
information as follows:
“Users of corporate reports are those we define as having a reasonable right to information
concerning the reporting Entity. We consider such rights arise from the public accountability
of the Entity whether or not supported by legally enforceable powers to demand information.
A reasonable right to information exists where the activities of an organisation impinge or may
impinge on the activities of the user group.”
The two underlying assumptions/concepts in the preparation of annual financial statements are
accruals and going concern. Financial information is prepared on an accruals basis. By
preparation of financial statements on a going concern basis directors would be asserting that
the entity will in the next twelve months realise revenues from the use of its assets in normal
trading activities than from their sale/disposal in which case the liquidation basis would be
most appropriate.
Student Note:
The IASB issued an exposure draft seeking the incorporation of the reporting entity concept
into the IASB conceptual framework. You should be up to date on the impending changes or
future developments going into your examinations. Ensure your source of such updates is
reputable/reliable.
The objectives of financial statements have been studied and articulated by many groups and
individuals across the world. Nikolai & Bazley (1988) presented these objectives as shown in
the following diagram:
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OBJECTIVES OF FINANCIAL REPORTING
General Objective
Derived External
User Objective
Derived Enterprise
Objective
Specific
Objectives
Provide information about
enterprise’s economic
resources obligations, and
owners’ equity
Provide information that is useful to
present and potential investors,
creditors and other users in making
investment, credit and similar decisions.
Provide information that is useful to
present and potential investors, creditors
and other users in assessing the amounts,
timing and uncertainty of prospective
cash receipts from dividends or interest
and the proceeds from the sale, redemption,
or maturity of securities or loans.
Provide the information to help investors,
creditors and others assessing the amounts,
timing and uncertainty of prospective net
cash inflows to the related enterprise.
Provide information about Provide information
enterprise’s comprehensive about enterprise’s
income ant its components. cash flows.
Source: Nikolai, L.A. & Bazley, J.D. Intermediate Accounting 4th Edition (1988) p20
1.6 QUALITATIVE CHARACTERISTICS OF ACCOUNTING INFORMATION
The quality of accounting information is an issue which has attracted the attention of both
supporters and critics of this information for many decades. Quality is an attribute with many
components, but to a number of people what comes to mind in this context is usefulness for
decision making purposes. In the recent past we have had frauds which were facilitated through
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the manipulation of accounting information reportedly perpetrated by Enron in the USA and
Century Bank in Zimbabwe as case examples. Fraudulent financial reporting, creative
accounting, aggressive accounting, earnings management, window dressing have widely been
reported around the globe. For a long time now, it has been observed that profits recorded in
the statement of profit or loss and other comprehensive income of a business is not necessarily
a true reflection of its financial strength as shown in the statement of financial position.
In other words, it is quite possible to see a business which is profitable experiencing cash flow
problems i.e. finding it difficult to meet its short-term (liquidity) or long term liabilities
(solvency). On the other hand, a business may have a lot of cash, some of which might have
been borrowed, and yet it is experiencing profitability or viability problems. Put in other words,
profit and cash are not one and the same thing.
Many professional bodies and regulatory agencies have attempted to identify the qualities of
accounting information which would make it valuable to a wide range of users.
1.6.1 Fundamental qualitative characteristics
Relevance refers to the ability of accounting information to influence the economic decisions
of users by helping them to evaluate past, present and future events and/or to confirm these
evaluations. According to SFAC 2,(a) predictive value and feedback/confirmatory value are key
characteristics which distinguish relevant from irrelevant information. This is because
informed prediction is a major aspect of the decision-making process, while feedback is
required to confirm or reject earlier decisions.
According to the IASB Conceptual Framework, information has the quality of reliability when
it is free from material error and bias, and can be accepted by users as a faithful representation
of the transactions and events referred to. A major test of reliability is that these transactions
and events should be accounted for and presented according to their substance and economic
reality, and not merely their legal form. Other aspects of reliability can be summarised as
follows:
The need for prudence arises from the fact that preparers of financial statements often face a
lot of uncertainty when determining the items and values to include in the statements. Prudence
is a state of mind under which the preparer exercises judgment in relation to the reporting of
income or expenses and the valuation of assets, liabilities and contingencies. A basic guide to
prudence is that the preparer should always accrue expenses and provide for potential losses,
but he should not anticipate profits by recording them prematurely.
The term 'economy of presentation' refers to the fact that accounting information should be
presented in a manner which is as economic and effective as possible. Figures should be
presented with clarity in mind, while charts and tables can often be used to highlight aspects of
the reporting entity's performance. In the final analysis however, the benefit of a particular
presentation format should always exceed its cost for it to be justified.
(a) Statement of Financial Accounting Concepts (U.S.A.)
Faithful representation is the characteristic that financial reports must faithfully (truthfully)
represent (state) that which they purport to represent (economic phenomena). They must be
complete, neutral and error free. Information is referred to as being neutral when it is free from
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bias. Bias is shown when the preparer of financial statements uses selection or presentation
methods which are meant to achieve predetermined results, for example, the overstatement or
understatement of income or expenses. The IASB has identified materiality as the threshold for
the recognition of particular items in financial statements. Information is considered material
if its omission or misstatement could influence the economic decisions of users made on the
basis of the financial statements. It should be noted that there is no generally applicable cut-off
figure or percentage for materiality. The decision on the materiality of an item or error will
depend on its size and/or relative importance in the overall context of the financial statements.
1.6.2 Enhancing qualitative characteristics
Verifiability is a qualitative characteristic that assures users that the financial information can
be independently cross checked. It assures both faithfulness of financial information and
objectivity. Objectivity is achieved in accounting information when the information is derived
from verifiable facts and meaningful estimates. The IASB Conceptual Framework refers to this
quality as faithful representation of the items which make up an entity's financial statements.
Objectivity is a crucial aspect of these statements because, without it, users would not have any
reason to believe what is contained in them. The Corporate Report explains this concept as
follows:
“The information presented should be objective or unbiased in that it should meet all proper
user needs, and neutral in that the perception of the measurer should not be biased towards the
interest of one user group. This implies the need for reporting standards which are themselves
neutral as between competing interests.”
The perceived objectivity of historic cost accounting in the measurement of financial statement
items is perhaps the major reason why attempts to introduce inflation - adjusted statements
have not met with a lot of success.
Comparability is the quality of accounting information which enables users to identify trends
in the reporting entity's financial position, operating performance and cash flows. Comparisons
can be made with regard to a single entity over different time periods, or between various
entities where a basis for comparison exists. According to Opperman et al (2002) the following
characteristics would enhance the comparability of financial statements:
i)
Consistency of accounting treatment for similar transactions and events
ii)
Disclosure of accounting policies applied by the reporting entity
iii)
Disclosure of changes in accounting policies and the effects of such changes
iv)
Presentation of corresponding information for the preceding periods, often referred
to as comparative figures.
Preparers of financial statements should not equate comparability to mere uniformity, which
can be achieved or contrived in an artificial sense. True comparability enables informed users
to distinguish between entities which share many similar characteristics.
Financial statements are realistic when they show a true and fair view of the reporting entity's
economic circumstances and future prospects. Preparers of these statements should not raise
the hopes of current and prospective investors that their economic problems can be solved
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overnight through involvement with the entity. In many cases, realism can be achieved through
a Chairman's report which gives a balanced view of the entity's performance in the current
period as well as an unbiased forecast of future performance.
Understandability is the attribute of accounting information which facilitates its
comprehension by users who are prepared to exert a reasonable effort. These users are assumed
to have a working knowledge of accounting as well as basic understanding of business and
economic issues. Understandability is a key requirement for users who need to make
investment decisions on their own behalf, as well as those who offer advisory services to
individual and corporate clients.
Timeliness is the characteristic that financial information is made available to decision makers
in time in order that they can use it to influence their economic decisions. It is another important
aspect of relevance. It is often necessary to make a trade-off between timeliness and accuracy
by providing information that is not completely accurate in a timely manner. In Zimbabwe,
listed companies are required by the ZSE to publish audited year-end financial statements in a
period not exceeding three months from the reporting date.
1.7 THE ELEMENTS OF FINANCIAL STATEMENTS
Financial statements summarise the effects of transactions and other events by classifying them
into broad groups according to their economic characteristics. These broad groups are referred
to as the elements of financial statements. The statement of profit or loss and other
comprehensive income, the statement of financial position, the statement of cash flows and the
statement of changes in equity (known as components of financial statements) all contain items
which contribute to the overall understanding of the reporting entity's operating performance,
changes in financial position, cash flows and equity structure. The elements which make up the
statement of financial position are as follows:
i) An asset is a resource controlled by the entity as a result of past events and from which future
economic benefits are expected to flow to the entity. These benefits are measured by the asset's
potential to contribute either directly or indirectly, to the flow of cash and cash equivalents to
the entity.
In assessing whether a resource item should be classified as an asset, the main issues to be
considered are its underlying substance and economic reality rather than just legal form
(substance over form principle). For example, the major consideration in respect of a finance
lease is that the lessee acquires the economic benefits from using the item for the greater part
of its useful life, while assuming an obligation to pay for the fair value of the item and the
related finance charge. Hence a leased asset in a finance lease transaction is shown on the
statement of financial position of the lessee.
The future economic benefits expected from an asset may flow to the entity in the following
ways:
a) used singly or in combination with other assets in the production of goods or services
to be sold by the entity ( a cash generation unit)
b) exchanged for other assets
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9
c) used to settle liabilities
d) distributed to the owners of the entity, thus meeting an obligation to these owners
Student Note:
The IASB is contemplating changing the definition of an asset. You should be up to date on
the impending changes or future developments on not only the asset definition but the IASB
conceptual framework as a whole, going into your examinations. Ensure your source of such
updates is reputable/reliable.
ii) A liability is a present obligation of the entity arising from past events. The settlement of
such an obligation usually means that the entity has to give up resources embodying economic
benefits in order to satisfy the other party's claims. The major ways in which obligations can
be settled are as follows:
a) payment of cash
b) transfer of other assets
c) provision of services
d) replacement of the present obligation with another obligation
e) conversion of the obligation to equity
Liabilities which can only be measured through an estimation process are referred to as
provisions. Such liabilities should be distinguished from amounts which are recognised in the
financial statements to provide for renewals or diminutions in the value of current and noncurrent assets.
iii) Equity is defined as the residual interest in an entity's assets after all its liabilities to third
parties are deducted. For a limited company, the major components of equity are the funds
contributed by shareholders, non-distributable as well as distributable reserves. Examples of
non-distributable reserves are share premium, foreign currency translation, capital redemption,
revaluation, share-settled share-based payment and cash flow hedge (FEC asset) reserves.
Examples of distributable reserves are general reserve and retained earnings. Details of an
entity's equity are shown in the statement of changes in equity, although final balances will be
included in the statement of financial position. For an all-equity financed entity, equity will be
equal to the book value of assets, regardless of their composition. However, total equity is
rarely equal to the aggregate market value of the entity's shares.
The elements which make up the statement of profit or loss and other comprehensive income
are as follows:
a) Income refers to economic benefits flowing to the entity during a particular period, other
than through transactions with owners and other providers of capital. The main sources of
income are the production and sale of goods, the provision of services, and other income-
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10
generating activities which constitute the entity's primary operations. Income consists of
revenue and gains.
b) Expenses are decreases in economic benefits flowing from the entity during a particular
period other than through transactions with owners and other providers of capital. The term
'expenses' includes losses as well as the depletion of assets which occur in the ordinary course
of business, for example, cost of goods sold, salaries and wages, utilities. The IASB Conceptual
Framework includes unrealised losses in the definition of expenses, for example, losses arising
from the effects of increases in the rate of exchange for a foreign currency in respect of an
entity's borrowings in that currency.
1.7.1 Guidelines for the recognition of individual elements of financial statements
Recognition is the process of including in the financial statements an item that meets the
definition of an element (that is, asset, liability, income or expense) and satisfies the criteria
for recognition. It involves the description of the item in words and by an amount and the
inclusion of that amount in the financial statements.
The recognition criteria are as stated below:
i) An asset is recognised in the statement of financial position when it is probable that
related future economic benefits will flow to the entity, and the asset's cost or value can
be measured reliably.
ii) A liability is recognised in the statement of financial position when it is probable that
an outflow of resources representing economic benefits will result from the settlement
of a current or future obligation. The amount at which the settlement will occur should
be capable of being measured reliably.
iii) Income is recognised in the statement of profit or loss and other comprehensive income
when there is an increase in an asset or a decrease in a liability, and this increase or
decrease can be measured reliably. The recognition of income should be limited to
items which can be measured reliably and have an acceptable level of uncertainty.
v)
Expenses are recognised in the statement of profit or loss and other comprehensive
income when a decrease in future economic benefits arising from a decrease in an
asset or an increase in a liability has occurred, and this decrease or increase can be
measured reliably. This recognition is based on a direct relationship between the
costs incurred and the earning of specific items or streams of income. When
economic benefits are expected to arise over many accounting periods and the
relationship between costs incurred and income generated is indirect, the expenses
should be recognised in the statement of profit or loss and other comprehensive
income on the basis of systematic and rational allocation procedures.
1.7.2 Measurement of the elements of financial statements
Measurement refers to the process of determining monetary amounts at which the financial
statement items are to be recognised and recorded. This requires the selection of particular
basis of measurement.
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11
The most commonly used bases are as follows:
Historical cost: Assets are recorded at the amount of cash or cash equivalents paid, or the fair
value of the consideration given to acquire them. Liabilities are recorded at the amount of
proceeds received in exchange for the obligation, or the amount of cash or cash equivalents to
be paid to satisfy the liability.
Current cost: Assets are recorded at the amount of cash or cash equivalents that would have
to be paid if the same or an equivalent asset were acquired. Liabilities are recorded at the
undiscounted amount of cash or cash equivalents that would be required to settle the obligation.
Realisable value: Assets are carried at the amount of cash or cash equivalents that could be
obtained by selling the asset in the normal course of business, less any realisation costs.
Liabilities are carried at their settlement value, that is, the undiscounted amounts of cash or
cash equivalents that would be required to satisfy the liabilities.
Present value: Assets are carried at the present discounted value of the future net cash inflows
that they are expected to generate in the normal course of business. Liabilities are carried at the
present discounted value of the future net cash outflows that would be required to satisfy the
liabilities.
Student Note:
The issue of measurement bases is another area that is undergoing discussion by the IASB. It
may end up categorising the bases into past, present and future thereby ceasing to carry the
above names. You should be up to date on the impending changes or future developments,
going into your examinations. Ensure your source of such updates is reputable/reliable.
1.8 CONCEPTS OF CAPITAL AND CAPITAL MAINTENANCE
Under the financial capital maintenance concept, capital is equal to the net assets or equity of
the entity. Profit is recognised only if the financial (or nominal) amount of the net assets at the
end of the period exceeds the related amount at the beginning of the period. However, it is
necessary to make adjustments for distributions to and contributions from owners during the
period.
Under the physical capital maintenance concept, capital is considered to be the productive
capacity of the entity based on a specified measurement, for example, units of output per period.
Profit is recognised only if the physical productive capacity (or operating capability) of the
entity at the end of the period exceeds the related capacity at the beginning of the period. As in
the case of financial capital maintenance, adjustments have to be made for distributions to and
contributions by owners during the period.
Under both concepts of capital maintenance, an entity is considered to have maintained its
capital if it has as much capital at the end of the period as it had at the beginning. Any amount
over and above that required to maintain the capital at the beginning of the period is profit. A
loss occurs if the capital at the end of the period is less than that recorded at the beginning. The
chosen concept of capital maintenance thus provides the point of reference according to which
ICSAZ - P.M. PARADZA
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profit is measured. This concept is a key requirement for distinguishing between an entity's
return on capital and its return of capital.
Student Note:
Take note that there is a difference between concept of financial capital and concept of financial
capital maintenance and similarly concept of physical capital and concept of physical capital
maintenance.
1.9 SUMMARY
This Unit focuses on theoretical aspects of Financial Accounting based on the IASB's
Conceptual Framework for the Preparation and Presentation of Financial Statements. This
framework is the foundation of all generally accepted accounting practice, as explained in
detail in various international financial reporting standards and international accounting
standards. In some cases, the recommended treatment for particular accounting situations is
explained in international financial reporting interpretations.
1.10 REFERENCES
NIKOLAI, L. A. & BAZLEY, J. D.
Intermediate accounting, 4th Edition PWS-Kent
Publishing Coy 1988
VORSTER, Q, KOORNHOF, C et al
Descriptive Accounting, 14th Edition,
LexisNexis/Butterworths 2010
IASB
International Financial Reporting Standards
2015
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13
UNIT TWO
THE REGULATORY FRAMEWORK OF ACCOUNTING
2.0 INTRODUCTION
Accounting is a service function which involves collecting, recording, classifying, analyzing
and communicating the results of economic activities to interested individuals and
organizations. It has already been observed that the major purpose of Financial Accounting is
to enable its users to make informed decisions on the financial position, operating performance
and cash flows of the reporting entities. Regulation involves intervention by a party external to
the entity concerning the way information should be prepared and reported. The question which
arises is why the entity should be told or advised how to report information on its activities by
parties other than its direct shareholders and other investors. The answer to this question can
be found partly in the controversy surrounding Financial Accounting as explained in Unit 1.
Apart from being custodians of shareholders' interests, corporate managers and accountants
often have their own interests to protect. These interests can be directly affected by the
accounting method which is chosen. A classic example is the fact that the FIFO method of
stock valuation is associated with higher reported profits than the LIFO method. In the absence
of regulation a management team whose bonuses are calculated on the basis of reported profits
will always have an incentive to use the FIFO method. On the other hand, if the team is
primarily interested in reducing the entity's tax liability, it is likely to choose the LIFO method.
This agency problem means that the conventional accounting model can break down if
preparers of accounting information are given complete freedom to do as they wish.
2.1 OBJECTIVES
By the end of this Unit you should be able to:
•
Identify and explain alternative methods of regulation
•
Outline the objectives of the International Accounting Standards Board (IASB)
•
Explain the IASB standard-setting process
•
Explain the objectives of the International Financial Reporting Standards
Interpretations Committee (formerly IFRIC) and its review process
•
Explain the relationship between IFRSs / IASs and national accounting standards
•
Outline the functions of the Zimbabwe Public Accountants and Auditors Board
(PAAB)
2.2 REGULATION OF FINANCIAL ACCOUNTING INFORMATION
According to Shayamapiki (2004), theory has provided two schools of thought with respect to
the regulation of accounting information which are:
a) regulation by market forces and
b) regulation by stakeholders.
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Regulation by market forces is based on the assumption that financial markets are efficient,
and they reward economic entities which provide a good quality of information in the required
quantities. (For instance, you shall learn from your Corporate Finance module that stock
markets such as the ZSE, JSE, LSE, and NYSE are viewed as having a weak form of efficiency,
semi-strong form of efficiency or strong form of efficiency in terms of how they process share
price information). On the other hand, entities which ignore the information needs of their
stakeholders will find it difficult and expensive to raise money in the capital markets (Your
Corporate Governance, Risks and Ethics module shall make this important point much clearer).
Regulation by stakeholders is based on the assumption that financial markets have a lot of
distortions (market imperfections), and the public interest cannot be left to the whims of such
markets. The most important type of external regulation is that which is imposed by the
government through the Companies Act and various statutory instruments which explain the
legislative requirements of the Act. These regulations are primarily intended to protect the
interests of shareholders and other users of financial statements who do not have the power to
dictate the form and contents of such statements.
The Zimbabwe Stock Exchange (ZSE) is another source of regulation with respect to the
accounting information provided by quoted companies. This organization has explained the
responsibilities of listed companies as follows:
“Disclosure of information is the whole basis of the listing requirements of the Zimbabwe
Stock Exchange. When a listing is granted, the company is required to maintain a standard of
continuing disclosure sufficient to enable investors and their advisors to assess its performance
and to estimate its prospects. To this end the prospectus on floatation must include inter alia,
full particulars of the company, its origins and history and its financial performance over the
previous five years. A reasoned forecast of current and future earnings and prospective
dividends is also required.
Such disclosure is essential for correct investment analysis and decision. It is the great
safeguard that governs the conduct of corporate managements in many of their activities, and
it is the best bulwark against reckless and irresponsible recommendations and sale of securities.
The Zimbabwe Stock Exchange is convinced that the public disclosure of the fullest possible
information about a company's activities is in the best interests of investors, shareholders and
the company itself. The Exchange also believes that managements should recognise and follow
the world-wide trend towards fuller and more frequent disclosure to shareholders.”
The Zimbabwe Stock Exchange is a major source of finance for companies seeking equity and
loan capital from the investing public and institutional investors. The exchange's rules are
usually enforced strictly, and one of the biggest deterrents to errant behaviour by quoted
companies is the withdrawal of the listing facility on a temporary or permanent basis.
2.3 OBJECTIVES OF THE INTERNATIONAL ACCOUNTING STANDARDS
BOARD
The International Accounting Standards Board (IASB) was established in 2001 to continue
with the work previously done by the International Accounting Standards Committee, a
working committee of the International Federation of Accountants (IFAC). The present day
IASB is headed by the IFRS Foundation.
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15
The objectives of the IASB are as follows:
a) to develop, in the public interest, a single set of high quality, understandable and
enforceable global accounting standards that require high quality, transparent and
comparable information in financial statements and other financial reports to help
investors and other users of such information to make economic decisions.
b) to promote the use and rigorous application of those standards.
c) to work actively with national standard-setters to bring about convergence of national
accounting standards and international financial reporting standards to high quality
solutions.
The main aim of IFRSs is to set out recognition, measurement, presentation and disclosure
requirements dealing with transactions and events which are important in general purpose
financial statements. The IASB intends to constantly review the international accounting
standards which were issued by the IASC (now IFRS Foundation), with a view to ensuring
their continued relevance in the accounting treatment of economic transactions and events. In
the long term, the IASB hopes to eliminate choice in accounting treatment. This is a major
departure from the IASC approach, which permitted different treatments for similar
transactions and events as explained in some international accounting standards. According to
this approach one treatment is identified as the benchmark treatment, while the other is
identified as the allowed alternative treatment.
2.4 THE IASB STANDARD-SETTING PROCESS (ALSO KNOWN AS THE DUE
PROCESS)
The due process for coming up with a new IFRS usually involves the following steps:
i.
The staff are asked to identify and review all the issues associated with the topic and to
consider the application of the IASB Conceptual Framework to the issues.
ii.
Study of national accounting requirements and practice and an exchange of views about
the issues with national standard-setters.
iii.
Consulting the IFRS Advisory Council about the advisability of adding the topic to the
IASB's agenda.
iv.
Formation of an advisory group to give advice to the IASB on the project.
v.
Publishing a discussion document for public comment.
vi.
Publishing for public comment an exposure draft approved by at least 8 votes of the
IASB, including any dissenting opinions held by IASB members.
vii.
Publishing within the exposure draft a basis for conclusions.
viii.
Consideration of all comments received within the comment period in discussion
documents and exposure drafts.
ix.
Consideration of the desirability of holding public hearings and conducting field tests,
and if considered desirable, the holding of such hearings and tests.
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x.
Approval of a standard by at least 8 votes of the IASB and inclusion in the published
standard of any dissenting opinion.
xi.
Publishing within the standard a basis for conclusions explaining, inter alia the steps in
the IASB's due process and how the board dealt with public comments on the exposure
draft.
2.5 THE IFRS STANDARD INTERPRETATION PROCESS
The due process for interpreting international financial reporting standards usually involves
the following steps:
i) The staff are asked to identify and review all the issues associated with the topic and
to consider the application of the IASB Conceptual Framework to the issues.
ii) Study of national accounting requirements and practice and an exchange of views
about the issues with national standard-setters, including national committees that
have responsibility for interpreting national standards.
iii) Publication of a draft interpretation for public comment if not more than 3 IFRS
Interpretation Committee members have voted against the proposal.
iv) Consideration of all comments received within the comment period on a draft
interpretation.
v) Approval by the IFRS Interpretations Committee of an interpretation if not more than
3 IFRS Interpretations Committee members have voted against the interpretation after
considering public comments on the draft interpretation.
vi) Approval of the interpretation by at least 9 votes of the IASB.
2.6 FUNCTIONS OF THE ZIMBABWE PUBLIC ACCOUNTANTS AND AUDITORS
BOARD (PAAB)
The PAAB was established by an Act of Parliament in 1996 under the Public Accountants and
Auditors Act (Chapter 27:12). It is made up of the representatives of professional accountancy
bodies such as the Institute of Chartered Accountants of Zimbabwe (ICAZ), the Institute of
Chartered Secretaries and Administrators in Zimbabwe (ICSAZ), the Zimbabwe branch of
Association of Chartered Certified Accountants (ACCA), the Zimbabwe branch of the
Chartered Institute of Management Accountants (CIMA) and the Zimbabwe Institute of Public
Finance and Accountancy. The functions of this Board include:
i) To advance the standards and effectiveness of the accounting profession in Zimbabwe.
ii) To represent the views of the accountancy profession on national, regional and
international issues.
iii) To evaluate and monitor the standards of qualifying examinations, courses, and training
set or offered by its constituent bodies.
iv) To evaluate and monitor examinations and training courses of foreign institutions - with
a view to making recommendations to its constituent bodies.
Its primary function is to register qualified accountants and auditors and to provide assurance
to the public and employers regarding the quality of accountancy services. The PAAB has an
established minimum criteria for its constituent members/bodies.
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2.7 HARMONISATION OF NATIONAL ACCOUNTING STANDARDS
One of the main purposes of the IASB Conceptual Framework is to assist the Board to promote
the international harmonization of regulations, accounting standards and procedures related to
the presentation of financial statements. This is done by providing a basis for reducing the
number of alternative accounting treatments permitted by some IASs.
IFRSs and IASs have improved financial reporting around the world through their use
a) as a basis for national accounting requirements in many countries.
b) as an international benchmark by some countries which have not yet developed or are
in the process of developing their own standards.
c) by stock exchanges and regulatory authorities that allow or require foreign or local
companies to present financial statements in accordance with IFRSs and IASs.
d) by regional economic bodies which rely on IFRSs and IASs to produce corporate
financial statements that meet the requirements of capital markets.
In Zimbabwe the PAAB through its technical committee, the Zimbabwe Accounting Practices
Board (ZAPB) is the official national standard-setting body, since 1993, recognized by the
IFRS Foundation.
2.8 SUMMARY
A key aspect of the regulatory environment of financial accounting is the relationship between
IFRSs, IASs and national accounting standards. It should be noted that the content and format
of financial statements are mainly governed by local regulations. Where legislation requires
deviation from IFRSs/ IASs, the local accountancy profession, should try and persuade the
relevant authorities about the benefits of international harmonization of accountancy rules and
regulations
The following IASB statement on the authority attaching to IFRSs/IASs should be noted:
“Standing alone, neither the IASB nor the accountancy profession has the power to enforce
international agreement or to require compliance with IFRSs/IASs. The success of IASB's
efforts is dependent upon the recognition and support of its work from many different interested
groups acting within the limits of their own jurisdiction. In most countries of the world the
accounting profession has a prestige and standing which is of great significance in these
efforts.”
2.9 REFERENCES
PENDRILL, D. & LEWIS, R.
Advanced Financial Accounting,
2nd Edition ELBS/Pitman 1985
SHAYAMAKIPI, S.H.
Readings in Company
Accounting ZOU Study Pack
2004
IASB
Preface to International Financial
Reporting Standards 2015
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UNIT THREE
FIRST-TIME ADOPTION OF INTERNATIONAL FINANCIAL
REPORTING STANDARDS (IFRS 1)
3.0 INTRODUCTION
In Unit 2, it was pointed out that the IASB and its affiliate accounting bodies throughout the
world do not have the power to enforce international agreement or to require compliance with
IFRSs or IASs. Greater levels of international harmonization can only be achieved by
persuading governments and other organizations which use or regulate financial statements to
move towards mandatory application of the standards. This involves a lot of consultation with
interested parties, to the extent of allowing them to participate meaningfully in the process
leading to the promulgation of new standards or the revision of existing ones. As an example
of such co-operation, the old IASC and the International Organization of Security Commissions
(IOSCO) worked closely together towards the use of IASs for cross-border share issues and
foreign listings. Basic agreement was achieved in May 2001, although further discussion was
required on the meaning of true and fair view, the capitalization of development costs and the
revaluation of property.
The IASB has now adopted a more proactive stance in the promotion of IFRSs and IASs, and
also narrowed down the options for the organizations which decide to use these standards. In
addition to the existing standards on areas like accounting policies, changes in accounting
estimates and errors (IAS 8), the Board has introduced a new standard entitled First-time
Adoption of International Financial Reporting Standards (IFRS1). The major purpose of IFRS
1 is to provide comprehensive guidance to preparers of financial statements when a reporting
entity adopts IFRSs for the first time through an explicit and unreserved statement of
compliance with these standards. IFRS 1 aims to ensure that the entity’s first IFRS financial
statements and its interim financial reports for part of the period covered by those statements,
contain high quality information that:
a) is transparent for users and comparable over all periods presented
b) provides a suitable starting point for accounting on the basis of IFRSs
c) can be generated at a cost that does not exceed the benefits to users
3.1 OBJECTIVES
By the end of this Unit, you should be able to:
•
Distinguish and explain the different approaches used by the IASB in the promotion of
standards to preparers and users of financial statements.
•
Define key terms in IFRS 1 and explain its scope.
•
Explain the accounting treatment of various financial statement items, with particular
focus on the opening IFRS statement of financial position.
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•
•
Explain various recognition and measurement issues which arise in the application of
IFRS 1.
Explain the exceptions which are permitted with regard to the retrospective application of
other IFRSs.
•
Outline the exemptions from other IFRSs which are available to preparers of financial
statements.
•
Explain the adjustments which should be effected in financial statements to ensure the
correct transition to IFRSs.
3.2 EXAMPLES OF IFRS FINANCIAL STATEMENTS
An entity’s financial statements can be described as its first IFRS statements if the entity
a) presented its most recent previous financial statements
i)
under national requirements that are not consistent with IFRSs in all respects
ii)
in conformity with IFRSs in all respects, except that the statements did not contain
an explicit and unreserved statement that they complied with IFRSs.
iii)
containing an explicit statement of compliance with only some IFRSs
iv)
under national requirements inconsistent with IFRS, using some individual IFRSs
to account for items in respect of which national requirements did not exist
v)
under national requirements with a reconciliation of some amounts to the amounts
determined under IFRSs
b) prepared financial statements under IFRSs for internal use only, without making them
available to external users
c) prepared a reporting package under IFRSs for consolidation purposes without preparing a
complete set of financial statements as defined in IAS 1 (Presentation of Financial
Statements)
d) did not present financial statements for previous periods
3.3 STEPS IN PREPARATION OF AN ENTITY’S OPENING STATEMENT OF
FINANCIAL POSITION
First time adopters should go through the following steps:
(1) Recognise all assets and liabilities when this is required by IFRSs.
Areas which may be affected include:
defined benefit pension fund
deferred taxation
assets and liabilities under finance leases
provisions where there is a legal or constructive obligation
derivative financial instruments
share-based payment
(2) Not recognize items as assets or liabilities if this is not permitted by IFRSs.
ICSAZ - P.M. PARADZA
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Areas which may be affected include:
provisions where there is no legal or constructive obligation
internally generated intangible assets
deferred tax where recovery is not considered probable.
(3) Reclassify items that are recognized under previous GAAP as one type of
asset, liability or component of equity but are differently classified under
IFRSs.
Areas which may be affected include:
investments accounted for in accordance with IAS 39
some financial instruments previously classified as equity
assets and liabilities that have been incorrectly offset e.g. an insurance recovery
against a provision.
non-current assets held-for-sale
non-controlling interest, if previously considered a liability.
(4) Apply IFRSs in the measurement of all recognized assets and liabilities.
Areas which may be affected include:
receivables
inventory
employee benefit obligations
deferred tax
impairment of property, plant and equipment
impairment of intangible assets.
3.4 ACCOUNTING TREATMENT ARISING FROM SPECIFIC APPLICATION OF
IFRSs
Retrospective application of an IFRS occurs when it is used to account for events and
transactions which took place before its promulgation. Prospective application of an IFRS
occurs when it is used to account for events and transactions which took place in the year of
promulgation and subsequent periods. At the transition date, the entity should prepare its
financial statements on the basis of IFRSs which are applicable at the reporting date, without
reference to those which have been superseded or withdrawn.
However, the Board will encourage early application of some IFRSs which are not yet
mandatory.
When an entity adopts IFRSs for the first time, the financial statements should be prepared on
the basis of IFRSs applied retrospectively, unless this is prohibited by the relevant standard or
interpretation. According to Korster et al (2004), this means that the entity has to investigate
transactions from the date that it had been established in order to identify and recognize assets
and liabilities that would have been recognized had the currently prevailing IFRSs applied from
the outset. Such a process may lead to significant restatement of some financial statement
ICSAZ - P.M. PARADZA
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items. The process would also present an opportunity to establish meaningful values for assets,
liabilities and equity items in the light of prevailing inflation rates.
The principle of comparability between financial statements which is emphasized in the
theoretical framework of accounting is extended to the accounting requirements of first-time
adopters of IFRSs. Comparability of information found in financial statements is a key
requirement for users of these statements and applies to individual entities and similar entities
which have adopted IFRSs at the same or different times.
IFRS 1 is a pervasive standard whose implementation will require a thorough understanding of
many other IFRSs, IASs and IASB pronouncements. The implementation guidance section of
IFRS 1 gives examples of how accounting issues related to other standards should be treated.
3.4.1 IAS 10 (Events after the reporting period)
Entity A’s first IFRS financial statements are for a period that ends on 31 December 20-5 and
include comparative information for one year.
In its GAAP financial statements for the previous 2 years, this entity had:
(a) made estimates of accrual expenses and provisions on those dates
(b) accounted on a cash basis for a defined benefit plan
(c) not recognized a provision for a court case arising from events in September 20-4; the
case was decided on the 30 June 20-5 and the entity was required to pay $80 000, which
it paid on 10 July 20-5.
In preparing its first IFRS financial statements, the entity concluded that the estimates of
accrued expenses and provisions were consistent with its accounting policies in accordance
with IFRSs. Although some of the accruals and provisions turned out to be underestimates or
overestimates the entity concluded that the estimates were reasonable and that no error had
occurred.
3.4.2 IFRS 1 Requirements
(i) The entity should not adjust the previous estimates for accrued expenses and
provisions.
(ii) The entity should make estimates based on actuarial assumptions to account for the
pension plan in accordance with IAS 19 (Employee Benefits). These assumptions
should not reflect conditions that arose after the relevant dates.
(iii) In relation to the court case, if previous GAAP was consistent with IAS 37 (Provisions,
Contingent liabilities and Contingent Assets), there is no need to recognise a provision
on 31 December 20-4.
If previous GAAP was not consistent with IAS 37, the entity should develop estimates in
accordance with that standard. The entity should recognise a provision on 31 December 20-4.
This provision should be measured by discounting the $80 000 paid on 10 July 20-5 to its
present value. The discount rate should comply with IAS 37 and reflect market conditions on
31 December 20-4.
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3.4.3 IAS 12 (Income Tax)
(i) An entity should apply IAS 12 to temporary differences between the carrying amount
of the assets and liabilities in its opening IFRS statement of financial position and their
tax bases.
(ii) The measurement of current and deferred tax should reflect tax rates and laws that have
been enacted or substantively enacted by the end of the reporting period. Changes in
tax rates and tax laws should be taken into account when they are in force or certain to
be in force in the future.
3.4.4 IAS 16 (Property, Plant and Equipment)
If an entity’s depreciation methods and rates based on its previous GAAP are in accordance
with IFRSs, the entity may account for any change in the estimated useful life or depreciation
pattern for property, plant and equipment prospectively i.e. going forward. However, if this is
not the case and the identified differences are material, the entity should adjust accumulated
depreciation in its opening IFRS statement of financial position, retrospectively. This is to
ensure that this statement complies with IFRSs.
An entity may elect to use one of the following amounts as the deemed cost of an item of
property, plant and equipment:
(a) the fair value on the date of transition to IFRSs.
(b) a revaluation in accordance with previous GAAP that meets the requirements of IFRS
1.
(c) the fair value at the date of an event such as a privatisation or initial public offering.
(d) the allocation of an amount determined under previous GAAP that meets the
requirements of IFRS 1.
(e) the carrying amount under previous GAAP of an item of property, plant and equipment
that is or was previously used in operations subject to rate regulation.
If revaluations in accordance with previous GAAP did not meet the criteria outlined in IFRS
1, an entity should measure the revalued assets in its opening statement of financial position
using one of the following bases.
(i) the original cost or deemed cost less any accumulated depreciation and any impairment
losses based on the cost model.
(ii) deemed cost - being the fair value on the date of transition to IFRSs.
(iii)the revalued amount, if the entity adopts the revaluation model as its accounting model
for all items of property, plant and equipment in the same class.
3.4.5 IAS 19 (Employee Benefits)
An entity’ s actuarial assumptions on the date of its transition to IFRSs are assumed to be
consistent with actuarial assumptions made for the same date using previous GAAP, unless
there is objective evidence that the latter are in errors. Any revisions to the assumptions
constitutes an actuarial gain or loss for the period in which the entity made the revisions.
In many cases, an entity’s first IFRS financial statements will reflect measurements of
employee benefits on three dates.
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(i)
(ii)
(iii)
the end of the first IFRS reporting period.
the date of the comparative statement of financial position.
the date of transition to IFRS.
3.5 THE IFRS 3 EXEMPTION
EXAMPLE 1
Business combination
Background
Entity B’s first IFRS financial statements are for a period that ends on 31 December 20x5 and
include comparative information for 20x4 only. On 1 July 20x1, entity B acquired 100 % of
subsidiary C. In accordance with its previous GAAP, entity B:
(a) classified the business combination as an acquisition by entity B.
(b) measured the assets acquired and liabilities assumed at the following amounts in
accordance with previous GAAP at 31 December 20x3 (date of transition to IFRS):
(i) identifiable assets less liabilities for which IFRSs require cost-based
measurement at a date after the business combination: CU200 (with a tax base
of CU150 and an applicable tax rate of 30%).
(ii) pension liability (for which the present value of the defined benefit obligation
measured in accordance with IAS 19 Employee Benefits is CU130 and the fair
value of plan assets is CU100): nil (because entity B used a pay as you go cash
method of accounting for pensions in accordance with its previous GAAP). The
tax base of the pension liability is also nil.
(iii)goodwill: CU180.
(c) did not, at the acquisition date, recognise deferred tax arising from temporary
differences associated with the identifiable assets acquired and liabilities assumed.
Application of requirements
In its opening (consolidated) IFRS statement of financial position, entity B:
(a) classifies the business combination as an acquisition by entity B even if the business
combination would have qualified in accordance with IFRS 3 as a reverse acquisition
by subsidiary C (paragraph C4(a) of the IFRS).
(b) does not adjust the accumulated amortisation of goodwill. Entity B tests the Goodwill
for impairment in accordance with IAS 36 Impairment of Assets and recognises any
resulting impairment loss, based on conditions that existed at the date of transition to
IFRSs. If no impairment exists, the carrying amount of the Goodwill remains at CU180
(paragraph C4(g) of the IFRS).
(c) for those net identifiable assets acquired for which IFRSs require cost-based
measurement at a date after the business combination, treats their carrying amount in
accordance with previous GAAP immediately after the business combination as their
deemed cost at that date (paragraph C4(e) of the IFRS).
(d) does not restate the accumulated depreciation and amortisation of the net identifiable
assets in (c), unless the depreciation methods and rates in accordance with previous
GAAP result in amounts that differ materially from those required in accordance with
IFRSs (for example, if they were adopted solely for tax purposes and do not reflect a
ICSAZ - P.M. PARADZA
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reasonable estimate of the asset’s useful life in accordance with IFRSs). If no such
restatement is made, the carrying amount of those assets in the opening IFRS statement
of financial position equals their carrying amount in accordance with previous GAAP
at the date of transition to IFRS (CU200) (paragraph IG7).
(e) if there is any indication that identifiable assets are impaired, test those assets for
impairment, based on conditions that existed at the date of transition to IFRS (see IAS
36).
(f) recognises the pension liability, and measure it, at the present value of the defined
obligation (CU130 to retained earnings (paragraph C4(d) of the IFRS). However, if
subsidiary C had already adopted IFRSs in an earlier period, entity B would measure
the pension liability at the same amount as in subsidiary C’s financial statements.
(paragraph D17 of the IFRS and IG Example 9).
(g) recognises a net deferred tax liability of CU20 at 30% arising from:
(i) the taxable temporary difference of CU50 (CU200 less CU150) associated with
the identifiable assets acquired and non-pension liabilities assumed, less
(ii) the deductible temporary difference of CU30 (CU30 less nil) associated with
the pension liability.
The entity recognises the resulting increase in the deferred tax liability as a deduction from
retained earnings (paragraph C4(k) of the IFRS). If a taxable temporary difference arises from
the initial recognition of the goodwill, entity B does not recognise the resulting deferred tax
liability (paragraph 15(a) of IAS 12 Income Taxes).
EXAMPLE 2
Business combination-restructuring provision
Background
Entity D’s first IFRS financial statements are for a period that ends on 31 December 20x5 and
include comparative information for 20x4 only. On 1 July 20x3, entity D acquired 100% of
subsidiary E. In accordance with its previous GAAP, entity D recognised an (undiscounted)
restructuring provision of CU100 that would not have qualified as an identifiable liability in
accordance with IFFRS 3. The recognition of this restructuring provision increased goodwill
by CU100. At 31 December 20x3 (date of transition to IFRSs), entity D:
(a) had paid restructuring costs of CU60, and;
(b) estimated that it would pay further costs of CU40 in 20x4, and that the effects of
discounting were immaterial. At 31 December 20x3, those further costs did not qualify
for recognition as a provision in accordance with IAS 37 Provisions, Contingent
Liabilities and Contingent Assets.
Application of requirements
In its opening IFRS statement of financial position, entity D:
(a) does not recognise a restructuring provision (paragraph C4(c) of the IFRS).
(b) does not adjust the amount assigned to goodwill. However, entity D tests the Goodwill
for impairment in accordance with IAS 36 Impairment of Assets, and recognises any
resulting impairment loss (paragraph C4(g) of the IFRS).
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(c) as a result of (a) and (b), reports retained earnings in its opening IFRS statement of
financial position that are higher by CU40 (before income taxes, and before income
taxes, and before recognising any impairment loss) than in the statement of financial
position at the same date in accordance with previous GAAP.
Note on Non-Controlling Interest
First-time adopters are required to apply the following mandatory requirements in IFRS 3:
a) Attribute total comprehensive income to the owners of the parent and to the noncontrolling interest if this shows a loss.
b) Account for changes in the parent’s ownership interest in a subsidiary that do not result
in loss of control.
c) Account for a loss of control over a subsidiary.
IFRS 10 Consolidated Financial Statements
A first time adopter should consolidate all its subsidiaries unless exempted by IFRS 10
Consolidated Financial Statements.
If such an entity did not consolidate a subsidiary in accordance with previous GAAP:
(a) in its consolidated financial statements, the entity should measure the subsidiary’s
assets and liabilities at the same carrying amounts as in the IFRS financial statements
of the
subsidiary. This should be done after adjusting for consolidation procedures and for the
effects of the business combination in which it acquired the subsidiary.
• if the subsidiary has not adopted IFRSs in its financial statements, the carrying amounts
are those which would be required by IFRSs.
(b) if the parent acquired the subsidiary in a business combination before the transition to
IFRSs, the parent should recognise goodwill.
(c) if the parent did not acquire the subsidiary in a business combination because it created
the subsidiary, the parent should not recognise goodwill.
If a first-time adopter adjusts the carrying amounts of assets and liabilities of its subsidiaries in
preparing its opening IFRS statement of financial position, any changes in non-controlling
interest and deferred tax should be taken into account.
IAS 34 Interim Financial Reporting
IAS 34 should be followed if an entity is required or elects to present an interim financial report.
However, there is no requirement for the entity to:
(i) present interim financial reports that comply with IAS 34
(ii) prepare new versions of interim financial reports which were based on previous GAAP.
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EXAMPLE 3
Interim financial reporting
Background
Entity R’s first IFRS financial statements are for a period that ends on 31 December 20x5, and
its first interim financial report in accordance with IAS 34 is for the quarter ended 31 March
20x5. Entity R prepared previous GAAP annual financial statements for the year ended 31
December 20x4, and prepared quarterly reports throughout 20x4.
Application of requirements
In each quarterly interim financial report for 20x5, entity R includes reconciliations of:
(a) its equity in accordance with previous GAAP at the end of the comparable quarter of
20x4 to its equity in accordance with IFRSs at that date, and;
(b) its total comprehensive income (or, if it did not report such a total, profit or loss) in
accordance with previous GAAP for its comparable quarter of 20x4 (current and year
to date) to its total comprehensive income in accordance with IFRSs.
In addition to the reconciliation required by (a) and (b) and the disclosures required by IAS 34,
entity R’s interim financial report for the first quarter of 20x5 includes reconciliations of (or a
cross-reference to another published document that includes these reconciliations):
(a) its equity in accordance with previous GAAP at 1 January 20x4 and 31 December 20x4
to its equity in accordance with IFRSs at those dates, and;
(b) its total comprehensive income (or, if it did not report such a total, profit or loss) for
20x4 in accordance with previous GAAP to its total comprehensive income for 20x4 in
accordance with IFRSs.
Each of the above reconciliations gives sufficient detail to enable users to understand the
material adjustments to the statement of financial position and statement of comprehensive
income. Entity R also explains the material adjustments to the statement of cash flows.
If entity R becomes aware of errors made in accordance with previous GAAP, the
reconciliations should distinguish the correction of those errors from changes in accounting
policies.
If entity R did not, in its most recent annual financial statements in accordance with previous
GAAP, disclose information material to an understanding of the current interim period, its
interim financial reports for 20x5 should disclose that information or include a cross-reference
to another published document that includes it (paragraph 33 of the IFRS).
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EXAMPLE 4
Business combination-intangible assets
Background
Entity F’s first IFRS financial statements are for a period that ends on 31 December 20x5 and
include comparative information for 20x4 only. On 1 July 20x1 entity F acquired 75% of
subsidiary G. In accordance with its previous GAAP, entity F assigned an initial carrying
amount of CU 200 to intangible assets that would not have qualified for recognition in
accordance with IAS 38 Intangible Assets. The tax base of the intangible assets was nil, giving
rise to a deferred tax liability (at 30%) of CU 60.
On 31 December 20x3 (the date of transition to IFRSs) the carrying amount of the intangible
assets in accordance with previous GAAP was CU 160, and the carrying amount of the related
deferred tax liability was CU 48 (30% of CU 160).
Application of requirements
Because the intangible assets do not qualify for recognition as separate assets in accordance
with IAS 38, entity F transfers them to goodwill, together with the related deferred tax liability
(CU 48) and non-controlling interests (paragraph C4(g)(i) of the IFRS). The related noncontrolling interests amount to CU 28 (25% of [CU 160-CU 48=CU 112]). Thus, the increase
in goodwill is CU 84-intangible assets (CU 160) less deferred tax liability (CU 48) less noncontrolling interests (CU 28).
Entity F tests the goodwill for impairment in accordance with IAS 36 Impairment of Assets
and recognises any resulting impairment loss, based on conditions that existed at the date of
transition to IFRSs (paragraph C4(g)(ii) of the IFRS).
Exemptions from other IFRSs
In the application of IFRS 1, an entity may use of specific exemptions related to the following
standards:
a)
business combinations (IFRS 3)
b)
fair value or revaluation as deemed cost (IFRS 3)
c)
employee benefits (IAS 19)
d)
cumulative translation differences (IAS 21)
e)
compound financial instruments (IAS 32)
f)
assets and liabilities of subsidiaries, associates and joint ventures (IAS 27)
g)
designation of previously recognised financial instruments (IAS 39)
h)
share-based payment (IFRS 2)
i)
insurance contracts (IFRS 4)
Exemptions to Retrospective Applications of other IFRSs
i) Derecognition of financial assets and financial liabilities:
First-time adopters should apply the derecognition requirements of IAS 39
retrospectively for transactions occurring on or after 1 January 2004. This means that if
an entity derecognised non-derivative financial assets/ liabilities under previous GAAP
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due to a transaction which occurred before 1 January 2004, it should not recognize those
assets and liabilities under IFRSs. However, the entity may apply the derecognition
provisions of IAS 39 retrospectively if the information required to do this was obtained
when the transactions were originally accounted for.
ii) Hedge accounting
An entity should not show in its opening IFRS statement of financial position a hedging
relationship which does not qualify as a hedge under IAS 39. Examples of such
relationships are:
•
•
•
where the hedging instrument is a cash instrument or written option.
where the hedged item is a net position unless an individual item within the
net position had been designated as a hedged item on the date of transition
to IFRS.
where the hedge covers interest risk in a held-to-maturity investment.
A transaction which does not meet the conditions for hedge accounting should be treated
according to paras 91 and 101 of IAS 39. In addition, transactions which occurred before
the date of transition to IFRSs should not be retrospectively classified as hedges.
iii) Estimates
An entity’s estimates under IFRSs at the date of transition to IFRSs should be consistent
with those made for the same date under previous GAAP, adjusting for differences in
accounting policies. The only exception to this rule is if there is objective evidence that
the original estimates were in error. Additional information about estimates that were
made under previous GAAP received after the transition date should be accounted for as
non-adjusting events after the reporting date according to IAS 10 (Events after the
Reporting Date). Note that estimates of market prices, interest rates and foreign exchange
rates should reflect market conditions at the transition date.
iv) Assets classified as held for sale and discontinued operations
The provisions of IFRS 5 (Non-current Assets Held for Sale and Discontinued
Operations) should be applied prospectively to non-current assets or disposal groups
which meet the relevant criteria after the effective date of the IFRS. Entities with
transition dates on or after 1 January 2005 should apply IFRS 5 retrospectively.
3.6 PRESENTATION AND DISCLOSURE
An entity should explain how the transition from previous GAAP to IFRSs affected its reported
financial position and cash flows. The required reconciliations should include:
a) reconciliations of its equity reported under previous GAAP to its equity under IFRSs
for both of the following dates:
i) the date of transition to IFRSs.
ii) the end of the latest period presented in the entity’s most recent annual financial
statements under previous GAAP.
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b) a reconciliation of the profit or loss reported under previous GAAP for the latest
period in the entity’s most recent annual financial statements to its profit or loss under
IFRSs for the same period.
c) if the entity recognized or reversed any impairment losses for the first time in
preparing its opening IFRS statement of financial position, the disclosures that IAS 36
(Impairment of Assets) would have required if those losses or reversals had been
recognized in the period beginning with the transition date.
If an entity presented a cash flow statement under its previous GAAP, it should also explain
the material adjustments to that statement. The correction of errors made under previous GAAP
should be distinguished from changes in accounting policies. However, the requirements of
IAS 8 (Accounting Policies, Changes in Accounting Estimates and Errors) about changes in
accounting policies do not apply in an entity’s first IFRS financial statements.
3.7 SUMMARY
This Unit outlines the transitional reporting requirements which should be followed by entities
adopting IFRSs for the first time. IFRS 1 makes it clear that the move to IFRSs requires a total
commitment on the part of the entities across all economic sectors and legal jurisdictions. This
standard sets the scene for extensive changes in accounting principles and procedures on a
worldwide basis.
3.8 REFERENCES
pwc
MANUAL OF ACCOUNTING, IFRS 2015
KOORNHOF, C et al
9th Edition NexisLexis/Butterworths 2004
ERNST & YOUNG
International GAAP 2005
IASB
International Financial Reporting Standards 2015
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UNIT FOUR
PRESENTATION OF FINANCIAL STATEMENTS (IAS 1)
4.0 INTRODUCTION
IAS 1 is the standard which sets out overall requirements for the presentation of financial
statements, as well as guidelines for their structure and minimum requirements for their
content. A key aspect of this standard is that it requires reporting entities to disclose as a
minimum in respect of previous periods, two of each of the statements and related notes.
Specifically, a statement of financial position should be shown as at the beginning of the earliest
comparative period whenever an entity retrospectively applies an accounting policy or makes
a retrospective restatement of items in its financial statements, or when it reclassifies certain
items in the statements.
Other important changes in the revised IAS 1 are as follows:
i)
All changes in equity arising from transactions with owners in their capacity as
owners i.e. owner changes in equity should be presented separately from non-owner
changes in equity. Entities are not permitted to present components of statement of
profit or loss and other comprehensive income, that is, non-owner changes in equity
in the statement of changes in equity.
ii)
Income and expenses should be presented in one statement, that is, a statement of
profit or loss and other comprehensive income or in 2 statements, that is, a separate
income statement and a statement of profit or loss and other comprehensive income
separately from owner changes in equity.
iii)
Components of other comprehensive income should be displayed in the statement
of comprehensive income.
iv)
Total comprehensive income should be presented in the financial statements.
4.1 OBJECTIVES
By the end of this Unit, you should be able to:
•
Identify and explain the components of financial statements.
•
List and explain the general features of financial statements.
•
List the elements of the various types of financial statements and make the required
disclosures.
•
List the disclosures which are required if a reporting entity considers it necessary to
depart from an IFRS.
•
Make the disclosures which are required on accounting policies in notes to the financial
statements.
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4.2 TERMINOLOGY
The standard defines the following key terms as follows:
General purpose financial statements (hereinafter referred to as financial statements) are those
intended to meet the needs of users who are not in a position to require an entity to prepare
reports tailored to meet their particular information needs.
Notes refer to quantitative or qualitative information in addition to that presented in the
statement of financial position, statement of profit or loss and other comprehensive income,
statement of changes in equity and statement of cash flows. Such notes provide narrative
descriptions or disaggregation of items presented in the financial statements which do not
qualify for separate recognition in the statements.
Other comprehensive income comprises items of income and expense including
reclassification adjustments that are not recognized in profit or loss as required or permitted by
other IFRSs.
The Financial Accounting Standards Board (USA) Statement of Financial Accounting
Concepts defined statement of profit or loss and other comprehensive income as the change in
the equity of a business entity during a period from transactions and other events and
circumstances from non-owner sources. It includes all changes in equity during a period except
those resulting from investments by owners and distributions to owners.
Reclassification adjustments are amounts reclassified to profit or loss in the current period that
were recognized in other comprehensive income in the current or previous periods.
Total comprehensive income is the change in an entity's equity during a period resulting from
transactions and other events other than changes resulting from transactions with owners in
their capacity as owners. Total comprehensive income is made up of all components of profit
or loss and other comprehensive income.
4.3
FINANCIAL STATEMENTS
4.3.1 Definition and purpose of financial statements
IAS 1 defines financial statements as a structured representation of the financial position and
financial performance of an entity. The purpose of these statements is to provide information
about the financial position, financial performance and cash flows of an entity useful to a wide
range of users when making economic decisions. The statement also shows the results of the
management's stewardship of the resources entrusted to it.
4.3.2 Complete set of financial statements/Components of financial statements
A complete set of financial statements consists of:
a) A statement of financial position at the reporting date
b) A statement of profit or loss and other comprehensive income for the period
c) A statement of changes in equity for the period
d) A statement of cash flows for the period
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e) Notes to the financial statements, comprising a summary of significant accounting
policies and other explanatory information.
f) A statement of financial position at the beginning of the earliest comparative period
when an entity applies an accounting policy retrospectively, or makes a retrospective
restatement of items in its financial statements or when it reclassifies some items in
these statements.
The standard states that an entity should present with equal prominence all of the financial
statements it has prepared for a period.
Although not required, the standard states that an entity may show outside the financial
statements, a financial review by its management which includes:
i)
The main factors which influences the entity's financial performance, including
changes in its operating environment, its response to those changes and their effects,
and its policy for investment to maintain and enhance financial performance.
ii)
The entity's sources of funding and its targeted ratio of liabilities to equity.
iii)
The entity's resources which are not recognized in the statement of financial
position in accordance with IFRSs.
It should also be noted that many entities do present, outside the financial statements, reports
and statements, for example, environmental reports and value added statements. This is usually
done in industries in which environmental factors are significant, and employees are considered
to be an important user group.
4.4
GENERAL ASPECTS OF IFRSs
4.4.1 Fair presentation and compliance with IFRSs
The standard states that financial statements should present fairly the financial position,
financial performance and cash flows of a reporting entity. Fair presentation refers to the
faithful representation of the effects of transactions, other events and conditions in accordance
with the definitions and recognition criteria for assets, liabilities, income and expenses set out
in the Conceptual Framework for Financial Reporting.
An entity whose financial statements comply with IFRSs should make an explicit and
unreserved statement of such compliance in the notes to its financial statements. However, an
entity should not describe financial statements as complying with IFRSs unless they comply
with all the requirements of these standards.
A fair presentation is normally achieved by complying with applicable IFRSs. This will usually
require the entity to
a) select and apply accounting policies in accordance with IAS 8 – Accounting policies,
changes in accounting estimates and errors.
b) present information, including accounting policies, in a manner that provides relevant,
reliable, comparable and understandable information.
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c) provide additional disclosures when compliance with the specific requirements in
IFRSs is insufficient to enable users to understand the impact of particular transactions,
other events and conditions on the entity's financial position and financial performance.
N.B. An important provision of IAS 1 is that an entity cannot rectify inappropriate accounting
policies either by disclosure of the accounting policies used, notes, or explanatory material.
4.4.2 Departure from applicable IFRSs
Sometimes the management of an entity may conclude that complying with a requirement in
an IFRS would be misleading, and conflict with the overall objectives of financial statements
as set out in the Framework. In such cases the entity should depart from the requirement if the
relevant regulatory framework requires, or does not prohibit such a departure. The following
disclosures would be required:
i)
That management has concluded that the financial statements present fairly the
entity's financial position, financial performance and cash flows.
ii)
That the entity has complied with applicable IFRSs, except that it has departed from
a particular requirement to achieve a fair presentation.
iii)
The title of the IFRS from which the entity has departed, the nature of the departure
including the treatment that the IFRS would require, the reason why that treatment
would be misleading under the circumstances, and the treatment adopted.
iv)
For each period presented, the financial effect of the departure on each item in the
financial statements that would have been reported in complying with the
requirement.
The disclosures in iii) and iv) above are also required if an entity departed from an IFRS
requirement in a prior period and the departure affects the amounts recognized in the financial
statements for the current period. Vorster, Koornhof et al (2006) have argued that if other
entities in similar circumstances comply with an IFRS requirement, this would be prima facie
proof that complying with the requirement would not be misleading and/or conflict with the
objectives of financial statements. In such cases, the entity seeking to depart from the
requirement would have to justify this course of action.
It is possible that an entity's management may conclude that complying with an IFRS
requirement would be misleading and be in conflict with the objectives of financial statements.
On the other hand, the relevant regulatory framework may prohibit departure from the
framework. Under these circumstances the entity should minimize the perceived misleading
aspects of non-compliance by disclosing the following:
a) The title of the IFRS, the nature of the requirement, and the reason why management has
concluded that complying with the requirement would be misleading and in conflict with the
objectives of financial statements.
b) For each period presented, the adjustments to each item in the financial statements that
management considered would be necessary to achieve a fair presentation.
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4.4.3 Going concern
When preparing financial statements, management should make an assessment of the entity's
ability to continue as a going concern. This is based on the assumption that the entity will be
in operational existence for the foreseeable future, generally taken to be twelve months. The
financial statements are thus prepared assuming that there is or will not be any intention or
necessity to liquidate or significantly curtail the entity's scale of operations.
According to Geisler (1983), signs that an entity may have going concern problems include:
i)
high or increasing debt to equity ratio (that is, a higher proportion of loan capital).
ii)
the entity's borrowing level being at or near the limit.
iii)
increasing dependence on short-term finance.
iv)
loan repayments falling due, with refinancing facilities not certain or not
immediately available.
v)
arrears in payments of loan interest, or difficulties in meeting these payments.
vi)
major litigation pending against the entity.
When management becomes aware of material uncertainties related to events or conditions that
may cast significant doubt on the entity's ability to continue as a going concern, these
uncertainties should be disclosed.
When an entity does not prepare financial statements on a going concern basis, it should
disclose this fact, together with the basis on which the statements have been prepared and the
reason why the entity is not considered to be a going concern.
4.4.4 Accrual basis
An entity should prepare its financial statements, except for cash flow information using the
accrual basis of accounting. This means that the entity should recognize items as assets,
liabilities, equity, income and expenses when they satisfy the definitions and recognition
criteria for those elements in the Framework.
4.4.5 Materiality and aggregation
An entity should present separately each material class of similar items. Items of a dissimilar
nature or function should be presented separately unless they are immaterial.
•
If a line item is not individually material it should be aggregated with other items either
in the financial statements or in the notes.
•
An item that is not sufficiently material to require separate presentation in the financial
statements may be disclosed in the notes.
4.4.6 Offsetting
An entity should not offset assets and liabilities or income and expenses unless this is required
or permitted by an IFRS. According to Vorster, Koornhof et al (2006), when assets are
measured net of valuation allowances e.g. obsolescence allowances on inventories and
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provisions for credit losses on debtors, this is not regarded as offsetting. On the other hand
“when income and expenditure are offset against one another, the entity should, in the light of
the materiality thereof, nevertheless consider disclosing in the notes to financial statements the
amounts that were offset against one another.”
IAS 1 states that an entity may present on a net basis gains and losses arising from a group of
similar transactions, for example, foreign exchange gains and losses, or gains and losses arising
from financial instruments held for trading. However, the entity should present such gains and
losses separately if they are material.
4.4.7 Frequency of reporting
An entity should present a complete set of financial statements, including comparative
information, at least annually. If the entity changes the end of its reporting period and presents
financial statements for a period longer or shorter than one year, it should disclose, in addition
to the period covered by the statements.
a) the reason for using a longer or shorter period.
b) the fact that amounts presented in the financial statements are not entirely comparable.
4.4.8 Comparative information
An entity should disclose comparative information in respect of the previous period for all
amounts reported in the current period's financial statements. This requirement includes
comparative information for narrative and descriptive information when it is essential to clarify
the current period's financial statements. The purpose of comparative information is to enable
users to discern and understand trends in the financial position, financial performance and cash
flows inherent in an entity's financial statements.
When an entity changes the presentation or classification of items in its financial statements, it
should reclassify comparative amounts unless this is impracticable. The following disclosures
are required when such a reclassification is undertaken.
a) the nature of the reclassification
b) the amount of each item or class of items that is reclassified
c) the reason for the reclassification
If it is impracticable to reclassify comparative amounts, an entity should disclose:
a) the reason for not reclassifying comparative amounts
b) the nature of the adjustments that would have been made if the amounts had been
reclassified.
4.5 STRUCTURE AND CONTENT OF FINANCIAL STATEMENTS
4.5.1 Identification of financial statements
An entity should identify financial statements which are being presented and distinguish them
from other related information in the same published document, commonly known as the
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annual report. The entity should display the following minimum information prominently in
the financial statements:
a) the name of the reporting entity or other means of identification and any change in that
information from the end of the previous reporting period.
b) whether the financial statements are of an individual entity or a group of entities.
c) the date of the end of the reporting period (previously known as the balance sheet date)
or the period covered by the set of financial statements or notes.
d) the currency used in the financial statements.
e) the level of rounding used in presenting amounts in the financial statements.
4.5.2 Information to be presented in the statement of financial position
As a minimum, the statement of financial position should include the following line items at
the relevant amounts.
i)
property, plant and equipment (IAS 16)
ii)
investment property (IAS 40)
iii)
intangible assets (IAS 38)
iv)
financial assets (IFRS 9)
v)
investments accounted for using the equity method (IAS 28)
vi)
biological assets (IAS 41)
vii)
inventories (IAS 2)
viii)
trade and other receivables
ix)
cash and cash equivalents
x)
the total of assets classified as held for sale and assets included for disposal groups
classified as held for sale in accordance with IFRS 5
xi)
trade and other payables
xii)
provisions
xiii)
financial liabilities (IFRS 9)
xiv)
liabilities and assets for current tax, as defined in IAS 12
xv)
deferred tax liabilities and deferred tax assets as defined in IAS 12
xvi)
liabilities included in disposal groups classified as held for sale in accordance with
IFRS 5
xvii)
non-controlling interests, presented within equity (IFRS 3)
xviii) issued capital and reserves attributable to owners of the parent
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An entity should present additional line items, headings and sub-totals in the statement of
financial position if such a presentation will enhance understanding of the entity's financial
position.
IAS 1 does not prescribe the order or format in which an entity should present various items,
but simply identifies items that are sufficiently different in nature or function to warrant
separate presentation in the statement of financial position.
The descriptions used and the ordering of items or aggregation of similar items may be
amended according to the nature of the entity and its transactions, to provide information that
is relevant to an understanding of the entity's financial position. An entity should make a
judgment about whether to present additional items separately based on
a) the nature and liquidity of assets
b) the function of assets within the entity
c) the amounts, nature and timing of liabilities
4.5.3 Classification of statement of financial position elements
The classification of assets and liabilities is important to users of financial statements, since it
indicates the extent to which they are available for direct use by the entity, or may continue to
be used to finance its operations. In some cases a presentation based on liquidity may provide
information that is reliable and more relevant. In all other cases, the general guidelines of
classification are as follows:
Assets
An entity should classify an asset as current when:
a) it expects to realize the carrying amount of the asset or intends to sell or consume it in
its normal operating cycle;
b) it holds the asset primarily for the purpose of trading;
c) it expects to realize the asset within twelve months after the reporting period;
d) the asset is cash or a cash equivalent, unless the asset is restricted from being
exchanged or used to settle a liability for at least twelve months after the reporting
period.
All other assets should be classified as non-current. The term non-current includes tangible,
intangible and financial assets of a long-term nature.
Liabilities
An entity should classify a liability as current when:
a) it expects to settle the liability in its normal operating cycle;
b) it holds the liability primarily for trading purposes;
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c) the liability is due to be settled within twelve months after the reporting period. For
example, the principal amount of a long term loan which is due for repayment within
the next twelve months with no potential of being rolled over; or
d) the entity does not have an unconditional right to defer settlement of the liability for at
least twelve months after the reporting period. For example, defaulting an interest
instalment on a financing arrangement which invokes a clause for immediate repayment
of the principal amount of the long term loan plus interest.
All other liabilities should be classified as non-current. An entity should classify its financial
liabilities as current when they are due to be settled within twelve months after the reporting
period even if:
i)
the original term was for a period longer than twelve months; and
ii)
an agreement to refinance, or to reschedule payments, on a long term basis is
completed after the reporting period and before the financial statements are
authorized for issue.
4.5.3.1 Information to be presented either in the statement of financial position or in the
notes
An entity should disclose, either in the statement of financial position or in the notes, further
sub- classifications of the line items presented in a manner that is appropriate to the entity's
operations. Some guidelines for disclosure are as follows:
i)
items of property, plant and equipment are disaggregated into classes in accordance
with IAS 16;
ii)
receivables are disaggregated into amounts receivable from trade customers,
receivables from related parties, prepayments and other amounts;
iii)
inventories are disaggregated in accordance with IAS 2, into classifications such as
merchandise, production supplies, materials, work-in-progress and finished goods;
iv)
provisions are disaggregated into provisions for employee benefits and other items;
v)
equity capital and reserves are disaggregated into various classes, for example, paidin capital, share premium and reserves.
4.5.3.2 Information to be presented either in the statement of financial position or the
statement of changes in equity or in the notes
An entity should disclose the following information, either in the statement of financial
position, or the statement of changes in equity, or in the notes
a) For each class of share capital
i)
the number of authorized shares.
iii)
the number of shares issued and fully paid, and issued but not fully paid
iv)
par value per share, or a statement that the shares have no par value.
ICSAZ - P.M. PARADZA
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v)
a reconciliation of the number of shares outstanding at the beginning and at the end
of the period.
vi)
the rights, preferences and restrictions attaching to each class, including restrictions
on the distributions of dividends and the repayment of capital.
vii)
shares in the entity held by the entity or by its subsidiaries or associates.
viii)
shares reserved or issued under options and contracts for the sale of shares,
including terms and amounts.
b) A description of the nature and purpose of each reserve within equity.
4.5.3.3 Overall presentation of the statement of financial position
P LTD & ITS SUBSIDIARIES
Statement of financial position as at 31 march
ASSETS
Non-current assets
Property, plant & equipment
Goodwill
Other intangible assets
Biological assets
Investments in associates
Other financial assets
Current assets
Inventories
Trade receivables
Other current assets
Cash & cash equivalents
EQUITY & LIABILITIES
Equity attributable to owners of the parent
Share capital
Retained earnings
Other components of equity
Non-controlling interests
Total equity
Non-current liabilities
Long term borrowings
Deferred tax
Long-term provisions
ICSAZ - P.M. PARADZA
20-7
$
20-6
$
xx
xx
xx
xx
xx
xx
xx
xx
xx
xx
xx
xx
xx
xx
xx
xx
xx
xx
xx
xx
xx
xx
xx
xx
xx
xx
xx
xx
xx
xx
xx
xx
xx
xx
xx
xx
xx
xx
xx
xx
xx
xx
xx
xx
40
Current Liabilities
Trade & other payables
Short-term borrowings
Current portion of long-term borrowings
Current tax payable
Short-term provisions
xx
xx
xx
xx
xx
xx
xx
xx
xx
xx
xx
xx
4.5.4 The Statement of profit or loss and other comprehensive income
The standard states that entities should present all items of income and expense recognised in
a period
a) in a single statement of profit or loss and other comprehensive income or
b) in 2 statements: a statement displaying components of profit or loss (separate income
statement) and a second statement beginning with profit or loss and showing
components of other comprehensive income(statement of profit or loss and other
comprehensive income)
4.5.5 Information to be presented in the statement of profit or loss and other
comprehensive income
As a minimum, this statement should include the following line items at the relevant amounts:
i)
revenue;
ii)
finance costs;
iii)
share of the profit or loss of associates and joint ventures based on the equity
method;
iv)
tax expense;
v)
a single amount comprising the total of
•
the post-tax profit or loss of discontinued operations
•
the post-tax gain or loss recognised on the measurement to fair value less
costs to sell or on the disposal of assets or disposal group(s) constituting the
discontinued operation;
vi)
profit or loss;
vii)
each component of statement of profit or loss and other comprehensive income
classified by nature, (excluding amounts in viii) below;
viii)
share of other comprehensive income of associates and joint ventures accounted
for using the equity method;
ix)
total comprehensive income.
An entity should disclose the following items in the statement of profit or loss and other
comprehensive income as allocations for the period:
ICSAZ - P.M. PARADZA
41
a) profit or loss for the period attributable to
i)
non-controlling interests
ii)
owners of the parent
b) total comprehensive income for the period attributable to:
i)
non-controlling interests
ii)
owners of the parent
An entity should present additional line items, headings and sub-totals in the statement of profit
or loss and other comprehensive income and the separate income statement (if presented), when
this enhances understanding of the entity’s financial performance. The standard explains that
this is necessary since the effects of an entity’s various activities, transactions and other events
differ in frequency, potential for gain and predictability. As a result, disclosing the components
of financial performance will assist users to predict this performance with a smaller margin of
error. Additional guidelines on preparing the statement of profit or loss and other
comprehensive income and the separate income statement are as follows:
•
An entity should amend the descriptions used and the ordering of items when this is
necessary to explain the elements of financial performance.
•
An entity should consider factors including materiality and the nature and function of
the items of income and expense.
•
An entity should not present any items of income or expense as extraordinary items in
the statement of profit or loss and other comprehensive income, the separate income
statement or the notes.
4.5.5.1 Profit or loss for the period
IAS 1 states that an entity should recognise all items of income and expense in a period in profit
or loss unless another IFRS requires or permits otherwise. For example, IAS 8 specifies two
such circumstances, that is, the correction of errors and the effect of changes in accounting
policies.
4.5.5.2 Other comprehensive income for the period
An entity should disclose the amount of income tax relative to each component of statement of
profit or loss and other comprehensive income, including reclassification adjustments, either
in the statement of profit or loss and other comprehensive income or in the notes. The
components of other comprehensive income for the period include:
a) changes in a revaluation surplus;
b) actuarial gains and losses on defined benefit plans recognised in accordance with IAS
19;
c) gains and losses arising from translating the financial statements of a foreign operation;
d) gains and losses on remeasuring available-for-sale financial assets;
ICSAZ - P.M. PARADZA
42
e) the effective portion of gains and losses on hedging instruments in a cash flow hedge.
Note that a reclassification adjustment should be included with the related component of other
comprehensive income in the period that the adjustment is reclassified to profit or loss. For
example, gains realised on the disposal of available-for-sale financial assets are included in the
profit or loss of the current period.
4.5.5.3 Information to be presented in the statement of profit or loss and other
comprehensive income or in the notes
When items of income or expense are material, an entity should disclose their nature and
amount separately. Items which require separate disclosure include:
i)
write-downs of inventories to net realisable value or of property, plant and
equipment to recoverable amount, as well as reversals of such write-downs;
ii)
restructurings of the activities of an entity and reversals of any provisions for the
costs of restructuring;
iii)
disposals of items of property, plant and equipment;
iv)
disposals of investments;
v)
discontinued operations;
vi)
litigation settlements;
vii)
other reversals of provisions.
4.5.6 Presentation of statement of profit or loss and other comprehensive income
According to para 99 of IAS 1 “An entity shall present an analysis of expenses recognised in
profit or loss using a classification based on either their nature or their function within the
entity, whichever provides information that is reliable or more relevant.”
When an entity uses the nature of expense method it aggregates depreciation, purchases of
materials, transport costs, employee benefits and advertising costs, but does not reallocate them
among functions within the entity. A simple format when using this method would be as
follows:
P LTD & ITS SUBSIDIARIES
Income statement for year ended 30 June 20-7
Revenue
Other income
Changes in inventories of finished goods and work-in-progress
Raw materials and consumables used
Employee benefits expense
Depreciation and amortisation expense
Other expenses
Profit before tax
ICSAZ - P.M. PARADZA
20-7
$
xx
xx
xx
xx
xx
xx
xx
xx
20-6
$
xx
xx
xx
xx
xx
xx
xx
xx
43
A simple format when using the function of expense method would be as follows:
P LTD & ITS SUBSIDIARIES
Income statement for year ended 30 June 20-7
Revenue
Cost of goods sold
Gross profit
Other income
Selling & distribution costs
Administration expenses
Other expenses
Profit before tax
20-7
$
xx
xx
xx
xx
xx
xx
xx
xx
20-6
$
xx
xx
xx
xx
xx
xx
xx
xx
Other expenses should appear as a specific note.
EXAMPLE – SIMPLE FORMAT (for recapping purposes only, you should no longer
be struggling with such a question at all at this stage of your studies)
ICSAZ May 2013 past examination question paper – Financial Accounting level (SCI
only)
The normal balances extracted from the books of Point Traders, a sole proprietor as at 30
September 2-12 are given below.
$
Capital, 1 October 2-11
117 744
Drawings
7 400
Heating and lighting expense
1 234
Stationery expense
1 446
Carriage inwards
3 600
Purchases
101 100
Sales
271 500
Carriage outwards
1 100
Advertising expense
515
Freehold premises at cost
200 000
Provision for depreciation – Freehold premises
50 000
Trade receivables
12 500
Trade payables
5 350
Inventory – 1 October 2-11
15 000
Sales returns
435
Purchases returns
210
Rent received
800
Office equipment at cost
25 000
Provision for depreciation – Office equipment
12 500
Motor vehicles at cost
175 000
Provision for depreciation – Motor vehicles
140 000
Wages and salary expense
39 511
Discount received
426
ICSAZ - P.M. PARADZA
44
Discount allowed
Telephone expenses
Rates expenses
Balance at bank
Cash in hand
Allowance for irrecoverable debts – 1 October 2-11
330
2 200
2 900
9 384
175
250
Notes to the financial statements at 30 September 2-12
i) Inventory on hand
19 375
ii) Rates prepaid
400
iii) Telephone charges accrued
40
iv) $500 of the trade receivable is to be written off as bad and the allowance for irrevocable
should be 5% of the remaining trade receivables.
v) Depreciation is to be provided on cost at the following rates:
Freehold premises
5%
Motor vehicles
20%
Office equipment
10%
REQUIRED
a) Prepare a statement of profit or loss and other comprehensive income for the year ended 30
September 2012, and
b) A statement of financial position as at that date. (you are required to prepare this part and
present all relevant workings for both parts)
SUGGESTED SOLUTION
a)
Point Traders
Statement of profit or loss and other comprehensive income for the year ended 30
September 2-12
$
Sales
271 550
Sales returns
(435)
Turnover
271 115
Cost of sales
Opening inventory
Purchases
Purchases returns
Carriage inwards
Closing inventory
Gross profit
ICSAZ - P.M. PARADZA
15 000
101 100
(210)
115 890
3 600
119 490
(19 375)
100 115
171 000
45
Other income
Discount received
Rent received
Selling & distribution costs
Carriage outwards
Advertising
Discount allowed
Administration expenses
Heating and lighting
Stationery
Wages and salaries expense
Telephone
Rates
Bad debts
Other expense
Depreciation expense
Profit before tax
426
800
1 226
172 226
1 100
515
330
1 945
1 234
1 446
39 511
2 240
2 500
850
47 781
47 500
97 226
75 000
4.5.7 Overall presentation of statement of profit or loss and other comprehensive income
N.B. The first thing you need to take note of is that the IASB published an amendment to IAS
1 called “presentation of items of other comprehensive income .” in 2011, which changed the
presentation of items contained in the other comprehensive income (OCI) section and their
classification within that section as follows.
Other comprehensive income (A + B)
xxx
A. Items that will not be reclassified to profit or loss:
Gains on property revaluation
Gains on investment in equity instruments (Financial assets at FVTOCI)
Actuarial gains (losses) on defined benefit pension plans
Share of gain (loss) on investment in associate`s property revaluation
Income tax relating to items that will not be reclassified
xxx
xxx
xxx
xxx
(xxx)
B. Items that may be reclassified subsequently to profit or loss:
Gains on translating foreign operations
Gains on cash flow hedges (for example, forward exchange contracts)
Income tax relating to items that may be reclassified
xxx
xxx
(xxx)
Important !!
In order to practice on the presentation of annual financial statements of a single entity (nongroup scenario) you may use Q2 ICSAZ November 2011 past examination question paper –
Mutamba Ltd.
ICSAZ - P.M. PARADZA
46
4.5.7.1 Function of expense method
Below is overall format for the statement of profit or loss and other comprehensive income
based on the function of expense method. The format is as before the aforementioned changes
in 2011 on the OCI section, you should notice the changes:
H LTD & ITS SUBSIDIARIES
Consolidated statement of profit or loss and other comprehensive income for the year
ended 31 March
Revenue
Cost of goods sold
Gross profit
Other operating income
Distribution costs
Administration expenses
Other operating expenses
Profit from operations
Finance costs
Share of profit of associates
Profit before tax
Company tax
Profit/loss for the year from continuing operations
Loss for the year from discontinued operations
Profit for the year
20-7
$
xx
xx
xx
xx
xx
xx
xx
xx
xx
xx
xx
xx
xx
xx
xx
20-6
$
xx
xx
xx
xx
xx
xx
xx
xx
xx
xx
xx
xx
xx
xx
Other comprehensive income
Exchange differences on translation foreign operations
Gains or losses arising on re-measuring FVTOCI
Gains or losses on hedging instruments in a cash flow hedge
Surplus/deficit on property, plant and equipment revaluation
Actuarial gains (losses) on defined benefit pension plans
Share of other comprehensive income of associates
Company tax relating to components of OCI
Other comprehensive income for the year net of tax
Total comprehensive income the year
xx
xx
xx
xx
xx
xx
xx
xx
xx
xx
xx
xx
xx
xx
xx
xx
xx
xx
xx
xx
xx
xx
xx
xx
xx
xx
xx
xx
xx
xx
xx
xx
Profit Attributable to:
Owners of the parent
Non-controlling interests
Total comprehensive income attributable to:
Owners of the parent
Non-controlling interests
Share Statistics
Earnings per share basic and diluted
ICSAZ - P.M. PARADZA
47
4.5.7.2 Nature of expense method
Below is overall format for the statement of profit or loss and other comprehensive income
based on the nature of expense method. The format is as before the aforementioned changes in
2011 on the OCI section, you should notice the changes:
H LTD & ITS SUBSIDIARIES
Consolidated statement of profit or loss and other comprehensive income for the year
ended 31 March
20-7
$
Revenue
xx
Other income
xx
Changes in inventories of finished goods and work-in-progress*1 xx
Work performed by the entity and capitalised*2
xx
Raw material purchased, and consumables used
xx
Employee benefits expense
xx
Depreciation and amortisation expense
xx
Impairment of property, plant & equipment
xx
Other operating expenses
xx
Profit from operations
xx
Finance costs
xx
Share of profit of associates
xx
Profit before tax
xx
Company tax
xx
Profit/loss for the year from continuing operations
xx
Loss for the year from discontinued operations
xx
Profit for the year
xx
20-6
$
xx
xx
xx
xx
xx
xx
xx
xx
xx
xx
xx
xx
xx
xx
xx
xx
Other comprehensive income
Exchange differences on translation of foreign operations
xx
Gains or losses on re-measuring available for sale financial assets xx
Gains or losses on hedging instruments in a cash flow hedge
xx
Surplus or deficit on property, plant and equipment revaluation
xx
Actuarial gains (losses) on defined benefit pension plans
xx
Share of other comprehensive income of associates
xx
Company tax relating to components of OCI
xx
Other comprehensive income for the year net of tax
xx
Total other comprehensive income for the year
xx
xx
xx
xx
xx
xx
xx
xx
xx
xx
Profit Attributable to:
Owners of the parent
Non-controlling interests
Total comprehensive income attributable to:
Owners of the parent
Non-controlling interests
ICSAZ - P.M. PARADZA
xx
xx
xx
xx
xx
xx
xx
xx
xx
xx
xx
xx
48
Share Statistics
Earnings per share basic and diluted
xx
xx
*1 An increase in inventory is deducted
*2 You should remember that from the IASB Conceptual Framework, an increase in assets
represents income, hence its added.
EXAMPLE – OVERALL PRESENTATION (EXCLUDING DISCONTINUED
OPERATIONS)
The following trial balance relates to P ltd and its subsidiaries
Consolidated trial balance as at 31 December 20-7
Selling & distribution costs
Company tax
Profit on sale of land
Dividend paid
Dividend received
Rent income
Share of profit in associate
Goodwill impairment loss
Cost of goods sold
Net controlling interest in net profit of subsidiaries
Interest expense
Salaries
Stationery
Sales
Depreciation of non-current assets
General reserve
Cash at bank
Investment in associates
Trade receivables
Property, plant & equipment
Goodwill
Trade payables
Current portion of interest bearing loans
Consolidated non-controlling interest
Long term borrowings
Ordinary share capital ($10 each)
Deferred tax
Preference share capital
Inventories 31/12/20-7
ICSAZ - P.M. PARADZA
DR
$
51 660
481 033
CR
$
70 000
112 000
9 800
4 200
210 000
8 400
1 465 240
63 140
46 620
249 200(i)
15 454
3 235 680
48 860(ii)
7 000
563 000
410 200
63 000
500 000
67 200
35 727
28 000
182 420
282 800
140 000
2 100
70 000
132 720(iii)
4 277 727
4 277 727
49
Notes on consolidated trial balance:
i)
Salaries
Administration
Selling & distribution
$
131 320
117 880
ii)
Depreciation of non-current assets
Delivery vehicles
Administration buildings
37 380
11 480
iii)
Inventories 31/12/20-7
Raw materials
Consumables
Work-in-progress
Finished goods
32 200 (20-6 30 100)
7 000 (20-6 5 880)
49 840 (20-6 40 460)
43 680 (20-6 35 840)
REQUIRED
Draw up the consolidated statement of profit or loss and other comprehensive income and
statement of financial position of the P Ltd group as at 31 December 20-7, based on IAS 1. Use
i) Function of expense method, and
ii) Nature of expense method
SUGGESTED SOLUTION
i) Function of expense method
P LTD & ITS SUBSIDIARIES
Consolidated statement of profit or loss and other comprehensive income for year end
31 December 20-7
$
Revenue
3 235 680
Cost of goods sold
(1 465 240)
Gross profit
1 770 440
Other Income
Profit on sale of land
70 000
Dividends received
9 800
Rent Income
4 200
84 000
Total income
1 854 440
Selling & distribution costs
Direct selling & distribution costs
(51 660)
Salaries of sales agents
(117 880)
Depreciation of delivery vehicles
(37 380)
(206 920)
Administration expenses
Salaries of administration personnel
(131 320)
Stationery expense
(15 454)
Depreciation of administration building
(11 480)
(158 254)
ICSAZ - P.M. PARADZA
50
Other expenses
Impairment loss on goodwill
Share of profit of associates
Finance costs
Profit before tax
Company tax
Net profit for the year
Other comprehensive income
Total comprehensive income for the year
(8 400)
1 480 866
210 000
(46 620)
1 644 246
(481 033)
1 163 213
Nil
1 163 213
Net profit attributable to owners of the parent
Non-controlling interest
1 100 073
63 140
1 163 213
Total comprehensive income attributable to owners of the parent
Non-controlling interest
1 100 073
63 140
1 163 213
$8.31
Earnings per share (140 000 shares)
ii) Nature of expense method
P LTD & ITS SUBSIDIARIES
Consolidated statement of profit or loss and other comprehensive income for year end
31 December 20-7
$
Revenue
3 235 680
Other income
Profit on sale of land
70 000
Dividends received
9 800
Rent income
4 200
84 000
Changes in inventories of finished goods and work-in-progress
(43 680 – 35 840 + 49 840 – 40 460)
17 220
Raw materials purchased and consumables used
[1 465 240 + (132 720 – 112 280)] + [(32 200 – 30 100 + (7 000 – 5 880)] (1 482 460)
Employee benefit expenses (117 880 + 131 320)
(249 200)
Depreciation and amortisation expense
Depreciation of non-current assets
(48 860)
Impairment loss on goodwill
(8 400)
(57 260)
Other expenses (51 660 + 15 454)
(67 114)
1 480 866
Share of profit of associates
210 000
Finance costs
(46 620)
Profit before tax
1 644 246
Company tax
(481 033)
Net profit for the year
1 163 213
ICSAZ - P.M. PARADZA
51
Other comprehensive income
Total comprehensive income for the year
Nil
1 163 213
Net profit attributable to owners of the parent
Non-controlling interest
1 100 073
63 140
1 163 213
Total comprehensive income attributable to owners of the parent
Non-controlling interest
1 100 073
63 140
1 163 213
$ 8.31
Earnings per share (140 000 shares)
P LTD & ITS SUBSIDIARIES
Consolidated statement of financial position as at 31 December 20-7
ASSETS
Non-current assets
Property, plant & equipment
Goodwill
Investment in associates
Current assets
Inventories
Trade receivables
Cash & cash equivalents
EQUITY & LIABILITIES
Equity attributable to owners of the parent
Ordinary share capital
General reserve
Retained earnings (1 100 073 – div 112 000)
Preference share capital
Consolidated non-controlling interest
Total Equity
Non-current liabilities
Long-term borrowings
Deferred tax
Current liabilities
Trade Payables
Current portion of interest bearing loans
ICSAZ - P.M. PARADZA
20-7
$
20-6
$
500 000
67 200
410 200
977 400
xx
xx
xx
xx
132 720
63 000
563 000
758 720
1 736 120
xx
xx
xx
xx
xx
140 000
7 000
988 073
70 000
182 420
1 387 493
xx
xx
xx
xx
xx
xx
282 800
2 100
284 900
xx
xx
xx
35 727
28 000
63 727
1 736 120
xx
xx
xx
xx
52
4.5.7.3 Presentation of the Statement of Changes in Equity
The standard states that an entity should present a statement of changes in equity showing:
a) total comprehensive income for the period, showing separately the total
amounts attributable to owners of the parent and to non-controlling interests.
b) for each component of equity, the effects of retrospective application or
retrospective restatement recognised in accordance with IAS 8.
c) for each component of equity, a reconciliation between the carrying amount at
the beginning and the end of the period, separately disclosing changes resulting
from
i) profit or loss
ii) each item of Other comprehensive income
iii) transactions with owners in their capacity as owners, showing separately contributions by
and distributions to owners and changes in ownership interests in subsidiaries that do not result
in a loss of control.
An entity should present, either in the statement of changes in equity or in the notes, the amount
of dividends recognised as distributions to owners during the period, and the related amount
per share.
A basic format for the statement of changes in equity (without a comparative year) would be
as follows:
Share Retained Translation Financial Cash Revaluation Total NCI Total
capital earnings of foreign assets at flow reserve
operations FVTOCI hedges
Balance b/d
01/01/20-6 xx
Correction
of error
Restated
Balance b/d xx
Issue of
share
capital
xx
Dividends
Total
comprehensive
income for
the year
xx
Transfer to
retained
earnings
Balance c/d
31/12/20-6 xx
ICSAZ - P.M. PARADZA
xx
xx
xx
xx
xx
xx
xx
xx
xx
xx
xx
xx
xx
xx
xx
xx
xx
xx
xx
xx
xx
(xx) (xx) (xx)
(xx)
xx
xx
xx
xx
xx
xx
xx
xx
xx
-
-
-
(xx)
-
-
-
xx
xx
xx
xx
xx
xx
xx
xx
53
EXAMPLE – STATEMENT OF CHANGES IN EQUITY
The following information relates to T Ltd. and its subsidiaries for the year ended 31 December
20-8:
1. The balances of the capital accounts and reserves of the group for the year ended 31
December 20-8 were as follows:
Ordinary share capital ($1 shares)
10% Redeemable preference share capital ($1 shares)
Share premium
Revaluation reserve
General reserve
Retained earnings
$
1 085 000
140 000
560 000
Nil
14 000
840 000
2. On 1 January 20-9 T Ltd's premises were revalued by $35 000.
3. On 31 March 20-9 70 000 ordinary shares of $1 each were issued at a premium of 20 cents
per share.
4. On 30 June 20-8 the total preference share capital was redeemed at par. No shares were
issued to finance this redemption.
5. On 31 July 20-9 a material error amounting to $22 750 was discovered in the books of T
Ltd. This error was corrected and it resulted in an increase of net profit by the same amount.
6. The group's consolidated net profit for the year was $77 000, while the non-controlling in
subsidiaries' profits amounted to $12 180. T Ltd declared and paid dividends of $24 500 on 31
December 20-9. 7. Preliminary expenses amounting to $1 400 were written off against the share
premium account during the year.
8. $14 000 was transferred to the general reserve on 31 December 20-9.
REQUIRED
Draw up the consolidated statement of changes in equity for the year ended 31 December 209
ICSAZ - P.M. PARADZA
54
SUGGESTED SOLUTION
T LTD & ITS SUBSIDIARY
Consolidated statement of changes in equity for year ended 31 December 20-9
Preference Capital
Total
Ordinary
Share Share
Share Redemption Revaluation General
N.C
equity
Capital Premium Capital Reserve
Reserve Reserve R.E. Interest
$
$
$
$
$
$
$
$
$
Balance
31/12/20-8 1085000 560000
Correction
of error
Restated
balance 1085000
Income
Recgnised
directly in
equity
Surplus on
revaluation
of property
Write-off,of
Preliminary
expenses
Profit for
the period
Dividends
Issue of
ordinary
shares
70000
Redemption
of preference
shares
Transfer to
general
reserve
140000
-
-
14 000 840000 - 2639000
22750
560000
140000
-
(1400)
-
14 000 862750 - 2661750
35000
33600
35000
35000
(1400)
-
22750
(1400)
-
-
64820 12180 77000
(24500)
(24500)
14000
84000
(140000)
140 000
(140 000)
14000
(140000)
(14000) -
Balance
13/12/20-7 1155000
572600
-
140 000
35000
28000 749070 12180 2691850
R.E – Retained Earnings
N.C Interest – Non-Controlling Interest
ICSAZ - P.M. PARADZA
55
4.6 DETERMINATION OF RECLASSIFICATION ADJUSTMENT
Reclassification adjustments relate to components of other comprehensive income that are
being recycled from Other comprehensive income to the profit and loss account in certain
circumstances, for instance disposal/de - recognition of an available for sale financial asset or
a foreign operation.
The standard states that an entity should disclose reclassification adjustments relating to each
component of other comprehensive income. The following example shows the calculation and
presentation of reclassification adjustments for available-for-sale financial assets recognised
and de- recognised in accordance with IAS 1 prior to its amendment.
EXAMPLE - RECLASSIFICATION
On 1 January 20-8, H Ltd purchased 5 000 $1 ordinary shares in S Ltd at $1.50 per share, and
classified these shares as Available for Sale Financial Assets per old IAS 39 – Financial
instruments. On 31 December 20-8, the fair value of these shares was $1.70, and on 31
December 20-9 this value had increased to $2.00. H Ltd sold all the shares on 31 December
20-9. S Ltd did not declare any dividends on these shares during the time they were held by H
Ltd. The company tax rate for the 2 years was 30%.
REQUIRED
a) Show the calculation of gains (net of tax) on the shares in the books of H Ltd for the
two years.
b) Show how the gains would be reported in the books of H Ltd for the two years.
SUGGESTED SOLUTION
20-9
20-8
Dr
$
Cr
$
1/01/20-8
Available for sale financial asset/Investment
in S Ltd`s securities (SFP)
7 500
Bank (SFP)
7 500
31/12/20-8
Available for sale financial asset/Investment
in S Ltd`s securities (SFP)
1 500
Gain on re-measurement (OCI)
1 500
31/12/20-8
Tax expense (OCI)
Deferred tax liabilities (SFP)
ICSAZ - P.M. PARADZA
Cr
$
7 500
7 500
1 000
450
31/12/20-9
Bank (SFP)
10 000
Available for sale financial asset/Investment
in S Ltd`s securities (SFP)
Dr
$
1 000
300
450
300
10 000
10 000
10 000
56
Reclassification of gain on re-measurement
(OCI) 1000 + 1500
2 500
Profit on disposal of Available for Sale
Financial Asset (P/L)
2 500
Deferred tax expense (P/L)
Tax expense (OCI) 450 + 300
750
750
Extract statement of profit or loss and other comprehensive income
2009
$
2008
$
Profit /loss:
Profit on disposal
Deferred tax expense
Profit after tax
2 500
(750)
1 750
Other comprehensive income:
Gain on re-measurement
Reclassification
Tax expense on items in OCI
OCI net of tax
1 500
1 000
(2 500)
300 (750 – 450) 300
(700)
700
Total comprehensive income
1 050
700
Note
The above example is only meant to assist you in understanding what goes on with the process
of reclassification. However, you should take note that financial assets at fair value through
other comprehensive income (FVTOCI) which were formally known as available for sale
financial assets under the old IAS 39 are now part of OCI items that are no longer reclassifiable. This follows an amendment to IAS 1 – Presentation of financial statements, in
2011. Per old IAS 39 and before amendment to IAS 1, the available for sale financial asset was
re-classifiable. Examples of items remaining as capable of reclassification in the amended IFRS
are gains on translating foreign operations and gains on cash flow hedges.
4.7 NOTES TO THE FINANCIAL STATEMENTS
According to IAS 1, notes to the financial statements should:
a) present information about the basis of preparation of the statements, and the specific
accounting policies used;
b) disclose the information required by IFRSs that is not presented elsewhere in the
statements;
c) provide information that is not presented elsewhere in the statements, but is relevant to
an understanding of any of them.
The standard states that an entity should cross-reference each item in the statements of financial
position and of statement of profit or loss and other comprehensive income, in the separate
ICSAZ - P.M. PARADZA
57
income statement (if one is presented) and in the statements of changes in equity and of cash
flows to any related information in the notes.
The recommended order of presenting notes to the financial statements is as follows:
a) statement of compliance with IFRSs
b) summary of significant accounting policies applied
c) supporting information for items in the statements of financial position and of statement
of profit or loss and other comprehensive income , in the separate income statement (if
one is presented), and in the statements of changes in equity and of cash flows, in the
order in which each statement and each line item is presented
d) other disclosures, including
i) contingent liabilities and unrecognised contractual commitments; and
ii) non-financial disclosures e.g. the entity's financial risk management objectives and policies
4.7.1 Disclosure of accounting policies
Entities are required to disclose in the summary of significant accounting policies
i)
the measurement basis or bases used in preparing the financial statements
ii)
the other accounting policies used that are relevant for an understanding of the
financial statements
Users of financial statements should be informed of the measurement basis or bases used in
these statements, for example, historical cost, current cost, net realisable value, fair value or
recoverable amount, because such information will significantly affect their analysis and
perceptions.
Entities are also required to disclose in the summary of their significant accounting policies or
other notes, judgements which have been made when applying the policies and which have the
most significant effect on the amounts recognised in the financial statements. Examples of
such judgements are as follows:
a)
whether financial assets are held-to-maturity investments
c) when all the significant risks and rewards of ownership of financial assets and lease
assets have been substantially transferred to other entities
d) whether, in substance, particular sales of goods are financing arrangements and
therefore do not give rise to revenue and
e) whether the substance of the relationship between the entity and a special purpose entity
indicates that the entity controls the special purpose entity.
4.7.2 Sources of estimation uncertainty
The SAICA Handbook of 2009 defines estimation uncertainty as the susceptibility of an
accounting estimate and related disclosures to an inherent lack of precision in its measurement.
ICSAZ - P.M. PARADZA
58
When determining the carrying amounts of some assets and liabilities, entities often need to
estimate the effects of uncertain future events on those assets and liabilities at the end of the
reporting period. Examples of items that are influenced by such events are:
i)
the recoverable amount of classes of property, plant and equipment
ii)
the effect of technological obsolescence on inventories
iii)
provisions subject to the outcome of current future litigation
iv)
long-term employee benefit liabilities, for example, pension liabilities
The standard states that an entity should disclose the assumptions it makes about the future, as
well as other sources of estimation uncertainty at the end of the reporting period. Such
assumptions should pose a significant risk resulting in a material adjustment to the carrying
amount of assets and liabilities within the next financial year. Information on these assets and
liabilities in the notes should include details of their nature and their carrying amount at the
end of the reporting period. Vorster, Koornhof et al (2009) have identified factors which
influence such valuations as follows:
•
the sensitivity of carrying amounts to the methods, assumptions and estimates
underlying their calculation, including the reasons for the sensitivity;
•
the expected resolution of an uncertainty and the range of reasonably possible outcomes
within the next reporting period in respect of the carrying amounts of the affected assets
and liabilities; and
•
an explanation of changes made to past assumptions concerning those assets and
liabilities, if the uncertainty remains unresolved.
ACTIVITY – IAS 1 (PRESENTATION) QUESTION INCLUDES TAX ASPECTS
(You are encouraged to attempt this activity only after you have covered the income taxes Unit)
The following is the trial balance of Mupfumi Ltd on 31 December 20-3:
Ordinary share capital – issued and fully paid up
Property plant and equipment at cost
Accumulated depreciation on property plant and equipment at 31 Dec 20-2
Retained earnings at 31 Dec 20-2
Provisional tax payments
Closing inventory (SFP)
Closing inventory (I/S)
Opening inventory (I/S)
Trade receivables
Dividend received – unlisted investment
Dividends paid
Trade and other payables
Long term borrowings
Bank overdraft
Sales
Purchases
:raw materials
:consumables
ICSAZ - P.M. PARADZA
$
(65 000)
1 318 000
(276 100)
(846 000)
350 000
94 800
(94 800)
80 200
706 600
(2 700)
65 000
(32 500)
(86 000)
(68 500)
(2 311 200)
920 200
18 900
59
Salaries paid
Interest paid – bank overdraft
Profit on sale of land
245 800
33 300
(50 000)
Nil
Additional information
1. Inventories consisted of the following on 31 December 20-3 and 20-2:
Raw materials
Consumables
Work in progress
Finished goods
20-2
$
23 000
5 000
35 600
31 200
94 800
20-3
$
21 500
4 200
28 900
25 600
80 200
2. The following salaries were paid during the year ended 31 December 20-3:
Factory employees
Advertising costs
Administrative staff
$
67 800
84 200
93 800
245 800
3. The following depreciation must still be provided for the current year:
$
Plant
Delivery vehicles
54 300
26 700
Assume that the wear and tear allowances from ZIMRA are $45 000 for plant and $25 000 for
delivery vehicles.
4. Land (owner occupied) of Mupfumi Ltd with a carrying amount of $250 000 was sold during
the year for an amount of $300 000. Ignore capital gains tax.
5. The authorized share capital consisted of:
70 000 ordinary shares of $1 each.
There was no new issue of shares during the year ended 31 December 20-3.
6. A transfer of $5 000 to an asset replacement reserve must still be made for the year ended
31 December 20-3.
7. Provision for current and deferred tax is done at 29%.
ICSAZ - P.M. PARADZA
60
REQUIRED
Prepare the annual financial statements of Mupfumi Ltd for the year ended 31 December 20-3
from the above information only. Only the following notes to the financial statements are
required in addition:
a) Share capital
b) Income tax expense
c) Inventories
d) Profit before tax
4.8 SUMMARY
This Unit is a comprehensive introduction to the structure and content of financial statements.
The Unit summarises the accounting and disclosure requirements related to general-purpose
financial statements, as explained in IAS 1 – Presentation of Financial Statements. In addition
to the guidelines given in the Framework for the Preparation and Presentation of Financial
Statements, the standard identifies and explains the bases for the preparation of general-purpose
financial statements as going concern, accrual basis, as well as materiality and aggregation.
Other important issues addressed by the standard are offsetting of assets and liabilities (or
income and expenses) frequency of reporting and the inclusion of comparative information in
financial statements.
4.9 REFERENCES
Kolitz, D. L & Service, C. L
GAAP: Graded questions on IFRS, 2012 Edition,
LexisNexis
Vorster, Q.; Koorhof, C. et al
Descriptive accounting, 15th Edition, LexisNexis
2010
Opperman, H.R.B.; BOOYSEN, S.F. et al
Accounting standards, 13th Edition, Juta & Co.
Ltd. 2009
IASB
International Financial Reporting Standards 2015
ICSAZ - P.M. PARADZA
61
UNIT FIVE
CONSOLIDATED FINANCIAL STATEMENTS
5.0 INTRODUCTION
Studies by Cilliers et al on emergence of holding companies and subsidiaries indicate that
growth of a business takes place in different ways, in an intensive manner by an increased
volume of purchases, production and sales without geographic expansion or in an extensive
manner by means of a geographic expansion such as utilisation of travelling representatives,
creating marketing agencies and formation of branches. When this is applied to the sphere of
companies, it manifests in two ways:
i)
Growth in size as above (organic growth)
ii)
Growth through combining with other companies (artificial growth)
In the Financial Accounting level preceding Advanced Accounting and Financial Reporting,
you were required to show accounting entries which are necessary when a limited company
takes over another business as a going concern. In such a situation, the company issues its
shares to the former owner (s) or partner (s) of the business that is being purchased. However,
it is also possible for a company to buy the shares of an existing company in order to secure
the supply of raw materials, to eliminate competition, to diversify into another field of business,
or for any other reason. Regardless of the acquisition method used, the company which invests
in another entity should show the effects of the acquisition on the date of the transaction as
well as in subsequent trading periods. IFRS 3 (Revised) defines a business combination as a
transaction or other event in which an acquirer obtains control of one or more businesses. To
quote IFRS 3, it states that:
A business combination is defined as follows:
“A transaction or other event in which an acquirer obtains control of one or more businesses.
Transactions sometimes referred to as ‘true mergers’ or ‘mergers of equals’ are also business
combinations as that term is used in this IFRS.” IFRS 3(2008) (Appendix A).
You should take note right from the outset that IFRS 3(Revised) applies to a transaction or
other event that meets the definition of a business combination as stated above.
5.1 OBJECTIVES
By the end of this Unit you should be able to:
•
•
•
Explain the different levels of ownership which an investing company may have in
another entity
Explain the different types of group structures
Undertake consolidation procedures when financial statements are drawn up on the
acquisition date and a date other than that on which the subsidiary was acquired
ICSAZ - P.M. PARADZA
62
•
•
•
•
•
•
•
•
Explain and show the correct accounting treatment of goodwill and gain on acquisition
Explain and show the correct accounting treatment of various inter-company
adjustments which arise from consolidations
Define a business combination, and identify the circumstances in which it is considered
to exist
Distinguish between different types of business combinations
Explain and implement the accounting requirements of different types of business
combination
Allocate the cost of a business combination to the assets acquired and
liabilities/contingent liabilities assumed
Explain the rules relating to the translation of the results and financial position of
foreign operations that are included in the financial statements of the entity by normal
consolidation or the equity method
Distinguish between monetary and non-monetary items, and explain how they are
accounted for under IAS 21
Important!!
Students are encouraged to go through the theory and not only master the calculations. A good
understanding of the theoretical aspects, no matter it is long winding, helps in picking any
changes to questions by examiners and increases the accuracy of calculations, rather than
cramming a particular type of question and answer. In short, full comprehension of theory
makes you more flexible and capable of application in and outside examinations.
5.2 INTERNATIONAL FINANCIAL REPORTING STANDARDS (IFRS) THAT
RELATE TO CONSOLIDATED FINANCIAL STATEMENTS
The list of IFRS that shall guide you ranges from:
IFRS 3 - Business combinations (Revised),
IFRS 10 - Consolidated financial statements,
IAS 27 (Revised) – Separate financial statements,
IFRS 13 - Fair value measurement,
IAS 28 - Investments in associates and joint ventures,
IFRS 9 - Financial Instruments,
IFRS 11 - Joint arrangements,
IFRS 12 Disclosure of interests in other entities,
IAS 21 – Effects of changes in foreign exchange rates, and
IAS 7 – Statement of cash flows
IFRS 10 includes a new definition of control that determines which entities are consolidated.
IFRS 10 replaces the part of IAS 27 – Consolidated and Separate Financial Statements related
to consolidated financial statements and replaces SIC 12 Consolidation — Special Purpose
Entities. IFRS 11 describes the accounting for arrangements in which there is joint control;
proportionate consolidation is not permitted for joint ventures (as newly defined). IFRS 11
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63
replaces IAS 31 Interests in Joint Ventures and SIC 13 Jointly Controlled Entities — NonMonetary Contributions by Venturers. IFRS 12 sets out the disclosure requirements for
subsidiaries, joint ventures, associates and “structured entities.” IFRS 12 replaces the
disclosure requirements previously included in IAS 27, IAS 31 and IAS 28. These IFRS were
effective for annual periods beginning on or after 1 January 2013. (Ernst and Young).
5.3 LEGAL PROVISIONS
The preparation and presentation of consolidated financial statements are regulated by the
Zimbabwe Companies Act (Chapter 24:03). Companies which are part of a group are required
to draw up separate financial statements to show their profit or loss for the period under review,
and their financial position on the reporting date. These statements are for the benefit of these
companies' shareholders (members), and they are prepared without considering the holding
company-subsidiary company relationship. However, S144(1) of the Companies Act requires
holding or parent companies to compile group accounts which include the accounts of the
holding company itself and those of its subsidiary (ies). These consolidated statements involve
the summing-up of the trading results and assets of the group as a whole.
Section 144 (2) states the following exemptions from the need to prepare consolidated
statements:
(i)
The holding company is, at the end of the financial year, itself a wholly-owned
subsidiary of another company incorporated in Zimbabwe.
(ii)
The holding company's directors are of the opinion that:
(a) it is impracticable, or would be of no real value to the members (in view of the insignificant
amounts involved) or would entail disproportionate expenses or delays.
(b) the result would be misleading or harmful to the holding company's business or any of its
subsidiaries
(c) the business of the holding company and that of the subsidiary or subsidiaries are so
different that they cannot reasonably be treated as a single undertaking
Note the following important provision on consolidated financial statements from Section
145(4):
"The group accounts laid before a company shall give a true and fair view of the state of affairs
and profit or loss of the company and the subsidiaries dealt with thereby as a whole, so far as
concerns members of the company; and in particular shall exclude inter-group balances and
any profit or loss arising from transactions within the group in so far as those profits or losses
may not have been realized or incurred so far as concerns members of the company."
A full set of consolidated financial statements comprises the holding company's own statement
of comprehensive income, statement of financial position and cash flow statements, as well as
the same statements for the group as a whole. In addition, notes are required to the financial
ICSAZ - P.M. PARADZA
64
statements showing details of the group's accounting policies on depreciation of non-current
assets, valuation of stock, and any other issues which are not clearly shown on the face of the
accounts. A directors' report should be attached to the statements with details on the following
(Section 147):
a) dividends already paid or recommended by the directors
b) the amounts they propose to transfer to group reserves
c) the amounts they are proposing as directors' remuneration
2. Any change during the financial year in the nature of the group's business, or in the classes
of business in which the group has an interest
A chairperson`s statement may also be published, in which the group's chairperson would make
any comments considered pertinent to the group's overall financial position and its prospects
for the future.
ACTIVITY – FINANCIAL ACCOUNTING LEVEL RECAP
1. Buying shares in another entity can result in three levels of ownership by the investor
company. Identify and explain these levels.
2. Explain the term 'control' in the context of consolidated financial statements per IFRS 10.
3. Under what circumstances is a holding company exempted from preparing consolidated
financial statements?
5.4 LEVELS OF OWNERSHIP
Buying shares in another entity can result in three levels of ownership by the investor company:
(i)
The shares bought may constitute a trade investment whose main purpose is to get
income in the form of dividends and/or capital gains when the investment is sold in
the future. Such investments are normally represented by the ownership of 19% or
less in the shares of the investee company. No special accounting problems arise
here, as the dividends received are simply credited in the investment income
account and debited in the bank account. At the end of the financial period, the
investment income account is debited and the statement of comprehensive income
is credited with the same amount.
This is a type of investment which is none of the below and is simply an asset held for accretion
of wealth, in other words a simple or passive investment. The provisions of IFRS 9 are used to
account for it.
(ii)
The shares purchased in another company may be substantial enough to ensure a
significant degree of influence over the operating, financial and administrative
ICSAZ - P.M. PARADZA
65
policies of the investee company. We use a rebuttable presumption that such
investments are normally represented by the ownership of between 20% and 50%
of voting shares in the investee company. In this case the investor company is said
to have a participating interest in the investee company which is then referred to as
an associate company of the investor company.
IAS 28 defines significant influence as the power to participate in the financial and operating
policy decisions of the investee but is not control or joint control over those policies.
(iii)
The shares purchased in another company may constitute the majority shareholding
in that company. This will be the case when the investment represents more than
50% of the voting shares or equity in the investee company. A group is then said to
come into existence giving rise to a holding company-subsidiary company
relationship in which the investor company exercises control.
Both IFRS 3 (revised) and IFRS 10 define control as the power to govern the financial and
operating policies of an entity so as to obtain benefits from its activities.
A company with a controlling interest in one or more other companies is also known as a parent
company. It is possible that a company which is a subsidiary of another company may have its
own subsidiary or subsidiaries.
In the horizontal group, the holding company (H) holds 90% of the shares in the first subsidiary
company (S1) and 70% of the shares in the second subsidiary company (S2). In the vertical
group, the holding company (H) holds 90% of the shares in the subsidiary (S), which in turn
holds 60% of the shares in the sub-subsidiary (SS). H's effective interest in SS is 54% (90% x
60%) obtained indirectly through S. In a mixed group it should be noted that the holding
company (H) has its own separate direct shareholding in SS amounting to 16%.
The shares of an investee company which are not held by the holding company belong to
outside shareholders. They constitute what is known as non-controlling interest (NCI). This
interest is defined as "that part of the net results of operations and of net assets of a subsidiary
attributable to interests which are not owned, directly or indirectly through subsidiaries, by the
parent."
N.B. A company may gradually increase its shareholding in another company from a trade
investment to an associate company/joint venture to a subsidiary company if the investing
company feels that it is in its best interest to do so. This is known as crossing the accounting
boundary.
5.5 CROSSING THE ACCOUNTING BOUNDARY
Any change in equity interests which crosses an accounting boundary causing a change in the
method of accounting is regarded as a significant economic event. Such a transaction is
therefore, accounted for as if the original asset (in the case of an increase in equity interest), or
the residual asset (in the case of a reduction in equity interest), were disposed of for fair value,
ICSAZ - P.M. PARADZA
66
and immediately reacquired for the same fair value. The implications of this change of principle
are:
• a previously-held interest (say, 10%) which is accounted for under IFRS 9 Financial
Instruments, and which is increased to a controlling interest (say, 75%) through a business
combination, is remeasured to fair value at acquisition date, and any gain recognised in profit
or loss. Similarly, gains previously recognised in other comprehensive income are reclassified
to profit or loss where required by the relevant IFRSs;
• a previously-held interest (say, 40%) which is accounted for as an associate under IAS 28 Investments in Associates or as a joint venture under IFRS 11 - Joint arrangements, and which
is increased to a controlling interest (say, 75%) through a business combination, is remeasured
to fair value, and any gain recognised in profit or loss;
• on disposal of a controlling interest, any retained interest in the former subsidiary is measured
at fair value on the date that control is lost. This fair value is reflected in the calculation of the
gain or loss on disposal attributable to the parent, and becomes the initial carrying amount for
subsequent accounting for the retained interest under IAS 28, IFRS 11 or IFRS 9 as appropriate;
and
• similar considerations apply to the partial disposal of an interest in an associate or a joint
venture.
N.B. Although the revised standards expressly deal with the above situations, they do not deal
with a ‘15% to 25%’ transaction – that is, a transaction that takes an investment accounted for
under IFRS 9 to an associate interest accounted for under IAS 28 or IFRS 11 – Joint
arrangements.
5.6 ACQUISITION METHOD OF ACCOUNTING
IFRS 3(2008) requires all business combinations to be accounted for using the acquisition
method. The four stages in the application of the acquisition method are listed below:
(a)
Identifying the acquirer;
(b)
Determining the acquisition date;
(c)
Recognising and measuring the identifiable assets acquired, the liabilities assumed and
any non-controlling interest in the acquiree; and
(d)
Recognising and measuring goodwill or a gain from a bargain purchase.
In summary the acquisition method is whereby the acquirer purchases the net assets and
recognizes the assets acquired and liabilities/contingent liabilities assumed, including those
identifiable assets not previously recognized by the acquiree. The measurement of the
acquirer's assets and liabilities is not affected by the transaction, because they are not part of
the transaction. The method is explained in detail below.
ICSAZ - P.M. PARADZA
67
5.6.1 Identifying the acquirer
The acquirer and the acquiree are identified by applying the guidance in IFRS 10 regarding the
concept of control.
To be in control the investor company has to have an interest in 51% to 100% of the equity
shares of the investee company. However, an investor company can exercise control over
another entity even if the shareholding is 50% or less of the voting power of that entity. This is
possible if any or all of following conditions are met: a) power over the investee as explained
by para 10-14 of IFRS 10, b) exposure or rights, to variable returns from its involvement with
the investee (para 15-16); and c) the ability to use its power over the investee to affect the
amount of the investor`s returns (para 17 -18). IAS 27 (2008) explained the power as follows:
a) Power over more than half of the voting rights by virtue of an agreement with other investors
b) Power to govern the financial and operating policies of the investee in terms of statute or
agreement
c) Power to appoint or remove the majority of the members of the investee's board of directors
d) Power to cast the majority of votes at meetings of the investee's board of directors
N.B. Potential voting rights must be considered in coming up to a conclusion on whether or
not control exists.
An entity may own instruments (e.g. share warrants, share call options, debt or equity
instruments that are convertible into ordinary shares) that have the potential (if exercised or
converted) to give the entity voting power or reduce another party’s voting power over the
financial and operating policies of another entity (potential voting rights).
• Where potential voting rights are currently exercisable or convertible, they are considered
when assessing whether an entity has the power to govern another entity’s financial and
operating policies. [IAS 27(2008).14]
• Where potential voting rights are not exercisable or convertible until a future date or until the
occurrence of a future event, they are not considered in making that assessment. [IAS
27(2008).14]
• However, the proportions of profit or loss and changes in equity allocated to the parent and
non-controlling interests are determined on the basis of present ownership, and do not reflect
any exercise or conversion of potential voting rights. [IAS 27(2008).19]
In assessing whether potential voting rights contribute to control, all of the facts and
circumstances that affect those rights should be considered (including the terms of exercise of
the rights and any other contractual arrangements), except the intention of management and the
financial ability to exercise or convert such rights. [IAS 27(2008).15]
ICSAZ - P.M. PARADZA
68
Hints that can be used to identify an acquirer include the following:
(i)
if the fair value of one of the combining entities is significantly greater than that of
the other combining entity the entity with the greater fair value is likely to be the
acquirer.
(ii)
if the business combination is effected through an exchange of voting ordinary
equity instruments for cash or other assets, the entity giving up cash or other assets
is likely to be the acquirer.
(iii)
if the business combination results in the management of one of the combining
entities being able to dominate the selection of the management team of the
resulting combined entity, the entity whose management is able to so dominate is
likely to be the acquirer.
(iv)
if the business combination is effected through an exchange of equity interests, the
entity that issues the equity interests is normally the acquirer; however, all the
relevant facts and circumstances should be taken into account
Tutorial Note:
Ensure students are aware of additional guidance in marginal cases, from IAS 27 (2008), on
determination of whether or not control exists. Any additional tutor centred material on control
from up to date IFRS in addition to the above can be cited to learners in class.
5.6.1.1 Reverse acquisitions/takeover
IFRS 3 (revised) defines this as a certain type of acquisition that occurs when the investor
company acquires the investee through a share exchange. The number of shares that the
investor company issues as purchase consideration to the equity participants of the investee
company will however, be considerably huge such that control of the business combination
after the acquisition/takeover will be with equity participants of the investee company (the
company taken over). Using the substance over form principle, it is shareholders of the investee
company who will now be having control of the business combination, such that the investee
company should be treated as the acquirer, though from a legal perspective the investor
company remains the acquirer. The investee company should apply the acquisition (or
purchase) method to the assets and liabilities of the investor company.
5.6.2 Determining the acquisition date
By definition, it is the date on which the acquirer obtains control of the acquiree. In terms of
its relationship to the timing of the payment of consideration IFRS 3(2008) explains that the
date on which the acquirer obtains control of the acquiree is generally the date on which the
acquirer legally transfers the consideration, acquires the assets and assumes the liabilities of
the acquiree – the closing date. However, the acquirer should consider all pertinent facts and
circumstances in identifying the acquisition date, and it might be that control is achieved on a
ICSAZ - P.M. PARADZA
69
date that is either earlier or later than the closing date. It should also be noted that the
measurement date for equity securities transferred as consideration is the acquisition date.
5.6.3 Recognising and measuring the identifiable assets acquired, the liabilities assumed
and any non-controlling interest in the acquiree
The recognition principle per IFRS 3(2008) is that, as of the acquisition date, the acquirer
should recognise, separately from goodwill, the identifiable assets acquired, the liabilities
assumed and any non-controlling interest in the acquiree. The conditions that attach to such
recognition principle are that for an identifiable asset or liability to meet criteria for recognition
as part of applying the acquisition method, it should:
•
meet the definition of an asset or liability in the Framework for the Preparation and
Presentation of Financial Statements at the acquisition date [IFRS 3(2008).11]; and
•
be part of the business acquired (the acquiree) rather than the result of a separate
transaction [IFRS 3(2008).12].
For post-acquisition reorganisation costs the standard requires that the acquirer expects but is
not obliged to incur in the future to effect its plan to exit an activity of an acquiree or to
terminate the employment of or relocate an acquiree’s employees are not liabilities at the
acquisition date. [IFRS 3(2008).11] This exclusion of an acquirer’s post-acquisition initiated
costs is consistent with IFRS 3(2004).
For unrecognised assets and liabilities the standard requires that the acquirer may recognise
some assets and liabilities that the acquiree had not previously recognised in its financial
statements. For example, the acquirer recognises the acquired identifiable intangible assets (e.g.
internally generated brand names, patents or customer relationships) that the acquiree did not
recognise as assets in its financial statements because it developed them internally and
expensed related costs to profit or loss. [IFRS 3(2008).13] The recognition of assets and
liabilities that were not recognised by the acquiree is consistent with IFRS 3(2004).
The measurement principle for assets and liabilities per IFRS 3(2008) stipulates that
identifiable assets acquired and liabilities assumed are measured at their acquisition-date fair
values, except in limited, stated cases. [IFRS 3(2008).18].
The assets and liabilities have to:
(i) Meet the definitions of assets and liabilities in the conceptual framework
(ii) Be part of what the acquiree (or its former owners) exchanged in the business combination
rather than the result of separate transactions
All fair value measurement is guided by IFRS 13.
Learner`s Note:
The student must be fully cognisant of the provisions of IFRS 13 – Fair values.
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Tutorial Note:
IFRS 13 provides illustrative examples on application of the standard to Business
Combinations, ensure students have awareness using at least two examples in class.
The measurement principle pertaining to the non-controlling interest in an acquiree for each
business combination per [IFRS 3(2008).19] is to initially measure it either at:
• at fair value; or
• at the non-controlling interest’s proportionate share of the acquiree’s identifiable net assets.
This choice is available for each business combination, so an entity may use fair value for one
business combination and the proportionate share of the acquiree’s identifiable net assets for
another.
IFRS 13 defines fair value. Fair value refers to the price that would be received to sell an asset
or paid to transfer a liability in an orderly transaction between market participants at the
measurement date.
The same standard lays out a hierarchy of inputs for arriving at fair value with a requirement
to use Level 1 inputs used where possible:
Level 1 Quoted prices in active markets for identical assets that the entity can access at
the measurement date [IFRS 13:77]
If an entity holds a position in a single asset or liability and the asset or liability is traded in an
active market, the fair value of the asset or liability is measured within Level 1 as the product
of the quoted price for the individual asset or liability and the quantity held by the entity, even
if the market's normal daily trading volume is not sufficient to absorb the quantity held and
placing orders to sell the position in a single transaction might affect the quoted price. [IFRS
13:80]
Level 2 Inputs other than quoted prices that are directly or indirectly observable for the
asset [IFRS 13:81]
Level 2 inputs include:
•
•
•
•
quoted prices for similar assets or liabilities in active markets
quoted prices for identical or similar assets or liabilities in markets that are not active
inputs other than quoted prices that are observable for the asset or liability, for example
(i)
interest rates and yield curves observable at commonly quoted intervals
(ii)
implied volatilities
(iii) credit spreads
inputs that are derived principally from or corroborated by observable market data by
correlation or other means ('market-corroborated inputs').
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71
Level 3 Unobservable inputs for the asset [IFRS 13:86]
Unobservable inputs are used to measure fair value to the extent that relevant observable inputs
are not available, thereby allowing for situations in which there is little, if any, market activity
for the asset or liability at the measurement date. An entity develops unobservable inputs using
the best information available in the circumstances, which might include the entity's own data,
taking into account all information about market participant assumptions that is reasonably
available. [IFRS 13:87-89]
Tutorial Note 2:
Help students to understand the application of the above guidance using at minimum two class
examples that include, at the same time, guidance on goodwill determination as given below.
ICSAZ November 2010 past examination question 1 (b) may be used as a starting point.
“Explain the two methods of measuring non-controlling interests at acquisition date in terms
of IFRS 3 (revised) – Business Combinations” (6 marks)
5.6.3.1 Fair valuation
EXAMPLE – FAIR VALUATION
The directors of Marchant have strong views on the usefulness of the financial statements after
their move to International Financial Reporting Standards (IFRSs). They feel that IFRSs
implement a fair value model. Nevertheless, they are of the opinion that IFRSs are failing users
of financial statements as they do not reflect the financial value of an entity.
REQUIRED
Discuss the directors’ views above as regards the use of fair value in IFRSs and the fact that
IFRSs do not reflect the financial value of an entity. (9 marks)
SUGGESTED SOLUTION
The following are the major points per the June 2014 ACCA corporate reporting examiner`s
guidance:
IFRSs utilise the ‘fair value’ concept and ‘present value’ more frequently than some other
accounting frameworks, for example, USA GAAPs, European Union countries which still cling
to some accounting frameworks. Some EU countries still use old IAS 14 – Segment reporting
instead of IFRS 8 – Operating segments and have their good reasons for that.
What IFRSs use is however, not a complete fair value system. IASB`s is a combination of fair
value and measurements at depreciated historical cost (you should remember that the IASB
ICSAZ - P.M. PARADZA
72
conceptual framework in its present state suggest four measurement bases namely the historical
basis, current cost basis, realisable value basis and present value basis).
One accounting standard that the IASB advises should be used is IFRS 13 – Fair value
measurement as it was developed to solve the problems in the application of the fair value
concept. However, IFRSs do not require that all assets and liabilities are valued at fair value.
The financial statements of many entities will measure most items at depreciated historical
cost, except where entities (investees) grow through acquisition (artificial growth) when
acquired assets and liabilities are valued at fair value on the acquisition date.
Other IFRS such as IAS 16 – Property, plant and equipment permit revaluation through other
comprehensive income provided it is carried out regularly. Similarly, IAS 40 – Investment
property allows as an option the subsequent measurement of investment properties at fair value
(fair value model) with corresponding changes in earnings as this better reflects the business
model of some property companies. However, the historical cost basis is still regularly used by
entities holding investment properties. The case is still the same with IAS 38 - Intangible assets
which also permits the measurement of intangible assets at fair value, with corresponding
changes in equity, but only if there is an active market, and a reliable valuation, for these assets
can be made.
Another accounting standard namely IFRS 9 – Financial instruments requires classification of
equity instruments (investment in equity shares of subsidiaries or simple investments) only as
financial assets at amortised cost and fair value through other comprehensive income or
through profit or loss. This again is driven by the entity’s business model for managing the
financial assets and the contractual characteristics of the financial assets.
From the above it can be seen that IFRS 3 – Business combinations, makes use of fair values
in measurement of assets and liabilities, with IFRS 13 being the main referral point. However,
the fact that IFRS 3 makes use of fair values in the measurement of assets and liabilities is often
misunderstood as meaning that financial statements prepared under IFRSs reflect the aggregate
financial value of an entity.
According to the IASB this is not the objective of general purpose financial statements. The
general purpose financial statements are meant to provide financial information about the
reporting entity which is useful to existing and potential investors, lenders and other creditors
in making decisions about providing resources to the entity. In other words they are not
designed to show the value of a reporting entity neither are they meant to disclose the selling
value of the entity, even though some of the identifiable assets and liabilities are recorded at
fair value.
An entity’s (investee`s) net assets are reported at market value only when it is acquired by
another entity and consolidated in group accounts.
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73
5.6.3.2 Other issues to be aware of on recognising and measuring the identifiable assets
acquired
Income taxes
The acquiree should recognize and measure a deferred tax asset or liability resulting from assets
acquired and liabilities assumed in a business combination in accordance with IAS 39. The
acquirer should also account for the potential tax effects of temporary differences and carryforwards of an acquiree in accordance with IAS 12.
i)
Employee benefits
The acquirer should recognize and measure a liability or asset (if any) related to the acquiree's
employee benefits arrangements in accordance with IAS 19.
ii)
Indemnification assets
An indemnification asset arises where the seller in a business combination contractually
indemnify the acquirer for the outcome of a contingency or uncertainty related to all or part of
a specific asset or liability.
For instance, the seller may indemnify the acquirer against losses above a certain amount on a
liability arising from a particular contingency, such as legal action or income tax uncertainty.
The result is that the acquirer obtains an indemnification asset.
The standard stipulates that the acquirer should recognize indemnification assets at the same
time that the indemnified item is recognised. Measurement should be on the same basis as the
indemnified item. That is at fair value of the indemnification assets if the indemnified item is
recognised at fair value.
iii)
Reacquired right (see comprehensive question under crossing the accounting
boundary – associate to subsidiary)
Reacquisition of a right arises where an acquirer reacquires a right that it had previously granted
to the acquiree to use one or more of the acquirer`s recognised or unrecognized assets. For
instance, a right to use acquirer`s trade name under a franchise agreement or right to use
acquirer`s technology under a technology licensing arrangement. A reacquired right is valued
on the basis of the remaining contractual term of the related contract regardless of whether
market participants would consider potential contractual renewals in determining its fair value
iv)
Intangible asset
An identifiable intangible asset such as development expenditure of the acquiree is recognized
by acquirer separately from goodwill. We use the separability criterion and contractual-legal
criterion to see whether or not an intangible asset is identifiable.
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74
Separability criterion
An intangible asset is separable if it is capable of being separated or divided from the entity
and sold, transferred, licensed, rented or exchanged, either individually or together with a
related contract, identifiable asset or liability [IAS 38.12(a)]. An acquired intangible meets the
separability criterion if there is evidence of exchange transactions for that type of asset or an
asset of a similar type, even if those transactions are infrequent and regardless of whether the
acquirer is involved in them [IFRS 3(2008).B33].
Contractual-legal criterion
An intangible that arises from contractual or other legal rights is identifiable regardless of
whether those rights are transferable or separable from the acquiree or from other rights and
obligations. [IFRS 38.12(b)]
v)
Contingent liabilities (see comprehensive question under crossing the accounting
boundary – associate to subsidiary)
According to IFRS 3 (2008), the acquirer should recognise a contingent liability assumed in a
business combination as of the acquisition date if:
1. it is a present obligation that arises from past events, and
2. Its fair value can be measured reliably
This is contrary to the provisions of IAS 37.
According to IAS 37 a contingent liability is:
a) a possible obligation that arises from past events and its existence will be confirmed only by
occurrence or non-occurrence of one or more uncertain future events not wholly within control
of the entity or,
b) a present obligation that arises from past events but is not recognised (simply disclosed)
because:
i.
it is not probable that an out flow of resources carrying economic benefits will flow
from the entity to settle it
ii.
the amount of the obligation cannot be measured with sufficient reliability
vi)
Restructuring and future losses
To prevent creative accounting an acquirer should not recognise liabilities for future losses or
other costs expected to be incurred as a result of the business combination. Per IFRS 3 (revised)
a plan to restructure a subsidiary following an acquisition is not a present obligation of the
acquiree at the acquisition date. Neither does it meet the definition of a contingent liability.
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75
5.6.4 RECOGNISING AND MEASURING GOODWILL OR A GAIN FROM A
BARGAIN PURCHASE
5.6.4.1 Goodwill
Goodwill represents a payment made by the acquirer in anticipation of future economic benefits
from assets that cannot be identified individually and separately recognized. It is any excess of
the cost of the acquisition over the acquirer's interest in the fair value of the identifiable net
assets acquired as at the date of the exchange transaction.
After initial recognition, the acquirer should measure goodwill at cost less any accumulated
impairment losses. IFRS 3(2004) prohibited the amortisation of goodwill. The acquirer should
test the goodwill for impairment annually or more frequently if events or changes in
circumstances show that it may be impaired.
Goodwill calculation for a simple group scenario (including horizontal group), where NCI
is measured at fair value should be set out as below:
Purchase consideration transferred
Less Parent`s proportionate share of the acquiree`s identifiable net assets
Parent`s share of goodwill
$
xx
(xx)
xx (A)
NCI measured at fair value
Less NCI’s proportionate share of the acquiree’s identifiable net assets
NCI`s share of goodwill
xx
(xx)
xx (B)
Total Goodwill*
xx (A+B)
* It is in effect the full goodwill method or new method.
N.B. 1 Acquiree`s identifiable net assets acquired as represented by:
Ordinary share capital
Share premium
Retained earnings on acquisition
Fair value adjustments, if any*
xx
xx
xx
xx
* Fair value adjustments
There are two possible ways to their treatment:
The acquiree company might include the revaluations in its own books in which case, you can
proceed directly to the consolidation, taking asset values and reserves figures straight from the
acquiree company's statement of financial position, or,
The revaluations are made as a consolidation adjustment without being incorporated in the
acquiree company's books in which case, you make the necessary adjustments to the
ICSAZ - P.M. PARADZA
76
subsidiary's statement of financial position as a working. You then proceed to the
consolidation.
N.B. 2 Purchase consideration is the amount which is paid by the transferor company (acquirer)
for the purchase of the business of the transferee (acquiree) company. In simple terms,
consideration is a payment in return for a service or something. It may appear in the separate
financial statements of the investor company as an investment in subsidiary/associate or cost
of investment.
According to IFRS 3(Revised), potential forms of consideration include:
• Cash
• Other assets
• A business or subsidiary of the acquirer
• Ordinary or preference instruments issued by the acquirer (Equity component)
• Options or warrants and member interests of mutual entities
• Contingent consideration*
* IFRS 3 (revised) defines contingent consideration as an obligation of the acquirer to transfer
additional assets or equity interests to the former owners of an acquiree as part of the exchange
for control of the acquiree if specified future events occur or conditions are met. It is measured
at fair value, at the acquisition date. It also may give the acquirer the right to the return of
previously transferred consideration if specified conditions are met.
If the post-acquisition fair value of the contingent consideration changes:
i)
Goodwill has to be re-measured given the change in fair value is due to additional
information obtained that affects the position at the acquisition date
ii)
Account for it under IFRS 9 if the consideration is in the form of a financial
instrument and the change is due to events which took place after the acquisition
date, for example, meeting earnings targets, for example loan notes.
iii)
Account for it under IAS 37 if the consideration is in the form of cash the change is
due to events which took place after the acquisition date
iv)
Do not re-measure the contingent consideration if it is an equity instrument.
N.B. Costs that relate to the acquisition must be recognized as an expense at the time of the
acquisition. They are not regarded as an asset as per IFRS 3 (revised). Transaction costs of
issuing debt or equity are to be accounted for under the rules of IFRS 9.
ICSAZ - P.M. PARADZA
77
Goodwill calculation for a simple group scenario (including horizontal group), where NCI
is measured at proportionate share of the acquiree’s identifiable net assets should be set
out as below:
Purchase consideration transferred
Less Parent`s proportionate share of the acquiree`s identifiable net assets
Parent`s share of goodwill
$
xx
(xx)
xx (A)
NCI measured at proportionate share of the acquiree’s identifiable net assets
Less NCI’s proportionate share of the acquiree’s identifiable net assets
NCI`s share of goodwill
xx
(xx)
xx (B)(Nil)
Total Goodwill
xx (A+B)
* It is in effect the partial goodwill method or the old method.
Always remember that what you will be calculating is purchased goodwill. Non-purchased
goodwill is not shown as an asset in the statement of financial position (internally generated
goodwill – IAS 38).
EXAMPLE: GOODWILL AND NON-CONTROLLING INTEREST (SIMPLE
GROUP)
ICSAZ past examination question paper (extract Q1) – Simple group
On 1 January 20-2 Pensive Limited acquired 80% interest in San Fransisco Ltd. Pensive Ltd
paid $450 000 for the investment. All the assets and liabilities were fairly valued on the date
of acquisition. The equity of San Fransisco on the date of acquisition was as follows:
Share capital (300 000 ordinary shares at $1 each)
Retained earnings
$
300 000
230 000
530 000
The equity investment is measured at fair value through other comprehensive income.
Pensive Limited elected to measure the non-controlling interest at their proportionate share of
the identifiable net assets at the acquisition date. Test for impairment at the reporting date
indicated goodwill was not impaired.
REQUIRED
Calculate goodwill at the reporting date, that is, 31 December 20-2.
ICSAZ - P.M. PARADZA
78
SUGGESTED SOLUTION
Purchase consideration transferred
Less Parent`s proportionate share of the acquiree`s identifiable net assets
Parent`s share of goodwill
$
450 000
(424 000)*1
26 000
NCI measured at proportionate share of the acquiree’s identifiable net assets
Less NCI’s proportionate share of the acquiree’s identifiable net assets
NCI`s share of goodwill
106 000*2
(106 000)
(Nil)
Total Goodwill
26 000
*1 Parent`s proportionate share of the acquiree`s identifiable net assets
0.8 x $530 000
*2 NCI measured at proportionate share of the acquiree’s identifiable net assets
0.2 x $530 000
N.B. Acquiree`s identifiable net assets acquired as represented by:
$
300 000
230 000
530 000
Ordinary share capital
Retained earnings on acquisition
ALTERNATIVE PRESENTATION (The analysis of equity method)
At Acquisition
Ordinary share capital
Retained earnings on acquisition
Investment in San Fransisco Ltd
Goodwill
Total
100%
$
300 000
230 000
530 000
At Acq
80%
$
240 000
184 000
424 000
450 000
26 000
Since Acq
80%
$
NCI
20%
$
60 000
46 000
106 000
EXAMPLE: GOODWILL AND NON-CONTROLLING INTEREST (HORIZONTAL
GROUP)
ICSAZ past examination question pilot paper (extract and adapted) – Horizontal group
On 1 January 20-2 Pensive Limited acquired 80% interest in San Fransisco Ltd. Pensive Ltd
paid $450 000 for the investment. All the assets and liabilities were fairly valued on the date
of acquisition. The equity of San Fransisco on the date of acquisition was as follows:
$
Share capital (300 000 ordinary shares at $1 each)
300 000
Retained earnings
230 000
530 000
ICSAZ - P.M. PARADZA
79
The equity investment is measured at fair value through other comprehensive income.
At the same date Pensive Limited acquired 48 000 shares in Steele for $80 000 cash. The equity
of San Fransisco on the date of acquisition was as follows:
$
Called up share capital ($1 ordinary shares)
60 000
Revaluation reserve on 1 January 20-2
16 000
Retained earnings on 1 January 20-2
8 000
84 000
Goodwill has been impaired by $7 800 since the acquisition took place.
Pensive Limited elected to measure the non-controlling interest at their proportionate share of
the identifiable net assets at the acquisition date.
REQUIRED
Calculate goodwill at the reporting date, that is, 31 December 20-2.
SUGGESTED SOLUTION
Goodwill – San Fransisco
Purchase consideration transferred
Less Parent`s proportionate share of the acquiree`s identifiable net assets
Parent`s share of goodwill
$
450 000
(424 000)*1
26 000
NCI measured at proportionate share of the acquiree’s identifiable net assets
Less NCI’s proportionate share of the acquiree’s identifiable net assets
NCI`s share of goodwill
106 000*2
(106 000)
(Nil)
Goodwill (26 000 + 0)
26 000
*1 Parent`s proportionate share of the acquiree`s identifiable net assets 0.8 x $530 000
*2 NCI measured at proportionate share of the acquiree’s identifiable net assets 0.2 x $530
000
N.B. Acquiree`s identifiable net assets acquired as represented by:
Ordinary share capital
Retained earnings on acquisition
ICSAZ - P.M. PARADZA
$
300 000
230 000
530 000
80
Goodwill – Steele
Purchase consideration transferred
Less Parent`s proportionate share of the acquiree`s identifiable net assets
Parent`s share of goodwill
$
80 000
(67 200)*1
12 800
NCI measured at proportionate share of the acquiree’s identifiable net assets
Less NCI’s proportionate share of the acquiree’s identifiable net assets
NCI`s share of goodwill
16 800*2
(16 800)
(Nil)
Goodwill at acquisition date (12 800 + 0)
Goodwill impairment
Goodwill at reporting date
12 800
(7 800)
5 000
Total Goodwill at reporting date (San Fransisco + Steele)
31 000
*1 Parent`s proportionate share of the acquiree`s identifiable net assets 0.8 x $84 000
48 000/60 000shares = 80%
*2 NCI measured at proportionate share of the acquiree’s identifiable net assets 0.2 x $84 000
12 000/60 000shares = 20%
N.B. Acquiree`s identifiable net assets acquired as represented by:
Ordinary share capital
Retained earnings on acquisition
Revaluation reserve
$
60 000
8 000
16 000
84 000
N.B. The acquiree company (Steele) in the horizontal group had already included the
revaluations in its own books in which case, you proceed directly to the consolidation, taking
asset values and reserves figures straight from the acquiree company's statement of financial
position or as given.
ICSAZ - P.M. PARADZA
81
ALTERNATIVE PRESENTATION (The analysis of equity method)
Goodwill – San Fransisco
At Acquisition
Ordinary share capital
Retained earnings on acquisition
Total
100%
$
300 000
230 000
530 000
At Acq
80%
$
240 000
184 000
424 000
450 000
26 000
Since Acq
80%
$
NCI
20%
$
60 000
46 000
106 000
Total
100%
60 000
16 000
8 000
84 000
At Acq
80%
48 000
12 800
6 400
67 200
80 000
12 800
(7 800)
5 000
Since Acq
80%
NCI
20%
12 000
3 200
1 600
16 800
Investment in San Fransisco Ltd
Goodwill
Goodwill – Steele
Ordinary share capital
Revaluation reserve
Retained earnings on acquisition
Investment in Steele
Goodwill at acquisition
Goodwill impairment
Goodwill at reporting date
Total Goodwill at reporting date (San Fransisco + Steele)
31 000
Tutorial Note:
N.B.1 The alternative layout above is still suitable for questions where NCI is measured at fair
value save that you may slightly twist its presentation as below:
Illustration:
Full Goodwill Method – San Fransisco
Assuming the current market price of San Fransisco`s equity shares at 1 January 20-2 was $2
per share. The NCI at fair value therefore, amounts to 20% x 300 000 x $2 = $120 000.
Total goodwill for the consolidated statement of financial position pertaining San Fransisco
alone sums up to $50 000 (26 000 + 24 000).
Twisting the analysis slightly helps in not breaking up on the NCI valuation up until year end.
Assume further that San Fransisco`s profit after tax for the year ended 31 December 20-2 is
$112 500 out of which $20 000 is transferred to a general reserve and $10 000 paid as dividend.
ICSAZ - P.M. PARADZA
82
The analysis of equity method
1. At Acquisition
Ordinary share capital
Retained earnings on acquisition
Total
100%
$
300 000
230 000
530 000
Goodwill
Investment in San Fransisco Ltd + NCI
2. Since Acquisition
Profit after tax
Transfer to general reserve
General Reserve
Dividend paid
112 500
(20 000)
20 000
(10 000)
632 500
At Acq
80%
$
240 000
184 000
424 000
26 000
450 000
Since Acq
80%
$
NCI
20%
$
60 000
46 000
106 000
24 000
120 000
90 000
(16 000)
16 000
(8 000)
82 000
22 500
(4 000)
4 000
(2 000)
140 500
Take notice that the option to value non-controlling interest at fair value, applies at acquisition.
At the year end, the non-controlling interest will have increased by its share of the subsidiary's
post-acquisition reserves ($22 500 – 4000 + 4000 – 2000) from $120 000 to $140 500.
Student Note:
N.B2 Even though an examination question may include some intelligent aspects, the basic
layout has to be kept. Take note of the differences brought in the further example below:
EXAMPLE: GOODWILL AND NON-CONTROLLING INTEREST (SIMPLE
GROUP)
ICSAZ May 2014 examination question paper (extract and adapted Q1) – Simple group
(the exam question needed NCI at proportionate share of the acquiree’s identifiable net assets, that aspect has been varied on this question)
Takashita and Samurai are in the same line of business. Takashita wanted to eliminate the
rivalry competition and acquired 60% of the ordinary business of Samurai on 1 November 203. The purchase cost was settled by issuing $280 000 ordinary 50 cents shares of Takashita at
$1.25 per share. $20 000 issue costs were incurred.
Extracts from the financial statements of Samurai for the year ended 31 December20-3 are as
shown below:
EQUITY
Ordinary shares of 100 cents
Share premium
Accumulated profits
ICSAZ - P.M. PARADZA
$
40 000
60 000
180 000
280 000
83
ASSETS
Non-current assets
140 000
RETAINED EARNINGS
Profit after tax
Dividend paid
Retained profit for the year
90 000
(30 000)
60 000
Additional Notes:
1. Takashita has adopted the full goodwill method in line with IFRS 3 (revised)
2. Goodwill has been tested at year end and has been impaired by $23 000. This
impairment should be included in the group`s consolidated administrative expenses.
3. The company`s policy is to account for pre-acquisition dividends as a reduction of the
cost of the investment in subsidiary.
4. At the date of acquisition the value of non-current assets of Samurai at open market
price was $200 000. No depreciation adjustment is made in the group accounts due to
the proximity of the acquisition date to the year-end date. The carrying value of tangible
non-current assets in Samurai`s accounts at the date of acquisition is deemed to be the
year end value. All other assets and liabilities of Samurai were stated at their fair value
at the time of acquisition.
5. On 1 December 20-3 Samurai paid a dividend of $30 000 and no further dividends were
declared for the year-end.
6. Takashita elected to measure the non-controlling interest at at fair value. The ordinary
shares of Takashita were valued at a market price per share of 950 cents at 1 November
20-3
REQUIRED
Calculate goodwill at the reporting date, that is, 31 December 20-3.
SUGGESTED SOLUTION
Purchase consideration transferred
Dividend paid from pre-acquisition retained profits (30 000 x 10/12 x 0.6)
Adjusted purchase consideration
Less Parent`s proportionate share of the acquiree`s identifiable net assets
Parent`s share of goodwill
$
350 000
(15 000)
335 000
(198 000)*1
137 000
NCI measured at fair value [(950/100 x 40 000) x 0.4]
Less NCI’s proportionate share of the acquiree’s identifiable net assets
NCI`s share of goodwill
152 000
(132 000)*2
20 000
Total Goodwill*
Goodwill impairment
Total Goodwill at reporting date
157 000
(23 000)
134 000
* the above is the full goodwill method or new method.
*1 Parent`s proportionate share of the acquiree`s identifiable net assets 0.6 x $330 000
*2 NCI measured at proportionate share of the acquiree’s identifiable net assets 0.4 x $330 000
ICSAZ - P.M. PARADZA
84
N.B. Acquiree`s identifiable net assets acquired as represented by:
Ordinary share capital
Share premium
Retained earnings on acquisition (180 000 – 60 000 + 10/12 x 60 000)
Fair value adjustment*
* Fair value adjustment
Non-current assets at open market price
Non-current assets at book value
Fair value adjustment
40 000
60 000
170 000
60 000
330 000
200 000
(140 000)
60 000
ALTERNATIVE PRESENTATION (The analysis of equity method)
1. At Acquisition
Ordinary share capital
Share premium
Retained earnings on acquisition
Fair value adjustment
Total
100%
$
40 000
60 000
170 000
60 000
330 000
Goodwill
Investment in Samurai + NCI
At Acq
60%
$
24 000
36 000
102 000
36 000
198 000
137 000
335 000
Since Acq
60%
$
NCI
40%
$
16 000
24 000
68 000
24 000
132 000
20 000
152 000
Do not forget to adjust good will for impairment
Total Goodwill ($137 000 + 20 000)
Goodwill impairment
Goodwill at reporting date
157 000
(23 000)
134 000
Tutorial Note:
N.B1 The revaluations are made as a consolidation adjustment without being incorporated in
the acquiree company's books in which case, you make the necessary adjustments to the
subsidiary's statement of financial position as a working. You then proceed to the
consolidation. This is the second of the two possible ways applicable in this instance.
N.B2 Costs that relate to the acquisition, for instance $20 000 issue costs, must be recognized
as an expense at the time of the acquisition. They are not regarded as an asset as per IFRS 3
(revised).
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85
ACTIVITY - GOODWILL CALCULATION FOR SIMPLE GROUP SCENARIO
(PAMELA LTD GROUP)
The extracts from the Trial Balance of Pamela Limited and Sarudzai Limited for the year
ended 28 February 20-3 are as shown below:
Pamela
$
Share Capital – 90 000 $1 ordinary shares
Investment in Sarudzai Ltd – ordinary shares
Sarudzai
$
(90 000)
65 000
Additional information:
1. On 1 March 20-0, Pamela Limited acquired 60% interest in Sarudzai Limited. On that
date the equity of Sarudzai Limited consisted of the following items:
Share capital 90 000 ordinary shares
Retained earnings
$90 000
$12 000
On the above acquisition date there were no unidentified assets, liabilities or contingent
liabilities* and the fair values of all assets, liabilities and contingent liabilities were confirmed
to be equal to the carrying amounts thereof.
2. The goodwill was tested for impairment at 28 February 20-3 and it was determined that
it had been impaired to $1 000 at the end of the current year. The group uses the
proportionate (partial) method to account for goodwill.
3. In all the companies, each share carries one vote.
REQUIRED
Calculate goodwill at the reporting date, that is, 28 February 20-3.
Tutorial Note:
* Ensure a class attempt of a goodwill calculation question involving contingent consideration
on calculation of purchase consideration and contingent liability that needs to be identified and
adjusted as necessary.
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86
Goodwill calculation for a vertical group scenario, where NCI is measured at fair value
should be set out as below:
If the Parent entity (H) acquires a 70% interest in the Subsidiary (S) and S acquires a 90%
interest in Subsidiary (SS) then H has 63% effective interest in SS and Non-Controlling Interest
(NCI) has 37% interest in SS. Another point to note is that if S acquires an interest in SS after
H`s acquisition date, then it is the group`s 70% in S which is acquiring a controlling stake in
SS.
H in S
S in SS
$
$
Purchase consideration transferred
xx
xx*1
Less Parent`s proportionate share of the acquiree`s identifiable net assets (xx)
(xx)*2
Parent`s share of goodwill
xx (A)
xx
NCI measured at fair value
Less NCI’s proportionate share of the acquiree’s identifiable net assets
NCI`s share of goodwill
xx
(xx)
xx (B)
xx
xx*3
xx
Goodwill
xx (A+B)
xx
N.B. 1 Acquiree`s identifiable net assets acquired as represented by:
Ordinary share capital
Share premium
Retained earnings on acquisition
Fair value adjustments, if any*
xx
xx
xx
xx
xx
xx
xx
xx
This still is in effect the full goodwill method.
*1 70% x S`s cost of investment in SS
*2 63% x Fair value of SS`s identifiable net assets
*3 37% x Fair value of SS`s identifiable net assets
Total Goodwill to SFP = Goodwill from P in S + Goodwill from S in SS
N.B. The presentation is the same even if S acquires an interest SS before H`s acquisition date.
Goodwill calculation for a complex group scenario, where NCI is measured at fair value
should be set out as below:
If the Parent entity (H) acquires a 70% interest in the Subsidiary (S) and S acquires a 90%
interest in Subsidiary (SS). At the same time H has a direct interest in SS pegged at 20% of its
equity shares.
H has 63% effective interest in SS through S + 20% direct interest in SS, that is, a Controlling
Interest of 83% interest in SS, leaving NCI with only 17% interest.
H in S H&S in SS
$
$
Purchase consideration transferred -Direct
xx
xx*1
-Indirect
xx*2
Less Parent`s proportionate share of the acquiree`s identifiable net assets (xx)
(xx)*3
Parent`s share of goodwill
xx (A)
xx
ICSAZ - P.M. PARADZA
87
NCI measured at fair value
Less NCI’s proportionate share of the acquiree’s identifiable net assets
NCI`s share of goodwill
xx
(xx)
xx (B)
xx
xx*4
xx
Goodwill
xx (A+B) xx
N.B. 1 Acquiree`s identifiable net assets acquired as represented by:
Ordinary share capital
Share premium
Retained earnings on acquisition
Fair value adjustments, if any*
xx
xx
xx
xx
xx
xx
xx
xx
This still is in effect the full goodwill method.
*1 H`s cost of investment in SS
*270% x S`s cost of investment in SS
*3 63% x Fair value of SS`s identifiable net assets
*4 37% x Fair value of SS`s identifiable net assets
Total Goodwill to SFP = Goodwill from P in S + Goodwill from S in SS
Goodwill calculation for a piecemeal acquisition of controlling interest scenario (from
Associate to Subsidiary), where NCI is measured at proportionate share of the acquiree’s
identifiable net assets should be set out as below:
Before acquisition of controlling interest in subsidiary P held 25% significant influence in S.
At acquisition of controlling interest P added 50% to garner 75% control in S.
Purchase consideration transferred
Fair value of previously held equity interest
Less Parent`s proportionate share of the acquiree`s identifiable net assets
Parent`s share of goodwill
H in S
$
xx*1
xx*2
(xx)*3
xx (A)
NCI measured at proportionate share of the acquiree’s identifiable net assets
Less NCI’s proportionate share of the acquiree’s identifiable net assets
NCI`s share of goodwill
xx*4
(xx)*4
xx (B)
Total Goodwill
xx (A+B)
N.B. 1 Acquiree`s identifiable net assets acquired as represented by:
Ordinary share capital
Share premium
Retained earnings on acquisition
Fair value adjustments, if any*
xx
xx
xx
xx
*1 Purchase consideration transferred at date of acquisition of controlling interest by H
*2 If as the associate interest was 25% and the additional interest acquired is 50% then the calculation is 25/50 x *1
*3 75% x the identifiable net assets of subsidiary at date of acquiring controlling interest by H
*4 25% x the identifiable net assets of subsidiary at date of acquiring controlling interest by H
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88
Goodwill calculation for a piecemeal acquisition of controlling interest scenario (from
Associate status to Parent-Subsidiary status), where NCI is measured at fair value should
be set out as below:
Before acquisition of controlling interest in subsidiary H held 25% significant influence in S.
At acquisition of controlling interest H added 50% to garner 75% control in S.
Purchase consideration transferred
Fair value of previously held equity interest
Less Parent`s proportionate share of the acquiree`s identifiable net assets
Parent`s share of goodwill
H in S
$
xx*1
xx*2
(xx)*3
xx (A)
NCI at fair value
Less NCI’s proportionate share of the acquiree’s identifiable net assets
NCI`s share of goodwill
xx*4
(xx)*5
xx (B)
Total Goodwill
xx (A+B)
N.B. 1 Acquiree`s identifiable net assets acquired as represented by:
Ordinary share capital
Share premium
Retained earnings on acquisition
Fair value adjustments, if any*
xx
xx
xx
xx
*1 Purchase consideration transferred at date of acquisition of controlling interest by H
*2 If as the associate interest was 25% x FV of subsidiary`s equity shares at date of
acquisition of controlling interest
*3 75% x the identifiable net assets of subsidiary at date of acquiring controlling interest by H
*4 25% x FV of subsidiary`s equity shares at date of acquisition of controlling interest by H
*5 25% x the identifiable net assets of subsidiary at date of acquiring controlling interest
5.6.4.2 Bargain Purchase Gain (Gain on Bargain Purchase)
It is possible for the acquirer's interests in the net assets of the acquiree to exceed the amount
paid for these assets (bargain purchase) - IFRS 3. This may occur in a forced sale in which
the seller is acting under compulsion. In this case, the acquirer is required to:
i)
ii)
reassess the identification and measurement of the acquiree's assets and liabilities
and measurement of the cost of the combination.
recognise immediately in the statement of comprehensive income any excess
remaining after that reassessment.
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89
5.7. BASIC CONSOLIDATION PROCEDURE
The two important steps according to Cilliers and Rossouw are:
(i)
(ii)
Elimination of the common items (intra-group transactions)
Aggregation of the remaining items
A group can generally be defined as a set of interconnected companies controlled by a single
company. Intra means within the group whereas inter means between or among different
groups. Intra-group clarifies that companies are part of the same group (Argos FinNeo
Research Publications).
5.7.1 Intra-company indebtedness
The effect of loans by one company in the group to another and the payment of interest on
intra-group loans should be eliminated on consolidation (IAS 27). Loans owing to/by other
companies in the group are deducted from the total long-term or current liabilities in the
consolidated statement of financial position, in order to show the net amounts owing to/from
third parties. Inter-company bills of exchange are treated in the same way although endorsed
bills which have not been discounted may not be set off.
EXAMPLE (A)
H Ltd owns all the shares in S Ltd. On 31 December 20-7, the group's reporting date, S Ltd's
payables included $2 500 borrowed from H Ltd. In the consolidated statement of financial
position $2 500 will be deducted from total receivables and total payables. If S Ltd is a partlyowned subsidiary, the same adjustment will be necessary. The share of the outside
shareholders will be captured through the non-controlling interest.
EXAMPLE (B)
If H Ltd has bills receivable amounting to $3 000 which have been accepted by S Ltd, the
consolidation adjustment will be to debit S Ltd's bills payable with $3 000 and credit H Ltd's
bills receivable with $3 000. If H Ltd discounts $2 000 of these bills and they have not yet
matured at the reporting date, only $1 000 will be included in bills receivable.
However, a contingent liability of $2 000 will be recognized in the books of H Ltd. In the
consolidated statement of financial position $1 000 will be deducted from total bills payable as
explained in the above paragraph for ordinary creditors and debtors.
5.7.2 Items in transit
Year-end adjustments are needed in respect of inventory or cash-in transit between member
companies of the group. These adjustments are usually made at the group's head office to
ensure that the current account balances of the companies are in order. After this reconciliation,
the intra-company current account balances should be eliminated from the consolidated
statement of financial position (IAS 27).
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90
EXAMPLE – GOODS AND CASH IN TRANSIT
The following information relates to H Ltd and its subsidiary S Ltd.
H Ltd's Books
Goods sent to S Ltd
Cash received from S Ltd
Motor vehicle purchased for S Ltd and delivered
Goods returned by S Ltd
$
187 200
100 800
72 000
15 360
S Ltd's Books
Goods received from H Ltd
Cash sent to H Ltd
Motor vehicle purchased by H Ltd and delivered
Goods returned to H Ltd
$
177 120
110 400
72 000
16 800
Net Profit for the year
46 080
Additional information
a) Goods valued at $10 080 sent by H Ltd had not been received by S Ltd at year end.
b) H Ltd had not received cash $9 600 sent by S Ltd.
c) H Ltd had not yet received goods valued at $1 440 returned by S Ltd.
REQUIRED
Show the current accounts in the books of H Ltd and S Ltd. Any adjustment for items in
transit should be done in the H Ltd's books.
SUGGETED SOLUTION
H LTD'S BOOKS
S LTD CURRENT ACCOUNT (Receivables)
Goods sent to S Ltd
Motor vehicle purchased for S Ltd and delivered
Net profit for the year
Goods returned by S Ltd
Cash received from S Ltd
Balance c/d – original
Less Cash in transit from S Ltd
Returns in transit from S Ltd
Goods in transit from to S Ltd
Balance c/d – revised
ICSAZ - P.M. PARADZA
$
187 200
72 000
46 080
(15 360)
(100 800)
189 120
(9 600)
(1 440)
(10 080)
168 000
91
S LTD'S BOOKS
H LTD CURRENT ACCOUNT (Payables)
Goods received from H Ltd
Motor vehicle purchased by H Ltd and delivered
Net profit for the year
Goods returned to H Ltd
Cash sent to H Ltd
Balance c/d – original
$
177 120
72 000
46 080
(16 800)
(110 400)
168 000
N.B. In the consolidated statement of financial position, the current accounts balances of H Ltd
and S Ltd will cancel each other out and will not be shown.
5.7.3 Bank balances
It is possible that two companies in a group may be using the same bank, with one company
having a credit balance while the other one has an overdraft. In this case, the amounts may be
set off against each other if the bank would agree to set off the amounts in its own records. This
would normally happen only if the company with surplus funds has guaranteed the liability of
its sister company operating on an overdraft.
5.7.4 Unrealised profit in inventories
If a company sells goods to another company in the same group at a mark-up, an adjustment is
necessary at the reporting date to eliminate the profit element (unrealised profit) in the
inventories held by the receiving company (IAS 27). An upstream transaction is when sales are
made from an associate to the investor. A downstream transactions are sales of assets from the
investor to an associate.
First, the double entry is as follows, where 60% is the parent's holding in the subsidiary, it has
sold to the subsidiary (downstream transaction) and $10 000 is the provision for unrealised
profit.
$
DEBIT
CREDIT
Group retained earnings/Cost of sales
Group inventories
$
10 000
DEBIT
Deferred tax asset (SFP)
xx
CREDIT
Group retained earnings/Deferred tax income (P/L)
Being elimination of unrealised profit and tax effects if any.
10 000
xx
Obviously with the above entry the profits of the seller company are being reduced and the
inventory of the buyer company being reduced.
Second, the double entry is as follows, where 60% is the parent's holding in the subsidiary, it
buys from the subsidiary (upstream transaction) and $10 000 is the provision for unrealised
profit.
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92
DEBIT
DEBIT
CREDIT
Group retained earnings/Cost of sales
NCI
Group inventories
$
6 000
4 000
$
10 000
Third, where 30% is the parent's holding in the associate, and $10 000 is the provision for
unrealised profit.
DEBIT Retained earnings of parent/Cost of sales $10 000 x 30% and CREDIT Group
inventories $10 000 x 30% for upstream transactions (associate sells to parent/subsidiary)
where the parent holds the inventories.
OR DEBIT Retained earnings of parent/subsidiary $10 000 x 30% CREDIT Investment in
associate $10 000 x 30% for downstream transactions, (parent/subsidiary sells to associate)
where the associate holds the inventory.
EXAMPLE: UNREALISED PROFIT IN CLOSING INVENTORY CALCULATION
H Ltd owns 90% of the shares in S Ltd. During the year ended 30 June 20-5, S Ltd. sold H Ltd
goods costing $750 000 at a 25% mark-up (Upstream transaction). On 30 June 20-5, H Ltd.
still had goods bought from S Ltd valued at $400 000 at the invoice price. The unrealised profit
in H Ltd's inventory is calculated as follows:
Mark-up on goods =25% (or 1/4)
Unrealised profit
Margin on goods = [1/(4+1)] = 1/5 = 20%
= 20% x $400 000
= $80 000
In the consolidated statement of profit or loss and other comprehensive income, $72 000, that
is, $80 000 x 90% is added to cost of sales in order to reduce group profit. The same figure is
deducted from inventory in the group statement of financial position.
Recap: Gross profit margin is the gross profit as a percentage of sales whereas mark-up is
gross profit as a percentage of cost of sales.
H Ltd owns 80% of the shares in S Ltd. During the year-ended 30 June 20-5, H Ltd sold to S
Ltd. goods costing $500 000 at a gross profit margin of 331/3%. On 30 June 20-5, S Ltd still
had goods bought from H Ltd valued at $300 000 at the invoice price. The unrealised profit in
S Ltd's inventory is calculated as follows:
Mark up on goods =50% (or 1/2), margin on goods = 33 1/3%, margin or gross profit on =$300
000 x 331/3% inventory bought from S Ltd =$100 000 H Ltd's (group`s) share of unrealized
profit = $100 000
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93
This adjustment (elimination of unrealised profit) is required because:
a) As a single reporting entity, the group preparing consolidated financial statements
cannot trade with itself and thus should not recognise profits from internal transactions.
Such profits are referred to as unrealised profits.
b) Failure to adjust for unrealised profits means that the group will be violating the lower
of cost or net realisable value rule, according to which stocks cannot be recorded above
cost if this cost is lower than the expected net realisable value. The prudence concept
would also be violated since the consolidated net profit would be overstated.
N.B. Beware of treatment of unrealised profit in opening inventory scenario.
This adjustment is required because:
a) As a single reporting entity, the group preparing consolidated financial statements cannot
trade with itself and thus should not recognise profits from internal transactions. Such profits
are referred to as unrealised profits.
b) Failure to adjust for unrealised profits means that the group will be violating the lower of
cost or net realisable value rule, according to which inventories cannot be recorded above cost
if this cost is lower than the expected net realisable value (IAS 2 – Inventories). The prudence
concept would also be violated since the consolidated net profit would be overstated.
5.7.5 Intra group sales and purchases
The group revenue is debited (reduced) and the group cost of sales credited as well (reduced).
5.7.6 Dividends declared out of pre-acquisition profits
A company which has just been acquired may declare a dividend from its pre-acquisition
profits, for which the holding company would be eligible. The holding company should treat
this dividend as a return of capital, not income. In this company's ledger, the amount received
will be debited in the bank account and credited in the investment account relating to the
subsidiary. The effect of this is to reduce the cost of the subsidiary shown in the holding
company's books.
5.7.7 Pre-acquisition losses
If a subsidiary has incurred an accumulated loss on the acquisition date, this effectively reduces
its share capital and reserves, because the accumulated loss figure will not be represented by
any real assets. Any profits made by the subsidiary after acquisition should not be used to
declare dividends, but used to reduce or eliminate the loss.
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94
5.7.8 Preference shares
The existence of preference shares in the capital of a subsidiary does not alter the basic
calculations for consolidated statement of financial positions. However, it is possible that all
the preference shares may belong to the non-controlling shareholders.
5.7.9 Intra-group profit on non-depreciable property, plant and equipment
A company in a group may sell non-depreciable property plant and equipment to another
company in the same group at a profit. In this case the full profit should be eliminated from
group assets as part of the consolidation process. This is regardless of which entity sold to the
assets to the other, that is, holding company to subsidiary, subsidiary to holding company or
subsidiary to subsidiary.
5.7.10 Intra-group profit on depreciable property, plant and equipment
Inter-company sales of property, plant and equipment that is subject to depreciation should be
adjusted for. In addition, it is necessary to write off excessive depreciation which is caused by
unrealised profit arising from such sales.
5.8 PRESENTATION OF GROUP FINANCIAL STATEMENTS
Learner`s Note
Take note of the overall formats for the statement of financial position and statement of profit
or loss and other comprehensive income under Unit 4 – Presentation of financial statements
(IAS 1) of this study guide. Over and above, take note of the specific changes to content of the
formats or presentation of the same components of financial statements for subsidiary,
associate and joint arrangements scenarios beginning with examples in this Unit and Class
examples.
5.9 SIMPLE/TRADE INVESTMENT (IFRS 9)
A simple investment is a financial asset.
As a recap of IFRS 9, a financial asset is any asset, that is, cash, an equity instrument of another
entity, a contractual right to receive cash or another financial asset from another entity and a
contract that will be settled in the entity`s own equity instruments, either a non-derivative or a
derivative.
Financial assets are initially measured at cost or fair value.
Fair value being the consideration given in acquisition of the financial asset and cost being the
transaction price.
Where the financial asset is classified at amortised cost, transaction costs directly attributable
to its acquisition are added to the transaction price to get the original cost.
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95
Amortised cost is the amount at which a financial asset or financial liability is measured at
initial recognition (transaction price/original cost) minus principal repayments plus or minus
cumulative amortisation of any differences between that initial amount and the maturity
amount, minus any amounts written down for impairment or un-collectability.
As a recap of IFRS 9, the effective interest method is used to calculate the amortised cost (using
an amortisation schedule) and allocating the interest income or interest expense (if a financial
liability) over the relevant accounting period.
In as far as consolidations are concerned, an investor company has the option to choose per
IFRS 9 whether to measure its simple investment in equity instruments of another entity at cost
or at fair value. If an election is made to measure the simple/trade investment at fair value,
classification is either at fair value through profit or loss (FVTPL) or at fair value through
other comprehensive income (FVTOCI).
If treated as a financial asset at fair value through profit or loss the fair value adjustment and
the tax effect are recognised in the profit or loss section of the statement of profit or loss and
other comprehensive income. The fair value gain or loss effect go through the retained
earnings to the statement of changes in equity. The journal entries are:
DEBIT
CREDIT
Investment in XX Ltd
Fair value gain (P/L)
$xx
$xx
DEBIT
Income tax expense (P/L)
$xx
CREDIT
Deferred tax liability (SFP)
$xx
Being recognition of a fair value gain on investment in XX Ltd and tax effects.
If treated as a financial asset at fair value through other comprehensive income (IFRS 7)
(formerly known an available for sale financial asset (IAS 39)), the fair value adjustment and
tax effect are recognised in the other comprehensive income section of the statement of profit
or loss and other comprehensive income.
Mark to market reserve
The fair value gain or loss effect go through the mark to market reserve (shown as available
for sale financial asset reserve in volume 2) to the statement of changes in equity. A mark to
market reserve represents the cumulative fair value adjustments in financial assets (equity
instruments) measured at fair value through other comprehensive income (IFRS 9). The journal
entries are:
DEBIT
CREDIT
Investment in XX Ltd
Fair value gain (OCI)
$xx
$xx
DEBIT
Income tax expense (OCI)
$xx
CREDIT
Deferred tax liability (SFP)
$xx
Being recognition of a fair value gain on investment in XX Ltd and tax effects.
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96
N.B1 The term 'investment in equity instruments' (IEI) may be used by examiners to denote
what, under IAS 39, was termed an available for sale financial asset now termed a financial
asset at fair value through other comprehensive income under IFRS 9.
You have successfully calculated the mark to market reserve (or the fair value
adjustment), what do you do with it on consolidation?
As a matter of principle any fair value adjustments (mark to market reserve) on either
subsidiaries, associates, joint ventures or joint operations that has been made by the
parent/holding company in its separate financial statements are eliminated on consolidation.
The reason being that the group is viewed by IFRS 3 as one economic entity in which case it
is impossible for a company to invest in itself or to fairly value that investment.
The consolidation journal entry that arises on elimination is as follows:
$
DEBIT
Mark to market reserve
xx
DEBIT
Deferred tax
xx
CREDIT
Investment in subsidiary/sub-subsidiary/associate/joint venture
Being elimination of fair value adjustment on either subsidiary or subsubsidiary/associate/joint venture.
$
xx
N.B2 The investment in subsidiary is basically your purchase consideration therefore, the credit
entry above adjusts it downwards on your way to correct calculation of goodwill at acquisition
date. See the analysis of shareholders` equity in Maria Ltd under Fadzai and its Subsidiaries
question tackled later in this module. You will see that the figure for investment in Maria Ltd
used in the analysis of shareholders` equity schedule is $110 000 both because it is given under
additional notes and also due to the journal entry below even if the figure had not been given:
Consolidation journal entry at initial acquisition date
$
$
DEBIT
Mark to market reserve
4 250
DEBIT
Deferred tax
750
DEBIT
Non-controlling interest
9 000
CREDIT
Investment in Maria Ltd
5 000
CREDIT
Investment in Maria Ltd (5000 further shares x $1.90)
9 500
In other words $124 500 as given in the separate trial balance of Fadzai Ltd less $14 500 =
$110 000.
It is important to know that the portion of the mark to market reserve in the separate books of
the parent company that relates to a simple or trade investment is however, not eliminated on
consolidation. This is because the trade or simple investment is merely a financial asset at fair
value through other comprehensive income (available for sale financial asset) in the separate
financial statements of the parent/investor company. Just like all other assets (non-current and
current) that survive elimination it is aggregated on consolidation.
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97
5.10 SIMPLE GROUP (IFRS 3 and IAS 27 REVISED)
5.10.1 Wholly owned subsidiary (100%)
Important Note!!
This area is dealt with in its fullness in the Financial Accounting level preceding Advanced
Accounting and Financial Reporting. Students are expected to have a fair amount of
comprehension of the matters, accounting treatment given to the related transactions and
preparation of the basic consolidated financial statements including treatment of taxation
aspects. If you had not gone through the area satisfactorily, you are encouraged to recap.
Examples below under 5.10.2 and 5.10.3, which are pretty straightforward may give you a start
point.
Always remember that after:
i)
identification and elimination of common items,
ii)
deduction of the purchase consideration from the group's current assets, since
before the acquisition it is not shown separately in the holding company's statement
of financial position, and
iii)
introduction of goodwill to the group statement of financial position,
simple consolidation involves the summation of the assets and liabilities of the holding
company and the subsidiary that remain. Note that all the equity items in the consolidated
statement of financial position are identical to those in the holding company's own statement
of financial position. The subsidiary's equity items at acquisition, in its own statement of
financial position, would have been used to calculate the goodwill arising on acquisition, a
process referred to as capitalisation hence they do not show in the consolidated statement of
financial position.
5.10.2 CONSOLIDATION OF A FULLY/WHOLLY OWNED SUBSIDIARY AT
ACQUISITION DATE
EXAMPLE 1 – REVISION
H Ltd. purchased 100% of the shares in S Ltd. on 1 January 20-5 for $580 000. The summarised
statements of financial position of H Ltd. and S Ltd. on that date was as follows:
ASSETS
Non-current assets
Current Assets
ICSAZ - P.M. PARADZA
H LTD
$
S LTD
$
528 500
671 195
317 100
132 125
98
EQUITY & LIABILITIES
Ordinary Share Capital
Share Premium
Capital Redemption Reserve
General Reserve
Retained Earnings
Current Liabilities
1 199 695
449 225
800 000
177 725
105 700
52 850
39 675
1 175 950
23 745
1 199 695
264 250
95 130
–
47 565
26 425
433 370
15 855
449 225
REQUIRED
a) Analysis of S Ltd's equity as at 1 January 20-5
b) The consolidated statement of financial position of H Ltd and S Ltd as at 1 January 20-5
SUGGESTED SOLUTION
a)
H LTD & ITS SUBSIDIARY
Analysis of shareholders` equity in s Ltd as at 1 January 20-5
Total
100%
$
At acquisition 1/1/20-5
Share Capital
Share Premium
General Reserve
Retained Profits
Investment in S Ltd
Goodwill
264 250
95 130
47 565
26 425
433 370
H Ltd
At acq
100%
$
H Ltd
Since acq
100%
$
264 250
95 130
47 565
26 425
433 370
580 000
146 630
NCI
–
–
$
–
–
–
–
–
N.B. The approach is simply another way of presenting the partial goodwill approach per IFRS
3 – Business combinations where parent`s and NCI`S proportionate share in the net assets
acquired of a subsidiary are calculated. Some of the examples in this module will keep
reminding you of this similarity when necessary. If the examiner specifically asks you to
present the analysis of shareholders` equity in the subsidiary, stick to this format.
Consolidation journal entry (present only when required)
Share Capital (S Ltd)
Share Premium (S Ltd)
General Reserve (S Ltd)
Retained Profit (S Ltd)
Goodwill (Consolidated SFP)
ICSAZ - P.M. PARADZA
Dr
$
264 250
95 250
47 565
26 425
146 630
Cr
$
99
Investment in S Ltd (H Ltd)
580 000
Being elimination of common items at acquisition and recognition of goodwill
b)
H LTD & ITS SUBSIDIARY
Consolidated statement of financial position as at 1 January 20-5
ASSETS
Non-current assets (528 500 + 317 100)
Goodwill
$
845 600
146 630
412 230
223 320
1 215 550
Current assets (671 195 + 132 125 – 580 000) [logical]
Total assets
EQUITY & LIABILITIES
Share Capital & Reserves
Share capital
Share premium
Capital redemption reserve
General reserve
Retained earnings
800 000
177 725
105 700
52 850
39 675
1 175 950
Nil
1 175 950
39 600
1 215 550
Non-controlling interest
Current liabilities (23 745 + 15 855)
Total equity & liabilities
5.10.3 CONSOLIDATION OF A FULLY/WHOLLY OWNED SUBSIDIARY POST
ACQUISITION
EXAMPLE 2 – REVISION
H Ltd acquired all the shares in S Ltd. on 1 January 20-5 for $729 000. The summarised
statement of financial positions of H Ltd. and S Ltd. on 31 December 20-5 were as follows:
ASSETS
Tangible Non-current assets
Investment in S Ltd: 262 500 ordinary shares at cost
Current assets
EQUITY & LIABILITIES
Ordinary share Capital ($1 shares)
Share Premium
Capital Redemption Reserve
General Reserve
Retained earnings
ICSAZ - P.M. PARADZA
H LTD
$
495 000
729 000
1 224 000
S LTD
$
357 000
Nil
357000
126 650
1 350 650
348 750
705 750
1 000 000
100 750
119 000
59 500
44 625
1 323 875
262 500
150 000
–
210 650
64 750
687 900
100
Current Liabilities
26 775
1 350 650
17 850
705 750
When H Ltd. bought its shares in S Ltd. the balances on the latter's reserves were as follows:
Share premium
General reserve
Retained profits
$150 000
$160 000
$20 000
REQUIRED
a) Analysis of S Ltd's equity as at 31 December 20-5
b) The consolidated statement of financial position of H Ltd. and S Ltd. as at 31 December
20-5.
SUGGESTED SOLUTION
a)
H LTD & ITS SUBSIDIARY
Analysis of shareholders` equity in S Ltd as at 31 December 20-5
Total
100%
$
1. At acquisition 1/1/20-5
Share Capital
Share Premium
General Reserve
Retained earnings
262 500
150 000
160 000
20 000
592 500
Investment in S Ltd
Goodwill
2. Since acquisition to 31/12/20-5
General Reserve (210 650-160 000)
Retained earnings (64 750-20 000)
50 650
44 750
687 900
H Ltd
At acq
100%
$
H Ltd
Since acq
100%
$
262 500
150 000
160 000
20 000
592 500
729 000
136 500
NCI
–
–
$
–*
–
–
–
–
50 650
44 750
95 400
–
–
–
* Nil – zero in the case in point given that the subsidiary is wholly owned.
N.B. If H Ltd had paid $550 000 for the net assets of S Ltd, a gain on bargain purchase of $42
500 would have arisen. Whereas goodwill is shown in the consolidated statement of financial
position, and tested for annually for impairments, a gain on bargain purchase is treated, in its
entirety, as income in the current financial year.
ICSAZ - P.M. PARADZA
101
b)
H LTD & ITS SUBSIDIARY
Consolidated statement of financial position as at 31 December 20-5
$
ASSETS
Tangible Non-current Assets (495 000 + 357 000)
Goodwill
852 000
136 500
988 500
475 400
1 463 900
Current Assets (126 650 + 348 750)
EQUITY & LIABILITIES
Ordinary share capital ($1 shares) (800 000 +264 250 - 264 250)
Share Premium
Capital Redemption Reserve
General Reserve (59 500 + 50 650)
Retained Profits (44 625 + 44 750)
$
1 000 000
100 750
119 000
110 150
89 375
1 419 275
44 625
1 463 900
Current Liabilities (26 775 + 17 850)
Notes
(i) H Ltd's investment in S Ltd ($729 000) has not been deducted from the group noncurrent or current assets because it is included in H Ltd's statement of financial position.
(ii) Revise carefully the treatment of changes in the subsidiary's reserves since acquisition,
that is, general reserve and retained profits in this case. Balances which existed at
acquisition are capitalised as explained earlier, while increases since acquisition are
added to corresponding items in the holding company's statement of financial position.
A decrease in a reserve would similarly be deducted from the holding company's figure.
If the subsidiary's retained profits changed from a negative amount at acquisition (an
accumulated loss) to a positive amount the two have to be added together when
analysing the subsidiary's equity.
Consolidation journal entry
Dr
$
262 500
150 000
160 000
20 000
136 500
Share Capital (S Ltd)
Share Premium (S Ltd)
General Reserve (S Ltd)
Retained Profit (S Ltd)
Goodwill (Consolidated SFP)
Investment in S Ltd (H Ltd)
Being elimination of common items at acquisition and recognition of goodwill
ICSAZ - P.M. PARADZA
Cr
$
729 000
102
Alternative layout
1. Goodwill calculation – Partial goodwill/Old method
$
729 000
(592 500)*1
136 500
Purchase consideration transferred
Less Parent`s proportionate share of the acquiree`s identifiable net assets
Parent`s share of goodwill
NCI measured at proportionate share of the acquiree’s identifiable net assets
Less NCI’s proportionate share of the acquiree’s identifiable net assets
NCI`s share of goodwill
Nil
(Nil)
Nil
Total Goodwill
136 500
N.B. Acquiree`s identifiable net assets acquired as represented by:
Ordinary share capital
Share premium
General reserve
Retained earnings on acquisition
$
262 500
150 000
160 000
20 000
592 500
2. Retained profits
Closing balances per question
Provision for unrealized profit
Overstated depreciation on fair value adjustment
Pre-acquisition retained profits
Group`s share:
H Ltd in S Ltd (100% x $44 750)
Impairment of goodwill for investment in S Ltd
3. Non-Controlling Interest
H Ltd
$
44 625
(Nil)
(Nil)
S Ltd
$
64 750
(Nil)*
(Nil)
(20 000)
44 750
44 750
(Nil)
89 375
Nil
* (Nil) – zero in the case in point.
5.10.4 Partial acquisitions (Partly owned subsidiary)
A partial acquisition is whereby a controlling interest is acquired, but with a proportion of
acquiree equity interests held by other investors referred to as ‘non-controlling interests’
(formerly ‘minority interests’). Non-Controlling Interest by definition is the equity in the
subsidiary not attributable, directly or indirectly, to a parent (IFRS 3 Revised). A choice is
available, on an acquisition-by- acquisition basis, to measure such non-controlling interests
either at their proportionate interest in the net identifiable assets of the acquiree (which is the
previous IFRS 3 (2004) requirement) or at fair value (which is a new option (IFRS 3 (Revised)
ICSAZ - P.M. PARADZA
103
and is mandatory under US GAAP). The choice of method has a consequential effect on the
balancing amount recognised as goodwill. The analysis of equity method which can still be
used with ease when non-controlling interests are at their proportionate interest in the net
identifiable assets of the acquiree can alternatively be used to calculate the goodwill/gain on
bargain purchase and any non-controlling interest arising on the acquisition of a subsidiary
The consolidated statement of financial position
Where the holding company owns less than 100% of the subsidiary's shares, it has been noted
above that the shareholders who own the remaining shares have the non-controlling interest in
the subsidiary. This interest now referred as a non-controlling interest, should be accounted for
in the consolidated statement of financial position, as it represents the percentage of the
subsidiary's assets belonging to these shareholders. This is what is known as the economic
entity concept. In other words IFRS 3 (revised) views the group as an economic entity. This
means that it treats all providers of equity including non-controlling interests as shareholders
in the group, even if they are not shareholders in the parent.
The purchase of a controlling interest by one company in another give rise to goodwill or cost
of the control if the amount paid exceeds the holding company's proportionate share of the
subsidiary's net assets taken over at the acquisition date. On the other hand, if the price paid is
less than the subsidiary's net assets, a gain on bargain purchase or negative goodwill will arise.
If the non-controlling interest is measured at fair value, goodwill attributed to the noncontrolling interest needs to be recognised in line with the view that the group is an economic
entity.
The overriding consideration in preparing a consolidated statement of financial position is to
ensure that it reflects a true and fair view of the group's trading results for the period under
review. As part of group financial statements, this statement is primarily for the benefit of the
holding company's shareholders, who need information to assess the overall performance of
the company in which they have invested as well as all its subsidiaries.
In order to produce a consolidated statement of financial position which is as realistic as
possible, it is necessary to make some adjustments similar to those already discussed. These
adjustments include unrealised profit in the inventories of the holding company or
subsidiaries/associates, loans and interest on inter-company loans, intercompany sales and
purchases, administration fees paid by subsidiaries to the holding company and inter-company
dividends.
These general principles for preparing a consolidated statement of financial position are the
same even when the subsidiary is wholly owned and any other situations involving subsidiaries.
Items like dividends, interest and administration fees received or paid within the group should
be eliminated in full, while income and expense items which result from transactions with third
parties are simply added up to come up with the consolidated totals. Remember that this is what
has been cited in this study guide as the basic consolidation procedure as suggested by Cilliers
& Rossouw.
ICSAZ - P.M. PARADZA
104
The consolidated statement of profit or loss and other comprehensive income
When a subsidiary is wholly owned simply perform the basic elimination and aggregation
procedure mentioned above. However, when the subsidiary is not wholly-owned, the
subsidiary's income and expense items are added to those of the holding company up to net
profit after tax. After this, the non-controlling interest in the subsidiary's after tax profit is
deducted to arrive at the amount attributable to the group. If there are any dividends outstanding
from the subsidiary, the holding company should accrue such dividends in its records before
inter-company adjustments are effected (means you perform a journal entry to bring them in
before the elimination journal entry).
The following key procedures should be noted when preparing a consolidated statement of
profit or loss and other comprehensive income.
Subsidiary's retained profits
i)
add the holding company's figure to its share of the increase in the subsidiary's
retained profits from the acquisition date to the end of the previous financial year
(post acquisition retained profits). The parent`s share of the subsidiary`s post
acquisition profits are deduced by simply subtracting the year end retained earnings
from the retained earnings at acquisition date. If the three step analysis* of
shareholders` equity method is used, as recommended by Cilliers and Rossouw, the
retained earnings post acquisition but before the beginning of the current financial
year are deduced by subtracting the retained earnings pre-acquisition from the
retained earnings balance brought forward for the current financial year. Authors
differ in approaches, this study guide is not selective, and in some instances
alternative ways of doing the same thing are shown.
Subsidiary's general (or other) reserves
ii)
add the holding company's transfer to reserves to its share of the subsidiary's
transfer at the end of the current financial year. The parent`s share of the
subsidiary`s post acquisition general or other reserves are deduced by simply
subtracting the year end reserves from the reserves at acquisition date. If the three
step analysis of shareholders` equity method is used, as recommended by Cilliers
and Rossouw, the reserves post acquisition but before the beginning of the current
financial year are deduced by subtracting the reserves pre-acquisition from the
reserves balance brought forward for the current financial year.
A three step analysis of the subsidiary shareholders` equity analysis comprises:
1. Analysis of equity at acquisition (share capital + reserves as representative of
net assets at fair value at acquisition date)
ICSAZ - P.M. PARADZA
105
2. Analysis since acquisition of reserves only, but before the beginning of the
current financial year
3. Analysis of current financial year profit after tax
N.B. the steps can be at least two in some instances depending on the question especially where
after the subsidiary`s equity balances at acquisition you are given the equity balances at the
reporting date at which components of financial statements are required.
5.10.5 CONSOLIDATION OF A PARTLY OWNED SUBSIDIARY AT ACQUISITION
DATE
EXAMPLE 3 – REVISION
The statement of financial positions of H Ltd and S Ltd on 31 March 20-5 were as follows:
ASSETS
Non-current assets
Current Assets
EQUITY & LIABILITIES
Ordinary share capital
Share Premium
Capital Redemption Reserve
General Reserve
Retained earnings
Current Liabilities
H LTD
$
652 500
601 725
1 254 225
S LTD
$
391 500
234 610
626 110
$
750 000
228 375
130 500
65 250
48 900
1 223 025
31 200
1 254 225
$
326 250
117 450
72 500
58 725
31 610
606 535
19 575
626 110
H Ltd purchased 80% of the shares in S Ltd for $650 000 on 31 March 20-5.
REQUIRED
a) Show the analysis of S Ltd's equity on 31 March 20-5
b) Draw up the consolidated statement of financial position of H Ltd. and S Ltd on that date
ICSAZ - P.M. PARADZA
106
SUGGESTED SOLUTION
a)
H LTD & ITS SUBSIDIARY
Analysis of shareholders` equity in S Ltd as at 31 March 20-5
Total
100%
$
At acquisition 31/3/20-5
Share Capital
Share Premium
Capital Redemption Reserve
General Reserve
Retained Earnings
326 250
117 450
72 500
58 725
31 610
606 535
Investment in S Ltd
Goodwill
H Ltd
At Acq
80%
$
H Ltd
Since Acq
80%
$
NCI
–
20%
$
261 000
93 960
58 000
46 980
25 288
485 228
650 000
164 772
65 250
23 490
14 500
11 745
6 322
121 307
Consolidation journal entry
Dr
$
326 250
117 450
72 500
58 725
31 610
164 772
Cr
$
Share Capital (S Ltd)
Share Premium (S Ltd)
Capital Redemption Reserve (S Ltd)
General Reserve (S Ltd)
Retained Earnings (S Ltd)
Goodwill (Consolidated SFP)
Non-Controlling Interest (Consolidated SFP)
121 307
Investment in S ltd (H Ltd)
650 000
Being elimination of common items at acquisition and recognition of goodwill and NCI
b)
H LTD & ITS SUBSIDIARY
Consolidated statement of financial position as at 31 March 20-5
ASSETS
Non-current assets (652 000 - 650 000 + 391 500)
Goodwill
Current assets (601 725 + 234 610)
Total assets
$
394 000
164 772
558 772
836 335
1 395 107
EQUITY & LIABILITIES
Share Capital & Reserves
ICSAZ - P.M. PARADZA
107
Share capital
Share premium
Capital redemption reserve
General reserve
Retained earnings
Non-controlling interest
Current liabilities (31 200 + 19 575)
Total equity & liabilities
750 000
228 375
130 500
65 250
48 900
1 223 025
121 307
1 344 332
50 775
1 395 107
EXAMPLE 4 – REVISION
H Ltd purchased 80% of the shares in S Ltd for $650 000 on 1 April 20-4. On that date the
equity and liabilities section of S Ltd's statement of financial position showed the following
balances:
$
Ordinary Share Capital
326 250
Share Premium
117 450
Capital Redemption Reserve
50 000
General Reserve
35 400
Retained Earnings
15 000
At 31 March 20-5
Capital Redemption Reserve
General Reserve
Retained Earnings
72 500
58 725
31 610
REQUIRED
a) An analysis of S Ltd's equity on 31 March 20-5
b) A consolidated statement of financial position on that date
SUGGESTED SOLUTION
a)
H LTD & ITS SUBSIDIARY
Analysis of shareholders` equity in S Ltd as at 31 March 20-5
H Ltd
H Ltd
NCI
Total
At Acq
Since Acq
100%
80%
80%
20%
$
$
$
$
1. At acquisition 1/4/20-5
Share Capital
326 250
261 000
65 250
Share Premium
117 450
93 960
23 490
Capital Redemption Reserve
50 000
40 000
10 000
General Reserve
35 400
28 320
7 080
Retained Earnings
15 000
12 000
3 000
544 100
435 280
108 820
ICSAZ - P.M. PARADZA
108
Investment in S Ltd
Goodwill
2. Since acquisition to 31/03/20-5
Capital Redemption Reserve
(72 500-50000)
Retained Earnings
(58 725-35 400)
General Reserve
(31 610-15 000)
650 000
214 720
22 500
18 000
4 500
23 325
18 660
4 665
16 610
606 535
13 288
49 948
3 322
121 307
b)
H LTD & ITS SUBSIDIARY
Consolidated statement of financial position as at 31 March 20-5
ASSETS
Tangible Non-current assets
Goodwill
$
1 044 000
214 720
1 258 720
186 335
1 445 055
Current Assets
EQUITY & LIABILITIES
Ordinary Share Capital
Share Premium
Capital Redemption Reserve (130 500 + 18 000)
General Reserve (65 250 + 18 660)
Retained Earnings (48 900 + 13 288)
750 000
228 375
148 500
83 910
62 188
1 272 973
121 307
1 394 280
50 775
1 445 055
Non-controlling interest
Current Liabilities
EXAMPLE 5 – REVISION (solution includes consolidation journal entries for intragroup
transactions)
The Statement of Comprehensive Income and statement of changes in equity of H Ltd and S
Ltd for the year-ended 31 December 20-5 were as follows:
Statement of comprehensive income for Y/E 31/12/20-5
Sales
Cost of goods sold
Gross profit
Dividend income - S Ltd
Interest income - S Ltd
ICSAZ - P.M. PARADZA
H LTD
$
630 000
(294 000)
336 000
25 000
12 500
S LTD
$
412 500
(147 250)
265 250
Nil
109
Trading Expenses
Salaries & wages
Rent & rates
Debenture interest
Directors fees
General expenses
Net profit before tax
Company tax
Net profit after tax
373 500
265 250
(91 500)
(80 150)
(18 750)
(47 500)
(39 625)
95 975
(38 390)
57 585
(55 375)
(51 925)
(12 500)
(31 250)
(20 500)
93 700
(37 480)
56 220
H Ltd - Statement of changes in equity for Y/E 31/12/20-5
Balance b/d
Net profit for the year after tax
Transfer to general reserve
Ordinary dividends paid
Balance c/f
Retained Profits
$
342 800
57 585
(100 000)
(85 000)
215 385
General Reserve
$
130 000
100 000
Nil
230 000
S Ltd - Statement of changes in equity for Y/E 31/12/20-5
Retained Profits
General Reserve
$
$
Balance b/d
167 000
120 000
Net profit for the year after tax
56 220
Transfer to general reserve
(60 000)
60 000
Ordinary dividends declared
(62 500)
Nil
100 720
180 000
Additional information
(i) H Ltd acquired 70% of the shares in S Ltd. on 1 January 20-3; on that date S Ltd's retained
profits were $100 000 while the general reserve stood at $50 000.
(ii) All the debentures in S Ltd have been issued to H Ltd.
(iii) H Ltd has not yet recorded the balance of dividends due from S Ltd. on 31 December 205.
(iv) $21 875 of the director's fees shown in S Ltd's statement of comprehensive Income has
been paid to H Ltd. This income has not been recorded in the books of H Ltd.
REQUIRED
a) The consolidated Statement of Comprehensive Income of H Ltd. and S Ltd. for the yearended 31 December 20-5
b) The consolidated statement of changes in equity for H Ltd and S Ltd for the year-ended 31
December 20-5
ICSAZ - P.M. PARADZA
110
SUGGESTED SOLUTION
H LTD & ITS SUBSIDIARY
Consolidated statement of comprehensive income for Y/E 31/12/20-5
$
$
Sales (630 000 + 412 500)
1 042 500
Cost of goods sold (294 000 + 147 250)
(441 250)
Gross profit
601 250
Dividends from S Ltd (43 750 - 43 750)
Nil
Interest from S Ltd (12 500 - 12 500)
Nil
Director's fees from S Ltd (21 875 - 21 875)
Nil
601 250
Trading Expenses Salaries & wages (91 500 + 55 375)
146 875
Rent & rates (80 150 + 51 925)
132 075
Debenture interest (18 750 + 12 500 - 12 500)
18 750
Directors fees (47 500 + 31 250 - 21 875)
56 875
General expense (39 625 + 20 500)
60 125
(414 700)
Net profit before tax
186 550
Company tax (38 390 + 37 480)
(75 870)
Net profit after tax
110 680
Attributable to:
Owners of the parent
93 814
Non-controlling interests
16 866*
110 680
* Calculated as the non-controlling shareholders' share of the subsidiary's own net profit after
tax for the year.
H LTD & ITS SUBSIDIARY
Consolidated statement of changes in equity for Y/E 31/12/20-5 (Extract)
Balance b/d
Net profit after tax
Transfer to general reserve
Ordinary dividends paid (H Ltd. only)
Balance c/f
Retained Profits
$
389 700(i)
93 814
(142 000)(iii)
(85 000)
256 514
(i)
H Ltd
S Ltd. (167 000 - 100 000) x 70%
342 800
46 900
389 700
(ii)
H Ltd
S Ltd (120 000 - 50 000) x 70%
130 000
49 000
179 000
(iii)
100 000
H Ltd
ICSAZ - P.M. PARADZA
General Reserve
$
179 000(ii)
142 000
321 000
111
S Ltd. (60 000 x 70%)
42 000
142 000
Journal entries in H in Ltd's Books
Dividends receivable (H Ltd)
Dividend income SCI (H Ltd)
(62 500 x 70%) - 25 000
Being entry to accrue dividend income not yet received
DR
$
18 750
CR
$
18 750
Dividend income SCI (H Ltd)
Dividend paid SOCIE (S Ltd)
Being elimination of common items
43 750
Interest income SCI (H Ltd)
Debenture interest (S Ltd)
Being elimination of common items
12 500
43 750
12 500
Directors fee receivable (H Ltd)
21 875
Directors fees SCI (H Ltd)
Being entry to accrue directors` fees from S Ltd not yet recorded
21 875
Directors fees SCI (H Ltd)
Directors fees paid (S Ltd)
Being elimination of common items
21 875
21 875
EXAMPLE 6 – REVISION (includes unrealised profit in closing inventory).
H Ltd. purchased 90% of the ordinary share in S Ltd. on 1 July 20-3. The Statement of
Comprehensive Income of the two companies on 30 June 20-5 were as follows:
Sales
Cost of goods sold
Gross profit
Dividends received
Interest received
Trading Expenses
Salaries & wages
Rent
Insurance
Interest paid (H Ltd)
Electricity & water
Depreciation of non-current assets
Other general expenses
Profit before tax
ICSAZ - P.M. PARADZA
H LTD
$
599 500
(239 800)
359 700
40 000
45 000
444 700
S LTD
$
455 620
(215 820)
239 800
(71 940)
(23 900)
(16 780)
(35 970)
(14 500)
(10 745)
(16 350)
(12 600)
(17 300)
(4 800)
127 535
(14 200)
(30 900)
(9 450)
277 530
Nil
239 800
112
Company tax
Profit after tax
(83 259)
194 271
(38 260)
89 275
H Ltd - Statement of changes in equity for Y/E 30/06/20-3 (Extract)
Balance b/d
Profit after tax
Transfer to general reserve
Ordinary dividends paid
Retained Profits
$
96 465
194 271
(75 000)
(60 000)
155 736
General Reserves
$
85 000
75 000
Nil
160 000
S Ltd - Statement of changes in equity for Y/E 30/06/20-5 (Extract)
Balance b/d
Profit after tax
Transfer to general reserve
Ordinary dividends paid
Retained Profits
$
73 800
89 275
(45 000)
(40 000)
58 075
General Reserves
$
30 000
45 000
Nil
75 000
Additional information
(i) When H Ltd bought its shares in S Ltd, the latter's reserves were: general reserves $20 000,
retained profits $40 000.
(ii) H Ltd sold to S Ltd goods worth $82 000 at invoice price during the year-ended 30 June
20-5. At year-end ¼ of these goods remained in stock. H Ltd. sells inventory to its subsidiary
at a mark- up of 1/3.
REQUIRED
(a) Consolidated Statement of Comprehensive Income for the year-ended 30 June 20-5.
(b) Consolidated statement of changes in equity for the year-ended 30 June 20-5.
SUGGESTED SOLUTION
H LTD & ITS SUBSIDIARY
Consolidated statement of comprehensive income for Y/E 30/06/20-5
$
$
Sales (599 500 + 455 620 - 82 000) (i)
973 120
Cost of goods sold [239 800 + 215 820 - 82 000 + 5 125(ii)]
(378 745)
Gross profit
594 375
Dividends received (40 000 - 36 000)
4 000
Interest received (45 000 - 16 350)
28 650
627 025
Trading Expenses
ICSAZ - P.M. PARADZA
113
Salaries & wages (71 940 + 35 970)
Rent (23 900 + 14 500)
Insurance (16 780 + 10 745)
Electricity & water (14 200 + 12 600)
Depreciation (30 900 + 17 300)
Other general expenses (9450 + 4 800)
Profit before tax
Company tax
Net profit after tax
Non-controlling interest (89 275 x 10%)
Consolidated net profit after tax
107 910
38 400
27 525
26 800
48 200
14 250
(263 085)
363 940
(121 519)
242 421
(8 928)
233 493
Notes
(i) Inter-company sale to be deducted from both consolidated sales and cost of goods sold
figures.
(ii) ¼ of the goods bought by S Ltd. from H Ltd were still in inventory at year-end. These
goods were worth $82 000 x 1/4 = $20 500 at invoice price. The profit element in the goods was
$20 500 x ¼ =5 125.
(iii) H Ltd received total dividends of $40 000. Of this amount $40 000 x 90% = $36 000 came
from S Ltd. and should be eliminated from the consolidated Statement of Comprehensive
Income.
(iv) H Ltd received interest amounting to $45 000. Of this amount, $16 350 came from S Ltd.
and should be eliminated from the consolidated Statement of Comprehensive Income.
Since no interest was paid to third parties, this item may be omitted altogether from the trading
expenses section of the consolidated Statement of Comprehensive Income.
N.B. Ordinary trading expenses like rent, insurance, electricity and water etc. do not require
any special adjustments unless there is an indication of inter-company transactions. They are
simply aggregated.
b)
H LTD & ITS SUBSIDIARY
Consolidated statement of changes in equity for Y/E 30/06/20-5
Balance b/d
Net profit after tax
Transfer to general reserve
Ordinary dividends paid
Balance c/f
Retained Earnings
$
126 885(i)
234 005
(115 500)(ii)
(60 000)
185 390
(i)
H Ltd
S Ltd (73 800 - 40 000) x 90%
96 465
30 420
126 885
(ii)
75 000
H Ltd
ICSAZ - P.M. PARADZA
General Reserve
$
94 000(iii)
115 500(ii)
Nil
209 500
114
S Ltd (45 000 x 90%)
40 500
115 500
(iii) H Ltd.
S Ltd (30 000 - 20 000) x 90%
85 000
9 000
94 000
Important Note!!
In all the above revision examples emphasis has not been on the NCI measured at fair value.
Measurement of NCI at proportionate share of the acquiree’s identifiable net assets was
applicable.
EXAMPLE 7 – REVISION (NCI measured at fair value)
Hyper acquired 75% of the equity share capital of Selma on 1 November 20-2 paying $1 800
000 in cash. At that date the retained earnings of Selma were $600 000. Below are the
statements of financial position of Hyper and Selma as at 31 October 20-4.
ASSETS
Non-current assets
Investment in Selma
Current assets
EQUITY & LIABILITIES
Share capital
Retained earnings
Non-current liabilities
Current liabilities
Hyper
$000
3 300
1 800
900
6 000
Selma
$000
1 500
Nil
1 300
2 800
3 000
1 800
200
1 000
6 000
1 000
800
100
900
2 800
It is group policy to value NCI using the fair value method. The fair value of the NCI holding
in Selma at 1 November 20-2 was $550 000.
As at 31 October 20-4 goodwill was impaired by $120 000.
REQUIRED
Consolidated statement of financial position as at 31 October 20-4.
ICSAZ - P.M. PARADZA
115
SUGGESTED SOLUTION
HYPER GROUP
Consolidated statement of financial position as at 31 October 20-4
$000
ASSETS
Non-current assets (3 300 + 1 500)
Goodwill
Current assets (900 + 1 300)
4 800
630
2 200
7 630
EQUITY & LIABILITIES
Share capital
Retained earnings
NCI
Non-current liabilities (200 + 100)
Current liabilities (1 000 + 900)
3 000
1 860
570
300
1 900
7 630
WORKINGS
1. Group structure
Hyper owns 75% shareholding in Selma. Acquisition date is 1 November 20-2
2. Net assets of subsidiary
Share capital
Retained earnings
At Acq
date
$000
1 000
600
1 600
At Reporting
date
$000
1 000
800
1 800
Therefore, post-acquisition reserves = $1800 - $1 600 = $200
3. Goodwill
Fair value of Hyper`s investment
NCI holding at fair value
Fair value of Selma`s net assets at acquisition date
Impairment at reporting date
4. NCI
At acquisition
NCI% x post acquisition reserves (25% x 200)
NCI% x goodwill impairment (25% x 120)
ICSAZ - P.M. PARADZA
1 800
550
(1 600)
750
(120)
630
550
50
(30)
570
116
5. Group reserves
Retained Earnings
1 800
150
(90)
1 860
Parent`s reserves
Parent`s % x post acquisition reserves (75% x 200)
Parent`s % x goodwill impairment (75% x 120)
ACTIVITY 1 – PARTIAL ACQUISITION
The statements of financial position of H Ltd and S Ltd. on 30 June 20-5 were as follows:
EQUITY & LIABILITIES
Authorised & Issued Share Capital ($10 shares)
Share Premium
Capital Redemption Reserve
General Reserve
Retained Earnings
Current Liabilities
ASSETS
Non-current assets
Current assets
H LTD
$
420 000
98 000
56 000
28 000
21 000
12 600
635 600
S LTD
$
140 000
50 400
–
25 200
14 000
8 400
238 000
280 000
355 600
635 600
168 000
70 000
238 000
H Ltd. bought 75% of the shares in S Ltd. for $220 000 on 1 July 20-4. On that date the equity
and liabilities section of S Ltd's statement of financial position showed the following balances:
Ordinary share capital
Share premium
General reserve
Retained profits
$
140 000
50 400
15 000
10 000
REQUIRED
a) Analysis of S Ltd's equity as at 30 June 20-5
b) Consolidated statement of financial position of H Ltd. as at 30 June 2005.
ICSAZ - P.M. PARADZA
117
ACTIVITY 2 – PARTIAL ACQUISITION
The summarised statements of financial position of Close and Steele as at 31 December 20-4
were as follows:
ASSETS
Non-Current Assets
Tangible assets
Investments
Current Assets
Current Account – Close
Cash at bank
Investments
Trade receivables
EQUITY AND LIABILITIES
Current liabilities
Trade payables
Current account – Steele
Share capital and reserves
Called up share capital ($1 ordinary shares)
Share premium account
Revaluation reserve on 1 January 20-4
Retained earnings on 1 January 20-4
Profit for 20-4
Close
$
Steele
$
84 000
80 000
164 000
58 200
Nil
58 200
Nil
10 000
62 700
18 000
90 700
254 700
3 200
3 000
21100
12 000
39 300
100 000
35 000
2 700
37 700
11 000
Nil
11 000
120 000
18 000
23 000
40 000
16 000
217 000
254 700
60 000
Nil
16 000
8 000
5 000
89 000
100 000
The following information is relevant:
1) On 31 December 20-3, Close acquired 48 000 shares in Steele for $80 000 cash.
2) The inventory of Close includes $4 000 goods from Steele invoiced to Close at cost
plus 25%.
3) A cheque for $500 from Close to Steele, sent before 31 December 20-4, was not
received by the latter company until January 20-5.
4) Goodwill has been impaired by $7 800 since the acquisition took place.
REQUIRED
Prepare the consolidated statement of financial position of Close and its subsidiary as at 31
December 20-4.
ICSAZ - P.M. PARADZA
118
EXAMPLE - TREATMENT OF PREFERENCE DIVIDENDS OF SUBSIDIARY
Statement of financial position as at 31 December 20-7
The following are the abridged financial statements of Zambuko Ltd and its subsidiary Ruya
Ltd.
ASSETS
Property, plant and equipment
Purchase consideration at fair value
- 75 000 ordinary shares
- 4 000 preference shares
Trade and other receivables
EQUITY AND LIABILITIES
Issued capital
- Ordinary shares, $2 each
- 12% preference shares $2 each
Retained profits
Trade and other payables
Zambuko Ltd
$
100 000
Ruya Ltd
$
240 000
172 500
8 000
53 500
334 000
Nil
Nil
96 000
336 000
200 000
40 000
70 000
310 000
24 000
334 000
200 000
20 000
80 000
300 000
36 000
336 000
Statement of changes in equity for the year ended 31 December 20-7
Ordinary
12% Preference
Share
Share
Retained
Capital
Capital
Profits
Total
Zambuko Ruya Zambuko Ruya Zambuko Ruya Zambuko Ruya
$
$
$
$
$
$
$
$
Op bal.
200 000 200 000 40 000 20 000 28 000
56 000 268 000 276 000
Profit aft.tax
42 000
24 000 42 000
24 000
Closing bal. 200 000 200 000 40 000 20 000 70 000
80 000 310 000 300 000
Zambuko Ltd acquired its interest in Ruya Ltd on 1 Jan 20-6 when the retained earnings of
Ruya Ltd were $30 000. On 1 Jan 20-6 no preference dividends were outstanding. Provision
must still be made for the 20-7 preference dividend. At the date of acquisition, consider the
carrying amount of the assets and liabilities of Ruya Ltd to be equal to the fair value thereof.
REQUIRED
1. Analysis of shareholders equity in Ruya Ltd as at 31 Dec 20-7.
2. Consolidated statement of profit or loss and other comprehensive income for the year ended
31 Dec 20-7.
3. Consolidated statement of financial position as at 31 Dec 20-7.
ICSAZ - P.M. PARADZA
119
SUGGESTED SOLUTION
1. Analysis of shareholders` equity in Ruya Ltd as at 31 Dec 20-7
a) At acquisition
Since Acq
75%
$
NCI
25%
$
50 000
7 500
57 500
26 000
19 500
6 500
c) Current financial year
Profit for the year
24 000
Preference dividend (12% x 20 000) (2 400)
277 600
18 000
(1 800)
35 700
6 000
(600)
69 400
Since Acq
40%
$
NCI
60%
$
12 000
960
(960)
Nil
1 440
(1 440)
12 000
Ordinary share capital
Retained profits on acquisition
Total
100%
$
200 000
30 000
230 000
Investment in Ruya Ltd
Goodwill
b) Since acquisition to beginning
of current financial year
Retained earnings on acquisition
($56 000 – 30 000)
a) At acquisition
Preference share capital
Investment in Ruya Ltd
Goodwill
b) Current financial year
Profit share
Preference dividend
Total
100%
$
20 000
2 400
(2 400)
20 000
At Acq
75%
$
150 000
22 500
172 500
172 500
Nil
At Acq
40%
$
8 000
8 000
Nil
2.
ZAMBUKO GROUP
Consolidated statement of profit or loss and other comprehensive income for the year
ended 31 Dec 20-7
$
Profit for the year (42 000 + 24 000)
66 000
Attributable to:
Equity holders of parent (balancing figure)
Non-controlling interest
ICSAZ - P.M. PARADZA
59 160
6 840
66 000
120
3. Consolidated statement of financial position as at 31 Dec 20-7
ASSETS
Non-Current assets
Property plant and equipment (100 000 + 240 000)
Current assets
Trade and other receivables (53 500 + 96 000)
EQUITY AND LIABILITIES
Issued capital
- Ordinary shares, $2 each
- 12 Preference shares, $2 each
Retained profits [(28 000+19 500) + 59 160 – 4 800]
Non-controlling interest (69 400 + 12 000)
Current liabilities
Shareholders for dividend (12% x 40 000) + 1 440
Trade and other payables (24 000 + 36 000)
$
340 000
149 500
489 500
200 000
40 000
101 860
81 400
423 260
6 240
60 000
66 240
489 500
Three situations that are highly likely to arise are:
i) Preference dividends outstanding at the reporting date as is the case with the above
example.
The subsidiary Ruya Ltd declared a dividend, but it was not yet paid out at the reporting date.
The effect on consolidation is that NCI is increased by the portion of the dividend or profit yet
to be received.
ii) Accumulated preference dividends at acquisition of subsidiary.
An amount in respect of the accumulated preference dividends is included in the calculation of
the purchase consideration of the preference share investment, implying that payment is made
for the preference share dividend to be declared later on (post acquisition). On declaration of
this dividend the investment (purchase consideration) is reduced accordingly. The principle
behind is what was applied to the goodwill calculation for the ICSAZ May 2014 examination
question paper - Takashita and Samurai. The question has been touched earlier in part in this
study guide,
iii) Arrear preference dividends.
With the preference shares being cumulative it will be necessary to provide for accrued
preference dividends. They have to be paid before it is permissible to pay the ordinary dividend.
ICSAZ - P.M. PARADZA
121
5.11 HORIZONTAL GROUP (IFRS 3 and IAS 27 REVISED)
Illustration of structure:
H Ltd (Holding co)
S1 Ltd (65%)
S2 Ltd (95%)
EXAMPLE 1 – HORIZONTAL RELATIONSHIP
The statement of financial positions of A Ltd. B Ltd. and C Ltd. on 30 September 20-5 were
as follows:
Statement of financial position as at 30 September 20-5
ASSETS
Tangible Non-current Assets
Investment in Group Companies
B Ltd.
C Ltd.
Current Assets
Inventory
Trade receivables
Cash at bank /on hand
Equity & Liabilities
Ordinary Share Capital
Retained Earnings
Trade payables
A LTD
$
B LTD
$
C LTD
$
1 896 000
680 400
478 800
63 000
340 000
84 000
3 240 000
33 600
27 300
23 100
764 400
16 800
10 500
25 200
531 300
2 100 000
1 077 000
63 000
3 240 000
630 000
105 000
29 400
764 400
420 000
84 000
27 300
531 300
525 000
332 000
Additional information
(i) A Ltd purchased 85% of the share capital of B Ltd. on 1 October 20-3 when the latter's
retained profits amounted to $45 000.
(ii) A Ltd. purchased 70% of the share capital of C Ltd. on 1 October 20-4 when the latter's
retained profits amounted to $32 000.
ICSAZ - P.M. PARADZA
122
(iii) Any goodwill arising from the acquisition of B Ltd and C Ltd. should not be amortised.
(iv) During the year-ended 30 September 20-5, A Ltd sold goods costing $15 000 to B Ltd for
$20 000. Half of these goods were in B Ltd's stock at the year-end.
(v) Inter-company debts at the year-end were as follows: $ B Ltd owed A Ltd 10 000 C Ltd.
owed B Ltd. 7 500
REQUIRED
a) Analysis of the subsidiaries' equity as at 30 September 20-5
b) Consolidated statement of financial position of A Ltd and its subsidiaries as at 30
September 20-5.
SUGGESTED SOLUTION
a.i)
A LTD & ITS SUBSIDIARIES
Analysis of shareholders` equity in B Ltd as at 30 September 20-5
Total
100%
$
1. At acquisition 1/10/20-3
Share Capital
630 000
Retained Earnings
45 000
675 000
Investment in S Ltd
Bargain Purchase Gain
A Ltd
At Acq
85%
$
A Ltd
Since Acq
85%
$
535 500
38 250
573 750
525 000
(48 750)
NCI
15%
$
94 500
6 750
101 250
2. Since acquisition to 30/09/20-5
Retained Earnings
(105 000 - 45 000)
60 000
51 000
9 000
735 000
51 000
110 250
a.ii)
A LTD & ITS SUBSIDIARIES
Analysis of shareholders` equity in C Ltd as at 30 September 20-5
Total
100%
$
A Ltd
At Acq
70%
$
1. At acquisition 1/10/20-4
Share Capital
420 000
Retained Earnings
32 000
452 000
Investment in S Ltd
Goodwill
294 000
22 400
316 400
332 000
15 600
ICSAZ - P.M. PARADZA
A Ltd
Since Acq
70%
$
NCI
30%
$
126 000
9 600
135 600
123
2. Since acquisition to 30/09/20-5
Retained Earnings
(84 000 - 32 000)
52 000
504 000
36 400
36 400
15 600
151 200
b)
A LTD & ITS SUBSIDIARIES
Consolidated statement of financial position as at 30 September 20-5
$
ASSETS
Non-current assets (1 896 000 + 680 400 + 478 800)
Current assets
Inventory (63 000 + 33 600 - 2500 + 16 800)
Trade receivables (340 000 - 10 000 + 27 300 - 7 500 + 10 500)
Cash at bank (84 000 + 23 100 + 25 200)
Total assets
3 055 200
110 900
360 300
132 300
3 658 700
EQUITY & LIABILITIES
Share Capital & Reserves
Share capital
Retained profits (1 070 000 - 2 500 + 51 000 + 36 400 + 48 750 - 15 600)
Non-controlling interest (110 250 + 151 200)
Current liabilities
Trade payables (63 000 + 29 400 - 10 000 + 27 300 - 7 500)
Total equity & liabilities
2 100 000
1 195 050
3 295 050
261 450
3 556 500
102 200
3 658 700
WORKINGS
1. Group structure: A Ltd has a controlling interest in both B Ltd (80%) and C Ltd (70%).
This is a horizontal group.
2. Unrealized profit in closing stock (20 000 - 15 000) x ½ = $2 500
3. Part of consolidation journal entries
Retained Profits (A Ltd)
Inventory (B Ltd)
Being unrealized profit in closing inventory
Dr
$
2 500
2 500
Payables (B Ltd)
Receivables (A Ltd)
10 000
Payables (C Ltd)
Receivables (B Ltd)
Being elimination of common items
7 500
ICSAZ - P.M. PARADZA
Cr
$
10 000
7 500
124
EXAMPLE 2 – HORIZONTAL RELATIONSHIP (NCI measured at fair value)
P Ltd acquired 75% of the ordinary shares in Q Ltd on 1 April 20-2. Paying $720 000 in cash.
On that date, the retained earnings of Q Ltd amounted to $240 000. P Ltd acquired 70% of the
ordinary shares in R Ltd on 1 April 20-3, paying $500 000 in cash. On that date, the retained
earnings of R Ltd amounted to $80 000. The statements of financial position of the companies
on 31 March 20-4 were as follows:
ASSETS
Tangible non-current assets
Investments in subsidiaries:
Q Ltd
R Ltd
Current assets
EQUITY & LIABILITIES
Ordinary share capital
Retained earnings
Non-current liabilities
Current liabilities
P Ltd
$
1 320 000
Q Ltd
$
600 000
R Ltd
$
750 000
720 000
500 000
360 000
2 900 000
520 000
1 120 000
415 000
1 165 000
1 200 000
720 000
580 000
400 000
2 900 000
400 000
320 000
100 000
300 000
1 120 000
500 000
315 000
100 000
250 000
1 165 000
It is group policy to value the non-controlling interest in subsidiaries using the fair value
method. The fair values of non-controlling interests in Q Ltd and R Ltd on the acquisition
dates were $220 000 and $190 000 respectively.
On 31 March 20-4 impairment tests required by IFRS 3 showed that Q Ltd`s goodwill was
impaired by $48 000 while that of R Ltd was equal to its book value.
REQUIRED
Draw up the consolidated statement of financial position as at 31 March 20-4. Show relevant
workings.
ICSAZ - P.M. PARADZA
125
SUGGESTED SOLUTION
P LTD GROUP
Consolidated statement of financial position as at 31 March 20-4
$
ASSETS
Tangible non-current assets (1 320 000 + 600 000 + 750 000)
Goodwill (252 000 + 110 000)
Currents assets (360 000 + 520 000 + 415 000)
2 670 000
362 000
1 295 000
4 327 000
EQUITY & LIABILITIES
Ordinary share capital
Retained earnings
Non-controlling interest (228 000 + 260 500)
1 200 000
908 500
488 500
2 597 000
780 000
950 000
4 327 000
Non-current liabilities (580 000 + 100 000 + 100 000)
Current liabilities (400 000 + 300 000 + 250 000)
WORKINGS
Goodwill computation
Fair value of P Ltd`s investment
NCI holding at fair value
Fair value of subsidiary`s net assets at acquisition
Goodwill at acquisition
Goodwill impairment
Non-controlling interests
At-acquisition
Post-acquisition
Share of goodwill impairment
Q Ltd
$
720 000
220 000
(640 000)
300 000
(48 000)
252 000
220 000
20 000(a)
12 000(c)
228 000
R Ltd
$
500 000
190 000
(580 000)
110 000
Nil
110 000
190 000
(b)70 500
Nil
260 500
a) (400 000 + 320 000) – (400 000 + 240 000 x 25%) = $20 000
b) (500 000 + 315 000) – (500 000 + 80 000 x 30%) = $70 500
c) 48 000 x 25% = $12 000
Retained earnings
P Ltd
Goodwill impairment
Q Ltd
R Ltd
720 000
(36 000) (d)
60 000 (e)
164 500 (f)
908 500
d) 48 000 x 75% = $36 000
e) (400 000 + 320 000) – (400 00 + 240 000 x 75%) = $60 000
f) (500 000 + 315 000) – (500 000 + 80 000 x 70%) = $164 500
ICSAZ - P.M. PARADZA
126
Tutorial Note:
Ensure class practice on at least two horizontal group questions involving the preparation of a
group statement of profit or loss and other comprehensive income and statement of changes in
equity.
5.12 VERTICAL GROUP (IFRS 3 and IAS 27 REVISED)
Consolidation procedures to be used under different circumstances
Transactions in shares may occur at any time during a company's financial year, with different
impacts on the structure of a group. The simplest possible situation is one in which the ultimate
holding company acquires its shares in the subsidiary on the same date that the subsidiary
acquires its shares in the sub-subsidiary. This is shown through the example below:
EXAMPLE 1
The summarized statements of financial position for three entities at 30 September 20-6 are
as shown below:
Sino Hydro
Long Cheng
Red Dragon
ASSETS
$000
$000
$000
Non-current assets
Property, plant & equipment 1 788 990
961 110
1 469 400
Investments (at cost)
1 455 000
1 005 000
Nil
Current assets
261 960
169 650
164 400
3 505 950
2 135 760
1 633 800
EQUITY & LIABILITIES
Share capital ($1 shares)
300 000
225 000
150 000
Retained earnings
2 626 200
1 576 500
1 307 250
2 926 200
1 801 500
1 457 250
Non-current liabilities
450 000
240 000
90 000
Current liabilities
129 750
94 260
86 550
3 505 950
2 135 760
1 633 800
Additional notes
1. Sino Hydro acquired 80% of equity shares of Long Cheng on 1 October 20-3 at a cost of $1
050 000 000. At this time, the retained earnings of Long Cheng were $765 000 000 and the fair
value of the non-controlling interest was $240 000 000.
2. At 1 October 20-3 it was determined that Land in the books of Long Cheng with a carrying
amount of $300 000 000 had a fair value of $405 000 000.
3. Long Cheng acquired 70% of the equity shares of Red Dragon on 1 October 20-4 at a cost
of $1 005 000 000. At this time, the retained earnings of Red Dragon were $855 000 and the
fair value of non-controlling interest was $525 000 000.
ICSAZ - P.M. PARADZA
127
4. At 1 October 20-4 it was determined that plant in the books of Red Dragon had a fair value
of $60 000 000 in excess of its carrying amount. The plant is being depreciated over its
remaining life of 10 years.
5. During the year ended 30 September 20-6 Sino Hydro sold $105 000 000 of goods to Long
Cheng at a margin of 20%. Long Cheng still held 1/5 of the goods in inventory at the reporting
date. It is group policy to measure NCI at fair value at acquisition. At 30 September 20-6 it was
determined that no impairment has occurred on goodwill of Long Cheng but that of Red Dragon
had been impaired by $24 000 000.
REQUIRED
Consolidated statement of financial position for the Sino Hydro group as at 30 September 206.
SUGGESTED SOLUTION
SINO HYDRO GROUP
Consolidated statement of financial position as at 30 September 20-6
ASSETS
Non-current assets
Property, plant & equipment
(1 788 990 + 961 110 + 1 469 400 + 105 000 + 60 000 – 12 000)
Goodwill (1 950 000 + 240 000)
Investments (1 455 000 + 1 005 000 – 1 050 000 – 1 005 000)
Current assets (261 960 + 169 650 + 164 400 – 4 200)
EQUITY & LIABILITIES
Share capital
Retained earnings
Non-controlling interest (201 300 + 708 150)
Non-current liabilities (450 000 + 240 000 + 90 000)
Current Liabilities (129 750 + 94 260 + 86 550)
ICSAZ - P.M. PARADZA
$000
4 372 500
435 000
405 000
591 810
5 804 310
300 000
3 504 300
3 804 300
909 450
4 713 750
780 000
310 560
5 804 310
128
WORKINGS
1. Group structure
Sino Hydro owns 80% in Long Cheng which owns 70% in Red Dragon whereas Long Cheng
is an 80% subsidiary since acquisition, and NCI being 20%; Red Dragon is effectively a 56%
subsidiary since its acquisition by Long Cheng and NCI being effectively 44%.
2. Net assets – Long Cheng
At Acq
date
$000
Share capital
225 000
Retained earnings
765 000
Fair value adjustment – Land (405 000 – 300 000) 105 000
1 095 000
At Reporting
date
$000
225 000
1 576 500
105 000
1 906 500
Therefore, post-acquisition profit = ( 1906 500 – 1 095 00) = $811 500
3. Net assets – Red Dragon
Share capital
Retained earnings
Fair value adjustment – Plant (given)
Depreciation adjustment (60 000 x 2/10)
At Acq
date
$000
150 000
855 000
60 000
Nil
1 065 000
At Reporting
date
$000
150 000
1307 250
60 000
(12 000)
1 505 250
Therefore, post-acquisition profit = ( 1 505 250 – 1 065 000) = $440 250
4. Goodwill – Long Cheng
Fair value of Sino Hydro`s investment
NCI at fair value
Fair value of Long Cheng`s net assets at acquisition
5. Goodwill – Red Dragon
Long Cheng`s investment in Red Dragon
NCI`s share of investment (20% x 1 005 000)
Fair value of Sino Hydro`s investment
NCI at fair value
Fair value of Long Red Dragon`s net assets
Goodwill at acquisition date
Impairment loss
Goodwill at reporting date
ICSAZ - P.M. PARADZA
1 050 000
240 000
(1 095 000)
195 000
1 005 000
(201 000)
804 000
525 000
(1 065 000)
264 000
(24 000)
240 000
129
6. NCI – Long Cheng
At acquisition
NCI% x post acquisition reserves (20% x 811 500)
NCI`s share of investment in Red Dragon
240 000
162 300
(201 000)
201 300
7. NCI – Red Dragon
At acquisition
NCI% x post acquisition reserves (44% x 440 250)
NCI% x impairment loss (44% x 24 000)
525 000
193 710
(10 560)
708 150
8.
Sino Hydro`s reserves
Provision for unrealized profit
Parent`s % x post acquisition reserves
- Long Cheng (80% x 811 500)
- Red Dragon (56% x 440 250)
Parent`s % x impairment loss (56% x 24 000)
Retained Earnings
2 626 200
(4 200)
649 200
246 540
(13 440)
3 504 300
9. Provision for unrealized profit
Inventory at hand (105 000 x 1/5)
Therefore unrealized profit = $21 000 x 20% = 4 200.
21 000
EXAMPLE 2 – ACQUISITION OF CONTROLLING INTEREST IN SUBSUBSIDIARY BY SUBSIDIARY AT THE SAME DATE IT IS ACQUIRED BY THE
ULTIMATE PARENT.
H Ltd purchased 75% of the shares in S Ltd on 1 January 20-5 for $600 000. S Ltd purchased
60% of the shares in SS Ltd. on the same date for $384 000. The statements of financial position
of these companies on the relevant dates were as follows:
H LTD
31/12/20-5
$
Ordinary share
capital ($1)
Share premium
General reserve
Retained profits
1 035 000
207 000
138 000
96 600
1 476 600
Non-current assets
741 750
Shares in subsidiary
600 000
Net current assets
134 850
1 476 600
ICSAZ - P.M. PARADZA
S LTD
31/12/20-4 31/12/20-5
$
$
SS LTD
31/12/20-4
31/12/05
$
$
345 000
120 750
75 900
55 200
596 850
103 500
384 000
109 350
596 850
300 000
110 400
89 700
69 000
569 100
310 500
300 000
110 400
120 000
92 800
623 200
420 000
258 600
569 100
203 200
623 200
345 000
120 750
103 500
86 250
655 500
207 000
384 000
64 500
655 500
130
REQUIRED
a) Analyse the equity structure of the subsidiaries as at 31 December 20-5
b) Draw up the consolidated balance sheet of the group as at 31 December 20-5.
SUGGESTED SOLUTION
a)
H LTD Analysis of SS Ltd's equity as at 31/12/20-4
Total equity
Price paid by S Ltd (75%)
Goodwill of H Ltd in SS Ltd
Total
$
569 100
384 000
H Ltd (45%)
$
256 095
(288 000)
31 905
NCI (55%)
$
313 005
Analysis of S Ltd's equity as at 31/12/20-4
Total equity
Price paid by H Ltd
Goodwill of H Ltd in S Ltd
Total
$
596 850
H Ltd (75%)
$
447 638
(600 000)
152 362
NCI (25%)
$
149 212
H LTD. Analysis of subsidiary reserves after acquisition
Total
$
Profit from SS: 1/1/20-5 to 31/12/20-5
Increase in general reserve
30 300
Increase in retained earnings
23 800
Profit from 1/1/20-5 to 31/31/20-5
Increase in general reserve
27 600
Increase in retained earnings
31 050
112 750
H Ltd (45%)
$
NCI (55%)
$
13 635
10 710
16 665
13 090
20 700
23 287
68 332
6 900
7 763
112 750
Summary of consolidated reserves 31/12/20-5
H LTD
S LTD
SS LTD
Share Premium
$
207 000
207 000
ICSAZ - P.M. PARADZA
Gen. Reserve
$
138 000
20 700
13 635
172 335
Retained Earnings
$
96 600
23 287
10 710
130 597
131
Calculation of consolidated non-controlling interest
In SS Ltd. 55% of equity as at 31/12/20-5 = $623 200 x 55%
= $342 760
In S Ltd. 25% of equity as at 31/12/20-5
After deducting cost of investment
Total consolidated minority interest
= (655 500 - 384 000) x 25%
= $67 875
= $342 760 + 67 875
=$410 635
Calculation of consolidated goodwill
$
152 362
31 905
184 267
H in S
H in SS
ai) Alternative layout
H LTD & ITS SUBSIDIARIES
Analysis of shareholders equity in SS Ltd as at 31 December 20-5
Total
100%
$
1. At acquisition 1/01/20-5
Share Capital
Share Premium
General Reserve
Retained Earnings
300 000
110 400
89 700
69 000
569 100
Investment in S Ltd
Goodwill
2. Since acquisition to 31/12/20-5
General Reserve (120 000 – 89 700) 30 300
Retained Earnings (92 800 – 69 000) 23 800
623 200
ICSAZ - P.M. PARADZA
S Ltd
At acq
60%
$
S Ltd
Since acq
60%
$
180 000
66 240
53 820
41 400
341 460
384 000
42 540
NCI
–
40%
$
120 000
44 160
35 880
27 600
227 640
18 180
14 280
32 460
12 120
9 520
249 280
132
aii)
H LTD & ITS SUBSIDIARIES
Analysis of shareholders equity in S Ltd as at 31 December 20-5
Total
100%
$
1. At acquisition 1/01/20-5
Share Capital
Share Premium
General Reserve
Retained Earnings
Goodwill in SS Ltd
345 000
120 750
75 900
55 200
(42 540)*1
554 310
Investment in S Ltd
Goodwill
2. Since acquisition to 31/12/20-5
General reserve (103 500 – 75 900)
27 600
General reserve in SS Ltd
18 180
31 050
Retained earnings (86 250 – 55 200)
Retained earnings in SS Ltd
14 280
645 420
H Ltd
At acq
75%
$
H Ltd
Since acq
75%
$
258 750
90 563
56 925
41 400
(31 905)
415 733
600 000
184 267
NCI
–
25%
$
86 250
30 187
18 975
13 800
(10 635)
138 577
20 700
13 635
23 288
10 710
68 558
6 900
4 545
7 762
3 570
161 129
* 1 Deduct goodwill in SS Ltd since effectively it is the group which has made the acquisition done by S Ltd in
SS Ltd. The same re-analysis is done by H for the group share of S Ltd`s share of SS Ltd post-acquisition reserves.
b)
H LTD & ITS SUBSIDIARIES
Consolidated statement of financial position as at 31 December 20-5
$
ASSETS
Non-current assets (741 750 + 207 000 + 420 000)
Goodwill
Net current assets (134 850 + 64 500 + 203 200)
Total assets
EQUITY & LIABILITIES
Share Capital & Reserves
Share capital
Share premium
General reserve (138 000 + 20 700 + 13 635)
Retained earnings (96 600 + 23 288 +10 710)
Non-controlling interest (161 354 + 249 280)
Total equity & liabilities
ICSAZ - P.M. PARADZA
1 368 750
184 267
1553 017
402 550
1 955 567
1 035 000
207 000
172 335
130 598
1 544 933
410 634
1 955 567
133
Alternative layout
Layout below is refined to suit IFRS 3 revised. You can still use the layouts above as long as
they are adjusted to meet the changes brought by IFRS 3 revised. Keeping all the possible
layouts close by is important as they also help you to appreciate what has changed and the
degree of change. That way you learn progressively. For instance, if you can perform the
analysis below as adjusted for IFRS 3 revised changes and get the right answer, it is acceptable.
See the illustration below on how to get Goodwill $184 267, Retained earnings $130 598,
General Reserve $172 335 and Non-controlling interests $410 634 in a different way and still
keep up with the IFRS.
Goodwill calculation for a vertical group scenario, where NCI is measured at
proportionate share of the acquiree`s net assets:
If the Parent entity (H Ltd) acquired a 75% interest in the Subsidiary (S Ltd) and S Ltd acquired
a 60% interest in Subsidiary (SS Ltd). H Ltd has 45% effective interest in SS Ltd and NonControlling Interest (NCI) has 55% interest in SS Ltd. Another point to note is that S Ltd
acquired an interest SS Ltd at the same date as H Ltd`s acquisition date. Therefore, it is the
group`s 75% in S Ltd which acquired a stake in SS Ltd. SS Ltd is nevertheless a sub-subsidiary
of H Ltd, because it is a subsidiary of S Ltd which in turn is a subsidiary of H Ltd. The chain
of control thus makes SS Ltd a sub-subsidiary of H Ltd which owns only 45% of its equity.
Purchase consideration transferred
Parent`s proportionate share of the acquiree`s net assets
Parent`s share of goodwill
P in S
S in SS
$
$
600 000
288 000*1
(447 638)
(256 095)*2
152 362 (A)
31 905
NCI measured at proportionate share of acquire`s net assets 149 212
Less NCI’s proportionate share of the acquiree’s net assets 149 212
NCI`s share of goodwill
Nil (B)
Goodwill
313 005
(313 005)*3
Nil
152 362 (A+B) 31 905
N.B. 1 Acquiree`s identifiable net assets acquired as represented by:
Ordinary share capital
345 000
Share premium
120 750
General reserve
75 900
Retained earnings on acquisition
55 200
596 850
300 000
110 400
89 700
69 000
569 100
This still is in effect the full goodwill method.
*1 75% x S`s cost of investment in SS
*2 45% x Fair value of SS`s identifiable net assets
*3 55% x Fair value of SS`s identifiable net assets
Total Goodwill to SFP = Goodwill from H in S + Goodwill from S in SS = $184 267
ICSAZ - P.M. PARADZA
134
Retained Profits
Closing balances per question
Provision for unrealized profit
Overstated depreciation on fair value adjustment
Pre-acquisition retained profits
Group`s share:
H Ltd in S Ltd (75% x $31 050)
H Ltd in SS Ltd (45% x $23 800)
H Ltd
$
96 600
(Nil)
(Nil)
S Ltd
$
86 250
(Nil)
(Nil)
(55 200)
31 050
SS Ltd
$
92 800
(Nil)*
(Nil)
(69 000)
23 800
S Ltd
$
103 500
(Nil)
(Nil)
(75 900)
27 600
SS Ltd
$
120 000
(Nil)*
(Nil)
(89 700)
30 300
S Ltd
$
149 212
7 763*
6 900*
(96 000)
67 875
SS Ltd
$
313 005
13 090
16 665
(Nil)
342 760
23 288
10 710
130 598
General Reserves
Closing balances per question
Provision for unrealized profit
Overstated depreciation on fair value adjustment
Pre-acquisition general reserves
Group`s share:
H Ltd in S Ltd (75% x $27 600)
H Ltd in SS Ltd (45% x $30 300)
H Ltd
$
138 000
(Nil)
(Nil)
20 700
13 635
172 335
Non-Controlling Interest
At acquisition
Share of post-acquisition retained earnings (25%/55%)
Share of post-acquisition general reserves (25%/55%)
NCI investment in SS Ltd (25% x 384 000)
* 25% x $31 050 = $ 7763 and 25% x $27 600 = $6 900
Total NCI to SFP = NCI from H in S + NCI from S in SS = $67 875 + $342 760 = $410 635
ICSAZ - P.M. PARADZA
135
EXAMPLE 3 – ACQUISITION OF CONTROLLING INTEREST IN SUBSUBSIDIARY BY SUBSIDIARY AFTER ACQUISITION BY THE ULTIMATE
PARENT OF CONTROLLING INTEREST IN SUBSIDIARY.
H Ltd. purchased 90% of the shares in S Ltd. on 1 April 20-4 for $780 000. S Ltd. purchased
70% of the shares in SS Ltd. on 1 April 20-5 for $500 000. The statements of financial position
of the 3 companies on the relevant dates were as follows:
H LTD
31/03/20-6
S LTD
31/03/20-4
S LTD
31/03/20-5
S LTD
31/03/20-6
$
$
$
$
$
$
400 000
400 000
400 000
240 000
240 000
140 000
140 000
140 000
128 000
128 000
88 000
120 000
196 000
104 000
136 000
64 000
692 000
80 000
740 000
112 000
848 000
80 000
552 000
120 000
624 000
800 000
780 000
560 000
-
140 000
500 000
220 000
500 000
360 000
416 000
132 000
1 712 000
132 000
692 000
100 000
740 000
128 000
848 000
192 000
552 000
208 000
624 000
Ordinary share
capital
1 200 000
Share
premium
240 000
General
reserve
160 000
Retained
profits
112 000
1 712 000
NCI assets
Shares in subs
Net-current
assets
SS LTD SS LTD
31/3/20-5 31/3/20-6
REQUIRED
a) Analysis of the subsidiaries' equity structures on 31 March 20-6.
b) Consolidated statement of financial position as at 31 March 20-6.
SUGGESTED SOLUTION
ai)
H LTD & ITS SUBSIDIARIES
Analysis of shareholders equity in SS Ltd as at 31 March 20-6
H Ltd
H Ltd
Total
At Acq
Since Acq
100%
70%
70%
$
$
$
1. At acquisition 1/04/20-5
Share Capital
240 000
168 000
Share Premium
128 000
89 600
General Reserve
104 000
72 800
Retained Earnings
80 000
56 000
552 000
386 400
Investment in S Ltd
500 000
Goodwill
113 600
ICSAZ - P.M. PARADZA
NCI
–
30%
$
72 000
38 400
31 200
24 000
165 600
136
2. Since acquisition to 31/03/20-6
General Reserve (136 000 - 104 000)
Retained Earnings (120 000 - 80 000)
32 000
40 000
624 000
22 400
28 000
50 400
9 600
12 000
187 200
aii)
H LTD & ITS SUBSIDIARIES
Analysis of shareholders equity in S Ltd as at 31 March 20-6
Total
100%
$
1. At acquisition 1/04/20-4
Share Capital
Share Premium
General Reserve
Retained earnings
400 000
140 000
88 000
64 000
692 000
Investment in S Ltd
Goodwill
2. Since acquisition to 31/03/20-5
General Reserve (120 000 - 88 000)
Retained Profits (80 000 - 64 000)
3. Since acquisition to 31/03/20-6
General Reserve (196 000 - 120 000)
General Reserve in SS Ltd
Retained Profits (112 000 - 80 000)
Retained Profits in SS Ltd
H Ltd
At Acq
90%
$
H Ltd
Since Acq
90%
$
360 000
126 000
79 200
57 600
622 800
780 000
157 200
NCI
–
10%
$
40 000
14 000
8 800
6 400
69 200
32 000
16 000
28 800
14 400
3 200
1 600
76 000
22 400
82 000
28 000
898 400
68 400
20 160
28 800
25 200
185 760
7 600
2 240
3 200
2 800
89 840
H LTD & ITS SUBSIDIARIES
Consolidated statement of financial position as at 31 March 20-6
ASSETS
Non-current assets (800 000 + 220 000 + 416 000)
Goodwill in subsidiaries (157 200 + 113 600)
Net-current assets (132 000 + 128 000 + 208 000)
EQUITY & LIABILITIES
Ordinary share capital
Share premium
General reserve
Retained profits
Non-controlling interest
ICSAZ - P.M. PARADZA
$
1 436 000
270 800
1 706 800
468 000
2 174 800
1 200 000
240 000
277 360
180 400
1 897 760
277 040
2 174 800
137
Alternative layout
Layout below is refined to suit IFRS 3 revised. You can still use the layouts above as long as
they are adjusted to meet the changes brought by IFRS 3 revised. Keeping all the possible
layouts close by is important as they also help you to appreciate what has changed and the
degree of change/s. That way you learn progressively. For instance, if you can perform the
analysis below as adjusted for IFRS 3 revised changes and get the right answer, it is acceptable.
See the illustration below and notice how Goodwill, NCI and the balancing figure have
changed. In this instance where acquisition of controlling interest in sub-subsidiary by
subsidiary is after acquisition by the ultimate parent of a controlling interest in subsidiary, it is
advised that you use the alternative format as below in exams to keep up with the IFRS.
You should also practice with a question that has an acquisition of controlling interest in subsubsidiary by subsidiary before acquisition by the ultimate parent of a controlling interest in
subsidiary.
Goodwill calculation for a vertical group scenario, where NCI is measured at
proportionate share of the acquiree`s net assets:
If the Parent entity (H Ltd) acquired a 90% interest in the Subsidiary (S Ltd) and S Ltd acquired
a 70% interest in Subsidiary (SS Ltd). H Ltd has 63% effective interest in SS Ltd and NonControlling Interest (NCI) has 37% interest in SS Ltd. Another point to note is that if S Ltd
acquired an interest SS (1 Apr 20-5) after P`s acquisition date 1 Apr 20-4. It is the group`s
90% in S which is acquired a controlling stake in SS.
P in S
S in SS
$
$
Purchase consideration transferred
780 000
450 000*1
Parent`s proportionate share of the acquiree`s net assets (622 800)
(347 760)*2
Parent`s share of goodwill
157 200 (A) 102 240
NCI measured at proportionate share of acquire`s net assets 69 200
Less NCI’s proportionate share of the acquiree’s net assets (69 200)
NCI`s share of goodwill
Nil (B)
Goodwill
204 240
(204 240)*3
Nil
157 200 (A+B) 102 240
N.B. 1 Acquiree`s identifiable net assets acquired as represented by:
Ordinary share capital
400 000
240 000
Share premium
140 000
128 000
General reserve
88 000
104 000
Retained earnings on acquisition
64 000
80 000
692 000
552 000
This still is in effect the full goodwill method.
*1 90% x S`s cost of investment in SS
*2 63% x Fair value of SS`s identifiable net assets
*3 37% x Fair value of SS`s identifiable net assets
Total Goodwill to SFP = Goodwill from H in S + Goodwill from S in SS = $259 440
ICSAZ - P.M. PARADZA
138
Retained Profits
Closing balances per question
Provision for unrealized profit
Overstated depreciation on fair value adjustment
Pre-acquisition retained profits
Group`s share:
H Ltd in S Ltd (90% x $48 000)
H Ltd in SS Ltd (63% x $40 000)
H Ltd
$
112 000
(Nil)
(Nil)
S Ltd
$
112 000
(Nil)
(Nil)
(64 000)
48 000
SS Ltd
$
120 000
(Nil)*
(Nil)
(80 000)
40 000
S Ltd
$
196 000
(Nil)
(Nil)
(88 000)
108 000
SS Ltd
$
136 000
(Nil)*
(Nil)
(104 000)
32 000
S Ltd
$
69 200
4 800*
10 800*
(50 000)
34 800
SS Ltd
$
204 240
14 800
11 840
(Nil)
230 880
43 200
25 200
180 400
General Reserves
Closing balances per question
Provision for unrealized profit
Overstated depreciation on fair value adjustment
Pre-acquisition general reserves
Group`s share:
H Ltd in S Ltd (90% x $108 000)
H Ltd in SS Ltd (63% x $32 000)
H Ltd
$
160 000
(Nil)
(Nil)
97 200
20 160
277 360
Non-Controlling Interest
At acquisition
Share of post-acquisition retained earnings (10%/37%)
Share of post-acquisition general reserves (10%/37%)
NCI investment in SS Ltd (10% x 500 000)
* 10% x $48 000 = $ 4 800 and 10% x $108 000 = $10 800
Total NCI to SFP = NCI from H in S + NCI from S in SS = $34 800 + $223 480 = $265 680
ICSAZ - P.M. PARADZA
139
Revised consolidated statement of financial position.
H LTD AND ITS SUBSIDIARIES
Consolidated statement of financial position as at 31 March 20-6
ASSETS
Non- current assets (800 000+220 000+ 416 000)
Goodwill in subsidiaries
$
1 436 000
259 440
1 695 440
468 000
2 163 440
Net current assets (132 000 + 128 000 + 208 000)
EQUITY & LIABILITIES
Ordinary share capital
Share premium
General reserve
Retained profits
Non-Controlling interest
1 200 000
240 000
277 360
180 400
265 680
2 163 440
5.13 COMPLEX GROUP (IFRS 3 and IAS 27 REVISED)
A complex group is one that has elements of both horizontal and vertical shareholdings. A
horizontal shareholding occurs when the holding company invests directly in more than one
subsidiary or associate company. A vertical shareholding occurs when the ultimate holding
company invests indirectly in a sub-subsidiary company through a subsidiary company. The
ultimate holding company may have its own direct investment in the sub-subsidiary. The
shareholding arising from such an investment is added to the indirect shareholding to give the
group's total shareholding in the sub-subsidiary.
Mixed relationship - H (Holding Co)
H
90%
S
16%
60%
SS
Note
H Ltd has its own direct shareholding in SS Ltd amounting to 16%. H Ltd also has an indirect
shareholding in SS Ltd through S Ltd. Effective interest of H Ltd in SS Ltd is 70% i.e (90% x
60%) + 16%.
ICSAZ - P.M. PARADZA
140
EXAMPLE 1 – COMPLEX GROUP/MIXED GROUP
The following are statements of financial position as at 31 December 20-9 for the Mosi-oaTunya Corporation, a conglomerate.
Companies
Mosi-oa-Tunya Corp
A` Zambezi Corp
Ruya Corp
$
387 500
362 500
750 000
$
220 000
230 000
450 000
$
Nil
600 000
600 000
EQUITY & LIABILITIES
Share capital ($1 shares)
400 000
Retained earnings
250 000
Liabilities
100 000
750 000
250 000
100 000
100 000
450 000
250 000
175 000
175 000
600 000
ASSETS
Investments (at cost)
Other assets
Mosi-oa-Tunya Corporation acquired 80% of the shares of A` Zambezi Corporation on 1
January 20-8 for $300 000. A` Zambezi`s retained earnings were $75 000 at that date. The fair
value of the non-controlling interest in A` Zambezi was $70 000.
Mosi-oa-Tunya acquired 30% of the shares of Ruya Corporation on 1 January 20-7 for $87 500
when Ruya Corporation`s retained earnings were $50 000.
A` Zambezi Corporation acquired 60% of the shares of Ruya on 1 January 20-8 paying $220
000 when Ruya`s retained earnings were $60 000. At this date the fair value of a 30% holding
in Ruya was $100 000 and the fair value of the NCI holding based on effective shareholding
was $72 500.
REQUIRED
Consolidated statement of financial position as at 31 December 20-9.
SUGGESTED SOLUTION
MOSI-OA-TUNYA CORPORATION AND ITS SUBISIDIARIES
Consolidated statement of financial position as at 31 December 20-9
ASSETS
Goodwill (45 000 + 38 500)
Investments (387 500 + 220 000 – 300 000 – 320 000 – 87 500)
Other assets (362 500 + 230 000 + 600 000)
EQUITY & LIABILITIES
Share capital
Retained earnings
Non-controlling interest (97 800 + 31 000)
Liabilities (100 000 + 100 000 + 175 000)
ICSAZ - P.M. PARADZA
$
83 500
Nil
1 192 500
1 276 000
400 000
372 200
128 800
375 000
1 276 000
141
WORKINGS
1. Group structure
Mosi –oa-Tunya
80% 1 Jan 20-8
30% 1 Jan 20-7
A` Zambezi
60% 1 Jan 20-8
Ruya
Consolidate A` Zambezi Corporation as an 80% subsidiary where NCI has 20% interest since
acquisition. Consolidate Ruya Corporation as a 78% subsidiary [30% + (80% x 60%) where
NCI has 22% interest.
2. Net Assets – A` Zambezi
Share capital
Retained earnings
At Acq
date
$000
250
75
325
At Reporting
date
$000
250
100
350
Therefore, post-acquisition reserves are $350 – 325 = $25
3. Net Assets – Ruya
Share capital
Retained earnings
At Acq
date
$000
250
60
310
At Reporting
date
$000
250
175
425
Therefore, post-acquisition reserves are $425 – 310 = $115
4. Goodwill – A` Zambezi investment
Fair value of Parent`s investment
NCI at fair value
Fair value of subsidiary`s net assets at acquisition
ICSAZ - P.M. PARADZA
300
70
(325)
45
142
5. Goodwill – Ruya investment
N.B. The additional shareholding of 48% is an indirect acquisition. Therefore, the cost of
investment will be subject to indirect holding adjustment.
Fair value of Parent`s investment
Fair value of previous 30%
Subsidiary`s cost of investment in Ruya
NCI`s share of investment in Ruya (20% x 220)
NCI at fair value
Fair value of subsidiary`s net assets at acquisition
6. NCI – A` Zambezi
At acquisition
NCI % x post acquisition reserves (20% x 25 000)
NCI`s share of investment in Ruya Ltd (20% x 220)
7. NCI – Ruya
At acquisition
NCI % x post acquisition reserves (22% x 115 000)
8. Group reserves
Parent`s reserves
In A` Zambezi (80% x 25)
In Ruya (78% x 115)
Gain on step acquisition
9. Step acquisition adjustment
Fair value – previous 30% (increase in goodwill)
Carrying value of previous 30% (cost)
Gain to profit or loss (increase to reserves)
ICSAZ - P.M. PARADZA
100
220
(44)
176
276.00
72.50
(310.00)
38.50
70
5
(44)
31
72.50
25.30
97.80
250.00
20.00
89.70
12.50
372.20
100.00
(87.50)
12.50
143
EXAMPLE 2 – COMPLEX GROUP/MIXED GROUP
The statements of financial position of 3 companies on 30 September 20-6 were as follows:
ASSETS
Tangible non-current assets
Investment in subsidiaries at cost:
88 200 ordinary shares of $10 each
in Y Ltd
31 360 ordinary shares of $10 each
in Z Ltd at cost
3 920 ordinary shares of $10 each
in Z Ltd each at cost
Net-current assets
EQUITY & LIABILITIES
Ordinary shares capital ($10 shares)
Reserves
X
$
980 000
Y
$
882 000
Z
$
450 000
1 176 000
343 000
294 000
2 492 850
147 000
1 372 000
42 850
196 000
646 000
1 715 000
777 850
2 492 850
980 000
392 000
1 372 000
392 000
254 000
646 000
X Ltd bought its shares in Y Ltd and Z Ltd on1 October 20-5. Y Ltd bought its shares in Z Ltd.
on the same date. On that date, the reserves of Y Ltd and Z Ltd were $120 000 and $100 000
respectively.
a) Analysis of the subsidiaries' equity on 30 September 20-6.
b) Consolidated statement of financial position as at 30 September 20-6.
SOLUTION
a)
X LTD AND ITS SUBSIDIARIES
Analysis of Y Ltd's equity as 30 September 20-6
Ordinary share capital
Reserves at 30/09/20-5
Increase to 30/09/20-6
Purchase consideration
Goodwill on acquisition
ICSAZ - P.M. PARADZA
Total
100%
$
980 000
120 000
272 000
1 372 000
H Ltd
At Acq
90%
$
882 000
108 000
Nil
990 000
(1 176 000)
186 000
H Ltd
Since Acq
90%
$
244 800
244 800
NCI
–
10%
$
98 000
12 000
27 200
137 200
144
X LTD AND ITS SUBSIDIARIES
Analysis of Z Ltd's equity as at 30 September 20-6
Ordinary share capital
Reserves at 30/09/20-5
Increase to 30/09/20-6
Total
100%
$
392 000
100 000
154 000
646 000
Purchase consideration
Goodwill on acquisition
H Ltd
At Acq
82%
$
321 440
82 000
Nil
403 440
(385 850)
17 590
H Ltd
Since Acq
82%
$
126 280
126 280
NCI
–
18%
$
70 560
18 000
27 720
116 280
b)
X LTD AND ITS SUBSIDIARIES
Consolidated statement of financial position as at 30 September 20-6
ASSETS
Tangible non-current assets (980 000 + 882 000 + 450 000)
Goodwill in subsidiaries (186 000 - 17 590)
Net current assets (294 000 + 147 000 + 196 000)
EQUITY & LIABILITIES
Ordinary share capital
Reserves (777 850 + 244 800 + 126 280)
Non-controlling interest (137 200 + 116 280)
$
2 312 000
168 410
637 000
3 117 410
1 715 000
1 148 930
253 480
3 117 410
Alternative layout
Layout below is refined to suit IFRS 3 revised. You can still use the layouts above as long as
they are adjusted to meet the changes brought by IFRS 3 revised. Keeping all the possible
layouts close by is important as they also help you to appreciate what has changed and the
degree of change. That way you learn progressively. For instance, if you can perform the
analysis below as adjusted for IFRS 3 revised changes and get the right answer, it is acceptable.
See the illustration below and notice how Goodwill, NCI and the balancing figure have
changed. It is advised that you use the alternative format as below in exams to keep up with
the IFRS.
Goodwill calculation for a complex group scenario, where NCI is measured at
proportionate share of the acquiree`s net assets:
If the Parent entity (X) acquired a 90% interest in the Subsidiary (Y) and Y acquired an 80%
interest in Subsidiary (Z). At the same time X has a direct interest in Z pegged at 10% of its
equity shares.
ICSAZ - P.M. PARADZA
145
X has 72% effective interest in Z through Y + 10% direct interest in Z, that is, a Controlling
Interest of 82% interest in Z, leaving NCI with only 18% interest.
X in Y
X&Y in Z
$
$
Purchase consideration transferred -Direct
1 176 000 42 850*1
-Indirect
308 700*2
Less Parent`s proportionate share of the acquiree`s net assets
(990 000) (403 440)*3
Parent`s share of goodwill
186 000
(51 890)
NCI measured at proportionate share of acquire`s net assets
Less NCI’s proportionate share of the acquiree’s net assets
NCI`s share of goodwill
110 000
88 560
(110 000) (88 560)*4
(Nil)
(Nil)
Goodwill
186 000
N.B. 1 Acquiree`s identifiable net assets acquired as represented by:
Ordinary share capital
980 000
Reserves
120 000
1 100 000
(51 890)
392 000
100 000
492 000
This still is in effect the full goodwill method.
*1 X`s cost of investment in Z
*2 90% x Y`s cost of investment in Z
*3 82% x Fair value of Z`s identifiable net assets
*4 18% x Fair value of Z`s identifiable net assets
Total Goodwill to SFP = Goodwill from X in Y + Goodwill from Y in Z = 186 000 – 51 890
= $134 110
Reserves
Closing balances per question
Provision for unrealized profit
Overstated depreciation on fair value adjustment
Pre-acquisition reserves
Group`s share:
X Ltd in Y Ltd (90% x $272 000)
X Ltd in Z Ltd (82% x $154 000)
X Ltd
$
777 850
(Nil)
(Nil)
Y Ltd
$
392 000
(Nil)
(Nil)
(120 000)
272 000
Z Ltd
$
254 000
(Nil)*
(Nil)
(100 000)
154 000
Y Ltd
$
110 000
27 200*
(34 300)
102 900
Z Ltd
$
88 560
27 720
(Nil)
116 280
244 800
126 280
1 148 930
Non-Controlling Interest
At acquisition
Share of post-acquisition reserves (10%/18%)
NCI investment in SS Ltd (10% x 343 000)
ICSAZ - P.M. PARADZA
146
* 10% x $272 000 = $27 200 and 10% x $108 000 = $10 800
Total NCI to SFP = NCI from H in Y + NCI from Y in Z = $102 900 + $116 280 = $219 180
Revised consolidated statement of financial position.
X LTD & ITS SUBSIDIARIES
Consolidated statement of financial position as at 30/09/20-6
ASSETS
Tangible non-current assets (980 000+882 000+450 000)
Goodwill in subsidiaries
Net current assets (294 000+ 147 000+196 000)
EQUITY & LIABILITIES
Ordinary share capital
Reserves
Non-controlling interest
$
2 312 000
134 110
2 446 110
637 000
3 083 110
1 715 000
1 148 930
219 180
3 083 110
Mark to market reserve – complex group
In keeping with one economic entity principle per IFRS 3 the market to market reserve still
have to be eliminated with the exception of that which belongs to a trade or simple investment.
You should note that, in a complex group question the mark to market reserve in the parent`s
separate financial statements may relate to both the subsidiary and a trade or simple investment
whereas the mark to market reserve in the subsidiary`s separate financial statements may relate
to both its own subsidiary (sub-subsidiary to the parent company) and own trade or simple
investment.
Below is the working you perform:
Mark to market reserve in the parent`s separate financial statements
Mark to market reserve in the subsidiary`s separate financial statements
xx
xx
xx
Mark to market reserve in parent` books relating to the subsidiary
(xx)
Mark to market reserve in subsidiary`s books relating to own subsidiary
(xx)
xx
NCI`s share of mark to market reserve relating to trade/simple investment in Sub (xx)
Mark to market reserve in consolidated financial statements
xx
5.14 INVESTMENT IN ASSOCIATE AND JOINT VENTURES (IAS 28)
An associate company is one in which the investor company holds a significant share which is,
however, not sufficient to ensure control of the investee company. Another distinguishing
feature of an associate company is that the investment must be held on a long-term basis, and
enable the investor company meaningful participation in the investee company's affairs. The
standard defines an associate as an entity, including an unincorporated entity such as a
ICSAZ - P.M. PARADZA
147
partnership, over which an investor has significant influence and which is neither a subsidiary
nor a joint venture of the investor.
Significant influence is the power to participate in the financial and operating policy decisions
of an economic activity but is not control or joint control over those policies.
A shareholding of 20% to 50% in the investee company is usually taken as being necessary to
establish an associate company relationship. However, other relevant circumstances should be
considered for example, an investee company may be an associate company due to the
concentration of the ownership of its shares.
IAS 28 (Accounting for Investments in Associates) states that significant influence by an
investor is usually shown by the existence of the following:
i) representation on the board of directors or equivalent governing body
ii) participation in the investee's policy making processes
iii) material transactions between the investor and the investee
iv) inter-change of managerial personnel
v) provision of essential technical information
Joint control is the contractually agreed sharing of control over an economic activity.
The equity method is a method of accounting whereby the investment is initially recorded at
cost and adjusted thereafter for the post acquisition change in the investor's share of net assets
of the investee. The profit or loss of the investor includes the investor's share of the profit or
loss of the investee and the investor’s other comprehensive income includes its share of the
investee's other comprehensive income.
IAS 28 requires all investments in associates and joint ventures to be accounted for using the
equity method, unless the investment is classified as “held for sale” in accordance with IFRS
5 in which case it should be accounted for under IFRS 5.
Important Note!!
You should be aware of the benefits of using the equity method as stated by IAS 28.
Cost method versus equity method
According to the cost method (only used if the investment is classified as held for sale in
accordance with IFRS 5 or for IAS 27 exceptions):
The investment in the investee is recorded at cost.
Income is recognised only to the extent that it presents distributions from the retained profits
of the investee subsequent to the date of acquisition. Distributions received in excess of such
ICSAZ - P.M. PARADZA
148
profits are considered a recovery of investment and recorded as a reduction of the cost of the
investment*1.
ILLUSTRATION – COST METHOD
Limpopo Limited acquired a 35% share in the equity share capital of Zambezi Limited on 1
January 20-5 for $60 000. The share capital of Zambezi Limited consists of 100 000 ordinary
shares of $1 each. Each share carries one vote. The profit for the period and dividends paid by
Zambezi Limited for the financial year ending 31 December 20-5 and 20-6 are as follows:
Profit for the period
Dividends paid
20-6
$
85 000
17 000
20-6
$
50 000
55 000
REQUIRED
Prepare the journal entries in the accounting records of Limpopo Limited for the year ended
31 December 20-5 and 20-6 to account for its investment in Zambezi limited according to the
cost method.
SUGGESTED SOLUTION
1 January 20-5
$
$
DEBIT
Investment in Zambezi Limited
60 000
CREDIT
Bank
60 000
Being recognition of the purchase consideration paid to 35% of Zambezi Limited`s equity
shares.
31 December 20-5
DEBIT
Bank (55 000 x 35%)
19 250
CREDIT
Dividend income
17 500
CREDIT
Investment in Zambezi Limited (55 000-50 000) x 35%
1 750*1
Being recognition of share of Zambezi Limited`s dividend declared.
31 December 20-6
DEBIT
Bank (17 000 x 35%)
CREDIT
Dividend income
Being recognition of share of Zambezi Limited`s dividend declared.
5 950
5 950
Equity method
An investment in associate is equity accounted in the consolidated financial statements
according to the equity method from the date on which it falls within the definition of an
associate, with the following circumstances being the only exceptions:
i)
ii)
An investment classified as held for sale in accordance with IFRS 5
The exceptional cases in IAS 27 where the standard allows a parent that also has an
investment in associate not to present consolidated annual financial statements; or
ICSAZ - P.M. PARADZA
149
iii)
All of the following apply
(a) The investor is a wholly-owned subsidiary or it is a partially owned subsidiary of another
entity and its other owners, including those not otherwise entitled to vote, have been informed
about, and do not object to, the investor not applying the equity method
(b) Its securities (debt or equity instruments) are not publicly traded
(c) It is not in the process of issuing securities in public securities markets (it did not file, nor
is it in the process of filing, its financial statements with a securities exchange commission
[SEC] for the purposes of issuing any class of instruments on the Zimbabwe Stock Exchange
or any other)
(d) The ultimate or any intermediate parent publishes or produces consolidated annual financial
statements that comply with International Financial Reporting Standards.
According to the equity method, the investment is initially measured at cost (not the cost
method, just original cost) and subsequently measured at the carrying amount increased or
decreased to recognise the investor`s share of post-acquisition profits or losses of the investee.
Distributions received from the investee have the effect of reducing the carrying amount of the
investment. The carrying amount may also need to be adjusted to reflect changes in the
investee's equity that are not recorded in the profit or loss section of the income statement.
These changes may arise from:
a) revaluation of property, plant and equipment and investments (OCI)
b) foreign exchange translation differences
c) adjustments of differences resulting from business combinations.
Guidelines for using the Equity Method
a) most recent available financial statements of the associate company should be used when
applying the equity method.
b) If the reporting dates of the investor company and the associate company are different, the
latter should prepare financial statements with the same year end as that of the former.
c) If the accounting policies of the investor company and the associate company are different,
the latter's financial statements should be appropriately adjusted before the equity method is
used.
d) If the investor company's share of an associate company's losses equals or exceeds the
carrying amount of the investment, the former should stop accruing further losses, but instead
report the investment at nil value.
ILLUSTRATION – EQUITY METHOD
Limpopo Limited acquired a 35% share in the equity share capital of Zambezi Limited on 1
January 20-5 for $60 000. The share capital of Zambezi Limited consists of 100 000 ordinary
shares of $1 each. Each share carries one vote. The profit for the period and dividends paid by
Zambezi Limited for the financial year ending 31 December 20-5 and 20-6 are as follows:
ICSAZ - P.M. PARADZA
150
Profit for the period
Dividends paid
20-6
$
85 000
17 000
20-5
$
50 000
55 000
REQUIRED
Prepare the journal entries in the accounting records of Limpopo Limited for the year ended 31
December 20-5 and 20-6 to account for its investment in Zambezi limited according to the cost
method.
SUGGESTED SOLUTION
1 January 20-5
$
$
DEBIT
Investment in Zambezi Limited
60 000
CREDIT
Bank
60 000
Being recognition of the purchase consideration paid to 35% of Zambezi Limited`s equity
shares.
31 December 20-5
DEBIT
Investment in Zambezi Limited (50 000 x 35%)
CREDIT
Share of profit after tax of associate
Being recognition of share of Zambezi Limited`s profit after tax.
31 December 20-5
DEBIT
Bank (55 000 x 35%)
CREDIT
Investment in Zambezi Limited
Being recognition of share of Zambezi Limited`s dividend declared.
31 December 20-6
DEBIT
Investment in Zambezi Limited (85 000 x 35%)
CREDIT
Share of profit after tax of associate
Being recognition of share of Zambezi Limited`s profit after tax.
31 December 20-6
DEBIT
Bank (17 000 x 35%)
CREDIT
Dividend income
Being recognition of share of Zambezi Limited`s dividend declared.
17 500
17 500
19 250
19 250
29 750
29 750
5 950
5 950
5.14.1 TREATMENT OF LOSSES IN ASSOCIATES
When an associate has incurred losses the carrying value of the investment can be written down
to nil. At this stage the use of the equity method ceases. Should the associate subsequently
become profitable the losses that may not have been recognised will first be recovered before
the use of the equity method recommences.
ICSAZ - P.M. PARADZA
151
EXAMPLE 1 – ASSOCIATE
The financial statements of 3 companies for the year-ended 30 June 20-6 were as follows:
Statement of comprehensive income for Y/E 30/06/20-6
Sales
Cost of goods sold
Gross profit
Distribution costs
Administration costs
Operating profits
Dividends receivable
- S Ltd 70 %
-A Ltd 25%
Profit before tax
Company tax
Net profit after tax
H Ltd
$
980 200
(245 050)
735 150
(98 020)
(49 010)
588 120
S Ltd
$
490 100
(147 030)
343 070
(24 505)
(29 406)
289 159
A Ltd
$
245 050
(98 020)
147 030
(29 406)
(34 307)
83 317
70 000
12 500
670 620
(245 000)
425 620
Nil
Nil
289 159
(107 800)
181 359
Nil
Nil
83 317
(39 200)
44 117
Statements of changes in equity for Y/E 30/06/20-6
Retained Earnings
H Ltd
$
946 400
425 620
1 372 020
(250 000)
1 122 020
Balance b/f
Net profit after tax
Proposed dividends
Balance c/f
S Ltd
$
283 920
181 359
465 279
(100 000)
365 279
A Ltd
$
185 920
44 117
230 037
(50 000)
180 037
Statements of financial position as at 30/06/20-6
ASSETS
Tangible non-current assets
Investment in quoted companies:
S Ltd (70%)
A Ltd (25%)
Current Assets
Inventory
Trade receivables
Dividends receivable
Cash at bank
ICSAZ - P.M. PARADZA
H LTD
$
S LTD
$
A LTD
$
980 000
295 000
260 000
396 981
88 218
–
42 600
822 799
39 208
34 307
–
52 460
384 975
344 000
63 000
343 070
352 872
82 500
85 300
2 250 742
152
EQUITY & LIABILITIES
Ordinary share capital
($1 shares)
Retained earnings
Long-term liabilities
Proposed dividends
500 000
250 000
100 000
1 122 020
378 722
250 000
2 250 742
365 279
107 520
100 000
822 799
180 037
54 938
50 000
384 975
Additional Information
When H Ltd acquired its shares in the other companies many years ago, the retained profits of
these companies were $150 000 and $86 200 for S Ltd. and A Ltd respectively.
REQUIRED
a) A consolidated income statement for the year-ended 30 June 20-6.
b) A consolidated statement of changes in equity for the year-ended 30 June 20-6.
c) A consolidated statement of financial position as at 30 June 20-6.
SUGGESTED SOLUTION
a)
H LTD & ITS SUBSIDIARY
Consolidated statement of comprehensive income for the year ended 30 June 20-6
$
Sales (980 200 + 490 100)
1 470 300
Cost of goods sold (245 050 + 147 030)
(392 080)
Gross profit
1 078 220
Distribution costs (98 020 + 24 505)
(122 525)
Administration costs (49 010 + 29 406)
(78 416)
Share of A Ltd`s profit (25% x 83 317)
20 829
Profit before tax
898 108
Company tax
H Ltd & its subsidiary (245 000 + 107 800)
(352 800)
A Ltd (25% x 39 200)
(9 800)
Profit after tax
535 508
Attributable to non-controlling interest
(54 408)
Attributable to equity holders of parent
481 100
ICSAZ - P.M. PARADZA
153
b)
H LTD & ITS SUBSIDIARY
Consolidated statement of changes in equity for the year ended 30 June 20-6
Bal b/d 1/07/20-5
Proposed dividends
Total
comprehensive
income
Bal c/d 30/09/20-5
Share
Capital
$
500 000
500 000
Retained
Earnings
$
1 065 074
(262 500)
Total
NCI
Total
$
1 565 074
(262 500)
$
160 176
(30 000)
$
1 725 250
(292 500)
481 100
1 283 674
481 100
1 783 724
54 408
184 584
535 558
1 968 308
Opening balance Retained earnings (964 400 + 93 744 + 24 930)
Opening balance NCI (120 000 + 40 176)
c)
H LTD & ITS SUBSIDIARY
Consolidated statement of financial position as at 30 June 20-6
$
ASSETS
Non-current assets (980 000 + 295 000)
Goodwill
Investment in A Ltd
Current assets
Inventory (343 070 + 396 981)
Trade receivables (352 872 + 88 218)
Cash at bank (85 300 + 42 600)
Total assets
EQUITY & LIABILITIES
Share Capital & Liabilities
Share capital
Retained earnings
Non-controlling interest
Non-current liabilities (378 722 + 107 520)
Current liabilities
Proposed dividends (250 000 + 30 000)
Total equity & liabilities
ICSAZ - P.M. PARADZA
1 275 000
64 000
86 459
1 425 459
740 051
441 090
127 900
2 734 500
500 000
1 283 674
1 783 674
184 584
1 968 258
486 242
280 000
2 734 500
154
H LTD & ITS SUBSIDIARY
WORKINGS
1. Analysis of shareholders equity in A Ltd as at 30 June 20-6
Total
100%
$
1. At acquisition
Share Capital
Retained Earnings
100 000
86 200
186 200
Investment in S Ltd
Goodwill
H Ltd
At Acq
25%
$
H Ltd
Since Acq
25%
$
25 000
21 550
46 550
63 000
16 450
NCI
–
–
$
–
–
–
2. Since acquisition to 1/07/20-5
Retained Profit
(185 920 - 86 200)
99 720
24 930
–
3. Current financial year
(1/07/20-5 to 30/06/20-6)
Profit after tax
44 117
Proposed dividends (50 000)
280 037
11 029
(12 500)
23 459
–
–
–
2. Analysis of shareholders equity in A Ltd as at 30 June 20-6
Total
100%
$
1. At acquisition
Share Capital
Retained Earnings
250 000
150 000
400 000
Investment in S Ltd
Goodwill
H Ltd
At Acq
70%
$
H Ltd
Since Acq
70%
$
175 000
105 000
280 000
344 000
64 000
NCI
–
30%
$
75 000
45 000
120 000
2. Since acquisition to 1/07/20-5
Retained Profits
(283 920 - 150 000) 133 920
93 744
40 176
3. Current financial year
(1/07/20-5 to 30/06/20-6)
Profit after tax
181 359
Proposed dividends (100 000)
615 279
126 951
(70 000)
150 695
54 408
(30 000)
184 584
ICSAZ - P.M. PARADZA
155
3. Part of consolidation journal entries
Dr
$
70 000
Proposed dividends SFP
(S Ltd) (70% x 100 000)
(A ltd) (25% x 50 000)
12 500
Dividends receivable SFP (H Ltd)
Being elimination of common items
Dividends receivable SCI (H ltd)
Proposed dividends SOCIE
Cr
$
82 500
82 500
(S Ltd)
(A Ltd)
70 000
12 500
Being elimination of common items
4. Carrying amount of investment in A Ltd
Purchase Consideration
Add post acquisition reserves
- Retained earnings
- Profit after tax
- Proposed dividends
63 000
24 930
11 029
(12 500)
23 459
86 459
Below is an alternative calculation of retained profits and other reserves of H Ltd and NCI for
the consolidated statement of financial position with the same results as above
Retained profits
H Ltd
$
1 122 020
(Nil)
(Nil)
Closing balances per question
Provision for unrealized profit
Overstated depreciation on fair value adjustment
Pre-acquisition retained profits
Group`s share:
H Ltd in S Ltd (70% x $215 279)
H Ltd in A Ltd (25% x $93 837)
Impairment of goodwill for investment in S Ltd
Impairment of investment in A Ltd
Share of dividend proposed in A ltd
S Ltd
$
365 279
(Nil)
(Nil)
(150 000)
215 279
A Ltd
$
180 037
(Nil)*
(Nil)
(86 200)
93 837
150 695
23 459
(Nil)
(Nil)
(12 500)
1 283 674
Non-Controlling Interest
At acquisition
Share of post-acquisition retained profits (30% x *215 279)
Share of post-acquisition reserves
Impairment of goodwill for investment in S Ltd
1 200 000
64 584
Nil
(Nil)
184 584
* (Nil) – zero in the case in point, if it were there it was subtractable.
ICSAZ - P.M. PARADZA
156
Important Note!!
You need to go in exams with basic awareness of accounting treatment where the investment
in an associate is held by a subsidiary in which there are non-controlling interests, in other
words a partially owned subsidiary. The examples you have encountered above are only cases
where the investment in an associate is held by the parent.
Student Note 1:
- Separate financial statements of the investor company carries an interest in an associate either:
i) at cost, or ii) per IFRS 9
- Application of Equity Method to joint ventures is covered under 5.15 beneath at the same
time their applicability to Joint Arrangements too is addressed.
Student Note 2:
There is nothing that can stop you from calculating goodwill on acquisition of an associate
because the principle of goodwill arising when purchase consideration exceeds fair value of
investee`s identifiable net assets still holds. However, it evidently is calculated using the partial
goodwill method since NCI is non-existent (the investor in effect is the NCI). In the
consolidated SFP you will not have this goodwill showing separately as the case is with a
subsidiary scenario. It is part or a component of the purchase consideration to which you add
investor`s share of investee`s post-acquisition reserves in order to get the carrying amount (your
line item). Impairment of such goodwill should naturally reduce the carrying amount of such
investment, but there is no separate testing for impairment of goodwill, as it forms part of the
carrying amount of an investment in an associate. The impairment loss is not allocated to any
asset, including goodwill, which forms part of the carrying amount of the investment in
associate. It is recognised in accordance with IAS 36 - Impairment of assets for each investment
in associate as a single asset. This is unlike how you treat goodwill in a subsidiary scenario.
Impairment Losses
If there is an indication that an investment in an associate company may be impaired, the
investor company should apply IAS 36 - Impairment of Assets. The valuation of the investment
should be based on:
i.
the investor company's share of the present value of the estimated future cash flows
expected to be generated by the investee company, including the proceeds from the
disposal of the investment.
ii.
the present value of the estimated future cash flows from dividends and the proceeds
from the investment's disposal.
ICSAZ - P.M. PARADZA
157
The consolidated statement of financial position
In the consolidated statement of financial position, the investor company's effective share in
the associate company should be shown. This is achieved by including the cost of the
investment less any amounts written off, and the holding company's share of the postacquisition retained profits (or losses) and reserves of the associate company.
The consolidated statement of profit or loss and other comprehensive income
The format for the consolidated statement of profit or loss and other comprehensive income
including an associate company appears as shown below:
$
Operating profit of holding/investor and subsidiaries
(after charging depreciation and all other trading expenses)
Share of profits or losses after tax of associate companies*
Profit before tax
Company tax expense (holding/investor company & subsidiaries)
Profit after tax
(A)
xx
xx
xx
(xx)
xx
Other comprehensive income
Gain on revaluation of non-current assets (holding/investor & subsidiaries)
Tax expense on other comprehensive income (holding/investor & subsidiaries)
Share of other comprehensive income after tax of associate companies
Other comprehensive income net of tax
(B)
xx
(xx)
xx
xx
Total comprehensive income
(A+B) xx
Non-Controlling Interest in subsidiaries total comprehensive income
Total comprehensive income attributable to equity holders of parent
(xx)
xx
* Alternatively
Operating profit of holding/investor and subsidiaries
Share of profits or losses before tax of associate companies
Profit before tax
Company tax expense
- holding/investor company & subsidiaries
- associate
Profit after tax
xx
xx
xx
(xx)
(xx)
xx
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5.15 JOINT ARRANGEMENTS (IFRS 11)
Joint arrangement, Joint control, Joint operation, Joint venture
IFRS 11 describes the accounting for ‘joint arrangements’ over which two or more parties have
joint control. Whereas current IFRS focuses more on the legal form of the arrangement when
determining the appropriate accounting, IFRS 11 focuses on the nature of the rights and
obligations of the arrangement. A joint arrangement can be either a joint venture or a joint
operation. Joint ventures are to be equity accounted as the IASB eliminated the option of
proportionate consolidation (Ernst and Young). It appears the proportionate consolidation
method is still applicable to a joint operator given that the standard requires that a joint operator
recognises line-by-line basis, its share of assets, liabilities, revenues and expenses and/or its
share of those items, if any.
Party to a joint arrangement
It is an entity that participates in a joint arrangement, regardless of whether that entity has joint
control of the arrangement.
Separate vehicle
This is a separately identifiable financial structure, including separate legal entities or entities
recognised by statute, regardless of whether those entities have a legal personality.
Whether a joint arrangement is a joint venture or a joint operation requires careful judgement*.
* Criteria provided by the standard for the above determination:
Question 1 – Does the legal form of the separate vehicle (a separate entity) formed give the
parties rights to the assets and obligations for the liabilities relating to the arrangement? If
answer is yes you have a joint operation, if no, ask the second question.
Question 2 – Do the terms of the contractual arrangement give the parties rights to the assets
and obligations for the liabilities relating to the arrangement? If the answer is yes you have a
joint operation, if no, ask the third and last question.
N.B. In the first place, if there is no contractual arrangement, then a joint arrangement does not
exist and this is what is key to distinguishing between joint arrangements from an investments
in associates.
Question 3 – Do other facts and circumstances give the parties rights to the assets and
obligations for the liabilities relating to the arrangement? If the answer is yes, at last you have
a joint operation, if no, absolutely you have a joint venture.
ICSAZ - P.M. PARADZA
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Student & Tutorial Note:
This distinction is critical if the correct accounting treatment is to be given to the acquisition
transaction given in a question. The accounting treatment for a joint venture is different from
that of a joint operation. This area has an impending exposure draft on acquisition of an interest
in a joint operation issued by the International Accounting Standards Board (IASB) in
December 2012. You should keep updated on its development.
A joint arrangement is an arrangement of which two or more parties have joint control.
Joint control is the contractually agreed sharing of control of an arrangement, which exists only
when decisions about the relevant activities require the unanimous consent of the parties
sharing control.
A joint operation is a joint arrangement whereby the parties that have joint control of the
arrangement have rights to the assets and obligations for the liabilities relating to the
arrangement.
A joint venture is a joint arrangement whereby the parties that have joint control of the
arrangement have rights to the net assets of the arrangement.
You should be aware of the application of IAS 28 (2011) to joint ventures and the accounting
treatment required through use of the equity method.
The consolidated statement of financial position is prepared by:
i)
including the interest in the joint venture at cost plus share of post-acquisition total
comprehensive income
ii)
including the group share of the post-acquisition total comprehensive income in
group reserves
The consolidated statement of profit or loss and other comprehensive income will include:
i)
the group share of the joint venture's profit or loss
ii)
the group share of the joint venture's other comprehensive income
Also take note that the use of the equity method should be discontinued from the date on which
the joint venturer ceases to have joint control over, or have significant influence on, a joint
venture.
You should be aware of the application of IAS 28 (2011) to joint operations and the accounting
treatment required through use of the line by line basis, more or less, the proportionate
consolidation method of the following items for the investor:
ICSAZ - P.M. PARADZA
160
i)
own assets, plus share of any jointly held assets
ii)
own liabilities, plus share of any jointly incurred liabilities
iii)
own revenue from the sale of its share of the output arising from the joint operation
iv)
share of the revenue from the sale of the output by the joint operation
v)
own expenses, plus share of any expenses incurred jointly
EXAMPLE – JOINT ARRANGEMENTS
Mhodzi Ltd, Manhanga Ltd and Chenga Ltd teamed up in a joint arrangement through
formation of a separate economic entity Ose Ltd.
Each of the teaming parties have 1/3 economic and ownership interest in Ose Ltd.
Ose Ltd is a separate vehicle with sole rights and obligations to its assets and liabilities at law
even though the contractual arrangement between the three teaming parties does not specify
their rights and obligations to assets and liabilities in Ose Ltd. In other words the parties have
rights to net assets (equity) of the joint arrangement thereby making it a joint venture not a joint
operation.
Mhodzi Ltd paid $50 000 for its interest in Ose Ltd on 1 January 20-8. It has joint control over
mining equipment hired out to small scale miners in Zimbabwe. The original cost of the mining
equipment is $210 000 per the contractual arrangement.
For the year ended 31 December 20-8 the mining equipment hired out/rented out generated
rental income amounting to $60 000 and administration and maintenance costs amounting to
$23 450. Depreciation expense included in the admin costs is $14 000 assuming a 15 year
useful life of the mining equipment.
REQUIRED
Extract disclosures in the Statement of financial position, statement of profit or loss and other
comprehensive income and notes to the financial statements.
ICSAZ - P.M. PARADZA
161
SUGGESTED SOLUTION
EXTRACT STATEMENT OF FINANCIAL POSITION AS AT 31 DECEMBER 20-8
Investment in joint venture
$
62 183
The calculation is per the equity method, that is, $50 000 + [1/3 x (60 000- 23 450)]
EXTRACT STATEMENT OF PROFIT OR LOSS AND OTHER COMPREHENSIVE
INCOME FOR THE YEAR ENDED 31 DECEMBER 20-8
Share of joint venture`s profit (1/3 x ($60 000 – 23 450)
$
12 183
EXTRACT NOTES TO THE FINANCIAL STATEMENTS
1. Accounting Policy
The company entered into a contractual arrangement in which it has a 1/3 economic and
ownership interest in Ose Ltd. The investment in the joint venture is measured using the equity
method in line with the prescription from IAS 28 – Investments in associates and joint ventures.
Ose Ltd has mining equipment that it owns and rents out for income generation.
Below is the summary financial information for Ose Ltd:
Non-current assets
Mining equipment (210 000 – 14 000)
$
196 000
Revenue
Rental income
60 000
Operating expenses
Depreciation
Other administration and maintenance costs ($23 450 – 14 000)
14 000
9 450
5.16 CROSSING THE BOUNDARY ACCOUNTING (IFRS 3 and IAS 27 REVISED)
Piecemeal or Step acquisitions
A piecemeal or step acquisition refers to obtaining a controlling interest through two or more
separate transactions (several successive share purchases). The IASB now requires the use of
the principle that a change in control is a significant economic event. Accordingly, changes to
IFRS 3 and IAS 27 work together with the effect that a business combination occurs, and
acquisition accounting (acquisition method) is applied, only at the date that control is achieved.
Consequently, goodwill is identified and net assets remeasured to fair value only in respect of
the transaction that achieved control, and not in respect of any earlier or subsequent
acquisitions of equity interests. In measuring goodwill, any previously-held interests in the
acquiree are first remeasured to fair value, with any gain recognised in profit or loss (including
ICSAZ - P.M. PARADZA
162
the reclassification to profit or loss of any gains previously recognised in other comprehensive
income if this would be required on disposal).
5.16.1 FROM ASSOCIATE TO SUBSIDIARY
The following examples to illustrate consolidation procedures when shares in a subsidiary
company are acquired in a ‘piecemeal’ approach to eventual control:
EXAMPLE 1 – ASSOCITATE TO SUBSIDIARY
1. The balance sheets of H Ltd and S Ltd on 31 December 20-6 were as follows:
H LTD
S LTD
ASSETS
$
$
Tangible non-current assets
635 200
530 000
Investment S Ltd at cost (288 000 shares)
508 800
Net-current assets
265 000
301 400
1 409 000
831 400
EQUITY & LIABILITIES
Ordinary share capital ($1 shares)
General reserve
Retained earnings
850 000
243 500
315 500
1 409 000
480 000
174 600
176 800
831 400
Additional information
H Ltd acquired 192 000 shares in S Ltd for $350 000 on 1 January 20-4 when S Ltd's reserves
were as follows:
General reserve
$50 000
Retained earnings
$80 000
H Ltd acquired a further 96 000 shares in S Ltd. for $158 800 on 1 January 20-5 when S
Ltd.'s reserves were as follows:
General reserve
$100 000
Retained profits
$140 000
Assume that H Ltd had always wanted to achieve eventual control of S Ltd.
REQUIRED
i) Goodwill and analysis of Parent`s share in S Ltd`s equity assuming NCI is measured at its
proportionate share of S Ltd`s identifiable net assets.
ii) Consolidated statement of financial position as at 31 December 20-6
SUGGESTED SOLUTION
IFRS 3 revised observes that a business combination occurs only when one entity obtains
control over another (from no control to having control, that is, a change in status scenario).
Therefore, using an alternative approach to the piecemeal method of analysis above, ignore all
ICSAZ - P.M. PARADZA
163
purchases made before control is achieved, that is, those purchases bringing the total holding
to less than 50%. That is how you should compute your answer.
Tutorial & Student Note:
You should take note that if you can impart /do what is below using the analysis of shareholders
equity method that is also welcome in exams. What is important is to ensure changes needed
by IFRS 3 have been applied in your computations.
After initial acquisition
After second acquisition
1 Jan 20-4
1 Jan 20-5
40% Significant influence Associate
60% Control
Subsidiary
Goodwill calculation for a piecemeal acquisition of controlling interest scenario (from
Associate to Subsidiary), where NCI is measured at proportionate share of the acquiree’s
identifiable net assets:
H in S
$
Purchase consideration transferred at date of acquiring control
158 800*1
Fair value of previously held equity interest
317 600*2
Less Parent`s proportionate share of the acquiree`s net assets
(432 000)*3
Parent`s share of goodwill
44 400 (A)
NCI measured at proportionate share of the acquiree’s net assets
Less NCI’s proportionate share of the acquiree’s net assets
NCI`s share of goodwill
Total Goodwill
N.B. 1 Acquiree`s identifiable net assets acquired as represented by:
Ordinary share capital
General reserve
Retained earnings on acquisition on acquisition of controlling stake
288 000*4
(288 000)*4
Nil (B)
44 400 (A+B)
480 000
100 000
140 000
720 000
*1 Purchase consideration transferred at date of acquisition of controlling interest by H
*2 If the associate interest was 40% and the additional interest acquired is 20% then the
calculation is 40/20 x *1
*3 60% x the identifiable net assets of subsidiary at date of acquiring controlling interest by H
60% x ($720 000)
*4 40% x the identifiable net assets of subsidiary at date of acquiring controlling interest by H
N.B. The previously held interest at fair value, together with any consideration transferred,
forms the cost of the combination used in order to calculate goodwill.
ICSAZ - P.M. PARADZA
164
Retained profits
H Ltd
$
Closing balances per question/at control acquisition 315 500
Loss on derecognition of investment in associate
(76 400)
Pre-acquisition reserves
Group`s share:
H Ltd in S Ltd at 40% (40% x $60 000)
H Ltd in S Ltd at 60% (60% x $36 800)
Less fair value gain recognised in H Ltd`s books
S Ltd (40%) S Ltd(60%)
$
$
140 000
176 800
(80 000)
60 000
(140 000)
36 800
24 000
22 080
(Nil)
285 180
Loss on derecognition of 40% significant influence
Fair value at date control achieved
H Ltd's share of carrying amount
317 600
394 000
(76 400)
(see point emphasis below)
General Reserves
H Ltd
$
Closing balances per question/at control acquisition 243 500
Pre-acquisition reserves
Group`s share:
H Ltd in S Ltd at 40% (40% x $50 000)
H Ltd in S Ltd at 60% (60% x $74 600)
S Ltd (40%) S Ltd(60%)
$
$
100 000
174 600
(50 000)
(100 000)
50 000
74 600
20 000
44 760
308 260
Non-Controlling Interest
At acquisition
Share of post-acquisition retained profit post control
Share of post-acquisition general reserves post control
S Ltd
$
288 000
14 720*
29 840*
332 560
* 40% x $36 800 = $14 720 and 40% x $74 600 = $29 840
ICSAZ - P.M. PARADZA
165
H LTD & ITS SUBSIDIARY
Consolidated statement of financial position as at 31 December 20-6
ASSETS
Tangible non-current assets (635 200 + 530 000)
Goodwill
Net current assets (265 000 + 301 400)
EQUITY
Ordinary share capital
General reserve
Retained profits
Non-controlling interest
$
1 165 200
44 400
1 209 600
566 400
1 776 000
850 000
308 260
285 180
332 560
1 776 000
Point Emphasis!!
N.B1 The above is what you do only when not given current market values of equity
instruments of S Ltd at date control is achieved by H Ltd. For instance if price is given as
$2.50 per share on an active market, the level 1 fair valuation of investment in associate
becomes possible and the calculation of profit or loss would differ slightly as shown below:
N.B2 Profit/Loss on derecognition of 40% significant influence
Fair value at date control obtained (40% x 480 000 shares x $2.5)
H Ltd's share of carrying amount 350 000 + [(140 – 80 + 100 – 50) x 40%]
The fair value of NCI at date control is achieved would have been
(40% x 480 000 shares x $2.50)
The fair value of H Ltd's previously held equity interest
(480 000 x 40% x $2.50)
ICSAZ - P.M. PARADZA
$
480 000
394 000
86 000
480 000
480 000
166
EXAMPLE – INCLUDING ASSOCIATE TO SUBSIDIARY, HORIZONTAL GROUP
& JOINT VENTURE (comprehensive question)
ACCA December 2014 examination question paper (Extracted from Q1, question
requirement adapted)
Joey, a public limited company, operates in the media sector. Joey has investments in two
companies. The draft statements of financial position at 30 November 20-4 are as follows:
Joey
$m
Margy
$m
Hulty
$m
3,295
2,000
1,200
1,675
700
5,670
Nil
2,000
Nil
1,200
Current assets
Total assets
985
6,655
861
2,861
150
1,350
EQUITY AND LIABILITIES
Share capital
Retained earnings
Other components of equity
Total equity
Non-current liabilities
Current liabilities
Total liabilities
Total equity and liabilities
850
3,340
250
4,440
1,895
320
2,215
6,655
1,020
980
80
2,080
675
106
781
2,861
600
350
40
990
200
160
360
1,350
ASSETS
Non-current assets
Property, plant and equipment
Investments in subsidiaries and other investments
Margy
Hulty
The following information is relevant to the preparation of the group financial statements:
1. On 1 December 20-1, Joey acquired 30% of the ordinary shares of Margy for a cash
consideration of $600 million when the fair value of Margy’s identifiable net assets was $1,840
million. Joey treated Margy as an associate and has equity accounted for Margy up to 1
December 20-3. Joey’s share of Margy’s undistributed profit amounted to $90 million and its
share of a revaluation gain amounted to $10 million. On 1 December 20-3, Joey acquired a
further 40% of the ordinary shares of Margy for a cash consideration of $975 million and gained
control of the company. The cash consideration has been added to the equity accounted balance
for Margy at 1 December 20-3 to give the carrying amount at 30 November 20-4.
At 1 December 20-3, the fair value of Margy’s identifiable net assets was $2,250 million. At 1
December 20-3, the fair value of the equity interest in Margy held by Joey before the business
combination was $705 million and the fair value of the non-controlling interest of 30% was
assessed as $620 million. The retained earnings and other components of equity of Margy at 1
December 20-3 were $900 million and $70 million respectively. It is group policy to measure
the non-controlling interest at fair value.
ICSAZ - P.M. PARADZA
167
2. At the time of the business combination with Margy, Joey has included in the fair value of
Margy’s identifiable net assets, an unrecognised contingent liability of $6 million in respect of
a warranty claim in progress against Margy. In March 20-4, there was a revision of the estimate
of the liability to $5 million. The amount has met the criteria to be recognised as a provision in
current liabilities in the financial statements of Margy and the revision of the estimate is
deemed to be a measurement period adjustment.
3. Additionally, buildings with a carrying amount of $200 million had been included in the fair
valuation of Margy at 1 December 20-3. The buildings have a remaining useful life of 20 years
at 1 December 20-3. However, Joey had commissioned an independent valuation of the
buildings of Margy which was not complete at 1 December 20-3 and therefore not considered
in the fair value of the identifiable net assets at the acquisition date. The valuations were
received on 1 April 20-4 and resulted in a decrease of $40 million in the fair value of property,
plant and equipment at the date of acquisition. This decrease does not affect the fair value of
the non-controlling interest at acquisition and has not been entered into the financial statements
of Margy. Buildings are depreciated on the straight-line basis and it is group policy to leave
revaluation gains on disposal in equity. The excess of the fair value of the net assets over their
carrying value, at 1 December 20-3, is due to an increase in the value of non-depreciable land
and the contingent liability.
4. On 1 December 20-3, Joey acquired 80% of the equity interests of Hulty, a private entity, in
exchange for cash of $700 million. Because the former owners of Hulty needed to dispose of
the investment quickly, they did not have sufficient time to market the investment to many
potential buyers. The fair value of the identifiable net assets was $960 million. Joey determined
that the fair value of the 20% non-controlling interest in Hulty at that date was $250 million.
Joey reviewed the procedures used to identify and measure the assets acquired and liabilities
assumed and to measure the fair value of both the non-controlling interest and the consideration
transferred. After that review, Hulty determined that the procedures and resulting measures
were appropriate. The retained earnings and other components of equity of Hulty at 1
December 20-3 were $300 million and $40 million respectively. The excess in fair value is due
to an unrecognised franchise right, which Joey had granted to Hulty on 1 December 20-2 for
five years. At the time of the acquisition, the franchise right could be sold for its market price.
It is group policy to measure the non-controlling interest at fair value (N.B. a reacquired right)
All goodwill arising on acquisitions has been impairment tested with no impairment being
required.
5. Joey is looking to expand into publishing and entered into an arrangement with Content
Publishing (CP), a public limited company, on 1 December 20-3. CP will provide content for
a range of books and online publications.
CP is entitled to a royalty calculated as 10% of sales and 30% of gross profit of the publications.
Joey has sole responsibility for all printing, binding, and platform maintenance of the online
website. The agreement states that key strategic sales and marketing decisions must be agreed
jointly. Joey selects the content to be covered in the publications but CP has the right of veto
over this content. However on 1 June 20-4, Joey and CP decided to set up a legal entity, JCP,
with equal shares and voting rights. CP continues to contribute content into JCP but does not
receive royalties. Joey continues the printing, binding and platform maintenance. The sales and
cost of sales in the period were $5 million and $2 million respectively. The whole of the sale
ICSAZ - P.M. PARADZA
168
proceeds and the costs of sales were recorded in Joey’s financial statements with no accounting
entries being made for JCP or amounts due to CP. Joey currently funds the operations. Assume
that the sales and costs accrue evenly throughout the year and that all of the transactions relating
to JCP have been in cash. (N.B. this is a joint venture scenario, therefore relate it, to either IAS
28`s or IFRS 11`s provisions)
REQUIRED:
Perform workings for goodwill and group`s share of joint venture profits for consolidation
purposes as at 30 November 20-4 (presentation of group SFP not necessary). (15 marks)
SUGGESTED SOLUTION
a) WORKINGS
i)
goodwill calculation for the horizontal group and crossing the accounting boundary scenario in the
question including accounting treatment of a contingent liability
You should remember that goodwill on investment in Margy is calculated at achievement of control (that is, at 1
December 20-3)
Joey in Margy
$m
Purchase consideration transferred at date of acquiring control
975*1
Fair value of previously held equity interest
705*2
Less Parent`s proportionate share of the acquiree`s net assets
(1 547)*3
Parent`s share of goodwill
133 (A)
NCI measured at fair value
Less NCI’s proportionate share of the acquiree’s net assets
NCI`s share of goodwill
Contingent liability
Total Goodwill
620
(663)*4
(43) (B)
(1)*5 (C)
89 (A+B-C)
N.B. 1 Acquiree`s identifiable net assets acquired as represented by:
Ordinary share capital
Other components of equity
Retained earnings on acquisition of controlling stake
Fair value adjustment
- Contingent liability
- Non depreciable land (excess)
Net assets as given
Less fair value adjustment - Buildings
Revised net assets
1 020
70
900
(6)
266
2 250
(40)*6
2 210
*1 Purchase consideration transferred at date of acquisition of controlling interest by Joey
*2 Given
*1 70% x the identifiable net assets of subsidiary at date of acquiring controlling interest by Joey (70% x $2 210)
*4 30% x the identifiable net assets of subsidiary at date of acquiring controlling interest by Joey
*5 Contingent liability ($6-5). Since the amount has met the criteria to be recognised as a provision in current
liabilities in the financial statements of Margy and the revision of the estimate is deemed to be a measurement
period adjustment, the goodwill at acquisition date is adjusted accordingly.
*6 Given. This is the decrease of $40 million in the fair value of property, plant and equipment at the date of
acquisition. This implies a depreciation charge needs to be calculated, that is, $40/20 years = $2. This will add to
Margy`s post acquisition profits.
ICSAZ - P.M. PARADZA
169
Goodwill on investment in Hulty
Joey in Hulty
$m
700
(768)*1
(68) (A)
Purchase consideration transferred
Less Parent`s proportionate share of the acquiree`s net assets
Parent`s share of goodwill
NCI measured at fair value
Less NCI’s proportionate share of the acquiree’s net assets
NCI`s share of goodwill
Total Goodwill
250
(192)*2
58 (B)
(10) (A+B)
N.B. 1 Acquiree`s identifiable net assets acquired as represented by:
Ordinary share capital
Other components of equity
Retained earnings on acquisition on acquisition of controlling stake
Fair value adjustment
- Reacquired franchise right (excess)
*1 80% x 960m
600
40
300
20
960
*2 20% x 960m
Goodwill at reporting date
The gain of $10m is recognised in profit or loss.
$89m
Allocation of joint venture`s profits
Revenue (5 x 6/12)
Cost of sales (2 x 6/12)
Gross profit
Less
Royalties to CP (10% x 2.5)
Publication fees to CP (30% x 2.50)
Joey`s share 1st six months
Joey`s share 2nd six months (50% x 1.50)
CP`s share 2nd six months (50% x 1.50)
1 December 20-4
to 31 May 20-4
$m
2.50
(1.00)
1.50
(0.25)
(0.45)
0.80
(0.80)
1 June 20-4
to 30 Nov 20-4
$m
2.50
(1.00)
1.50
1.50
(0.75)
(0.75)
-
Group share of joint venture profits (0.80 + 0.75) = $1.55m
EXAMPLE 2 – ASSOCIATE TO SUBSIDIARY – SEVERAL ACQUISITION DATES METHOD
The statements of financial position of H Ltd as at 31 December 20-6 were as follows:
ASSETS
Tangible non-current assets
Investment in S Ltd. at cost
Net current assets
EQUITY & LIABILITIES
Ordinary share capital ($1 shares)
Share premium
General reserve
Retained earnings
ICSAZ - P.M. PARADZA
H LTD
$
368 500
700 700
253 400
1 322 600
800 000
208 200
110 860
203 540
1 322 600
S LTD
$
627 900
340 100
968 000
350 000
200 000
418 000
968 000
170
The following information relates to S Ltd on the indicated dates:
Date
1/01/20-4
1/01/20-5
1/01/20-6
Ordinary
Share
Capital
$
350 000
350 000
350 000
General
Reserve
Retained
Earnings
% Acquired
by H Ltd.
$
120 000
135 000
144 000
$
186 200
271 900
324 500
$
25%
10%
40%
Cost of
Shares
Acquired
$
295 600
88 700
316 400
REQUIRED
Analysis of S Ltd's equity and consolidated statement of financial position assuming H Ltd had always wanted
to achieve eventual control of S Ltd.
SUGGESTED SOLUTION
H LTD AND ITS SUBSIDIARIES
Analysis of shareholders equity in S Ltd as at 31 December 20-6
TOTAL
$
Ordinary share capital
350 000
Retained earnings 1/01/20-4 186 200
General Reserve 1/01/20-4 120 000
Purchase consideration for 87 500 shares
Goodwill on acquisition
Increase in
General Reserve to 1/1/20-5
(135 000 - 120 000)
15 000
Retained earnings to 1/1/20-5
(271 900 - 186 200)
85 700
H LTD
25%
$
87 500
46 550
30 000
164 050
295 600
131 550
H LTD
10%
$
35 000
18 620
12 000
H LTD
40%
$
140 000
74 480
48 000
NCI
25%
$
87 500
46 580
30 000
3 750
1 500
6 000
3 750
21 425
8 570
75 690
88 700
13 010
34 280
21 425
2 250
900
3 600
2 250
13 150
5 260
21 040
327 400
316 400
(11 000)
13 150
14 000
5 600
22 400
14 000
23 375
77 950
9 350
21 110
37 400
59 800
23 375
242 000
Purchase consideration for 35 000 shares
Goodwill on further acquisition
Increase in
General Reserve to 1/1/20-6
(144 000 - 135 000)
9 000
Retained earnings to 1/1/20-6
(324 500 - 271 900)
52 600
Purchase consideration for 140 000 shares
Gain on bargain purchase
Increase in
General Reserve to 31/12/20-6
(200 000 - 144 000)
56 000
Retained earnings to 31/12/20-6
(418 000 - 324 500)
93 500
968 000
See alternative layout of the above equity analysis on the following page, as you proceed being tutored or
practicing, with the rest of solution as suggested.
ICSAZ - P.M. PARADZA
171
H LTD AND ITS SUBSIDIARIES
Analysis of shareholders equity in S Ltd as at 31 December 20-6
H Ltd
At Acq
25%-35%-75%
$
Total
100%
$
1. At acquisition 1/01/20-4
Share Capital
350 000
General Reserve
120 000
Retained Earnings
186 200
656 200
Investment in S Ltd
Goodwill
87 500 (a)
30 000
46 550
164 050
295 600
131 550
2. Since acquisition to 1/01/20-5
General Reserve
(135 000 - 120 000) 15 000
Retained Profits
(271 900 - 186 200) 85 700
756 900
3. Further acquisition at 1/01/20-5
(10% x 756 900)
Investment in S Ltd
Goodwill
ICSAZ - P.M. PARADZA
3 750 (b)
11 250
21 425
25 175
64 275
567 675
(75 690)
3 150 (c)
18 410
46 735
327 400
316 400
(11 000)
6. Since acquisition 1/01/20-6
General Reserve
(200 000 - 144 000) 56 000
Retained Profits
(418 000 - 324 500) 93 500
968 000
a) 25% x 350 000 = $87 500,
262 500
90 000
139 650
492 150
75 690
88 700
13 010
4. Since acquisition 1/01/20-5 to 1/01/20-6
General Reserve
(144 000 - 135 000) 9 000
Retained Profits
(324 500 - 271 900) 52 600
818 500
5. Further acquisition at 1/01/20-6
(40% x 818 500)
Investment in S Ltd
Bargain Purchase Gain
H Ltd
NCI
Since Acq
–
25%-35%-75% 75%-65%-25%
$
$
b) 35% x 15 000 = 3750
5 850
34 190
532 025
(327 400)
42 000(d)
14 000
70 125
158 860
23 375
242 000
c) 35% x 9000 = $3 150
d) 75% x 56 000 = $42 000
172
Summary of Goodwill (subsidiary)
Shares acquired 1/01/20-4
Shares acquired 1/01/20-5
Shares acquired 1/01/20-6
$
131 550
13 010
(11 000)
133 560
Summary of General Reserve (subsidiary)
Shares acquired 1/01/20-4 (3 750 + 2 250 + 14 000)
Share acquired 1/01/20-5 (900 + 5 600)
Shares acquired 1/01/20-6
Summary of Retained Profits (subsidiary)
Shares acquired 1/01/20-4 (21 425 + 13 150 + 23 375)
Shares acquired 1/01/20-5 (5 260 + 9 350)
Shares acquired 1/01/20-6
20 000
6 500
22 400
48 900
57 950
14 610
37 400
109 960
H LTD AND ITS SUBSIDIARIES
Consolidated statement of financial position as at 31 December 20-6
ASSETS
Tangible non-current assets (368 500 + 627 900)
Goodwill in subsidiary
Net current asset (253 400 + 340 100)
EQUITY & LIABLILITIES
Ordinary share capital
Share premium
General reserve (110 860 + 48 900)
Retained profits (203 540 + 109 960)
Non-controlling interest
$
996 400
133 560
1 129 900
593 500
1 723 460
800 000
208 200
159 760
313 500
242 000
1 723 460
The several acquisition dates method used in this example entails that you determine as has
been done above, the difference between the purchase consideration and the carrying amount
of the investment for each separate block of shares purchased, including acquisitions before
control was achieved. Instead of being asked to use the principle that a Business Combination
occurs only at the date that control is achieved, (see item 5.16 of this Unit), it is possible in
examinations to be asked to use this method.
Several acquisition dates is similar to the phrase “assuming that the Holding company (H) had
always wanted to achieve eventual control.”
5.16.2 TRADE/SIMPLE INVESTMENT TO SUBSIDIARY
Treatment of a simple investment in subsidiary is similar to that used to account for a movement
from associate status to subsidiary by the revised IFRS 3.
ICSAZ - P.M. PARADZA
173
5.16.3 FROM SUBSIDIARY TO SUBSIDIARY (controlling interest increased)
This is a transaction between owners within the same group. It is an increase in holding in the
existing subsidiary with no change in status. No change in status means no difference in control
over the subsidiary before and after the change in ownership. Another thing to note is that if
the non-controlling interest takes up its shares in full from the allotted rights/options by the
subsidiary, then the shareholdings in the subsidiary remain the same as before even after the
rights issue. The controlling and non-controlling interest percentages remain the same. This is
not what no change in status means. No change in status is in the sense of the accounting
boundary not having been crossed.
However, if NCI renounces part of the shares from the rights granted, the holding company
(H) as part of the internal shareholders has the right of first pre-emption. Therefore, taking over
by the holding company of shares from rights renounced by the non-controlling interest, leads
to the shareholdings of the parent and NCI to increase and decrease by the same percentage at
the same time. Still there will be no change in status if the increase only serves to increase the
controlling stake in the subsidiary. All that is needed is for you to:
1) Calculate the adjustment to parents`s equity in the subsidiary
IFRS 3 requires the difference between the additional interest achieved by the parent and the
purchase consideration paid (for instance, new shares in the subsidiary from the rights issue x
the rights price) to be recognized as part of a change in ownership reserve.
Accounting requirements:
Taking note that as the parent's share increases, the NCI`s share decreases, the calculation of
the adjustment to parent`s equity is as follows:
Fair value of consideration paid
Decrease in NCI in net assets at date of transaction
Decrease in NCI in goodwill at date of transaction
Adjustment to parent's equity (a reduction)
$
(xx)
xx
xx*1
(xx)
*1 This line is only required where non-controlling interests are measured at fair value at the
date of acquisition (that is, where there is a decrease in the non-controlling interest share of
goodwill already recognised).
2) Decrease/increase in NCI
N.B. Besides the parent and NCI figures no other figures in the statement of financial position
are affected
ICSAZ - P.M. PARADZA
174
EXAMPLE 2 – CHANGES IN SHAREHOLDINGS THROUGH A RIGHTS ISSUE BY
SUBSIDIARY - SEVERAL ACQUISITION DATES METHOD.
The following represents the abridged trial balances of H Ltd and S ltd as at 31 December 205
H Ltd
$
S Ltd
$
300 000
Nil
164 000
200 000
16 000
22 000
702 000
200 000
50 000
125 000
100 000
Nil
8 000
483 000
Property, plant and equipment
351 000
Investment in S Ltd (166 000 ordinary shares at fair value) 242 000
Trade receivables
49 000
Tax expense
60 000
Dividend paid 31/05/20-5
Nil
702 000
407 000
Share capital
$1 Ordinary Shares
Share premium
Retained Profits 31/12/20-4
Profit before dividend income
Dividend received
Trade payables
23 500
32 500
20 000
483 000
1. H Ltd obtained 120 000 shares in S Ltd on 1 January 20-3 when the shareholders equity of
S Ltd was:
Share capital
Retained earnings
$150 000
$30 000
2. On 30 June 20-5 S Ltd had a rights issue of 1 ordinary share for every 3 held as $2 per
share
3. The rights issue was taken up as follows:
Non-controlling interest
H Ltd
4 000 shares
46 000 shares
4. Assume a tax rate of 30%
5. S Ltd`s profit before tax and tax expense accrued for 20-5 as follows:
Total
Profit before tax
Tax expense
Profit after tax
ICSAZ - P.M. PARADZA
$
100 000
32 500
67 500
1/1/20-5
to 30/06/20-5
$
40 000
14 500
25 500
1/7/20-5
to 31/12/20-5
$
60 000
18 000
42 000
175
6. Goodwill has not been impaired at year end.
REQUIRED
Consolidated annual financial statements of H Ltd and its subsidiary for the year ended 31
December 20-5
SUGGESTED SOLUTION
H LTD & ITS SUBSIDIARY
Consolidated statement of comprehensive income for the year ended 31 December 20-5
$
300 000
(92 500)
207 500
(12 240)
195 260
Profit before tax (200 000 + 100 000)
Company tax (60 000 + 32 500)
Profit after tax
Attributable to non-controlling interest (5 100 + 7 140)
Attributable to equity holders of parent
H LTD & ITS SUBSIDIARY
Consolidated statement of changes in equity for the year ended 31 December 20-5
Share
Capital
$
300 000
Bal b/d 1/01/20-5
Proposed dividends
Rights issue
Total comprehensive
income
Bal c/d 30/12/20-5
300 000
Retained
Earnings
$
240 000
Total
NCI
Total
$
540 000
$
55 000
(4 000)
12 500
$
595 000
(4 000)
12 500
195 260
435 260
195 260
735 260
12 240
75 740
207 500
811 000
H LTD & ITS SUBSIDIARY
Consolidated statement of financial position as at 31 December 20-5
$
ASSETS
Non-current assets
Property, plant & equipment (351 000 + 407 000)
Goodwill (6000 + 4 500)
758 000
10 500
768 500
Current assets
Trade receivables (49 000 + 23 500)
Total assets
72 500
841 000
Equity & Liabilities
Share Capital & Reserves
Share capital
Retained profits
300 000
435 260
ICSAZ - P.M. PARADZA
176
735 260
75 740
811 000
30 000
841 000
Non-controlling interest
Current liabilities (22 000 + 8 000)
Total equity & liabilities
WORKINGS
H LTD & ITS SUBSIDIARY
Analysis of shareholders equity in A Ltd as at 31 December 20-5
Total
100%
$
1. At acquisition 1/1/20-3
Share Capital
Retained Profits
H Ltd
At Acq
80% - 83%
$
H Ltd
Since Acq
80% - 83%
$
NCI
–
20% - 17%
$
150 000
30 000
180 000
Investment in S Ltd (242 000 (46000 x 2))
Goodwill
120 000
24 000
144 000
150 000
6 000
30 000
6 000
36 000
2. Since acquisition to 1/01/20-5
Retained Profit (125 000 – 30 000) 95 000
76 000
19 000
3. Current financial year (1/01/20-5 to 31/12/20-5)
Profit after tax to 30/06/20-5 25 500
Dividend paid
(20 000)
280 500
Rights issue (as given)
Share premium (83%:17%)
50 000
50 000
380 500
Investment in S Ltd (46 00 x 2)
Goodwill
Profit after tax 1/07/20-5 to 31/12/20-5 42 000
422 500
20 400
(16 000)
80 400
46 000
41 500
87 500
92 000
4 500
5 100
(4 000)
20 100
4 000
8 500
68 600
34 860
115 260
7 140
75 740
N.B. A holding company's effective interest may change as a result of a rights issue by its
subsidiary company. You can use the above example and the one below to understand the
required adjustments if the holding company's shareholding increases. On both instances the
several acquisition dates method has been used.
ICSAZ - P.M. PARADZA
177
FURTHER EXAMPLE - PIECEMEAL ACQUISITION THROUGH A RIGHTS ISSUE
BY SUBSIDIARY (SEVERAL ACQUISITIONS METHOD)
H ltd purchased 75 000 ordinary shares in S Ltd on 1 April 20-6 for $1 500 000, when S Ltd`s
capital and reserves were as follows:
Ordinary Share Capital ($10 shares)
Retained Earnings
$1 000 000
$724 500
On 1 April 20-7 S ltd made a rights issue on the basis of 1 for every 4 shares currently held, at
$15 per share.
The non-controlling shareholders subscribed for only 3000 shares thereby renouncing their
rights to the remainder of the shares. H Ltd subscribed for its shares and the balance of shares
renounced by non-controlling shareholders in exercise of first pre-emption rights and in terms
of an underwriting agreement.
S Ltd`s retained earnings on 1 April 20-7 amounted to $1 250 000.
REQUIRED
Analysis of S Ltd`s equity on 1 April 20-7
SUGGESTED SOLUTION
H LTD & ITS SUBSIDIARY
Analysis of shareholders` equity in S LTD as at 1 April 20-7
Total
100%
$
1. At acquisition 1/4/20-6
Share Capital
Retained Earnings
1 000 000
724 500
1 724 500
Investment in S ltd
Goodwill
2. Since acquisition to 1/04/20-7
Retained Earnings (1 250 000 – 724 500)
Investment in S ltd
Goodwill
2 625 000
H Ltd
Since Acq
75%-78%
$
750 000
543 375
1 293 375
1 500 000
206 625
525 500
3. Effects of Rights Issue at 1/04/20-7
Share Capital
250 000
Share Premium
125 000
ICSAZ - P.M. PARADZA
H Ltd
At Acq
75%-78%
$
97 500
317 500
330 000
12 500
219 125
NCI
NCI
25-22%
$
250 000
181 125
431 125
394 125
131 375
220 000
30 000
27 500
.
394 125
.
620 000
178
WORKINGS
1. Percentage control before rights issue
75 000 x 100
100 000
= 75%
2. Percentage control after rights issue
75 000 + (75 000 x ¼) + (25 000 x ¼ - 3000) x 100
100 000 + 100 000 x ¼
= 78%
3. Increase in ordinary share capital from rights issue
25 000 x $10
= $250 000
Share premium from rights issue
25 000 x ($15 - $10)
= $125 000
4. Split of ordinary share capital from rights issue
H ltd 22 000 x $10
NCI
3 000 x $10
= $220 000
= $30 000
5. Split of share premium from rights issue
H ltd 78% x 125 000
NCI 22% x 125 000
= $97 500
= $27 500
5.16.4 FULL DISPOSAL OF SUBSIDIARY (no crossing of boundary) and PARTIAL
DISPOSAL (SUBSIDIARY TO ASSOCIATE/SUBSIDIARY TO SUBSIDIARY)
Disposal of interest
On disposal of a controlling interest, any residual interest is remeasured to fair value and
reflected in any profit or loss on disposal (IFRS 3).
When accounting for the total or partial disposal of an interest in a subsidiary, it is necessary
to ascertain the disposal value of the asset involved, the cost of the asset, and the profit or sale
on the investment. The true cost of the investment consists of the original purchase
consideration of the shares, adjusted for movements in capital and reserves since acquisition.
If all the shares in a subsidiary are sold for cash or other consideration, that subsidiary will not
need to be consolidated at the end of the period in question. However, a partial sale means that
the investee company remains a subsidiary, or becomes an associate or simple investment of
the investor company. Cilliers et al (2009) have noted that accounting for the disposal of shares
in subsidiaries consists of three elements, that is:
ICSAZ - P.M. PARADZA
179
a) Recognition of the asset received for the disposal, that is, cash proceeds.
b) Derecognition of the carrying amount of the asset disposed of from the asset account i.e.
shares in the other entity.
c) Recognition of any gain or loss on disposal (either in profit or loss or directly in equity,
depending on whether control in the other entity has been lost.
Accounting requirements
Take note that as the parent's share decreases, the NCI`s share increases.
The following is the calculation of the adjustment to parent`s equity is as follows:
$
(xx)
xx
xx
(xx)
Fair value of consideration paid
Increase in NCI in net assets at date of transaction
Increase in NCI in goodwill at date of transaction
Adjustment to parent's equity (an addition)
N.B. Besides the parent and NCI figures no other figures in the statement of financial position
are affected
FULL DISPOSAL OF SUBSIDIARY (no crossing of boundary)
Calculation of gain or loss on sale of an interest in the parent`s separate books:
Fair value of consideration received
Less carrying value of investment disposed of
Profit or loss on disposal of interest
$
xx
(xx)
xx
PARTIAL DISPOSAL (SUBSIDIARY TO ASSOCIATE)
The accounting boundary is crossed and the key calculations are as follows (see practice
question below ACCA June 2014 past examination question paper)
Calculation of gain or loss on sale of an interest in the parent`s separate books
Fair value of consideration received
Less carrying value of investment disposed of
Profit or loss on disposal of interest
Calculation of gain or loss on sale of interest in the group`s books
Fair value of consideration received
Fair value of any investment retained
Less share of consolidated carrying value at date control lost:
net assets
goodwill
less non-controlling interests
Group profit or loss
ICSAZ - P.M. PARADZA
$
xx
(xx)
xx
$
xx
xx
xx
xx
(xx)
xx
180
Calculation of adjustment of parent`s equity reserves
$
Fair value of consideration paid
Increase in NCI in net assets at date of transaction
Increase in NCI in goodwill at date of transaction
Adjustment to parent's equity (an addition)
(xx)
xx
xx*1
xx
*1 only if NCI is measured at fair value at acquisition date
DISPOSAL OF INTEREST (SUBSIDIARY TO SUBSIDIARY)
This is treated as merely a transaction between internal investors and the key calculation is as
follows (see practice question below ACCA June 2014 past examination question paper)
Calculation is the adjustment to parent`s equity:
$
Fair value of consideration paid
Increase in NCI in net assets at date of transaction
Increase in NCI in goodwill at date of transaction
Adjustment to parent's equity (an addition)
(xx)
xx
xx
xx
EXAMPLE – DISPOSAL (SUBSIDIARY TO SUBSIDIARY AND SUBSIDIARY TO
ASSOCIATE
ACCA June 2014 examination question paper (Extracted from Q1, question requirement
adapted)
The following draft financial statements relate to Marchant, a public limited company for the
year ended 30 April 20-4.
Marchant
$m
Revenue
400
Cost of sales
(312)
Gross profit
88
Other income
21
Administrative costs
(15)
Other expenses
(35)
Operating profit
59
Finance costs
(5)
Finance income
6
Profit before tax
60
Income tax expense
(19)
Profit for the year
41
Other comprehensive income – revaluation surplus 10
Total comprehensive income for year
51
ICSAZ - P.M. PARADZA
Nathan
$m
115
(65)
50
7
(9)
(19)
29
(6)
5
28
(9)
19
19
Option
$m
70
(36)
34
2
(12)
(8)
16
(4)
8
20
(5)
15
15
181
The following information is relevant to the preparation of the group statement of profit or loss
and other comprehensive income:
1. On 1 May 20-2, Marchant acquired 60% of the equity interests of Nathan, a public limited
company. The purchase consideration comprised cash of $80 million and the fair value of the
identifiable net assets acquired was $110 million at that date. The fair value of the noncontrolling interest (NCI) in Nathan was $45 million on 1 May 20-2. Marchant wishes to use
the ‘full goodwill’ method for all acquisitions. The share capital and retained earnings of
Nathan were $25 million and $65 million respectively and other components of equity were $6
million at the date of acquisition. The excess of the fair value of the identifiable net assets at
acquisition is due to non-depreciable land.
Goodwill has been impairment tested annually and as at 30 April 20-3 had reduced in value by
20%. However at 30 April 20-4, the impairment of goodwill had reversed and goodwill was
valued at $2 million above its original value. This upward change in value has already been
included in above draft financial statements of Marchant prior to the preparation of the group
accounts.
2. Marchant disposed of an 8% equity interest in Nathan on 30 April 20-4 for a cash
consideration of $18 million and had accounted for the gain or loss in other income. The
carrying value of the net assets of Nathan at 30 April 20-4 was $120 million before any
adjustments on consolidation. Marchant accounts for investments in subsidiaries using IFRS 9
Financial Instruments and has made an election to show gains and losses in other
comprehensive income. The carrying value of the investment in Nathan was $90 million at 30
April 20-3 and $95 million at 30 April 20-4 before the disposal of the equity interest.
3. Marchant acquired 60% of the equity interests of Option, a public limited company, on 30
April 20-2. The purchase consideration was cash of $70 million. Option’s identifiable net assets
were fair valued at $86 million and the NCI had a fair value of $28 million at that date. On 1
November 20-3, Marchant disposed of a 40% equity interest in Option for a consideration of
$50 million. Option’s identifiable net assets were $90 million and the value of the NCI was
$34 million at the date of disposal. The remaining equity interest was fair valued at $40 million.
After the disposal, Marchant exerts significant influence. Any increase in net assets since
acquisition has been reported in profit or loss and the carrying value of the investment in Option
had not changed since acquisition. Goodwill had been impairment tested and no impairment
was required. No entries had been made in the financial statements of Marchant for this
transaction other than for cash received.
4. Marchant sold inventory to Nathan for $12 million at fair value. Marchant made a loss on
the transaction of $2 million and Nathan still holds $8 million in inventory at the year end.
5. Ignore the taxation effects of the above adjustments unless specified. Any expense
adjustments should be amended in other expenses.
REQUIRED:
Prepare a consolidated statement of profit or loss and other comprehensive income extract for
the year ended 30 April 20-4 for the Marchant Group. (20 marks)
ICSAZ - P.M. PARADZA
182
SUGGESTED SOLUTION
Marchant Group
Extract consolidated statement of profit or loss and other comprehensive income for the
year ended 30 April 20-4
$m
Revenue (400+115-12+70 x 6/12)
538.00
Cost of sales (312 + 65 – 12 + 36 x 6/12)
(383.00)
Gross profit
155.00
w3.2
w4.2
Other income (21+7 - 5.33
+22
)
28.00
Total income
183.00
Administrative costs (15+9+12 x 6/12)
(30.00)
Other expenses (35+19+ 8 x 6/12 + 5 relevant journal entry)
(8.00)
Share of profit after tax of associate (20% x 15 x 6/12)
1.50
Operating profit
146.50
Other comprehensive income – revaluation surplus [10-5 (95 -90) CA 30/4/20-4 – CA 30/4/20-3]
5.00
Workings:
1. Calculation of goodwill in Nathan at acquisition
Marchant in Nathan
$m
Purchase consideration transferred
80*1
Less Parent`s proportionate share of the acquiree`s identifiable net assets
(66)*2
Parent`s share of goodwill
14 (A)
NCI at fair value
Less NCI’s proportionate share of the acquiree’s identifiable net assets
NCI`s share of goodwill
Total Goodwill
Impairment (20% x $15m)
Revised Goodwill at 30/4/20-3
N.B. 1 Acquiree`s identifiable net assets acquired as represented by:
Ordinary share capital
Other components of equity
Retained earnings on acquisition
Fair value adjustments (balancing figure) – non-depreciable land
45*3
(44)*4
1 (B)
15 (A+B)
(3)
12
25
6
65
14
110
*1 Purchase consideration transferred at date of acquisition by Marchant
*2 60% x the identifiable net assets of subsidiary at date of acquisition (60% x 110)
*3 Given
*5 40% x the identifiable net assets of subsidiary at date of acquisition (40% x 110)
ICSAZ - P.M. PARADZA
183
Financial effect of impairment reversal done in error*
$m
12
5
17
Carrying amount of goodwill after impairment test
Impairment reversal (balancing figure)
Recoverable amount of goodwill
* Goodwill written off is not recovered.
Relevant journal entry:
DEBIT
P/L (Other expenses)
CREDIT
Goodwill
$m
5
$m
5
2. Calculation of goodwill in Nathan at acquisition
Marchant in Option
$m
Purchase consideration transferred
70.00*1
Less Parent`s proportionate share of the acquiree`s identifiable net assets (0.6 x 86) (51.60)*2
Parent`s share of goodwill
18.40
NCI at fair value
Less NCI’s proportionate share of the acquiree’s identifiable net assets (0.4 x 86)
NCI`s share of goodwill
Total Goodwill (18.40 – 6.40)
28.00*3
(34.40)*4
(6.40)
12.00
3. Subsidiary to subsidiary calculations (reduction in control in Nathan from 60% to 52%
- accounting boundary not crossed)
3.1 Calculation of adjustment to parent`s equity
Fair value of consideration received
Increase NCI`s proportionate share of net assets [8% x (120 + 14*1)]
Increase in NCI`S share of goodwill (8% x 12)
Adjustment to parent`s equity
18.00
(10.72)
(0.96)
6.32
*1 Fair value adjustment on non-depreciable land
3.2 Calculation of gain or loss on partial sale of interest in Parent`s (Marchannt`s) books
Fair value of consideration received
Carrying value of investment disposed of (8%/60% x 95) (proportion)
Profit
18.00
(12.67)
5.33
This profit is not recognised in profit or loss on the sale of Nathan in the group accounts given
that the sale is a movement in equity (an exchange between owners in one economic unit – that
is, the differing holding and subsidiary company no longer carry out their commercial activities
on a footing of complete economic independence). Therefore, the profit from a decrease in
holding in the existing subsidiary with no change in status is eliminated.
ICSAZ - P.M. PARADZA
184
4. Subsidiary to associate calculations (reduction in control in Nathan from 60% to 20%
- accounting boundary crossed)
4.1 Calculation of gain or loss on partial sale of interest in Parent`s (Marchannt`s) books
Fair value of consideration received
Carrying value of investment disposed of (40% x 90)
Profit
50.00
(36.00)
14.00
4.2 Calculation of gain or loss on partial sale of interest in Parent`s (Marchannt`s) books
Fair value of consideration received
Add Fair value of investment retained
50.00
40.00
90.00
Share of consolidated carrying value at the date control is lost:
Net assets
Goodwill lost
NCI (given)
Profit
(90.00)
(12.00)
34.00
22.00
5. Unrealised loss given the goods have been sold internally at their fair value needs no
adjustment. Treatment is unlike that of unrealised profit in closing inventory.
EXAMPLE 1 – DISPOSAL OF INTEREST
The following trial balance refers to Fadzai Ltd and its subsidiary Maria Ltd for the year ended
31 December 20-4.
Debits
Property, plant & equipment
Investment in Maria Ltd at fair value
Trade receivables
Dividends paid 30 June 20-4
Dividends declared 31 December 20-4
Income tax expense
Credits
Share capital of $1 ordinary shares
Mark to market reserve
Retained earnings 1 January 20-4
Deferred tax to mark to market reserve
Trade and other payables
Profit before tax
Proceeds on sale of shares
ICSAZ - P.M. PARADZA
Fadzai Ltd
$
Maria Ltd
$
488 000
124 500
36 500
30 000
25 000
25 000
729 000
194 000
400 000
4 250
150 000
750
20 000
116 500
37 500
729 000
42 000
24 000
10 000
15 000
285 000
100 000
90 000
15 000
80 000
285 000
185
Additional information
1. On 1 July 20-1 Fadzai Ltd acquired 70% of equity of Maria Ltd. At that date the equity
of Maria Ltd consisted of the following items:
Share capital - $1 ordinary shares
$100 000
Retained earnings
$50 000
Fadzai Ltd paid $110 000 for the investment.
2. On 1 January 20-4 Fadzai Ltd purchased a further 5 000 ordinary shares in Maria Ltd
at $1.90 per share. On 1 July 20-4 Fadzai Ltd sold 15 000 of its ordinary shares in Maria
Ltd. Investments are accounted for on a first in first out basis. Capital gains tax is 20%.
3. Maria Ltd earned its profits evenly throughout the year.
4. The interim dividends were paid by Fadzai Ltd and Maria Ltd on 30 June 20-4. The
final dividends have been recorded in the accounting records of both companies at 31
December 20-4.
5. Assume a tax rate of 30%.
6. Fadzai Ltd`s policy for recognizing gains and losses on the subsequent re-measurement
of available for sale financial assets is to transfer them to equity.
7. Assume that each share carries one vote.
8. The fair value of identifiable assets, liabilities and contingent liabilities at acquisition
date of Maria Ltd were considered to be equal to the carrying amount thereof.
REQUIRED
Prepare the consolidated annual financial statements of Fadzai Ltd and its subsidiary for the
year ended 31 December 20-4.
Adapted from ICSAZ November 2012 past exam question paper
Calculations are to be done to the nearest $1.00
Your answer must comply with the requirements of the companies Act and Generally Accepted
Accounting Practice. Notes and comparative figures are not required.
SUGGESTED SOLUTION
FADZAI LTD AND ITS SUBSIDIARIES
Consolidated statement of comprehensive income for the year ended 31 December 20-4
$
ICSAZ - P.M. PARADZA
186
Profit before tax (116 500 – 18 000 – 6000 + 80 000 + 6 725)
Income tax expense (25 000 + 15 000 + 2 720)
Profit after tax
Attributable to non-controlling interest
Attributable to equity holders of parent
179 225
42 720
136 505
(21 125)
115 380
Consolidated statement of changes in equity for the year ended 31 December 20-4
Share
Capital
$
Bal b/d 1/01/20-4
400 000
Dividends paid & proposed (55 000)
Effect of further acquisition &
Disposal of interest in Maria Ltd
Total comprehensive income
Bal c/d 31/12/20-4
400 000
Retained
Earnings
$
178 000
(55 000)
115 380
238 380
Total
NCI
Total
$
578 000
(10 000)
$
57 000
(65 000)
$
635 000
115 380
638 380
20 275
21 125
88 400
20 275
136 505
726 780
Opening balance - Retained earnings (150 000 + 28 000)
Opening balance - NCI (30 000 + 15 000 + 12 000)
Dividend paid and proposed - Fadzai Ltd (30 000 + 25 000)
Dividend paid and proposed - Maria Ltd (6 000 + 4 000)
Effect of disposal of interest in Maria Ltd (21 000 + 1 900 + 6 875 + 9 500)
Consolidated statement of financial position as at 31 December 20-4
ASSETS
Non-current assets
Property, plant and equipment (488 000 + 194 000)
Goodwill
Current assets
Trade receivables (36 500 + 42 000)
Total assets
EQUITY & LIABILITIES
Share Capital & Reserves
Share capital
Retained earnings
Non-controlling interest
Non-current liabilities
Deferred tax
Current liabilities
Trade & other payables (20 000 + 15 000)
Total equity & liabilities
ICSAZ - P.M. PARADZA
$
682 000
4 000
686 000
78 500
764 500
400 000
238 380
638 380
88 400
726 780
2 720
35 000
764 500
187
ANALYSIS OF SHAREHOLDERS EQUITY IN A LTD AS AT 31 DECEMBER 20-4
1. At acquisition 1/07/20-1
Share Capital
Retained Profits
H Ltd
At Acq
H Ltd
Since Acq
NCI
Total
100%
70%-75%-60%
70%-75%-60%
30%-35-40%
$
$
100 000
50 000
150 000
70 000
35 000
105 000
110 000
5 000
Investment in Maria ltd
Goodwill
2. Since acquisition to 1/01/20-4
Retained Profits (90 000 – 50 000)
Further acquisition
(5% x 190 000)
Investment in Maria Ltd (5 000 x 1.9)
Goodwill
9 500*1
9 500
-
3. Current financial year (1/01/20-4 to
30/06/20-4)
Profit after tax (80 000 – 15 000) x 6/12
32 500
Interim dividend
(24 000)
198 500
$
30 000
15 000
45 000
28 000*2
40 000
190 000
Disposal of interest in Maria ltd
Net assets in Maria Ltd at 1/07/20-1 ceded
(105 000 x 20%)
Goodwill at 1/07/20-1 realized
(5 000 x 20%)
Net assets in Maria Ltd at 1/01/20-4 ceded
(9 500 x 20%)
Since acquisition reserves in Maria Ltd ceded
(34 375 x 20%)
Profit after tax
32 500
Final dividend declared
(10 000)
221 000
$
12 000
(9 500)*1
24 375*2
(18 000)
34 375
(21 000)*1
8 125
(6 000)
49 625
21 000*1
(1 000)
(1 900)
4 000
1 900
(6 875)
19 500*2
(6 000)
41 000
6 875
13 000
(4 000)
88 400
*1 As parent`s equity reduced, NCI increased, and true for the vice versa. This is reflective of an exchange between owners.
*2 70% x 40 000 = 28 000, 75% x 32 500 = 24 375, 60% x 32 500 = 19 500. To reflect the step acquisitions/several acquisition dates effects.
WORKINGS
1. Percentage of control – Fadzai in Maria Ltd
At 1/07/20-1 (given)
At 1/01/20-4 [70% + (5 000/100 000 x 100)]
At 1/07/20-4 [75% - (15 000/100 000 x 100)
]
ICSAZ - P.M. PARADZA
= 70%
= 75%
= 60%
188
2. Profit or loss on disposal of interest in Maria Ltd
Proceeds on sale of shares – carrying amount of investment
$37 500 – [(110 000 + 9 500 + 28 000 + 24 375 – 18 000) x 20%]
= $6 725
3. Capital gain on sale of shares in Maria Ltd
(Proceeds on sale of shares – cost of shares sold) x applicable tax rate
$37 500 – ([(110 000 + 9 500) x 20%] ) x 20%
= $2 720
DEBIT
Income tax expense
$2 720
CREDIT
Deferred tax liability
$2 720
4. Percentage of interest in Maria Ltd ceded to NCI (15 000/75 000) x 100
= 20%
[You are encouraged to see what changes would come up if other approaches are used, for instance, applying the
IASB`s requirement in IFRS 3 (revised), that is, use of the principle that a Business Combination occurs only at the
date that control is achieved, see item 5.16 of this Unit]
Notes
a) Guidance on fair valuation or marking to market is given by IFRS 13 though the
practice itself evolved long before the accounting standard was adopted. The fair
valuation of an asset based on current market values of similar assets/investments
results in the creation of a mark to market reserve. The valuation upward or downward
attracts a deferred tax liability or asset.
b) In accounting for financial instruments, the FIFO method assumes that the shares
purchased first will be sold first, whereas the AVCO method stipulates that every time
shares are purchased the carrying amount/cost per share be re-calculated to arrive at a
new carrying amount/cost per share
c) According to the old IAS 39 an available for sale financial asset is a non-derivative
financial asset that is not a:
loan and receivable
held to maturity investment
financial asset at fair value through profit & loss
[New IFRS 9 – has brought about new classification, however, components are more or less similar to the above, it is just the
umbrella naming that has changed]
Any financial instrument, except for derivatives, can be designated by an entity as
available for sale on election or by default.
d) In Zimbabwe and at present, the capital gains tax, which is a tax levied on capital gains
arising on disposal of a specified asset namely immovable property or marketable
securities (shares or debentures), is levied at 20%, assuming the specified asset was
acquired after 1 February 2009. A capital gains tax rate of 5% is charged on gains from
sale of specified assets bought before 1 February 2009. If the security (share or
debenture) is that for an unlisted entity, the capital gains tax rate from 1 September
2010 is between 5 – 10%.
5.16.5 PARTIAL DISPOSAL (SUBSIDIARY TO TRADE/SIMPLE INVESTMENT)
This entails reverting back to IFRS 9 accounting.
ICSAZ - P.M. PARADZA
189
5.17 Use of a Presentation Currency Other Than the Functional (IAS 21)
Of interest in consolidations is the part of IAS 21 that deals with a foreign operation a net
investment in a foreign operation to be particular. By definition a foreign operation is a
subsidiary, associate, joint venture or branch of a reporting entity, the activities of which are
based or conducted in a country or currency other than those of the reporting entity. Whereas
a net investment in a foreign operation is the amount of the reporting entity's interest in the net
assets of that operation.
If the subsidiary is treated as an extension of the parent then the foreign subsidiary has the same
functional currency as the parent. In this case there is no need to translate the foreign
subsidiary`s results on consolidating. Therefore, it is important to determine the functional
currency, guidance of which is given by the standard as follows. The currency:
a) That mainly influences the price at which goods and services are sold
b) Of the country whose competitive forces and regulations mainly influence the entity’s
pricing structure
c) That influences the costs of the entity
d) In which funds are generated
e) In which receipts from operating activities are retained
The first three items are generally considered to be the most influential in deciding the
functional currency. You consider the first three and if they do not give you a clear picture, you
go on to consider the last two.
If it is treated as a net investment then the foreign subsidiary has a different functional currency
from the parent. In this case the subsidiary`s financial statements have to be translated first for
consolidation.
An foreign entity whose functional currency is the currency of a hyperinflationary economy
should restate its financial statements in accordance with IAS 29 before applying the
appropriate translation method per IAS 21. When the economy ceases to be hyperinflationary
and the entity no longer restates its financial statements in accordance with IAS 29, it should
use as the historical costs for translation into the presentation currency the amounts restated to
the price level at the date the entity ceased restating its financial statements.
5.17.1 Translation into the Presentation Currency
An entity may present its financial statements in any currency, which may differ from the
functional currency. In that case, the entity's results and financial position should be translated
into the presentation currency. For example, if a group contains companies with different
ICSAZ - P.M. PARADZA
190
functional currencies, the results and financial position of the companies should be expressed
in a common currency so that consolidated financial statements can be prepared.
The results and financial position of an entity whose functional currency is not the currency of
a hyperinflationary economy should be translated into a different presentation currency using
the following procedures:
i)
Assets and liabilities for each statement of financial position presented (including
comparative figures) should be translated at the closing rate at the reporting date
ii)
Income and expenses for each statement of profit or loss and other comprehensive
income (including comparative figures) should be translated at the exchange rate
ruling at the dates of the transactions.
iii)
All resulting exchange differences should be recognized in other comprehensive
income.
Exchange differences result mainly from:
a) translating income and expenses at the exchange rate at the dates of the transactions and
assets and liabilities at the closing rates; such differences arise both on income and expense
items recognized in profit or loss and on those recognized directly in equity
b) translating the opening set assets at a closing rate that differs from the previous closing rate
IAS 21 explains that some exchange differences are not recognized in profit or loss because
related changes in exchange rates have little or no direct effect on an entity's present and future
cash flows from operations.
If the differences relate to a partly-owned foreign operation accumulated exchange differences
arising from translation and attributable to non-controlling interest should be allocated to and
recognized as part of non-controlling interest in the consolidated statement of financial
position.
5.17.2 Translation of a Foreign Operation
The incorporation of the results and financial position of a foreign operation with those of a
reporting entity should be based on normal consolidation procedures, for example, the
elimination of intra-group balances and intra group transactions. However, an intra- group
monetary asset or liability cannot be eliminated against the corresponding intra group liability
or asset without showing the results of currency fluctuations in the consolidated financial
statements. This is because the monetary item represents a commitment to convert once
currency to another, and exposes the reporting entity to a gain or loss through currency
fluctuations. In the consolidated financial statements of the reporting entity, such an exchange
difference will continue to be recognized in profit or loss (in case of an extension of parent),
recognized in other comprehensive income (in case of an independent subsidiary) and
accumulated in a separate component of equity until the disposal of the foreign operation.
ICSAZ - P.M. PARADZA
191
When the financial year-end of a foreign operation is different from that of reporting entity, the
foreign operation often prepares additional statements whose date coincides with the financial
year- end of the reporting entity. If this is not done, IAS 27 permits the use of a different
reporting date as long as the difference is not more than three months. In addition, adjustments
should be made for significant transactions or other events that occur between the different
dates. In such cases, the assets and liabilities of the foreign operation are translated at the
exchange rate at the date of the reporting date of foreign operation are translated at the exchange
at the reporting date of foreign operation. Adjustments are required for significant changes in
exchange rates up to the date of the reporting entity in accordance with IAS 27.
EXAMPLE – FOREIGN OPERATION
ACCA June 2011 examination question paper (Extracted from Q1, question requirement
adapted)
Rose, a public limited company, operates in the mining sector. The draft statements of financial
position are as follows, at 30 April 20-1:
ASSETS
Non-current assets
Property, plant and equipment
Investments in subsidiaries
Petal
Stem
Financial assets
Current assets
Total assets
EQUITY AND LIABILITIES
Share capital
Retained earnings
Other components of equity
Total equity
Non-current liabilities
Current liabilities
Total liabilities
Total equity and liabilities
Rose
$m
Petal
$m
Stem
Dinars m
370
110
380
113
46
15
544
118
662
7
117
100
217
50
430
330
760
158
256
7
421
56
185
241
662
38
56
4
98
42
77
119
217
200
300
Nil
500
160
100
260
760
The following information is relevant to the preparation of the group financial statements:
1. On 1 May 20-0, Rose acquired 70% of the equity interests of Petal, a public limited company.
The purchase consideration comprised cash of $94 million. The fair value of the identifiable
net assets recognised by Petal was $120 million excluding the patent below. The identifiable
net assets of Petal at 1 May 20-0 included a patent which had a fair value of $4 million. This
had not been recognised in the financial statements of Petal. The patent had a remaining term
of four years to run at that date and is not renewable. The retained earnings of Petal were $49
ICSAZ - P.M. PARADZA
192
million and other components of equity were $3 million at the date of acquisition. The
remaining excess of the fair value of the net assets is due to an increase in the value of land.
Rose wishes to use the ‘full goodwill’ method. The fair value of the non-controlling interest in
Petal was $46 million on 1 May 20-0. There have been no issues of ordinary shares since
acquisition and goodwill on acquisition is not impaired.
Rose acquired a further 10% interest from the non-controlling interest in Petal on 30 April 201 for a cash consideration of $19 million.
2. Rose acquired 52% of the ordinary shares of Stem on 1 May 20-0 when Stem’s retained
earnings were 220 million dinars. The fair value of the identifiable net assets of Stem on 1 May
20-0 was 495 million dinars. The excess of the fair value over the net assets of Stem is due to
an increase in the value of land. The fair value of the non-controlling interest in Stem at 1 May
20-0 was 250 million dinars.
Stem is located in a foreign country and operates a mine. The income of Stem is denominated
and settled in dinars. The output of the mine is routinely traded in dinars and its price is
determined initially by local supply and demand. Stem pays 40% of its costs and expenses in
dollars with the remainder being incurred locally and settled in dinars. Stem’s management has
a considerable degree of authority and autonomy in carrying out the operations of Stem and is
not dependent upon group companies for finance.
Rose wishes to use the ‘full goodwill’ method to consolidate the financial statements of Stem.
There have been no issues of ordinary shares and no impairment of goodwill since acquisition.
The following exchange rates are relevant to the preparation of the group financial statements:
Dinars to $
1 May 20-0
30 April 20-1
Average for year to 30 April 20-1
6
5
5·8
3. Rose has a property located in the same country as Stem. The property was acquired on 1
May 20-0 and is carried at a cost of 30 million dinars. The property is depreciated over 20 years
on the straight-line method. At 30 April 20-1, the property was revalued to 35 million dinars.
Depreciation has been charged for the year but the revaluation has not been taken into account
in the preparation of the financial statements as at 30 April 20-1.
4. Rose purchased plant for $20 million on 1 May 20-7 (i.e 2007) with an estimated useful life
of six years. Its estimated residual value at that date was $1·4 million. At 1 May 20-0 (i.e 2010),
the estimated residual value changed to $2·6 million. The change in the residual value has not
been taken into account when preparing the financial statements as at 30 April 20-1 (2011).
REQUIRED:
ICSAZ - P.M. PARADZA
193
i) Discuss and apply the principles set out in IAS 21 – The Effects of Changes in Foreign
Exchange Rates in order to determine the functional currency of Stem. (7 marks)
ii) Perform workings to come up with goodwill, NCI, adjustment to parent`s equity as a result
of the exchange transaction between group owners, patent`s carrying amount, FCTR,
overstated depreciation on local plant, revaluation surplus on foreign property and PPE, all for
consolidation purposes. You should clearly show the exchange difference arising on the
translation of Stem’s net assets. Ignore deferred taxation. (25 marks)
SUGGESTED SOLUTION
i) You should use what has been stated under 5.17 of this Unit to form the basis of your answer
ii) Workings
1. Analysis of shareholders equity in Stem
Dinars
m
At acquisition 1/5/20-0
Share capital
200
Retained earnings
220
FV adjustment – Land 75(495-420)
495
Goodwill
Purchase cons + NCI 250*NCI
Since acquisition
Retained earnings
80(300-220)
FCTR – Exchange diff
575
Goodwill – Exchange diff*(6.2-5.17)
Rate
Total At Acq
$m
$m
100%
52%
6
6
6
33.33
36.67
12.50
82.50
6
5.8
5
Since Acq
$m
52%
17.33
19.07
6.50
42.90
3.10
46.00
13.79
18.71
115.00
1.03
116.03
NCI
$m
48%
16.00
17.60
6.00
39.60
2.07
41.67
7.17
9.73
16.90
0.54
17.44
6.62
8.98
57.27
0.49
57.76
Since Acq
$m
70-80%
NCI
$m
30-20%
11.40
0.90
*Total goodwill at acquisition (3.10 + 2.07) = $5.17
*Total goodwill at reporting date 5.17 x 6/5 = $6.20
2. Analysis of shareholders equity in Petal
At acquisition 1/5/20-0
Ordinary share capital
Other equity
ICSAZ - P.M. PARADZA
Total
$m
100%
38.00
3.00
At Acq
$m
70-80%
26.60
2.10
194
Retained earnings on acquisition
Fair value adjustment (124-94) Excess
Patent
49.00
30.00
4.00
124.00
Goodwill
Investment in Petal + NCI
Since acquisition
Retained earnings (56-49)
34.30
21.00
2.80
86.80
7.20
94.00
14.70
9.00
1.20
37.20
8.80
46.00
7.00
131.00
Further acquisition 30/4/20-1(10/30 x 48.10)
Purchase consideration
Adjustment to parent`s equity (reduction)
131.00
16.03
19.00
2.97
4.90
2.10
48.10
(16.03)
4.90
32.07
Goodwill at reporting date [6.20 + (7.20 + 8.80)] = $22.20
NCI at reporting date (57.76 + 32.07) = $89.83
Intangible asset (patent) at reporting date 4-1 = $3
Group FCTR at reporting date (9.73 + 0.54) = $10.27
3. Property, plant and equipment at reporting date
$m
Rose
Petal
Stem
Increase in value of land – Petal (120 – (38 + 49 + 3))
30.00
Change in residual value Cost $20 – residual value $1·4 = 18·60
New depreciable amount at 1 May 2010
17·40
3
Less depreciation to date (18·6 x /6)
9·30
Amount to be depreciated
8·10
Depreciation over remaining three years p.a
2·70
1
Amount charged in year (18·6 x /6)
3·10
Depreciation overstated
Overseas property cost (30m/6 dinars)
5.00
5m
Depreciation ( /20)
(0·25)
Revalued amount (35/5)
7.00
Revaluation surplus to equity ($7m – 4·75m)
$m
370.00
110.00
91.00
571.00
0·40
2·25
603·65
Alternative way to come up with $0.40 and $2.25
Plant - Rose
1/5/2007
Cost
1/5/2010
Accumulated depreciation [3 x (20-1.4)/6]
Carrying amount
Current year depreciation [(10.7 – 2.6)/3]
ICSAZ - P.M. PARADZA
$m
20.00
9.30
10.70
2.70
195
Old annual depreciation charge [(20-1.4)/6]
Depreciation overstated (change not accounted for)
3.10
0.40
Foreign Property – Rose
1/5/2010
Cost 30 dinars/6
30/4/2011
Depreciation 5.00/20 years
30/4/2011
Carrying amount
30/4/2011
Revaluation reserve (balancing figure)
30/2/2011
Valuation 35 dinars/5
5.00
0.25
4.75
2.25
7.00
EXAMPLE – FOREIGN OPERATION IN A HYPERINFLATIONARY
ENVIRONMENT
ICSAZ November 2003 – Question 4 Past examination paper
The following information was obtained from the trial balance of Sipho Limited and Dehyper
Limited for the year ended 31 December 20-2:
Share capital
Accumulated profit – 1 January 20-2
Vehicles
Accumulated depreciation – vehicles
Buildings
Trade receivables
Bank
Investment in Dehyper Limited
Sales
Cost of sales
Rental paid
Depreciation – vehicles
Taxation
Operating costs
Sipho Limited
$000
Dr/(Cr)
(800 000)
(634 000)
1 520 000
(267 000)
133 000
87 000
120 000
(890 000)
350 000
112 500
160 000
108 500
Dehyper Limited
$000
Dr/(Cr)
(500 000)
330 000
(27 500)
120 000
45 000
32 000
(622 000)
250 000
80 000
27 500
80 000
185 000
Additional information
1. Sipho Limited acquired a 40% interest in Dehyper Limited on 1 January 20-2. Dehyper
is a jointly controlled asset, and it is not structured through a separate vehicle.
2. Dehyper is operating in a country with hyper-inflation. The inflation rate was 36%
during 20-2.
3. The operations of Dehyper Limited are seasonal. Approximately 60% of the company`s
sales take place during the first 4 months of the year.
4. On 1 July 20-2 Dehyper Limited entered into an agreement to rent an additional storage
room for a period of the year. The annual lease instalment of K80 000 was paid on the
same date.
5. All of Dehyper Limited vehicles were acquired on 1 March 20-2 and the buildings were
purchased on 1 February 20-2. The vehicles are written off on the straight line method
over ten years.
ICSAZ - P.M. PARADZA
196
6. Unless indicated otherwise, operating costs were incurred evenly throughout the year.
7. It is the group`s policy to amortise goodwill on the straight-line basis over 5 years.
8. The following exchange rates were applicable during the year:
9.
1 January 20-2
$1 = K2
31 December 20-2
$1 = K3
REQUIRED
Prepare the consolidated statement of profit or loss and other comprehensive income for the
year ended 31 December 20-2 and the statement of financial position of Sipho Limited at the
same date. Round amounts off to the nearest dollar. (25 marks)
SUGGESTED SOLUTION
The arrangement is a joint operation. IFRS 11 - Joint arrangements requires that a joint operator
recognises line-by-line the following in relation to its interest in a joint operation:
(i)
(ii)
(iii)
(iv)
(v)
its assets, including its share of any jointly held assets
its liabilities, including its share of any jointly incurred liabilities
its revenue from the sale of its share of the output arising from the joint operation
its share of the revenue from the sale of the output by the joint operation, and
its expenses, including its share of any expenses incurred jointly.
The accounting treatment stated above applies both to the separate and consolidated financial
statements of the joint operator.
SIPHO LIMITED GROUP
Consolidated statement of profit or loss and other comprehensive income for the year
ended 31 December 20-2
$
990 227
Revenue [890 000 + (250 567 w1 x 40%)]
(390 284)
Cost of sales [350 000 + (100 710 w1 x 40%)]
Gross profit
599 943
Operating costs (w4)
(271 654)
Profit before tax
324 289
Taxation [160 000 + (26 667 w1 x 40%)]
(170 667)
Profit for the year
157 622
SIPHO LIMITED GROUP
Consolidated statement of financial position as at 31 December 20-2
$
ASSETS
Non-current assets
Property, plant and equipment [(1 520 000 – 267 000 +
(141 132 + 52 816 -11 761) w1 x 40%]
ICSAZ - P.M. PARADZA
1 325 875
197
Intangible assets (Goodwill)
20 000
Current assets
Prepaid rentals (15 367 x w1 x 40%)
Trade receivables [133 000 + (15 000 w1 x 40%)]
Bank [87 000 + (10 667 w1 x 40%)]
6 147
139 000
91 267
1 578 289
EQUITY & LIABILITIES
Capital & Reserves
Share Capital
Accumulated earnings
Foreign currency translation reserve (23 333 w3 x 40%)
800 000
787 622
(9 333)
1 578 289
WORKINGS
w1 Adjustment and translation of trial balance of Dehyper Limited
Kwacha
DR
Share capital (500 000 x 136/100)
Vehicles (330 000 x 136/106)
423 396
Acc depn -Veh (27 500 x 136/106)
Buildings (120 000 x 136/103)
158 447
Trade receivables
45 000
Bank
32 000
Sales
Cost of sales
302 130
Rentals paid (80 000 x 136/118)/2
46 102
Rentals prepaid (80 000 x 136/118)/2 46 102
Depreciation-Veh (27 500 x 136/106) 35 283
Taxation
80 000
Operating costs (185 000 x 136/118) 213 220
Loss due to restatement
85 303
1 466 983
CR
680 000
35 283
751 700
1 466 983
680 000/3
423 396/3
35 283/3
158 447/3
45 000/3
32 000/3
751 700/3
302 130/3
46 102/3
46 102/3
35 283/3
80 000/3
213 220/3
85 303/3
$
DR/(CR)
(226 667)
141 132
(11 761)
52 816
15 000
10 667
(250 567)
100 710
15 267
15 267
11 761
26 667
71 073
28 435
Nil
Sales = 622 000 x 60% x 136/(100+112)/2 + [622 000 x 40% x 136/(112 + 136)/2] = 751 700
Cost of sales = 250 000 x 60% x 136/(100+112)/2 + [250 000 x 40% x 136/(112 + 136)/2] =
302 130
106 is used on vehicles and is calculated as follows: 36/12 x 2 months + 100 (base year)
w2 Goodwill
Shares acquired at 1 January 20-2 (500 000/2 x 40%)
Purchase consideration
Goodwill
100 000
120 000
20 000
w3 Foreign currency translation reserve
ICSAZ - P.M. PARADZA
198
Share capital 1 January 20-2 (500 000/2)
Share capital 31 December 20-2 (w1)
250 000
226 667
23 333
w4 Operating costs
Given
Hyper Limited (71 073 (w1) x 40%)
Depreciation [112 500 + (11 761 (w1) x 40%]
Rental (15 367 (w1) x 40%)
Restatement loss (28 435 (w1) x 40%)
108 500
28 429
117 204
6 147
11 374
271 654
ACTIVITY – GROUP SCENARIO WITH A FOREIGN OPERATION
Zim Ltd. acquired 90 of the shares in Moza Ltd. in Mozambique on 1 January 20-5 for $90
000. On that date the retained profit of Moza Ltd. amounted to M15 000 and the exchange rate
of the meticais (M) to the Zimbabwe dollar ($) was M 1 = $2.00. The following are the financial
statements of Zim Ltd. and Moza Ltd. in respect of the year- ended 31 December 20-9:
Income Statement for the Year-ended 31 December 20-9
Operating profit
Dividends received
Net profit before taxation
Taxation
Net profit for the year after tax
Zim Ltd.
$
270 291
15 039
285 600
(133 800)
151 800
Moza Ltd.
M
105 000
–
(105 000)
(52 500)
52 500
Statement of changes in equity for the year-ended 31 December 20-9
Balance on 31 December 20-0
Net profit for the year after tax
Dividends paid and proposed
Balance on 31 December 20-1
Retained
Earnings
Zim Ltd
$
247 200
151 800
(30 000)
369 000
Retained
Earnings
Moza Ltd
$
111 000
52 500
(13 500)
150 000
Statement of financial position as at 31 December 20-9
ASSETS
Non-current assets
Property, plant & equipment
Investment in Moza Ltd.
ICSAZ - P.M. PARADZA
Zim Ltd
$
Moza Ltd.
$
216 000
90 000
120 000
–
199
Other investments
Current assets
Inventory
Accounts receivable
Bills receivable
Bank
EQUITY & LIABILITIES
Capital and reserves
Share capital
Retained earnings
Non-current liabilities
Interest-bearing loan
Current Liabilities
Accounts payable
Shareholders for dividends
51 000
357 000
–
120 000
114 000
165 000
84 000
57 000
420 000
777 777
42 000
189 000
–
21 000
252 000
372 000
240 000
369 000
609 000
30 000
150 000
180 000
–
75 000
168 000
–
777 000
116 000
1 000
372 000
Additional information
1. The retained profit of Moza Ltd. on the indicated dates were as follows:
Date
31 December 20-5
31 December 20-6
31 December 20-7
Retained Earnings
28 500
49 500
75 000
2. The exchange rates of the meticais to the Zimbabwe Dollar on the indicated dates were as
Follows:
Date
31 December 20-5
31 December 20-6
31 December 20-7
31 December 20-8
31 December 20-9
Average for the year-ended 31 December 20-9
Exchange Rate
M 1.00 = $2.20
M 1.00 = $2.50
M 1.00 = $3.00
M 1.00 = $2.40
M.1.00 = $.230
M 1.00 = $2.20
3. Taxation and dividends are paid on 31 December of each year.
4. The group treats Moza Ltd. as a foreign entity for the purpose of translating its balances in
the course of preparing consolidated financial statements.
REQUIRED
ICSAZ - P.M. PARADZA
200
Prepare the consolidated income statement and consolidated statement of financial position of
Zim Ltd. and its subsidiary for the year-ended 31 December 2001
5.17.3 Disposal of a Foreign Operation
On the disposal of a foreign operation, the cumulative amount of the exchange differences
relating to that foreign operation recognized in other comprehensive income/equity, shall be
recognized in profit or loss when the gain or loss on disposal is recognized. Such disposal may
be in the form of a sale, a liquidation, repayment of share capital or full/ partial abandonment
of the foreign operation. The payment of a dividend by the foreign entity should be reclassified
from equity to profit or loss. In the case of a partial disposal, only the proportionate share of
the related accumulated exchange difference is included in the gain or loss.
5.19 WORKSHEET APPROACH TO CONSOLIDATION QUESTIONS [IFRS 3
(2004)]
ILLUSTRATION OF BUSINESS COMBINATION EFFECTED IN STAGES
R Ltd purchased 25% of the ordinary shares in S Ltd on 1 July 20-8 for $14 700 000 cash. On
that date, the fair value of S Ltd's identifiable net assets was $45 000 000, while their carrying
amount amounted to $33 600 000. This company had no liabilities or contingent liabilities on
that date. Its financial position and fair value information on July 20-8 were as follows:
ASSETS
Land
Cash and receivables
EQUITY
Ordinary share capital ($100 shares)
Retained profits
Carrying amounts
$
25 200 000
8 400 000
33 600 000
Fair values
$
36 600 000
8 400 000
45 000 000
20 000 000
13 600 000
33 600 000
During the year ended 30 June 20-9, S Ltd made a net profit of $31 500 000, but did not pay
any dividends. During the same period, the fair value of its land increased by $13 400 000,
although this increase was not reflected in the statement of financial position at 30 June 2009
as shown below:
ASSETS
Land
Cash and receivables
EQUITY
Ordinary share capital ($100 shares)
ICSAZ - P.M. PARADZA
Carrying amounts
$
25 200 000
35 000 000
60 200 000
Fair values
$
50 000 000
35 000 000
85 000 000
20 000 000
201
Retained profits
40 200 000
60 200 000
On 1 July 20-9, R Ltd purchased an additional 45% of the ordinary shares in S Ltd for $100
000 000 cash, thereby obtaining control. On that date, S Ltd's ordinary shares had a market
value of $350 per share. During the year ended 30 June 20-9, R Ltd's ordinary share capital
amounted to $120 000 000. This company's assets consist of only cash and the investment in S
Ltd.
REQUIRED
a) Draw up the statement of financial position of R Ltd on 30 June 20-9.
b) Draw up a consolidation worksheet for R Ltd on July 20-9 (after acquisition of additional
shares in S Ltd)
SUGGESTED SOLUTION
a) Separate financial statement of financial position of R Ltd on 30 June 20-9
Assets
Investment in S Ltd
Cash
$
17 500 000(i)
105 300 000
122 800 000
Equity
Ordinary share capital ($100 shares)
Retained profits
120 000 000(ii)
2 800 000(i)
122 800 000
i)
R Ltd's initial 25% investment in S Ltd is measured at $14 700 000, that is, the
purchase price. However, S Ltd's 200 000 ordinary shares have a market price of
$350 per share on 1 July 20-9. The carrying amount of the original investment is
measured in R Ltd's financial statements to (200 000 x $350) x 25% = $17 500 000.
The increase of (17 500 000 - 14 700 000) = $2 800 000 is recognised in profit or
loss for the period
ii)
balancing figure
ICSAZ - P.M. PARADZA
202
b) Investor`s consolidation worksheet (per IFRS 3 - 2004)
Separate financial
statements
R Ltd
S Ltd
$
$
000
000
Consolidation
adjustments
Debit
Credit
$
$
000
000
Land
-
24 800(i)
Goodwill
-
3 450(iii)
-
61 750(iv)
ASSETS
Non-current assets
25 200
Investment in S Ltd
17 500
Current assets
Cash
Total assets
105 300
122 800
Consolidated
figures
$
000
50 000
65 200
2 800(ii)
14 700(iii)
35 000
60 200
EQUITY
Share capital & reserves
Ordinary Share Cap. 120 000
100 000(iv)
20 000
6 000(v)
5 000(iii)
40 300
155 500
120 000
9 000(iv)
Revaluation Reserve
-
Retained Profits
Non-controlling int.
Total equity
2 850(iii)
11 160(iv)
7 440(v)
2 800
122 800
40 200
60 200
24 800(i)
3 350
2 800(ii)
3 400(iii)
18 090(iv)
12 060(v)
167 800
6 650
25 500(v)
167 800
25 500
155 500
SUPPORT WORKINGS TO THE CONSOLIDATION WORKSHEET ABOVE:
Analysis of Equity (25%)
Ordinary Share Capital
Retained Profits
Revaluation Reserve
ICSAZ - P.M. PARADZA
Total
$
000
100%
20 000
13 600
11 400
At Acq
$
000
25%
5 000
3 400
3 350
203
45 000
11 250
14 700
3 450
Total
$
000
100%
20 000
40 200
24 800
85 000
At Acq
$
000
45%
9 000
18 090
11 160
38 250
100 000
61 750
Investment in S ltd
Goodwill
Analysis of Equity (45%)
Ordinary Share Capital
Retained Profits
Revaluation Reserve
Investment in S ltd
Goodwill
5.20 CONSOLIDATION DISCLOSURES
5.20.1 IFRS 12
Significant judgments and assumptions
An entity discloses information about significant judgments and assumptions it has made
(and changes in those judgments and assumptions) in determining: [IFRS 12:7]
•
•
•
that it controls another entity
that it has joint control of an arrangement or significant influence over another
entity
the type of joint arrangement (that is, joint operation or joint venture) when the
arrangement has been structured through a separate vehicle.
Interests in subsidiaries
An entity shall disclose information that enables users of its consolidated financial statements
to: [IFRS 12:10]
•
•
•
•
•
•
understand the composition of the group
understand the non-controlling interests in the group's activities and cash flows
evaluate the nature and extent of significant restrictions on its ability to access
or use assets, and settle liabilities, of the group
evaluate the nature of, and changes in, the risks associated with its interests in
consolidated structured entities
evaluate the consequences of changes in its ownership interest in a subsidiary
that do not result in a loss of control
evaluate the consequences of losing control of a subsidiary during the reporting
period.
ICSAZ - P.M. PARADZA
204
Interests in joint arrangements and associates
An entity shall disclose information that enables users of its financial statements to evaluate:
[IFRS 12:20]
•
•
the nature, extent and financial effects of its interests in joint arrangements and
associates, including the nature and effects of its contractual relationship with
the other investors with joint control of, or significant influence over, joint
arrangements and associates
the nature of, and changes in, the risks associated with its interests in joint
ventures and associates.
Interests in unconsolidated structured entities
An entity shall disclose information that enables users of its financial statements to: [IFRS
12:24]
•
•
understand the nature and extent of its interests in unconsolidated structured
entities
evaluate the nature of, and changes in, the risks associated with its interests in
unconsolidated structured entities.
Source IFRS 12
5.20.2 IAS 21
i) An entity should disclose
a) the amount of exchange differences recognized in profit or loss, except for those arising on
financial instruments measured at fair value through profit or loss in accordance with IFRS 9
b ) Net exchange recognized in other comprehensive income and accumulated in a generate
component of equity and reconciliation of the amount of such differences at the beginning and
end of the period
ii) When the presentation currency is different from the functional currency, that fact should
be stated, together with disclosure of the functional currency and the reason for using a different
presentation currency.
iii) When there is a change in the functional currency of either the reporting entity or a
significant foreign operation, that fact and the reason for the change in functional currency
should be disclosed.
iv) When an entity presents its financial statements in a currency that is different from its
functional currency, it should describe the financial statements as complying with international
financial reporting standard only if they comply with all requirements of IFRSs including the
relevant transaction method.
ICSAZ - P.M. PARADZA
205
v) When an entity displays its financial statements or other financial information in a currency
that is different from either its functional currency or its presentation currency and the
requirements in iv) are not met, it should:
a) clearly identify the information as supplementary information to distinguish it from the
information that complies with international financial reporting standards;
b) disclose the currency in which the supplementary information is displayed;
c) disclose the entity's functional currency and the method of translation used to determine the
supplementary information.
5.21 SUMMARY
This Unit explains the consolidation procedures which are used to combine the financial
statements of companies which belong to the same group. Group components of financial
statements consists of the Consolidated Statement of Comprehensive Income, the Consolidated
Statement of Changes in Equity, the Consolidated Statement of Financial Position and the
Consolidated Statement of Cash Flows, which will be discussed in the next Unit. Additional
information on a group's trading results, financial position and cash flows can be found in the
Notes to the Financial Statements and the Chairperson's statement.
5.22 REFERENCES
Bonham, Curtis et al.
International GAAP 2012
Cilliers, H. S., Rossouw. S, Faul, M. A., 2010
Group Statements Vol 1 and 2,
13th Edition, Butterworths
London
Deloitte.
Business combinations and
changes in ownership interests
IASB
International Financial Reporting
Standards 2015
Pwc
Manual of Accounting, IFRS
2015
KOPPESCHAAR Z. R. et al
Descriptive Accounting, IFRS
Focus, 18th Edition, LewisNexis
IRZA, A. A.; ORRELL, M.; HOLT. G. J.,
Wiley IFRS Practical
Implementation and Guide
Workbook, 2nd Edition, Hoboken,
New Jersey, 2008
University of South Africa
Group Financial Accounting
ICSAZ - P.M. PARADZA
206
UNIT SIX
GROUP STATEMENT OF CASHFLOWS (IAS 7)
6.0 INTRODUCTION
In order to give a fuller picture of the operations and financial position of a reporting entity,
IAS 7 requires the preparation of statements of cash flow by single entities and, by implication
consolidated statements of cash flow for group companies. According to this standard,
information in statements of cash flow enables users to evaluate changes in the entity's net
assets, its financial structure, and its ability to effect the amounts and timing of cash flows in
order to adapt to changing circumstances and opportunities. In the 2004 revision of the
standard, the IASB adopted a pure cash flow approach, according to which only transactions
which involve the use of cash and cash equivalents are highlighted in the cash flow statements.
6.1 OBJECTIVES
By the end of this Unit, you should be able to:
•
Identify the major categories of cash flows, and list the transactions which are included
in these categories.
•
Prepare consolidated statements of cash flow using the direct and indirect methods.
•
Account correctly for the acquisition and disposal of subsidiaries in the context of cash
flow statements.
•
Identify the cash flows related to investments in associates and movements in minority
shareholders interest.
•
Explain alternative methods of accounting for investments in associates.
•
Prepare consolidated financial statements for groups which include associates.
6.2 CLASSIFICATION OF CASH FLOWS
IAS 7 states that a statement of cash flows should report cash flows during the reporting period
classified on the basis of reporting, investing and financing activities. Categories which are
found in standards published by other accounting bodies, for example, returns on investments
and servicing of finance are not recognized by this standard.
1. Cash flows from operating activities are those which are primarily derived from an
entity's primary revenue-generating activities.
2. Cash flows from investing activities are those which show the extent to which
expenditures have been made for resources intended to generate future income and cash
flows.
ICSAZ - P.M. PARADZA
207
3. Cash flows from financing activities are those which are based on transactions between
the entity and its capital providers
6.2.1 DIFFERENT TYPES OF CASH FLOWS
i. Cash flows from interest and dividends received and paid should be disclosed separately,
interest paid is mainly an operating item, while interest received is an investing item, and
dividends received are an investing item, while dividends paid are a financing item.
ii. Cash flows related to taxation should be classified as operating items, unless they can be
specifically identified with financing and investing activities. When taxation-related cash flows
are identified with various activities, the amount of taxes paid should be shown.
Note that these are recommendations which should be followed consistently once adopted. Para
33 of IAS 7 states that there is currently no consensus on the classification of the items for
entities that are not financial institutions. As a result, Interest paid and interest and dividends
received may be classified as operating cash flows because they enter into the determination of
profit or loss. Alternatively interest paid and interest and dividends received may be classified
as financing cash flows and investing cash flows respectively, because they are costs of
obtaining financial resources or returns on investments." According to para 34, dividends paid
may be classified as a financing cash flow, because they represent a cost of obtaining financial
resources. On the other hand, the dividends may be regarded as a cash flow from operating
activities "in order to assist users to determine the ability of an entity to pay dividends out of
operating cash flows."
6.2.2 TREATMENT OF GROUP CASH FLOWS
Bonham. Curtis et al (2004) have observed that IAS 7 does not distinguish between single
entities and groups, and there are no specific requirements on the preparation of consolidated
cash flow statements. This means that such statements should only show the movements of
cash and cash equivalents into and out of the group. Inter-company transactions and balances
should be eliminated as explained in Unit 5. However, it should be noted that dividends paid
to minority shareholders are an actual cash outflow from the viewpoint of the holding
company's shareholders. Such dividends should therefore be included in the consolidated cash
flow statement.
Important Note!!
You should be aware of the benefits of preparing the statement of cash flows as stated by IAS
7
6.3 PREPARATION AND PRESENTATION OF GROUP STATEMENT OF CASH
FLOWS
A consolidated cash flow statement can be prepared directly from the consolidated income
statement and the consolidated statement of financial position of the current and previous
periods, if all the necessary information is available. It is also possible to base the consolidated
ICSAZ - P.M. PARADZA
208
statements of cash flow on the individual cash flow statements of the group companies, with
special adjustments being required in relation to associates.
There are two approaches to the presentation of group cash flows, these are:
i)
The direct approach, and
ii)
The indirect approach
Student Note:
Where not given elaborately, the holding company ordinary dividend paid is equal to the
closing retained earnings less the summation of opening retained earnings + current year profit
after tax - transfer to general reserves - preference dividend.
6.3.1 Direct approach
XYZ LTD AND ITS SUBSIDIARIES
Consolidated statement of cash flows for the year ended 31 December 20-X1
(Assuming disposal of interest in subsidiary during the current financial year)
$000
1. Cash flow from operating activities
Cash received from customers (w1)
Cash paid to suppliers and employees (w2)
Cash generated from operations
Interest received (can possibly appear under heading 2. below)
Interest paid
Dividend received (can possibly appear under heading 2. below)
Dividend paid (can possibly appear under heading 3. below)
Dividend paid to non-controlling interest (w3)
Dividend received from associate (w4) (can possibly appear under heading 2. below)
Taxation paid (w5)
Net cash inflow or outflow from operating activities
xxx
(xxx)
xxx
xxx
(xxx)
xxx
(xxx)
(xxx)
xxx
(xxx)
xxx
2. Cash flow from investing activities
Net proceeds from disposal of interest in subsidiary (Note4)
Proceeds from disposal of non-current assets
Acquisition of non-current assets
Net cash inflow or outflow from investing activities
xxx
xxx
(xxx)
xxx
3. Cash flow from financing activities
Proceeds from share issue
Repayment of long term loans
Net cash inflow or outflow from financing activities
xxx
(xxx)
xxx
4. Increase or decrease in cash and cash equivalents
Cash and cash equivalents
Cash and cash equivalents
xxx
xxx
xxx
ICSAZ - P.M. PARADZA
209
N.B. Cash and cash equivalents usually comprise of cash at hand, cash at bank and short term investments
Notes to the statement of cash flows
Note 2 – Analysis of the balances of cash and cash equivalents as shown in the statement
of financial position
Cash at hand
Short term investments
Bank overdraft
Total
20X1
$
xxxhigher
xxxhigher
(xxx)lower
xxx
20X0
$
xxxlower
xxxlower
(xxx)higher
xxx
Change
$
xxx
xxx
xxx
xxx
Note 3 – Net proceeds from disposal of interest in subsidiary (It is possible to present this
as a working where notes to statement of cash flows are not required by an examination
question)
Property, plant and equipment
Inventory
Trade receivables
Trade receivable
Cash at bank
Non-current liabilities
Trade payables
Net assets
Non-controlling interest`s share of net assets
Net assets attributable to equity holders of parent
Goodwill (where given)
Profit on disposal of interest in subsidiary
Gross proceeds
Cash at bank disposed of in subsidiary’s net assets
Net proceeds from disposal of interest in subsidiary
$
xxx
xxx
xxx
xxx
xxx
(xxx)
(xxx)
xxx
(xxx)
xxx
xxx
xxx
xxx
xxx
(xxx)
xxx
Workings
(Only for selected areas not covered at Introduction to Financial Accounting and
Financial Accounting Level)
$
w1. Cash received from Customers
Opening balance trade receivables
xxx
Current year revenue (use credit sales when given)
xxx
Closing balance trade receivables
(xxx)
xxx
Trade receivables disposed of in subsidiary’s net assets
(xxx)
Cash received from credit customers
xxx
(cash
sales
when
given
or
identifiable
separately)
Current year revenue
xxx
Cash received from customers
xxx
ICSAZ - P.M. PARADZA
210
w2. Cash paid to Suppliers and Employees
Opening balance trade payables
Current year purchases (credit purchases where given)
Closing balance trade payables
Trade payables disposed of in subsidiary’s net assets
Cash paid to credit suppliers
Current year purchases (cash purchases when given or identifiable separately)
Cash paid to suppliers
Other operating expenses paid cash
Cash paid to suppliers and employees
xxx
xxx
(xxx)
xxx
(xxx)
xxx
xxx
xxx
xxx
xxx
w3. Dividend paid to Non-controlling interest
Opening balance NCI
Profit after tax attributable to NCI
NCI in subsidiary disposed of
Closing balance NCI
Dividend paid to NCI
xxx
xxx
(xxx)
xxx
xxx
w4. Dividend received from Associate
Opening balance Investment in Associate
Share of profit after tax in Associate
Closing balance Investment in Associate
Dividend received from Associate
xxx
xxx
(xxx)
xxx
w5. Taxation paid
Opening balance current tax payable
Opening balance deferred tax liability
Current year tax expense
Closing balance current tax payable
Closing balance deferred tax liability
Taxation paid
xxx
xxx
xxx
(xxx)
(xxx)
xxx
6.3.2 Indirect approach
The difference arises only in the presentation of cash generated from operations. The format
from then on is similar to that of the direct method above.
XYZ LTD AND ITS SUBSIDIARIES
Consolidated statement of cash flows for the year ended 31 December 20-X1
$000
1. Cash flow from operating activities
Profit before tax
Adjustment for non-cash items
Depreciation
Loss on disposal of non-current assets
Foreign exchange loss
Fair value gain
ICSAZ - P.M. PARADZA
xxx
xxx
xxx
xxx
(xxx)
211
Adjustment for non-operating items
Interest income
Interest expense
Dividend income
Adjustment for changes in working capital
Increase in trade receivables*1
Increase in inventory *1
Increase in trade payables *1
Increase in accruals
Increase in prepayments
Cash generated from operations
Interest received
Interest paid
Dividend received
Dividend paid
Dividend paid to non-controlling interest
Dividend received from associate
Taxation paid
Net cash inflow or outflow from operating activities
(xxx)
xxx
(xxx)
(xxx)
(xxx)
xxx
xxx
(xxx)
xxx
xxx
(xxx)
xxx
(xxx)
(xxx)
xxx
(xxx)
xxx
Dividend paid is omitted on the adjustment for non-operating items because it is paid from
profit after tax.
*1 Do not forget to adjust these line items for the effects of the disposal of interest in subsidiary.
6.4 FOREIGN CURRENCY CASH FLOWS
IAS 7 states that cash flows arising from transactions in a foreign currency should be recorded
in a reporting entity's currency by using the spot rate between this currency and the foreign
currency at the date of the transaction. In addition, the cash flows of a foreign subsidiary should
be translated at the exchange rate between the entity's currency and the currency at the dates of
the transactions. Unrealized gains and losses arising from changes in foreign currency
exchange rates should not be treated as cash flows. However, the effect of such changes on
cash and cash equivalents held or payable in a foreign currency is reported in the cash flow
statement when reconciling cash and cash equivalent balances at the beginning and end of the
period.
EXAMPLE - BASED ON APPENDIX A IN IAS 7 (ACQUISITION OF SUBSIDIARY
DURING THE YEAR)
The financial statements of H Ltd and its subsidiaries for the year-ended 31 March 20-6 as
follows:
Consolidated income statement for the year ended 30 March 20-6
Sales
Cost of goods sold
Gross profit
Depreciation
$
1 379 250
(1 170 000)
209 250
(20 250)
ICSAZ - P.M. PARADZA
212
Administrative & selling expenses
Interest expense
Investment income
Foreign exchange loss
Profit before taxation
Tax expense
Profit after tax
( 40 950)
(18 000)
22 500
( 1 800)
150 750
(13 500)
137 550
Consolidated statement of financial position as at 31 March 20-6
ASSETS
Non-current assets
Property, plant & equipment (cost)
Accumulated depreciation
Portfolio investments
Current Assets
Inventory
Accounts receivable
Cash & cash equivalents
Total assets
EQUITY & LIABILITIES
Share capital and reserves
Share capital
Retained earnings
Long-term debt
Current Liabilities
Accounts payable
Income tax payable
Interest payable
Total equity and liabilities
20-5
$
20-6
$
85 950
(47 700)
38 250
112 500
150 750
167 850
(65 250)
102 600
112 500
215 100
87 750
54 000
7 200
148 950
299 700
45 000
85 500
10 350
140 850
355 950
56 250
62 100
118 350
46 800
165 150
67 500
145 350
212 850
103 500
316 350
85 050
45 000
4 500
134 550
299 700
11 250
10 350
18 000
39 600
355 950
Additional information
i)
During the year, the holding company acquired all the shares of the subsidiary for
$26 550. The fair values of the assets acquired and liabilities assumed were as
follows:
$
Inventories
4 500
Accounts receivable
4 500
Cash
1 800
Property, plant & equipment
29 250
ICSAZ - P.M. PARADZA
213
Accounts payable
Long-term debt
ii)
iii)
iv)
v)
4 500
9 000
$11 250 was raised from the issue of additional shares.
Dividends paid amounted to $54 000.
During the year, the group paid $56 250 to acquire additional property, plant and
equipment.
Plant which had cost $3 600 and had accumulated depreciation of $2 700 was sold
for $9 900.
REQUIRED
a) Consolidated statement of cash flow for the year-ended 31 March 20-6 using the
direct method.
b) Consolidated statement of cash flows for year ended 31 March 20-6 using the indirect
method.
SUGGESTED SOLUTION
a)
H LTD AND ITS SUBSIDIARIES
Consolidated statement of cash flows for the year ended 31 March 20-6 (Direct method)
$
1. Cash flow from operating activities
Cash received from customers (w1)
1 352 250
Cash paid to suppliers and employees (w2)
1 242 000
Cash generated from operations
110 250
Interest paid (w5)
(45 000)
Income tax paid (w4)
(7 650)
Dividend paid
(54 000)
Net cash inflow from operating activities
3 600a
2. Cash flow from investing activities
Net cash paid on acquisition of interest in subsidiary (w6)
Acquisition of property, plant and equipment (w8)
Proceeds from plant disposal
Investment income
Net cash outflow from investing activities
(24 750)
(56 250)
9 900
13 500
57 600b
3. Cash flow from financing activities
Proceeds from issue of shares
Proceeds from long term debt (w7)
Net cash inflow from financing activities
11 250
47 700
58 950c
4. Increase in cash and cash equivalents (a+b+c) = (10 350 – 5 400)
Restated opening cash and cash equivalents (w9)
Closing cash and cash equivalents
4 950
5 400
10 350
ICSAZ - P.M. PARADZA
214
WORKINGS
$
w1. Cash received from customers
Opening balance trade receivables
Add trade receivables from subsidiary acquired
Add current year revenue
Less closing balance trade receivables
w2. Cash paid to suppliers and employees
Opening balance trade payables
Add trade payables from subsidiary acquired
Add current year purchases
Less closing balance trade payables
Add other operating expenses paid cash
w3. Purchases
Cost of sales
Closing inventory
Opening inventory (87 750 + 4500)
w4. Income tax paid
Opening balance
Tax expense
Closing balance
w5. Interest paid
Opening interest payable
Interest expense
Closing interest payable
54 000
4 500
1 379 250
(85 500)
1 352 250
85 050
4 500
1 122 750
(11 250)
1 201 050
40 950
1 242 000
1 170 000
45 000
(92 250)
1 122 750
4 500
13 500
(10 350)
7 650
45 000
18 000
(18 000)
45 000
w6. Net cash paid on acquisition of interest in subsidiary (present as a note if required)
Property, plant and equipment
Inventory
Accounts receivable
Cash
Accounts payable
Long term debt
Goodwill
Gross cash paid on acquisition of interest in subsidiary
Less cash in subsidiary`s net assets acquired
ICSAZ - P.M. PARADZA
29 250
4 500
4 500
1 800
(4 500)
(9 000)
26 550
Nil
26 550
(1 800)
24 750
215
w7. Proceeds from long term debt
Closing balance
Less long term debt assumed from subsidiary`s net assets acquired
Less Opening balance
w8. Acquisition of property, plant and equipment
Closing carrying amount
Carrying amount of plant disposed of
Less property, plant and equipment in subsidiary`s net assets acquired
Less opening carrying amount
w9. Restated opening cash and cash equivalents
Opening cash and cash equivalents
Less foreign exchange loss
103 500
(9 000)
(46 800)
47 700
167 850
3 600
(29 250)
(85 950)
56 250
7 200
(1 800)
5 400
b)
Consolidated statement of cash flows for the year ended 31 March 20-6
(Indirect method)
$
1. Cash flow from operating activities
Profit before tax
Adjustment for non-cash items
Depreciation
Foreign exchange loss
Adjustment for non-operational items
Interest expense
Investment income
Profit on sale of plant [9 900 - (3 600 - 2700)]
Adjustment for changes in working capital
Decrease in inventory
Increase in accounts receivable
Decrease in accounts payable
Cash generated from operations
150 750
20 250
1 800
18 000
(13 500)
(9 000)
47 250
(27 000)
(78 300)
110 250
N.B.1 The format from then on is similar to that of the direct method above.
N.B.2 You can still make use of T – Accounts.
ICSAZ - P.M. PARADZA
216
EXAMPLE - DISPOSAL OF INTEREST IN SUBSIDIARY DURING THE YEAR
The financial statements of X Ltd. and its subsidiaries for the year-ended 30 June 20-6 were as
follows:
Consolidated income statement for year ended 30 June 20-6
$
3 126 000
99 120
3 225 120
(1 651 200)
1 573 920
(271 200)
1 302 720
Operating profit before tax
Gain on disposal of shares
Net profit before tax
Tax expense
Net profit after tax
Non-controlling interest
Profit after tax
Consolidated statement of changes in equity for year ended 30 June 20-6
Retained
Earnings
$
4 462 800
1 302 720
(480 000)
5 285 520
Balance b/f
Profit after tax
Dividends proposed - X Ltd
Balance c/f
Consolidated statement of financial position as at 30 June 20-6
ASSETS
Tangible non-current assets at cost
Accumulated depreciated
Goodwill on consolidation
Current Assets
Inventory
Trade receivables
Negotiable certificates of deposit
Cash/bank balances
EQUITY & LIABILITIES
Ordinary share capital
Retained earnings
Non-controlling interest
ICSAZ - P.M. PARADZA
20-5
$
12 200 000
(4 248 000)
7 952 000
596 000
8 548 000
20-6
$
10 200 000
(4 076 000)
6 124 000
312 000
6 436 000
2 472 000
1 796 000
2 000 000
288 000
6 556 000
15 104 000
2 644 000
936 000
2 500 000
840 000
6 920 000
13 356 000
3 200 000
4 462 800
1 489 200
9 152 000
3 200 000
5 285 520
1 058 400
9 543 920
217
Current Liabilities
Trade payables
Tax payable
Bank Overdraft
Proposed dividends - X Ltd
- Non-controlling interest
1 804 000
2 024 000
1 644 000
420 000
60 000
5 952 000
15 104 000
1 608 880
1 651 200
–
480 000
72 000
3 812 080
13 356 000
Additional information
X Ltd. sold all its shares in Z Ltd. on 1 April 20-6. Prior to this transaction, X Ltd. had owned
60% of the shares in Z Ltd. The details of the transaction were as follows:
$
$
Proceeds of sale
1 280 000
Non-current assets at cost
2 000 000
Accumulated depreciation
(828 000)
1 172 000
Inventory
164 000
Trade receivables
531 200
Cash
106 800
Trade payables
(236 000)
Tax payable
(243 200)
1 494 800
Group`s share (60%)
896 880
Goodwill
284 000
(1 180 880)
Gain on disposal of interest in subsidiary
99 120
REQUIRED
Draw up a consolidated cash flow statement for the year-ended 30 June 20-6, using the
indirect method.
SUGGESTED SOLUTION
X LTD AND ITS SUBSIDIARY
Consolidated statement of cash flows for the year ended 30 June 20-6
$000
1. Cash flow from operating activities
Profit before tax
3 126.00
Adjustment for non-cash items
Depreciation
656.00
Adjustment for changes in working capital
Increase in inventory (2 644 + 164 - 2 472)
(336.00)
Decrease in trade receivables (936 + 531.2 - 1796)
328.80
Increase in trade payables (1 608.8 + 236 - 1 804)
40.80
Cash generated from operations
3 815.60
Dividend paid - X Ltd
(420.00)
ICSAZ - P.M. PARADZA
218
- Non-controlling interest
Taxation paid
Net Cash Inflow from operating activities
(92.00)
(7 780.80)
1 522.80
2. Cash flow from investing Activities
Net proceeds from disposal of interest in subsidiary
Net cash inflow from investing activities
1 173.20
1 173.20
3. Cash flow from financing Activities
Nil
4. Increase in cash and cash equivalents
Opening cash and cash equivalents (-1 644 + 288 + 2 000)
Closing cash and cash equivalents (840 + 2 500)
2 696.00
644.00
3 340.00
Non-current Assets
Balance b/d
Dr ($000)
12 200
Disposal
Balance b/d
12 200
Accumulated Depreciation
Disposal of subsidiary
Balance c/d
828
4 076
4 904
Balanced b/d
SCI
Cr ($000)
2 000
10 200
12 200
4 248
656
4 904
Dividend Payable a/c (X Ltd)
Bank
Balance c/d
420
480
900
Balance b/d
SCI
420
480
900
Non-controlling Interest a/c
NCI disposal
Dividends paid X
NCI
Balance c/d
Balance c/d
598.00
60.00
32.00
72.00
1 058.40
1 820.40
Balance b/d
SCI
Balance b/d
60.00
271.20
1 489.20
1 820.40
Taxation Payable
Bank
Disposal
Balance c/d
ICSAZ - P.M. PARADZA
1 780.80
243.20
1 651.20
3 675.20
Balance b/d
SCI
2 024.00
1 651.20
3 675.20
219
WORKINGS
w1. Acquisition of property, plant and equipment
Balance b/d
Less Disposal of on sale of interest in subsidiary
Less Balance c/d
w2. Depreciation charge
Balance b/d
Less Disposal of on sale of interest in subsidiary
Less Balance c/d
w3. Dividend paid - X Ltd
Balance b/d
add SOCIE
Less Balance c/d
w4. Dividend paid to non-controlling interest
Balance b/d - proposed dividend
- NCI
Add SCI
Less NCI Disposed of on sale of interest in subsidiary
Balance c/d - proposed dividend
- NCI
$
12 200
(2 000)
(10 200)
Nil
4 248
(828)
4 076
656
420
480
(480)
420
60.00
1 489.20
271.20
(598.00)
(72.00)
(1 058.40)
92.00
w5. Net cash proceeds from disposal of investment in Z Ltd (present as a note if
required)
Property plant & equipment
Inventory
Trade receivables
Cash
Trade payables
Taxation
Non-controlling interest
Attributable for equity holders of parent
Goodwill
Carrying amount
Profit on disposal
Gross Proceed
Less Cash in net assets of subsidiary sold
ICSAZ - P.M. PARADZA
$
1 172.00
164.00
531.20
106.80
(236.00)
(243.20)
1 494.80
(598.00)
896.80
284.00
1 180.80
99.20
1 280.00
(106.80)
1 173.20
220
ACTIVITY - ACQUISITION OF SUBSIDIARY DURING THE YEAR
The financial statement of H. Ltd and it subsidiary for the year ended 31 March 20-6 were as
follows.
Summarised consolidated income statement for the year ended 31 March 20-6
$
1 358 000
602 000
756 000
Profit before tax
Tax expense
Net profit after tax
Attributable to:
Owners of the parent
Non-controlling interest
659 400
96 600
756 000
Consolidated statement of financial position as at 31 March 20-6
ASSETS
Non-current assets
Tangible non-current assets
Goodwill on consolidation
Current assets
Inventory
Short-term investments
Trade receivables
Cash/bank
EQUITY & LIABILITIES
Ordinary share capital
Share premium
Retained earnings
Non-controlling interest
Current Liabilities
Trade payables
Tax payable
Proposed dividends
ICSAZ - P.M. PARADZA
20-5
$
896 840
350 000
1 246 840
20-6
$
1 496 460
420 000
1 916 460
688 800
288 400
229 600
44 940
2 498 580
820 400
343 000
429 800
127 540
3 637 200
300 000
812 000
432 180
1 544 180
500 000
500 000
981 400
477 400
2 458 800
219 400
504 000
231 000
2 498 580
310 400
602 000
266 000
3 637 200
221
Consolidated statement of changes in equity for year ended 31 March 20-6
Retained
Earnings
$
812 000
659 400
(224 000)
(266 000)
981 400
Balance b/f
Consolidated net profit after tax
Dividends
- paid
- proposed
Balance c/f
Additional information
1. During the year, the acquired all the shares in another company. The details of the transaction
were as follows:
$
Purchase consideration
160 000
$1 Ordinary shares
448 000
Tangible non-current assets
196 000
Goodwill on consolidation
70 000
Inventory
98 000
Receivables
126 000
Payables
(42 000)
2. Details for tangible non-current assets
Net book value 1 April 20-5
Additions
Depreciation
Freehold
Property
$
574 000
385 000
(14 000)
945 000
Machinery Total
& Vehicles
$
$
322 840
896 840
273 000
658 000
(44 380)
(58 380)
551 460
1 496 460
REQUIRED
Draw up a consolidated statement of cash flows for the year-ended 31 March 20-6, using the
indirect method
6.5 SUMMARY
This Unit completes the consideration of basic consolidated financial statements, including the
main adjustments which are normally required. The consolidated cash flow statement is a
reclassification of the items found in other financial statements to put more emphasis on actual
cash flows for the reporting period.
6.6 REFERENCES
KOPPESCHAAR Z. R. et al
Descriptive Accounting, IFRS
Focus, 18th Edition, LewisNexis
University of South Africa
Group Financial Accounting
ICSAZ - P.M. PARADZA
222
UNIT SEVEN
FAIR VALUE MEASUREMENT (IFRS 13)
7.0 INTRODUCTION
IFRS 13 gives comprehensive guidance related to other standards which require or permit fair
value measurements or disclosures about fair value measurements. Fair value should be
distinguished from other measurements which may be based on it, for example, fair value less
costs to sell, value in use and replacement cost. Many earlier IASs and IFRSs have references
to the measurement and disclosure of fair value, but IFRS 13 is the standard which consolidates
and clarifies accounting requirements related to fair value. According to the IASB,
inconsistencies in the requirements for measuring fair value and for disclosing information
about fair value measurements have contributed to diversity in implementation, and reduced
the comparability of information reported in financial statements.
7.1 OBJECTIVES
By the end of this Unit, you should be able to:
•
Define and explain the concept of fair value.
•
Explain how the concept of fair value can be applied to an entity’s liabilities and its
own equity instruments.
•
Explain the determination of fair value where there are no observable markets.
•
Identify and explain different valuation techniques which are available under IFRS 13.
•
Explain and apply the fair value hierarchy under IFRS 13.
7.2 TERMINOLOGY
IFRS 13 defines some key terms as follows:
Active market is a market in which transactions for an asset or liability take place with
sufficient frequency and volume to provide pricing information on an ongoing basis.
Entry price is the price paid to acquire an asset or received to assume a liability in an exchange
transaction.
Exit price is the price that would be received to sell an asset or paid to transfer a liability.
Fair value is the price that would be received to sell an asset or paid to transfer a liability in
an orderly transaction between market participation at the measurement date.
Orderly transaction is a transaction that assumes exposure to the market for a period before
the measurement date to allow for marketing activities that are usual and customary for
transactions involving the related assets or liabilities. It is not a forced transaction e.g. a forced
liquidation or distress sale.
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223
Observable inputs are inputs that are developed using market data e.g. publicly available
information about actual events or transactions. Such inputs reflect the assumptions that market
participants would use when pricing an asset or liability.
Unobservable inputs are inputs for which market data are not available. Such inputs are
developed using the best information available about the assumptions that market participants
would use when pricing an asset or a liability.
7.3 THE ESSENTIALS OF A FAIR VALUE MEASUREMENT
IFRS 13 explains that a fair value measurement requires an entity to determine the following:
a) the particular asset or liability being measured.
b) for a non-financial asset, the highest and best use of the asset, and whether the asset is used
in combination with other assets or on a stand-alone basis.
c) the market in which an orderly transaction would take place for the asset or liability; and
d) the appropriate valuation technique(s) to use when measuring fair value .
7.4 KEY FEATURES OF FAIR VALUE MEASUREMENT
1. The asset or liability being measured
When measuring fair value, an asset should take into account the characteristics of the asset or
liability which would be considered by market participants on the measuring date. Such
characteristics include:
•
•
the condition and location of the asset
restrictions, if any, on the sale or use of the asset.
The asset or liability measured at fair value may be either of the following:
a) a stand-alone asset or liability e.g. a financial instrument or a non-financial
asset; or
b) a group of assets, a group of liabilities or a group of assets and liabilities e.g.
a cash generating unit or a business
2. The transaction
A fair value measurement assumes that the transaction to sell the asset or transfer the liability
takes place either:
a) in the principal market for the asset or liability; or
b) in the absence of a principal market, in the most advantageous market for the
asset or liability.
3. Market participants
An entity should measure the fair value of an asset or a liability using the assumptions that
market participants would use when pricing the asset or liability, assuming that these market
participants are acting in their economic best interest.
ICSAZ - P.M. PARADZA
224
It should be noted that in developing the assumptions, an entity is not required to identify
specific market participants
Who are market participants?
These are buyers and sellers in the principal or most advantageous market for the asset or
liability that have all of the following characteristics:
i)
They are independent of each other i.e. they are not related parties as
defined in IAS 24.
However the price in a related party transaction may be used as an input to a fair value
measurement, if there is evidence that the transaction was entered into at market terms.
ii)
iii)
iv)
they are knowledgeable, having a reasonable understanding about the
asset or liability about the transaction using all available information.
This should include information that is obtained through due diligence
efforts.
They are able to enter into a transaction for the asset or liability
They are willing to enter into a transaction for the asset or liability, but
they are not forced or otherwise compelled to do so.
4. The price
Fair value is the price that would be received to sell an asset or paid to transfer a liability in an
orderly transaction in the principal or most advantageous market. These requirements apply on
the measurement dates under current market conditions, regardless of whether the price is
directly observable or estimated using another valuation technique.
The price used to measure the fair value of an asset or liability should not be adjusted for
transaction costs
The price used to measure the fair value of an asset or liability should be adjusted for transport
costs, if location is a characteristic of the asset.
A BIRD’S EYE VIEW FROM THE PROFESSION
(Deloitte Canada November 2014)
How to determine fair value- key considerations
Once you have established the item that is the subject of fair value measurement (and/or
disclosure), the nuts and bolts of IFRS 13 come into play. The standard could appear
overwhelming-it is comprised of 99 paragraphs of core guidance plus a further 47 paragraphs
of application guidance (Appendix B to IFRS 13). As you get more familiar with the standard,
the fear of fair value will likely subside. In the meantime, the table which follows sets out a
summary of the key consideration in how to determine fair value under IFRS 13.
ICSAZ - P.M. PARADZA
225
7.5 APPLICATION TO SPECIFIC CATEGORIES OF ASSETS AND LIABILITIES
7.5.1
Highest and best use of non-financial assets
IFRS 13 requirement
Our Insights
Unit of account- The determination •
of the unit of account must be
established prior to determining
fair value and is defined as the
level at which an asset or liability is
aggregated or disaggregated in an •
IFRS for recognition purposes.
The unit of account is determined
under the IFRS applicable to the
asset or liability (or group of assets
and liabilities) that requires fair
value measurement.
Market- fair value measurement
under IFRS 13 assumes that a
transaction to sell an asset or
transfer a liability takes place in the
principal market (or the most
advantageous market in the
absence of the principal market).
The principal market is the
market with the greatest volume
and level of activity for the asset or
liability. The most advantageous
market is the market that
maximizes the amount that would
be received to sell the asset or
minimizes the amount that would
be paid to transfer the liability, after
taking into account transaction
costs.
Market
participant
assumptions- A fair value
measurement under IFRS 13
requires an entity to consider the
assumptions market participants,
acting in their economic best
interest, would use when pricing
the asset or a liability.
•
•
•
•
•
•
•
Market participants are defined as
having
the
following
characteristics:
•
Independent of each other (i.e.
unrelated parties).
•
Knowledge and using all •
available information.
•
Ability of entering into the
transaction.
•
Willingness to enter into a
transaction (i.e. not a forced
transaction).
Inputs
and
valuation •
techniques- IFRS 13 does not
mandate the use of a particular
valuation technique(s) but sets out
a principle requiring an entity to
ICSAZ - P.M. PARADZA
The item for which fair value is determined may be a single asset or
liability such as a derivative instrument or a share in a publicly traded
entity or it may be a group of assets (i.e. a portfolio of deposits) or
group of assets and liabilities (e.g. a cash-generating unit, a business
or an asset group which is held-for-sale).
IFRS 13 does not generally provide specific guidance on the
determination of the unit of the account-rather it directs preparers to
other IFRSs to make this determination. IFRS 13 does specifically
address one area relating to the unit of account in the form of guidance
for financial assets and financial liabilities with offsetting positions.
Here IFRS 13 includes a ‘’portfolio exception’’ allowing a specified
level of grouping when a portfolio of financial assets and financial
liabilities are managed together with offsetting market risks or
counterparty credit risk. This exception is subject to your entity meeting
certain eligibility criteria. (IFRS 13.48-52)
If there is a principal market, the price in that market must be used,
either directly or as an input into a valuation technique. IFRS 13 does
not permit the use of a price in the most advantageous market if a
principal market price is available!
This said, it is not necessary to perform an exhaustive search of all
possible markets to identify the principal market (or, in the absence of
a principal market, the most advantageous market). However, all
information that is reasonably available should be considered and the
basis for your conclusions should be documented.
There is a presumption in the standard that the market in which the
entity normally transacts to sell the asset or transfer the liability is the
principal or most advantageous market unless there is evidence to the
contrary.
Where your entity transacts in various markets (such as when assets
are sold on multiple commodity and/or equity exchanges), your entity
should document which particular market price is used and what
process was followed to determine the appropriate market to use for
determining fair value.
The key concept here is that the standard requires your entity to put
itself in the place of a market participant and exclude any entity specific
factors that might impact the price that your entity is willing to accept
in the sale of an asset or be paid in the transfer of a liability.
So, for example, the relevant characteristics of an asset might include
or relate to:
-the condition and location of the asset; and
-restrictions, if any, on the sale or use of the asset.
Here, you would need to consider the extent to which a market
participant would take the above characteristics into account when the
extent to which restrictions on the sale or use of the asset should be
reflected in fair value are very much contingent on where the source of
the restriction comes from and whether or not the restriction is
separable from the asset.
Depending on the particular item that is the subject of the fair value
measurement, the analysis of determining exactly what a participant
would consider may, in some cases, prove to be challenging. As such,
in more challenging cases, we would recommend consulting with your
auditors and advisors
IFRS 13 is clear that the valuation technique used by your entity must
maximise the use of relevant observable inputs and minimize the use
of unobservable inputs. For example, if a quoted price is available for
a specific asset, this price must be used instead of an entity-specific
assumption about the price.
226
determine a valuation technique
that is “appropriate in the •
circumstances”,
for
which
sufficient data is available and for
which the use of relevant
observable inputs is maximized.
•
IFRS 13 discusses three widely
used valuation techniques which
are:
•
The market approach
•
The cost approach
•
The income approach
Valuation techniques should be
applied consistently from one
period to the next.
Further, there is a direct correlation between the level of disclosures
required and the level of unobservable inputs-the more the degree of
unobservable data used in your valuation technique, the more the
degree of disclosure that you must include in your financial statements.
A change in a valuation technique can be made but only if the change
results in a measurement that is equally or more representative of fair
value. Any such change, where justified, is considered to be a change
in estimate (IFRS 13.66).
The fair value measurement of a non-financial asset should take into account a market
participant’s ability to generate economic benefits by using the asset in its highest and best use,
or by selling it to another market participant that could use the asset in its highest and best use.
Highest and best use is determined if using the asset is physically possible, legally permissible
and financially feasible taking into account the following:
•
•
•
the physical characteristics of the asset that market participants would consider when
pricing the asset e.g. the location or size of a property.
any legal restrictions on the use of the asset that market participants would consider
when pricing the asset e.g. zoning regulation applicable to a property.
the generation of adequate income or cash flows to produce an investment return that
market participants would require from an investment in that asset.
KEY POINT
An entity’s current use of a non-financial asset is assumed to be its highest and best use unless
market or other factors suggest that a different use by market participants would maximize the
value of the asset.
7.5.2 The valuation basis for non-financial assets
1) The highest and best use of a non-financial asset may provide maximum value to market
participants through its use in combination with other assets as a group and/or in
combination with other assets and liabilities e.g. a business.
a) The highest and best use of the asset may be to use it in combination with other assets
or with other assets and liabilities. In this case, the fair value of the asset is the price
that would be received in a current transaction to sell the asset. This assumes that the
asset’s complimentary assets would be available to market participants.
b) Liabilities associated with the asset and with the complimentary assets include
liabilities that fund working capital, but do not include liabilities used to fund assets
other than those within the group of assets.
c) Assumptions about the highest and best use of non-financial assets should be consistent
for all the assets for which the highest and best use is relevant.
ICSAZ - P.M. PARADZA
227
1. The highest and best use of a non-financial asset may provide maximum value to market
participants on a stand-alone basis. If this is the case, the fair value of the asset is the
price that would be received in a current transaction to sell the asset to market
participants that would use the asset on this basis.
•
IFRS 13 does not specify the unit of account to be used in the fair value
measurement of a non-financial asset. Such measurement is based on the
assumption that the asset is sold consistently with the unit of the account identified
in other standards.
7.5.3 General principles applicable to liabilities and an entity’s own equity instruments
a) A fair value measurement assumes that a financial or non-financial liability or an
entity’s own equity instrument is transferred to a market participant at the
measurement date. Such a transfer assumes the following:
1.
2.
The liability would remain outstanding and the market participant
transferee would be required to fulfil the obligation. This means that
the liability would not be settled with the counterparty or otherwise
extinguished on the measurement date.
The entity’s own equity instrument would remain outstanding and the
market participant transferee would take on the rights and obligations
associated with this instrument. This means that the instrument would
not be cancelled or otherwise extinguished on the measurement date.
N.B. In all cases, an entity should maximize the use of relevant observable inputs and
minimize the use of unobservable inputs to meet the objective of a fair value
measurement.
7.5.4 Liabilities and equity instruments held by other parties as assets
When a quoted price for the transfer of an identical or a similar liability or entity’s own equity
instrument is not available and the identical item is held by another party as an asset, an entity
should measure the fair value of the liability or equity instrument from the perspective of a
market participant that holds the identical item as an asset at the measurement date.
In such cases, an entity should measure the fair value of the liability or equity instrument as
follows:
Using the quoted price in an active market for the identical item held by another party
as an asset, if that price is available.
If that price is not available, using other observable inputs, such as the quoted price in
a market that is not active for the identical item held by another party as an asset.
If the observable prices in (a) and (b) are not available, using another valuation
technique, such as:
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An income approach (e.g. a present value technique that takes into account the
future cash flows that a market participant would expect to receive from holding
the liability or equity instrument as an asset.
A market approach (e.g. using quoted prices for similar liabilities or equity
instruments held by bother parties as an assets.
An entity should adjust the quoted price of a liability or an entity’s own equity instrument held
by another party as an asset only if there are factors specific to the asset that are not applicable
to the fair value measurement of the liability or equity instrument. An entity should ensure that
the price of the asset does not reflect the effect of a restriction preventing the sale of that asset.
Some factors that may indicate that the quoted price of the asset should be adjusted include the
following:
a)
The quoted price for the asset relates to a similar (but not identical) liability or
equity instrument held by another party as an asset. For example, the liability
or equity instrument may have a particular characteristic (e.g. the credit quality
of the issuer that is different from that reflected in the fair value of the similar
liability or equity instrument held as an asset).
b)
The unit of account for the asset is not the same as for the liability or equity
instrument e.g. for liabilities in some cases the price for an asset reflects a
combined price for a package comprising both the amounts due from the issuer
and a third party credit enhancement. If the unit of account for the liability is
not for the combined package, the objective is to measure the fair value of the
issuer’s liability, not the fair value of the combined package. Thus in such cases,
the entity would adjust the observed price for the asset to exclude the effect of
the third party credit enhancement.
7.5.5 Liabilities and equity instruments held by other parties as assets
When a quoted price for the transfer of an identical or a similar liability or entity’s own equity
instrument is not available and the identical item is held by another party as an asset, an entity
should measure the fair value of the liability or equity instrument from the perspective of a
market participant that owes the liability or has issued the claim on equity. For example, when
applying a present value technique an entity might take into account either of the following:
(a) The future cash outflows that a market participant would expect to incur in fulfilling
the obligation, including the compensation that a market participant would require for
taking on the obligation.
(b) The amount that a market participant would receive to enter into or issue an identical
liability or equity instrument, using the assumptions that market participants would use
when pricing the identical item (e.g. having the same credit characteristics) in the
principal (or most advantageous) market for issuing a liability or an equity instrument
with the same contractual terms.
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7.5.6 Non-performance risk
The fair value of a liability reflects the effect of non-performance risk. Non- performance risk
includes but may not be limited to, an entity’s own credit risk (as defined in IFRS 7 Financial
Instruments: Disclosures). Non-performance risk is assumed to be same before and after the
transfer of the liability.
When measuring the fair value of a liability, an entity should take into account the effect of its
credit risk (credit standing) and any other factors that might influence the likelihood that the
obligation will or will not be fulfilled. That effect may differ depending on the liability, for
example:
a)
b)
whether the liability is an obligation to deliver cash (a financial liability) or an
obligation to deliver goods or services (a non-financial liability).
the term of credit enhancements related to the liability, if any.
The fair value of a liability reflects the effects of non-performance risk on the basis of its unit
of account. The issuer of a liability issued with an inseparable third-party credit enhancement
that is accounted for separately from the liability should not include the effect of the credit
enhancement (e.g. a third party guarantee of debt) in the fair value measurement of the liability.
If the credit enhancement is accounted for separately from the liability, the issuer would take
into account its own credit standing and not that of the third party guarantor when measuring
the fair value of the liability.
WHAT IS THE TRUE VALUE OF A LIABILITY?
The fair value of a liability should reflect the effect of non-performance risk. The risk includes,
but is not limited to an entity’s own credit risk. According to IFRS 7, an entity should disclose
information that enables users of its financial statements to evaluate the nature and extent of
risks arising from financial instruments to which the entity is exposed at the end of the reporting
period. In the context of fair value measurement, non-performance risk is assumed to be the
same before and after the transfer of the liability.
When measuring the fair value of a liability, an entity should take into account the effect of its
credit risk (credit standing) and any other factors that might influence the likelihood that the
obligation will or will not be fulfilled. This likelihood will depend on:
a) whether the liability is an obligation to deliver cash (i.e. financial liability) or an
obligation to deliver goods or services (i.e. a non-financial liability)
b) the terms of any credit enhancements related to the liability.
An example of a credit enhancement is a third-party guarantee of debt. The issuer of a liability
issued with an inseparable third-party credit enhancement accounted for separately from the
liability should not include the effect of the enhancement in the fair value measurement of the
liability.
The fair value of a financial liability with a demand feature e.g. a demand deposit, is not less
than the amount payable on demand, discounted from the first date that the amount could be
required to be paid.
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7.5.7 The offsetting of positions in market risks or counterparty credit risk.
An entity that holds a group of financial assets and financial liabilities is exposed to market
risks and to the credit risk of the individual counterparties. The entity may manage the financial
assets and financial liabilities on the basis of its net exposure to either market risks or credit
risks. In that case the entity is permitted to use an exception to IFRS 13 for measuring fair
value. The exception allows the entity to fair value the assets and liabilities on the basis of:
a) the price that would be received to sell a net long position (an asset)for a particular
risk exposure; or
b) the price that would be paid to transfer a net short position (a liability) for a
particular risk exposure;
in an orderly transaction between market participants at the measurement date under
current market conditions.
This means that the entity should measure the fair value of the group of financial assets and
financial liabilities consistently with how market participants would price the net risk exposure
at the measurement date. This exception is only available if the entity does the following:
i) manages the group of financial assets and financial liabilities on the basis of its
net exposure to a particular market risk(s)or to credit risk of a counterparty in
accordance with the entity’s documented risk management or investment strategy;
ii) provides information on that basis about the group of financial assets and financial
liabilities to the entities key management personnel
iii) is required or has elected to measure the financial assets and financial liabilities at fair
value in the statement of financial position at the end of each reporting period.
•
An accounting policy decision is required in accordance with IAS 8 for the entity
to use the exception explained above.
7.6. VALUATION TECHNIQUES
The objective of using a valuation technique is to estimate the price at which an orderly
transaction to sell the asset or to transfer the liability would take place between market
participants at the measurement date under current market conditions.
Sometimes the transaction price is based on fair value on initial recognition, while a valuation
technique based on unobservable inputs is used to measure fair value in subsequent periods. In
that case, the valuation technique should be calibrated so that at initial recognition the result of
the valuation of the valuation technique equals the transaction price.
There are 2 main purposes of calibration:
(i)
(ii)
It ensures that the valuation technique reflects current market conditions
It helps an entity to determine whether an adjustment to the valuation technique is
necessary
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How does this work?
The valuation techniques which are used to measure fair value should maximise the use of
relevant observable inputs and minimise the use of unobservable inputs. If an asset or a liability
measured at fair value has a bid price and an ask price (e.g. an input from a dealer market), the
price within the bid-ask spread that is most representative of fair value should be used to
measure fair value regardless of how the input is categorised. However, IFRS 13 permits the
use of mid-market pricing and other pricing conventions that are used by market pricing
participants within the bid-ask spread.
7.6.1 Inputs to valuation techniques
Level 1 inputs are quoted prices (unadjusted) in active markets for identical assets or liabilities
that the entity can access at the measurement date.
A quoted price in an active market provides the most reliable evidence of fair value and shall
be used without adjustment to measure fair value whenever available, except as specified in
IFRS 13.
A level 1 input will be available for many financial liabilities, some of which might be
exchanged in multiple active markets (e.g. on different exchanges). Therefore, the emphasis
within level 1 is on determining both of the following:
(a) the principal market for the asset or liability or, in the absence of a principal
market, the most advantageous market for the asset or liability; and
(b) whether the entity can enter into a transaction for the asset or liability at the
price in that market at the measurement date.
If an entity holds a position in a single asset or liability (including a position comprising a large
number of identical assets or liabilities, such as a holding of financial instruments) and the asset
or liability is traded in an active market, the fair value of the asset or liability shall be measured
within level 1 as the product of the quoted price for the individual asset or liability and the
quantity held by the entity. That is the case even if a market’s normal daily trading volume is
not sufficient to absorb the quantity held and placing orders to sell the position in a single
transaction might affect the quoted price.
Level 2 Inputs
Level 2 inputs are inputs other than quoted prices included within level 1 that are observable
for the asset or liability, either directly or indirectly.
If the asset or liability has a specified (contractual) term, a level 2 input must be observable for
substantially the full term of the asset or liability. Level 2 inputs include the following:
a)
quoted prices for similar assets or liabilities in active markets.
b)
quoted prices for identical or similar assets or liabilities in markets that are not
active.
c)
inputs other than quoted prices that are observable for the asset or liability, for
example:
i)
interest rates and yield curves observable at commonly quoted intervals;
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ii)
iii)
d)
implied volatilities; and
credit spreads.
market-corroborated inputs.
Adjustments to Level 2 inputs will vary depending on factors specific to the asset or liability.
Those factors include the following:
a) the condition or location of the asset;
b) the extent to which inputs relate to items that are comparable to the asset or liability;
and
c) the volume or level of activity in the markets within which the inputs are observed.
An adjustment to a Level 2 input that is significant to the entire measurement might result in a
fair measurement categorised within Level 3 of the fair value hierarchy if the adjustment uses
significant unobservable inputs.
Level 3 Inputs
Level 3 inputs are unobservable inputs for the asset or liability.
Unobservable inputs shall be used to measure fair value to the extent that relevant observable
inputs are not available, thereby allowing for situations in which there is little, if any, market
activity for the asset or liability at the measurement date. However, the fair value measurement
objective remains the same, i.e. an exit price at the measurement date from the perspective of
a market participant that holds the asset or owes the liability. Therefore, unobservable inputs
shall reflect the assumptions that market participants would use when pricing the asset or
liability, including assumptions about risk.
Assumptions about risk include the risk inherent in a particular valuation technique used to
measure fair value (such as a pricing model) and the risk inherent in the inputs to the valuation
technique. A measurement that does not include an adjustment for risk would not represent a
fair value measurement if market participants would include one when pricing the asset or
liability. For example, it might be necessary to include a risk adjustment when there is
significant decrease in the volume or level of activity when compared with normal market
activity for the asset or liability, or similar assets or liabilities, and the entity has determined
that the transaction price or quoted prices does not represent fair value.
An entity should develop unobservable inputs using the best information available in the
circumstances, which might include the entity’s own data. In developing unobservable inputs,
an entity may begin with its own data, but it should adjust those data if reasonably available
information indicates that other market participants would use different data or there is
something particular to the entity that is not available to other market participants (e.g. an
entity-specific synergy). An entity need not undertake exhaustive efforts to obtain information
about market participant assumptions. However, an entity should take into account all
information about market participant assumptions that is reasonably available.
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7.6.2 Valuation techniques
Market approach
This is an approach which uses prices and other relevant information generated by market
transactions involving identical or comparable/similar assets, liabilities or a group of assets and
liabilities e.g. a business. Such approaches often use market multiples derived from a set of
comparables.
An example of the market approach is matrix pricing. This is a mathematical technique used
mainly in the valuation of financial instruments e.g. debt securities.
•
This method does not rely exclusively on quoted prices for the securities, but rather
on the relationship of the securities to other benchmark quoted securities. The method
is very useful when the security being valued is not frequently traded.
Bid, ruling and asking prices: the bid-ask spread
The following terms are frequently used in securities trading.
Bid price is the price at which buyers are willing to buy an asset on a specific date or sellers
are willing to transfer a liability on the same date.
Ruling price is the last price at which the asset or liability was traded in the market.
Asking price is the price at which sellers are willing to sell an asset on a specific date or buyers
are willing to assume a liability on the same date.
Cost approach
This approach is based on the price a market participant buyer would pay to acquire or construct
a substitute asset of comparable utility, adjusted for obsolescence. The method reflects the
amount that would be required currently to replace the service capacity of the asset, often
referred to as current replacement cost. Current replacement cost can be used to estimate the
fair value of tangible assets that are used in combination with other assets or with other assets
and liabilities.
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The following diagram shows the application of the cost approach.
Identify new cost of modern equivalent asset
Adjust for age/economic obsolescence /deterioration
Depreciated replacement cost/fair value
Source: pwc –Manual of Accounting IFRS 2015 Vol.1 p 5022
Income approach
This approach converts future amounts e.g. cash flows or income and expenses to a single
current (discounted) amount. The fair value measurement should reflect current market
expectations about the future amounts.
Examples of the income approach are
a) present value techniques
b) option pricing models
c) the multi period excess earnings method, which is used to measure the fair value of some
intangible assets.
7.6.3 The components of a present value measurement
As an application of the income approach, present value is a technique used to relate future
amounts to a present amount based on a discount rate. The fair value measurement of an asset
or liability using this method should incorporate all the following elements from the perspective
of market participants on the measurement date.
i)
ii)
an estimate of future cash flows for the asset or liability being measured.
expectations about possible variations in the amount and timing of the cash flows
representing the uncertainty inherent in the cash flows.
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iii)
iv)
v)
vi)
the time value of money, represented by the rate of risk-free monetary assets that
have maturity dates or durations coinciding with the period covered by the cash
flows.
the price for bearing the uncertainty inherent in the cash flow i.e. the risk premium.
other factors that market participants would take into account under the
circumstances.
for a liability, the non-performance risk relating to that liability, including the
entity’s own credit risk.
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7.6.4 Overview of the Fair Value Framework
The fair value measurement framework is shown in the following diagram:
The asset or liability
Highest and best use and
Principal (or most
advantageous) market
Market participant
characteristics
Valuation premises (non–financial
assets only)
Valuation techniques
Inputs
Disclosures
including fair value
hierarchy
categorization
(based on the
lowest level input
that is significant
to fair value)
Fair value. the price
in an orderly
transaction
between market
participants
If needed, allocate to
unit of account
Source: EY - Fair Value Measurement November 2012
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7.7 SUMMARY
IFRS explains how to measure fair value for financial reporting purposes. The standard does
not require fair value measurement in addition to those already required or permitted by other
IFRSs. While other IFRSs stipulate the items which should be measured at fair value, IFRS 13
addresses the issue of how fair value is actually measured. The requirements and guidelines in
this standard apply to both individual assets and liabilities, as well as groups of assets and
liabilities.
7.8 REFERENCES
pwc
Manual of Accounting IFRS 2015 Volume 1
Bloomsbury Professional 2015
VON WELL, R., PRETORIUS, D.&
FERREIRA, P.H.
GAAP Handbook
Financial Accounting & Reporting Practice 2014
Vo1.1 LexisNexis 2014
ERNST & YOUNG
Applying IFRS: IFRS 13 Fair Value Measurement
2012
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UNIT EIGHT
REGULATORY DEFERRAL ACCOUNTS (IFRS 14)
8.0 INTRODUCTION
IFRS 14 is an interim standard which gives reporting entities guidance on the treatment of
outstanding expenses or income that would not be recognized as liabilities or assets by entities
whose pricing structures are not subject to regulation. The standard permits first –time adopters
of international financial reporting standards, to continue to recognize regulatory deferral
account balances in their first IFRS financial statements based on their previous generally
accepted accounting principles. However, entities which adopt this optional standard should
continue to use it in their subsequent financial statements. The International Accounting
Standards Boards (IASB) has justified this standard by noting that income and expenses which
are subject to rate regulation are usually significant for entities which undertake rate-regulated
activities e.g. utilities, telecommunications and transport industries. A major object of this
standard is to ensure that users of financial statements are able to identify the amounts of
regulatory deferral account balances as well as movements in those balances. This will make
it easier to compare the financial statements of regulated entities with those which are not
regulated. .
8.1 OBJECTIVES
By the end of this Unit, you should be able to
•
Explain the reason for a separate standard on the financial statements of regulated
entities.
•
Relate the requirements of IFRS 14 to those outlined in IAS 8 (Accounting Policies,
Changes in Accounting Estimates and Errors).
•
State the conditions under which an entity may apply the requirements of IFRS 14 in
its first IFRS financial statements.
•
Explain the provisions of IFRS 14 in relation to the recognition, measurement,
impairment and derecognition of regulatory deferral balances.
8.2 DEFINITIONS
IFRS 14 defines some key terms as follows:
An entity’s first IFRS financial statements refers to the entity’s first set of annual financial
statements in which it adopts IFRSs by an explicit and unreserved statement of compliance
with IFRSs.
Previous GAAP is the basis of accounting that a first-time adopter used immediately before
adopting IFRS.
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Rate –regulated activities are an entity’s activities that are subject to rate regulation.
Rate regulation is a framework for establishing the prices that can be charged to customers
for goods and services, which framework is subject to oversight and/or approval by a rate
regulator.
Rate-regulator is an authorized body that is empowered by statute or regulation to establish
the rate or a range of rates that bind an entity.
Regulatory deferred account balance refers to the balance of any expense or income account
that would not be recognized as an asset or a liability with other standards. Such a balance
qualifies for deferral because it is included, or is expected to be included by the rate regulator
in establishing the rate(s) that can be charged to customers.
Highlights of the standard
•
•
•
It permits an entity that adopts IFRSs to continue to use, in its first and subsequent IFRS
financial statements, its previous GAAP accounting policies for the recognition,
measurement, impairment and derecognition of regulatory deferral account balances
without specifically considering the requirements of part 11 of IAS 8.
It requires entities to present regulatory deferral account balances as line items in the
statement of profit or loss and other comprehensive income
It requires specific disclosures to identify the nature of, and risks associated with, the
rate regulation that has resulted in the recognition of regulatory deferral account
balances.
THE DETERMINATION OF REGULATORY DEFERRAL ACCOUNT BALANCES
Regulatory deferral account balances to be recognized are restricted to the incremental
amounts from what would otherwise be recognized as assets and liabilities under IFRSs
and the conceptual framework. The measurement of these balances effectively entails
a two-step process
• An entity would first determine the carrying amount of its assets and liabilities,
excluding IFRS 14.
• These amounts would then be compared with the assets and liabilities determined under
the entity’s previous GAAP presentation (i.e. its rate –regulated balances )
The differences would represent the regulatory deferral debit or credit account balances to
be recognized by the entity.
Source: Appling IFRS for IFS 14 Regulatory Deferral Accounts - EY
November 2014.
8.3 CONDITIONS OF USE.
a)An entity may apply the requirements of IFRS 14 in its first IFRS financial statements if
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and only if:
i)it conducts rate-regulated activities.
ii) it recognised amounts that qualify as regulatory deferral account balances in its financial
statement according to its previous GAAP.
b) an entity should apply the requirements of IFRS 14 in its financial statements for
subsequent periods if, and only if, it recognised regulatory deferral account balances by
electing to apply the requirements of this standard.
An entity that is within the scope of, and that elects to apply IFRS 14 should apply all of its
requirements to all regulatory deferral account balances that arise from all its rate-regulated
activities.
8.4 KEY PROVISIONS RELATED TO RECOGNITION, MEASUREMENT,
IMPAIRMENT AND DERECOGNITION ISSUES.
1. Temporary exemption from para 11 of IAS 8.
An entity that has rate-regulated activities and elects to apply IFRS 14, should apply paras
10 and 12 of IAS 8, but is exempt from applying para 11 of this standard when developing
its accounting policies.
Para 10 states that:
In the absence of an IFRS that specifically applies to a transaction, other event or transaction,
management should use its judgment to develop an accounting policy which ensures
information that is
a) relevant to the economic decision –making needs of users and:
b) reliable, in that the financial statements
(i)
represent faithfully the financial position ,financial performance and cash
flows of the entity
(ii)
reflect the economic substance of transactions, other events and conditions,
and not merely the legal form.
(iii) are neutral ,i.e. free from bias
(iv)
are prudent
(v)
are complete in all material respects
Para 12 states
In making the judgment described in para 10, management may also consider the most recent
pronouncements of other standard-setting bodies that use a similar conceptual framework to
develop accounting standards, other accounting literature and accepted industry practices, to
the extent that these do not conflict with the sources in para 11.
THE PARA 11 EXEMPTION
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In making the judgment described in para 10, management should refer to, and consider the
applicability of the following sources in descending order:
a)
b)
The requirements in IFRSs dealing with similar and related issues ;and
The definitions, recognition criteria and measurement concepts for assets,
liabilities, income and expense in the framework.
2. Continuation of existing accounting policies
On initial adoption of IFRS 14, an entity should continue to apply its previous GAAP
accounting policies for the recognition, measurement and derecognition of regulatory
deferral account balances, with the exception of any changes permitted by paras 13-15 .The
presentation requirements of this standard may require changes to the entity’s previous
GAAP presentation policies.
3. Changes in accounting policies
An entity should not change its accounting policies in order to comply with the
requirements for recognizing regulatory deferral account balances. The entity may only
change its accounting policies for the recognition, measurement, impairment and
derecognition of regulatory deferral account balances if the change makes the financial
statements more relevant to the economic decision making needs of users and no less
reliable: or
•
More reliable and no less relevant to those needs.
IAS 8 states the criteria to be used when judging relevance and reliability.
4. Interacting with other standards
Any specific exception, exemption or additional requirements related to the interaction of
IFRS 14 with other standards are outlined in Appendix B of this standard as follows:
In accounting policies required by IFRS. This is because the recognition of regulatory
deferral account balances for such timing differences would be consistent with the existing
recognition policy applied in accordance with paragraph 11 and would not represent the
introduction of a new accounting policy. Similarly, paragraph 13 does not prohibit the
recognition of regulatory deferral account balances arising from timing differences that did
not exist immediately prior to the date of transition to IFRS but are consistent with the
entity’s accounting policies established in accordance with paragraph 11 (for example,
storm damage costs).
8.5.1 Application of IAS 10 Events after the Reporting period
An entity may need to use estimates and assumptions in the recognition and measurement of
its regulatory deferral account balances. For events that occur between the end of the reporting
period and the date when the financial statements are authorized for issue, the entity should
apply IAS 10 to identify whether those estimates and assumptions should be adjusted to reflect
those events.
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8.5.2 Application of IAS 12 Income Taxes
IAS 12 requires, with certain limited exceptions, an entity to recognize a deferred tax asset for
all temporary differences. A rate-regulated entity shall apply IAS 12 to all of its activities,
including its rate-regulated activities, to identify the amount of income tax that is to be
recognized.
In some rate regulatory schemes, the rate regulator permits or requires an entity to increase its
future rates in order to recover some or all of the entity’s income tax expenses. In such
circumstances, this might result in the entity recognizing a regulatory deferral account balance
in the statement of financial position related to income tax, in accordance with its accounting
policies established in accordance with paragraph 11-12. The recognition of this regulatory
deferral account balance that relates to income tax might itself create an additional temporary
difference for which a further deferred tax amount would be recognized.
Regardless of the presentation and disclosure requirements of IAS 12, when an entity
recognises a deferred tax asset or a deferred tax liability as a result of recognising regulatory
deferral account balances, the entity should not include that deferred tax amount within the
total deferred tax asset (liability) balances. Instead, the entity should present the deferred tax
asset (liability) that arises as a result of recognising regulatory deferral account balances either;
(a) with the line items that are presented in the statement of profit or loss and other
comprehensive income for the movements in regulatory deferral account debit
balances; or
(b) as separate line items alongside the related line items that are presented in the statement
of profit or loss and other comprehensive income for the movement in regulatory
deferral account balances.
Similarly, when an entity recognises the movement in a deferred tax asset (liability) that arises
as a result of recognised regulatory deferral account balances, the entity shall not include the
movement in that deferred tax amount within the tax expense (income) line item that is
presented in the statement of profit or loss and other comprehensive income. Instead, the entity
should present the movement in the deferred tax asset (liability) that arises as a result of
recognised regulatory deferral accounts balances either:
a) with the line items that are presented in the statement of profit or loss and other
comprehensive income for the movements in regulatory deferral account
balances: or
b) as separate line item alongside the related line items that are presented in the
statement (s) of profits or loss and other comprehensive income for the
movement in regulatory deferral accounts balances.
8.5.3 Application of Earnings per Share
Paragraph 66 of IAS 33 requires some entities to present, in the statement of profit or loss and
other comprehensive income, basic and diluted earnings per share both for profit or loss from
continuing operations and profit or loss that is attributable to the ordinary equity holders of the
parent entity. In addition, paragraph 68 of IAS 33 requires an entity that reports a discontinued
operation to disclose the basic and diluted amounts per share for the discontinued operation
either in the statement of profit or loss and other comprehensive income or in the notes.
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For each earnings per share amount presented in accordance with IAS 33, an entity applying
this standard should present additional basic and diluted earnings per share amounts that are
calculated in the same way. However, those amounts should exclude the net movement in the
regulatory deferral accounts balances consistent with the requirement in paragraph 73 of IAS
33. An entity should present the earnings per share amounts required by paragraph 26 of this
standard with equal prominence to the earnings per share amounts required by IAS 33 for all
periods presented
8.5.4 Application of IAS 36 Impairment of Assets
Paras 11-12 of IFRS 14 require an entity to continue to apply its previous GAAP accounting
policies for the identification, recognition, measurement and reversal of any impairment of its
recognised regulatory deferral account balances. Consequently, IAS 36 does not apply to the
separate regulatory account balances recognised. However, that standard may require an entity
to perform an impairment test on a cash-generating unit which includes regulatory deferral
account balances.
8.5.5Application of IFRS 3 Business Combinations
The core principle of IFRS 3 is that an acquirer of a business should recognise the assets
acquired and the liabilities assumed at their acquisition-date fair values. That standard provides
limited exceptions to its recognition and measurement principles.
8.5.6 Application of IFRS 5 Non-current Assets Held for Sale and Discontinued
Operations
Paras 11-12 of IFRS 14 require an entity to continue applying its previous accounting policies
for the recognition, measurement, impairment and derecognition of regulatory deferral account
balances. Consequently, the measurement requirements of IFRS 5 do not apply to the
regulatory deferral account balances which have been recognised by an entity.
N.B. When an entity that elects to apply IFRS 14 presents a discontinued operation, it should
not include the movement in regulatory deferral account balances that arose from the rateregulated activities of the discontinued operation within the line items that are required by IFRS
5. Instead, the entity shall present the movement in regulatory deferral account balances that
arose from the rate-regulated activities of the discontinued operation either:
a) within the line item that is presented for movement in the regulatory deferral accounts
balances related to profit or loss :or
b) as a separate line item alongside the related line item that is presented for movement in
the regulatory deferral account balances related to profit or loss.
Similarly notwithstanding the requirements of para 38 of IFRS 5, when an entity presents a
disposal group, the entity should not include the total of the regulatory deferral account debit
balances and credit balances that are part of the disposal group within the line items that are
required by IFRS 5. Instead, the entity should present the total of regulatory deferral account
debit balances and credit balances that are part of the disposal group either:
a) within the line item that is presented for the regulatory deferral account debit balances
and credit balances.
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b) as a separate line item alongside the other regulatory deferral account debit balances
and credit balances.
If the entity chose to include the regulatory deferral account balances and movements in those
balances that are related to the disposal group or discontinued operation within the related
regulated deferral account line items, it may be necessary to disclose them separately as part of
the analysis of the regulatory deferral account line items described by para 33 of IFRS 14.
8.5.7 Application of IFRS 10 Consolidated Financial Statements and IAS 28 Investments
in Associates and Joint Ventures
Para 19 of IFRS 10 requires that a parent should prepare consolidated financial statements
using uniform accounting policies for like transactions and other events in similar
circumstances. Para 8 of IFRS 14 states that an entity should apply all of its requirements to all
regulatory deferral account balances arising from all of the entity’s rate-regulated activities.
Consequently if a parent recognises regulatory deferral account balances in its consolidated
financial statements in accordance with IFRS 14, it should apply the same accounting policies
to the regulatory deferral account balances arising in all of its subsidiaries. This will apply
irrespective of whether the subsidiaries recognise those balances in their own financial
statements.
Similarly paras 35-36 of IAS 28 require that, in applying the equity method, an entity’s
financial statements should be prepared using uniform accounting policies for like transactions
and events in similar circumstances. Consequently adjustments should be made to make the
associate or joint venture’s accounting policies for the recognition, measurement, impairment
and derecognition of regulatory deferral account balances conform to those of the investing
entity in applying the equity method.
8.5.8 Application of IFRS 12 Disclosure of Interests in Other Entities
Para 12 (e) of IFRS 12 requires an entity to disclose, for each of its subsidiaries that have noncontrolling interests that are material to the reporting entity, the profit or loss that was allocated
to non-controlling interests of the subsidiary during the reporting period. An entity that
recognises regulatory deferral account balances in accordance with IFRS 14 should disclose
the net movement in regulatory deferral account balances that is included within the amounts
that are required to be disclosed by para 12 (e) of IFRS 12.
Paragraph 12 (g) of IFRS 12 requires an entity to disclose, for each of its subsidiaries that have
non-controlling interests that are material to the reporting entity, summarised financial
information about the subsidiary, as specified in para B10 of IFRS 12. Similarly, paragraph 21
(b) ii) of IFRS 12 requires an entity to disclose, for each joint venture and associate that is
material to the reporting entity, summarised financial information as specified in para B12-B13
of IFRS 12. Para B16 Of IFRS 12 specifies the summary financial information that an entity is
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245
required to disclose for all other associates and joint ventures that are not individually material
in accordance with para 21(c) of IFRS 12.
In addition to the information specified in paras 12, 21, B10, B12-B13 and B16 of IFRS 12, an
entity that recognises regulatory deferral account balances in accordance with this standard
shall also disclose the total regulatory deferral account debit balance, the total regulatory
deferral account credit balance and the net movements in those balances, split between amounts
recognised in profit or loss and amounts recognised in other comprehensive income.
8.6. SUMMARY
This Unit summarizes the accounting requirements of IFRS 14, with a focus on the standard’s
implications for other standards. The use of IFRS 14 will enable rate-regulated entities to adopt
international financial reporting standards while the IASB continues its work on a
comprehensive standard on this topic. IFRS 14 requires its adopters to show separately their
regulatory deferral account balances in the statements of financial position and the statement
of profit or loss and other comprehensive income.
8.7 REFERENCES
ERNST & YOUNG
Applying IFRS for IFRS 14
Regulatory Deferral Accounts
IASB
International Financial Reporting Standards 2015
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UNIT NINE
INCOME TAXES (IAS 12)
9.0 INTRODUCTION
It is important to note right from the start that tax theory relies a lot on the subject of law. Tax
practice is to a greater extent an accounting discipline save that accounting is historic in nature
and focuses on profit calculated on the basis of the accruals concept whereas taxation uses that
historic information, but focusing on profit arrived at on the cash basis.
In Zimbabwe, the responsibility to calculate and collect direct and indirect tax is in the hands
of Zimbabwe Revenue Authority (ZIMRA). ZIMRA is headed by a commissioner general who
is assisted by specially trained assessors and other specialists. The Commissioner-General is
vested with the power and responsibility to administer the tax statutes of both
corporates/organizations and individuals. The determination of taxable income and tax liability
is based on information provided by the taxpayers in the form of financial statements if it is
corporate tax. ZIMRA normally accepts the figures submitted by tax payers on the basis of
good faith though at present, companies whose shares are quoted on the Zimbabwe Stock
Exchange (ZSE) are required by the Companies Act to have their financial statements audited
by professional accounting firms. As the tax authority, it reserves the right to reject or amend
any figures, and to institute investigations where there are signs of dishonesty on the part of
the taxpayer. This Unit therefore, focuses on taxation of limited liability companies.
The Commissioner-General is empowered to estimate any taxpayer’s taxable income if one
fails to submit a required return. In addition to the tax payable, the Commissioner-General is
also empowered to impose penalties for any default. These penalties are 100% of the basic tax
chargeable. Section 46 outlines some grounds for penalties.
.
9.1 OBJECTIVES
By the end of this Unit, you should be able to:
•
Explain the difference between accounting profits and taxable profits
•
Explain the sources of deferred tax assets and deferred tax liabilities
•
Undertake computations for deferred tax using the statement of financial position and
income statement approaches
•
Explain deferred tax aspects related to investments in subsidiaries, branches, associates
and interests in joint arrangements
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9.2 LEGAL PROVISIONS (What is below is for recap on the subject of taxation)
Over the recent years we have had an Income Tax bill gazetted on 1 December 2012,
proposing to replace the Income Tax Act (Chapter 23:06) enacted in 1967 with Income
Tax Act (Chapter 23.13).
This will result in a move from source basis to residence basis of taxation. Source to
Residence based tax system means from Zimbabwe source* to Global).
* With Income Tax Act (chapter 23:06) income is not taxable in Zimbabwe unless it is
from a Zimbabwean source or is deemed to be from a Zimbabwean source (section 12).
Source is one of the words used extensively in tax matters, but is not defined by the
Act.
The move is in line with best practice in other countries like South Africa, Mozambique,
Tanzania, UK which are already on residence basis
The objectives of this move are to widen the tax base, restrict expenditures claimable
and simplify the tax law. Receipts that were previously not taxable will now be taxable.
Restriction of general deduction formula to expenditure incurred “in the production of
income”
Gross income definition will be replaced by a clearer distinction of income types. The
definition which will be replaced is the one per section 8(1) which means the total
amount received by or accrued to a person from a source within or deemed source
within Zimbabwe in any year of assessment excluding any amount of a capital nature.
Sources: Tax Management Service, 2013 & Ernst & Young (Mgodi)
9.3 CORPORATE TAX
It is tax on business income. All companies and individuals, that is, sole traders, public or
private companies, including consultants earning income from business operations are liable
to pay corporate tax. The general rate of corporate tax and aids levy payable in each
forthcoming year is pre-announced by the Finance Minister on presentation of the National
Budget.
Remittance of corporate tax is per the Quarterly Payment Dates (QPDs) for all companies and
individuals who have a tax liability arising from trade and investment income. The
Commissioner-General requires from the taxpayer, estimates of his total taxable income for the
current year. It is the tax on this estimate that will be payable according to the QPDs. This
approach results in over or under provision/payment of current tax given that the quarterly
payments are based on estimated profits.
An assessed loss brought forward from the previous year should be taken into account when
estimating the taxable income for the purposes of provisional tax.
Interest will be charged on any amount of provisional tax due but unpaid after the Quarterly
Payment Date. Interest will also be charged where estimates prove to be insufficient unless
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248
there are special circumstances (such as an increase in the rates). There are no penalties as for
late payment of provisional tax (Deloite Final Course Board Notes).
9.4 CURRENT TAX
Is tax payable and calculated using the appropriate tax rate from taxable income/profit. Taxable
income is net profit adjusted for cash items and other items determined by the tax authorities.
The Taxation Framework shows the two approaches below for determination of taxable
income:
(A) DETERMINATION OF TAXABLE INCOME FOR THE YEAR (Tax Computation)
Accounting Profit
$
xxx
Add back
Depreciation/amortization
Fines and penalties
Charitable donations
Company formation expenses
Alterations and improvements to non-current assets
Interest on loan used to purchase shares
Provision for irrecoverable debts as expressed in % form
xxx
xxx
xxx
xxx
xxx
xxx
xxx
Less
Dividends received
*Capital allowances
Profit on sale of assets
Interest received from financial institutions, etc
Taxable income
xxx
xxx
xxx
xxx
xxx
* Capital allowances refer to the tax authorities` depreciation and usually calculated by them,
that is, Special initial allowance, wear and tear, minimum lease payments on finance leases
You should remember that in your Taxation studies where the financial statements have not
been prepared for you, the following framework may be used:
(B) FRAMEWORK FOR DETERMINATION OF TAXABLE INCOME
Gross income [s 8, s10 & s12]
Less Exemption [s14]
Income
xxx
xxx
xxx
Less Allowable deduction [s15, s17 & s18]
Taxable Income
xxx
xxx
N.B. Items contained in the brackets are sections of the Income Tax Act Chapter 23.06.
There is not much difference between terminology used in taxation and that used in accounting.
Gross income is synonymous to gross sales.
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DEFINITIONS OF TERMS ASSOCIATED WITH THE CURRENT TAX
COMPUTATION
Accounting profit – Net profit or loss for a period before deducting tax expense.
Taxable profit (tax loss) - The profit (loss) for a period, determined in accordance with the
rules established by the taxation authorities, upon which income taxes are payable
(recoverable).
Tax expense (tax income) - The aggregate amount included in the determination of net profit
or loss for the period in respect of current tax and deferred tax.
Current tax - The amount of income taxes payable (recoverable) in respect of the taxable
profit (tax loss) for a period. In other words it is the amount actually payable to the tax
authorities in relation to the trading activities of the entity during the period.
Permanent differences – These arise from items of income and expenditure which are not
taxable or deductible in the computation of taxable profits at any time, for example, private
entertainment expenses, fines, tax free interest on paid-up permanent shares (PUPS)
Temporary differences – These are variations between the tax base of the asset or liability
and its carrying amount in the statement of financial position. The tax base of an asset or a
liability is the amount attributed to it for tax purposes.
N.B. We have two types of temporary differences namely, taxable temporary differences and
deductible temporary differences.
Timing differences – is used interchangeably with the term temporary difference. It refers to
the differences between book income versus taxable income as a result of items of revenue or
expense that are recognized in one period for taxes, but in a different period for the books.
EXAMPLE – TAX COMPUTATION
The income statement of X Ltd for the most recent year was as follows:
Operating Profit
$
3 063 700
Less: Operating Expenses
Depreciation on non-current assets
Entertainment expenses
Interest Expense
(437 000)
(104 500)
(72 200)
Profit for the year
2 450 000
The entertainment expenses above were of a private nature. ZIMRA granted the company a
capital allowance of $617 500 on non-current assets. The actual amount of interest paid by the
company was $55 100.
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250
REQUIRED
Calculate the taxable income and tax payable if the tax rate is 25% (excluding Aids levy).
Calculate the current year tax charge to profit or loss if tax due on previous period was agreed
in this current year with the tax authorities to be $40 000.00 when, at first, it had been estimated
to be $33 000.00 in that previous year.
SUGGESTED SOLUTION
X Ltd
Calculation of Taxable Income (Current Tax Computation)
Accounting profit
Add.
Depreciation (accountant`s – straight line, reducing balance, sum of digits, etc)
Private entertainment expenses (only business entertainment is permitted)
Interest expense (this is on an accruals basis)
$
2 450 000
437 000
104 500
72 200
Less.
Capital allowances (tax authorities` depreciation – SIA or Wear and Tear)
Interest paid (cash basis)
(617 500)
(55 100)
Taxable income/profit
Tax payable @ 25%
2 391 100
597 775
Alternative presentation
Calculation of Taxable Income (Current Tax Computation)
Accounting profit
Permanent differences
Private entertainment expenses (only business entertainment is permitted)
$
2 450 000
104 500
Temporary differences
Depreciation on non-current assets (accountant`s)
Capital allowances (tax authorities` depreciation)
Interest expense (this is on an accruals basis)
Interest paid (cash basis)
437 000
(617 500)
72 200
(55 100)
Taxable income/profit
Tax payable @ 25%
2 391 100
597 775
Tax charge to profit or loss:
Current tax expense
Overprovision of previous year`s tax
Deferred tax* (2 391 100 – 2 450 000) x 25% (Income Statement approach)
605 500
597 775
(7 000)
14 725
* Deferred tax aspects are considered beneath. Main emphasis here is on current tax payable computation.
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251
Treatment of Tax loss carry forward and Tax loss carry back
IAS 12 requires recognition as an asset of the benefit relating to any tax loss that can be carried
back to recover current tax of a previous period. This is acceptable because it is probable that
the benefit will flow to the entity and it can be reliably measured.
EXAMPLE
In 2013 Chirandu Ltd paid $355 000 in tax on its profits. In 2014 the company made tax losses
of $85 000. ZIMRA rules allow losses to be carried back to offset against current tax of prior
years. Tax rate has remained 25% (excluding Aids levy).
REQUIRED
Tax charge and tax liability for 2014.
SUGGESTED SOLUTION
Tax refund due on tax losses = 25% x $85 000 = $21 250.
The double entry will be:
Dr Tax receivable (statement of financial position)
Cr Tax repayment (statement of profit or loss and other comprehensive income)
$21 250
$21 250
Tax receivable is shown as an asset until the refund is received from the tax authorities. Another
way is to deduce what is remittable to ZIMRA over the two years as $67 500, [$88 750 (0.25
x 355 000) less 21 250].
An entity may have unused tax losses or credits which it can offset against taxable profits at
the end of a period on computing current tax. IAS 12 states that a deferred tax asset may be
recognized in such circumstances, however, to the extent that it is probable future taxable profit
will be available against which the unused tax losses or credits can be utilized. The criteria for
recognition of deferred tax assets here is the same as for recognizing deferred tax assets arising
from deductible differences.
That unused tax losses exist gives a fair amount of knowledge that future taxable profit may
not be available. In such an instance, a deferred tax asset arising from unused tax losses or
credits should be recognized only to the extent that the entity has sufficient taxable temporary
differences or there is other convincing evidence that sufficient taxable profit will be available
against which the unused losses/credits can be utilized by the entity.
The criteria that the entity uses to assess the probability that taxable profit will be available
against which unused tax losses/credits can be utilized are:
i) Existence of sufficient taxable temporary differences (same tax authority/taxable entity)
against which unused tax losses/credits can be utilized before they expire;
ii) Probability that the entity will have taxable profits before the unused tax losses/credits
expire;
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252
iii) Whether the unused tax losses result from identifiable causes that are unlikely to recur; and
iv) Availability of tax planning opportunities.
EXAMPLE - TAX LOSS CARRY FORWARD (GROUP SCENARIO)
ICSAZ November 2005 Examination question paper (Q1 part 1)
H Ltd has two 100% owned subsidiary companies, X Ltd and Y Ltd. The following temporary
differences and assessed losses have been identified within each of these companies:
Taxable temporary difference
Deductible temporary difference
Assessed losses
H Ltd
$000
20
10
X Ltd
000
150
160
30
Y Ltd
$000
200
50
220
It not considered probable that Y Ltd will have taxable income in the future. It is considered
probable that X Ltd will have taxable income in the future. Furthermore, deductible temporary
differences in X Ltd totalling $100 000 (included in the figures above) have arisen from noncurrent assets in South Africa.
All other assessed losses and temporary differences relate to Zimbabwean operations.
Assume that the tax rate in Zimbabwe and South Africa is 30% and 35% respectively.
REQUIRED
Assuming that H Ltd wishes to offset deferred tax assets and liabilities in the statement of
financial position to the greatest extent possible, show the deferred tax amounts that would
appear in the consolidated statement of financial position of H Ltd. (10 marks)
SUGGESTED SOLUTION
Deferred tax amounts to appear in the consolidated statement of financial position of H
Ltd
$000
H Ltd Net taxable difference x tax rate
(20TTD – 10DTD) x 30%
X Ltd Zimbabwean component
[150 – (160-100) – 30] x 30%
South Africa component
(100 x 35%*1)
Y Ltd See note (200 – 50) x 30%
Deferred tax liability/(asset)
H Ltd
X Ltd
Y Ltd
Total
3
Nil
Nil
3
Nil
18
Nil
18
Nil
Nil
3*2
(35)
Nil
(17)
Nil
45
45
(35)
45
31
Note
In Y Ltd`s case, a deferred tax asset of $21 000 was supposed to have arisen, that is, (200TTD –
50DTD – 220DTD) x 30%, however, according to the examiner there are no probable taxable
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253
profits in the future in as far as Y Ltd is concerned. IAS 12 states that a deferred tax asset
arising from unused tax losses or credits should be recognized only to the extent that the entity
has sufficient taxable temporary differences or the extent to which there is other convincing
evidence that sufficient taxable profit will be available against which the unused losses/credits
can be utilized by the entity. In the case in point with no other information given, Y Ltd cannot
use the $220 000 assessed tax loss carry forward.
*1 The income generated by assets in SA is taxed at 35%, the corporate tax rate in South Africa.
Generally in a situation of higher tax rate paid in a foreign country than in Zimbabwe, no tax
is paid when consignment of goods arrives. In a situation where lower tax is paid in a foreign
country than in Zimbabwe, additional tax (only the variance) is payable on the goods on arrival.
This is so as to avoid double taxation.
*2 The deferred tax liability/asset per each company in the business combination must be shown
on your way to showing the aggregated position for consolidation as has been asked by the
examiner. In practice each company of the group pays own corporate tax separately.
9.5 TAX BASE
Tax base of an asset – It is the amount that will be deductible for tax purposes against any
taxable economic benefits that the entity expects to derive from the use of the asset. If the
benefits are not taxable, the tax base of the asset will be equal to its book value or carrying
amount.
Tax base of a liability – It is the liability`s carrying amount less any amount that will be
deductible for tax purposes in respect of that liability in future periods.
Tax base for revenue received in advance – It is the resulting liability`s carrying amount, less
any amount of the revenue that will not be taxable in future periods.
ILLUSTRATIVE EXAMPLES RELATING TO THE TAX BASE
Examples – Tax base of an asset
1. A machine cost 100. For tax purposes, depreciation of 30 has already been deducted in the
current and prior periods and the remaining cost will be deductible in future periods, either as
depreciation or through a deduction on disposal. Revenue generated by using the machine is
taxable, any gain on disposal of the machine will be taxable and any loss on disposal will be
deductible for tax purposes. The tax base of the machine is 70.
2. Interest receivable has a carrying amount of 100. The related interest revenue will be taxed
on a cash basis. The tax base of the interest receivable is nil.
3. Trade receivables have a carrying amount of 100. The related revenue has already been
included in taxable profit (tax loss). The tax base of the trade receivables is 100.
4. Dividends receivable from a subsidiary have a carrying amount of 100. The dividends are
not taxable. In substance, the entire carrying amount of the asset is deductible against the
economic benefits. Consequently, the tax base of the dividends receivable is 100.a
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254
5. A loan receivable has a carrying amount of 100. The repayment of the loan will have no tax
consequences. The tax base of the loan is 100
a. Under this analysis, there is no taxable temporary difference. An alternative analysis is that
the accrued dividends receivable have a tax base of nil and that a tax rate of nil is applied to
the resulting taxable temporary difference of 100. Under both analyses, there is no deferred tax
liability.
Source: IASB`s IAS 12
Examples – Tax base of a liability
1. Current liabilities include accrued expenses with a carrying amount of 100. The related
expense will be deducted for tax purposes on a cash basis. The tax base of the accrued expenses
is nil.
2. Current liabilities include interest revenue received in advance, with a carrying amount of
100. The related interest revenue was taxed on a cash basis. The tax base of the interest received
in advance is nil.
3. Current liabilities include accrued expenses with a carrying amount of 100. The related
expense has already been deducted for tax purposes. The tax base of the accrued expenses is
100.
4. Current liabilities include accrued fines and penalties with a carrying amount of 100. Fines
and penalties are not deductible for tax purposes. The tax base of the accrued fines and
penalties is 100.a
5. A loan payable has a carrying amount of 100. The repayment of the loan will have no tax
consequences. The tax base of the loan is 100.
a. Under this analysis, there is no deductible temporary difference. An alternative analysis is
that the accrued fines and penalties payable have a tax base of nil and that a tax rate of nil is
applied to the resulting deductible temporary difference of 100. Under both analyses, there is
no deferred tax asset.
Source: IASB`s IAS 12
9.6 DEFERRED TAX
(For you to have a quick insight on basis/accounting methods that will be used in deferred tax figurative examples, you may first read items
9.7 and 9.8 of this Unit)
It is tax arising from temporary differences. To account for deferred tax under IAS 12,
first prepare a statement of financial position that shows all the assets and liabilities at
the reporting date and their tax base. This is the comprehensive liability basis.
As a general rule of thumb, if what is being accounted for is an asset or expense, and carrying
amount (or accounting profit) exceeds tax base (or taxable income), the temporary difference
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255
that arises is a taxable temporary difference leading to a deferred tax liability. If what is being
accounted for is a liability or income received in advance, and carrying amount (or accounting
profit) exceeds tax base (or taxable income), the temporary difference that arises is a deductible
temporary difference leading to a deferred tax asset.
N.B. You compare the carrying amount versus tax base when using the statement of financial
position approach as permitted by IAS 12. The income statement approach whereby you
compare the accounting profit versus taxable profit to establish the same deferred tax results is
also mentioned in this study guide. This is only to give you an extended view and something
you can use only as proof to your statement of financial position approach workings.
9.6.1 Taxable Temporary Differences (Individual Firm Scenario)
9.6.1.1 Definition
A taxable temporary difference results in the payment of tax when the carrying amount of the
asset or liability is settled. In simple terms, this means that a deferred tax liability* will arise
when the carrying value of the asset is greater than its tax base or when the carrying value of
the liability is less than its tax base.
9.6.1.2 Sources
The following are the sources of/circumstances that give rise to taxable temporary differences
from a statement of profit or loss and other comprehensive income perspective:
a) Interest revenue received in arrears and included in accounting profit on the basis of time
apportionment and in computation of taxable profit on a cash basis.
b) Revenue from sale of goods which is included in the accounting profit on delivery of goods
and in the computation of tax on receipt of cash.
c) Depreciation of a non-current asset that is accelerated for tax purposes, due to the purchase
of new assets whose capital allowances against taxable profits outweigh depreciation
chargeable on the existing asset in the year of acquisition.
d) Capitalized development costs amortized in the profit or loss yet deducted in full on
computation of taxable profit in the year of incurrence.
e) Prepaid expenses already deducted on computation of taxable profit for current or previous
periods on a cash basis.
The following are the sources of/circumstances that give rise to taxable temporary differences
from a statement of financial position perspective:
a) Depreciation of an asset which for tax purposes is not deductible for the reason that only
capital allowances are.
b) The recording of a loan at the amount received (principal amount) less transaction costs
causes the carrying amount of the loan at each year-end to increase due to amortization of the
transaction costs yet the same transaction costs would have been deducted for tax purposes in
the year of receipt of the loan on a cash basis.
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256
c) The liability component of a compound financial instrument (you should remember a
compound financial instrument such as a convertible debenture has an equity and a liability
component) which is measured at a discount to the amount repayable at maturity with that
discount not being deductible for tax purposes.
* Deferred tax assets are the amounts of tax recoverable in future periods in respect of:
a) deductible temporary differences
b) the carry-forward of unused tax losses
c) the carry forward of unused tax credits
EXAMPLE 1
Makwiro Plates was incorporated on 1 Jan 20-2 on 1 January 20-2. In the year ended 31
December 20-2 the company made a profit before tax of $121 000.
This figure was after a depreciation charge of $11 000.
During the period the company made the following capital additions:
Plant
Motor vehicles
$
48 000
12 000
Tax allowances for 2002 are $15 000
Corporate tax is chargeable at the rate of 30%
REQUIRED (10 marks)
a) Calculate the corporate income tax liability for the year ended 31 December 20-2.
b) Calculate the deferred tax balance that is required in the statement of financial position
as at 31 December 20-2
c) Prepare a note showing the movement on the deferred tax account and thus calculate
the deferred tax charge for the year ended 31 December 20-2.
d) Prepare the statement of profit or loss and other comprehensive income note which
shows the compilation of the tax expense for the year ended 31 December 20-2
e) Prepare a note which reconciles accounting profit multiplied by the applicable tax rate
and the tax expense.
f) Prepare a statement of financial position note showing the movement on deferred tax
in respect of each type of temporary difference.
SUGGESTED SOLUTION
a) Corporate income tax liability (tax computation)
Profit per accounts
Depreciation
Tax allowances
ICSAZ - P.M. PARADZA
$
121 000
11 000
132 000
(15 000)
257
Taxable profit
117 000
Tax payable – 30%
35 100
b) Deferred tax liability (statement of financial position approach)
Tax base
Carrying amount (60 000 – 11 000)
Taxable temporary difference
45 000
49 000
(4 000)
Deferred tax liability – 30%
(1 200)
c) Movement on the deferred tax liability
Balance b/d
Deferred tax expense
Balance c/d
Nil
1 200
1 200
d) Statement of profit or loss and other comprehensive income note
Current tax expense
Deferred tax expense
Tax expense
35 100
1 200
36 300
e) Reconciliation of the accounting profit multiplied by the applicable tax rate to
the tax expense
Accounting profit
Tax – 30%
Tax expense
121 000
36 300
36 300
f) Movement on deferred tax by each category of temporary difference
Property plant and equipment
b/d
Nil
Movement
1 200
c/d
1 200
EXAMPLE 2
Continuing from the previous year. The following information is relevant for the year ended
31 December 20-3.
1. Capital transactions
Depreciation charge
Tax allowances
$
14 000
16 000
2. Interest payable
On 1 April 20-3 the company issued $25 000 of 8% loan stock. Interest is paid in arrears on 30
September and 30 March.
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258
3. Interest receivable
On 1 April Makwiro Plates purchased debentures having a nominal value of $4 000. Interest at
15% p.a is receivable on 30 September and 30 March. The investment is regarded as a financial
asset at fair value through other comprehensive income.
4. Provision for warranty
In preparing the financial statements for the year to 31 December 20-3, the company has
recognized a provision for warranty payments in the amount of $1 200. This has been correctly
recognized in accordance with IAS 37 – Provisions, contingent liabilities and contingent assets,
and the amount has been expensed. The warranty expense is deductible only when paid.
5. Fine
During the period the company has paid a fine of $6 000.
6. Further information
The accounting profit before tax for the year was $125 000
REQUIRED (10 marks)
a) Calculate the corporate income tax liability for the year ended 31 December 20-3
b) Calculate the deferred tax balance that is required in the statement of financial position
as at 31 December 20-3
c) Prepare a note showing the movement on the deferred tax account and thus calculate
the deferred tax charge for the year ended 31 December 20-3
d) Prepare the income statement note which shows the compilation of the tax expense for
the year ended 31 December 20-3
e) Prepare a note which reconciles accounting profit multiplied by the applicable tax rate
and the tax expense
f) Prepare a statement of financial position note showing the movement on deferred tax
in respect of each type of temporary difference.
SUGGESTED SOLUTION
a) Corporate income tax liability (tax computation)
Profit per accounts
Interest payable (temporary difference)
Provision (temporary difference)
Fine (permanent difference)
Depreciation (temporary difference)
Tax allowances (temporary difference)
Interest receivable (temporary difference)
Taxable profit
ICSAZ - P.M. PARADZA
$
125 000
500
1 200
6 000
14 000
146 700
(16 000)
(150)
130 550
259
Tax payable – 30%
39 165
b) Deferred tax liability (statement of financial position approach)
Carrying
amount
$
Property plant & equipment 35 000
(49 b/d – 14)/45 b/d – 16)
Interest payable
(500)
(25 000 x 8% x 3/12)
Interest receivable
150
(4 000 x 15% x 3/12)
Provision
(1 200)
33 450
Tax
base
$
29 000
Temporary
difference
$
6 000
Nil
(500)
Nil
150
Nil
29 000
(1 200)
4 450
Deferred tax liability – 30% x 4 450
(1 335)
c) Movement on the deferred tax liability
Balance b/d
Deferred tax expense
Balance c/d
1 200
135
1 335
d) Statement of profit or loss and other comprehensive income note
Current tax expense
Deferred tax expense
Tax expense
39 165
135
39 300
e) Reconciliation of the accounting profit multiplied by the applicable tax rate to the
tax expense
Accounting profit
Tax – 30%
Tax effect on permanent differences/non-deductible expenses
(6 000 x 30%)
Tax expense
125 000
37 500
1 800
39 300
f) Movement on deferred tax by each category of temporary difference
Property plant and equipment
ICSAZ - P.M. PARADZA
B/d
1 200
Movement
600
C/f
1 800
260
Interest payable
Interest receivable
Provision
Nil
Nil
Nil
1 200
(150)
45
(360)
135
(150)
45
(360)
1 335
Tutorial Note:
Ensure thorough preparation of students in class, with examples of theory and at least 1 practice
question on this area/relate explanation to any of the examples in this study guide.
9.6.3 Taxable Temporary Differences (Group Scenario)
(Investments in Subsidiaries, Branches, Associates and Interests in Joint Arrangements)
The following are the sources of/circumstances that give rise to taxable temporary
differences:
a) The carrying amount of an asset that is increased to fair value in a business combination that
is an acquisition, and no equivalent adjustment being made for tax purposes.
b) Unrealized losses resulting from intragroup transactions that are eliminated by inclusion in
the carrying amount of inventory or property, plant and equipment.
c) Retained earnings of subsidiaries, branches, associates and joint ventures that are included
in consolidated retained earnings, but income taxes payable if the profits are distributed to the
reporting parent.
d) Investments in foreign subsidiaries, branches or associates or interests in foreign joint
ventures that are affected by changes in foreign exchange rates.
e) An entity that accounts in its own currency, for the cost of the non-monetary assets of a
foreign operation that is integral to the reporting entity's operations but the taxable profit or tax
loss of the foreign operation is determined in the foreign currency.
Tutorial Note:
Ensure thorough preparation of students in class, with examples of theory and at least 1 practice
question on this area.
9.6.4 Deductible Temporary Differences (Individual Firm Scenario)
Definition
Deductible temporary differences are differences that result in amounts being deductible in
determining taxable profit or loss in future periods when the carrying value of the asset or
liability is recovered or settled. When the carrying value of the liability is greater than its tax
base or when the carrying value of the asset is less than its tax base, a deferred tax asset* may
arise.
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261
Sources
The following are the sources of/circumstances that give rise to deductible temporary
differences from a statement of profit or loss and other comprehensive income perspective:
a) Pension costs that are deducted when calculating accounting profit as cost of employee
service and not deducted on calculation of taxable profit until the entity pays retirement benefits
or contributes to the fund.
b) Difference between the accumulated depreciation of the non-current asset and the
accumulated capital allowance up to the end of the financial year.
c) Purchase cost of inventory sold which is deducted as a cost of sale on delivery of goods on
calculation of accounting profit versus its treatment on calculation of taxable profit whereby it
is only deductible when cash is received.
d) Impairment losses to inventory (when written down to NRV) or non-current assets (when
written down to recoverable amount) in calculating accounting profit, which on calculation of
taxable profit are not deductible.
e) Research costs which per IAS 38 are treated as expenses on calculating accounting profit
yet not deductible for tax purposes until later periods when the internally generated intangible
asset`s development is actually completed.
f) Deferred income which shows in the statement of financial position but having already been
included in taxable profit calculation for the current or previous periods.
g) Government grants showing in the statement of financial position as deferred income but
not taxable in future periods.
* Deferred tax liabilities are the amounts of tax payable in future periods in respect of taxable
temporary differences.
Tutorial Note:
Ensure thorough preparation of students in class, with examples of theory and at least 1 practice
question on this area/relate explanation to any of the examples in this study guide.
9.6.5 Deductible Temporary Differences (Group Scenario)
(Investments in Subsidiaries, Branches, Associates and Interests in Joint Arrangements)
The following are the sources of/circumstances that give rise to deductible temporary
differences:
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262
a) A liability recognized at its fair value in a business combination, that is an acquisition, but
none of the related expense is deducted in determining taxable profit until a later period when
the parent is satisfied of availability of profits/profitability of the acquired subsidiary.
b) Unrealized profits resulting from intragroup transactions that are eliminated from the
carrying amount of assets, such as inventory or property, plant or equipment, but with no
equivalent adjustment being made for tax purposes.
c) Investments in foreign subsidiaries, branches or associates or interests in foreign joint
ventures that are affected by changes in foreign exchange rates.
d) where a foreign operation accounts for its non-monetary assets in its own (functional)
currency and its taxable profit or loss is determined in a different currency (under the
presentation currency method) which causes changes in the exchange rate to result in temporary
differences with the resulting deferred tax being charged or credited to profit or loss.
Summary of the effects of temporary differences
i.
ii.
An originating difference which reduces the tax charge in one period will increase
the tax charge and create tax liabilities in future accounting periods at the time it is
reversed.
An originating difference which increases the tax charge in one period will reduce
the tax charge and create tax assets (prepayment of tax) in future accounting
periods.
Tutorial Note: GROUPS
Students need to be taught how to account for deferred tax under group scenarios/business
combinations.
ACTIVITY 1 – COMPREHENSIVE
The following is an extract of Tokwe Mukosi Ltd`s trial balance for the year ended 31 Dec
20-4:
$
Accounts receivable
1
10 000
Accounts payable
2
30 000
Van at cost
3
800 000
Accumulated depreciation – Van
3
80 000
Deferred tax – 1 Jan 20-4
9 000
Retained earnings – 1 Jan 20-4
655 000
Loss before tax
4
125 500
Dividends declared – 31 December 20-4
5
85 000
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263
The loss before tax in the above trial balance includes all the undermentioned additional
information:
1. The accounts receivable balance in the above trial balance consists only of rent paid in
advance for the property the company currently occupies. The rent paid in advance relates to
the rental for January 20-5, which was already paid in December 20-4. The accounts receivable
balance at the end of the previous financial year amounted to nil.
2. The accounts payable in the above trial balance consists only of unearned sales revenue
received in advance for lay away (lay by) sales of goods which will be delivered in Jan 20-5
when the buyer makes the final payment. The accounts payable balance at the end of the
previous financial year amounted to nil. The sales revenue received in advance is included in
gross income for tax purposes.
3. On 1 January 20-4, a van with an original cost of $600 000, was involved in a car accident
and was damaged beyond repair. A claim was lodged with the company`s insurers and the
company received proceeds of $500 000. The carrying amount and tax base of the van on the
day of the accident amounted to $480 000 and $450 000 respectively. On 30 June 20.4, the
company purchased a new minibus for $800 000 to replace the above mentioned van.
4. Fine of $6 000 was paid for contravention of the Companies Act.
5. Donations of $40 000 were paid, of which $32 000 are not allowed for tax purposes.
6. $11 000 employees tax (PAYE) was paid during the month of December 20-4 in respect of
salaries and wages for November 20-4.
7. Foreign income amounting to $190 000 is not taxable in Zimbabwe in terms of a double
taxation agreement with another country. The company paid foreign taxes of $25 000 on this
income.
8. Dividends received in respect of listed investments and unlisted investments in Zimbabwe
amounted to $105 000.
9. The company`s previous dividend cycle ended on 31 December 20-3. There are no unutilized
credits, in respect of dividends received in previous periods, available. The company`s directors
are certain that the company will generate future taxable income and that dividends will be
declared from retained earnings in future.
10. The company provides for deferred tax on all temporary differences according to the
comprehensive basis by using the statement of financial position approach. There is certainty
beyond any reasonable doubt that the company will have sufficient taxable profit in future
against which any unused tax losses can be utilized. There are no other temporary differences
except those mentioned in the question.
11. The corporate tax rate changed from 30% in 20-3 to 29% in 20-4.
12. Ignore the implications of capital gains tax.
REQUIRED
ICSAZ - P.M. PARADZA
264
a) Calculate the taxable income or loss of Tokwe Mukosi Ltd for the year ended 31 December
20-4 (7.5marks)
b) Calculate the deferred tax movement (including the rate change) in the statement of profit
and loss and other comprehensive income of Tokwe Mukosi Ltd for the year ended 31
December 20-4, using the statement of financial position approach. (4.5marks)
c) Using the answer above prepare the journal entry for the tax movement (including tax rate
change) in the statement of profit and loss and other comprehensive income of Tokwe Mukosi
Ltd for the year ended 31 December 20-4 (2.5 marks)
d) Disclose only the income tax expense note (including tax rate reconciliation using only $
values) to the annual financial statements of Tokwe Mukosi Ltd for the year ended 31
December 20-4, complying with the relevant IFRS and legislation. (15.5 marks)
ACTIVITY 2
Obrien Ltd bought a new truck for $5 850 000 on 1 January 20-5, and the truck is being
depreciated in the accounts at 20% straight line over 5 years. The estimated residual value of
the truck is $450 000. Capital allowances on this truck received for tax purposes were 20-5 $1
350 000, 20-6 $1 269 000, 20-7 $1 062 000, 20-8 $918 000, 20-9 $801 000. Obrien Ltd` annual
profits before tax for the 5 years after charging depreciation amounted to $2 700 000. The tax
rate throughout this period was 30%.
REQUIRED
a) Calculate tax payable for the 5 years
b) Calculate the deferred tax amounts for the 5 years, using the income statement approach*
first and statement of financial position approach second.
c) Statement of profit or loss and other comprehensive income extract to show current and
deferred tax amounts
d) Ledger accounts related to taxation, for the 5 years
* for knowing alternative approaches to coming up with the same results only. IAS 12 prefers the comprehensive liability
approach.
9.7 METHODS OF ACCOUNTING FOR DEFERRED TAX
Deferral or liability methods for use in instances where tax rates change
Where the corporate rate of income tax fluctuates from one year to another, as is the case with
our yearly national budget pronouncements by the Minister of Finance, a problem arises in
respect of the amount of deferred tax to be credited (debited) to profit or loss in later years. The
amount can be calculated using either of two methods namely:
The deferral method which assumes that the deferred tax account is an item of 'deferred tax
relief, which is credited to profits in the years in which the timing differences are reversed.
ICSAZ - P.M. PARADZA
265
Therefore, the tax effects of timing differences are calculated using tax rates current when the
differences arise.
Or the liability method which assumes that the tax effects of timing differences should be
regarded as amounts of tax ultimately due by or to the company. Therefore, deferred tax
provisions are calculated at the rate at which it is estimated that tax will be paid (or recovered)
when the timing differences reverse.
Under this method (liability method), the total originating or reversing timing difference for
the year is converted into a deferred tax amount at the current rate of tax (and if any change in
the rate of tax has occurred in the year, only a single adjustment to the opening balance on the
deferred tax account is required).
9.8 BASES FOR ACCOUNTING FOR DEFERRED TAX
9.8.1 Nil provision or flow through approach
According to this method, no adjustment should be made to the accounts of a particular year to
take temporary differences into account. The statement of comprehensive income should only
be debited with the actual tax charge when it becomes known. The main argument used in
support of this method is that there is no direct relationship between the accounting profit of
an entity and its taxable profit for a given period. If through good tax planning, the company
manages to keep its tax liability at a low level, the statement of comprehensive income should
reflect this benefit.
However, it should be noted that any attempt to ignore future tax obligations arising from
current profitable activities militates against the accruals and prudence concepts of accounting.
Profit after tax is a key indicator of a company`s performance, regardless of whether tax is
considered to be an expense or an appropriation of profits. Another viewpoint is that a deferred
tax liability effectively constitutes a source of funds, while a deferred tax asset is analogous to
a use of funds. Therefore, ignoring these issues in favour of accuracy in the tax expense figure
would certainly be not good accounting practice.
The flow through perspective sees advocates putting emphasis on the difficulty of estimating
future taxable profits, which may render the deferred tax liability or asset virtually meaningless.
The actual tax charge is believed by proponents to be objectively calculated.
9.8.2 Full provision or comprehensive allocation approach
In this method, a provision is required to be made in respect of the tax liability of future periods,
on the basis that all temporary differences will reverse in the future. The main aim of this
method is to eliminate or minimize the distortion in a company`s taxable income and tax charge
arising from temporary differences. This is done by spreading out as realistically as possible
any benefits from the delayed payment of tax over the years receiving these benefits. In
pursuance of this, the tax expense estimated in the statement of comprehensive income should
be split into two parts, that is, one relating to the current year (current tax expense) and the
other relating to future years (deferred tax expense).
The advantage of doing this is that the accruals and prudence concepts are adhered to, thereby
minimizing the over/understatement of taxable income arising from an exclusive reliance on
cash flows. The disadvantage is that, in practice, if a company owns many assets which were
ICSAZ - P.M. PARADZA
266
purchased on different dates and are depreciated in different years, it becomes not an easy task
to identify the origination and reversal of timing differences, unless a comprehensive recording
system is used. Purchasing additional depreciable assets has the effect of rolling over the
deferred tax, especially if capital allowances on the asset are always higher than the
depreciation charged in the accounts. As a result, the deferred tax liability may never be fully
discharged and will end up having the nature of a permanent loan from the government.
9.8.3 Partial provision approach
In this method a provision is made for the effects of temporary differences that can be
reasonably expected to arise in the future. The net effect of all the differences is considered in
arriving at the deferred tax figure. A decision is made as to whether a provision should be
created, increased or decreased, at the end of the year under review. If the company has
determined that a deferred tax liability exists and chooses to make a provision for it, the
amounts of the under provision should be disclosed in the notes to the financial statements. In
using this approach, care should be taken to base the analysis on realistic and/or reasonable
assumptions if the accounts are to show a true and fair view.
If an entity owns several depreciable assets and expects to undertake a capital expenditure
programme, the estimated useful lives of both the existing and future assets should be
incorporated in the calculations. According to Elliot et al (2002) the partial provision approach
is based on the philosophy that “deferred taxation should be accounted for in respect of the net
amount by which it is probable that any payment of tax will be temporarily deferred or
accelerated by the operation of timing/temporary differences which will reverse in the
foreseeable future without being replaced.”
The replacement of timing differences referred to above arises in the context of accelerated
capital allowances. This occurs when allowances on new assets have the effect of offsetting
differences which are about to reverse, resulting in the creation of tax assets, or in indefinite
postponement of tax liabilities due to the roll over effect. IAS 12 (revised) requires that deferred
tax assets should be recognized only when it is probable that taxable profits will be available
against which the deferred tax asset can be utilized. If an entity has a history of tax losses, it
should recognize deferred tax assets only to the extent that is has sufficient taxable temporary
differences or there is convincing evidence that sufficient taxable profits will be available.
9.9 DEFERRED TAX AND NON CURRENT ASSET REVALUATIONS (IAS 16)
Tutorial Note:
Students must be reminded on how deferred tax aspects apply to a non-current asset revaluation
scenario if an entity chooses the revaluation model for subsequent measurement per IAS 16.
9.10 DISCLOSURE REQUIREMENTS
EXAMPLE - PRACTICE
A manufacturing company bought new equipment on 1 January 20-3 for $4 600 000. The
equipment had an expected useful life of 5 years and is being depreciated on the straight-line
basis with no residual value.
ICSAZ - P.M. PARADZA
267
For tax purposes, ZIMRA allowed wear and tear on the following basis:
50% in the first year
30% in the second year
20% in the third year
On 31 December 20-6 the company sold the equipment $1 200 000. The profit before tax for
20-5 was $1 104 000 and for 20-6 it was $1 380 000. The tax rate was 35% throughout the
period 20-3 to 20-6. The company's financial year end is 31 December.
REQUIRED
a) Calculate the temporary differences and deferred tax assets/liabilities for the years 20-3 to
20-6) Calculate the taxable profit and current tax expense for 20-5 and 20-6
c) Disclose the relevant information on the face of the extract financial statements for the yearended 31 December 20-6 to comply with IAS 12.
SUGGESTED SOLUTION
a) Temporary difference and deferred tax assets/liabilities
CA
$
TB
$
TD
$
DTL
$
IS
$
Dr/(Cr)
31/12/20-3
3 680 000
2 300 000
1 380 000
483 000
483 000
31/12/20-4
2 760 000
920 000
1 840 000
644 000
161 000
31/12/20-5
1 840 000
1 840 000
Nil
644 000
Nil
31/12/20-6
Nil
Nil
Nil
Nil
(644 000)
CA = Carrying amount, TB = Tax Base, TD = Timing Difference, DTL = Deferred Tax and
Liability IS = Income Statement
b) Taxable profit and tax expense
Profit before tax
Depreciation for accounting purposes
Recoupment for tax purposes
Wear & tear for tax purposes
Taxable profit
Current tax expense at 35%
20-6
$
1 380 000
920 000
1 200 000
Nil
3 500 000
1 225 000
20-5
$
1 104 000
920 000
(920 000)
1 104 000
386 400
c) Face disclosures on extract financial statements
Extract income statement for year-ended 31 December 20-6
20-6
$
ICSAZ - P.M. PARADZA
20-5
$
268
Profit before tax
Income tax expense
Profit after tax
1 380 000
(581 000)
799 000
1 104 000
(386 400)
717 600
Extract statement of financial position as at 31 December 20-6
20-6
$
EQUITY & LIABILITIES
Non-current liabilities
Deferred tax liability
20-5
$
644 000
ACTIVITY 3
a) Define the following terms:
i) a temporary difference
ii) a tax base of an asset
iii) a tax base of a liability
iv) a taxable temporary difference and give an example of when one might arise
v) a deductible temporary difference and give an example of when one might arise
vi) tax liabilities
vii) tax assets
b) Deferred tax liabilities must always be recognized.
True/False?
c) Deferred tax assets must always be recognized.
True/False?
d) The portion of a capital profit that is exempt from tax will cause a temporary difference and
deferred tax.
True/False?
e) The income receivable balance will cause a temporary difference and deferred tax.
True/False?
f) Deferred tax relating to an asset is always measured based on management is intentions with
regard to the future recovery of the asset's carrying amount.
True/false
g) Explain what tax rates to use when measuring deferred tax balances.
h) The taxable temporary differences at 31 December 20-5 were $100 000 and the taxable
temporary differences at 31 December 20-5 were $120 000. The tax rate is 30% in both years.
Show the journal entry and identify what the deferred tax balance will be reflected in at the
statement of financial position.
i) The deductible temporary differences at 31 December 20-5 were $100 000 and the deductible
temporary differences at 31 December 20-6 were $120 000. The tax rate is 30% in 20-5 but a
new tax rate of 40% was announced in the Minister of Finance's budget speech on 15 December
20-6. Show the journal entry and identify what the deferred tax balance will be reflected at in
the statement of financial position.
Source: GAAP: Graded questions, D L Koutz & C L Service, 2012
ACTIVITY 4
The draft results of operations of Hobbit Limited for the year ended 31 December 20-1 is
shown below:
ICSAZ - P.M. PARADZA
269
$
1 000 000
(400 000)
600 000
300 000
900 000
(403 000)
497 000
Revenue
Cost of sales
Gross profit
Other income
Other expenses
Profit before taxation
The following end of year adjustments need to be accounted for:
1. Rent received in advance of $ 5 000 is included in other income (taxable in 20-1)
2. Rate prepaid of $ 6 000 in respect of 20-2 are included in other expenses (deductible for tax
purposes in 20-1)
3. Advertising costs payable at year-end total $10 000 (deductible for tax purposes in 20-1)
4. Interest income of $20 000 is receivable at year-end (taxable in 20-1)
5. Dividend income of $30 000 is included in other income (exempt from tax)
6. Fines of (9 000 in other expenses (not deductible for tax purposes)
7. The deferred tax accrued at 31 December 20-0 had a credit balance of $12 000 which related
purely to taxable temporary difference arising from capital allowances on plant. The tax base
of plant at 31 December 20-0 was $115 000. At 31 December 20-1 the carrying amount of plant
amounted to $85 000. No plant was sold or purchased during the year. 8. There are no other
differences between accounting profit and taxable profit other than those evident from the
information given.
Part A
The statutory normal tax rate has remained unchanged for many years at 30%.
Part B
The statutory normal tax rate was 40% up to 31 December 20-2 and that the rate changed to
30% during the year ended 31 December 20-1.
REQUIRED (for both Part A and B):
a) Prepare an extract from the Statement of Comprehensive Income of Hobbit Ltd for the year
ended 31 December 20-1, starting with profit before tax. (comparatives are not required)
b) Show how deferred tax will be disclosed on the statement of financial position of hobbit Ltd
at 31 December 20-1 c) Prepare the notes to the financial statements relating to taxation and
deferred tax at 31 December 20-1.
Source: GAAP: Graded questions, D L Koutz & C L Service, 2012
9.11 SUMMARY
This Unit touched on the treatment of company tax from the viewpoint of reporting entities.
The Unit focuses on the principles involved, as well as the calculation of tax expenses and
ICSAZ - P.M. PARADZA
270
income related to the current and future periods. The relationship between amounts shown in
the books of an entity and those of the tax authority is also discussed and illustrated. Of major
interest is the fact that entities are allowed to benefit from confirmed tax losses and unused tax
credits provided certain conditions laid out by the IFRS are met. One such
provision/requirement is that the entity moves back into profit-making position after a period
of losses
9.12 REFERENCE
Accountancy Tuition Centre (International Holdings) Ltd, 2007
Denmark Training
Advanced Financial Accounting &
Reporting, ICSAZ Study Pack (2009)
University of South Africa (UNISA), 2014
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271
UNIT TEN
SHARE-BASED PAYMENT (IFRS 2)
10.0 INTRODUCTION
The increased sophistication of commercial activities has resulted in a wide range of payment
methods, including the use of share options as remuneration for services rendered by
employees. The main advantage of these methods is flexibility, since the paying organization
does not need to rely on hard cash to meet its obligations. The disadvantage or challenge is that
such methods require new ways of accounting in order to capture the essence of the
transactions. Shares and share options tend to be attractive to employees and other parties since
they are usually denominated in terms of market value, which benefits the payees if the
organization is doing well. The purpose of this Unit is to examine these innovative ways of
effecting payments.
10.1 OBJECTIVES
By the end of this Unit you should be able to
•
identify and explain the measurement principles and specific requirements for the
major types of share-based transactions;
•
Distinguish between the different types of share based payments;
•
Explain the recognition criteria for share-based transactions;
•
Define vesting conditions and explain their accounting treatment in the context of
share based transactions;
•
Explain the disclosure requirements for the share-based transactions.
10.2 SCOPE
The term 'share-based payment' refers to transactions in which payments are effected through
assets, equity or their cash equivalents. IFRS 2 mandatory for all share-based payment
transactions including:
i)
Equity-settled share-based transactions in which the entity receives goods or
services as consideration for its equity instruments including shares and share
options.
ii)
Cash-settled share-based transactions, in which the entity receives goods or services
by incurring liabilities to suppliers or amounts that are based on the price or value
of the entity's share or other equity instruments.
iii)
Transactions in which the entity receives or acquires goods or services and agrees
with the supplier whether the settlement will be in cash or other assets or equity
instruments.
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272
This standard does not apply to transactions in which the entity acquired goods as part of net
assets acquired in a business combination, which is explained in IFRS 3. Only equity
instruments granted to employees in this capacity are dealt with in IFRS 2.
10.3 KEY DEFINITIONS
Grant Date
The date on which the entity and another party e.g. an employee agree to a share-based payment
arrangement. This occurs when the entity and the counterparty have a shared understanding of
the terms and conditions of the agreement that they have gone into. On this date the entity gives
the counterparty the right to cash, other assets or equity instruments as long as the specified
vesting conditions are fulfilled. If the agreement is subject to an approval process, grant date is
the date on which approval is obtained.
Measurement Date
The date on which the fair value of the equity instruments granted is measured for the purpose
of IFRS 2. For transactions with employees and others providing similar services, the
measurement date is the same as the grant date. For transactions with parties other than
employees, the measurement date is the date on which the entity obtains the goods or the
counterparty renders a service.
Vesting Conditions /period
This is the condition which must be satisfied for the counterparty to become entitled to receive
cash, other assets or equity instruments of the entity, under a share-based payment agreement.
Vesting conditions include service conditions, which requires the other party to complete
specified performance targets to be met. The vesting period refers to the period during which
all the specified vesting conditions of a share-based payment agreement are to be met.
Market Conditions
These are conditions upon which the exercise price, vesting or exercisability of an equity
instrument depends, that is related to the market price of the entity's equity instruments e.g.
attaining a specific share price or achieving a specified target based on the market price of the
entity's equity instruments relative to an index of market price of the equity instruments of
other entities.
Intrinsic Value
This is the difference between the fair value of the shares to which the counterparty is entitled
and the fixed price that the counterparty is or will be required to pay for the share. For example,
a share option with an exercise price of $40, on a share with a fair value of $55, has an intrinsic
value of $15.
10.4 RECOGNITION CRITERIA
An entity should recognise the goods or services received or acquired in a share-based payment
transaction when it obtains the goods or as the services are received. The entity should
recognise a corresponding increase in equity if the goods or service were received in an equity-
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273
settled share-based payment transaction, or a liability if the goods or services were acquired in
a cash-settled share-based transaction.
When the goods or services received or acquired in a share-based payment transaction do not
qualify as assets, they should be recorded as expenses.
10.5 EQUITY-SETTLED SHARE -BASED PAYMENT TRANSACTIONS
Para 10 of IFRS 2 states the key measurement rule as follows: "For equity-settled share-based
payment transactions, the entity shall measure the goods or services received, and the
corresponding increase in equity, directly at the fair value of the goods or services received
unless that fair value cannot be estimated reliably. If the entity cannot estimate reliably the fair
value of the goods or services received, the entity shall measure their value and the
corresponding increase in equity, indirectly by reference to the fair value of the equity
instruments granted." An entity should measure the fair value of services received from
employees based on the fair value of the equity instruments granted. The reasons for this waiver
are as follows:
a) It is usually not possible to measure directly the services received for specific components
of an employee's total remuneration,
b) It may not be possible to independently determine the fair value of the total remuneration
without reference to the fair value of the equity instruments granted, and
c) It is difficult to estimate the fair value of additional benefits paid to employees in the form
of shares or share options as part of a bonus arrangement.
For transactions with third parties who are not employees, it is normally assumed that the fair
value of the goods or services received can be estimated reliably. However, if this is not the
case, the entity should measure the goods or increase in equity-based transactions on the fair
value of the equity instruments granted. This should be done on the date that the entity obtains
or the counterparty renders services.
Transactions in which services are received
•
If there is no vesting period, the counterparty will be immediately entitled to the equity
instruments granted. On the grant date the entity should recognise the service received
in full, with a corresponding increase in equity.
•
If there is a vesting period, meaning that the counterparty will render the services during
an agreed future period, the entity should account for the services as they are provided,
and recognise a corresponding increase in equity.
EXAMPLE - TRANSACTIONS WHERE SERVICES ARE RECEIVED BUT TO BE
SETTLED BY EQUITY INSTRUMENTS
A Ltd. grants 50 share options to each of its 150 employees. The individual employees will be
entitled to the options if they work for the company over the next four years. The company
estimates that the fair value of each option is $100. It also estimates that 15% of the employees
will forfeit their rights to the options after failing to complete the required period of service.
ICSAZ - P.M. PARADZA
274
REQUIRED
a) Calculate the remuneration expense and the cumulative remuneration expense for each of
the four years assuming that the estimates are correct
SUGGESTED SOLUTION
a)
Year
1
2
3
4
Workings
Remuneration
expense for
the period
$
1
7500 options x 85% x $100 x /4 years
159 375
2
159 375
(7500 x 85% x $100 x /4 years) – 159 375
3
(7500 x 85%x $100 x /4 years) – 318 750
159 375
4
(7500 x 85% x $100 x /4 years) – 478 125
159 375
Cumulative
remuneration
expense
$
159 375
318 750
478 125
637 500
b) Calculate the remuneration expense and the cumulative remuneration expense for each of
the four years assuming the following:
Year 1
15 employees leave; the company revises its estimate of total resignations over
the 4 year period from 15% to 10%
Year 2
18 employees leave; the company revises its estimate of total resignations over
the 4 year period from 10% to 16%
Year 3
14 employees leave; the company revises its estimate of total resignations over
the 4 year period from 16% to 13%
Year 4
no employees leave.
SUGGESTED SOLUTION
A total of 47 employees forfeited their entitlement to the share options during the 4 year period.
The total number of options which vested at the end of this period is 103 employees x 50
options = 5150 options.
Year
1
2
3
4
Workings
Remuneration
expense for
the period
$
1
168 750
7500 options x 90% x $100 x /4 years
2
(7500 x 84% x $100 x /4 years) – 168750
146 250
3
(7500 x 87% x $100 x /4 years) – 315 000
174 375
4
(5150 options x $100 x /4) – 489 375
25 675
ICSAZ - P.M. PARADZA
Cumulative
remuneration
expense
$
168 750
315 000
489 375
515 050
275
EXAMPLE - GRANT WITH A MARKET CONDITION, IN WHICH THE LENGTH
OF THE VESTING PERIOD VARIES
At the beginning of Year 1 B Ltd. grants 8 000 share options with a 10-year life to each of 10
senior executives. The options will vest and become exercisable if and when the company's
share price increases from $120 to $150, on condition that the individual remains in service
until the share price target is achieved.
Using a binomial option pricing model*, the company estimates that the fair value of the
options at grant date is $30 per option. Of all the possible outcomes, the most likely outcome
of the market condition is that the share price target will be achieved at the end of year 5, thus
the company expects the vesting period to be 5 years. The company also estimates that 2
executives will have left by the end of 5 years, implying that 8 000 options x 8 executives = 64
000 options will vest at the end of that year. From years 1 to 4, the company continues to
believe that 2 executives will leave by the end of year 5. However, 1 executive left in each of
years 3, 4 and 5. The share price was achieved at the end of year 6.
* You shall learn this model in your Financial Management module.
REQUIRED
Calculate the remuneration expense and the cumulative remuneration expense for each of the
years up to the end of the vesting period.
SUGGESTED SOLUTION
Year
Workings
Remuneration
expense for
the period
$
Cumulative
remuneration
expense
$
1
64 000 options x $30 x 1/5
384 000
384 000
2
(64000 options x $30 x 2/5) – 384 000
384 000
768 000
3
(64 000 options x $30 x 3/5) – 768 000
384 000
1 152 000
4
(64 000 options x $30 x 4/5) – 1 152 000
384 000
1 536 000
5
(56 000 options x $30 x 5/5) – 1 536 000
144 000
1 680 000
EXAMPLE - ACCOUNTING FOR SHARE OPTIONS BASED ON THE INTRINSIC
VALUE METHOD
At the beginning of year 1, D Ltd. granted 750 share options each to 80 employees. The share
options will vest at the end of year 3, provided the individual employees would be in service at
that time. These options have a life of 10 years, with both the exercise price and the company's
share price being $70 at the grant date. On this date, it was not possible to estimate reliably the
fair value of the options. Initial estimate of leavers was 12.5%.
ICSAZ - P.M. PARADZA
276
At the end of year 1, 3 employees had left, and the company estimated that 7 more employees
would leave in the next 2 years. 2 employees left during year 2, and the estimate of the number
of shares expected to vest was revised to 85%. Another 2 employees left during year 3.
The following table shows details of the company's share price from years 1 to 10 and the
number of options exercised from years 4 to 10. Assume that all these options were exercised
at the end of the years in question.
Year-end option exercised
1
2
3
4
5
6
7
8
9
10
Share price at
74
78
90
95
100
120
128
143
150
166
Number of shares
0
0
0
7000
7500
6000
5800
8000
4200
3000
REQUIRED
Calculate the remuneration expense and the cumulative remuneration expense for each of the
years 1 to 10.
SUGGESTED SOLUTION
N.B. Use of the intrinsic value is because fair value cannot be measured reliably. The intrinsic
value is remeasured at each reporting date until final settlement.
Year
1
2
3
4
5
6
7
8
9
10
Workings
Remuneration
expense for
the period
$
1
60 000 options x 87.5% x ($74-70) x /3 years 70 000
[60 000 x 85% x ($78-70) x 2/3] – 70 000
202 000
3
[54 750 x ($90-70) x /3] – 272 000
823 000
47 750 x (95-90)+7 000 exercised x ($95-90) 273 750
40 250 x ($100-95)+7 500 x ($100-95)
238 750
34 250 x ($120-100)+6000 x (120-100)
805 000
28 450 x ($128-120)+5 800 x ($128-120)
274 000
20 450 x ($143-128)+8 000 x ($143-128)
426 750
16 250 x ($150-143)+4 200 x ($150-143)
143 150
3 000 exercised options x ($166-150)
48 000
Cumulative
remuneration
expense
$
70 000
272 000
1 095 000
1 368 750
1 607 500
2 412 500
2 686 500
3 113 250
3 256 400
3 304 400
10.6 CASH-SETTLED SHARE-BASED PAYMENT TRANSACTIONS
Para 30 of IFRS 2 states the key measurement rule as follows: "For cash-settled share-based
payment transactions, the entity shall measure the goods or services acquired and the liability
ICSAZ - P.M. PARADZA
277
incurred at the fair value of the liability. Until the liability is settled, the entity shall remeasure
the fair value of the liability at each reporting date and at the date of settlement, with any
changes in fair value recognised in profit or loss for the period."
Examples of such transactions are as follows:
a) The entity may grant share appreciation rights to its employees as part of their remuneration
package. In such a scheme, the employees will be entitled to future cash payments based on
expected increases in the entity's share price over a given period.
b) The entity may grant its employees the right to receive future cash payments based on shares
that are issued as redeemable, either compulsorily on cessation of employment or at the
option of the employees.
c) The general recognition rule for such transactions is that the entity should recognise the
services received, and a liability to pay for those services, as the services are being rendered.
Option 1 - If the appreciation rights vest immediately, the services received and the related
liability should be recognised immediately.
Option 2 - If there is a vesting period for the rights, the entity should recognise the services
received and the related liability as the services are being rendered. This will
necessitate an apportionment of the remuneration expense over the relevant periods.
An entity is required to account separately for services received in respect of different
components of a compound financial instrument used to effect payment. For the debt
component, the entity should recognize the services received, and a liability to pay for those
services, as the counterparty renders the services. For the equity component, the entity should
recognize the services received and an increase in equity, as the counterparty renders the
services.
EXAMPLE – SHARE APPRECIATION RIGHTS
E Ltd granted 1 000 cash share appreciation rights to each of its 120 employees, on condition
that they remained in its employ for the next 3 years.
During year 1, 22 employees left. The company estimated that another 28 would leave in the
next 2 years. During year 2, 15 employees left and it was estimated that 17 would leave during
year 3. During year 3, 16 employees left. The employees exercised their rights as follows:
End of year
3
4
5
ICSAZ - P.M. PARADZA
No of employees
25
20
22
67
278
The company estimated the fair values and the intrinsic values of the SARs at the end of the
relevant years as follows:
Year
1
2
3
4
5
REQUIRED
Fair Value
$
33
51
63
60
Intrinsic Value
$
40
46
58
Calculate the total remuneration expense and the related liability at the end of each of the
years 1 to 5.
SUGGESTED SOLUTION
Year
Workings
Remuneration
$
770 000
1 474 000
402 000
1 000 000
1 402 000
Liability
$
770 000
2 244 000
2 646 000
1
2
3
(120-50*) employees x 1 000 SARs x $33 x 1/3
[(120-54) x 1 000 SARs x 51x 2/3] – $770 000
[(120-53-25) x 1 000 SARs x 63 x 3/3] – 2 244 000
+ [25 employees x 1 000 SARs x 40
4
[(42-20) x 1 000 SARs x $60] – 2 646 000
+20 employees x 1 000 SARs x $46
(1 326 000)
920 000
(406 000)
1 320 000
5
($0 – $1 320 000)
+22 employees x 1 000 SARs x $58
(1 320 000)
1 276 000
(44 000)
0
*
Year 1 actual leavers are 22 employees + provision for leavers in the next two years 28 = 50 Year 2 actual leavers
are (22 + 15) + provision for leavers in the next one year 17 = 54
Year 3 actual leavers are (22 + 15 + 16) + nil provision for leavers = 53
An entity may acquire goods or services by incurring liabilities to the suppliers of these goods
and services for amounts based on the price of the entity's shares or other equity instruments.
In such cases, the entity is required to recognize initially the goods or services, and a liability
to pay for them when they are acquired, measured at the fair value of the liability. Subsequently,
the entity should recognize changes in the fair value of the liability until it is settled.
EXAMPLE – SHARE-BASED PAYMENT ARRANGEMENTS WITH CASH
ALTERNATIVE
F Ltd granted an employee the right to choose either 1500 phantom shares (that is, the right to
a payment equal to the value of 1 500 shares) or 1 800 shares. This grant is conditional upon
the completion of 3 years` service. If the employee chooses the share alternative, the shares
ICSAZ - P.M. PARADZA
279
must be held for at least 3 years after the vesting date. At the grant date, the entity's share price
is $100 per share. At the end of years 1, 2 and 3 the share price is $115, $128 and $136
respectively. The entity does not expect to pay dividends in the next 3 years, and estimates that
the grant date fair value of the share alternative is $90 per share.
REQUIRED
Calculate the amounts to be posted to expense, equity (that is, share capital) and liability
accounts at the end of years 1 to 3 if the employee chooses
i) the cash alternative and
ii) the equity alternative
SUGGESTED SOLUTION
Fair value of equity alternative 1 800 shares x $90 =
Fair value of cash alternative = 1 500 shares x $100 =
Fair value of equity component of compound instrument =$162 000-50 000 =
$162 000
$150 000
$12 000
Year
1
Liability
57 500
2
Workings
Liability component (1500 x $115 x 1/3)
Equity component (12 000 x 1/3)
Expense
57 500
4 000
4 000
Liability component (1 500 x 128 x 2/3) – 57 500
Equity component ($12 000 x 1/3)
70 500
4 000
4 000
Liability component(1 500 x $136 x 3/3)–(57 500+70 500) 76 000
Equity component ($12 000 x 1/3)
4 000
3
End of year 3
Scenario 1: Cash of $204 000 paid
Scenario 1 Totals
Scenario 2: 1 800 shares issued
Scenario 2: Totals
Equity
70 500
76 000
4 000
(204 000)
0
216 000
244 800
256 800
A share-based payment transaction may give an entity a choice of whether to settle in cash or
by issuing equity instruments. In such a case the entity should determine whether it has a
present obligation to settle the transaction in cash. This would normally be the case if:
i)
ii)
iii)
the choice of settlement in equity instruments has no commercial value (e.g.
because the entity is legally prohibited from issuing shares);
the entity has a past practice or stated policy of settling in cash;
the entity generally settles in cash when the counterparty requests a cash settlement.
10.7 DISCLOSURE REQUIREMENTS
IFRS 2 stipulates the following disclosure requirements for share-based payment transactions.
a) An entity should disclose information that enables users of its financial statements to
understand the nature and extent of share-based payment arrangements that occurred during
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280
the period. The required information includes the number and weighted average exercise
prices of share options
i) outstanding at the beginning of the period
ii) granted during the period
iii) forfeited during the period
iv) exercised during the period
v) outstanding at the end of the period
vi) exercisable at the end of the period
b) An entity should disclose information that enables users of its financial statements to
understand how the fair value of the goods or services received, or the fair value of the equity
instruments granted during the period was determined. For share options granted during the
period, the required information includes the option pricing model used and the inputs into
that the model e.g. the weighted average share price, exercise price, expected volatility,
option life, expected dividends, the risk-free interest rate and the assumptions made to
incorporate the effects of any expected early exercise.
c) An entity should disclose information that enables users of its financial statements to
understand the effect of share-based payment transactions on the entity's profit or loss for
the period and its financial position. The required information includes
i) any goods or services which did not qualify for recognition as assets and were
immediately expensed and
ii) the total carrying amount of liabilities which arose from share-based payment
transactions.
N.B. Full details of required disclosures can be found in paras 44 to 52 of IFRS 2.
ACTIVITY
Outline the disclosure requirements for share-based payment transactions. Base your answer
on International Financial Reporting Standard 2.
10.8 SUMMARY
This Unit summarizes and explains the accounting requirements of share-based transactions.
The 2 main types of transaction which fall under description are equity-settled share-based
transactions and cash-settled share-transactions. In addition, there are other transactions
whereby the reporting entity can pay for goods and services as well as equity instruments which
are used to affect payment. The examples given in this Unit are in addition to those provided
in the implementation guidance section of IFRS 2.
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281
10.9 REFERENCES
BONHAM, M.
International GAAP 2012
CURTIS, M.
LexisNexis/ Ernst & Young 2004
VORSTER, Q
Descriptive Accounting
KOORNHOF, C et al
LexisNexis/Butterworths 11th Edition
2011
IASB
International Financial Reporting
Standards 2015
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282
UNIT ELEVEN
SERVICE CONCESSION ARRANGEMENTS (IFRIC 12 – SIC 29)
11.0 INTRODUCTION
In each annual pronouncement of the National Budget by the Finance Minister, the government
of Zimbabwe has always called for the involvement of the private sector in what are commonly
referred to as Public Private Partnerships (PPPs), in the implementation of major public
infrastructural projects such as toll roads, dams, hospitals and schools. This is due to the
realisation that the government cannot single handedly deal with the provision of public
infrastructure. Concepts such as Build Own Operate Transfer (BOOT), Build Own Operate
(BOT), classification of target areas as Special Economic Zones that qualify for certain tax
privileges, are employed in order to entice the private sector players into cherry picking the
investments that they can willingly participate in line with the government`s broad policy/ies.
Service concession arrangements is a subject area that is contributory to project management
accounting which falls under project management. Project management is a broad discipline
with own set of international standards that are summed up in the Project Management Book
of Knowledge (PMBOK). Construction of major artefacts is by nature capital expenditure and
on most occasions exceeds a year. Among other issues, IFRIC 12 seeks to address a lack of
international guidance on how private operators should report their involvement in service concession arrangements with governments and other public sector entities. This Unit looks at the
accounting aspects involved on an area that is still an interpretation, and not an IFRS.
11.1 OBJECTIVES
By the end of this Unit you should be able to:
•
Define a service concession arrangement
•
Account for a service concession arrangement in line with the guidance made to date
by the IFRIC.
11.2 KEY DEFINITION
A service concession arrangement is an arrangement whereby a government or other public
sector body contracts with a private operator to develop (or upgrade), operate and maintain the
grantor's infrastructure assets such as roads, bridges, tunnels, airports, energy distribution
networks, prisons or hospitals. The grantor (government) controls or regulates what services
the operator must provide using the assets, to whom, and at what price, and also controls any
significant residual interest in the assets at the end of the term of the arrangement. Service
concession arrangements between the government and private players have been witnessed in
projects which have required huge initial capital outlays by their nature, for example, the
Bulawayo-Beitbridge-Railway (BBR) in Zimbabwe and the massive construction of
infrastructure that South Africa underwent prior to the hosting of the 2010 World Cup.
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283
11.3 TYPES OF SERVICE CONCESSION ARRANGEMENTS
11.3.1 Granting of a financial asset
The private operator receives a financial asset, an unconditional contractual right to receive a
specified or determinable amount of cash or another financial asset from the government in
return for constructing or upgrading a public sector asset, and then operating and maintaining
the asset for a specified period of time. The latter is the build-operate-transfer (BOT) concept.
The government guarantees to pay for any shortfall between amounts received from users of
the public service and specified or determinable amounts.
11.3.2 Granting of an intangible asset
The private operators receives an intangible asset (for example a licence) which is a right to
charge for the use of a public sector asset that it constructs or upgrades and then must operate
and maintain for a specified period of time. A right to charge users is conditional in the sense
that the amounts are contingent on the extent to which the public uses the service.
11.3.3 Combined arrangement
It is possible that both types of arrangement may exist within a single contract.
11.4 Accounting for service concession arrangements
11.4.1 Financial asset model
The private operator recognises a financial asset to the extent that it has an unconditional
contractual right to receive cash or another financial asset from or at the direction of the grantor
for the construction services. The operator has an unconditional right to receive cash if the
grantor contractually guarantees to pay the operator
i.
specified or determinable amounts or
ii.
the shortfall, if any, between amounts received from users of the public service and
specified or determinable amounts, even if payment is contingent on the operator
ensuring that the infrastructure meets specified quality or efficiency requirements.
The operator measures the financial asset at fair value.
11.4.2 Intangible asset model
The operator recognises an intangible asset to the extent that it receives a right (a licence) to
charge users of the public service. A right to charge users of the public service is not an
unconditional right to receive cash because the amounts are contingent on the extent that the
public uses the service.
The operator measures the intangible asset at fair value.
11.4.3 Operating revenue
The private operator of a service concession arrangement recognises and measures revenue in
accordance with IFRS 15 for the services it performs.
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284
11.4.4 Accounting by the government (grantor)
The interpretation does not address accounting for the government side of service concession
arrangements.
EXAMPLE – INTANGIBLE ASSET MODEL
The government of Zimbabwe (grantor) gave Vavaki Vamhizha Contractors, a successful and
financially sound private operator in the construction industry, a licence to charge users for the
use of a toll road under the following contractual terms.
The operator must construct a major road and complete the project within 2 years after which
it is maintained and operated to a specified standard for 8 years, that is, from years 3 to 10. The
operator is also required to resurface the road by the time the original surface would have
deteriorated below the specified standard. Vavaki Vamhizha Contractors estimates that such
resurfacing will be undertaken at the end of year 8 of the 10 years. The following are the costs
it expects to incur if it is to fulfil its obligation to both the grantor and the public.
Construction costs
Operating services (per year)
Road resurfacing
Year
1
2
3-10
8
$m
500
500
10
100
The terms of the arrangement allow the operator to collect toll fees from transporters, both light
to heavy duty vehicles using the road. Forecasts indicate that the vehicle numbers will remain
constant over the duration of the contract. Toll fees receivable in total from year 3 to 10 amount
to $200m. An assumption must be made that the cash flows to occur in arrears.
The operator estimates that the fair value of its consideration received will be equal to the
forecast construction costs plus a 5% margin. The operator uses the allowed alternative
treatment in IAS 23 – Borrowing costs. In other words, it capitalises borrowing costs at 6.7%
per annum during the construction phase.
The resurfacing obligation should be recognised and measured in accordance with IAS 37 –
Provisions, contingent liabilities and contingent assets at the best estimate of expenditure
required to settle the present obligation at the reporting date. Assume that this estimate is
proportional to the number of vehicles that have used the road by that date and increases by
$17m (discounted to the current value) each year.
REQUIRED
Account for the financial effects to Vavaki Vamhizha Contractors if it is to be involved in the
above transaction over the ten year period. Adhere to the provisions of IFRIC 12 – Service
concession arrangements.
ICSAZ - P.M. PARADZA
285
SUGGESTED SOLUTION
a) Initial measurement of the intangible asset
$
525.00
525.00
1 050.00
Capitalisation of borrowing costs as per IAS 23 (500 borrowed in Y1 x 0.067)
33.50
Initial cost of intangible asset at end of year 2
1 083.50
Construction revenue in year 1 ($500m x 1.05)
Construction revenue in year 2 ($500m x 1.05)
N.B. The interest on the $500m borrowed and directed to construction in year 2 will be
expensed instead because it becomes due after the construction phase.
b) Annual construction profit in years 1 and 2
Construction revenue
Construction costs
Construction profit
525.00
(500.00)
25.00
b) Annual amortisation charges
Amortizable amount
Estimate useful life (years)
Amortisation charge (1084/8)
1 084.00
8
135.50
c) Provision for resurfacing obligation
Year
3
4
5
6
7
8
Total
$
$
$
$
$
$
$
12.29 13.12 13.99 14.93 15.93 17.00 87.26
Obligation arising in each year
($17m discounted at 6.7%)
Increase in earlier year`s provision
Nil 0.88 1.61 2.48 3.51 4.71 13.19
Expense recognised in profit or loss 12.29 14.00 15.60 17.41 19.44 21.71 100.45
WORKINGS
Obligation arising in each year
Year 7 –
17m x 1.067-1
Year 6 –
17m x 1.067-2
Year 5 –
17m x 1.067-3
Year 4 –
17m x 1.067-4
Year 3 –
17m x 1.067-5
Increase in provision
Year 4 –
(13.43-12.29)m x 1.067-4
Year 5 –
(14.25-12.29)m x 1.067-3
Year 6 –
(15.11-12.29)m x 1.067-2
Year 7 –
(16.03-12.29)m x 1.067-1
Year 8 –
(17-12.29)m x 1.0670
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286
N.B. The amount of resurfacing is pegged at $100m at end of year 8. Hence the setting aside
of a future $17m per year where interest earnable is 6.7% should be accounted for as has been
done above.
d) Statement of cash flows for the years 1 to 10
Year
1
2
3
4
$
$
$
$
Balance b/fwd Nil
(500) (1034) (913)
Add receipts
Toll fees
Nil
Nil
200
200
Nil
(500) (834) (713)
Less payments
Construction cost (500) (500)
Borrowing costs Nil
(34) (69)
(61)
Operating costs Nil
Nil
(10)
(10)
Road resurfacing Nil
Nil
Nil
Nil
Balance c/fwd (500) (1034) (913) (784)
5
$
(784)
6
$
(647)
7
$
(500)
8
$
(343)
9
$
(276)
10
Total
$
$
(105) Nil
200
(584)
200
(447)
200
(300)
200
(143)
200
(176)
200
(95)
1600
1600
(53)
(10)
Nil
(647)
(43)
(10)
Nil
(500)
(33)
(10)
Nil
(343)
(23)
(10)
(100)
(276)
(19)
(10)
Nil
(105)
(7)
(10)
Nil
78
(1000)
(342)
(80)
(100)
78
e) Statement of profit or loss and other comprehensive income for the years 1 to 10
Year
1
$
525
Revenue
Operating costs
Construction
(500)
Borrowing costs Nil
Operating costs Nil
Road resurfacing Nil
Amortisation
Profit/loss
25
2
$
525
(500)
Nil
Nil
Nil
25
3
$
200
4
$
200
5
$
200
6
$
200
7
$
200
8
$
200
9
$
200
10 Total
$
$
200 2650
(69)
(10)
(12)
(135)
(26)
(61)
(10)
(14)
(135)
(20)
(53)
(10)
(16)
(135)
(14)
(43)
(10)
(17)
(135)
(6)
(33)
(10)
(19)
(136)
3
(23)
(10)
(22)
(136)
9
(19)
(10)
(7)
(10)
(136)
35
(1000)
(308)
(80)
(100)
(136) (1084)
47
78
f) Statement of financial position for the years 1 to 10
Year
ASSETS
Licence
Current asset
1
$
2
$
3
$
4
$
5
$
6
$
7
$
8
$
9
$
10
$
525
1084
949
814
679
544
408
272
136
525
1084
949
814
679
544
408
272
136
Nil
78
78
50
1034
24
913
12
949
4
784
26
814
(10)
647
42
679
(16)
500
59
544
(13)
343
78
408
(4)
276
31
105
272
136
EQUITY & LIABILITIES
Retained earnings
25
Non-current liability
500
Resurfacing provision
525
1084
78
Nil
Nil
78
N.B. the cash flows are representative of the non-current liability (borrowings made for the
construction of a qualifying asset)
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287
11.5 DISCLOSURES
The disclosures required by the interpretation should be provided individually for each service
concession arrangement or in aggregate for each class of such arrangements. A class is a
grouping of arrangements involving the provision of services of a similar nature, for example,
toll collections, telecommunications and water reticulation services.
11.6 SUMMARY
This Unit dwelt on guidance from IFRIC 12 on accounting treatment for service concession
arrangements, that is, public-private-partnerships. The disclosure requirements are found in
SIC 29.
11.6 REFERENCES
pwc
Manual of Accounting, IFRS
2015
IASB
IFRIC 12
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288
UNIT TWELVE
PROPERTY, PLANT AND EQUIPMENT (IAS 16)
12.0 INTRODUCTION
The term property, plant and equipment refers to tangible assets which a) are held for use in
the production or supply of goods or services, for rental to others, or for administrative purposes
and b) are expected to be used for more than one period.
IAS 16 states that the major issues in accounting for such assets are the recognition criteria,
determination of carrying amounts, depreciation charges and impairment losses. Other
standards which deal with specific aspects include IAS 36 (Impairment of Assets), IAS 38
(Intangible Assets), IAS 40 (Investment Property) and IFRS 5 (Non-current Assets Held for
Sale and Discontinued Operations).
12.1 OBJECTIVES
By the end of this Unit, you should be able to:
•
Explain the key aspects related to the recognition and measurement of property, plant
and equipment.
•
Give examples of costs which are directly attributable to the acquisition and
construction of property, plant and equipment.
•
Distinguish between the initial costs and subsequent costs related to items of property,
plant and equipment.
•
Explain the factors which influence the determination of depreciable values and
depreciation periods of property, plant and equipment.
•
Identify and explain the factors which should be taken into account when derecognising
items of property, plant and equipment.
•
Outline the disclosure requirements for property, plant and equipment.
12.2 KEY DEFINITIONS
Cost is the amount of cash or cash equivalents paid or the fair value of other consideration
given to acquire an asset at the time of its acquisition or construction. The term cost also applies
to the amount attributed to that asset when it is initially recognized in accordance with the
specific requirements of other standards.
Fair value is the amount for which an asset could be exchanged between knowledgeable,
willing parties in an arm's length transaction.
Recoverable amount is the higher of an asset's net selling price and its value in use.
Value in use is the present value of the future cash flows expected to be derived from an asset.
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289
The residual value of an asset is the estimated amount that can be obtained from its disposal,
after deducting the likely disposal costs, if the asset were already of the age and in the condition
expected at the end of its useful life.
12.3 ELEMENTS OF COST
The cost of an item of property, plant and equipment consists of
a) its purchase price, including any import duties and non-refundable purchase taxes, after
deducting trade discounts and rebates;
b) any costs which are incurred in bringing the asset to a location and condition which would
enable it to be put into the intended use;
c) the costs of dismantling and removing the item and restoring the site on which it is located,
if such costs are met by the entity.
Examples of costs which are directly attributable to property, plant and equipment are:
i) costs of employee benefits arising directly from the construction or acquisition of the
items
ii) costs of site preparation
iii) initial delivery and handling costs
iv) installation and assembly costs
v) costs of testing whether the items are functioning properly
vi) professional fees related to the construction or acquisition of the items e.g. architect's
fees or conveyancing fees.
Examples of costs that are not costs of an item of property, plant and equipment are:
a) costs of opening a new facility
b) costs of introducing a new product or service (including costs of advertising and
promotional activities
c) costs of conducting business in a new location or with a new class of customer (including
costs of staff training)
d) administration and other general overhead costs
In addition, the following costs should not be included in the carrying amount of an item of
property, plant and equipment:
a)costs incurred while an item capable of operating in the intended manner is yet to be
brought into use or is operated at less than full capacity.
b) initial operating losses, for example those incurred while demand for the item builds up
c)
costs of relocating or reorganizing part or all of an entity's operations
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290
12.4. RECOGNITION CRITERIA
The cost of an item of property, plant and equipment should only be recognised as an asset if
a) it is probable that future economic benefits associated with the item will flow to the entity
b) the cost of the item to the entity can be measured reliably
IAS 16 does not spell out specific units of measurement for recognition e.g. what transaction
size would result in an item of property, plant and equipment being recognised. This means
that judgement is required when applying general recognition guidelines to an entity's
circumstances. In this regard, the standard defines entity-specific value as the present value
that the entity expects to obtain from the continued use of an asset and from its disposal at the
end of its useful life, or expects to incur when settling a related liability.
12.4.1 Initial costs
An entity may acquire some items of property, plant and equipment which do not directly
increase future economic benefits. Such items may qualify as assets if they enable the entity to
derive future economic benefits from related assets. For example, plant enhancements for
safety or environmental reasons are recognised as assets, since without them the entity's
business will be adversely affected.
12.4.2 Subsequent costs
Unless they specifically qualify as assets, expenses incurred on property, plant and equipment
should be recognised in the statement of profit or loss and other comprehensive income.
Examples of such costs are labour and consumables related to day-to-day servicing of various
items. An important example of subsequent costs which are included in assets is major periodic
inspection of commercial aircraft. The cost of such inspection is included in the carrying
amount of the property, plant and equipment as a replacement if the recognition criteria are
satisfied. If at the end of an asset's life an entity has to incur a cost to dispose of the asset, such
a cost is referred to as a scrapping cost. For example, at the end of its life a building may need
to be demolished. The anticipated demolition costs, if they can be estimated, constitute
scrapping costs. Such costs are added to the original costs of the asset and will become part of
its original costs which also qualify for depreciation if applicable.
12.4.3 Determination of cost
The basic principle is that an item of property, plant and equipment is the cash price equivalent
at the recognition date. In the case of deferred payments, the difference between this amount
and the total payments should be recognised as interest expense over the credit period, unless
it is included in the carrying amount of the item in accordance with the allowed alternative
treatment in IAS 23 (Borrowing Costs). Some items of property, plant and equipment may be
acquired in exchange for non-monetary assets. The cost of such items should be measured at
fair value unless:
(i)
the exchange transaction lacks commercial substance; or
(ii)
it is not possible to measure reliably the fair value of the asset received or given up.
An exchange transaction is considered to have commercial substance if:
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291
a) the configuration (risk, timing and amount) of the asset's cash flows differs from
that of the transferred asset;
b) the entity-specific value of the entity's operations are affected by the transaction
as a result of the exchange;
c) the difference in (a) or (b) is significant in relation to the fair value of the assets
exchanged.
The fair value of an asset for which similar market transactions are not available can be reliably
estimated if:
i)
the variations in the fair value estimates are not significant for that asset;
ii)
the probabilities of the various estimates within the range can be reasonably
assessed and used in estimating the asset's fair value.
The fair value of the asset given up is normally used to measure the cost of the asset received,
unless the fair value of this other asset can be determined more reliably.
ACTIVITY
Discuss the accounting requirements for property, plant and equipment under the following
headings
a) Recognition of items of property, plant and equipment
b) Elements of cost
12.5. MEASUREMENT AFTER INITIAL RECOGNITION
Companies have a choice of 2 methods to account for property, plant and equipment items
which meet recognition criteria.
12.5.1 The cost model
According to this model, an item of property, plant and equipment should be recorded at its
original cost less any accumulated depreciation and accumulated impairment losses.
12.5.2 The revaluation model
According to this model, an item of property, plant and equipment whose fair value can be
measured reliably may be measured at a revalued amount. This is the item's fair value at the
revaluation date less any subsequent accumulated depreciation and impairment losses.
Revaluations should be carried out with sufficient frequency to ensure that the item's carrying
amount does not differ materially from its market value at the statement of financial position
date. The valuation of assets under this model should be done by people who have the necessary
qualifications and experience. Specialised assets which do not have reference market values
can be valued at their depreciated replacement costs. A significant difference between an asset's
carrying amount and its fair value indicates the need for a new valuation.
When an item of property, plant and equipment is revalued, any accumulated depreciation at
the revaluation date is treated in one of the following ways:
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292
a) restated proportionately with the change in the gross carrying amount of the asset, so that its
carrying amount after revaluation will equal the revalued amount;
b) eliminated against the gross carrying amount of the asset and the net amount restated to its
revalued amount.
If an item of property, plant and equipment is revalued, the entire class of assets to which it
belongs should be revalued. This is done to avoid selective revaluation of assets and reporting
of amounts in financial statements that represent a mixture of costs and values on different
dates.
12.6 DEPRECIATION PRINCIPLES
If an asset's carrying amount increases through a revaluation, the increase should be recognised
in other comprehensive income and accumulated in equity under the heading of revaluation
surplus, with the asset account being debited with the same amount. However, the increase
should be recognised in profit or loss to the extent that it reverses a revaluation decrease of the
same asset previously recognised in profit or loss. If an asset's carrying amount decreases
through a revaluation, the decrease should be recognised in profit or loss, with the asset account
being credited with the same amount. However, the decrease should be recognised in other
comprehensive income to the extent of any credit balance existing in the revaluation surplus in
respect of that asset. The decrease recognised in other comprehensive income reduces the
amount accumulated in equity under the heading of revaluation surplus.
When an asset is derecognised because it is no longer in use, a revaluation surplus related to
that asset may be transferred directly to retained profits. If part of the surplus is transferred
while the asset is still in use, the amount involved should be the difference between depreciation
based on the revalued carrying amount of the asset and that based on its original cost. It is not
permitted to make transfers from the revaluation surplus to retained profits through the
statement of profit or loss and other comprehensive income. The periodic depreciation charge
for a particular asset should be recognised in this statement unless it is included in the carrying
amount of another asset. This would be the case if the future economic benefits embodied in
an asset are consumed in the production of the other asset.
The following factors should be considered when estimating the useful life of an asset for
purposes of calculating depreciation:
i)
The expected usage of the asset; this usage is normally assessed in relation to the
asset's capacity or physical output.
ii)
The expected physical wear and tear which depends on operational factors like the
number of shifts for which the asset which will be used, the company's repair and
maintenance programme and the care and maintenance of the asset when it is idle.
iii)
Technical obsolescence from changes or improvement in production, or from a
change in the market demand for the product or service output of the asset.
iv) Legal or other constraints on the asset's use e.g. the expiry date of a related lease.
Regardless of the physical condition of particular assets a company's asset management policy
may require the disposal of assets after a specific period of time, or after the consumption of a
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293
specified proportion of the economic benefits expected from the assets. This means that the
useful life of a depreciable asset may be different from its economic life.
12.7 ACCOUNTING FOR DEPRECIATION-PRACTICAL ASPECTS
The depreciation method used for a particular asset or group of assets should reflect the pattern
in which the asset’s future economic benefits are expected to be consumed by the company.
The depreciation method used for each asset or group of assets should be reviewed at the end
of at least each financial year. If there has been a significant change in the consumption pattern
of the benefits incorporated in the asset (s) the method or its application should be changed to
reflect the new situation. Such a change is accounted for prospectively as a change in
accounting estimate in accordance with IAS 8.
It is possible to use a number of depreciation methods to account for this expense in the
financial statements of a company, but any such method should be applied consistently. The
total depreciation charge over an asset's useful life will not be affected by the depreciation
method chosen if the fundamental basis of calculating depreciation has not changed.
In order to correctly calculate depreciation on an asset, the cost of the asset should be correctly
determined. Opperman, Booysen et al (2002) have provided the following useful summary
about the initial cost of an asset.
It should include purchase price less trade discounts, administration costs, import duties, nonrefundable purchase taxes, capitalised borrowing costs, and direct costs of bringing the asset to
working condition, e.g. site preparation, the estimated cost of dismantling and removing and
restoring the asset, to the extent that it can be recognised as a provision under IAS 37.
It should exclude finance costs, general overheads, rebates, start-up costs, pre-production
expenses, initial losses and internal profits.
EXAMPLE – DETERMINATION OF ORIGINAL COST
X Ltd purchased a machine on 1 January 20-7 for cash. The following details relate to the
asset.
$
Purchase price
4 500 000
Delivery costs
135 000
Installation costs
270 000
General administration costs
45 000
Pre-production costs
315 000
Initial operating losses
450 000
Additional information
1. The administration costs are of a general and indirect nature.
2. The pre-production costs were necessary to bring the machine to the desired working
condition.
3. The initial operating losses are attributable to the production of small quantities when the
machine was first put into use.
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294
4. The machine was put into use on the date of acquisition.
5. The machine is depreciated using the straight-line method, based on a useful life of 10
years and a residual value of $1 300 000.
REQUIRED
a) Calculate the cost price at which the asset should be recognised
b) Calculate the asset's carrying amount as at 31 December 20-7
SUGGESTED SOLUTION
a) Original cost price
Purchase price
Delivery costs
Installation costs
Pre-production costs
$
4 500 000
135 000
270 000
315 000
5 220 000
b) Carrying amount
Cost price
Depreciation (10 years)
$
5 220 000
(392 000)
4 828 000
EXAMPLE – PPE DISCLOSURE
Y Ltd's register of property, plant and equipment on 1 January 20-8 contained the following
information:
$
$
Land at cost
13 500 000
Machinery at cost
Machine A
1 350 000
Machine B
5 670 000
Machine C
1 620 000
8 640 000
Accumulated depreciation
Machine A
630 000
Machine B
1 134 000
Machine C
370 000
2 134 000
Motor vehicles at cost
5 400 000
Accumulated depreciation
2 800 000
Furniture at cost
1 980 000
Accumulated depreciation
720 000
Additional information
i)
The above PPE items are depreciated as follows
-own machinery 25% reducing balance;
-furniture 15% straight line;
-leased machinery 20% reducing balance;
-motor vehicles 20% straight-line.
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295
ii)
iii)
iv)
On 30 June 20-8, a delivery vehicle which originally cost $1 600 000 was sold for
$675 000, and this amount was erroneously credited to the motor vehicle account.
The accumulated depreciation on this vehicle on 1 January 20-8 was $990 000.
Machine B was put into operation on 1 January 20-7, and is held in terms of a
finance lease agreement.
The land consists of Lot 215 Waterfalls Township, and was purchased in 20-5. The
directors estimate that the current market value of this asset on 31 December 20-8
is $30 000 000. The land is not depreciated. It is not classified as an investment
property.
REQUIRED
Disclose the PPE items and the related depreciation in the financial statements of X Ltd for the
year- ended 31 December 20-8 to comply with IAS 16 and generally accepted accounting
practice. Show all workings.
SUGGESTED SOLUTION
X LTD
Statement of comprehensive income for Y/E 31/12/20-8 (extract)
$000
$000
Operating profit is after taking into account
the following items:
Depreciation of non-current assets (Note 2)
Machinery
1 400
Motor vehicles
1 080
Furniture
297
Profit on disposal of vehicle
225
Statement of financial position as at 31/12/20-8
$000
ASSETS
Non-current Assets
Property plant &equipment
20 639
Notes to the financial statements
1. Accounting policy
Property, plant and equipment are stated at cost. Land is not depreciated. Other tangible non
-current assets are depreciated as follows
– own machinery: 25% reducing balance
– leased machinery: 20% reducing balance
– motor vehicles: 20% straight line
– furniture: 15 % straight line
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296
2. Property, plant and equipment
Land
$000
13 500
Cost prices,
Accum. Dep
31/12/20-7
Carrying amt
1/01/20- 8
13 500
Depreciation
Current year
–
Disposal
during year
–
Carrying
amount
13 500
Cost price,
13 500
Acc Dep
31/12/20-8
–
Mach A
$000
1 350
Mach B
$000
5 670
Mach C M. Veh
$000
$000
1 620
5 400
Furn
$000
1 980
Total
$000
29 520
(630)
(1134)
(370)
(2 800)
(720)
(5 654)
720
4 536
1 250
2 600
1 260
23 866
(180)
(907)
(313)
(1080)
(297)
(2 777)
–
–
–
(450)
–
(450)
540
1 350
3 629
5 670
937
1 620
1 070
3 800
963
1 980
20 639
27 920
(810)
(2041)
(683)
(2 730)
(1 017) (7 281)
ACTIVITY - REVALUATION MODEL
A company has revalued its freehold premises and decided to incorporate the revaluation in
the financial statements. The following information is provided:
Statement of financial position extract as at 30/06/20-7
Freehold premises at cost
Accumulated depreciation
$
3 500 000
(1 200 000)
2 300 000
Depreciation is being provided on the premises at 2½% on a straight line basis
The premises were revalued at $5 000 000 on 30 September 20-7. There is no change in the
remaining estimated life of this asset.
REQUIRED
Show the relevant extracts from the company's financial statements for the year-ended 30
June 20-8.
12.8 IMPAIRMENT OF ASSETS
The determination of whether an item of property, plant and equipment has been impaired is
explained in IAS 36 (Impairment of Assets). That standard sets out how an entity should review
the carrying amount of its assets, determine the recoverable amount of the assets, and recognise
or reverse the recognition of an impairment loss.
Any compensation from third parties for items of property, plant and equipment that were
impaired, lost or given up should be included in the statement of profit or loss and other
comprehensive income when the compensation becomes receivable. The standard states that
impairments or losses of such items, related claims for or payments of compensation from third
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297
parties, as well as any subsequent purchase or construction of replacement assets should be
treated as separate economic events which are accounted for in terms of specific guidelines in
IAS 16 and other standards.
For example, the carrying amount of an item of property, plant and equipment should be
derecognised on disposal, or when no future economic benefits are expected from its use and/or
disposal. At this point, a gain or loss on disposal should be determined and included in the
statement of profit or loss and other comprehensive income, although gains should not be
classified as revenue. A disposal may occur by way of sale, entering into a finance lease, or
making a donation.
12.9 DISCLOSURE REQUIREMENTS
A company's financial statements should disclose, for each class of property, plant and
equipment:
i)
the measurement basis used to determine the gross carrying amount;
ii)
the depreciation method used;
iii)
the useful lives or depreciation rates used;
iv)
the gross carrying amount and the accumulated depreciation (aggregated with
accumulated impairment losses) at the beginning and end of the period;
v)
a reconciliation of the carrying amount at the beginning and end of the period
showing:
a) additions
b) assets classified as held for sale or included in a disposal group classified as
held for sale in accordance with IFRS 5 (Non-current Assets Held for Sale and
Discontinued Operations)
c) acquisitions through business combinations
d) increases or decreases resulting from revaluations and from impairment
losses recognised or reversed directly in equity in accordance with IAS 36.
e) impairment losses recognised in the income statement in accordance with
IAS 36
f) depreciation
g) the net exchange difference arising on the translation of the financial
statements from the functional currency into a different presentation currency
h) the existence and the amount of restrictions on title and property, plant and
equipment pledged as security for liabilities
i) the amount of expenditures recognised in the carrying amount of an item of
property, plant and equipment during the course of its construction
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298
j) the amount of contractual commitments for the acquisition of property, plant
and equipment
k) if not separately disclosed in the income statement, the amount of
compensation from third parties for items of property, plant and equipment
that were impaired, lost or given up
l) if items of property, plant and equipment are stated at revalued amounts, the
following should be disclosed:
i) the effective date of the revaluation
ii) whether an independent valuer was involved
iii) the methods and significant assumptions applied in estimating the
fair values of the items
iv) the extent to which the item’s fair values were determined directly
by reference to observable prices in an active market or recent
market transactions on arm’s length terms, or were estimated using
other valuation techniques
v) for each revalued class of property, plant and equipment, the carrying
amount that would have been recognised had the assets been carried
under the cost model
vi) the revaluation surplus, indicating the change for the period and any
restrictions on the distribution of balance to share holders
ACTIVITY - DISCLOSURES
State the disclosure requirements for property, plant and equipment, as outlined in IAS 16.
12.10 SUMMARY
This Unit explains the major accounting and disclosure requirements for property, plant and
equipment. It is based on IAS 16, which is one of many standards dealing with assets. Related
standards include IAS 36 (Impairment of Assets), IAS 38 (Intangible Assets), IAS 40
(Investment Property) and IFRS 6 (Exploration for and Evaluation of Mineral Resources).
12.11 REFERENCES
BONHAM, M.
CURTIS, M. et al
International GAAP 2005
LexisNexis/Ernst & Young 2004
VORSTER,Q.
KOORNHOF, C. et al
Descriptive Accounting
LexisNexis/Butterworths 15th Edition
2010
IASB
International Financial Reporting
Standards 2015
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299
UNIT THIRTEEN
NON-CURRENT ASSETS HELD FOR SALE AND DISCONTINUED
OPERATIONS (IFRS 5)
13.0 INTRODUCTION
Non-current assets is a generic term that includes all assets which are not acquired for disposal
through normal business operations. Different types of non-current assets are discussed in IAS
16 (Property, Plant & Equipment), IAS 36 (Impairment of Assets), IAS 38 (Intangible Assets),
IAS 40 (Investment Property) and IAS 41 (Biological Assets). At this level in your studies, it
should be noted that the simple distinction between current and non-current assets is no longer
sufficient to ensure the proper accounting for transactions involving assets. IFRS 5 considers
areas which were identified in the Statement of Financial Accounting Standard 144 (U.S.A.),
that is, (i) the classification, measurement and presentation of assets held for sale and (ii) the
classification and presentation of discontinued operations.
13.1 OBJECTIVES
By the end of this Unit, you should be able to:
•
Identify the main aspects of IFRS 5
•
Distinguish between non-current assets held for sale and discontinued operations
•
Identify, explain and give examples of disposal groups.
13.2 KEY DEFINITIONS
A current asset is an asset that meets the following criteria:
i)
It is expected to be realized in, or is intended for sale or consumption in the entity's
normal operations
ii)
It is held primarily for trading purposes
iii)
It is expected to be realized within 12 months after the statement of financial
position date
iv)
It is a cash or cash equivalent asset, unless it is restricted from being exchanged or
used to settle a liability for at least 12 months after the statement of financial
position date.
A discontinued operation is a component of an entity that either has been disposed of or is
classified as held for sale and i) represents a separate major line of business or geographical
line of operations ii) is part of a single coordinated plan to dispose of a separate major line of
business or geographical line of operations iii) is a subsidiary acquired exclusively with a view
to resale
A disposal group is a group of assets to be disposed of, by sale or otherwise, together as a group
in a single transaction, and liabilities directly associated with those assets that will be
transferred in the transaction.
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300
b) this recognition does not exceed the cumulative impairment loss that had been previously
recognized on applicable non-current assets The impairment loss or any subsequent gain
recognized for a disposal group will reduce or increase the carrying amount of the non-current
assets that are affected by the measurement rules of IFRS 5, in the correct allocation order.
13.3 CLASSIFICATION OF NON-CURRENT ASSETS (OR DISPOSAL GROUPS) AS
HELD FOR SALE
An entity should classify a non-current asset or disposal group as held for sale if its carrying
amount is expected to be recovered principally through a sale transaction rather than through
continuing use. An asset fits this description if it is available for immediate sale in its present
condition on terms that are usual and customary for similar assets. Furthermore IFRS 5 states
that in order to be classified as held for sale, an asset or disposal group should meet the
following conditions:
a) existence of a commitment to plan to sell by management
b) availability of the asset for immediate sale
c) existence of an active programme initiated to locate the buyer
d) high probability that the sale will take place within 12 months of classification
e) existence of active marketing of the asset at a reasonable price
f) it must be highly unlikely that the plan will change or be reversed
g) assurance of approval of shareholders if it is required in the jurisdiction.
N.B. A non-current asset or disposal group is classified as held for distribution to owners when
the entity is committed to distribute the asset or group of assets to the owners. The conditions
necessary for this classification are similar to those which apply to non-current assets or
disposal groups held for sale.
13.4 MEASUREMENT PRINCIPLES
13.4.1 At the time of classification as held-for-sale
Immediately before classification of the asset or group as held for sale, the asset`s carrying
amount is measured in accordance with applicable IFRSs (for example, IAS 16, IAS 36, IAS
38)
13.4.2 After classification as held-for-sale
Once classified as held for sale the asset or disposal group is measured at the lower of carrying
amount and fair value less costs to sell.
13.4.3 Impairment
13.4.3.1 At the time of classification as held for sale
Immediately before classification of an asset or disposal group as held for sale, impairment is
measured in accordance with the applicable IFRS.
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301
Two entries suffice:
$
Either DEBIT
Income statement
CREDIT
Non-current asset
Being impairment loss recognition
xx
Or
xx
DEBIT
Revaluation Reserve
CREDIT
Non-current asset
Being impairment loss recognition
$
xx
xx
N.B. On the second instance the impairment loss is treated as a revaluation decrease because
the asset would have been measured at the revalued amount.
13.4.3.2 After classification as held-for-sale
The impairment loss will be a result of comparison of the adjusted carrying amount of the
asset/disposal group to its fair value less costs to sell. Only one entry type suffices:
DEBIT
CREDIT
Income statement
Non-current asset held for sale
xx
xx
13.4.4 Impairment reversal (subsequent increases in fair value)
IFRS 5 stipulates that a gain or any subsequent increase in fair value less costs to sell of an
asset can be recognized in the profit or loss to the extent that it is not in excess of cumulative
impairment loss recognized in accordance with IFRS 5 and previously with IAS 36.
N.B. Assets or disposal groups classified as held for sale should not be depreciated.
13.4.5 Disclosures
i.
A non-current asset or disposal group classified as held for sale is disclosed separately
in the statement of financial position
ii.
Similarly, liabilities for a disposal group classified as held for sale are disclosed
separately in the statement of financial position
iii.
Description of nature of assets held for sale and facts and circumstances surrounding
the sale
EXAMPLE 1 – A REPLICA OF QUESTION 2a November 2007
On 31 December 20-5, an entity had an asset with a carrying amount of $250 000. On that date,
management decided to sell the asset for $220 000 by 28 February 20-6. A buyer was found
who signed an irrevocable sale agreement based on this amount. Available information showed
that the costs to sell the asset would amount to $15 000.
REQUIRED
Outline the accounting treatment for the asset in terms of IFRS 5 on 31 December 20-5.
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302
SUGGESTED SOLUTION
On 31 December 20-5 the asset is classified as held for sale. Once classified as held for sale
the asset should show at the lower of carrying amount or fair value less costs to sell. The
following should be noted:
Carrying amount as given is
$250 000
Fair value less costs to sell ($220 000 – 15 000)
$205 000
The new carrying amount, is the lower of the above two, that is $205 000.
Relevant journal entry/ies:
DEBIT
Non-current asset held for sale
CREDIT
Non-current asset
Being transfer of asset from non-current to held for sale
DEBIT
Income statement
CREDIT
Non-current asset
Being impairment loss on transfer
$
$
205 000
205 000
45 000
45 000
The above entries can be summarized by the steps below:
Step 1: Ascertain the carrying amount of the asset on 31 December 20-5, that is, $250 000
Step 2: Ascertain the asset's fair value less costs to sell, that is, $220 000 - 15 000= $205 000
Step 3: Ascertain the amount at which the asset should be measured: The measurement basis
is the lower of the asset's carrying amount and fair value less costs to sell ($250 000 and $205
000), that is, $205 000
Step 4: Transfer the asset from non-current assets to current assets in the statement of financial
position in the sub-section 'held for sale' at a value of $205 000
Step 5: In the income statement, an impairment loss of $45 000 ($250 000 - 205 000) should
be recognized
EXAMPLE 2 – IMPAIRMENT REVERSAL
On 31 March 20-7, an entity with a June 30 financial year-end decided to dispose of an
individual asset which was correctly classified as held for sale and had a carrying amount of
$7 500 000.
This recorded amount incorporates the following: original cost $13 900 000, accumulated
depreciation $4 300 000 and previously recognized impairment losses of $2 100 000. The
asset's estimated fair value less costs to sell when it was classified as held for sale was $6 800
000.
On 30 June 20-7, the asset was remeasured, and its fair value less costs to sell was estimated at
$9 750 000.
REQUIRED
Calculate the amounts which should be recognized in the entity's financial statements in
relation to the asset.
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SUGGESTED SOLUTION
Amounts to be recognized in the statement of comprehensive income
$
31 March 20-7
Impairment loss
Carrying amount (13 900 000-4 300 000-2 100 000)
Fair value less costs to sell
Expense in the income statement
30 June 20-7
Gain on subsequent re-measurement
Carrying amount
Fair value less costs to sell
Potential gain
Less previously recognized impairment losses;
At initial classification
On re-measurement (30/06/20-7)
Excess gain (not recognizable in current period)
7 500 000
6 800 000
700 000
6 800 000
9 750 000
2 950 000
(2 400 000)
(700 000)
150 000
N.B. A potential gain can only be recognized up to the limit of previously recognized
impairment losses. Therefore the gain to be recognized is limited to $2 800 000.
Amounts to be recognized in the statement of financial position 31 March 20-7
New carrying amount immediately after classification of asset
as held for sale (lower of carrying amount and fair value less costs to sell)
$
6 800 000
30 June 20-7
New carrying amount immediately after re-measurement
Fair value less costs to sell 31/03/20-7
Net gain (loss) on re-measurement
Carrying amount
6 800 000
2 800 000
9 600 000
N.B. An asset which has been classified as held for sale should not continue to be depreciated.
EXAMPLE 3 – REPLICA OF Q2b November 2007
On 1 October 20-6, an entity with a 31 December financial year end decided to sell a group of
assets within the following year. The group of assets meets with the condition for classification
as held for sale. The carrying amount of individual asserts are as follows:
Land (01/01/20-6)
3 500 000
Buildings (01/01/20-6)
12 000 000
Plant and equipment (01/01/20-6)
10 500 000
Inventory (1/10/20-6) Net realizable value $1 600 000
2 100 000
Investments (1/10/20-6) Fair value
2 900 000
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304
Liabilities related to plant and equipment (1/10/20-6)
1 050 000
Fair value of disposal group (1/10/20-6)
25 800 000
Disposal costs for the whole group
2 500 000
Buildings are depreciated at 20% p.a reducing balance and plant and equipment at 10% p.a
straight line method. Plant has an original cost of $15 000 000.
REQUIRED
Outline the accounting treatment for the group of assets in terms of IFRS 5 on 1 October 20-6.
SUGGESTED SOLUTION
On 1 October 20-6 the asset is declared held for sale. This is exactly 9 months into the current
financial year.
Due to the fact that the question gives values at the start of the year you can deduce that the
following will be the entries 1 immediately before classification and 2 once classified:
Immediately before classification as held for sale at 1 October 20-6 (Using the old applicable
IFRS – IAS 16)
Plant and equipment [10 500 000 – (10% x $15 000 000 x 9/12)] straight line
Land
Buildings [12 000 000 – (20% x 12 000 000 x 9/12)] reducing balance
Inventory
Investments
Liabilities
Carrying amount
$
9 375 000
3 500 000
10 200 000
1 600 000
2 900 000
(1 050 000)
26 525 000
Once classified at 1 October 20-6 as held for sale (should show at the lower of carrying amount
as calculated above or fair value less costs to sell)
Carrying amount
26 525 000
Fair value less costs to sell (25 800 000 – 2 500 000)
23 300 000
Therefore new carrying amount is
$23 300 000
Relevant journal entry/ies:
DEBIT
Non-current assets held for sale
CREDIT
Non-current assets
Being transfer of asset from non-current to held for sale
DEBIT
CREDIT
Income statement
Land (3 500 000/ 23 075 000 x 3 225 000)
Buildings (10 200 000/23 075 000 x 3 225 000)
Plant and equipment
Being impairment loss on transfer
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$
$
23 300 000
23 300 000
3 225 000
489 166
1 425 569
1 310 265
305
An entity should measure a non-current asset classified as held for sale at the lower of its
carrying amount and fair value less costs to sell. When the sale is expected to occur after one
year, the entity should measure the costs to sell at their present value. Any increase in the
present value of the costs to sell that is related to the passage of time should be presented in
profit or loss as a financing cost. An entity should measure a non-current asset classified as
held for distribution to owners at the lower of its carrying amount and fair value less costs to
distribute.
EXAMPLE 4 – IMPAIRMENT REVERSAL
On 1 January 20-8 an entity with a 30 June financial year end decided to dispose of a group of
assets within the following year. These assets met the conditions for classification as held for
sale at that date. The carrying amounts of the assets and other relevant information was as
follows:
$
Land (1/7/20-7)
14 136 150
Factory building (1/7/20-7) Depreciated at 10% p.a. reducing balance
67 146 810
Plant and equipment (1/7/20-7) Depreciated at 15% reducing balance
26 800 000
Inventory (1/7/20-7)
7 500 000
Inventory (30/6/20-8) lower of cost or NRV
5 900 000
Liabilities related to plant
- 1/7/20-7
4 650 000
- 30/06/20-8
3 480 000
Investments (1/07/20-7) (fair value)
15 000 000
(30/06/20-8) fair value
18 000 000
Additional information
Fair value of disposal group (30/06/20-8)
145 000 000
Disposal costs
5 960 000
Cumulative impairment loss recognized to 1/10/20-7
6 500 000
REQUIRED
Outline the accounting treatment for the group of assets in terms of IFRS 5 on 30/06/20-8
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306
SUGGESTED SOLUTION
Immediately before classification as held for sale (Use of old IFRS – IAS 16)
N.B. Factory building and plant and equipment are only subjected to depreciation for the first
6 months after which the provision for non-depreciation once classified at 1/1/20-8 applies.
$
14 136 150
63 789 508
25 460 000
5 900 000
(3480 000)
18 000 000
123 805 658
Land
Factory building (67 146 850 – 10% x 67 146 850 x 6/12)
Plant and equipment (26 800 000 – 10% x 26 800 000 x 6/12)
Inventory
Liabilities
Investments
Carrying amount
Once classified as held for sale at 1/1/20-8 (Asset should show at lower of carrying amount or
fair value less costs to sell)
Carrying amount
Fair value less costs to sell (145 000 000 – 5 960 000)
Impairment reversal
123 805 658
139 040 000
15 234 342
However, this is limited to $6 500 000, according to IFRS 5. Reversals should not be in excess
of cumulative impairment loss recognized in accordance with IFRS 5 and previously with IAS
36. Also the standard prohibits the reinstatement of any goodwill once it has been written off.
Relevant journal entries:
$
DEBIT
Non-current asset held for sale
CREDIT
Non-current asset
$
123 805 658
123 805 658
DEBIT
Land (held for sale) (14 136 150/103 385 658 x 6 500 000)
DEBIT
Building (held for sale) (63 789 508/103 385 658 x 6 500 000) 4 010 535
DEBIT
Plant (held for sale) (25 460 000/103 385 658 x 6 500 000)
CREDIT
Income statement
888 759
1 600 706
6 500 000
Therefore, new carrying amount is $130 305 658
EXAMPLE 5 – IMPAIRMENT REVERSAL
On 31 March 20-7 an entity with a June 30 financial year end decided to dispose of an
individual asset which was correctly classified as held for sale and had a carrying amount of
$7 500 000.
This recorded carrying amount incorporates the following:
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307
Cost
Accumulated depreciation
Previous impairment loss
$
13 900 000
(4 300 000)
(2 100 000)
7 500 000
The asset`s estimated fair value less costs to sell was estimated at $6 800 000 on classification
as held for sale. On 30 June 20-7 the asset was re-measured and its fair value less costs to sell
was estimated at $9 750 000.
REQUIRED
Calculate amounts which should be recognized in the entity`s financial statements in relation
to the asset.
SUGGESTED SOLUTION
Impairment at classification as held for sale
Carrying amount
Fair value costs to sell
7 500 000
6 800 000
700 000
Therefore, the cumulative impairment loss is $2 800 000, that is, $2 100 000 + $700 000
Impairment on re-measurement
Carrying amount
Fair value less costs to sell
Impairment reversal before limit application
6 800 000
9 750 000
(2 950 000)
The impairment reversal should be limited to $2 800 000
The new carrying amount is therefore, $9 600 000, that is, $6 800 000 + $2 800 000
ACTIVITY – IFRS 5 THEORY
Minny intends to dispose of a major line of business in the above scenario and the entity has
stated that the held for sale criteria were met under IFRS 5 Non-current Assets Held for Sale
and Discontinued Operations. The criteria in IFRS 5 are very strict and regulators have been
known to question entities on the application of the standard. The two criteria which must be
met before an asset or disposal group will be defined as recovered principally through sale are:
that it must be available for immediate sale in its present condition and the sale must be highly
probable.
REQUIRED
Discuss what is meant in IFRS 5 by ‘available for immediate sale in its present condition’ and
‘the sale must be highly probable’, setting out briefly why regulators may question entities on
the application of the standard. (7 marks)
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13.5 DECLASSIFICATION OF AN ASSETS HELD FOR SALE OR DISPOSAL
GROUP.
13.5.1 Declassification of an asset held for sale
An entity with a 31 December financial year end classified an intangible asset as held for sale
on 31 December 2-09. On that date, the asset had a carrying amount of $12 500 000 down from
original cost of $20 000 000. The asset is being amortized at 25% on a reducing balance
method. Due to a favourable change in circumstances the entity decided to retain the asset,
which was then reclassified as no longer held for sale, with effect from 30 June 2-10. On that
date the asset`s recoverable amount was $9 450 000 and changed to straight line, with no
estimate for residual value. Useful life was revised to 4 years.
REQUIRED
Show in different steps accounting treatment for the asset in terms of IFRS 5.
SUGGESTED SOLUTION
1. Carrying amount at 30/06/2-10 had the intangible asset not been classified as held for sale.
$
Carrying amount at 31 December 20-9
12 500 000
Less amortization to 30 June 2-10 (12 500 000 x 25% x 6/12)
1 562 500
Carrying amount at 30 June 2-10
10 937 500
However, at 30 June 2-10 the intangible asset`s recoverable amount is
9 450 000
The lower of the two is the one at which the intangible asset will show.
Impairment loss (10 937 500 – 9 450 000)
1 487 500
2. Separate impairment on declassification (overall impairment)
Carrying amount after classification as held for sale
Carrying amount on declassification as held for sale
Effective impairment loss (overrides $1 487 500)
12 500 000
(9 450 000)
3 050 000
3. New amortization onwards (remaining half of financial year)
(9 450 000/4 x 6/12)
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1 181 200
309
13.5.2 Declassification of an asset held for sale in a disposal group
An entity with a 31 December financial year end classified assets as a disposal group on 1
January 20-0. The following information relates to the classification.
CA before
classification
$
Freehold land and buildings 75 325 000
Plant and Equipment
24 759 000
Inventory
6 900 000
Liabilities
(5 600 000)
Investments
13 250 000
114 634 000
Impairment
loss allocated
$
4 338 000
1 426 500
5 764 500
CA after
classification
$
70 987 000
23 332 500
6 900 000
(5 600 000)
13 250 000
108 869 500
Original cost of plant and equipment
35 000 000
Depreciation on plant and equipment (no residual value)
20% straight line
Recoverable amount of plant and equipment (31/03/20-0)
23 480 000
Remaining useful life of plant and equipment (31/03/20-0)
3 years
On 31 March 20-0, the entity secured a large contract with an overseas customer and decided
to remove the plant and equipment from the disposal group. However, the assets in that group
still collectively met the conditions for classification as held for sale on 31 March 20-0.
REQUIRED
Show in different steps the accounting treatment for the plant and equipment in terms of IFRS
5.
SUGGESTED SOLUTION
Step 1. Carrying amount had the asset not been classified as held for sale
Carrying amount before classification at 1/1/20-0
Depreciation to 31/3/20-0 (35 000 000 x 20% x 3/12)
Carrying amount at 31/3/20-0
$
24 759 000
(1 750 000)
23 009 000
However, recoverable amount at 31/3/20-0
23 480 000
The lower of the two is the one at which the intangible asset will show.
Since carrying amount is less than recoverable amount there is no impairment loss.
Step 2. Separate impairment on declassification
Carrying amount after classification as held for sale
Carrying amount on declassification as held for sale
Effective impairment loss
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23 332 500
23 009 000
323 500
310
Step 3. New depreciation onwards (remaining 9 months)
(23 009 000/3 x 9/12)
5 752 250
Step 4. New carrying amount of disposal group excluding the declassified plant and
equipment
(108 869 500 – 23 332 500)
85 537 000
13.6 DISCONTINUED OPERATIONS
13.6.1 Definition
A discontinued operation is 1 a component of an entity that has 2 either been disposed of or is
classified as held for sale and 3 represents a separate major line of business or geographical
area, that is part of a single coordinated plan of disposal, or is a subsidiary acquired exclusively
with a view to resale.
13.6.2 Presentation and disclosure
i) Relating to Notes to financial statements
•
A description of the discontinuing operation
•
The business or geographical segment in which it is reported
•
Date or period in which discontinuance is expected to be completed if known
ii) Relating to the statement of financial position and notes
•
Carrying amount at reporting date of all assets to be disposed of
•
Carrying amount at reporting date of all liabilities to be disposed of
iii) Relating to statement of profit or loss and other comprehensive income and notes
An entity should disclose:
a) a single amount on the face of the statement of comprehensive income consisting of
ai) the post-tax gain or loss on discontinued operations
aii) the post-tax gain or loss recognized on the measurement to fair value less costs to sell or
on disposal of the assets or disposal group constituting the discontinuing operation
b) an analysis of the single amount into:
•
Revenue
•
Expenses
•
Profit or loss before tax
•
Income tax expense
•
The gain or loss recognized on the measurement to fair value less costs to sell or on
disposal of the assets or disposal group constituting the discontinuing operation.
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311
iv) The amount of income from continuing operations and from discontinuing operations
attributable to owners of the parent
v) Relating to statement of cash flows. Discontinued operation`s net cash flows attributable to:
•
Operating activities
•
Investing activities
•
Financing activities
Tuition Note:
It is advisable to ensure a question on presentation of discontinued operations is attempted with
the students in class.
13.7 SUMMARY
This Unit focuses on the accounting requirements for non-current assets which are held with a
view to their disposal, as well as discontinued operations. The Unit is based on IFRS 5, which
brings together aspects from other standards including IAS 16 - Property, plant & equipment,
IAS 38 – Intangible assets and the old IAS 35 (Discontinuing Operations)
13.8 REFERENCES
IASB
International Financial Reporting Standard (IFRS) 5
UNIT FOURTEEN
THE VALUATION OF SHARES AND OTHER BUSINESS INTERESTS
14.0 INTRODUCTION
Individuals go into business with the main purpose of making profits for themselves and
securing their future in the long-term. For most small businesses, the major source of capital is
the owner- manager, also referred to as the entrepreneur. The ownership structure of a business
normally become more complex as it achieves growth through sales and acquisition of assets.
In earlier studies, it was emphasized that the affairs of a business entity should be accounted
for separately from those of the owner(s). Whether a business is organized as a sole
proprietorship, a partnership or a company, it will acquire an existence of its own from the day
of inception. This existence is normally associated with a value which is attached to the
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312
business by the owner(s) and other interested parties. The starting point for determining the
value of an asset is its original cost, which consists of all the expenditure which has been
incurred to acquire or construct it. The valuation of a business or any part of it tends to be
subjective, depending on the purpose for which it is being carried out.
Valuation can be defined as the process of arriving at a value for an asset expressed in monetary
terms. The basic principle of valuation is that the value now should represent the present value
of future benefits. Valuation occurs whenever expected benefits of a decision are compared
with expected costs. However, because the future is uncertain, the present value is also subject
to uncertainty. All else being equal, the value of an asset with a more uncertain future will be
less than that for an asset with a more certain future. Besides, it is possible to establish a market
value for an asset/security since there is frequently an active market trading in similar
assets/securities.
14.1 OBJECTIVES
By the end of this Unit, you should be able to:
•
Explain the various purposes of valuing businesses
•
Apply different methods of valuing businesses and investments in a business
•
Undertake cum-div and ex-div valuations
•
Explain the approaches used to value business interests from the viewpoint of a majority
shareholder and an investor without control
14.2 SOURCES AND TYPES OF VALUE
If a business is a going concern, it will normally have a value which is associated with various
aspects of its operations including location, customer base and merchandise range. If a
prospective buyer of the business is prepared to pay more than the total value of individual
assets, this is a recognition that the business has goodwill, referred to as the ‘good name’ of the
business or ‘cost of control’ or ‘the probability that old customers will continue dealing with
the business’. The value of a business will tend to grow if the owner invests both time and
money in it and does not expect to achieve overnight success.
The following are examples of value:
Net replacement value – the amount which the owner of an asset would need to pay for an
identical or similar asset at current prices
Net realizable value – the amount which would be obtained from the sale of an asset during
the normal course of business after deducting selling expenses.
Discounted present value – the value of an asset to the owner in real terms, that is, after taking
into account the present and future cash flows related to the asset.
Current value – a combination of the net replacement value and net realizable value of an
asset, used in the determination of its overall value to the business.
Other items besides a business, which are frequently valued are:
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313
i)
ii)
iii)
iv)
v)
Real assets namely tangible and intangible non-current assets
Ordinary shares, that is, the claim that the owners of the company have against its
assets after all other liabilities and commitments have been met.
Preference shares which are an investment in a company that ranks before ordinary
shares but after debt in claims against the assets of the company.
Debentures – long term loans at predetermined interest rates.
Options – the right to purchase an asset/share in the future at a given price. The
option will have a value if it is expected that the price will rise above the exercise
price in the interim period.
14.3 DETERMINANTS OF VALUE WHERE SHARES ARE NOT DEALT WITH ON
A STOCK EXCHANGE
a) The nature of the business
b) The gearing of share capital
c) Accuracy of the statement of financial position
d) Whether any undistributed net income exists
e) Adequacy of depreciation/amortization provision
f) Ratios of non-current to current assets, of non-current assets to capital and of current
assets to current liabilities
g) Prospects of steady return of income
h) Nature of security
i) Rights attaching to various classes of shares
j) Possibility of bonus share distributions
k) Continuity of management or projected changes
l) Whether death or retirement of the controlling shareholder/owner will affect the
company
m) General trend of trade
n) Trend of earnings in relation to capital
o) Political, financial and other external factors
Source: RRC
14.4 METHODS OF VALUING SHARES
The following are some of the methods for valuing shares:
14.4.1 Earnings basis (Also known as Net income basis or Earnings capacity basis)
This approach is based on an estimate of the present value of a company's future earnings or
dividends.
EXAMPLE 1 – EARNINGS BASIS
The current dividend may be $10.00 per share, while the investor's minimum acceptable rate
of return is $25 per share. If the par value of the shares is $100, calculate value of each share?
Value per share
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= Par value x Expected rate of return
Required rate of return
314
= $100
x
10
25
= $40
If the required rate of return increases through the incorporation of a risk factor, the share value
will decrease. The earnings yield valuation method is based on the investment ratio of the same
name. The earnings yield formula is earnings per share/market price per share. If the earnings
yield and earnings per share are given, it will be possible to calculate the market value of the
shares in question. For companies whose shares are not quoted on the stock exchange, it is
necessary to obtain or estimate the earnings yields of similar quoted companies in order to
come up with comparable results. The dividend yield formula, dividend per share/market price
per share can also be used to value a company's shares if the dividend yield and dividend per
share figures are available.
EXAMPLE 2 – EARNINGS BASIS
The following information relates to D Ltd:
Dividend yield over the past 5 years is 10%, earnings yield over the past 5 years is 20%,
dividend per share over the past 5 years is $3.00, dividends pay-out ratio over the past 5 years
is 25% and the number of shares in issue is 100 000.
REQUIRED
Calculate:
a) The company's value per ordinary share and market capitalization using the dividend
yield method
b) The company's value per ordinary share and market capitalization using the earnings
yield method
SUGGESTED SOLUTION
a) Dividend yield
0.10
=
Dividend per share
Market price per share
=
3.00
0.10
=
$30
3.00
MPS
Market price per share
Market capitalization
=
= $30.00 x 100 000
= $3 000 000
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315
b) Dividend payout ratio =
0.25
=
3.00
EPS
Earnings per share
Earnings yield
0.20
=
Dividend per share
Earnings per share
=
3.00
0.25
=
$12
=
Earnings per share
Market price per share
=
12.00
0.20
=
$60
12.00
MPS
Market price per share
= $60. 00 x 100 000
Market capitalization
= $6 000 000
It is also possible to estimate the market value of quoted shares by using the company's price
to earnings (P/E) ratio. This is an approximation of the earnings expected by the market based
on the current market price of its shares. The ratio for the P/E ratio is market price ÷ earnings
per share. This means that the share price of a company with a P/E ratio of 10 and earnings per
share of $5.00 is $5.00 x 10= $50.00. In order to use this method for private (unquoted)
companies it is necessary to adjust their P/E ratios down because their shares are not as
marketable as those of public (quoted) companies.
ACTIVITY – EARNINGS BASIS
The following information relates to B Ltd:
Dividend yield over the past 3 years is 15%, earnings yield over the past 3 years is 32%,
dividend per share over the past 3 years is $6.00, dividend pay-out ratio over the past 3 years
is 20% and the number of ordinary shares in issue is 150 000.
REQUIRED
a) The company's value per ordinary share and market capitalization using the dividend yield
method
b) The company's value per ordinary share and market capitalization using the earnings method
ICSAZ - P.M. PARADZA
316
c) The company's value per ordinary share and market capitalization if the par value of the
shares is $50.00, the shareholders minimum required rate of return is 35% and other relevant
information is as shown above.
14.4.2 Net Assets Basis (Also known as the Equity basis)
This method is based on a comparison of the book or carrying values of a company's assets
with their revised values. The extent of the revision depends on the purpose of the valuation,
for example, to record more realistic values for current and non-current assets. Current and
non-current liabilities are usually taken at their face values. According to RRC the steps to
follow are:
1. Draw up a detailed statement of assets and liabilities of the company ensuring that:
i)
assets are properly valued. This means that non-current assets are carried at cost
less adequate depreciation or amortization. Current assets are at cost or net
realizable value if lower, with an adequate provision for irrecoverable debts.
ii)
liabilities are properly assessed and all accruals included. If there are any contingent
liabilities an estimate must be made.
iii)
Unless it is the super profits method which recalculates goodwill, the book value of
goodwill is written off.
2. From the value of assets above, deduct all external liabilities such as:
i)
debentures
ii)
mortgage loans
iii)
amounts due to sundry payables
3. The balancing figure is the value of net assets or equity value or net worth of the business
concern.
EXAMPLE – BOOK VALUE BASIS AND MARKET VALUE BASIS
The statement of financial position and revised values of C Ltd's assets as at 30 June 20-6 were
as follows;
Current SFP
Values
$
EQUITY & LIABILITIES
Ordinary share capital ($10 shares)
Share premium account
General reserve
Trade payables
ICSAZ - P.M. PARADZA
Revised
Values
$
1 800 000
580 000
436 000
260 000
317
Proposed dividends
100 000
3 176 000
ASSETS
Land & buildings
Plant &machinery
Motor vehicles
Furniture & fittings
Goodwill
Inventories
Trade Receivables
Bank
1 508 000
290 000
421 000
310 000
135 000
232 000
160 000
120 000
3 176 000
3 000 000
217 500
203 000
270 000
Nil
136 400
145 000
120 000
REQUIRED
Calculate the value of the company's ordinary shares based on the net assets method.
SUGGESTED SOLUTION
$
Total assets as per statement of financial position
Add: Increase in land & buildings
Less : decrease in plant and machinery
“
“ motor vehicles
“
“ furniture
“
“ goodwill
“
“ inventories
“
“ receivable
72 500
218 000
40 000
135 000
95 600
15 000
less : Trade payables
260 000
Proposed dividends
Net assets
No of shares in issue
Value per ordinary share
100 000
$
3 176 000
1 492 000
4 668 000
(576 100)
4 091 900
(360 000)
3 731 900
180 000
20.73
Alternative method based on adjustment of equity:
Total equity as per statement of financial position
(1 800 000+ 580 000 +436 000)
Add: Increase in land & buildings
Less: decrease in other assets
Net assets
No of shares in issue
Value per share ordinary share
$
2 816 000
1 492 000
(576 100)
3 731_900
180 000
20.73
Alternative method based on revised values of assets:
ICSAZ - P.M. PARADZA
318
$
3 000 000
217 500
203 000
270 000
136 400
145 000
120 000
4 091 900
Land & buildings
Plant & machinery
Motor vehicles’
Furniture & fittings
Inventories
Receivables
Bank
Less: Trade payables
Proposed dividends
Net assets
No of shares in issue
Value per ordinary share
260 000
(100 000)
(360 000)
3 731 900
180 000
20.73
N.B. In the above calculations, proposed dividends have been included in current liabilities,
resulting in an ex-dividend valuation. A valuation in which proposed dividends are excluded
from current liabilities is known as a cum-dividend valuation
14.4.3 Valuation of Various Sources of Capital
It is possible for a company to use many types of capital, for example, ordinary shares,
preference shares and debentures. The holders of such financing instruments will be
specifically interested in their values, in addition to the general performance of the company.
It should be noted that the market values and the nominal values of market investments are
usually different. Such investments normally assume values which are more or less than those
at which they were originally issued.
When the shares of the business being valued are dealt with on a recognized stock exchange,
the value current market value/quoted market price of the shares is accepted for valuation
purposes (that is market capitalization). Studies by RRC revealed that even though this price is
determined by the price mechanism (interaction of demand and supply), it still is difficult to
accept it as a true reflection of the value due to the following reasons:
a) market prices may be subject to considerable fluctuation from day to day;
b) the publication of a buyer`s or seller`s quotation does not necessarily imply that the
shares are actually being dealt in; and
c) the price will tend to be more stable if the dealings are frequent and of a reasonable
amount
Over the limitations cited above other factors that cause the share value to be distorted are:
i) the prospect of future dividends based on the earnings capacity of the company
ii) the degree of security and risk which is indicated by the excess of assets over liabilities of
the company
When a company issues debentures, they are usually subject to redemption on agreed terms
and conditions, with the repayment(s) being in a lump sum or in instalments. The most common
ICSAZ - P.M. PARADZA
319
options for redeeming debentures are at the end of a given period, by regular annual drawings
out of profits, by purchase on the open market, or by creating a sinking fund. The company
benefiting from the debentures needs to provide for the repayment of capital and interest.
However, the extent of the benefit can only be ascertained by calculating the present value of
the cash flows.
EXAMPLE - VALUATION OF DEBT
A company issued $10 000 000 25% debentures of $100 each on 1 January 20-6. These
debentures were redeemable on 31 December 20-0 at a premium of 10%. A fair return on the
debentures would be 25%. Calculate the present value of the debentures on 1 January 20-6.
SUGGESTED SOLUTION
$
Present value of capital $10 000 000 x 0.3277 =
3 277 000
(PV of $10 000 000 to be received at the end of 5 years, using a discount factor of 25%)
Present value of premium on redemption ($10 000 000 x 10/100 x 0.3277) = 327 700
3 604 700
Present value of interest payments
31/12/20-6 $10 000 000 x 25% x 0.8000
2 000 000
3 1/12/20-7 $2 500 000 x 0.6400
1 600 000
3 1/12/20-8 $2 500 000 x 0.5120
1 280 000
3 1/12/20-9 $2 500 000 x 0.4096
1 024 000
31/12/20-0 $2 500 000 x 0.3277
819 250
6 723 250
Total present value
10 327 950
Value of each debenture
Number of debentures
Alternative calculation of present value of interest
Nominal value of annual interest
Annuity factor of $1 over 5 years at 25% = 2.6893
Present value of interest = $2 500 000 x 2.6893
10 327 950
100 000
$103.27
=
$2 500 000
=
$6 723 250
The present value of preference shares can be calculated by capitalizing the actual or
anticipated return represented by the dividend by the investors' rate of return.
The present value of preference shares can be calculated by capitalizing the actual or
anticipated return represented by the dividend by the investor`s rate of return.
EXAMPLE – PREFERENCE STOCK VALUATION
Calculate the present value of preference shares with the following data:
Required rate of return
=
Actual rate of return (preference dividend) =
Nominal value per share
=
ICSAZ - P.M. PARADZA
20%
15%
$50
320
SUGGESTED SOLUTION:
Value per preference share
= Par value x
Actual rate
Required rate
=
$50 x 15
20
= $37. 50
In addition to the net assets basis explained earlier, ordinary shares can also be valued using
the earnings basis. The net profits of the company whose shares are being valued are averaged
out over a given period to give an anticipated annual return. To ensure a realistic calculation,
adjustments are made for preference dividends and provisions for bad debts, and any other
aspects which affect the sustainability of profits after interest and tax.
EXAMPLE – VALUATION OF ORDINARY STOCK
The annual profits after interest and tax of C Ltd for the past 3 years were as follows: 20-6 $1
176 000; 20-7 $1 652 000 :20-8 $1 918 000. The company's share capital consists of 2 000 000
ordinary shares of $2.50 each and 50 000 16% non- cumulative preference shares of $3 each.
On 31 December 20-8, it was decided to institute a provision for bad debts amounting to $160
000.
REQUIRED
Calculate the value per ordinary share and total market capitalization (based on ordinary
shares). Assume that the average return on capital employed in C Ltd's industry is 20%.
SUGGESTED SOLUTION
$
4 586 000
Total profits over the past 3 years
(1 176 000 + 1 652 000 + 1 918 000 - 160 000)
Average profits over the past 3 years
4 586 000
3
= 1 528 667
(24 000)
1 504 667
Less Annual preference dividend (150 000 x 16%)
Anticipated annual return
Anticipated rate of return
Value per ordinary share
=
Annual return
=
=
1 504 667
/5 000 000 x 100
30.09%
= Par value x Anticipated rate of return
Required (average return)
=
=
ICSAZ - P.M. PARADZA
/Ordinary share capital
2.50 x 30.09%
20%
$3.76
321
Total market capitalization
=
=
$3.76 x 2 000 000
$ 7 520 000
COMPREHENSIVE EXAMPLE
The statement of financial position of E Ltd on 31 March 20-7 was as follows:
ASSETS
Non-current assets (NBV)
Current Assets
Inventory
Trade receivables
Share issue expenses
Debenture discount
Cash & bank balances
Prepayments
EQUITY & LIABILITIES
Share capital & reserves
120 000 Ordinary shares of $10 each, fully paid
50 000 15% Cumulative preference shares of $10 each, fully paid
Share premium account
General reserve
Retained profits
Non-current liabilities
30% Mortgage debentures
Current Liabilities
Trade payables
Proposed ordinary dividend
Expense payables
$
2 046 000
288 000
196 000
20 000
12 800
31 200
4 000
552 000
2 598 000
1 200 000
500 000
168 000
250 000
170 000
2 288 000
150 000
114 500
36 000
9 500
160 000
2 598 000
Additional information
i. The cumulative preference dividends are in arrears by one year.
ii. Bad debts of $48 000 should be written off; in addition, a provision for bad debts amounting
to 5% should be set up
iii. Included in the non-current assets are premises valued at $585 000. A realistic value for
these premises would be $ 1 000 000. All the other assets are fairly stated in the statement of
financial position.
iv. E Ltd's net profit after debenture interest but before tax for the past 3 years were:
Year-ended 31 March
20-5
ICSAZ - P.M. PARADZA
$
450 000
322
20-6
20-7
596 000
648 000
The tax rates were 40% for 20-5 and 20-6 and 35% for 20-7.
v. The average return on capital employed in B Ltd's industry is 25%.
REQUIRED
a) Calculate the value of ordinary shares in B Ltd, using the net assets basis and the earnings
basis.
b) Calculate the value of the cumulative preference shares in E Ltd, using the earnings basis.
SUGGESTED SOLUTION
a) Ordinary shares (Net assets basis)
Total assets as per balance sheet
Add: increase in value of premises
(1 000 000-585 000)
$
Less: 15% Cumulative preference shares
30% Mortgage debentures
Trade payables
Expense payables
500 000
150 000
114 500
9 500
Less: Preference dividend
(500 000 x 15% x 2years)
Debenture discount
Share issue expenses
Irrecoverable debts
Allowance for irrecoverable debts
Ordinary shareholders effective interest
150 000
12 800
20 000
48 000
7 400
No of ordinary shares in issue
Value per ordinary share (cum-div)
$
2 598 000
415 000
3 013 000
(774 000)
2 239 000
(238 200)
2 000 800
120 000
2 000 800
120 000
= 16.67
Notes
1. Preference shares and the related dividends are deducted from total assets like other
liabilities because they have to be provided for before ordinary shares and ordinary
dividends in the event of the company’s winding up.
2.
Since the current liabilities shown in the balance sheet do not include debenture
interest, it can be assumed that the current year’s interest has been paid.
3. Items which do not represent real assets but are included in current assets are deducted
from total assets. In this example the fictitious assets are debenture discount and share
ICSAZ - P.M. PARADZA
323
issue expenses. An important example of a fictitious asset is a debit balance on the
retained profits account.
Earnings basis
Net profit before tax
Company tax
$
$
20-5
450 000
180 000
20-6
596 000
238 400
20-7
(648 000 - 48 000 -7 400) 207 410
Total adjusted profits over 3 years
Net profit after tax
$
270 000
357 600
385 190
1 012 790
Average profits over 3 years
=
Less: Annual cumulative preference dividend (500 000 x 15%)
Anticipated annual return
Anticipated rate of return = (Annual return/ordinary share capital)
Value per ordinary share
(Par value x Anticipated rate of return/Required rate of return
b) PREFERENCE SHARES-EARNINGS BASIS
Required rate of return
Actual rate of return (preference dividend)
Value per cumulative preference share
(Par value x Actual rate/ Required rate)
1 012 790
3
337 597
(75 000)
.
262 597
262 597 x 100
1 200 000
= 21.88%
= $10. 00 x 21.88/25
= $8.75
=
25%
=
15%
= $10. 00 x 15
25
= $6.00
COMPREHENSIVE ACTIVITY
The statement of financial position of T Ltd on 30 June 20-7 was as follows
ASSETS
Tangible non-current assets
Land & buildings
Fixtures & fittings
Motor vehicles
ICSAZ - P.M. PARADZA
$
1 215 000
145 800
337 500
1 698 300
324
Goodwill
Quoted investments (cost)
Current assets
Inventory
Receivables
Cash & bank balances
EQUITY & LIABILITIES
Share capital & reserves
Ordinary share capital ($100 shares)
20% Cumulative preference shares ($10 shares)
Capital redemption reserve
General reserve
Retained earnings
30% Debentures ($10 nominal value)
Current Liabilities
Payables
Proposed ordinary dividends
203 000
364 000
340 200
410 400
265 000
1 015 600
3 280 900
1 500 000
150 000
1 650 000
243 000
162 000
269 225
2 324 225
400 000
2 724 225
421 675
135 000
556 675
3 280 900
Additional information
1. All the assets are fairly valued except
– the current value of the land and buildings is $1 600 000
– the market value of the quoted investment is $300 000
– the debtors figure should be reduced to $350 000
2. The debentures are redeemable at a premium of 10% at the end of 4 years.
3. The net profit before interest and tax for the year-ended 30 June 20-7 was $3 172 500. The
current rate of company tax is 35%. It is expected that these earnings will be maintained in the
foreseeable future.
4. The fair rates of return for companies in the same industry are as follows
– Ordinary shares (earnings yield) 18%
– Ordinary shares (dividend yield) 15%
– Preference shares 16%
– Debentures 22%
REQUIRED
Show calculations to determine the value of the following as at 30 June 20-7:
a) Cumulative preference shares
b) Debentures
c) Ordinary shares using the net assets method
d) Ordinary shares using the maintainable earnings method
14.5 SUPER PROFITS AND THE VALUATION OF GOODWILL
ICSAZ - P.M. PARADZA
325
The theoretical and practical importance of the valuation of financial and real assets cannot be
over- emphasized. Researchers in both Accounting and Finance have pointed out, or at least
argued, that the value of an asset is more related to the income stream that is expected to be
derived from using it in the future, than to its nominal or historical cost. However, there is no
doubt that the original cost of an asset is an important point of reference for any valuation
exercise. The super profits method is a combination of the earnings and asset-based valuation
methods. In contrast to the net assets method, the super-profits method recognizes goodwill as
an integral part of the resources invested in a business. This method attempts to establish a
realistic value of goodwill, instead of considering it as purely a fictitious asset.
The term 'super-profits' refers to the excess of a company's actual or expected profits over what
is considered a reasonable return on capital employed, also known as the cost of capital. A
company which makes above average profits will increase its goodwill, which in most cases
can be recovered if the business is disposed of. In accounting, we are primarily interested in
establishing a value for this asset. This valuation is based on an estimate of the rate of return
which should be used to capitalize future maintainable earnings. Some scholars have described
goodwill as a 'self-destructing asset' in the sense that any goodwill which arises today is likely
to lose its value gradually over time, while at the same time being replaced by newer layers of
goodwill. According to R Lewis and D.Pendrill (1985). "The essence of the super-profit
method is that the additional profits are regarded as riskier than the expected return and the
super-profit should therefore be capitalized at a lower multiple (or higher capitalization rate)
than the expected return." Despite the theoretical appeal of the super-profits method, the above
authors have noted the practical difficulty of estimating the expected rate of return on the assets
employed by a particular business. However, in most cases this can be done by referring to the
average rate of return expected by similar businesses.
14.5.1 Placing a value on super profits
EXAMPLE 1 – ILLUSTRATION OF SUPER PROFIT AND GOODWILL
CALCULATION
A company with a capital of $250 000 has assets excluding goodwill of $600 000 and liabilities
of $250 000. Its net income is $65 000 per annum. A fair return is 10% ‘pure’ interest and 5%
risk premium. Calculate the amount of super-profit and the value of goodwill to be included in
valuation of the business concern.
SUGGESTED SOLUTION
Assets
Less Liabilities
Net worth excluding goodwill
$
600 000
250 000)
350 000
Total net income
Less Interest expense (15% x 350 000)
Super profit
65 000
(52 500)
12 500
ICSAZ - P.M. PARADZA
326
Therefore, value of goodwill =
12 500
0.15
=
$83 333
J.M Samuels, F.M.Wilkes & R.E. Brayshaw (1995) outlined the following practical procedure
for using the super-profits approach:
i) Value the net assets of the business on a going concern basis.
ii) Establish an acceptable rate of return on assets of this type.
iii) Find the annual profits that would be assumed to result from the use of the assets so as to
earn the rate established in ii).
iv) Estimate the profits that can be expected to be earned from the business over the next few
years.
v) Deduct the acceptable profit figure in 3 from the estimated profits in iv). If the estimate is
higher, the difference can be regarded as super-profits
vi) Multiply the super-profits by an agreed factor-say 3 or 5 to represent the number of years
super-profits are to be purchased.
vii) The value of the business is i) plus vi), that is, the value of the net assets plus, say 5 years
purchase of super-profits.
EXAMPLE 2 - SUPER PROFITS METHOD
The following is the abridged statement of financial position of Chiko Limited as at 30 June
20-6
ASSETS
$
Non-current assets
Land and buildings
Motor vehicles
Machinery and equipment
Goodwill
200 000
100 000
17 000
63 000
20 000
Current Assets (excl. preliminary expenses)
Inventory
Sundry receivables
Cash at bank
Preliminary expenses
Total Assets
103 000
50 000
45 000
8 000
7 000
310 000
EQUITY AND LIABILITIES
Capital and Reserves
150 000 ordinary shares of $1 each
50 000 8% preference shares of $1 each
General reserve
Retained earnings
ICSAZ - P.M. PARADZA
245 000
150 000
50 000
18 000
27 000
245 000
327
Non-current liabilities
500 7% debentures of $100 each
Current liabilities
Total Equity and Liabilities
50 000
15 000
310 000
Additional information:
1. The assets of Chiko Limited are shown at fair values in the statement of financial
position, except for land and buildings and machinery and equipment which have
recently been valued by a sworn appraiser at $150 000 and $45 000 respectively.
Goodwill is shown at cost price of 10 years ago. The values of the assets are based on
a going concern basis. On a liquidation basis the following values realize on certain
assets:
$
Land and buildings
150 000
Motor vehicles
15 000
Machinery and equipment
40 000
Inventory
35 000
2. The expected future income of the company, after adding back debenture interest, is
$55 000 per annum after tax of 40%. It can be accepted that this income will last for
the next 3 years.
3. The debentures are redeemable in full after 6 years at a premium of 5%.
4. The following can be taken as fair rates of return:
15% after tax for the business as a whole
10% before tax for the preference shares
8% before tax for the debentures
5. In the event of the company being liquidated 10% of the receivables will be
irrecoverable, while payables will be prepared to give a discount of 5% if they are
assured of full repayment.
REQUIRED
Calculate
i)
the value of the business using the super profits method and applying J.M
Samuel`s et al seven steps
ii)
the value of preference shares;
iii)
the value of debentures; and
iv)
the value of each ordinary share after applying RRC`s three steps.
Adapted from Rapsail accounting and consultancy services
ICSAZ - P.M. PARADZA
328
SUGGESTED SOLUTION
i)
Step i.
Net assets employed excluding goodwill on a going concern basis
Land and buildings
Motor vehicles
Machinery and equipment
Current assets
Current liabilities
$
150 000
17 000
45 000
103 000
315 000
(15 000)
300 000
Step ii.
Acceptable rate of return is 15%.
Step iii.
Annual profits assumed to result from the use of the assets so as to earn the rate established in
ii).
15% x $300 000
=
$45 000
Step iv.
Estimate of profits expected earnable over the next 3 years.
$55 000
Step v.
Super profit per annum
$55 000 – 45 000
=
$10 000
Goodwill $10 000 x PVIFA at 15% for a 3 year period
($10 000 x 2.283)
$22 830
Step vi.
Step vii.
Value of the business ($300 000 + 22 830)
$322 830
ii)
Value of preference shares 8/10 x $50 000
iii)
Value of redeemable debt = Coupon amount x PVIFA + Principal x PVIF
($3 500 x 4.623) + [($50 000 + 2 500) x 0.630]
$49 256
iv)
Net assets employed by the business including goodwill (step i) $322 830
ICSAZ - P.M. PARADZA
$45 000
329
Preference shares (step ii)
Debentures (step ii)
Net worth (Equity) (step iii – balancing figure)
Value of each ordinary share $233 574/150 000 shares
(40 000)
(49 256)
$233 574
=
$1.56
You will recall from earlier studies that there are many methods of valuing goodwill depending
on the nature of the business, for example, average profits over a certain number of years, gross
annual fees over a certain number of years and the discounted momentum method. Similar
concepts are used in the valuation of super profits.
EXAMPLE 3 – SUPER PROFITS METHOD
The balance sheet of Y Ltd on 31 December 20-2 was as follows:
ASSETS
Tangible non-current assets
Goodwill
Net current assets
EQUITY & LIABILTIES
Ordinary share capital ($10 shares)
General reserve
Retained profits
$
2 250 000
375 000
875 000
3 500 000
2 000 000
825 000
675 000
3 500 000
The net profits of Y Ltd. after tax for the next 5 years are expected to be as follows:
31/12/20-3
31/12/20-4
31/12/20-5
31/12/20-6
31/12/20-7
A fair return on the business as a whole is estimated at 20%
$
850 000
1 575 000
1 100 000
1 225 600
1 340 000
REQUIRED
Calculate the value per ordinary share using the super-profits method. Super- profits are at
their maximum value on 1 January 20-3 and will gradually decrease until they reach a value
of nil at the end of 5 years.
SUGGESTED SOLUTION
Capital employed
ICSAZ - P.M. PARADZA
$
3 500 000
330
Less Book value of goodwill*
Adjusted net worth
Fair return on adjusted net worth (20% x 3 125 000)
Average annual profits
(850 000+1575 000+1 100 000+1 225 600+1 340 000)/5years =
Super profits Y/E
31/12/20-3
Super profits Y/E
31/12/20-4
$593 120 x 3
=
4
Super profits Y/E 31/12/20 -5
$593 120 x 2
=
4
Super profits Y/E 31/12/20-6
$593 120 x 1
=
4
Super profits Y/E 31/12/20-7
=
(375 000)
3 125 000
625 000
1 218 120
593 120 (100%)
444 840 (75%)
296 560 (50%)
148 280 (25%)
Nil
* Book value of goodwill is subtracted because the super profits method prefers a realistic
value of goodwill.
$
Present value of super profits
Y/E 31/12/20-3
$593 120 x 0.8333
494 246.90
Y/E 31/12/20-4
$444 840 x 0.6944
308 896.90
Y/E 31/12/20-5
$296 560 x 0.5787
171 619.27
Y/E 31/12/20-6
$148 280 x 0.4823
71 515.44
1 046 278.51
Present value of super profits
1 046 279
Intrinsic value of tangible assets (adjusted net worth)
3 125 000
Present value of ordinary shares
4 171 279
Number of ordinary shares in issue
200 000
Value per ordinary share
4 171 279
200 000
=
$20.86
14.6 VALUATION BASED ON MARKET PRICE
Ordinary shares and preferences shares are normally issued with a par value which is also
referred to as book value or nominal value of the shares. This is a reference value which does
not change unless the company's share capital is restructured. However, the shares and other
securities of publicly quoted companies will usually have market values which depend on
economic and non-economic factors, particularly demand and supply. Such values are very
useful in the context of mergers and acquisitions.
ACTIVITY – BUSINESS VALUATION
HF (Private) Ltd figures for the upper part of the statement of financial position be correctly
presented as follows:
ASSETS
Non-current assets
ICSAZ - P.M. PARADZA
$000
331
Property, plant and equipment
Land and buildings (market value $12 800 000)
Plant and Equipment
Vacant land (market value $800 000)
Financial Assets
Listed investments (market value $192 000)
Current assets
Inventories
Trade and other receivables
11 680
8 000
3 200
480
160
1 600
320
1 280
13 440
EQUITY & LIABILITIES
Capital and reserves
Issued ordinary share capital
Accumulated profits
1 600
8 640
10 240
Non-current liabilities
Interest bearing borrowings
Current liabilities
Trade and other payables
Short-term borrowings
1 600
640
960
13 440
The following is an extract from the income statement of HF (Private) Limited:
Income statement (extract) for year-ended 31 Dec 20-0
Net profit before tax
Dividends from listed investments
Net profit before finance costs
Finance costs
Net profit before tax
Tax expense
Net profit after tax
$000
10 131.20
44.80
10 176.00
(512.00)
9 664.00
(2 886.40)
6 777.60
40% is considered a fair rate of return on ordinary shares in HF (Private Limited). The
applicable income tax rate is 30% and the super profits are expected to last for 3 years.
REQUIRED
a) Calculate the value of a 100% interest in HF (Private Limited) at 3 December, 20-0 using
the super profits method.
b) Briefly discuss advantages and disadvantages of the super profits method of business
valuation.
ICSAZ November 2001 past examination question paper
14.7 THE VALUE OF CONTROL OF A BUSINESS
It should be clear that ownership or majority control in a business gives an investor certain
advantages which are not available to other investors. These advantages include the ability to
determine the level of investment, as well as control over financial and operating policies.
ICSAZ - P.M. PARADZA
332
Although the introduction of new policies and changes in existing ones are subject to approval
by the board of directors, real power usually lies in the hands of individual and institutional
investors who own the biggest percentage of voting shares. An important advantage which
should be specifically mentioned is the ability to control the company's dividend policy, which
has a direct impact on the wealth of both major and non-controlling shareholders.
14.7.1 Perspective of an investor without control
Most of the examples discussed so far in this Unit relate to investors with substantial
ownership/control interests in the business which is being valued. Investors who own
insignificant percentages of shares generally have little influence over the policies which affect
their welfare. However, Section 198 of the Companies Act provides relief to such investors if
there is proof that their rights have been violated. The court may take the following actions to
protect the interests of these investors:
i.
Regulate the conduct of the company's affairs in the future.
ii.
Require the company to desist from the act(s) being complained of or to undertake
any act(s) which have been wrongly omitted.
iii.
Authorize civil proceedings to be brought in the name and on behalf of the company
by any person(s) that the court may direct.
iv.
Provide for the purchase of the shares of any members of the company by other
members or by the company itself.
Non-controlling shareholders are mostly interested in the dividends that they can receive from
the company(ies) in which they have invested. Such dividends are declared periodically and in
the case of ordinary shares are not guaranteed. Essentially therefore, these shareholders are
passive recipients of dividends as and when they are declared. Earnings based methods like
dividend yield, earnings yield and price/earnings ratio can serve the valuation needs of small
investors quite well.
14.8 SUMMARY
The valuation of a company or specific investments within it may be undertaken for different
purposes e.g. to determine the terms of a share exchange in a merger or acquisition, to facilitate
tax calculations for estate duty purposes and provide information to be included in a prospectus
or reporting accountant's report. Objectivity is difficult to achieve because one party's view will
depend on whether he/she is the buyer or seller in the proposed transaction. However, the most
important issue is that agreement must be reached for the transaction to be concluded. Another
important factor in the valuation of going concerns is whether the prospective investor is
interested in a major shareholding, or an insignificant parcel of shares.
14.9 REFERENCES
GEE, P. Spice & Pegler
Book-keeping and Accounts,
(ELBS/Butterworths) 19th Edition 1985
REES, B.
Financial Analysis Prentice Hall Europe
2 Edition 1995
ICSAZ - P.M. PARADZA
333
SAMUELS, J.M., WILKES, F.M. &BRAYSHAW, R.E. Management of Company
Finance. Chapman & Hall 6th Edition
1995
LEWIS, R.E. & PENDRILL, D
Advanced Financial Accounting.
ELBS/Pitman 2 Edition 1985
ARNOLD, J. & MOIZER, P.
A survey of the methods used by
investment analysts to appraise
investments in ordinary shares in
Accounting and Business Research
Autumn 1984 pg 195-208
Rapid Results College, 2006
ICSAZ - P.M. PARADZA
334
UNIT FIFTEEN
CAPITAL REORGANISATION AND RECONSTRUCTIONS
15.0 INTRODUCTION
A company may find itself in unexpected circumstances which require major changes in its
financial structure, as represented by the equity and liabilities section of the statement of
financial position. For example, there may be a shortage of funds to meet operational needs.
This may be due to overtrading which is as a result of a business trying to do too much too
quickly with too little. This is an internal factor and a sign of poor working capital management.
External factors such as the arrival of an aggressive competitor or a harsh economic
environment may also be contributory.
The clearest sign that things are not well on a company`s economic front is the occurrence of
persistent losses as indicated by a debit balance on the retained earnings account. Other signs
are undercapitalization of key activities or departments, failure to meet long-term or short term
liabilities and failure to pay dividends. The ways to address these challenges vary from increase
in capital to consolidation of existing capital. Restructuring is also the other way to address the
challenges. It involves an agreement among the existing shareholders and creditors to change
the company`s capital structure. If external restructuring is followed, new funds are injected
into the company in a bid to start on a clean slate after a series of losses. The other way to look
at it is that, if a company is in debt and facing difficulties with its creditors, it may adjust matters
so that the unsecured debenture holder or creditor gains rights over the assets thus becoming a
secured debenture holder. Or the creditor may even become a shareholder by an issue of shares
to extinguish the debt. Reorganization and restructuring are basically situations where existing
relationships between the company and persons associated with it changes and the change is
such that members are required to approve.
.
15.1 OBJECTIVES
By the end of this Unit, you should be able to:
•
•
•
•
•
•
Explain the concepts of company reorganization and reconstruction
Outline the provisions of the Companies Act on the power of a company to purchase
its own shares
Explain the provisions of the Companies Act on the power of a company to reduce its
capital
Explain the liabilities of members on the winding up of a company
Show accounting entries related to a reconstruction scheme on the basis of information
that has been provided
Draft a possible reconstruction scheme on the basis of information that has been
provided
ICSAZ - P.M. PARADZA
335
15.2 LEGAL PROVISIONS (What is below is for recap on the provisions of corporate law)
15.2.1 Reorganization
Section 91 of the Companies Act is what is relevant when considering a situation where a
company is in low water and needs to obtain fresh capital. Rights attaching to existing classes
of shares are altered to give preferential rights to persons who may then be persuaded to supply
the further capital required, a practice that amounts to a reorganization of capital.
The procedure followed in order to vary the rights of shareholders is that the company or a
member approaches the court with a request that a meeting of those members, whose rights it
is sought to alter, be called. The variation has to be sanctioned by a majority in number
representing 75% in number of the members voting at the meeting. It is then that the court will
confirm the variation which becomes binding on all members of the class concerned. Over and
above variation, the same section permits consolidation of shares of different classes into one
class, for example, converting all preference shares into ordinary shares; division of shares into
different classes; and combination, that is, a consolidation into one class followed by the
division of that class into further classes.
Reorganization permits arrangements with creditors and debenture holders. It can be utilized
for reconstructing except where the reconstruction is clearly according to Section 250 which is
part of the provisions specifically applicable to members` voluntary winding up.
15.2.2 Reconstruction
To reconstruct is to put back together from component parts, pieces or remains. As a Company
Secretary, you may have to direct the process of a reconstruction. It is provided for by section
250, the steps involved, in summary, are as follows:
a) A special resolution to reconstruct or amalgamate
b) Voluntary liquidation of the old company
c) Making provisions for dissentients
d) Division of purchase consideration among members of the old company in accordance with
their rights under the Memorandum or Articles of the old company
e) Irrevocable binding of creditors by the reconstruction or amalgamation
The advantages of reconstructing are that the fully paid shares in the old company can be
replaced by the partly paid shares in the new. This enables further increase (raising) of capital.
Thus a reduction of capital is carried out without resorting to the usual procedure laid down by
the Act.
In detail the procedure for reconstruction is:
1. Once it has been decided that the reconstruction of the company is desirable, with a majority
of shareholders agreeable to the idea, the directors discuss and fix the details of the scheme.
2. The directors furnish security to the satisfaction of the Master of High Court that all debts
of the company will be duly paid within 12 months of commencement of winding up.
Voluntary winding up is controllable by shareholders only when the company is able to pay its
ICSAZ - P.M. PARADZA
336
debts, if not so, the creditors are in charge with the liquidator`s authority coming from the Court
or the creditors.
3. A draft agreement to effect the sale of the old company to the new company is made.
4. The Board will then have to authorize the calling of an Extraordinary General Meeting
(EGM) to pass a special resolution, with a notice and a circular letter on reasons being sent to
the shareholders.
5. The EGM is held and resolution passed, since the support of shareholders will be assured.
The Registrar is notified within 14 days of the decision for voluntary winding up, and a notice
given in the Gazette.
6. For a further seven days nothing is done to allow for any shareholders who wish to record
their refusal by serving a notice on the liquidator requiring him/her to purchase his/her interest
(shares) or refrain from proceeding with the scheme.
7. Once the 7 days are expired, and objectors having been provided for, the new company is
registered and agreement entered into between it and the liquidator of the old concern.
8. The new company proceeds to allot shares to those who have applied for them.
9. With its liabilities repaid and the proceeds of the sale of its business (shares in the new
company) distributed to shareholders, the old company is finally liquidated and ceases to exist.
15.2.3 Capital Reduction
According to section 92, a company may if authorized by its articles, reduce its share capital
through a special resolution which has been authorized by the court.
Specifically the company is allowed to:
a) Extinguish or reduce the liability on any of its shares in respect of share capital that is not
yet paid up
b) Cancel any paid up share capital that has been lost or is not represented by assets
c) Pay off any paid up share capital which is in excess of the company`s requirements
Section 96 states that a present or previous member of the company undertaking a Capital
Reconstruction shall only be liable to pay the difference between the new value of shares and
any amount which has already been paid or is considered to have been paid. This is an extension
of the limited liability principle since a reconstruction can be the precursor to a winding up if
things do not work out well.
15.2.4 Power of a company to alter share capital (section 87)
A company may by special resolution change the provisions of its memorandum in order to:
a) Increase its share capital through new issue of shares
b) Consolidate and divide all or any part of its share capital into shares of larger amount than
its existing shares
ICSAZ - P.M. PARADZA
337
c) Convert all or any of its paid up shares into stock and reconvert such stock into shares of any
denomination.
d) Sub-divide its shares or any of them into shares of smaller amounts than is fixed by the
memorandum
e) Cancel shares which at the time of the passing of the relevant resolution have not been
subscribed for, and reduce the amount of share capital by the amount so cancelled.
f) Convert any of its shares, whether issued or not, into shares of another class
15.2.5 Winding up
Section 199 states that the winding up of a company may be by the court (when it is
compulsory) or through the action of members (when it is voluntary).
15.2.5.1 Liabilities of members on winding up
Section 201 requires that every present and past member shall, subject to this section, be liable
to contribute to the assets of the company an amount sufficient for payment of its creditors and
other liabilities and costs, winding up charges and expenses, and for the adjustment of the rights
of the contributories among themselves. The following exceptions to the general rule should
be noted:
i) in the case of a company limited by shares, the maximum amount due from a member will
be that not yet paid on allotted shares;
ii) in the case of a company limited by guarantee, the maximum amount from a member will
be that which he undertook to contribute in the event of a winding up; and
iii) a past member shall not be liable to contribute if he has ceased to be a member of the
company for one year or more before the commencement of the winding up.
15.2.5.2 Consequences of voluntary winding up (Section 256)
a) The company`s property will be distributed among the members according to their rights
and interests.
b) the liquidator may exercise the court`s powers to determine a list of contributories, make
calls on them and adjust their rights.
c) the list of contributories shall be prima facie evidence of the liabilities of the identified
persons/companies to the company.
d) when several liquidators have been appointed, they may exercise the relevant powers
received at the time of appointment; however, if there is a default in the determination of
such powers, they shall be exercised by no less than two liquidators.
e) at the request of a contributory or a creditor, the Master may appoint a provisional liquidator
if nobody is occupying the position.
ICSAZ - P.M. PARADZA
338
15.2.5.3 Distribution of proceeds on a company`s winding up
The Companies Act does not specify the order in which the proceeds from a company`s assets
should be distributed in a winding up. However, the distributor should ensure that the available
assets are distributed as equitably as possible once the amounts due have been determined.
Lewis and Pendrill (1985) outlined the following priority order for meeting a company`s
claims:
i. Debts secured by a fixed charge, which should be paid out of the proceeds of the identified
assets
ii. Liquidation costs
iii. Preferential creditors
iv. Creditors secured by a floating charge, which should be paid out of the proceeds of any
available assets
v. Unsecured creditors
vi. Preference shareholders
vii. Ordinary shareholders
15.3 Accounting entries for Reconstruction Schemes
Accounting for a reconstruction scheme which has already been agreed on is fairly straight
forward. Paradza (2003) outlined the following procedure for recording the related
transactions:
1. The capital accounts which are affected are debited, while a Capital Reconstruction account
is opened and credited with the amounts by which capital is being reduced.
2. The Capital Reconstruction account is debited while any new share capital accounts are
opened and credited with the relevant amounts.
3. Any debit on the retained profits account is transferred to the Capital Reconstruction account.
4. Fictitious assets such as goodwill or other overstated assets are written down, with the
necessary amounts being debited in the Capital Reconstruction account.
5. Any credit balance remaining on the Capital Reconstruction account should be transferred
to a Non-Distributable Reserve. A debit balance remaining of the Capital Reconstruction
account indicates that the scheme was not well crafted.
Important Note!!
Questions on this topic may involve journal entries and/or ledger accounts. You should be
familiar with both methods of answering the questions
ICSAZ - P.M. PARADZA
339
EXAMPLE 1 – T LTD
The statement of financial position of T Ltd as at 30 June 20-5 was as follows:
STATEMENT OF FINANCIAL POSITION AS AT 30/06/20-5
ASSETS
Tangible Non-current Assets
Land & buildings
Plant & machinery
Motor vehicles
$
748 000
673 200
430 100
1 851 300
130 900
1 982 200
Goodwill
Current Assets
Inventory
Debtors
EQUITY & LIABILITIES
Authorised & Issued Share Capital
14960 Ordinary shares of $100
each, fully paid
Share premium account
Retained profits
Long-term liabilities
30% Debentures
Current Liabilities
Trade creditors
Bank overdraft
Accrued debenture interest
$
374 000
207 570
581 570
2 563 770
1 496 000
380 000
(274 500)
560 000
255 030
97 240
50 000
402 270
2 563 770
In anticipation of improved trading conditions, the directors of T Ltd. decided to undertake
the following reconstruction scheme, which was approved by the shareholders on 1 July 20-5.
i. The ordinary shares to be reduced to $75 par value.
ii. All the intangible assets to be eliminated.
iii. The following assets to be revalued as shown:
Plant and machinery
$530 000
Motor vehicles
$340 000
Land & buildings
$1 162 270
Inventory
$327 000
Receivables
$155 000
iv. The debenture holders to waive the interest outstanding on their debentures
v. The cost of the scheme was expected to be $100 000.
vi. The bank agreed to continue providing the overdraft facility.
ICSAZ - P.M. PARADZA
340
REQUIRED
a) Draw up journal entries relating to the scheme
b) Draw up ledger accounts affected by the scheme
c) Draw up the company’s STATEMENT OF FINANCIAL POSITION after completion of
the scheme.
SUGGESTED SOLUTION
a) Journal Entries
i. DR Ordinary Share Capital A/C
CR
Capital Reconstruction A/C
Being entry to show the reduction
of ordinary shares to $75 per share
$
374 000
374 000
ii. DR Accrued Debenture Interest A/C
CR
Capital Reconstruction A/C
Being interest waived by debenture
holders in pursuance of the
reconstruction scheme
50 000
iii. DR Capital Reconstruction A/C
CR
Goodwill A/C
Retained Profits A/C
Plant & machinery A/C
Motor Vehicles A/C
Stock A/C
Debtors A/C
Being entry to show the elimination
of intangible assets and the writing
down of some tangible assets in
accordance with the reconstruction
scheme.
738 270
iv. DR Land & Buildings A/C
CR
Capital Reconstruction A/C
Being entry to record an increase
in the value of land and buildings
50 000
130 900
274 500
143 200
90 100
47 000
52 570
414 270
v. DR Capital Reconstruction A/C
100 000
CR
Bank A/C
Being entry to record the costs of the reconstruction scheme
ICSAZ - P.M. PARADZA
$
414 270
100 000
341
b) Ledger Accounts
ORDINARY SHARE CAPITAL A/C
$
$
Capital Reconstruction A/C 374 000
Balance b/d
Balance b/d
1 122 000
1 496 000
1 496 000
.
1 496 000
Balance b/d
1 122 000
CAPITAL RECONSTRUCTION A/C
Goodwill A/C
Retained Profits A/C
Plant & Machinery A/C
Motor Vehicles A/C
Stock A/C
Debtors
Bank A/C (costs)
130 900
274 500
143 200
90 100
47 000
52 570
100 000
838 270
Ordinary Share Capital A/c
Accrued Debenture Interest
Land and Buildings A/C
374 000
50 000
414 270
.
838 270
ACCRUED DEBENTURE INTEREST A/C
Capital Reconstruction A/c 50 000
Balance b/d
50 000
GOODWILL A/C
Balance b/d
130 900
Capital Reconstruction A/c
130 900
RETAINED PROFITS A/C
Balance b/d
274 500
Capital Reconstruction A/c
274 500
PLANT AND MACHINERY A/C
Balance b/d
673 200
Balance b/d
673 200
530 000
Capital Reconstruction A/c
Balance c/d
143 200
530 000
673 200
MOTOR VEHICLES A/C
Balance b/d
430 100
Balance b/d
430 100
340 000
ICSAZ - P.M. PARADZA
Capital Reconstruction A/c 90 100
Balance c/d
340 000
430 100
342
INVENTORY A/C
Balance b/d
374 000
Balance b/d
374 000
327 000
Capital Reconstruction A/c
Balance c/d
97 240
327 000
374 000
RECEIVABLES A/C
Balance b/d
207 570
Balance b/d
207 750
155 000
Capital Reconstruction A/c
Balance c/d
52 570
155 000
207 750
BANK A/C (OVERDRAFT)
Balance c/d
197 240
Balance b/d
Capital Reconstruction A/c
97 240
100 000
197 240
197 240
197 240
Balance b/d
LAND AND BUILDINGS A/C
414 270
Balance c/d
Balance b/d
1 162 270
Capital Reconstruction A/C 748 000
1 162 270
Balance b/d
1 162 270
c)
.
1 162 270
Statement of financial position as at 1 July 20-3
ASSETS
Tangible Non-current assets
Land & buildings
Plant & machinery
Motor vehicles
Current assets
Inventory
Receivables
EQUITY & LIABILITIES
Authorised & Issued share Capital
14960 ordinary shares of $75
each, fully paid
Share premium account
Long-term liabilities
30% Debentures ($10 each)
ICSAZ - P.M. PARADZA
$
$
1 162 270
530 000
340 000
2 032 270
327 000
155 000
482 000
2 514 270
1 122 000
380 000
1 502 000
560 000
343
Current Liabilities
Trade creditors
Bank overdraft
255 030
197 240
452 270
2 514 270
ACTIVITY – ABC LTD
After suffering a series of trading losses, ABC Ltd. decided to reduce its capital of 100 000
ordinary shares of $25 each fully paid to 100 000 ordinary shares of $15 each fully paid. The
company’s statement of financial position as at 31 December 20-5 was as follows.
Statement of financial position as at 31/12/20-5
Tangible Non-current assets
ASSETS
Freehold property
Plant & machinery
Motor vehicles
Other Non-current assets
Goodwill
Current Assets
Inventory
Receivables
Cash at bank
EQUITY & LIABILITIES
Ordinary share capital
Share premium
Retained earnings
20% Mortgage debentures
Payables
$
$
625 000
1 037 500
473 500
2 136 000
475 000
601 175
875 500
356 500
1 833 175
4 444 175
2 500 000
566 250
( 578 250)
2 488 000
1 250 000
706 175
4 444 175
N.B. the creditors figure includes a full year’s unpaid debenture interest.
The shareholders and debenture holders agreed on the following reconstruction scheme.
i.
Write off the balance on the retained earnings account
ii.
Write off the value balance on the goodwill account
iii. Reduce the value of plant and machinery by $300 000
iv.
Reduce the value of inventory by 20%
v.
Create a provision for bad debts amounting to 25%
vi.
Increase the value of the freehold property to $1 200 000
vii.
Waive outstanding interest on the mortgage debentures and convert these debentures
into ordinary shares of $15 each.
ICSAZ - P.M. PARADZA
344
Required
a) Show the journal entries necessary to give effect to the above
b) Draw up the ledger accounts affected by the scheme
c) Draw up the company’s statement of financial position after completion on the
scheme on 1 January 20-6
ACTIVITY - LEGAL PROVISIONS
Explain the legal provisions related to capital reorganization and reconstructions under the
following headings:
a) Reduction of capital
b) Power of a company to alter its capital
c) Liability of a company's members on a winding up
15.4 SELF DESIGN OF CAPITAL RECONSTRUCTION SCHEMES
EXAMPLE 1 - DESIGN OF A CAPITAL RECONSTRUCTION SCHEME
The statement of financial position of XYZ Ltd on 31 March 20-6 is as follows:
Statement of financial position as at 31 March 20-6
ASSETS
Tangible Non-current Assets
Land & buildings
Plant & machinery
Fixture & fittings
$
2 700 000
1 650 000
840 000
5 190 000
Other Non-current Assets
Goodwill
Patents & trade marks
2 000 000
1 500 000
Current Assets
Inventory
Trade receivables
Cash on hand
1 598 000
2 300 000
260 000
EQUITY & LIABILITIES
Authorised & Issued Capital
250 000 Ordinary shares of $20 each
100 000 15% Cumulative preference
shares of $10 each
Retained profits
Long-term Liabilities
20% Secured debentures
ICSAZ - P.M. PARADZA
$
3 500 000
415 800
12 848 000
5 000 000
1 000 000
(1 682 000)
2 500 000
345
Current Liabilities
Trade payables
Preference dividends
Bank overdraft
Debenture interest
2 980 000
300 000
1 750 000
1 000 000
6 030 000
12 848 000
Additional Information
i.
ii.
iii.
iv.
v.
vi.
vii.
The dividends on the cumulative preference shares are 1 year in arrear, excluding the
amount at the end of the year.
The company’s directors believe that trading conditions have improved significantly in
the past few months, and that average net profits of $7 800 000 p.a. can be expected if
a reconstruction scheme can be agreed on.
The debenture holders are prepared to forgo the interest due to them in support of the
scheme. They will also provide additional cash amounting to $2 500 000 on a floating
charge with an interest rate of 25% p.a. in order to reduce the existing bank overdraft
and inject working capital of $750 000.
The preference shareholders are prepared to forgo ⅔ of the dividends due to them, on
condition that the balance is paid immediately.
The company’s shareholders and debentures holders are willing to accept any equitable
scheme which will prevent its collapse. However, the trade creditors are not prepared
to accept any reduction.
The existing debentures are secured on the factory building which has a market value
of $1 000 000. The other land and buildings are estimated to have a market value of $4
500 000.
The net realizable values of the other assets are as follows:
Plant and machinery
Fixtures and fittings
Stock
Debtors
viii.
ix.
$
1 200 000
650 000
1 375 000
2 100 000
The costs of the reconstruction scheme are expected to be $450 000. If a scheme cannot
be agreed on, the company will have to be liquidated, which option involves costs of
$4 000 000.
All the parties have agreed that patents and trademarks should appear in the new
statement of financial position at only ⅔ of their book value.
REQUIRED
a) Calculate the amount of the required capital reduction.
b) Make an assessment, supported by figures of the losses which must be incurred
by the various parties in reconstruction scheme.
c) Draft a reconstruction scheme which is likely to be supported by the various
parties.
d) Draw up the ledger accounts affected by the scheme.
e) Draw up a statement of financial position based on the suggested scheme.
ICSAZ - P.M. PARADZA
346
SUGGESTED SOLUTION
a) Calculation of the required Capital Reconstruction
$
450 000(downward)
190 000(downward)
223 000(downward)
200 000(downward)
2 000 000(downward)
500 000(downward – a 1/3)
1 682 000(downward)
450 000(downward-bank)
5 695 000
Adjustments of plant and machinery
Adjustment of fixtures and fittings
Adjustments of stock
Adjustment of debtors
Elimination of goodwill
Elimination of patents and trademarks
Elimination of adverse balance on retained profits
Cost of the scheme
Adjustment of surplus on revaluation of
land and buildings (1 000 000+4 500 000
-2 700 000)
Net reduction
(2 800 000)(upward)
2 895 000
b) Assessment of losses
Distribution of assets and net cash inflows if the company is liquidated:
Factory building
1 000 000
Payable to secured debenture holders 1 000 000
Other properties (land and buildings)
4 500 000
Plant and machinery
1 200 000
Fixtures and fittings
650 000
Patents and trademarks
1 000 000
Stock
1 375 000
Debtors
2 100 000
10 825 000
Liquidation costs
4 000 000
Available for unsecured creditors (possible net cash inflow)
6 825 000
Yet the amounts due to unsecured creditors are as follows:
Bank overdraft
Debenture holders
Capital
Interest
Paid out security
Trade creditors
2 500 000
1 000 000
3 500 000
1 000 000
1 750 000
2 500 000
3 280 000
7 530 000
Therefore, from the above calculations it can be seen that there is $6 825 000 to pay unsecured
creditors amounting to $7 530 000, that is, 91cents in the $. The various parties would therefore
receive less than the amounts owed to them if the company is liquidated. They would therefore,
be willing to give your reconstruction scheme a chance.
ICSAZ - P.M. PARADZA
347
c) Possible reconstruction scheme (your proposal)
Capital Reduction
$
250 000 Ordinary shares of $20 each
to be converted to ordinary shares
of $14 each
100 000 15% Cumulative preference shares
of $10 each to be converted to 15%
cumulative $8.05
⅔ of preference dividends due to be written off
Accrued debenture interest to be written off
Total reduction [see (a) above]
1 500 000
195 000
200 000
1 000 000
2 895 000
LEDGER ACCOUNTS
Land and Buildings A/C
Balance b/d
Capital Reconstruction a/c
Balance b/d
2 700 000
Balance c/d
2 800 000
5 500 000
5 500 000
Plant and Machinery A/C
Balance c/d
1 650 000
Balance b/d
1 650 000
1 200 000
Capital Reconstruction a/c
Balance c/d
5 500 000
5 500 000
4 500 000
1 200 000
1 650 000
Fixture and Fittings A/C
Balance b/d
840 000
Balance b/d
840 000
650 000
Goodwill A/C
Balance b/d
2 000 000
Capital Reduction a/c
Balance c/d
Capital Reconstruction a/c
190 000
650 000
840 000
2 000 000
Trade Marks and Patents A/C
Balance b/d
1 500 000
Balance b/d
1 500 000
1 500 000
Inventory A/C
Balance b/d
1 598 000
Balance b/d
1 598 000
1 375 000
ICSAZ - P.M. PARADZA
Capital Reconstruction a/c
Balance c/d
Capital Reconstruction a/c
Balance c/d
500 000
1 000 000
1 500 000
223 000
1 375 000
1 598 000
348
Trade Receivables A/C
Balance b/d
2 300 000
Capital Reconstruction A/C
Balance c/d
Balance b/d
2 300 000
2 100 000
Bank A/C
25% Debentures
2 500 000
Balance b/d
Capital Reconstruction a/c
(reconstruction costs)
Preference dividends a/c
Balance c/d
2 500 000
200 000
Balance b/d
200 000
2 100 000
2 300 000
1 750 000
450 000
100 000
200 000
2 500 000
Ordinary Share Capital A/C
Capital Reconstruction a/c
Ordinary share Capital ($14)
1 500 000
3 500 000
5 000 000
Balance b/d
5 000 000
5 000 000
Ordinary Share Capital A/C
Balance c/d
3 500 000
Ordinary Share Capital
($20 shares)
Balance b/d
3 500 000
3 500 000
15% Cumulative Preference Share Capital A/C ($10 shares)
Capital Reconstruction a/c
195 000
15% Cum. Preference share Capital
(805 shares)
805 000
1 000 000
Balance b/d
1 000 000
1 000 000
15% Cumulative Preference share Capital A/C ($8.05 shares)
Balance c/d
805 000
15% Cum. Preference share
Capital a/c
Balance b/d
805 000
805 000
Preference Dividends A/C
Capital Reconstruction a/c
Bank
ICSAZ - P.M. PARADZA
200 000
100 000
300 000
Balance b/d
300 000
300 000
349
Retained Profits A/C
Balance c/d
1 682 000
Capital Reconstruction a/c
1 682 000
25% Debentures A/C
Balance c/d
2 500 000
Bank a/c
Balance b/d
2 500 000
2 500 000
Debenture interest A/C
Capital Reconstruction a/c
1 000 000
Balance b/d
1 000 000
Capital Reconstruction A/C
Plant & machinery a/c
Fixtures & fittings a/c
Goodwill a/c
Trade marks & Patents
Stock a/c
Debtors a/c
Bank (reconstructions costs)
Retained Profit a/c
450 000
190 000
2 000 000
500 000
223 000
200 000
450 000
1 682 000
5 695 000
Land & Buildings a/c
2 800 000
Ordinary Share Capital a/c
1 500 000
($20 shares)
15% Cum. Pref. Share Cap. a/c 195 000
($10 shares)
Preference Dividends a/c
200 000
Debenture interest a/c
1 000 000
5 695 000
Statement of financial position as at 1 April 20-6
ASSETS
Tangible Non-current Assets
Land & buildings (1 000 000 + 4 500 000)
Plant & machinery
Fixtures & fittings
$
5 500 000
1 200 000
650 000
7 350 000
Other Non-current Assets
Patents & trade marks
Current Assets
Inventory
Receivables
Cash at bank
Cash on hand
EQUITY & LIABILITES
Authorised & Issued Capital
250 000 Ordinary shares of
14 each, fully paid (5 000 000 – 1 500 000)
100 000 15% Cumulative preference
ICSAZ - P.M. PARADZA
$
1 000 000
1 375 000
2 100 000
200 000
260 000
3 935 000
12 285 000
3 500 000
350
shares of $16 $8.05 each
fully paid (1 000 000 – 195 000)
Long-term Liabilities
20% Secured debentures
25% Debentures (floating charge)
805 000
2 500 000
2 500 000
Current Liabilities
Payables
5 000 000
2 980 000
12 285 000
EXAMPLE 2 – SCHEME DESIGN
The statement of financial position of B ltd on 31 December 20-0 was as shown below:
ASSETS
Non-Current Assets
Land and Buildings
Plant and Machinery
Goodwill
Current Assets
Inventory
Receivables
Investments
Total Assets
$
415 300
250 000
55 000
386 000
290 800
152 100
1 549 200
EQUITY & LIABILITIES
Share Capital & Reserves
Share Capital Authorized & Issued 550 000 $1 Ordinary Shares
220 000 $1 16% Cumulative Preference Shares
Retained Profit/ (Loss)
$
550 000
220 000
(225 000)
Non-Current Liabilities
20% Debentures
338 900
Current Liabilities
Preference Dividend
Payables
Bank Overdraft
Total Equity & Liabilities
140 800
249 500
275 000
1 549 200
The directors are confident that the difficult years are now gone and the business can be
profitable beginning next year at $390 000 p.a. before interest and tax. Tax rate is 30%. They
have figured out new lines of production and it will be important to convince creditors not to
force liquidation.
Additional Information
No preference dividend has been paid for 4 years to 31 December 2010 but preference
shareholders are willing to forgo the dividends owing to them.
Goodwill arose years ago on acquisition of another company and nothing has been written off.
ICSAZ - P.M. PARADZA
351
The following values have been placed on assets:
By Directors
Going Concern
$
500 000
100 000
225 000
150 000
Land and Buildings
Plant and Machinery
Inventory
Receivables
By Experts
Liquidation
Agreed
60% of value
80% of value
75% of value
$110 000 cash resources are required to modify plant and machinery and inventory worth $80
000 is needed to produce new lines.
Payables owed $50 000 will have a preferential claim on liquidation. 6 months unpaid
debenture interest is included in payables.
The bank will convert $100 000 0f the overdraft into a 5 year loan at 15% p.a. but the balance
of $175 000 has to be paid off immediately.
$60 000 is set aside for the reconstruction scheme.
REQUIRED
Suggest a possible reconstruction scheme of your own.
Draw up the company`s statement of financial position after the scheme has been completed.
SUGGESTED SOLUTION
Step 1 Establish the adjustments necessary to bring values to acceptable levels:
Write off
Goodwill
Write down
Plant and Machinery ($250 000 – 100 000)
Inventory ($386 000 – 225 000)
Receivables ($290 800 – 150 000)
Cost of Scheme
Retained Loss
Land and Buildings ($500 000 – 415 300)
Allow for
Eliminate
Write up
Net Reduction
$
55 000
150 000
161 000
140 800
60 000
225 000
(84 700)
707 100
Step 2 Determine what interested parties might expect to get from liquidation if that
route is taken:
$
Realizable
From sale of land and buildings
500 000
From sale of plant and machinery (60% x 100 000)
60 000
From sale of inventory (80% x 225 000)
180 000
From receivables (75% x 150 000)
112 500
From sale of investments
152 100
1 004 600
Payable
20% Debentures
338 900
6
33 890
Debenture Interest (20% x 338 900 x /12)
ICSAZ - P.M. PARADZA
352
Bank Overdraft
Preference Creditors
Other Payables ($550 000 – 33 890 – 50 000)
275 000
50 000
460 110
1 157 900
There is $1 004 600 to pay $1 157 900 to unsecured creditors, that is, $87 cents in the dollar.
The parties would therefore receive less if the company is liquidated.
Step 3 Determine cash resources needed if the scheme to save the company from
liquidation is pursued:
To pay overdraft
To undertake reconstruction
To modify existing plant
To purchase inventory for new lines
To pay preferential creditors
To pay debenture interest
From sale of investments
$
175 000
60 000
110 000
80 000
50 000
33 890
508 890
(152 100)
356 790
Step 4 Suggest a possible reconstruction scheme:
$
Net reduction per step 1
707 100
Preference dividend written off
(140 800)
550 000 existing ordinary shares of $1 to be converted to 20c each
(440 000)
to be converted to 42.59c each
220 000 existing cumulative preference shares of $1
(126 300)
+ a rights issue of 4 for every 1 existing ordinary share, 2 200 000 ordinary shares at new par
value of 20 cents in order to meet required cash resources and contingencies.
$440 000
Step 5 Table the proposed reconstruction scheme as above and you may support it with
a forecast I/S as below:
$
Anticipated annual operating profit
390 000
Interest on bank loan (15% x $100 000)
(15 000)
Interest on debentures (20% x $338 900)
(67 780)
Profit before tax
307 220
Tax expense (30%)
(92 166)
Profit after tax
215 054
Preference dividend (16% x $93 700)
(14 992)
Ordinary earnings
200 062
EPS ($200 062/2 750 000shares)
ICSAZ - P.M. PARADZA
7 cents
353
B Ltd
Statement of financial position as at 31 December 20.0
(on implementing scheme)
ASSETS
Non-Current Assets
Land & Buildings
Plant and Machinery ($100 000 + 110 000)
$
500 000
210 000
Current Assets
Inventory ($225 000 + 80 000)
Receivables
Cash at bank ($440 000 – 356 790) or (152 100+440 000 – 508 890)
Total Assets
EQUITY & LIABILITIES
Share Capital & Reserves
Ordinary Share Capital, 2 750 000 shares at 20 cents each
or ($110 000 + 440 000)
Cumulative Preference Share Capital, 220 000 shares at 42.59c each
Non-Current Liabilities
15% 5 Year Bank Loan
20% Debentures
305 000
150 000
83 210
1 248 210
$
550 000
93 700
100 000
338 900
Current Liabilities
Payables (249 500 – 50 000 – 33 890)
Total Equity & Liabilities
165 610
1 248 210
15.5 SUMMARY
This Unit deals with the accounting requirements for capital reorganizations. Increases of
equity and non-equity capital are explained in intermediate Accounting courses. In this Unit
the focus is on reconstructing schemes which involve a reduction of capital, using guidelines
given in the Companies Act. The redemption of shares and debentures is a special case of
capital reconstruction
15.6 REFERENCES
Denmark Training Services
Financial Accounting 3 –
Volume 2, ICSAZ Study Pack
2009
GEE, P.
Spicer & Pegler`s Bookkeeping
and Accounts
ELBS/Butterworths, 19 Edition,
1985
Rapid Results College, 2006
ICSAZ - P.M. PARADZA
354
UNIT SIXTEEN
ADVANCED INTERPRETATION OF FINANCIAL STATEMENTS
16.0 INTRODUCTION
According to IAS 1, the objective of general purpose financial statements is to provide
information about the financial position, financial performance and cash flows of an entity that
is useful to a wide range of users in making economic decisions. These statements also show
the extent to which the company i.e. the reporting entity's management has been able to use
available resources in order to meet profitability targets and increase value for shareholders
and other investors. A key requirement for understanding these statements is that users must
have a working knowledge of business accounting, or else they will need to rely on financial
advisors to interpret the statements for them. In earlier accounting courses, ratio analysis was
presented as a fairly simple and effective way of getting an insight into the operating
performance and other aspects of a company. Although this is true in a broad sense, it is
important to recall the weaknesses of ratio analysis and put it in its proper context. For example,
static ratio analysis is limited because it shows only part of the company's overall situation. If
a ratio based on performance or financial position is calculated on a particular day and found
acceptable, this will be no indication that the same position applied at the end of the previous
period. The use of estimates, provisions and alternative accounting bases in the preparation of
financial statements means that the company's management may deliberately seek to mislead
investors and other users on various aspects of its performance, cash flows or financial position.
It is therefore, in the interest of these stakeholders that they study financial statements diligently
in order to maximize value for money from their investments.
16.1 OBJECTIVES
By the end of this Unit, you should be able to:
•
Explain the meaning and significance of financial statements
•
Distinguish between general purpose financial statements and those prepared for
specific needs
•
Use different methods of interpreting financial statements
•
Compare and contrast conventional ratio analysis to more modern ratio-based
methods of assessing the performance and financial position of companies
16.2 USES OF RATIO ANALYSIS
As indicated above, ratio analysis is a useful starting point for summarizing and understanding
the operating performance, financial position and cash flows of a company. The specific uses
of ratio analysis are as follows:
a) To summarise masses of data
A ratio is a figure which captures the relationship between 2 figures in the same set of financial
statements. These figures may both be from the statement of comprehensive income or the
statement of financial position or be from different statements. Ratios based on the statement
ICSAZ - P.M. PARADZA
355
of cash flows would normally not combine information from the other statements. Regardless
of the basis of calculation, ratios represent a considerable simplification of the information
found in financial statements. Such simplification can be very useful to a prospective investor
who wants to identify a company or companies for further consideration.
b) To establish trends
Trend or horizontal analysis involves the use of ratios to ascertain the general direction of a
company's key performance indicators. Such analysis will show whether the performance has
been improving or deteriorating over the past few years. Periods of static performance will also
be highlighted. Although historical information should be used with great caution, such
analysis gives an investor or financial analyst an initial indication of whether he should pursue
the investment or not. A useful pointer in trend analysis is the relationship of the calculated
ratios to industry averages. These averages are often used as bench-marks on the understanding
that companies operating in the same industry generally face similar conditions. Research by
B. Lev (1969) showed that companies' financial ratios tend to move towards industry ratios
overtime. The usefulness of inter-firm comparison schemes based on industry averages can be
enhanced if the following points are noted
i. The company should only be compared with companies of similar size in terms of assets and
turnover
ii. The company should be compared with other companies in the same market segment e.g.
capital goods, consumer goods (FMCG)
iii. The use of different accounting policies should be taken into account to make companies
results comparable. These policies normally involve the calculation of depreciation on noncurrent assets, the valuation of stock and provisions for bad debts or deferred tax.
iv. Different companies may not have the same financial year-ends. Some companies may
publish interim financial statements while others do not.
v. Companies may use different ways of obtaining non-current assets e.g. outright purchase,
leasing or lease-back. The return on capital employed (ROCE) for such companies may differ
markedly.
A variation of inter-firm comparison schemes involves inter-divisional comparisons for
companies which are organized on the basis of operating divisions or strategic business units.
Such comparisons are made difficult by the fact that the divisions may be of different sizes,
which affects the level of capital employed. In addition, it is not easy to identify and control
factors which are not under the exclusive control of divisional managers. A realistic ROCE can
only be calculated if the following issues are adequately addressed:
i.
What constitutes capital employed? This may be measured as shareholders equity,
shareholders equity plus total liabilities or total assets.
ii.
How are the assets which make up the capital base valued? The denominator of the
ratio may be total assets or net assets.
iii.
How is the profit determined? The numerator of the ratio may be calculated before
or after tax.
ICSAZ - P.M. PARADZA
356
c) To assist in formulating decision models
Despite their perceived weaknesses, ratios are often used as the basis for formulating decision
models in conjunction with time series and other statistical techniques. Applications of this use
of ratios include share valuation, decision models for mergers and acquisitions, bond rating and
the prediction of corporate failure. Although sophisticated quantitative models are often
associated with higher confidence levels in decision making, they do not always result in better
decisions than parsimonious models.
d) To standardize for size
A very important use of ratios is to ensure comparability between companies of different sizes.
Without such standardization, it would not be clear to what extent a big company which makes
a net profit after tax of $3.5 billion has performed better than a smaller company which has
posted similarly calculated profit of $1.2 billion for the same period. Standardization is usually
achieved through the use of common-size statements, in which related financial statement items
are expressed as a percentage of one figure. Sales are normally used as the basis for calculation
in the statement of comprehensive income while total assets are used in the statement of
financial position.
REVISION ACTIVITY
The financial statements of M Ltd for a certain period together with comparative figures were
as follows:
Income statements for year-ended 30 September
20-5
$
$
$
Sales (all on credit)
11 200 000
Cost of goods sold
Opening stock
875 000
1 575 000
Purchases (all on credit)
7 966 000
11 991 000
8 841 000
13 566 000
Less Closing stock
(1 575 000)
(7 266 000)
(2 420 000)
Gross profit
3 934 000
Less
Administration expenses
567 000
1 130 000
Distribution expenses
1 210 000
2 355 000
Debenture interest
expenses
700 000
(2 477 000)
1 000 000
Profit before tax
1 457 000
Taxation
( 473 525)
Net profit after tax
983 475
Share price (year-end)
$9.83
ICSAZ - P.M. PARADZA
20-6
$
17 500 000
(11 146 000)
6 354 000
(4 485 000)
1 869 000
( 607 425)
1 261 575
$12.62
357
Statements of changes in equity (Extract)
Retained Profits
20-5
20-6
$
$
Balance b/d
345 700
379 175
Net Profit for the year
983 475
1 261 575
1 329 175
1 640 750
Dividends Paid
Preference
(750 000)
(750 000)
Ordinary
(200 000)
(300 000)
Balance c/d
379 175
590 750
Statement of financial position as at 30 September
ASSETS
Tangible Non-current assets
Land & buildings
Plant & machinery
Motor vehicles
Current assets
Inventory
Acc. receivables
Cash at bank
EQUITY & LIABILITIES
Ordinary shares (100 each)
Preference shares ($100 each)
General reserve
Retained profits
20% Debentures
Current liabilities
Acc. payables
Taxation
2 246 750
473 525
20-5
$
20-6
$
7 650 000
3 920 000
2 800 000
14 370 000
7 650 000
7 840 000
3 500 000
18 990 000
1 575 000
5 185 300
3 819 150
10 579 450
24 949 450
2 420 000
3 510 013
1 848 837
7 778 850
26 768 850
10 000 000
7 500 000
850 000
379 175
3 500 000
10 000 000
7 500 000
2 253 250
590 750
5 000 000
817 425
2 720 275 607 425
24 949 450
1 424 850
26 768 850
Note: The 20% debentures are secured over land and buildings.
REQUIRED
a) Undertake a comprehensive ratio analysis for M Ltd in respect of the 2 years, based on the
following categories
i. Profitability
ii. Liquidity
iii. Activity
iv. Gearing
v. Investment
ICSAZ - P.M. PARADZA
358
Show the results in tabular format and round off calculations to 2 decimal places. Comment
briefly on the changes in the ratios between the 2 years.
b) M Ltd invested an additional $2 000 000 in plant and machinery in order to modernize its
operations for more efficient production.
i. What was the major source of funds for this investment?
ii. With the use of relevant ratios and any other given information, state the risks
faced by the company as a result of this method of financing.
iii. What other method of financing could the company have used to raise the
funds required?
c) The financial manager of M Ltd. has indicated that the company needs additional short-term
financing, and has suggested applying for an overdraft facility with a local bank. Basing your
analysis on relevant ratios, state the reasons why the bank may or may not grant the facility.
[HEXCO-FIN. ACC 3 APRIL 2003(Adapted)]
16.4 Common Size Statements
A common size statement is one in which the individual items are expressed as a percentage
of one figure. The purpose of such a statement is to ensure greater comparability of figures in
the context of vertical or trend analysis. The statement reduces the components of financial
statements to a common basis by adjusting for key aspects like size and turnover when the
operating performance, financial position or cash flows of many companies are being
compared.
EXAMPLE - VERTICAL ANALYSIS
The financial statements of N Ltd. for a 3 year period were as follows:
Income statement for the Y/E 31 December
Sales
Cost of goods sold
Gross profit
Trading Expenses
Administrative expenses
Selling & distribution expenses
Interest expense
Net profit before tax
Company tax
Net profit after tax
Retained earnings b/d
Proposed ordinary dividend
Proposed preference dividend
Retained earnings c/d
ICSAZ - P.M. PARADZA
20-4
20-5
4 575 000
6 932 250
(1 891 000) (2 552 850)
2 684 000
4 379 400
20-6
9 472 500
(3 416 000)
6 056 500
(747 500)
( 516 670)
( 500 000)
919 830
(367 932)
551 898
423 600
975 498
(225 000)
(200 000)
550 498
(1 433 500)
( 663 680)
(1 250 000)
2 709 320
(1 083 728)
1 625 592
1 168 079
2 793 671
( 450 000)
( 200 000)
2 143 671
(951 600)
( 565 165)
(875 000)
1 987 635
( 795 054)
1 192 581
550 498
1 743 079
( 375 000)
( 200 000)
1 168 079
359
Statement of financial position as at 31 December
ASSETS
Tangible Non-current Assets
Land & buildings
Plant & equipment
Motor vehicles
Current Assets
Inventory
Receivables
Bills receivable
Cash at bank
EQUITY & LIABILITIES
Ordinary share capital
Share premium account
10% preference share capital
Retained profits
25% Debentures
Current Liabilities
Payables
Bills payable
Proposed ordinary dividends
Proposed preference dividends
20-4
$
20-5
$
20-6
$
2 623 000
1 762 900
1 372 400
5 758 300
4 160 000
2 604 500
2 293 800
9 058 300
5 361 500
3 995 640
2 455 072
11 812 212
798 490
673 135
366 000
638 975
8 234 900
1 151 600
1 038 750
546 931
869 250
12 664 831
1 406 480
1 320 000
610 000
928 700
16 077 392
1 500 000
2 000 000
550 498
4 050 498
2 000 000
2 500 000
625 000
2 000 000
1 168 079
6 293 079
3 500 000
3 000 000
750 000
2 000 000
2 143 671
7 893 671
5 000 000
559 402
1 200 000
225 000
200 000
8 234 900
796 752
1 500 000
375 000
200 000
12 664 831
733 721
1 800 000
450 000
200 000
16 077 392
REQUIRED
Draw up common size financial statements for the 3 years based
a) Sales for the income statements
b) Total assets and total liabilities for the statements of financial position
c) Cash received from customers for the statements of cash flows
N.B. The income statements and the statements of changes in equity are combined for
the purposes of this Unit.
ICSAZ - P.M. PARADZA
360
SUGGESTED SOLUTION
a) Common size income statements for years-ended 31 December
Sales
Cost of goods sold
Gross profit
Administrative expenses
Selling & distribution expenses
Interest expenses
Net profit before tax
Company tax
Net profit after tax
20-4
%
100.00
41.34
58.66
(16.34)
(11.29)
(10.93)
20.10
(8.00)
12.10
20-5
%
100.00
36.83
63.17
(13.73)
(8.15)
(12.62)
28.67
11.47
17.20
20-6
%
100.00
36.07
63.93
(15.13)
(7.01)
(13.20)
28.59
11.49
17.10
b) Common size statements of financial position as at 31 December
ASSETS
Tangible Non-current assets
Land & buildings
Plant & equipment
Motor vehicles
Current assets
Inventory
Receivables
Bills receivable
Cash at bank
EQUITY & LIABILITIES
Ordinary share capital
Share premium account
10% Preference share capital
Retained profits
25% Debentures
Current liabilities
Payables
Bills payable
Proposed ordinary dividends
Proposed preference dividends
ICSAZ - P.M. PARADZA
20-4
%
20-5
%
20-6
%
31.86
21.41
16.67
69.94
32.85
20.57
18.12
71.54
33.35
24.86
15.27
73.48
9.70
8.18
4.45
7.76
100.00
9.10
8.21
4.31
6.87
100.00
8.75
8.21
3.80
5.78
100.00
18.22
24.29
6.69
49.20
24.29
19.74
4.94
15.80
10.56
51.04
27.64
18.66
4.67
12.44
13.72
49.49
31.10
6.80
14.58
2.74
2.43
100.00
4.97
11.85
2.96
1.58
100.00
4.18
11.20
2.80
1.25
100.00
361
c) Statement of cash flows for year-ended 31 December (Direct Method)
Operating activities
Cash received from customers
Cash paid to suppliers
Cash paid for operating expenses
(admin expenses + S&D expenses)
Company tax paid
Debenture interest paid
Investing activities
Purchase of land & buildings
Purchase of plant & equipment
Purchase of motor vehicles
Financing activities
Issue of ordinary shares-nominal value
Issue of ordinary shares-share premium
Issue of debentures
Payment of ordinary dividends
Payment of preference dividends
Net increase in cash & cash equivalents
Cash & cash equivalents at the beginning
Cash & cash equivalents at the end
20-5
$
6 385 704
(2 368 610)
(1 516 765)
20-6
$
9 128 181
(3 433 911)
(2 097 180)
2 500 329
( 795 054)
( 875 000)
830 275
3 957 090
(1 083 728)
(1 250 000)
1 263 362
(1 537 000)
( 841 600)
( 921 400)
(2 469 725)
(1 201 500)
(1 391 140)
( 161 272)
(1 490 550)
1 000 000
625 000
1 500 000
( 225 000)
( 200 000)
230 275
638 975
869 250
500 000
125 000
1 500 000
( 375 000)
( 200 000)
59 450
869 250
928 700
Common size statement of cash flows for the year- ended 31 December
Cash received from customers
Cash paid to suppliers
Cash paid for operating expenses
Company tax paid
Debenture tax paid
Purchase of land & buildings
Purchase of plant & equipment
Purchase of motor vehicles
Issue of ordinary shares (incl. premium)
Issue of debentures
Payment of ordinary dividends
Payment of preference dividends
Net increase in cash & cash equivalents
ICSAZ - P.M. PARADZA
20-05
100%
(37.10)
(23.76)
(12.45)
(13.71)
(24.07)
(13.18)
(14.43)
25.45
23.49
(3.53)
(3.14)
3.61
20-6
100%
(37.62)
(22.98)
(11.88)
(13.70)
(13.17)
(15.24)
(1.77)
6.8
16.44
(4.11)
(2.20)
0.57
362
ACTIVITY
The financial statements of V Ltd. for a 3-year period were as follows:
Income statements for years-ended 31 March
Sales
Costs of goods sold
Trading Expenses
Administrative expenses
Selling & distribution expenses
Interest expenses
Net profit before tax
Company tax
Net profit after tax
Retained profits b/d
Proposed ordinary dividend
Proposed preference dividend
Retained profits c/d
20-7
$
4 306 250
(1 725 000)
2 581 250
20-8
$
5 625 000
(2 325 000)
3 300 000
20-9
$
6 727 500
(3 000 000)
3 727 500
(642 000)
(450 000)
(250 000)
1 239 250
(395 700)
843 550
2 656 450
3 500 000
(1 000 000)
( 450 000)
2 050 000
(770 000)
(611 750)
(250 000)
1 668 250
(567 300)
1 100 950
2 050 000
3 150 950
(1 000 000)
( 450 000)
1 700 950
(1 200 000)
( 550 000)
( 250 000)
1 727 500
( 591 000)
1 136 500
1 700 950
2 837 450
(1 000 000)
( 450 000)
1 387 450
Statement of financial position as at 31 March
ASSETS
Tangible Non-current assets
Freehold premises
Plant & equipment
Furniture & fittings
Motor vehicles
Other Non-current assets
Patents & trademarks
Current assets
Inventory
Receivables
Prepaid admin. Expenses
Cash at bank
EQUITY & LIABILITES
Ordinary share capital
30% Preference share capital
Retained profits
25% Debentures
ICSAZ - P.M. PARADZA
$
$
$
3 325 000
2 275 000
1 995 000
1 690 000
3 550 000
2 500 000
2 290 000
2 000 000
4 425 000
3 124 255
2 290 000
2 000 000
1 750 000
1 750 000
690 750
826 000
243 000
409 500
13 204 250
400 000
554 050
329 400
460 000
13 833 450
612 215
688 370
294 830
532 780
13 967 450
6 000 000
1 500 000
2 050 000
9 550 000
1 000 000
7 500 000
1 500 000
1 700 950
10 700 950
1 000 000
7 500 000
1 500 000
1 387 450
10 387 450
1 000 000
363
Current liabilities
Payables
Accrued S&D expenses
Proposed ordinary dividends
Proposed preference dividends
672 600
531 650
1 000 000
450 000
13 204 250
525 000
157 500
1 000 000
450 000
13 833 450
750 000
380 000
1 000 000
450 000
13 967 450
REQUIRED
Draw up common size financial statements for the 3 years based on:
a) Sales for the income statements
b) Total assets and total equity liabilities for the balance sheets
c) Cash received from customers for the statements of cash-flows (years-ended 31 March 208 and 20-9 only)
16.5 RELATIONSHIPS AMONG RATIOS
A ratio has been described as a shorthand notation for the relationship between two or more
things, specifically accounting items in the context of financial analysis. However, behind this
simplification lies a lot of analytical power which can be exploited by management, investors
and others if the relationship is properly understood. You will recall from earlier studies that
there are some items which affect the preparation of both the statement of comprehensive
income and the statement of financial position, e.g closing inventory, prepayments and
accruals. In addition, the net profit or retained profits figure is another important link between
the two statements. When a cash flow statement is prepared on the indirect method, adjustments
have to be made to ensure a proper reconciliation between opening and closing cash and cash
equivalents. These observations suggest that a lot of useful information can be obtained if some
of the ratios can be broken down into their component parts. For example, the overall
profitability of a company for a given period will be affected by the relationship between net
profit and sales, as well as the asset turnover rate, which indicates the level of capacity
utilization.
ICSAZ - P.M. PARADZA
364
The relationships among ratios can be presented in the form of a pyramid as follows:
ICSAZ - P.M. PARADZA
365
PYRAMID OF RATIOS
ROCE-
Profit
Capital Employed/ Assets
Profit
Sales
Gross profit
Sales
Sales
Capital employed/ Assets
Net Profit
Sales
Sales
Non-current Assets
Sales
Net Assets
Materials Labour Overheads
Sales
Sales
Sales
Selling Costs Admin
Sales
Sales
Sales
Expenses
Stock
Trade receivables
Sales
Source: Adapted from Spicer & Pegler’s Book Keeping & Accounts (19th Edition) p419
An alternative classification of ratios was provided by E.L. Du Pont De Nemours in the
U.S.A. The relationships among the ratios are as follows:
DU PONT ANALYSIS
Basic Ratios
Marketing
Efficiency
Production
Efficiency
Profit
Sales
Capital Leverage
x
Funds
Efficiency
Growth in Equity
x
Return on
Capital
Profit
Capital
x
Return on
Equity
Profit
Equity
Sales
Assets
=
Leverage on
Capital
Profit
Assets
Leverage on Equity
Funds
Efficiency
x
Assets
Capital
=
Profit
Assets
Return on Capital
(Capital Efficiency
Profit
Capital
Leverage on
Equity
Return on
Equity
Capital
Equity
Profit
Equity
=
Retention
Rate
Growth in
Equity
Profit-Dividends =
Profit
Retained Earning
Equity
Source: Financial Management by Philippatoes & Shihler p19
ICSAZ - P.M. PARADZA
366
16.6. THE PREDICTION OF COMPANY FAILURE
In Accounting and Finance, the term 'failure' may refer to an actual or impending condition e.g.
inability to meet financial obligations or a looming technical insolvency i.e. a situation where
a company's capital and liabilities exceed its assets. Other situations which indicate failure are
voluntary or compulsory liquidation, or even lack of funds to take advantage of profitable
business opportunities. Many studies on corporate failure have focused on the identification of
characteristics shared by companies which have failed in the past. One of the best-known
approaches involves multivariate analysis of several ratios which are thought to have a bearing
on a company's prospects for failure. The analyst uses a combination of the calculated ratios to
produce a weighted figure which is interpreted as signifying failure or non-failure.
16.6.1 The Use of Z-scores
In his article "Financial ratios, discriminant analysis and the prediction of corporate
bankruptcy" (1968), E.I. Altman based his analysis on a sample of 33 failed and 33 non-failed
companies (the control group). He used multiple discriminant analysis to identify five financial
ratios which he modelled into a Z-score, in an attempt to capture the major differences between
failed and non-failed companies.
This score is calculated as follows:
Z=0.012 X1+0.014 X2 +0.033 X3+0.06 X4+0.01 X5
Where X1
= Working capital/Total assets
X2
= Retained earnings/Total assets
X3
= Profit before interest & tax/Total assets
X4
= Market capitalization/Book value of debts
X5
= Sales/Total assets
The terms used in the equation are defined as follows:
Working capital
= current assets less current liabilities
Total assets
= non-current assets plus investments plus current assets
Retained earnings
= all accumulated reserves
Market capitalization = number of shares issued x share price (or book value of equity,
reserves and preference shares if the company is not quoted)
Book value of debt
= all debt i.e. short-term, medium-term and long-term
Interpretation: If the Z-score is 3.0 and above the company is considered safe. Companies
whose score is below 1.8 are considered to be in danger. Research based on this formula has
shown that the accuracy of results depends on the nearness of the data to the predicted failure.
A major advantage of this analysis is that the information can alert management and other
stakeholders to the need to take action that can avert the potential failure. However, attempts
to apply the method to all types of companies are likely to lead to distorted conclusions.
ICSAZ - P.M. PARADZA
367
An alternative Z-score was provided by R. J. Taffler (1977). His score for manufacturing
companies is as follows;
i) Profitability measure
=
Profit before tax (53%)
Current liabilities
ii) Working capital measure
=
Current assets (13%)
Current liabilities
iii) Financial risk measure
=
Current liabilities (18%)
Total assets
iv) Liquidity measure = No credit interval (NCI) i.e. the number of days that a company
can continue to finance its operations with its own resources if it can no longer
generate revenue (16%)
Interpretation: If the Z -score is negative the company is considered to be at risk. The
percentages in brackets indicate the relative weighting of the model's components.
ACTIVITY – Z SCORES
Discuss the prediction of company failure based on the following:
a) Limitations of conventional ratio analysis
b) The use of Z-scores
16.7 SUMMARY
The purpose of this Unit is to build on the basic ratio analysis and interpretation of financial
statements which were explained in earlier studies. It is clear that ratios are a good starting
point for any user of financial statements who would like to gain a closer understanding of a
company's operating results and financial position. The techniques of failure prediction which
are discussed in the Unit can be used by management and other stakeholders to take action
before disaster strikes.
16.8 REFERENCES
FINANCIAL TRAINING SERVICES LTD
Advanced Financial Accounting CIMA
Study Pack 1990
LEWIS, R & PENDRILL. D.
Advanced Financial Accounting (2nd
Edition) ELBSI Pitman 1985
PARADZA P.M.
Financial Accounting 3 IAC Study Pack
2010
ICSAZ - P.M. PARADZA
368
UNIT SEVENTEEN
EARNINGS PER SHARE
17.0 INTRODUCTION
The quality of earnings has occupied the minds of researchers in Accounting and Finance for
hundreds of years. There has been a lot of controversy over what the annual earnings figure or
'net profit after tax' figure really represents. Supporters of traditional accounting believe that
this discipline is the only meaningful way of determining an entity's trading results over a
particular period, and its financial position at the end of that period. On the other hand, critics
mostly from the side of Corporate Finance, think that they have used superior analytical
techniques to prove the myth on which accounting figures are based. These critics premise their
arguments on the multiplicity of estimates, provisions and pure guesswork which form an
important part of professional accountants' work.
Despite the polarized views, there is no doubt that the earnings figure is a very important point
of departure in analysing an entity's financial statements. Given that the preparation and
verification of such statements is the bread and butter of mainstream accountants, it is
instructive to note that financial analysts who use the fundamental approach mostly focus on
the prediction of key performance indicators like earnings per share, price-earnings ratio and
dividend yield. In real life it is almost impossible to think about the dividend payout ratio,
without reference to the earnings which have made the dividends possible.
Although the weaknesses in the measurement of earnings are acknowledged, this concept
continues to play a pivotal role in the minds of investors when they decide to increase, decrease
or maintain their holdings in particular counters. The purpose of this Unit is to enable you to
gain a greater understanding of this important concept.
17.1 OBJECTIVES
By the end of this Unit, you should be able to:
•
•
•
Define and explain the importance of earnings per share
Distinguish between issued ordinary shares and potential ordinary shares, and explain
their impact on the calculation of earnings per share found in IAS 33
Implement the guidelines for calculating earnings per share found in IAS 33
17.2 DEFINITION OF EARNINGS PER SHARE
According to IAS 33, an entity should calculate basic earnings per share for profit or loss
attributable to ordinary equity holders of the parent entity (if applicable), as well as the profit
or loss from continuing operations attributable to those equity holders. In the IAS 33 definition,
basic earnings per share is calculated by dividing profit or loss attributable to ordinary equity
holders of the parent entity ( the numerator) by the weighted average number of ordinary shares
outstanding the (denominator) during the period.
ICSAZ - P.M. PARADZA
369
17.3 THE MEANING OF EARNINGS PER SHARE
The main aim of earnings per share figures is to show the earnings power of a company in
relation to the number of shares which are entitled to dividends out of those earnings. Taxes
and preference dividends are important commitments which normally have to be met out of
those profits attributable to equity shareholders. According to IAS 33, the after-tax amount of
preference dividends that is deducted in the statement of changes in equity consists of:
a) the after-tax amount of any preference dividends on non-cumulative preference shares
declared in respect of the period
b) the after-tax amount of the preference dividends for cumulative preference shares
required for the period, whether or not dividends have been declared.
N.B. that earnings per share figures do not include any amounts for previous periods.
The measurement of earnings per share puts a lot of emphasis on the number of shares whose
holders are entitled to periodic earnings. The term weighted average number of shares in the
IAS 33 definition is a reference to the fact that different numbers of shares may be in issue
throughout a period. This weighted average takes into account the number of shares
outstanding at the beginning of the period, adjusted by the number of shares bought back or
issued during the period multiplied by a time-weighted factor. This factor is the number of days
that the shares are outstanding as a proportion of the total number of days in the period.
Shares are included in the denominator of the earnings per share formula with effect from the
date that cash or other consideration is due, which is normally the date of issue.
Examples of such circumstances are as follows:
(i) Ordinary shares issued in exchange for cash are included when cash is receivable
(i) Ordinary shares issued on the voluntary reinvestment of dividends (resulting in noncash dividends) are included when the dividends are reinvested
(ii) Ordinary shares issued as a result of the conversion of a debt instrument to equity are
included from the date that the interest ceases to accrue
(iii) Ordinary shares issued in lieu of principal or interest on other financial instruments
are included from the date that interest ceases to accrue
(iv) Ordinary shares issued in exchange for the settlement of a liability are included from
the settlement date
(v) Ordinary shares issued as consideration for the acquisition of an asset other than cash
are included from the date on which the acquisition is organized
(vi) Ordinary shares issued for the rendering of services to the entity are included as the
services are rendered
The denominator in the earnings per share formula is affected by events which increase or
decrease the ordinary shares outstanding without a corresponding change in resources.
Examples of such changes are:
(a) a capitalization or bonus issue (stock dividend)
(b) a bonus element in a rights issue to existing shareholders
(c) a share split, which involves the division of existing shares into smaller denominations
ICSAZ - P.M. PARADZA
370
(d) a reverse share split, which involves a consolidation of existing shares into bigger
denominations
17.4 THE DILUTION OF EARNINGS
Earnings are said to be diluted when they have to be shared among shareholders holding a
greater number of shares without a corresponding increase in resources. IAS 33 defines dilution
as ‘a reduction in earnings per share or an increase in loss per share resulting from the
assumption that convertible instruments are converted, that options or warrants are exercised,
or that ordinary shares are issued upon the satisfaction of specified conditions.’
If such share increases result in higher earnings per share or lower loss per share figures, antidilution will have occurred.
The purpose of diluted earnings per share is to indicate the profit attributed to each ordinary
share in a company after taking into account all dilutive potential ordinary shares outstanding
during the period.
The key measurement aspects related to dilution of earnings are as follows:
(i) The profit or loss attributed to ordinary shareholders is increased by the after-tax
amount of dividends and interest recognized in respect of the dilutive potential ordinary
shares; this profit or loss should be adjusted for any other changes in income or expense
that would result from the conversion of the dilutive potential ordinary shares;
(ii) The weighted average number of ordinary shares outstanding is increased by the
weighted average number of additional ordinary shares that would have been
outstanding if all dilutive potential ordinary shares were converted.
When calculating diluted earnings per share, dilutive potential ordinary shares are deemed to
have been converted into ordinary shares at the beginning of the relevant period, or if later, the
actual date of issue of the potential ordinary shares.
ACTIVITY 17.1
a) Distinguish between basic and diluted earnings per share
b) Give examples of specific circumstances that would affect the calculation of basic earnings
per share.
17.5 CALCULATION OF EARNINGS PER SHARE
The calculation of earnings per share is straight-forward where the company has a simple
capital structure (that is, 1 or 2 classes of shares ranking for dividends) and the number of
shares did not change during the period under review. The following example based on IAS 33
will be used to illustrate the computations under different circumstances.
ICSAZ - P.M. PARADZA
371
1. Simple capital structure
Issued share capital
100 000 ordinary shares of $10 each, fully paid
60 000 15% non-cumulative preference shares of $10 each, fully paid
Profit after tax
$
1 000 000
600 000
Trading results for the year-ended 31 December
20-4
20-3
$
$
882 000
750 000
There was no change in the company's issued capital for the 2 years.
REQUIRED
Show the calculation and presentation of EPS figures for the year-ended 31 December 20-4
with comparative figures for the previous year.
SUGGESTED SOLUTION
Calculation of EPS
Profit after tax
Less: Preference dividend
Attributable earnings
No. of ordinary shares
20-4
$
882 000
(90 000)
792 000
100 000
20-3
$
750 000
(90 000)
660 000
100 000
Presentation on SCI (as an additional statistic)
Earnings per ordinary share of $10
20-4
7.92
792c
20-5
$6.60
660c
Extract notes to the financial statements
5. The calculation of earnings per share is based on earnings of $792 000 (20-3 $660 000)
and 100 000 ordinary shares in issue throughout the 2 years-ended 31 December 20-4.
2. Issue for cash at full market or for other full consideration during the year
Issued share capital up to 30 June 20-4
100 000 ordinary shares of $10 each, fully paid
60 000 15% preference shares of $10 each, fully paid
$
1 000 000
600 000
On 1 July 20-5 the company issued 50 000 ordinary shares of $10 each for cash at par.
ICSAZ - P.M. PARADZA
372
Profit after tax
Trading results for the year-ended 31 December
20-5
20-4
$
$
1 430 000
1 125 000
Calculation of EPS
Profit after tax
Less preference dividend
Attributable earnings
Weighted average number of ordinary shares:
1 January
Issued 1 July 20-4: 50 000 x ½
1 430 000
(90 000)
1 340 000
1 125 000
(90 000)
1 035 000
100 000
25 000
125 000
100 000
Nil
100 000
Presentation on SCI for the year ended 31 December (additional statistic)
Earnings per share of $10
20-5
$
10.72
107c
20-4
$
10.35
104c
Extract notes to the financial statements
5. The calculation of earnings per share is based on earnings of $1340 000 (20-4: $1035 000)
and on the weighted average of 125 000 ordinary shares in issue during the year (20-4: 100
000 shares)
3. Bonus (capitalisation or scrip) issue during the year
Issued share capital up to 31 March 20-6
$150 000 ordinary shares of $10 each, fully paid
100 000 20% preference shares of $10 each, fully paid
1 500 000
1 000 000
On 1 April 20-6, the company made a bonus issue to ordinary shareholders on the basis of 1
share for every 4 shares held.
Trading results for the year ended 31 December
Profit after tax
ICSAZ - P.M. PARADZA
20-6
$
2 240 000
20-5
$
1 760 000
373
Calculation of EPS for the year ended 31 December
Profit after tax
Less: Preference dividend
Attributable earnings
No. of ordinary shares 1 January
Bonus issue 1 April 20-6
No. of shares ranking for dividend
20-6
$
2 240 000
(200 000)
2 040 000
150 000
37 500
187 500
20-5
$
1 760 000
(200 000)
1 560 000
150 000
37 500
187 500
Presentation on SCI for the year-ended 31 December (additional statistics)
Earnings per ordinary share of $10
20-6
$
10.88
20-5
$
8.32
Extract notes to the financial statements
5. The calculation of earnings per share is based on earnings of $ 2 040 000 (20-5: $1 560 000)
and 187 500 ordinary shares in issue after the bonus issue on 1 April 20-6. The earnings per
share for 20-5 have been adjusted accordingly.
Tutorial note:
Shares which are issued as a result of capitalising profits or reserves normally rank for dividend
after the issue unless they are specifically excluded by the directors.
4. Share exchange
Issued share capital up to 30 September 20-7
187 500 ordinary shares of $10 each, fully paid
100 000 20% preference shares of $10 each, fully paid
$
1 875 000
1 000 000
On 1 October 20-7 the company issued 50 000 ordinary shares and 30 000 20% preference
shares for a controlling share in another company.
Profit after tax
Trading results for the year-ended 31 December
20-7
20-6
$
$
3 135 000
2 500 000
N.B. The investor company included the whole of the investee company's profit for 20-7 in
the consolidated income statement on the basis that substantial agreement on the share
exchange had been reached by 1 January 20-7. The company will therefore calculate its EPS
ICSAZ - P.M. PARADZA
374
on the assumption that both the ordinary shares and the preference shares were issued on 1
January 20-7. The new preference shares qualified for dividend from the date of issue.
Calculation of EPS for the year-ended 31 December
Profit after tax
Less: Preference dividend
(1 000 000 + 3 00 000) x 20%
Attributable earnings
2-08
$
3 135 000
(260 000)
–
2 875 000
2-07
$
2 500 000
(200 000)
–
2 300 000
No. of ordinary shares for the year-ended 31 December
1 January
Issued 1 October but assumed to rank for
dividend the whole year
2-08
$
187 500
2-07
$
187 500
50 000
237 500
–
187 500
Presentation on SCI for the year-ended 31 December (additional statistic)
Earnings per ordinary share of $10
2-08
$
12.11
2-07
$
12.27
Extract notes to the financial statements
4. The calculation of earnings per share is based on earnings of $2 875 000 (20-6: $2 300 000),
after adjustment for a full year's dividend on the increased preference capital of 237 500 shares
(20- 6: 187 500 shares) on the basis that the additional 50 000 ordinary shares issued on 1
October 20-7 had been in issue for the whole of 20-7.
5) Rights issue at less than fair value
If a company raises capital by means of a rights issue and the issue price is less than the fair
value of the company’s shares when issued, a bonus element arises.
The formula for the calculation of the Rights factor used to deduce the bonus element of
shares in a rights issue is as shown below:
Fair Value per share immediately prior to the exercise of rights
Theoretical ex-rights fair value per share
The formula for the denominator, the theoretical ex-rights fair value per share is as shown
below;
Fair value of outstanding shares prior to exercise of the rights + Amount received from rights issue
Number of shares outstanding after the exercise of the rights
ICSAZ - P.M. PARADZA
375
ACTIVITY - BASIC EPS
The following is an extract from the statement of comprehensive income of W Ltd for the
year ended 31 December 20-5
Revenue
Cost of sales
Expenses
Profit before tax
Tax expense
Profit for the period
20-5
$
5 000 000
(3 000 000)
2 000 000
(800 000)
1 200 000
(360 000)
840 000
20-4
$
4 600 000
(2 000 000)
2 600 000
(1 100 000)
1 500 000
(600 000)
900 000
Extract from the statement of changes in equity for the year ended 31 December 20-5
Balance at 31 December 20-3
Profit for the year
Balance at 31 Dec 20-4
Profit for the year
Non-cumulative preference dividend
Ordinary dividend
Cumulative preference dividend
Balance at 31 Dec 20-5
Retained Profit
$
100 000
900 000
1 000 000
840 000
(20 000)
(60 000)
(40 000)
1 720 000
The Capital Structure on 31 December was as follows:
20-5
$
Ordinary shares of $1 each
900 000
10% Cumulative preference at $1 each
200 000
20% Non-cumulative preference shares at $1 each 100 000
20-4
$
600 000
200 000
100 000
Additional Information
1. On 30 April 19-5 W Ltd had a rights issue of 1 ordinary share for every 5 ordinary shares
held at $2 per share for cash. The market price prior to the announcement of the right issue was
$3.50 per share. Management considered that for the issue to be successful, they could have
issued the shares at $3.20, which was their fair value.
2. On 30 June 20-5 W Ltd had a capitalisation issue of 1 ordinary share for every 3 ordinary
shares held.
REQUIRED
Calculate and disclose basic EPS. Notes and comparative figures are required
ICSAZ - P.M. PARADZA
376
17.6 CONVERTIBLE SECURITIES
Where a company has securities which represent dilutive potential ordinary shares e.g.
convertible debentures and convertible preference shares, a diluted EPS figure should be
calculated in addition to the basic EPS. The number of ordinary shares issuable on the
conversion of dilutive potential ordinary shares depends on the original terms of these shares.
When there is more than one conversion basis, the calculation assumes the most advantageous
rate or exercise price from the view point of the holder of securities
In the diluted EPS calculation, the amount of net profit or loss for the period should be adjusted
for the after-tax effect of:
(i) any dividends on dilutive potential ordinary shares which have been deducted in
determining the attributable profit;
(ii) Interest recognized during the period in respect of the dilutive potential ordinary share;
(iii) Any other changes in income or expenses which would result from the conversion of
these shares
These adjustments should be effected because the dividends, income and interest associated
with the currently issued securities would fall away on conversion resulting in gains or losses
for the company. The tax effects of convertible potential ordinary shares should be specifically
taken into account.
EXAMPLE – BASIC & DILUTED EPS
Issued Share Capital to 30 September 20-8
250 000 ordinary shares of $20 each, fully paid
150 000 30% preference shares of $10 each, fully paid
$
5 000 000
1 500 000
On 1 October 20-8 the company issued 100 000 20% convertible debentures of $10 each at
par. Each $1 000 nominal stock of the debentures will be convertible into ordinary shares as
follows:
31/12/2-12
31/12/2-13
31/12/2-14
31/12/2-15
200 shares
180 shares
150 shares
120 shares
Trading results for the year-ended 31 December
Profit before interest and tax
Debenture interest (20-8:¼ of a year)
Profit before tax
Company tax at 35%
Profit after tax
ICSAZ - P.M. PARADZA
2-09
2-08
$
$
10 450 000
9 625 000
(200 000)
(50 000)
10 250 000
9 575 000
(3 587 500) (3 351 250)
6 662 500
6 223 750
377
Calculation of EPS for the year ended 31 December
i. Basic EPS
2-09
$
6 662 500
(450 000)
6 212 500
250 000
Profit after tax
Less Preference dividend
Attributable earnings
No. of ordinary shares
2-08
$
6 223 750
(450 000)
6 223 750
250 000
ii Diluted EPS
Attributable earnings as above
Add: Interest on convertible debentures
Less: Tax on the interest (35%)
Adjusted earnings
$
6 212 500
200 000
(70 000)
130 000
6 342 500
$
6 223 750
50 000
(17 500)
32 500
6 256 200
Up to 2-11 the maximum number of potential ordinary shares will be at the rate of 200 per $1
000 nominal value, that is, (1 000 000 ÷ 1 000) x 200 = 200 000 making a total of 450 000
shares.
The weighted average number of shares and issuable for 20-8 is:
250 000 x ¾ (to 30/09/20-8)
=
450 000 x ¼ (1/10/20-8 to 31/12/20-8)
=
Total weighted average no. of shares
187 500
112 500
300 000
Presentation on income statement for the year-ended 31 December (additional statistic)
Earnings per ordinary share of $20
Diluted earnings per ordinary share of $20
2-09
$
24.85
14.09
2-08
$
24.90
20.85
17.7 OPTIONS, WARRANTS AND THEIR EQUIVALENTS
IAS 33 states that options, warrants and similar instruments are dilutive when they would result
in the issue of ordinary shares for less than the average market price of ordinary shares during
the period. The amount of the dilution is the average market price of ordinary shares during the
period less the issue price. When calculating diluted earnings per share, these instruments are
split into two parts:
(a) A contract to issue a certain number of the ordinary shares at their average market price
during the period. Such ordinary shares are assumed to be fairly priced and are therefore
neither dilutive nor anti-dilutive. The shares are not taken into account in the
calculation.
(b) A contract to issue the remaining ordinary shares for no consideration, that is, a bonus
aspect. Such shares do not result in any proceeds, and have no effect on the profit or
loss attributable to outstanding ordinary shares. These shares are dilutive and should be
added to outstanding shares in the calculation.
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378
17.8 CONTINGENTLY ISSUABLE SHARES
Shares whose issue depends on the occurrence of specified but uncertain future events are
treated as outstanding and included in the calculation of diluted earnings per share when the
events have taken place. Such shares are included in the calculation from the date of the
contingent share agreement, if later.
If the issue conditions are not met, the number of contingently issuable shares to be included
in the diluted earnings per share calculation should be based on the number that would be
issuable if the end of the period coincided with the end of the contingent period.
17.9 CONTRACTS THAT MAY BE SETTLED IN ORDINARY SHARES OR CASH
A company may issue a contract that may be settled in ordinary shares or cash at its option. In
such a case the company should assume that the contract will be settled in ordinary shares, and
include the resulting potential ordinary shares in the calculation of diluted earnings per share
if they are dilutive.
If a contract may be settled in shares or cash at the holder's option, the more dilutive of cash
settlement and share settlement should be used in calculating diluted earnings per share. An
example of such a contract is a debt instrument that, on maturity, gives the company a right to
pay off the principal amount in cash or using its own ordinary shares.
17.10 WRITTEN PUT OPTIONS
Contracts that require a company to buy back its own shares e.g. written options and forward
purchase contracts, should be included in the calculation of diluted earnings per share if the
effect is dilutive.
If the exercise price is more than the average market price for the period, the potentially dilutive
effect on earnings per share should be calculated as follows:
(i) It is assumed that at the beginning of the period sufficient ordinary shares will be issued
at the average market price during the period to meet the required payment;
(ii) It is assumed that the issue proceeds are applied to meet the required payment;
(iii)The difference between the numbers of ordinary shares assumed issued and the number
of ordinary shares received should be included in the calculation of diluted earnings per
share.
17.11 PRESENTATION OF EARNINGS PER SHARE INFORMATION
A company should present on the face of the income statement basic and diluted earnings per
share. The information to be presented relates to:
(i) Profit or loss from continuing operations attributable to ordinary shareholders of a
single class;
(ii) profit or loss from continuing operations attributable to ordinary shareholders of
different classes.
Basic and diluted earnings per share should be presented with equal prominence for all periods
under review.
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379
A company that reports a discontinued operation should present the basic and diluted earnings
per share for that operation on the face of the income statement or in the notes to the financial
statements. Negative earnings per share figures are required to be presented.
17.12 DISCLOSURE REQUIREMENTS
The disclosure requirements of IAS 33 are as follows:
(a) The amounts used as the numerators in calculating basic and diluted earnings per share,
and a reconciliation of those amounts to the profit or loss attributable to the ordinary
shareholders for the period.
(b) The weighted average number of ordinary shares used as the denominator in calculating
basic and diluted earnings per share, and a reconciliation of these denominators to each
other. The reconciliation should include the individual effect of each class of
instruments that has an impact on earnings per share.
(c) Instruments including contingently issuable shares that could potentially dilute basic
earnings per share in the future, but were not included in the calculation of diluted
earnings per share because they are anti-dilutive for the period(s) presented.
(d) A description of ordinary share transactions or potential ordinary share transactions that
occurred after the statement of financial position date and that would have significantly
changed the number of ordinary shares or potential ordinary shares if these transactions
had occurred before the end of the period.
ACTIVITY 17.2
As additional practice, go through the examples in the Implementation Guidance Section of
IAS 33 (2011 edition). Pay particular attention to Example 12.
17.14 SUMMARY
IAS 33 is a standard which recognizes the key role of earnings per share in the assessment of
corporate performance. This Unit explains some of the important aspects of the standard, and
gives additional examples to those shown in the implementation guidance section. This section
reflects the wide range of financing options which are used by reporting entities.
17.15 REFERENCES
IASB
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International Financial Reporting Standards 2015
380
UNIT EIGHTEEN
INTANGIBLE ASSETS (IAS 38)
18.0 INTRODUCTION
Before major changes which were occasioned by the promulgation of IFRS 3 - Business
Combinations, the key characteristic of an intangible asset was considered to be lack of
physical substance. The most important consideration in this context is the difficulty of
separating goodwill from other non-physical assets, for example, copyrights, patents and
trademarks, as well as research and development.
In line with the related changes in other standards, the revised IAS 38 focuses on the criteria
for the initial recognition of an intangible asset, and the treatment of subsequent expenditure
on such an asset. This standard removed two key assumptions which formed part of the old
standard, that is, (i) the useful life of an intangible asset is always finite and (ii) the useful life
of such an asset cannot exceed 20 years from the date on which it becomes available for use.
According to the revised IAS 38, the useful life of an intangible asset arising from contractual
or other legal rights should not exceed the period of those rights. On the other hand, if the rights
are conveyed for a renewable term, the useful life should include the renewal period(s) only if
there is evidence to support renewal by the entity without significant cost. The main purpose
of this Unit is to give a comprehensive explanation of how intangible assets should be
accounted for in financial statements.
18.1 OBJECTIVES
By the end of this Unit, you should be able to
•
Distinguish between a tangible asset and an intangible asset
•
Identify assets which are not covered by the revised IAS 38
•
Explain the circumstances under which an intangible asset may be considered to have
an indefinite useful life
•
Explain the accounting and disclosure requirements for intangible assets
18.2 KEY DEFINITIONS
An asset is a resource which is controlled by an entity as a result of past events, and from which
future economic benefits are expected to flow to the entity (IASB conceptual framework).
N.B. There currently is an exposure draft seeking to change the definition of an asset. You
should be aware of the possible new definition.
An intangible asset is a non-monetary asset without physical substance, identifiable, controlled
as a result of past events and able to provide future economic benefits to the acquiring entity.
An intangible asset is identifiable if it meets either the separability criterion or contractual legal
criterion. By separability criterion it means an intangible asset is separable if it is capable of
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381
being separated or divided from the entity and sold, transferred, licensed, rented or exchanged,
either individually or together with a related contract, identifiable asset or liability [IAS
38.12(a)]. By contractual-legal criterion it means an intangible asset that arises from
contractual or other legal rights is identifiable regardless of whether those rights are
transferable or separable or from other rights and obligations [IAS 38.12(b)]. Examples of
legally protected rights are copyrights, restraint of trade agreements (where permitted) or the
legal duty by employees to maintain confidentiality. These benefits may include revenue from
the sale of products or services, cost savings in production processes and other cash inflows
arising from the entity's use of the assets. Control over technical knowledge or know-how is
another example of a legally enforceable right.
An active market is a market in which all the following conditions exist:
a) the items traded in the market are homogeneous
b) willing buyers and willing sellers can normally be found at any time
c) prices are available to the public.
IFRS 13 defines an active market as a market in which transactions for the asset or liability
take place with sufficient frequency and volume to provide pricing information on an ongoing
basis.
Entity-specific value is the present value of the cash flows which an entity expects to arise from
the continuing use of an asset, and from its disposal at the end of its useful life or expects to
incur when settling a liability.
18.3 EXCLUSIONS
IAS 38 states that this standard does not apply to intangible assets held by an entity for sale in
the ordinary course of business, deferred tax assets, leases, assets arising from employee
benefits, financial assets as defined in IAS 32, goodwill acquired in a business combination,
deferred acquisition costs and intangible assets, arising from an insurer's contractual rights
under insurance contracts, and non-current intangible assets classified as held for sale or
included in a disposal group that is classified as held for sale. Other exceptions to control of
intangible assets are customer loyalty, human intellectual property, loyalty and market share.
N.B. Goodwill arising upon acquisition of a subsidiary in a business combination qualifies to
be an intangible asset and is shown separately from the rest of the intangible assets.
18.4 RECOGNITION AND MEASUREMENT OF INTANGIBLE ASSETS
An intangible asset should be recognised if:
(i)
it is probable that the expected future economic benefits that are attributable to the
asset will indeed flow to the entity
(ii)
the cost of the asset can be measured reliably
According to the standard, an entity should assess the probability of expected future economic
benefits based on reasonable and supportable assumptions. These assumptions should represent
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382
management's best estimate of the economic conditions that will exist over the asset's useful
life. An intangible asset should initially be measured at cost.
18.5 ACQUISITION
18.5.1 SEPARATE ACQUISITION OF INTANGIBLE ASSETS
The cost of a separately acquired intangible asset consists of:
a) its purchase price, including import duties and non-refundable purchase taxes, after
deducting any trade discounts and rebates;
b) directly attributable costs of preparing the asset for its intended use; such costs include:
i. costs of employee benefits arising directly from bringing the asset to its working
condition;
ii. professional fees arising directly from bringing the asset to its working condition;
and
iii. costs of testing whether the asset is functioning properly.
An entity should cease to recognise costs in the carrying amount of an intangible asset when it
is in a condition which it is intended by management.
The following costs should be specifically excluded from the asset's carrying amount:
i)
costs incurred while the asset is already capable of operating in the intended
manner, but has not yet been brought into use; and
ii)
initial operating losses, for example those incurred as the demand for the asset's
output is building up.
EXAMPLE – SEPARATE ACQUISITION
Kutaura (Pvt) Ltd. was granted a radio and TV broadcasting licence on 31 December 20-6. The
company incurred the following costs in relation to this licence:
Payment to broadcasting consultant
Legal fees
Employee costs (apportioned)
Initial operating losses
Purchase price
$
570 000
285 000
150 000
100 000
1 000 000
REQUIRED
Calculate the amount at which the licence should be recorded in the company's financial
statements.
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383
SUGGESTED SOLUTION
The total cost of the licence is arrived at as follows:
Purchase of licence
Payment to broadcasting consultant
Legal fees
Employee costs
Total
$
1 000 000
570 000
285 000
150 000
2 005 000
Note that initial operating losses are excluded from the above calculation.
18.5.2 ACQUISITION AS PART OF A BUSINESS COMBINATION
The measurement and recognition criteria for intangible assets which are acquired through
business combinations should be noted carefully, because of the need to comply with related
provisions in IFRS 3. According to that standard, the cost of an intangible asset acquired in this
manner is its fair value at the time of the transaction. This value should reflect market
expectations about the probability of future economic benefits flowing to the entity.
According to revised IAS 38 "………………an acquirer recognizes at the acquisition date,
separately from goodwill an intangible asset of the acquiree if the asset's fair value can be
measured reliably, irrespective of whether the asset had been recognised by the acquiree before
the business combination."
The standard gives an example of an acquiree's in-process research and development project,
which should be recognised by the acquirer if:
a) it meets the definition of an asset
b) it is identifiable, that is, separable or arises from contractual or other legal rights
The measurement of an intangible asset's value may be subject to a number of possible
outcomes with different probabilities. Despite this uncertainty, it should still be possible to
come up with a reasonable, probability-weighted estimate of the asset's fair value. If the asset
has a finite useful life, it is normally assumed that its fair value can be measured reliably. The
guidelines for establishing the fair value of assets are stated as follows:
1. Quoted market prices in an active market will provide the most reliable estimate of the fair
value of an intangible asset. The appropriate market price is usually the current bid price or the
price applied to the most recent similar transaction. However, such a transaction can only be
used to estimate fair value if there has not been a significant change in economic circumstances
between the transaction date and the date of the estimate.
2. Where there is no active market for an intangible asset, its fair value is the amount that the
entity would have paid for it at the acquisition date in an arm's length transaction between
knowledgeable and willing parties, on the basis of the most reliable information that is
available.
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384
3. An entity which is regularly involved in the purchase and sale of unique intangible assets
may develop its own techniques for estimating their fair values.
Such techniques include:
i.
applying multiples that reflect market transactions to indicators related to the asset's
profitability, for example, revenues and market share, or to the royalties that could
be obtained from licensing the asset to another party in an arm's length transaction;
and
ii.
discounting the estimated future net cash flows from the asset (net present value
technique).
18.5.3 ACQUISITION BY WAY OF A GOVERNMENT GRANT
An intangible asset may be acquired free of charge or for a nominal amount through a
government grant. Examples of assets which may be obtained in this way are airport landing
rights, licences to operate radio or television stations, and import licences or quotas. According
to IAS 20 - Accounting for Government Grants and Disclosure of Government Assistance an
entity may recognise both the asset and the grant initially at fair value. Alternatively, the asset
may be recorded at the nominal amount plus any expenditure that is directly attributable to
preparing the asset for its intended use.
18.5.4 EXCHANGE OF ASSETS
If an intangible asset is acquired through a direct exchange with an existing asset, the value at
which the new asset is recorded depends on whether the exchanged assets are similar. For
similar assets, the value of the new asset will be identical to that of the asset given up. For
dissimilar assets, the value of the new asset consists of the old asset's fair value plus any cash
adjustment.
IAS 38 states that the cost of an intangible asset acquired through an exchange should be
measured at fair value unless:
i)
the exchange transaction lacks commercial substance or
ii)
the fair values of the asset received and that given up cannot be reliably measured
An entity can determine if an exchange transaction has commercial substance by assessing the
extent to which its future cash flows are expected to change as a result of the transaction. The
conditions for a transaction to have commercial substance are:
a) the configuration (that is, the risk, timing and amount) of the asset received is different
from that of the asset given up;
b) the entity-specific value of the portion of the entity's operations affected by the
transaction changes as a result of the exchange based on after-tax cash flows ; and
c) the difference in (a) or (b) is significant relative to the fair values of the exchanged
assets.
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385
ACTIVITY - AQUISITION
1. Explain the provisions of IAS 38 on intangible assets with specific reference to
a) Separate acquisition
b) Acquisition as part of a business combination
c) Acquisition by way of a government grant
d) Exchange of assets
2. L. Chingoma invented a helicopter engine which was designed for local flight conditions.
He entered into a patent agreement with ABC Air Charters, which wanted to undertake
commercial production of the helicopter. The terms of the agreement were as follows:
$
Cost of prototype (cash payment to L. Chingoma)
Issue of Class B shares to L. Chingoma
250 000
1 250 000
ABC Air Charters incurred the following additional expenses:
Import duties for spare parts to finalise design
300 000
Costs incurred when the helicopter was already capable of operating commercially, but before
operating licence was received from the government
200 000
REQUIRED
Calculate the cost of the patent to ABC Air Charters.
18.6 INTERNALLY-GENERATED GOODWILL
Internally-generated goodwill arises from expenditure undertaken by an entity to generate
future economic benefits, which however, results in an intangible asset that does not meet
recognition criteria of IAS 38. Such goodwill should not be recognised as an asset because it
is not an identifiable resource controlled by the entity that can be measured reliably at cost. It
should be noted that differences between the market value of an entity and the carrying amount
of its identifiable net assets will often incorporate many factors that influence its value.
However, such differences will not necessarily represent the cost of intangible assets owned by
the entity.
The standard states categorically that internally-generated goodwill should not be recognised
as an asset.
18.7 INTERNALLY-GENERATED INTANGIBLE ASSETS
According to IAS 38, it is sometimes difficult to assess whether an internally generated asset
qualifies for recognition due to problems in:
- identifying whether and when there is an identifiable asset that will generate expected future
economic benefits; and
ICSAZ - P.M. PARADZA
386
- determining the cost of the asset reliably; in many cases, it is difficult to distinguish between
the cost of generating an intangible asset internally and the cost of maintaining or enhancing
the entity's internally-generated goodwill or of undertaking day-to-day operations.
When assessing whether an internally-generated intangible asset meets the criteria for
recognition, an entity should classify the asset's generation into a research phase and a
development phase.
18.7.1 RESEARCH PHASE
An entity should not recognise any intangible asset arising from research or the research phase
of an internal project. All expenditure on such research should be recognised as an expense
when it is incurred. The reason for this treatment is that, at this stage an entity cannot
demonstrate that an intangible asset exists that will generate probable future economic benefits.
Examples of research activities are:
i)
activities aimed at obtaining new knowledge
ii)
the search for, evaluation and final selection of, application of research findings or
other knowledge
iii)
the search for alternatives of materials, devices, products, processes systems or
services
iv)
the formulation, decision evaluation and final selection of possible alternatives for
new or improved materials, devices, products, processes, systems or services
18.7.2. DEVELOPMENT PHASE
The standard permits the recognition of an intangible asset arising from development or from
the development phase of an internal project. The following conditions apply to such
recognition:
i)
the technical feasibility of completing the asset so that it will be available for use or
sale
ii)
the entity's ability to use or sell the asset
iii)
the entity's intention to complete the asset and use or sell it
iv)
availability of information on how the asset will generate probable future economic
benefits e.g. through outright sale or internal use of the asset
v)
availability of adequate technical, financial and other resources to complete the
development and to use or sell the asset
vi)
the entity's ability to measure reliably the expenditure attributable to the asset during
its development
Examples of development activities are:
a) the design, construction and testing of pre-production or pre-use proto types
b) the design of tools, jigs, moulds and dies involving new technology
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387
c) the design, construction and operation of a pilot plant that is not of a scale economically
feasible for commercial production
d) the design, construction and testing of a chosen alternative for new or improved
materials, devices, products, processes, systems or services
18.7.3 PROHIBITION TO RECOGNISE CERTAIN ITEMS AS INTANGIBLE ASSETS
The standard states that internally-generated brands, mastheads, publishing titles, customer
lists and similar items should not be recognised as intangible assets. This is because it is
difficult to distinguish the cost of such items from the cost of developing the business as a
whole.
18.7.4 INITIAL COST OF AN INTERNALLY-GENERATED ASSET
The cost of an internally-generated intangible asset consists of all directly attributable costs
that are necessary to create, produce, and prepare the asset to make it operate in the manner
intended by management. Examples of such costs are:
a) costs of materials and services used or consumed in generating the intangible asset
b) costs of employee benefits resulting from the generation of the intangible asset
c) fees to register a legal right
d) amortisation of patents and licences that are used to generate the intangible asset
The following do not form part of the cost of an internally-generated intangible asset:
i)
selling, administrative and other general overhead expenditure, unless this
expenditure can be directly attributed to preparing the asset for use
ii)
identified inefficiencies and initial operating losses incurred before the asset
achieves planned performance
iii)
expenditure on training staff to operate the asset (training costs)
Treatment of an internally generated intangible asset such as computer software for use
(bespoke enterprise resource planning application software) or for sale (as is done by specialist
application software developers) is as follows:
1. The criteria for capitalising development expenditure applies otherwise the costs of
development should be expensed.
2. The capitalised cost should be amortised over the useful life of the computer or
operating software.
EXAMPLE – INTERNALLY GENERATED INTANGIBLE ASSET
The IASB has issued SIC-32 (Intangible Assets-Web site Costs) to illustrate how web site
development costs should be recognised and accounted for. According to the Interpretation, an
entity may incur internal expenditure on the development and operation of its own web site for
internal and external use. A web site designed for external access may be used for various
purposes, for example, to promote and advertise the entity's own products and services, provide
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388
on-line services, and sell products and services. A web site designed for internal access may be
used to store company policies and customer details, and search for required information.
The stages of developing a web site are as follows:
i)
Planning - this includes undertaking feasibility studies, defining objectives and
specifications, evaluating alternatives and selecting preferences
ii)
Application and infrastructure development - this includes obtaining a domain
name, purchasing and/or developing hardware and operating software, installing
developed applications and stress testing
iii)
Graphical design development - this includes designing the appearance of web
pages
iv)
Content development - this includes creating, purchasing, preparing and uploading
information either textual or graphical in nature on the web site before its
development is completed; this information may either be stored in separate data
bases that are integrated into (or accessed from) the web site or coded directly into
web pages.
The issues which arise when considering internal expenditure on the development and
operation of an entity's own web site are as follows:
a) whether the web site is an internally-generated intangible asset that is subject to the
requirements of IAS 38
b) the appropriate accounting treatment of such expenditure
Important exclusions
An entity hosting its web site:
The expenditure should be recognised as an expense when the services are received. If an entity
incurs expenditure on the development or operation of a web site (or web site software) for sale
to another entity; such expenditure should be treated as revenue expenditure.
18.8 RECOGNITION OF EXPENSES RELATED TO INTANGIBLE ITEMS
Expenditure on intangible items should be recognised as expenses unless it forms part of the
cost of an intangible asset that meets the recognition criteria, or the item is acquired in a
business combination and cannot be recognised as an intangible asset. In that case, the
expenditure should form part of the amount attributed to goodwill at the acquisition date.
Examples of expenditure which should be recognised as expenses when incurred are:
a) expenditure on start-up activities, unless this expenditure is included in the cost of an
item of property, plant and equipment (IAS 16); such activities involve development
costs like legal and secretarial services, opening a new facility or business or launching
new products or processes
b) expenditure on training activities
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389
c) expenditure on advertising and promotional activities
d) expenditure on relocating or re-organising part or all of an entity
N.B. Expenditure on an intangible item that was initially recognised as an expense should not
be recognised as part of the cost of an intangible asset at a later date.
18.9 ALTERNATIVE BASES OF MEASUREMENT AFTER INITIAL
RECOGNITION
IAS 38 gives reporting entities two alternative methods for measuring intangible assets after
initial recognition. According to the cost model, an intangible asset should be carried at its cost
less any accumulated amortisation and accumulated impairment losses. According to the
revaluation model, an intangible asset should be carried at a revaluation amount which is its
fair value on the revaluation date less any subsequent accumulated impairment losses. Fair
value should be determined by reference to an active market. Revaluations should be made
with such frequency that at the statement of financial position date, the asset's carrying amount
does not differ materially from its fair value. Frequent revaluations are unnecessary for
intangible assets which have insignificant movements in fair value. The items within a class of
intangible assets should be revalued simultaneously to avoid selective revaluation of assets and
the mixture of asset costs and values which arose on different dates.
18.9.1 ACCOUNTING TREATMENT OF ACCUMULATED AMORTIZATION
When an intangible asset is revalued, accumulated amortisation on the asset can be treated in
two ways:
a) restated proportionately to the change in the gross carrying amount of the asset, so that
the carrying amount of the asset after revaluation equals its revalued amount
b) eliminated against the gross carrying amount of the asset, with the net amount being
restated to the revalued amount of the asset
EXAMPLE – REVALUATION MODEL
X Ltd. purchased a transferable hunting quota from the Parks and Wildlife Authority on 1
January 20-5. The following information on the quota is available:
$
Cost of quota (1/1/20-5)
Accumulated amortisation (31/12/20-8)
Total useful life (straight-line)
Financial year-end
On 1 January 20-9 the quota had a fair value of $4 200 000
3 500 000
2 100 000
5 years
31 December
REQUIRED
Show two ways of accounting for accumulated amortisation on the quota, based on the
guidance in IAS 38.
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390
SUGGESTED SOLUTION
Method 1 - Proportionate increase in accumulated amortization (Gross replacement
method)
$
Carrying amount 31/12/20-8 (3 500 000 – 2 100 000)
1 400 000
Fair value
4 200 000
Calculation of gross cost (3 500 000/1 400 000 x 4 200 000)
10 500 000
Total revised accumulated amortisation (2 100 000/1 400 000 x 4 200 000)
6 300 000
Cost
Accumulated depreciation
Value/Carrying amount
Gross Cost
Surplus
Net Cost
$
$
$
10 500 000
7 000 000
(6 300 000) (4 200 000)
4 200 000
2 800 000
Journal Entry
$
3 500 000
(2 100 000)
1 400 000
$
DEBIT
Hunting quota (10 500 000 - 3 500 000)
7 000 000
CREDIT
Accumulated amortisation (6 300 000 - 2 100 000) 4 200 000
CREDIT
Revaluation surplus
2 800 000
Being entry to show surplus on revaluation of hunting quota
N.B. The method brings about accumulated depreciation in the books that had not been
recognised before. That is its disadvantage. Gross replacement cost is the current market value
of a similar new intangible asset to the one being revalued; this is usually the case with a
desktop revaluation using the asset register.
Method 2 - Elimination of amortization (Net replacement method)
$
Carrying amount on 31/12/ 20-8
1 400 000
Fair value
4 200 000
Journal Entry
$
$
DEBIT
Accumulated amortisation
2 100 000
CREDIT
Hunting quota
2 100 000
Being entry to eliminate accumulated amortisation on revaluation of hunting quota
DEBIT
Hunting quota
2 800 000
CREDIT
Revaluation surplus (4 200 000 - 1 400 000)
2 800 000
Being entry to adjust the value of the quota by the revaluation surplus
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391
Alternatively
DEBIT
Accumulated amortisation
2 100 000
DEBIT
Hunting quota at fair value
4 200 000
CREDIT
Hunting quota at cost
3 500 000
CREDIT
Revaluation surplus
2 800 000
Being composite journal entry to show the effect of revaluing the quota
N.B. Net replacement cost is the current market value of a similar old intangible asset to the
one being revalued; this is usually the case with a revaluation after a physical inspection.
18.9.2 OTHER REVALUATION GUIDELINES
i) If an intangible asset in a class of revalued intangible assets cannot be revalued due to
lack of an active market, the asset should be carried at cost less any accumulated
amortisation and impairment losses.
ii) If the fair value of a revalued intangible asset can no longer be determined by reference
to an active market, the asset's carrying amount should be equated to its revalued
amount at the date of the last revaluation less any subsequent accumulated impairment
losses.
iii) If an intangible asset's carrying amount is increased through a revaluation, the increase
should be credited directly to equity as a revaluation surplus. However, this increase or
part of it, should be recognised in profit or loss if it reverses a revaluation decrease of
the same asset which was previously recognised in profit or loss. If an intangible asset's
carrying amount is decreased as a result of a revaluation, this decrease, or part of it,
should be debited directly to equity as a reversal of a revaluation surplus, to the extent
of any credit balance in that surplus.
The revaluation model explained in IAS 38 does not permit
a) the revaluation of intangible assets that were not previously recognised as assets
b) the initial recognition of intangible assets at amounts other than cost
When a revaluation surplus is realised through sale or use of the asset, it may be transferred
directly to retained earnings. If the surplus is realised through the asset's use, the realised
surplus consists of the difference between the amortisation based on the asset's revalued
carrying amount and the amount that would have been recognised based on the asset's historical
cost. Note that the transfer from the revaluation surplus to retained earnings should not be made
through profit or loss.
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ACTIVITY – GROSS REPLACEMENT AND NET REPLACEMENT COST MODELS
T Ltd acquired a transferable intangible asset on 1 July 20-6. The following information relates
to the asset:
Cost of asset
Accumulated amortisation (30/6/20-7)
Total useful life (straight-line)
Financial year-end
On 1 July 2-07, the asset had a fair value of
$2 800 000
$560 000
10 years
30 June
$3 360 000
REQUIRED
Show two ways of accounting for accumulated amortisation on the asset, based on the guidance
in IAS 38.
18.10 ESTIMATING THE USEFUL LIFE OF AN INTANGIBLE ASSET
IAS 38 states that an entity should assess whether the useful life of an intangible asset is finite
or indefinite. An asset's useful life is indefinite if there is no foreseeable limit to the period over
which it is expected to generate net cash inflows for the entity. The assessment is based on an
analysis of all the available information and other relevant factors. However, difficulties
experienced in accurately determining an intangible asset's useful life do not justify the
classification of that life as indefinite. The IASB has removed the presumptive maximum
useful life of intangible assets, which was set at 20 years, even if such assets have finite useful
lives. This means that it is possible for an entity to keep such assets in its books without
amortising them at all.
The factors which should be considered in determining the useful life of an intangible asset
include:
(i)
the expected usage of the asset by the entity, and whether the asset can be managed
efficiently by another management team;
(ii)
typical product life cycles for the asset, and public information on estimates of
useful lives of similar assets that are used in a similar way;
(iii)
the stability of the industry in which the asset is being used, and changes in the
market demand for the products or services output from the asset;
(iv)
expected actions by competitors or potential competitors;
(v)
technical, technological, commercial or other aspects of obsolescence;
(vi)
the level of maintenance expenditure required to obtain the expected future
economic benefits from the asset and the entity's ability and intention to reach such
a level;
(vii)
the period of control over the asset and legal or similar limits on the use of the asset,
such as the expiry dates of related leases; and
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393
(viii) whether the useful life of the asset is dependent on the useful life of other assets of
the entity.
18.11 INTANGIBLE ASSETS WITH FINITE USEFUL LIVES
Para 97 of the standard makes the following provisions concerning the amortisation period and
amortisation method for intangible assets with finite useful lives:
a) The depreciable amount of an intangible asset with a finite useful life should be
allocated on a systematic basis over its useful life.
b) Amortisation of such an asset should begin when it is available for use, that is, when it
is in the location and condition necessary for it to operate in the manner intended by
management
c) Amortisation should cease at the earlier of the date that the asset is classified as held
for sale (or included in a disposal group that is classified as held for sale) and the date
that the asset is derecognised.
d) The amortisation method used should reflect the pattern in which the asset's future
economic benefits are expected to be consumed by the entity. If this pattern cannot be
determined reliably, the straight-line method should be used.
e) The amortisation charge for each period should be recognised in profit or loss unless
this or another standard permits or requires it to be included in the carrying amount of
another asset.
18.12 RESIDUAL VALUE
The residual value of an intangible asset with a finite useful life should be assumed to be zero
unless:
i)
there is a commitment by a third party to purchase the asset at the end of its useful
life.
ii)
there is an active market for the asset and:
a) its residual value can be determined by reference to that market
b) it is probable that such a market will exist at the end of the asset's useful life
18.13 REVIEW OF AMORTISATION PERIOD AND AMORTISATION METHOD
Para 104 of the standard states that the amortisation period and the amortisation method for an
intangible asset with a finite useful life should be reviewed at least at the end of each financial
year. The following provisions should be noted:
•
If the expected life of the asset is different from previous estimates, the amortisation
period should be changed accordingly
•
If there has been a change in the expected pattern of consumption of the future
economic benefits embodied in the asset, the amortisation method should be changed
to reflect the changed pattern.
•
Such changes should be accounted for as changes in accounting estimates in accordance
with IAS 8.
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18.14 INTANGIBLE ASSETS WITH INDEFINITE USEFUL LIVES
According to para 107 of the standard, an intangible asset with an indefinite useful life should
not be amortised. The standard notes that, based on IAS 36, an entity should test such an asset
for impairment by comparing its recoverable amount with its carrying amount either annually
or whenever there is an indication that the asset may be impaired.
In addition, the useful life of an intangible asset that is not being amortised should be reviewed
at the end of each period to determine whether the indefinite life assessment is still appropriate.
If this is not the case, the entity should change the asset's useful life assessment from indefinite
to finite, and account for this as a change in accounting estimate.
18.15 RETIREMENTS AND DISPOSALS
a) An intangible asset should be derecognised on disposal or when no future economic
benefits are expected from its use or disposal.
b) (i) The gain or loss arising from the derecognition of an intangible asset should be
determined as the difference between the net disposal proceeds and the carrying amount
of the asset.
(ii) Such gain or loss should be recognised in profit or loss when the asset is
derecognised.
18.16 DISCLOSURE REQUIREMENTS
According to para 118 of the standard, entities should disclose the following information for
each class of intangible assets, distinguishing between internally-generated intangible assets
and other intangible assets:
i)
whether the useful lives are indefinite or finite and, if finite, the useful lives or the
amortisation rates used;
ii)
the amortisation methods used for intangible assets with finite useful lives
iii)
the gross carrying amount and any accumulated amortisation (aggregated with
accumulated impairment losses) at the beginning and end of the period;
iv)
the line item(s) of the statement of comprehensive income in which any
amortisation of intangible assets is included;
v)
a reconciliation of the carrying amount at the beginning and end of the period
showing:
(a) additions, indicating separately those from internal development, those acquired
separately, and those acquired through business combinations;
(b) assets classified as held for sale or included in a disposal group classified as held
for sale and other disposals;
(c) increases or decreases during the period resulting from revaluations and from
impairment losses recognised or reversed in other comprehensive income;
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395
(d) impairment losses recognised or reversed in profit or loss during the period in
accordance with IAS 36;
(e) any amortisation recognised during the period;
(f) net exchange differences arising on the translation of the financial statements
into the presentation currency, and on the translation of a foreign operation into the
presentation currency of the entity;
(g) other changes in the carrying amount during the period
vi)
for an intangible asset assessed as having an indefinite useful life, the carrying
amount of that asset and the reasons for the assessment of an indefinite useful life;
vii)
a description, the carrying amount and remaining amortisation period of an
individual intangible asset that is material to the entity's financial statements;
viii)
for intangible assets acquired by way of a government grant and initially recognised
at fair value:
(a) the fair value initially recognised for these assets;
(b) their carrying amount;
(c) whether they are measured after recognition under the cost model or the
revaluation model
ix)
the existence and carrying amounts of intangible assets whose title is restricted, and
the carrying amounts of intangible assets pledged as security for liabilities;
x)
the amount of contractual commitments for the acquisition of intangible assets
xi)
for intangible assets which are accounted for at revalued amounts:
(a) by class of intangible assets
•
the effective date of the revaluation
•
the carrying amount of revalued intangible assets
•
the carrying amount that would have been recognised had the revalued
class of intangible assets been measured after recognition using the cost
model
(b) the amount of the revaluation surplus that relates to intangible assets at the
beginning and end of the period, indicating the changes during the period and
any restrictions on the distribution of the balance to shareholders;
(c) the methods and significant assumptions applied in estimating the fair values of
the assets.
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18.17 SUMMARY
IAS 38 prescribes the accounting treatment for intangible assets, a type of asset which is
becoming more important in the statements of financial position of many companies. The
standard distinguishes between pure research whose aim is to acquire new scientific or
technical knowledge and the application of such knowledge before the commencement of
commercial production. The standard gives detailed guidelines on recognition and
measurement and disclosure issues related to different types of intangible assets.
18.18 REFERENCES
IASB
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International Financial Reporting Standards 2015
397
UNIT NINETEEN
LEASING (IAS 17)
19.0 INTRODUCTION
According to IAS 17, a lease is an agreement whereby the lessor conveys to the lessee, in return
for a payment or series of payments, the right to use an asset for an agreed period of time.
Under a lease agreement, the lessor (owner) rents the asset to the lessee for the period specified
in the agreement. The major advantage to the lessor is that the asset can generate a guaranteed
income stream up to the end of the lease period. On the other hand, the lessee will be in a
position to use the asset without a heavy capital outlay. Due to the smaller payments involved,
the lessee is able to use its cash resources for other purposes. However, it should be noted that
total lease payments will generally make the leased asset more expensive than if it were
purchased for cash.
19.1 OBJECTIVES
By the end of this Unit, you should be able to:
•
Explain the difference between finance leases and operating leases;
•
List the factors which show the existence of a finance lease;
•
Account for leases in the books of the lessor and the lessee;
•
Account for the effect of taxes on leases;
•
Outline relevant disclosures in the books of the lessor and the lessee;
•
Account for sale and lease back transactions in the books of the lessor and the lessee.
19.2 KEY DEFINITIONS
The lease term is the non-cancellable period for which the lessee has contracted to use the asset,
together with any further terms for which the lessee has an option to continue to use the asset,
with or without further payment, when at the inception of the lease it is reasonably certain that
this option will be exercised.
The commencement of the lease term is the date from which the lessee is entitled to exercise
its right to use the leased asset. It is the date of initial recognition of the lease i.e. the recognition
of the assets, liabilities, income or expenses resulting from the lease, as appropriate.
Minimum lease payments are the payments during the lease-term that the lessee is or can be
required to make, excluding contingent rent, costs for services and taxes to be paid and
reimbursed to the lessor, as well as:
(a) For a lessee, any amounts guaranteed by the lessee or by a party related to the lessee
(b) For a lessor, any residual value guaranteed to the lessor by:
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398
(i) A party related to the lessee;
(ii) A third party unrelated to the lessor that is financially capable of meeting the
guarantee.
19.3 GUARANTEED RESIDUAL VALUE
(a) For a lessee, that part of the residual value that is guaranteed by the lessee or a party
related to the lessee;
(b) For a lessor, that part of the residual value that is guaranteed by the lessee or a third
party unrelated to the lessor that is financially capable of meeting the guarantee
For both cases, the amount of the guarantee is the maximum amount that is payable.
Unguaranteed residual value is the portion of the leased asset's residual value whose realization
is not assured or guaranteed solely by a party related to the lessor.
Gross investment in the lease is the aggregate of:
(i) The minimum lease payments receivable by the lessor under a finance lease;
(ii) Any unguaranteed residual value accruing to the lessor.
Net investment in the lease is the gross investment in the lease discounted at the interest rate
implicit in the lease.
Unearned finance income is the difference between the gross investment in the lease and the
net investment in the lease.
The interest rate implicit in the lease is the discount rate that, at the inception of the lease, will
cause the aggregate present value of:
(a) The minimum lease payments and;
(b) The unguaranteed residual value to be equal to the sum of:
(i) The fair value of the leased asset and;
(ii) Any initial direct costs of the lessor.
The lessee's incremental borrowing rate of interest is the rate of interest that the lessee would
have to pay on a similar lease or, if that is not determinable, the rate that at the inception of the
lease, the lessee would incur to borrow over a similar term, and with a similar security, the
funds necessary to purchase the asset.
19.3.1 Classification of leases
A lease is classified as a finance lease if it transfers substantially all the risks and rewards
incidental to ownership. The risks include the possibility of losses from idle capacity or
technological obsolescence, and fluctuations in returns due to changing economic conditions.
Any lease which does not meet the conditions for a finance lease is classified as an operating
lease. The determination of whether a lease is a finance lease or an operating lease should take
into account the substance of the transaction rather than its legal form.
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19.3.2 Prima Facie Proof of a Finance Lease
The terms which indicate the existence of a finance lease include:
(i) The agreement contains a bargain purchase option allowing the lessee to take over the
asset for a nominal amount at the end of the term.
(ii) The lease term is for the major part of the asset's useful life, even if legal title is not
eventually transferred.
(iii) At the inception of the lease, the present value of the minimum lease payments
amounts to at least substantially all of the leased asset's fair value.
(iv) The leased asset is of such a specialized nature that only the lessee can use it without
major modification.
(v) If the lessee can cancel the lease, the lessor's losses associated with the cancellation
are met by the lessee.
(vi) Gains or losses in the fair value of the asset's residual value accrue to the lessee; this
could take the form of a rent rebate equal to the asset's sale proceeds at the end of the
lease.
(vii)
The lessee is able to continue the lease for a secondary period at a rental which
is substantially below the market rate.
.
IAS 40 gives a lessee the option to classify a property interest held under an operating lease as
an investment property. If the lessee does this, the property should be treated as a finance lease,
with the fair value model being used for the asset recognized. The lessee will continue to
account for the property as a finance lease, even if a subsequent event changes the nature of
the property.
Examples of such changes in classification are:
(a) The lessee occupies the property, which is then transferred to owner-occupied property
at a deemed cost equal to its fair value at the date of change in use.
(b) The lessee grants a sub-lease that transfers substantially all of the risks and rewards
incidental to the asset's ownership to an unrelated third party.
It is important to note that the classification of a lease is undertaken at its inception. Any
subsequent re-classification will essentially constitute a new lease. However, changes in
estimates e.g. the asset's economic life or its residual value, or changes in circumstances e.g.
default by the lessee, are not considered to give rise to a new lease for accounting purposes.
ACTIVITY – FINANCE LEASE VERSUS OPERATING LEASE
a) Distinguish between a finance lease and an operating lease
b) Outline the terms which indicate the existence of a finance lease.
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400
19.4. ACCOUNTING FOR LEASES IN THE FINANCIAL STATEMENTS OF
LESSEES
The substance over form principle requires the capitalization of assets obtained through finance
leases, which means that such assets should be recorded in the balance sheet. Two major issues
which arise relate to the value at which such assets should be capitalized, and the determination
of the finance charge related to the lease agreement.
According to para 20 of IAS 17, the initial recognition of leased assets should be treated as
follows: ''At the commencement of the term, lessees shall recognize finance leases as assets
and liabilities at amounts equal to the fair value of the leased property or, if lower, the present
value of the minimum lease payments, each determined at the inception of the lease.'
The major purpose of this para is to ensure that a finance lease is recognized in the lessee's
balance sheet as both an asset and an obligation to make future lease payments.
Further provisions of this para which should be noted are as follows:
i.
The discount rate to be used in the calculation of the present value of the minimum
lease payments is the interest rate implicit in the lease, or the lease's incremental
borrowing rate of interest
ii.
Any initial direct costs incurred by the lessee should be added to the asset's value
The minimum lease payments which are determined in (i) above should be apportioned
between the finance charge and the reduction of the outstanding liability. The finance charge
is the difference between the minimum lease payments and the initial capitalised value of the
asset. Para 25 of IAS 17 requires that the finance charge should be allocated to each period of
the lease term to ensure a constant periodic rate of interest on the remaining liability. Any
contingent rent should be charged as an expense in the period to which it relates.
The depreciation policy for depreciable leased assets should be consistent with that for other
depreciable assets that are owned by the lessee. The relevant amounts should be determined in
accordance with IAS 16 (Property, Plant and Equipment) and IAS 38 (Intangible Assets). If
there is no reasonable certainty that the lessee will obtain ownership by the end of the lease
term, the asset should be fully depreciated over the shorter of this term and its useful life.
19.4. 1 Operating Leases
The lease payments made for assets obtained through operating leases should be recognized
as an expense on a straight-line basis during the term. However, if there is a more realistic
method of apportioning the expense, that method should be used.
EXAMPLE - CALCULATION OF INTEREST RATE IMPLICIT IN LEASE WHERE
MINIMUM LEASE PAYMENTS ARE PAID IN ADVANCE
An asset with a useful life of 5 years is to be leased for the 5 years at a cost of $500 000 payable
annually in advance. The cash price of the asset is $ 2 084 950. Calculate the interest rate
implicit in the lease.
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401
SUGGESTED SOLUTION
Fair value of asset
Duration of lease agreement
Amount effectively borrowed
Annuity factor
Interest rate implicit in
the lease (discount rate for
annuity factor of 3.1699
over four years)
= $2 084 950
= 5 years
= $ 2 084 950 – 500 000 (1st instalment)
= $1 584 950
= $1 584 950/500 000
= 3.1699
= 10%
(Use present value of annuity factor table and identify the discount rate which applies to 4
years and 3.1699)
N.B. In terms of payments, 4 years is taken as the effective duration of the lease agreement
because the first payment is made at the commencement of the lease.
Proof of present value
Beginning of year
Instalment
1
2
3
4
5
$
500 000
500 000
500 000
500 000
500 000
Discount factor
(10%)
1
0.9091
0.8264
0.7513
0.6830
Present Value
$
500 000
454 550
413 200
375 650
341 500
2 084 900
The difference of $50 between the present value of lease payments and the fair value of the
leased asset is due to rounding off of figures. Alternatively, the present value of minimum
lease payments can be calculated as follows:
Annual payment x annuity factor + initial payment
=
($500 000 x 3.1699) + $500 000
=
$2 084 950
Actuarial Method – (amortization table for allocating annual minimum lease payment
in advance between capital and interest portion)
Year
1
2
3
4
Opening Bal Finance Charge
$
$
1 584 950
158 495
1 243 445
124 345
867 790
86 779
454 569
45 457
ICSAZ - P.M. PARADZA
Total
$
1 743 445
1 367 790
954 569
500 000
Instalment
$
500 000
500 000
500 000
500 000
Closing Bal
$
1 243 445
867 790
454 569
402
EXAMPLE - CALCULATION OF INTEREST RATE IMPLICIT IN LEASE WHERE
MINIMUM LEASE PAYMENTS ARE PAID IN ARREARS
An asset with a useful life of 5 years is to be leased for the 5 years at a cost of $500 000 payable
annually in arrears. The cash price of the asset is $1 716 550. Calculate the interest rate implicit
in the lease.
SUGGESTED SOLUTION
Fair value of asset
Duration of lease agreement
Amount effectively borrowed
Annuity factor
Interest rate implicit in the lease
(discount rate for annuity factor
of 3. 4331 over 5 years)
= $1 716 550
= 5 years
= $1 716 550
= $1 716 550/500 000
= 3.4331
= 14%
N.B. In terms of payments, 5 years is taken as the effective duration of the lease agreement
because the first payment is made one year after the commencement of the lease.
Proof of present value
End of Year
1
2
3
4
5
Instalment
$
500 000
500 000
500 000
500 000
500 000
Discount Factor
(14%)
0.8772
0.7695
0.6750
0.5921
0.5194
Present value
$
438 600
384 750
337 500
296 050
259 700
1 716 600
The difference between the present value of lease payments and the fair value of the leased
asset is due to rounding off errors.
Alternatively, present value of minimum lease payments can be calculated as follows:
=Annual payment x annuity factor
=$500 000 x 3.4331
= $1 716 550
EXAMPLE - ALLOCATION OF FINANCE CHARGES
The finance charge is the difference between the gross rentals paid to the lessor and the present
value of the minimum lease payments. Each individual payment consists of a finance charge
portion and an amount representing the capital obligation to pay the agreed rentals.
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403
There are 3 main methods of allocating finance charges over the lease duration. Refer to the
figures in example above.
Actuarial method (amortization table when lease instalments are in arrears)
Year
1
2
3
4
5
Capital sum
at start of
period
$
1 716 550. 00
1 456 867. 00
1 160 828. 38
832 344. 35
438 612.56
Finance
charge
Sub-Total
$
240 317. 00
203 961. 38
162 515. 97
115 268. 21
61 405.76
$
1 956 867.00
1 660 828.38
1 323 344.35
938 612.56
500 018.32
Lease payment Capital sum
at end of
period
$
$
500 000.00
1 456 867.00
500 000.00
1 160 828.38
500 000.00
832 344.35
500 000.00
438 612.56
500 000.00
-
In practice, the difference of $18.32 at the end of year 5 represents an overpayment which can
be credited in the income statement. Note that the finance charge represents a constant
periodic rate of interest on the remaining balance of the capital sum.
Sum-of-digits method
This is the same method which is sometimes used to calculate the depreciation of non-current
assets. The digits representing the number of years in the lease period are added. The
fractions used to determine the periodic finance charge are arranged in reverse order.
For the same example above, the calculations would be as follows:
Number of years
=5
Sum of digits
= 1+2+3+4+5
= 15
Total finance charge
= ($500 000 x 5) - 1 716 550
= $783 450
Allocation of finance charge
Year
1
2
3
4
5
783 450 x 5
15
783 450 x 4
15
783 450 x 3
15
783 450 x 2
15
783 450 x 1
15
= 261 150
= 208 920
= 156 690
= 104 460
=
52 230
783 450
If the lease payments are made in advance, the above calculations would be based on 4 years
instead of 5 years. This is because the amount outstanding at the beginning of year
(immediately after the last payment) would be nil.
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404
The constant rate of interest required for the allocation of finance charges can be checked as
follows using the actuarial method format:
Year
1
2
3
4
5
Capital sum
at start of
period
$
1 716 550
1 477 700
1 086 620
843 310
447 770
Year
1
2
3
4
5
Finance
charge
Sub-total
Lease
payment
$
261 150
208 920
156 690
104 460
52 230
$
1 977 700
1 686 620
1 343 310
947 770
500 000
$
500 000
500 000
500 000
500 000
500 000
Effective Interest Rate
261 150
1 716 550
208 920
1 477 700
156 690
1 186 620
104 460
843 310
52 230
447 770
Capital sum
at end of
period
$
1 477 700
1 186 620
843 310
447 770
-
=
15.22%
=
14.14%
=
13.21%
=
12.39%
=
11.67%
The sum-of-digits method is not recommended by IAS 17 because it does not produce a
constant effective rate of interest based on the capital sum owing at the beginning of each year.
However, IAS 17 allows lessees to use approximations to simplify calculations when allocating
finance charges. The straight-line method should generally not be used to allocate finance
charges because it distorts the effective rate of interest even more than the sum-of-digits
method.
19.5 ACCOUNTING FOR LEASES IN THE FINANCIAL STATEMENTS OF
LESSORS
Under a finance lease, the lessor will substantially transfer all the risks and rewards related to
legal ownership of the leased asset. In the lessor's books, lease payments received are treated
as repayment of principal and finance income to reimburse and reward the lessor. The lessor
may use its own resources or borrowed funds to finance the acquisition of leased assets.
Lessors often incur initial direct costs which include commissions, legal fees and internal costs
directly related to the finalisation of lease agreements. Such costs are incorporated in the
measurement of finance lease receivables and have the effect of reducing the amount of income
recognized over the lease period.
The recognition of finance income should ensure a constant periodic rate of return on the
lessor's net investment in the finance lease. The lease payments relating to a period, excluding
costs for services are netted off against the gross investment to reduce both the principal and
the unearned finance income.
ICSAZ - P.M. PARADZA
405
Estimated unguaranteed residual values used to calculate the lessor's gross investment in the
lease should be reviewed regularly. If there has been a reduction in such a value, the income
allocated to the related period should be revised and the income statement should be debited
with any reduction in the accrued amounts. Manufacturers or dealers sometimes offer to
customers the choice of either buying or leasing assets. Such arrangements normally give rise
to two types of income:
a) profit or loss related to an outright sale of the leased asset at normal selling prices,
reflecting any applicable volume or trade discounts
b) finance income over the lease period
Para 42 of IAS 17 requires that manufacturer or dealer lessors should recognize selling profit
or loss for all accounting periods according to the policy followed for outright sales. If the rate
of interest used is below market level, the selling profit should not exceed that which would be
associated with market interest rates. The costs incurred by such lessors when negotiating and
arranging leases should be recognized as expenses when selling profit is determined.
EXAMPLE – FINANCE LEASE IN THE BOOKS OF THE LESSOR
On 1 January 20-4 X Ltd. entered into a lease agreement to supply equipment to Y Ltd.
Information related to the agreement was as follows:
Equipment bought by X Ltd for
Guaranteed residual value
Lease period
Annual instalment (payable in arrears)
Commencement of lease period 1 January 20-4
Effective rate of return
Available allowances:
50%
Special initial allowance:
1st year
2nd year
25%
rd
3 year
25%
The tax rate is 32.5%
The lessor will retain the asset on expiry of the agreement.
X Ltd uses the actuarial method to recognize finance income.
$10 000 000
$2 500 000
3 years
$4 224 580
22.0263%
REQUIRED
(i) Calculate the following amounts in the statements of X Ltd. for the years-ended 31
December 20-4 to 20-6 to comply with IAS 17
a) Deferred tax income or expenses
b) Deferred tax asset or liability
c) Finance income
d) Unearned finance income
e) Gross investment and net investment in the lease
(ii) Show the Deferred Tax Account in the ledger for the 3 years-ended 31 December 20-6.
ICSAZ - P.M. PARADZA
406
SUGGESTED SOLUTION
Tax base of equipment
Cost/tax base
Special initial allowance
Deferred tax calculations
20-4
20-5
20-6
$
$
$
10 000 000
5 000 000
2 500 000
(5 000 000) (2 500 000) (2 500 000)
5 000 000
2 500 000
-
CARRYING AMOUNT OF INVESTMENT IN LEASE
20-4
20-5
20-6
$
$
$
Gross investment
15 173 740(i) 10 949 160(ii) 6 724 580(iii)
less Current year instalment
(4 224 580) (4 224 580) (6 724580)(iv)
Unearned finance income
5 173 740
2 971 110
1 213 841
Earned finance income
(2 202 630) (1 757 269)
(1 213 841)
Net investment
7 978 050
5 510 739l
i.
ii.
iii.
iv.
Sum of instalments + guaranteed residual value (RV)
= (4 224 580 x 3) + 2 500 000
Gross investment 1st year less 1st year instalment
= $15 173 740-4 224 580
Gross investment 2nd year less 2nd year instalment
= 10 949 160- 4 224 580
Includes guaranteed residual value $2 500 000
Total finance income over the lease period
Cash flows
Instalments received (4 224 580 x 3)
Add: Guranteed residual value
Cash outflow
Purchase price of equipment
Finance income
=
$15 173 740
=
$10 949 160
=
$6 724 580
$
12 673 740
2 500 000
15 173 740
(10 000 000)
5 173 740
Amortization table for finance income
Year- Capital sum at
Ended start of period
31 Dec
$
20-4 10 000 000
Interest
charge at
22.01263%
$
2 202 630
Sub-total
Instalment
$
12 202 630
$
4 224 580
Capital sum
at end of
period
$
7 978 050
20-5
7 978 050
1 757 269
9 735 319
4 224 580
5 510 739
20-6
5 510 739
1 213 841(a)
6 724 580
6 724 580(b)
(a) Includes adjustment for rounding off of figures
(b) Includes adjustment for guaranteed residual value
ICSAZ - P.M. PARADZA
407
DEFERRED TAX ASSETS LIABILITIES & EXPENSE
31/12/20-4
Equipment
Investment in lease (net)
Net temporary difference
Deferred tax (DT) asset
D.T. liability
CARRYING
AMOUNT
$
TAX
BASE
$
5 000 000
7 978 050
Closing D.T. liability
31/12/20-4
D.T. expense for the year
(v) 5 000 000 x 32.5%
(vi)7 978 050 x 32.5%
31/12/20-5
Equipment
Investment in lease (net)
Net temporary difference
D.T. asset
DT liability
Closing D.T. liability
Opening D.T. liability
D.T. income for the year
_________
967 866
= 1 625 000
= 2 592 866
CARRYING
AMOUNT
$
= 812 500
= 1 790 990
31/12/20-6
CARYING
AMOUNT
$
-
D.T. liability
Opening D.T. liability
D.T. income for the year
ICSAZ - P.M. PARADZA
TAX
BASE
$
2 500 000
5 510 739
(vii) 2 500 000 x 32.5%
(viii) 5 510 739 x 32.5%
Equipment
Investment in lease (net)
Net temporary difference
TIMING
DIFFERENCE
$
(5 000 000)
7 978 000
2 978 050
1 625 000(v)
2 592 866(vi)
TAX
BASE
$
-
TIMING
DIFFERENCE
$
(2 500 000)
5 510 739
3 010 739
812 500(vii)
1 790 990(viii)
978 490
(967 866)
10 624
TEMPORARY
DIFFERENCE
$
978 490
978 490
408
DEFERRED TAX A/C
Dec 31 Income statement
Dec 31 Balance c/d
$
1 625 000
967 866
2 592 866
20-5
Dec 31 Balance c/d
978 490
Dec 31 Income Statement
978 490
20-6
978 490
$
Dec 31 Income Statement 2 592 866
2 592 866
20-5
Jan 1 Balance b/d
967 866
Dec 31 Income statement
10 624
978 490
20-6
Jan 1 Balance b/d
978 490
19.5.1 Disclosure Requirements for Leases
A. Finance Leases
(i) For each class of assets, the net carrying amount at the balance sheet date
(ii) A reconciliation between the total of future minimum lease payments at the balance
sheet date and their present value. The same information should also be disclosed
in respect of the following periods:
(a) Not later than one year;
(b) Later than one year and not later than five years;
(c) Later than five years.
(iii) Contingent rents recognized as an expense for the period. The total of future
minimum sub-lease payments expected to be received under non- cancellable subleases at the balance sheet date;
(iv) General description of the lessee's material leasing arrangements including, but
not limited to the following:
(a) the basis on which contingent rent payable is determined
(b) the existence and terms of renewal or purchase options and any escalation
clauses
(c) any restrictions imposed by lease arrangements e.g. those concerning
dividends, additional debt and further leasing
B. Operating Leases
The disclosure requirements with regard to operating leases are identical to those for finance
leases under;
19.6. CHANGES IN INTEREST RATES
Many lease agreements are subject to changes in interest rates. The purpose of variable rate
agreements is to protect the lessor if the market rate increases and the lessee if the market rate
decreases. An increase in this rate will make it more expensive for the lessor to continue
financing the asset for the lessee's benefit. The lessor will therefore need to be compensated
against this loss. A decrease in this rate will make it cheaper for the lessor to continue financing
the asset. It would only be fair to pass on this reduced cost to the lessee, although this does not
always happen.
ICSAZ - P.M. PARADZA
409
In the books of the lessor, a change in the interest rate is accounted for as a change in estimate,
with effect from the applicable date i.e. prospectively rather than retrospectively. The change
will affect the gross investment in the lease as well as unearned finance income. Note the
following journal entries to be recorded:
•
For an increase in the interest rate
DR
Gross investment in the lease
CR
Unearned finance income
$
xx
$
xx
Being entry to record change in the gross investment and unearned finance income caused by
an increase in the interest rate
•
For a decrease in the interest rate
DR
Unearned finance income
CR
Gross investment in the lease
xx
xx
Being entry to record change in the gross investment and unearned finance income caused by
a decrease in the interest rate.
FURTHER EXAMPLE - FINANCE LEASES IN THE BOOKS OF THE LESSOR
U Ltd leased an asset to V Ltd on 1 July 20-7 under a finance lease agreement. The cash price
of the asset was $17 299 200 with 5 annual instalments of $8 500 000 being payable in arrears.
The first instalment was due on 30 June 20-8. At the commencement of the period, the interest
rate was 40% p.a. However this rate increased to 50% p.a. on 1 July 20-9 and remained at this
level for the remaining part of the lease term. The annual instalment went up to $9 596 730 p.a.
in tandem with the increase in the interest rate.
REQUIRED
a) (i) Prepare an interest amortisation table in the books of U Ltd to cover the period 1July
20-7 to 30 June 2-12 based on the initial interest rate.
(ii) Prepare an interest amortisation table in the books of U Ltd to cover the period 1
July 20-7 to 30 June 2-12 to take into account the change in the interest rate.
b) Prepare journal entries related to the transactions in the books of U Ltd.
SUGGESTED SOLUTION
(a)(i) Amortization table
Year ended
30 June
20-8
20-9
2-10
2-11
2-12
`
Capital sum
at start of
period
$
17 299 200
15 718 880
13 506 432
10 409 005
6 072 607
ICSAZ - P.M. PARADZA
Interest
charge
at 40%
$
6 919 680
6 287 552
5 402 573
4 163 603
2 427 393
25 200 800
Subtotal
Lease
payment
$
24 218 880
22 006 432
18 909 005
14 572 607
8 500 000
$
8 500 000
8 500 000
8 500 000
8 500 000
8 500 000
42 500 000
Capital sum
at the end
of period
$
15 718 880
13 506 432
10 409 005
6 072 607
-
410
ii) Amortization table
Year-ended
30 June
20-8
20-9
2-10
2-11
2-12
Capital sum
at start of
period
$
17 299 200
15 718 880
13 506 432
10 662 918
6 397 647
Interest
charge
at 40%-50%
$
6 919 690
6 287 552
6 753 216
5 331 459
3 199 083
28 490 990
Subtotal
Lease
payment
$
24 218 880
22 006 432
20 259 648
15 994 377
9 596 730
$
8 500 000
8 500 000
9 596 730
9 596 730
9 596 730
45 790 190
Capital sum
at the end
period
$
15 718 880
13 506 432
10 662 918
6 397 647
-
b) Journal Entries
20-7
July 1
DR
Gross investment in the lease
42 500 000
CR
Unearned finance income
25 200 800
CR
Asset
17 299 200
Being entry to record gross investment and the total finance income at the inception of the
lease.
20-8
June 30
DR
CR
Bank
8 500 000
Gross investment in the lease
Being entry to record annual instalment received
8 500 000
DR
Unearned finance income
6 919 680
CR
Finance income
6 919 680
Being entry to transfer earned portion of unearned finance income to finance income
20-9
June 30
DR
Bank
8 500 000
CR
Gross investment in the lease
8 500 000
Being entry to record annual instalment received
20-9
July 1
2-10
June 30
DR
CR
Unearned finance income
6 287 552
Finance income
6 287 552
Being entry to transfer earned portion of unearned finance
income to finance income
DR
CR
Gross investment in the lease
3 290 190
Unearned finance income
Being entry to record change in gross investment
related to increase in the interest rate
(45 790 190-42 500 000)
DR
CR
Bank
ICSAZ - P.M. PARADZA
3 290 190
9 596 730
Gross investment in the lease
Being entry to record annual instalment received
9 596 730
411
2-11
June 30
2-12
June 30
DR
CR
Unearned finance income
6 753 216
Finance income
6 753 216
Being entry to transfer earned portion of unearned finance
income to finance income
DR
CR
Bank
9 596 730
Gross investment in the lease
Being entry to record annual instalment received
DR
CR
Unearned finance income
5 331 459
Finance income
5 331 459
Being entry to transfer earned portion of unearned finance
income to finance income
DR
CR
Bank
DR
CR
Unearned finance income
3 199 083
Finance income
3 199 083
Being entry to transfer earned portion of unearned finance
income to finance income
9 596 730
Gross investment in the lease
Being entry to record annual instalment received
9 596 730
9 596 730
19.7. SALE AND LEASEBACK TRANSACTIONS
A sale and leaseback transaction is one which involves the sale of an asset, which is then leased
back to the original owner. The lease payment and the sale package are usually related since
they are negotiated as a package, and therefore do not need to represent market values. The
accounting treatment of such transactions depends on the type of lease involved.
19.7.1 Finance lease
The essence of a finance leaseback is that the lessor provides finance to the lessee, with the
asset being used as security. IAS 17 states that any excess of sales proceeds over the asset's
book value should not be immediately recognized by the lessee, but instead deferred and
amortised over the lease term. This apparent profit has the effect of increasing the value of the
asset, as if a revaluation has occurred.
19.7.2 Operating lease
The essence of an operating leaseback is that the previous owner has ceded his ownership rights
to the lessor in a 'real' sale. In principle, IAS 17 allows the lessee to recognize the full profit on
the sale. However, the following specific circumstances should be noted:
(i) Asset is sold at fair value –The profit or loss should be recognized immediately;
(ii) Asset is sold below fair value –The profit or loss should be recognized immediately,
however, if a loss from such a transaction is expected to be compensated for by future
lease payments at below market price, it should be deferred and amortised against these
payments
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412
(iii) Asset is sold at a loss i.e. book value of the asset exceeds its fair value –The loss should
be recognized immediately;
(iv) Asset is sold above fair value –the profit consists of two components i.e. the difference
between the asset's book value and its fair value, which is recognised immediately and
the difference between the asset's fair value and the selling price, which is credited in
the income statement over the lease term.
19.8 DISCLOSURE REQUIREMENTS FOR LESSORS
19.8.1 Finance leases
(i) A reconciliation between the gross investment in the lease at the balance sheet date and
the present value of minimum lease payments receivable at the same date In addition,
an entity should disclose the gross investment in the lease and the present value of
minimum lease payments receivable at the balance sheet date, for each of the following
periods:
a. Not later than one year;
b. Later than one year and not later than five years;
c. Later than five years.
(ii) Unearned finance income;
(iii) The unguaranteed residual value accruing to the benefit of the lessor;
(iv) The accumulated allowance for uncollectible minimum lease payments receivable;
(v) Contingent rents recognised as income in the period;
(vi) A general description of the lessor's material leasing arrangements.
19.8.2 Operating leases
(i) The future minimum lease payments under non-cancellable operating leases in the
aggregate and for each of the following periods:
(a) not later than one year;
(b) later than one year and not later than five years;
(c) Later than five years.
(ii) Total contingent rents recognised as income during the period;
(iii) A general description of the lessor's leasing arrangements
ACTIVITY – FINANCE LEASE IN THE BOOKS OF THE LEASEE
T Ltd is an airplane manufacturer, listed on the Zimbabwe Stock Exchange.
On 1 January 20-3, T Ltd entered into a finance lease (as a lessee) over a motor vehicle with a
cost of $700 000.
Details of the lease agreement are as follows: Payment of $200 754 are made annually in
advance The lease term is 4 years The interest rate implicit in the lease is 10%
T Ltd depreciates the motor vehicles over 4 years, on a straight line basis, to a nil residual
value. T Ltd’s profit before tax is $900 000 in 20-3 (correctly calculated).
ZIMRA Grants a 20% capital allowance on owned assets but allows a deduction from taxable
profits of the lease payments if the asset is leased.
ICSAZ - P.M. PARADZA
413
There are no other differences between accounting profit and taxable profit other than those
evident from the information provided. T limited satisfies the requirements to raise deferred
tax assets.
There are no components of other comprehensive income.
The only interest incurred by T Ltd relates to this lease.
The normal taxis 30%.
REQUIRED:
(a) Prepare the 20-3 journal entries with regard to the above lease agreement;
(b) Draft the following to fully disclose the above lease and its tax effects;
(c) Statement of comprehensive income for the year ended 31 December 20-3;
(d) Statement of financial position as at 31 December 20-3;
(e) Notes to the financial statements for the year ended 31 December 20-3
N.B. Accounting policy note is required, whilst the deferred tax note is not required.
Adapted from GAAP: Graded questions, DL KOLITZ & CL SERVICE, 2012
19.9 SUMMARY
This Unit is an introduction to accounting for lease transactions, which have become more
popular in this country in the past decade or so. The substance-over-form concept which is
emphasized in terms of finance leases is important from the viewpoints of creditors and other
investors, as well as regulators who want to ascertain the 'true and fair' status of reporting
entities A leasing arrangement often represents a win-win situation for the parties involved.
The lessor is assured of a constant stream of income without necessarily giving up ownership,
while the lessee is guaranteed availability of the asset as long as it meets his needs.
19.10 REFERENCES
OPPERMANN, H.R.B
Accounting Standards: Questions & Solutions
BOOYSEN, S.F. et al
14th Edition, Juta & Co Ltd, 2011
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414
UNIT TWENTY
IMPAIRMENT OF ASSETS (IAS 36)
20.0 INTRODUCTION
This standard sets out accounting procedures for the determination, recognition and disclosure
of assets whose carrying amounts exceed their recoverable amounts at the reporting date. Due
to the wide range of assets which may be described as impaired, the standard specifically
excludes inventories (covered by IAS 2), assets arising from construction contracts (IAS 11),
deferred tax assets (IAS 12), assets related to employee benefits (IAS 19), financial assets
(IFRS 9), investment property (IAS 40) that is measured at fair value, biological assets (IAS
41) related to agricultural activity that are measured at fair value less costs to sell, deferred
acquisition costs as well as intangible assets arising from an insurer's contractual rights and
non-current assets classified as held for sale. The standard applies to financial assets which are
classified as subsidiaries, associates and joint ventures. A key aspect of the standard is the
determination of an asset's fair value in the context of an active market. IFRS 13 defines fair
value and provides the hierarchy of inputs for arriving at fair value.
20.1 OBJECTIVES
By the end of this Unit, you should be able to:
•
Distinguish between fair value less costs to sell (net selling amount) and value in use
•
Outline the procedures which can be used to identify impaired assets
•
Identify the internal and external sources of information which can be used to establish
the impairment of assets
•
Explain the concept of and accounting requirements for cash generating units
20.2 KEY DEFINITIONS
An active market is one in which all the following conditions exist:
a) the goods and services traded in the market are homogeneous
b) willing buyers and sellers can normally be found at any time
c) prices are available to the public
IFRS 13 defines an active market 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.
A cash-generating unit is the smallest identifiable group of assets that generates inflows that
are largely independent of the cash flows from other assets or groups of assets.
Costs of disposal are incremental costs that are directly attributable to the disposal of an asset
or cash-generating unit, excluding finance costs and income tax expense.
ICSAZ - P.M. PARADZA
415
Fair value less costs to sell (net selling amount) is the amount obtained from the sale of an
asset or cash-generating unit in an arm's length transaction between knowledgeable, willing
parties, less the costs of disposal.
An impairment loss is the amount by which the carrying amount of an asset or cash-generating
unit exceeds its recoverable amount.
The recoverable amount of an asset or cash-generating unit is the higher of its fair value less
costs to sell (net selling amount) and its value in use.
Value in use is the present value of the future cash flows expected to be derived from an asset
or cash- generating unit.
20.3 IDENTIFYING IMPAIRED ASSETS
An entity should assess at each reporting date whether there is any indication that an asset may
be impaired. If there is such an indication, the entity should estimate the asset's recoverable
amount. Regardless of whether there is an indication of impairment, the entity should also:
a) test an intangible asset with an indefinite useful life or an intangible asset not yet
available for use for impairment by comparing its carrying amount with its recoverable
amount; an asset which was initially recognised during the current annual period should
be tested for impairment before the end of this period;
b) test goodwill acquired in a business combination for impairment annually.
The following indications should be taken into account when assessing an asset for impairment.
External sources of information
i)
During the period, an asset's market value has declined significantly more than
would be expected as a result of the passage of time or normal use.
ii)
Significant changes with an adverse impact on the entity have occurred during the
period, or are expected to occur in the near future in the technological, market,
economic or legal environment in which the entity operates or in the market to
which an asset is dedicated.
iii)
Market interest rates or other market rates of return on investments have increased
during the period, and those increases are likely to affect the discount rate used in
calculating an asset's value in use and decrease the asset's recoverable amount
materially.
iv)
The carrying amount of the entity's net assets is more than its market capitalisation.
Internal sources of information
i)
There is evidence of obsolescence or physical damage of an asset
ii)
Significant changes with an adverse effect on the entity have occurred during the
period, or are expected to occur in the near future, in the extent to which or the
manner in which an asset will be used; these changes include the asset becoming
idle, plans to discontinue or restructure the operation to which an asset belongs,
ICSAZ - P.M. PARADZA
416
plans to dispose of an asset before the previously expected date, and determining
that an asset's useful life is now finite rather than indefinite.
iii)
There is evidence from internal reporting indicating that an asset's economic
performance is or will be, worse than expected. Examples of such evidence are:
a) cash flows for acquiring the asset, or subsequent cash needs for operating or
maintaining it, that are significantly higher than those originally budgeted;
b) actual net cash flows or operating profit or loss related to the asset that are
significantly worse than those budgeted.
Dividend from a subsidiary, joint arrangement or associate
Existence of evidence that:
(i)
the carrying amount of the investment in the separate financial statements exceeds
the carrying amounts in the consolidated financial statements of the investee's net
assets, including associated goodwill; or
(ii)
the dividend exceeds the total comprehensive income of the subsidiary, jointarrangement or associate in the period during which the dividend is declared.
The principle of materiality should be applied when determining whether an asset's recoverable
amount needs to be estimated. In the case of market interest rates which have increased during
the period, no such estimate is required if:
i)
the discount rate used in calculating the asset's value in use is not likely to be
affected by the increase in those rates, for example, increases in short-term interest
rates may not materially affect the discount rate to be used for an asset that has a
long remaining useful life.
ii)
the discount rate used in calculating the asset's value in use is likely to be affected
by the increase in these rates, but previous sensitivity analysis of the recoverable
amount shows that:
a) it is unlikely that there will be a material decrease in recoverable amount because
future cash flows are also likely to increase, for example, the entity may be able to
adjust its revenues to compensate for any increase in market rates;
b) the decrease in recoverable amount is unlikely to result in a material impairment
loss.
20.4 MEASURING RECOVERABLE AMOUNT
The requirements/guidelines for measuring an asset's recoverable amount are as follows:
i)
It is not always necessary to determine both an asset's fair value less costs to sell
and its value in use. If either of these amounts exceeds the asset's carrying amount,
this indicates that it is not impaired.
ii)
It may be possible to determine fair value less costs to sell, even if an asset is not
traded in an active market. However, this may be difficult because there is no basis
ICSAZ - P.M. PARADZA
417
for making a reliable estimate of the amount obtainable from selling the asset in an
arm's length transaction between knowledgeable and willing parties. In such cases,
the asset's value in use may be used as its recoverable amount.
iii)
If there is no reason to believe that an asset's value in use materially exceeds its fair
value less costs to sell, the asset's fair value less costs to sell may be used as its
recoverable amount. This is often the case for assets that are held for sale.
Recoverable amount should be determined for an individual asset, unless it does not generate
cash inflows that are largely independent of those from other assets or groups of assets. In that
case, recoverable amount should be determined from the cash-generating unit to which the
asset belongs.
The exceptions to this rule:
i)
the asset's fair value less costs to sell is higher than its carrying amount;
ii)
the asset's value in use can be estimated to be close to its fair value less costs to sell,
and this fair value can be determined.
In the case of an intangible asset with an indefinite useful life, the most detailed calculation of
its recoverable amount made in a preceding period may be used to test it for impairment in the
current period, if the following conditions are met:
a) if the asset is tested for impairment as part of a cash-generating unit, and the assets and
liabilities making up that unit have not changed significantly since the most recent
recoverable amount calculation;
b) the most recent recoverable amount calculation resulted in an amount that exceeded the
asset's carrying amount by a substantial margin; and
c) based on an analysis of events that have occurred and circumstances that have changed
since the most recent recoverable amount calculation, the likelihood that a current
recoverable amount determination would be less than the asset's carrying amount is
remote.
ACTIVITY 20.1
a) What do you understand by the term 'impairment of assets'?
b) What are the indications which should be taken into account when assessing an asset for
impairment?
20.5 MEASURING FAIR VALUE LESS COSTS TO SELL
According to IAS 36, the best indicator of an asset's net selling amount is the selling price in a
binding sale agreement in an arm's length transaction, adjusted for incremental costs that would
be directly attributable to the asset's disposal.
Other considerations are as follows:
•
If there is no binding agreement but the asset is traded in an active market, net selling
amount is the asset's market price less the disposal costs. In many cases the closest
ICSAZ - P.M. PARADZA
418
approximation to the market price is the current bid price, or the price of the most recent
transaction, as long as there has been no major change in trading conditions.
•
If there is no binding sale agreement or active market for an asset, net selling amount
is based on the best available information on the amount that the entity could obtain, at
the reporting date from the asset's disposal in an arm's length transaction between
knowledgeable, willing parties, after deducting disposal costs.
•
Disposal costs, other than those that have been recognised as liabilities should be
deducted in determining net selling amount. Examples of disposal costs are legal costs,
stamp duty and similar transaction taxes, costs of removing the asset, and direct
incremental costs to bring the asset into saleable condition
20.6 MEASURING VALUE IN USE
Value-in-use. The discounted present value of the future cash flows expected to arise from an
asset or a cash-generating unit.
The following aspects should be considered when calculating an asset's value in use:
i)
an estimate of the future cash flows that the entity expects to derive from the asset
ii)
expectations about possible variations in the amount of timing of those future cash
flows
iii)
the time value of money, represented by the current market risk-free rate of interest
iv)
the cost of bearing the uncertainty inherent in the asset
v)
other factors, for example, lack of liquidity that market participants would take into
account when pricing the future cash flows the entity expects to derive from the
asset.
The basic steps in estimating an asset's value in use are as follows:
a) estimating the future cash inflows and outflows to be derived from use of the asset and
its ultimate disposal
b) applying the appropriate discount to those future net cash flows
Adjustments for risk can be reflected either as adjustments to the future cash flows or as
adjustments to the discount rate. In either case, the aim is to estimate the expected present
value of the future cash flows based on the weighted average of all possible outcomes. A
discount rate should not take into account risks in respect of which future cash flows have
already been adjusted.
In measuring value in use an entity should:
i)
base cash flow projections on reasonable and supportable assumptions representing
management's best estimate of the range of economic conditions that will exist over
the remaining useful life of the asset; in this assessment greater weight should be
given to external evidence.
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ii)
base cash flow projections on the most recent financial budgets/forecasts approved
by management, but should exclude any estimated cash inflows or outflows
expected to rise from future restructurings or from improving or enhancing the
asset's performance; projections based on these budgets/forecasts should not exceed
5 years unless this can be justified.
iii)
estimate cash flow projections beyond the period covered by the most recent
budgets/forecasts by extrapolating the projections based on these budgets/forecasts
using a steady or declining growth rate for subsequent years, unless an increasing
rate can be justified.
The estimates for future net cash flows should include:
a) projections of cash from the asset's continuing use
b) projections of cash outflows that are necessarily incurred to generate cash inflows from
the asset's continuing use and can be directly attributed, or allocated on a reasonable
and consistent basis to the asset
c) net cash flows, if any, to be received (paid) for the asset's disposal at the end of its
useful life.
To avoid double-counting, estimates of future cash flows should not include:
a) cash inflows from assets that generate cash inflows that are largely independent of the
cash inflows from the asset under review
b) cash outflows that relate to obligations that have been recognised as liabilities (for
example, trade payables, pensions and provisions)
Estimates of future cash flows should also exclude:
a) cash inflows from financing activities
b) income tax receipts or payments The reason for excluding these cash flows is that the
calculations for relevant cash flows are based on a pre-tax discount rate which reflects
current market assessments of the time value of money and the risks related to the
financing of the assets.
20.7 RECOGNISING AND MEASURING AN IMPAIRMENT LOSS
1. If the recoverable amount of an asset is less than its carrying amount, this carrying amount
should be reduced to the recoverable amount. This reduction constitutes the recognition of an
impairment loss.
2. The recognition of the impairment loss is shown immediately in the statement of profit or
loss and other comprehensive income, unless the asset is carried at a revalued amount in
accordance with another standard. An impairment loss of a revalued asset should be treated as
a revaluation decrease to the extent that the loss does not exceed the revaluation surplus for the
asset.
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3. If the amount estimated for an impairment loss is greater than the carrying amount of the
asset to which it relates, the entity should recognise a liability if this is required by another
standard.
4. After the recognition of an impairment loss, the depreciation or amortisation charge for the
asset should be adjusted in future periods to allocate the asset's revised carrying amount, less
its residual value, on a systematic basis over its remaining useful life.
20.8 IDENTIFYING THE CASH-GENERATING UNIT TO WHICH AN ASSET
BELONGS
Cash-generating unit. The smallest group of assets that can be identified that generates cash
flows independently of the cash flows from other assets.
IAS 36 applies the concept of cash-generating units where it is not possible to estimate the
recoverable amount of individual assets because of the nature of the assets and their
contribution to the entity's cash flows. In such cases, an entity should determine the recoverable
amount of the cash- generating units to which the individual assets belong. The recoverable
amount of an individual asset cannot be determined if:
a) the asset's value in use cannot be estimated to be close to its fair value less costs to sell,
for example, when the future cash flows from the asset's continuing use are not
negligible
b) the asset does not generate cash inflows that are largely independent of those from other
assets.
The identification of an asset's cash-generating unit is an exercise which requires judgement.
Issues to be taken into account include how management monitors and makes decisions about
continuing use or disposing of the entity's assets and operations (for example, by product lines,
business units, locations or regions).
The standard explains that if an active market exists for the output produced by an asset or
group of assets, that asset or group of assets should be identified as a cash-generating unit, even
if some of the output is used internally. If the cash inflows generated by any asset or cash
generating unit are affected by internal transfer pricing, the entity should use management's
best estimate of future prices that could be obtained in arm's length transactions to project:
a) the future cash inflows used to determine the asset's or cash-generating unit's value in
use
b) the future cash outflows used to determine the value in use of any other assets or
c) cash generating units that are affected by the internal transfer pricing
The standard requires that cash-generating units should be identified consistently from period
to period for the same asset or types of assets, unless a change is justified.
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EXAMPLE (FROM IAS 36) PLANT FOR AN INTERMEDIATE STEP IN A
PRODUCTION PROCESS
A significant raw material used for Plant Y's final production is an intermediate product bought
from Plant X of the same entity. X's products are sold to Y at a transfer price that passes all
margins to X. 80% of Y's final production is sold to outside customers, 60% of X's final
production is sold to Y and the remaining 40% is sold to outside customers.
For each of the following cases, what are the cash-generating units for X and Y?
Case 1: X could sell the products it is currently selling to Y in an active market. The internal
transfer prices are higher than market prices.
Case 2: There is no active market for the products X is currently selling to Y.
SUGGESTED SOLUTION
Case 1: X could sell its products in an active market and so generate cash inflows that would
be independent of the cash flows from Y, therefore, it is likely that X is a separate cashgenerating unit, although part of its production is used by Y.
It is also likely that Y is a separate cash-generating unit. Y sells 80% of its products to outside
customers. Therefore, its cash inflows can be considered to be largely independent.
Internal transfer prices do not reflect market prices for X`s output. Therefore, in determining
value in use of both X and Y, the entity should adjust its financial budget/forecasts to reflect
management's best estimate of future prices that could be achieved in arm's length transactions
for those of X's products that are used internally.
Case 2: It is likely that the recoverable amount of each plant cannot be assessed independently
of the recoverable amount of the other plant because:
a) most of X’s production is used internally and cannot be sold in an active market. This means
that X's cash inflows depend on the demand for Y's products. Therefore, X cannot be
considered to generate cash inflows that are largely independent of those of Y.
b) the two plants are managed together.
As a result, it is likely that X and Y together are the smallest group of assets that generate
largely independent cash inflows.
ACTIVITY 20.2
A manufacturing entity owns several vehicles. The vehicles are several years old and could be
sold only for scrap value. They do not generate cash independently from the entity.
REQUIRED
How will the recoverable value of the vehicles be determined?
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ACTIVITY 20.3
A railway entity has a contract with the government that requires service on each of 10 different
routes. The trains operating on each route and the income from each route can be identified
easily. Two of the routes make substantially more profit than the others. The entity also
operates a taxi service, a bus company, and a travel agency.
REQUIRED
What is the lowest level of cash-generating units that can be used by the entity?
20.9 RECOVERABLE AMOUNT AND CARRYING AMOUNT OF A CASHGENERATING UNIT
IAS 36 states that the carrying amount of a cash-generating unit should be determined on a
basis that is consistent with the way in which its recoverable amount is determined. This means
that the same items should be included in the calculations.
The carrying amount of a cash-generating unit should:
•
include only those assets that can be attributed directly, or allocated on a reasonable
and consistent basis, to the cash-generating unit and will generate cash inflows which
affect the determination of the unit's value in use;
•
exclude the carrying amount of recognised liabilities, unless the recoverable amount of
the cash-generating unit cannot be determined without taking such liabilities into
account.
When assets are grouped to determine their recoverable amounts, the entity should include in
the cash-generating units all assets that generate or are used to generate the relevant cash flow
streams. If this is not done, the unit may appear to be fully recoverable when in fact there has
been an impairment loss. Although some assets may contribute to the estimated cash flows of
a unit, they cannot be allocated to the unit on a reasonable and consistent basis. Examples of
such assets are goodwill or corporate assets, for example, the head office building.
Although liabilities are generally excluded in the determination of the recoverable amounts of
cash- generating units, there are times when it is necessary to include them. An example of this
is when the disposal of a unit would require the buyer to assume a liability attached to it. In
such a case, the fair value less costs to sell or the estimated cash flow from the ultimate disposal
of the unit would be the estimated selling price of the unit's assets and the liability together,
less the disposal costs. In order to make a meaningful comparison between the unit's carrying
amount and its recoverable amount the liability's carrying amount should be deducted when
calculating both the unit's value in use and its carrying amount.
20.10 ALLOCATING GOODWILL TO CASH-GENERATING UNITS
In order to test a cash-generating unit for impairment, any goodwill acquired in a business
combination should, from the acquisition date, be allocated to each of the acquiring entity's
cash-generating units that are expected to benefit from the combination. This rule applies
ICSAZ - P.M. PARADZA
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regardless of whether other assets or liabilities of the acquired entity have been assigned to the
units. Each unit or group of units to which the goodwill is allocated should:
a) represent the lowest level within the entity at which the goodwill can be monitored for
internal management purposes;
b) not be larger than a segment based on either the entity's primary or secondary reporting
format in accordance with IFRS 8 (Operating Segments)
It is important to note that goodwill does not generate cash flows independently of other assets
or groups of assets, and often contributes to the cash flows of many cash-generating units. This
means that in most cases it is not possible to allocate goodwill objectively to individual cashgenerating units, but only to groups of such units. According to IFRS 3, the initial accounting
for a business combination may be determined only provisionally by the end of the period in
which the combination is effected. In such a case, the acquirer should:
i)
account for the combination using the provisional values.
ii)
recognise any adjustments to those values by completing the initial accounting
within 12 months of the acquisition date
If goodwill has been allocated to a cash-generating unit and the entity disposes of an operation
within that unit, the goodwill associated with the operation should be
a) included in the operation's carrying amount when determining the gain or loss on
disposal;
b) measured on the basis of the relative values of the operation disposed of and the portion
of the cash-generating unit that is retained, unless there is a better method of reflecting
the goodwill.
EXAMPLE (FROM IAS 36)
An entity sells an operation that was part of a cash-generating unit to which goodwill has been
allocated. The goodwill allocated to the unit cannot be identified or associated with an asset
group at a level lower than that unit, except arbitrarily.
Because the goodwill allocated to the cash-generating unit cannot be non-arbitrarily identified
or associated with an asset group at a level lower than that unit, the goodwill associated with
the operation disposed of should be measured on the basis of the relative values of the operation
disposed of and retained portion of the unit.
If an entity reorganises its reporting structure in a way that changes the composition of one or
more cash-generating units to which goodwill has been allocated, the goodwill should be
reallocated to the affected units. This is done using a relative value approach similar to that
used when an entity disposes of an operation within a cash-generating unit, unless there is a
better method of reflecting the goodwill.
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20.11 TESTING CASH-GENERATING UNITS WITH GOODWILL FOR
IMPAIRMENT
IAS 36 requires that each cash-generating unit to which goodwill has been allocated should be
tested for impairment annually. The test should also be performed whenever there is an
indication that the unit may be impaired. This is done by comparing the unit's carrying amount
including the goodwill, with its recoverable amount.
•
If the recoverable amount exceeds the carrying amount, the unit and the goodwill
attached to it will be considered as not impaired;
•
If the carrying amount exceeds the recoverable amount the entity should recognise an
impairment loss.
20.11.1 Testing cash-generating units for impairment with no goodwill attached to them
When it is not possible to allocate goodwill to a cash-generating unit on a reasonable and
consistent basis, goodwill should be allocated to a group of units which contains the one which
could not be individually allocated. For such units, the impairment test should be undertaken
whenever there is an indication that the unit may be impaired. This is done by comparing the
unit's carrying amount excluding goodwill with its recoverable amount. Any impairment loss
which arises is allocated to the assets of this unit proportionately based on the carrying amounts
of the assets.
EXAMPLE – P LTD
P Ltd. acquired all the shares in Q Ltd. on 1 January 20-6 for $35 000 000. Q Ltd comprises 3
cash generating units i.e. X, Y and Z. The fair value of these units' net assets were $12 500 000,
$8 400 000 and $6 000 000 respectively. The following information relates to these units:
31/12/20-6
X
$
16 000 000
Net carrying amount
(excluding goodwill)
Recoverable amount
18 300 000
(including effect on goodwill)
Y
$
6 500 000
Z
$
3 800 000
TOTAL
$
26 300 000
9 700 000
3 300 000
31 300 000
REQUIRED
Calculate impairment losses for the cash generating units (where applicable) on 31 December
20-6. Assume that goodwill can be allocated to the units based on the fair values of their net
assets.
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SUGGESTED SOLUTION
31/12/20-6
X
$
16 000 000
Y
$
6 500 000
Net carrying amount
(excluding goodwill)
Recoverable amount
(including effect on goodwill)
–
X 8 100 000* x 12 500/26 900 3 763 941
8 400
Y 8 100 000 x
/26 900
–
2 529 368
Z 8 100 000 x 6 000/26 900
–
–
19 763 941 9 029 368
Recoverable amounts
18 300 000 9 700 000
Impairment loss
1 463 941
–
*[$35 000 000-(12 500 000 + 8 400 000 + 6 000 000)]
X
$
3 800 000
TOTAL
$
26 300 000
–
–
3 763 941
2 529 368
1 806 691
5 606 691
3 300 000
2 306 691
1 806 691
34 400 000
31 300 000
3 100 000
i) The impairment loss of $1 463 941 will be offset against the goodwill of $3 763 941
allocated to X, leaving goodwill of $2 300 000 in the cash generating unit.
ii) The impairment loss of $2 306 691 will exhaust the allocated goodwill of $1 806 691
allocated to Z, and the remaining impairment loss of $500 000 will be allocated to the
individual assets in the cash-generating units based on their carrying amounts.
iii) The overall impairment loss of $3 100 000 calculated by using the total figures of $34 400
000 and $31 300 000 is not significant, since goodwill has been allocated to the individual cash
generating units.
EXAMPLE – P Ltd continued
Use the information in Example 4 above. However, assume that goodwill cannot be allocated
to the individual cash generating units.
REQUIRED
Calculate impairment losses for the cash generating units where applicable
SUGGESTED SOLUTION
31/12/ 20-6
X
$
Net carrying amounts
of assets
16 000 000
Recoverable amounts
18 300 000
Impairment loss on
individual CGU
–
Net carrying amount for
3 CGU's with no goodwill
attached to them individually
Y
$
Z
$
TOTAL
$
6 500 000
9 700 000
3 800 000
3 300 000
26 300 000
–
500 000*
(500 000)
25 800 000
*The impairment loss is allocated to the individual assets in unit Z, based on their carrying
amounts.
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20.12 CORPORATE ASSETS
IAS 36 defines corporate assets as assets other than goodwill that contribute to the future cash
flows of both the cash-generating unit under review and other cash-generating units. Examples
of corporate assets are a factory building, computer equipment, or a research and development
centre. A major characteristic of such assets is that they do not generate cash inflows
independently of other assets or groups of assets, and their carrying amount cannot be fully
attributed to the cash-generating unit under review.
Since corporate assets do not give rise to cash inflows on their own, their recoverable amounts
can only be determined in the event of a disposal. If there is an indication that a corporate asset
which is still in use may be impaired, recoverable amount can only be estimated in relation to
the cash- generating unit or group of cash-generating units to which the asset belongs.
When testing a cash-generating unit for impairment, an entity should identify all the corporate
assets that relate to the unit being reviewed. If a portion of the carrying amount of a corporate
asset:
a) can be allocated on a reasonable and consistent basis to that unit, the entity should
compare the carrying amount of the unit, including the portion of the carrying amount
of the corporate asset allocated to the unit, with its recoverable amount;
b) cannot be allocated on a reasonable and consistent basis to that unit, the entity should
i) compare the carrying amount of the unit, excluding the corporate asset, with its
recoverable amount and recognise any impairment loss.
ii) identify the smallest group of cash generating units that includes the cash- generating
unit under review and to which a portion of the carrying amount of the corporate asset
can be allocated on a reasonable and consistent basis and.
iii) compare the carrying amount of that group of cash-generating units, including the
portion of the carrying amount of the corporate asset allocated to that group of units,
with the recoverable amount of the group of units.
20.13 RECOGNITION OF IMPAIRMENT LOSS FOR A CASH-GENERATING UNIT
An impairment loss is recognised for a cash-generating unit if the recoverable amount of the
unit or a group of units is less than the carrying amount of the unit or group of units. The loss
should be allocated to reduce the carrying amount of the assets in the following order:
a) to reduce the carrying amount of any goodwill allocated to the cash-generating unit or group
of units
b) to the other assets of the unit or group of units pro rata on the basis of the carrying amount
of each asset.
When allocating an impairment loss, an entity should not reduce the carrying amount of an
asset below the highest of
a) its fair value less costs to sell;
b) its value in use (if separately determinable); and
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427
c) zero
The amount of the impairment loss that would otherwise have been allocated to the asset should
be allocated proportionately to the other assets of the unit or group of units.
Tutorial Note:
You may use the example below (Multiplex) or any other, more or less similar, to ensure
students grasp the application of the criteria stated above.
EXAMPLE - IMPAIRMENT LOSS RECOGNITION FOR A CASH-GENERATING
UNIT
On 1 January 20-0 Multiplex acquired the whole of Steamdays, a company that operates a
scenic railway along a coast of a popular tourist area. The summarised statement of financial
position at fair values of Steamdays on 1 January 20-0 reflecting the terms of the acquisition
was:
Goodwill
Operating licence
Property – train stations and land
Rail track and coaches
Two steam engines
Purchase consideration
$
200 000
1 200 000
300 000
300 000
1 000 000
3 000 000
The operating licence is for ten years. It was renewed on 1 January 20-0 by the transport
authority and is stated at cost of its renewal. Carrying values of property, rail track and coaches
are based on their value in use. Engines are valued at their net selling prices.
On 1 February 20-0 the boiler of one of the steam engines exploded completely destroying the
whole engine. Fortunately no one was injured but the engine was beyond repair. Due to its age
a replacement could not be obtained. Because of the reduced passenger capacity the estimated
value in use of the whole of the business after the accident was assessed at $2 000 000.
Passenger numbers after the accident were below expectations even after the reduction of
capacity. A market research report concluded that tourists were not using the railway because
of their fear of a similar accident occurring to the remaining engine. In the light of this the
value in use of the business was re-assessed on 31 March 20-0 at $1 800 000. On this date
Multiplex received an offer of $900 000 in respect of the operating licence (it is transferable).
The realisable value of the other net assets has not changed significantly.
REQUIRED
Calculate the carrying value of the assets of Steamdays (in Multiplex`s consolidated statement
of financial position) at 1 February 20-0 and 31 March 20-0 after recognising the impairment
losses.
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SUGGESTED SOLUTION
Goodwill
$
000
1 Jan 20-0
200
Impairment loss (200)
1 Feb 20-0
Nil
Impairment loss Nil
31 Mar 20-0
Nil
Op. Licence
$
000
1 200
(200)
1 000
(100)
900
Property
$
000
300
(50)
250
(50)
200
Rail Track
$
000
300
(50)
250
(50)
200
Engines Total
$
$
000
000
1 000
3 000
(500) (1 000)
500
2 000
Nil
(200)
500
1 800
N.B. the order instructed by the standard a-c is what has been used in coming up with solution
above.
EXAMPLE - X LTD
X Ltd acquired Y Ltd on 1 July 2006 for $50 000 000. The acquiree company has 2 independent
operations winch meet the definition of a cash generating unit. One operation is in South Africa
while the other is in D.R.C
The following information relates to the D.R.C. operation on the date of acquisition:
$
15 000 000
5 600 000
20 600 000
Fair value of identifiable assets
Goodwill
Total purchase price
Depreciation on tangible non-current assets is provided for on a straight-line basis over 6
years. Intangible non-current assets are not amortised, but tested for impairment on an annual
basis. Residual values are not applicable.
On 30 June 20-8 the D.R.C. announced significant restrictions on locally-based companies,
which impacted negatively on Y Ltd's business. The value in use of this business on that date
was $9 600 000.
REQUIRED
Calculate and allocate the impairment loss for the D.R.C. operation and show how it is
allocated.
SUGGESTED SOLUTION
Goodwill
$
Cost
5 600 000
Accumulated depreciation
–
Carrying amount
5 600 000
Impairment loss
5 600 000
Recoverable amount
–
Identifiable
assets
$
15 000 000
(5 000 000)
10 000 000
4 000 000
9 600 000
Total
$
20 600 000
(5 000 000)
15 600 000
6 000 000
9 600 000
Note that the impairment loss of the D.R.C. cash generating unit should be allocated first to goodwill and then to other assets.
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20.14 REVERSAL OF IMPAIRMENT LOSSES
IAS 36 states that an entity should check at each reporting date for indications whether an
impairment loss recognised in previous periods for an asset other than goodwill may no longer
exist or has decreased. If there is such an indication, the entity should estimate the asset's
recoverable amount. The following indications should be considered when making the
assessment.
External sources of information
i)
The asset's market value has increased significantly during the period
ii)
Significant changes with a favourable impact on the entity have occurred during the
period, or are expected to occur in the near future, in the technological market or legal
environment in which the entity operates or in the market to which the asset is
dedicated
iii)
Market interest rates or other market rates of return on investments have decreased
during the period, these decreases are likely to affect the discount rate used in
calculating the asset's value in use and increase its recoverable amount significantly.
Internal sources of information
i)
Significant changes with a favourable impact on the entity have occurred during the
period, or are expected to occur in the near future, in the extent to which or the
manner in which the asset is used or is expected to be used. These changes include
costs incurred during the period to improve or enhance the asset's performance or
restructure the operation to which the asset belongs.
ii)
There is evidence from internal reporting indicating that the asset's economic
performance is, or will be better than expected.
Specific conditions for reversal of impairment loss
An impairment loss which was recognised in earlier periods for an asset other than goodwill
should only be reversed if there has been a change in the estimates used to determine its
recoverable amount since the last impairment loss was recognised. If this is the case, the asset's
carrying amount should be increased to its recoverable amount, representing a reversal of the
impairment loss.
The standard notes that the reversal of an impairment loss reflects an increase in the estimated
service potential of an asset, since an impairment loss was last recognised for the asset. Such
an increase may be related to
i)
A change in the basis for calculating the asset's recoverable amount (that is, whether
the amount is based on fair value less costs to sell or value in use);
ii)
If recoverable amount was based on value in use, a change in the amount or timing
of estimated future cash flows or in the discount rate;
iii)
If recoverable amount was based on fair value less costs to sell, a change in
estimates of the components of fair value less costs to sell;
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20.14.1 Guidelines for reversing an impairment loss for individual assets
i) The increased carrying amount of an asset other than goodwill attributable to the reversal of
an impairment loss should not exceed the carrying amount that would have been determined
net of amortisation or depreciation if no impairment had been recognised for the asset in prior
years.
ii) The reversal of an impairment loss for an asset other than goodwill should be recognised
immediately in the statement of comprehensive income, unless the asset is carried at a revalued
amount. Any such reversal should be treated as a revaluation increase in terms of the relevant
standard.
iii) After the reversal of an impairment loss has been recognized, the depreciation or
amortisation charge for the asset should be adjusted in future periods to allocate its revised
carrying amount, less its residual value, on a systematic basis over its remaining useful life.
20.14.2 Guidelines for reversing an impairment loss for a cash-generating unit
i) The reversal of an impairment loss for a cash-generating unit should be allocated to the unit's
assets, proportionately to the carrying amounts of those assets.
ii) In allocating the reversal of an impairment loss for a cash-generating unit, an asset's carrying
amount should not be increased above the lower of
a) its recoverable amount (if determinable) and
b) the carrying amount that would have been determined (net of amortisation or depreciation)
had no impairment been recognised for the asset in prior periods.
The amount of the reversal of the impairment loss that would otherwise have been allocated to
the asset should be allocated proportionately to the other assets in the unit, except goodwill.
An impairment loss recognised for goodwill should not be reversed in a subsequent period.
ACTIVITY – 20.4
ICSAZ November 2003 Question 3 Past examination paper
It is generally recognised in practice that non-current assets should not be carried in the
statement of financial position at values that are greater than they are ‘worth’. In the past there
has been little guidance in this area with the result that impairment losses were not recognised
on a consistent and timely basis or were not recognised at all; up until IAS 36 – Impairment of
assets came up.
REQUIRED
a)
i) Define an impairment loss and explain when companies should carry out a review for
impairment of assets. (2 marks)
ii) Describe the circumstances that may indicate that a company`s assets may have
become impaired. (5 marks)
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431
b)
Sisonke Limited is a company which has two production lines. For the current year the
profit resulting from the music production line decreased significantly because of better
prices offered by competition.
On 31 October 20-3, non-current assets of the company consist of the following:
Plant and equipment
Furniture and fittings
Goodwill
Cost
$000
23 100
4 900
6 200
Acc Depn/Amort
$000
8 200
2 400
2 100
C/A
$000
14 900
2 500
4 100
The music production line represents a cash generating unit. The carrying amount of
non-current assets of the music production line on 31 October 20-3.
Plant and equipment
Furniture and fittings
Cost
$000
9 600
2 300
Acc Depn/Amort
$000
3 200
1 100
C/A
$000
6 400
1 200
Acc Depn – Accumulated depreciation
Acc Amort – Accumulated amortisation
In addition you established that the net selling price of the furniture and fittings of the
music production line, which amounted to $950 000 on 31 October 20-3 and 40% of
the goodwill was allocated to the music production line.
The net cash flows expected from the music production line are as follows:
2004
2005
2006
2007
2008
Sales
$000
18 000
19 400
20 200
16 100
8 200
Cost of Sales
$000
12 400
12 900
13 200
12 100
6 600
Op. Costs
$000
3 600
3 900
4 100
3 200
1 800
Op. costs – Operating costs
At the end of 20-8, the plant and equipment, and the furniture and fittings of the music
production line should be sold for $500 000 after deducting selling costs.
An applicable discount rate after taxation is 12.6%. Assume a normal tax rate of 30%.
REQUIRED
Calculate the impairment loss of the music production line for the year ended 31
October 20-3 and the carrying amount of goodwill of Sisonke Limited.
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ACTIVITY – REVERSAL (CGU)
On 1 January 20-2, Olive Ltd acquired a controlling interest in Liona Ltd. The purchase
consideration of $100 million was made up as follows:
North Africa
Southern Africa
East Africa
Purchase price
$000
50 000
30 000
20 000
Carrying amount
$000
40 000
25 000
14 000
Goodwill
$000
10 000
5 000
6 000
In January 20-2 a civil war started in Southern Africa which reduced the Region`s output by
60%. On 31 December 20-2, it was estimated that the recoverable amount of the investment in
this region was $10 million. At the end of 2003 the civil war ceased and output increased by
80%. Olive Ltd depreciates all non-current assets, save for goodwill, over 5 years using straight
line basis.
REQUIRED
a) Calculate the impairment loss and its allocation on 31 December 20-2. (4 marks)
b) Calculate the impairment loss reversal on 31 December 20-3, if the recoverable amount on
that date is $8 million. (6 marks)
20.15 DISCLOSURE REQUIREMENTS
20.15.1
For each class of asset an entity shall disclose
a) Impairment losses recognized in profit or loss
b) Impairment losses reversed in profit or loss
c) The line item in the profit or loss in which the impairment losses are included.
Additionally, any impairment losses recognized directly in equity should be disclosed,
including reversals of impairment losses.
20.15.2
only:
Each operating segment should disclose these items in terms of primary segments
•
impairment losses recognized and reversed in the period both in profit or loss and
directly in equity.
20.15.3 If an individual impairment loss or reversal is material, then this information should
be disclosed:
(a) The events and circumstances leading to the impairment loss
(b) The amount of the loss
(c) If it relates to an individual asset, the nature of the asset and the segment to which it relates
(d) For a cash-generating unit, the description of the amount of the impairment loss or reversal
by class of assets and segment should be disclosed.
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433
(e) If the recoverable amount is fair value less costs to sell, the basis for determining fair value
must be disclosed.
(f) If the recoverable amount is the value in use, the discount rate should be disclosed.
20.15.4 If the impairment losses recognized or reversed are material in relation to the financial
statements as a whole, the main classes of assets affected should be disclosed and the main
events and circumstances that lead to the recognition of those losses should be disclosed.
20.15.5 Detailed information about the estimates used to measure the recoverable amounts
of the cash-generating units that contain goodwill or intangible assets with an indefinite useful
life should also be set out.
20.16 SUMMARY
This Unit explains various methods which can be used to ensure that an entity's non-current
assets are recorded and maintained in its financial statements at realistic amounts. IAS 36
focuses on the impairment of assets, which refers to a permanent diminution in the value of
assets, although such decreases are sometimes reversible. The standard makes an important
distinction in the accounting treatment of goodwill and other non- tangible assets with regard
to their impairment.
20.17 REFERENCES
VORSTER, Q., 2010
Descriptive Accounting 15th
Edition, LexisNexis, Durban
MIRZA, A. A.; ORRELL, M.; HOLT. G. J., 2008
Wiley IFRS Practical
Implementation and Guide
Workbook, 2nd Edition, Hoboken,
New Jersey
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UNIT TWENTY-ONE
EMPLOYEE BENEFITS (IAS 19 – Revised [2014])
21.0 INTRODUCTION
The standard deals with the accounting treatment for and disclosure of benefits paid or provided
by the employers to their employees for services rendered. An employee benefit is any form of
consideration given by the entity in exchange for the services rendered by the employee. It is
different from an equity compensation benefit that is dealt with in IFRS 2 (Share-based
payment).
21.1 OBJECTIVES
By the end of this Unit, you should be able to:
•
Identify the major categories of employee benefits
•
Distinguish between defined benefit contribution plan and defined benefit plan
•
Explain the recognition and measurement rules for employee benefits
•
Explain the use of actuarial assumptions in the determination of employee benefits
•
Outline the disclosure requirements for employee benefits
21.2 CHANGES TO THE OLD IAS 19 (IFRS UPDATE, 2014: ERNST & YOUNG)
(What is below is for old students to appreciate the changes. New students should simply embrace the revised standard)
IAS 19 Employee Benefits was revised with effect from annual periods beginning on or
after 1 January 2013.
The revised standard included a number of amendments that range from fundamental changes
to simple clarifications and re-wording. The more significant changes include the following:
For defined benefit plans, the ability to defer recognition of actuarial gains and losses (that is,
the corridor approach) was removed. As revised, amounts recorded in profit or loss are limited
to current and past service costs, gains or losses on settlements, and net interest income
(expense). All other changes in the net defined benefit asset (liability), including actuarial gains
and losses, are recognized in other comprehensive income with no subsequent
recycling/reclassification to profit or loss.
Expected returns on plan assets are no longer recognized in profit or loss. Expected returns
were replaced by recording interest income in profit or loss, which is calculated using the
discount rate used to measure the pension obligation. Previously it was possible to be given a
separate expected return rate for use on plan assets above the discount rate for use on plan
obligation.
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435
Objectives for disclosures of defined benefit plans are explicitly stated in the revised standard,
along with new and revised disclosure requirements. These new disclosures include
quantitative information about the sensitivity of the defined benefit obligation to a reasonably
possible change in each significant actuarial assumption.
Termination benefits are recognized at the earlier of when the offer of termination cannot be
withdrawn, or when the related restructuring costs are recognized under IAS 37 – Provisions,
Contingent Liabilities and Contingent Assets.
The distinction between short-term and other long-term employee benefits is based on the
expected timing of settlement rather than the employee’s entitlement to the benefits.
Effective for annual periods beginning on or after 1 July 2014:
IAS 19 requires an entity to consider contributions from employees or third parties when
accounting for defined benefit plans. IAS 19 requires such contributions that are linked to
service to be attributed to periods of service as a negative benefit.
The amendments clarify that, if the amount of the contributions is independent of the number
of years of service, an entity is permitted to recognize such contributions as a reduction in the
service cost in the period in which the service is rendered, instead of allocating the contributions
to the periods of service. Examples of such contributions include those that are a fixed
percentage of the employee’s salary, a fixed amount of contributions throughout the service
period, or contributions that depend on the employee’s age.
N.B All that has been said above can be summarized as below according to Silvia, 2014.
Before the change
These differences were called “actuarial gains or losses” and you could apply the socalled corridor method.
It means that if the accumulated unrecognized actuarial gains or losses exceeded 10% of the
greater of the defined benefit obligation or the fair value of plan assets, a portion of that net
gain or loss was required to be recognized immediately as income or expense.
And you needed to calculate this portion as the excess divided by the expected average working
lives of the participating employees.
Later, the option to recognize actuarial gains and losses to other comprehensive income in full
was added.
After the changes
These differences are called “re-measurements” now and they include the bigger group of
various differences:
•
Actuarial gains and losses on the defined benefit obligation,
ICSAZ - P.M. PARADZA
436
•
The difference between actual investment returns and the return implied by the net
interest cost; and,
•
The effect of the asset ceiling.
The good news is that you don’t need to worry about corridors, because amended IAS 19
requires posting all these re-measurements directly to other comprehensive income. Corridor
method is no longer permitted.
Other changes to IAS 19 Employee benefits
Apart from the above mentioned changes, there are a few other things to watch out for:
•
•
Past-service cost related to unvested benefits is recognized immediately after plan
amendment and is no longer spread over a future-service period.
We shall be using pre-tax rate (not post-tax rate) in order to discount benefits to their
present value.
Accounting treatment of termination benefits
Termination benefit is simply a benefit received for terminating the employment before the
normal retirement date (given certain conditions are met).
Here, nothing much changed, but the standard IAS 19 now makes it clearer that when
employees need to provide future service in order to get the benefit, then it is NOT a
termination benefit.
For example, a nuclear power plant in South Africa shuts down its operations and needs to lay
off some employees. Some employees are offered the lump-sum payment of ZAR 500 000 for
voluntary acceptance of terminating the employment. Some employees are offered a bonus of
ZAR 100 000 for staying with the nuclear power plant until its complete shutdown after 3
years.
In this case, new IAS 19 makes clear that the bonus of ZAR 500 000 is termination benefit as
it does not require future service.
However, the bonus of ZAR 100 000 is NOT a termination benefit, because it requires future
service until the closure of power plant. This bonus should be treated as part of a defined benefit
plan.
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21.3 CLASSIFICATION OF EMPLOYEE BENEFITS
There are four classes namely:
21.3.1 Short-term benefits
Wages and salaries
Social security contributions
Paid annual leave
Paid sick leave
Paid maternity/paternity leave
Vocational holiday benefit*
Profit shares and bonuses
Paid military service*
Paid jury service
Non-monetary benefits, for example, medical care, housing, cars, free or subsidized goods or
services
N.B. They are expected to be settled wholly before twelve months after the reporting date of
the period in which the employees render the related services
* Some European Nations, for example, Turkey have since approved a paid military service
bill, the aim of which was to decrease the number of absentees and people who get their military
service deferred as well as realize some very important social services (provided to relatives of
soldiers killed/handicapped on the battle front) in accordance with their Paid Military Service
law. This is not yet the case in Zimbabwe.
* relates to educational leave days granted to allow the employee to gain necessary skills and
improve their job or career more or less similar to study leave.
EXAMPLE – SHORT TERM EMPLOYMENT BENEFITS WITH TAX ASPECTS
The Zimbabwean economy has undergone a liquidity crunch for quite some time. The global
financial crisis has made the situation even worse for companies. As a result those charged
with governance at Ngiyay`bongela Enterprises have decided to scale down operations as
follows:
1. Old age employees, 55 years upwards, have been given only one option, which is to
retire involuntarily. They are to be paid a severance package of 8 months’ salary per
each employee, no matter the number of years served.
2. Employees below 55 years of age can voluntarily choose retirement immediately and
can get a lump sum payment of 4 months’ salary. If they stay with the company they
are, as part of the restructuring, given a lump sum payment of 5% of their annual salary,
the 13th cheque included and must welcome a 30% reduction of the current monthly
salary.
Ngiyay`bongela Enterprises has a 31 December financial year end. For the year 2-13 the lump
sum payments were made on 10 January 2-14. Zimra acknowledged the lump sum payments
were allowable for tax purposes.
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438
All 10 employees above 55 years of age had a monthly salary of $1 200 each. The annual salary
for all the other employees stood at $1 285 000, the 13th cheque included. Being 20 employees
below 55 years of age, 12 of them chose to stay with the company. They earned 35% of the
total salaries and wages bill.
Corporate tax rate is 25% per annum and deferred tax is computed using the statement of
financial position approach per IAS 12 – Income taxes.
REQUIRED
Relevant journal entries and the related tax aspects for the year ended 31 December 2-13 in as
far as the information permits.
SUGGESTED SOLUTION
31 December 2-13
DEBIT
Terminal benefits
DEDIT
Salaries and wages
CREDIT
Provision for employee benefits
Being provision for terminal employee benefits.
*1 (10 x 1 200 x 8) + (65% x 1 285 000/13months) x 4]
*2 5% x 35% x 1 285 000
31 December 2-13
DEBIT
Deferred tax asset
CREDIT
Deferred tax income
Being provision for deferred tax at 25%.
$
353 000.00*1
22 487.50*2
$
375 487.50
93 872.00
93 872.00
The following tax aspects relate to the restructuring transactions above:
Current tax payable
The tax authorities have permitted the company to deduct the restructuring costs as provided
for above on computation of tax payable. This is because:
a) the expenses are incidental to the production of gross income and not of a capital nature.
b) the other legislative provisions, for example, the Labour Act have not been violated.
(assuming all provisions of the Labour law have been adhered to)
Generally the tax authorities use the cash basis and do not allow for provisions unless the actual
cash expense has been paid. From a normal accounting perspective, the accruals basis is used
and provisions are deducted in coming up with profit before tax.
Deferred tax receivable
The provision for salaries and wages, bonus and other employee benefits represents a liability
in the statement of financial position. This is the carrying amount. The tax base will be nil given
that the tax authorities wait to take account of the effect of the transaction only after cash has
ICSAZ - P.M. PARADZA
439
been paid out or costs are due and payable. The resultant temporary difference is deductible
hence a deferred tax asset.
Tutorial Note 1:
Ensure preparation of students in class, with practice question examples on at least any three
of the above short-term employee benefits.
Tutorial Note 2:
Ensure preparation of students in class, with practice question examples on tax implications,
current and deferred tax, using at least any of the above short-term employee benefits.
21.3.2 Post-employment benefits
Pensions
Post-employment medical care
Post-employment life insurance
N.B They are employee benefits payable after the completion of employment.
21.3.3 Termination benefits (Lump sum payments)
Early retirement payments
Redundancy payments/ Severance pay
N.B Are employee benefits given in exchange for the termination of an employee’s
employment as a result of:
(a) The entity's decision to terminate an employee's employment before the normal retirement
date, or
(b) Employee's decision to accept an offer of benefits in exchange for the termination of
employment (voluntary retrenchment).
21.3.4 Other long-term benefits
Profit shares
Bonuses or deferred compensation payable later than 12 months after the year end
Sabbatical leave – a time period in which a person does not report to their job but remains
employed with the company, for example to rest for a month.
Long-service benefits
Long-term disability benefits
N.B Are all employee benefits other than short-term employee benefits, post-employment
benefits and termination benefits.
N.B Benefits may be paid to the employees themselves, to their dependants (spouses,
children, etc) or to third parties.
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440
21.4 PRACTICE QUESTION AND SUGGESTED SOLUTION ON SOME OF THE
KEY DEFINITIONS
QUESTION – KEY DEFINITIONS
Define and explain the following terms:
a) Defined contribution plan
b) Multi-Employer plan
c) Current Service cost
d) Past Service cost
e) Vested Employee benefits
f) Actuarial gains and losses
g) Return on plan assets
REQUIRED
Discuss the recognition criteria and measurement provision of IAS 19 with regard to the
compensated absences.
SUGGESTED SOLUTION
a) Defined contribution plan
It is a 1post retirement plan under which an enterprise pays 2 fixed contributions into a 3 separate
entity (fund manager). The enterprise has no legal or constructive obligation* to pay further
contributions if the fund does not hold sufficient assets to pay all employee benefits as they fall
due.
*Legal obligation is established by statute. Constructive obligation is as a result of repeated
past practice expected to remain the same in the future by another party.
N.B. Take note of what you should not leave out inscribed 1, 2 etc if you are to increase your
chances of correctly defining a defined contributing plan in an examination.
b) Multi employer plan
It is a 1 defined contribution plan or a 2 defined benefit plan other than a 3 state plan that pools
assets contributed by various enterprises not under 4 common control and makes use of those
assets to provide benefits to employees of 5 more than one enterprise.
c) Current service cost
It is the 1 increase in the 2 present value of the 3 defined benefit obligation resulting from
employee service in the 4 current period.
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441
d) Past service cost
It is the 1 change in the 2 defined benefit obligation, as a result of 3 amendments or curtailments
relating to employee service in 4 prior periods. An amendment that improves existing benefits
leads to a positive past service cost whereas a curtailment of existing employee benefits leads
to a negative past service cost.
An amendment is when an entity either introduces a defined benefits plan or changes the
benefits
payable under an existing plan.
A curtailment is when an entity significantly reduces the number of employees covered by a
plan.
e) Vested employee benefits
These are 1 entitlements, the 2 rights to which, under the terms of a 3 defined benefit obligation,
are not conditional on continued/future employment. If arising from a past service cost they
accrue to the employee in the financial year the plan is amended. On termination of
employment, an employee receives a cash payment on any benefits vesting.
f) Actuarial gains and losses
Actuarial gains and losses are as a result of the difference between the 1 previous actuarial
assumptions and 2 what has actually happened (experience adjustments), as well as the 3
changes in actuarial assumptions. They are recognized in 4 other comprehensive income and
are 4 not reclassified to profit or loss per IAS 1 (revised).
Actuarial assumptions are so called because of the use of an Actuary. By definition an actuary
is a statistician who calculates insurance premiums, risks, dividends, and annuity rates
(Encarta, 2009)
f) Return on plan assets
It is any difference between the 1 new fair value of a plan asset and 2 what has been recognized
up to the reporting date (that is, the opening balance of the plan asset, interest, and any cash
payments into or out of the plan). It is treated as a re-measurement and is recognized in other
comprehensive income per IAS 1 (revised).
Recognition criteria and measurement of compensated absences
Compensated absences are short term employee benefits.
According to IAS 19, compensated absences can be split into two, namely accumulating
compensated absences and non-accumulating compensated absences.
An example of an accumulating compensated absence is annual leave which at times
accumulates into the following year when not used whereas an example of a non-accumulating
compensated absence is maternity or paternity leave. It can be vesting or non-vesting.
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442
For accumulating compensated absences, the expected cost of short term employee benefits are
recognized as and when the employee renders service that increases his or her entitlement to
such compensation.
For non-accumulating compensated absences, the expected short term employee benefits are
recognized when the specific absence occurs.
The measurement required is that of the expected cost additionally expected to be paid as a
result of the unused entitlement that has accumulated at the reporting date. This is because
accumulating compensated absences continue into the following year.
Non-accumulating compensated absences are not carried forward because they lapse when not
used in the current financial period.
Tutorial Note:
Ensure preparation of students in class, with practice question examples, on the following areas
to do with compensated absences:
a) Accumulating vesting short-term compensated absences
b) Accumulating non-vesting short term compensated absences
c) Non-accumulating compensated absences
d) Accumulated short-term compensated absences with the financial year end and leave cycle
on different dates
FAST FORWARD
21.5 APPLICATION OF THE PROJECTED UNIT CREDIT METHOD
The projected unit credit method is also known as the actuarial method or the years of service
method. The standard states that the projected unit credit method sees each period of service
as giving rise to an additional unit of benefit entitlement and therefore, measures each unit
separately to build up the final obligation.
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443
How the method is applied is best illustrated through the example below:
EXAMPLE 1
A lump sum benefit is payable on termination of service and equal to 1 % of the final salary
for each year of service. The salary in year 1 is $10 000 and assumed to increase at 7%
(compound) annually. The discount rate used is 10% per annum.
REQUIRED
Show how the obligation builds up for an employee who is expected to leave at the end of
year 5, assuming there are no changes in actuarial assumptions.
SUGGESTED SOLUTION
First - determine the final salary payable
Salary
$
10 000
10 700
11 449
12 250
13 108 (Final)
10 000 x 1.070
10 000 x 1.071
10 000 x 1.072
10 000 x 1.073
10 000 x 1.074
Year 1
Year 2
Year 3
Year 4
Year 5
Second – show how the obligation builds up through a table
Year
1
2
3
4
5
$
$
$
$
$
Opening balance
-
131.08
262.16
393.24
524.32
Current year benefits
(1% x 13 108)
Closing balance
131.08
131.08
131.08
131.08
131.08
131.08
262.16
393.24
524.32
655.40
Opening obligation
-
89.53
196.96
324.99
476.65
Interest @ 10%p.a
-
8.95
19.70
32.50
47.67
Current service cost
89.53
98.48
108.33
119.16
131.08
Closing balance
89.53
196.96
324.99
476.65
655.40
N.B. Current service cost for year 1 = 131.08 x 1.10-4, for year 2 = 131.08 x 1.10-3. $131.08
is due in year 1 but payable in year 5, therefore, it will be worth only $89.53 in year 5
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444
21.6 POST-EMPLOYMENT BENEFITS
21.6.1 Accounting for defined contribution schemes
The accounting for a defined contribution scheme is simpler because the employer’s obligation
for each period is determined by the amount that had to be contributed to the scheme for that
period.
EXAMPLE 2
Rwendo Ltd incurred gross salaries and wages for the year ended 31 December 2014
amounting to $840 000.00. Its employer`s contribution towards the defined contribution fund,
on behalf of employees is 3.5%. That of employees is 3.5%, to make the combined (National
Pension Scheme) NPS contribution 7% of the monthly gross salaries and wages bill, excluding
the (Workers Insurance Compensation Fund) WCIF premium.
REQUIRED
Notes to the financial statements of Rwendo Ltd in respect of employee benefits for the year
ended 31 December 2014. Ignore tax implications.
SUGGESTED SOLUTION
Rwendo Ltd
1. Accounting Policy
1.1 The organization provides for postemployment benefits to employees, which represent
pensions. Contributions to a defined contribution plan are recognized when employees provide
services to employers.
2. Profit before tax
Included in profit before tax are:
Employee benefit expense
Short term employee benefits
Defined contribution plan expense (840 000 x 3.5%)*
$
869 400
840 000
29 400
* Employer`s contribution on behalf of the employee. Contributions by both employee and
employer to a defined contribution plan should be recognized as an expense in the period they
are payable (except to the extent that labour costs may be included within the cost of assets)
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445
Contributions can be based on a formula that uses employee compensation as the basis for
calculation of the employer’s obligation. For NSSA this is given and is currently pegged at
3.5% which is exactly the same percentage the employee contributes.
There are no actuarial assumptions required to measure the obligation or expense, and there are
no actuarial gains or losses.
Any liability for unpaid contributions that are due as at the end of the period should be
recognized as a liability (accrued expense).
If the employer has made payments in excess of the required amount, this excess is treated as
a prepayment to the extent that the excess will lead to reduction in future contributions or refund
of cash.
21.6.2 Accounting for defined benefit plans
The obligation of an employer under a defined benefit plan is to provide an agreed amount of
benefits to current and former employees in the future. Benefits may be in the form of cash
payments or could be in-kind in terms of medical or other benefits.
Normally benefits will be based on age, length of service, and wage and salary levels. Pensions
and other long-term benefits plans are basically measured in the same way. Actuarial gains and
losses of long-term benefits plans other than pensions are reported immediately in net income.
The defined benefit plan can be unfunded, partially funded, or wholly funded by the employer.
The employer contributes to a separate entity or fund that is legally separate from the reporting
entity.
This fund then pays the benefits. The payment of benefits depends on the fund’s financial
position and the performance of its investments.
However, the payment of benefits will also depend on the employer’s ability to pay and to
make good any shortfall in the fund. The employer is essentially guaranteeing the fund’s
investment and actuarial risk.
Accounting for defined benefit plans is more complex because actuarial assumptions are
needed to determine the obligation and the expenses. Often the actual results differ from those
determined under the actuarial valuation method. The difference between these results creates
actuarial gains and losses.
Discounting is used because the obligations often will be settled several years after the
employee gives the service. Usually actuaries are employed to calculate the defined benefit
obligation and also the current and past service costs.
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446
Recognition and measurement of the expenses and liability of a defined benefit pension
plan.
1. Measure the deficit or surplus, using the actuarial technique, which is the Projected Unit
Credit Method, to make a reliable estimate of the amount of future benefits employees have
earned from service in relation to the current and prior years. The benefit should be discounted
to arrive at the present value of the defined benefit obligation and the current service cost. The
fair value of any plan assets should be deducted from the present value of the defined benefit
obligation.
2. The surplus or deficit measured above may have to be adjusted if a net benefit asset has to
be restricted by the asset ceiling.
3. Determine the amounts to be recognized in profit or loss namely:
(a) Current service cost
(b) Any past service cost and gain or loss on settlement
(c) Net interest on the net defined benefit liability (asset). This is the net of the interest charge
on the plan obligation and the interest income recognized on the plan assets.
4. Determine the re-measurements of the net defined benefit liability (asset), to be recognized
in other comprehensive income (items that will not be reclassified to profit or loss):
(a) Actuarial gains and losses
(b) Return on plan assets (excluding amounts included in net interest on the net defined benefit
liability (asset))
(c) Any change in the effect of the asset ceiling (excluding amounts included in net interest on
the net defined benefit liability (asset))
EXAMPLE 3
All the employees of Zimbabwe Mining Development Corporation (ZMDC) belong to the
Mining Industry Pension Fund, which is a defined benefit plan. The policy of ZMDC is to
recognize the minimum re-measurements, that is, the actuarial gains on the defined benefit
obligation, the difference between actual investment returns and return implied by the net
interest cost and the effect of asset ceiling. On 1 July 20-8 there were no prospects for cash
refunds or contribution reductions.
The following information on ZMDC relates to the year ended 30 June 20-9:
Post-employment benefits
Present value at 1/7/20-8
Current service costs
Interest cost
Benefits paid out
Actuarial loss for the period: bal figure
Present value at 30/6/20-9
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$
134 400 000
14 910 000
12 096 000
(15 750 000)
945 000
146 601 000
447
Plan Assets
Fair value at 1/7/20-8
Interest on plan assets (11.09%)
Contributions to plan assets
Benefits paid out
Gain on re-measurements through OCI: bal figure
Fair value at 30/6/20-9
125 400 000
13 911 563
51 306 000
(15 750 000)
303 937
175 171 500
Present value of future contribution reductions at 30/6/20-9 is $390 000
REQUIRED
Draft Notes to the financial statements of ZMDC as at 30 June 20-9
SUGGESTED SOLUTION
Zimbabwe Mining Development Corporation (ZMDC)
Notes for the year ended 30 June 20-9
1. Accounting Policy
The company makes provision for post-employment benefits to employees which represent
pensions. For the defined benefit scheme actuarial valuation of the scheme`s obligation is
performed at each year end.
2. Profit before tax
Included in profit before tax are the following:
Employee benefit expense
Current service cost
Net interest on the net defined benefit liability (asset)
[12 096 000 – 13 911 563]
Excess actuarial loss
Past service cost
Effect of curtailments and settlements
Included in other comprehensive income are the following:
Unrecognized asset (effect of the asset ceiling)
2. Post-employment benefit liability/(asset)
PV of plan obligation
FV of plan assets
Unrecognized actuarial losses
Unrecognized past service cost
Unrecognized increase in liability on initial adoption
Unrecognized asset on application of limit (asset ceiling test)
ICSAZ - P.M. PARADZA
$
13 094 437
14 910 000
(1 815 563)
-
28 180 500
390 000
146 601 000
(175 171 500)
(28 570 500)
28 180 500
448
WORKINGS
1. Calculation of defined benefit liability
PV of plan obligation
FV of plan assets
Unrecognized past service cost
Unrecognized increase in liability on initial adoption
Defined benefit asset
146 601 000
(175 171 500)
(28 570 500)
(28 570 500)
2. Application of para 58 limit (Asset ceiling test)
Unrecognized past service cost
PV of available future refunds and reductions
390 000
390 000
N.B. $390 000 being less than $28 570 500, ZMDC recognizes an asset of $390 000 and
discloses in notes that the limit reduced the carrying amount of the asset by $28 180 500. In
other words IAS 19 stipulates that the defined benefit asset is limited to the lower of the surplus
in the defined benefit and the asset ceiling.
This is what the phrase “asset ceiling test” means. It relates to a threshold established by IAS
19 to ensure that any defined benefit asset (that is, a pension surplus) is carried at no more than
its recoverable amount. Any net asset is restricted to the amount of cash savings that will be
available to the entity in future. Asset ceiling is by definition the present value of any economic
benefits available in the form of refunds from the plan or reductions in the future contributions
to the plan.
*N/A - actuarial losses that fall within corridor are no longer required by the revised IAS 19.
EXAMPLE 4
The following information relates to Secured Future Pension Fund which is a funded defined
benefit plan. On 1 October 20-7 the present value of the obligation and the fair value of the
plan assets both amounted to $56 000 000.00.
Other relevant current and projected information was as follows:
Year ended 30 Sep
Pre-tax discount rate at start of the year
Current service cost
Benefits paid
Contributions
Present value of obligation at 30 Sep
Fair value of plan assets at 30 Sep
20-8
15%
8 200 000
8 250 000
5 040 000
63 896 000
63 115 700
20-9
12%
7 500 000
10 000 000
5 600 000
72 032 000
66 632 986
20-0
10%
8 600 000
10 640 000
6 150 000
79 605 520
65 956 285
During the year ended 30 Sep 20-9, the plan was amended to provide additional benefits with
effect from 1 Oct 20-8. The present value on 1 Oct 20-8 of additional benefits for employee
service before that date was $2 800 000 covering both vested and non-vested benefits. On that
ICSAZ - P.M. PARADZA
449
date the entity estimated that the average period until the non-vested benefits would become
vested was 4 years.
REQUIRED
Prepare schedules showing:
a) Changes in the present value of the obligation and in the fair value of plan assets
b) The amounts to be recognized in the statement of financial position and the income
statement
SUGGESTED SOLUTION
a)
XYZ Ltd
Summary of the changes in the Present Value of the obligation and in the Fair Value of
the plan assets and determination of the amount of actuarial gains or losses for the year
ended 30 September:
PV of obligation at 1 Oct
Interest cost (15%; 12%; 10%)
Current service cost
Past service cost
- non vested
- vested
Benefits paid
Actuarial (gain)/loss on obligation: bal figure
PV of obligation at 30 Sep
20-8
20-9
20-0
$
$
$
56 000 000
63 896 000
72 032 000
8 400 000
7 667 520
7 203 200
8 200 000
7 500 000
8 600 000
1 700 000
2 800 000
(8 250 000) (10 000 000) (10 640 000)
(454 000) (1 531 520) 2 410 320
63 896 000
72 032 000 79 605 520
FV of plan assets at 1 Oct
Interest on plan assets (15%; 12%; 10%)
Contributions
Benefits paid
Gain on measurement through OCI: bal figure
FV of plan assets at 30 Sep
56 000 000
63 115 700
66 632 986
8 400 000
7 573 884
6 663 299
5 040 000
5 600 000
6 150 000
(8 250 000) (10 000 000) (10 640 000)
1 925 700
343 402
(2 850 000)
63 115 700
66 632 986 65 956 285
b)
(i) Amounts to be recognized in the Statement of Comprehensive Income (P/L section)
Included in the profit before tax figure are the following items:
Current year post benefit expense
8 200 000
Current service cost
8 200 000
Net interest on defined benefit liability (asset)
Past service cost (vested & non vested)
-
ICSAZ - P.M. PARADZA
10 393 636
7 500 000
93 636
2 800 000
9 139 901
8 600 000
539 901
-
450
Included in other comprehensive income are the following items:
Actuarial (gain)/loss on obligation: bal figure
(454 000) (1 531 520)
Return on plan assets (excl amounts in net-interest) 1 925 700
343 402
2 410 320
(2 850 000)
(ii) Amounts to be recognized in the Statement of Financial Position
Post-employment benefit liability/(asset)
PV of obligation
PV of plan assets
780 300
5 399 014
13 649 235
63 896 000 72 032 000
79 605 520
(63 115 700) (66 632 986) (65 956 285)
N.B. Return on plan assets excludes interest cost and expected return amounts on the net
defined benefit liability (asset).
N.B. A change in the effect of the asset ceiling excludes interest cost and expected return
amounts on the net defined benefit liability (asset).
Present value of a defined benefit obligation. The present value before deducting any plan
assets or any expected payments required to settle the obligation that has occurred as a result
of the service of employees in the current and previous periods.
Plan assets are assets held by the employee benefit fund, including any qualifying insurance
policies.
21.7 EXAMPLES OF ACTUARIAL ASSUMPTIONS
Non-financial actuarial assumptions are made on employee turnover, disability and early
retirement, mortality rates during and after employment and future increases in salaries (if these
will affect the eventual size of future benefits such as pension payments), demographic
assumptions about the future characteristics of current and former employees and their
dependents who are entitled to benefits from an entity, claim rates under medical aid plans
Financial assumptions relate to the estimates for, the discount rates, future salary and benefit
levels, in the case of medical benefits, future medical costs including, where material and the
cost of administering claims and benefit payments.
21.8 DISCLOSURES
21.8.1 for a defined contribution plan
A description of the plan and the amount recognized as an expense in the period
21.8.2 for a defined benefit plan
Information that:
(a) Explains the characteristics of its defined benefit plan and risks associated with it;
(b) Identifies and explains the amounts in its financial statements arising from its defined
benefit plan; and
ICSAZ - P.M. PARADZA
451
(c) Describes how its defined benefit plan may affect the amount, timing and uncertainty of the
entity’s future cash flows.
ACTIVITY
IAS 19 “Employee benefits” deals with the treatment of post-employment benefits such as
pensions and other retirement benefits. Post-employment benefits are classified as either
defined contribution or defined benefit plans.
REQUIRED
a) Describe the relevant features and required accounting treatment of defined benefit
plans under IAS 19 (7 marks)
b) Tongat operates a defined benefit plan for its employees. The plan is reviewed annually.
Tongat`s actuaries have provided the following information:
At 31 March 20-4
At 31 March 20-5
$000
$000
Present value of obligation
1 500
1 750
Future value of plan assets
1 500
1 650
Current service cost - year to 31 March 20-5
160
Contributions paid - year to 31 March 20-5
85
Benefits paid to employees - year to 31 March 20-5
125
Expected return/Discount rate on plan assets/liabilities at 1 April 20-4
12%
Prepare extracts of Tongat`s financial statements for the year to 31 March 20-5 in
compliance with IAS 19 in so far as the information permits. (8 marks)
21.9 CORPORATE SECRETARYSHIP AND PENSION FUNDS
Establishment of a Pension Fund for employees requires that there be a Trust Deed and a set
of rules that regulate the Fund. The Trust Deed`s provisions are:
1. Parties to the contract are the principal company and the trustees
2. Contributions are made by the member employees and the employer
3. Definition of powers of trustees
4. Duties and obligations of trustees (including keeping of accounts and records)
5. Manner of dealing with expenses incurred by the trustees in Fund administration
6. Remuneration of trustees
7. Indemnity of trustees against actionable claims, costs and liabilities (exception being breach
of trust circumstances)
8. Power of the principal to remove and replace any trustee by resolution.
9. Dispensing with necessity for security
Fund Rules should mainly be on:
a) Membership
b) Contributions
c) Application, allocation and rates of pension
ICSAZ - P.M. PARADZA
452
d) Members` rights on cessation of service
e) Death of member or dependent
f) Regulations governing payment of pensions
g) Provision for money not claimed
h) Upkeep of register and accounts
i) Statement of financial position, audit report and actuarial reports
j) Settlement of differences
k) Alteration of rules
l) Discontinuance of membership by employees
m) Termination of the Fund
21.10 GENERAL KNOWLEDGE (This is meant for the learner to appreciate practical
corporate communication to employees pertaining pension plans)
Below are citations from a Staff Handbook of one Zimbabwean company:
Is it possible for a company to run a defined benefit plan and a defined contribution plan
at the same time?
Indeed it is possible.
Does the Company have a Pension Scheme for its employees?
Yes. The company operates an excellent Staff Pension Scheme (a “Defined Benefit Scheme”
also known as a “Final Salary Scheme”) for its employees in conjunction with the National
Social Security Scheme (NSSA)
What is a pension?
When an employee retires, he/she may still have more active years to live during which he/she
must continue to support himself/herself and his/her family. It is unlikely that he/she will have
enough savings to do so himself and would have to rely on his/her family for support, which
will be difficult if they are dispersed or, have their own financial commitments. Obviously a
continuing steady income is the answer, and a pension fund aims to provide this.
A pension fund is an arrangement whereby the employee makes a steady contribution
throughout his/her working life which is matched by a similar or larger amount from his/her
employer to a fund, which on his/her retirement will make regular payments to him or her. It
is therefore, a form of saving and the size of the eventual pension depends on the length of
one`s service and one`s earnings in the year prior to one`s retirement (final salary). For each
year of service with the company, an employee gets two percent of his or her earnings in the
year prior to his/her retirement.
What do I contribute?
Your monthly contribution is 6% of your gross salary of which 3.5% is paid to the National
Social Security Scheme (NSSA) and the balance to the staff defined benefit scheme. In terms
of the legislation, you and the company are each obliged to contribute 3.5% of your monthly
ICSAZ - P.M. PARADZA
453
salary up to maximum (earnings ceiling) of $700.00 per month to NSSA per statutory
instrument 61 of 2013, excluding Workers Compensation Insurance Fund (WCIF) premium
which is also deductible and payable to NSSA.
Who may join the scheme and possibility of withdrawal?
All those members of staff who have completed three months service are required to join as a
condition of service. Therefore, eligible staff will join at the first available opportunity this
being the first of the month they qualify. In terms of the Pension and Provident Funds Act and
Regulations membership of the scheme is continuous. An employee is therefore obliged to
remain a member of the scheme for as long as they are a full-time staff member of the company.
At what age is an employee expected to retire?
The normal retirement age for our scheme is when a member reaches the age of 65 years. The
retirement only becomes effective on the last day of the month in which the member reaches
age 65.
What to expect as pension on Normal Retirement Date
This is dependent on three functions which may be variable from employee to employee. These
are: Your Pensionable Service, your Pensionable Earnings and following on from that your
Final Pensionable Earnings. Each of which is defined as follows:
Pensionable service – the total years and months of service which you will have served with
the company from date of commencement of your employment to the date of your retirement.
Pensionable Earnings – basic salary or wage per annum.
Final Pensionable Earnings – the Pensionable Earnings on the revision date immediately
preceding Normal Retirement Date (same as earnings in the year prior to retirement).
How are my benefits at Normal Retirement Age calculated?
Assuming that your Final Pensionable Earnings, in the year prior to retirement, are $17 500.00
per annum and you have served the company as an employee for 35 years (pensionable service).
Given that your pension accrues for each year of pensionable service at 2% or 1/50 of your
final pensionable earnings, your pension will be calculated as follows:
17 500 x 35 x 0.02 or 17 500 x 35/50 = $12 250.00 per annum.
Part of it will be paid by the National Social Security Scheme (NSSA) and the balance by the
company`s Staff Pension Scheme (a defined benefit plan).
N.B. How we calculated the final salary (earnings in the year prior to retirement) that is $13
108, using the Projected Unit Credit Method in Example 1 of this Unit. In this real world case
example, we have cited above, that final salary is $17 500 and was given by the company for
illustrative purposes to its employee`s seeking to understand the defined benefit plan before
joining. 1% of final salary $131.08 is used in Example 1 but in this real world case 2% has
ICSAZ - P.M. PARADZA
454
been used. At end of 5 years the employee had a benefit receivable (obligation to the company)
amounting to $655 out of the final salary of $13 108 yet in the real world case above after 35
years the employee had a benefit receivable of $12 250.00 out of the final salary of $17500.
What has not been shown by this real world example is how the $12 550 builds up. This figure
is similar to $13 108, which in example 1 of this study guide we had to calculate per what the
IAS 19 advises.
Benefits on Voluntary Early Retirement
A member may by mutual consent of the employer proceed on retirement before reaching
normal retirement. The only other requirement will be that the member should be aged at least
55 years. It is apparent that you will have put in less of service than envisaged at the outset. It
is equally obvious that you have retired at a younger age you can expect to receive your pension
for a longer period. Lastly because you are taking out your benefits earlier than had been
budgeted for, the scheme will have to forgo some interest already budgeted for. Now to protect
the scheme against your early departure there is a penalty applied to your pension. This means
that your pension is discounted by 6% for each year you early retire by as illustrated below:
Assuming that your Final Pensionable Earnings are $36 000 and that your completed
pensionable service years are 20. In which case your pension should be calculated as $14 400
per annum ($36 000 x 20 x 0.02) which is payable at intervals of your choice, for as long as
you live after retirement or for five years after retirement whichever is longer. However
assuming that you go on early retirement five years before normal retirement date, your
pensionable service will be reduced by 5 years so that it becomes 15 years. Your final
pensionable earnings are assumed to remain unchanged at $36 000. Your pension is initially
calculated as follows:
$36 000 x 15 x 0.02 = $10 800
This is then reduced as follows:
5 x 6% x $10 800 = $ 3 240
Therefore your early retirement pension will be $10 800 - $3 240 = $7 560.
The calculation is similar if incapacitated by ill-health to such an extent that one cannot perform
his/her normal gainful occupation for which he/she is reasonably suited by education, training
and experience so that they proceed on retirement, having furnished the company with medical
evidence to that effect.
Commutation of Pension
When you retire you have the option to exchange up to 1/3 of your pension for a cash payment.
This cash payment is free of income tax. According to the Income Tax Act`s section 8(1)(n) Retirement annuity commutation, any portion above one-third of a commutation of a
retirement annuity is taxable. Similarly according to section 8(1)(r) - Pension commutation,
any commutation is exempt if the pension itself would not have been subject to tax. If your
pension is very small and does not exceed the limit set from time to time by the Registrar of
ICSAZ - P.M. PARADZA
455
Pension and Provident Funds, you may commute your entire pension for a lump sum cash
payment
As an illustration,
Assume that your Final Pensionable Earnings are $36 000 and that you have completed 20
years` pensionable service. Your pension will be calculated as follows: 36 000 x 0.02 x 20 =
$14 400. Assuming further that you want to commute one-third of your pension for a cash sum,
the third is $ 4 800 per annum. The cash sum payable, which will be much more than the $4
800 from which it is calculated, is reached using commutation factors that are liable to change
from time to time and vary according to age of retirement. The remaining two-thirds of your
pension will be $9 600 per annum.
What about the Funeral Benefit Scheme?
Should you die of whatever cause, an amount of $2 000 will immediately be made available
by the company to help meet funeral expenses. This amount will be claimed back from the
National Social Security Scheme.
21.11 SUMMARY
The purpose of IAS 19 is to prescribe the accounting and disclosure requirements for various
types of employee benefits. The standard distinguishes between two main types of postemployment benefit plans, that is, the defined contribution plan and the defined benefit plan.
This Unit gave examples and activities on short term and post-employment benefits, in addition
to those shown in the standard. This Unit also explained the key role of actuarial assumptions
when recognizing and accounting for the benefits.
21. 12 REFERENCES
Accountancy Tuition Centre (International Holdings) Ltd
Southampton Assurance Company of Zimbabwe Ltd
(Now ZB Life)
A Staff Guide to our Pension
Scheme
IASB
International Financial Reporting
Standard (IAS) 19, Revised 2015
VORSTER, Q. KOORNHOF, C.; et al
Descriptive Accounting,
LexisNexis/Butterworths, 15th
Edition, 2010
ICSAZ - P.M. PARADZA
456
SUBJECT INDEX
A
Accounting by the government (grantor) (service concessions)
285
Accounting entries for reconstruction schemes
339
Accounting for leases in the financial statements of lessees
401
Accounting profits and taxable profits
247
Accounting treatment of accumulated amortization
390
Accounting treatment of defined benefit plans
452
Acquired identified intangible assets
70
Acquisition method of accounting
67
Acquisition of an intangible assert by way of government grant
385
Acquisition of an intangible asset by way of exchange
385
Acquisition of intangible assets as part of a business combination
384
Activity market
415
Actuarial assumptions
435, 442, 444, 446, 451
Actuarial gain or losses
23, 436, 446, 450
Alternative bases of measurement and recognition (intangible asset)
Asset (conceptual framework)
390
9
Associate companies
158
B
Basic earnings per share
Business combination
369
244, 254, 261, 263, 273, 298, 381, 382, 384, 386, 416
Business combination effected in stages
201
Business combination involving bargain purchase gain
Business valuation
89, 123, 172
332
C
Calculation of deferred tax
257
Calculation of minimum lease payments
403
ICSAZ - P.M. PARADZA
457
Calculation of required capital reduction
346
Capital reduction
337
Carrying amount of investment in lease
407
Cash and cash equivalents
Cash generating units
210, 212
415, 421, 423, 434
Cash settled share based payment transactions
277
Cash flow from financing activities
209
Cash flow from investing activity
209
Cash flow from operating activities
208
Cash-generating unit
415
Cash-settled share-based payment transactions
277
Changes in interest rates (leasing)
409
Changes in shareholdings through a rights issue
175, 178
Classification of leases
399
Classified as held for distribution to owners
301
Classified as held for sale
301
Combined arrangement (service concessions)
284
Commencement of lease term
398, 401
Common size statements
359
Comparative information
22, 24, 25, 28, 36, 61
Complete set of financial statements
Complex groups
20, 32, 36
87, 140, 141, 144, 145, 147
Comprehensive liability method
266
Concepts of capital and capital maintenance
2, 12
Consequences of voluntary winding up
338
Consolidated statement of financial position
52, 82, 90, 92, 95, 98, 99, 104, 428
Contingent liabilities
75
Contingently issuable shares
379
Contractual legal criterion
381
Corporate assets (impairment of assets)
ICSAZ - P.M. PARADZA
423, 427
458
Corporate assets
427
Cost method
148
Cost model
292
Cost
289
Crossing the accounting boundary
68
Current tax payable
250
Current tax
250
Current value
314
Curtailments and settlements
448
D
Decision models
3, 4, 357
Decision usefulness of financial accounting
1
Declassification of an asset held for sale
309
Defined combination plans
363, 367
Departure from applicable IFRS
34
Depreciation principles
293
Descriptive approach to financial accounting theory
2
Descriptive approach
2
Design of capital reconstruction schemes
263
Development phase
387
Diluted earnings per share
371
Discontinued operation
300
Discontinued operations
311
Discontinued present value
314
Disposal group
300
Dividend yield method
315
Dividends declared out of pre-acquisition profits
94
Due process
16
E
Earnings basis (valuation)
315
ICSAZ - P.M. PARADZA
459
Earnings per share
243
Earnings yield method
315
Elements of cost
290
Empirical approach
3
Entity- specific value
382
Equity (conceptual framework)
11
Equity method
148
Equity of compensation benefits
435
Equity-settled share based payment transactions
274
Example of actuarial assumptions
451
Expense (conceptual framework)
11
External sources of information (impairment of assets)
431
F
Fair valuation
72
Fair value
12, 23, 289
Finance lease
398, 399, 405
Finance leases
409
Financial asset model
284
Financing activities
207, 214, 420
Foreign currency cash flows
212
Foreign exchange difference
191
Foreign operation
190
Full provision approach
267
Function of expense method
47
Functional currency
190, 298
G
Government grants
262
Grant date
273
Grant with a market condition
276
Guaranteed residual value
399
ICSAZ - P.M. PARADZA
460
Guidelines for using the equity method
150
I
IASB – conceptual framework
4, 5, 7, 8, 49
Impairment of assets
297
Income (conceptual framework)
11
Indemnification assets
74
Intangible asset model
284
Interest rate implicit in lease
401
Internally generated goodwill
386
Internally-generated intangible assets
386
Intrinsic value
273
Investing activities
207, 209
Investment in associate
46, 147
J
Joint control
159, 161
Joint operation
159, 161
Joint venture
159, 161
L
Liability (conceptual framework)
11
M
Mark to market reserve
96
Market capitalization
315, 316
Materiality and aggregation
35
Measurement of elements of financial statements
11
N
Nature of expense method
48
Net asset basis (valuation)
317
Net realizable value
314
Net replacement value
314
Normative general approach
3
ICSAZ - P.M. PARADZA
461
Normative specific approach
3
O
Offsetting
35
Operating activity
190, 207, 208
Operating lease
409
Operating leases
401, 409
Other-long term benefits
440
P
Partial provision approach
267
Permanent difference
250
Post service cost
442
Post-employment benefits
440
Power of company to alter share capital
337
Pre-acquisition losses
94
Provision for resurfacing obligation
286
R
Reacquired right
74
Reclassification
56
Reconstruction scheme design
351
Reconstruction schemes
345
Reconstruction
336
Recoverable amount
289
Reorganization
336
Research phase
387
Residual value
290, 394
Return on plan assets
442
Revaluation model
292
Reversal of impairment losses
430
Reverse acquisition
69
S
ICSAZ - P.M. PARADZA
462
Separability criterion
381
Share appreciation rights
278
Share based payment arrangements with cash alternative
279
Short term benefits
438
Simple investment
95
Specific conditions of reversal of impairment of losses
430
Sum of digits method
404
Super profits method
326, 327
T
Tax computation
250
Tax loss carry back
252
Tax loss carry forward
252
Temporary difference
250
Termination benefits
440
Timing difference
250
U
Uses of ratio analysis
355
V
Valuation based on market price
331
Valuation of debt
320
Valuation of ordinary stock
321
Value in use
289
Vested employee benefits
442
Vesting conditions
273
W
Winding up
338
Written put options
379
ICSAZ - P.M. PARADZA
463
ICSAZ - P.M. PARADZA
464