Acca p2 (Int) Lrp j11 - Answers

KAP LA N P UBL IS HI NG 44

ANSWERS

LE CTURE R RESO URCE P ACK: ANSW ERS


GROUP ACCOUNTING

HARDEN AND SOLDER

(a) Consolidated statement of financial position of Harden as at 30 September 20X2

$000 $000

Non-current assets

Property, plant and equipment (3,980 + 2,300 + 200) 6,480

Patents (250 + 420) 670

Consolidated goodwill (W3) 200 _____

870

Investments

Associated entity (W6) 960

Others (150 + 200) 350 _____

1,310 _____

8,660

Current assets

Inventory (570 + 400) 970

Trade receivables (420 + 380 − 70 − 50) 680

Bank

150 _____

1,800 _____

Total assets 10,460 _____

Equity and liabilities

Equity share capital of $1 each 2,000

Share premium 1,000

Retained earnings (W5) 5,180

Non-controlling interest (W4) 730 _____

Total equity of the group 8,910

Non-current liabilities

Deferred tax 200

Current liabilities

Trade payables (750 + 450 − 70) 1,130

Taxation 140

Overdraft 80 _____

1,350 _____

Total equity and liabilities 10,460 _____

PAP E R P 2 ( INT ) : CORPO RATE REP ORT ING

46 KAP LA N P UBL IS HI NG

Workings (Note: all figures in $000)

(W1) Group structure

(W2) Net assets – Solder

Date of acquisition

Reporting date

$000 $000

Equity capital 1,000 1,000

Share premium 500 500

Retained earnings 1,200 _____

1,900 _____

2,700 3,400

Fair value adj: Lan

Overhead costs accrual (W7)

200

_____

200

(50) _____

2,900 _____

3,550 _____

Net assets – Active

Date of acquisition

Statement of financial

position date $000 $000

Share capital 500 500


Retained earnings 800 _____

1,200 _____

1,400 _____

1,800 _____

(W3) Goodwill

$000

Solder

Cost of investment 2,500

Fair value of NCI at acquisition 600 _____

3,100

Less: 100% of net assets at acquisition (W2) 2,900

_____

Goodwill 200 _____

80%

Harden

Solder

Active

40%



(W4) Non-controlling interest

$000

FC of NCI at acquisition 600

20% (3,550 – 2,900) 130

_____

730 _____

(W5) Group retained earnings

$000

100% Harden 4,500

80% Solder – post-acquisition profits: 80% (3,550 – 2,900)(W2) 520

40% Active – post-acquisition profits: 40% (1,800 – 1,400)(W2) 160 _____

5,180 _____

(W6) Investment in associate

$000

Cost of shares 800

40%(1,800 – 1,400)(W2) 160 _____

960 _____

(W7) Elimination of current accounts

The current accounts of Harden and Solder were agreed at $70,000 before the charge for the allocation of central overheads. When Harden processed this transaction it would have debited Solder’s current account to give a balance of $120,000 which must be eliminated. The corresponding adjustments are to eliminate $70,000 from Solder’s payables and debit $50,000 to the retained earnings of Solder. In summary:

Dr Cr

Payables (elimination of intra group creditor) 70

Retained earnings of Solder, reflecting the charge 50

Receivables (elimination of intra-group debtor) 120

This additional expense has been included as a reduction in net assets of Solder at the reporting date.



GEORGE

(a) Goodwill = Fair value of consideration paid

Less: Fair value of net assets acquired

IFRS 3 gives guidance on how these fair values should be determined.

Fair value of consideration paid

$000

Shares (4

3 8m $4) 24,000

Deferred cash ($8m 0.873) 6,984 ______

30,984 ______

Tutorial note: Note 3.4 of the question tells us that the relevant discount rate is 7%, so the

present value of receiving $8m in two years’ time is $8m discount factor for two years at 7%.

Net assets acquired

$000

Land and buildings (market value) 18,000

Plant and machinery (depreciated replacement cost) ($22m 8

5) 13,750

Inventories (sales price less profit allowance) (14.5 – 3) 11,500

(damaged goods at sales value) 100

Trade receivables (9 – 0.4) 8,600

Non-current borrowing (W1) (4,314)

Deferred tax (1.5 + 3) (4,500)

Trade payables (6,000)

Tax payable (1,000)

Bank overdraft (3,000)

Provisions (W2) (400) ______

32,736 ______

Goodwill: $000

Cost of investment - Part (a) 30,894

Fair value of the NCI 7,500

______

38,484

Fair value of net assets at acquisition 32,736

______

5,748

______



Workings

(W1) Present value of borrowings of Bungle is given by the following DCF calculation

Time Cash flow Discount factor at 7%

Present value

$m $m

1 – 3 Interest 10% 4 = 0.4 2.624 1.050

3 Repayment

4 0.816 3.264 ____

4.314 ____

(W2) Bungle is committed at the date of the fair value exercise to clear the $0.4m costs on closing the outlets. The $0.8m is not unavoidable; it is a post-acquisition matter and not a liability at 30 June 20X7.

(b) George group

Consolidated statement of financial position as at 30 June 20X7

$000 $000

Non-current assets

Property, plant and equipment (50 + 25 + 18 + 13.75) 106,750

Goodwill (W1) 5,748 _______

112,498

Current assets

Inventories (18 + 12 + 11.6 – 120

20 1.5) 41,350

Inventory in transit (120

100 0.6) 500

Trade receivables (15 + 10 + 8.6 – 1.2) 32,400 _______

74,250 _______

Total assets 186,748 _______

Equity attributable to equity holders of the parent

Equity share capital (25 + 6 new issue) 31,000

Share premium (10 + (6 $3)) 28,000

Retained earnings (W2) 31,650 _______

90,650

Non-controlling interests (W3) 7,500

Non-current liabilities

Interest-bearing borrowing (20 + 4.314) 24,314

Deferred tax (2 + 11 + 4.5) 17,500

Deferred consideration on purchase of Bungle 6,984

Provision for closure costs of retail outlets 400 _______

49,198



Current liabilities

Trade payables (10 + 6.5 + 6 – 0.6) 21,900

Tax payable (2 + 2.5 + 1) 5,500

Bank overdraft (5 + 4 + 3) 12,000 _______

39,400 _______

Total equity and liabilities 186,748 _______

Tutorial note: It is not clear whether the closure costs are payable within 12 months or after 12 months, so the provision could either be shown as a non-current liability or as a current liability.

Workings

(W1) Goodwill

George bought its equity shares in Zippy at par (costing $15m), so no goodwill arose then. The only goodwill in the consolidated statement of financial position is the goodwill arising on the purchase of Bungle, calculated in part (a).

(W2) Retained earnings

$000

George 24,000

Zippy (100% 8) 8,000

Bungle (only just acquired) −

Unrealised profits 120

20 (1.5 + 0.6)

(350) ______

31,650 ______

(W3) Non-controlling interest $000

Fair value at acquisition 7,500 7,500



FINANCIAL STATEMENTS

Tutorial notes: calculate group's indirect interest in GHI: 80% 75% = 60% holding. Add back management charge in DEF reserves. Adjust DEF’s pre-acquisition reserves for fair value adjustments. Ensure fair value of DEF equipment is included at 31.12.X3 but take care with depreciation calculation.

(a) Group statement of financial position for ABC at 31 December 20X3

$m $m

Non-current assets

Intangible – goodwill (502 + 160)(W3) 662

Tangible (1,840 + 520 + 863 + 200 42 ) 3,323

_____

3,985

Current assets

Inventory (350 + 212 + 108 − 20) 650

Receivables (213 + 127 + 82 − 10) 412

Bank (234 + 26 + 19) 279 _____

1,341 _____

5,326 _____

equity capital 500

Retained earnings (W3) 3,609 _____

4,109

Non-controlling interests (W4) 526

_____

Total equity of the group 4,635

Current liabilities

Trade payables (262 +151+92) 505

Taxation payable (112 + 47 + 27) 186

_____

691

_____

5,326 _____

(b) Fair values are used in the preparation of the consolidated financial statements as they represent the cost to the group of the acquired entity. Fair value is defined (IFRS 3) as the amount at which an asset or liability could be exchanged in an arm's length transaction between informed and willing parties, other than in a forced or liquidation sale.

Both the consideration for the acquisition and the assets acquired are stated at their fair value.

This allows the amount of goodwill included in the acquisition to be reliably measured. It also ensures consistency of calculation from acquisition to acquisition. Use of fair values also



ensures that groups are unable to achieve post-acquisition profits on subsequent sales of assets included in books at book cost rather than fair value. Additionally, in including non-current assets at their fair value, the group depreciation charge will be adjusted accordingly so that the group accounts are charged with a realistic level of depreciation.

Workings

(W1) Shareholdings

DEF GHI

Direct 80% −

Indirect − ___ 80% 75% 60%

___

80% 60%

NCI 20% ___

40% ___

100% ___

100% ___

(W2) Net assets of each subsidiary

DEF: Acquisition Rep date

$m $m

Equity capital 200 200

Retained earnings 800 1,330

FVA adjust: inventory 50 ---

FVA adjust: eqiuipt 200 200

FVA – equipt depreciation (100)

Management charge (10)

URPS - inventory (20)

_____ _____

1,250 1,600

_____ _____

GHI Acquisition Rep date

$m $m


Retained earnings 320 510

_____ _____

420 610

_____ _____



(W3) Full goodwill for each subsidiary

DEF: $m


Fair value of NCI 300

_____

1,752

Less: net assets at date of acquisition (W2) (1,250)

_____

Full goodwill at acquisition 502

_____

GHI $m

Group cost of investment (80% 500) 400


_____

580

Less: net assets at date of acquisition (W2) (420)

_____


_____

(W4) NCI at fair value

$m

DEF : FV at acquisition 300

DEF: (20% (1,600 – 1,250) 70

GHI: FV at acquisition 180

GHI: (40% (610 – 420) 76

_____

626

Less: Indirect Holding Adjustment (20% 500)) (100)

_____


_____

(W5) Consolidated retained earnings

$m

ABC 3,215

DEF: (80% (1,600 – 1,250) 280

GHI: (60% (610 – 420) 114

_____

3,609

_____



X GROUP

X Group consolidated statement of financial position as at 31 March 20X9

Workings

X Y Z W CBS

$m $m $m $m $m

ASSETS

Non-current assets

Tangible assets

(fair value adj)

(Depreciation – 3 years)

900 100

+30

(9)

30

+10

(3)

40 1,058

Intangible assets 30

(30)

Investment

In Y 320

In Z 90

In W (W6) 50

3

53

Goodwill (W2) 55

Current assets 640 360 75

(15)

(W1)

73 1,060

Total assets X X X 113 2,226

EQUITY AND LIABILITIES

Equitycapital 360 150 50 80 360

Share premium 250 120 10 6 250

Retained earnings

(W1, W5)

1,050 210

(30)

(9)

3

30

(3)

(15)

17 1,090

Non-controlling interests (W4)

161

Current liabilities 200 150 15 10 365

2,226




X has a direct controlling interest in Y (2/3) from 1 April 20X6.

X has an effective controlling interest in Z from 1 April 20X6.

X is able to exercise significant influence over W, via control of Y who owns a 30% interest in W from 1 April 20X6..

(W2) Net assets summary

Y At date of acquisition At date of consolidation $m $m $m $m



Retained earnings:

Per the question 120 210 Write off of intangible (30) (30) Excess depreciation (9)

Inventory (6) Doubtful debt (9) Adj re associate W 3

Award 36

Fair value adjustment 30 141 30 204

411 474

Z At date of acquisition At date of consolidation $m $m $m $m


Share premium 10 10

Retained profits:

Per the question 20 30

Excess depreciation (3)

Inventory (5)

Unrealised profit (15)

Fair value adjustment 10 25 10 22

85 82

(W3) Goodwill

In Y In Z $m $m

Cost to group 320

Cost to group: (2/3 × 90) 60

Share of net assets

2/3 × 411 (274)

60% × 85 (51)

46 9




$m

In Y

1/3 468 158

NCI cost of investment in Y’s cost of investment in Z

1/3 90 (30)

In Z

40% 82 (W2) 33

161

(W5) Consolidated retained earnings

$m

All of X 1,050

Share of Y

2/3 (474 - 411) (W2) 42

Share of Z

60% (12 15) (W2) (2)

1,090

(W6) Investment in the associate

Net assets summary

At date of acquisition

At date of consolidation

W $m $m


Share premium 6 6


93 103

Carrying value of associate at reporting date

$m

Cost 50

Add: 30% ×(103 – 93) 3

53

Adjustment required in Y’s financial statements

Need to replace the carrying value at cost (= 50) with the carrying value under the equity accounting method (= 53)

Dr Investment in W 3

Cr Retained earnings 3



EASTER GROUP

(a) Consolidated income statement for the year ended 31 December 20X7

$000

Group revenue 1,002,000

Operating costs (890,000) ________

Profit from operations 112,000

Income from associates (30% of 39,000) 11,700

________

Profit before tax 123,700

Tax (35,000) ________

Profit after tax 88,700

Retained profit b/f (W2) 14,100 ________

Retained profit c/f 102,800 ________

Consolidated statement of financial position as at 31 December 20X7

Assets: $000

Sundry assets 359,000

Investments in associates (W1) 43,800 ________

402,800 ________

Equity and liabilities:

Equity capital 200,000

Retained earnings (W2) 102,800 ________

302,800

Trade payables 100,000 ________

402,800 ________

Workings

(W1) Carrying value of associate: $000

Cost of investment = 30,000

30% (51,000 – 5,000) = 13,800

43,800

(W2) Retained earnings c/fwd b/fwd

Easter 89,000 12,000

Eggs: 30% (51,000 – 5,000) 13,800 30% (12,000 – 5,000) 2,100

102,800 14,100



(b) Accounting for the impact of a disposal of a wholly-owned subsidiary

Impact on financial statements of parent entity:

$000

Disposal proceeds: 5,000

Cost of shares (2,000)

_______

Gain to parent entity 3,000

Tax charge @ 30% (900) Required for group financial statements

_______

Impact on group financial statements of disposal of subsidiary:

$000 $000

Disposal proceeds 5,000

Add: FV of any residual interest nil

----------

5,000

CV of subsidiary at disposal date:

Net assets 3,000

Unimpaired goodwill (W1) 500

----------

3,500

Less: CV of NCI at disposal date (nil)

---------- (3,500)

----------

Exceptional item –

gain on disposal of subsidiary

1,500

----------

Tax charge

(include as part of group tax charge)

900

----------

(W1) Goodwill at acquisition: $000

Cost of shares 2,000

Fair value of net assets at acquisition (1,500)

----------

Full goodwill 500

----------



HOME AND AWAY

(a) Home Group

Consolidated statement of financial position as at 30 June 20X1

$000 $000

Non-current assets

Property, plant and equipment 42,500

Goodwill (W3) 1,750 ______

44,250

Current assets

Inventories 14,000

Receivables (W8) 16,250

Cash 80 ______

30,330 ______

74,580 ______

$000 $000

Equity attributable to equity holders of the parent

Equity capital 25,000

Reserves (W5)

Retained earnings (W6) 29,294

Group exchange differences on net investment in foreign subsidiary (W7)

(884)

______

28,410

______

53,410 Non-controlling interest (W4) 4,420

______

57,830

Current liabilities

Trade payables (W8) 11,000

Tax 1,500

Bank overdraft 4,250

______

16,750 ______

74,580 ______ ______



Workings


Home

Away

(W2) Net assets of subsidiary in functional currency:

Acquisition Rep date

T000 T000

Equity capital 40,000 40,000

Retained earnings 22,880 24,080

______ ______

62,880 64.080

______ ______

Exchange difference on cost of investment in parent’s accounts:

$000 Rate T000

Investment translated at historic rate 14,000 3.75 52,500 Investment translated at closing rate 13,125 4.00 52,500 ______

Loss retranslation of cost of investment 875

______

(W3) Goodwill in functional currency of subsidiary

T000 T000

Cost of investment $14,000 @ 3.75 52,500

75% of 62,880 (W2) (47,160)

______

Parent share of goodwill 5,340

Fair value of NCI 17,380

25% of 62,880 (W2) (15,720)

NCI share of goodwill ______ 1,660

______

Full goodwill at acquisition 7,000

______

$000

Translate at closing rate @ 4.00 1,750

______

75% subsidiary



Note: the two-step calculation of full goodwill will help to allocate the exchange gains and losses relating to goodwill in a foreign subsidiary (see (W7) later)


T000

Fair value of NCI at acquisition 17,380

25% of (64,080 – 62,880) (W2) 3,00

______

17,680

______

$000

Translated at closing rate @4.00 4,420 ______

(W5) Group reserves

Rate $000 Home 29,060 Loss on retranslation of cost of investment (W3) (875) Group share of post-acquisition retained earnings:

75% of (64,080 – 62,880) (W2) 4.00 225 ______

28,410

______

This comprises two components: $000

Group retained earnings (W7) 29,294

Group share of exchange differences (W8) (884)

______

28,410

______

(W6) Group retained earnings:

Rate $000 Home 29,060 Group share of post-acquisition retained earnings:

75% of (64,080 – 62,880) (W2) 3.85 234 ______

28,410

______



(W7) Exchange differences on net investment in a foreign subsidiary

Exchange diffs

Total Group NCI

T000 Rate $000 $000 $000 $000

Goodwill (W3) 7,000 3.75 acq’n 1,867

7,000 4.00 closing 1,750

Loss _____ (117) (90) (27)

Op net assets 62,880 3.75 acq’n 16,768

4.00 closing 15,720

Loss _____ (1,048) (786) (262)

Profit for year 1,200 3.85 ave 311

4.00 closing 300

Loss _____ (11) (8) (3)

_____ _____ _____

Total: (1176) (884) (292)

_____ _____ _____

Notes:

The exchange difference arising on goodwill is allocated between the group and NCI based upon their respective share of goodwill at acquisition per W3.

The exchange difference arising on the net assets at acquisition and on the profit of the year are allocated based upon their respective shareholdings in the subsidiary (75:25)

The total exchange differences are accounted for as other comprehensive income in the group statement of comprehensive income.

The group share of the exchange differences are taken to equity – see (W5) earlier.

(c) Home Group

Consolidated income statement for the year ended 30 June 20X1

$000

Revenue (W2) 16,945

Cost of sales (W3) (8,597) ______

Gross profit 8,348

Other operating expenses (W4) (4,049) ______

Profit from operations 4,299

Finance cost (100 + (200 ÷ 3.85)) (152) ______

Profit before tax 4,147

Income tax expense (900 + (1,600 ÷ 3.85)) (1,315) ______

Profit for the year 2,832

Other comprehensive income: total exchange differences arising on net (1,176)



investment in foreign subsidiary for the year: (W8 earlier) ______

Total comprehensive income for the year 1,656

______

Profit for the year attributable to:

Equity holders of the parent 2,624

Non-controlling interest (W5) 208 ______

2,832 ______

Total comprehensive income for the year attributable to:

Equity holders of the parent 1,740

Non-controlling interest (208 (W5) – (292) (W8 earlier) (84) ______

1,656 ______

Workings

(W1) Average translation rate for the year = 3.85 for Away

(W2) Revenue

$000

Home 12,000

Away (20,000 ÷ 3.85) 5,195

Less: Management charge (250) ______

16,945 ______

(W3) Cost of sales

$000

Home 6,000

Away (10,000 ÷ 3.85) 2,597 ______

8,597 ______

(W4) Other operating expenses

$000

Home 3,000

Away (5,000 ÷ 3.85) 1,299

Less: Management charge (250) ______

4,049 ______


25% profit after tax of Away ÷ 3.85 = $208,000



HAND

Key answer tips

Read the question carefully to ensure that you apply the requirements of IFRS 3 Revised.

(i) Acquisition of Finger

IFRS 3 revised ‘Business combinations’

The revision of IFRS 3 revised has introduced the option on an individual transaction basis to measure non-controlling interest at the fair value of their proportion of identifiable assets and liabilities or at full fair value. The second method will record goodwill on the non-controlling interest as well as on the acquired controlling interest. This is often referred to as ‘gross’ or ‘full’ goodwill. The revision of IFRS 3 has also affected the purchase consideration. The $500,000 professional costs cannot be included as part of the goodwill calculation and must be taken as an expense in the consolidated income statement. Therefore, there is a choice of two accounting treatments when accounting for goodwill on acquisition – on a partial (old method) basis or on a full (fair value) (new method) basis. As always we need to know the group structure. Hand has acquired 3,000,000 out of the 4,000,000 shares of Finger and therefore has a 75 % holding which does give control and makes Finger a subsidiary.

Controlling interest 75%

Non-controlling interest 25%

Remember though that goodwill may not be proportionate. The consideration given by Hand for the shares of Finger works out at $4.25 per share, i.e. consideration (see W1). of $12.75m for 3 million shares. This is considerably higher than the market price of Finger’s shares ($3.25) before the acquisition. This probably reflects the cost of gaining control. Even though NCI own 25% of the shares they only own 10% of the goodwill 500 (see W2) 5,000 (see W2) = 10%

Goodwill can then be calculated either as:

(W1) Partial basis $000

Purchase consideration

Shares issued (3000 ½ $6) 9,000

Cash (3,000 $1.25) 3,750

_____

Total cost to parent 12,750

For 75% (11,000) (8,250)

______

Goodwill – parents share 4,500

(W2) Full goodwill – new method $000

Cost to parent (as above) 12,750

FV of NCI 3,250

______

16,000

Fair value of the net assets at acquisition 11,000

______

Full goodwill at acquisition 5,000



Alternatively: $000

Goodwill (parent share as above) 4,500

NCI share of goodwill:

25% 4m shares = 1m shares

1m shares $3.25 = 3,250

NCI in Finger’s net assets 11,000 25% (2,750)

______

NCI share of goodwill (see above) 500

______

Total of gross goodwill (see above) 5,000

______

Choosing full goodwill will increase reported net assets on the statement of financial position which means any future impairment of goodwill will be greater.

(ii) New management entity

The start-up costs of the new management entity have been capitalised as goodwill even though no acquisition has taken place. This approach will enhance the profitability of Hand as the costs will be subject to impairment tests if treated as goodwill rather than written off in total in the income statement.

As no business acquisition has taken place, there is conflict with IAS 38 Intangible assets which precludes the recognition of internally generated goodwill which is effectively what the entity is doing. Accounting standards do not deal with ‘notional acquisitions’ and the recognition of goodwill from an internal formation of a new entity must be viewed with scepticism.

IFRS 3 Business Combinations requires such administration costs to be written off to the income statement. These costs do not sit easily with the rules in IAS 38 and they ought to be expensed. Where an ESOP trust holds assets on behalf of employees, the assets should be recognised as assets of the ‘sponsoring’ entity, i.e. the property management entity. However, on consolidation this asset must be eliminated as these shares are those of the subsidiary and not the holding entity and do not now constitute assets of the group. Therefore, current assets should be reduced by $40,000 (20,000 shares at $2) and also non-controlling interest by $40,000.

(iii) Step acquisition

With this step acquisition the date of acquisition is the date Hand gained control i.e.1 January 2008. Goodwill will need to be calculated at this date. The original holding of a 20% interest in Thumb will need to be restated to its fair value of £24m with the gain of $4m being recorded in the income statement.

Goodwill can then be calculated as follows:

$m

Purchase consideration (24 + 60) 84


____

124

Fair value of net assets at acquisition (110)

` ____


____



As Hand is using the fair value (full goodwill policy) the NCI part will also need reflecting in the NCI account. The group reserves will need to reflect the gain of $4m on the previous holding in Thumb.

(iv) Foreign subsidiary, Solar

The following computation sets out the accounting treatment of the sale of the foreign subsidiary, Solar. Note Solar was a 100% subsidiary so there is no non-controlling interest implication. As Solar was formed rather than acquired there is nil goodwill. IAS 21 The Effects of Changes in Foreign Exchange Rates, requires the cumulative exchange losses (see W1 &W2) to be recognised in profit or loss for the year-ended 30 November 2008.

IAS 27 Consolidated and Separate Financial Statements requires the exchange losses to be included as part of the gain on disposal. As a result the gain on sale is reduced to $13 million.

(W1) Forex loss in year to 30 November 2007

Opening net assets 100 @ OR 1.1 = 91

Opening net assets 100 @ CR 1.4 = 71 ____ (20) Profit 40 @ AR 1.2 = 33

Profit 40 @ CR 1.4 = 29 (4) ____ ____ Total Forex loss year to 30 November 2007 (24)

(W2) Forex gain in year to 30 November 2008

Opening net assets 140 @ OR 1.4 = 100

Opening net assets 140 @ CR 1.3 = 108 ____ 8 Profit (160 – 140) 20 @ AR 1.5 = 13

Profit 20 @ CR 1.3 = 15 ____ 2 ____ Total forex gain for year ended 30 Nov 2008 10 (8 + 2) ____

(W3) Cumulative forex loss

2007 Forex loss (24) less 2008 Forex gain 10 = (14)

OR

30 November 2007 30 November 2008

€m €m

Share capital 100 100


Shareholders’ equity 140 160

Net assets 140 160

Translated into dollars: $m $m

Net assets (140 ÷1.4) 100 (160 ÷ 1.3) 123

Share capital (100 ÷ 1.1) 91 91

Retained earnings (40 ÷ 1.2) 33 33

(20 ÷ 1.5) 13 46

Exchange reserve (24) (24)

Gain 10 (14)

100 123



Gain/loss on sale Hand Group

$m $m

Sale proceeds (195 ÷ 1.3) 150 150

Cost of investment (91)

Net asset value (123)

Exchange losses (24 – 10) (14) _____ Gain on sale 59 13 _____

(v) Treatment of Planet

The results of the associated entity are not immaterial and ought to be shown in the consolidated financial statements. The carrying value of the investment in the consolidated financial statements at 30 November 2008 should be:

$000


Loss for year (25% 680 1/2) (85)

_____

2,015

_____

IAS 28 Investments in Associates requires investors to account for the appropriate share of a loss making associate even though there may be no obligation to make good such deficits. Because of the nature of the losses incurred, an impairment review should be undertaken as regards the investment in the associate. The carrying amount should be compared with the recoverable amount which is the higher of net selling price and value in use. The net selling price of the investment in the associate is $1.8 million. The determination of the value-in-use is a little more difficult. One could use the cash flows anticipated from the dividends to be received over the next five years. This would amount to approximately $822,600 (dividends of

25% 7.6 million 10c discounted for five years at 5%). In addition to this, there would be the proceeds of the sale of the investment after five years which is currently indeterminable. Therefore, the best measure of the recoverable amount would be the net selling price and the investment in the associate should be written down to $1.8 million. The impairment loss is, therefore, $215,000 ($2,015,000 – $1.8 million). (The investment in the associate and the share of the associate’s losses should be disclosed separately.)



HEBDEN

Hebden Group – Group cash flow statement for the year ended 31 July 20X1

$m

Cash flows from operating activities

Net profit before tax 4,012

Adjustments for

Goodwill impairment 48

Depreciation 650

Investment income (100)

Interest expense 300

Profit on sale of non-current assets (300)

Profit from associated undertakings (990) _____

Operating profit before working capital changes 3,620

Increase in trade receivables (3,700 − 2,550 − 56) (1,094)

Increase in inventories (3,950 − 2,000 − 64) (1,886)

Increase in trade payables (1,000 − 560 − (170 − 34)) 304 _____

Cash generated from operations 944

Interest paid (300 − disct 6 − 80 + 60) (274)

Income taxes paid (W3) (300) _____

Net cash from operating activities 370 _____

Cash flows from investing activities

Acquisition of Hendry net of cash acquired (Note 1) 196

Purchase of property, plant and equipment (W4) (2,170)

Proceeds from sale of equipment 1,100

Dividends received from associated undertakings (W1) 435

Dividends received 75 _____

Net cash used in investing activities (364) _____

Cash flows from financing activities

Proceeds from issue of equity capital (W6) 4,906

Proceeds from long-term borrowings (W7) 2,900

Payment of finance lease liabilities (W8) (1,526)

Dividends paid by Hebden (4,600+2,442-6,242) (800)

Dividends paid to non-controlling interests (W2) (96) _____

Net cash from financing activities 5,384 _____

Net increase in cash and cash equivalents for the year 5,390

Cash and cash equivalents at beginning of period 3,640 _____

Cash and cash equivalents at end of period 9,030 _____



Notes

(1) Acquisition of subsidiary – goodwill at full fair value

$m

Cash paid 28

Fair value of shares issued (NV 440m + SP 110m) 550

_____

Fair value of consideration paid by parent 578


_____

712


_____

208

_____

Net cash impact of acquisition: $m

Cash paid on acquisition (28)

Net cash balances acquired 224

_____

Net cash inflow from acquisition of subsidiary 196

_____

(2) Non-cash transactions

With respect to non-cash transactions, Hebden Group purchased Hendry on 1 August 20X0. Part of the consideration comprised 440 million equity shares of $1 with a fair value of $550 million. To the extent that there was a share issue, the fair value of the shares issued will be used in the calculation of goodwill, and to increase share capital and share premium as appropriate. Note that such share issues are a non-cash transaction. Goodwill is required to be calculated on a full fair value basis and this will enable any impairment of goodwill in the year to be identified.

The entity entered into finance lease agreements totalling $1,700 million during the financial year. The long-term borrowings are stated on an amortised cost basis which results in a non-cash charge of $6 million.

Workings

(W1) Dividends from associated undertakings

Opening balance 1.8.X0 2,000

Add: Share of profit 990

Less: Taxation (355)

Less: Closing balance 31.7.X1 (2,200) _____

Cash inflow 435 _____



(W2) Dividends paid to non-controlling interest

Opening balance 1.8.X0 −

Add: Profit for year 200

Acquisition of Hendry - FV of NCI 134

Less: Closing balance (238) _____

96 _____

(W3) Taxation paid

Opening balances 1.8.X0

Income tax 834

Deferred tax 26 ___

860

Income statement 990

Tax on acquisition of Hendry 34

Less: Closing balances 31.7.X1

Income tax 1,524

Deferred tax 60 ___

(1,584) _____

Cash outflow 300 _____

(W4) Payments for non-current assets

Acquisitions in period 4,200

Less: Arising from acquisition (330)

Leased assets (1,700) _____

Cash outflow 2,170 _____

(W5) Purchase of subsidiary

Cash acquired from acquisition 224

Less: Cash in consideration (28) _____

Cash inflow 196 _____

(W6) Issue of equity share capital

Balance 31.7.X1 − equity shares 7,880 share premium 5,766

Non-cash consideration − equity shares (440) share premium (110)

Less: Opening balance 1.8.X0

Less: Opening balance 1.8.X0 − equity shares (4,000) share premium (4,190)

_____

4,906 _____



(W7) New long term loans

Balance 31.7.X1 2,906

Less: Finance cost – discount (6) _____

Cash inflow 2,900 _____

(W8) Repayments of finance lease obligations

Balance 1.8.X0 (1,340 + 400) 1,740

New lease commitments 1,700

Less: Closing balance 31.7.X1 (1,434 + 480) (1,914) _____

1,526 _____

(W9) Impairment of goodwill

Balance 1.8.X0 nil

Goodwill on acquisition of Hendry (Note 1) 208

Less: Closing balance 31.7.X1 (160) _____

Impairment in year 48 _____



BARON

Baron Group – Cash flow statement for the year ended 30 November 20X1

$m $m $m

Cash flows from operating activities

Net profit before taxation 598

Adjustments for:

Impairment of intangibles (W5) 20

Depreciation 150

Interest income (net) (8)

Defence costs of take-over bid 20

Loss on disposal of tangible non-current assets (W3) 7

Loss on disposal of discontinued operations 25

Profit from joint venture (75)

Bid defence cash outflow (5) ___

Operating profit before working capital changes 732

Increase in trade receivables (W1) (189)

Increase in inventories (720 − 680 + 60) (100)

Increase in trade payables (1,300 − 973 + 105) 432 ___


Interest paid (30 + 19 − 40) (9)

Income taxes paid (W2) (105) ___

Net cash from operating activities 761


Disposal of subsidiary (130 − 75) (55)

Interest received (4 + 27 − 5) 26

Purchase of tangible non-current assets (380)

Sale of tangible non-current assets (W3) 68

Purchase of corporate bonds (35)

Purchase of government securities (28)

Purchase of interest in joint venture (25) ___

(88) ___

Net cash used in investing activities (429)


Dividends paid (130)

Dividends paid to non-controlling interests (W4) (231) ___

Net cash used in financing activities (361) ___

Net decrease in cash and cash equivalents (29)

Cash and cash equivalents at beginning of period (133 + 21) 154 ___

Cash and cash equivalents at end of period (101 + 24) 125 ___



Note: IAS 7 allows interest and dividends paid to be classified as financing or operating activities. Cash and cash equivalents have been classified strictly on a policy of liquidation within 3 months. Alternative classifications, if discussed, may be acceptable.

Workings

(W1) Trade receivables

$m

Trade receivables – 30.11.X1 680

Less: Interest receivable (5) ___

675 ___

Trade receivables – 30.11.X0 540

Less: Interest receivable (4) ___

536 ___

Increase in trade receivables 139

Subsidiary – trade receivables 50 ___

189 ___

(W2) Taxation Taxation on profit 191

Tax in subsidiary disposed of (25)

Opening balance on taxation account 220

Closing balance on taxation account (261)

Taxation on joint venture (20) ___

105 ___

(W3) Non-current assets Cost/valuation – disposals 680

Depreciation (95) ___

Carrying value 585

Less: Subsidiary disposed of (310) ___

275

Less: Transfer to joint venture (200) ___

Carrying value disposed of 75

Loss on disposal (7) ___

Cash proceeds 68 ___

(W4) Non-controlling interest − opening balance 570

− Sale of Piece (20% of 420) (84)

Profit for year 75

− Closing balance (330) ___

Non-controlling interest – equity dividend 231 ___



(W5) Intangible assets - goodwill

Intangible assets – opening balance 144

Written off to income statement on disposal (64)

Impairment loss during year (20) ___

Closing balance 30.11.X1 60 ___

(W6) Joint venture in Kevla

Investment – assets 200

– cash 25 ___

225

Profit for period 75

Tax expense (20) ___

55 ___

280

Loss on revaluation (15) ___

265 ___



DUKE

Duke Group – group cash flow statement for the year ended 31 May 20X2

Cash flows from operating activities $m $m

Net profit before taxation 734

Adjustments for: Goodwill impairment (W1) 10 Depreciation 39 Interest income (net) (3) Profit on disposal of tangible non-current assets (15) Profit from associated entity (98)

___

(67) ___

Operating profit before working capital changes 667

Increase in trade receivables (660 – 530 – 25 – 17 + 15) (103)

Increase in inventories (750 – 588 – 30) (132)

Increase in trade payables (1,193 – 913 – 20 – 9) 251 ___

16 ___


Interest paid (31 – 9) (22)

Income taxes paid (W4) (220) ___

(242) ___

Net cash from operating activities 441


Acquisition of subsidiary (net of cash received) (17 – 35) 18

Interest received (15 + 34 – 17) 32

Dividend from associated entity (W2) 3

Purchase of tangible non-current assets (278 – 60 – 100) (118)

Sale of tangible non-current assets (30 + 15) 45

Purchase of trade investments (W5) (635) ___

Net cash used in investing activities (655)


Proceeds of issuance of share capital (options) 20

Proceeds from long-term borrowings (W5) 242

Dividends paid (W7) (126)

Dividends paid to non-controlling interests (W3) (17) ___

Net cash from financing activities 119 ___

Net decrease in cash and cash equivalents (95)

Cash and cash equivalents at beginning of period 140 ___

Cash and cash equivalents at end of period 45 ___



Workings

(W1) Purchase of subsidiary

$m $m

Purchase consideration ($80m equity shares plus $17m cash) 97

Fair value of NCI at acquisition 28 ___

125


___

Full goodwill 25

___

Goodwill account: Opening balance 83

Goodwill on Regent (as above) 25 ___

108

Impairment loss (10) ___

Closing balance 98 ___

(W2) Associated entity

Balance as at 1 June 20X1 220

Income for the period (98 – 15) – net of tax 83

Dividends received – cash flow (balancing figure) (3) ___

Balance as at 31 May 20X2 300 ___

(W3) Dividends paid

Dividend paid to the non-controlling interest:

Opening balance (b/s) 150

Profit attributable to the non-controlling interest 97

Fair value of NCI at acquiistion 28

Dividend paid to minority (balancing figure) (17) ___

Closing balance (b/s) 258 ___

(W4) Taxation

Balance at 31 May 20X1 300

Income statement (213 − 15) 198

Taxation – Regent 30

Tax paid (balancing figure) (220) ___

Balance at 31 May 20X2 308 ___



(W5) Investments and non-current liabilities

Cash flow

Trade investments – balance 31 May 20X1 50

Foreign equity investment 605 605

Exchange difference (205) ___

400

Purchased in year – other 30 _____

30 ___

Trade investments – balance 31 May 20X2 480 _____

635 ___

Non-current liabilities – interest bearing borrowings

Balance at 31 May 20X1 930

Loan taken out to finance equity investment 310 310

Exchange difference (10) ___

300

Bills of exchange 100

Cash paid (balancing figure) (68) _____

(68) ___

Balance at 31 May 20X2 1,262 _____

242 ___

(W6) Note as the purchase of tangible non-current assets is being financed by the supplier in part, and the bill of exchange of $100m has not been paid, then the purchase of tangible non-current assets in terms of its cash effect is reduced.

(W7) Dividend paid by Duke

$m

Retained earnings b fwd 103

Profit for the year 424

Exchange differences:

on foreign equity investment (205)

on foreign borrowings 10

Dividend piad (bal fig) (126

_____

Retained earnings c fwd 206

_____



APPLYING ACCOUNTING STANDARDS

TIMBER PRODUCTS

(a) Substance over form

The objective of the substance over form principle is to ensure that the substance of an entity’s transactions is reported in its financial statements. The commercial effect of the entity’s transactions, and any resulting assets, liabilities, gains or losses, should be faithfully represented in its financial statements. This will affect the accounting for any arrangement the effect of which is to inappropriately omit assets and liabilities from the statement of financial position. The principle achieves this by requiring financial statements to be prepared reporting the substance rather than the legal form of transactions.

(b) Transactions

(i) How to determine the substance/whether to include in statement of financial position/recognition

The legal form of this transaction is that it is a sale. The issue is to decide whether this is the substance of the contract or whether it is in fact a financing transaction.

Legal form

Dr Cash Cr Sales

No inventory on the SOFP at the reporting date.

Alternative?

Dr Cash Cr Loan

Inventory retained on the year end SOFP.

Interest charged through the income statement.

This decision requires an analysis of the terms of the contract. Usually this involves an examination of:

the main feature of the transaction to decide if it is a real sale or not (e.g. sale to a bank; banks do not buy wood, they lend money)

which party has access to the risks and rewards of ownership.

In this case there is no need because the contract specifies that the timber will be repurchased. Therefore it is not a real sale in the first place! Timber Products has not transferred the risks and rewards of ownership of the timber and this transaction is a financing transaction. Timber Products have in fact borrowed money on the security of the timber. The timber will therefore appear as inventory in the statement of financial position and the loan will appear as a liability.

Carrying value of the liability

The liability is a financial liability within the definition in IAS 39. This standard requires that liabilities (other than those held for trading or otherwise designated as being measured at fair value through profit or loss) are carried at their amortised cost using the effective interest rate method. This means that the carrying value of the liability will be increased by the interest charge based on the rate that is inherent in the



contract and reduced by any cash flows (though in this case there are none). Each year there will be an interest element charged to the income statement and added to the liability.

Calculation of the effective interest rate

Total finance charge over the term of the loan is:

$m

Total repayments 56.1

Amount borrowed (40) ____

Interest 16.1 ____

This must be spread to the income statement using the effective rate. This is calculated as the IRR of the loan as follows:

5 40/1.56 − 1 = 0.07 or 7%

The annual interest cost and the carrying value of the loan at each year end over the life of the loan is given below. (This is not required in the question but is given for tutorial purposes.)

Period Opening Interest Cash Closing balance @ 7% flow balance

1 40 2.8 − 42.8

2 42.8 3.0 − 45.8

3 45.8 3.2 − 49.0

4 49 3.4 − 52.4

5 52.4 3.7 (56.1) −

The statement of financial position as at 31 October 20X1 will show:

$m

Inventory 40.0

Loan payable after more than one year 42.8

Note: The loan is secured by inventory of $40m at cost.

The income statement will show:

Interest payable [7% of $40m] $2.8

(ii) How to determine the substance/whether to include in statement of financial position/derecognition

The problem in this transaction is to determine at which point Timber Products should recognise the sale. Is the substance of the transaction such that it is right to recognise the sale at the point of delivery of the furniture or at a later date?

If the sale is recognised on delivery of the furniture then the financial statements of Timber Products should recognise revenue of $10m for the year and its closing statement of financial position will show a receivable of $4m ($10m − $6m).

If the sale is not recognised at delivery, but at some later date then Timber Products should recognise revenue of $6m for the year. The inventory held by the retailers at the year end would be treated as that of Timber Products and appear on its statement of financial position.



The decision as to when the sale is recognised requires an examination of the terms of the contract. The contract contains some terms that support recognition at delivery and some that suggest a later date to be appropriate.

Factors supporting recognition at delivery:

Retailer pays insurance (bears the risk of ownership).

Price fixed at delivery (retailer has risks and benefits of price change).

Factors supporting recognition at a time after delivery:

Retailer may return the goods (TP retains risk and rewards of ownership).

BUT this right has never been exercised.

On balance it seems that this sale should be recognised at delivery. In substance once the goods leave Timber Products they never return.

(iii) Debt factoring

The correct accounting treatment for debt factoring is determined by the rules on derecognition of financial assets set out in IAS 39.

IAS 39 requires that an enterprise should derecognise a financial asset when and only when it loses control of the contractual rights that comprise the financial asset. IAS 39 states that whether an enterprise has lost control of a financial asset depends on both the enterprise’s position and that of the transferee.

In the situation specified Timber Products has neither the right to reacquire the asset nor is it obligated to redeem the asset on terms that effectively give a lender’s return to Ready Support. In this case Timber Products should derecognise the asset.

IAS 39 points out that a derecognition of a financial asset may be coupled with the recognition of a new financial asset or liability. This is the case in this situation.

The difference between the book value of the receivables ($15m) and the cash receipt ($13.5m) is a new financial asset ($1.5m) on TP’s statement of financial position. It represents the right to receive money from Ready Support in the future.

The guarantee of $200,000 is treated as a separate financial instrument, created as a result of the transfer, to be recognised as a financial liability by TP and a financial asset by RS.

At the period end the following information will appear in the financial statements:

$m

Proceeds

Cash (90% 15m) 13.5 BS

New financial asset 1.5 BS

15

Book value of amount transferred 15

Maximum potential liability under the recourse agreement 0.2

(15.2)

Loss on disposal 0.2 IS



(c) Computer controlled equipment

There would appear to be two possible approaches. One would be to approach the transaction as a secured loan; the other as a leasing arrangement.

Secured loan considerations

The question to be answered is what risks have Timber Products borne in this transaction.

It clearly bears the operating risk in the form of maintenance and insurance costs. It needs to be determined whether it has also borne the charge for covering the finance cost of the equipment during construction. Further information is required in considering this transaction to assess whether Extractor-Plus is in effect receiving a lender’s return. If that were the case, the equipment would appear as an asset in the statement of financial position and an amount equal to the cost of the asset as a loan secured on the asset.

Leasing considerations

More information is necessary to establish whether there has been an attempt to word the agreement so that it falls outside the IAS 17 definition of a finance lease. The additional information would include matters such as the cost of the equipment, the length of the contract, and any minimum lease payments particularly in the event of low hourly usage.



AZTECH

(a) Interaction of standards

Circumstances may arise where subsequent to initial recognition, the book value of a tangible non-current asset may not be economically recovered from future business activity. Although future production may be possible, this may be insufficient to recover the current book value in the future. IAS 36 requires a write down of the book value to the recoverable amount and the reduction in value should be charged as an immediate expense in the income statement. If it reverses a previous revaluation uplift, it should be charged directly against the revaluation surplus (IAS 16). Thus the two standards need to be consulted in this area as any impairment loss of a revalued asset requires consideration of the determination of whether the asset is impaired (IAS 36) and how this loss is going to be dealt with if the asset has been revalued (IAS 16). Additionally IAS 36 deals with the depreciation charge for an impaired asset and the reversal of an impairment loss of an asset. Again in this latter case if the asset has been revalued, both IAS 16 and IAS 36 need consulting.

After the initial recognition of an asset an enterprise may incur further expenditure on that asset. IAS 37 has stated that periodic maintenance costs cannot be accrued in advance of a shut down and decommissioning costs and other environmental costs relating to an asset must be recognised as soon as there is an obligating event. These costs cannot be built up over the life of an asset but must be provided for in full when the obligating event occurs. IAS 37 deals with the measurement and recognition of the provision (i.e. the credit entry) and IAS 16 deals with the accounting for the debit entry resulting in a smooth interaction between the two statements.

(b) Transactions

(i) Valuation of hotels

IAS 16 states that on the revaluation of land and buildings, they should usually be valued on the basis of their market value. Properties held for sale should be valued on the basis of the lower of their carrying amount and their fair value less costs to sell (IFRS 5).

Thus on 31 March 20X4, the hotels will be valued as follows:

$m $m

Open market value 19

Less: Property to be sold (2.5) ____

16.5

Property surplus to requirements (carrying value) 3 ____

Fair value less costs to sell (lower) ($2.5m – $0.2m) 2.3 ____

Statement of financial position value 18.8 ____

Expenditure on non-current tangible assets to maintain the asset at its current level does not negate the need to charge depreciation. The primary effect of maintaining an asset will be to increase its economic life but a programme of maintenance will not affect the assets’ residual value at the end of its economic life. Additionally depreciation is a matching exercise not an attempt at valuation. The only items of property which may not be subject to depreciation are investment properties, properties held for sale and land. Buildings are deemed to have a limited life and are



therefore depreciable assets (IAS 16 para 58). Therefore the policy is unacceptable under IAS 16.

(ii) Aircraft fleet

At 31 March 20X4

$000

Cost of manufacture 28,000

Interest capitalised ($20m × 10% + ($20m × 110% × 10%) × ¾) 3,650 ______

31,650 ______

Capitalisation of finance costs should cease when the assets are substantially complete (as required by IAS 23). Hence only 1¾ years finance costs are capitalised. Initial recognition of the assets will be at cost. However if the amount recognised when a non-current tangible asset is constructed exceeds its recoverable amount then it should be written down to its recoverable amount based on the principle in IAS 36 Impairment of Assets that assets should not be valued at above their recoverable amount. The recoverable amount is the higher of net selling price and value in use. Thus the fleet of aircraft will be recognised in the statement of financial position at $30 million.

31 March 20X5 Carrying Depreciation Carrying value value 1.4.20X4 31.3.20X5 $000 $000 $000

Engines 9,000 3,000 6,000

Body 21,000 ______

2,625 _____

18,375 ______

30,000 ______

5,625 _____

24,375

Revaluation loss to income statement (3,375) ______

Closing book amount (market value) 21,000 ______

The impairment loss of 3,375 is allocated pro rata between the engines and the body,

i.e. 375,24

000,6 3,375 to the engines and

375,24

375,18 3,375 to the body.


Engines 5,169 2,585 2,584

Body 15,831 ______

2,262 _____

13,569 ______

21,000 ______

4,847 _____

16,153

To Income statement 3,375

To Revaluation reserves 72 ______

Closing book amount (market value) 19,600 ______



IAS 16 (paragraph 39) states that where an asset’s carrying amount is increased as a result of a revaluation, then the increase should be credited to equity. However, if this reverses a revaluation decrease of the same asset then part should be recognised in income to the extent of the previous revaluation loss.


Engines 3,135 3,135 –

Body 16,465 ______

2,744 _____

13,721 ______

19,600 ______

5,879 _____

13,721

Add cost of new engines 15,000 ______

Closing book amount 28,721 ______



WORLDWIDE NUCLEAR FUELS

Key answer tips

This question only concerns provisions. You are not required to write about contingencies in part (a).

(a) Explanation

(i) Need for guidance

The IASB was anxious to ensure that only those amounts meeting its definition of liabilities should be reported in the statement of financial position. The IASB defines a provision as a ‘liability of uncertain timing or amount’. It was keen to prevent entities from providing for future operating losses as it considered that they should be accounted for in the future.

It is often quite difficult to differentiate between provisions and other liabilities and reclassification from one category to another is not uncommon. The importance of the distinction is that provisions are often subject to disclosure requirements which do not apply to other liabilities. For example, legislation often requires disclosure of the movement on a provision in the year but not for other liabilities. However even such disclosure does not solve the difficulty with provisioning as quite often the largest disclosed balance is ‘other provisions’ with no information being disclosed in the financial statements.

The transparency of disclosure is possibly the most important issue in accounting for provisions. Once a provision has been established it is possible to bypass the income statement with expenditure that is charged to it. Some of the provisions that have been set up in this manner have been very large. Planned expenditures for several years may be aggregated into one large provision that is reported as an exceptional item. The user of financial statements may then add the provision back to income in the year and fail to take account of charges made to that provision in future years. (This is often referred to as ‘big bath accounting’.)

There has been concern that the basis on which provisions have been recognised has not been clear. In some cases the recognition of provisions has been based on management’s intentions rather than on the basis of a present obligation. Thus management has been able to exercise discretion over the timing of recognition of provisions with the following effects:

inconsistency between the accounting for provisions between different entities

the smoothing of earnings by management

the impairment of the statement of financial position as a useful statement.

It is important that provisions are recognised and measured on a consistent basis and that sufficient information is disclosed in the notes to the financial statements to enable users to understand their nature, timing and amount.

(ii) Recognition

IAS 37 utilises the Framework document and concludes that provisions are an element of the liabilities and not a separate element of the financial statements. Provisions should be recognised when and only when:

an enterprise has a present legal or constructive obligation as a result of past events

it is probable that an outflow of resources embodying economic benefits will be required to settle the obligation



a reasonable estimate of the amount required to settle the obligation can be made.

An obligation exists when the entity has no realistic alternative to making a transfer of economic benefits. This is the case only where the obligation can be enforced by law or in the case of constructive obligation (see below). No provision is recognised for costs that need to be incurred to operate in the future. The only liabilities recognised are those that exist at the statement of financial position date. The obligations must have arisen from past events and must exist independently from the entity’s future actions. If the entity can avoid the expenditure by its future actions then no provision is recognised. These rules are designed to allow a provision to escape recognition only in rare cases. In these rare cases there is an obligation if having taken into account all available evidence it is more likely than not that a present obligation exists at the statement of financial position date.

It is not necessary to know the identity of the party to whom the obligation is owed in order for an obligation to exist but in principle there must be another party. The obligation may be to the public at large. The mere intention or necessity to incur expenditure is not enough to create an obligation. Where there are a number of similar obligations, the whole class of obligations must be considered when determining whether economic benefits will be transferred.

There is a need to provide for legal obligations although there is the important issue of timing and the identification of the past event which triggers the recognition. However IAS 37 also deals with the concept of ‘constructive obligation’. For example where a retail store gives refunds to dissatisfied customers even though there is no legal obligation to do so in order that it will preserve its reputation. Therefore, an entity may be committed to certain expenditure because any alternative would be too onerous to contemplate. The determination of a constructive obligation is extremely difficult and is a somewhat subjective concept.

An event may give rise to an obligation at a later date because of changes in the law or because of a constructive obligation. Provision will be made when the law is virtually certain to be enacted or the entity publicly accepts responsibility for the event in a way which creates a constructive obligation.

The rules for recognition are expanded to deal explicitly with certain specific cases:

no provision should be recognised for future operating losses

a constructive obligation for restructuring only exists and thus a provision recognised when the recognition criteria laid out in IAS 37 are satisfied

if an enterprise has a contract which is onerous, the present obligation should be recognised and measured as a provision.

IAS 37 essentially looks at the problem of provisions from a statement of financial position perspective choosing to concentrate on liability recognition rather than the recognition of an expense.

(b) Transactions

(i) Decommissioning costs

IAS 37 has a significant impact on decommissioning activities. It appears that the entity is building up the required provision over the useful life of the radioactive facility, often called the ‘units of production method’. However IAS 37 requires the provision to be the best estimate of the expenditure required to settle the obligation at the statement of financial position date. The provision should be capitalised as an



asset if the expenditure provides access to future economic benefits. If this is not the case, then the provision should be charged immediately to the income statement. IAS 37 does not prescribe the accounting treatment for the resulting debit but amendments have been made to IAS 16 Property, Plant and Equipment to ensure a smooth interaction between the two standards. The asset so created will be written off over the life of the facility subject to the usual impairment test in IAS 36 Impairment of Assets. Thus the decommissioning costs of $1,231m (undiscounted) not yet provided for will have to be brought onto the statement of financial position at its discounted amount and a corresponding asset created.

The current practice adopted by the entity as regards the discounting of the provision is inconsistent. The provision is based on future cash flows but the discount rate is based upon current market rates of interest. IAS 37 suggests that the discount rate should be a pre-tax rate that reflects current market assessments of the time value of money and the risks specific to the liability. The discount rate should not reflect risks for which future cash flow estimates have been adjusted. Therefore, the provision should be based on current prices discounted by the current market rate.

The entity currently makes a reserve adjustment for changes in price levels. However this adjustment would have two elements and should be charged to the income statement. The first element would be the current adjustment on the total provision for changes in the discount rate and the second element would be an interest element representing the unwinding of the discount. Thus the income statement would be charged with the amortisation of the asset created by the setting up of the provision and also with an adjustment for the change in price levels and the unwinding of the discount. IAS 37 requires separate disclosure of this latter amount and suggests that it should be classified as an interest expense.

It appears that any subsequent amendment of the provision should be recognised in the income statement.

(ii) Oil entity

One of the quite explicit rules of IAS 37 is that no provision should be made for future operating losses. However, if the entity has entered into an onerous contract then a provision will be required. An onerous contract is one entered into with another party under which the unavoidable costs of fulfilling the contract exceed the revenues to be received and where the entity would have to pay compensation to the other party if the contract was not fulfilled. Thus it appears that the contract should be loss making by nature. Thus in this case the provision of $135m would remain in the financial statements and would affect the fair value exercise and the computation of goodwill.

Provisions for environmental liabilities should be recognised when the entity becomes obliged (legally or constructively) to rectify environmental damage or perform restorative work on the environment. A provision should only be made where the entity has no real option but to carry out remedial work. The mere existence of environmental contamination caused by the entity’s activities does not in itself give rise to an obligation. Thus in this case there is no current obligation. However it can be argued that there is a ‘constructive obligation’ to provide for the remedial work because the conduct of the entity has created a valid expectation that the entity will clean up the environment. Thus there is no easy solution to the problem as it will be determined by the subjective assessment of the directors and auditors as to whether there is a ‘constructive obligation’. It is a difficult concept and one which will result in different interpretations. If one takes example 2B in IAS 37 as a guide then a provision should be made.



IMPAIRMENT LOSS

Key answer tips

The key requirement word in part (a) (i) is describe and so your answer must be more than simply a list of ‘bullet points’.

Answer part (a) (ii) by explaining how impairment is measured and then how it is recognised. (This is the logical order in which to tackle the two aspects of the requirement, even though the question says ‘recognition and measurement’.)

Remember that the carrying amount of assets should not be reduced below their fair value less costs to sell.

(a) IAS 36

(i) Circumstances

In identifying whether an impairment of an asset may have occurred an enterprise should consider the following indications:

there has been a significant decrease in the market value of the asset in excess of the normal process of depreciation

there has been a significant adverse change in either the business or the market in which the asset is involved. This will include changes in the technological, economic or legal environment in which the enterprise operates

there has been a significant adverse change in the manner in which the asset has been used

evidence is available that indicates that the economic performance of the asset will be worse than expected

the asset has suffered considerable physical change, obsolescence or physical damage

there has been an accumulation of costs significantly in excess of those originally expected in the acquisition or construction of an asset so that it may affect profitability

the management is committed to a significant reorganisation programme

where an asset is valued in terms of value in use and the actual cash flows are less than the estimated cash flows before discounting

market interest rates or other market rates of return on investments have increased during the period and those increases are likely to decrease materially the asset’s recoverable amount.

(ii) Recognition and measurement

IAS 36 Impairment of Assets says that if there is an indication of impairment, then a review must be undertaken to confirm this fact and establish the extent of the impairment. An asset should not be valued at an amount greater than its cost or recoverable amount in a historical cost system. The recoverable amount is defined as the higher of fair value less costs to sell and value in use (net present value of future cash flows). The above rule applies, also, to assets which have been revalued to replacement cost. The required approach is to compare the carrying value of the asset with its fair value less costs to sell or value in use. If either the fair value less costs to sell or value in use exceeds the carrying value then no write down is necessary and there is no need to estimate the other amount. If the recoverable amount is lower



than the carrying value, the asset is impaired and the carrying amount of the asset should be reduced to its recoverable amount. Impairments should be calculated on a pre-tax basis and any tax consequences picked up under IAS 12 (revised) Income Taxes.

The reduction is deemed to be an impairment loss and should be recognised as an expense immediately in the income statement. Sometimes it may not be possible to determine fair value less costs to sell and in this case the recoverable amount may be taken as its value in use. If there is no reason to believe that the asset’s value in use materially exceeds its fair value less costs to sell, the asset’s recoverable amount is its fair value less costs to sell. This often will be the case where the asset is held for disposal and the sale is imminent.

If it is not possible to estimate the recoverable amount of an asset individually, the recoverable amount of the asset’s cash generating unit should be determined. Where an asset does not generate independent cash flows, value in use can only be determined for the asset’s cash generating unit. An impairment loss for a cash generating unit should only be recognised where its recoverable amount is less than the carrying amounts of the items in that unit. Any impairment loss for a cash generating unit should be allocated first to goodwill, then to other assets on a pro rata basis. Any specific impairment of assets should be dealt with initially. The discount rate to be used should be a pre-tax market determined rate that reflects current assessments of the time value of money and risks specific to the asset.

An impairment loss relating to a revalued asset is treated as a revaluation decrease and therefore charged to revaluation account. Where the impairment loss is greater than the carrying amount of the asset, a liability should only be recognised where it is required by other International Standards. After recognition of an impairment loss, the depreciation charge should be adjusted to allocate the revised carrying amount (less residual value) systematically over its remaining life. An enterprise should review the statement of financial position to assess whether a recognised impairment loss still exists or has decreased. Any reversal of an impairment loss should be recognised in the income statement.

(b) AB

(i) Impairment of machinery

AB will have undertaken an impairment review because of the effect of the inventory losses and the problems associated with the taxi business. In the case of the productive machinery the carrying value will be compared with its recoverable amount. The recoverable amount is the higher of an asset’s fair value less costs to sell and its value in use. The fair value less costs to sell of the asset is $120,000. The value in use is $100,000 discounted at 10% for three years i.e. $248,600 approx. Thus the recoverable amount would be deemed to be $248,600. AB would therefore write down the asset to its value in use and recognise the loss in the income statement.

(ii) Impairment of the car taxi business

AB will recognise the impairment losses relating to the taxi business in the following way. (Impairment losses should be recognised if the recoverable amount of the cash generating unit is less than the carrying value of the items of that unit.)



At 1 February 20X1

1.1.X1 Impairment loss 1.2.X1 $000 $000 $000

Goodwill 40 (15) 25

Intangible assets 30 30

Vehicles 120 (30) 90

Sundry net assets 40 ___

___

40 ___

230 ___

(45) ___

185 ___

An impairment loss of $30,000 is recognised first for the stolen vehicles and the balance ($15,000) is attributed to goodwill.

At 1 March 20X1

1.2.X1 Impairment loss 1.2.X1 $000 $000 $000

Goodwill 25 (25)

Intangible assets 30 (5) 25

Vehicles 90 90

Sundry net assets 40 ___

___

40 ___

185 ___

(30) ___

155 ___

The impairment identified should usually be allocated firstly to goodwill and then to other assets on a pro-rata basis.

In this case the question has told us that the fair value less costs to sell of all assets except the licence have remained constant. The assets were originally measured at their fair value less costs to sell. IAS 36 says that any asset within the cash generating unit cannot be reduced below its fair value less costs to sell. Therefore it is only the licence that can be impaired.

AB recognises a further impairment loss of $30,000 although the value in use of the business is lower ($150,000). The carrying amounts of the individual assets are not reduced below their fair value less costs to sell.



RP GROUP

Key answer tips

The key requirement word in part (b) is discuss. Therefore your answer should look at all the potential issues and should be specific to the events described in the question. You are not required to make general comments about related party relationships.

(a) Explanation and discussion

(i) Importance of related party disclosures

Related party relationships are part of the normal business process. Entities operate the separate parts of their business through subsidiaries and associates and acquire interests in other enterprises for investment or commercial reasons. Thus control or significant influence can be exercised over the investee by the investing entity. These relationships can have a significant effect on the financial position and operating results of the entity and lead to transactions which would not normally be undertaken. For example, a entity may sell a large proportion of its production to its parent entity because it cannot and could not find a market elsewhere. Additionally the transactions may be effected at prices which would not be acceptable to unrelated parties.

Even if there are no transactions between the related parties it is still possible for the operating results and financial position of an enterprise to be affected by the relationship. A recently acquired subsidiary can be forced to finish a relationship with a entity in order to benefit group entities. Transactions may be entered into on terms different from those applicable to an unrelated party. For example, a holding entity may lease equipment to a subsidiary on terms unrelated to market rates for equivalent leases.

In the absence of contrary information, it is assumed that the financial statements of an entity reflect transactions carried out on an arm’s length basis and that the entity has independent discretionary power over its actions and pursues its activities independently. If these assumptions are not justified because of related party transactions, then disclosure of this fact should be made. Even if transactions are at arm’s length, the disclosure of related party transactions is useful because it is likely that future transactions may be affected by such relationships. The main issues in determining such disclosures are the identification of related parties, the types of transactions and arrangements and the information to be disclosed.

(ii) Discussion of exemption on grounds of size

The disclosure of related party information is as important to the user of the accounts of small entities as it is to the user of larger entities. If the transaction involves individuals who have an interest in the small entity then it may have greater significance because of the disproportionate influence that this individual may have. The directors may also be the shareholders and this degree of control may affect the nature of certain transactions with the entity. It is argued that the confidential nature of such disclosures would affect a small entity but these disclosures are likely to be excluded from abbreviated accounts made available to the public. In any event if these disclosures are so significant then it can be argued that they ought to be disclosed.

It is possible that the costs of providing the information to be disclosed could outweigh the benefits of reporting it. However, this point of view is difficult to



evaluate but the value of appropriate related party disclosures is particularly important and relevant information in small entity accounts since transactions with related parties are more likely to be material.

It is felt by some that the entity legislation in many countries in this area is sufficient to enable adequate disclosure. However entities and other legislation give a certain amount of information as regards the disclosure of directors and other officers’ transactions but these requirements only give limited assurance and therefore IAS 24 Related Party Disclosures extends these requirements and helps produce a more comprehensive set of regulations in the area. In other countries there is no legislation in this area and the disclosure of related party transactions is a sensitive issue. IAS 24 attempts to ensure that some degree of uniformity exists in the disclosure of such transactions.

(b) Several events

(i) Management buyout

IAS 24 does not require disclosure of the relationship and transactions between the reporting entity and providers of finance in the normal course of their business even though they may influence decisions. Thus as RP is a merchant bank there are no requirements to disclose transactions between RP and AB because of this relationship. However, RP has a twenty-five per cent equity interest in AB. IAS 24 states that an associate is a related party. Thus under IAS 28 Investments in Associates if RP has 20% or more of the voting power it is presumed that significant influence exists and that AB is an associate. However if it can be demonstrated that significant influence does not exist, then it is not an associate. Thus the equity holding in AB may not necessarily mean that AB is an associate especially as the remaining seventy-five per cent of the shares are held by the management of AB who are likely to control decisions on strategic issues. Also merchant banks often do not regard entities in which they have invested as associates but as an investment. Often if the business of the investor is to provide capital to the entity accompanied by advice and guidance then the holding should be accounted for as an investment rather than an associate.

However, IAS 28 presumes that a person owning or able to exercise control over twenty per cent or more of the voting rights of the reporting entity is a related party. An investor with a twenty-five per cent equity holding and a director on the board would be expected to have influence over the financial and operating policies in such a way as to inhibit the pursuit of their separate interests. If it can be shown that such influence does not exist, then there is no related party relationship. The two entities are not necessarily related parties simply because they have a main board director on the board of AB, although IAS 28 does state that significant influence may be evidenced by representation on the board. Thus the determination of a related party relationship requires consideration of several issues.

If, however, it is deemed that they are related parties then all material transactions will require disclosure including the management fees, interest, dividends and the terms of the loan.

(ii) Subsidiary

A subsidiary is a related party, so transactions between RP and X should certainly be disclosed for the period when X was a subsidiary. IAS 24 does not address the situation where an undertaking ceases to be a subsidiary during the year. However international practice would seem to indicate that the transactions between the parties should also probably be disclosed to the extent that they were undertaken when X was not part of the group. Disclosure should be made of transactions between



related parties if they were related at any time during the financial period. Thus any transactions between RP and X during the year to 31 October 20X1 will be disclosed, but transactions prior to 1 July 20X1 would have been eliminated on consolidation. There is no related party relationship between RP and Z, as it is simply a business transaction unless there has been a subordinating of interests when entering into the transaction due to influence or control.

(iii) Retirement benefit scheme

Retirement benefit schemes for the benefit of employees of the reporting entity are related parties of the entity according to IAS 24. Additionally, the rendering or receipt of services is an example given in the IAS as regards a situation which could lead to disclosure and also the payment of contributions involves the transfer of resources which has a degree of flexibility attached to it even though IAS 19 (revised) Employee Benefits attempts to regulate the accounting for retirement benefit contributions. Contributions paid to the scheme must be disclosed under IAS 24 depending upon the nature of the plan and whether or not the reporting enterprise controlled the plan, but it is the other transactions with RP which must also be considered. Thus the transfers of non-current assets ($10m) and the recharge of administrative costs ($3m) must be disclosed. The pension scheme’s investment managers would not normally be considered a related party of the reporting sponsoring entity and it does not follow that related parties of the pension scheme are also the entity’s related parties. There would however be a related party relationship if it can be demonstrated that the investment manager can exercise significant influence over the financial and operating decisions of RP through his position as non-executive director of that entity. Directors under IAS 24 are deemed to be related parties. The fact that the investment manager is paid $25,000 as a fee and this is not material to the group does not mean that it should not be disclosed. Materiality is looked at in the context of its significance to the other related party which in this instance is the investment manager. It is possible that the fee will be material in this respect.



KIRK

Key answer tips

Remember that the question has specifically asked for journals. See the Tutorial Notes for explanations. Some of the adjustments affect the non-controlling interest.

(a) IAS 18 specifies when it is appropriate to recognise revenue. In respect of the sale of goods, IAS 18 states that the seller should only recognise revenue once the entity has transferred to the buyer the significant risks and rewards of ownership of the goods, and it is probable that the economic benefits associated with the sale will flow to the entity.

Where goods are supplied on sale or return, the ‘seller’ is retaining significant risks until the ‘purchaser’ decides to keep the goods, or the return period expires. It is premature to recognise revenue when the goods are supplied. Looking at things from a statement of financial position point of view, a receivable cannot be recognised as an asset at the date of supplying the goods, since the Framework only permits recognition when it is probable that the future economic benefit associated with the sale will flow to the entity. At the date of supply it is too early to be able to judge whether the receipt of benefit is probable.

In the income statement for the year ended 31 December 20X2 we should recognise the revenue from deliveries made to customers between 1 December 20X1 and 30 November 20X2. Goods delivered during December 20X2 should not be recognised as revenue but should be reinstated as inventory in the statement of financial position, measured at cost.

The following journal is required:

$m $m

DR Revenue (30 – 20) 10

CR Cost of sales (100

80 10) 8

CR Trade receivables 30

DR Inventory (100

80 30) 24

DR Opening retained earnings (100

20 20) 4

Being accounting entries necessary to record goods supplied on a sale or return basis.

Tutorial note:

The journal entries can be explained as follows:

(i) Revenue is reduced by $30m and increased by $20m, a net reduction of $10m.

(ii) If revenue is reduced by $10m, then the cost of those sales must also be eliminated. A

20% sales margin means that the cost of sales is 80% 10 = $8m.

(iii) The receivables in respect of the December 20X2 sales are no longer recognised.

(iv) The December 20X2 deliveries are still recognised in inventory at a value of 80% 30 = $24m.

(v) 20X1 profits were overstated by 20% 20 = $4m.



(b) An impairment review has been carried out on the cash-generating unit at 31 December 20X2 and has revealed an impairment loss, calculated as the total carrying value of the net assets of the unit less the recoverable amount of the unit.

Goodwill purchased on 1 January 20W8: 72 – (80% 70) = $16m

The subsidiary is not wholly owned. For the purposes of the impairment test, goodwill must be grossed up to include the notional non-controlling interest, as required by IAS 36.

Total carrying value of net assets of subsidiary is:

$m

Goodwill (16 100/80) 20

Separable net assets 80 ___

100 ___

Recoverable amount of the subsidiary

= Higher of net selling price and value in use

= Higher of $80m and $90m

= $90m

So the impairment loss = 100 – 90 = $10m.

According to IAS 36, this loss must be applied:

first against any assets that are known to be impaired;

next to any goodwill allocated to the unit;

finally to the other assets in the unit on a pro-rata basis.

We are told that there is obsolete plant with a carrying value of $5m, so this is written off first,

leaving $4m (80% 5) to be written off goodwill. No pro-rata reduction is required.


$m $m

DR Cost of sales (5 + 4) 9

CR Property, plant and equipment 5

CR Intangible non-current assets 4

DR Non-controlling interest (in statement of financial position) 1

CR Non-controlling interest (in income statement) 1

Being accounting entries necessary to record impairment of 80% subsidiary.

Tutorial note:


(i) The impairment loss of $9m is charged as an additional cost of sales. Because the financial statements only recognise the group’s share of goodwill, only 80% of the impairment loss relating to the goodwill is recognised.

(ii) The obsolete plant of $5m is written down.

(iii) The balance of the impairment loss is charged against goodwill as required by IAS 36.



(iv), (v) The impairment occurs in an 80% subsidiary, so 20% of the net assets (including the plant) are financed by non-controlling interests. 20% of the write-down in plant is

therefore charged to non-controlling interests, amounting to 20% $5m = $1m.

(c) This is a ‘sale’ followed by a compulsory repurchase, so the substance is that there was never a sale in the first place. The substance is that the subsidiary retains its interest in the property and recognises a loan raised on the security of the property.

Relevant accounting standards are IAS 1, that requires the application of substance over form, and IAS 39, that requires financial liabilities of this nature to be measured at amortised cost.

We can see that the annual interest rate on the loan is 10%, since the repurchase price increases by 10% pa. The economic substance is therefore that the $100m received is really a loan with an annual finance cost of 10%.


$m $m

DR Current liabilities (suspense) 100

DR Finance cost (10% 100) 10

CR Non-current liability (loan) 110

DR Cost of sales (amortisation) (80 20) 4

CR Accumulated amortisation 4

DR Non-controlling interest (in statement of financial position) (40% 14) 5.6

CR Non-controlling interest (in income statement) 5.6

Being accounting entries necessary to record the loan received secured on leasehold property.

Tutorial note:


(i) Remove the $100m received out of the suspense account.

(ii) Charge in the income statement a finance charge for the year of 10% $100m = $10m.

(iii) Credit the principal plus accrued interest to a loan account shown in non-current liabilities.

(iv) Depreciate the property now that it remains in non-current assets, in accordance with IAS 16. Strictly the charge is for amortisation rather than depreciation since the property is held on leasehold rather than freehold.

(v) The event takes place in a 60% owned subsidiary, so the 40% non-controlling interest

must be charged its share of the additional expenses arising. 40% (10 finance cost +

4 amortisation) = 40% $14m = $5.6m.



ANT

Key answer tips

Notice that fewer marks are available for part (a) than for parts (b) and (c); allocate your time accordingly.

(a) IAS 12 is clear on the circumstances in which a deferred tax asset can be recognised as a result of unused tax losses. An asset should only be recognised to the extent that it is probable that future taxable profit will be available against which the unused tax losses can be utilised.

We are told in the question that there is little indication that demand will pick up in the foreseeable future, so we cannot say it is probable that future profits will be available.

No deferred tax asset should be recognised in respect of the taxable loss. The journal adjustment necessary will be:

$m $m

DR Income tax expense in the income statement 6

CR Deferred tax non-current liability 6

Being the writing off of the asset wrongly established in the deferred tax provision. It should be written off as part of the tax charge for the year.

(b) Ant has taken out a loan of 40m Francos which will appear in its own individual statement of financial position. This loan is a monetary liability that must be retranslated into dollars at the statement of financial position date. IAS 21 requires that monetary assets and liabilities must normally be retranslated using the closing rate, with any exchange difference arising being recognised in the income statement for the year.

The loan was originally booked at 1.6

F 40m = $25m.

It must be retranslated to 1.5

F 40m = $26.67m.

There would need to be a journal adjustment to recognise the exchange loss arising:

$m $m

DR Exchange loss in income statement 1.67

CR Non-current liability: foreign loan 1.67

The subsidiary has its own independent operations (i.e., the Franco is its functional currency), so IAS 21 requires that the closing rate method should be used to translate the subsidiary’s figures before being consolidated into the group figures. An exchange difference will arise on retranslating the opening overseas net assets to the closing rate, amounting in this case to:

1.5

F 40m –

1.6

F 40m = $1.67m

IAS 21 requires this exchange gain to be recognised in equity, i.e. taken to a reserve. Currently the draft accounts include the net assets of the subsidiary at $25m. A journal is therefore required as follows:



$m $m

DR Various net assets of subsidiary 1.67

CR Exchange gain taken to equity 1.67

IAS 39 contains special rules in the case of an overseas loan hedging an overseas net investment. In this case, the exchange difference arising on retranslating the loan should be taken to equity, to match with the exchange difference arising on the net investment.

The two journals identified above have to be reconsidered in the light of this special hedging rule in the standard. The journals now become:

$m $m

DR Exchange loss, taken to equity 1.67



CR Exchange gain, taken to equity 1.67

The two exchange differences will exactly cancel each other out as matching entries in equity, so in this instance the accounting entries can be described in a single journal:

$m $m



(c) These are convertible loan notes. IAS 32 requires convertible loan notes to be split so that their equity element and their liability element can be presented separately in the statement of financial position.

The initial net proceeds of the notes is:

$m

Proceeds (2m $90) 180.0

Less: Underwriting costs (4.0)

Other direct costs (0.5) _____

175.5 _____

This net proceeds of $175.5m must be split between the equity element (given in the question) of $22.5m and the balance, being the liability element of $153m.

The initial recognition of the loan notes is therefore to include $22.5m within ‘equity’ on the statement of financial position, and to include $153m within ‘non-current liabilities’.

We must now consider the finance cost on the liability. The liability increases from $153m at

1 November 20X2 to 2m $135 = $270m on 31 October 20X7, i.e. after five years. The annual growth rate in the liability is given by:

153 (l + r)5 = 270

l + r = (153

270) 3

1

= 1.12

r = 12% pa



Tutorial note:

Alternatively you could use discount tables to find the discount rate at which the five-year

discount factor is 270

153 = 0.567. Again this is 12%.

IAS 39 requires financial liabilities to be initially measured at the fair value of the consideration received, less transaction costs, and subsequently measured at amortised cost. Therefore at 31 October 20X3 the liability element of the notes should be measured at $153m

1.12 = $171.36m.

The correcting journal entry required is as follows:

$m $m

Equity (remove draft entry) 180

Equity (equity element of notes) 22.5

Non-current liabilities (liability element of notes) 171.36

Finance cost (charged in income statement) 18.36

Administrative expenses (remove draft entry) 4.5

Being the accounting entries necessary to present the convertible loan notes in accordance with IAS 32 and IAS 39.



SATELLITE

Key answer tips

Remember to account for the non-controlling interest element of the adjustments where this is appropriate.

(a) Operating lease

The requirement of the lease that the building be returned in good condition means that there is an obligation to a third party which has occurred because of a past event which is the signing of the lease. The obligation cannot be avoided. However, IAS 37 Provisions, Contingent Liabilities and Contingent Assets states that future repairs and maintenance costs are not present obligations resulting from past events as they relate to the future operation of the business and therefore should be capitalised as assets or written off as operating expenses when incurred. However, the lessee may have to incur periodic charges for maintenance or make good dilapidations or other damage during the rental period. The recognition of such liabilities is not precluded by the standard if the event giving rise to the obligation under the lease has occurred. Thus in the case of Satellite, due to the severe weather damage, a provision for $1.2 million should be set up.

However, there is a further complication as there is still a need to determine whether a more general provision should be built up over the six years for the dilapidation costs. It could be argued that the event giving rise to the obligation under the lease is the passage of time and, therefore, $1 million ought to be provided for. A stricter interpretation could be that a specific event has to occur and there has to be specific dilapidation before any provision can be made. (For example, where there has been weather damage.) In conclusion, there should be provision of $1.2 million for the renovating due to the exceptional weather damage and a further provision of say ($6 million – $1.2 million divided by 6, i.e. $800,000) for the obligation under the lease as it cannot be avoided. If the operating lease was terminated immediately, then some expenditure would be required on the interior of the building and the exterior would require complete renovation. Thus the total provision required is $2 million.

It is possible that if the spirit of IAS 37 were adopted that the provision required could be based on actual dilapidation in the year. This would be difficult to estimate and may not be more accurate than the arbitrary allocation made above.

Finance lease

In the case of the finance lease, which relates to the warehouse, an obligation to restore the building to its original state arose when the sports facility was created. It appears that Universe cannot avoid the reinstatement costs and, therefore, full provision of $2 million should be made. Universe should set up a corresponding asset as the sports facility represents access to future economic benefits that are to be enjoyed over more than one period. The amount will be added to the finance lease costs and additional depreciation of 10% of $2 million will be charged as follows:

$000

DR Group retained profits 160

Non-controlling interest 40

CR Depreciation 200



The statement of financial position value of the leased building is ($8 million + $2 million – $200,000) $9.8 million. However, the recoverable amount of the lease is $9.5 million and, therefore, the asset is impaired and requires writing down to this amount:

$000

DR Group retained earnings 240

Non-controlling interest 60

CR Leased asset 300

Owned assets

Major periodic repairs to non-current assets are not provided for under IAS 37. These repairs are not present obligations of the entity as they relate to the future operations of the entity. If there is declining service potential then the asset should be depreciated to reflect this and expenditure on repairs and maintenance should be capitalised to reflect the restoration of service potential. Also the repairs in the case of Satellite could be avoided by selling the buildings. Thus no provision for the $6 million can be made.

Database

IAS 38 Intangible Assets sets out the criteria that should be met in order to recognise an internally generated intangible asset. An enterprise is required to demonstrate the technical feasibility of the asset, the ability to complete and use or sell the asset, the probable future economic benefits of the asset and the availability of adequate technical, financial and other resources before it can be recognised. Obviously the value of the asset must be capable of reliable measurement. The asset should be capable of generating net cash inflows in excess of net cash outflows. This test is essentially an impairment test.

The standard prohibits the recognition of internally generated brands, mastheads, publishing titles and customer lists and similar items as intangible assets. It could be argued that the database falls into this category but because it is generating future income, it is felt that recognition can occur.

The asset can be recognised at the value of its future revenue earning capacity, i.e. $2 million. To date $3 million is being amortised over five years. Therefore the adjustment should be:

$

DR Group retained earnings 800,000

Non-controlling interest 200,000

CR Intangible asset 1,000,000

Write down of development cost to $2 million

DR Intangible asset 600,000

CR Group retained earnings 480,000


Reversal of amortisation to date

DR Group retained earnings 400,000


CR Intangible asset 500,000

Amortisation over four year life



Fair value adjustments

The time limit for fair value adjustments imposed by IFRS 3 Business Combinations applies only to the acquired assets and liabilities. There is no time limit on the recognition of goodwill relating to contingent consideration. Therefore, an additional amount of goodwill of $8 million is recognised and a liability of $8 million shown. The increase in goodwill should be subject to annual impairment tests in the same way as any other goodwill arising on acquisition.

$m

DR Goodwill 8

CR Current liabilities 8

(b) Revised group statement of financial position as at 30 November 20X2

$000

Non-current assets

Intangible assets (5,180 – 1,000 + 600 – 500 + 8,000) 12,280

Tangible assets (38,120 + 2,000 – 200 – 300) 39,620 ______

51,900

Net current assets (27,900 – 8,000) 19,900 ______

Total assets less current liabilities 71,800 ______

Equity and liabilities:

Called up share capital 16,100

Share premium account 5,000

Retained earnings

(27,400 – 2,000 – 160 – 240 – 800 + 480 – 400) 24,280

Non-controlling interests (9,100 – 40 – 60 – 200 + 120 – 100) 8,820

Non-current liabilities: interest bearing borrowings 12,700

Provisions (900 + 2,000 + 2,000) 4,900 ______

71,800 ______



FINANCIAL INSTRUMENTS

Key answer tips

Don’t be put off by the title to this question. It’s an exercise dealing with the basics of financial instruments, including IFRS 9 requirements and you should make a good attempt at it, even if you hope the topic does not turn up in the exam!

(a) Definitions: IAS 32 provides the basic definitions to enable classification as a financial asset, financial liability or equity. The definition has been retained in relation to financial assets following the publication of IFRS 9 in November 2009. A financial instrument is defined as any contract that gives rise to a financial asset of one entity and a financial liability or equity instrument of another entity. An entity’s asset is a financial asset if it is cash, an equity instrument of another entity, a contractual right to receive cash or to exchange financial assets/liabilities on terms potentially favourable to the entity or a contract which may be settled in the entity’s own equity instruments. Examples are trade receivables and investments in equity or loans. An entity’s liability is a financial liability if it is a contractual right to deliver cash or to exchange financial assets/liabilities on terms potentially unfavourable to the entity or a contract which may be settled in the entity’s own equity instruments. Examples are trade payables and loans. An equity instrument is a contract in respect of the residual interest in the assets of another entity once all that entity’s liabilities have been deducted. A derivative is a financial instrument that derives its value in response to the changes in the price of some underlying item, e.g. shares, foreign exchange rates, interest rates. Derivatives require no initial investment or the investment is small. They are settled at a future date and transform the risk profile of the entity. Examples of derivatives include options, swaps, forward contracts and futures. Recognition: The basic recognition criteria for financial assets and financial liabilities are contained within IFRS 9 for financial assets and IAS 39 for financial liabilities respectively. When IFRS 9 was published in November 2009, it dealt only with recognition and measurement of financial assets. In due course, the scope of IFRS 9 will be extended to include recognition and measurement of financial liabilities, impairment and hedging arrangements. An entity should recognise a financial asset or a financial liability on its statement of financial position when the entity becomes a party to the contractual provisions of the instrument, rather than when the contract is settled. An entity should derecognise a financial asset when either of the following has occurred: • The asset has been sold so that the risks and rewards of ownership have passed away. • The contractual rights to the cash flow of the financial asset have expired. An entity should derecognise a financial liability when the liability has been extinguished. The four categories of financial asset previously recognised by IAS 39, together with their accounting treatment, no longer apply. Arguably, the provisions of IFRS 9 will simplify the categorisation and accounting treatment of financial assets for many, but not necessarily all, entities. Upon initial recognition of a financial asset, it is measured at fair value. This is likely to be purchase consideration paid, and will normally exclude transactions costs. Subsequent measurement will then depend upon the nature of the financial instrument as follows:



Equity instruments: Equity instruments are normally measured at fair value through profit or loss. This designation will include any financial assets held for trading purposes and will also include equity derivatives. Unlike IAS 39, there is no longer a general exception for unquoted equity investments to be measured at cost. Instead, IFRS 9 provides guidance when cost may, or may not be, a reliable indicator of fair value. This is now likely to include convertible debt as such financial assets will fail the contractual cash flow characteristics test to be measured at amortised cost (see below). It is also possible to designate equity instruments at fair value through other comprehensive income. Such a designation is irrevocable and must take place upon initial recognition of the financial asset. Initial recognition will also include directly attributable transactions costs. This designation cannot include equity instruments held for trading, nor can it include equity derivatives. It is expected to include long-term strategic investments held on a continuing basis; i.e. not those acquired with the primary intention of taking advantage in changes in fair value. Where financial assets are designated as fair value through other comprehensive income, any changes in fair value will be reflected as part of other comprehensive income. This accounting treatment will therefore deal with the effect of any impairment through other comprehensive income. There is no requirement to make transfers between equity and profit or loss to account for impairment losses; there is no recycling of any gains or losses recognised in earlier periods. Note that dividend income received on such financial assets will continue to be recognised in profit or loss for the year, unless it represents a recovery of part of the investment. Debt instruments: As with equity instruments, IFRS 9 specifies that the normal accounting treatment for debt instruments is that they are measured at fair value though profit or loss. However, it is possible to measure debt instruments at amortised cost provided the following two tests are passed.

The business model test which considers the underlying purpose for holding the financial asset. If the purpose is to collect in contractual cash flows, normally up to maturity date, this would suggest that the test has been passed. If the purpose is to dispose of such financial assets in response to changes in fair value, this would suggest that the business model test has been failed.

The contractual cash flow characteristics test considers the nature of the cash flows and other returns on a debt instrument. The cash flows must be solely returns of principal and interest if the debt instrument is to be measured at amortised cost. If this is not the case, for example convertible debt includes the right to opt for conversion of the debt into equity shares at a later date, the test is failed.

Therefore, debt instruments may be measured at fair value through profit or loss if they fail either or both of the two test noted above. It is still possible to measure a debt instrument at fair value though profit or loss even if both tests have been passed if, by doing so, an accounting mismatch that could arise from measuring assets and liabilities on different bases is reduced or removed. The recognition and measurement criteria of IFRS 9 may therefore result in debt instruments which are traded on an active market (i.e. with a reliable fair value) being measured at amortised cost.



Financial liabilities are still dealt with by IAS 39 and fall into two classifications. They are ether financial liabilities at fair value through profit or loss, or financial liabilities measured at amortised cost. Where financial assets or liabilities are measured at amortised cost, the consequence is that a constant rate of return or constant rate of finance cost is recognised in profit or loss each year. Impairment of financial assets: The recognition and measurement criteria within IFRS 9 simplify the accounting for impairment of financial assets. Those financial assets measured at fair value, either through profit or loss, or through other comprehensive income, recognise any impairment during the accounting period within changes to fair value. In the case of financial assets at fair value through profit or loss, there is no recycling or recognition in profit or loss of any amounts taken to other comprehensive income. For financial assets measured at amortised cost, IAS 39 requires that there must be an assessment as to whether or not there is objective evidence that a financial asset is impaired. If there is evidence that this may be the case, an impairment review must be performed. (b) (i) IAS 39 requires that, in all circumstances, the financial liability is initially recorded at the fair value of the consideration received, i.e. the cash received. It is then accounted for using amortised cost. This means the liability varies for two reasons, first an increase by the finance cost which should be charged to profit or loss at a constant actuarial rate (DR finance charge, CR liability) and second a reduction by the actual cash paid (DR liability, CR cash).

Instrument 1 Balance b’fwd Finance cost Cash return Balance c’fwd $ $ $ $

Year 1 200,000 20,000 (nil) 220,000 Year 2 220,000 22,000 (nil) 242,000 Year 3 242,000 24,200 (266,200) nil


Year 1 150,263 15,026 (nil) 165,289 Year 2 165,289 16,529 (nil) 181,818 Year 3 181,818 18,182 (200,000) nil


Year 1 190,000 19,000 (4,000) 205,000 Year 2 205,000 20,500 (4,000) 221,500 Year 3 221,500 22,150 (243,650) (ii) This transaction is a cash flow hedge and is currently regulated by the provisions of IAS 39 until IFRS 9 is extended to include hedging arrangements. Because the forward rate agreement has no fair value at its inception, the need to account for the derivative first arises at the end of the reporting period when it has a value and the change in value has to be recorded. Because it has been designated a cash flow hedge, the change in value is recognised in other comprehensive income to be carried forward at 31 July to match against the future cash flow. The value of this contract is in showing a loss of $20,000 at the end of the reporting period because Thompson is locked into buying €400,000 for $200,000 when everyone else can buy for $180,000, hence Thompson is $20,000 worse off because it hedged the position.



To recognise the loss in reserves: DR Other comprehensive income 20,000 CR Liability – derivative 20,000 Note that if this transaction had not been designated a hedging instrument then the loss would be recognised immediately in profit or loss. Please note therefore the same derivative entered into by two different entities can be accounted for by them in two different ways depending on whether it is designated a hedge or not. In the following January the forward contract will be settled and closed, and the balance of the reserve capitalised as Thompson is buying a non-current asset. Thompson has known all along that the cost of the asset was being fixed at $200,000. DR Liability – derivative 20,000 CR Cash 20,000 DR Plant 200,000 CR Cash 180,000 CR Reserves 20,000 (iii) Penzance has an equity instrument which IFRS 9 requires to be measured at fair value. As it is held for trading purposes, it cannot be designated as fair value through other comprehensive income; it must be through profit or loss. Initial recognition is at the consideration paid of $300,000, excluding any transactions costs. DR Asset $300,000 CR Cash $300,000 At the end of the reporting period, the asset must be remeasured to fair value following the measurement rules in IFRS 9. The gain is recorded in income. DR Asset $100,000 CR Profit or loss $100,000 On disposal the asset is derecognised and a gain on disposal is reported in income. DR Cash $450,000 CR Asset $400,000 CR Profit or loss $50,000

Acca p2 (Int) Lrp j11 - Answers

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