Professional Level – Essentials Module Time allowed Reading and planning: 15 minutes Writing: 3 hours This paper is divided into two sections: Section A – This ONE question is compulsory and MUST be attempted Section B – TWO questions ONLY to be attempted Do NOT open this paper until instructed by the supervisor. During reading and planning time only the question paper may be annotated. You must NOT write in your answer booklet until instructed by the supervisor. This question paper must not be removed from the examination hall. Paper P2 (UK) Corporate Reporting (United Kingdom) Tuesday 11 December 2007 The Association of Chartered Certified Accountants
Transcript
Professional Level – Essentials Module
Time allowedReading and planning: 15 minutesWriting: 3 hours
This paper is divided into two sections:
Section A – This ONE question is compulsory and MUST be attempted
Section B – TWO questions ONLY to be attempted
Do NOT open this paper until instructed by the supervisor.During reading and planning time only the question paper may be annotated. You must NOT write in your answer booklet untilinstructed by the supervisor.This question paper must not be removed from the examination hall.
Pape
r P2 (
UK
)
Corporate Reporting(United Kingdom)
Tuesday 11 December 2007
The Association of Chartered Certified Accountants
This is a blank page.The question paper begins on page 3.
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Section A – This ONE question is compulsory and MUST be attempted
1 Beth, a public limited company, has produced the following draft balance sheets as at 30 November 2007. Lose andGain are both public limited companies:
Beth Lose Gain£m £m £m
Fixed assetsTangible assets 1,700 200 300Intangible assets 275Investment in Lose 225Investment in Gain 180
The following information is relevant to the preparation of the group financial statements of the Beth Group:
(i) Date of acquisition Holding Profit and loss Purchaseacquired reserve at acquisition consideration
£m £mLose: 1 December 2005 20% 80 65
1 December 2006 60% 150 160Gain: 1 December 2006 30% 260 180
Lose and Gain have not issued any share capital since the acquisition of the shareholdings by Beth. The fairvalues of the net assets of Lose and Gain were the same as their carrying amounts at the date of the acquisitions.
Beth did not have significant influence over Lose at any time before gaining control of Lose, but does havesignificant influence over Gain. The recoverable amount of the net assets of Gain has been deemed to be £610 million at 30 November 2007 and goodwill is amortised over 12 years.
(ii) Lose entered into an operating lease for a building on 1 December 2006. The building was converted into officespace during the year at a cost to Lose of £10 million. The operating lease is for a period of six years, at the endof which the building must be returned to the lessor in its original condition. Lose thinks that it would cost £2 million to convert the building back to its original condition at prices at 30 November 2007. The entries thathad been made in the financial statements of Lose were the charge for operating lease rentals (£4 million perannum) and the improvements to the building. Both items had been charged to the profit and loss account. Theimprovements were completed during the financial year.
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(iii) On 1 October 2007, Beth sold stock costing £18 million to Gain for £28 million. At 30 November 2007, thestock was still held by Gain. The stock was sold to a third party on 15 December 2007 for £35 million.
(iv) Beth had contracted to purchase an item of plant and machinery for 12 million euros on the following terms:
Payable on signing contract (1 September 2007) 50%Payable on delivery and installation (11 December 2007) 50%
The amount payable on signing the contract (the deposit) was paid on the due date and is refundable. Thefollowing exchange rates are relevant:
2007 Euros to £1 1 September 0·7530 November 0·8511 December 0·79
The deposit is included in debtors at the rate of exchange on 1 September 2007. A full year’s charge fordepreciation of tangible assets is made in the year of acquisition using the straight line method over six years.
(v) Beth sold some debtors which arose during November 2007 to a factoring company on 30 November 2007.The debtors sold are unlikely to default in payment based on past experience, but they are long dated withpayment not due until 1 June 2008. Beth has given the factor a guarantee that it will reimburse any amountsnot received by the factor. Beth received £45 million from the factor, being 90% of the debtors sold. The debtorsare not included in the balance sheet of Beth and the balance not received from the factor (10% of the debtorsfactored) of £5 million has been written off against the profit and loss reserve.
(vi) Beth granted 200 share options to each of its 10,000 employees on 1 December 2006. The shares vest if theemployees work for the Group for the next two years. On 1 December 2006, Beth estimated that there would be1,000 eligible employees leaving in each year up to the vesting date. At 30 November 2007, 600 eligibleemployees had left the company. The estimate of the number of employees leaving in the year to 30 November2008 was 500 at 30 November 2007. The fair value of each share option at the grant date (1 December 2006)was £10. The share options have not been accounted for in the financial statements.
(vii) The Beth Group operates in the oil industry and contamination of land occurs including the pollution of seas andrivers. The Group only cleans up the contamination if it is a legal requirement to do so in the country where itoperates. The following information has been produced for Beth by a group of environmental consultants for theyear ended 30 November 2007:
Cost to clean up Law existing in countrycontamination
£m5 No7 To come into force in December 20074 Yes
The directors of Beth have a widely publicised environmental attitude which shows little regard to the effects onthe environment of their business. The Group does not currently produce a separate environmental report and noprovision for environmental costs has been made in the financial statements. Any provisions would be shown aslong term liabilities. Beth is likely to operate in these countries for several years.
Other informationBeth is currently suffering a degree of stagnation in its business development. Its domestic and international marketsare being maintained, but it is not attracting new customers. Its share price has not increased whilst that of itscompetitors has seen a rise of between 10% and 20%. Additionally it has recently received a significant amount ofadverse publicity because of its poor environmental record and is to be investigated by regulators in several countries.Although Beth is a leading supplier of oil products, it has never felt the need to promote socially responsible policiesand practices or make positive contributions to society because it has always maintained its market share. It isrenowned for poor customer support and bearing little regard for the customs and cultures in the communities whereit does business. It had recently made a decision not to pay the creditor amounts owing to certain small and mediumentities (SMEs) as the directors feel that SMEs do not have sufficient resources to challenge the non-payment in acourt of law. The management of the company is quite authoritarian and tends not to value employees’ ideas andcontributions.
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Required:
(a) Prepare the consolidated balance sheet of the Beth Group as at 30 November 2007 in accordance with UKGenerally Accepted Accounting Practice. (35 marks)
(b) Describe to the Beth Group the possible advantages of producing a separate environmental report.(8 marks)
(c) Discuss the ethical and social responsibilities of the Beth Group and whether a change in the ethical andsocial attitudes of the management could improve business performance. (7 marks)
Note: requirement (c) includes 2 professional marks for development of the discussion of the ethical and socialresponsibilities of the Beth Group.
(50 marks)
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Section B – TWO questions ONLY to be attempted
2 Macaljoy, a public limited company, is a leading support services company which focuses on the building industry.The company would like advice on how to treat certain items under FRS17, ‘Retirement Benefits’ and FRS12‘Provisions, Contingent Liabilities and Contingent Assets’. The company operates the Macaljoy (2006) Pension Planwhich commenced on 1 November 2006 and the Macaljoy (1990) Pension Plan, which was closed to new entrantsfrom 31 October 2006, but which was open to future service accrual for the employees already in the scheme. Theassets of the schemes are held separately from those of the company in funds under the control of trustees. Thefollowing information relates to the two schemes:
Macaljoy (1990) Pension Plan
The terms of the plan are as follows:
(i) employees contribute 6% of their salaries to the plan(ii) Macaljoy contributes, currently, the same amount to the plan for the benefit of the employees(iii) On retirement, employees are guaranteed a pension which is based upon the number of years service with the
company and their final salary
The following details relate to the plan in the year to 31 October 2007:
£mPresent value of obligation at 1 November 2006 200Present value of obligation at 31 October 2007 240Fair value of plan assets at 1 November 2006 190Fair value of plan assets at 31 October 2007 225Current service cost 20Pension benefits paid 19Total contributions paid to the scheme for year to 31 October 2007 17
Macaljoy (2006) Pension Plan
Under the terms of the plan, Macaljoy does not guarantee any return on the contributions paid into the fund. Thecompany’s legal and constructive obligation is limited to the amount that is contributed to the fund. The followingdetails relate to this scheme:
£mFair value of plan assets at 31 October 2007 21Contributions paid by company for year to 31 October 2007 10Contributions paid by employees for year to 31 October 2007 10
The discount rates and expected return on plan assets for the two plans are:
1 November 2006 31 October 2007Discount rate 5% 6%Expected return on plan assets 7% 8%
The company would like advice on how to treat the two pension plans, for the year ended 31 October 2007, togetherwith an explanation of the differences between a defined contribution plan and a defined benefit plan.
Warranties
Additionally the company manufactures and sells building equipment on which it gives a standard one year warrantyto all customers. The company has extended the warranty to two years for certain major customers and has insuredagainst the cost of the second year of the warranty. The warranty has been extended at nil cost to the customer. Theclaims made under the extended warranty are made in the first instance against Macaljoy and then Macaljoy in turnmakes a counter claim against the insurance company. Past experience has shown that 80% of the buildingequipment will not be subject to warranty claims in the first year, 15% will have minor defects and 5% will requiremajor repair. Macaljoy estimates that in the second year of the warranty, 20% of the items sold will have minor defectsand 10% will require major repair.
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In the year to 31 October 2007, the following information is relevant:
Standard warranty Extended warranty Selling price per unit(units) (units) (both)(£)
Sales 2,000 5,000 1,000
Major repair Minor defect£ £
Cost of repair (average) 500 100
Assume that sales of equipment are on 31 October 2007 and any warranty claims are made at 31 October in theyear of the claim. Assume a risk adjusted discount rate of 4%.
Required:
Draft a report suitable for presentation to the directors of Macaljoy which:
(a) (i) Discusses the nature of and differences between a defined contribution plan and a defined benefit planwith specific reference to the company’s two schemes. (7 marks)
(ii) Shows the accounting treatment for the two Macaljoy pension plans for the year ended 31 October 2007under FRS17 ‘Retirement Benefits’. (7 marks)
(b) (i) Discusses the principles involved in accounting for claims made under the above warranty provision.(6 marks)
(ii) Shows the accounting treatment for the above warranty provision under FRS12 ‘Provisions, ContingentLiabilities and Contingent Assets’ for the year ended 31 October 2007. (3 marks)
Appropriateness of the format and presentation of the report and communication of advice. (2 marks)
(25 marks)
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3 Ghorse, a public limited company, operates in the fashion sector and had undertaken a group re-organisation duringthe current financial year to 31 October 2007. As a result the following events occurred:
(a) Ghorse identified two wholly owned subsidiaries which it had decided to sell. One of the subsidiaries, Cee, wassold on 31 October 2007 and the details relating to that subsidiary were as follows:
£mSale proceeds 8Carrying value of net assets in consolidated financial statements at 31 October 2007 3Unamortised goodwill at 31 October 2007 2
The sale proceeds had been recorded in the financial statements but the profit or loss on disposal had not beencalculated. Operating profit before interest and tax includes £1 million relating to Cee.
The sale of the other subsidiary, Gee, will occur after the year end and after the financial statements have beensigned (1 December 2007). At the year end the net assets of Gee were £8 million and unamortised goodwillwas £3 million. Gee has made a net loss of £2 million from 1 November up to the date the financial statementshave been signed. At 1 December 2007 the sale of Gee was being negotiated. The expected sale proceeds were£6 million and selling costs were expected to be £500,000. The recoverable amount at 1 December 2007 ofGee was £5·5 million. (7 marks)
(b) As a consequence of the re-organisation, and a change in government legislation, the tax authorities have alloweda revaluation of the tangible fixed assets of the holding company for tax purposes to market value at 31 October2007. There has been no change in the carrying values of the tangible fixed assets in the financial statements.The tax written down value (WDV) and the carrying values after the revaluation are as follows:
Carrying amount Tax WDV at Tax WDV atat 31 October 31 October 2007 31 October 2007
2007 after revaluation before revaluation£m £m £m
Property 50 65 48Vehicles 30 35 28
Other taxable timing differences amounted to £5 million at 31 October 2007. The deferred tax provision at31 October 2007 had been calculated using the tax values before revaluation. Assume tax is paid at 30%.
(6 marks)
(c) A subsidiary company had purchased computerised equipment for £4 million on 31 October 2006 to improvethe manufacturing process. Whilst re-organising the group, Ghorse had discovered that the manufacturer of thecomputerised equipment was now selling the same system for £2·5 million. The projected cash flows from theequipment are:
Year ended 31 October Cash flows£m
2008 1·32009 2·22010 2·3
The residual value of the equipment is assumed to be zero. The company uses a discount rate of 10%. Thedirectors think that the net realisable value of the equipment is £2 million. The directors of Ghorse propose towrite down the tangible fixed asset to the new selling price of £2·5 million. The company’s policy is to depreciateits computer equipment by 25% per annum on the straight line basis. (5 marks)
(d) The manufacturing property of the group, other than the head office, was held on an operating lease over 8 years. On re-organisation on 31 October 2007, the lease has been renegotiated and is held for 12 years at arent of £5 million per annum paid in arrears. The fair value of the property is £35 million and its remainingeconomic life is 13 years. The lease relates to the buildings and not the land. The factor to be used for an annuityat 10% for 12 years is 6·8137. (5 marks)
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The directors are worried about the impact that the above changes will have on the value of its tangible fixed assetsand its key performance indicator which is ‘Return on Capital Employed’ (ROCE). ROCE is defined as operating profitbefore interest and tax from continuing operations divided by share capital and reserves. The directors have calculatedROCE as £30 million divided by £220 million, i.e. 13·6% before any adjustments required by the above.
Formation of opinion on impact on ROCE. (2 marks)
Required:
Discuss the accounting treatment of the above transactions and the impact that the resulting adjustment to thefinancial statements would have on ROCE.
Note: your answer should include appropriate calculations where necessary and a discussion of the accountingprinciples involved.
(25 marks)
4 The Accounting Standards Board (ASB) has welcomed the International Accounting Standards Board’s (IASB) projectto revisit its conceptual framework for financial accounting and reporting. The goals of the project are to build on theexisting frameworks and converge them into a common framework. The Accounting Standards Board is monitoringand contributing to the work of the IASB in an attempt to produce a common universally accepted framework forfinancial accounting and reporting.
Required:
(a) Discuss why there is a need to develop an agreed universally accepted conceptual framework and the extentto which a conceptual framework can be used to resolve practical accounting issues. (13 marks)
(b) Discuss the key issues which will need to be addressed in determining the basic components of a commonuniversally accepted conceptual framework. (10 marks)
Appropriateness and quality of the above discussion. (2 marks)
(25 marks)
End of Question Paper
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Answers
Professional Level – Essentials Module, Paper P2 (UK)Corporate Reporting (United Kingdom) December 2007 Answers
1 (a) Beth GroupConsolidated Balance Sheet at 30 November 2007
Creditors: amounts falling due within one year (1,380 + 100 + 45) (1,525)––––––
Net current assets 624––––––
Total assets less current liabilities 3,015Creditors: amounts falling due after more than one year (700 + 11 + 2) (713)
––––––Net assets 2,302
––––––Share capital of £1 1,500Other reserves (300 + 9) 309Profit and loss reserve 431Minority interest 62
––––––2,302
––––––
Working 1
Goodwill calculation – Lose
Where a business combination involves more than one transaction, the cost of the combination is the aggregate cost of eachtransaction at the date of acquisition. Goodwill is calculated using the fair value of the net assets at the date control is gained.
1 Dec 2005 1 Dec 2006£m £m £m £m
Purchase consideration 65 160less net assets acquiredShare capital 100 Share capital 100Profit and loss reserve 150 Profit and loss reserve 150
–––– ––––250 250–––– ––––
20% thereof (50) 60% thereof (150)–––– ––––
Goodwill 15 Goodwill 10–––– ––––
Total Goodwill (£15 million + £10 million) i.e. £25 million.Amortisation is £25 million ÷ 12, i.e. £2 million.Therefore goodwill is £23 million at 30 November 2007.
Working 2
Minority Interest
20% of £(100 + 200 + 10 – 2)million £61·6 million
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Working 3
Group Reserves
£mProfit and loss reserve – Beth 400Post acquisition reserves – Lose(200 + 10 – 2 – 150) x 20% 11·6(200 + 10 – 2 – 150) x 60% 34·8Impairment of associate (working 4) (6)Amortisation of goodwill (2)Associate’s profit less inter company (12 – 3) 9Loss on monetary item – foreign currency (working 6) (1)Factor – reversal of entry (working 7) 5Share options (working 8) (9)Provision (working 9) (11)
––––––Profit and loss reserve at 30 November 2007 431·4
––––––
Working 4
Associate investment in Gain
Equity Method
£mCost of investment 180Profit £(300 – 260)m x 30% 12
––––192
less inter company profit (working 5) (3)––––
Carrying value in balance sheet 189––––
Where there has been an impairment of goodwill in an associate, then the goodwill should be written down (FRS9 para 38).In this case the impairment of goodwill is £6 million (below).
£mCarrying value 189Recoverable amount (£610m x 30%) (183)
––––Impairment 6
––––
Alternatively goodwill could be amortised (180 – 30% of (200 + 260)) £42 million ÷ 12 i.e. £3·5m and the balance of£2·5m treated as an impairment loss.
Working 5: Inter company profit
FRS9 requires profits and losses resulting from transactions between the investor and an associate to be recognised in theinvestor’s financial statements only to the extent of the unrelated investor’s interests in the associate. Effectively part of Beth’sprofit on the sale is eliminated to the extent of the company’s shareholding in Gain.
£mStock: Selling price 28
Cost (18)–––
Profit 10–––
Profit eliminated £10 million x 30%, i.e. £3 millionDR Profit and loss account £3 millionCR Investment in associate £3 million
Working 6 Deposit paid
If the payment to the supplier is a deposit and is refundable, then the amount is deemed to be a monetary amount whichshould be retranslated at the year end.
Deposit paid 50% x 12 million euros ÷ 0·75 = £8 million
At 30 November 2007, the deposit would be retranslated at 6 million euros ÷ 0·85, i.e. £7 million. Therefore, there will bean exchange loss of £(8 – 7) million, i.e. £1 million.
DR Profit and loss reserve £1 millionCR Debtors £1 million
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Working 7 Factored debtors
FRS26 requires derecognition of a financial asset if the contractual rights to the cash flows have expired or the financial assethas been transferred and so have the risks and rewards of ownership of the asset. In the case of the sale of the debtors, thefirst criterion above has been met but the second has not necessarily been met. Although the debtors are high quality debts,there is still a risk of default particularly as they are long dated, and that the risk still lies with Beth. Therefore, the debtorsshould continue to be recognised and the monies received shown as a current liability. The reversing entries should be:
£mDR Debtors 50
CR Current liabilities 45Profit and loss reserve 5
Working 8 Share options
200 options x (10,000 – 1,100) x 1/2 x £10 = £8·9 million
DR Profit and loss reserve £9 million (rounded)CR Equity £9 million
At the grant date, the fair value of the award is determined but then at each reporting date until vesting, a best estimate ofthe cumulative charge to the profit and loss account is made, taking into account:
(i) the grant date fair value of the award (£10 per option)(ii) the current best estimate of the number of awards that will vest (89%)(iii) the expired portion of the vesting period (1 year)
Working 9 Environmental provision
An enterprise must recognise a provision if, and only if:
(i) a present obligation (legal or constructive) has arisen as a result of a past event (the obligating event)(ii) payment is probable (‘more likely than not’), and(iii) the amount can be estimated reliably
In this case, a provision should be made to include the costs of contamination in the countries where the law is to be enactedor has been enacted as there will be a legal obligation in those countries. Moral obligations to rectify environmental damagedo not justify making a provision. Therefore, a provision of £(7 + 4) million, i.e. £11 million, should be made.
DR Profit and loss £11 millionCR Long-term liabilities £11 million
Working 10 Operating Lease
Lose should capitalise the leasehold improvements of £10 million and depreciate them over the term of the lease inaccordance with FRS15 ‘Tangible Fixed Assets’. Because the improvements have occurred, an obligation arises out of the pastevent, and a provision of £2 million should be made for the conversion of the building back to its original condition.
Thus the following entries should be made in Lose’s financial statements:
£mDR Tangible fixed assets 10CR Profit and loss account 10DR Tangible fixed assets 2CR Provision for ‘decommissioning’ 2
Depreciation on the capitalised amounts should be charged over the term of the lease as depreciation is charged in full ontangible fixed assets in the year of acquisition. Thus depreciation will be accounted for as follows:
£mDR Profit and loss account (£10m + £2m) ÷ 6 years 2
––––CR Tangible fixed assets 2
––––
(b) An environmental report allows an organisation to communicate with different stakeholders. The benefits of an environmentalreport include:
(i) evaluating environmental performance can highlight inefficiencies in operations and help to improve managementsystems. Beth could identify opportunities to reduce resource use, waste and operating costs
(ii) communicating the efforts being made to improve social and environmental performance can foster community supportfor a business and can also contribute towards its reputation as a good corporate citizen. At present Beth has a poorreputation in this regard
(iii) reporting efforts to improve the organisation’s environmental, social and economic performance can lead to increasedconsumer confidence in its products and services
(iv) commitment to reporting on current impacts and identifying ways to improve environmental performance can improverelationships with regulators, and could reduce the potential threat of litigation which is hanging over Beth
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(v) investors, financial analysts and brokers increasingly ask about the sustainability aspects of operations. A high qualityreport shows the measures the organisation is taking to reduce risks, and will make Beth more attractive to investors
(vi) disclosing the organisation’s environmental, social and economic best practices can give a competitive market edge.Currently Beth’s corporate image is poor and this has partly contributed to its poor stock market performance
(vii) the international trend towards improved corporate sustainability is growing and access to international markets willrequire increasing transparency, and this will help Beth’s corporate image
(viii) large organisations are increasingly requiring material and service suppliers and contractors to submit performanceinformation to satisfy the expectations of their own shareholders. Disclosing such information can make the company amore attractive supplier than their competitors, and increase Beth’s market share
It is important to ensure that the policies are robust and effective and not just compliance based.
(c) Corporate social responsibility (CSR) is concerned with business ethics and the company’s accountability to its stakeholders,and about the way it meets its wider obligations. CSR emphasises the need for companies to adopt a coherent approach toa range of stakeholders including investors, employees, suppliers, and customers. Beth has paid little regard to the promotionof socially and ethically responsible policies. For example, the decision to not pay the SME creditors on the grounds that theycould not afford to sue the company is ethically unacceptable. Additionally Beth pays little regard to local customs andcultures in its business dealings.
The stagnation being suffered by Beth could perhaps be reversed if it adopted more environmentally friendly policies. Thecorporate image is suffering because of its attitude to the environment. Environmentally friendly policies could be cost effectiveif they help to increase market share and reduce the amount of litigation costs it has to suffer. The communication of thesepolicies would be through the environmental report, and it is critical that stakeholders feel that the company is beingtransparent in its disclosures.
Evidence of corporate misbehaviour (Enron, WorldCom) has stimulated interest in the behaviour of companies. There hasbeen pressure for companies to show more awareness and concern, not only for the environment, but for the rights andinterests of the people they do business with. Governments have made it clear that directors must consider the short-termand long-term consequences of their actions, and take into account their relationships with employees and the impact of thebusiness on the community and the environment. The behaviour of Beth will have had an adverse effect on their corporateimage.
CSR requires the directors to address strategic issues about the aims, purposes, and operational methods of the organisation,and some redefinition of the business model that assumes that profit motive and shareholder interests define the core purposeof the company. The profits of Beth will suffer if employees are not valued and there is poor customer support.
Arrangements should be put in place to ensure that the business is conducted in a responsible manner. The board shouldlook at broad social and environmental issues affecting the company and set policy and targets, monitoring performance andimprovements.
2 Report to the Directors of Macaljoy plc
Terms of Reference
This report sets out the differences between a defined contribution and defined benefit plan, and the accounting treatment of thecompany’s pension plans. It also discusses the principles involved in accounting for warranty claims, and the accounting treatmentof those claims.
(a) Pension plans – FRS17
A defined contribution plan is a pension plan whereby an employer pays fixed contributions into a separate fund and has nolegal or constructive obligation to pay further contributions. Payments or benefits provided to employees may be a simpledistribution of total fund assets, or a third party (an insurance company) may, for example, agree to provide an agreed levelof payments or benefits. Any actuarial and investment risks of defined contribution plans are assumed by the employee orthe third party. The employer is not required to make up any shortfall in assets and all plans that are not defined contributionplans are deemed to be defined benefit plans.
Defined benefit, therefore, is the residual category whereby, if an employer cannot demonstrate that all actuarial andinvestment risk has been shifted to another party and its obligations limited to contributions made during the period, then theplan is a defined benefit plan. Any benefit formula that is not solely based on the amount of contributions, or that includes aguarantee from the entity or a specified return, means that elements of risk remain with the employer and must be accountedfor as a defined benefit plan. An employer may create a defined benefit obligation where no legal obligation exists if it has apractice of guaranteeing the benefits. An employer’s obligation under a defined benefit plan is to provide the agreed amountof benefits to current and former employees. The differentiating factor between defined benefit and defined contributionschemes is in determining where the risks lie.
In a defined benefit scheme it is the employer that underwrites the vast majority of costs so that if investment returns are pooror costs increase the employer needs to either make adjustments to the scheme or to increase levels of contribution.Alternatively, if investment returns are good, then contribution levels could be reduced. In a defined contribution scheme thecontributions are paid at a fixed level and, therefore, it is the scheme member who is shouldering these risks. If they fail totake action by increasing contribution rates when investment returns are poor or costs increase, then their retirement benefitswill be lower than they had planned for.
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For defined contribution plans, the cost to be recognised in the period is the contribution payable in exchange for servicerendered by employees during the period. The accounting for a defined contribution plan is straightforward because theemployer’s obligation for each period is determined by the amount to be contributed for that period. Often, contributions arebased on a formula that uses employee compensation in the period as its base. No actuarial assumptions are required tomeasure the obligation or the expense, and there are no actuarial gains or losses.
The employer should account for the contribution payable at the end of each period based on employee services renderedduring that period, reduced by any payments made during the period. If the employer has made payments in excess of thoserequired, the excess is a prepaid expense to the extent that the excess will lead to a reduction in future contributions or a cashrefund.
For defined benefit plans, the amount recognised in the balance sheet should be the present value of the defined benefitobligation (that is, the present value of expected future payments required to settle the obligation resulting from employeeservice in the current and prior periods), as adjusted for any invested past service cost, and reduced by the fair value of planassets at the balance sheet date. If the balance is an asset, the amount recognised may be limited under FRS17.
In the case of Macaljoy, the 1990 plan is a defined benefit plan as the employer has the investment risk as the company isguaranteeing a pension based on the service lives of the employees in the scheme. The employer’s liability is not limited tothe amount of the contributions. There is a risk that if the investment returns fall short, the employer will have to make goodthe shortfall in the scheme. The 2006 plan, however, is a defined contribution scheme because the employer’s liability islimited to the contributions paid.
A curtailment is an event that reduces the expected years of future service of present employees or reduces for a number ofemployees, the accrual of defined benefits for some or all of their future service (FRS17 para 2).
Curtailments have the effect of reducing obligations relating to future service and, by definition, have a material impact onthe entity’s financial statements. The fact that no new employees are to be admitted to the 1990 plan does not constitute acurtailment because future service qualifies for pension rights for those in the scheme prior to 31 October 2006.
The accounting for the two plans is as follows. The company does not recognise any assets or liabilities for the definedcontribution scheme but charges the contributions payable for the period (£10 million) to operating profit. The contributionspaid by the employees will be part of the wages and salaries costs and when paid will reduce cash. The accounting for thedefined benefit plan results in a liability of £15 million as at 31 October 2007, a charge in the statement of recognised gainsand losses of £5·3 million, and an expense in the income statement of £16·7 million for the year (see Appendix 1) whichcomprises an operating charge of £20 million for the current service cost and a net return of £3·3 million on the net assetsof the fund.
(b) Provisions – FRS12
An entity must recognise a provision under FRS12 if, and only if:
(a) a present obligation (legal or constructive) has arisen as a result of a past event (the obligating event)(b) it probably requires a transfer of economic benefit(c) the amount can be estimated reliably
An obligating event is an event that creates a legal or constructive obligation and, therefore, results in an enterprise havingno realistic alternative but to settle the obligation. A constructive obligation arises if past practice creates a valid expectationon the part of a third party. If it is more likely than not that no present obligation exists, the enterprise should disclose acontingent liability, unless the possibility of an outflow of resources is remote.
The amount recognised as a provision should be the best estimate of the expenditure required to settle the present obligationat the balance sheet date, that is, the amount that an enterprise would rationally pay to settle the obligation at the balancesheet date or to transfer it to a third party. This means provisions for large populations of events such as warranties, aremeasured at a probability weighted expected value. In reaching its best estimate, the entity should take into account the risksand uncertainties that surround the underlying events.
Expected cash outflows should be discounted to their present values, where the effect of the time value of money is materialusing a risk adjusted rate (it should not reflect risks for which future cash flows have been adjusted). If some or all of theexpenditure required to settle a provision is expected to be reimbursed by another party, the reimbursement should berecognised as a separate asset when, and only when, it is virtually certain that reimbursement will be received if the entitysettles the obligation. The amount recognised should not exceed the amount of the provision. In measuring a provision futureevents should be considered. The provision for the warranty claim will be determined by using the expected value method.
The past event which causes the obligation is the initial sale of the product with the warranty given at that time. It would beappropriate for the company to make a provision for the Year 1 warranty of £280,000 and Year 2 warranty of £350,000,which represents the best estimate of the obligation (see Appendix 2). Only if the insurance company have validated thecounter claim will Macaljoy be able to recognise the asset and income. Recovery has to be virtually certain. If it is not virtuallycertain, then Macaljoy may be able to recognise a contingent asset. Generally contingent assets are never recognised butdisclosed where an inflow of economic benefits is probable.
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The company could discount the provision if it was considered that the time value of money was material. The majority ofprovisions will reverse in the short term (within two years) and, therefore, the effects of discounting are likely to be immaterial.In this case, using the risk adjusted rate (FRS12), the provision would be reduced to £269,000 in Year 1 and £323,000 inYear 2. The company will have to determine whether this is material.
Appendix 1
The accounting for the defined benefit plan is as follows:
31 October 2007 1 November 2006£m £m
Present value of obligation 240 200Fair value of plan assets (225) (190)
–––– ––––Liability recognised in balance sheet 15 10
–––– ––––
Expense in profit and loss account for the year ended 31 October 2007:
£m £mCurrent service cost – operating charge 20Interest on pension scheme liabilities (10)Expected return on pension scheme assets 13·3
–––––Net return 3·3
–––––Net expense 16·7
–––––Analysis of amount in Statement of Recognised Gains and Losses:
£mActual return less expected return on
pension scheme assets (w2) 23.7Experience gains and losses arising on
scheme liabilities (w2) (29)–––––
Actuarial loss on obligation (net) (5·3)–––––
Appendix 2
Year 1 warranty
Expected value Discounted expectedvalue (4%)
£000 £00080% x Nil 015% x 7,000 x £100 1055% x 7,000 x £500 175
–––– ––––280 269–––– ––––
Year 2 extended warranty
Expected value Discounted expectedvalue (4%)
£00070% x Nil 020% x 5,000 x £100 10010% x 5,000 x £500 250
–––– ––––350 323–––– ––––
Working 1
Movement in net liability in balance sheet at 31 October 2007:
£mOpening liability 10Expense 16·7Contributions (17)Actuarial loss 5·3
–––––Closing liability 15
–––––
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Working 2
Changes in the present value of the obligation and fair value of plan assets.
31 October 2007£m
Present value of obligation at 1 November 2006 200Interest (5% of 200) 10Current service cost 20Benefits paid (19)Actuarial loss on obligation 29
––––––Present value of obligation at 31 October 2007 240
––––––Fair value of plan assets at 1 November 2006 190Expected return on assets (7% of 190) 13·3Contributions 17Benefits paid (19)Actuarial gain on plan assets 23·7
––––––Fair value of plan assets at 31 October 2007 225
––––––
3 The company should account for the events as follows:
(a) Discontinued operations are defined by FRS3 ‘Reporting Financial Performance’ as those operations which satisfy thefollowing:
(i) the sale or termination is completed either in the period or before the earlier of three months after the year end and thedate on which the financial statements are approved
(ii) if a termination, the former activities have ceased permanently(iii) the sale or termination has a material affect on the nature and focus of the operations and represents a material reduction
in the operating facilities(iv) the assets, liabilities, results and activities are clearly distinguishable, physically, operationally and for financial reporting
purposes.
In this case, Cee will qualify as a discontinued operation because it has been sold prior to the year end. The results shouldbe disclosed as part of the profit and loss account heading ‘discontinued operations’. The profit or loss on sale of £3 million£(8m – 3m – 2m) should be shown as an exceptional item after operating profit and before interest, and should also bedisclosed as ‘discontinued operations’. However, Gee will not be treated as a discontinued operation as the sale has not beencompleted before the earlier of three months after the year end and the date upon which the financial statements wereapproved (1 December 2007). FRS3 does allow some degree of hindsight as it states that a binding contract entered intoafter the balance sheet date may provide evidence of asset values and commitments at the balance sheet date. Thus the saleof Gee may give insight into the value of Gee at the year end in terms of any possible impairment of the subsidiary.
In the case of Gee, as there is no binding sale agreement, there is no obligation and, therefore, no provision for the cost ofthe decision to sell or future operating losses should be made. However, any impairment in value of the subsidiary, includinggoodwill should be made regardless of a binding sale agreement. Thus FRS11 ‘Impairment of Fixed Assets and Goodwill’should be utilised. If the carrying amount and goodwill of Gee exceeds the recoverable amount, the value of the subsidiaryis impaired at 31 October 2007. In the case of Gee the recoverable amount at 1 December 2007 is £5·5 million. The netassets plus goodwill at the year end are valued at (£8 million + £3 million) £11 million. Thus at 31 October 2007, therecoverable amount can be calculated as £5·5 million plus the loss to 1 December 2007 £2 million, i.e. £7·5 million. Thesubsidiary would, therefore, seem to be impaired by £3·5 million. This impairment loss would not be treated as adiscontinued operation. These amounts will affect ROCE in the following way:
(i) the operating profit of Cee will be eliminated (£1 million)(ii) the profit on the sale of Cee will be excluded from operating profit but included in capital employed(iii) the impairment loss will affect operating profit and capital employed.
(b) Timing differences can give rise to deferred tax assets. FRS19 ‘Deferred tax’ states that deferred tax assets should berecognised to the extent that they are regarded as recoverable which means that it is more than likely that there will be suitabletaxable profits from which the future reversal of the timing differences can be deducted (FRS19 paragraph 23). The companymust make sufficient taxable profits and it is not acceptable that the company is not making losses. Suitable taxable profitsmeans that the tax authority would permit the timing difference in respect of the deferred tax asset to be offset. Sources ofsuitable taxable profits may be:
(i) those generated in the same taxable company and assessed by the tax authorities as being available for offset(ii) those generated in the same period when the deferred tax asset is expected to be reversed
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The recognition of deferred tax assets will result in the recognition of income, in the profit and loss account.
The deferred tax asset would be £15 million x 30%, i.e. £4·5 million subject to there being sufficient taxable profit. Thedeferred tax provision relating to these assets would have been:
Carrying Amount Tax WDV Timing Difference£m £m £m
Property 50 48 2Vehicles 30 28 2
–––4
Other taxable temporary differences 5–––
9–––
£9 million at 30%, i.e. £2·7 million
The impact on the profit and loss account would be significant as the deferred tax provision of £2·7 million would be releasedand a deferred tax asset of £4·5 million credited to it. These adjustments will not affect profit before interest and tax. Howeveran asset of £4·5 million will be created in the balance sheet which will affect ROCE.
(c) At each balance sheet date, Ghorse should review all assets to look for any indication that an asset may be impaired, i.e.where the asset’s carrying amount (£3 million) is in excess of the greater of its net realisable value and its value in use. FRS11has a list of external and internal indicators of impairment. If there is an indication that an asset may be impaired, then theasset’s recoverable amount must be calculated.
The recoverable amount is the higher of an asset’s net realisable value (NRV) and its value in use which is the discountedpresent value of estimated future cash flows expected to arise from:
(i) the continuing use of an asset, and from(ii) its disposal at the end of its useful life
If the manufacturer has reduced the selling price, it does not mean necessarily that the asset is impaired. One indicator ofimpairment is where the asset’s market value has declined significantly more than expected in the period as a result of thepassage of time or normal usage. The value-in-use of the equipment will be £4·7 million.
Year ended 31 October Cash flows Discounted (10%)£m £m
2008 1·3 1·22009 2·2 1·82010 2·3 1·7
––––Value in use – 4·7
––––
The net realisable value of the asset is estimated at £2 million. Therefore, the recoverable amount is £4·7 million which ishigher than the carrying value of £3 million and, therefore, the equipment is not impaired with no effect on ROCE.
(d) Under SSAP21, ‘Accounting for Leases and Hire Purchase Contracts’, operating lease payments should be recognised as anexpense in the profit and loss account over the lease term on a straight-line basis, unless another systematic basis is morerepresentative of the time pattern of the user’s benefit.
The provisions of the lease have changed significantly and would need to be reassessed.
The lease term is now for the major part of the economic life of the assets, and at the inception of the lease, the present valueof the minimum lease payments is more than 90% (97·4%) of the fair value of the leased asset. (Fair value £35 million,NPV of lease payments £34·1 million) Even if title is not transferred at the end of the lease the lease can still be a financelease. Any change in the estimate of the length of life of a lease would not change its classification but where the provisionsof the lease have changed, re-assessment of its classification takes place. Thus it would appear that the lease is now a financelease, and it would be shown in the balance sheet at the present value of the lease payments as this is lower than the fairvalue. This change in classification will not affect ROCE but it will increase tangible fixed assets by £34·1 million and liabilitiesby the same amount.
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Effect on ROCE
£mOperating profit before tax and interest 30Less profit on discontinued operations (1)Impairment (3·5)
–––––25·5
–––––
£mCapital employed 220Less impairment (3·5)Profit on sale of Cee 3Deferred tax asset (4·5 + 2·7) 7·2
––––––226·7––––––
ROCE will fall from 13·6% to 11·2% (25·5/226·7) and thus the directors’ fears that a ROCE would be adversely affected arejustified.
4 (a) The IASB wish their standards to be ‘principles-based’ and in order for this to be the case, the standards must be based onfundamental concepts. These concepts need to constitute a framework which is sound, comprehensive and internallyconsistent. Without agreement on a framework, standard setting is based upon the personal conceptual frameworks of theindividual standard setters which may change as the membership of the body changes and results in standards that are notconsistent with each other. Such a framework is designed not only to assist standard setters, but also preparers of financialstatements, auditors and users.
A common goal of the ASB is to converge their standards with other national standard setters. Difficulties will be encounteredconverging their standards if decisions are based on different frameworks. The ASB and IASB have been pursuing a numberof projects that are aimed at achieving convergence on certain issues. Convergence will be difficult if there is no consistencyin the underlying framework being used.
Frameworks differ in their authoritative status. The Statement of Principles requires management to expressly consider it if nostandard or interpretation specifically applies or deals with a similar and related issue. However, certain national frameworkshave a lower standing. For example, entities are not required to consider the concepts embodied in certain nationalframeworks in preparing financial statements. Thus the development of an agreed framework would eliminate differences inthe standing of conceptual frameworks and lead to greater consistency in financial statements internationally.
The existing concepts within most frameworks are quite similar. However, these concepts need revising to reflect changes inmarkets, business practices and the economic environment since the concepts were developed. The existing frameworks needdeveloping to reflect these changes and to fill gaps in the frameworks. For example, the Statement of Principles does notcontain a definition of the reporting entity. An agreed universally accepted framework could deal with this problem, especiallyif priority was given to the issues likely to give short-term standard setting benefits.
The ASB attempted initially to resolve accounting and reporting problems by developing accounting standards without anaccepted theoretical frame of reference. The result has been inconsistency in the development of standards both nationallyand internationally. The frameworks were developed when several of their current standards were in existence. In the absenceof an agreed conceptual framework the same theoretical issues are revisited on several occasions by standard setters. Theresult is inconsistencies and incompatible concepts. Examples of this are substance over form and matching versus prudence.Some standard setters permit two methods of accounting for the same set of circumstances.
Additionally there have been differences in the way that standard setters have practically used the principles in frameworks.Some standard setters have produced a large number of highly detailed accounting rules with less emphasis on generalprinciples. A robust framework might reduce the need for detailed rules although companies operate in a different legal andstatutory context and this may be difficult. It is important that a framework must result in standards that account appropriatelyfor actual business practice.
An agreed framework will not solve all accounting issues, nor will it obviate the need for judgement to be exercised in resolvingaccounting issues. It can provide a framework within which those judgements can be made.
A framework provides standard setters with both a foundation for setting standards and concepts to use as tools for resolvingaccounting and reporting issues. A framework provides a basic reasoning on which to consider the merits of alternatives. Itdoes not provide all the answers, but narrows the range of alternatives to be considered by eliminating some that areinconsistent with it. It, thereby, contributes to greater efficiency in the standard setting process by avoiding the necessity ofhaving to redebate fundamental issues and facilitates any debate about specific technical issues. A framework should alsoreduce political pressures in making accounting judgements. The use of a framework reduces the influence of personal biasesin accounting decisions.
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However, concepts statements are by their nature very general and theoretical in their wording, which leads to alternativeconclusions being drawn. Whilst individual standards should be consistent with the framework, in the absence of a specificstandard, it does not follow that concepts will provide practical solutions. Management can use its judgement in developingand applying an accounting policy but can also use accounting standards issued by other bodies. Thus a conceptualframework may not totally provide solutions to practical accounting problems.
(b) There are several issues which have to be addressed in determining the basic components if an agreed conceptual frameworkis to be successfully developed. These are:
(i) Objectives
Agreement will be required as to whether financial statements are to be produced for shareholders or a wide range ofusers and whether decision usefulness is the key criteria or stewardship. Additionally there is the question of whetherthe objective is to provide information in making credit and investment decisions.
(ii) Qualitative Characteristics
The qualities to be sought in making decisions about financial reporting need to be determined. The decision usefulnessof financial reports is determined by these characteristics.
There are issues concerning the trade-offs between relevance and reliability. An example of this concerns the use of fairvalues and historical costs. It has been argued that historical costs are more reliable although not as relevant as fairvalues. Additionally there is a conflict between neutrality and the traditions of prudence or conservatism. Materiality andcosts versus benefits have to be taken into account.
(iii) Definitions of the elements of financial statements
The principles behind the definitions of the elements of financial statements need agreement.
There are issues concerning whether ‘control’ should be included in the definition of an asset or become part of therecognition criteria. Also the definition of ‘control’ is an issue particularly with financial instruments. For example, doesthe holder of a call option ‘control’ the underlying asset? Some of the ASB’s standards contravene its own conceptualframework, the ‘Statement of Principles’ (SOP). FRS 10 requires the capitalisation of goodwill as an asset despite thefact that it can be argued that goodwill does not meet the definition of an asset in the SOP. FRS 19 requires therecognition of deferred tax liabilities that do not meet the liability definition. Similarly equity and liabilities need to becapable of being clearly distinguished. Certain financial instruments could either be liabilities or equity. For exampleobligations settled in shares.
(iv) Recognition and De-recognition
The principles of recognition and de-recognition of assets and liabilities need reviewing. Most frameworks haverecognition criteria, but there are issues over the timing of recognition. For example, should an asset be recognised whena value can be placed on it or when a cost has been incurred? If an asset or liability does not meet recognition criteriawhen acquired or incurred, what subsequent event causes the asset or liability to be recognised? The SOP does notdiscuss de-recognition. It can be argued that an item should be de-recognised when it does not meet the recognitioncriteria, but financial instruments standards (FRS 26) require other factors to occur before financial assets can be de-recognised. Different attributes should be considered such as legal ownership, control, risks or rewards.
(v) Measurement
More detailed discussion of the use of measurement concepts, such as historical cost, fair value, current cost, etc arerequired and also more guidance on measurement techniques. Measurement concepts should address initialmeasurement and subsequent measurement in the form of revaluations, impairment and depreciation which in turngives rise to issues about classification of gains or losses in income or in equity.
(vi) Reporting entity
Issues have arisen over what sorts of entities should issue financial statements, and which entities should be includedin consolidated financial statements. A question arises as to whether the legal entity or the economic unit should be thereporting unit. Complex business arrangements raise issues over what entities should be consolidated and the basisupon which entities are consolidated. For example, should the basis of consolidation be ‘control’ and what does ‘control’mean?
(vii) Presentation and disclosure
Financial reporting should provide information that enables users to assess amounts, timing and uncertainty of theentity’s future cash flows, its assets, liabilities and equity. It should provide management explanations and the limitationsof the information in the reports. Discussions as to the boundaries of presentation and disclosure are required.
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Professional Level – Essentials Module, Paper P2 (UK)Corporate Reporting (United Kingdom) December 2007 Marking Scheme
(b) up to 2 marks per key issue 10(i) Objectives(ii) Qualitative Characteristics(iii) Definitions(iv) Recognition and de-recognition(v) Measurement(vi) Reporting entity(vii) Presentation and disclosure
Appropriateness and quality of discussion 2–––
MAXIMUM 25–––
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Professional Level – Essentials Module
Time allowedReading and planning: 15 minutesWriting: 3 hours
This paper is divided into two sections:
Section A – This ONE question is compulsory and MUST be attempted
Section B – TWO questions ONLY to be attempted
Do NOT open this paper until instructed by the supervisor.
During reading and planning time only the question paper may be annotated. You must NOT write in your answer booklet untilinstructed by the supervisor.
This question paper must not be removed from the examination hall.
Pape
r P2 (
UK
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Corporate Reporting(United Kingdom)
Tuesday 9 December 2008
The Association of Chartered Certified Accountants
Section A – This ONE question is compulsory and MUST be attempted
1 The following draft group financial statements relate to Warrburt, a public limited company:
Warrburt Group: Balance sheet as at 30 November 2008
–––––– ––––––Current assetsStocks 135 198Debtors 92 163Cash at bank and in hand 312 323
–––––– ––––––539 684
–––––– ––––––Creditors – amounts falling due within one year:Creditors (115) (180)Current tax payable (35) (42)Short term provisions (5) (4)
–––––– ––––––(155) (226)
–––––– ––––––Net current assets 384 458
–––––– ––––––Total assets less current liabilities 1,284 1,308
–––––– ––––––Creditors: amounts falling due after more than one year:Bank and other borrowings (20) (64)Provisions for liabilitiesDeferred tax (28) (26)Pension liability (100) (96)
–––––– ––––––(148) (186)
–––––– ––––––Net assets 1,136 1,122
–––––– ––––––
Capital and reserves:Called up share capital 650 595Other reserves 27 20Profit and loss reserve 389 454
Warrburt Group: Profit and loss account for the year ended 30 November 2008
£mTurnover 910Cost of sales (886)
–––––Gross profit 24Other income 31Distribution costs (40)Administrative expenses (35)
–––––Group operating loss (20)Interest payable (9)Share of profit of associate 8
–––––Loss on ordinary activities before tax (21)Tax on ordinary activities (31)
–––––Loss for the year on ordinary activities (52)Equity-minority interests (22)
–––––Loss for year (74)
–––––
Statement of group total recognised gains and losses for year ended 30 November 2008
£m £mLoss for financial year (74)Available-for-sale financial assets after tax 27Gains on property revaluation 4Actuarial losses on defined benefit plan (6) 25
––––– –––––Total recognised losses for year (49)
–––––
Reconciliation of movements in group shareholders funds for year ended 30 November 2008
£mLoss for financial year (74)Dividends (9)Other recognised gains and losses for year (above) 25Proceeds of ordinary shares for cash 55
–––––Net change in shareholders funds (3)Shareholders funds at 30 November 2007 1,069
––––––Shareholders funds at 30 November 2008 1,066
––––––
The following information relates to the financial statements of Warrburt:
(i) Warrburt holds available-for-sale (AFS) financial assets which are owned by the holding company. The followingschedule relates to those assets.
£mBalance 1 December 2007 150Less sales of AFS financial assets at carrying value (38)Add gain on revaluation of AFS financial assets 30
––––142––––
The sale proceeds of the AFS financial assets were £45 million. Profit on the sale of AFS financial assets is shownas ‘other income’ in the financial statements. The deferred tax arising on the revaluation gain of £3 million hasbeen taken into account in arriving at the gain in the statement of group total recognised gains and losses for theyear. Profit held in equity on the AFS financial assets that were sold of £24 million, has been transferred to profitand loss reserve.
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(ii) The defined benefit liability is shown in provisions for liabilities in the Balance Sheet and comprises the following:
£mLiability at 1 December 2007 96Expense in profit and loss account 8Contributions to scheme (paid) (10)Actuarial losses 6
––––Liability at 30 November 2008 100
––––
The benefits paid in the period by the trustees of the scheme were £3 million. There is no tax impact with regardsto the defined benefit liability.
(iii) The tangible assets in the balance sheet comprise the following:
£mCarrying value at 1 December 2007 360Additions at cost 78Gains on property revaluation 4Disposals (56)Depreciation (36)
–––––Carrying value at 30 November 2008 350
–––––
Plant and machinery with a carrying value of £1 million had been destroyed by fire in the year. The asset wasreplaced by the insurance company with new plant and machinery which was valued at £3 million. Themachines were acquired directly by the insurance company and no cash payment was made to Warrburt. Thecompany included the net gain on this transaction in ‘additions at cost’ and ‘other income’.
The disposal proceeds were £63 million. The gain on disposal is included in administrative expenses.
The remaining additions at cost comprised imported plant and machinery from an overseas supplier on 30 June2008. The cost of the plant and machinery was 380 million dinars with 280 million dinars being paid on 31 October 2008 and the balance to be paid on 31 December 2008.
The rates of exchange were as follows:
Dinars to £130 June 2008 531 October 2008 4·930 November 2008 4·8
Exchange gains and losses are included in administrative expenses.
(iv) Warrburt purchased a 25% interest in an associate for cash on 1 December 2007. The net assets of the associateat the date of acquisition were £300 million. The associate made a profit after tax of £24 million and paid adividend of £8 million out of these profits in the year ended 30 November 2008. Assume a tax rate of 25%.
(v) An impairment test had been carried out at 30 November 2008, on goodwill and other intangible assets. Theresult showed that goodwill was impaired by £20 million and other intangible assets by £12 million. Noadditional amortisation had been charged in the period.
(vi) The short term provisions relate to finance costs which are payable within six months.
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(vii) The movement on the profit and loss reserve and other reserves was as follows:
Profit/loss Otherreserve reserves
£m £mOpening balance at 1 December 2007 454 20Loss for financial year (74)Available-for-sale financial assets – net gain 27
– transfer to profit/loss reserve 24 (24)Gain on property revaluation 4Dividends paid (9)Actuarial loss on defined benefit scheme (6)
–––– –––Closing balance at 30 November 2008 389 27
–––– –––
Warrburt’s directors are concerned about the results for the year and the subsequent effect on the cash flow statement.They have suggested that the proceeds of the sale of tangible fixed assets and the sale of available-for-sale financialassets should be included in ‘cash generated from operations’. The directors are afraid of an adverse market reactionto their results and of the importance of meeting targets in order to ensure job security, and feel that the adjustmentsfor the proceeds would enhance the ‘cash health’ of the business.
Required:
(a) Prepare a group cash flow statement for Warrburt for the year ended 30 November 2008 in accordance withFRS1, ‘Cash Flow Statements’, using the indirect method. (35 marks)
(b) Discuss the key issues which the cash flow statement highlights regarding the cash flow of the company.(10 marks)
(c) Discuss the ethical responsibility of the company accountant in ensuring that manipulation of the cash flowstatement, such as that suggested by the directors, does not occur. (5 marks)
Note: requirements (b) and (c) include 2 professional marks in total for the quality of the discussion.
(50 marks)
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Section B – TWO questions ONLY to be attempted
2 Marrgrett, a public limited company, is currently planning to acquire and sell interests in other entities and has askedfor advice on the impact of FRS 2 ‘Accounting for Subsidiary Undertakings’, FRS 7 ‘Fair values in AcquisitionAccounting’, FRS 10 ‘Goodwill and Intangible assets’ and any other relevant standards on these plans.
The company is considering purchasing additional shares in an associate, Josey, a public limited company. Theholding will increase from 30% stake to 70% stake by offering the shareholders of Josey, cash and shares inMarrgrett. Marrgrett anticipates that it will pay £5 million in transaction costs to lawyers and bankers including thecosts of raising capital for the acquisition. Josey had previously been the subject of a management buyout. In orderthat the current management shareholders may remain in the business, Marrgrett is going to offer them share optionsin Josey subject to them remaining in employment for two years after the acquisition. Additionally, Marrgrett will offerthe same shareholders shares in the holding company which are contingent upon a certain level of profitability beingachieved by Josey. Each shareholder will receive shares of the holding company up to a value of £50,000, if Joseyachieves a pre-determined rate of return on capital employed for the next two years.
Josey has several marketing-related intangible assets that are used primarily in marketing or promotion of its products.These include trade names and internet domain names. These are not currently recognised in Josey’s financialstatements. Josey operates in a country where depreciation is calculated in accordance with local tax law rather thanby reference to the estimated useful life of the fixed assets. Because of its plans to change the overall structure of thebusiness, Marrgrett wishes to recognise a re-organisation provision at the date of the business combination and hasassigned provisional values to some of the assets of Josey.
To finance the acquisition of Josey, Marrgrett intends to dispose of a partial interest in two subsidiaries. Marrgrett willretain control of the first subsidiary but will sell the apparent controlling interest in the second subsidiary, Wells, apublic limited company. Marrgrett decided to dispose of Wells, partially to its management. The group will retain 45%of the ordinary shares, management will have 35% of the ordinary shares and other shareholders will hold 20%. Allshareholders will hold share options which are convertible into ordinary shares. The options are held in the sameproportion as the ordinary shares. Management’s options are only convertible if certain profit targets are met. Theremainder are convertible after three years.
Required:
Discuss the principles and nature of the accounting treatment of the above plans under Financial ReportingStandards.
Note: this requirement includes 2 professional marks for the quality of the discussion.
(25 marks)
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3 Johan, a public limited company, operates in the telecommunications industry. The industry is capital intensive withheavy investment in licences and network infrastructure. Competition in the sector is fierce and technologicaladvances are a characteristic of the industry. Johan has responded to these factors by offering incentives to customersand, in an attempt to acquire and retain them, Johan purchased a telecom licence on 1 December 2006 for £120 million. The licence has a term of six years and cannot be used until the network assets and infrastructure areready for use. The related network assets and infrastructure became ready for use on 1 December 2007. Johan couldnot operate in the country without the licence and is not permitted to sell the licence. Johan expects its subscriberbase to grow over the period of the licence but is disappointed with its market share for the year to 30 November2008. The licence agreement does not deal with the renewal of the licence but there is an expectation that theregulator will grant a single renewal for the same period of time as long as certain criteria regarding network buildquality and service quality are met. Johan has no experience of the charge that will be made by the regulator for therenewal but other licences have been renewed at a nominal cost. The licence is currently stated at its original cost of£120 million in the balance sheet under fixed assets.
Johan is considering extending its network and has carried out a feasibility study during the year to 30 November2008. The design and planning department of Johan has identified five possible geographical areas for the extensionof its network. The internal costs of this study were £150,000 and the external costs were £100,000 during the yearto 30 November 2008. Following the feasibility study, Johan chose a geographical area where it was going to installa base station for the telephone network. The location of the base station is dependent upon getting planningpermission. A further independent study was carried out by third party consultants to provide a preferred location inthe area, as there is a need for the optimal operation of the network in terms of signal quality and coverage. Johanproposes to build a base station on the recommended site on which planning permission has been obtained. The thirdparty consultants have charged £50,000 for the study. Additionally Johan has paid £300,000 as a single paymenttogether with £60,000 a month to the government of the region for access to the land upon which the base stationwill be situated. The contract with the government is for a period of 12 years and commenced on 1 November 2008.There is no right of renewal of the contract and legal title to the land remains with the government.
Johan purchases telephone handsets from a manufacturer for £200 each, and sells the handsets direct to customersfor £150 if they purchase call credit (call card) in advance on what is called a prepaid phone. The costs of selling thehandset are estimated at £1 per set. The customers using a prepaid phone pay £21 for each call card at the purchasedate. Call cards expire six months from the date of first sale. There is an average unused call credit of £3 per cardafter six months and the card is activated when sold.
Johan also sells handsets to dealers for £150 and invoices the dealers for those handsets. The dealer can return thehandset up to a service contract being signed by a customer. When the customer signs a service contract, thecustomer receives the handset free of charge. Johan allows the dealer a commission of £280 on the connection of acustomer and the transaction with the dealer is settled net by a payment of £130 by Johan to the dealer being thecost of the handset to the dealer (£150) deducted from the commission (£280). The handset cannot be soldseparately by the dealer and the service contract lasts for a 12 month period. Dealers do not sell prepaid phones, andJohan receives monthly revenue from the service contract.
The managing director, a non-accountant, has asked for an explanation of the accounting principles and practiceswhich should be used to account for the above events.
Required:
Discuss the principles and practices which should be used in the financial year to 30 November 2008 to accountfor:
(a) the licences; (8 marks)
(b) the costs incurred in extending the network; (7 marks)
(c) the purchase of handsets and the recognition of revenue from customers and dealers. (8 marks)
Appropriateness and quality of discussion. (2 marks)
(25 marks)
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4 Whilst acknowledging the importance of high quality corporate reporting, the recommendations to improve it aresometimes questioned on the basis that the marketplace for capital can determine the nature and quality of corporatereporting. It could be argued that additional accounting and disclosure standards would only distort a marketmechanism that already works well and would add costs to the reporting mechanism, with no apparent benefit. Itcould be said that accounting standards create costly, inefficient, and unnecessary regulation. It could be argued thatincreased disclosure reduces risks and offers a degree of protection to users. However, increased disclosure has severalcosts to the preparer of financial statements.
Required:
(a) Explain why accounting standards are needed to help the market mechanism work effectively for the benefitof preparers and users of corporate reports. (9 marks)
(b) Discuss the relative costs to the preparer and benefits to the users of financial statements of increaseddisclosure of information in financial statements. (14 marks)
Quality of discussion and reasoning. (2 marks)
(25 marks)
End of Question Paper
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Answers
Professional Level – Essentials Module, Paper P2 (UK)Corporate Reporting (United Kingdom) December 2008 Answers
1 (a) Warrburt GroupConsolidated Cash Flow Statement for year ended 30 November 2008
£m £mNet cash flow from operating activities (working iii) 80Dividends from associate 2Returns on investment and servicing of finance (13)Taxation (37)Capital expenditure and financial investment 51Acquisitions and disposals – associate (96)Equity dividends paid (9)
––––Cash outflow before management of liquid resources (22)FinancingIssue of ordinary shares 55Decrease in debt (44)
––––11
––––Decrease in cash in period (11)
––––
Working
(i) Available-for-sale financial assets
The sale proceeds of the AFS financial assets were £45 million thus creating a profit of £7 million. The profit on thesale of AFS financial assets has been shown in other income but the profit held in equity (£24 million) has beentransferred to retained earnings when it should have been released to other income.
£mSale proceeds 45Carrying value (38)
–––Profit 7
–––
The profit of £7 million will be included in the adjustments to operating activities.
(ii) The benefits paid to beneficiaries of the retirement benefit scheme are paid out of the scheme’s assets and not thecompany’s. Hence there is no cash flow effect. The loss on the disposal of the destroyed assets of £1 million and thegain of £3 million should not be recognised in the cash flow statement as it does not have a cash flow effect.
(iii) £mGroup operating loss (20)Depreciation 36Gain on sale of fixed assets (7)Exchange loss 2Gain on insurance proceeds (3 – 1) (2)Impairment of goodwill and intangible assets 32Available for sale financial assets – gain (working 1) (7)Retirement benefit expense 8Contributions to the scheme (10)Decrease in stocks 63Decrease in debtors 71Decrease in creditors (115 – 21 – 180) (86)
–––Net cash flow from operating activities 80
–––
Returns on investment and servicing of financeInterest paid (working vi) 8Minority interest dividend (working vii) 5
–––13
–––
Capital expenditure and financial investment Purchase of tangible fixed assets (working viii) (57)Sale of tangible fixed assets 63Sale of AFS financial assets 45
–––51
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(iv) Associate
£mBalance at 30 November 2008 100Less profit for period £24m x 25% (6)Add dividend received £8m x 25% 2
–––Cost of acquisition (cash) 96
–––
Therefore, cash paid for the investment is £96 million, and cash received from the dividend is £2 million. The share ofthe profit of the associate before tax is £8 million and taxation will therefore be £2 million.
(v) Taxation
£m £mOpening tax balances at 1 December 2007:Deferred tax 26Current tax 42
–––68
Charge for year (31 + 3) 34Tax on associate’s profit (2)Less closing tax balances at 30 November 2008:Deferred tax 28Current tax 35
–––(63)–––
Cash paid 37–––
The tax charge on the AFS financial asset (£3m) is adjusted on the tax charge for the year.
(vi) Short term provisions
£mOpening balance at 1 December 2007 4Finance costs 9Cash paid (8)
–––Closing balance at 30 November 2008 5
–––
(vii) Minority interest
£mOpening balance at 1 December 2007 53Current year amount 22Dividend paid (5)
–––Closing balance at 30 November 2008 70
–––
(viii) Additions of Fixed Assets
The purchase will be recorded at 380 million dinars ÷ 5, i.e. £76 million. At 31 October 2008, the cash outflow willbe recorded at 280 million dinars ÷ 4·9, i.e. £57 million giving a loss on exchange of £1 million (57 – 280/5). At theyear end the monetary liability will be recorded at 100 million dinars ÷ 4·8, i.e. £21 million giving a loss on exchangeof £1 million. (21 – (100/5)) The total loss will be eliminated from cash generated from operations (£2 million), thecash flow will be £57 million and the decrease in creditors will be adjusted by £21 million.
(b) Financial statement ratios can provide useful measures of liquidity but an analysis of the information in the cash flowstatement, particularly net cash flow generated from operations, can provide additional insights into the liquidity of Warrburt.It is important to look at the generation of cash and its efficient usage. An entity must generate cash from trading activity inorder to avoid the constant raising of funds from non-trading sources. The company has generated cash in the period (£80m)despite sustaining a significant loss (£21m loss). The problem is the fact that the entity will not be able to sustain this levelof cash generation if losses continue.
An important measure of the capacity of the funds generated by trading is the ability to generate sufficient cash to cover thecurrent liabilities. In the case of Warrburt, the cash generated from operating activities is £80m but current liabilities are£155m. Thus the cash flow has not covered the current liabilities.
Operating cash flow (£80 million) determines the extent to which Warrburt has generated sufficient funds to repay loans,maintain operating capability, pay dividends and make new investments without external financing. Operating cash flowappears to be healthy, partially through the release of cash from working capital. This cash flow has been used to paycontributions to the pension scheme, pay finance costs and income taxes. These uses of cash generated would be normal forany entity. However, the release of working capital has also financed in part the investing activities of the entity which includes
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the purchase of an associate and fixed assets. The activities have been financed partly out of working capital but also throughthe sale of fixed assets and AFS financial assets. It seems also that the issue of share capital has been utilised to repay thelong term borrowings and pay dividends. Also a significant amount of cash has been raised through selling AFS investments.This may not continue in the future as it will depend on the liquidity of the market. This action seems to indicate that thelong term borrowings have effectively been ‘capitalised’. The main issue raised by the cash flow statement is the use ofworking capital to partially finance investing activities. However the working capital ratio and liquidity ratio are still quitehealthy but will deteriorate if the trend continues.
(c) Companies can give the impression that they are generating more cash than they are, by manipulating cash flow. The wayin which acquisitions, loans and, as in this case, the sale of assets, is shown in the cash flow statement, can change thenature of operating cash flow and hence the impression given by the financial statements. The classification of cash flowscan give useful information to users and operating cash flow is a key figure. The role of ethics in the training and professionallives of accountants is extremely important. Decision-makers expect the financial statements to be true and fair and fairlyrepresent the underlying transactions.
There is a fine line between deliberate misrepresentation and acceptable presentation of information. Pressures onmanagement can result in the misrepresentation of information. Financial statements must comply with Financial ReportingStandards (FRS), the Statement of Principles and legislation. Transparency, and full and accurate disclosure is important ifthe financial statements are not to be misleading. Accountants must possess a high degree of professional integrity and theprofession’s reputation depends upon it. Ethics describes a set of moral principles taken as a reference point. These principlesare outside the technical and practical application of accounting and require judgement in their application. Professionalaccountancy bodies set out ethical guidelines covering standards of behaviour, and acceptable practice within which theirmembers operate. These regulations are supported by a number of codes, for example, on corporate governance which assistaccountants in making ethical decisions. The accountant in Warrburt has a responsibility not to mask the true nature of thecash flow statement. Showing the sale of assets as an operating cash flow would be misleading if the nature of the transactionwas masked. Users of financial statements would not expect its inclusion in this heading and could be misled. The potentialmisrepresentation is unacceptable. The accountant should try and persuade the directors to follow acceptable accountingprinciples and comply with accounting standards. There are implications for the truth and fairness of the financial statementsand the accountant should consider his position if the directors insist on the adjustments in terms of pointing the inaccuraciesout to the auditors.
2 The Companies Act and FRS 7 ‘Fair values in acquisition accounting’ state that the acquisition cost of a subsidiary is made up ofcash consideration, fair value of other consideration and expenses of acquisition. The consideration is the amount paid for thebusiness acquired and is measured at fair value. Consideration will include cash, shares, assets, contingent consideration, equityinstruments, options and warrants. When an associate becomes a subsidiary, a proportion of the associate’s results have alreadybeen dealt with in the consolidated profit and loss account and balance sheet. Goodwill will already have been calculated on theacquisition of the interest in the associate and will have been amortised. The method of accounting for goodwill set out in theCompanies Act still applies and goodwill should be calculated by taking the difference between the fair value of the group’s shareof the net assets and the total acquisition cost of the interests. Under this method the group’s share of the post acquisition profitsof the associate become reclassified as goodwill, thus reducing goodwill. FRS 2 recognises that this accounting treatment isinconsistent with the way the investment was previously treated and this could lead to failure to give a true and fair view. ThereforeFRS 2 requires that goodwill should be calculated as the sum of goodwill arising on each purchase adjusted for any subsequentdiminution in value.
The fees payable in transaction costs need to be analysed into two elements. Costs of raising capital for the acquisition and feesincurred directly in making an acquisition. Costs relating to issuing shares should be charged against reserves and the sharepremium account would be available for this. Other costs which may be capitalised are defined in FRS 7 as ‘fees and other costsincurred directly in making an acquisition’. These costs must not include internal costs, but may include the costs of lawyers andbankers. The work carried out by advisors is likely to overlap the work on raising capital and so reasonable allocations may haveto be made.
It is common for part of the consideration to be contingent upon future events. Marrgrett wishes some of the existingshareholders/employees to remain in the business and has, therefore, offered share options as an incentive to these persons. Theissue is whether these options form part of the purchase consideration or are compensation for post acquisition services. Theconditions attached to the award will determine the accounting treatment. In this case there are employment conditions and,therefore, the options should be treated as compensation and valued under FRS 20 ‘Share based payment’. Thus a charge willappear in post acquisition earnings for employee services as the options were awarded to reward future services of employeesrather than to acquire the business.
The additional shares to a fixed value of £50,000 are contingent upon the future returns on capital employed. Marrgrett only wantsto make additional payments if the business is successful. All consideration should be fair valued at the date of acquisition,including the above contingent consideration. The contingent consideration payable in shares where the number of shares variesto give the recipient a fixed value (£50,000) meets the definition of a financial liability under FRS 25 ‘Financial Instruments:Disclosure and Presentation’. As a result the liability will have to be fair valued and any subsequent remeasurement will berecognised in the income statement. There is no requirement for the payments to be probable.
Intangible assets acquired as part of a business acquisition should be capitalised separately if their value can be measured reliablyon initial recognition. The normal principles for valuing assets acquired in an acquisition will apply to intangible assets. FRS 7states that where an intangible is recognised, its fair value should be based on its replacement cost which is normally estimated
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market value. FRS 10 requires reliable measurement also. Intangible assets that have a readily obtainable market value are quiterare. However if the company regularly buys and sells intangibles such as trade names, then, Marrgrett may have developedvaluation techniques which allow them to be capitalised separately from goodwill. If valuation techniques have not been developedby the company as regards the trade and internet domain names, then the value of the intangibles will be subsumed withingoodwill.
Uniform accounting policies should be used to determine the amounts to be included in the consolidated financial statements.Problems can arise where subsidiaries are subject to different tax law as it may not be practicable to require subsidiaries to changetheir accounting policies as there may be local regulation which requires certain treatments in the financial statements. In order tocomply with FRS 2, an adjustment must be made on consolidation to the depreciation charge and the accumulated depreciationin order to bring it into line with group practice. An adjustment to deferred taxation may also be required.
FRS 7 requires the fair value exercise to be complete in time for the publication of Marrgrett’s first post acquisition financialstatements. If it cannot be completed by this time, provisional values should be included which should be amended in the nextfinancial statements with any corresponding adjustment to goodwill. The company will not be able to recognise the re-organisationprovision at the date of the business combination. The ability of the acquirer to recognise a liability for reducing or changing theactivities of the acquiree is restricted under FRS 7. A restructuring provision can only be recognised in a business combinationwhen the acquiree has at the acquisition date already committed to the expenditure or course of action. These conditions areunlikely to have existed at the acquisition date. A restructuring plan that is conditional on the completion of a business combinationis not recognised in accounting for the acquisition but the expense will be met against post acquisition earnings.
Where a group reduces its stake in a subsidiary, any profit or loss should be calculated as the difference between the carryingamount of the net assets of the subsidiary before the reduction in holding and the carrying amount attributable to the group’sinterest after the reduction together with any proceeds received. The net assets compared should include any related goodwill notpreviously written off through the profit and loss account. Where the undertaking continues to be subsidiary after the disposal, theminority interests in the subsidiary are increased by the carrying amount of the net assets that are now attributable to the minoritybecause of the decrease in the company’s stake. No amount of goodwill is attributable to the minority.
As regards the disposal of the second subsidiary to its management, it is necessary to decide whether Marrgrett has the power toexercise or actually exercises dominant influence or manages the subsidiary on a unified basis. If this is the case, then the companywill remain a subsidiary. If Marrgrett does not have dominant influence, then a view will have to be taken as to whether it isprobable that the profit target will be met. If it is considered probable that they will be met, the company would not be a subsidiaryand would not be consolidated. Full details of the conversion rights would be disclosed in the financial statements.
3 LicencesAn intangible asset meets the identifiability criterion when the asset is capable of being disposed of separately from the business.An intangible asset is a non-financial fixed asset that does not have physical substance but is identifiable and controlled by anentity through custody or legal rights (FRS 10 ‘Goodwill and Intangible Assets’). FRS 10 defines intangible assets as non financialassets that do not have physical substance but are controlled by the entity through custody or legal rights. A key component of thedefinition of intangible assets is control. FRS 5 defines control in the context of an asset as ‘the ability to obtain future economicbenefits relating to an asset and to restrict the access of others to those benefits’. In the context of intangible assets FRS 10 sayscontrol must be exercised through custody or legal rights. Intangible assets purchased separately should be capitalised at cost. Thelicence will therefore meet the criteria for recognition as an intangible asset at cost. The intangible can only be revalued if it has areadily ascertainable market value. As the licence cannot be sold, the intangible cannot be revalued.
FRS 10 requires intangible assets to be carried at cost less amortisation and impairment losses. Amortisation is the systematicallocation of the depreciable amount of an intangible asset over its useful life. The depreciable amount is the asset’s cost less itsresidual value. The licence will have no residual value. The depreciable amount should be allocated on a systematic basis over itsuseful life. The method of amortisation should reflect the pattern in which the asset’s economic benefits are expected to beconsumed. If that pattern cannot be determined reliably, the straight line method of amortisation must be used. The licence doesnot suffer wear and tear from usage, that is the number of customers using the service. The economic benefits of the licence relateto Johan’s ability to benefit from the use of the licence. The economic benefits relate to the passage of time and the useful life ofthe licence is now shorter. Therefore, the asset depletes on a time basis and the straight line basis is appropriate. The licenceshould be amortised from the date that the network is available for use; that is from 1 December 2007. An impairment reviewshould have been undertaken at 30 November 2007 when the licence was not being amortised. Although the licence is capableof being used on the date it was purchased, it cannot be used until the associated network assets and infrastructure are availablefor use. Johan expects the regulator to renew the licence at the end of the initial term and thus consideration should be given toamortising the licence over the two licence periods, i.e. a period of 11 years (five years and six years) as the licence could berenewed at a nominal cost. However, Johan has no real experience of renewing licences and cannot reliably determine whatamounts, if any, would be payable to the regulator. Therefore, the licence should be amortised over a five year period, that is £24 million per annum. There is a rebuttable presumption that the useful life does not exceed 20 years but a longer or indefinitelife is permitted in certain circumstances.
There are indications that the value of the licence may be impaired. The market share for the year to 30 November 2008 isdisappointing and competition is fierce in the sector, and retention of customers difficult. Therefore, an impairment test should beundertaken. Johan should classify the licence and network assets as a single income generating unit (IGU) for impairmentpurposes. The licence cannot generate revenue in its own right and the smallest group of assets that generates independentrevenue will be the licence and network assets. The impairment indicators point to the need to test this income generating unit forimpairment. FRS 10 requires an impairment review for all intangibles at the end of the first full year following their acquisition.
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Costs incurred in extending networkThere are no specific recognition criteria in FRS 15 ‘Tangible Fixed Assets’. However a fixed asset must have physical substanceand be used on a continuing basis in the business and must satisfy the definition of an asset in FRS 5 ‘Reporting the substanceof transactions’ and the Statement of Principles. FRS 5 says that an asset is ‘rights or other access to future economic benefitscontrolled by an entity as a result of past transactions or events’.
It is necessary to assess the degree of certainty attaching to the future economic benefits and the basis of the evidence availableat the time of initial recognition. The cost incurred during the initial feasibility study (£250,000) should be expensed as incurredas the flow of economic benefits to Johan as a result of the study would have been uncertain.
FRS 15 states that the cost of an item of a fixed asset comprises amongst other costs, directly attributable costs of bringing theasset into working condition for its intended use. Cost is the purchase price plus directly attributable costs. Examples of costs aresite preparation costs, and installation and assembly costs. The selection of the base station site is critical for the optimal operationof the network and is part of the process of bringing the network assets to a working condition. Thus the costs incurred by engaginga consultant (£50,000) to find an optimal site can be capitalised as it is part of the cost of constructing the network anddepreciated accordingly as planning permission has been obtained.
Under SSAP 21, ‘Accounting for Leases and Hire Purchase Contracts’, a lease is defined as an agreement whereby the lessorconveys to the lessee, in return for a payment or series of payments, the right to use an asset for an agreed period of time. A financelease is a lease that transfers substantially all the risks and rewards incidental to ownership of the leased asset to the lessee.SSAP21 presumes a transfer of the risks and rewards if at the inception of the lease, the present value of the minimum leasepayments amounts to substantially all (normally 90% or more) of the fair value of the leased assets. An operating lease is a leaseother than a finance lease. In the case of the contract regarding the land, there is no ownership transfer and the term is not for themajor part of the asset’s life as it is land which has an indefinite economic life. Thus substantially all of the risks and rewardsincidental to ownership have not been transferred. The contract should be treated, therefore, as an operating lease. The paymentof £300,000 should be treated as a prepayment in the balance sheet and charged to the profit and loss account over the life ofthe contract on the straight line basis. The monthly payments will be expensed and no value placed on the lease contract in thebalance sheet.
Handsets and revenue recognitionThe stock of handsets should be measured at the lower of cost and net realisable value (SSAP 9 ‘Stocks and Long term contracts’).Johan should recognise a provision at the point of purchase for the handsets to be sold at a loss. The stock should be written downto its net realisable value (NRV) of £149 per handset as they are sold both to prepaid customers and dealers. The NRV is £51less than cost. Net realisable value is the estimated selling price in the normal course of business less the estimated selling costs.
‘FRS 5 Application note G’ requires the recognition of revenue by reference to the stage of completion of the transaction at thebalance sheet date. Revenue associated with the provision of services should be recognised as service as rendered. Johan shouldrecord the receipt of £21 per call card as deferred revenue at the point of sale. Revenue of £18 should be recognised over the sixmonth period from the date of sale. The unused call credit of £3 would be recognised when the card expires as that is the pointat which the obligation of Johan ceases. Revenue is earned from the provision of services and not from the physical sale of thecard.
‘FRS 5 Application note G’ analyses the factors that determine whether a seller is acting as a principal or agent. In order for a sellerto account for a transaction as a principal, there should normally be exposure to all the significant risks associated with the sellingprice or the stock. Other factors include where the seller assumes the credit risk. It appears that Johan is acting as a principal.Additionally where there are two or more transactions, they should be taken together if the commercial effect cannot be understoodwithout reference to the series of transactions as a whole.
As a result of the above, Johan should not recognise revenue when the handset is sold to the dealer, as the dealer is acting as anagent for the sale of the handset and the service contract. Johan has retained the risk of the loss in value of the handset as theycan be returned by the dealer and the price set for the handset is under the control of Johan. The handset sale and the provisionof the service would have to be assessed as to their separability. However, the handset cannot be sold separately and iscommercially linked to the provision of the service. Johan would, therefore, recognise the net payment of £130 as a customeracquisition cost which may qualify as an intangible asset under FRS 10, and the revenue from the service contract will berecognised as the service is rendered. The intangible asset would be amortised over the 12 month contract. The cost of the handsetfrom the manufacturer will be charged as cost of goods sold (£200).
4 (a) It could be argued that the marketplace already offers powerful incentives for high-quality reporting as it rewards such byeasing or restricting access to capital or raising or lowering the cost of borrowing capital depending on the quality of the entity’sreports. However, accounting standards play an important role in helping the market mechanism work effectively. Accountingstandards are needed because they:
– Promote a common understanding of the nature of corporate performance and this facilitates any negotiations betweenusers and companies about the content of financial statements. For example, many loan agreements specify that acompany provide the lender with financial statements prepared in accordance with generally accepted accountingprinciples or Financial Reporting Standards. Both the company and the lender understand the terms and are comfortablethat statements prepared according to those standards will meet certain information needs. Without standards, thestatements would be less useful to the lender, and the company and the lender would have to agree to create some formof acceptable standards which would be inefficient and less effective.
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– Assist neutral and unbiased reporting. Companies may wish to portray their past performance and future prospects inthe most favourable light. Users are aware of this potential bias and are sceptical about the information they receive.Standards build credibility and confidence in the capital marketplace to the benefit of both users and companies.
– Improve the comparability of information across companies and national boundaries. Without standards, there would belittle basis to compare one company with others across national boundaries which is a key feature of relevantinformation.
– Create credibility in financial statements. Auditors verify that information is reported in accordance with standards andthis creates public confidence in financial statements.
– Facilitate consistency of information by producing data in accordance with an agreed conceptual framework. A consistentapproach to the development and presentation of information assists users in accessing information in an efficientmanner and facilitates decision-making.
(b) Increased information disclosure benefits users by reducing the likelihood that they will misallocate their capital. This isobviously a direct benefit to individual users of corporate reports. The disclosure reduces the risk of misallocation of capitalby enabling users to improve their assessments of a company’s prospects. This creates three important results.
(i) Users use information disclosed to increase their investment returns and by definition support the most profitablecompanies which are likely to be those that contribute most to economic growth. Thus, an important benefit ofinformation disclosure is that it improves the effectiveness of the investment process.
(ii) The second result lies in the effect on the liquidity of the capital markets. A more liquid market assists the effectiveallocation of capital by allowing users to reallocate their capital quickly. The degree of information asymmetry betweenthe buyer and seller and the degree of uncertainty of the buyer and the seller will affect the liquidity of the market aslower asymmetry and less uncertainty will increase the number of transactions and make the market more liquid.Disclosure will affect uncertainty and information asymmetry.
(iii) Information disclosure helps users understand the risk of a prospective investment. Without any information, the userhas no way of assessing a company’s prospects. Information disclosure helps investors predict companies’ economicprospects. Getting a better understanding of the true economic risk could lower the price of capital for the company. Itis difficult to prove however that the average cost of capital is lowered by information disclosure, even though it islogically and practically impossible to assess a company’s risk without relevant information. Lower capital costs promoteinvestment, which can stimulate productivity and economic growth.
However although increased information can benefit users, there are problems of understandability and information overload.
Information disclosure provides a degree of protection to users. The benefit is fairness to users and is part of corporateaccountability to society as a whole.
The main costs to the preparer of financial statements are as follows:
(i) the cost of developing and disseminating information, (ii) the cost of possible litigation attributable to information disclosure, (iii) the cost of competitive disadvantage attributable to disclosure.
The costs of developing and disseminating the information include those of gathering, creating and auditing the information.
Additional costs to preparers include training costs, changes to systems, and the more complex and greater the informationprovided, the more it will cost the company.
Although litigation costs are known to arise from information disclosure, it does not follow that all information disclosure leadsto litigation costs. Cases can arise from insufficient disclosure and misleading disclosure. Only the latter is normally promptedby the presentation of information disclosure. Fuller disclosure could lead to lower costs of litigation as the stock market wouldhave more realistic expectations of the company’s prospects and the discrepancy between the valuation implicit in the marketprice and the valuation based on a company’s financial statements would be lower. However, litigation costs do notnecessarily increase with the extent of the disclosure. Increased disclosure could reduce litigation costs.
Disclosure could weaken a company’s ability to generate future cash flows by aiding its competitors. The effect of disclosureon competitiveness involves benefits as well as costs. Competitive disadvantage could be created if disclosure is made relatingto strategies, plans, (for example, planned product development, new market targeting) or information about operations (forexample, production-cost figures). There is a significant difference between the purpose of disclosure to users andcompetitors. The purpose of disclosure to users is to help them to estimate the amount, timing, and certainty of future cashflows. Competitors are not trying to predict a company’s future cash flows, and information of use in that context is notnecessarily of use in obtaining competitive advantage. Overlap between information designed to meet users’ needs andinformation designed to further the purposes of a competitor is often coincidental. Every company that could suffer competitivedisadvantage from disclosure could gain competitive advantage from comparable disclosure by competitors. Published figuresare often aggregated with little use to competitors.
Companies bargain with suppliers and with customers, and information disclosure could give those parties an advantage innegotiations. In such cases, the advantage would be a cost for the disclosing entity. However, the cost would be offsetwhenever information disclosure was presented by both parties, each would receive an advantage and a disadvantage.
There are other criteria to consider such as whether the information to be disclosed is about the company. This is both abenefit and a cost criterion. Users of corporate reports need company-specific data, and it is typically more costly to obtain
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and present information about matters external to the company. Additionally, consideration must be given as to whether thecompany is the best source for the information. It could be inefficient for a company to obtain or develop data that other, moreexpert parties could develop and present or do develop at present.
There are many benefits to information disclosure and users have unmet information needs. It cannot be known with anycertainty what the optimal disclosure level is for companies. Some companies through voluntary disclosure may haveachieved their optimal level. But there are no quantitative measures of how levels of disclosure stand with respect to optimallevels. Standard setters have to make such estimates as best they can, guided by prudence, and by what evidence of benefitsand costs they can obtain.
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Professional Level – Essentials Module, Paper P2 (UK)Corporate Reporting (United Kingdom) December 2008 Marking Scheme
Marks1 (a) Group operating loss 1
AFS financial instruments 4Defined benefit 3Tangible fixed assets 6Insurance proceeds 2Associate 4Goodwill and intangibles 1Finance costs 2Taxation 4Working capital 4Proceeds of share issue 1Repayment of borrowings 1Dividends 1Minority interest 1
–––35
–––
(b) Operating cash flow and discussion 10
(c) Discussion including professional marks 5–––
AVAILABLE 50–––
2 Consideration 6Contingent consideration 5Intangible assets 3Uniform accounting policies 3Finalisation and reorganisation provision 2Subsidiaries 4Professional marks 2
The Association of Chartered Certifi ed Accountants
Corporate Reporting(United Kingdom)
Tuesday 15 December 2009
Time allowed
Reading and planning: 15 minutesWriting: 3 hours
This paper is divided into two sections:
Section A – This ONE question is compulsory and MUST be attempted
Section B – TWO questions ONLY to be attempted
Do NOT open this paper until instructed by the supervisor.
During reading and planning time only the question paper may
be annotated. You must NOT write in your answer booklet until
instructed by the supervisor.
This question paper must not be removed from the examination hall.
Pape
r P2 (
UK
)
2
Section A – THIS ONE question is compulsory and MUST be attempted
1 Grange, a public limited company, operates in the manufacturing sector. The draft balance sheets of the group companies are as follows at 30 November 2009:
Grange Park Fence £m £m £m Fixed assets: Tangible assets 251 311 238 Investments in subsidiaries Park 340 Fence 134 Investment in Sitin 16 ––––– ––––– ––––– 741 311 238 ––––– ––––– ––––– Current assets 481 304 141 ––––– ––––– ––––– Creditors: amounts falling due within one year Trade creditors (178 ) (71 ) (105 ) Provisions for liabilities (10 ) (6 ) (4 ) ––––– ––––– ––––– (188 ) (77 ) (109 ) ––––– ––––– ––––– Net current assets 293 227 32 ––––– ––––– ––––– Total assets less current liabilities 1,034 538 270 ––––– ––––– ––––– Creditors: amounts falling due after more than one year (172 ) (124 ) (38 ) ––––– ––––– ––––– Net assets 862 414 232 ––––– ––––– –––––
Capital and reserves Called up share capital 430 230 150 Profi t and loss reserve 410 170 65 Other reserves 22 14 17 ––––– ––––– ––––– Capital employed 862 414 232 ––––– ––––– –––––
The following information is relevant to the preparation of the group fi nancial statements:
(i) On 1 June 2008, Grange acquired 60% of the equity interests of Park, a public limited company. The purchase consideration comprised cash of £250 million. Excluding the franchise referred to below, the fair value of the identifi able net assets was £360 million. The excess of the fair value of the net assets is due to an increase in the value of non-depreciable land.
Park held a franchise right, which at 1 June 2008 had a fair value of £10 million. This had not been recognised in the fi nancial statements of Park. The franchise agreement had a remaining term of fi ve years to run at that date and is not renewable. Park still holds this franchise right at the year-end.
The profi t and loss reserve of Park was £115 million and other reserves were £10 million at the date of acquisition.
Grange acquired a further 20% interest in Park on 30 November 2009 for a cash consideration of £90 million when the fair value of the net assets of Park was not materially different from their book value. Group policy is not to amortise goodwill but to annually impairment test. There has been no impairment of goodwill to date.
(ii) On 31 July 2008, Grange acquired a 100% of the equity interests of Fence for a cash consideration of £214 million. The identifi able net assets of Fence had a provisional fair value of £202 million, including any contingent liabilities. At the time of the business combination, Fence had a contingent liability with a fair value of £30 million. At 30 November 2009, the contingent liability met the recognition criteria of FRS12 ‘Provisions,
contingent liabilities and contingent assets’ and the revised estimate of the fair value of this liability was £25 million. The accountant of Fence is yet to account for this revised liability.
3 [P.T.O.
Grange had not completed the valuation of an element of fi xed assets of Fence at 31 July 2008 and the valuation was not completed by 30 November 2008. The valuation was received on 30 June 2009 and the excess of the fair value over book value at the date of acquisition was estimated at £4 million. The asset had a useful economic life of 10 years at 31 July 2008.
The profi t and loss reserve of Fence was £73 million and other reserves were £9 million at 31 July 2008 before any adjustment for the contingent liability.
On 30 November 2009, Grange disposed of 25% of its equity interest in Fence for a consideration of £80 million. The disposal proceeds had been credited to the cost of the investment in the balance sheet.
(iii) On 30 June 2008, Grange had acquired a 100% interest in Sitin, a public limited company for a cash consideration of £39 million. Sitin’s identifi able net assets were fair valued at £32 million.
On 30 November 2009, Grange disposed of 60% of the equity of Sitin when its identifi able net assets were £36 million. Of the increase in net assets, £3 million had been reported in the profi t and loss account and £1 million had been reported in the Statement of Recognised Gains and Losses as profi t on an available-for-sale asset. The sale proceeds were £23 million. Grange could still exert signifi cant infl uence after the disposal of the interest. The only accounting entry made in Grange’s fi nancial statements was to increase cash and reduce the cost of the investment in Sitin.
(iv) Grange acquired a plot of land on 1 December 2008 in an area where the land is expected to rise signifi cantly in value if plans for regeneration go ahead in the area. The land is currently held at cost of £6 million in fi xed assets until Grange decides what should be done with the land. The market value of the land at 30 November 2009 was £8 million but as at 15 December 2009, this had reduced to £7 million as there was some uncertainty surrounding the viability of the regeneration plan.
(v) Grange anticipates that it will be fi ned £1 million by the local regulator for environmental pollution. It also anticipates that it will have to pay compensation to local residents of £6 million although this is only the best estimate of that liability. In addition, the regulator has requested that certain changes be made to the manufacturing process in order to make the process more environmentally friendly. This is anticipated to cost the company £4 million.
(vi) Grange has a property located in a foreign country, which was acquired at a cost of 8 million dinars on 30 November 2008 when the exchange rate was £1 = 2 dinars. At 30 November 2009, the property was revalued to 12 million dinars. The exchange rate at 30 November 2009 was £1 = 1·5 dinars. The property was being carried at its value as at 30 November 2008. The company policy is to revalue property whenever material differences exist between book and fair value. Depreciation on the property can be assumed to be immaterial.
(vii) Grange has prepared a plan for reorganising the parent company’s own operations. The board of directors has discussed the plan but further work has to be carried out before they can approve it. However, Grange has made a public announcement as regards the reorganisation and wishes to make a reorganisation provision at 30 November 2009 of £30 million. The plan will generate cost savings. The directors have calculated the value in use of the net assets of the parent company as being £870 million if the reorganisation takes place and £830 million if the reorganisation does not take place. Grange is concerned that the parent company’s fi xed assets have lost value during the period because of a decline in property prices in the region and feel that any impairment charge would relate to these assets. There is no reserve within other reserves relating to prior revaluation of these fi xed assets.
(viii) Grange uses accounting policies which maximise its return on capital employed. The directors of Grange feel that they are acting ethically in using this approach as they feel that as long as they follow ‘professional rules’, then there is no problem. They have adopted a similar philosophy in the way they conduct their business affairs. The fi nance director had recently received information that one of their key customers, Brook, a public limited company, was having serious liquidity problems. This information was received from a close friend who was employed by Brook. However, he also learned that Brook had approached a rival company, Field, a public limited company, for credit and knew that if Field granted Brook credit then there was a high probability that the outstanding balance owed by Brook to Grange would be paid. Field had approached the director for an informal credit reference for Brook who until recently had always paid promptly. The director was intending to give Brook a good reference because of its recent prompt payment history as the director felt that there was no obligation or rule which required him to mention the company’s liquidity problems. (There is no change required to the fi nancial statements as a result of the above information.)
4
Required:
(a) Calculate the gain or loss arising on the disposal of the equity interest in Sitin. (6 marks)
(b) Prepare a consolidated balance sheet of the Grange Group at 30 November 2009 in accordance with UK
Financial Reporting Standards. (35 marks)
(c) Discuss the view that ethical behaviour is simply a matter of compliance with professional rules setting out
whether the fi nance director simply had to consider ‘rules’ when determining whether to give Brook a good
credit reference. (7 marks)
Professional marks will be awarded in part (c) for clarity and expression. (2 marks)
(50 marks)
5 [P.T.O.
Section B – TWO questions ONLY are compulsory and MUST be attempted
2 (a) Key, a public limited company, is concerned about the reduction in the general availability of credit and the sudden tightening of the conditions required to obtain a loan from banks. There has been a reduction in credit availability and a rise in interest rates. It seems as though there has ceased to be a clear relationship between interest rates and credit availability, and lenders and investors are seeking less risky investments. The directors are trying to determine the practical implications for the fi nancial statements particularly because of large write downs of assets in the banking sector, tightening of credit conditions, and falling sales and asset prices. They are particularly concerned about the impairment of assets and the market inputs they use in impairment testing. They are afraid that they may experience signifi cant impairment charges in the coming fi nancial year. They are unsure as to how they should test for impairment and any considerations, which should be taken into account.
Required:
Discuss the main considerations that the company should take into account when impairment testing fi xed
assets in the above economic climate. (8 marks)
Professional marks will be awarded in part (a) for clarity and expression. (2 marks)
(b) Additionally there are specifi c assets on which the company wishes to seek advice. The company holds certain fi xed assets, which are in a development area and carried at cost less depreciation. These assets cost £3 million on 1 June 2008 and are depreciated on the straight-line basis over their useful life of fi ve years. An impairment review was carried out on 31 May 2009 and the projected cash fl ows relating to these assets were as follows:
Year to 31 May 2010 31 May 2011 31 May 2012 31 May 2013 Cash fl ows (£000) 280 450 500 550
The company used a discount rate of 5%. At 30 November 2009, the directors used the same cash fl ow projections and noticed that the resultant value in use was above the carrying amount of the assets and wished to reverse any impairment loss calculated at 31 May 2009. The government has indicated that it may compensate the company for any loss in value of the assets up to 20% of the impairment loss.
Key holds a fi xed asset, which was purchased for £10 million on 1 December 2006 with an expected useful life of 10 years. On 1 December 2008, it was revalued to £8·8 million. At 30 November 2009, the asset was reviewed for impairment as a result of current conditions and written down to its recoverable amount of £5·5 million.
Key committed itself at the beginning of the fi nancial year to selling a subsidiary that was underperforming following the economic downturn. As a result of the economic downturn, the subsidiary was not sold by the end of the year. However, shortly after the year-end, the company accepted an offer to sell the subsidiary for £15 million. There is no binding sale agreement. The net assets and purchased goodwill of the subsidiary were £17 million and £3 million respectively at 30 November 2009 and it is assumed that the subsidiary makes neither profi t nor loss to any subsequent date of disposal.
Required:
Discuss with suitable computations, how to account for any potential impairment of the above assets in the
fi nancial statements for the year ended 30 November 2009. (15 marks)
Note: The following discount factors may be relevant
Year 1 0·9524 Year 2 0·9070 Year 3 0·8638 Year 4 0·8227
(25 marks)
6
3 Burley, a public limited company, operates in the energy industry. It has entered into several arrangements with other entities as follows:
(i) Burley and Slite, a public limited company, jointly control an oilfi eld. Burley has a 60% interest and Slite a 40% interest and the companies are entitled to extract oil in these proportions. An agreement was signed on 1 December 2008, which allowed for the net cash settlement of any over/under extraction by one company. The net cash settlement would be at the market price of oil at the date of settlement. Both parties have used this method of settlement before. 200,000 barrels of oil were produced up to 1 October 2009 but none were produced after this up to 30 November 2009 due to production diffi culties. The oil was all sold to third parties at £100 per barrel. Burley has extracted 10,000 barrels more than the company’s quota and Slite has under extracted by the same amount. The market price of oil at the year-end of 30 November 2009 was £105 per barrel. The excess oil extracted by Burley was settled on 12 December 2009 under the terms of the agreement at £95 per barrel.
Burley had purchased oil from another supplier because of the production diffi culties at £98 per barrel and has oil stock of 5,000 barrels at the year-end, purchased from this source. Slite had no stock of oil. Neither company had oil stock at 1 December 2008. Selling costs are £2 per barrel.
Burley wishes to know how to account for the recognition of revenue, the excess oil extracted and the oil stock at the year-end. (10 marks)
(ii) Burley also entered into an agreement with Jorge, and Heavy, both public limited companies on 1 December 2008. Each of the companies holds one third of the equity in an entity, Wells, a public limited company, which operates off shore oilrigs. Any decisions regarding the operating and fi nancial policies relating to Wells have to be approved by two thirds of the venturers. Burley wants to account for the interest in the entity by using the gross equity method, and wishes advice on the matter.
The oilrigs of Wells started operating on 1 December 1998 and are measured at cost. The useful life of the rigs is 40 years. The initial cost of the rigs was £240 million, which included decommissioning costs (discounted) of £20 million. At 1 December 2008, the carrying amount of the decommissioning liability has grown to £32·6 million, but the net present value of decommissioning liability has decreased to £18·5 million as a result of the increase in the risk-adjusted discount rate from 5% to 7%. Burley is unsure how to account for the oilrigs in the fi nancial statements of Wells for the year ended 30 November 2009.
Burley owns a 10% interest in a pipeline, which is used to transport the oil from the offshore oilrig to a refi nery on the land. Burley has joint control over the pipeline and has to pay its share of the maintenance costs. Burley has the right to use 10% of the capacity of the pipeline. Burley wishes to show the pipeline as an investment in its fi nancial statements to 30 November 2009. (9 marks)
(iii) Burley has purchased a transferable interest in an oil exploration licence. Initial surveys of the region designated for exploration indicate that there are substantial oil deposits present but further surveys will be required in order to establish the nature and extent of the deposits. Burley also has to determine whether the extraction of the oil is commercially viable. Past experience has shown that the licence can increase substantially in value if further information as to the viability of the extraction of the oil becomes available. Burley wishes to capitalise the cost of the licence but is unsure as to whether the accounting policy is compliant with UK Financial Reporting Standards. (4 marks)
Required:
Discuss with suitable computations where necessary, how the above arrangements and events would be accounted
for in the fi nancial statements of Burley.
Professional marks will be awarded in question 3 for clarity and expression. (2 marks)
(25 marks)
7
4 The defi nition of a fi nancial instrument captures a wide variety of assets and liabilities including cash, evidence of an ownership interest in an entity, or a contractual right to receive, or deliver cash or another fi nancial instrument. Preparers, auditors and users of fi nancial statements have found the requirements for reporting fi nancial assets and liabilities to be very complex, problematical and sometimes subjective. The result is that there is a need to develop new standards of reporting for fi nancial instruments that are principle-based and signifi cantly less complex than current requirements. It is important that a standard in this area should allow users to understand the economic substance of the transaction and preparers to properly apply generally accepted accounting principles.
Required:
(a) (i) Discuss how the measurement of fi nancial instruments under UK Financial Reporting Standards can
create confusion and complexity for preparers and users of fi nancial statements. (9 marks)
(ii) Set out the reasons why using fair value to measure all fi nancial instruments may result in less complexity
in the application of FRS 26 ‘Financial Instruments: recognition and measurement’ but may lead to
uncertainty in fi nancial statements. (9 marks)
Professional marks will be awarded in part (a) for clarity and expression. (2 marks)
(b) A company borrowed £47 million on 1 December 2008 when the market and effective interest rate was 5%. On 30 November 2009, the company borrowed an additional £45 million when the current market and effective interest rate was 7·4%. Both fi nancial liabilities are repayable on 30 November 2013 and are single payment notes whereby interest and capital are repaid on that date.
Required:
Discuss the accounting for the above fi nancial liabilities under current accounting standards using amortised
cost, and additionally using fair value as at 30 November 2009. (5 marks)
(25 marks)
End of Question Paper
Answers
11
Professional Level – Essentials Module, Paper P2 (UK)
Corporate Reporting (United Kingdom) December 2009 Answers
1 (a) Disposal of equity interest in Sitin
The loss recognised in the profi t and loss account would be as follows:
£m Fair value of consideration 23 less net assets and goodwill derecognised net assets (60% of 36) (21·6 ) goodwill (£39 – £32 million) x 60% (4·2 ) –––––––– Loss on disposal (2·8 ) ––––––––
Sitin will be treated as an associate and will be valued at (40% x (£36m + £7m) i.e. £17·2 million
(b) Grange plc
Consolidated Balance Sheet at 30 November 2009 £m Fixed Assets: Tangible assets (W6) 775·47 Investment property (W7) 8 Goodwill (32·8 + 8 – 2) 38·8 Intangible assets (10 – 3) 7 Investment in Sitin (part (a)) 17·2 –––––––– 846·47 –––––––– Current assets 926 Creditors: amounts falling due within one year Trade creditors (354 ) Provisions for liabilities (52 ) –––––––– (406 ) –––––––– Net current assets 520 –––––––– Total assets less current liabilities 1,366·47 –––––––– Creditors: amounts falling due after more than one year (334 ) –––––––– Net assets 1,032·47 ––––––––
Capital and reserves Called up share capital 430 Profi t and loss reserve (W3) 425·25 Other reserves (W3) 39·4 –––––––– 894·65 –––––––– Minority interest 137·82 –––––––– Capital employed 1,032·47 ––––––––
Working 1 Park Goodwill and subsequent acquisition £m Fair value of consideration for 60% interest 250 Fair value of identifi able net assets acquired (60% of 360) (216 ) Franchise right (60% of 10) (6 ) –––––––– Goodwill 28 ––––––––
12
Depreciation of Franchise right
1 June 2008 to 30 November 2009 – £10m divided by 5 years multiplied by 1·5 years is £3 million
Dr Profi t or loss £3 million Cr Franchise right £3 million
Fair value of consideration for 20% interest 90 Fair value of identifi able net assets acquired (20% of 414) (82·8 ) Fair value of land (20% of 5) (1 ) Franchise right (20% of 7) (1·4 ) –––––– Goodwill 4·8 ––––––
Total goodwill is £(28 + 4·8)m i.e. £32·8m
Working 2 Fence goodwill and disposal £m Fair value of consideration 214 Fair value of net assets held (202 ) Increase in value of PPE (4 ) –––––– Goodwill 8 ––––––
Sale of equity interest in Fence Fair value of consideration received 80 Less (Net Assets per question at 30 November 2009 232 – provision created 25 + Fair value of PPE at acquisition 4 – depreciation of fair value adjustment 0·53 (4 x 16/12 x 1/10) x 25% (52·62 ) Goodwill (8 x 25%) (2 ) –––––– Gain on sale to the group 25·38 ––––––
Because a provisional fair value had been recognised and the valuation for the fi xed asset was received within 12 months of the date of the acquisition, the fair value of the net assets at acquisition is adjusted thus affecting goodwill.
At the date of acquisition the liability was a contingent liability and it was only events in the post acquisition period that has resulted in the liability crystallising. The contingent liability consolidation adjustment is reversed and a provision created accordingly. No adjustment will be made to goodwill arising on acquisition.
At acquisition 31 July 2008 Dr Retained earnings £30 million Cr Contingent liability £30 million
In the period to 30 November 2009 Dr Contingent Liability/provisions £5 million Cr Profi t or Loss £5 million
Working 3 Profi t and loss account reserve and other reserves Retained earnings £m Grange: Balance at 30 November 2009 410 Associate profi ts Sitin (post acquisition profi t 3 x 100%) 3 Loss on disposal of Sitin (2·8 ) Impairment (31 ) Provision for legal claims (7 ) Post acquisition reserves: Park (60% x (year end retained earnings 170 – acquisition profi t 115 – franchise amortisation 3)) 31·2 Fence (100% x (year end retained earnings 65 – acquisition retained earnings 73 + conversion of contingent liability and reduction 5 – FV PPE depreciation 0·53)) (3·53 ) Fence – profi t on sale 25·38 ––––––– 425·25 –––––––
13
Other reserves £m Balance at 30 November 2009 22 Post acqn reserves – Park (60% x (14 – 10)) 2·4 – Fence (17 – 9) 8 – Sitin (post acquisition) 1 Revaluation surplus – foreign property 4 Investment property – gain 2 ––––––– 39·4 –––––––
Working 4 Provisions £m Balance at 30 November 2009 Grange 10 Park 6 Fence 4 ––––––– 20 Contingency 30 Cancellation of contingency and introduction of provision (5 ) Provision for environmental claims 7 ––––––– 52 –––––––
Working 5 Minority Interest £m Park (20% of (414 + land 5 + franchise 7)) 85·2 Fence (W2) 52·62 ––––––– Total 137·82 –––––––
Working 6 Fixed assets £m £m Grange 251 Park 311 Fence 238 800 ––––– Increase in value of land – Park (360 – 230 – 115 – 10) 5 Investment property – reclassifi ed (6 ) Impairment – Grange (W9) (31 ) Increase in value of fi xed assets – Fence 4 Less: increased depreciation (4 x 16/12 ÷ 10) (0·53 ) Revaluation surplus – foreign property 4 ––––––– 775·47 –––––––
Working 7 The land should be classifi ed as an investment property. Although Grange has not decided what to do with the land, it is being
held for capital appreciation. SSAP 19 ‘Investment Property’ states that land held for investment potential is an investment property. The land will be measured at open market value. The fall in value of the investment property after the year-end will not affect its year-end valuation as the uncertainty relating to the regeneration occurred after the year-end.
Dr Investment property £6 million Cr Tangible assets £6 million
Dr Investment property £2 million Cr Other reserves £2 million No depreciation will be charged
Working 8 Provision for environmental claims The environmental obligations of £1 million and £6 million (total £7 million) arise from past events but the costs of £4 million
relating to the improvement of the manufacturing process relate to the company’s future operations and should not be provided for.
Dr Profi t and loss account £7 million Cr Provision £7 million
14
Working 9 Restructuring A provision for restructuring should not be recognised, as a constructive obligation does not exist. A constructive obligation
arises when an entity both has a detailed formal plan and makes an announcement of the plan to those affected. The events to date do not provide suffi cient detail that would permit recognition of a constructive obligation. Therefore no provision for reorganisation should be made and the costs and benefi ts of the plan should not be taken into account when determining the impairment loss. Any impairment loss can be allocated to non-current assets, as this is the area in which the directors feel that loss has occurred.
£m Carrying value of Grange’s net assets 862 Revaluation surplus 4 Provision for legal claims (7 ) Investment property 2 ––––– 861 Value-in-use (pre-restructuring) 830 ––––– Impairment to fi xed assets (31 ) –––––
Working 10 Foreign property £m Value at 30 November 2009 (12m dinars/1·5) 8 Value at acquisition 30 November 2008 4 ––––– Revaluation surplus to equity 4 ––––– Change in fair value (4m dinars at 1·5) 2·67 Exchange rate change 1·33 ––––– (8m dinars at 2 minus 12 million dinars at 1·5) 4 –––––
(c) Rules are a very important element of ethics. Usually this means focusing upon the rules contained in the accounting profession’s code of professional conduct and references to legislation and corporate codes of conduct. They are an effi cient means by which the accounting profession can communicate its expectations as to what behaviour is expected.
A view that equates ethical behaviour with compliance to professional rules could create a narrow perception of what ethical behaviour constitutes. Compliance with rules is not necessarily the same as ethical behaviour. Ethics and rules can be different. Ethical principles and values are used to judge the appropriateness of any rule.
Accountants should have the ability to conclude that a particular rule is inappropriate, unfair, or possibly unethical in any given circumstance. Rules are the starting point for any ethical question and rules are objective measures of ethical standards. In fact, rules are the value judgments as to what is right for accountants and refl ect the profession’s view about what constitutes good behaviour. Accountants who view ethical issues within this rigid framework are likely to suffer a moral crisis when encountering problems for which there is no readily apparent rule.
An overemphasis on ethical codes of behaviour tends to reinforce a perception of ethics as being punitive and does not promote the positive aspects of ethics that are designed to promote the reputation of an accounting fi rm and its clients, as well as standards within the profession. The resolution of ethical problems depends on the application of commonly shared ethical principles with appropriate skill and judgment. Ethical behaviour is based on universal principles and reasoned public debate and is diffi cult to capture in ‘rules’.
Accountants have to make accounting policy choices on a regular basis. Stakeholders rely on the information reported by accountants to make informed decisions about the entity at hand. All decisions require judgment, and judgment depends on personal values with the decision needing to be made on some basis such as following rules, obeying authority, caring for others, justice, or whether the choice is right. These values and several others compete as the criterion for making a choice. Such personal values incorporate ethical values that dictate whether any accounting value chosen is a good or poor surrogate for economic value. To maintain the faith of the public, accountants must be highly ethical in their work. The focus on independence (confl ict of interest) and associated compliance requirements may absorb considerable resources and conceptual space in relation to ethics in practice. This response is driven by a strong commitment within the fi rms to meet their statutory and regulatory obligations. The primary focus on Independence may have narrowed some fi rms’ appreciation of what constitutes broader ethical performance. As a result it may be that the increasing codifi cation and compliance focus on one or two key aspects of ethical behaviour may be in fact eroding or preventing a more holistic approach to enabling ethics in practice.
If the director tells Field about the liquidity problems of Brook, then a confi dence has been betrayed but there is a question of honesty if the true situation is not divulged. Another issue is whether the fi nancial director has a duty to several stakeholders including the shareholders and employees of Grange as if the information is disclosed about the poor liquidity position of Brook, then the amounts owing to Grange may not be paid. However, there may be a duty to disclose all the information to Field but if the information is deemed to be insider information then it should not be disclosed.
15
The fi nance director’s reputation and career may suffer if Brook goes into liquidation especially as he will be responsible for the amounts owing by Brook. Another issue is whether the friend of the director has the right to expect him to keep the information private and if the shareholders of Grange stand to lose as a result of not divulging the information. There may be an expectation that such information should be disclosed. Finally, should Field expect any credit information to be accurate or simply be a note of Brook’s credit history? Thus it can be seen that the ethical and moral dilemmas facing the director of Grange are not simply a matter of following rules but are a complex mix of issues concerning trust, duty of care, insider information, confi dentiality and morality.
2 (a) FRS 11 ‘Impairment of fi xed assets and goodwill’ states that an asset is impaired when its carrying amount will not be recovered from its continuing use or from its sale. An entity must determine at each reporting date whether there is any indication that an asset is impaired. If an indicator of impairment exists then the asset’s recoverable amount must be determined and compared with its carrying amount to assess the amount of any impairment. Accounting for the impairment of fi xed assets can be diffi cult as FRS 11 is a complex accounting standard. The turbulence in the markets and signs of economic downturn will cause many companies to revisit their business plans and revise fi nancial forecasts. As a result of these changes, there may be signifi cant impairment charges. Indicators of impairment may arise from either the external environment in which the entity operates or from within the entity’s own operating environment. Thus the current economic downturn is an obvious indicator of impairment, which may cause the entity to experience signifi cant impairment charges.
Assets should be tested for impairment at as low a level as possible, at individual asset level where possible. However, many assets do not generate cash infl ows independently from other assets and such assets will usually be tested within the income-generating unit (IGU) to which the asset belongs. Cash fl ow projections should be based on reasonable assumptions that represent management’s best estimate of the range of economic conditions that will exist over the remaining useful life of the asset. The discount rate used is the rate which refl ects the specifi c risks of the asset or IGU.
The basic principle is that an asset may not be carried in the balance sheet at more than its recoverable amount. An asset’s recoverable amount is the higher of:
(a) the amount for which the asset could be sold in an arm’s length transaction between knowledgeable and willing parties, net of costs of disposal (fair value less costs to sell); and
(b) the present value of the future cash fl ows that are expected to be derived from the asset (value in use). The expected future cash fl ows include those from the asset’s continued use in the business and those from its ultimate disposal. Value in use (VIU) is explicitly based on present value calculations.
This measurement basis refl ects the economic decisions that a company’s management team makes when assets become impaired from the viewpoint of whether the business is better off disposing of the asset or continuing to use it. The assumptions used in arriving at the recoverable amount need to be ‘reasonable and supportable’ regardless of whether impairment calculations are based on fair value less costs to sell or value in use. The acceptable range for such assumptions will change over time and forecasts for revenue growth and profi t margins are likely to have fallen in the economic climate. The assumptions made by management should be in line with the assumptions made by industry commentators or analysts. Variances from market will need to be justifi ed and highlighted in fi nancial statement disclosures. Whatever method is used to calculate the recoverable amount; the value needs to be considered in the light of available market evidence. If other entities in the same sector are taking impairment charges, the absence of an impairment charge has to be justifi ed because the market will be asking the same question. It is important to inform the market about how it is dealing with the conditions, and be thinking about how different parts of the business are affected, and the market inputs they use in impairment testing. Impairment testing should be commenced as soon as possible as an impairment test process takes a signifi cant amount of time. It includes identifying impairment indicators, assessing or reassessing the cash fl ows, determining the discount rates, testing the reasonableness of the assumptions and benchmarking the assumptions with the market. Goodwill does not have to be tested for impairment at the year-end; it can be tested earlier and if any impairment indicator arises at the balance sheet date, the impairment assessment can be updated. Also it is important to comply with all disclosure requirements such as the discount rate and long-term growth rate assumptions in a discounted cash fl ow model and describe what the key assumptions are and what they are based on.
It is important that the cash fl ows being tested are consistent with the assets being tested. The forecast cash fl ows should make allowance for investment in working capital if the business is expected to grow. When the detailed calculations have been completed, the company should check that their conclusions make sense by comparison to any market data such as share prices and analysts reports. Market capitalisation below net asset value is an impairment indicator, and calculations of recoverable amount are required. If the market capitalisation is lower than a value-in-use calculation, then the VIU assumptions may require reassessment. For example, the cash fl ow projections might not be as expected by the market, and the reasons for this must be scrutinised. Discount rates should be scrutinised in order to see if they are logical. Discount rates may have risen too as risk premiums rise. Many factors affect discount rates in impairment calculations. These include corporate lending rates, cost of capital and risks associated with cash fl ows, which are all increasing in the current volatile environment and can potentially result in an increase of the discount rate.
16
(b) An asset’s carrying amount may not be recovered from future business activity. Wherever indicators of impairment exist, a review for impairment should be carried out. Where impairment is identifi ed, a write-down of the carrying value to the recoverable amount should be charged as an immediate expense in the income statement. Using a discount rate of 5%, the value in use of the non-current assets is:
Year to 31 May 2010 31 May 2011 31 May 2012 31 May 2013 Total Discounted cash fl ows (£000) 267 408 431 452 1,558
The carrying value of the non-current assets at 31 May 2009 is £3 million – depreciation of £600,000. i.e. £2·4 million. Therefore the assets are impaired by £842,000 (£2·4m – £1·558m).
FRS 11 requires an assessment at each balance sheet date whether there is an indication that an impairment loss may have decreased. This does not apply to goodwill. FRS 11 states that increase in value in use should not be recognised if they arise from the unwinding of the discount or the occurrence of forecast cash fl ows. In this case, the increase in value will be due to the unwinding of the discount and the increase in the cash fl ows used in the calculation. Compensation received in the form of reimbursements from governmental indemnities is recorded in the profi t and loss account when the compensation becomes receivable. It is treated as a separate economic event and accounted for as such. At this time the government has only stated that it may reimburse the company and therefore credit should not be taken for any potential government receipt.
For a revalued asset, FRS 11 distinguishes two types of impairment. These are impairments arising from a clear consumption of economic benefi ts and other impairments of revalued fi xed assets. The former should be recognised in the profi t and loss account as it is effectively depreciation whilst other impairments should be recognised in the statement of total recognised gains and losses (STRGL) until the carrying amount reaches depreciated historical cost. Any balance of the loss is then treated as an expense in the profi t and loss account. This latter category is intended to cover impairments caused by a general fall in prices such as would occur in the present economic climate experienced by the company. Thus the revaluation gain and the impairment loss would be treated as follows:
Depreciated historical cost (£m) Revalued carrying value (£m) 1 December 2006 10 10 Depreciation (2 years) (2 ) (2 ) Revaluation 0·8 –––– –––– 1 December 2008 8 8·8 –––– –––– Depreciation (1 ) (1·1 ) Impairment loss (1·5 ) (2·2 ) –––– –––– 30 November 2009 after impairment loss 5·5 5·5 –––– ––––
The impairment loss of £2·2 million is charged to equity until the carrying amount reaches depreciated historical cost and thereafter it goes to profi t or loss. It is assumed that the company will transfer an amount from revaluation surplus to retained earnings to cover the excess depreciation of £0·1 million as allowed by company law. Therefore the impairment loss charged to STRGL would be £(0·8 – 0·1) million i.e. £0·7 million and the remainder of £1·5 million would be charged to profi t or loss.
A plan by management to dispose of an asset or group of assets due to underperformance could be deemed to be an indicator of impairment. Where a decision is made to sell a subsidiary, the amounts expected to be received would provide a basis for measuring the recoverable amount of the entity. It seems that the subsidiary’s assets are impaired because their carrying amount is not recoverable from the proceeds of sale. FRS 3 ‘Reporting Financial Performance’ and FRS 12 ‘Provisions,
Contingent Liabilities and Contingent Assets’ prohibit recognition of provisions for liabilities in respect of sales or terminations of businesses until there is a binding sale contract or constructive obligation. Provisions do not include amounts written off fi xed assets and both FRS 3 and FRS 12 refer to the need to review assets for impairment before any provisions are recognised. Thus an impairment loss of £5 million (£17m + £3m – £15m) should be recognised as soon as a disposal is envisaged. The impairment loss would be allocated fi rst to write off goodwill of £3 million and then to write down the subsidiary’s fi xed assets by £2 million.
3 (i) The basic principle of revenue recognition is that a seller should recognise revenue when it obtains the right to consideration in exchange for performance (FRS 5 Application Note G). Revenue should be measured at the fair value of the consideration. Burley should recognise a purchase from Slite for the amount of the excess amount extracted (10,000 barrels x £100). The substance of the transaction is that Slite has sold the oil to Burley at the point of production at market value at that time. Burley should recognise all of the oil it has sold to the third parties as revenue including that purchased from Slite as the criteria above are met. The amount payable to Slite will change with movements in the oil price. The balance at the year-end is a fi nancial liability, which should refl ect the best estimate of the amount of cash payable, which at the year-end would be £1,050,000. The best estimate will be based in the price of oil on 30 November 2009. At the year end there will be an expense of £50,000 as the liability will have increased from £1 million. The amount payable will be revised after the year-end to refl ect changes in the price of oil and would have amounted to £950,000. Thus giving a gain of £100,000 to profi t or loss in the following accounting period.
Events after the balance sheet date are events, which could be favourable or unfavourable and occur between the end of the reporting period and the date that the fi nancial statements are authorised for issue. [FRS 21 Para 3]
An adjusting event is an event after the reporting period that provides further evidence of conditions that existed at the end of the reporting period, including an event that indicates that the going concern assumption in relation to the whole part or part
17
of the enterprise is not appropriate. A non-adjusting event is an event after the reporting period that is indicative of a condition that arose after the end of the reporting period. [FRS 21 Para 3]
Stock is required to be stated at the lower of cost and net realisable value (NRV). NRV is the estimated selling price in the ordinary course of business, less the estimated cost of completion and the estimated costs necessary to make the sale. Any write-down to NRV should be recognised as an expense in the period in which the write-down occurs. Estimates of NRV are based on the most reliable evidence available at the time the estimates are made. These estimates consider fl uctuations in price directly relating to events occurring after the end of the fi nancial period to the extent that they confi rm conditions at the end of the accounting period.
Burley should calculate NRV by reference to the market price of oil at the balance sheet date. The price of oil changes frequently in response to many factors and therefore changes in the market price since the balance sheet date refl ect events since that date. These represent non-adjusting events therefore the decline in the price of oil since the date of the fi nancial statements will not be adjusted in those statements. The stock will be valued at cost of £98 per barrel as this is lower than NRV of £(105 – 2) i.e. £103 at the year-end.
Workings 1 DR (£) CR (£) Purchases/Stock (10,000 x 100) 1m Slite – fi nancial liability 1m At year end Expense 50,000 Slite – fi nancial liability (10,000 x £(105 – 100)) 50,000 After year end Slite – Financial liability (10,000 x £(105 – 95) 100,000 Profi t and loss account 100,000 Cash paid to Slite is £950,000 on 12 December 2009
(ii) FRS 9 ‘Associates and Joint Ventures’ states that a joint venture is:
An entity in which the reporting entity holds an interest on a long-term basis and is jointly controlled by the reporting entity and one or more other venturers under a contractual arrangement.
Joint control is present where none of the entities alone can control that entity but all together can do so and decisions on fi nancial and operating policy essential to the activities, economic performance and fi nancial position of that venture require each venturer’s consent. Joint control implies that each venturer should play an active role in setting the operating and fi nancial policies of the joint venture, at least at general strategy level. The effect of this requirement is that each venturer has a veto on high-level strategic decisions. A joint venture must be a separate entity actually carrying on a business of its own. Where this is not the case, it is a joint arrangement that is not an entity. Accounting for joint ventures in the consolidated fi nancial statements joint ventures should be included under the gross equity method.
Thus Burley cannot use the gross equity method, as Wells is not jointly controlled. A decision can be made by gaining the approval of two thirds of the venturers and not by unanimous agreement. Two out of the three venturers can make the decision. Thus each investor must account for their interest in the entity as an associate since they have signifi cant infl uence but not control. Equity accounting will be used.
One of the key differences between decommissioning costs and other costs of acquisition is the timing of costs. Decommissioning costs will not become payable until some future date. Consequently, there is likely to be uncertainty over the amount of costs that will be incurred. Management should record its best estimate of the entity’s obligations.
Discounting is used to address the impact of the delayed cash fl ows. The amount capitalised, as part of the assets will be the amount estimated to be paid, discounted to the date of initial recognition. The related credit is recognised in provisions. The entity would record changes in the existing liability due to changes in discount rate and these changes are added to, or deducted from, the cost of the related asset in the current period.
Thus in the case of Wells, the accounting for the decommissioning is as follows.
The carrying amount of the asset will be £m Carrying amount at 1 December 2008 (240 – depreciation 60 – 14·1 decrease In decommissioning costs) 165·9 Less depreciation 165·9 ÷ 30 years (5·5) ––––– Carrying amount at 30 November 2009 160·4 ––––– Finance cost (£32·6 million – £14·1 million) at 7% 1·3 Decommissioning liability will be (£32·6m – £14·1m) 18·5 ––––– Decommissioning liability at 30 November 2009 19·8 –––––
A ‘joint arrangement’ that is not an entity is defi ned by FRS 9 as a contractual arrangement under which the participants engage in joint activities that do not create an entity because it would not be carrying on a trade or business of its own. Thus cost sharing or risk taking arrangements are joint arrangements and the standard gives shared production facilities as an example of a joint arrangement. Thus the pipeline is an example of a joint arrangement.
18
FRS 9 requires that the venturer should recognise in its fi nancial statements its share of the joint assets, liabilities and cash fl ows, measured according to the terms of the agreement. Therefore Burley should not show the asset as an investment but as fi xed assets. Any joint liabilities or expenses incurred should be shown also.
(iii) An asset is a right or other access to future economic benefi ts controlled by an entity as a result of past transactions or events (Statement of Principles). An asset should be recognised when there is suffi cient evidence that there has been a change in assets or liabilities, which can be measured with suffi cient reliability.
FRS 10 ‘Goodwill and Intangible assets’ defi nes intangible assets as ‘non-fi nancial fi xed assets that do not have physical substance but are identifi able and are controlled by the entity through custody or legal rights’. Separability is a key element of the defi nition of an intangible asset. Some intangibles are more clearly separable than others but determining where this point lies is quite subjective. Another component is control. FRS 5 defi nes control as the ability to obtain future economic benefi ts relating to an asset and to restrict the access of others to those benefi ts. In the context of intangible assets, FRS 10 states that control must be exercised through custody or legal rights. Thus in the case of the licence, control is exercised by legal rights that restrict the access of others.
Thus the licence can be capitalised at cost and amortised. If the exploration of the area does not lead to the discovery of oil, and activities are discontinued in the area, then an impairment test will be performed.
4 (a) (i) Financial instruments can be measured under FRS in a variety of ways. For example fi nancial assets utilise the equity method for associates, fair value with gains and losses in earnings, fair value with gains and losses in equity until realised. Financial liabilities can also utilise different measurement methods including fair value with gains and losses in earnings and amortised cost. The measurement methods used under FRS sometimes portray an estimate of current value and others portray original cost. Some of the measurements include the effect of impairment losses, which are recognised differently under FRS. For example fi nancial assets at fair value through profi t/loss (FVTPL) recognise changes in value in earnings, whilst those classifi ed as ‘available for sale’ are measured at fair value with changes in equity except for those impairments that are required to be reported in earnings.
The above can result in two identical instruments being measured differently by the same entity because management’s intentions for realising the value of the instrument may determine the way it is measured (FVTPL compared to held to maturity investments). Management also has the option of valuing a fi nancial instrument at fair value or at amortised cost (‘available for sale’ compared to ‘loans and receivables’). Also the percentage of the ownership interest acquired will determine how the holding is accounted for (associate – equity method, subsidiary acquisition method).
The different ways in which fi nancial instruments can be measured creates problems for preparers and users of fi nancial statements because of the following:
(a) The criteria for deciding which instrument can be measured in a certain way are complex and diffi cult to apply. It is sometimes diffi cult to determine whether an instrument is equity or a liability and the criteria can be applied in different ways as new types of instruments are created.
(b) Management can choose how to account for an instrument or can be forced into a treatment that they would have preferred to avoid. For example if there is no proper documentation of the risk management or investment strategy then the FVTPL category may not be available for use and the default category of ‘available for sale’ may have to be utilised.
(c) Different gains or losses resulting from different measurement methods may be combined in the same line item in the profi t and loss account.
(d) It is not always apparent which measurement principle has been applied to which instrument and what the implications are of the difference. Comparability is affected and the interpretation of fi nancial statements is diffi cult and time consuming.
(ii) There are several approaches that can be taken to solve the measurement and related problems. There is pressure to develop standards, which are principle-based and less complex. A long-term solution is to measure all fi nancial instruments using a single measurement principle thus making reported information easier to understand and allowing comparisons between entities and periods. If fair value was used for all types of fi nancial instrument then:
(a) There would be no need to ‘classify’ fi nancial instruments (b) There would be no requirement to report how impairment losses have been quantifi ed. (c) There would be no need for rules as regards transfers between measurement categories (d) There would be no measurement mismatches between fi nancial instruments and the need for fair value hedge
accounting would be reduced (e) Identifi cation and separation of embedded derivatives would not be required (this may be required for non-fi nancial
instruments) (f) A single measurement method would eliminate the confusion about which method was being used for different types
of fi nancial instruments (g) Entities with comparable credit ratings and obligations will report liabilities at comparable amounts even if borrowings
occurred at different times at different interest rates. The reverse is true also. Different credit ratings and obligations will result in the reporting of different liabilities
(h) Fair value would better refl ect the cash fl ows that would be paid if liabilities were transferred at the re-measurement date
19
Fair value would result in an entity reporting the same measure for security payment obligations with identical cash fl ow amounts and timing. At present different amounts are likely to be reported if the two obligations were incurred at different times if market interest rates change.
There is uncertainty inherent in all estimates and fair value measurements, and there is the risk that fi nancial statements will be seen as more arbitrary with fair value because management has even more ability to affect the fi nancial statements. Accountants need to be trained to recognise biases with respect to accounting estimates and fair value measurements so they can advise entities. It is important to demonstrate consistency in how an entity has applied the fair value principles and developed valuations to ensure credibility with investors, lenders and auditors. Although entities may select which assets and liabilities they wish to value under FRS 26, outside parties will be looking for consistency in how the standard was applied. Circumstances and market conditions change. Markets may become illiquid and the predicative models may not provide an ongoing advantage for the entity.
(b) Using amortised cost, both fi nancial liabilities will result in single payments, which are almost identical at the same point in time in the future (£59·9 million). (£47m x 1·05 for 5 years and £45m x 1·074 for 4 years). However, the carrying amounts at 30 November 2009 would be different. The initial loan would be carried at £47 million plus interest of £2·35 million, i.e. £49·35 million, whilst the new loan would be carried at £45 million even though the obligation at 30 November 2013 would be approximately the same. If the two loans were carried at fair value, then the initial loan would be carried at £45 million thus showing a net profi t of £2 million (interest expense of £2·35 million and unrealised gain of £4·35 million).
21
Professional Level – Essentials Module, Paper P2 (UK)
Corporate Reporting (United Kingdom) December 2009 Marking Scheme
Marks1 (a) Fair value of consideration 1 Fair value of residual interest 1 Gain reported in comprehensive income 1 Net assets 1 Goodwill 2 ––– 6 –––
(b) Fixed assets 6 Investment property 2 Goodwill 3 Profi t and loss reserve 8 Other reserves 5 Minority interest 2 Creditors 1 Provisions for liabilities 3 Intangible assets 2 Current assets 1 Investment in Associate 2 ––– 35 –––
(c) Subjective up to 7 Professional marks 2 ––– 50 –––
2 (a) Impairment process 4 General considerations 4 Professional marks 2
(b) Fixed asset at cost 6 Fixed asset at valuation 6 Subsidiary intention to dispose 3 ––– 25 –––
3 Revenue recognition 4 Stock 3 Events after reporting period 2 Joint venture 3 Accounting for entity 2 Decommissioning 5 Asset defi nition FRS 10/FRS 5 4 Professional marks 2 ––– 25 –––
Time allowedReading and planning: 15 minutesWriting: 3 hours
This paper is divided into two sections:
Section A – This ONE question is compulsory and MUST be attempted
Section B – TWO questions ONLY to be attempted
Do NOT open this paper until instructed by the supervisor.
During reading and planning time only the question paper may be annotated. You must NOT write in your answer booklet untilinstructed by the supervisor.
This question paper must not be removed from the examination hall.
Pape
r P2 (
UK
)
Corporate Reporting(United Kingdom)
Tuesday 14 December 2010
The Association of Chartered Certified Accountants
Section A – This ONE question is compulsory and MUST be attempted
1 The following draft group financial statements relate to Jocatt, a public limited company:
Jocatt Group: Profit and Loss Account for the year ended 30 November 2010
£mTurnover 432Cost of sales (317)
––––––Gross profit 115Other income 25Distribution costs (55·5)Administrative expenses (36)Interest paid (6)Gains on property 9Share of profit of associate 6
––––––Profit on ordinary activities before tax 57·5Tax on ordinary activities (11)
––––––––––––Profit for the year on ordinary activities 46·5Minority interest (10)
––––––Profit for year 36·5
––––––
Statement of group total recognised gains and losses for the year ended 30 November 2010 (after tax)
Profit for financial year 36·5Gain on available-for-sale financial assets (AFS) 2Losses on property revaluation (7)Investment property gain 1·5Actuarial losses on defined benefit plan (6)
––––––Total recognised gains and losses for the year 27
––––––––––––
Reconciliation of movements in group shareholders’ funds for year ended 30 November 2010
£mProfit for the financial year 36·5Dividends (5)Other recognised gains and losses for the year (above) (9·5)Proceeds of ordinary shares for cash 15
––––––Net addition to shareholders’ funds 37Shareholders’ funds at 30 November 2009 619
––––––Shareholders’ funds at 30 November 2010 656
––––––
The following information relates to the financial statements of Jocatt:
(i) On 1 December 2008, Jocatt acquired 8% of the ordinary shares of Tigret. Jocatt had treated this investmentas available-for-sale in the financial statements to 30 November 2009. On 1 December 2009, Jocatt acquireda further 52% of the ordinary shares of Tigret and gained control of the company. The consideration for theacquisitions was as follows:
Holding Consideration£m
1 December 2008 8% 51 December 2009 52% 32·6
––––– –––—60% 37·6
––––– –––—
3 [P.T.O.
At 1 December 2009, the fair value of the 8% holding in Tigret held by Jocatt at the time of the businesscombination was £6 million. No gain or loss on the 8% holding in Tigret had been reported in the financialstatements at 1 December 2009. The purchase consideration at 1 December 2009 comprised cash of £17·6 million and shares of £15 million.
The fair value of the identifiable net assets of Tigret, excluding deferred tax assets and liabilities, at the date ofacquisition comprised the following:
The tax written down value of the identifiable net assets of Tigret was £40 million at 1 December 2009. Thetax rate of Tigret is 30%.
(ii) On 30 November 2010, Tigret made a rights issue on a 1 for 4 basis. The issue was fully subscribed and raised£5 million in cash.
(iii) Jocatt purchased a research project from a third party including certain patents on 1 December 2009 for £8 million and recognised it as an intangible asset. During the year, Jocatt incurred further costs, whichincluded £2 million on completing the research phase, £4 million in developing the product for sale and £1 million for the initial marketing costs. There were no other additions to intangible assets in the period otherthan those on the acquisition of Tigret.
(iv) Jocatt operates a defined benefit scheme. The current service costs for the year ended 30 November 2010 are£10 million. Jocatt enhanced the benefits on 1 December 2009 at a cost of £2 million. These benefits vestimmediately. The expected return on plan assets was £8 million for the year.
(v) Jocatt owns an investment property. During the year, part of the heating system of the property, which had acarrying value of £0·5 million, was replaced by a new system, which cost £1 million.
(vi) Jocatt had exchanged surplus land with a carrying value of £10 million for cash of £15 million and plant valuedat £4 million. The transaction has commercial substance. Depreciation for the period for tangible fixed assetswas £27 million.
(vii) Goodwill relating to subsidiaries is not amortised but had been impairment tested in the year to 30 November2010 and any impairment accounted for.
(viii) Deferred tax of £1 million arose on the gains on available-for-sale investments in the year.
(ix) The associate did not pay any dividends in the year.
(x) The movement on the profit and loss reserve and other reserves was as follows:
Profit/loss Other reservereserves
£m £mOpening balance at 1 December 2009 324 20Profit for financial year 36·5Available-for-sale financial asset – net gain 2Losses on property revaluation (7)Dividends paid (5)Actuarial loss on defined benefit scheme (6)Gain on investment property 1·5
–––––– ––––Closing balance at 30 November 2010 349·5 16·5
–––––– ––––
4
Required:
(a) Prepare a group cash flow statement for the Jocatt Group using the indirect method under FRS 1 Cash flowstatements.
Note: Ignore deferred taxation other than where it is mentioned in the question. (35 marks)
(b) Jocatt operates in the energy industry and undertakes complex natural gas trading arrangements, which involveexchanges in resources with other companies in the industry. Jocatt is entering into a long-term contract for thesupply of gas and is raising a loan on the strength of this contract. The proceeds of the loan are to be receivedover the year to 30 November 2011 and are to be repaid over four years to 30 November 2015. Jocatt wishesto report the proceeds as operating cash flow because it is related to a long-term purchase contract. The directorsof Jocatt receive extra income if the operating cash flow exceeds a predetermined target for the year and feel thatthe indirect method is more useful and informative to users of financial statements than the direct method.
(i) Comment on the directors’ view that the indirect method of preparing cash flow statements is moreuseful and informative to users than the direct method. (7 marks)
(ii) Discuss the reasons why the directors may wish to report the loan proceeds as an operating cash flowrather than a financing cash flow and whether there are any ethical implications of adopting thistreatment. (6 marks)
Professional marks will be awarded in part (b) for the clarity and quality of discussion. (2 marks)
(50 marks)
5 [P.T.O.
Section B – TWO questions ONLY to be attempted
2 Margie, a public limited company, has entered into several share related transactions during the period and wishes toobtain advice on how to account for the transactions.
(a) Margie has entered into a contract with a producer to purchase 350 tonnes of wheat. The purchase price will besettled in cash at an amount equal to the value of 2,500 of Margie’s shares. Margie may settle the contract atany time by paying the producer an amount equal to the current market value of 2,500 of Margie shares, lessthe market value of 350 tonnes of wheat. Margie has entered into the contract as part of its hedging strategy andhas no intention of taking physical delivery of the wheat. Margie wishes to treat this transaction as a share basedpayment transaction under FRS 20 Share-based payment. (7 marks)
(b) Margie has acquired 100% of the share capital of Antalya in a business combination on 1 December 2009.Antalya had previously granted a share-based payment to its employees with a four-year vesting period. Itsemployees have rendered the required service for the award at the acquisition date but have not yet exercisedtheir options. The fair value of the award at 1 December 2009 is £20 million and Margie is obliged to replacethe share-based payment awards of Antalya with awards of its own.
Margie issues a replacement award that does not require post-combination services. The fair value of thereplacement award at the acquisition date is £22 million. Margie does not know how to account for the awardon the acquisition of Antalya. (6 marks)
(c) Margie issued shares during the financial year. Some of those shares were subscribed for by employees who wereexisting shareholders, and some were issued to an entity, Grief, which owned 5% of Margie’s share capital.Before the shares were issued, Margie offered to buy a building from Grief and agreed that the purchase pricewould be settled by the issue of shares. Margie wondered whether these transactions should be accounted forunder FRS 20. (4 marks)
(d) Margie granted 100 options to each of its 4,000 employees at a fair value of £10 each on 1 December 2007.The options vest upon the company’s share price reaching £15, provided the employee has remained in thecompany’s service until that time. The terms and conditions of the options are that the market condition can bemet in either year three, four or five of the employee’s service.
At the grant date, Margie estimated that the expected vesting period would be four years which is consistent withthe assumptions used in estimating the fair value of the options granted. The company’s share price reached £15on 30 November 2010. (6 marks)
Required:
Discuss, with suitable computations where applicable, how the above transactions would be dealt with in thefinancial statements of Margie for the year ending 30 November 2010.
Professional marks will be awarded in question 2 for the clarity and quality of discussion. (2 marks)
(25 marks)
6
3 (a) Greenie, a public limited company, builds, develops and operates airports. During the financial year to 30 November 2010, a section of an airport collapsed and, as a result, several people were hurt. The accidentresulted in the closure of the terminal and legal action against Greenie. When the financial statements for theyear ended 30 November 2010 were being prepared, the investigation into the accident and the reconstructionof the section of the airport damaged were still in progress and no legal action had yet been brought in connectionwith the accident. The expert report that was to be presented to the civil courts in order to determine the causeof the accident and to assess the respective responsibilities of the various parties involved, was expected in 2011.
Financial damages arising related to the additional costs and operating losses relating to the unavailability of thebuilding. The nature and extent of the damages, and the details of any compensation payments had yet to beestablished. The directors of Greenie felt that at present, there was no requirement to record the impact of theaccident in the financial statements.
Compensation agreements had been arranged with the victims, and these claims were all covered by Greenie’sinsurance policy. In each case, compensation paid by the insurance company was subject to a waiver of anyjudicial proceedings against Greenie and its insurers. If any compensation is eventually payable to third parties,this is expected to be covered by the insurance policies.
The directors of Greenie felt that the conditions for recognising a provision or disclosing a contingent liability hadnot been met. Therefore Greenie did not recognise a provision in respect of the accident nor did it disclose anyrelated contingent liability or a note setting out the nature of the accident and potential claims in its financialstatements for the year ended 30 November 2010. (6 marks)
(b) Greenie was one of three shareholders in a regional airport Manair. As at 30 November 2010, the majorityshareholder held 60·1% of voting shares, the second shareholder held 20% of voting shares and Greenie held19·9% of voting shares. The board of directors consisted of ten members. The majority shareholder wasrepresented by six of the board members, while Greenie and the other shareholder were represented by twomembers each. A shareholders’ agreement stated that certain board and shareholder resolutions required eitherunanimous or majority decision. There is no indication that the majority shareholder and the other shareholdersact together in a common way. During the financial year, Greenie had provided Manair with maintenance andtechnical services and had sold the entity a software licence for £5 million. Additionally, Greenie had sent a teamof management experts to give business advice to the board of Manair. Greenie did not account for its investmentin Manair as an associate, because of a lack of significant influence over the entity. Greenie felt that the majorityowner of Manair used its influence as the parent to control and govern its subsidiary. (10 marks)
(c) Greenie has issued 1 million shares of £1 nominal value for the acquisition of franchise rights at a local airport.Similar franchise rights are sold in cash transactions on a regular basis and Greenie has been offered a similarfranchise right at another airport for £2·3 million. This price is consistent with other prices given the marketconditions. The share price of Greenie was £2·50 at the date of the transaction. Greenie wishes to record thetransaction at the nominal value of the shares issued.
Greenie also showed irredeemable preference shares as equity instruments in its balance sheet. The terms ofissue of the instruments give the holders a contractual right to an annual fixed cash dividend and the entitlementto a participating dividend based on any dividends paid on ordinary shares. Greenie felt that the presentation ofthe preference shares with a liability component in compliance with FRS 25 Financial instruments: presentationwould be so misleading in the circumstances that it would conflict with the objective of financial statements setout in the ASB’s ‘Statement of Principles’. The reason given by Greenie for this presentation was that the sharesparticipated in future profits and thus had the characteristics of permanent capital because of the profitparticipation element of the shares. (7 marks)
Required:
Discuss how the above financial transactions should be dealt with in the financial statements of Greenie for theyear ended 30 November 2010.
Professional marks will be awarded in question 3 for the clarity and quality of discussion. (2 marks)
(25 marks)
7 [P.T.O.
4 (a) The principal aim when developing accounting standards for small to medium-sized enterprises (SMEs) is toprovide a framework that generates relevant, reliable, and useful information which should provide a high qualityand understandable set of accounting standards suitable for SMEs. There is no universally agreed definition ofan SME and it is difficult for a single definition to capture all the dimensions of a small or medium-sized business.The main argument for separate SME accounting standards is the undue cost burden of reporting, which isproportionately heavier for smaller firms.
Required:
(i) Discuss the different approaches, principles and considerations which should be taken into account indeveloping an accounting standard for SMEs. (6 marks)
(ii) Evaluate the main arguments for separate SME accounting standards and discuss whether an entity’ssize is the ideal criterion for defining an SME. (7 marks)
Professional marks will be awarded for the clarity and quality of discussion. (2 marks)
(b) Havata is a small entity that adopts UK GAAP. Havata has had considerable growth over the last few years andis looking to obtain a listing on the Stock Exchange. It realises that the financial statements will have to complywith International Financial Reporting Standards (IFRS). The directors would like advice on how to account forthe following two transactions taking into account that it wishes to gain a Stock Exchange listing.
(i) Havata has a non-specialised property and has a policy of revaluation. The revalued cost and associatedaccumulated depreciation as at 1 November 2009 were £16 million (£2 million land and £14 millionbuildings) and £1·5 million respectively. Buildings have an original useful life of 50 years.
Havata operates in fiercely competitive conditions as the industry is in temporary decline. Havata’s directorshave obtained the following valuations from an independent surveyor.
Land Buildings£m £m
Open market value 1·5 8·5Value in use 1·5 9·2Existing use value 1·5 7·8
If Havata decides to sell the property it would incur selling costs of 2·5%. IFRS treatment of this property inthis instance is that a property shall not be carried at more than recoverable amount which is effectively thehigher of an asset’s net selling price and its value in use. Ignore the impact of deferred taxation. (5 marks)
(ii) IFRS requires investment property to be measured at fair value with gains on fair value reported in profit orloss or on a ‘cost’ basis similar to that in FRS 15 Tangible fixed assets. Fair value is defined as the price atwhich the property can be exchanged between knowledgeable, willing parties in an arm’s length transaction.This generally means the highest and best value that can be gained for the asset.
The company owns an investment property which comprises land and an old hotel. The company currentlyadopts SSAP 19 Investment Property. The property was purchased on 1 December 2009 for £9 million(land £8·7 million and building £0·3 million). Properties of this type were deemed to have a useful life of50 years. The carrying value of the property at market value at 30 November 2010 is £10 million (landvaluation £9·5 million, building £0·5 million). The company could sell the land for redevelopment forhousing for £15 million and this would involve demolishing the hotel. Alternatively, Harvata could demolishthe hotel itself at a cost of £200,000 and sell it for £15·1 million. Under IFRS deferred tax is provided onrevaluation gains. The tax rate applicable to Havata is 30%. (5 marks)
Required:
Discuss the accounting implications of Havata using UK GAAP rather than IFRS in the financial statementsfor the year ended 30 November 2010.
(25 marks)
End of Question Paper
8
Answers
Professional Level – Essentials Module, Paper P2 (UK)Corporate Reporting (United Kingdom) December 2010 Answers
1 (a) Jocatt GroupCash Flow Statement for the year ended 30 November 2010
£m £mCash flow from operating activities (note 1) 289·5Returns on investment and servicing of finance (note 2) (16·4)Taxation (w (iv)) (16·5)Capital expenditure and financial investment (note 3) (102)Acquisitions and disposals (note 4) (58·6)Equity dividends paid (5)
––––––Cash inflow before use of liquid resources and financing 91Financing:Repayment of long-term loan (4)Rights issue minority interest 2
(2)––––––
Net increase in cash in period 89––––––
Notes
1 Cashflow from operating activities:
£m £mOperating profit (57·5 – 6 – 9 + 6) 48·5Adjustments to operating activities:Retirement benefit expense (working (vii)) 4Depreciation on fixed assets 27Loss on replacement of investment property component part (working (viii)) 0·5Amortisation of intangible assets (working (ix)) 17Impairment of goodwill (working (i)) 31·5Cash paid to retirement benefit scheme (working (vii)) (7)Decrease in debtors (113 – 62 + 5) 56Decrease in stocks (128 – 105) 23Increase in creditors (144 – 55) 89
£mPurchase of fixed assets (working (vi)) (98)Additions – investment property (working (viii)) (1)Proceeds from sale of land (working (vi)) 15Intangible assets (working (ix)) (12)Purchases of AFS investments (working (x)) (6)
–––––(102)–––––
4 Acquisitions and disposals
Purchase of associate (working (iii)) (48)Purchase of subsidiary (17·6 – 7) (working (ii)) (10·6)
––––––(58·6)
––––––
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Workings
(i) Tigret goodwill
£m1 December 2009 – consideration 32·6Cost of equity interest held before business combination 5
––––––Purchase consideration 37·6Identifiable net assets (45 x 60%) (27)Deferred tax (45 – 40) x 30% x 60% 0·9
––––––Goodwill 11·5
––––––
Therefore goodwill is impaired by £68m plus £11·5m minus £48m i.e. £31·5m
(ii) Purchase of subsidiary
The purchase of the subsidiary is adjusted for in the cash flow statement by eliminating the assets acquired, as theywere not included in the opening balances. The effect of the purchase is as follows:
Dr (£m) Cr (£m)Fixed assets 15Intangible assets 18Debtors 5Cash 7Goodwill 11·5AFS investments 5Share capital 15Cash 17·6MI (net assets 45 – deferred tax 1·5 x 40%) 17·4Deferred tax 1·5
––––– –––––56·5 56·5
––––– –––––
(iii) Associate
£mOpening balance at 1 December 2009 NilProfit for period 6Cost of acquisition (cash) 48
–––Closing balance at 30 November 2010 54
–––
(iv) Taxation
£m £mOpening tax balances at 1 December 2009:Deferred tax 41Current tax 30
–––71
Deferred tax on acquisition 1·5Charge for year (11 + 1) 12Less closing tax balances at 30 November 2010:Deferred tax 35Current tax 33
–––(68)–––––
Cash paid 16·5–––––
The tax charge on the AFS financial asset gain (£1m) is adjusted on the tax charge for the year.
(v) Minority Interest
£mOpening balance at 1 December 2009 36On acquisition 17·4Current year amount 10Dividend paid (10·4)Rights issue (5 x 40%) 2
–––Closing balance at 30 November 2010 55
–––
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The receipt from the rights issue is a cash inflow into the group and should be shown as a financing activity. Thereforethe dividend paid will be £10·4 million and the cash from the rights issues will be £2 million.
(vi) Fixed assetsOpening balance at 1 December 2009 254Revaluation loss (7)Plant in exchange transaction 4Sale of land (10)Depreciation (27)On acquisition of Tigret 15Current year additions 98
––––Closing balance at 30 November 2010 327
––––
The profit on the sale of the land is £15m plus £4 million minus carrying value £10 million, i.e. £9 million
(vii) Defined benefit scheme
Opening balance at 1 December 2009 22Current service costs 10Past service costs 2Expected return on assets (8)
–––Charge to profit and loss account 4Actuarial losses 6Contributions paid (7)
–––Closing balance at 30 November 2010 25
–––
(viii) Investment property
Opening balance at 1 December 2009 6Acquisition 1Disposal (0·5)Gain 1·5
––––Closing balance at 30 November 2010 8
––––
(ix) Intangible assets
Opening balance at 1 December 2009 72Acquisitions (8 + 4) 12Tigret 18Amortisation (17)
–––Closing balance at 30 November 2010 85
–––
(x) Available for sale financial assets
Opening balance at 1 December 2009 90Acquisitions (cash) 6Tigret (5)Gain (including tax) 3
–––Closing balance at 30 November 2010 94
–––
(xi) Share capital
Opening balance at 1 December 2009 275Acquisition of Tigret 15
––––Closing balance at 30 November 2010 290
––––
(b) (i) The vast majority of companies use the indirect method for the preparation of cash flow statements. Most companiesjustify this on the grounds that the direct method is too costly. The direct method presents major categories of gross cashinflows and outflows on the face of the cash flow statement. The indirect method shows the same operating cash flowsexcept that the net figure is produced by adjusting operating profit for non-cash items and bringing in cash flows relatingto any provision in respect of operating items, whether or not the provision was included in operating profit. The directmethod shows cash from operations made up from individual operating cash flows. Users often prefer the direct methodbecause it shows the major categories of cash flows. The complicated adjustments required by the indirect method aredifficult to understand and provide entities with more leeway for manipulation of cash flows. The adjustments made toreconcile net profit before tax to cash from operations are confusing to users. In many cases these cannot be reconciledto observed changes in the balance sheet. Thus users will only be able to understand the size of the difference betweenoperating profit and cash from operations. The direct method allows for reporting operating cash flows by understandable
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categories as they can see the amount of cash collected from customers, cash paid to suppliers, cash paid to employeesand cash paid for other operating expenses. Users can gain a better understanding of the major trends in cash flowsand can compare these cash flows with those of the entity’s competitors.
An issue for users is the abuse of the classifications of specific cash flows. Misclassification can occur amongst thesections of the statement. Cash outflows that should have been reported in the operating section may be classified asreturns on investments and servicing of finance with the result that companies enhance operating cash flows. Thecomplexity of the adjustments to net profit before tax can lead to manipulation of cash flow reporting. Information aboutcash flows should help users to understand the operations of the entity, evaluate its financing activities, assess itsliquidity or solvency or interpret earnings information. A problem for users is the fact that entities can choose the methodused and there is not enough guidance on the classification of cash flows in the various sections of the indirect methodused in FRS 1.
(ii) The directors wish to manipulate the cash flow statement in order to enhance their income. As stated above, the indirectmethod lends itself more easily to the manipulation of cash flows because of the complexity of the adjustments to netprofit before tax and the directors are trying to make use of the lack of accounting knowledge of many users of accountswho are not sophisticated in their knowledge of cash flow accounting.
Corporate reporting involves the development and disclosure of information, which the entity knows is going to be used.The information has to be truthful and neutral. The nature of the responsibility of the directors requires a high level ofethical behaviour. Shareholders, potential shareholders, and other users of the financial statements rely heavily on thefinancial statements of a company as they can use this information to make an informed decision about investment.They rely on the directors to present a true and fair view of the company. Unethical behaviour is difficult to control ordefine. The directors must consider how to best apply accounting standards even when faced with issues that couldcause them to lose income. The directors should not pursue self-interest or fail to maintain objectivity and independence,and must act with appropriate professional judgement. Therefore the proceeds of the loan should be reported as cashflows from financial activities.
2 (a) The arrangement is not within the scope of FRS 20 Share-based payment because the contract may be settled net and hasnot been entered into in order to satisfy Margie’s expected purchase, sale or usage requirements. Margie has not purchasedthe wheat but has entered into a financial contract to pay or receive a cash amount. The arrangement should be dealt within accordance with FRS 26 Financial instruments: recognition and measurement.
Contracts to buy or sell non-financial items are within the scope of FRS 26 if they can be settled net in cash or anotherfinancial asset and are not entered into and held for the purpose of the receipt or delivery of a non-financial item in accordancewith the entity’s expected purchase, sale, or usage requirements. Contracts to buy or sell non-financial items are inside thescope if net settlement occurs. The following situations constitute net settlement:
(a) the terms of the contract permit either counterparty to settle net;(b) there is a past practice of net settling similar contracts;(c) there is a past practice, for similar contracts, of taking delivery of the underlying and selling it within a short period after
delivery to generate a profit from short-term fluctuations in price, or from a dealer’s margin; or(d) the non-financial item is readily convertible to cash.
The contract will be accounted for as a derivative and should be valued at fair value (asset or liability at fair value). Initiallythe contract should be valued at nil as under the terms of a commercial contract the value of 2,500 shares should equate tothe value of 350 tonnes of wheat. At each period end the contract would be revalued and it would be expected that differenceswill arise between the values of wheat and Margie shares as their respective market values will be dependent on a numberof differing factors. The net difference should be taken to profit or loss.
As Margie has no intention of taking delivery of the wheat this does not appear to be a hedging contract as no firmcommitment exists to purchase neither is this a highly probable forecast transaction.
(b) Share-based payment awards exchanged for awards held by the acquiree’s employees are measured in accordance with FRS 20 Share-based payment. If the acquirer is obliged to replace the awards, some or all of the fair value of the replacementawards must be included in the consideration. The amount not included in the consideration will be recognised as acompensation expense. If the acquirer is not obliged to exchange the acquiree’s awards, the acquirer does not adjust theconsideration even if the acquirer does replace the awards. A portion of the fair value of the award granted by Margie isaccounted in the cost of the business combination and a portion under FRS 20, even though no post-combination servicesare required. The amount included in the cost of the business combination is the fair value of Antalya’s award at theacquisition date (£20 million). Any additional amount, which in this case is £2 million, is accounted for as a post-combination expense under FRS 20. This amount is recognised immediately as a post-combination expense because nopost-combination services are required.
(c) The shares issued to the employees were issued in their capacity as shareholders and not in exchange for their services. Theemployees were not required to complete a period of service in exchange for the shares. Thus the transaction is outside thescope of FRS 20.
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As regards the purchase of the building, Grief did not act in its capacity as a shareholder as Margie approached the companywith the proposal to buy the building. Grief was a supplier of a building and as such the transaction comes under FRS 20.The building is valued at fair value with equity being credited with the same amount.
(d) Where the vesting period is linked to a market performance condition, an entity should estimate the expected vesting period.If the actual vesting period is shorter than estimated, the charge should be accelerated in the period that the entity deliversthe cash or equity instruments to the counterparty. When the vesting period is longer, the expense is recognised over theoriginally estimated vesting period. The effect of a vesting condition may be to change the length of the vesting period. In thiscase, paragraph 15 of FRS 20 Share-based payment requires the entity to presume that the services to be rendered by theemployees as consideration for the equity instruments granted will be received in the future, over the expected vesting period.Hence, the entity will have to estimate the length of the expected vesting period at grant date, based on the most likelyoutcome of the performance condition. If the performance condition is a market condition, the estimate of the length of theexpected vesting period must be consistent with the assumptions used in estimating the fair value of the share options grantedand is not subsequently revised.
Margie expects the market condition to be met in 2011 and thus anticipates that it will charge £1 million per annum untilthat date (100 x 4,000 x £10 divided by 4 years). As the market condition has been met in the year to 30 November 2010,the expense charged in the year would be £2 million (£4 million – £2 million already charged) as the remaining expenseshould be accelerated and charged in the year.
3 (a) FRS 12 paragraph 14, states that an entity must recognise a provision if, and only if:
(i) a present obligation (legal or constructive) has arisen as a result of a past event (the obligating event),(ii) payment to settle the obligation is probable ('more likely than not'), and(iii) the amount can be estimated reliably.
An obligating event is an event that creates a legal or constructive obligation and, therefore, results in an enterprise havingno realistic alternative but to settle the obligation.
At the date of the financial statements, there was no current obligation for Greenie. In particular, no action had been broughtin connection with the accident. It was not yet probable that an outflow of resources would be required to settle the obligation.
Greenie may need to disclose a contingent liability. FRS 12 defines a contingent liability as:
(a) a possible obligation that has arisen from past events and whose existence will be confirmed by the occurrence or notof uncertain future events; or
(b) a present obligation that has arisen from past events but is not recognised because:(i) it is not probable that a transfer of economic benefits will be required to settle the obligation; or (ii) the amount of the obligation cannot be measured with sufficient reliability.
FRS 12 requires that entities should not recognise contingent liabilities but should disclose them, unless the possibility of anoutflow of economic resources is remote. It appears that Greenie should disclose a contingent liability. The fact that the realnature and extent of the damages, including whether they qualify for compensation and details of any compensationpayments remained to be established all indicated the level of uncertainty attaching to the case. The degree of uncertainty isnot such that the possibility of an outflow of resource could be considered remote. Had this been the case, no disclosureunder FRS 12 would have been required.
Thus the conditions for establishing a liability are not fulfilled. However, a contingent liability should be disclosed as requiredby FRS 12.
The possible recovery of these costs from the insurer give rise to consideration of whether a contingent asset should bedisclosed. Given the status of the expert report, any information as to whether judicial involvement is likely will not beavailable until 2011. Thus this contingent asset is more possible than probable. As such no disclosure of the contingent assetshould be included.
(b) Greenie appears to have significant influence over Manair, and therefore, it should be accounted for as an associate. Accordingto paragraph 4 of FRS 9 Associates and joint ventures, an associate is an entity (other than a subsidiary) in which the investorhas a participating interest and over whose operating and financial policies the investor exercises a significant influence.
A participating interest is an interest held in the shares of another entity held on a long-term basis for the investor’s benefitand is linked to the exercise of significant influence over the investee’s operating and financial policies. A shareholding of 20%of the ordinary shares of an entity is presumed to be a participating interest.
Significant influence is the involvement of the investor in the policy decisions of the entity such as the expansion of thebusiness, changes in products, markets and activities and dividend policy. Where an investor holds 20% or more of the votingpower of the investee, it is presumed that the investor has a participating interest unless it can be clearly demonstrated thatthis is not the case.
In certain cases, whether significant influence exists should also be assessed when an investor holds less than 20% especiallywhere it appears that the substance of the arrangement indicates significant influence. Greenie holds 19·9% of the votingshares and it appears as though there has been an attempt to avoid accounting for Manair as an associate. The fact that one
15
investor holds a majority share of the voting power can indicate that other investors do not have significant influence. Asubstantial or majority ownership by an investor does not, however, necessarily preclude other investors from havingsignificant influence. The existence of significant influence by an investor is usually evidenced in one or more of the followingways:
(i) representation on the board of directors or equivalent governing body of the investee;(ii) participation in the policy-making process;(iii) material transactions between the investor and the investee;(iv) interchange of managerial personnel; or(v) provision of essential technical information.
The shareholders’ agreement allows Greenie to participate in some decisions. It needs to be determined whether these includestrategic decisions of Manair, although this is very likely. The representation on the board of directors combined with theadditional rights Greenie had under the shareholders’ agreement, give Greenie the power to participate in some policydecisions. Additionally, Greenie had sent a team of management experts to give business advice to the board of Manair.
In addition, there is evidence of material transactions between the investor and the investee and indications that Greenieprovided Manair with maintenance and technical services. Both of these facts are examples of how significant influence mightbe evidenced.
Based on an assessment of all the facts, it appears that Greenie has significant influence over Manair and that Manair shouldbe considered an associate and accounted for using the equity method of accounting.
Finally, as it is likely that Manair is an associated undertaking of Greenie, the transactions themselves would be deemedrelated party transactions. Greenie would need to disclose within its own financial statements the relationship, an outline ofthe transactions including their total value, outstanding balances including any debts deemed irrecoverable or doubtful.
(c) The franchise right should be recognised using the principles in FRS 20 Share-based payment. The asset should berecognised at the fair value of the rights acquired and the existence of exchange transactions and prices for similar franchiserights means that a fair value can be established. The franchise right should therefore be recorded at £2·3 million. If the fairvalue had not been reliably measurable then the franchise right would have been recorded at the fair value of the equityinstruments issued, i.e. £2·5 million
Normally irredeemable preference shares would be classified as equity. The contractual obligation to pay the fixed cashdividend creates a liability component and the right to participate in ordinary dividends creates an equity component. IfGreenie were to comply with FRS 25 Financial instruments: presentation, it would require the preference shares to be treatedas compound financial instruments with both an equity and liability component. The value of the equity component is theresidual amount after deducting the separately determined liability component from the fair value of the instrument as awhole.
Under FRS 25, it would seem that substantially all of the carrying value of the Greenie’s preference shares would be allocatedto the liability component because of the dividend elements and the fixed net cash dividend would be treated as a financecost.
Departure from a requirement of a standard is allowed only in the extremely rare circumstances where it would affect the trueand fair view of the financial statements. Greenie’s argument that the presentation of the preference shares in accordancewith FRS 25 would be misleading, is not acceptable. The fact that it would not reflect the nature of the instruments as havingcharacteristics of permanent capital providing participation in future profits is not a valid argument. Additional disclosure isrequired when compliance with the specific requirements in FRS is insufficient to enable a user to understand the impact ofparticular transactions or conditions on financial position and financial performance. A fair presentation would be achievedby complying with FRS 25 and providing additional disclosures to explain the characteristics of the preference shares.
4 (a) (i) There are several approaches which could have been taken in developing standards for SMEs. One course of actionwould have been for GAAP for SMEs to be developed on a national basis, with international standards focusing onaccounting for listed company activities. The main issue would be that the practices developed for SMEs may not beconsistent and may lack comparability across national boundaries. Additionally, if a SME wishes to list its shares on acapital market, the transition to international standards would be more difficult.
Another approach would be to detail the exemptions given to smaller entities in the mainstream accounting standards.For example, an appendix would be included within the standard detailing the exemptions given to smaller enterprises.
A third approach would be to introduce a separate set of standards comprising all the issues addressed in standards,which are relevant to SMEs.
Finally, a self-contained set of accounting principles that are based on full standards could be created. The standardswould be simplified so that they are suitable for SMEs. This would create separate and distinct frameworks which wouldbe applied in full and without the choice of the most suitable accounting policy from full standards or the SME standard.
The latter is naturally a modified version of the full standard, and not an independently developed set of standards beingbased on recognised concepts and principles which should allow easier transition to full accounting standards if the SMEdecides to become a public listed entity.
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The principal aim when developing accounting standards for small to medium-sized enterprises (SMEs) is to provide aframework that generates relevant, reliable, and useful information. The result should be a high quality andunderstandable set of accounting standards suitable for SMEs. The users of financial statements are likely to be differentfor SMEs compared to multinational companies. Where there is no public disclosure, the only groups likely to receivethe information are management, shareholders, and perhaps government agencies.
There are a number of accounting standards and disclosures that probably do not provide useful information for the usersof SME financial statements, such as the requirement to produce consolidated accounts, to provide for deferred taxation,and to recognise profits on long-term contracts. In deciding on the modifications to make to accounting standards, theneeds of the users will have to be taken into account, as well as the costs and other burdens imposed upon SMEs.Relaxation of some of the measurement and recognition criteria has to be made in order to achieve the reduction in thesecosts and burdens. Some disclosure requirements are intended to meet the needs of listed entities, or to assist users inmaking forecasts of the future. Users of financial statements of SMEs often do not make such kinds of forecasts. Thereis a major problem in the development and implementation of such standards. It cannot be assumed that the statementsof principles and the underlying theory and principles, which are based on the information needs of large publiccompany stakeholders, apply equally to SMEs. Small companies pursue different strategies, and their goals are morelikely to be survival and stability rather than growth and profit maximisation. The stewardship function is often absentin small companies, with the accounts playing an agency role between the owner-manager and the bank.
In the UK, the development of Financial Reporting Standards for Smaller Entities (FRSSE) led to the ‘Big GAAP, LittleGAAP’ debate. This gives rise to the question of whether a different basis of ‘true and fair view’ should be allowed toexist within the same jurisdiction.
The most important difference between an SME and a listed public company lies in the nature of ownership. The formeris characterised by the entrepreneur or family investing their own capital and running the business. The latter is alwaysrun by directors acting on behalf of institutional investors who own the majority of shares. It is this divorce of ownershipand control that creates the need for directors to be held accountable to shareholders, and to adhere to the disclosurerequirements laid down by law and standard setters.
(ii) The main argument for separate SME accounting standards is the undue cost burden of reporting, which isproportionately heavier for smaller firms. The cost burden of applying a full set of accounting standards may not bejustified on the basis of user needs. This is because the main users of SME reports are easily identified and are few innumber. Further, much of the current reporting framework is based on the needs of large business, so SMEs perceivethat the full statutory financial statements are less relevant to the users of SME accounts. SMEs also use financialstatements for a narrower range of decisions, as they have less complex transactions and therefore less need for thesophisticated analysis of financial statements.
The main argument against different reporting requirements for SMEs (differential reporting) is that if accounting rulesare not held to apply universally, then users of accounts may lose confidence in the rules and it may lead to a two-tiersystem of reporting. Companies should not be subject to different rules which could give rise to different ‘true and fairviews’. However, this assumes that the users are different, which may not be the case, and that the users are tooinflexible to understand different accounting bases. Accounting rules already have many areas of choice.
Other arguments against differential reporting include the need for comparability and reliability. Additionally, there is anargument that full statutory financial statements are in the public interest, not only for users but also as a measure ofprotection for minority shareholders and other stakeholders, satisfying some of their information needs.
The accounting needs of a small business are simple, but as the business gets bigger, so does its need for moresophisticated internal information and disclosure to the outside world. The question arises as to whether SME standardsshould apply to all unlisted entities, or just those listed entities below a certain size. There are arguments for using thelegal form of a company as a basis, but firms with different legal forms often have similar economic structures and hencethe legal form does not reflect actual economic substance.
An entity’s size may not be the ideal criterion for differential reporting because it is relative and also depends on otherfactors, such as industry sector. Size is a weak indicator of the costs and benefits of financial reporting, and may not bethe best way to determine what an SME is. SMEs could be defined by reference to ownership and the management ofthe entity, as SMEs are not necessarily just smaller versions of public companies. However, the main characteristic whichdistinguishes SMEs from other entities is the degree of public accountability, and so the definition of what constitutesan SME has to revolve around those entities that do not have public accountability. It would not be practical to determineglobally-applicable values, because the definition of what constitutes an SME will vary from country to country.Therefore, it should be left to individual countries to adopt measures that reflect their local economic and socialenvironment. There is no universally-agreed definition of an SME. No single definition can capture all the dimensions ofa small or medium-sized business, or cannot be expected to reflect the differences between firms, sectors, or countriesat different levels of development. Most definitions based on size use measures such as number of employees, balancesheet total, or annual turnover.
(b) (i) The accounting of the land and buildings is currently accountable under FRS 11 Impairment of fixed assets and goodwilland FRS 15 Tangible fixed assets. As the property is non-specialised and there is a policy of revaluation it should bevalued at existing use value. Where there is evidence of impairment such as the temporary decline, a revalued propertymust be valued at the lower of existing use value and recoverable amount (FRS 15 para 54). Therefore the building
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element would be depreciated by £0·28 million (£14 million/50 years) resulting in a net book value of £14·22 million(£16 million less £1·5 million less £0·28 million). As there is evidence of impairment the asset would be valued at thehigher of value in use of £10·7 million (£1·5 million + £9·2 million) and net selling price of £9·75 million ((£1·5 million + £8·5 million) x 97·5%), so £10·7 million, giving a loss of £3·52 million (£14·22 million less £10·7 million). This is where similarity between IFRS and UK GAAP ends. Under UK GAAP because the building isnon-specialised and a policy of revaluation exists and existing use value of £9·3 million (£1·5 million + £7·8 million)is lower than recoverable amount, the building requires to be further written down by £1·4 million (£10·7 million less£9·3 million). The total loss of £4·92 million would be allocated as follows:
– From initial carrying amount of £14·22 million to depreciated historic cost (not given) should be sent to equity– From depreciated historic cost to recoverable amount of £10·7 million to profit and loss– From recoverable amount of £10·7 million to £9·3 million to equity
UK GAAP results in additional losses over and above IFRS, therefore IFRS would give a better result for the stockexchange listing.
(ii) Investment properties.
The property is currently accounted for under SSAP 19 Investment Properties. The property would be revalued at eachaccounting period end with any gains or losses (unless deemed permanent) taken to equity. Permanent diminutions invalue would be taken to the profit and loss account. SSAP 19 does not require the asset to be depreciated therefore £1 million (£10 million less £9 million) is the surplus on revaluation shown within equity as at 1 November 2009 (land£0·8 million (£9·5 million less £8·7 million) and hotel £0·2 million (£0·5 million less £0·3 million)).
The market value is the best price reasonably obtainable by the buyer. The ‘highest and best use’ value may result inthe fair value being determined on the basis of the redevelopment of the site. Any future capital expenditure that wouldbe undertaken to get the investment property to its highest and best use by third parties should be reflected in theproperty’s fair value but not if the work is to be undertaken by the owner. As at 30 November 2010, the ‘highest andthe best value’ is £15 million which can be obtained for the land for its potential use. As the building will be demolished,none of the value need be allocated to the building. Additionally, there would be no point in spending additional monieson demolishing the building as the cost outweighs the increase in value. The land would be valued at £15 million andthe building at zero. The loss on the building is £0·5 million of which £0·2 million would be taken against therevaluation reserve with the balance to profit and loss. The land component would be subject to an uplift of £5·5 million(£15 million less £9·5 million), all of which would be shown within the revaluation reserve. Deferred taxation wouldnot be provided as there was not a binding sale agreement.
IFRS allows a company to choose either fair value or depreciated cost as an accounting policy for measuring investmentproperty. The company wishes to obtain a Stock Market listing and therefore it would appear to be more beneficial toshow holding gains in profit and loss, and therefore the fair value model will be used.
Where fair value is used, gains and losses are recognised in the profit and loss account. Therefore had Havata adoptedIFRS then it would not have been necessary to consider the land and hotel separately as the gains and losses on boththe components should be posted to profit and loss. Under IFRS deferred tax is applicable and hence the gains wouldbe chargeable to 30% deferred taxation. A net gain of £0·7 million would be shown in the year ended 30 November2009 (hence brought forward reserves as at 1 December 2009) and £3·5 million (£5 million less 30% deferredtaxation) in the year ended 30 November 2010.
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Professional Level – Essentials Module, Paper P2 (UK)Corporate Reporting (United Kingdom) December 2010 Marking Scheme
Marks1 (a) Operating Profit 4
Retirement benefit expense 2Depreciation on fixed assets 1Depreciation on investment property 1Amortisation of intangible assets 1Impairment of goodwill 4Decrease in trade debtors 2Decrease in stocks 1Increase in trade creditors 1Cash paid to retirement benefit scheme 1Interest paid 1Tax paid 2Purchase of associate 2Purchase of fixed assets 2Purchase of subsidiary 1Additions – investment property 1Proceeds from sale of land 1Intangible assets 1Purchases of AFS investments 1Repayment of long-term borrowings 1Rights issue MI 1Minority interest dividend 1Dividends paid 1Net increase in cash 1
Time allowedReading and planning: 15 minutesWriting: 3 hours
This paper is divided into two sections:
Section A – This ONE question is compulsory and MUST be attempted
Section B – TWO questions ONLY to be attempted
Do NOT open this paper until instructed by the supervisor.
During reading and planning time only the question paper may be annotated. You must NOT write in your answer booklet untilinstructed by the supervisor.
This question paper must not be removed from the examination hall.
Pape
r P2 (
UK
)
Corporate Reporting(United Kingdom)
Tuesday 13 December 2011
The Association of Chartered Certified Accountants
Section A – THIS ONE question is compulsory and MUST be attempted
1 Traveler, a public limited company, operates in the manufacturing sector. The draft statements of financial position areas follows at 30 November 2011:
Traveler Data Captive$m $m $m
Assets:Non-current assetsProperty, plant and equipment 439 810 620Investments in subsidiariesData 820Captive 541Financial assets 108 10 20
–––––– –––––– –––––1,908 820 640
Defined benefit asset 72Current assets 995 781 350
–––––– –––––– –––––Total assets 2,975 1,601 990
–––––– –––––– –––––
Equity and liabilities:Share capital 1,120 600 390Retained earnings 1,066 442 169Other components of equity 60 37 45
–––––– –––––– –––––Total equity and liabilities 2,975 1,601 990
–––––– –––––– –––––
The following information is relevant to the preparation of the group financial statements:
1 On 1 December 2010, Traveler acquired 60% of the equity interests of Data, a public limited company. Thepurchase consideration comprised cash of $600 million. At acquisition, the fair value of the non-controllinginterest in Data was $395 million. Traveler wishes to use the ‘full goodwill’ method. On 1 December 2010, thefair value of the identifiable net assets acquired was $935 million and retained earnings of Data were $299 million and other components of equity were $26 million. The excess in fair value is due to non-depreciable land.
On 30 November 2011, Traveler acquired a further 20% interest in Data for a cash consideration of $220 million.
2 On 1 December 2010, Traveler acquired 80% of the equity interests of Captive for a consideration of $541 million. The consideration comprised cash of $477 million and the transfer of non-depreciable land witha fair value of $64 million. The carrying amount of the land at the acquisition date was $56 million. At the yearend, this asset was still included in the non-current assets of Traveler and the sale proceeds had been creditedto profit or loss.
At the date of acquisition, the identifiable net assets of Captive had a fair value of $526 million, retained earningswere $90 million and other components of equity were $24 million. The excess in fair value is due to non-depreciable land. This acquisition was accounted for using the partial goodwill method in accordance withIFRS 3 (Revised) Business Combinations.
3 Goodwill was impairment tested after the additional acquisition in Data on 30 November 2011. The recoverableamount of Data was $1,099 million and that of Captive was $700 million.
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4 Included in the financial assets of Traveler is a ten-year 7% loan. At 30 November 2011, the borrower was infinancial difficulties and its credit rating had been downgraded. Traveler has adopted IFRS 9 FinancialInstruments and the loan asset is currently held at amortised cost of $29 million. Traveler now wishes to valuethe loan at fair value using current market interest rates. Traveler has agreed for the loan to be restructured; therewill only be three more annual payments of $8 million starting in one year’s time. Current market interest ratesare 8%, the original effective interest rate is 6·7% and the effective interest rate under the revised paymentschedule is 6·3%.
5 Traveler acquired a new factory on 1 December 2010. The cost of the factory was $50 million and it has aresidual value of $2 million. The factory has a flat roof, which needs replacing every five years. The cost of theroof was $5 million. The useful economic life of the factory is 25 years. No depreciation has been charged forthe year. Traveler wishes to account for the factory and roof as a single asset and depreciate the whole factoryover its economic life. Traveler uses straight-line depreciation.
6 The actuarial value of Traveler’s pension plan showed a surplus at 1 December 2010 of $72 million, representedby the fair value of the assets of $250 million, the present value of the defined benefit obligation of $200 millionand net unrecognised actuarial losses of $22 million. The average remaining working lives of the employees is10 years. Traveler uses the corridor approach for recognising actuarial gains and losses. The aggregate of thecurrent service cost, interest cost and expected return on assets amounted to a cost of $55 million for the year.After consulting with the actuaries, the company decided to reduce its contributions for the year to $45 million.The contributions were paid on 7 December 2011. No entries had been made in the financial statements for theabove amounts. At the year end, the unrecognised actuarial losses were $20 million and the present value ofavailable future refunds and reductions in future contributions was $18 million.
Required:
(a) Prepare a consolidated statement of financial position for the Traveler Group for the year ended 30 November2011. (35 marks)
(b) Traveler has three distinct business segments. Having only recently moved to IFRS, they are unsure as to the keydifferences between the UK standard SSAP 25 Segmental reporting and IFRS 8 Operating Segments.
Required:
Advise the management of Traveler of the key differences between SSAP 25 and IFRS 8. (7 marks)
(c) Segmental information reported externally is more useful if it conforms to information used by management inmaking decisions. The information can differ from that reported in the financial statements. Althoughreconciliations are required, these can be complex and difficult to understand. Additionally, there are otherstandards where subjectivity is involved and often the profit motive determines which accounting practice tofollow. The directors have a responsibility to shareholders in disclosing information to enhance corporate valuebut this may conflict with their corporate social responsibility.
Required:
Discuss how the ethics of corporate social responsibility disclosure are difficult to reconcile with shareholderexpectations. (6 marks)
Professional marks will be awarded in part (c) for clarity and expression of your discussion. (2 marks)
(50 marks)
3 [P.T.O.
Section B – TWO questions ONLY to be attempted
2 Decany owns 100% of the ordinary share capital of Ceed and Rant. All three entities are public limited companies.The group operates in the shipbuilding industry, which is currently a depressed market. Rant has made losses for thelast three years and its liquidity is poor. The view of the directors is that Rant needs some cash investment. Thedirectors have decided to put forward a restructuring plan as at 30 November 2011. Under this plan:
1. Ceed is to purchase the whole of Decany’s investment in Rant. The purchase consideration is to be $98 millionpayable in cash to Decany and this amount will then be loaned on a long-term unsecured basis to Rant; and
2. Ceed will purchase land with a carrying amount of $10 million from Rant for a total purchase consideration of$15 million. The land has a mortgage outstanding on it of $4 million. The total purchase consideration of $15 million comprises five million $1 nominal value non-voting shares issued by Ceed to Rant and the $4 millionmortgage liability which Ceed will assume; and
3. A dividend of $25 million will be paid from Ceed to Decany to reduce the accumulated reserves of Ceed.
The Statements of Financial Position of Decany and its subsidiaries at 30 November 2011 are summarised below:
Decany Ceed Rant$m $m $m
Non-current assetsTangible non-current assets at depreciated cost/valuation 600 170 45Cost of investment in Ceed 130Cost of investment in Rant 95Current assets 155 130 20
–––– –––– –––980 300 65–––– –––– –––
Equity and reservesShare capital 140 70 35Retained earnings 750 220 5
As a result of the restructuring, several of Ceed’s employees will be made redundant. According to the detailed plan,the costs of redundancy will be spread over two years with $4 million being payable in one year’s time and $6 millionin two years’ time. The market yield of high quality corporate bonds is 3%. The directors feel that the overallrestructure will cost $2 million.
As Ceed is now a holding company, the directors are unsure as to the requirements to prepare group accounts underUK Company law. All companies are incorporated in the UK.
Required:
(a) (i) Prepare the individual entity statements of financial position after the proposed restructuring plan;(13 marks)
(ii) Set out the requirements of UK law as regards the requirement to produce group accounts, advising thedirectors as to the position of Ceed. (5 marks)
(b) Discuss the key implications of the proposed plans for the restructuring of the group. (5 marks)
Professional marks will be awarded in part (b) for clarity and expression of your discussion. (2 marks)
(25 marks)
4
3 Scramble, a public limited company, is a developer of online computer games.
(a) At 30 November 2011, 65% of Scramble’s total assets were mainly represented by internally developed
intangible assets comprising the capitalised costs of the development and production of online computer games.
These games generate all of Scramble’s revenue. The costs incurred in relation to maintaining the games at the
same standard of performance are expensed to the statement of comprehensive income. The accounting policy
note states that intangible assets are valued at historical cost. Scramble considers the games to have an indefinite
useful life, which is reconsidered annually when the intangible assets are tested for impairment. Scramble
determines value in use using the estimated future cash flows which include maintenance expenses, capital
expenses incurred in developing different versions of the games and the expected increase in turnover resulting
from the above mentioned cash outflows. Scramble does not conduct an analysis or investigation of differences
between expected and actual cash flows. Tax effects were also taken into account. (7 marks)
(b) Scramble has two cash generating units (CGU) which hold 90% of the internally developed intangible assets.
Scramble reported a consolidated net loss for the period and an impairment charge in respect of the two CGUs
representing 63% of the consolidated profit before tax and 29% of the total costs in the period. The recoverable
amount of the CGUs is defined, in this case, as value in use. Specific discount rates are not directly available
from the market, and Scramble estimates the discount rates, using its weighted average cost of capital. In
calculating the cost of debt as an input to the determination of the discount rate, Scramble used the risk-free rate
adjusted by the company specific average credit spread of its outstanding debt, which had been raised two years
previously. As Scramble did not have any need for additional financing and did not need to repay any of the
existing loans before 2014, Scramble did not see any reason for using a different discount rate. Scramble did not
disclose either the events and circumstances that led to the recognition of the impairment loss or the amount of
the loss recognised in respect of each cash-generating unit. Scramble felt that the events and circumstances that
led to the recognition of a loss in respect of the first CGU were common knowledge in the market and the events
and the circumstances that led to the recognition loss of the second CGU were not needed to be disclosed.
(7 marks)
(c) Scramble wished to diversify its operations and purchased a professional football club, Rashing. In Rashing’s
financial statements for the year ended 30 November 2011, it was proposed to include significant intangible
assets which related to acquired players’ registration rights comprising registration and agents’ fees. The agents’
fees were paid by the club to players’ agents either when a player is transferred to the club or when the contract
of a player is extended. Scramble believes that the registration rights of the players are intangible assets but that
the agents fees do not meet the criteria to be recognised as intangible assets as they are not directly attributable
to the costs of players’ contracts. Additionally, Rashing has purchased the rights to 25% of the revenue from ticket
sales generated by another football club, Santash, in a different league. Rashing does not sell these tickets nor
has any discretion over the pricing of the tickets. Rashing wishes to show these rights as intangible assets in its
financial statements. (9 marks)
Required:
Discuss the validity of the accounting treatments proposed by Scramble in its financial statements for the year
ended 30 November 2011.
The mark allocation is shown against each of the three accounting treatments above.
Professional marks will be awarded for clarity and expression of your discussion. (2 marks)
(25 marks)
5 [P.T.O.
4 It is argued that there is limited revenue recognition guidance available from IFRS with many companies following thecurrent provisions of US GAAP. The revenue recognition standard, IAS 18 Revenue, has been criticised because anentity applying the standards might recognise amounts in the financial statements that do not faithfully represent thenature of the transactions. It has been further argued that current standards are inconsistent with principles used inother accounting standards, and further that the notion of the risks and rewards of ownership has also beensubjectively applied in sale transactions.
Required:
(a) (i) Discuss the main weaknesses in the current standard on revenue recognition; (11 marks)
(ii) Discuss the reasons why it might be relevant to take into account credit risk and the time value of moneyin assessing revenue recognition. (5 marks)
Professional marks will be awarded in part (a) for clarity and expression of your discussion. (2 marks)
(b) (i) Venue enters into a contract with a customer to provide computers at a value of $1 million. The terms arethat payment is due one month after the sale of the goods. On the basis of experience with other contractorswith similar characteristics, Venue considers that there is a 5% risk that the customer will not pay theamount due after the goods have been delivered and the property transferred. Venue subsequently felt thatthe financial condition of the customer has deteriorated and that the trade receivable is further impaired by$100,000.
(ii) Venue has also sold a computer hardware system to a customer and, because of the current difficulties inthe market, Venue has agreed to defer receipt of the selling price of $2 million until two years after thehardware has been transferred to the customer.
Venue has also been offering discounts to customers if products were sold with terms whereby payment wasdue now but the transfer of the product was made in one year. A sale had been made under these termsand payment of $3 million had been received. A discount rate of 4% should be used in any calculations.
Required:
Discuss how both of the above transactions would be treated in subsequent financial statements under IAS 18 and also whether there would be difference in treatment if the collectability of the debt and the timevalue of money were taken into account. (7 marks)
(25 marks)
End of Question Paper
6
Answers
Professional Level – Essentials Module, Paper P2 (UK)Corporate Reporting (United Kingdom) December 2011 Answers
1 (a) Traveler plc
Consolidated Statement of Financial Position at 30 November 2011
$m $mFair value of consideration for 60% interest 600Fair value of non-controlling interest 395Fair value of identifiable net assets acquired:Share capital 600Retained earnings 299OCE 26FV adjustment – land (balance) 10
–––––(935)
–––––Goodwill 60
–––––
Further acquisition of 20%
$m $mFair value of consideration 220NCI at 1 December 2010 395Increase in net assets to 30 November 2011:((1,079 + 10) – 935) x 40% 61·6
––––––NCI 30 November 2011 456·6
––––––Transfer to equity 20/40 228·3
––––––Positive movement in equity 8·3
––––––
The net assets of Data have increased from $935 to $1,089 million $(1,079 + fair value adjustment 10), i.e. $154 million.The NCI proportion is 40% of $154 million, i.e. $61·6 million.
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Working 2
Captive
$m $mPurchase consideration 541Less fair value of identifiable net assets:Share capital 390Retained earnings 90OCE 24FV adjustment – land (balance) 22
––––526 x 80% 420·8
––––––Goodwill 120·2
––––––
The assets transferred as part of the consideration need to be removed from non-current assets, and the gain on disposalneeds to be calculated. The proceeds of $64m credited to profit needs to be removed. The sale consideration is $64 millionand the carrying amount is $56 million, giving a gain on disposal of $8 million. The adjustment required to arrive at the gainis:
Dr Retained earnings $56mCr Non-current assets $56m
Working 3
Impairment of goodwill
DataGoodwill 60Identifiable net assets Net assets 1,079FV adjustment – land 10
––––––1,089
––––––Total 1,149Recoverable amount (1,099)
––––––Goodwill impairment 50
––––––
The goodwill impairment relating to Data will be split 80/20 between the group and the NCI. Thus retained earnings will bedebited with $40 million and NCI with $10 million.
Note: IAS 36 Appendix C, paragraphs C5 to C9 states that when NCI is valued at fair value, any goodwill impairment shouldbe allocated on the basis of the allocation used for profit or loss. Given that the impairment review arose at the year endwhen Traveler’s shareholding was 80%, this is now the basis of profit allocation and hence has been used in determiningthe split between group and NCI. It could be argued that a 60:40 allocation between group and NCI is also appropriate asthis was how profits that arose in the year have been apportioned and the impariment is a loss that arose in the year, albeitat the year end.
Captive
$m $mGoodwill 120·2Unrecognised non-controlling interest (20%) 30·05Identifiable net assets Net assets 604FV adjustment – land 22
––––626
––––––––Total 776·25Recoverable amount (700)
––––––––Goodwill impairment on grossed up amount 76·25
––––––––Goodwill impairment on Traveler’s share (80% x 76·25) 61
––––––––
Goodwill is therefore $(60 + 120·2 – 50 – 61)million, i.e. $69·2 million.
Working 4
Financial asset
Under IFRS 9, debt instruments are subsequently measured at amortised cost if:
(a) The asset is held within a business model whose objective is to hold the assets to collect the contractual cash flows;and
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(b) The contractual terms of the financial asset give rise, on specified dates, to cash flows that are solely payments ofprincipal and interest on the principal outstanding.
All other debt instruments are subsequently measured at fair value. The classification of an instrument is determined on initialrecognition and reclassifications are only permitted on the change of an entity’s business model and are expected to occuronly infrequently. Traveler cannot measure the instrument at fair value as the objective for holding the financial asset has notchanged.
The impairment loss is calculated by discounting the annual payments using the original effective interest rate of 6·7% asfollows:
$mCarrying value 29·00PV of future cash flows:Year 1 8m x 1/1·067 7·50Year 2 8m x 1/1·0672 7·03Year 3 8m x 1/1·0673 6·59
–––––(21·12)
–––––––Impairment to profit or loss 7·88
–––––––
The carrying value will be $(108 + 10 + 20 – 7·88)m, i.e. $130·12m
Working 5
Retained earnings
$mTraveler – Balance at 30 November 2011 1,066Sale of non-current asset (W2) (56)Impairment of goodwill (W3) $(40 + 61)m (101)Impairment of financial instrument (W4) (7·88)Defined benefit cost (W8) (55)Write off of defined benefit asset (24)Depreciation for year factory (W9) (2·72)Post acquisition reserves: Data (60% of $(442 – 299)m) 85·8
Captive (80% of $(169 – 90)m) 63·2––––––––
968·4––––––––
Other components of equity
$mTraveler – Balance at 30 November 2011 60Data post acqn (60% of $(37 – 26)m) 6·6Captive (80% x $(45 – 24)m) 16·8Positive movement in equity 8·3
$mData (W1) 228·3Impairment of Data goodwill (W3) (10)Captive (20% x $(604 + 22)m) 125·2
––––––343·5––––––
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Working 8
Defined benefit pension fund
The entries for the pension scheme would be as follows:
Dr profit or loss $55mCr defined benefit asset $55m
Pension costDr defined benefit asset $45mCr current liabilities $45m
Accrual of contributions
The defined benefit asset would be as follows:
PV of obligation at 1 December 2010 200Fair value of assets at 1 December 2010 (250)Actuarial losses (22)
––––Pension surplus at 1 December 2010 (72)Pension costs 55Contributions accrued (45)
––––Pension surplus at 30 November 2011 (62)Restriction of amount recognised as asset (see below) 24
––––Pension surplus at 30 November 2011 (38)
––––
There would not be any recognition of actuarial losses as the limits of the corridor (10% of the fair value of the assets, i.e. $25 million) are greater than the unrecognised losses. However, there will be a ceiling placed on the amount to be recognisedas an asset. This will be the total of the unrecognised actuarial losses of $20 million and the present value of available futurerefunds and reductions in future contributions of $18 million. That is $38 million. Therefore the defined benefit asset will bereduced by $(62 – 38) million, i.e. $24 million.
Working 9
Property, plant and equipment
Traveler cannot treat the roof and the building as a single asset. They must be treated separately. The roof will be depreciatedover five years at $1 million per annum and the remainder will be depreciated over 25 years taking into account the residualvalue. ($45m – 2m)/25 years, i.e. $1·72million per annum. The total depreciation for the year is $2·72 million.
$m $mTraveler 439Data 810Captive 620
––––1,869
Increase in value of land – Data (W1) 10Increase in value of land – Captive (W2) 22Less depreciation (2·72)Less disposal of asset (W2) (56)
–––––––––1,842·28–––––––––
Working 10
Non-current liabilities
$m $mTraveler 455Data 323Captive 73
––––851––––
Current assets
$m $mTraveler 995Data 781Captive 350
––––2,126
––––––
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(b) IFRS 8 Operating Segments defines operating segments in terms of the structure of the entity and how it manages itself. Inthe UK, SSAP 25 Segmental Reporting identifies two types of segment: classes of business and geographical segments andadopts a ‘risks and returns’ approach. The reportable segments are identified as those with a return on investment that is outof line with the remainder of the business, subject to different degrees of risk or different rates of growth and have differentpotential for future development. Segmental reporting based on SSAP 25’s classes of business criteria can result in reportingsimilar to that achieved under IFRS 8.
The segmental reporting requirements under IFRS 8 are greater than those under SSAP 25. IFRS 8 requires entities to report:segment profit or loss; liabilities; revenue from external customers; revenue from other segments; interest revenue; interestexpense; depreciation and amortisation; material items of income and expense; the entity’s interest in profit and loss ofassociates and joint ventures accounted for by the equity method; and income tax expense or income and material non-cashitems other than depreciation and amortisation.
SSAP 25 requires reporting of segment information to be presented in accordance with accounting policies, whereas IFRS 8uses the management approach, so the basis in which information is presented for internal purposes which compensates forthe greater reporting requirements.
SSAP 25 only requires entities to report segment: turnover distinguishing between that from external customers and that fromother segments; results before taxation, minority interests and extraordinary items; and net assets.
The two standards use slightly different criteria to assess whether a segment merits separate reporting based onturnover/revenue. SSAP 25 requires this assessment to be made on third party turnover only whereas IFRS 8 requires theassessment to be based on sales to external customers and inter-segment sales.
The scope of IFRS 8 and SSAP 25 differs. IFRS 8 applies to entities whose debt or equity securities are publicly traded or inthe process of being so. SSAP 25 applies to public companies, banking and insurance companies and groups and certainother large entities. In addition, the Companies Acts also contain segmental reporting requirements that apply to all companiesreporting under UK GAAP. The Act and SSAP 25 each contain an exemption from disclosure requirements where, in thedirectors’ opinion, it would be seriously prejudicial to the interests of the reporting entity. IFRS 8 applies to both theidentification of segments and the amounts reported which may be non-GAAP. Under both standards, an explanation of thebasis on which segment information is prepared is required as is a reconciliation of the segmental information to the amountsrecognised in the financial statements.
(c) Traditional ethical conduct relating to disclosure is insufficient when applied to corporate social responsibility (CSR) disclosurebecause the role of company is linked with the role of citizen, which is held to a higher ethical standard. Corporate citizensare companies acting on behalf of a social interest, which may or may not affect revenues. These socially beneficial actionsraise the ethical standard for such companies because of altruistic intentions, which is entirely different from the profit-generating purpose of a company. The ethical expectations of corporate citizens are thus more demanding than thosefor businesses without a social interest, especially in the way corporate citizens communicate their practices.
The ethics of corporate social responsibility disclosure are difficult to reconcile with shareholder expectations. Companies mustremain profitable but there may be conflict. Maintaining integrity becomes more challenging when a company may report lessprofit and thus lower directors’ bonuses. The problem that faces many companies is how to ethically, legally, and effectivelydisclose information while maintaining their market position.
It can be argued that increased CSR disclosure is in itself a form of socially responsible behaviour, and that by offering moreinformation to the public, companies better meet their responsibilities to stakeholders. There are ethical implications ofcompanies using CSR reporting for the sole purpose of improving revenue. The ethical implications are exacerbated if thedesired effects of disclosing responsible conduct are solely to improve profitability. Disclosing good conduct solely for profit isunacceptable because it exploits something of much higher value (right conduct) to promote something which may be thoughtas being of lower value (profit).
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2 (a) (i) Cash Purchase of Rant by Ceed
Decany Ceed Rant$m $m $m
Non-current assetsTangible non-current assets at depreciated cost/valuation 600 185 35Cost of investment in Ceed 130 11Cost of investment in Rant 98Loan receivable 98Current assets 180 32 118
–––––– –––––– ––––1,008 315 164
–––––– –––––– ––––
Equity and reservesShare capital 140 75 35Share premium 6Retained earnings 776 185·5 10
The communication of the restructuring creates a valid and constructive expectation and should be provided for in thecompany incurring the cost. It should be provided in Ceed’s financial statements as Ceed will incur these costs.
Redundancy costs should be recognised at the present value of the future cash flows:
$m4m x 1/1·03 3·96m x 1/1·032 5·6
–––9·5–––
The provision for restructuring of $9·5m will be shown in Ceed’s and overall restructuring provision in Decany’s records($2 million).
Purchase of Rant
The cost of the investment in Ceed’s financial statements will be $98 million and current assets will be reduced by thesame amount. Decany will record a loan receivable of $98 million and a profit of $3 million. The loan to Rant will berecorded in long-term loans and in current assets.
Transfer of land
Nominal value of shares allotted 5Fair value of consideration receivedValue of land $15mLess mortgage ($4m) 11
––––– –––Premium on shares allotted 6
–––
The value of the shares issued to Decany would be the land less the mortgage, which is $11 million.
(ii) The Companies Act 2006 provides that a company that is subject to the small companies regime and is a parentcompany is not obliged to prepare group accounts in addition to its individual accounts, (restating s.248 of the 1985Act), but it may opt to do so. The current exemption in s.248 of the 1985 Act from preparation of group accounts byparent companies heading medium sized groups has been abolished, following the substantial increase in the financialthresholds for medium sized groups in 2004.
The sections relating to group accounts have been reorganised to make them easier to follow.
Sections 399 to 402 re-enact sections of the 1985 Act. Section 399 concerns the requirements and exemptions fromrequirements in relation to group accounts. Parent companies not subject to the small companies regime have the dutyto prepare consolidated accounts unless exempt from having to do so under ss.400 to 402. Section 400 provides anexemption from preparing group accounts for companies included in EEA group accounts of a larger group. Section 401provides such an exemption for companies included in non-EEA group accounts of a larger group, and s.402 provides
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an exemption when all the company’s subsidiary undertakings could be excluded from consolidation in Companies Actgroup accounts.
To be a small company, at least two of the following conditions must be met:
– annual turnover must be £6·5 million or less; – the balance sheet total must be £3·26 million or less; – the average number of employees must be 50 or fewer.
Depending on the rate of exchange we would need to determine whether Ceed meets the criteria for a small companybut, irrespective of this, it does meet the criteria under s.400 as all companies are incorporated in the UK. ThereforeCeed does not have to produce group accounts for itself and Rant.
(b) The plan has no impact on the group financial statements as all of the internal transactions will be eliminated on consolidationbut does affect the individual accounts of the companies. The reconstruction only masks the problem facing Rant. It does notsolve or alter the business risk currently being faced by the group. The proposed provision for restructuring has to meet therequirements of IAS 37 Provisions, Contingent Liabilities and Contingent Assets before it can be included in the financialstatements. There must be a detailed formal plan produced and a valid expectation in those affected that the plan will becarried out. The provision appears to be large considering that the reconstruction does not involve major relocation of assetsand there is a separate provision for redundancy. The transactions outlined in the plans are essentially under common controland must be viewed in this light. This plan overcomes the short-term cash flow problem of Rant and results in an increasein the accumulated reserves. The plan does show the financial statements of the individual entities in a better light except forthe significant increase in long-term loans in Rant’s statement of financial position. The profit on the sale of the land fromRant to Ceed will be eliminated on consolidation.
In the financial statements of Rant, the investment in Ceed should be accounted for under IFRS 9. There is now cash availablefor Rant and this may make the plan attractive. However, the dividend from Ceed to Decany will reduce the accumulatedreserves of Ceed but if paid in cash will reduce the current assets of Ceed to a critical level.
The purchase consideration relating to Rant may be a transaction at an overvalue in order to secure the financial stability ofthe former entity. A range of values are possible which are current value, carrying amount or possibly at zero value dependingon the purpose of the reorganisation. Another question which arises is whether the sale of Rant gives rise to a realised profit.Further, there may be a question as to whether Ceed has effectively made a distribution. This may arise where the purchaseconsideration was well in excess of the fair value of Rant. An alternative to a cash purchase would be a share exchange. Inthis case, local legislation would need to be reviewed in order to determine the requirements for the setting up of any sharepremium account.
3 (a) The internally generated intangibles are capitalised in accordance with IAS 38, Intangible Assets. It appears that Scramble iscorrectly expensing the maintenance costs as these do not enhance the asset over and above original benefits.
The decision to keep intangibles at historical cost is a matter of choice and therefore policy. Scramble’s accounting policy inthis regard is acceptable.
An intangible asset can have a finite or indefinite life and IAS 38 states that an intangible asset shall be regarded by the entityas having an indefinite useful life when, based on an analysis of all of the relevant factors, there is no foreseeable limit to theperiod over which the asset is expected to generate net cash inflows for the entity.
An indefinite life does not mean infinite and IAS 38 comments that given the history of rapid changes in technology, computersoftware and many other intangible assets are susceptible to technological obsolescence and the useful life may be short.
If the life of an intangible is indefinite then, in accordance with IAS 36, an entity is required to test for impairment bycomparing its recoverable amount with its carrying amount
(a) annually, and(b) whenever there is an indication that the intangible asset may be impaired.
The useful life of an intangible asset that is not being amortised shall be reviewed each period to determine whether eventsand circumstances continue to support an indefinite useful life assessment for that asset. To determine whether the asset isimpaired, IAS 36 must be applied and the intangible asset’s recoverable amount should be compared to its carrying amount.
The way in which Scramble determines its value in use cash flows for impairment testing purposes does not comply with IAS 36 Impairment of Assets. Cash flow projections should be based on reasonable and supportable assumptions, the mostrecent budgets and forecasts, and extrapolation for periods beyond budgeted projections. Management should assess thereasonableness of its assumptions by examining the causes of differences between past cash flow projections and actual cashflows. This process does not seem to have been carried out by Scramble. Additionally, cash flow projections should relate tothe asset in its current condition and future restructurings to which the entity is not committed and expenditures to improveor enhance the asset’s performance should not be anticipated. The cash flows utilised to determine the value in use were notestimated for the asset in its current condition, as they included those which were expected to be incurred in improving thegames and cash inflows expected as a result of those improvements. Further estimates of future cash flows should not includecash inflows or outflows from financing activities, or income tax receipts or payments. Scramble has taken into account thetax effects of future cash flows.
15
(b) The calculation of the discount rate is not wholly in accordance with the requirements of IAS 36 because the discount rateapplied did not reflect the market assessment of the contributing factors. According to IAS 36, the discount rate to be appliedin these circumstances is a pre-tax rate that reflects the current market assessment of the time value of money and the risksspecific to the assets for which the future cash flow estimated have not been adjusted. IAS 36 specifies that a rate that reflectsthe current market assessment of the time value of the money and the risks specific to the assets is the return that theinvestors would require if they chose an investment that would generate cash flows of amounts, timing and risk profileequivalent to those that the entity expects to derive from the assets.
If a market-determined asset-specific rate is not available, a surrogate must be used that reflects the time value of money overthe asset’s life as well as country risk, currency risk, price risk, and cash flow risk. This would include considering the entity’sown weighted average cost of capital, the entity’s incremental borrowing rate and other market borrowing rates. Therefore,the inputs to the determination of the discount rates should be based on current credit spread levels in order to reflect thecurrent market assessment of the time value of the money and asset specific risks. The credit spread input applied shouldreflect the current market assessment of the credit spread at the moment of impairment testing, irrespective of the fact thatScramble did not intend taking any additional financing.
Scramble has not complied with the disclosure requirements of IAS 36, in that neither the events and circumstances that ledto the impairment loss nor the amounts attributable to the two CGUs were separately disclosed. IAS 36 requires disclosureof the amount of the loss and as regards the cash-generating unit, a description of the amount of impairment loss by classof assets. The fact that the circumstances were common knowledge in the market is not a substitution for the disclosure ofthe events and circumstances.
(c) According to IAS 38, the three critical attributes of an intangible asset are:
1. Identifiability;2. control (power to obtain benefits from the asset);3. future economic benefits (such as revenues or reduced future costs).
An intangible asset is identifiable when it is separable or arises from contractual or other legal rights, regardless of whetherthose rights are transferable or separable from the entity or from other rights and obligations.
IAS 38 requires an entity to recognise an intangible asset if, and only if, it is probable that the future economic benefits thatare attributable to the asset will flow to the entity; and the cost of the asset can be measured reliably.
This requirement applies whether an intangible asset is acquired externally or generated internally. The probability of futureeconomic benefits must be based on reasonable and supportable assumptions about conditions that will exist over the life ofthe asset. The probability recognition criterion is always considered to be satisfied for intangible assets that are acquiredseparately or in a business combination.
The registration rights meet the definition and recognition criteria of IAS 38 because they arise from contractual rights.Scramble has control because the right can be transferred or extended and the economic benefits result from the fee incomeScramble can earn as fans come to see the player play.
Under IAS 38 the cost of separately acquired assets comprises: (a) its purchase price, including import duties and non-refundable purchase taxes, after deducting trade discounts and rebates; and (b) any directly attributable cost of preparingthe asset for its intended use. IAS 38 gives examples of directly attributable costs which include professional fees arisingdirectly from bringing the asset to its working conditions. In this business, the players’ registration rights meet the definitionof intangible assets and the agents’ fees represent professional fees incurred in bringing the asset into use.
The requirements above apply to costs incurred initially to acquire or internally generate an intangible asset and those incurredsubsequently to add to, replace part of, or service it. Thus the agents’ fees paid on the extension of players’ contracts can beconsidered costs incurred to service the player registration rights and should be treated as intangible assets.
Where an entity purchases the rights to a proportion of the revenue that a football club generates from ticket sales, it willgenerally have acquired a financial asset. Where the entity has no discretion over pricing or selling of the tickets and is onlyentitled to cash generated from ticket sales, this represents a contractual right to receive cash. If, however, Rashing hadpurchased the rights to sell the tickets for a football club, and was responsible for selling the tickets, then this would createan intangible asset. In this instance Rashing should recognise a financial asset in accordance with IFRS 9. The asset wouldbe classed as either amortised cost or fair value depending on Rashing’s model for managing the financial asset and thecontractual cash flow characteristics of the financial asset. A financial instrument would be classed as amortised cost if bothof the following conditions are met:
(a) The asset is held within a business model whose objective is to hold assets to collect contractual cash flows. (b) The contractual terms of the financial asset give rise on specified dates to cash flows that are solely payments of principal
and interest on the principal amount outstanding.
Rashing does not meet this criteria because although Rashing receives regular cash flows, these are not solely payments ofinterest and capital and are based on ticket revenues and therefore match attendance. As such, the fair value model is moreappropriate.
16
4 (a) (i) Revenue recognition standards have been criticised because an entity applying those standards might recognise amountsin the financial statements that do not faithfully represent the nature of the transactions. This can happen becauserevenue recognition for the sale of goods depends largely on the transference of the risks and rewards of ownership toa customer. Thus an entity might still recognise inventory because not all of the significant risks and rewards have passedto the customer even though the customer has obtained substantial control of the good. This is inconsistent with theIASB’s definition of an asset, which depends on control of the good, not the risks and rewards of owning the good.
The notion of risks and rewards in IAS 18 Revenue can also cause problems when a transaction involves both the saleof goods and related services. An entity often considers the transaction as a whole in order to determine when the risksand rewards of ownership are transferred. As a result, an entity can recognise all of the revenue on delivery of a good,even though it has remaining contractual obligations relating to services to be rendered, for example a warranty ormaintenance agreement.
Thus the revenue recognised does not represent the pattern of the transfer to the customer of all of the goods andservices in the contract. Additionally, an entity might recognise all of the profit in the contract before the entity hasfulfilled all of its obligations, depending upon how the accruals for the services are measured.
Another deficiency in IFRSs relates to the lack of guidance for transactions involving the delivery of more than one goodor service, often called a multiple-element arrangement. IAS 18 states that in certain circumstances, it is necessary toapply the revenue recognition criteria to the separately identifiable components of a single transaction in order to reflectthe substance of the transaction. IAS 18 does not state clearly when or how an entity should separate a singletransaction into components. Often, IAS 18 is viewed as allowing the recognition of all the revenue for a multiple-elementarrangement upon delivery of the first element if all the elements are sold together. However, a different interpretation isoften placed on IAS 18 and revenue is deferred on all the elements until delivery of the final element.
Guidance on how to measure the elements in a multi-element arrangement is missing also, with entities applyingdifferent measurement approaches to similar transactions.
There is difficulty in distinguishing between goods and services. Some entities have been accounting for constructionservice contracts (sale of real estate), recognising revenue throughout the construction process, whilst other entities wereaccounting for similar contracts as contracts for goods, recognising revenue when the risks and rewards of owning thereal estate were transferred to the customer. The lack of a clear distinction between goods and services has reduced thecomparability of revenue across different entities.
There is inconsistency between standards. Under some standards, entities recognise revenue as the activities take placeeven if the customer does not control and have the risks and rewards of ownership of the item. In contrast, the principleof IAS 18 for the sale of goods is that revenue should be recognised only when an entity transfers control and the risksand rewards of ownership of the goods to the customer.
(ii) In most cases, the effect of a customer’s credit risk will not be material and the entity will measure the transaction atthe invoice amount. However, sometimes the customer defaults on payment for reasons other than the non-performanceby the entity. There may be situations where an entity enters into similar transactions with customers and the entityexpects some of those customers to default. In these cases it may be prudent to take account of the fact that some ofthe revenue will not be received. It also would be consistent with other standards to use a probability-weighted amountof consideration that will be expected to be received. If the amount of consideration in these cases cannot be reasonablyestimated, it makes sense not to recognise revenue until the cash is collected or estimated with reasonable certainty.
Normally the time value of money will be immaterial. However in some contracts, the effect could be material if paymentis received significantly before or after the goods or services have been transferred. In these cases, it may be morerelevant for the entity to take into account the time value of money by discounting the consideration using a rate, whichreflects the time value of money and the credit risk. Effectively it will be treated as a financing transaction. The use ofdiscount rates is always quite a subjective way of measuring transactions.
(b) (i) Under IAS 18, revenue would be recognised of $1 million and a trade receivable of the same amount set up. The debtwould be assessed periodically for impairment and, in this case, it would be deemed to be impaired by $100,000. The5% risk of not paying does not create a receivables expense as it is the risk of not paying the entire balance and henceis insignificant. If the scenario had been that 5% of the revenue was uncollectable in this instance a receivables expenseof $50,000 would be required. This impairment would be recognised as an expense rather than a reduction in revenue.However, if credit risk were taken into account in assessing revenue to be recognised, the transaction price would bereduced to $950,000. Revenue and a receivable would be recognised of this amount. The impairment of $100,000would be recognised as an expense and not as a reduction in revenue.
(ii) Where payment is deferred, the substance of the arrangement is that there is both a sale and a financing transaction.Under IAS 18, it is already necessary to discount the consideration to present value in order to arrive at fair value. Inthis instance, the treatment is the same whether IAS 18 is being applied or the proposed accounting treatment.
Venue would recognise revenue of $2 million/(1·04 x 1·04), i.e. $1·85 million. The interest would then be unwoundover the period of the credit given and should be recognised as such. In many situations, entities will sell the same typeof goods on a cash or credit basis. In such cases, the cash price equivalent may normally be the more readilydeterminable indicator of fair value.
17
In terms of the cash payment in advance, under IAS 18, cash would be debited with $3 million and a deferred incomeliability set up in the financial statements of the same amount. No revenue is immediately recorded but when deliveryhas occurred in one year’s time, revenue is recognised of $3 million.
If the time value of money was taken into account, Venue would recognise a contract liability of $3 million and cash of$3 million. During the year to the date of the transfer of the product, an interest expense of ($3 million/1·04) – $3 million, i.e. $120,000 would be recognised and the liability would be increased to $3·12 million. When the productis transferred to the customer, Venue would recognise revenue of $3·12 million.
18
Professional Level – Essentials Module, Paper P2 (UK)Corporate Reporting (United Kingdom) December 2011 Marking Scheme
4 (a) Main weaknesses IAS 18 11Credit risk/time value 5
Professional marks 2
(b) Subjective 7–––25–––
19
Professional Level – Essentials Module
Time allowedReading and planning: 15 minutesWriting: 3 hours
This paper is divided into two sections:
Section A – This ONE question is compulsory and MUST be attempted
Section B – TWO questions ONLY to be attempted
Do NOT open this paper until instructed by the supervisor.
During reading and planning time only the question paper may be annotated. You must NOT write in your answer booklet untilinstructed by the supervisor.
This question paper must not be removed from the examination hall.
Pape
r P2 (
UK
)
Corporate Reporting(United Kingdom)
Tuesday 11 December 2012
The Association of Chartered Certified Accountants
Section A – THIS ONE question is compulsory and MUST be attempted
1 Minny is a company which operates in the service sector. Minny has business relationships with Bower and Heeny.All three entities are public limited companies. The draft statements of financial position of these entities are as followsat 30 November 2012:
Minny Bower Heeny$m $m $m
Assets:Non-current assetsProperty, plant and equipment 920 300 310Investments in subsidiariesBower 730Heeny 320Investment in Puttin 48Intangible assets 198 30 35
–––––– –––––– ––––1,896 650 345
–––––– –––––– ––––Current assets 895 480 250
–––––– –––––– ––––Total assets 2,791 1,130 595
–––––– –––––– ––––
Equity and liabilities:Share capital 920 400 200Other components of equity 73 37 25Retained earnings 895 442 139
–––––– –––––– ––––Total equity and liabilities 2,791 1,130 595
–––––– –––––– ––––
The following information is relevant to the preparation of the group financial statements:
1. On 1 December 2010, Minny acquired 70% of the equity interests of Bower. The purchase considerationcomprised cash of $730 million. At acquisition, the fair value of the non-controlling interest in Bower was $295 million. On 1 December 2010, the fair value of the identifiable net assets acquired was $835 million andretained earnings of Bower were $319 million and other components of equity were $27 million. The excess infair value is due to non-depreciable land.
2. On 1 December 2011, Bower acquired 80% of the equity interests of Heeny for a cash consideration of $320 million. The fair value of a 20% holding of the non-controlling interest was $72 million; a 30% holdingwas $108 million and a 44% holding was $161 million. At the date of acquisition, the identifiable net assets ofHeeny had a fair value of $362 million, retained earnings were $106 million and other components of equitywere $20 million. The excess in fair value is due to non-depreciable land.
It is the group’s policy to measure the non-controlling interest at fair value at the date of acquisition.
3. Both Bower and Heeny were impairment tested at 30 November 2012. The recoverable amounts of both cashgenerating units as stated in the individual financial statements at 30 November 2012 were Bower, $1,425million, and Heeny, $604 million, respectively. The directors of Minny felt that any impairment of assets was dueto the poor performance of the intangible assets. The recoverable amount has been determined withoutconsideration of liabilities which all relate to the financing of operations.
4. Minny acquired a 14% interest in Puttin, a public limited company, on 1 December 2010 for a cashconsideration of $18 million. The investment was accounted for under IFRS 9 Financial Instruments and wasdesignated as at fair value through other comprehensive income. On 1 June 2012, Minny acquired an additional
2
16% interest in Puttin for a cash consideration of $27 million and achieved significant influence. The value ofthe original 14% investment on 1 June 2012 was $21 million. Puttin made profits after tax of $20 million and$30 million for the years to 30 November 2011 and 30 November 2012 respectively. On 30 November 2012,Minny received a dividend from Puttin of $2 million, which has been credited to other components of equity.
5. Minny purchased patents of $10 million to use in a project to develop new products on 1 December 2011.Minny has completed the investigative phase of the project, incurring an additional cost of $7 million and hasdetermined that the product can be developed profitably. An effective and working prototype was created at acost of $4 million and in order to put the product into a condition for sale, a further $3 million was spent. Finally,marketing costs of $2 million were incurred. All of the above costs are included in the intangible assets of Minny.
6. Minny intends to dispose of a major line of the parent’s business operations. At the date the held for sale criteriawere met, the carrying amount of the assets and liabilities comprising the line of business were:
$mProperty, plant and equipment (PPE) 49Inventory 18Current liabilities 3
It is anticipated that Minny will realise $30 million for the business. No adjustments have been made in thefinancial statements in relation to the above decision.
Required:
(a) Prepare the consolidated statement of financial position for the Minny Group as at 30 November 2012.(35 marks)
(b) Minny intended to dispose of part of the business in the above scenario and the business met the held for salecriteria.
Required:
Discuss the differences between the treatment of held for sale and discontinued operations under UK GAAPand International Financial Reporting Standards. (8 marks)
(c) Bower has a property which has a carrying value of $2 million at 30 November 2012. This property had beenrevalued at the year end and a revaluation surplus had been recorded. The directors were intending to revaluethe property at a value of $1 million immediately after the year end and then sell the property to Minny for thisamount within a short period of time.
Required:
Discuss the ethical, legal and accounting implications under UK accounting standards of the above-intendedsale of assets to Minny by Bower. (7 marks)
(50 marks)
3 [P.T.O.
Section B – TWO questions ONLY to be attempted
2 (a) Coate, a public limited company, is a producer of ecologically friendly electrical power (green electricity). Coate’srevenue comprises mainly the sale of electricity and green certificates. Coate obtains green certificates under anational government scheme. Green certificates represent the environmental value of green electricity. Thenational government requires suppliers who do not produce green electricity to purchase a certain number ofgreen certificates. Suppliers who do not produce green electricity can buy green certificates either on the marketon which they are traded or directly from a producer such as Coate. The national government wishes to giveincentives to producers such as Coate by allowing them to gain extra income in this way.
Coate obtains the certificates from the national government on satisfactory completion of an audit by anindependent organisation, which confirms the origin of production. Coate then receives a certain number of greencertificates from the national government depending on the volume of green electricity generated. The greencertificates are allocated to Coate on a quarterly basis by the national government and Coate can trade the greencertificates.
Coate is uncertain as to the accounting treatment of the green certificates in its financial statements for the periodended 30 November 2012 and how to treat the green certificates which were not sold at the end of the reportingperiod. (7 marks)
(b) During the year ended 30 November 2012, Coate acquired an overseas subsidiary whose financial statementsare prepared in a different currency to Coate. The amounts reported in the consolidated statement of cash flowsincluded the effect of changes in foreign exchange rates arising on the retranslation of its overseas operations.Additionally, the group’s consolidated statement of cash flows reported as a loss the effect of foreign exchangerate changes on cash and cash equivalents as Coate held some foreign currency of its own denominated in cash.
(5 marks)
(c) Coate also sold 50% of a previously wholly owned subsidiary, Patten, to a third party, Manis. Manis is in thesame industry as Coate. Coate has continued to account for the investment in Patten as a subsidiary in itsconsolidated financial statements. The main reason for this accounting treatment was the agreement that hadbeen made with Manis, under which Coate would exercise general control over Patten’s operating and financialpolicies. Coate has appointed three out of four directors to the board. The agreement also stated that certaindecisions required consensus by the two shareholders.
Under the shareholder agreement, consensus is required with respect to:
– significant changes in the company’s activities;– plans or budgets that deviate from the business plan;– accounting policies; acquisition of assets above a certain value; employment or dismissal of senior
employees; distribution of dividends or establishment of loan facilities.
Coate feels that the consensus required above does not constitute a hindrance to the power to control Patten, asit is customary within the industry to require shareholder consensus for decisions of the types listed in theshareholders’ agreement. (6 marks)
(d) In the notes to Coate’s financial statements for the year ended 30 November 2012, the tax expense included anamount in respect of ‘Adjustments to current tax in respect of prior years’ and this expense had been treated asa prior year adjustment. These items related to adjustments arising from tax audits by the authorities in relationto previous reporting periods.
The issues that resulted in the tax audit adjustment were not a breach of tax law but related predominantly totransfer pricing issues, for which there was a range of possible outcomes that were negotiated during 2012 withthe taxation authorities. Further at 30 November 2011, Coate had accounted for all known issues arising fromthe audits to that date and the tax adjustment could not have been foreseen as at 30 November 2011, as theaudit authorities changed the scope of the audit. No penalties were expected to be applied by the taxationauthorities. (5 marks)
4
Required:
Discuss how the above events should be accounted for in the individual or, as appropriate, the consolidatedfinancial statements of Coate.
Note: The mark allocation is shown against each of the four events above.
Professional marks will be awarded in question 2 for the clarity and quality of the presentation and discussion.(2 marks)
(25 marks)
5 [P.T.O.
3 Blackcutt is a local government organisation whose financial statements are prepared using International FinancialReporting Standards.
(a) Blackcutt wishes to create a credible investment property portfolio with a view to determining if any property maybe considered surplus to the functional objectives and requirements of the local government organisation. Thefollowing portfolio of property is owned by Blackcutt.
Blackcutt owns several plots of land. Some of the land is owned by Blackcutt for capital appreciation and thismay be sold at any time in the future. Other plots of land have no current purpose as Blackcutt has notdetermined whether it will use the land to provide services such as those provided by national parks or for short-term sale in the ordinary course of operations.
The local government organisation supplements its income by buying and selling property. The housingdepartment regularly sells part of its housing inventory in the ordinary course of its operations as a result ofchanging demographics. Part of the inventory, which is not held for sale, is to provide housing to low-incomeemployees at below market rental. The rent paid by employees covers the cost of maintenance of the property.
(7 marks)
(b) Blackcutt has outsourced its waste collection to a private sector provider called Waste and Co and pays an annualamount to Waste and Co for its services. Waste and Co purchases the vehicles and uses them exclusively forBlackcutt’s waste collection. The vehicles are painted with the Blackcutt local government organisation name andcolours. Blackcutt can use the vehicles and the vehicles are used for waste collection for nearly all of the asset’slife. In the event of Waste and Co’s business ceasing, Blackcutt can obtain legal title to the vehicles and carry onthe waste collection service. (6 marks)
(c) Blackcutt owns a warehouse. Chemco has leased the warehouse from Blackcutt and is using it as a storagefacility for chemicals. The national government has announced its intention to enact environmental legislationrequiring property owners to accept liability for environmental pollution. As a result, Blackcutt has introduced ahazardous chemical policy and begun to apply the policy to its properties. Blackcutt has had a report that thechemicals have contaminated the land surrounding the warehouse. Blackcutt has no recourse against Chemcoor its insurance company for the clean-up costs of the pollution. At 30 November 2012, it is virtually certain thatdraft legislation requiring a clean up of land already contaminated will be enacted shortly after the year end.
(4 marks)
(d) On 1 December 2006, Blackcutt opened a school at a cost of $5 million. The estimated useful life of the schoolwas 25 years. On 30 November 2012, the school was closed because numbers using the school declinedunexpectedly due to a population shift caused by the closure of a major employer in the area. The school is tobe converted for use as a library, and there is no expectation that numbers using the school will increase in thefuture and thus the building will not be reopened for use as a school. The current replacement cost for a libraryof equivalent size to the school is $2·1 million. Because of the nature of the non-current asset, value-in-use andnet selling price are unrealistic estimates of the value of the school. The change in use has no effect on theestimated life of the building. (6 marks)
Required:
Discuss how the above events should be accounted for in the financial statements of Blackcutt.
Note: The mark allocation is shown against each of the four events above.
Professional marks will be awarded in question 3 for the clarity and quality of the presentation and discussion.(2 marks)
(25 marks)
6
4 (a) The International Accounting Standards Board has recently completed a joint project with the FinancialAccounting Standards Board (FASB) on fair value measurement by issuing IFRS 13 Fair Value Measurement.IFRS 13 defines fair value, establishes a framework for measuring fair value and requires significant disclosuresrelating to fair value measurement.
The IASB wanted to enhance the guidance available for assessing fair value in order that users could better gaugethe valuation techniques and inputs used to measure fair value. There are no new requirements as to when fairvalue accounting is required, but the IFRS gives guidance regarding fair value measurements in existingstandards. Fair value measurements are categorised into a three-level hierarchy, based on the type of inputs tothe valuation techniques used. However, the guidance in IFRS 13 does not apply to transactions dealt with bycertain specific standards.
Required:
(i) Discuss the main principles of fair value measurement as set out in IFRS 13. (7 marks)
(ii) Describe the three level hierarchy for fair value measurements used in IFRS 13. (6 marks)
(b) Jayach, a public limited company, is reviewing the fair valuation of certain assets and liabilities in the light of theintroduction of IFRS 13.
It carries an asset that is traded in different markets and is uncertain as to which valuation to use. The asset hasto be valued at fair value under International Financial Reporting Standards. Jayach currently only buys and sellsthe asset in the Australasian market. The data relating to the asset are set out below:
Year to 30 November 2012 Asian European AustralasianMarket Market Market
Volume of market – units 4 million 2 million 1 millionPrice $19 $16 $22Costs of entering the market $2 $2 $3Transaction costs $1 $2 $2
Additionally, Jayach had acquired an entity on 30 November 2012 and is required to fair value adecommissioning liability. The entity has to decommission a mine at the end of its useful life, which is in threeyears’ time. Jayach has determined that it will use a valuation technique to measure the fair value of the liability.If Jayach were allowed to transfer the liability to another market participant, then the following data would beused.
Input AmountLabour and material cost $2 millionOverhead 30% of labour and material costThird party mark-up – industry average 20%Annual inflation rate 5%Risk adjustment – uncertainty relating to cash flows 6%Risk-free rate of government bonds 4%Entity’s non-performance risk 2%
Jayach needs advice on how to fair value the liability.
Required:
Discuss, with relevant computations, how Jayach should fair value the above asset and liability under IFRS 13. (10 marks)
Professional marks will be awarded in question 4 for the clarity and quality of the presentation and discussion.(2 marks)
(25 marks)
End of Question Paper
7
Answers
Professional Level – Essentials Module, Paper P2 (UK)Corporate Reporting (United Kingdom) December 2012 Answers
1 Minny Group
(a) Consolidated Statement of Financial Position at 30 November 2012
$mAssets:Non-current assets:Property, plant and equipment (W9) 1,606·00Goodwill (W2) 190·00Intangible assets (W8) 227·00Investment in Puttin (W3) 50·50
–––––––––2,073·50
–––––––––Current assets (W10) 1,607·00
–––––––––Disposal group (W11) 33·00
–––––––––Total assets 3,713·50
–––––––––
Equity and liabilitiesEquity attributable to owners of parentShare capital 920·00Retained earnings (W5) 936·08Other components of equity (W5) 77·80
–––––––––Disposal group (W11) 3·00Current liabilities (W6) 671·00
–––––––––Total liabilities 1,385·00
–––––––––Total equity and liabilities 3,713·50
–––––––––
Working 1
Bower
$m $mPurchase consideration 730Fair value of non-controlling interest 295Fair value of identifiable net assets acquired:Share capital 400Retained earnings 319OCE 27FV adjustment – land 89
––––(835)––––
Goodwill 190––––
Working 2
Heeny
$m $mPurchase consideration – 320Less consideration belonging to NCI – (30% of $320) (96)NCI fair value of 44% holding 161Fair value of identifiable net assets:Share capital 200Retained earnings 106OCE 20FV adjustment – land 36
––––(362)––––
Goodwill 23––––
11
Impairment test of Bower and Heeny
Bower Heeny$m $m
Goodwill 190 23
Assets 1,130 595Fair value adjustment 89 36
–––––– ––––Total asset value 1,409 654Recoverable amount (1,425) (604)
–––––– ––––Impairment n/a 50
There is no impairment in the case of Bower but Heeny’s assets are impaired. Goodwill of $23 million plus $27 million ofthe intangible assets will be written off. The reason for the latter write down is because the directors feel that the reason forthe reduction in the recoverable amount is due to the intangible assets’ poor performance.
Group reserves will be debited with $28 million and NCI with $22 million, being the loss in value of the assets split accordingto the profit sharing ratio.
Total goodwill is therefore ($190m + $23m – $23m impairment), i.e. $190 million
Working 3
Puttin
The gain of $3 million ($21m – $18m) recorded within OCE up to 1 June 2012 would not be transferred to profit or loss forthe year but can be transferred within equity and hence to retained earnings under IFRS 9 Financial Instruments.
The amount included in the consolidated statement of financial position would be:
$mCost ($21 million + $27 million) 48Share of post-acquisition profits ($30 million x 0·5 x 30%) 4·5Less dividend received (2·0)
–––––50·5
–––––
The dividend should have been credited to Minny’s profit or loss and not OCI. Dividend income as an investment and as anassociate is treated in the same way as a credit to profit or loss. There is no impairment as the carrying amount of theinvestment in the separate financial statements does not exceed the carrying amount in the consolidated financial statementsnor does the dividend exceed the total comprehensive income of the associate in the period in which the dividend is declared.
Working 4
Intangible assets
Minny should recognise the $10 million as an intangible asset plus the cost of the prototype of $4 million and the $3 millionto get it into condition for sale. The remainder of the costs should be expensed including the marketing costs. This totals $9 million, which should be taken out of intangibles and expensed.
Dr Retained earnings $9 millionCr Intangible assets $9 million
Working 5
Retained earnings
$mBalance at 30 November 2012: Minny 895·00Post-acquisition reserves: Bower (70% of (442 – 319)) 86·10
Heeny (56% of (139 – 106)) 18·48Puttin: fair value of investment at acquisition from OCE 3·00Puttin: share of post-acquisition retained profits (W3) (4·5 – 2) 2·50Dividend income from OCE 2·00Intangible assets (9·00)Impairment loss on goodwill of Heeny (W2) (28)Impairment loss on disposal group (W11) (34)
–––––––Total 936·08
–––––––
12
Other components of equity
$mBalance at 30 November 2012: Minny 73Post-acquisition reserves: Bower (70% of (37 – 27)) 7
Heeny (56% of (25 – 20)) 2·8Dividend income to retained earnings (2)Transfer to retained earnings (3)
–––––77·8
–––––
Working 6
Current liabilities
$mBalance at 30 November 2012Minny 408Bower 128Heeny 138
––––674
Disposal group (3)––––671––––
Working 7
Non-controlling interest
$mBower (W1) 295Heeny (W2) – purchase consideration (96)Fair value 161Post-acquisition reserves – BowerRetained earnings (30% of (442 – 319)) 36·9OCE (30% of (37 – 27)) 3HeenyRetained earnings (44% of (139 – 106)) 14·52OCE (44% of (25 – 20)) 2·2Impairment loss (22)
–––––––394·62–––––––
Working 8
Intangibles
$m $mMinny 198Bower 30Heeny 35Intangible expensed (9)Impairment of intangible (27)
–––– ––––227––––
Working 9
Property, plant and equipment
$m $mMinny 920Bower 300Heeny 310
––––1,530
Increase in value of land – Bower (W1) 89Increase in value of land – Heeny (W2) 36
The assets and liabilities will be shown as single line items in the statement of financial position. Assets at ($67 – 34 m),i.e. $33 million and liabilities at $3 million. A plan to dispose of net assets is an impairment indicator.
(b) IFRS 5 Non-current Assets Held for Sale and Discontinued Operations sets out requirements for the classification,measurement and presentation of non-current assets held for sale. There is no equivalent UK standard. IFRS 5 introducesthe concept of a ‘disposal group’. Assets classified as held for sale and the assets in a disposal group that is classified as heldfor sale are presented separately from other assets in the statement of financial position. The liabilities of a disposal groupclassified as held for sale should be presented separately from other liabilities. There is no equivalent UK rule.
An asset held for sale, or included within a disposal group that is held for sale, is not depreciated under IFRS 5. This differsfrom UK GAAP where depreciation would continue until the asset was actually disposed of.
Under IFRS 5, subsidiaries acquired exclusively with a view to resale that meet the conditions to be classified as held for saleare consolidated, but their results are presented within the single line item for discontinued operations. They are presentedin the statement of financial position as two separate items, that is, assets including goodwill, and liabilities measured at fairvalue less costs to sell. Under UK GAAP, these subsidiaries are exempt from consolidation and are included in the statementof financial position as a single asset at fair value based on net proceeds.
The definitions of discontinued operations differ. Under IFRS 5, a discontinued operation is a separate major line of businessor geographical area of operations or is part of a single plan to dispose of a major line of business or geographical area ofoperations or is a subsidiary acquired exclusively with a view to resale. FRS 3 Reporting Financial Performance requires thediscontinued operation to have a material effect on the nature and focus of the reporting entity’s operations. Under IFRS 5,an operation is classified as discontinued at the date the operation meets the criteria to be classified as held for sale or whenthe entity has disposed of the operation. ‘Held for sale’ means that the asset (or disposal group) must be available forimmediate sale in its present condition and its sale must be highly probable. To be highly probable, management should becommitted to a plan to sell and an active programme to locate a buyer and complete the plan should have begun. The saleshould be completed within one year of the date of classification as held for resale except if this is delayed due tocircumstances beyond the entity’s control. Disposed operations may qualify as discontinued earlier than they might have doneunder UK GAAP as FRS 3 specifies a three month cut-off period after the period end. IFRS 5 requires a single number to bedisclosed on the face of the income statement, being the total of (i) the discontinued operations’ post-tax profit/loss and (ii) the post-tax gain/loss recognised in the measurement of the fair value less costs to sell or on the disposal of thediscontinued operations’ assets. A breakdown of this number is required to be given either on the face of the statement ofcomprehensive income or in the notes. FRS 3 requires disclosure of the split in the pre-tax figures on the face of the incomestatement.
IFRS 5 requires disclosure of the net cash flows attributable to operating, investing and financing activities of discontinuedoperations, whereas under UK GAAP, FRS 1 Cash Flow Statements only encourages disclosure of cash flows fromdiscontinued operations.
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(c) A revaluation loss of $1 million will occur on the revaluation after the year end. Under FRS 15 Tangible Fixed Assets,revaluation losses are recognised in the profit and loss account if they result from a clear consumption of economic benefits.All other losses are recognised in STRGL until the asset’s carrying amount reaches its depreciated historical cost, and then inthe profit and loss account, except to the extent that the asset’s recoverable amount is greater than its revalued amount. It ispossible to have debit balances in the revaluation reserves. However the revaluation may have other implications. Questionsshould be asked about the authenticity of the valuation placed on the property if the valuation has been carried out by thedirectors. Further, the transfer may constitute a distribution of non cash assets. A company may distribute non-cash assetsbut if a company undertakes a transaction for a consideration at less than fair value then the legality of the transaction mustbe reviewed. The transfer of the asset from Bower to Minny appears to be a distribution of profits. The shortfall between therevaluation and the carrying value is $1 million and on sale, this may be treated as a distribution. The sale is likely to belegal but the boundary between ethical practices and legality is sometimes blurred. Questions would be asked of the directorsas to why they would want to sell an asset at half of its apparent current value. It raises suspicion as to the motives of theentity. Corporate reporting involves the development and disclosure of information, which should be truthful and neutral. Thenature of the responsibility of the directors requires a high level of ethical behaviour. Shareholders, potential shareholders,and other users of the financial statements rely heavily on the financial statements of a company as they can use thisinformation to make an informed decision about investment. They rely on the directors to present a true and fair view of thecompany. Unethical behaviour is difficult to control or define. However, it is likely that this action will cause a degree ofmistrust between the directors and shareholders unless there is a logical and business reason for their actions.
2 (a) Coate should determine, apply and disclose appropriate policies covering the acquisition, the presentation and measurementof the certificates in its financial statements. The green certificates should be accounted for as government grants inaccordance with IAS 20 Accounting for Government Grants and Disclosure of Government Assistance. The green certificatesqualify as government grants in accordance with IAS 20, as they represent assistance by government in the form of resourcesprovided to an entity in return for past compliance with certain conditions relating to its operating activities. A governmentgrant is recognised only when there is reasonable assurance that the entity will comply with any conditions attached to thegrant and the grant will be received.
A grant is recognised as income over the period necessary to match it with the related costs, for which they are intended tocompensate, on a systematic basis.
The certificates are income-related grants according to the standard as the certificates are not long-term assets. Thequalification of the green certificates as income-related grants has implications for the financial statements. In accordancewith IAS 20, the green certificates must be shown as a credit in profit or loss, either separately or under a general headingsuch as ‘Other income’. Alternatively, they must be deducted in reporting the related expense. Additionally, Coate shoulddisclose an accounting policy for government grants and provide the additional disclosures required in respect of the natureand extent of the government assistance given and any unfulfilled conditions or other contingencies attaching.
To the extent that the certificates were not sold by the end of the accounting period, Coate should recognise them underinventories in accordance with IAS 2 Inventories, as they are held for sale in the ordinary course of business within themeaning of the standard. On sale, the income from green certificates is shown as ‘Sale of green certificates’ in accordancewith IAS 18 Revenue and the related green certificates, included in inventory, are charged to production as part of the costof sales.
The journal entry to record the quarterly receipt of the grant is:
DR Certificate (SOFP) $fair value of certificate at receiptCR Deferred revenue (SOFP) $fair value of certificate at receipt
On the sale of a certificate – this is when its value is realised and the following entries will be posted:
DR Deferred revenue (SOFP) $fair value of certificate at receiptCR Cost of sale (SOCI) $fair value of certificate at receipt
Being a contribution to the cost of generating electricity.
DR Bank/Receivable (SOFP) $fair value of tradeCR Certificate (SOFP) $fair value of certificate at receiptDR/CR Revenue (SOCI) $balance
Being the surplus or deficit as compared to the proceeds received from the national government and hence the true value ofthe sale of the certificate.
The accounting policies relating to the accounting treatment of the green certificates should be disclosed in the financialstatements as required by IAS 1 Presentation of Financial Statements.
(b) IAS 7 Statement of Cash Flows states that unrealised gains and losses arising from changes in foreign exchange rates are notcash flows. However, the effect of exchange rate changes on cash and cash equivalents held or due in a foreign currency isreported in the statement of cash flows in order to reconcile cash and cash equivalents at the beginning and the end of theperiod. This amount is presented separately from cash flows from operating, investing and financing activities and includesthe differences had those cash flows been reported at the end of period exchange rates.
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The method of translation for foreign operations in IAS 21 The Effects of Changes in Foreign Exchange Rates requiresmonetary and non-monetary assets and liabilities to be translated at the closing rate, and income and expense items to betranslated at the rate ruling at the date of the transaction or an average rate that approximates to the actual exchange rates.All exchange differences are taken to a separate component of equity, until disposal of the foreign operation when they arereclassified to profit or loss.
All exchange differences relating to the retranslation of a foreign operation’s opening net assets to the closing rate will havebeen recognised in other comprehensive income and presented in a separate component of equity. As such exchangedifferences have no cash flow effect, they will not be included in the consolidated statement of cash flows. However, theopening net assets of Coate include foreign currency cash and cash equivalents; therefore the exchange difference arising ontheir retranslation at the closing rate for the current period will have been reflected in the closing balances in the financialstatements. Such translation differences should be reported in the cash flow statement to determine the total movement incash and cash equivalents in the period.
(c) In accordance with IFRS 10 Consolidated Financial Statements, an investor considers all relevant facts and circumstanceswhen assessing whether it controls an investee. An investor controls an investee when it is exposed, or has rights, to variablereturns from its involvement with the investee and has the ability to affect those returns through its power over the investee.
An investor controls an investee if and only if the investor has all of the following elements:
– power over the investee, that is the investor has existing rights that give it the ability to direct the relevant activities (theactivities that significantly affect the investee’s returns)
– exposure, or rights, to variable returns from its involvement with the investee – the ability to use its power over the investee to affect the amount of the investor’s returns.
Power arises from rights which may be obvious through voting rights or be complex because of contractual arrangements. Aninvestor that holds only protective rights cannot have power over an investee and so cannot control an investee. A parent mustalso have the ability to use its power over the investee to affect its returns from its involvement with the investee.
The shareholder agreement shows that Coate has influence over the company but the restrictions in the agreement withregards to decisions to be made in the ordinary course of business, such as consensus between shareholders required foracquisition of assets above a certain value, employment or dismissal of senior employees, distribution of dividends orestablishment of loan facilities, indicates that Coate does not control Patten. Such terms of the agreement indicate theexistence of a joint arrangement in accordance with IFRS 11 Joint Arrangements, that is a joint venture, as decisions aremade at entity level operations and not regarding individual assets and liabilities.
Coate argued that the restrictions do not constitute a hindrance to the power to control, as it is customary within the industryto require shareholder consensus for decisions of the types listed in the shareholders’ agreement.
However, the agreement contains so many significant restrictions with respect to operating and financial decisions that it doesnot entail control of Patten. As shareholder consensus is required in respect of many significant decisions, Coate is unable toutilise the position it has at board level where it has the power to cast the majority of votes.
As such, Coate is required to deconsolidate Patten as a subsidiary from its group accounts as it does not control the entity.Further, Coate should account for Patten in accordance with IAS 28 Associates and Joint Ventures. This will require Coate toequity account for Patten within the consolidated financial statements.
(d) The tax adjustments resulting from the taxation authority audits should be treated as a change in an accounting estimate andnot as a prior period adjustment. Tax expenses are difficult to estimate correctly and tax computations are open for review oraudit by taxation authorities for a number of years after the end of the reporting period. IAS 8 Accounting Policies, Changesin Accounting Estimates and Errors provides that the effect of a change in an accounting estimate should be recognisedprospectively by including it in profit or loss in the period of the change. It also states that an entity should correct materialprior period errors retrospectively in the first set of financial statements authorised for issue after their discovery by restatingthe comparative amounts. A prior period error is an omission from or misstatement in the entity’s financial statements arisingfrom a failure to use or misuse of reliable information that was available at the time of authorisation of the financial statementsand could reasonably be expected to have been obtained and taken into account at the time of their preparation andpresentation.
IAS 12 Income Taxes requires separate disclosure of the major components of the tax expense. It states that such componentsmay include any adjustments recognised in the period for current tax of prior periods and the deferred tax expense. Thus,separate disclosure of these elements of the tax adjustments is required. The audit adjustments did not arise from a failureto use reliable information, which was available during previous reporting periods, as Coate correctly applied the provisionsof tax law. The issues that the adjustments related to were transfer pricing issues for which there was a range of possibleoutcomes that were negotiated during 2012 with the taxation authorities. This indicates that these adjustments wereeffectively a change in an accounting estimate. Further at 30 November 2011, Coate had accounted for all known issuesarising from the audits to that date and the adjustment could not have been foreseen as at 30 November 2011, as the auditauthorities changed the scope of the audit. Thus, the adjustments could not have been made at 30 November 2011 as theinformation and conditions did not exist at that date. Further, no penalties were expected to be applied by the taxationauthorities, which indicates that there were no errors in the provision of information to the authorities, which again points toa change in accounting estimate and not a prior period error.
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3 (a) IAS 40 Investment Property sets out the accounting treatment for investment property and the related disclosurerequirements. It deals with the recognition, measurement and disclosure of investment property. The scope includes propertyheld for capital appreciation or to earn rentals. Investment property is defined as property held by the owner or held on afinance lease to earn rentals or for capital appreciation or both, rather than for:
– use in producing or supplying goods or services or for administrative purposes; or– sale in the ordinary course of business.
The definition excludes owner-occupied property, property intended for sale in the ordinary course of business, property beingconstructed on behalf of third parties and property that is leased to a third party under a finance lease.
Where the fair value model under IAS 40 is applied, such a property is measured at fair value. Where an entity providesancillary services to occupants of a property owned by the entity, the property is an investment property if such ancillaryservices are a relatively insignificant portion of the arrangement as a whole. Where, however, such services are a moresignificant portion, such as in a hotel, the property is treated not as investment property, but as an owner-occupied property.
Investment property should be recognised as an asset when it is probable that the future economic benefits associated withthe property will flow to the entity and the cost of the property can be reliably measured.
Thus, the land that is owned by Blackcutt for capital appreciation which may be sold at any time in the future and the landthat has no current purpose are both considered to be investment property under IAS 40. If the land has no current purpose,it is considered to be held for capital appreciation.
Blackcutt supplements its income by buying and selling property, and the housing department regularly sells part of itshousing inventory. As these sales are in the ordinary course of its operations and are routinely occurring, then the housingstock held for sale will be classified as inventory. The part of the inventory held to provide housing to low-income employeesat below market rental will not be treated as investment property as the property is not held for capital appreciation and theincome just covers the cost of maintaining the properties and thus is not for profit. The property is held to provide housingservices rather than rentals. The rental revenue is incidental to the purposes for which the property is held. This property willbe accounted for under IAS 16 Property, Plant and Equipment. The property is treated as owner-occupied as set out above.
(b) An entity may enter into an arrangement that does not take the legal form of a lease but conveys a right to use an asset. Anentity should use the Conceptual Framework for Financial Reporting in conjunction with IAS 17 Leases to determine whethersuch arrangements are, or contain, leases that should be accounted for in accordance with the standard. Determining whetheran arrangement is, or contains, a lease is based on the substance of the arrangement and requires an assessment of:
(i) the risks and rewards of the arrangement and how best to recognise them;(ii) the right to use the asset or direct others to use the asset;(iii) the right to control the use of the underlying asset by operating the asset or directing others to operate the asset;(iv) who obtains much of the benefit from the asset.
In this case, the private sector provider purchases the vehicles and uses them exclusively for the local governmentorganisation. The vehicles are ostensibly those of Blackcutt as they are painted with the local government name and colours.Blackcutt can use the vehicles and the vehicles are used in this connection for nearly all of the asset’s life. In the event of theprivate sector provider’s business ceasing, Blackcutt can repossess the vehicles and carry on the refuse collection service.Thus, the arrangement fits the terms of a lease and Blackcutt should account for the vehicles as a finance lease.
The value associated with the lease can be obtained by considering the fair value of acquiring the vehicle. This will also bethe initial lease obligation. The payment made by Blackcutt to the leasing company may be two-fold, representing the costof the lease obligation and the service element relating to the cost of the collection of the waste.
(c) A provision shall be recognised under IAS 37 Provisions, Contingent Liabilities and Contingent Assets when there is a presentobligation (legal or constructive) as a result of a past event, it is probable that an outflow of resources embodying economicbenefits or service potential will be required to settle the obligation, and a reliable estimate can be made of the amount of theobligation. If the above conditions are not met, no provision shall be recognised. In this case, the obligating event is thecontamination of the land because of the virtual certainty of legislation requiring the clean up. Additionally, there is probablygoing to be an outflow of resources embodying economic benefits because Blackcutt has no recourse against the entity or itsinsurance company. Therefore a provision is recognised for the best estimate of the costs of the clean up. As Blackcutt hasno recourse against Chemco, recovery of the costs of clean up is not likely and hence no corresponding receivable should berecorded.
(d) An asset is carried at more than its recoverable amount if its carrying amount exceeds the amount to be recovered throughuse or sale of the asset. If this is the case, the asset is described as impaired and IAS 36 Impairment of Assets requires therecognition of an impairment loss. At the end of each reporting period, an assessment should take place as to whether thereis any indication that an asset may be impaired. If any indication exists, the recoverable amount should be estimated takinginto account the concept of materiality in identifying whether the recoverable amount of an asset needs to be estimated. If noindication of an impairment loss is present, IAS 36 does not require a formal estimate of the recoverable amount, with theexception of intangible assets.
Impairment in this case is indicated because the purpose for which the building is used has changed significantly from aplace for educating students to a library and this is not anticipated to change for the foreseeable future. There is insufficient
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information to determine value in use and net selling price (fair value less selling costs); as such, depreciated replacementcost should be used as an approximation of recoverable amount. An impairment loss using a depreciated replacement costapproach would be determined as follows:
Thus Blackcutt would record the impairment loss of $2·204m.
4 (a) (i) Fair value has had a different meaning depending on the context and usage. The IASB’s definition is the price that wouldbe received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at themeasurement date. Basically it is an exit price. Fair value is focused on the assumptions of the market place and is notentity specific. It therefore takes into account any assumptions about risk. Fair value is measured using the sameassumptions and taking into account the same characteristics of the asset or liability as market participants would. Suchconditions would include the condition and location of the asset and any restrictions on its sale or use. Further, it is notrelevant if the entity insists that prices are too low relative to its own valuation of the asset and that it would be unwillingto sell at low prices. Prices to be used are those in ‘an orderly transaction’. An orderly transaction is one that assumesexposure to the market for a period before the date of measurement to allow for normal marketing activities and to ensurethat it is not a forced transaction. If the transaction is not ‘orderly’, then there will not have been enough time to createcompetition and potential buyers may reduce the price that they are willing to pay. Similarly, if a seller is forced to accepta price in a short period of time, the price may not be representative. It does not follow that a market in which there arefew transactions is not orderly. If there has been competitive tension, sufficient time and information about the asset,then this may result in a fair value for the asset.
IFRS 13 does not specify the unit of account for measuring fair value. This means that it is left to the individual standardto determine the unit of account for fair value measurement. A unit of account is the single asset or liability or group ofassets or liabilities. The characteristic of an asset or liability must be distinguished from a characteristic arising from theholding of an asset or liability by an entity. An example of this is that if an entity sold a large block of shares, it mayhave to do so at a discount to the market price. This is a characteristic of holding the asset rather than of the asset itselfand should not be taken into account when fair valuing the asset.
Fair value measurement assumes that the transaction to sell the asset or transfer the liability takes place in the principalmarket for the asset or liability or, in the absence of a principal market, in the most advantageous market for the assetor liability. The principal market is the one with the greatest volume and level of activity for the asset or liability that canbe accessed by the entity.
The most advantageous market is the one which maximises the amount that would be received for the asset orminimises the amount that would be paid to transfer the liability after transport and transaction costs.
An entity does not have to carry out an exhaustive search to identify either market but should take into account allavailable information. Although transaction costs are taken into account when identifying the most advantageous market,the fair value is not after adjustment for transaction costs because these costs are characteristics of the transaction andnot the asset or liability. If location is a factor, then the market price is adjusted for the costs incurred to transport theasset to that market. Market participants must be independent of each other and knowledgeable, and able and willingto enter into transactions.
IFRS 13 sets out a valuation approach, which refers to a broad range of techniques, which can be used. Thesetechniques are threefold. The market, income and cost approaches.
(ii) When measuring fair value, the entity is required to maximise the use of observable inputs and minimise the use ofunobservable inputs. To this end, the standard introduces a fair value hierarchy, which prioritises the inputs into the fairvalue measurement process.
Level 1 inputs are quoted prices (unadjusted) in active markets for items identical to the asset or liability beingmeasured. As with current IFRS, if there is a quoted price in an active market, an entity uses that price withoutadjustment when measuring fair value. An example of this would be prices quoted on a stock exchange. The entity needsto be able to access the market at the measurement date. Active markets are ones where transactions take place withsufficient frequency and volume for pricing information to be provided. An alternative method may be used where it isexpedient. The standard sets out certain criteria where this may be applicable. For example, where the price quoted inan active market does not represent fair value at the measurement date. An example of this may be where a significantevent takes place after the close of the market such as a business reorganisation or combination.
The determination of whether a fair value measurement is level 2 or level 3 inputs depends on whether the inputs areobservable inputs or unobservable inputs and their significance.
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Level 2 inputs are inputs other than the quoted prices in level 1 that are directly or indirectly observable for that assetor liability. They are quoted assets or liabilities for similar items in active markets or supported by market data. Forexample, interest rates, credit spreads or yield curves. Adjustments may be needed to level 2 inputs and if thisadjustment is significant, then it may require the fair value to be classified as level 3.
Level 3 inputs are unobservable inputs. The use of these inputs should be kept to a minimum. However, situations mayoccur where relevant inputs are not observable and therefore these inputs must be developed to reflect the assumptionsthat market participants would use when determining an appropriate price for the asset or liability. The entity shouldmaximise the use of relevant observable inputs and minimise the use of unobservable inputs. The general principle ofusing an exit price remains and IFRS 13 does not preclude an entity from using its own data. For example, cash flowforecasts may be used to value an entity that is not listed. Each fair value measurement is categorised based on thelowest level input that is significant to it.
(b) Year to 31 December 2012 Asian Market European Market Australasian MarketVolume of market – units 4 million 2 million 1 millionPrice $19 $16 $22Costs of entering the market ($2) ($2) (n/a) see notePotential fair value $17 $14 $22Transaction costs ($1) ($2) ($2)
–––– –––– ––––Net profit $16 $12 $20
–––– –––– ––––
Note: As Jayach buys and sells in Australasia, the costs of entering the market are not relevant as these would not be incurred.Further transaction costs are not considered as these are not included as part of the valuation.
The principal market for the asset is the Asian market because of the fact that it has the highest level of activity due to thehighest volume of units sold. The most advantageous market is the Australasian market because it returns the best profit perunit. If the information about the markets is reasonably available, then Jayach should base its fair value on prices in the Asianmarket due to it being the principal market, assuming that Jayach can access the market. The pricing is taken from thismarket even though the entity does not currently transact in the market and is not the most advantageous. The fair valuewould be $17, as transport costs would be taken into account but not transaction costs.
If the entity cannot access the Asian or European market, or reliable information about the markets is not available, Jayachwould use the data from the Australasian market and the fair value would be $22. The principal market is not always themarket in which the entity transacts. Market participants must be independent of each other and knowledgeable, and ableand willing to enter into transactions.
Input Amount ($ 000)Labour and material cost 2,000Overhead (30%) 600Third party mark-up – industry average (20% of 2,600) 520
––––––Total 3,120Annual inflation rate (3,120 x 5% compounded for three years) 492
––––––Total 3,612Risk adjustment – 6% 217
––––––Total 3,829Discounted at risk-free rate of government bonds plus entity’s non-performance risk – 6% 3,215
The fair value of a liability assumes that it is transferred to a market participant at the measurement date. In many cases thereis no observable market to provide pricing information. In this case, the fair value is based on the perspective of a marketparticipant who holds the identical instrument as an asset. If there is no corresponding asset, then a valuation technique isused. This would be the case with the decommissioning activity. The fair value of a liability reflects any compensation for riskand profit margin that a market participant might require to undertake the activity plus the non-performance risk based onthe entity’s own credit standing. Thus the fair value of the decommissioning liability would be $3,215,000.
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Professional Level – Essentials Module, Paper P2 (UK)Corporate Reporting (United Kingdom) December 2012 Marking Scheme
Marks1 (a) Property, plant and equipment 5
Goodwill 5Intangible assets 1Investment in Puttin 4Current assets 1Disposal group 5Retained earnings 6Other components of equity 4Non-controlling interest 3Current liabilities 1
–––35
–––
(b) 1 mark per point up to maximum – definition 4Discussion 4
(c) 1 mark per point for ethical, legal and accounting implications 7–––50–––
2 (a) 1 mark per point up to maximum 7
(b) 1 mark per point up to maximum 5
(c) 1 mark per point up to maximum 6
(d) 1 mark per point up to maximum 5
Professional marks 2–––25–––
3 (a) 1 mark per point up to maximum 7
(b) 1 mark per point up to maximum 6
(c) 1 mark per point up to maximum 4
(d) 1 mark per point up to maximum 6
Professional marks 2–––25–––
4 (a) (i) 1 mark per point up to maximum 7
(ii) IFRS 13 hierarchy 6
(b) 1 mark per point up to maximum 6Calculations 4
Professional marks 2–––25–––
21
Professional Level – Essentials Module
Time allowedReading and planning: 15 minutesWriting: 3 hours
This paper is divided into two sections:
Section A – This ONE question is compulsory and MUST be attempted
Section B – TWO questions ONLY to be attempted
Do NOT open this paper until instructed by the supervisor.
During reading and planning time only the question paper may be annotated. You must NOT write in your answer booklet untilinstructed by the supervisor.
This question paper must not be removed from the examination hall.
Pape
r P2 (UK)
Corporate Reporting(United Kingdom)
Tuesday 10 December 2013
The Association of Chartered Certified Accountants
Section A – THIS ONE question is compulsory and MUST be attempted
1 The following draft group financial statements relate to Angel, a public limited company:
Angel Group: Statement of financial position as at 30 November 2013
30 November 30 November2013 2012$m $m
AssetsNon-current assetsProperty, plant and equipment 475 465Goodwill 105 120Other intangible assets 150 240Investment in associate 80 –Financial assets 215 180
–––––– ––––––1,025 1,005–––––– ––––––
Current assetsInventories 155 190Trade receivables 125 180Cash and cash equivalents 465 355
–––––– ––––––745 725
–––––– ––––––Total assets 1,770 1,730
–––––– ––––––
Equity and liabilitiesShare capital 850 625Retained earnings 456 359Other components of equity 29 20
–––––– ––––––Total equity and liabilities 1,770 1,730
–––––– ––––––
2
Angel Group: Statement of profit or loss and other comprehensive income for the year ended 30 November 2013
$mRevenue 1,238Cost of sales (986)
––––––Gross profit 252Other income 30Administrative expenses (45)Other expenses (50)
––––––Operating profit 187Finance costs (11)Share of profit of equity accounted investees (net of tax) 12
––––––Profit before tax 188Income tax expense (46)
––––––Profit for the year 142
––––––
Profit attributable to:Owners of parent 111Non-controlling interest 31
––––––142
––––––
Other comprehensive income:Items that will not be reclassified to profit or lossRevaluation of property, plant and equipment 8Actuarial losses on defined benefit plan (4)Tax relating to items not reclassified (2)
––––––Total items that will not be reclassified to profit or loss 2
––––––Items that may be reclassified to profit or lossFinancial assets 4Tax relating to items which may be reclassified (1)
––––––Total items that may be reclassified subsequently to profit or loss 3
––––––Other comprehensive income (net of tax) for the year 5
––––––Total comprehensive income for year 147
––––––
Total comprehensive income attributable to:
$mOwners of the parent 116Non-controlling interest 31
–––––147
–––––
3 [P.T.O.
Angel Group: Statement of changes in equity for the year ended 30 November 2013
Share Retained Other Other Total Non- Totalcapital earnings components components controlling
of equity – of equity – interestfinancial revaluationassets reservereserve
$m $m $m $m $m $m $mBalance 1 December 2012 625 359 15 5 1,004 65 1,069Share capital issued 225 225 225Dividends for year (10) (10) (6) (16)Total comprehensive 107 3 6 116 31 147income for the year
The following information relates to the financial statements of the Angel Group:
(i) Angel decided to renovate a building which had a zero book value at 1 December 2012. As a result, $3 millionwas spent during the year on its renovation. On 30 November 2013, Angel received a cash grant of $2 millionfrom the government to cover some of the refurbishment cost and the creation of new jobs which had resultedfrom the use of the building. The grant related equally to both job creation and renovation. The only elementsrecorded in the financial statements were a charge to revenue for the refurbishment of the building and the receiptof the cash grant, which has been credited to additions of property, plant and equipment (PPE). The buildingwas revalued at 30 November 2013 at $7 million.
Angel treats grant income on capital-based projects as deferred income.
(ii) On 1 December 2012, Angel acquired all of the share capital of Sweety for $30 million. The book values andfair values of the identifiable assets and liabilities of Sweety at the date of acquisition are set out below, togetherwith their tax base. Goodwill arising on acquisition is not deductible for tax purposes. There were no otheracquisitions in the period. The tax rate is 30%. The fair values in the table below have been reflected in the year-end balances of the Angel Group.
Carrying values Tax base Fair values$million $million $million
(excludingdeferredtaxation)
Property, plant and equipment 12 10 14Inventory 5 4 6Trade receivables 3 3 3Cash and cash equivalents 2 2 2
(iii) The retirement benefit is classified as a long-term borrowing in the statement of financial position and comprisesthe following:
$mNet obligation at 1 December 2012 74Net interest cost 3Current service cost 8Contributions to scheme (9)Re-measurements – actuarial losses 4
–––Net obligation at 30 November 2013 80
–––
The benefits paid in the period by the trustees of the scheme were $6 million. Angel had included the obligationassumed on the purchase of Sweety in current service cost above, although the charge to administrative expenseswas correct in the statement of profit and loss and other comprehensive income. There were no tax implicationsregarding the retirement benefit obligation. The defined benefit cost is included in administrative expenses.
(iv) The property, plant and equipment (PPE) comprises the following:
$mCarrying value at 1 December 2012 465Additions at cost including assets acquired 80on the purchase of subsidiaryGains on property revaluation 8Disposals (49)Depreciation (29)
––––Carrying value at 30 November 2013 475
––––
Angel has constructed a machine which is a qualifying asset under IAS 23 Borrowing Costs and has paidconstruction costs of $4 million. This amount has been charged to other expenses. Angel Group paid $11 millionin interest in the year, which includes $1 million of interest which Angel wishes to capitalise under IAS 23. Therewas no deferred tax implication regarding this transaction.
The disposal proceeds were $63 million. The gain on disposal is included in administrative expenses.
(v) Angel purchased a 30% interest in an associate for cash on 1 December 2012. The net assets of the associateat the date of acquisition were $280 million. The associate made a profit after tax of $40 million and paid adividend of $10 million out of these profits in the year ended 30 November 2013.
(vi) An impairment test carried out at 30 November 2013 showed that goodwill and other intangible assets wereimpaired. The impairment of goodwill relates to 100% owned subsidiaries.
(vii) The following schedule relates to the financial assets owned by Angel:
$mBalance 1 December 2012 180Less sales of financial assets at carrying value (26)Add purchases of financial assets 57Add gain on revaluation of financial assets 4
––––Balance at 30 November 2013 215
––––
The sale proceeds of the financial assets were $40 million. Profit on the sale of the financial assets is includedin ‘other income’ in the financial statements.
(viii) The finance costs were all paid in cash in the period.
Required:
(a) Prepare a consolidated statement of cash flows using the indirect method for the Angel Group plc for theyear ended 30 November 2013 in accordance with the requirements of IAS 7 Statement of Cash Flows.
Note: The notes to the statement of cash flows are not required. (35 marks)
5 [P.T.O.
(b) Angel’s directors have been reviewing the financial statements of a UK entity, which have been prepared underUK GAAP and which it intends to acquire. They have observed significant differences in the way in whichdeferred tax is measured in the entity’s financial statements.
Required:
(i) Describe the key differences between accounting for deferred taxation under UK GAAP and InternationalFinancial Reporting Standards.
(ii) Describe how these differences would affect the accounting for deferred tax on the acquisition of Sweetyabove. (9 marks)
(c) All accounting professionals are responsible for acting in the public interest, and for promoting professional ethics.The directors of Angel feel that when managing the affairs of a company the profit motive could conflict with thepublic interest and accounting ethics. In their view, the profit motive is more important than ethical behaviourand codes of ethics are irrelevant and unimportant.
Required:
Discuss the above views of the directors regarding the fact that codes of ethics are irrelevant andunimportant. (6 marks)
(50 marks)
6
Section B – TWO questions ONLY to be attempted
2 (a) (i) Havanna owns a chain of health clubs. In May 2013, Havanna decided to sell one of its regional businessdivisions through a mixed asset and share deal. The decision to sell the division at a price of $40 millionwas made public in November 2013 and gained shareholder approval in December 2013. It was decidedthat the payment of any agreed sale price could be deferred until 30 November 2015. The business divisionwas presented as a disposal group in the statement of financial position as at 30 November 2013. At theinitial classification of the division as held for sale, its net carrying amount was $90 million. In writing downthe disposal group’s carrying amount, Havanna accounted for an impairment loss of $30 million whichrepresented the difference between the carrying amount and value of the assets measured in accordancewith applicable International Financial Reporting Standards (IFRS).
In the financial statements at 30 November 2013, Havanna showed the following costs as provisionsrelating to the continuing operations. These costs were related to the business division being sold and wereas follows:
(i) A loss relating to a potential write-off of a trade receivable which had gone into liquidation. The tradereceivable had sold the goods to a third party and the division had guaranteed the receipt of the saleproceeds;
(ii) An expense relating to the discounting of the long-term receivable on the fixed amount of the sale priceof the disposal group;
(iii) A provision was charged which related to the expected transaction costs of the sale including legaladvice and lawyer fees.
The directors wish to know how to treat the above transactions. (9 marks)
(ii) Havanna has decided to sell its main office building to a third party and lease it back on a 10-year lease.The lease has been classified as an operating lease. The current fair value of the property is $5 million andthe carrying value of the asset is $4·2 million. The market for property is very difficult in the jurisdiction andHavanna therefore requires guidance on the consequences of selling the office building at a range of prices.The following prices have been achieved in the market during the last few months for similar office buildings:
(i) $5 million(ii) $6 million(iii) $4·8 million(iv) $4 million
Havanna would like advice on how to account for the sale and leaseback, with an explanation of the effectwhich the different selling prices would have on the financial statements, assuming that the fair value of theproperty is $5 million. (8 marks)
Required:
Advise Havanna on how the above transactions should be dealt with in its financial statements with referenceto International Financial Reporting Standards where appropriate.
Note: The mark allocation is shown against each of the two issues above.
(b) A government needs to determine an appropriate regime in order to reduce the reporting burden on companiesand therefore has to select an appropriate accounting framework for those companies, whilst ensuring thatdirectors’ actions are reported. Havanna has heard that the UK government is to allow qualifying companieswhich prepare their accounts under IFRS to move to UK GAAP for any reason, provided this is no more frequentlythan once every five years.
Required
Discuss the apparent risks of allowing this course of action. (6 marks)
Professional marks will be awarded in question 2 for clarity and quality of presentation. (2 marks)
(25 marks)
7 [P.T.O.
3 (a) Bental, a listed bank, has a subsidiary, Hexal, which has two classes of shares, A and B. A-shares carry votingpowers and B-shares are issued to meet Hexal’s regulatory requirements. Under the terms of a shareholders’agreement, each shareholder is obliged to capitalise any dividends in the form of additional investment in B-shares. The shareholder agreement also stipulates that Bental agrees to buy the B-shares of the minorityshareholders through a put option under the following conditions:
– The minority shareholders can exercise their put options when their ownership in B-shares exceeds theregulatory requirement, or
– The minority shareholders can exercise their put options every three years. The exercise price is the originalcost paid by the shareholders.
In Bental’s consolidated financial statements, the B-shares owned by minority shareholders are to be reported asa non-controlling interest. (7 marks)
(b) Bental has entered into a number of swap arrangements. Some of these transactions qualified for cash flow hedgeaccounting in accordance with IAS 39 Financial Instruments: Recognition and Measurement. The hedges wereconsidered to be effective. At 30 November 2013, Bental decided to cancel the hedging relationships and hadto pay compensation. The forecast hedged transactions were still expected to occur and Bental recognised theentire amount of the compensation in profit or loss.
Additionally, Bental also has an investment in a foreign entity over which it has significant influence and thereforeaccounts for the entity as an associate. The entity’s functional currency differs from Bental’s and in theconsolidated financial statements, the associate’s results fluctuate with changes in the exchange rate. Bentalwishes to designate the investment as a hedged item in a fair value hedge in its individual and consolidatedfinancial statements. (6 marks)
(c) On 1 September 2013, Bental entered into a business combination with another listed bank, Lental. Thebusiness combination has taken place in two stages, which were contingent upon each other. On 1 September2013, Bental acquired 45% of the share capital and voting rights of Lental for cash. On 1 November 2013,Lental merged with Bental and Bental issued new A-shares to Lental’s shareholders for their 55% interest.
On 31 August 2013, Bental had a market value of $70 million and Lental a market value of $90 million. Bental’sbusiness represents 45% and Lental’s business 55% of the total value of the combined businesses.
After the transaction, the former shareholders of Bental excluding those of Lental owned 51% and the formershareholders of Lental owned 49% of the votes of the combined entity. The Chief Operating Officer (COO) ofLental is the biggest individual owner of the combined entity with a 25% interest. The purchase agreementprovides for a board of six directors for the combined entity, five of whom will be former board members of Bentalwith one seat reserved for a former board member of Lental. The board of directors nominates the members ofthe management team. The management comprised the COO and four other members, two from Bental and twofrom Lental. Under the terms of the purchase agreement, the COO of Lental is the COO of the combined entity.
Bental proposes to account for the transaction as a business combination and identify Lental as the acquirer.(10 marks)
Required:
Discuss whether the accounting practices and policies outlined above are acceptable under InternationalFinancial Reporting Standards.
Note: The mark allocation is shown against each of the three issues above.
Professional marks will be awarded in question 3 for clarity and quality of presentation. (2 marks)
(25 marks)
8
9
4 (a) Due to the complexity of International Financial Reporting Standards (IFRS), often judgements used at the timeof transition to IFRS have resulted in prior period adjustments and changes in estimates being disclosed infinancial statements. The selection of accounting policy and estimation techniques is intended to aidcomparability and consistency in financial statements. However, IFRS also place particular emphasis on the needto take into account qualitative characteristics and the use of professional judgement when preparing the financialstatements. Although IFRS may appear prescriptive, the achievement of all the objectives for a set of financialstatements will rely on the skills of the preparer. Entities should follow the requirements of IAS 8 AccountingPolicies, Changes in Accounting Estimates and Errors when selecting or changing accounting policies, changingestimation techniques, and correcting errors.
However, the application of IAS 8 is additionally often dependent upon the application of materiality analysis toidentify issues and guide reporting. Entities also often consider the acceptability of the use of hindsight in theirreporting.
Required:
(i) Discuss how judgement and materiality play a significant part in the selection of an entity’s accountingpolicies.
(ii) Discuss the circumstances where an entity may change its accounting policies, setting out how a changeof accounting policy is applied and the difficulties faced by entities where a change in accounting policyis made.
(iii) Discuss why the current treatment of prior period errors could lead to earnings management bycompanies, together with any further arguments against the current treatment.
Credit will be given for relevant examples.
Note: The total marks will be split equally between each part. (15 marks)
(b) In 2013, Zack, a public limited company, commenced construction of a shopping centre. It considers that inorder to fairly recognise the costs of its property, plant and equipment, it needs to enhance its accounting policiesby capitalising borrowing costs incurred whilst the shopping centre is under construction. A review of pasttransactions suggests that there has been one other project involving assets with substantial construction periodswhere there would be a material misstatement of the asset balance if borrowing costs were not capitalised. Thisproject was completed in the year ended 30 November 2012. Previously, Zack had expensed the borrowing costsas they were incurred. The borrowing costs which could be capitalised are $2 million for the 2012 asset and $3 million for the 2013 asset.
A review of the depreciation schedules of the larger plant and equipment not affected by the above has resultedin Zack concluding that the basis on which these assets are depreciated would better reflect the resourcesconsumed if calculations were on a reducing balance basis, rather than a straight-line basis. The revision wouldresult in an increase in depreciation for the year to 30 November 2012 of $5 million, an increase for the yearend 30 November 2013 of $6 million and an estimated increase for the year ending 30 November 2014 of $8 million.
Additionally, Zack has discovered that its accruals systems for year-end creditors for the financial year 30 November 2012 processed certain accruals twice in the ledger. This meant that expenditure services wereoverstated in the financial statements by $2 million. However, Zack has since reviewed its final accounts systemsand processes and has made appropriate changes and introduced additional internal controls to ensure that suchestimation problems are unlikely to recur.
All of the above transactions are material to Zack.
Required:
Discuss how the above events should be shown in the financial statements of Zack for the year ended 30 November 2013. (8 marks)
Professional marks will be awarded in question 4 for clarity and quality of presentation. (2 marks)
(25 marks)
End of Question Paper
Answers
Professional Level – Essentials Module, Paper P2 (UK)Corporate Reporting (United Kingdom) December 2013 Answers
1 (a) Angel Group
Statement of cash flows for the year ended 30 November 2013
$mProfit for the year (W1) 197Adjustments to operating activitiesFinancial assets – profit on sale (W5) (14)Retirement benefit expense (W7) 10Depreciation (W1) 29Profit on sale of PPE (W1) (14)Associate’s profit (W3) (12)Impairment of goodwill and intangible assets (26·5 + 90) (W6) 116·5Finance costs 10
––––––322·5
Movements in working capitalDecrease in trade receivables (180 – 125 + 3) 58Decrease in inventories (190 – 155 + 6) 41Decrease in trade payables (361 – 155 + 4) (210)
––––––Cash generated from operating activities 211·5Cash paid to retirement benefit scheme (W7) (9)Interest paid (10)Income taxes paid (W4) (135·5)
––––––Net cash generated by operating activities 57
––––––Cash flows from investing activitiesSale of financial assets (W5) 40Purchase of financial assets (57)Purchase of property, plant and equipment (PPE) (W1) (76)Cash grant for PPE (W1) 1Purchase of subsidiary (30 – 2) (W2) (28)Proceeds from sale of PPE (W1) 63Dividend received from associate (W3) 3Purchase of associate (W3) (71)
––––––Net cash flows used by investing activities (125)
––––––Cash flows from financing activitiesProceeds of issue of share capital 225Repayment of long-term borrowings (31)Dividends paid (10)Non-controlling interest dividend (6)
––––––Net cash generated by financing activities 178
––––––Net increase in cash and cash equivalents 110Cash and cash equivalents at beginning of period 355
––––––Cash and cash equivalents at end of period 465
––––––
Workings
Working 1 Property, plant and equipment – building renovation
The following transactions need to be made to recognise the asset in the entity’s statement of financial position as of 30 November 2013.
Dr Property, plant and equipment $7mCr OCI $4mCr Retained earnings (to correct) $3m
The accounting policy of the Angel Group is to treat capital-based grants as deferred income.
However, the grant of $2m relates to capital expenditure and revenue. The grant should be split equally over revenue andcapital.
The correcting entries should therefore be:
Dr PPE $2mCr Retained earnings $1mCr Deferred income (long-term liabilities) $1m
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Thus from a cash flow perspective, net profit before taxation should be adjusted by $3 million and additions to PPE increasedby $3 million. Additionally, cash flows from investing activities should show the grant received of $1 million, net profit beforetaxation should increase by $1 million and additions to PPE increase by $2 million.
Current carrying amount of PPE before adjustments
$mOpening balance at 1 December 2012 465Revaluation 8Additions 66Disposals (49)Subsidiary acquisition 14Depreciation (29)
––––Closing balance at 30 November 2013 475
––––
Additions for the year are $66m above, plus the adjustments re the grant and building of $3 million and $2 million and theconstruction costs of $5 million, i.e. $76 million.
Thus profit before tax will be $188 million + $3 million + $1 million grant + $1 million capitalised interest + $4 millionconstruction costs charged to other expenses, i.e. $197 million.
Working 2 Purchase of subsidiary
The purchase of the subsidiary is adjusted for in the statement of cash flows by eliminating the assets and liabilities acquired,as they were not included in the opening balances. The fair values will be used, as they will be the values utilised onacquisition.
Calculation of deferred tax arising on acquisition:
$mFair values of Sweety’s identifiable net assets excluding deferred tax 20Less tax base (15)
––––Temporary difference arising on acquisition 5Net deferred tax liability arising on acquisition (30% x $5m) 1·5
––––
Calculation of goodwill:
$mPurchase consideration 30Fair value of net assets (net of deferred tax) (20)Deferred taxation 1·5
––––Goodwill arising on acquisition 11·5
––––
Working 3 Associate$m
Balance at 30 November 2013 80Less profit for period $40m x 30% (12)Add dividend received $10m x 30% 3
––––Cost of acquisition (cash) 71
––––
Therefore, cash paid for the investment is $71 million, and cash received from the dividend is $3 million.
Working 4 Taxation
$m $mOpening tax balances at 1 December 2012Deferred tax 31Current tax 138
––––169
Charge for year 46Deferred tax on acquisition (W2) 1·5Tax on revaluation PPE 2Tax on financial assets 1Less closing tax balances at 30 November 2013:Deferred tax 35Current tax 49
––––(84)
––––––Cash paid 135·5
––––––
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Working 5 Financial assets
The sale proceeds of the financial assets were $40 million. Thus, an adjustment for the profit of $14 million on the sale ofthe financial assets has to be made. The deferred tax of $1 million arose on the gain on revaluation.
Working 6 Goodwill
$mOpening balance at 1 December 2012 120Current year amount on subsidiary (W2) 11·5Impairment (26·5)
––––Closing balance at 30 November 2013 105
––––
Working 7 Retirement benefit
$mOpening balance at 1 December 2012 74Remeasurement 4Current year service cost plus interest 11Contributions paid (9)
––––Closing balance at 30 November 2013 80
––––
An adjustment has to be made in the statement of cash flow for the current year amount ($11 million) and the purchase ofthe subsidiary ($1 million), giving a net adjustment of $10 million.
(b) Under IAS 12 Income Taxes, deferred taxation is based on temporary differences, i.e. differences between the carryingamount of an asset or liability in the statement of financial position and its tax base (subject to certain exceptions). UnderFRS 19 Deferred Tax, deferred tax is based on timing differences which are differences between an entity’s taxable profits andits results as stated in the financial statements which arise from the inclusion of gains and losses in tax assessments indifferent periods to those when recognised in the financial statements. The timing differences are those which have originatedbut not reversed as at the year-end date (subject to certain exceptions). In addition, other significant differences may arisefrom the difference between the timing difference and temporary difference approach, e.g. in respect of foreign currencytranslation, intra-group transactions or in relation to certain structured products.
Under IAS 12, a deferred tax liability is recognised for all taxable temporary differences except to the extent that it arises fromthe initial recognition of goodwill, or the initial recognition of an asset or liability in a transaction which is not a businesscombination and, at the time of the transaction, affects neither accounting profit nor taxable profit (tax loss).
Under FRS 19, deferred tax is recognised on timing differences which have originated but not reversed by the year-end date,but not on permanent differences. Specific rules apply for certain types of timing differences, e.g. capital allowances, whichcan lead to differences from IFRS.
Under IAS 12, a deferred tax liability is recognised for all taxable temporary differences associated with investments insubsidiaries, etc, except to the extent that the parent, investor or venturer is able to control the timing of the reversal of thetemporary difference and it is probable that the temporary difference will not reverse in the foreseeable future. Under FRS 19,a deferred tax provision is required only to the extent that dividends payable by a subsidiary, associate or joint venture havebeen accrued at the balance sheet date or a binding agreement to distribute the past earnings in future has been made.
Under IAS 12, a deferred tax asset is recognised to the extent that it is probable that there will be taxable profit against whicha deductible temporary difference can be used, unless the deferred tax asset arises from the initial recognition of an asset orliability which is not from a business combination and, at the time of the transaction, affects neither accounting profit nortaxable profit. Under FRS 19, deferred tax assets are only recognised to the extent that they are regarded as recoverable, i.e.it is more likely than not that there will be suitable taxable profits from which the future reversal of the underlying timingdifferences can be deducted.
Under IAS 12, discounting of deferred tax balances is not permitted but under FRS 19, discounting is permitted but notrequired.
Under IAS 12, the calculation of deferred tax should take into account the manner in which the entity expects to recover orsettle the carrying amount of its assets and liabilities. Therefore PPE is recovered through use to the extent of its depreciableamount (cost less residual value), and through sale at its residual value. Under FRS 19, the manner in which an entityrecovers or settles an asset or a liability is not relevant. Specific rules are included on capital allowances, revaluations androllover relief.
Under IAS 12, the deferred tax liability or asset arising from revaluation of a non-depreciable asset should be measured onthe basis of the tax consequences which would follow from the recovery of the carrying amount of the asset through sale. Anon-depreciable asset differs from an asset, which is not depreciated but is by its nature depreciable, such as an investmentproperty.
FRS 19 says that deferred tax should be recognised on timing differences arising when an asset is continuously revalued tofair value with changes in fair value being recognised in profit or loss. For other non-monetary assets, deferred tax is only
15
recognised if there is a binding agreement to sell the revalued asset and the reporting entity has recognised the gains andlosses expected to arise on sale unless, if at the balance sheet date, it is more likely than not that the gain will be rolled over.
The treatment of the deferred tax arising on Sweety is significantly different under IAS 12 Income Taxes than under FRS 19Deferred Tax. Under FRS 19, no deferred tax would have been provided on the temporary differences arising on fair valueadjustments unless Sweety had recognised the tax effect of any revaluation as if it were a timing difference in its own financialstatements. This would only have occurred if Sweety had entered into a binding sale agreement to sell the assets and rolloverrelief was not available. Thus where assets are revalued upwards on acquisition, no deferred tax is provided for under FRS 19.
(c) The directors should be persuaded that professional ethics are an inherent part of the profession as well as other majorprofessions such as law and engineering. Professional ethics are a set of moral standards applicable to all professionals. Eachprofessional body has its own ethical code such as the ACCA’s Code of Ethics and Conduct, which requires its members toadhere to a set of fundamental principles in the course of their professional duty, such as confidentiality, objectivity,professional behaviour, integrity and professional competence and due care.
The main aim of professional ethics is to serve as a moral guideline for professional accountants. By referring back to the setof ethical guidelines, the accountant is able to decide on the most appropriate course of action, which will be in line with theprofessional body’s stance on ethics. The presence of a code of ethics is a form of declaration by the professional body to thepublic that it is committed to ensuring the highest level of professionalism amongst its members.
Often there may be ethical principles, which conflict with the profit motive and it may be difficult to decide on a course ofaction. Ethical guidelines can help by developing ethical reasoning in accountants by providing insight into how to deal withconflicting principles and why a certain course of action is desirable. Individuals may hold inadequate beliefs or hold on toinadequate ethical values. An accountant has an ethical obligation to encourage the directors to operate within certainboundaries when determining the profit figure. Users are becoming reactive to unethical behaviour by directors. This is leadingto greater investment in ethical companies with the result that unethical practices can have a greater impact on the value ofan entity than the reporting of a smaller profit figure. Ethical guidelines enable individuals to understand the nature of one’sown opinion and ethical values. Ethical guidelines help identify the basic ethical principles which should be applied. This willinvolve not only code-based decisions but also the application of principles which should enable the determination of whatshould be done in a given situation. This should not conflict with the profit motive unless directors are acting unscrupulously.Ethical guidance gives a checklist to be applied so that outcomes can be determined. Ethical issues are becoming more andmore complex and it is critical to have an underlying structure of ethical reasoning, and not purely be driven by the profitmotive.
2 (a) (i) According to IFRS 5 Non-current Assets Held for Sale and Discontinued Operations, the carrying amounts of all theassets and liabilities in a disposal group are to be measured in accordance with applicable IFRSs, immediately beforethe initial classification of the disposal group as held for sale. Resulting adjustments are also recognised in accordancewith applicable IFRSs. After classification as held for sale, non-current assets or disposal groups which are classified asheld for sale are measured at the lower of carrying amount and fair value less costs to sell. Impairment must beconsidered both at the time of classification as held for sale and subsequently. At the time of classification as held forsale, immediately prior to classifying an asset or disposal group as held for sale, the entity should measure and recogniseimpairment in accordance with the applicable IFRSs. Any impairment loss is recognised in profit or loss unless the assethad been measured at a revalued amount under IAS 16 Property, Plant and Equipment or IAS 38 Intangible Assets, inwhich case the impairment is treated as a revaluation decrease. After classification as held for sale, the entity shouldcalculate any impairment loss based on the difference between the adjusted carrying amounts of the asset/disposalgroup and fair value less costs to sell. Any impairment loss which arises by using the measurement principles in IFRS 5 must be recognised in profit or loss. For assets carried at fair value prior to initial classification, the requirementto deduct costs to sell from fair value will result in an immediate charge to profit or loss.
The division should recognise an additional impairment loss of $20 million. The initial impairment loss of $30 millionis not sufficient as there will be a further impairment loss based on the difference between the adjusted carrying amountsof the asset/disposal group and fair value less costs to sell.
Additionally, the trade receivable should have been tested for impairment immediately before classification of the divisionas held for sale and the resulting loss should have been recognised against the net carrying amount of the disposal groupat initial classification as held for sale. Since the sales contract stipulated that the division would refund the tradereceivable in the event that the proceeds were not collected, the expected sales price of the disposal group should havebeen adjusted to take into account the potential refund.
As regards the expense relating to the discounting effect, the ‘fair value less costs to sell’ of the disposal group shouldhave incorporated the effect of discounting given that payment was deferred until 2015. As regards the provision fortransaction costs, the expected transaction costs should be considered as an additional cost of the transaction and,therefore, are a component of the costs to sell. All three items should therefore have been taken into account in thecalculation of fair value less costs to sell and not be presented as provisions relating to continuing operations in thestatement of financial position.
(ii) As Havanna has decided that the leaseback is in substance an operating lease, then:
– it recognises the lease payments in expenses over the life of the lease
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– it treats the property, plant and equipment asset as an asset held for sale, measuring and classifying it inaccordance with IFRS 5. It derecognises the property, plant and equipment asset and transfers any associatedrevaluation reserve balance to retained earnings. As a point of principle, when a leaseback is an operating leaseand the sales price is at fair value, there has in effect been a normal sale transaction and any profit or loss isrecognised immediately.
However, in recognising the sale proceeds, Havanna should consider how the sale price compares with the fair value ofthe asset, and should account for the proceeds as follows:
(i) If the sale proceeds match the fair value of the asset, then the whole gain or loss on disposal is recognisedimmediately. Thus if the asset is sold for $5 million, a gain of $0·8 million will be recognised in profit or loss.
(ii) If the sale proceeds are greater than the fair value of the asset, which is unlikely in the current market, this impliesthe creation of an artificial gain. The sale proceeds are treated differently to the above. The difference between thefair value of the asset and its carrying value is recognised immediately in profit or loss.
The excess amount of the sale proceeds over the fair value of the asset is deferred and released to profit or lossover the life of the leaseback. Thus if the selling price were $6 million, a gain of $0·8 million would still be recordedbut the balance of $1 million would be credited to profit or loss over the lease period of 10 years at $100,000 perannum.
(iii) Where the sale proceeds are less than the fair value of the asset, then any profit or loss is recognised immediately,unless it is clear that the loss is compensated for by lower lease rentals, in which case the loss is deferred andamortised to expenses over the life of the leaseback.
As property valuations are, by their nature, estimates and therefore include a degree of tolerance, if the asset weresold for $4·8 million, the difference between the sale proceeds and the fair value of the asset is relatively smalland probably indicates that the sale is genuinely at fair value. The sale proceeds would therefore be recognised infull and a gain of $0·6 million recorded.
If the sale proceeds were $4 million, there is a large difference between the fair value of the asset and the saleproceeds which cannot be explained by estimation tolerances in the valuation. It appears that the sale proceedsare artificially low which in turn is likely to be reflected in artificially low lease rentals charged. Therefore the saleproceeds of $4 million are recognised but the resulting $0·2 million loss on disposal is not recognised immediately.Instead, it is deferred and amortised to expenses over the 10-year life of the lease at $20,000 per annum.
(b) There is a risk that giving a company power to change from IFRS to UK GAAP once within a five-year period might result incompanies being able to misrepresent their position by switching between accounting regimes depending on which showstheir performance in a better light. The cost of misrepresentation will, in the long term, result in a reduction in shareholdervalue. However, the new accounting framework proposed by the ASB for UK Financial Reporting Standards will be based noton existing UK GAAP but on IFRS. Since the accounting differences between the two are now less significant, the risk ofarbitrage between the two sets of financial statements is lessened.
Whether financial statements are prepared under IFRS or UK GAAP, the Companies Act 2006 still requires that the accountsof a company must give a true and fair view of the company’s results and financial position. Additionally, there are transitionalrules in accounting standards which mean that the risk of lack of comparability of accounts between periods when thecompany changes between accounting framework is minimised. There are also similarities between the ‘frameworks’ of UKGAAP and IFRS. Companies will only exercise the option to change from IFRS to UK GAAP if the benefits for them outweighthe costs and thus this will not happen very frequently. There may be scope for tax arbitrage, but these will be addressed byapplication of the powers of the tax authorities, rather than by keeping restrictions in company law.
3 (a) Bental’s decision to classify B-shares as non-controlling interests is incorrect and the shares with a contingent put option area financial liability in accordance with IAS 32 Financial Instruments: Presentation. Bental has a clear contractual obligationto buy B-shares from the non-controlling interest under agreed terms and thus this contractual obligation is a financial liabilityas defined in IAS 32. IAS 32 defines a financial liability as a contractual obligation to deliver cash or another financial assetto another entity. If there were an unconditional right to avoid delivering cash or another financial liability, the instrumentwould be considered as an equity instrument. Otherwise, a financial instrument qualifies as a financial liability if thecontingent payment condition is beyond the control of both the entity and the holder of the instrument. A contingentsettlement provision which requires settlement in cash or variable number of the entity’s own shares only on the occurrenceof an event which is very unlikely to occur is not considered to be genuine and, hence, an instrument including such aprovision would be an equity instrument (IAS 32). A financial liability is partly defined (IAS 32) as any liability which is acontractual obligation to deliver cash or another financial asset to another entity. However, Bental does not have anunconditional right to avoid delivering cash or another financial asset to settle the obligation. Thus, the minority shareholders’holdings of B-shares should be treated as a financial liability in the consolidated financial statements.
(b) According to IAS 39 Financial Instruments: Recognition and Measurement, when a hedging instrument expires or is sold,terminated or exercised, the entity discontinues prospectively the hedge accounting. If hedge accounting ceases for a cashflow hedge relationship because the forecast transaction is no longer expected to occur, gains and losses deferred in othercomprehensive income must be taken to profit or loss immediately. If the transaction is still expected to occur and the hedge
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relationship ceases, the amounts accumulated in equity will be retained in equity until the hedged item affects profit or loss.Therefore, on termination of the hedge, Bental should recognise the cash payment against the fair value of the swaps. Hence,there would be no effect on profit or loss at the date of termination. The reclassification of the gain or loss accumulated inother comprehensive income should be reflected in the period during which the hedged cash flows will affect profit or loss.
IAS 39 does not allow an equity investment to be a hedged item in a fair value hedge because the equity method recognisesin profit or loss the investor’s share of the associate’s profit or loss rather than changes in the investment’s fair value. It maybe possible to designate such an investment in its separate financial statements if the fair value can be measured reliably.
(c) IFRS 3 Business Combinations requires an acquirer to be identified in all business combinations, the acquirer being thecombining entity which obtains control of the other combined entity. Guidance to be applied in determining the acquirer isprovided in IFRS 10 Consolidated Financial Statements. IFRS 10 says that an investor controls an investee when it isexposed, or has rights, to variable returns from its involvement with the investee and has the ability to affect those returnsthrough its power over the investee. IFRS 10 states that power arises from rights. Sometimes it is straightforward to assesspower by looking at the voting rights obtained. When the parent acquires more than half of the voting rights of the entity, itnormally has power if the relevant activities of the investee are directed by a vote or if a majority of the members of thegoverning body are appointed by a vote of the holder of the majority of the voting rights. Other rights which may give theinvestor power are:
– rights to appoint, reassign or remove members of key management personnel– rights to appoint or remove another entity which directs the relevant activities– rights to direct the investee to enter into or veto any changes to transactions for the benefit of the investor, and other
rights (such as decision-making rights specified in a management contract).
There is a presumption that an entity achieves control over another entity by acquiring more than one half of the voting rights,unless it can be demonstrated that such ownership does not constitute control. If the guidance in IFRS 10 does not clearlyindicate which of the combining entities is the acquirer, IFRS 3 sets out other factors to be considered. The acquirer is usuallythe entity which transfers cash or other assets. In this scenario, as Bental is the entity giving up a cash amount correspondingto 45% of the purchase price, this represents a significant share of the total purchase consideration. When there is anexchange of equity interests in a business combination, the entity which issues the equity interests is normally the acquirer.In this case, as the majority of the purchase consideration is settled in equity instruments, Bental would appear to be theacquirer. However, all pertinent facts and circumstances should be considered to determine which of the combining entitieshas the power to govern the financial and operating policies of the other entity. The acquirer is usually the combining entitywhose shareholders retain or receive the largest portion of the voting rights in the combined entity. The shareholders of Bental,the smaller of the two combining entities, appear to have obtained control since their share amounts to 51% of the votingrights after the transaction. A controlling ownership, however, does not necessarily mean that the entity has the power togovern the combined entity’s financial and operating policies so as to obtain benefits from its activities. Additionally, theacquirer could be deemed to be the entity whose owners have the ability to appoint or remove a majority of the members ofthe governing body of the combined entity. Five out of six members of the board here are former board members of Bental,which again suggests that Bental is the acquirer. Additionally, the acquirer could be deemed the entity whose formermanagement dominates the management of the combined entity. However, the management team consists of the COO plustwo former employees of Lental as compared to two former employees of Bental. Therefore, the former management of Lentalhas a greater representation. Although the board nominates the management team, the COO will have significant influencethrough his share ownership and the selection of the team.
Other indications implying control may be the relative size of the combining entities in terms of, for example, assets, revenuesor profit. As the fair value of Lental ($90 million) is significantly greater than Bental ($70 million), this would point towardsLental as the acquirer.
The arguments supporting Bental or Lental as the acquirer are finely balanced and therefore it is difficult to identify an acquirerin this case. It can be argued that Bental can be identified as the acquirer, on the basis that:
– Bental issued the equity interest – Bental is the entity transferring the cash or other assets and – Bental has the marginal controlling interest (51%).
4 (a) (i) The selection of accounting policy and estimation techniques is intended to aid comparability and consistency infinancial statements. Entities should follow the requirements of IAS 8 Accounting Policies, Changes in AccountingEstimates and Errors, when selecting or changing accounting policies, changing estimation techniques, and correctingerrors. An entity should determine the accounting policy to be applied to an item with direct reference to IFRS butaccounting policies need not be applied if the effect of applying them would be immaterial. IAS 8 also notes that it isinappropriate to make or leave uncorrected immaterial departures from IFRS to achieve a particular position. Where IFRSdoes not specifically apply to a transaction, judgement should be used in developing or applying an accounting policy,which results in financial information which is relevant to the decision-making and assessment needs of users. IFRSalso requires that policies are reliable and are prudent. In making that judgement, entities must refer to guidance inIFRS, which deals with similar issues and then subsequently to definitions, and criteria in the Framework. Additionally,entities can refer to recent pronouncements of other standard setters who use similar conceptual frameworks. Entitiesshould select and apply their accounting policies consistently for similar transactions. If IFRS specifically permits differentaccounting policies for categories of similar items, an entity should apply an appropriate policy for each of the categories
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in question and apply these accounting policies consistently for each category. For example, for different classes ofproperty, plant and equipment, some may be carried at fair value and some at historical cost.
(ii) A change in accounting policy should only be made if the change is required by IFRS, or it will result in the financialstatements providing reliable and more relevant financial information. Significant changes in accounting policy otherthan those specified by IFRS should be relatively rare. IFRS specifies the accounting policies for a high percentage ofthe typical transactions which are faced by entities. There are therefore limited opportunities for an entity to choose anaccounting policy, as opposed to a basis for estimating figures which will satisfy such a policy.
IAS 8 states that the introduction of an accounting policy to account for transactions where circumstances have changedis not a change in accounting policy. Similarly, an accounting policy for transactions which did not occur previously orwhich were immaterial is not a change in accounting policy and therefore would be applied prospectively.
For example, where an entity changes the use of a property from an administration building to a residential space andtherefore an investment property, this would result in a different treatment of revaluation gains and losses. However, thisis not a change in accounting policy and so no restatement of comparative amounts should be made.
A change in accounting policy is applied retrospectively unless there are transitional arrangements in place. Transitionalprovisions are often included in new or revised standards and may not require full retrospective application.
Sometimes it is difficult to achieve comparability of prior periods with the current period where, for example, data mightnot have been collected in the prior periods to allow retrospective application. Restating comparative information for priorperiods often requires complex and detailed estimation. This, in itself, does not prevent reliable adjustments.
When making estimates for prior periods, the basis of estimation should reflect the circumstances which existed at thetime and it becomes increasingly difficult to define those circumstances with the passage of time. Estimates andcircumstances might be influenced by knowledge of events and circumstances which have arisen since the prior period.
IAS 8 does not permit the use of hindsight when applying a new accounting policy, either in making assumptions aboutwhat management’s intentions would have been in a prior period or in estimating amounts to be recognised, measuredor disclosed in a prior period.
When it is impracticable to determine the effect of a change in accounting policy on comparative information, the entityis required to apply the new accounting policy to the carrying amounts of the assets and liabilities as at the beginningof the earliest period for which retrospective application is practicable. This could actually be the current period but theentity should attempt to apply the policy from the earliest date possible.
(iii) IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors requires prior period errors to be amendedretrospectively by restating the comparatives as if the error had never occurred. Hence, the impact of any prior perioderrors is shown through retained earnings rather than being included in the current period’s profit or loss. Managerscould use this treatment for prior period errors as a method for manipulating current period earnings. Restatements dueto errors and irregularities can be considered to indicate poor earnings quality, and to threaten investor confidence,particularly if they occur frequently. Thus, it might appear that the factors associated with earnings corrections could belinked to earnings management.
Arguments against the approach in IAS 8 are:
– that the standard allows inappropriate use of hindsight; – that the treatment renders errors less prominent to users; and– that it allows amounts to be debited or credited to retained profits without ever being included in a current period
profit or loss.
Managers have considerable discretion regarding the degree of attention drawn to such changes. The informationcontent and prominence to users of disclosures regarding prior period errors are issues of significance, with potentialeconomic and earnings quality implications. Expenses could be moved backward into a prior period, with the result thatmanagers are given a possible alternative strategy with which to manage earnings. It is possible to misclassify liabilities,for example, as non-current rather than current, or even simply miscalculate reported earnings per share. Under IAS 8,the prior period error can then be amended the following year, with no lingering effects on the statement of financialposition as a result of the manipulation.
(b) IAS 23 Borrowing Costs states that such costs which are directly attributable to the acquisition, construction or production ofa qualifying asset form part of the cost of that asset and, therefore, should be capitalised. Other borrowing costs are recognisedas an expense. Thus the change in accounting policy actually only brings Zack in line with IFRS, with the result that there isan accounting error which will require a prior period adjustment. In applying the new accounting policy, Zack has identifiedthat there is another asset where there is a material impact if borrowing costs should have been capitalised during theconstruction period. This contract was completed during 2012. Thus, the financial statements for the year ended 30 November 2012 should be restated to apply the new policy to this asset. The effects of the restatement are as follows: at30 November 2012, the carrying amount of property, plant and equipment is restated upwards by $2 million lessdepreciation for the period and this would result in an increase in profit or loss for the period of the same amount. Disclosuresrelating to prior period errors include: the nature of the prior period error for each prior period presented, to the extentpracticable; the amount of the correction for each financial statement line item affected; and for basic and diluted earningsper share, the amount of the correction at the beginning of the earliest prior period presented. The disclosure would includethe nature of the prior period error.
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The line items in the statement of profit or loss and other comprehensive income would also change. For the current period,Zack would disclose the impact of the prior period error of $3 million. It can be assumed that, because the asset is underconstruction, there will be no depreciation on the asset.
The change in the depreciation method is not a change in an accounting policy but a change in an accounting estimate. Forchanges in accounting estimates, Zack should disclose the nature and the amount of the change which affects the currentperiod or which it is expected to have in future periods. It should be noted that IAS 8 does permit an exception where it isimpracticable to estimate the effect on future periods. Where the effect on future periods is not disclosed because it isimpracticable, that fact should be disclosed. The revision results in an increase in depreciation for 2013 of $6m and thedisclosure of an estimated increase for 2014 of $8m.
The systems error has resulted in a prior period error. In order to correct this error, Zack should restate the prior yearinformation for the year ended 30 November 2012 for the $2m in the statement of profit or loss and other comprehensiveincome. Additionally, the trade creditors figure in the statement of financial position is overstated by $2 million and shouldbe restated. The movement in reserves note will also require restating. This is not a correction of an accounting estimate.
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Professional Level – Essentials Module, Paper P2 (UK)Corporate Reporting (United Kingdom) December 2013 Marking Scheme
Marks1 (a) Net profit before taxation 4
Net cash generated from operations 16Cash flow from investing activities 10Cash flow from financing activities 5
–––35–––
(b) Subjective assessment of discussion 9
(c) Subjective assessment – 1 mark per point 6–––50–––
2 (a) (i) IFRS 5 explanation 9
(ii) Leases 8
(b) Subjective 1 mark per point 6
Professional marks 2–––25–––
3 (a) Financial instrument explanation up to 7
(b) Hedged items 6
(c) IFRS 3 explanation 10
Professional marks 2–––25–––
4 (a) Subjective 15
(b) Subjective 8
Professional marks 2–––25–––
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Professional Level – Essentials Module
Time allowedReading and planning: 15 minutesWriting: 3 hours
This paper is divided into two sections:
Section A – This ONE question is compulsory and MUST be attempted
Section B – TWO questions ONLY to be attempted
Do NOT open this paper until instructed by the supervisor.
During reading and planning time only the question paper may be annotated. You must NOT write in your answer booklet untilinstructed by the supervisor.
This question paper must not be removed from the examination hall.
Pape
r P2 (UK)
Corporate Reporting(United Kingdom)
Tuesday 9 December 2014
The Association of Chartered Certified Accountants
This is a blank page.The question paper begins on page 3.
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Section A – THIS ONE question is compulsory and MUST be attempted
1 (a) Joey, a public limited company, operates in the media sector. Joey has investments in two companies. The draftstatements of financial position at 30 November 2014 are as follows:
Joey Margy Hulty$m $m $m
Assets:Non-current assetsProperty, plant and equipment 3,295 2,000 1,200Investments in subsidiaries and other investmentsMargy 1,675Hulty 700
–––––– –––––– ––––––Total equity and liabilities 6,655 2,861 1,350
–––––– –––––– ––––––
The following information is relevant to the preparation of the group financial statements:
1. On 1 December 2011, Joey acquired 30% of the ordinary shares of Margy for a cash consideration of $600 million when the fair value of Margy’s identifiable net assets was $1,840 million. Joey treated Margyas an associate and has equity accounted for Margy up to 1 December 2013. Joey’s share of Margy’sundistributed profit amounted to $90 million and its share of a revaluation gain amounted to $10 million.On 1 December 2013, Joey acquired a further 40% of the ordinary shares of Margy for a cash considerationof $975 million and gained control of the company. The cash consideration has been added to the equityaccounted balance for Margy at 1 December 2013 to give the carrying amount at 30 November 2014.
At 1 December 2013, the fair value of Margy’s identifiable net assets was $2,250 million. At 1 December2013, the fair value of the equity interest in Margy held by Joey before the business combination was $705 million and the fair value of the non-controlling interest of 30% was assessed as $620 million. Theretained earnings and other components of equity of Margy at 1 December 2013 were $900 million and$70 million respectively. It is group policy to measure the non-controlling interest at fair value.
2. At the time of the business combination with Margy, Joey has included in the fair value of Margy’sidentifiable net assets an unrecognised contingent liability of $6 million in respect of a warranty claim inprogress against Margy. In March 2014, there was a revision of the estimate of the liability to $5 million.The amount has met the criteria to be recognised as a provision in current liabilities in the financialstatements of Margy and it is deemed to be a measurement period adjustment.
3. Additionally, buildings with a carrying amount of $200 million had been included in the fair valuation ofMargy at 1 December 2013. The buildings have a remaining useful life of 20 years at 1 December 2013.However, Joey had commissioned an independent valuation of the buildings of Margy which was notcomplete at 1 December 2013 and therefore not considered in the fair value of the identifiable net assetsat the acquisition date. The valuations were received on 1 April 2014 and resulted in a decrease of
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$40 million in the fair value of property, plant and equipment at the date of acquisition. This decrease doesnot affect the fair value of the non-controlling interest at acquisition and has not been entered into thefinancial statements of Margy. Buildings are depreciated on the straight-line basis and it is group policy toleave revaluation gains on disposal in equity. The excess of the fair value of the net assets over their carryingvalue, at 1 December 2013, is due to an increase in the value of non-depreciable land and the contingentliability.
4. On 1 December 2013, Joey acquired 80% of the equity interests of Hulty, a private entity, in exchange forcash of $700 million. Because the former owners of Hulty needed to dispose of the investment quickly, theydid not have sufficient time to market the investment to many potential buyers. The fair value of theidentifiable net assets was $960 million. Joey determined that the fair value of the 20% non-controllinginterest in Hulty at that date was $250 million. Joey reviewed the procedures used to identify and measurethe assets acquired and liabilities assumed and to measure the fair value of both the non-controlling interestand the consideration transferred. After that review, Hulty determined that the procedures and resultingmeasures were appropriate. The retained earnings and other components of equity of Hulty at 1 December2013 were $300 million and $40 million respectively. The excess in fair value is due to an unrecognisedfranchise right, which Joey had granted to Hulty on 1 December 2012 for five years. At the time of theacquisition, the franchise right could be sold for its market price. It is group policy to measure the non-controlling interest at fair value.
All goodwill arising on acquisitions has been impairment tested with no impairment being required.
5. Joey is looking to expand into publishing and entered into an arrangement with Content Publishing (CP), apublic limited company, on 1 December 2013. CP will provide content for a range of books and onlinepublications.
CP is entitled to a royalty calculated as 10% of sales and 30% of gross profit of the publications. Joey hassole responsibility for all printing, binding, and platform maintenance of the online website. The agreementstates that key strategic sales and marketing decisions must be agreed jointly. Joey selects the content to becovered in the publications but CP has the right of veto over this content. However on 1 June 2014, Joeyand CP decided to set up a legal entity, JCP, with equal shares and voting rights. CP continues to contributecontent into JCP but does not receive royalties. Joey continues the printing, binding and platformmaintenance. The sales and cost of sales in the period were $5 million and $2 million respectively. Thewhole of the sale proceeds and the costs of sales were recorded in Joey’s financial statements with noaccounting entries being made for JCP or amounts due to CP. Joey currently funds the operations. Assumethat the sales and costs accrue evenly throughout the year and that all of the transactions relating to JCPhave been in cash.
6. At 30 November 2013, Joey carried a property in its statement of financial position at its revalued amountof $14 million in accordance with IAS 16 Property, Plant and Equipment. Depreciation is charged at$300,000 per year on the straight line basis. In March 2014, the management decided to sell the propertyand it was advertised for sale. By 31 March 2014, the sale was considered to be highly probable and thecriteria for IFRS 5 Non-current Assets Held for Sale and Discontinued Operations were met at this date. Atthat date, the asset’s fair value was $15·4 million and its value in use was $15·8 million. Costs to sell theasset were estimated at $300,000. On 30 November 2014, the property was sold for $15·6 million. Thetransactions regarding the property are deemed to be material and no entries have been made in thefinancial statements regarding this property since 30 November 2013 as the cash receipts from the salewere not received until December 2014.
Required:
Prepare the group consolidated statement of financial position of Joey as at 30 November 2014.(35 marks)
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(b) The directors of Joey have heard that the Financial Reporting Council in the UK has published three FinancialReporting Standards (FRSs), which will replace UK GAAP in the UK and Republic of Ireland. They are confusedas to the nature of the new standards and whether their UK operations including the holding company areaffected or qualify for the use of the standards.
Required:
Outline the key changes to UK GAAP and discuss the eligibility criteria for any UK operations of the JoeyGroup. (8 marks)
(c) Joey’s directors feel that they need a significant injection of capital in order to modernise plant and equipmentas the company has been promised new orders if it can produce goods to an international quality. The bank’scurrent lending policies require borrowers to demonstrate good projected cash flow, as well as a level ofprofitability which would indicate that repayments would be made. However, the current projected cash flowstatement would not satisfy the bank’s criteria for lending. The directors have told the bank that the company isin an excellent financial position, that the financial results and cash flow projections will meet the criteria andthat the chief accountant will forward a report to this effect shortly. The chief accountant has only recently joinedJoey and has openly stated that he cannot afford to lose his job because of his financial commitments.
Required:
Discuss the potential ethical conflicts which may arise in the above scenario and the ethical principles whichwould guide how a professional accountant should respond in this situation. (7 marks)
(50 marks)
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Section B – TWO questions ONLY to be attempted
2 (a) Coatmin is a government-controlled bank. Coatmin was taken over by the government during the recent financialcrisis. Coatmin does not directly trade with other government-controlled banks but has underwritten thedevelopment of the nationally owned railway and postal service. The directors of Coatmin are concerned aboutthe volume and cost of disclosing its related party interests because they extend theoretically to all othergovernment-controlled enterprises and banks. They wish general advice on the nature and importance of thedisclosure of related party relationships and specific advice on the disclosure of the above relationships in thefinancial statements. (5 marks)
(b) At the start of the financial year to 30 November 2013, Coatmin gave a financial guarantee contract on behalfof one of its subsidiaries, a charitable organisation, committing it to repay the principal amount of $60 million ifthe subsidiary defaulted on any payments due under a loan. The loan related to the financing of the constructionof new office premises and has a term of three years. It is being repaid by equal annual instalments of principalwith the first payment having been paid. Coatmin has not secured any compensation in return for giving theguarantee, but assessed that it had a fair value of $1·2 million. The guarantee is measured at fair value throughprofit or loss. The guarantee was given on the basis that it was probable that it would not be called upon. At 30 November 2014, Coatmin became aware of the fact that the subsidiary was having financial difficulties withthe result that it has not paid the second instalment of principal. It is assessed that it is probable that theguarantee will now be called. However, just before the signing of the financial statements for the year ended 30 November 2014, the subsidiary secured a donation which enabled it to make the second repayment beforethe guarantee was called upon. It is now anticipated that the subsidiary will be able to meet the final payment.Discounting is immaterial and the fair value of the guarantee is higher than the value determined under IAS 37Provisions, Contingent Liabilities and Contingent Assets. Coatmin wishes to know the principles behindaccounting for the above guarantee under IFRS and how the transaction would be accounted for in the financialrecords. (7 marks)
(c) Coatmin’s creditworthiness has been worsening but it has entered into an interest rate swap agreement whichacts as a hedge against a $2 million 2% bond issue which matures on 31 May 2016. The notional amount ofthe swap is $2 million with settlement every 12 months. The start date of the swap was 1 December 2013 andit matures on 31 May 2016. The swap is enacted for nil consideration. Coatmin receives interest at 1·75% ayear and pays on the basis of the 12-month LIBOR rate. At inception, Coatmin designates the swap as a hedgein the variability in the fair value of the bond issue.
Fair value Fair value1 December 2013 30 November 2014
$000 $000Fixed interest bond 2,000 1,910Interest rate swap Nil 203
Coatmin wishes to know the circumstances in which it can use hedge accounting and needs advice on the useof hedge accounting for the above transactions. (7 marks)
(d) Coatmin provides loans to customers and funds the loans by selling bonds in the market. The liability isdesignated as at fair value through profit or loss. The bonds have a fair value increase of $50 million in the yearto 30 November 2014 of which $5 million relates to the reduction in Coatmin’s creditworthiness. The directorsof Coatmin would like advice on how to account for this movement. (4 marks)
Required:
Discuss, with suitable calculations where necessary, the accounting treatment of the above transactions in thefinancial statements of Coatmin.
Note: The mark allocation is shown against each of the questions above.
Professional marks will be awarded in question 2 for clarity and quality of presentation. (2 marks)
(25 marks)
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3 (a) Kayte operates in the shipping industry and owns vessels for transportation. In June 2014, Kayte acquiredCeemone whose assets were entirely investments in small companies. The small companies each owned andoperated one or two shipping vessels. There were no employees in Ceemone or the small companies. At theacquisition date, there were only limited activities related to managing the small companies as most activitieswere outsourced. All the personnel in Ceemone were employed by a separate management company. Thecompanies owning the vessels had an agreement with the management company concerning assistance withchartering, purchase and sale of vessels and any technical management. The management company used ashipbroker to assist with some of these tasks.
Kayte accounted for the investment in Ceemone as an asset acquisition. The consideration paid and relatedtransaction costs were recognised as the acquisition price of the vessels. Kayte argued that the vessels were onlypassive investments and that Ceemone did not own a business consisting of processes, since all activitiesregarding commercial and technical management were outsourced to the management company. As a result, theacquisition was accounted for as if the vessels were acquired on a stand-alone basis.
Additionally, Kayte had borrowed heavily to purchase some vessels and was struggling to meet its debtobligations. Kayte had sold some of these vessels but in some cases, the bank did not wish Kayte to sell thevessel. In these cases, the vessel was transferred to a new entity, in which the bank retained a variable interestbased upon the level of the indebtedness. Kayte’s directors felt that the entity was a subsidiary of the bank andare uncertain as to whether they have complied with the requirements of IFRS 3 Business Combinations andIFRS 10 Consolidated Financial Statements as regards the above transactions.
Required:
Discuss the accounting treatment of the above transactions in the financial statements of Kayte.(12 marks)
(b) Kayte owns an entity, which currently uses ‘old’ UK GAAP to prepare its financial statements. The directors ofKayte are unsure of the business implications of the new Financial Reporting Standards (new UK GAAP), andalso how accounting for certain transactions differs from IFRS for SMEs. They are particularly concerned aboutthe accounting for income tax.
Required:
Prepare a report to the Directors of Kayte, setting out the business implications of a change from ‘old’ to‘new’ UK GAAP and an explanation as to how income tax would be accounted for under ‘new’ UK GAAP ascompared to IFRS for SMEs. (11 marks)
Professional marks will be awarded in question 3 for clarity and quality of presentation. (2 marks)
(25 marks)
7 [P.T.O.
8
4 (a) An assessment of accounting practices for asset impairments is especially important in the context of financialreporting quality in that it requires the exercise of considerable management judgement and reporting discretion.The importance of this issue is heightened during periods of ongoing economic uncertainty as a result of the needfor companies to reflect the loss of economic value in a timely fashion through the mechanism of asset write-downs. There are many factors which can affect the quality of impairment accounting and disclosures.These factors include changes in circumstance in the reporting period, the market capitalisation of the entity, theallocation of goodwill to cash generating units, valuation issues and the nature of the disclosures.
Required:
Discuss the importance and significance of the above factors when conducting an impairment test underIAS 36 Impairment of Assets. (13 marks)
(b) (i) Estoil is an international company providing parts for the automotive industry. It operates in many differentjurisdictions with different currencies. During 2014, Estoil experienced financial difficulties marked by adecline in revenue, a reorganisation and restructuring of the business and it reported a loss for the year. Animpairment test of goodwill was performed but no impairment was recognised. Estoil applied one discountrate for all cash flows for all cash generating units (CGUs), irrespective of the currency in which the cashflows would be generated. The discount rate used was the weighted average cost of capital (WACC) andEstoil used the 10-year government bond rate for its jurisdiction as the risk free rate in this calculation.Additionally, Estoil built its model using a forecast denominated in the functional currency of the parentcompany. Estoil felt that any other approach would require a level of detail which was unrealistic andimpracticable. Estoil argued that the different CGUs represented different risk profiles in the short term, butover a longer business cycle, there was no basis for claiming that their risk profiles were different.
(ii) Fariole specialises in the communications sector with three main CGUs. Goodwill was a significantcomponent of total assets. Fariole performed an impairment test of the CGUs. The cash flow projections werebased on the most recent financial budgets approved by management. The realised cash flows for the CGUswere negative in 2014 and far below budgeted cash flows for that period. The directors had significantlyraised cash flow forecasts for 2015 with little justification. The projected cash flows were calculated byadding back depreciation charges to the budgeted result for the period with expected changes in workingcapital and capital expenditure not taken into account.
Required:
Discuss the acceptability of the above accounting practices under IAS 36 Impairment of Assets.(10 marks)
Professional marks will be awarded in question 4 for clarity and quality of presentation. (2 marks)
(25 marks)
End of Question Paper
Answers
Professional Level – Essentials Module, Paper P2 (UK)Corporate Reporting (United Kingdom) December 2014 Answers
1 (a) Joey plc
Consolidated statement of financial position at 30 November 2014
$mAssets:Non-current assetsProperty, plant and equipment (W8) 6,709Goodwill (W1) 89Intangible assets – franchise right (W2) 15Investment in joint venture (W10) 0·75
–––––––––6,813·75
Current assets (W6) 2,011·3–––––––––
Total assets 8,825·05–––––––––
Equity and liabilities:Equity attributable to owners of parentShare capital 850Retained earnings (W4) 3,450·25Other components of equity (W5) 258·5
$m $mFair value of consideration for 40% interest 975Non-controlling interest – fair value 620Previously held interest of 30% – fair value 705Fair value of identifiable net assets acquired:Share capital 1,020Retained earnings 900OCE 70FV adjustment – land (balance) 266
– contingent liability (6)––––––
(2,250)Add decrease in fair value of buildings 40Measurement period adjustment – contingent liability ($6m – $5m) (1)
––––––Goodwill 89
––––––
Tutorial noteThe carrying amount of Margy at 1 December 2013 is (cash $600 + profit $90m + revaluation gain $10m) $700 millionand this interest is fair valued at the date of acquisition to $705 million, giving a revaluation gain of $5 million which goesto profit or loss. The previous revaluation gain of $10 million would not be reclassified to profit or loss even if the interest inMargy were disposed of.
The carrying amount of property, plant and equipment as of 30 November 2014 is decreased by $40 million less the excessdepreciation charged of $2 million, i.e. $38 million. The carrying amount of goodwill is increased by $40 million anddepreciation expense for 2014 is decreased by $2 million. This latter decrease in expense is split between retained earnings($1·4m) and NCI ($0·6m).
IFRS 3 Business Combinations requires Joey to measure contingent liabilities subsequent to the date of acquisition at thehigher of the amount which would be recognised in accordance with IAS 37 Provisions, Contingent Liabilities and ContingentAssets, and the amount initially recognised, less any appropriate cumulative amortisation in accordance with IAS 18Revenue. These requirements should be applied only for the period in which the item is considered to be a contingentliability. In this case, the contingent liability has subsequently met the requirements to be reclassified as a provision, andwill be measured in accordance with IAS 37 rather than IFRS 3.
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As a result the liability has been measured at March 2014 at $5 million, and recognised through profit or loss during theyear ended 30 November 2014. This represents a pre-combination loss which must be credited back to NCI and groupreserves. Therefore NCI is credited with $1·5 million and retained earnings with $3·5 million.
Working 2 Hulty
Joey measures the gain on its purchase of the 80% interest in Hulty as follows:
$m $mPurchase consideration – Hulty 700Non-controlling interest 250Less fair value of identifiable net assets:Share capital 600Retained earnings 300OCE 40FV – franchise right 20
––––(960)––––
Gain on bargain purchase (10)––––
The gain of $10 million is recognised in profit or loss. Additionally, Joey recognises an identified intangible asset for thereacquired right at its fair value of $20 million. This right will be amortised over the remaining term of the franchise agreementof four years. Thus $5 million will be credited to the franchise right account (to give a balance of $15 million) and debitedto retained earnings $4 million and NCI $1 million.
Working 3 Asset held for sale
IFRS 5 Non-current Assets Held for Sale and Discontinued Operations criteria are met at 31 March 2014. Therefore, Joeyshould depreciate the property until the date of reclassification as held for sale. Thus, the depreciation charge is $300,000x 4/12 = $100,000. The carrying value of the property is therefore $13·9 million.
The property should be revalued to its fair value at that date of $15·4 million as the difference between the property’s carryingamount at that date and its fair value is deemed to be material. The revaluation increase of $1·5 million is recognised in othercomprehensive income in accordance with IAS 16 Property, Plant and Equipment.
Joey should consider whether the property is impaired by comparing its carrying amount (fair value) with its recoverableamount (higher of value in use and fair value less costs to sell). No impairment loss is recognised because value in use of$15·8 million is higher than fair value less costs to sell of $15·1 million. The property should be reclassified as held for saleand remeasured to fair value less costs to sell ($15·1 million), which results in the recognition of a loss of $300,000 whichshould be recognised in profit or loss.
When the property is disposed of on 30 November 2014, a profit on disposal of $200,000 is recognised (net proceeds of$15·3 million less carrying amount of $15·1 million). Any remaining revaluation reserve relating to the property is notrecognised in profit or loss, nor transferred to retained earnings in accordance with IAS 16 because of group policy.
Accounting entries
Dr Profit or loss $100,000Cr Property $100,000
The depreciation up to the date of reclassification as held for sale.
Dr Property $1·5 millionCr OCI $1·5 million
The increase in the value of the property to fair value at the date of the reclassification.
Dr Profit or loss $300,000Cr Property $300,000
Loss arising on reclassification.
Dr Accounts receivable $15·3 millionCr Property $15·1 millionCr Profit or loss $0·2 million
The disposal of the property at the year end.
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Working 4 Retained earnings
$mJoeyBalance at 30 November 2014 3,340Revaluation gain – Margy 5Depreciation reduction (70% x 2) 1·4Liability adjustment (70% x 5) 3·5Amortisation – franchise right (80% x 5) (4)Gain on bargain purchase 10Asset held for sale – depreciation prior to reclassification (W3) (0·1)Asset held for sale – remeasurement (W3) (0·3)Asset held for sale – gain on sale (W3) 0·2Joint operation (W10) (0·7)Joint venture (W10) 0·75Joint venture (W10) (1·5)Post-acquisition reserves: Margy (70% of (980 – 900)) 56
Hulty (80% of (350 – 300)) 40–––––––––3,450·25–––––––––
Working 5 Other components of equity
$mBalance at 30 November 2014 – Joey 250Asset held for sale (W3) 1·5Post-acquisition reserves: Margy post acquisition (70% of 80 – 70) 7
Hulty (80% x (40 – 40)) 0––––––258·5––––––
Working 6 Current assets
$mBalance at 30 November 2014Joey 985Margy 861Hulty 150Sale of property (W3) 15·3
––––––––2,011·3––––––––
Working 7 Non-controlling interest
$mMargy (W1) 620Hulty (W2) 250Post-acquisition retained earnings – Margy (30% of 980 – 900) 24Post-acquisition retained earnings – Hulty (20% of 350 – 300) 10OCE – post acquisition – Margy (30% of 80 – 70) 3OCE – post acquisition – Hulty (20% of 40 – 40) 0Depreciation reduction (30% x 2) 0·6Franchise right – amortisation (20% x 5) (1)Liability adjustment (30% x 5) 1·5
––––––908·1––––––
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Working 8 Property, plant and equipment
$m $mBalance at 30 November 2014Joey 3,295Margy 2,000Hulty 1,200
––––––––6,495
Decrease in value of building – Margy (W1) (38)Increase in value of land – Margy (W1) 266Asset held for sale – depreciation prior to reclassification (W3) (0·1)Asset held for sale – remeasurement prior reclassification 1·5Asset held for sale – remeasurement after reclassification (0·3)Asset held for sale – disposal (15·1) 214
–––––––– ––––––6,709––––––
Working 9 Liabilities
$m $mNon-current liabilities – balance at 30 November 2014Joey 1,895Margy 675Hulty 200
–––––– ––––––2,770––––––
$m $mCurrent liabilities – balance at 30 November 2014Joey 320Margy 106Hulty 160Joint operation – CP 0·7Joint venture 1·5
––––– ––––––588·2––––––
Working 10 Joint venture
For the period to 31 May 2014, the requirement for unanimous key strategic decisions means this is a joint venture. Sincethere is no legal entity, it would be classified as a joint operation. Joey would account for its direct rights to the underlyingresults and assets.
Up until 31 May 2014, the joint operation had the following results:
$mRevenue (5 x 6/12) 2·5Cost of sales (2 x 6/12) (1)
–––––Gross profit 1·5
–––––
What belongs to Joey is therefore:
$mSales (90% x 2·5) 2·25 Cost of sales (printing, binding, platform – all by Joey) (1)
–––––Gross profit 1·25Profit royalty to CP (calculated as 30% of $1·5m) (0·45)
–––––Net profit 0·8
–––––
Therefore Joey should adjust the accounting for the period to 31 May 2014 as follows:
Dr Profit or loss ($0·45m above + ($2·5m x 10%), i.e. $0·25 million) $0·7 millionCr Accounts payable CP $0·7 million
From 1 June 2014, Joey has a share of the net assets rather than direct rights; the joint operation would be classified as ajoint venture and must be equity accounted. Therefore the adjustment to the current accounting will be:
Remove profit of new entity JCP:
Dr Profit or loss $1·5 millionCr JCP – profit for period $1·5 million
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Recognise Joey’s equity-accounted share of JCP’s profit:
Dr Investment in joint venture (($5m – $2m)/2 x 50%) $0·75 millionCr Profit or loss $0·75 million
(b) Report to the directors of Joey
Key changes to UK GAAP and eligibility criteria
The Financial Reporting Council in the UK has published three Financial Reporting Standards, which will replace UK GAAPin the UK and Republic of Ireland. These are:
(1) FRS 100, Application of financial reporting requirements; (2) FRS 101, Reduced disclosure framework; and (3) FRS 102, The Financial Reporting Standard applicable in the UK and Republic of Ireland. This will be the new FRS for
UK GAAP reporters.
FRS 100 sets out the overall financial reporting requirements, giving many entities a choice of detailed accountingrequirements depending on factors such as size, and whether or not they are part of a listed group. FRS 100 providescompanies with an opportunity to take advantage of reduced disclosures and identifies whether entities need to produce theirconsolidated or individual financial statements in accordance with EU IFRS, FRS 102 or the Financial Reporting Standard forSmaller Entities (FRSSE).
It does not extend the mandatory application of EU-adopted IFRS. In the absence of a requirement to prepare EU IFRSfinancial statements, the individual accounts or consolidated accounts of any qualifying entity are prepared in accordancewith one of the following:
(1) EU IFRS(2) FRS 101 for the individual accounts of a qualifying entity (3) FRS 102(4) FRSSE
The last three options above are all ‘Companies Act’ accounts. FRS 101 provides companies with an opportunity to takeadvantage of reduced disclosures. However, companies should consider the advantages and disadvantages of the optionsbefore making a decision as to which regime to adopt. There are transitional arrangements for entities which change the basisof preparation of their financial statements.
Entities which are not required to use IFRS but wish to use its recognition and measurement requirements can choose toapply FRS 101 in their individual financial statements, benefiting from reduced disclosures, as long as they are qualifyingentities. FRS 101 permits UK subsidiaries to adopt EU IFRS for their individual financial statements but within the reduceddisclosure framework (RDF). This option is also available for the parent company’s individual financial statements. Thedisclosure exemptions do not apply to consolidated financial statements of intermediate groups, as they are only available forindividual financial statements of qualifying entities. FRS 101 contains various exemptions from IFRS disclosures. Some ofthese require that equivalent disclosures are included in the consolidated financial statements of the group in which the entityis consolidated. FRS 102 replaces the majority of current UK accounting standards and adopts an IFRS-based frameworkwith proportionate disclosure requirements and improves the accounting and reporting for financial instruments. It is basedon the IFRS for SMEs but with significant changes in order to address company law and to include extra accounting options.
A qualifying entity for these purposes is one which is a member of a group where the parent of that group prepares publiclyavailable consolidated financial statements, and that member is included in the consolidation.
In order to use RDF, the shareholders should have been notified in writing and those holding a certain percentage of shareshave not objected, EU adopted IFRS have been applied and the financial statements make specified disclosures relating tothe exemptions.
A shareholder may object to the use of the disclosure exemptions only if the shareholder is the immediate parent of the entity,if the shareholder or shareholders hold more than half of the allotted shares in the entity which are not held by the immediateparent, or if the shareholder or shareholders hold 5% or more of the total allotted shares in the entity.
(c) Joey needs a significant injection of capital in order to modernise plant and equipment and the bank requires the companyto demonstrate good projected cash flow and profitability. However, the projected cash flow statement does not satisfy thebank’s criteria and the directors have told the bank that the financial results will meet the criteria. Thus there is pressure onthe chief accountant to forward a financial report which meets the bank’s criteria. The chief accountant cannot afford to losehis job because of his financial commitments and this in itself creates an ethical dilemma for the accountant, as not only isthere self-interest of the accountant involved but also the interests of the company and its workforce. The accountant has torely upon his moral and ethical judgement in these circumstances.
Ethical standards are used by members of a profession to decide the right course of action in given circumstances. Ethics relyon logical and rational reasoning to reach a decision, morals are a behavioural code of conduct to which an individual ascribesand ethical rules create an obligation to undertake a particular course of action. Conflict can arise between personal andethical values but when an individual becomes a member of a profession, there is a recognition that there is acceptance ofthe standards of that profession which include its code of ethics and values. The ethical rules of the accounting professionrepresent an attempt to codify principles. A profession is distinguished by having a specialised body of knowledge, a social
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commitment, the ability to regulate itself and high social status. The profession should seek to promote or preserve publicinterest. Professional accountants make a bargain with society in which they promise to serve the public interest which may,at times, be at their own expense. Accountants, as professionals, cannot rely exclusively on rules to define how they will actethically. Members of the profession have a responsibility to present the truth in a fair and honest fashion and in a spirit ofpublic service. In such circumstances, accountants should think carefully before seeking creative accounting solutions toparticular problems. Thus, in this case, the chief accountant should insist that the report to the bank is a true reflection ofthe current financial position, irrespective of the consequences for himself.
2 (a) Under IAS 24 Related Party Disclosures, disclosures are required in respect of an entity’s transactions with related parties.Related parties include parents, subsidiaries, members of key management personnel of the entity or of a parent of the entityand post-employment benefit plans.
Where there have been related party transactions during the period, management discloses the nature of the relationship, aswell as information about the transactions and outstanding balances, including commitments, necessary for users tounderstand the potential impact of the relationship on the financial statements. Disclosure is made by category of related partyand by major type of transaction. Management only discloses that related party transactions were made on terms equivalentto those which prevail in arm’s length transactions if such terms can be substantiated.
Government-related entities are defined as entities which are controlled, jointly controlled or significantly influenced by thegovernment. The financial crisis widened the range of entities subject to the related party disclosure requirements. Thefinancial support provided by governments to financial institutions in many countries meant that the government controlssignificantly influenced some of those entities. A government-controlled bank would, in principle, be required to disclosedetails of its transactions, deposits and commitments with all other government-controlled banks and with the central bank.However, IAS 24 has an exemption from all of the disclosure requirements of IAS 24 for transactions between government-related entities and the government, and all other government-related entities. Coatmin is exempt from thedisclosure requirements in relation to related party transactions and outstanding balances, including commitments, with:
(a) a government which has control, joint control or significant influence over the reporting entity; and
(b) another entity which is a related party because the same government has control, joint control or significant influenceover both the reporting entity and the other entity.
Those disclosures are replaced with a requirement to disclose:
(a) the name of the government and the nature of their relationship; and
(b) (i) the nature and amount of any individually significant transactions; and (ii) the extent of any collectively significant transactions qualitatively or quantitatively.
The disclosures provide more meaningful information about the nature of an entity’s relationship with the government andmaterial transactions.
(b) IFRS 9 Financial Instruments says that an entity should classify all financial liabilities as subsequently measured at amortisedcost using the effective interest method, except for:
(a) financial liabilities at fair value through profit or loss. Such liabilities, including derivatives which are liabilities, shall besubsequently measured at fair value.
(b) financial liabilities which arise when a transfer of a financial asset does not qualify for de-recognition or when thecontinuing involvement approach applies.
(c) financial guarantee contracts as defined in the standard. After initial recognition, an issuer of such a contract shallsubsequently measure it at the higher of:
(i) the amount determined in accordance with IAS 37 Provisions, Contingent Liabilities and Contingent Assets, and(ii) the amount initially recognised less, when appropriate, cumulative amortisation recognised in accordance with
IAS 18 Revenue.
In addition, financial guarantees and loan commitments which entities choose to measure at fair value through profit or losswill have all fair value movements in profit or loss, with no transfer to OCI. Changes in the credit risk of liabilities relating toloan commitment and financial guarantee contracts are not required to be presented in other comprehensive income.
The accounting entries on the assumption that discounting would not be material will therefore be:
1 December 2012
Dr Profit or loss $1·2 millionCr Financial liabilities $1·2 million
To record the loss incurred in giving the guarantee.
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30 November 2013
Dr Financial liabilities $0·4 millionCr Profit or loss $0·4 million
To amortise the initial fair value over the life of the guarantee, reflecting the reduction in exposure as a result of the firstrepayment by the subsidiary.
30 November 2014
Dr Profit or loss $39·2 millionCr Financial liabilities $39·2 million
To provide for the calling of the guarantee – the difference between the possible $40 million call and the carrying amount ofthe guarantee of $0·8 million.
Dr Financial liabilities $39·6 millionCr Profit or loss $39·6 million
To move from the provision back to measurement at amortised initial value following event after the reporting period changein probabilities of the guarantee being called.
An event after the reporting period is an event, which could be favourable or unfavourable, which occurs between the end ofthe reporting period and the date when the financial statements are authorised for issue. The above is an adjusting eventwhich is an event after the reporting period which provides further evidence of conditions which existed at the end of thereporting period.
(c) IAS 39 Financial Instruments: Recognition and Measurement permits hedge accounting under certain circumstancesprovided that the hedging relationship is:
(a) formally designated and documented, including the entity’s risk management objective and strategy for undertaking thehedge, identification of the hedging instrument, the hedged item, the nature of the risk being hedged, and how the entitywill assess the hedging instrument’s effectiveness; and
(b) expected to be highly effective in achieving offsetting changes in fair value or cash flows attributable to the hedged riskas designated and documented, and effectiveness can be reliably measured; and
(c) assessed on an ongoing basis and determined to have been highly effective.
A hedging instrument is an instrument whose fair value or cash flows are expected to offset changes in the fair value or cashflows of a designated hedged item. All derivative contracts with an external counterparty may be designated as hedginginstruments except for some written options. A non-derivative financial asset or liability may not be designated as a hedginginstrument except as a hedge of foreign currency risk. For hedge accounting purposes, only instruments which involve a partyexternal to the reporting entity can be designated as a hedging instrument. This applies to intragroup transactions as well withthe exception of certain foreign currency hedges of forecast intragroup transactions. However, they may qualify for hedgeaccounting in individual financial statements.
IAS 39 requires hedge effectiveness to be assessed both prospectively and retrospectively in order to qualify for hedgeaccounting at the inception of a hedge and, at a minimum, at each reporting date. The changes in the fair value of the hedgeditem, in this case, attributable to the hedged risk must be expected to be highly effective in offsetting the changes in the fairvalue of the hedging instrument on a prospective basis, and on a retrospective basis where actual results are within a rangeof 80% to 125%. All hedge ineffectiveness is recognised immediately in profit or loss including ineffectiveness within the80% to 125% window.
Fair value Fair value Change in value1 December 2013 30 November 2014
$000 $000 $000Fixed interest bond 2,000 1,910 90Interest rate swap Nil 203 203Effectiveness 226% or 44%
Therefore hedge accounting is not permitted as the results of the effectiveness test fall outside the acceptable range of 80%to 125%. The main reason for the difference in the fair value movements is likely to be Coatmin’s deterioratingcreditworthiness. IAS 39 allows an entity to designate any portion of the risk in a financial asset as the hedged item. Hedgeeffectiveness is easier to achieve if the hedged risk matches the hedging instrument as closely as possible. Coatmin shouldredesignate the risk being hedged and try to exclude the credit risk from the hedging relationship. Maybe it could hedgechanges in the bond’s fair value to changes in the risk free interest rate.
(d) IFRS 9 requires gains and losses on financial liabilities designated as at fair value through profit or loss to be split into theamount of change in the fair value which is attributable to changes in the credit risk of the liability, which is shown in othercomprehensive income, and the remaining amount of change in the fair value of the liability which is shown in profit or loss.IFRS 9 allows the recognition of the full amount of change in the fair value in the profit or loss only if the recognition ofchanges in the liability’s credit risk in other comprehensive income would create an accounting mismatch in profit or loss.
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This is determined at initial recognition and is not reassessed. Amounts presented in other comprehensive income are notsubsequently transferred to profit or loss, and the entity may only transfer the cumulative gain or loss within equity. ThusCoatmin should charge $5 million to OCI and $45 million to the profit or loss.
3 (a) The accounting for the transaction as an asset acquisition does not comply with the requirements of IFRS 3 BusinessCombinations and should have been accounted as a business combination. This would mean that transaction costs wouldbe expensed, the vessels recognised at fair value, any deferred tax recognised at nominal value and the difference betweenthese amounts and the consideration paid to be recognised as goodwill.
In accordance with IFRS 3, an entity should determine whether a transaction is a business combination by applying thedefinition of a business in IFRS 3. A business is an integrated set of activities and assets which is capable of being conductedand managed for the purpose of providing a return in the form of dividends, lower costs or other economic benefits directlyto investors or other owners, members or participants. A business consists of inputs and processes applied to those inputswhich have the ability to create outputs. Although businesses usually have outputs, outputs are not required to qualify as abusiness.
When analysing the transaction, the following elements are relevant:
(i) Inputs: Shares in vessel owning companies, charter arrangements, outsourcing arrangements with a managementcompany, and relationships with a shipping broker.
(ii) Processes: Activities regarding chartering and operating the vessels, financing the business, purchase and sales ofvessels.
(iii) Outputs: Ceemone would generate revenue from charter agreements and has the ability to gain economic benefit fromthe vessels.
IFRS 3 states that whether a seller operated a set of assets and activities as a business or intends to operate it as a businessis not relevant in evaluating whether it is a business. It is not relevant therefore that some activities were outsourced asCeemone could chose to conduct and manage the integrated set of assets and activities as a business. As a result, theacquisition included all the elements which constitute a business, in accordance with IFRS 3.
IFRS 10 Consolidated Financial Statements sets out the situation where an investor controls an investee. This is the case, ifand only if, the investor has all of the following elements:
(i) power over the investee, that is, the investor has existing rights which give it the ability to direct the relevant activities(the activities which significantly affect the investee’s returns);
(ii) exposure, or rights, to variable returns from its involvement with the investee;
(iii) the ability to use its power over the investee to affect the amount of the investor’s returns.
Where a party has all three elements, then it is a parent; where at least one element is missing, then it is not. In every case,IFRS 10 looks to the substance of the arrangement and not just to its legal form. Each situation needs to be assessedindividually. The question arises in this case as to whether the entities created are subsidiaries of the bank. The bank is likelyto have power over the investee, may be exposed to variable returns and certainly may have the power to affect the amountof the returns. Thus the bank is likely to have a measure of control but the extent will depend on the constitution of the entity.
(b) Report to directors of Kayte
Business implications of new UK GAAP and specific accounting issues
For many entities, there may be a cash tax impact as a result of the transition away from current UK and Irish GAAP, whichwill impact the tax payable to or receivable from HM Revenue and Customs. UK tax liabilities are based upon local entityaccounting profits. It is important that stakeholders understand this. Differing treatments of goodwill, lease incentives andintangible assets can affect tax outcomes. Where accounting adjustments are made on transition, these may impact theamount of distributable reserves. Additionally, changes to the accounting and financial reporting requirements will oftenrequire information not previously compiled. Entities will need to consider whether their existing systems and reportingstructures can provide all of the information required under the new accounting framework.
Employee remuneration packages are often linked to accounting performance through profit-related bonus arrangements andshare option arrangements and these remuneration arrangements will need to be assessed to understand the potential impact.It may be necessary to agree revised financial terms. Often banking covenants or other finance arrangements are linked tokey financial reporting measures. It may be necessary to renegotiate borrowing arrangements. Entities will need to considerhow they will manage the transition and consider how they will approach the training of the necessary finance team membersunder a new accounting framework. A challenges for groups is the rolling out of the new accounting frameworks across anumber of companies. It may be useful to consider entity rationalisation in order to simplify their structure to ensure the mostefficient transition.
It is essential to manage the expectations of those affected across the business. The board of directors must fully understandthe extent of the changes and determine a communications strategy to address the need of all stakeholders.
The section on income tax in IFRS for SMEs has been replaced completely in FRS 102 The Financial Reporting Standardapplicable in the UK and Republic of Ireland.
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A current tax liability is recognised for tax payable on taxable profit for the current and past periods. If the amount of tax paidfor the current and past periods exceeds the amount of tax payable for those periods, the excess is recognised as a currenttax asset. A current tax asset is recognised for the benefit of a tax loss which can be carried back to recover tax paid in aprevious period. FRS 102 requires disclosure of the tax expense relating to discontinued operations.
Current tax assets and liabilities and deferred tax assets and liabilities can be offset if there is a legally enforceable right ofset-off and there is an intention to settle simultaneously or on a net basis.
FRS 102 recognises deferred tax utilising timing differences, and not temporary differences which is the IFRS for SMEsapproach. New UK GAAP requires a new ‘timing difference plus’ approach which is a similar approach to old UK GAAP butwith specific additional adjustments required to recognise additional deferred tax balances. It is probable that the result willbe similar to that under IFRS for SMEs, except in rare circumstances. Timing differences are differences between taxable profitand accounting profit which originate in one period and reverse in one or more subsequent periods. Timing differences arisebecause certain items are included in the accounts of a period which is different from that in which they are dealt with fortaxation purposes.
Under FRS 102, deferred taxation should be recognised in respect of all timing differences at the reporting date, subject tocertain exceptions and for differences arising in a business combination. Under the IFRS for SMEs, a ‘balance sheet’ approachis taken, based on temporary differences. Temporary differences are differences between the tax base of an asset or liabilityand its carrying amount in the statement of financial position.
Both FRS 102 and IFRS for SMEs prohibit discounting of deferred tax assets and liabilities.
4 (a) All assets, including goodwill and intangible assets, have to be tested for impairment at the end of each reporting period, ifthere are indicators of impairment. The main issues in relation to IAS 36 Impairment of Assets are as follows:
Changes in circumstances
Changes in circumstances between the date of the impairment test and the next reporting period end may give rise toimpairment indicators. If so, more than one impairment test may be required in an annual period. Where an annualimpairment test is required for goodwill and certain other intangible assets, IAS 36 allows the impairment test to be performedat any time during the period, provided it is performed at the same time every year.
Many entities test goodwill at an interim period in the year. In times of high uncertainty, goodwill may have to be tested forimpairment at year end and at a subsequent interim reporting date as well, if indicators of impairment arise after the annualtest has been performed.
If an entity has to test for impairment at the end of the reporting date as well as at the scheduled annual date, it does notnecessarily mean that the whole budget process needs to be redone, as top-down adjustments may be sufficient to assessany changes in the period since the latest goodwill impairment review.
Volatility in financial statements may indicate impairment. For example, falls or rises in commodity prices may affectimpairment indicators for energy and mining entities, and require those assets to be tested for impairment in the next interimfinancial statements.
Market capitalisation as a special impairment indicator
Market capitalisation is a powerful indicator as, if it shows a lower figure than the book value of net assets, it inescapablysuggests the market considers that the business is overvalued. However, the market may have taken account of factors otherthan the return which the entity is generating on its assets. A market capitalisation below book equity will not necessarily leadto an equivalent impairment loss. Entities should examine their cash generating units (CGUs) in these circumstances and mayhave to test goodwill for impairment. IAS 36 does not require a formal reconciliation between market capitalisation of theentity, fair value less costs to sell (FVLCS) and value in use (VIU). However, entities need to be able to understand the reasonfor the shortfall.
Allocating and reallocating goodwill to cash generating unit (CGU)
Given the complexity, sensitivity and need for significant judgement, companies experience issues assessing goodwill forimpairment. The identification of CGUs and the allocation of acquired goodwill is unique to each entity and requires significantjudgement. This allocation process in itself determines the appropriate carrying amount to test and should be a reasonableand supportable method.
Acquired goodwill is allocated to each of the acquirer’s CGUs, or to a group of CGUs, which are expected to benefit from thesynergies of the combination. If CGUs are subsequently revised or operations disposed of, IAS 36 requires goodwill to bereallocated, based on ‘relative values’, to the units affected. However, the standard does not expand on what is meant by‘relative value’. It does not mandate FVLCS as the basis, but it might mean that the entity has to carry out a valuation processon the part retained. There could be reasonable ways of estimating relative value by using an appropriate industry or businesssurrogate (for example, revenue, profits, industry KPIs).
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Valuation issues
IAS 36 requires the recoverable amount of an asset or CGU to be measured as the higher of the asset’s or CGU’s FVLCS andVIU. Measuring the FVLCS and VIU of an asset or CGU requires the use of assumptions and estimates.
The following issues are proving particularly troublesome:
(a) The use of a discounted cash flow (DCF) methodology to estimate FVLCS.
(b) Determining the types of future cash flows which should be included in the measurement of VIU, in particular, thoserelating to restructuring programmes. IAS 36 requires an asset or CGU to be tested in its current status, not the statuswhich management wishes it was in or hopes to get it into in the near future. Therefore, the standard requires VIU tobe measured at the net present value of the future cash flows the entity expects to derive from the asset or CGU in itscurrent condition over its remaining useful life. This means ignoring many management plans for enhancing theperformance of the asset or CGU.
(c) Determining the appropriate discount rate to apply. Unlike the cash flows used in an impairment test which are entity-specific, the discount rate is supposed to appropriately reflect the current market assessment of the time value ofmoney and the risks specific to the asset or CGU.
When a specific rate for an asset or CGU is not directly available from the market, which is usually the case, the entity’sweighted average cost of capital (WACC) can be used as a starting point. While not prescribed, WACC is by far the mostcommonly used base for the discount rate. However, the appropriate way to calculate the WACC is a complex subject,but the objective must be to obtain a rate, which is sensible and justifiable. In any event the rate can be subjective.
(d) The impact of taxation on the impairment test, given the requirement in IAS 36 to measure VIU using pre-tax cash flowsand discount rates. VIU, as defined by IAS 36, is primarily an accounting concept and not necessarily a businessvaluation of the asset or CGU. For calculating VIU, IAS 36 requires pre-tax cash flows and a pre-tax discount rate.
WACC is a post-tax rate, as are most observable equity rates used by valuers. Because of the issues in calculating anappropriate pre-tax discount rate and because it aligns more closely with their normal business valuation approach,some entities attempt to perform a VIU calculation based on a post-tax rate and post-tax cash flows.
(e) Ensuring that the recoverable amount and carrying amount which are being compared are consistently determined. Forexample, pensions are mentioned by IAS 36 as items which might be included in the recoverable amount of a CGU. Inpractice, this could be fraught with difficulty, and entities will have to reflect the costs of providing pensions to employeesand may need to make a pragmatic allocation to estimate a pension cost as part of the employee cost cash flow.
(f) The incorporation of corporate assets into the impairment test. If possible, the corporate assets are to be allocated toindividual CGUs on a ‘reasonable and consistent basis’. This is not expanded upon in IAS 36 and affords some flexibility,but can lead to inconsistency. The same criteria must be applied at all times.
Disclosures
Disclosure is a key communication to investors by management. Disclosures which describe the factors which could result inimpairment become even more important when value has been eroded. Goodwill impairment disclosures are a requirement,but can be a problem. The key question is whether sufficient disclosure has been made about the uncertainty of theimpairment calculation. Sensitivity disclosures about adverse situations, such as those triggered by volatile prices, provideuseful information and whether a possible change in a key assumption, such as the discount rate, could lead to recoverableamount being equal to carrying amount, or result in impairment losses.
(b) (i) The discount rate used by Estoil has not been calculated in accordance with the requirements of IAS 36 Impairment ofAssets. According to IAS 36, the future cash flows are estimated in the currency in which they will be generated andthen discounted using a discount rate appropriate for that currency. IAS 36 requires the present value to be translatedusing the spot exchange rate at the date of the value in use calculation. Furthermore, the currency in which the estimatedcash flows are denominated affects many of the inputs to the WACC calculation, including the risk free interest rate.Estoil has used the 10-year government bond rate for its jurisdiction as the risk free rate in the calculation of the discountrate. As government bond rates differ between countries due to different expectations about future inflation, value in usecould be calculated incorrectly due to the disparity between the expected inflation reflected in the estimated cash flowsand the risk free rate.
According to IAS 36, the discount rate should reflect the risks specific to the asset. Accordingly, one discount rate for allthe CGUs does not represent the risk profile of each CGU. The discount rate generally should be determined using theWACC of the CGU or of the company of which the CGU is currently part. Using a company’s WACC for all CGUs isappropriate only if the specific risks associated with the specific CGUs do not diverge materially from the remainder ofthe group. In the case of Estoil, this is not apparent.
(ii) It appears that the cash flow forecasts were not prepared based on the requirements of IAS 36. IAS 36 states that cashflow projections used in measuring value in use shall be based on reasonable and supportable assumptions whichrepresent management’s best estimate of the range of economic conditions which will exist over the remaining usefullife of the asset. IAS 36 also states that management must assess the reasonableness of the assumptions by examiningthe causes of differences between past cash flow projections and actual cash. Management should ensure that theassumptions on which its current cash flow projections are based are consistent with past actual outcomes. Despite thefact that the realised cash flows for 2014 were negative and far below projected cash flows, the directors hadsignificantly raised budgeted cash flows for 2015 without justification. There are serious doubts about Fariole’s abilityto establish realistic budgets.
20
According to IAS 36, estimates of future cash flows should include:
(i) projections of cash inflows from the continuing use of the asset;
(ii) projections of cash outflows which are necessarily incurred to generate the cash inflows from continuing use of theasset; and
(iii) net cash flows to be received (or paid) for the disposal of the asset at the end of its useful life.
IAS 36 states that projected cash outflows should include those required for the day-to-day servicing of the asset whichincludes future cash outflows to maintain the level of economic benefits expected to arise from the asset in its currentcondition. It is highly unlikely that no investments in working capital or operating assets would need to be made tomaintain the assets of the CGUs in their current condition. Therefore, the cash flow projections used by Fariole are notin compliance with IAS 36.
21
Professional Level – Essentials Module, Paper P2 (UK)Corporate Reporting (United Kingdom) December 2014 Marking Scheme
Marks1 (a) Property, plant and equipment 5
Goodwill 6Assets held for sale 5Current assets/total non-current liabilities 1Retained earnings 6Other components of equity 3Non-controlling interest 3Current liabilities 1Joint venture 5
–––35
(b) Subjective assessment of discussion 81 mark per element
(c) Subjective assessment – 1 mark per point 7–––50–––
Time allowedReading and planning: 15 minutesWriting: 3 hours
This paper is divided into two sections:
Section A – This ONE question is compulsory and MUST be attempted
Section B – TWO questions ONLY to be attempted
Do NOT open this paper until instructed by the supervisor.
During reading and planning time only the question paper may be annotated. You must NOT write in your answer booklet untilinstructed by the supervisor.
This question paper must not be removed from the examination hall.
Pape
r P2 (
UK
)
Corporate Reporting(United Kingdom)
Tuesday 10 June 2008
The Association of Chartered Certified Accountants
Section A – This ONE question is compulsory and MUST be attempted
1 The following draft balance sheets relate to Ribby, Hall, and Zian, all public limited companies, as at 31 May 2008:
Ribby Hall Zian£m £m Dinars m
Fixed AssetsTangible assets 250 120 360Investment in Hall 98 – –Investment in Zian 30 – –Financial assets 10 5 148
–––– –––– ––––388 125 508–––– –––– ––––
Current assets 22 17 120Creditors: amounts falling due within one year (110) (7) (72)
–––– –––– ––––Net current assets/liabilities (88) 10 48
–––– –––– ––––Total assets less current liabilities 300 135 556Creditors: amounts falling due more than one year (90) (5) (48)
–––– –––– ––––Net assets 210 130 508
–––– –––– ––––Ordinary shares 60 40 209Other reserves 30 10 –Profit and loss reserve 120 80 299
–––– –––– ––––Capital employed 210 130 508
–––– –––– ––––
The following information needs to be taken account of in the preparation of the group financial statements of Ribby:
(i) Ribby acquired 70% of the ordinary shares of Hall on 1 June 2006 when Hall’s other reserves were £10 millionand the profit and loss reserve was £60 million. The fair value of the net assets of Hall was £120 million at thedate of acquisition. Ribby acquired 60% of the ordinary shares of Zian for 330 million dinars on 1 June 2006when Zian’s profit and loss reserve was 220 million dinars. The fair value of the net assets of Zian on 1 June2006 was 495 million dinars. The excess of the fair value over the net assets of Hall and Zian is due to anincrease in the value of non-depreciable land. There have been no issues of ordinary shares since acquisitionand goodwill has been impairment tested annually for both Hall and Zian and has not been impaired. Acceptedgroup policy is non-amortisation of goodwill under the ‘true and fair view override’ provisions of company law.
(ii) Zian is located in a foreign country and imports its raw materials at a price which is normally denominated inpounds sterling. The product is sold locally at selling prices denominated in dinars, and determined by localcompetition. All selling and operating expenses are incurred locally and paid in dinars. Distribution of profits isdetermined by the parent company, Ribby. Zian has financed part of its operations through a £4 million loanfrom Hall which was raised on 1 June 2007. This is included in the financial assets of Hall and the figure forcreditors: amounts falling due more than one year of Zian. Zian’s management have a considerable degree ofauthority and autonomy in carrying out the operations of Zian and other than the loan from Hall, are notdependent upon group companies for finance.
(iii) Ribby has a building which it purchased on 1 June 2007 for 40 million dinars and which is located overseas.The building is carried at cost and has been depreciated on the straight-line basis over its useful life of 20 years.At 31 May 2008, as a result of an impairment review, the recoverable amount of the building was estimated tobe 36 million dinars.
(iv) Ribby has a long-term loan of £10 million which is owed to a third party bank. At 31 May 2008, Ribby decidedthat it would repay the loan early on 1 July 2008 and formally agreed this repayment with the bank prior to theyear end. The agreement sets out that there will be an early repayment penalty of £1 million.
(v) The directors of Ribby announced on 1 June 2007 that a bonus of £6 million would be paid to the employeesof Ribby if they achieved a certain target production level by 31 May 2008. The bonus is to be paid partly incash and partly in share options. Half of the bonus will be paid in cash on 30 November 2008 whether or not
2
the employees are still working for Ribby. The other half will be given in share options on the same date providedthat the employee is still in service on 30 November 2008. The exercise price and number of options will befixed by management on 30 November 2008. The target production was met and management expect 10% ofemployees to leave between 31 May 2008 and 30 November 2008. No entry has been made in the financialstatements of Ribby.
(vi) Ribby operates a defined benefit pension plan that provides a pension of 1·2% of the final salary for each yearof service, subject to a minimum of four years service. On 1 June 2007, Ribby improved the pension entitlementso that employees receive 1·4% of their final salary for each year of service. This improvement applied to all prioryears service of the employees. As a result the present value of the defined benefit obligation on 1 June 2007increased by £4 million as follows:
£mEmployees with more than four years service 3Employees with less than four years service (average service of two years) 1
–––4
–––
Ribby had not accounted for the improvement in the pension plan.
(vii) Ribby is considering selling its subsidiary, Hall. Just prior to the year end, Hall sold stock to Ribby at a price of£6 million. The carrying value of the stock in the financial records of Hall was £2 million. The cash was receivedbefore the year end, and as a result the bank overdraft of Hall was virtually eliminated at 31 May 2008. Afterthe year end the transaction was reversed and it was agreed that this type of transaction would be carried outagain when the interim financial statements were produced for Hall, if the company had not been sold by thatdate.
(viii) The following exchange rates are relevant to the preparation of the group financial statements:
Dinars to £1 June 2006 111 June 2007 1031 May 2008 12Average for year to 31 May 2008 10·5
Required:
(a) Discuss and apply the principles set out in FRS 23 ‘The effects of changes in foreign exchange rates’ in orderto determine the functional currency of Zian. (8 marks)
(b) Prepare a consolidated balance sheet of the Ribby Group at 31 May 2008 in accordance with UK FinancialReporting Standards. (35 marks)
(c) Discuss how the manipulation of financial statements by company accountants is inconsistent with theirresponsibilities as members of the accounting profession setting out the distinguishing features of aprofession and the privileges that society gives to a profession. (Your answer should include reference to theabove scenario.) (7 marks)
Note: requirement (c) includes 2 marks for the quality of the discussion.
(50 marks)
3 [P.T.O.
Section B – TWO questions ONLY to be attempted
2 (a) Norman, a public limited company, has three business segments which are currently reported in its financialstatements. Norman is an international hotel group which reports to management on the basis of region. Theresults of the regional segments for the year ended 31 May 2008 are as follows:
Region Revenue Segment Segment SegmentExternal Internal profit assets liabilities
£m £m £m £m £mEuropean 210 3 10 300 200South East Asia 300 2 60 800 300Other regions 500 5 105 2,000 1,400
There were no significant inter company balances in the segment assets and liabilities. The hotels are located incapital cities in the various regions, and the company sets individual performance indicators for each hotel basedon its city location.
Required:
Discuss the principles in SSAP25 ‘Segmental Reporting’ for the determination of a company’s reportablesegments and how these principles would be applied for Norman plc using the information given above.
(11 marks)
(b) One of the hotels owned by Norman is a hotel complex which includes a theme park, a casino and a golf course,as well as a hotel. The theme park, casino, and hotel were sold in the year ended 31 May 2008 to Conquest, apublic limited company, for £200 million but the sale agreement stated that Norman would continue to operateand manage the three businesses for their remaining useful life of 15 years. The residual interest in the businessreverts back to Norman after the 15 year period. Norman would receive 75% of the net profit of the businessesas operator fees and Conquest would receive the remaining 25%. Norman has guaranteed to Conquest that thenet minimum profit paid to Conquest would not be less than £15 million. (4 marks)
Norman has recently started issuing vouchers to customers when they stay in its hotels. The vouchers entitle thecustomers to a £30 discount on a subsequent room booking within three months of their stay. Historicalexperience has shown that only one in five vouchers are redeemed by the customer. At the company’s year endof 31 May 2008, it is estimated that there are vouchers worth £20 million which are eligible for discount. Theincome from room sales for the year is £300 million and Norman is unsure how to report the income from roomsales in the financial statements. (4 marks)
Norman has obtained a significant amount of grant income for the development of hotels in Europe. The grantshave been received from government bodies and relate to the size of the hotel which has been built by the grantassistance. The intention of the grant income was to create jobs in areas where there was significantunemployment. The grant received of £70 million will have to be repaid if the cost of building the hotels is lessthan £500 million. (4 marks)
Appropriateness and quality of discussion (2 marks)
Required:
Discuss how the above income would be treated in the financial statements of Norman for the year ended31 May 2008.
(25 marks)
4
3 Sirus is a large national public limited company (plc). The directors’ service agreements require each director topurchase ‘B’ ordinary shares on becoming a director and this capital is returned to the director on leaving thecompany. Any decision to pay a dividend on the ‘B’ shares must be approved in a general meeting by a majority ofall of the shareholders in the company. Directors are the only holders of ‘B’ shares.
Sirus would like advice on how to account under Financial Reporting Standards (FRSs) for the following events in itsfinancial statements for the year ended 30 April 2008:
(a) The capital subscribed to Sirus by the directors and shareholders is shown as follows in the balance sheet as at30 April 2008:
Equity£m
Ordinary ‘A’ shares 100Ordinary ‘B’ shares 20Profit and loss reserve 30
––––Total equity 150
––––
On 30 April 2008 the directors recommended that £3 million of the profits should be paid to the holders of theordinary ‘B’ shares, in addition to the £10 million paid to directors under their employment contracts. Thepayment of £3 million had not been approved in a general meeting. The directors would like advice as to whetherthe capital subscribed by the directors (the ordinary ‘B’ shares) is equity or a liability and how to treat thepayments out of profits to them. (6 marks)
(b) When a director retires, amounts become payable to the directors as a form of retirement benefit as an annuity.These amounts are not based on salaries paid to the director under an employment contract. Sirus hascontractual or constructive obligations to make payments to former directors as at 30 April 2008 as follows:
(i) certain former directors are paid a fixed annual amount for a fixed term beginning on the first anniversary ofthe director’s retirement. If the director dies, an amount representing the present value of the future paymentis paid to the director’s estate
(ii) in the case of other former directors, they are paid a fixed annual amount which ceases on death.
The rights to the annuities are determined by the length of service of the former directors and are set out in theformer directors’ service contracts. (6 marks)
(c) On 1 May 2007 Sirus acquired another company, Marne plc. The directors of Marne, who were the onlyshareholders, were offered an increased profit share in the enlarged business for a period of two years after thedate of acquisition as an incentive to accept the purchase offer. After this period, normal remuneration levels willbe resumed. Sirus estimated that this would cost them £5 million at 30 April 2008, and a further £6 million at30 April 2009. These amounts will be paid in cash shortly after the respective year ends. (5 marks)
(d) Sirus raised a loan with a bank of £2 million on 1 May 2007. The market interest rate of 8% per annum is tobe paid annually in arrears and the principal is to be repaid in 10 years time. The terms of the loan allow Sirusto redeem the loan after seven years by paying the full amount of the interest to be charged over the ten yearperiod, plus a penalty of £200,000 and the principal of £2 million. The effective interest rate of the repaymentoption is 9·1%. The directors of Sirus are currently restructuring the funding of the company and are in initialdiscussions with the bank about the possibility of repaying the loan within the next financial year. Sirus isuncertain about the accounting treatment for the current loan agreement and whether the loan can be shown asa current liability because of the discussions with the bank. (6 marks)
Appropriateness of the format and presentation of the report and quality of discussion (2 marks)
Required:
Draft a report to the directors of Sirus which discusses the principles and nature of the accounting treatment ofthe above elements under Financial Reporting Standards in the financial statements for the year ended 30 April2008.
(25 marks)
5 [P.T.O.
4 Increasingly the accounting standards adopted in the United Kingdom are not being developed by the AccountingStandards Board (ASB) but are developed by the International Accounting Standards Board (IASB) and incorporatedinto UK Generally Accepted Accounting Practice (UK GAAP). Accounting Standards published recently have beenclosely aligned to International Financial Reporting Standards (IFRSs). The role of the ASB has changed fromdeveloping UK GAAP to implementing IFRSs.
Required:
(a) Explain whether consistency between UK GAAP and IFRS is important. (7 marks)
(b) Discuss whether the alignment of recent Financial Reporting Standards (FRSs) to IFRS has led to greaterinconsistency between financial statements. (10 marks)
(c) Discuss how management judgement and the regulatory framework can have a significant impact on theconfidence placed in financial statements. (6 marks)
Appropriateness and quality of discussion (2 marks)
(25 marks)
End of Question Paper
6
Answers
Professional Level – Essentials Module, P2 (UK)Corporate Reporting (United Kingdom) June 2008 Answers
1 (a) The functional currency is the currency of the primary economic environment in which the entity operates (FRS23). Theprimary economic environment in which an entity operates is normally the one in which it primarily generates and expendscash. An entity’s management considers the following factors in determining its functional currency (FRS23):
(i) the currency that dominates the determination of the sales prices; and(ii) the currency that most influences operating costs
The currency that dominates the determination of sales prices will normally be the currency in which the sales prices for goodsand services are denominated and settled. It will also normally be the currency of the country whose competitive forces andregulations have the greatest impact on sales prices. In this case it would appear that currency is the dinar as Zian sells itsproducts locally and the prices are determined by local competition. However, the currency that most influences operatingcosts is in fact the pound sterling, as Zian imports goods which are paid for in pounds although all selling and operatingexpenses are paid in dinars. The emphasis is, however, on the currency of the economy that determines the pricing oftransactions, as opposed to the currency in which transactions are denominated.
Factors other than the dominant currency for sales prices and operating costs are also considered when identifying thefunctional currency. The currency in which an entity’s finances are denominated is also considered. Zian has partly financedits operations by raising a £4 million loan from Hall but it is not dependent upon group companies for finance. The focus ison the currency in which funds from financing activities are generated and the currency in which receipts from operatingactivities are retained.
Additional factors include consideration of the autonomy of a foreign operation from the reporting entity and the level oftransactions between the two. Zian operates with a considerable degree of autonomy both financially and in terms of itsmanagement. Consideration is given to whether the foreign operation generates sufficient functional cash flows to meet itscash needs which in this case Zian does as it does not depend on the group for finance.
It would be said that the above indicators give a mixed view but the functional currency that most faithfully represents theeconomic effects of the underlying transactions, events, and conditions is the dinar, as it most affects sales prices and is mostrelevant to the financing of an entity. The degree of autonomy and independence provides additional supporting evidence indetermining the entity’s functional currency.
(b) Consolidated Balance Sheet of Ribby Group at 31 May 2008
Loans between subsidiaries cannot be treated as part of the holding company’s net investment in a foreign subsidiary(FRS23). Zian will recognise an exchange difference on the loan from Hall in its profit and loss account and theexchange difference will flow through to the consolidated profit and loss account and will not be reclassified as a separatecomponent of equity.
Dinarsm
Loan at 1 June 2007 £4 million at 10 dinars 40Loan at 31 May 2008 £4 million at 12 dinars 48
–––Exchange loss 8
–––
The loan of £4 million should be eliminated on consolidation.
The fair value adjustment at acquisition is:
Dinarsm
Ordinary shares 209Profit and loss reserve 220Fair value adjustment 66
––––Fair value of net assets 495
––––
Goodwill
Dm Rate £mCost of acquisition 330 11 30less net assets acquired (60% of 495) (297) 11 (27)
–––– –––Goodwill 33 3
–––– –––
Goodwill is treated as a foreign currency asset which is retranslated at the closing rate. Therefore, goodwill at 31 May2008 will be 33 million dinars ÷ 12, i.e. £2·8 million
Therefore, an exchange loss of £0·2 million will be recorded in consolidated reserves.
Profit and loss reserve of Zian is 60% of £2.1 million, i.e. £1·3 million
(iii) Minority Interest
£m £mZian: 40% of £(45 + 2·1)million 18·8Hall: 30% of total equity 130
Revaluation 10Profit adjustment – stock (4)
––––136––––
40·8––––59·6––––
(iv) Building: Ribby
£mCarrying value at 31 May 2008 3·8(40 million dinars ÷ 10 = £4 million)(Depreciation £0·2 million)Value after impairment (36 million dinars ÷ 12) (3)
––––Impairment loss 0·8
––––
(v) Early repayment of loan
As the company has entered into an agreement to repay the debt early plus a penalty, it should adjust the carrying valueof the financial liability to reflect actual and revised estimated cash flows (FRS26). Therefore, the carrying amount ofthe debt should be increased by £1 million and be transferred to current liabilities.
(vi) Past service cost
A past service cost of £3 million should be recognised immediately as those benefits have already vested and should becharged as an expense. The remaining £1 million should be recognised on a straight line basis over the two year periodthat it takes to vest. The pension entitlement has not yet vested fully as it is given in return for services over the remainingtwo year period. Thus the following entries will be required to account for the past service costs.
£mDR Profit and loss reserve £(3 + 0·5)m 3·5CR Long-term liabilities (defined benefit obligation) 3·5
11
(vii) Accounting for sale of stock (see part (c))
The transaction should not be shown as a sale. Stock should be reinstated at £2 million instead of £6 million and adecrease in profit and loss reserve of £4 million should occur in the accounting records of Hall.
CR Stock £4 millionDR Profit and loss reserve of Hall £4 million
The cash position should be reversed also increasing cash by £6 million and current liabilities by the same amount.
(viii) Bonus to employees of Ribby
A liability of £3 million should be accrued for the bonus to be paid in cash to the employees of Ribby. The managementshould also recognise an expense of (2/3 x 90% x £3 million) £1·8 million, with a corresponding increase in equity. Theterms of the share options have not been fixed and, therefore, the grant date becomes 30 November 2008 as this isthe date that the terms and conditions will be fixed. However, FRS20 requires the entity to recognise the services whenreceived and, therefore, adjustment is required to the financial statements. Once the terms are fixed, the fair value canbe calculated and any adjustments made.
£mDR Expense – profit and loss reserve 4·8CR Equity – other reserves 1·8CR Current liabilities 3
(ix) Goodwill: Hall
£mCost of investment 98less net assets acquired (70% of £120 million) (84)
––––Goodwill 14
––––
Alternatively
£mCost of investment 98Ordinary shares 40Other reserves 10Profit and loss reserve 60
Past service costs (3·5)Exchange loss – goodwill (0·2)Impairment loss – building (0·8)Loan (working v) (1)Bonus to employees (working viii) (4·8)
–––––––122·2
–––––––
(xii) Long-term liabilitiesRibby 90Hall 5Zian 4·7
–––––99·7
Increase- carrying amount of debt 1Elimination of loan (4)Past service costs 3·5Transfer to current liabilities (11)
–––––––89·2
–––––––
(c) Accounting and ethical implications of sale of stock
Manipulation of financial statements often does not involve breaking laws but the purpose of financial statements is to presenta fair representation of the company’s position, and if the financial statements are misrepresented on purpose then this couldbe deemed unethical. The financial statements in this case are being manipulated to show a certain outcome so that Hallmay be shown to be in a better financial position if the company is sold. The profit and loss reserve of Hall will be increasedby £4 million, and the cash received would improve liquidity. Additionally this type of transaction was going to be carried outagain in the interim accounts if Hall was not sold. Accountants have the responsibility to issue financial statements that donot mislead the public as the public assumes that such professionals are acting in an ethical capacity, thus giving the financialstatements credibility.
A profession is distinguished by having a:
(i) specialised body of knowledge(ii) commitment to the social good(iii) ability to regulate itself(iv) high social status
Accountants should seek to promote or preserve the public interest. If the idea of a profession is to have any significance,then it must make a bargain with society in which they promise conscientiously to serve the public interest. In return, societyallocates certain privileges. These might include one or more of the following:
– the right to engage in self-regulation– the exclusive right to perform particular functions– special status
There is more to being an accountant than is captured by the definition of the professional. It can be argued that accountantsshould have the presentation of truth, in a fair and accurate manner, as a goal.
2 (a) Segment Reporting
SSAP25 ‘Segmental Reporting’ supports the provisions of the Companies Acts by saying that it is the directors’ responsibilityto determine the analysis of the segments. The standard aims to provide guidance on factors which should influence thedefinition of segments. Such factors include operations which are subject to different degrees of risk or return on capitalemployed, have experienced different rates of growth, and have different potential for future development. Having establishedthat a segment is distinguishable based on the above criteria, it is necessary to consider whether a segment is significantenough to warrant separate disclosure. A segment will normally be significant if:
(a) its turnover from third parties is 10% or more of the total third party turnover, or(b) its segment result (profit or loss) is 10% or more of the combined result of all segments in profit or of all segments in
loss, whichever combined result is the greater, or(c) its net assets are 10% or more of the total net assets of the entity
13
A class of business is defined as a distinguishable component of an entity that provides a separate product or resource. Toidentify reportable classes of business, directors should consider the nature of products, processes, markets distributionchannels, the organisation of the entity and any legal factors.
The segmental information needs to reflect the company’s risk and returns profile, and to inform users of the nature of thatprofile. Thus in determining business or geographical segments, products or services with significantly different risks, rewards,and future prospects should not be combined together to create a reportable segment. SSAP25 explains the criteria foridentifying whether separate segments exist but this explanation is only for guidance purposes. The directors have to exercisetheir judgement in this area. It would appear that separate business segments do not exist for Norman but that separategeographical segments do exist. The standard’s definition of a geographical segment is ‘a geographical area comprising anindividual country or group of countries in which an entity operates, or to which it supplies products or services’ (SSAP25para 31). In addition it emphasises that geographical analysis needs to consider two distinct aspects:
(i) analysis by operating location (origin basis)(ii) analysis by destination of sale or service (destination basis)
Different risk environments are an important factor in determining segments.
In the case of the existing segments the European segment meets the criteria for a segment as its reported revenue fromexternal sales (£210 million) is more than 10% of the combined revenue (£1,010 million). However, it fails the profit/lossand net asset tests. Its results are a profit of £10 million which is less than 10% of the greater of the reported profit or reportedloss. The profit reported is £175 million. Similarly its segment net assets of £100 million are less than 10% of the combinedsegment assets £1,200 million). The South East Asia segment passes all of the threshold tests. If the company changes itssegments then the above tests will have to be reperformed.
There may be other regions which might fall under the definition of a segment and Norman should review the risk profile ofthe ‘other regions’ segment. The fact that performance indicators are set for each hotel will not affect the determination of thegeographical segments under SSAP25.
(b) Property is sometimes sold with a degree of continuing involvement by the seller so that the risks and rewards of ownershiphave not been transferred. The nature and extent of the buyer’s involvement will determine how the transaction is accountedfor. The substance of the transaction is determined by looking at the transaction as a whole and FRS5 ‘Reporting thesubstance of transactions’ requires this by stating that where two or more transactions are linked, they should be treated asa single transaction in order to understand the commercial effect. In the case of the sale of the hotel, theme park and casino,Norman should not recognise a sale as the company continues to enjoy substantially all of the risks and rewards of thebusinesses, and still operates and manages them. Additionally the residual interest in the business reverts back to Norman.Also Norman, has guaranteed the income level for the purchaser as the minimum payment to Conquest will be £15 milliona year. The transaction is in substance a financing arrangement and the proceeds should be treated as a loan and the paymentof profits as interest.
The principles of FRS5 require that revenue in respect of each separate component of a transaction is measured at its fairvalue. FRS5 Application note G provides specific guidance on vouchers under the heading ‘Separation and linking ofcontractual arrangements’. Where vouchers are issued as part of a sales transaction and are redeemable against futurepurchases, revenue should be reported at the amount of the consideration received/receivable less the voucher’s fair value.In substance, the customer is purchasing both goods or services and a voucher. The fair value of the voucher is determinedby reference to the value to the holder and not the cost to the issuer. Factors to be taken into account when estimating thefair value, would be the discount the customer obtains, the percentage of vouchers that would be redeemed, and the timevalue of money. As only one in five vouchers are redeemed, then effectively the hotel has sold goods worth (£300 + £4) million, i.e. £304 million for a consideration of £300 million. Thus allocating the discount between the two elementswould mean that (300 ÷ 304 x £300m) i.e. £296·1 million will be allocated to the room sales and the balance of £3·9 million to the vouchers. The deferred portion of the proceeds is only recognised when the obligations are fulfilled.
The recognition of government grants is covered by SSAP4 ‘Accounting for government grants’. The accruals concept is usedby the standard to match the grant received with the related costs. The relationship between the grant and the relatedexpenditure is the key to establishing the accounting treatment. Grants should not be recognised until there is reasonableassurance that the company can comply with the conditions relating to their receipt and the grant will be received. Provisionshould be made if it appears that the grant may have to be repaid.
There may be difficulties of matching costs and revenues when the terms of the grant do not specify precisely the expensetowards which the grant contributes. In this case the grant appears to relate to both the building of hotels and the creation ofemployment. However, if the grant was related to revenue expenditure, then the terms would have been related to payroll ora fixed amount per job created. Hence it would appear that the grant is capital based and should be matched against thedepreciation of the hotels by using a deferred income approach or by deducting the cost from the asset. The former methodis used because of Companies Acts requirements. Additionally the grant is only to be repaid if the cost of the hotel is less than£500 million which itself would seem to indicate that the grant is capital based. If the company feels that the cost will notreach £500 million, a provision should be made for the estimated liability if the grant has been recognised.
14
3 Report to the directors of Sirus
Terms of Reference
This report sets out the impact of Financial Reporting Standards on:
(a) the directors’ interests in Sirus(b) the directors’ retirement benefits(c) the acquisition of Marne(d) the proposed repayment of the loan
(a) Directors’ interests in Sirus
The capital should be presented either as a financial liability or equity. FRS25 ‘Financial Instruments: Presentation’ says thata financial liability is:
Any liability that is:
– a contractual obligation:
to deliver cash or another financial asset to another entity; or to exchange financial assets or financial liabilities with another entity under conditions that are potentially unfavourableto the entity; or
– a contract that will or may be settled in the entity’s own equity instruments
It also defines equity as: any contract that evidences a residual interest in the assets of an entity after deducting all of itsliabilities. Those instruments that do not meet the definition of a liability will be classified as equity. The entity must, therefore,have an unconditional right to avoid delivery of cash or another financial asset.
The definition of a financial instrument used in FRS25 is the same as that in FRS26.
The fundamental principle of FRS25 is that a financial instrument should be classified as either a financial liability or an equityinstrument according to the substance of the contract, not its legal form. The enterprise must make the decision at the timethe instrument is initially recognised.
The capital subscribed by the directors has a mandatory redemption feature at a future date, thus the substance is that thereis a contractual obligation to deliver cash and, therefore, should be recognised as a liability. In contrast, if the return of capitalwas discretionary and Sirus has an unconditional right to avoid paying cash or assets to the directors, then the capital wouldbe classed as equity. The financial liability will be stated at the present value of the redemption amount. This may becalculated by discounting the amount over the life of the service contract. Subsequently financial liabilities are carried at fairvalue throught profit or loss or at amortised cost under FRS26. In this case, the liability is likely to be held at amortised cost.
Any distribution of profits would be classed as an appropriation of equity because the shareholders of Sirus have the right torefuse payment of profits and thus the £3 million that is to be divided between the directors will be classed as an appropriationof equity rather than as an expense. As the dividend has not been paid or approved, the dividend will not appear as a liabilityin the balance sheet. Effectively it is being treated like a proposed dividend. The £10 million paid to directors underremuneration contracts will be treated as an expense.
(b) Directors’ retirement benefits
The directors’ retirement benefits are unfunded plans which may fall under FRS17 ‘Retirement Benefits’.
Sirus should review its contractual or constructive obligation to make retirement benefit payments to its former directors at thetime when they leave the firm. The payments may create a financial liability under FRS25, or may give rise to a liability ofuncertain timing and amount which may fall within the scope of FRS12 ‘Provisions, contingent liabilities and contingentassets’. Certain former directors are paid a fixed annuity for a fixed term which is payable annually, and on death, the presentvalue of future payments are paid to the director’s estate. An annuity meets the definition of a financial liability under FRS25,if there is a contractual obligation to deliver cash or a financial asset. The latter form of annuity falls within the scope ofFRS25/26. The present value of the annuity payments should be determined. The liability is recognised because the directorshave a contractual right to the annuity and the firm has no discretion in terms of withholding the payment. As the rights tothe annuities are earned over the period of the service of the directors, then the costs should be recognised also over theservice period.
Where an annuity has a life contingent element and, therefore, embodies a mortality risk, it falls outside the scope of FRS26because the annuity will meet the definition of an insurance contract which is scoped out of FRS26, along with employers’rights and obligations under FRS17. Such annuities will, therefore, fall within the scope of FRS12 if a constructive obligationexists. Sirus should assess the probability of the future cash outflow of the present obligation. Because there are a numberof similar obligations, FRS12 requires that the class of obligations as a whole should be considered (similar to a warrantyprovision). A provision should be made for the best estimate of the costs of the annuity and this would include any liabilityfor post retirement payments to directors earned to date. The liability should be built up over the service period rather thanjust when the director leaves. In practice the liability may be calculated on an actuarial basis consistent with the principlesin FRS17. The liability should be recalculated on an annual basis, as for any provision, to take account of changes in directorsand other factors. The liability will be discounted where the effect is material.
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(c) Acquisition of Marne
All business combinations within the scope of FRS2 ‘Accounting for subsidiary undertakings’ must be accounted for using theacquisition method. Sirus is the acquirer of Marne and must measure the cost of a business combination at the sum of thefair values, at the date of exchange, of assets given, liabilities incurred or assumed, in exchange for control of Marne; plusany costs directly attributable to the combination. If the cost is subject to adjustment contingent on future events, FRS7requires the acquirer to include the amount of that adjustment in the cost of the combination at the acquisition date if areasonable estimate of the fair value of amounts expected to be payable in the future can be made. However, if the contingentpayment either is not probable or cannot be measured reliably, it is not measured as part of the initial cost of the businesscombination. The issue with the increased profit share payable to the directors of Marne is whether the payment constitutesremuneration or consideration for the business acquired. Because the directors of Marne fall back to normal remunerationlevels after the two year period, it appears that this additional payment will constitute part of the purchase consideration withthe resultant increase in goodwill. It seems as though these payments can be measured reliably and therefore the cost of theacquisition should be increased by the net present value of £11 million at 1 May 2007 (FRS7 para 77) being £5 milliondiscounted for 1 year and £6 million for 2 years.
(d) Repayment of loan
If at the beginning of the loan agreement, it was expected that the repayment option would not be exercised, then the effectiveinterest rate would be 8% and at 30 April 2008, the loan would be stated at £2 million in the balance sheet with interest of£160,000 having been paid and accounted for. If, however, at 1 May 2007, the option was expected to be exercised, thenthe effective interest rate would be 9·1% and at 30 April 2008, the cash interest paid would have been £160,000 and theinterest charged to the profit and loss account would have been (9·1% x £2 million) £182,000, giving a balance sheet figureof £2,022,000 for the amount of the financial liability. However, FRS26 requires the carrying amount of the financialinstrument to be adjusted to reflect actual and revised estimated cash flows. Thus, even if the option was not expected to beexercised at the outset but at a later date exercise became likely, then the carrying amount would be revised so that itrepresented the expected future cash flows using the effective interest rate. As regards the discussions with the bank overrepayment in the next financial year, if the loan was shown as current, then the requirements of the Companies Acts wouldnot be met. Sirus has an unconditional right to defer settlement for longer than twelve months and the liability is not due tobe legally settled in 12 months. Sirus’s discussions should not be considered when determining the loan’s classification.
It is hoped that the above report clarifies matters.
4 (a) Consistency between UK standards and IFRS is important for the following reasons:
– it enhances the credibility and clarity of financial reporting in the UK.– there are companies who continue to prepare financial statements under UK standards and wish to ensure that they are
consistent with IFRS so as to avoid a two tier system of reporting.– it will facilitate the movement of accountants between organisations using either UK GAAP or IFRS and lower barriers
to the free-movement of accountants in business across jurisdictions.– it helps to ensure the comparability of financial statements whatever the size of the company.– it allows companies to enjoy a lower cost of capital as a result of their financial statements being more readily
understood.
The development of IFRS has led to a change in the role of the ASB in terms of its importance in the development of UKaccounting standards. UK GAAP mostly applies to private companies, subsidiaries of listed companies and Small and MediumEntities (SMEs). Consistency with IFRS is important as long as the standards are not over engineered and too complex. If thisoccurs then they will not be fit for purpose for the UK entities that they are aimed at.
(b) The implementation of International Financial Reporting Standards (IFRS) in the UK involves major change for companies asIFRS introduces significant changes in accounting practices that often were not formerly required by UK GAAP. For examplefinancial instruments in many instances have appeared on the balance sheets of companies for the first time. As a result,financial statements are often significantly more complex than financial statements which were based on UK GAAP. Thiscomplexity is caused by the more extensive recognition and measurement rules and a greater number of disclosurerequirements. Because of this complexity, it can be difficult for users of financial statements to understand and interpret them,and thus can lead to inconsistency of interpretation of those financial statements.
For example the implementation of the financial instruments standards (FRS25 ‘Financial Instruments – disclosure andpresentation’, and FRS26 ‘Financial Instruments: recognition and measurement’) has led to many changes in UK accounting.The reclassification as liabilities of minority interests holding put options, split accounting for convertible bonds, revaluationof ‘available-for-sale’ investments at fair value recognised directly in equity and revaluation at fair value of all derivatives,including embedded derivatives, with the impact of the change recognised directly in equity for cash flow hedges are someof the changes and complexities that IFRSs incorporated into UK GAAP have introduced.
Often IFRSs introduced into UK GAAP are silent on certain issues and involve significant estimation. For example FRS20,‘Share based payment’, does not require any specific disclosures as to the choice of the appropriate valuation model or howthe number of equity settled awards, which will vest, have been estimated. FRS20 does require ‘information that enablesusers to understand how the fair value of the equity instruments granted was determined’ but the level of detail is left up tothe company. The most popular model used by companies under this standard is the Black–Scholes–Merton method but thismodel does not allow for the possibility of exercise before the end of the option’s life. However irrespective of this, many
16
companies use it.It is possible to interpret some of the IFRS introduced in different ways and in some standards, there is insufficient guidance.
The identification of the functional currency under FRS23, ‘The effects of changes in foreign exchange rates’, can besubjective. For example the functional currency can be determined by the currency in which the commodities a companyproduces are commonly traded, or the currency which influences its operating costs, and both can be different.
Another potential problem surrounds the adoption of standards. Some of the new IFRSs have an adoption date of 1 January2009 and if these are adopted in the UK, there could be inconsistency if companies adopt the standards early. The applicationof FRS25 and FRS26 was quite complex in terms of which entities were required to adopt the standards and when adoptionshould take place. Some companies adopted the standards early and some companies did not. The main changes broughtabout by the gradual adoption of IFRS, will relate to recognition and measurement rather than the form and presentation offinancial statements.
(c) Management judgement may have a significant impact under UK GAAP. FRS utilises fair values extensively. Managementhave to use their judgement in selecting valuation methods and formulating assumptions when dealing with such areas asonerous contracts, share-based payments, pensions, intangible assets acquired in business combinations and impairment ofassets. Differences in methods or assumptions can have a major impact on amounts recognised in financial statements.
In addition to the FRS, a sound financial reporting infrastructure is required. This implies effective corporate governancepractices, high quality auditing standards and practices, and an effective enforcement or oversight mechanism. Therefore,consistency and comparability of financial statements will also depend on the robust nature of the other elements of thefinancial reporting infrastructure.
The Financial Reporting Council has developed a ‘Strategic Framework’ in the UK which is designed to provide confidence incorporate reporting in the UK. The aim is to facilitate co-operation between stakeholders in order to promote confidence incorporate reporting. Confidence is gained where there is
(a) an effective legislative and regulatory framework which defines high standards in corporate governance and reporting,including standards and guidance from the Government, the FRC, and professional bodies
(b) implementation of the framework by those responsible for governance which includes boards, auditors and theprofession
(c) effective monitoring of the quality and integrity of reporting and governance by shareholders, audit committees,regulatory authorities, and professional bodies
A poor regulatory framework would undermine confidence in corporate reporting and governance.
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Professional Level – Essentials Module, P2 (UK)Corporate Reporting (United Kingdom) June 2008 Marking Scheme
Marks1 (a) Consideration of factors 6
Conclusion 2–––
8–––
(b) Translation of Zian 6Loan 2Goodwill: Zian 4Minority interest 4Building 3Early repayment of loan 1Pension costs 2Stock 1Bonus 3Goodwill: Hall 2P/L Reserve Hall 2
Zian 1Ribby 3
Other reserves 1–––35
–––
(c) Accounting 2Ethical discussion 3Quality of discussion 2
–––7
–––MAXIMUM 50
–––
2 (a) Identification of segments 2Definition 2Reporting information 2Norman applicability 5
–––11
–––
(b) Sale of businesses 4Vouchers 4Grant income 4Quality of discussion 2
–––14
–––MAXIMUM 25
–––
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Marks3 (a) Definition of financial liability and equity 3
Principle in FRS25 1Discussion 2
(b) FRS17 1Financial liability 2Provision 1Build up over service period 1Recalculate annually 1
(c) Purchase method 1Cost of business combinations 1Future payment 1Remuneration versus cost of acquisition 2
(d) Not exercised 2Expected exercise 1FRS26 1Current v non-current 2
Communication in report 2–––
MAXIMUM 25–––
4 (a) 2 marks per point to max 6Consistency of IFRS 1
–––7
–––
(b) Changes from national GAAP 2Complexity 2Silence and estimation 2Subjectivity 2Adoption date 2
Time allowedReading and planning: 15 minutesWriting: 3 hours
This paper is divided into two sections:
Section A – This ONE question is compulsory and MUST be attempted
Section B – TWO questions ONLY to be attempted
Do NOT open this paper until instructed by the supervisor.
During reading and planning time only the question paper may be annotated. You must NOT write in your answer booklet untilinstructed by the supervisor.
This question paper must not be removed from the examination hall.
Pape
r P2 (
UK
)
Corporate Reporting(United Kingdom)
Tuesday 9 June 2009
The Association of Chartered Certified Accountants
This is a blank page.The question paper begins on page 3.
2
Section A – This ONE question is compulsory and MUST be attempted
1 Bravado, a public limited company has acquired two subsidiaries and an associate. The draft balance sheets are asfollows at 31 May 2009:
Bravado Message Mixted£m £m £m
Fixed assetsTangible assets 260 230 161Investments in subsidiariesMessage 300Mixted 133Investment in associate – Clarity 20Available-for-sale financial assets 51 6 5
–––– –––– ––––764 236 166–––– –––– ––––
Current assets:Stock and work in progress 135 55 73Trade debtors 91 45 32Cash at bank and in hand 102 100 8
–––– –––– ––––328 200 113–––– –––– ––––
Creditors: amounts falling due within one yearTrade creditors (115) (30) (60)Tax payable (60) (8) (24)
–––– –––– ––––(175) (38) (84)–––– –––– ––––
Net current assets 153 162 29–––– –––– ––––
Total assets less current liabilities 917 398 195–––– –––– ––––
Creditors: amounts falling due after more than one yearLong-term borrowings (120) (15) (5)Deferred tax (25) (9) (3)
–––– –––– ––––(145) (24) (8)–––– –––– ––––
Net assets 772 374 187–––– –––– ––––
Share capital 520 220 100Other reserves 12 4 7Profit and loss reserve 240 150 80
–––– –––– ––––Capital employed 772 374 187
–––– –––– ––––
The following information is relevant to the preparation of the group financial statements:
(i) On 1 June 2008, Bravado acquired 80% of the equity interests of Message, a private entity. The purchaseconsideration comprised cash of £300 million. The fair value of the identifiable net assets of Message was £400 million including any related deferred tax liability arising on acquisition. The owners of Message had todispose of the entity for tax purposes by a specified date and, therefore, sold the entity to the first company tobid for it which was Bravado. The retained earnings of Message were £136 million and other reserves were £4 million at the date of acquisition. There had been no new issue of capital by Message since the date ofacquisition and the excess of the fair value of the net assets is due to an increase in the value of non-depreciableland.
(ii) On 1 June 2007, Bravado acquired 6% of the ordinary shares of Mixted for £10 million and this investment wastreated as available-for-sale. The value of the investment at 31 May 2008 was £15 million and this value hasbeen included in the cost of the investment in the balance sheet at 31 May 2009. On 1 June 2008, Bravado
3 [P.T.O.
acquired a further 64% of the ordinary shares of Mixted and gained control of the company. The considerationfor this acquisition was £118 million.
Under the purchase agreement of 1 June 2008, Bravado is required to pay on 31 May 2010 30% of the profitsof Mixted for each of the financial years to 31 May 2009 and 31 May 2010. The fair value of this arrangementwas estimated at £12 million at 1 June 2008 and at 31 May 2009 this value had not changed. This amounthas not been included in the financial statements.
At 1 June 2008, the fair value of the identifiable net assets (excluding deferred tax assets and liabilities) of Mixtedwas £170 million and the retained earnings and other reserves were £55 million and £7 million respectively.There had been no new issue of share capital by Mixted since the date of acquisition and the excess of the fairvalue of the net assets is due to an increase in the value of tangible fixed assets.
The fair value of the tangible fixed assets was provisional pending receipt of the final valuations for these assets.These valuations were received on 1 December 2008 and they resulted in a further increase of £6 million in thefair value of the net assets at the date of acquisition. The tax written down value of the identifiable net assets ofMixted was £166 million at 1 June 2008. The tax rate of Mixted is 30%.
(iii) Bravado acquired at 10% interest in Clarity, a public limited company, on 1 June 2007 for £8 million. Theinvestment was accounted for as an available-for-sale investment and at 31 May 2008, its value was £9 million.On 1 June 2008, Bravado acquired an additional 15% interest in Clarity for £11 million and achieved significantinfluence. Clarity made profits after dividends of £6 million and £10 million for the years to 31 May 2008 and31 May 2009. The investment in Clarity was impairment tested at 31 May 2009. The test resulted in Clarityhaving a recoverable amount of £18 million.
(iv) On 1 June 2007, Bravado purchased an equity instrument of 11 million dinars which was its fair value. Theinstrument was classified as available-for-sale. The relevant exchange rates and fair values were as follows:
£ to dinars Fair value of instrument– dinars
1 June 2007 4·5 1131 May 2008 5·1 1031 May 2009 4·8 7
Bravado has not recorded any change in the value of the instrument since 31 May 2008. The reduction in fairvalue as at 31 May 2009 is deemed to be as a result of impairment.
(v) Bravado manufactures equipment for the retail industry. The stock is currently valued at cost. There is a marketfor the part-completed product at each stage of production. The cost structure of the equipment is as follows:
Cost per unit Selling Price£ £
Production process – 1st stage 1,000 1,050Conversion costs – 2nd stage 500
––––––Finished product 1,500 1,700
––––––
The selling costs are £10 per unit and Bravado has 100,000 units at the first stage of production and 200,000units of the finished product at 31 May 2009. Shortly before the year end, a competitor released a new modelonto the market which caused the equipment manufactured by Bravado to become less attractive to customers.The result was a reduction in the selling price to £1,450 of the finished product and £950 for 1st stage product.
(vi) The directors have included a loan to a director of Bravado in cash at bank and in hand of £1 million. The loanhas no specific repayment date on it but is repayable on demand. The directors feel that there is no problem withthis accounting entry as there is choice of accounting policy within accounting standards and that showing theloan as cash is their choice of accounting policy as there is no standard which says that this policy cannot beutilised.
(vii) On 1 June 2007, Bravado had made an award of 1,000 share options to each of its 2,000 employees. Theemployees had to remain in employment for the vesting period of three years. The fair value of each option on1 June 2007 was £6. The share price of Bravado dropped during 2007 and the management decided to reducethe exercise price of the share options. Thus on 1 June 2008, the fair value of the original share options was £2
4
and the fair value of the repriced option was £3. At the date of the award and 31 May 2008, managementestimated that 10% of employees would leave the company before the vesting date. During the year to 31 May2009, it was determined that the number of employees leaving would only be 7%. Bravado had accounted forthe options in the financial statements to 31 May 2008.
(viii) There is no impairment of goodwill arising on the acquisitions and goodwill is amortised over three years.Tangible assets are depreciated on the straight-line basis over seven years.
Bravado is constantly changing the composition of the group and is currently negotiating the acquisition of anothersubsidiary, Fusion. The subsidiary is likely to be acquired after the year end by a public offer of shares but before thedate on which the financial statements are approved by the Board of Directors. Fusion is being acquired in order toprevent another competitor from acquiring the business and currently sells the majority of its output to Bravado. TheDirectors wish to include Fusion in the group accounts for the year ending 31 May 2009 because they feel that Fusionis controlled by Bravado as Fusion is dependent upon Bravado for the majority of its sales.
Required:
(a) Prepare a consolidated balance sheet as at 31 May 2009 for the Bravado Group. (35 marks)
(b) Discuss the view that Bravado controls Fusion and therefore should be consolidated in the financialstatements for the year ending 31 May 2009. (8 marks)
(c) Discuss the view of the directors that there is no problem with showing a loan to a director as cash takinginto account their ethical and other responsibilities as directors of the company. (5 marks)
Professional marks will be awarded in part (c) for clarity and expression of your discussion. (2 marks)
(50 marks)
5 [P.T.O.
Section B – TWO questions ONLY to be attempted
2 The directors of Aron, a public limited company, are worried about the challenging market conditions which thecompany is facing. The markets are volatile and illiquid. The government is injecting liquidity into the economy. Thedirectors are concerned about the significant shift towards the use of fair values in financial statements. FRS 26‘Financial Instruments: recognition and measurement’ defines fair value and requires the initial measurement offinancial instruments to be at fair value. The directors are uncertain of the relevance of fair value measurements inthese current market conditions.
Required:
(a) Briefly discuss how the fair value of financial instruments is determined, commenting on the relevance of fairvalue measurements for financial instruments where markets are volatile and illiquid. (4 marks)
(b) Further they would like advice on accounting for the following transactions within the financial statements for theyear ended 31 May 2009:
(i) Aron issued one million convertible bonds on 1 June 2006. The bonds had a term of three years and wereissued with a total fair value of £100 million which is also the par value. Interest is paid annually in arrearsat a rate of 6% per annum and bonds, without the conversion option, attracted an interest rate of 9% perannum on 1 June 2006. The company incurred issue costs of £1 million. If the investor did not convert toshares, they would have been redeemed at par. At maturity all of the bonds were converted into 25 millionordinary shares of £1 of Aron. No bonds could be converted before that date. The directors are uncertainhow the bonds should have been accounted for up to the date of the conversion on 31 May 2009 and havebeen told that the impact of the issue costs is to increase the effective interest rate to 9·38%. (6 marks)
(ii) Aron held 3% holding of the shares in Smart, a public limited company. The investment was classified asavailable-for-sale and at 31 May 2009 was fair valued at £5 million. The cumulative gain recognised inequity relating to the available-for-sale investment was £400,000. On the same day, the whole of the sharecapital of Smart was acquired by Given, a public limited company, and as a result, Aron received shares inGiven with a fair value of £5·5 million in exchange for its holding in Smart. The company wishes to knowhow the exchange of shares in Smart for the shares in Given should be accounted for in its financial records.
(4 marks)
(iii) The functional and presentation currency of Aron is the pound sterling (£). Aron has a wholly owned foreignsubsidiary, Gao, whose functional currency is the zloti. Gao owns a debt instrument which is held for trading.In Gao’s financial statements for the year ended 31 May 2008, the debt instrument was carried at its fairvalue of 10 million zloti.
At 31 May 2009, the fair value of the debt instrument had increased to 12 million zloti. The exchange rateswere:
Zloti to £131 May 2008 331 May 2009 2Average rate for year to 31 May 2009 2·5
The company wishes to know how to account for this instrument in Gao’s entity financial statements andthe consolidated financial statements of the group. (5 marks)
(iv) Aron granted interest free loans to its employees on 1 June 2008 of £10 million. The loans will be paidback on 31 May 2010 as a single payment by the employees. The market rate of interest for a two-yearloan on both of the above dates is 6% per annum. The company is unsure how to account for the loan butwishes to classify the loans as ‘loans and receivables’ under FRS 26 ‘Financial Instruments: recognition andmeasurement’. (4 marks)
6
Required:
Discuss, with relevant computations, how the above financial instruments should be accounted for in thefinancial statements for the year ended 31 May 2009.
Note. The mark allocation is shown against each of the transactions above.
Note. The following discount and annuity factors may be of use
1 year 0·9434 0·9174 0·9142 0·9434 0·9174 0·91742 years 0·8900 0·8417 0·8358 1·8334 1·7591 1·75003 years 0·8396 0·7722 0·7642 2·6730 2·5313 2·5142
Professional marks will be awarded in question 2 for clarity and quality of discussion. (2 marks)
(25 marks)
7 [P.T.O.
3 Carpart, a public limited company, is a vehicle part manufacturer, and sells vehicles purchased from the manufacturer.Carpart has entered into supply arrangements for the supply of car seats to two local companies, Vehiclex andAutoseat.
(i) Vehiclex
This contract will last for five years and Carpart will manufacture seats to a certain specification which will requirethe construction of machinery for the purpose. The price of each car seat has been agreed so that it includes anamount to cover the cost of constructing the machinery but there is no commitment to a minimum order of seatsto guarantee the recovery of the costs of constructing the machinery. Carpart retains the ownership of themachinery and wishes to recognise part of the revenue from the contract in its current financial statements tocover the cost of the machinery which will be constructed over the next year. (4 marks)
(ii) Autoseat
Autoseat is purchasing car seats from Carpart. The contract is to last for three years and Carpart is to design,develop and manufacture the car seats. Carpart will construct machinery for this purpose but the machinery isso specific that it cannot be used on other contracts. Carpart maintains the machinery but the know-how hasbeen granted royalty free to Autoseat. The price of each car seat includes a fixed price to cover the cost of themachinery. If Autoseat decides not to purchase a minimum number of seats to cover the cost of the machinery,then Autoseat has to repay Carpart for the cost of the machinery including any interest incurred.
Autoseat can purchase the machinery at any time in order to safeguard against the cessation of production byCarpart. The purchase price would be the cost of the machinery not yet recovered by Carpart. The machineryhas a life of three years and the seats are only sold to Autoseat who sets the levels of production for a period.Autoseat can perform a pre-delivery inspection on each seat and can reject defective seats. (9 marks)
(iii) Vehicle sales
Carpart sells vehicles on a contract for their market price (approximately £20,000 each) at a mark-up of 25%on cost. The expected life of each vehicle is five years. After four years, the car is repurchased by Carpart at 20%of its original selling price. This price is expected to be significantly less than its fair value. The car must bemaintained and serviced by the customer in accordance with certain guidelines and must be in good conditionif Carpart is to repurchase the vehicle.
The same vehicles are also sold with an option that can be exercised by the buyer two years after sale. Underthis option, the customer has the right to ask Carpart to repurchase the vehicle for 70% of its original purchaseprice. It is thought that the buyers will exercise the option. At the end of two years, the fair value of the vehicleis expected to be 55% of the original purchase price. If the option is not exercised, then the buyer keeps thevehicle.
Carpart also uses some of its vehicles for demonstration purposes. These vehicles are normally used for thispurpose for an eighteen month period. After this period, the vehicles are sold at a reduced price based upon theircondition and mileage. (10 marks)
Professional marks will be awarded for clarity and quality of your discussion. (2 marks)
Required:
Discuss how the above transactions would be accounted for under Financial Reporting Standards in the financialstatements of Carpart.
Note. The mark allocation is shown against each of the arrangements above.
(25 marks)
8
4 (a) Accounting for defined benefit pension schemes is a complex area of great importance. In some cases, the netpension liability even exceeds the market capitalisation of the company. The financial statements of a companymust provide investors, analysts and companies with clear, reliable and comparable information on a company’spension obligations, discount rates and expected returns on plan assets.
Required:
(i) Discuss
(a) the general principle behind the components of a pension scheme’s liabilities and whether thesecomponents reflect the characteristics of a present obligation under FRS 12 ‘Provisions,Contingencies and Commitments’. (7 marks)
(b) the view that pension fund assets and liabilities should be consolidated with the rest of thecompany’s assets and liabilities and should not be shown as a ‘net presentation’ in the balancesheet. (4 marks)
(ii) Discuss the implications of the current accounting practices in FRS 17 ‘Retirement Benefits’ for dealingwith the setting of discount rates for pension obligations and the expected returns on plan assets.
(6 marks)
Professional marks will be awarded in part (a) for clarity and quality of discussion. (2 marks)
(b) Smith, a public limited company and Brown a public limited company utilise FRS 17 ‘Retirement Benefits’ toaccount for their pension plans. The following information refers to the company pension plans for the year to30 April 2009:
(i) At 1 May 2008, plan assets of both companies were fair valued at £200 million.
(ii) At 30 April 2009, the fair value of the plan assets of Smith was £219 million and that of Brown was £276million.
(iii) The contributions received were £70 million and benefits paid were £26 million for both companies. Theseamounts were paid and received on 1 November 2008.
(iv) The expected return on plan assets was 7% at 1 May 2008 and 8% on 30 April 2009.
(v) Actuarial losses on the obligation for the year were negligible for both companies.
Required:
Show how the use of the expected return on assets can cause comparison issues for potential investors usingthe above scenario for illustration. (6 marks)
(25 marks)
End of Question Paper
9
Answers
Professional Level – Essentials Module, Paper P2 (UK)Corporate Reporting (United Kingdom) June 2009 Answers
1 (a) Bravado plcConsolidated Balance Sheet at 31 May 2009
£mFixed assets:Tangible assets W9 703Positive goodwill W2 12·6Negative goodwill W2 (17·1)Investment in associate W3 18Available for sale financial assets W10 44·6
–––––––––761·1
–––––––––Current assets:Stock and work in progress W10 245Trade debtors W11 168Loans to directors 1Cash at bank and in hand 209
–––––––––623
–––––––––Creditors: amounts falling due within one yearTrade creditors W6 217Tax payable 92
–––––––––309
–––––––––Net current assets 314
–––––––––Total assets less current liabilities 1,075·1
–––––––––Creditors: amounts falling due after more than one yearLong-term borrowings 140Deferred tax W10 39·4
–––––––––179·4
–––––––––Net assets 895·7
–––––––––
Share capital 520Other reserves W5 9·3Profit and loss reserve W5 224·62
–––––––––Total shareholders funds 753·92
–––––––––Minority interest W7 141·78
–––––––––Capital employed 895·7
–––––––––
Working 1
Message
Message:Gain on bargain purchase
£mIdentifiable net assets 400Minority interest (20% x 400) (80)Consideration (300)
–––––Gain on bargain purchase (negative goodwill) 20
–––––
AmortisationNegative goodwill (£20m divided by 7 years) 2·9
Negative goodwill up to the fair values of the non-monetary assets acquired should be amortised to the profit and loss accountin the periods in which the non-monetary assets are recovered. i.e. seven years.
13
Working 2
Mixted
Goodwill£m
1 June 2008 (133 – 15) 118Contingent consideration 12
––––Total consideration transferred 130Cost of equity interest held before business combination 10
––––140––––
Identifiable net assets 170Increase in value 6Deferred tax (166 – 156) x 30% (3)
––––––173––––––
Net assets attributable to Bravado (70%) 121·1––––––
Goodwill (140 – 121·1) 18·9––––––
Amortisation (divided by 3 years) 6·3
Goodwill in the balance sheet should disclose positive and negative goodwill separately (FRS10 para 48), hence Messagenegative goodwill of £17·1m and Mixted positive goodwill of £12·6m should not be netted off.Minority interest (30% x 176 – 3) i.e. £51·9m
Working 3
Clarity
The gain of 1 recorded within other equity needs to be removed thereby reducing the value of the original investment to costas it has been classified as available for sale.
DR Other components of equity (9 – 8) 1CR Investment in associate 1
The amount included in the consolidated balance sheet would be:
£mCost (£8 million + £11 million) 19Share of post acquisition profits (£10 million x 25%) 2·5
–––––21·5
The investment in associate would then need to be impaired by £3·5 million to reduce the investment to the recoverableamount of £18 million. The loss of £3·5 million being taken to profit and loss.
Working 4
Available for sale instrument
Date Exchange rate Value Change in fair valueDinars m £m £m
1 June 2007 4·5 11 49·531 May 2008 5·1 10 51 1·531 May 2009 4·8 7 33·6 (17·4)
The asset’s fair value in the overseas currency has declined for successive periods. However, no impairment loss is recognisedin the year ended 31 May 2008 as there is no loss in the reporting currency (£). The gain of £1·5 million would be recordedin equity. However, in the year to 31 May 2009 an impairment loss of £17·4 million will be recorded as follows:
£mDR Other components of equity 1·5DR Profit/loss account 15·9CR AFS investments 17·4
14
Working 5
Profit and loss reserve
£mBravado:Balance at 31 May 2009 240Associate profits 2·5Impairment loss (3·5)AFS impairment (15·9)Write down of stock (18)Negative goodwill – amortisation 2·9Goodwill amortisation (6·3)Share based payment (4·8)Post acquisition reserves: Message 11·2
Mixted 16·52–––––––224·62–––––––
Message: Post acquisition reserves (150 – 136) i.e. £14mGroup reserves – 80% 11·2MI – 20% 2·8
–––––––14
–––––––
Mixted: Post acquisition reserves:at 31 May 2009 (80 – 55) 25Less increase in depreciation (2)Add deferred tax movement 0·6
–––––––23·6
–––––––Group reserves – 70% 16·52MI – 30% 7·08
–––––––23·6
–––––––
Bravado: other reserves £mBalance at 31 May 2009 12Investment in associate W3 (1)Impairment loss – AFS. W4 (1·5)Share based payment 4·8Available for sale profit on investment in Mixted (5)
–––––9·3
–––––
Working 6
Current liabilities – trade payables £mBalance at 31 May 2009Bravado 115Message 30Mixted 60
SSAP 9 states that events occurring between the balance sheet and the date of completion of the financial statements needto be considered in arriving at the net realisable value. The loss in value should be adjusted for. Additionally although theselling price per stage can be determined, net realisable value (NRV) is based on the selling price of the finished product, andthis should be used to calculate NRV.
£Selling price of units 1,450Less selling costs (10)
––––––NRV 1,440Less conversion costs (500)
––––––NRV at 1st stage 940
––––––
Write down £m200,000 units x (1,500 – 1,440) 12100,000 units x (1,000 – 940) 6
––––––18
––––––
There will have to be an investigation of the difference between the total value of the above stock and the amount in thefinancial statements.
Working 9
Tangible fixed assets
£m £mBravado 260Message 230Mixted 161
––––651
Increase in value of land – Message (400 – 220 – 136 – 4) 40Increase in value of PPE – Mixted (176 – 100 – 55 – 7) 14Less: increased depreciation (14 ÷ 7) (2)
––––703––––
Working 10
Available for sale financial assets £m £mBravado 51Message 6Mixted 5
–––62
Less impairment loss (17·4)–––––44·6
–––––
Stock £m £mBravado 135Message 55Mixted 73
––––263
Less: write down to NRV (18)––––245––––
Deferred tax £m £mBravado 25Message 9Mixted 3
––––37
Arising on acquisition 3Movement to year end (0·6)
–––––39·4
–––––
16
Working 11
Trade debtors
£m £mBravado 91Message 45Mixted 32
–––168––––
Working 12
Share optionsYear to 31 May 2008Expense for year is 1,000 x 2,000 x £6 x 90% x 1/3 = £3·6m
Expense to 31 May 2009Expense for year is 1,000 x 2,000 x 93% x ((£6 x 2/3) + (1 x 1/2)) i.e. £8·4Less expense for year to 31 May 2008 (£3·6m) i.e. £4·8m
Where a modification increases the fair value of the equity instruments granted, an entity should include the incremental valuein the measurement of the amount recognised for services.
(b) The Companies Act and FRS 2 ‘Accounting for subsidiary undertakings’ require consolidation of undertakings over which thecompany has power to control. The effective date is the date on which control passes to the new parent company. FRS 2requires this date to be the date of acquisition. The date will be when the company has the ability to direct the financial andoperating policies of the other undertaking with a view to gaining economic benefits. The gaining of economic benefits canbe widely interpreted to include the receipt of current or future profits, the prevention of a key supplier going out of business,the reduction of the losses of the acquiring group or as in the case of Bravado, the prevention of another competitor fromacquiring the company (Fusion). FRS 2 says that the date that control passes is a matter of fact and cannot be artificiallyaltered. The additional factors that should be taken into account are when the acquirer starts to direct the operating andfinancial policies of the acquired undertaking and the date that the consideration is paid. Where there is an offer of shares asin this case, then the date that control is transferred is the date that the offer becomes unconditional. That is the date thatthere is a sufficient number of acceptances received to enable Bravado to exercise control over Fusion. The negotiations topurchase a subsidiary may take a considerable period of time. If the effective date of acquisition is after the year end ofBravado but before the consolidated financial statements are approved, the transaction should be treated as a non-adjustingpost balance sheet event in accordance with FRS 21 ‘Events after the balance sheet date’. If Bravado wishes to show theimpact of the acquisition of Fusion then additional information should be shown in the notes to the financial statements.
(c) Showing a loan as cash is misleading. The Statement of Principles says that financial statements should have certaincharacteristics:
These concepts would preclude the showing of directors’ loans in cash. Such information needs separate disclosure as it isrelevant to users as it shows the nature of the practices carried out by the company. Reliability requires information to be freefrom bias and faithfully represent transactions. Comparability is not possible if transactions are not correctly classified.Directors are responsible for the statutory financial statements and if they believe that they are not complying with FRS, theyshould take all steps to ensure that the error or irregularity is rectified. Every director will be deemed to have knowledge ofthe content of the financial statements. In the UK, loans to directors must be approved by the shareholders. Directors have aresponsibility to act honestly and ethically and not be motivated by personal interest and gain. A loan of this nature couldcreate a conflict of interest as the directors’ personal interests may interfere or conflict with those of the company’s. Theaccurate and full recording of business activities is essential to fulfil the financial and legal obligations of a director as is theefficient use of corporate assets. The loan to a director conflicts with the latter principle.
2 (a) Discussion of fair value and its relevance
The fair value of an asset is the amount at which that asset could be bought or sold in a current transaction between willingparties, other than in a liquidation. The fair value of a liability is the amount at which that liability could be incurred or settledin a current transaction between willing parties, other than in a liquidation. If available, a quoted market price in an activemarket is the best evidence of fair value and should be used as the basis for the measurement. If a quoted market price isnot available, preparers should make an estimate of fair value using the best information available in the circumstances. Thismay include discounting future cash flows or using pricing models such as Black-Scholes. However, these methods all usean element of estimation which in itself can create discrepancies in the values that result. In an efficient market thesedifferences should be immaterial.
17
The ASB has concluded that fair value is the most relevant measure for most financial instruments. Fair value measurementsprovide more transparency than historical cost based measurements. Reliability is as important as relevance because relevantinformation that is not reliable is of no use to an investor. Fair value measurements should be reliable and computed in amanner that is faithful to the underlying economics of the transaction. Measuring financial instruments at fair value shouldnot necessarily mean abandoning historical cost information.
However, market conditions will affect fair value measurements. In many circumstances, quoted market prices areunavailable. As a result, difficulties occur when making estimates of fair value. It is difficult to apply fair value measures inilliquid markets and to decide how and when models should be used for fair valuation. Fair value information can provide avalue at the point in time that it is measured but its relevance will depend on the volatility of the market inputs and whetherthe instruments are actively traded or are held for the long term. Fair value provides an important indicator of risk profile andexposure but to fully understand this and to put it into context, the entity must disclose sufficient information.
(b) Some compound instruments have both a liability and an equity component from the issuer’s perspective. In this case, FRS 25 ‘Financial Instruments: Disclosure and Presentation’ requires that the component parts be accounted for andpresented separately according to their substance based on the definitions of liabilities and equity. The split is made atissuance and not revised for subsequent changes in market interest rates, share prices, or other events that change thelikelihood that the conversion option will be exercised.
(i) Convertible Bond
A convertible bond contains two components. One is a financial liability, namely the issuer’s contractual obligation topay cash in the form of interest or capital, and the other is an equity instrument, which is the holder’s option to convertinto shares. When the initial carrying amount of a compound financial instrument is required to be allocated to its equityand liability components, the equity component is assigned the residual amount after deducting from the fair value ofthe instrument as a whole the amount separately determined for the liability component.
In the case of the bond, the liability element will be determined by discounting the future stream of cash flows whichwill be the interest to be paid and the final capital balance assuming no conversion. The discount rate used will be 9%which is the market rate for similar bonds without the conversion right. The difference between cash received and theliability component is the value of the option.
£000Present value of interest at end of:Year 1 (31 May 2007) (£100m x 6%) ÷ 1·09 5,505Year 2 (31 May 2008) (£100m x 6%) ÷ 1·092 5,050Year 3 (31 May 2009) (£100m + (£100m x 6%)) ÷ 1·093 81,852
––––––––Total liability component 92,407Total equity element 7,593
––––––––Proceeds of issue 100,000
––––––––
The issue cost will have to be allocated between the liability and equity components in proportion to the above proceeds.
The credit to equity of £7,517 would not be re-measured. The liability component of £91,483 would be measured atamortised cost using the effective interest rate of 9·38%, as this spreads the issue costs over the term of the bond. Theinterest payments will reduce the liability in getting to the year end. The initial entries would have been:
£000 £000Dr Cash 100,000 Cr Cash 1,000
Cr Liability 92,407 Dr Liability 924Cr Equity 7,593 Dr Equity 76
The liability component balance on 31 May 2009 becomes £100,000 as a result of the effective interest rate of 9·38%being applied and cashflows at 6% based on nominal value.
On conversion of the bond on 31 May 2009, Aron would issue 25 million ordinary shares of £1 and the original equitycomponent together with the balance on the liability will become the consideration.
18
£000Share capital – 25 million at £1 25,000Share premium 82,517
––––––––Equity and liability components (100,000 + 7,593 – 76) 107,517
––––––––
(ii) Shares in Smart
In this situation Aron has to determine if the transfer of shares in Smart qualifies for derecognition. The criteria are firstlyto determine that the asset has been transferred, and then to determine whether or not the entity has transferredsubstantially all of the risks and rewards of ownership of the asset. If substantially all the risks and rewards have beentransferred, the asset is derecognised. If substantially all the risks and rewards have been retained, derecognition of theasset is precluded. (FRS 26)
In this case the transfer of shares qualifies for derecognition as Aron no longer retains any risks and rewards ofownership. In addition Aron obtains a new financial asset which is the shares in Given which should be recognised atfair value. The transaction will be accounted for as follows:
£mProceeds 5·5Carrying amount of shares in Smart 5
––––Gain on recognition 0·5Gain in equity reclassified 0·4
––––Gain to profit/loss 0·9
––––
The gain on disposal will be £900,000. The accounting entries would be:
£m £mDr Shares in Given 5·5 Cr Gain on sale 0·4
Cr Shares in Smart 5 Dr Equity 0·4Cr Gain on sale 0·5Gain on sale Transfer of accrued gain in equity
(iii) Foreign Subsidiary
In this situation, FRS 26 will apply to the debt instrument in the foreign subsidiary’s financial statements and FRS 23,‘The Effects of Changes in Foreign Exchange Rates’, will apply in translating the financial statements of the subsidiary.Under FRS 23, all exchange differences resulting from translation are recognised in equity until disposal of thesubsidiary. This includes exchange differences on financial instruments carried at fair value through profit or loss andfinancial assets classified as available-for-sale.
As the debt instrument is held for trading it will be carried at fair value through profit or loss in Gao’s financial statements.Thus at 31 May 2009, there will be a fair value gain of 2 million zloti which will be credited to the profit and lossaccount of Gao. In the consolidated financial statements, the carrying value of the debt at 1 June 2008 would havebeen £3·3 million (10 million zloti ÷ 3). At the year end this carrying value will have increased to £6 million (12 million zloti ÷ 2). Aron will translate the profit and loss account of Gao using the average rate of 2·5 zloti to thedollar. Although the fair value of the debt instrument has increased by £2·7 million, Aron will only recognise 2 millionzloti ÷ 2·5, i.e. £800,000 of this in the consolidated profit and loss account with the remaining increase in value of(£2·7 – £0·8) million, i.e. £1,900,000 being classified as equity until the disposal of the foreign subsidiary.
£mOpening balance at 1 December 2008 3·3Increase in year 2·7
––––Closing balance at 30 November 2009 6·0
––––
Dr Debt instrument 2·7
Cr Consolidated profit and loss account 0·8Cr Equity 1·9
(iv) Interest Free Loans
When a financial asset is recognised initially, FRS 26 requires it to be measured at fair value, plus transaction costs incertain situations. Normally the fair value is the fair value of the consideration given. However, the fair value of aninterest free loan may not necessarily be its face amount. The instrument’s fair value may be evidenced by comparisonwith other market transactions in the same instrument. In this case, the fair value may be estimated as the discountedpresent value of future receipts using the market interest rate. The difference between the fair value of the loan and theface value of the loan will be treated as employee remuneration under FRS 17 ‘Retirement Benefits’.
19
£mFair value of loan at 1 June 2008 (10/(1·062)) 8·9Employee compensation 1·1
–––––10
–––––
The employee compensation would be charged to the profit and loss account over the two-year period. As the companywishes to classify the asset as loans and receivables, it will be measured at 31 May 2009, at amortised cost using theeffective interest method. In this case the effective interest rate will be 6% and the value of the loan in the statement offinancial position will be (£8·9 million x 1·06) i.e. £9·43 million. Interest of £0·53 million will be credited to the incomestatement.
At 1 June 2008£m
Dr Loan 8·9Dr Employee compensation 1·1
Cr Cash 10
At 31 May 2009Dr Loan 0·53Cr Profit and loss account – interest 0·53
3 Supply arrangements
(i) Vehiclex
A transaction may contain separately identifiable components that should be accounted for separately. FRS 5 Application noteG states that a contractual arrangement with two or more components should be accounted for as two or more separatetransactions only where the commercial substance is that the individual components operate independently of one another.Components operate independently where each element represents a separable good or service that the seller can provide tocustomers on a stand alone basis or as an optional extra. If there are a number of elements to the transaction, then therevenue recognition criteria should be applied to each element separately. In this case there is no contract to sell themachinery to Vehiclex and thus no revenue can be recognised in respect of the machinery. The machinery is for the use ofCarpart and the contract is not a construction contract under SSAP 9 ‘Stock and Long-term contracts’ The machinery isaccounted for under FRS 15 ‘Tangible Fixed Assets’ and depreciated assuming that the future economic benefits of themachinery will flow to Carpart and the cost can be measured reliably. Carpart should conduct impairments reviews to ensurethe carrying amount is not in excess of recoverable amount whenever there is deemed to be an indication of impairment. Seatorders not covering the minimum required would be an example of an impairment indicator. The impairment review of themachine would most probably be conducted with the machinery forming part of an income generating unit. The contract tomanufacture seats is not a service or construction contract but is a contract for the production of goods. The contract is acontract to sell goods and FRS5 Application note G is applicable with revenue recognised on sale.
(ii) Autoseat
Companies often enter into agreements that do not take the legal form of a lease but still convey the right to use an asset inreturn of payment. FRS 5 ‘Reporting the substance of transactions’ helps determine the nature of the transaction by ensuringthat the commercial effect of the transaction is looked at. If it is determined that the arrangement constitutes a lease, then itis accounted for under SSAP 21 ‘Accounting for Leases and Hire Purchase Contracts’. SSAP 21 includes in the definition ofa lease any arrangement not described as a lease, in which one party retains ownership but conveys the right to use an assetfor an agreed period of time in return for specific rentals. Assessment should be made based on the substance of thearrangement which means assessing if fulfilment of the contract is dependent upon the use of a specified asset and thecontract conveys the right to use the asset. The completion of the contract depends upon the construction and use of a specificasset which is the specialised machinery which is dedicated to the production of the seats and cannot be used for otherproduction. All of the output is to be sold to Autoseat who can inspect the seats and reject defective seats before delivery. Thecontract allows Autoseat the right to use the asset because it controls the underlying use as it is remote that any other partywill receive any more than an insignificant amount of its production. The only customer is Autoseat who sets the levels ofproduction and has a purchase option at any time; Autoseat is committed to fully repay the cost of the machinery. Thepayments for the lease are separable from any other elements in the contract as Carpart will recover the cost of the machinerythrough a fixed price per seat over the life of the contract.
The contract therefore contains a finance lease because of the specialised nature of the machinery and because the contractis for the life of the asset (three years). The payments under the contract will be separated between the lease element andthe revenue for the sale of the car seats. Carpart will recognise a lease receivable equal to the net present value of theminimum lease payments. Carpart does not normally sell machinery nor recognises revenue on the sale of machinery and,therefore, no gain or loss should be recognised on recognition and the initial carrying amount of the receivable will equal theproduction cost of the machinery. Lease payments will be split into interest income and receipt of the lease receivables.
20
(iii) Car Sales
A sale and repurchase agreement for a non-financial asset must be analysed to determine if the seller has transferred the risksand rewards of ownership to the buyer. If this has occurred then revenue is recognised. Where the seller has retained therisks and rewards of ownership, the transaction is a financial arrangement even if the legal title has been transferred.
In the case of vehicles sold and repurchased at the end of their expected life, Carpart should recognise revenue on the saleof the vehicle. The residual risk that remains with Carpart is not significant at 25% of the sale price as this is thought to besubstantially less than the market price. The agreed repurchase period also covers all of the vehicles economic life. The carhas to be maintained and serviced by the purchaser and must be returned in good condition. Thus the transfer of thesignificant risks and rewards of ownership to the buyer has taken place.
In the case of the sale with an option to repurchase, Carpart has not transferred the significant risks and rewards of ownershipat the date of the transaction. The repurchase price is significant and the agreed repurchase period is less than substantiallyall of the economic life of the vehicle. The repurchase price is above the fair value of the vehicle and thus the risks ofownership have not been transferred. Also the company feels that the option will be exercised. The transaction is accountedfor as an operating lease under SSAP 21. The cars will be accounted for as operating leases until the option expires. Thevehicles will be taken out of the inventory and debited to ‘assets under operating lease’. The cash received will be splitbetween rentals received in advance (30%) and long-term liabilities (70%) which will be discounted. The rental income willbe recognised in the profit and loss account over the two-year period.
Demonstration vehicles
The demonstration vehicles should be taken out of inventory and capitalised as tangible fixed assets at cost. They meet therecognition criteria as they are held for administration purposes and are expected to be used in more than one accountingperiod. They should be depreciated whilst being used as demonstration vehicles and when they are to be sold they arereclassified from fixed assets to stock and depreciation ceased.
4 (a) (i) Pension obligations arise under employment contracts in exchange for services. Liabilities arise when there is a presentobligation to transfer economic benefits (Statement of Principles). Scheme liabilities can be defined as ‘the liabilities ofa defined benefit scheme for outgoings due after the valuation date’. It is at the time that the services are provided thata liability arises and reflect the benefits that the employer is committed to provide up to the valuation date. Thecomponents of the scheme liabilities reflect the characteristics of a present obligation in FRS 12 ‘Provisions,contingencies and commitments’. The liability is subject to a number of uncertainties including those relating to futureprices and demographic factors such as mortality rates. These factors are relevant to the measurement of the liability,not whether it exists. The liability includes increases that the entity by legal or constructive obligation is presentlycommitted to pay. Where the entity has discretion over the amount of the future benefit, it should not be included in theliability. The liability should also not reflect future possible changes to the entity’s or the pension scheme’s financialposition but should include changes to the pension scheme that have vested. The general principle of FRS 17‘Retirement Benefits’ is that the obligation arises over the period of the employees service and represents a long termaccrual of a portion of those total benefits.
A gross presentation would appropriately reflect the economic substance and be consistent with accounting principlesapplied elsewhere in the standards. There is no conceptual reason why FRS should provide an exemption from theconsolidation of pension plans particularly where the employer has control over the plan assets and liabilities. Thepresentation of the assets and liabilities should reflect the substance of the relationship between the employer and thescheme, particularly where the employer has the decision-making powers of the plan and can direct the trustees of theplan or can determine the investment, funding or benefit policy. However, it could be argued that the user of financialstatements is interested in the ‘net position/liability’ and the ‘gross’ position can easily be obtained from the notes to thefinancial statements.
(ii) FRS 17 states that the rate to be used to discount pension obligations should be determined by reference to marketyields at the balance sheet date on high quality corporate bonds long dated AA rated corporate bonds. Yields on AAcorporate bonds have steadily declined and equity markets have become increasingly volatile, plunging many schemesinto deficit. Recently schemes have unexpectedly benefited from the current market turmoil. The discount rate used todiscount liabilities is now so high that it more than compensates for the problems of falling interest rates, rising inflationand volatile equity markets. The discount rate should reflect the time value of money, based on the expected timing ofthe benefit payments. The discount rate does not reflect investment risk or actuarial risk as other actuarial assumptionsdeal with these items. FRS17 is not specific on what it considers to be a high quality bond and therefore this can leadto variation in the discount rates used. The result is that there is a measure of subjectivity in the setting of discount rateswhich could lead to management of earnings and the reduction of liabilities. The ASB’s belief is that a risk free rate isthe most accurate measure of the liabilities.
The return on plan assets is defined as interest, dividends and other revenue derived from plan assets, together withrealised and unrealised gains or losses on plan assets, less any costs of administering the plan less any tax payable bythe plan itself. The amount recognised in the financial statements under FRS 17 is the expected return on assets, andthe difference between the expected return and actual return in the period is an actuarial gain or loss. The expectedreturn is based on market expectations at the beginning of the period for returns over the entire life of the relatedobligation. The standard also requires an adjustment to be made to the expected return for changes in the assetsthroughout the year. This return is a very subjective assumption and an increase in the return can create income at theexpense of actuarial losses.
21
(b) In the case of Smith and Brown, the companies have experienced dramatically different investment performance in the year.
The expected and actual return on plan assets was:
Smith (£m) Brown (£)Fair value of plan assets (30 April 2009) 219 276Less fair value of plan assets (1 May 2008) (200) (200)Less contributions received (70) (70)add benefits paid 26 26
––––– –––––Actual return on plan assets (loss) (25) 32
––––– –––––
The expected return on plan assets was
Return on £200 million for one year at 7% 14Return on net contributions at 3·5% approx for six months ((70 – 26) at 3·5%) 1·5Expected return on plan assets – 2009 15·5
The difference between the expected return and the actual return represents an actuarial loss in the case of Smith of £40·5 million (being expected gain £15·5 becoming an actual loss £25) and an actuarial gain of £16·5 million in the caseof Brown (being expected gain £15·5 becoming an actual gain of £32).
Despite very different performance, the amount shown as expected return on plan assets in the profit and loss account wouldbe identical for both companies and the actuarial gains and losses would be recognised in the current period in the STRGL.The investment performance of Smith has been poor and Brown has been good. However, this is not reflected in the profitand loss account. It can only be deduced from the disclosure of the actuarial gains and losses. It is the ‘real’ return on planassets which is important, and not the expected return. Thus the use of the expected return on the plan assets can createcomparison issues for the potential investor especially if the complexities of FRS 17 are not fully understood.
22
Professional Level – Essentials Module, Paper P2 (UK)Corporate Reporting (United Kingdom) June 2009 Marking Scheme
Marks1 (a) Message 4
Mixted 5Clarity 3AFS instrument 3Profit and loss reserve 3Post acquisition reserves 2Other components of equity 2Current liabilities 1MI 2Stock 2Tangible assets 2AFS 1Deferred tax 1Share based payment 3Trade debtors 1
–––35
(b) Subjective 8
(c) Subjective 7–––
AVAILABLE 50–––
2 (a) Fair value – subjective 4
(b) Convertible bond: explanation 2calculation 4
Shares in Smart: explanation 2calculation 2
Foreign subsidiary: explanation of principles 2accounting treatment 3
Interest free loan: explanation of principles 2accounting treatment 2
Quality of explanations 2–––21
–––AVAILABLE 25
–––
3 Vehiclex – FRS 5 2FRS 15 1SSAP 9 1
Autoseat – Discussion 6Finance lease 3
Sale of vehicles – Risks and rewards 3Repurchase four years 2Repurchase two years 3Demonstration 2
Professional marks 2–––
AVAILABLE 25–––
23
Marks4 (a) Obligation – subjective 7
Consolidation – subjective 4Discount/return on assets – subjective 6Quality of discussion 2
–––19
(b) Calculation and discussion 6–––
AVAILABLE 25–––
24
Professional Level – Essentials Module
The Association of Chartered Certifi ed Accountants
Corporate Reporting(United Kingdom)
Tuesday 15 June 2010
Time allowed
Reading and planning: 15 minutesWriting: 3 hours
This paper is divided into two sections:
Section A – This ONE question is compulsory and MUST be attempted
Section B – TWO questions ONLY to be attempted
Do NOT open this paper until instructed by the supervisor.
During reading and planning time only the question paper may
be annotated. You must NOT write in your answer booklet until
instructed by the supervisor.
This question paper must not be removed from the examination hall.
Pape
r P
2 (
UK
)
2
Section A – THIS ONE question is compulsory and MUST be attempted
1 The following fi nancial statements relate to Ashanti, a public limited company.
Ashanti Group: Profi t and Loss Account and Statement of Total Recognised Gains and Losses for the year ended 30 April 2010.
Ashanti Bochem Ceram £m £m £m Turnover 810 235 142 Cost of sales (686) (137) (84) ––––– ––––– ––––– Gross profi t 124 98 58 Distribution costs (30) (21) (26) Administration expenses (55) (29) (12) Other operating income 31 17 12 ––––– ––––– ––––– Operating profi t before interest 70 65 32 Net interest costs (8) (6) (8) ––––– ––––– ––––– Profi t on ordinary activities before tax 62 59 24 Taxation (21) (23) (10) ––––– ––––– ––––– Profi t on ordinary activities after taxation 41 36 14 ––––– ––––– ––––– ––––– ––––– ––––– Statement of Total Recognised Gains and Losses Profi t for fi nancial year 41 36 14 Available-for-sale fi nancial assets (AFS) 20 9 6 Gains (net) on fi xed assets revaluation 12 6 – Actuarial losses on defi ned benefi t plan (14) – – ––––– ––––– ––––– Total Recognised Gains and Losses for year 59 51 20 ––––– ––––– ––––– ––––– ––––– –––––
The following information is relevant to the preparation of the group fi nancial statements:
1. On 1 May 2008, Ashanti acquired 70% of the equity interests of Bochem, a public limited company. The purchase consideration comprised cash of £150 million and the fair value of the identifi able net assets was £160 million at that date. The share capital and retained earnings of Bochem were £55 million and £85 million respectively and other reserves were £10 million at the date of acquisition. The excess of the fair value of the identifi able net assets at acquisition is due to an increase in the value of plant, which is depreciated on the straight-line method and has a fi ve year remaining life at the date of acquisition. Ashanti disposed of a 10% equity interest to the minority interests (MI) of Bochem on 30 April 2010 for a cash consideration of £34 million. The carrying value of the net assets of Bochem at 30 April 2010 was £210 million before any adjustments on consolidation. Goodwill has been impairment tested annually and as at 30 April 2009 had reduced in value by 15% and at 30 April 2010 had lost a further 5% of its original value before the sale of the equity interest to the MI.
2. Bochem acquired 80% of the equity interests of Ceram, a public limited company, on 1 May 2008. The purchase consideration was cash of £136 million. Ceram’s identifi able net assets were fair valued at £115 million. On 1 November 2009, Bochem disposed of 50% of the equity of Ceram for a consideration of £90 million. Ceram’s identifi able net assets were £160 million at the date of disposal. After the disposal, Bochem can still exert signifi cant infl uence. Goodwill had been impairment tested and no impairment had occurred. Ceram’s profi ts are deemed to accrue evenly over the year.
3. Ashanti has sold stock to both Bochem and Ceram in October 2009. The sale price of the stock was £10 million and £5 million respectively. Ashanti sells goods at a gross profi t margin of 20% to group companies and third parties. At the year-end, half of the stock sold to Bochem remained unsold but the entire stock sold to Ceram had been sold to third parties.
4. On 1 May 2007, Ashanti purchased a £20 million fi ve-year bond with semi annual interest of 5% payable on 31 October and 30 April. The purchase price of the bond was £21·62 million. The effective annual interest rate is 8% or 4% on a semi annual basis. The bond is classifi ed as available-for-sale. At 1 May 2009, the amortised cost of the bond was £21·05 million and the loss recognised in equity was £0·6 million, resulting in a carrying
3 [P.T.O.
value of £20·45 million (no change to the effective annual interest rate). The issuer of the bond did not pay the interest due on 31 October 2009 and 30 April 2010. Ashanti feels that as at 30 April 2010, the bond is impaired and that the best estimates of total future cash receipts are £2·34 million on 30 April 2011 and £8 million on 30 April 2012. The current interest rate for discounting cash fl ows as at 30 April 2010 is 10%. No accounting entries have been made in the fi nancial statements for the above bond since 30 April 2009.
5. Ashanti sold £5 million of goods to a customer who recently made an announcement that it is restructuring its debts with its suppliers including Ashanti. It is probable that Ashanti will not recover the amounts outstanding. The goods were sold after the announcement was made although the order was placed prior to the announcement. Ashanti wishes to make an additional provision of £8 million against the total debtor balance at the year end, of which £5 million relates to this sale.
6. Ashanti owned a piece of plant and machinery, which cost £12 million and was purchased on 1 May 2008. It is being depreciated over 10 years on the straight-line basis with zero residual value. On 30 April 2009, it was revalued to £13 million and on 30 April 2010, the plant and machinery was again revalued to £8 million. However, an impairment review indicated that the recoverable amount of the asset was £9 million. The whole of the revaluation loss had been posted to the statement of total recognised gains and losses and depreciation has been charged for the year. It is Ashanti’s company policy not to make transfers for excess depreciation following revaluation and there is no obvious consumption of economic benefi ts regarding the plant and machinery.
7. Ashanti anticipates that it will be fi ned £40,000 by the local regulator for a mis-selling offence. The company has not paid the fi ne at the year end nor has it accounted for it. It also anticipates that there will be an additional obligation to pay £170,000 to its customers for the mis-selling. The regulator has requested that the company make future changes to its system of selling and this is expected to cost £150,000 of which £30,000 relates to re-training.
8. Ignore any taxation effects of the above adjustments and the disclosure requirements of FRS 3 ‘Reporting Financial Performance’.
Required:
(a) Prepare a Consolidated Profi t and Loss Account and Statement of Total Recognised Gains and Losses for the
year ended 30 April 2010 for the Ashanti Group. (35 marks)
The directors of Ashanti have heard that the Accounting Standards Board (ASB) has issued amendments to the rules regarding reclassifi cation of fi nancial instruments. The directors believe that the ASB has issued these amendments to reduce the difference between US GAAP and Financial Reporting Standards (FRS) in respect of reclassifi cation of fi nancial assets. Reclassifi cation, which was previously severely restricted under the FRS, is now permitted in specifi c circumstances if the conditions and disclosure requirements are followed. They feel that this will give them the capability of managing their earnings, as they will be able to reclassify loss making fi nancial assets and smooth income. They feel that there is no problem with managing earnings as long as the shareholders do not fi nd out and as long as the accounting practices are within the guidelines set out in FRS.
Required:
(b) Describe the amendments to the rules regarding reclassifi cation of fi nancial assets issued in October 2008 by
the ASB, discussing how these rules could lead to ‘management of earnings’. (7 marks)
(c) Discuss the nature of and incentives for ‘management of earnings’ and whether such a process can be deemed
to be ethically acceptable. (6 marks)
Professional marks will be awarded in question 1(c) for clarity and quality of discussion. (2 marks)
(50 marks)
4
Section B – TWO questions ONLY to be attempted
2 (a) Cate is an entity in the software industry. Cate had incurred substantial losses in the fi nancial years 31 May 2004 to 31 May 2009. In the fi nancial year to 31 May 2010 Cate made a small profi t before tax. This included signifi cant non-operating gains. In 2009, Cate recognised a material deferred tax asset in respect of carried forward losses, which will expire during 2012. Cate again recognised the deferred tax asset in 2010 on the basis of anticipated performance in the years from 2010 to 2012, based on budgets prepared in 2010. The budgets included high growth rates in profi tability. Cate argued that the budgets were realistic as there were positive indications from customers about future orders. Cate also had plans to expand sales to new markets and to sell new products whose development would be completed soon. Cate was taking measures to increase sales, implementing new programmes to improve both productivity and profi tability. Deferred tax assets less deferred tax liabilities represent 25% of shareholders’ equity at 31 May 2010. There are no tax planning opportunities available to Cate that would create taxable profi t in the near future. (5 marks)
(b) At 31 May 2010 Cate held an investment in and had a signifi cant infl uence over Bates, a public limited company. Cate had carried out an impairment test in respect of its investment in accordance with the procedures prescribed in FRS 11, ‘Impairment of fi xed assets and goodwill’. Cate argued that fair value was the only measure applicable in this case as value in use was not determinable as expected cash fl ow estimates had not been produced. Cate stated that there were no plans to dispose of the shareholding and hence there was no binding sale agreement. Cate also stated that the quoted share price was not an appropriate measure when considering the fair value of Cate’s signifi cant infl uence on Bates. Therefore, Cate estimated the fair value of its interest in Bates through application of two measurement techniques; one based on earnings multiples and the other based on an option–pricing model. Neither of these methods supported the existence of an impairment loss as of 31 May 2010. (5 marks)
(c) At 1 April 2009 Cate had a direct holding of shares giving 70% of the voting rights in Date. In May 2010, Date issued new shares, which were wholly subscribed for by a new investor. After the increase in capital, Cate retained an interest of 35% of the voting rights in its former subsidiary Date. At the same time, the shareholders of Date signed an agreement providing new governance rules for Date. Based on this new agreement, Cate was no longer to be represented on Date’s board or participate in its management. As a consequence Cate considered that its decision not to subscribe to the issue of new shares was equivalent to a decision to disinvest in Date. Cate argued that the decision not to invest clearly showed its new intention not to recover the investment in Date principally through continuing use of the asset and was considering selling the investment. Due to the fact that Date is a separate line of business (with separate cash fl ows, management and customers), Cate considered that the results of Date for the period to 31 May 2010 should be presented based on principles provided by FRS 3 ‘Reporting Financial Performance’. (8 marks)
(d) In its 2010 fi nancial statements, Cate disclosed the existence of a voluntary fund established in order to provide a retirement benefi t plan (Plan) to employees. Cate considers its contributions to the Plan to be voluntary, and has not recorded any related liability in its consolidated fi nancial statements. Cate has a history of paying benefi ts to its former employees, even increasing them to keep pace with infl ation since the commencement of the Plan. The main characteristics of the Plan are as follows:
(i) the Plan is totally funded by Cate; (ii) the contributions for the Plan are made periodically; (iii) the retirement benefi t is calculated based on a percentage of the fi nal salaries of Plan participants dependent
on the years of service; (iv) the annual contributions to the Plan are determined as a function of the fair value of the assets less the liability
arising from past services.
Cate argues that it should not have to recognise the Plan because, according to the underlying contract, it can terminate its contributions to the Plan, if and when it wishes. The termination clauses of the contract establish that Cate must immediately purchase lifetime annuities from an insurance company for all the retired employees who are already receiving benefi t when the termination of the contribution is communicated. (5 marks)
5 [P.T.O.
Required:
Discuss whether the accounting treatments proposed by the company are acceptable under Financial Reporting
Standards.
Professional marks will be awarded in this question for clarity and quality of discussion. (2 marks)
The mark allocation is shown against each of the four parts above.
(25 marks)
6
3 Seltec, a public limited company, processes and sells edible oils and uses several fi nancial instruments to spread the risk of fl uctuation in the price of the edible oils. The entity operates in an environment where the transactions are normally denominated in pounds sterling. The functional currency of Seltec is the pound sterling.
(a) The entity uses forward and futures contracts to protect it against fl uctuation in the price of edible oils. Where forwards are used the company often takes delivery of the edible oil and sells it shortly afterwards. The contracts are constructed with future delivery in mind but the contracts also allow net settlement in cash as an alternative. The net settlement is based on the change in the price of the oil since the start of the contract. Seltec uses the proceeds of a net settlement to purchase a different type of oil or purchase from a different supplier. Where futures are used these sometimes relate to edible oils of a different type and market than those of Seltec’s own stock of edible oil. The company intends to apply hedge accounting to these contracts in order to protect itself from earnings volatility. Seltec has also entered into a long-term arrangement to buy oil from a foreign entity whose currency is the dinar. The commitment stipulates that the fi xed purchase price will be denominated in dollars.
Seltec is unsure as to the nature of derivatives and hedge accounting techniques and has asked your advice on how the above fi nancial instruments should be dealt with in the fi nancial statements. (14 marks)
(b) Seltec has decided to enter the retail market and has recently purchased two well-known brand names in the edible oil industry. One of the brand names has been in existence for many years and has a good reputation for quality. The other brand name is named after a famous fi lm star who has been actively promoting the edible oil as being a healthier option than other brands of oil. This type of oil has only been on the market for a short time. Seltec is fi nding it diffi cult to estimate the useful life of the brands and therefore intends to treat the brands as having indefi nite lives.
In order to sell the oil, Seltec has purchased two limited liability companies from a company that owns several retail outlets. Each entity owns retail outlets in several shopping complexes. The only assets of each entity are the retail outlets. There is no operational activity and at present the entities have no employees. Seltec is unclear as to how the purchase of the brands and the entities should be accounted for. (9 marks)
Required:
Discuss the accounting principles involved in accounting for the above transactions and how the above transactions
should be treated in the fi nancial statements of Seltec.
Professional marks will be awarded in this question for clarity and quality of discussion. (2 marks)
The mark allocation is shown against each of the two parts above.
(25 marks)
7
4 (a) Leasing is important to Holcombe, a public limited company, as a method of fi nancing the business. The Directors feel that it is important that they provide users of fi nancial statements with a complete and understandable picture of the entity’s leasing activities. They believe that the current accounting model is inadequate and does not meet the needs of users of fi nancial statements.
Holcombe has leased plant for a fi xed term of six years and the useful life of the plant is 12 years. The lease is non-cancellable, and there are no rights to extend the lease term or purchase the machine at the end of the term. There are no guarantees of its value at that point. The lessor does not have the right of access to the plant until the end of the contract or unless permission is granted by Holcombe.
Fixed lease payments are due annually over the lease term after delivery of the plant, which is maintained by Holcombe. Holcombe accounts for the lease as an operating lease but the directors are unsure as to whether the accounting treatment of an operating lease is conceptually correct.
Required:
(i) Discuss the reasons why the current lease accounting standards may fail to meet the needs of users and
could be said to be conceptually fl awed; (7 marks)
(ii) Discuss whether the plant operating lease in the fi nancial statements of Holcombe meets the defi nition
of an asset and liability as set out in the ‘Statement of Principles for Financial Reporting.’ (7 marks)
Professional marks will be awarded in part (a) (i) and (ii) for clarity and quality of discussion. (2 marks)
(b) Holcombe also owns an offi ce building with a remaining useful life of 30 years. The carrying amount of the building is £120 million and its fair value is £150 million. On 1 May 2009, Holcombe sells the building to Brook, a public limited company, for its fair value and leases it back for fi ve years at an annual rental payable in arrears of £16 million on the last day of the fi nancial year (30 April). This is a fair market rental. Holcombe’s incremental borrowing rate is 8%.
On 1 May 2009, Holcombe has also entered into a short operating lease agreement to lease another building. The lease will last for three years and is currently £5 million per annum. However an infl ation adjustment will be made at the conclusion of leasing years 1 and 2. Currently infl ation is 4% per annum.
The following discount factors are relevant (8%).
Single cash fl ow Annuity Year 1 0·926 0·926 Year 2 0·857 1·783 Year 3 0·794 2·577 Year 4 0·735 3·312 Year 5 0·681 3·993
Required:
(i) Show the accounting entries in the year of the sale and lease back assuming that the operating lease is
recognised as an asset in the balance sheet of Holcombe; (6 marks)
(ii) State how the infl ation adjustment on the short term operating lease should be dealt with in the fi nancial
statements of Holcombe. (3 marks)
(25 marks)
End of Question Paper
Answers
11
Professional Level – Essentials Module, Paper P2 (UK)
Corporate Reporting (United Kingdom) June 2010 Answers
1 (a) Ashanti Group: Profi t and Loss Account for the year ended 30 April 2010 (see working 1)
Ashanti £m
Turnover 1,096Cost of sales (851 ) –––––––Gross profi t 245Distribution costs (64 )Administration expenses (94·71 )Other operating income 54 –––––––Operating profi t before interest 140·29Loss on sale of operations (9·44 )Profi t from associate 2·1Net interest costs (33·31 ) –––––––Profi t on ordinary activities before tax 99·64Taxation (49 ) –––––––Profi t on ordinary activities after taxation 50·64 ––––––– –––––––Minority Interest (W8) (8·66 ) ––––––– –––––––Profi t on ordinary activities after minority interest 41·98 ––––––– –––––––Statement of Total Recognised Gains and LossesProfi t for fi nancial year 50·64Available-for-sale fi nancial assets (AFS) 32·6Associate gain 0·9Gains (net) on fi xed assets revaluation 18·6Actuarial losses on defi ned benefi t plan (14 ) –––––––Total Recognised Gains and Losses for year 88·74 ––––––– –––––––
Total Recognised Gains and Losses attributable to:
£mEquity holders of the parent 73·99Minority interest (W8) (8·66 + 6·09) 14·75 ––––––– 88·74 –––––––
12
Working 1
Ashanti Bochem Ceram Adjustment Total £m £m £m £m £mTurnover 810 235 71 (15 )Revenue from illiquid customer (5 ) 1,096Inter company profi t (£5m x 20%) (1 )Cost of sales (686 ) (137 ) (42 ) 15 (851) –––––– ––––– ––– ––– ––––––Gross profi t 118 98 29 245Distribution costs (30 ) (21 ) (13 ) (64)Administrative expenses (55 ) (29 ) (6 )Mis-selling accrual (W7) (0·21 )Depreciation (W2) (2 )Loss on revaluation of plant and machinery (W6) (0·6 )Impairment of goodwill (W2) (1·9 ) (94·71)Other income 31 17 6 54Accrual of bond interest (W4) 1·67Impairment of bond (W4) (13·98 )Impairment of trade receivable (3 )Net interest costs (8 ) (6 ) (4 ) (33·31)Sale of equity interest (W2) 8·06Loss on sale of Ceram (W3) (17·5 ) (9·44)Share of profi ts of associate (W3) 2·1 2·10 –––––– ––––– ––– ––––––Profi t before tax 46·04 41·6 12 99·64Income tax expense (21 ) (23 ) (5 ) (49) –––––– ––––– ––– ––––––Profi t for the year 25·04 18·6 7 50·64 –––––– ––––– ––– –––––– –––––– ––––– ––– ––––––Statement of Total Recognised Gains and LossesAvailable for sale fi nancial assets 20 9 3 32·6Loss on bond now recognised 0·6Gains on property revaluation 12 6 –Revaluation adjustment 0·6 18·6Actuarial losses on defi ned benefi t plan (14 ) – – (14)Share of associate available-for-sale fi nancial assets (W3) 0·9 0·9 –––––– ––––– ––– ––––––Recognised Gains and Losses 19·2 15·9 3 38·1 –––––– ––––– ––– ––––––Total Recognised Gains and Losses 44·24 34·5 10 88·74 –––––– ––––– ––– –––––– –––––– ––––– ––– ––––––
Working 2 Bochem
£mFair value of consideration for 70% interest 150Fair value of identifi able net assets acquired (70% of £160m) (112) –––––Goodwill 38 –––––Depreciation of plantFair value of identifi able net assets 160Book value (£55m + £85m + £10m) (150) –––––Plant revaluation 10 –––––Dr Profi t or loss (£10 x 1/5) 2Dr Retained earnings 2Cr Accumulated depreciation 4
Goodwill impairmentUp to 30 April 2009, £38m x 15% £5·7 millionFurther impairment up to 30 April 2010, £38 x 5% £1·9 million ––––Total impairment £7·6 million ––––
Sale of equity interest in BochemFair value of consideration received 34Less Net assets disposed (Net assets per question atyear end £210m + Fair value of PPE at acquisition£10m – depreciation of fair value adjustment £4m) x 10% (21·6)Goodwill (38 – 7·6) x 10/70 (4·34) –––––Gain on disposal 8·06 –––––
13
Working 3 Ceram
£m £mFair value of consideration for 80% interest 136Indirect holding in Ceram – MI (30% of 136) (40·8 ) 95·2 –––––Fair value of identifi able net assets acquired (56% x £115m) (64·4 ) –––––Goodwill 30·8 –––––
The fair value of the consideration held in Ceram represents the 80% shareholding purchased by Bochem. The 30% element that belongs to the MI of Bochem needs to be deducted thereby giving the net balance representing the effective 56% (70% of 80%) shareholding from the group viewpoint.
As Bochem has sold a controlling interest in Ceram, a gain or loss on disposal should be calculated. Additionally, the results of Ceram should only be consolidated in the profi t and loss account for the six months to 1 November 2009. Thereafter Ceram should be equity accounted. However, goodwill could be calculated from the entity’s perspective which would give a signifi cantly different goodwill and gain/loss on disposal fi gure.
The loss recognised in the profi t and loss account would be as follows:
£mFair value of consideration 90Less: net assets and goodwill derecognised net assets (160 x 50%) (80 ) goodwill (30·8 x 50/56) (27·5 ) –––––Loss on disposal to profi t or loss (17·5 ) –––––
The loss above has been calculated from Bochem’s viewpoint and therefore a portion of this loss belongs to the MI of Bochem.
The share of the profi ts of the associate would be 30% of a half years’ profi t (£7m) i.e. £2·1 million and 30% of half of the gain on the AFS investments i.e. £0·9 million.
Working 4 Bond
£mCarrying value at 1 May 2009 20·45Accrual of half year interest (4%) to 31 October 2009 0·82 –––––– 21·27Accrual of half year interest (4%) to 30 April 2010 0·85 ––––––Carrying value at 30 April 2010 22·12 ––––––Interest accrual (0·82 + 0·85) 1·67Fair value of bond at 30 April(£2·34m discounted at 10% + £8m discounted at 10% for two years) 8·74 ––––––Impairment of bond (22·12 – 8·74) 13·38Reclassifi cation of loss in equity 0·6 ––––––Impairment recognised in profi t or loss 13·98 ––––––
Note: the accrual of interest could also be based on the amortised cost at 1 May 2009 as an alternative to the carrying value.
Working 5
Ashanti should not record the revenue of £5 million, as it is not probable that economic benefi t relating to the sale will fl ow to Ashanti. The revenue will be recorded when the customer pays for the goods. The cost of the goods will remain in the fi nancial statements and the allowance for doubtful debts will be reduced to £3 million.
Working 6
£mCarrying value at 1 May 2009 13Less depreciation for year (1·44 ) –––––– 11·56Fall in value to depreciated historical cost to STRGL (1·96 ) ––––––Depreciated historical cost at end of year to April 2010 9·6Fall in value to recoverable amount to P/L (0·6 ) –––––– 9Fall in value – revaluation to STRGL (1 ) ––––––Value in balance sheet 8 ––––––
14
The above treatment is applied where there is no obvious consumption of economic benefi ts as regards the fi xed assets.
At 30 April 2009, a revaluation gain of (£13m – £12m – depreciation £1·2m) £2·2 million would be recorded in equity for the plant and machinery. At 30 April 2010, the value of the PPE would be £13m – depreciation of £1·44m i.e. £11·56m. Thus there will be a revaluation loss of £11·56m – £8m i.e. £3·56m. Of this amount £2·96 million (£1·96m + £1m) will be charged against revaluation surplus in reserves and £0·6 million will be charged to profi t or loss.
Working 7
A provision should be made under FRS 12 for the mis-selling obligation as the costs clearly arise from a past event which was the sale of goods to the customers. Ashanti should provide for the fi ne and the amount anticipated to be paid to customers. The costs to improve the company’s system and the training costs relate to the company’s future operations and are not provided for.
Accrual is therefore £40,000 + £170,000 = £0·21m
Working 8
Minority interest (MI)MI in profi ts for year is (30% of £18·6m + 44% of £7 million) = £8·66mMI in other recognised income is (30% x £15·9m + 44% of £3m) = £6·09m –––––––– £14·75m ––––––––
(b) The Accounting Standards Board (ASB) has published amendments to FRS 26 Financial Instruments: Recognition and Measurement and FRS 29 Financial Instruments: Disclosures. The amendments are an attempt to create a ‘level playing fi eld’ with US GAAP regarding the ability to reclassify fi nancial assets. The changes to FRS 26 permit an entity to reclassify non-derivative fi nancial assets out of the ‘fair value through profi t or loss’ (FVTPL) and ‘available-for-sale’ (AFS) categories in limited circumstances. Such reclassifi cations will create additional disclosures. The amendments will only permit reclassifi cation of certain non-derivative fi nancial assets. Financial liabilities, derivatives and fi nancial assets that are designated as at FVTPL on initial recognition under the ‘fair value option’ cannot be reclassifi ed. The amendments therefore only permit reclassifi cation of debt and equity fi nancial assets subject to meeting specifi ed criteria. The amendments do not permit reclassifi cation into FVTPL or AFS at initial recognition.
A debt instrument that would have met the defi nition of loans and receivables, if it had not been required to be classifi ed as held for trading at initial recognition, may be reclassifi ed to loans and receivables if the entity has the intention and ability to hold the asset for the foreseeable future or until maturity. A debt instrument classifi ed as AFS that would have met the defi nition of loans and receivables may be reclassifi ed to the category if the entity has the same intention and ability as above. Any other debt instrument, or any equity instrument, may be reclassifi ed from FVTPL to AFS, or from FVTPL to Held to Maturity (HTM) (in the case of debt instruments only), if the fi nancial asset is no longer held for the purpose of selling in the near term – but only in ‘rare’ circumstances. The ASB acknowledged that volatile and illiquid market conditions are a possible example of a ‘rare’ circumstance.
All reclassifi cations must be made at the fair value of the fi nancial asset at the date of reclassifi cation. Any previously recognised gains or losses cannot be reversed. The fair value at the date of reclassifi cation becomes the new cost or amortised cost of the fi nancial asset, as applicable.
For reclassifi cations out of AFS, FRS 26 requires the amounts previously recognised in STRGL to be reclassifi ed to profi t and loss either through the effective interest rate or at disposal. Amounts deferred in equity may also need to be reclassifi ed to profi t or loss if there is impairment.
Allowing reclassifi cation, even in limited circumstances, will allow an entity to manage its reported profi t or loss by avoiding future fair value gains or losses on the reclassifi ed assets. The intention of this is to ensure that previously impaired cash fl ows are refl ected in the profi t and loss account over the life of the asset rather than as immediate income effectively deferring the loss in the hope that economic conditions will improve. The ASB normally publishes an exposure draft of any proposed amendments to standards to invite comments from interested parties. However, the ASB decided to proceed directly to issuing the amendments without any due process. This exceptional step could lead to management of earnings by some entities as the amendments relax the existing requirements to provide ‘short-term relief’ for some entities. This relief effectively means that anticipated losses could be avoided by entities. It could be argued that the amendments are a short-term response to a current crisis, which because of the lack of exposure could lead to longer-term issues.
(c) ‘Earnings management’ has been defi ned in various ways. It can be described as the purposeful intervention in the external fi nancial reporting process with the intent of obtaining some private gain. Alternatively it can be the use of judgment in fi nancial reporting and in structuring transactions to alter fi nancial reports to either mislead stakeholders about the underlying economic performance of the company, or to infl uence contractual outcomes that depend on reported accounting judgments.
Incentives lie at the heart of earnings management. Managers should make accounting judgments and decisions solely with the intention of fairly reporting operating performance. However, there are often economic incentives for managers to engage in earnings management, because the value of the fi rm and the wealth of its managers or owners are normally linked to reported earnings. Contractual incentives to manage earnings arise when contracts between a company and other parties rely upon fi nancial statements to determine fi nancial exchanges between them. By managing the results of operations, managers can alter the amount and timing of those exchanges. Contractual situations could stimulate earnings management. These would
15
include debt covenants, management compensation agreements, job security, and trade union negotiations. Market incentives to manage earnings arise when managers perceive a connection between reported earnings and the company’s market value. Regulatory incentives to manage earnings arise when reported earnings are thought to infl uence the actions of regulators or government offi cials. By managing the results of operations, managers may infl uence the actions of regulators or government offi cials, thereby minimising political scrutiny and the effects of regulation.
One way in which directors can manage earnings is by manipulation of accruals with no direct cash fl ow consequences. Examples of accrual manipulation include under-provisioning for irrecoverable debt expenses, delaying of asset write-offs and opportunistic selection of accounting methods. Accrual manipulation is a convenient form of earnings management because it has no direct cash fl ow implications and can be done after the year-end when managers are better informed about earnings. However, managers also have incentives to manipulate real activities during the year with the specifi c objective of meeting certain earnings targets. Real activity manipulation affects both cash fl ows and earnings.
Where management does not try to manipulate earnings, there is a positive effect on earnings quality. The earnings data is more reliable because management is not infl uencing or manipulating earnings by changing accounting methods, or deferring expenses or accelerating revenues to bring about desired short-term earnings results. The absence of earnings management does not, however, guarantee high earnings quality. Some information or events that may affect future earnings may not be disclosed in the fi nancial statements. Thus, the concept of earnings management is related to the concept of earnings quality. One major objective of the ASB Statement of Principles is to assist investors and creditors in making investing and lending decisions. The Statement refers not only to the reliability of fi nancial statements, but also to the relevance and predictive value of information presented in fi nancial statements.
Entities have a social and ethical responsibility not to mislead stakeholders. Ethics can and should be part of a corporate strategy, but a company’s fi rst priority often is its survival and optimising its profi ts in a sustainable way. Management of earnings may therefore appear to have a degree of legitimacy in this regard but there is an obvious confl ict. An ethical position that leads to substantial and long-term disadvantages in the market place will not be acceptable to an entity.
It is reasonable and realistic not to rely exclusively on personal morality. A suitable economic, ethical and legal framework attempts to ensure that the behaviour of directors conforms to moral standards. Stakeholders depend on the moral integrity of the entity’s directors. Stakeholders rely upon core values such as trustworthiness, truthfulness, honesty, and independence although these cannot be established exclusively by regulation and professional codes of ethics. Thus there is a moral dilemma for directors in terms of managing earnings for the benefi t of the entity, which might directly benefi t stakeholders and themselves whilst at the same time possibly misleading the same stakeholders.
2 (a) Deferred taxation
A deferred tax asset should be recognised if it is more likely than not that it will be recovered. A key requirement of FRS 19 ‘Deferred Tax’ is that deferred tax assets should only be ‘recognised’ to the extent that, on the basis of all available evidence, it can be regarded as more likely than not that there will be suitable profi ts from which the future reversal of the underlying timing differences can be deducted. The recognition of deferred tax assets on losses carried forward does not seem to be in accordance with FRS 19. Cate is not able to provide convincing evidence that suffi cient taxable profi ts will be generated against which the unused tax losses can be offset. According to FRS 19 the existence of unused tax losses is strong evidence that future taxable profi t may not be available against which to offset the losses. Therefore when an entity has a history of recent losses, the entity recognises deferred tax assets arising from unused tax losses only to the extent that the entity has evidence that there will be suitable taxable profi ts from which the future reversal of the underlying timing differences can be deducted. As Cate has a history of recent losses and as it does not have suffi cient taxable temporary differences, Cate needs to provide convincing other evidence that suffi cient taxable profi t would be available against which the unused tax losses could be offset. The unused tax losses in question did not result from identifi able causes, which were unlikely to recur as the losses are due to ordinary business activities. Additionally there are no tax planning opportunities available to Cate that would create taxable profi t in the period in which the unused tax losses could be offset (FRS 19).
Thus at 31 May 2010 it is unlikely that the entity would generate taxable profi ts before the unused tax losses expired. The improved performance in 2010 would not be indicative of future good performance as Cate would have suffered a net loss before tax had it not been for the non-operating gains.
Cate’s anticipation of improved future trading could not alone be regarded as meeting the requirement for strong evidence of future profi ts. When assessing the use of carry-forward tax losses, weight should be given to revenues from existing orders or confi rmed contracts rather than those that are merely expected from improved trading. Thus the recognition of deferred tax assets on losses carried forward is not in accordance with FRS 19 as Cate is not able to provide convincing evidence that suffi cient taxable profi ts would be generated against which the unused tax losses could be offset.
(b) Investment
Cate’s position for an investment where the investor has signifi cant infl uence and its method of calculating fair value can be challenged.
An asset’s recoverable amount represents its greatest value to the business in terms of its cash fl ows that it can generate i.e. the higher of net realisable value (which is what the asset can be sold for less direct selling expenses) and value in use (the cash fl ows that are expected to be generated from its continued use including those from its ultimate disposal). The assets recoverable amount is compared with its carrying value to indicate any impairment. Both net realisable value and value in use
16
can be diffi cult to determine. However, it is not always necessary to calculate both measures, as if the NRV or value in use is greater than the carrying amount, there is no need to estimate the other amount.
It should be possible in this case to calculate a fi gure for the recoverable amount. Cate’s view that market price cannot refl ect the fair value of signifi cant holdings of equity such as an investment in an associate is incorrect as FRS 11 ‘Impairment of fi xed assets and goodwill’ prescribes the method of conducting the impairment test in such circumstances by stating that if there is no binding sale agreement but an asset is traded in an active market, fair value less costs to sell is the asset’s market price less the costs of disposal. Further, the appropriate market price is usually the current bid price.
Additionally investments in associates generate discrete cash fl ows and should be considered individually. Their value in use should normally be based on the future cash fl ows of the underlying entities that are attributable to the group’s interest rather than on the dividend cash fl ows. Investments in associates come within the scope of FRS 11. Estimates of future cash fl ows should be produced. These cash fl ows are then discounted to present value hence giving value in use.
It seems as though Cate wishes to avoid an impairment charge on the investment.
(c) FRS 3 ‘Reporting Financial Performance’
An undertaking will cease to be a subsidiary when a group sells or reduces its percentage interest in the undertaking below 50%. Similarly a parent may lose control because of changes in the rights it holds or those held by another party in that undertaking. A reduction in the percentage interest may arise from a direct disposal or from an indirect disposal, for example the exercise of share options by another party or the subsidiary issues shares to other non-group parties as in the case of Cate. A gain or loss will normally arise in both cases. A partial disposal of an interest in a subsidiary in which the parent company loses control but retains an interest as an associate or trade investment creates the recognition of a gain or loss on the interest disposed of. The profi t or loss should be calculated as the difference between the carrying amount of the net assets of the subsidiary attributable to the group’s interest before the reduction and the carrying amount of the net assets of the subsidiary attributable to the group’s interest after the reduction including any proceeds received. The net assets include any related goodwill not written off. In this case, Cate should stop consolidating Date on a line-by-line basis from the date that control was lost. Further investigation is required into whether the holding is treated as an associate or trade investment. The agreement that Cate is no longer represented on the board or able to participate in management would suggest loss of signifi cant infl uence despite the 35% of voting rights retained.
FRS 3 requires the profi t or loss on sale of an asset to be calculated by reference to the carrying value of that asset and confl icts with FRS 2 calculation above as goodwill is used in the calculation. Also the important components, which FRS 3 requires to be highlighted, are:
(a) the results of continuing operations (separately highlighting the results of acquisitions in the year, if material); (b) the results of discontinued operations; (c) the results of exceptional transactions – analysed over continuing and discontinued operations.
FRS 3 defi nes a discontinued operation as an operation that is sold or terminated and that satisfi es all of the following conditions:
(a) the sale or termination is completed either in the period or before the earlier of three months after the commencement of the subsequent period or the date on which the fi nancial statements are approved;
(b) if a termination, the former activities have ceased permanently; (c) the sale or termination has a material effect on the nature and focus of the reporting entity’s operations and represents a
material reduction in its operating facilities resulting either from its withdrawal from a particular market (whether class of business or geographical) or from a material reduction in turnover in continuing markets;
(d) the assets, liabilities, results of operations and activities are clearly distinguishable, physically and operationally and for fi nancial reporting purposes.
Cate has not met all of the conditions of FRS 3 but it could be argued that the best presentation in the fi nancial statements is that set out in FRS 3 for the following reasons.
The decision not to subscribe to the issue of new shares of Date is clearly a change in the strategy of Cate. Further by deciding not to subscribe to the issue of new shares of Date, Cate agreed to the dilution and the loss of control, which could be argued, is similar to a decision to sell shares while retaining a continuing interest in the entity. Also Date represents a separate distinguishable line of business, which is a determining factor in FRS 3, and information disclosed on FRS 3 principles highlights the impact of Date on Cate’s fi nancial statements. Finally, the agreement between Date’s shareholders confi rms that Cate has lost control over its former subsidiary.
The results of Date should be classifi ed as discontinued if the retained interest is not being subject to signifi cant infl uence by the group.
(d) Defi ned benefi t plan
The Plan is not a defi ned contribution plan because Cate has a legal or constructive obligation to pay further contributions if the fund does not have suffi cient assets to pay all employee benefi ts relating to employee service in the current and prior periods (FRS 17 Para’s 2, 20). All other post-employment benefi t plans that do not qualify as a defi ned contribution plan are, by defi nition therefore defi ned benefi t plans. Defi ned benefi t plans may be unfunded, or they may be wholly or partly funded. Also FRS 17 indicates that Cate’s plan is a defi ned benefi t plan as it shows that an entity’s obligation is not limited to the amount that it agrees to contribute to the fund. An example of a constructive obligation is a practice of granting annual increases
17
to pensions in payment and deferred pensions that are discretionary but are in practice granted as a measure of protection against infl ation. The cost of the increases should be factored into the annual service cost and scheme liability. According to the terms of the Plan, if Cate opts to terminate, Cate is responsible for discharging the liability created by the Plan. FRS 17 says that an entity should account not only for its legal obligation under the formal terms of a defi ned benefi t plan, but also for any constructive obligation that arises from the enterprise’s informal practices. Informal practices give rise to a constructive obligation where the enterprise has no realistic alternative but to pay employee benefi ts. Even if the Plan were not considered to be a defi ned benefi t plan under FRS 17, Cate would have a constructive obligation to provide the benefi t, having a history of paying benefi ts. The practice has created a valid expectation on the part of employees that the amounts will be paid in the future. Therefore Cate should account for the Plan as a defi ned benefi t plan in accordance with FRS 17. Cate has to recognise, at a minimum, its net present liability for the benefi ts to be paid under the Plan.
3 Financial Instruments
(a) FRS 26 Financial Instruments ‘Recognition and measurement’ states that derivative is a fi nancial instrument:
(i) Whose value changes in response to the change in an underlying variable such as an interest rate, commodity or security price, or index; such as the price of edible oil;
(ii) That requires no initial investment, or one that is smaller than would be required for a contract with similar response to changes in market factors; in the case of the future purchase of oil, the initial investment is nil; and
(iii) That is settled at a future date.
However, when a contract’s purpose is to take physical delivery in the normal course of business, then normally the contract is not considered to be a derivative contract, unless the entity has a practice of settling the contracts on a net basis. In this case the contracts will be considered to be derivative contracts and should be accounted for at fair value through profi t and loss. Even though the entity sometimes takes physical delivery, the entity has a practice of settling similar contracts on a net basis and taking delivery, only to sell shortly afterwards. Hedge accounting techniques may be used if the conditions in FRS 26 are met.
FRS 26 permits hedge accounting under certain circumstances provided that the hedging relationship is: formally designated and documented, including the entity’s risk management objective and strategy for undertaking the hedge, identifi cation of the hedging instrument, the hedged item, the nature of the risk being hedged, and how the entity will assess the hedging instrument’s effectiveness; and expected to be highly effective in achieving offsetting changes in fair value or cash fl ows attributable to the hedged risk as designated and documented, and the effectiveness can be reliably measured.
Seltec would use cash fl ow or fair value hedge accounting. A fair value hedge is a hedge of the exposure to changes in fair value of a recognised asset or liability or a previously unrecognised fi rm commitment to buy or sell an asset at a fi xed price or an identifi ed portion of such an asset, liability or fi rm commitment, that is attributable to a particular risk and could affect profi t or loss. The gain or loss from the change in fair value of the hedging instrument is recognised immediately in profi t or loss. At the same time the carrying amount of the hedged item is adjusted for the corresponding gain or loss with respect to the hedged risk, which is also recognised immediately in net profi t or loss.
A cash fl ow hedge is a hedge of the exposure to variability in cash fl ows that (i) is attributable to a particular risk associated with a recognised asset or liability (such as all or some future interest payments on variable rate debt) or a highly probable forecast transaction and (ii) could affect profi t or loss [FRS 26]. The portion of the gain or loss on the hedging instrument that is determined to be an effective hedge is recognised directly in equity and reclassifi ed to the profi t and loss account when the hedged cash transaction affects profi t or loss [FRS 26].
FRS 26 is restrictive because of the diffi culty of isolating and measuring the cash fl ows attributable to the specifi c risks for the non-fi nancial items. Assuming all of the documentation criteria are met, Seltec can use hedge accounting but may favour a fair value hedge in order to reduce earnings volatility. All price changes of the edible oil will be taken into account including its type and geographical location and compared with changes in the value of the future. If the contracts have different price elements, then ineffectiveness will occur. Hedge accounting can be applied as long as the ineffectiveness is not outside the range 80%–125%.
FRS 26 defi nes an embedded derivative as a component of a hybrid instrument that also includes a non-derivative host contract, with the effect that some of the cash fl ows of the instrument vary in a way similar to a stand-alone derivative. As derivatives must be accounted for at fair value in the balance sheet with changes recognised through profi t or loss, so must some embedded derivatives. FRS 26 requires that an embedded derivative should be separated from its host contract and accounted for as a derivative when:
(i) the economic risks and characteristics of the embedded derivative are not closely related to those of the host contract; (ii) a separate instrument with the same terms as the embedded derivative would meet the defi nition of a derivative; and (iii) the entire instrument is not measured at fair value with changes in fair value recognised in profi t or loss.
If an embedded derivative is separated, the host contract is accounted for under the appropriate standard. A foreign currency denominated contract contains an embedded derivative unless it meets one of the following criteria:
(i) the foreign currency denominated in the contract is that of either party to the contract, (ii) the currency of the contract is that in which the related good or service is routinely denominated in commercial
transactions, (iii) the currency is that commonly used in such contracts in the market in which the transaction takes place.
18
In this case the dollar is not the functional currency of either party, oil is not routinely denominated in dollars but sterling as most of Seltec’s trade as regards the oil appears to be in sterling and the currency is not that normally used in business transactions in the environment in which Seltec carries out its business. Additionally, the economic risks are not closely related as currency fl uctuations and changes in the price of oil have different risks. The host contract is not measured at fair value but would meet the defi nition of a derivative if it were a separate instrument with the same terms. The currency derivative should therefore be accounted for at fair value through profi t or loss.
(b) Intangible assets and purchase of entities
FRS 10 states that where intangible assets are regarded as having limited useful economic lives, they should be amortised on a systematic basis over those lives.
Where intangible assets are regarded as having indefi nite useful economic lives, they should not be amortised.
A life of more than 20 years, or an indefi nite life, may only be taken if:
(a) the durability of the intangible asset can be demonstrated and justifi es estimating the useful economic life to exceed 20 years; (b) the goodwill or intangible asset is capable of continued measurement (so that annual impairment reviews will be feasible).
The useful life of an intangible asset is defi ned in FRS 10 as ‘the period over which the entity expects to derive economic benefi ts from that asset’.
Factors that should be considered are:
(i) The nature of the business and the stability of the industry as well as the entity’s commitment to support the brand (ii) The extent to which the brand has long-term potential that is not underpinned by short-term fashion or trends. That is,
the brand has had a period of proven success (iii) The extent to which the products carrying the brand are resistant to changes in the operating environment. These products
should be resistant to changes in legal, technological and competitive environments.
These factors combine to present an overall picture of the durability of the brand. The brand of oil, which has been in existence for many years, could be said to have an indefi nite life as it has already proven its longevity having been successful for many years. FRS 10 requires that the useful life be reviewed at the end of each reporting period and revised if necessary. Its useful life should be reviewed each reporting period to determine whether events and circumstances continue to support an indefi nite useful life assessment for that asset. If they do not, the change in the useful life assessment from indefi nite to fi nite should be accounted for as a change in an accounting estimate. There should be an impairment review at the end of each reporting period.
However, the oil named after a famous fi lm star is likely to decline in popularity as the popularity of the fi lm star declines. It is a new product and its longevity has not been proven and therefore it is likely to have a fi nite life. The cost less residual value of an intangible asset with a fi nite useful life should be amortised on a systematic basis over that life. The amortisation method should refl ect the expected pattern of depletion but a straight-line method should be chosen unless another method can be demonstrated to be more appropriate.
A business combination is a transaction or event in which an acquirer obtains control of one or more undertakings. An undertaking is defi ned as a ‘body corporate, partnership or an unincorporated association carrying on a trade or business with or without a view to profi t’. The two entitles do not meet the defi nition of an undertaking in FRS 2 ‘Accounting for Subsidiary Undertakings’ as they are not carrying on a trade such as real estate management which are applied to the retail space that they own. The entities do not generate any outputs such as rental income. Therefore the acquisition should be treated as a purchase of assets.
4 (a) (i) The existing accounting model for leases has been criticised for failing to meet the needs of users of fi nancial statements. It can be argued that operating leases give rise to assets and liabilities that should be recognised in the fi nancial statements of lessees. Consequently, users may adjust the amounts recognised in fi nancial statements in an attempt to recognise those assets and liabilities and refl ect the effect of lease contracts in profi t or loss. The information available to users in the notes to the fi nancial statements is often insuffi cient to make reliable adjustments to the fi nancial statements.
The existence of two different accounting methods for fi nance leases and operating leases means that similar transactions can be accounted for very differently. This affects the comparability of fi nancial statements. Also current accounting standards provide opportunities to structure transactions so as to achieve a specifi c lease classifi cation. If the lease is classifi ed as an operating lease, the lessee obtains a source of fi nancing that can be diffi cult for users to understand, as it is not recognised in the fi nancial statements.
Existing accounting methods have been criticised for their complexity. In particular, it has proved diffi cult to defi ne the dividing line between the principles relating to fi nance and operating leases. As a result, standards use a mixture of subjective judgments and rule based criteria that can be diffi cult to apply.
The existing accounting model can be said to be conceptually fl awed. On entering an operating lease contract, the lessee obtains a valuable right to use the leased item. This right meets the Statement of Principle’s defi nition of an asset. Additionally the lessee assumes an obligation to pay rentals that meet the Statement of Principle’s defi nition of a liability. However, if the lessee classifi es the lease as an operating lease, that right and obligation are not recognised.
19
There are signifi cant and growing differences between the accounting methods for leases and other contractual arrangements. This has led to inconsistent accounting for arrangements that meet the defi nition of a lease and similar arrangements that do not. For example leases are fi nancial instruments but they are scoped out of FRS 25/26.
(ii) An asset is a right or other access to future economic benefi ts controlled by an entity as a result of past transactions or events. Holcombe has the right to use the leased plant as an economic resource because the entity can use it to generate cash infl ows or reduce cash outfl ows. Similarly, Holcombe controls the right to use the leased item during the lease term because the lessor is unable to recover or have access to the resource without the consent of the lessee or unless there is a breach of contract. The control results from past events, which is the signing of the lease contract and the receipt of the plant by the lessee. Holcombe also maintains the asset.
Unless the lessee breaches the contract, Holcombe has an unconditional right to use the leased item. Future economic benefi ts will fl ow to the lessee from the use of the leased item during the lease term. Thus it could be concluded that the lessee’s right to use a leased item for the lease term meets the defi nitions of an asset in the Statement of Principles.
A liability is an obligation to transfer economic benefi ts as a result of past transactions or events. The obligation to pay rentals is a liability. Unless Holcombe breaches the contract, the lessor has no contractual right to take possession of the item until the end of the lease term. Equally, the entity has no contractual right to terminate the lease and avoid paying rentals. Therefore, the lessee has an unconditional obligation to pay rentals. Thus the entity has a present obligation to pay rentals which arises out of a past event, which is the signing of the lease contract and the receipt of the item by the lessee. Finally the obligation is expected to result in an outfl ow of economic benefi ts in the form of cash.
Thus the entity’s obligation to pay rentals meets the defi nition of a liability in the Statement of Principles.
(b) (i) On sale of the building Holcombe will recognise the following in the fi nancial statements to 30 April 2010:
Dr Cash £150m Cr Offi ce building £120m Cr Deferred Income (B/S) £30m Recognition of gain on the sale of the building
Dr Deferred Income (B/S) £6m Cr Deferred Income (P&L) £6m Release of the gain on sale of the building (£30m/5 years)
Dr Operating lease asset £63·89m Cr Obligation to pay rentals £63·89m Recognition of the leaseback at net present value of lease payments using 8% discount rate
In the fi rst year of the leaseback, Holcombe will recognise the following:
Dr Lease obligation – rentals £16m Cr Cash £16m Recognition of payment of rentals
Dr Interest expense £5·11m Cr Lease obligation £5·11m Recognition of interest expense (£63·89m x 8%)
Dr Depreciation expense £12·78m Cr Right-of-use asset £12·78m Recognition of depreciation of operating lease asset over fi ve years (£63·89m/5 years). The balance sheet will show a
carrying value of £51·11m being cost of £63·89m less depreciation of £12·78m.
An alternative to the above is to leave the carrying amount of the asset unchanged and the proceeds are effectively treated as a creditor. This is not referred to in SSAP 21 but is suggested as an alternative in para 155 of the guidance notes to the standard. The justifi cation of this treatment is that the substance of the transaction is the raising of fi nance and there is no reason why the asset value should be changed. Payments under the terms of the lease should be split between capital and fi nance charge. The fi nance charge should be charged to the profi t and loss account and the capital part deducted from the creditor fi gure.
(ii) Infl ation adjustments should be recognised in the period in which they are incurred as they are effectively contingent rent and are not included in any minimum lease calculations. The amount would be recognised when a present obligation exists that will require a transfer of economic benefi ts. Thus in this case, Holcombe would recognise operating rentals of £5 million in year 1, £5 million in year 2 plus the infl ation adjustment at the beginning of year 2, and £5 million in year 3 plus the infl ation adjustment at the beginning of year 2 plus infl ation adjustment at the beginning of year 3. Based on current infl ation, the rent will be £5·2 million in year 2 and £5·408 million in year 3.
21
Professional Level – Essentials Module, Paper P2 (UK)
Corporate Reporting (United Kingdom) June 2010 Marking Scheme
Marks1 (a) Consolidated Profi t and loss account 5 Bochem 8 Ceram 6 Stock 2 Bond 4 PPE 3 Impairment of customer 2 Employee benefi ts 2 MI 3 ––– 35
(b) Amendments to FRS 26/FRS 29 4 Management of earnings 3
(c) Description of management of earnings 3 Moral/ethical considerations 3 Professional marks 2 ––– 50 –––
2 Deferred tax 5 Investment in associate 5 FRS 3 Discussion and conclusion 8 FRS 17 Discussion and conclusion 5 Professional marks 2 ––– 25 –––
3 Hedge accounting 5 Futures 5 Embedded derivative 4 Brands 5 Business combinations 4 Professional marks 2 ––– 25 –––
4 (a) (i) Subjective 7
(ii) Subjective 7 Professional marks 2
(b) (i) Recognition of gain 1 Recognition of the leaseback 1 Recognition of payment of rentals 2 Recognition of interest expense and depreciation 2
(ii) Contingent rentals 3 ––– 25 –––
Professional Level – Essentials Module
Time allowedReading and planning: 15 minutesWriting: 3 hours
This paper is divided into two sections:
Section A – This ONE question is compulsory and MUST be attempted
Section B – TWO questions ONLY to be attempted
Do NOT open this paper until instructed by the supervisor.
During reading and planning time only the question paper may be annotated. You must NOT write in your answer booklet untilinstructed by the supervisor.
This question paper must not be removed from the examination hall.
Pape
r P2 (
UK
)
Corporate Reporting(United Kingdom)
Tuesday 14 June 2011
The Association of Chartered Certified Accountants
Section A – This ONE question is compulsory and MUST be attempted
1 Rose, a public limited company, operates in the mining sector. The draft statements of financial position are as follows,at 30 April 2011:
Rose Petal Stem$m $m Dinars m
Assets:Non-current assetsProperty, plant and equipment 370 110 380Investments in subsidiariesPetal 113Stem 46Financial assets 15 7 50
–––– –––– ––––544 117 430
Current assets 118 100 330–––– –––– ––––
Total assets 662 217 760–––– –––– ––––
Equity and liabilities:Share capital 158 38 200Retained earnings 256 56 300Other components of equity 7 4 –
–––– –––– ––––Total equity and liabilities 662 217 760
–––– –––– ––––
The following information is relevant to the preparation of the group financial statements:
1 On 1 May 2010, Rose acquired 70% of the equity interests of Petal, a public limited company. The purchaseconsideration comprised cash of $94 million. The fair value of the identifiable net assets recognised by Petal was$120 million excluding the patent below. The identifiable net assets of Petal at 1 May 2010 included a patentwhich had a fair value of $4 million. This had not been recognised in the financial statements of Petal. The patenthad a remaining term of four years to run at that date and is not renewable. The retained earnings of Petal were$49 million and other components of equity were $3 million at the date of acquisition. The remaining excess ofthe fair value of the net assets is due to an increase in the value of land.
Rose wishes to use the ‘full goodwill’ method. The fair value of the non-controlling interest in Petal was $46 million on 1 May 2010. There have been no issues of ordinary shares since acquisition and goodwill onacquisition is not impaired.
Rose acquired a further 10% interest from the non-controlling interest in Petal on 30 April 2011 for a cashconsideration of $19 million.
2 Rose acquired 52% of the ordinary shares of Stem on 1 May 2010 when Stem’s retained earnings were 220 million dinars. The fair value of the identifiable net assets of Stem on 1 May 2010 was 495 million dinars.The excess of the fair value over the net assets of Stem is due to an increase in the value of land. The fair valueof the non-controlling interest in Stem at 1 May 2010 was 250 million dinars. Stem is located in a foreigncountry and operates a mine. Rose wishes to use the ‘full goodwill’ method to consolidate the financial statementsof Stem. There have been no issues of ordinary shares and no impairment of goodwill since acquisition. Thefunctional currency of Stem is the dinar.
2
The following exchange rates are relevant to the preparation of the group financial statements:
Dinars to $1 May 2010 630 April 2011 5Average for year to 30 April 2011 5·8
Stem currently operates under severe long-term restrictions that impair its ability to transfer funds to Rose. Controlof Stem has not been lost by Rose.
3 Rose has a property located in the same country as Stem. The property was acquired on 1 May 2010 and iscarried at a cost of 30 million dinars. The property is depreciated over 20 years on the straight-line method. At 30 April 2011, the property was revalued to 35 million dinars. Depreciation has been charged for the year butthe revaluation has not been taken into account in the preparation of the financial statements as at 30 April2011.
4 Rose commenced a long-term bonus scheme for employees at 1 May 2010. Under the scheme employeesreceive a cumulative bonus on the completion of five years service. The bonus is 2% of the total of the annualsalary of the employees. The total salary of employees for the year to 30 April 2011 was $40 million and adiscount rate of 8% is assumed. Additionally at 30 April 2011, it is assumed that all employees will receive thebonus and that salaries will rise by 5% per year.
5 Rose purchased plant for $20 million on 1 May 2007 with an estimated useful life of six years. Its estimatedresidual value at that date was $1·4 million. At 1 May 2010, the estimated residual value changed to $2·6 million. The change in the residual value has not been taken into account when preparing the financialstatements as at 30 April 2011.
Required:
(a) (i) Describe the UK Companies Act rules regarding the exclusion of subsidiaries from consolidation,discussing whether Stem would be excluded from consolidation under UK GAAP and InternationalFinancial Reporting Standards. (6 marks)
(ii) Prepare a consolidated statement of financial position of the Rose Group at 30 April 2011, inaccordance with International Financial Reporting Standards (IFRS), showing the exchange differencearising on the translation of Stem’s net assets. Ignore deferred taxation. (35 marks)
(b) Rose was considering acquiring a service company. Rose decided that in valuing the net assets of the servicecompany, the most advantageous accounting policies from UK GAAP and International Financial ReportingStandards would be utilised. The following accounting practices were proposed to be adopted by Rose.
(i) The deferred taxation balance was to be arrived at after discounting future amounts;
(ii) A lease of land and buildings was to be split into two elements. The lease of land was to be treated as anoperating lease and that of the building as a finance lease;
(iii) A choice was to be made not to capitalise development costs.
Required:
Discuss whether the above accounting practices are acceptable under UK GAAP and/or IFRS and whetherattempting to choose the most advantageous accounting treatment raises any ethical issues. (7 marks)
Professional marks will be awarded in part (b) for clarity and quality of the discussion. (2 marks)
(50 marks)
3 [P.T.O.
Section B – TWO questions ONLY to be attempted
2 Lockfine, a public limited company, operates in the fishing industry and has recently made the transition toInternational Financial Reporting Standards (IFRS). Lockfine’s reporting date is 30 April 2011.
(a) In the IFRS opening statement of financial position at 1 May 2009, Lockfine elected to measure its fishing fleetat fair value and use that fair value as deemed cost in accordance with IFRS 1 First Time Adoption ofInternational Financial Reporting Standards. The fair value was an estimate based on valuations provided by twoindependent selling agents, both of whom provided a range of values within which the valuation might beconsidered acceptable. Lockfine calculated fair value at the average of the highest amounts in the two rangesprovided. One of the agents’ valuations was not supported by any description of the method adopted or theassumptions underlying the calculation. Valuations were principally based on discussions with various potentialbuyers. Lockfine wished to know the principles behind the use of deemed cost and whether agents’ estimateswere a reliable form of evidence on which to base the fair value calculation of tangible assets to be then adoptedas deemed cost. (6 marks)
(b) Lockfine was unsure as to whether it could elect to apply IFRS 3 Business Combinations retrospectively to pastbusiness combinations on a selective basis, because there was no purchase price allocation available for certainbusiness combinations in its opening IFRS statement of financial position.
As a result of a major business combination, fishing rights of that combination were included as part of goodwill.The rights could not be recognised as a separately identifiable intangible asset at acquisition under the local GAAPbecause a reliable value was unobtainable for the rights. The fishing rights operated for a specified period of time.
On transition from local GAAP to IFRS, the fishing rights were included in goodwill and not separately identifiedbecause they did not meet the qualifying criteria set out in IFRS 1, even though it was known that the fishingrights had a finite life and would be fully impaired or amortised over the period specified by the rights. Lockfinewished to amortise the fishing rights over their useful life and calculate any impairment of goodwill as twoseparate calculations. (6 marks)
(c) Lockfine has internally developed intangible assets comprising the capitalised expenses of the acquisition andproduction of electronic map data which indicates the main fishing grounds in the world. The intangible assetsgenerate revenue for the company in their use by the fishing fleet and are a material asset in the statement offinancial position. Lockfine had constructed a database of the electronic maps. The costs incurred in bringing theinformation about a certain region of the world to a higher standard of performance are capitalised. The costsrelated to maintaining the information about a certain region at that same standard of performance are expensed.Lockfine’s accounting policy states that intangible assets are valued at historical cost. The company considers thedatabase to have an indefinite useful life which is reconsidered annually when it is tested for impairment. Thereasons supporting the assessment of an indefinite useful life were not however disclosed in the financialstatements and neither did the company disclose how it satisfied the criteria for recognising an intangible assetarising from development. (6 marks)
(d) The Lockfine board has agreed two restructuring projects during the year to 30 April 2011:
Plan A involves selling 50% of its off-shore fleet in one year’s time. Additionally, the plan is to make 40% of itsseamen redundant. Lockfine will carry out further analysis before deciding which of its fleets and relatedemployees will be affected. In previous announcements to the public, Lockfine has suggested that it mayrestructure the off-shore fleet in the future.
Plan B involves the reorganisation of the headquarters in 18 months’ time, and includes the redundancy of 20%of the headquarters’ workforce. The company has made announcements before the year end but there was athree month consultation period which ended just after the year end, whereby Lockfine was negotiating withemployee representatives. Thus individual employees had not been notified by the year end.
Lockfine proposes recognising a provision in respect of Plan A but not Plan B. (5 marks)
Professional marks will be awarded in question 2 for clarity and quality of discussion. (2 marks)
4
Required:
Discuss the principles and practices to be used by Lockfine in accounting for the above valuation and recognitionissues.
(25 marks)
5 [P.T.O.
3 Alexandra, a public limited company, designs and manages business solutions and IT infrastructures.
(a) In November 2010, Alexandra defaulted on an interest payment on an issued bond loan of $100 millionrepayable in 2015. The loan agreement stipulates that such default leads to an obligation to repay the whole ofthe loan immediately, including accrued interest and expenses. The bondholders, however, issued a waiverpostponing the interest payment until 31 May 2011. On 17 May 2011 Alexandra felt that a further waiver wasrequired, so requested a meeting of the bondholders and agreed a further waiver of the interest payment to 5 July 2011, when Alexandra was confident it could make the payments. Alexandra classified the loan as long-term debt in its statement of financial position at 30 April 2011 on the basis that the loan was not in defaultat the end of the reporting period as the bondholders had issued waivers and had not sought redemption.
(6 marks)
(b) Alexandra enters into contracts with both customers and suppliers. The supplier solves system problems andprovides new releases and updates for software. Alexandra provides maintenance services for its customers. Inprevious years, Alexandra recognised revenue and related costs on software maintenance contracts when thecustomer was invoiced, which was at the beginning of the contract period. Contracts typically run for two years.
During 2010, Alexandra had acquired Xavier Co, which recognised revenue, derived from a similar type ofmaintenance contract as Alexandra, on a straight-line basis over the term of the contract. Alexandra consideredboth its own and the policy of Xavier Co to comply with the requirements of IAS 18 Revenue but it decided toadopt the practice of Xavier Co for itself and the group. Alexandra concluded that the two recognition methodsdid not, in substance, represent two different accounting policies and did not, therefore, consider adoption of thenew practice to be a change in policy.
In the year to 30 April 2011, Alexandra recognised revenue (and the related costs) on a straight-line basis overthe contract term, treating this as a change in an accounting estimate. As a result, revenue and cost of sales wereadjusted, reducing the year’s profits by some $6 million. (5 marks)
(c) Alexandra has a two-tier board structure consisting of a management and a supervisory board. Alexandraremunerates its board members as follows:
In the group financial statements, within the related parties note under IAS 24 Related Party Disclosures,Alexandra disclosed the total remuneration paid to directors and non-executive directors and a total for each ofthese boards. No further breakdown of the remuneration was provided.
The management board comprises both the executive and non-executive directors. The remuneration of the non-executive directors, however, was not included in the key management disclosures. Some members of thesupervisory and management boards are of a particular nationality. Alexandra was of the opinion that in thatjurisdiction, it is not acceptable to provide information about remuneration that could be traced back toindividuals. Consequently, Alexandra explained that it had provided the related party information in the annualaccounts in an ambiguous way to prevent users of the financial statements from tracing remuneration informationback to specific individuals. (5 marks)
(d) Alexandra’s pension plan was accounted for as a defined benefit plan in 2010. In the year ended 30 April 2011,Alexandra changed the accounting method used for the scheme and accounted for it as a defined contributionplan, restating the comparative 2010 financial information. The effect of the restatement was significant. In the2011 financial statements, Alexandra explained that, during the year, the arrangements underlying the retirementbenefit plan had been subject to detailed review. Since the pension liabilities are fully insured and indexation offuture liabilities can be limited up to and including the funds available in a special trust account set up for theplan, which is not at the disposal of Alexandra, the plan qualifies as a defined contribution plan under IAS 19Employee Benefits rather than a defined benefit plan. Furthermore, the trust account is built up by the insurancecompany from the surplus yield on investments. The pension plan is an average pay plan in respect of whichthe entity pays insurance premiums to a third party insurance company to fund the plan. Every year 1% of thepension fund is built up and employees pay a contribution of 4% of their salary, with the employer paying the
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balance of the contribution. If an employee leaves Alexandra and transfers the pension to another fund, Alexandrais liable for, or is refunded the difference between the benefits the employee is entitled to and the insurancepremiums paid. (7 marks)
Professional marks will be awarded in question 3 for clarity and quality of discussion. (2 marks)
Required:
Discuss how the above transactions should be dealt with in the financial statements of Alexandra for the yearended 30 April 2011.
(25 marks)
7 [P.T.O.
4 The publication of IFRS 9, Financial Instruments, represents the completion of the first stage of a three-part projectto replace IAS 39 Financial Instruments: Recognition and Measurement with a new standard. The new standardpurports to enhance the ability of investors and other users of financial information to understand the accounting offinancial assets and reduces complexity.
Required:
(a) (i) Discuss the approach taken by IFRS 9 in measuring and classifying financial assets and the main effectthat IFRS 9 will have on accounting for financial assets. (11 marks)
(ii) Grainger, a public limited company, has decided to adopt IFRS 9 prior to January 2012 and has decided torestate comparative information under IAS 8 Accounting Policies, Changes in Accounting Estimates andErrors. The entity has an investment in a financial asset which was carried at amortised cost under IAS 39but will be valued at fair value through profit and loss (FVTPL) under IFRS 9. The carrying value of the assetswas $105,000 on 30 April 2010 and $110,400 on 30 April 2011. The fair value of the asset was$106,500 on 30 April 2010 and $111,000 on 30 April 2011. Grainger has determined that the asset willbe valued at FVTPL at 30 April 2011.
Required:
Discuss how the financial asset will be accounted for in the financial statements of Grainger in the yearended 30 April 2011. (4 marks)
(b) Recently, criticisms have been made against the current IFRS impairment model for financial assets (the incurredloss model). The issue with the incurred loss model is that impairment losses (and resulting write-downs in thereported value of financial assets) can only be recognised when there is evidence that they exist and have beenincurred. Reporting entities are not allowed currently to consider the effects of expected losses. There is a viewthat earlier recognition of loan losses could potentially reduce the problems incurred in a credit crisis.
Grainger has a portfolio of loans of $5 million which was initially recognised on 1 May 2010. The loans maturein 10 years and carry an interest rate of 16%. Grainger estimates that no loans will default in the first two yearsbut from the third year onwards, loans will default at an annual rate of about 9%. If the loans default as expected,the rate of return from the portfolio will be approximately 9·07%. The number of loans are fixed without any newlending or any other impairment provisions.
Required:
(i) Discuss briefly the issues related to considering the effects of expected losses in dealing with impairmentof financial assets. (4 marks)
(ii) Calculate the impact on the financial statements up to the year ended 30 April 2013 if Graingeranticipated the expected losses on the loan portfolio in year three. (4 marks)
Professional marks will be awarded in question 4 for clarity and quality of discussion. (2 marks)
(25 marks)
End of Question Paper
8
Answers
Professional Level – Essentials Module, Paper P2 (UK)Corporate Reporting (United Kingdom) June 2011 Answers
1 (a) (i) Under the Companies Act 2006, where a parent company prepares group accounts under the Act, all the subsidiaryundertakings of the company must be included in the consolidation, subject to the following exceptions.
(i) A subsidiary undertaking may be excluded from consolidation if its inclusion is not material for the purpose of givinga true and fair view (but two or more undertakings may be excluded only if they are not material taken together),
(ii) A subsidiary undertaking may be excluded from consolidation where severe long-term restrictions substantiallyhinder the exercise of the rights of the parent company over the assets or management of that undertaking,
(iii) or the information necessary for the preparation of group accounts cannot be obtained without disproportionateexpense or undue delay,
(iv) or the interest of the parent company is held exclusively with a view to subsequent resale.
The Act permits exclusion on the grounds of severe long-term restrictions but does not require exclusion. FRS 2Accounting for subsidiary undertakings requires exclusion on these grounds, but IFRS 27 Consolidated and separatefinancial statements does not permit a parent to exclude from consolidation a subsidiary that operates under severe long-term restrictions that significantly impair its ability to transfer funds to the parent. The existence of severe long-termrestrictions does not, in the opinion of IAS 27, preclude control. In order for the subsidiary to be not consolidated, controlhas to be lost. In the case of Stem, control has not been lost and the subsidiary should be consolidated.
(ii) Rose plc
Consolidated Statement of Financial Position at 30 April 2011
$m $mFair value of consideration for 70% interest 94Fair value of non-controlling interest 46 140
–––Fair value of identifiable net assets (120)
–––––Total premium 20
–––––Comprising
Patent 4Goodwill 16
Amortisation of patent
1 May 2010 to 30 April 2011 – $4m divided by 4 years multiplied, i.e. $1 million
Dr Profit or loss $1 millionCr Patent $1 million
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Acquisition of further interest
The net assets of Petal have increased from $124m (38 + 49 + 3 + 4 patent + 30 land (W6)) million to 131m (98 + 3 patent + 30 land (W6)) million at 30 April 2011. They have increased by $7 million and therefore the NCI has increasedby 30% of $7 million, i.e. $2·1 million.
$mPetal NCI 1 May 2010 46Increase in net assets 2·1
–––––––Net assets 30 April 2011 48·1Transfer to equity 10/30 (16·03)
–––––––Balance at 30 April 2011 32·07
–––––––Fair value of consideration 19Transfer to equity (16·03)
–––––––Negative movement (debit) in equity 2·97
–––––––
Working 2
Stem – translation and calculation of goodwill
Dinars Dinars Rate $mm m – fair
value adjProperty, plant and equipment 380 75 5 91Financial assets 50 5 10Current assets 330 5 66
Goodwill is treated as a foreign currency asset, which is retranslated at the closing rate. Goodwill in the consolidated statementof financial position at 30 April 2011 will be 31 million dinars divided by 5, i.e. $6·2 million. Therefore an exchange gainof $1·03m will be recorded in retained earnings ($0·54m) and NCI ($0·49m).
Exchange difference on Stem’s net assets
$mNet assets at 1 May 2010 $(33·33 + 36·67 + 12·5)m 82·5Exchange difference arising on Stem’s net assets 18·71Profit for year (80m dinars/5·8) 13·79
–––––––Net assets at 30 April 2011 (575m dinars/5) 115
–––––––
The exchange difference is allocated between group and NCI according to shareholding, group ($9·73m) (W3) and NCI($8·98m) (W5).
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Working 3
Tutorial note: The exchange reserve has been shown separately. It is acceptable to have combined this with retainedearnings.
Retained earnings
$mRose: balance at 30 April 2011 256Current service cost – bonus scheme (W9) (0·65)Depreciation overcharged 0·4Post acquisition reserves: Petal (70% x (56 – 49 – 1)) 4·2
Stem (52% x 13·79) 7·17–––––––267·12–––––––
Exchange reserveExchange gain on goodwill (W2) 0·54Exchange gain on net assets 9·73
–––––––Total 10·27
–––––––
Other components of equity
$mRose: balance at 30 April 2011 7Post acqn reserves – Petal (70% x (4 – 3)) 0·7Petal – negative movement in equity (W1) (2·97)Revaluation surplus – overseas property (W6) 2·25
–––––––6·98
–––––––
Working 4
Current liabilities
$mRose 185Petal 77Stem 20
––––282––––
Working 5
Non-controlling interest
$mPetal (W1) 32·07Stem at acquisition (W2) 41·67Exchange gain – goodwill (W2) 0·49Profit for year (13·79 x 48%) 6·62Exchange gain on net assets (W2) 8·98
––––––Total 89·83
––––––
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Working 6
Property, plant and equipment
$m $mRose 370Petal 110Stem 91
––––571
Increase in value of land – Petal (120 – (38 + 49 + 3)) 30Change in residual valueCost $20 – residual value $1·4 = $18·6mNew depreciable amount at 1 May 2010 $17·4mLess depreciation to date (18·6 x 3/6) $9·3m
–––––––Amount to be depreciated $8·1m
–––––––Depreciation over remaining three years p.a $2·7mAmount charged in year (18·6 x 1/6) $3·1m
The cumulative bonus payable will be $4·42 million.
The benefit allocated to each year will be this figure divided by five years. That is $884,000 per year. The current servicecost is the present value of this amount at 30 April 2011. That is $884,000 divided by 1·08 for four years, i.e $0·65m.
30 April 30 April 30 April 30 April 30 April 2011 2012 2013 2014 2015$m $m $m $m $m
Benefit 2% of salary which increases at 5% 800 840 882 926 972Bonus cumulative 800 1,640 2,522 3,448 4,420
(b) In respect of deferred tax, IAS 12 Income Taxes is conceptually different from FRS 19 Deferred Taxation. Under IAS 12,deferred tax is recognised on the basis of taxable temporary difference (subject to certain exceptions). Temporary differencesinclude all timing differences and many permanent differences. Under FRS 19, deferred tax is recognised on the basis oftiming differences (subject to certain exceptions). IAS 12 prohibits the discounting of deferred tax. FRS 19 permits, but doesnot require, discounting of deferred tax. Discounting of deferred tax assets and liabilities is only valid if the timing differencesunderlying those assets and liabilities give rise to future cash flows that are not already measured at their present value.
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IAS 17 Leases suggests that lease of land and buildings should be allocated at inception of the lease into a separate lease ofland and a lease of buildings (IAS 17 para 15a and 16). Given the indefinite life associated with land, leases of land wouldnormally be treated as operating leases. The relative fair values of the land and buildings respectively should be used to splitthe present value of the minimum lease payments. If this cannot be determined reliably or the land element is deemedimmaterial then the entire lease should be treated in accordance with the building element. (Tutorial note: 2009‘Improvements to IFRSs’ removed the prescriptive requirement to consider land and building components of a leaseseparately (deletion of para 14 and 15 IAS 17). Current guidance appears less prescribed.)
Under SSAP 21 Accounting for leases and hire purchase contracts, leases of land and buildings are subject to the sameaccounting requirements as other leased assets. They should be either classified as finance or operating leases and the landand buildings should be considered together. The present value test is often difficult to apply to property leases under UKGAAP. The principles of FRS 5 will help determine the true nature of the lease.
Under IAS 38, Intangible Assets, research costs must be written off as incurred, whereas development costs should becapitalised where particular criteria are met. There is no choice of accounting policy. This contrasts with SSAP 13 Accountingfor Research and Development where an entity may choose to capitalise development costs or not. The Companies Actpermits development costs to be capitalised but only in special circumstances. It does not define what these circumstancesare and it is necessary to look to SSAP 13 for guidance.
Management often seeks loopholes in financial reporting standards that allow them to adjust the financial statements as faras is practicable to achieve their desired aim. These adjustments amount to unethical practices when they fall outside thebounds of acceptable accounting practice. Reasons for such behaviour often include market expectations, personal realisationof a bonus, and maintenance of position within a market sector. In most cases conformance to acceptable accountingpractices is a matter of personal integrity. It is often a matter of intent and therefore if the management of Rose is pursuingsuch policies with the intention of misleading users, then there is an ethical issue.
2 (a) The question arises as to whether the selling agents’ estimates can be used to calculate fair value in accordance with IFRS1 First Time Adoption of International Financial Reporting Standards. Assets carried at cost (e.g. property, plant andequipment) may be measured at their fair value at the date of the opening IFRS statement of financial position. Fair valuebecomes the ‘deemed cost’ going forward under the IFRS cost model. Deemed cost is an amount used as a surrogate for costor depreciated cost at a given date. If, before the date of its first IFRS statement of financial position, the entity had revaluedany of these assets under its previous GAAP either to fair value or to a price-index-adjusted cost, that previous GAAP revaluedamount at the date of the revaluation can become the deemed cost of the asset under IFRS 1. It is generally advantageousto use independent estimates when determining fair value, but Lockfine should ensure that the valuation is prepared inaccordance with the requirements of the relevant IFRS standard. An independent valuation should generally, as a minimum,include enough information for Lockfine to assess whether or not this is the case. The selling agents’ estimates provided verylittle information about the valuation methods and underlying assumptions that they could not, in themselves, be relied uponfor determining fair value in accordance with IAS 16 Property, Plant and Equipment. Furthermore it would not be prudent tovalue the boats at the average of the higher end of the range of values.
IFRS 1, however, does not set out detailed requirements under which fair value should be determined. Issuers who adopt fairvalue as deemed cost have only to provide the limited disclosures; the methods and assumptions for determining the fairvalue do not have to be disclosed. The revaluation has to be broadly comparable to fair value. The use of fair value as deemedcost is a cost effective alternative approach for entities which do not perform a full retrospective application of the requirementsto IAS 16. Thus Lockfine was not in breach of IFRS 1 and can determine fair value on the basis of selling agent estimates.
(b) In accordance with IFRS 1, an entity which, during the transition process to IFRS, decides to retrospectively apply IFRS 3 toa certain business combination must apply that decision consistently to all business combinations occurring between the dateon which it decides to adopt IFRS 3 and the date of transition. The decision to apply IFRS 3 cannot be made selectively. Theentity must consider all similar transactions carried out in that period; and when allocating values to the various assets(including intangibles) and liabilities of the entity acquired in a business combination to which IFRS 3 is applied, an entitymust necessarily have documentation to support its purchase price allocation. If there is no such basis, alternative or intuitivemethods of price allocation cannot be used unless they are based on the strict application of the standards. The requirementsof IFRS 1 apply in respect of an entity’s first IFRS financial statements and cannot be extended or applied to other similarsituations.
Lockfine was unable to obtain a reliable value for the fishing rights, and thus it was not possible to separate the intangibleasset within goodwill. IAS 38 requires an entity to recognise an intangible asset, whether purchased or self-created (at cost)if, and only if:
– it is probable that the future economic benefits that are attributable to the asset will flow to the entity; and – the cost of the asset can be measured reliably.
As Lockfine was unable to satisfy the second recognition criteria of IAS 38, the company was also not able to elect to use thefair value of the fishing rights as its deemed cost as permitted by IFRS 1. As a result the goodwill presented in the first financialstatements under IFRS, insofar as it did not require a write-down due to impairment at the date of transition to IFRS, will bethe same as its net carrying amount at the date of transition. The intangible asset with a finite useful life, subsumed withingoodwill, cannot be separately identified, amortised and presented as another item. Goodwill which includes a subsumedintangible asset with a finite life, should be subject to annual impairment testing in accordance with IAS 36 and no part of
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the goodwill balance should be systematically amortised through the income statement. The impairment of goodwill shouldbe accounted for in accordance with IAS 36 which requires that there should be an annual impairment test.
(c) An intangible asset is an identifiable non-monetary asset without physical substance. Thus, the three critical attributes of anintangible asset are:
(a) identifiability(b) control (power to obtain benefits from the asset)(c) future economic benefits (such as revenues or reduced future costs)
The electronic maps meet the above three criteria for recognition as an intangible asset as they are identifiable, Lockfine hascontrol over them and future revenue will flow from the maps. The maps will be recognised because there are future economicbenefits attributable to the maps and the cost can be measured reliably. After initial recognition the benchmark treatment isthat intangible assets should be carried at cost less any amortisation and impairment losses and thus Lockfine’s accountingpolicy is in compliance with IAS 38.
An intangible asset has an indefinite useful life when there is no foreseeable limit to the period over which the asset isexpected to generate net cash inflows for the entity. The term indefinite does not mean infinite. An important underlyingassumption in assessing the useful life of an intangible asset is that it reflects only the level of future maintenance expenditurerequired to maintain the asset ‘at its standard of performance assessed at the time of estimating the asset’s useful life’. Theindefinite useful life should not depend on planned future expenditure in excess of that required to maintain the asset. Thecompany’s accounting practice in this regard seems to be in compliance with IAS 38. IAS 38 identifies certain factors thatmay affect the useful life and it is important that Lockfine complies with IAS 38 in this regard. For example, technical,technological or commercial obsolescence and expected actions by competitors. IAS 38 specifies the criteria that an entitymust be able to satisfy in order to recognise an intangible asset arising from development. There is no specific requirementthat this be disclosed. However, IAS 1 Presentation of Financial Statements requires that an entity discloses accountingpolicies relevant to an understanding of its financial statements. Given that the internally generated intangible assets are amaterial amount of total assets, this information should also have been disclosed.
(d) The restructuring plans should be considered separately as they relate to separate and different events.
According to IAS 37, Provisions, Contingent Liabilities and Contingent Assets, a constructive obligation to restructure arisesonly when an entity:
(a) Has a detailed formal restructuring plan identifying at least:
(i) the business activities, or part of the business activities, concerned;(ii) the principal locations affected;(iii) the location, function and approximate number of employees who will be compensated for terminating their
services;(iv) the expenditure that will be undertaken;(v) the implementation date of the plan; and, in addition,
(b) Has raised a valid expectation among the affected parties that it will carry out the restructuring by starting to implementthat plan or announcing its main features to those affected by it.
For a plan to be sufficient to give rise to a constructive obligation when communicated to those affected by it, itsimplementation needs to be planned to begin as soon as possible and to be completed in a timeframe that makes significantchanges to the plan unlikely (IAS 37).
In the case of Plan A, even though Lockfine has made a decision to sell 50% of the operation and has announced thatdecision publicly, Lockfine is not committed to the restructure until both (a) and (b) above have been satisfied. A provisionfor restructuring should not be recognised. A constructive obligation arises only when a company has a detailed formal planand makes an announcement of the plan to those affected by it. The plan to date does not provide sufficient detail that wouldpermit Lockfine to recognise a constructive obligation. Neither the specific fleet nor employees have been identified as yet.
In the case of Plan B, Lockfine should recognise a provision. At the date of the financial statements, there has to be a detailedplan and the company has to have raised a valid expectation in those affected by starting to implement that plan orannouncing its main features to those affected by it. A public announcement constitutes a constructive obligation torestructure only if it is made in such a way and in such detail that it gives rise to a valid expectation. It is not necessary thatthe individual employees of Lockfine be notified as the employee representatives have been notified. It will be necessary tolook at the nature of the negotiations and if the discussions are about the terms of the redundancy and not a change in plans,then a provision should be made.
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3 (a) The loan should have been classified as short-term debt. According to IAS 1, a liability should be classified as current if it isdue to be settled within 12 months after the date of the statement of financial position. If an issuer breaches an undertakingunder a long-term loan agreement on or before the date of the statement of financial position, such that the debt becomespayable on demand, the loan is classified as current even if the lender agrees, after the statement of financial position date,not to demand payment as a consequence of the breach. It follows that a liability should also be classified as current if awaiver is issued before the date of the statement of financial position, but does not give the entity a period of grace ending atleast 12 months after the date of the statement of financial position. The default on the interest payment in Novemberrepresented a default that could have led to a claim from the bondholders to repay the whole of the loan immediately, inclusiveof incurred interest and expenses. As a further waiver was issued after the date of the statement of financial position, andonly postponed payment for a short period, Alexandra did not have an unconditional right to defer the payment for at least12 months after the date of the statement of financial position as required by the standard in order to be classified as long-term debt. Alexandra should also consider the impact that a recall of the borrowing would have on the going concern status.If the going concern status is questionable then Alexandra would need to provide additional disclosure surrounding theuncertainty and the possible outcomes if waivers are not renewed. If Alexandra ceases to be a going concern then the financialstatements would need to be prepared on a break-up basis.
(b) The change in accounting treatment should have been presented as a correction of an error in accordance with IAS 8,Accounting Policies, Changes in Accounting Estimates and Errors, as the previous policy applied was not in accordance withIAS 18, Revenue, which requires revenue arising from transactions involving the rendering of services to be recognised withreference to the stage of completion at the date of the statement of financial position. The change in accounting treatmentshould not be accounted for as a change in estimate. According to IAS 8 changes in an accounting estimate result fromchanges in circumstances, new information or more experience, which was not the case. Alexandra presented the change asa change in accounting estimate as, in its view, its previous policy complied with the standard and did not breach any of itsrequirements. However, IAS 18 paragraph 20, requires that revenue associated with the rendering of a service should berecognised by reference to the stage of completion of the transaction at the end of the reporting period, providing that theoutcome of the transaction can be estimated reliably. IAS 18 further states that, when the outcome cannot be estimatedreliably, revenue should be recognised only to the extent that expenses are recoverable. Given that the maintenance contractwith the customer involved the rendering of services over a two-year period, the previous policy applied of recognising revenueon invoice at the commencement of the contract did not comply with IAS 18. The subsequent change in policy to one whichrecognised revenue over the contract term, therefore, was the correction of an error rather than a change in estimate andshould have been presented as such in accordance with IAS 8 and been effected retrospectively. In the opening balance ofretained earnings, the income from maintenance contracts that has been recognised in full in the year end 30 April 2010,needs to be split between that occurring in the year and that to be recognised in future periods. This will result in a net debitto opening retained earnings as less income will be recognised in the prior year. Comparative figures for the income statementrequire restatement accordingly.
In the current year, the maintenance contracts have already been dealt with following the correct accounting policy. Theincome from the maintenance contracts deferred from the revised opening balance will be recognised in the current year asfar as they relate to that period. As the maintenance contracts only run for two years, it is likely that most of the incomedeferred from the prior year will be recognised in the current period. The outcome of this is that there will be less of an impacton the income statement as although this year’s profits have reduced by $6m, there will be an addition of profits resultingfrom the recognition of maintenance income deferred from last year.
(c) The exclusion of the remuneration of the non-executive directors from key management personnel disclosures did not complywith the requirements of IAS 24 which defines key management personnel as those persons having authority andresponsibility for planning, directing and controlling the activities of the entity, directly or indirectly, including any director(whether executive or otherwise) of that entity. Alexandra did not comply with paragraph 16 of the standard, which alsorequires key management personnel remuneration to be analysed by category. The explanation of Alexandra is not acceptable.IAS 24 states that an entity should disclose key management personnel compensation in total and for each of the followingcategories:
(a) short-term employee benefits; (b) post-employment benefits; (c) other long-term benefits; (d) termination benefits; and (e) share-based payment.
Providing such disclosure will not give information on what individual board members earn as only totals for each categoryneed be disclosed, hence will not breach any cultural protocol. However legislation from local government and almostcertainly local corporate governance will require greater disclosure for public entities such as Alexandra.
By not providing an analysis of the total remuneration into the categories prescribed by the standard, the disclosure of keymanagement personnel did not comply with the requirements of IAS 24.
(d) Alexandra’s pension arrangement does not meet the criteria as outlined in IAS 19 Employee Benefits for defined contributionaccounting on the grounds that the risks, although potentially limited, remained with Alexandra.
Alexandra has to provide for an average pay pension plan with limited indexation, the indexation being limited to the amountavailable in the trust fund. The pension plan qualifies as a defined benefit plan under IAS 19.
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The following should be taken into account:
The insurance contract is between Alexandra and the insurance company, not between the employee and the insurer; theinsurance contract is renewed every year. The insurance company determines the insurance premium payable by Alexandraannually.
The premium for the employee is fixed and the balance of the required premium rests with Alexandra, exposing the entity tochanges in premiums depending on the return on the investments by the insurer and changes in actuarial assumptions. Theinsurance contract states that when an employee leaves Alexandra and transfers his pension to another fund, Alexandra isliable for or is refunded the difference between the benefits the employee is entitled to based on the pension formula and theentitlement based on the insurance premiums paid. Alexandra is exposed to actuarial risks, i.e. a shortfall or over funding asa consequence of differences between returns compared to assumptions or other actuarial differences.
There are the following risks associated with the pension plan:
– Investment risk: the insurance company insures against this risk for Alexandra. The insurance premium is determinedevery year, the insurance company can transfer part of this risk to Alexandra to cover shortfalls. Therefore, the risk isnot wholly transferred to the insurance company.
– Individual transfer of funds: on transfer of funds, any surplus is refunded to Alexandra while unfunded amounts have tobe paid; a risk that can preclude defined contribution accounting.
– The agreement between Alexandra and the employees does not include any indication that, in the case of a shortfall inthe funding of the plan, the entitlement of the employees may be reduced. Consequently, Alexandra has a legal orconstructive obligation to pay further amounts if the insurer did not pay all future employee benefits relating to employeeservice in the current and prior periods. Therefore the plan is a defined benefit plan.
4 (a) (i) IFRS 9 Financial Instruments retains a mixed measurement model with some assets measured at amortised cost andothers at fair value. The distinction between the two models is based on the business model of each entity and arequirement to assess whether the cash flows of the instrument are only principal and interest. The business modelapproach is fundamental to the standard and is an attempt to align the accounting with the way in which managementuses its assets in its business whilst also looking at the characteristics of the business. A debt instrument generally mustbe measured at amortised cost if both the ‘business model test’ and the ‘contractual cash flow characteristics test’ aresatisfied. The business model test is whether the objective of the entity’s business model is to hold the financial assetto collect the contractual cash flows rather than have the objective to sell the instrument prior to its contractual maturityto realise its fair value changes.
The contractual cash flow characteristics test is whether the contractual terms of the financial asset give rise, on specifieddates, to cash flows that are solely payments of principal and interest on the principal amount outstanding.
All recognised financial assets that are currently in the scope of IAS 39 will be measured at either amortised cost or fairvalue. The standard contains only the two primary measurement categories for financial assets unlike IAS 39 wherethere were multiple measurement categories. Thus the existing IAS 39 categories of held to maturity, loans andreceivables and available-for-sale are eliminated along with the tainting provisions of the standard.
A debt instrument (e.g. loan receivable) that is held within a business model whose objective is to collect the contractualcash flows and has contractual cash flows that are solely payments of principal and interest generally must be measuredat amortised cost. All other debt instruments must be measured at fair value through profit or loss (FVTPL). Aninvestment in a convertible loan note would not qualify for measurement at amortised cost because of the inclusion ofthe conversion option, which is not deemed to represent payments of principal and interest. This criterion will permitamortised cost measurement when the cash flows on a loan are entirely fixed such as a fixed interest rate loan or whereinterest is floating or a combination of fixed and floating interest rates.
IFRS 9 contains an option to classify financial assets that meet the amortised cost criteria as at FVTPL if doing soeliminates or reduces an accounting mismatch. An example of this may be where an entity holds a fixed rate loanreceivable that it hedges with an interest rate swap that swaps the fixed rates for floating rates. Measuring the loan assetat amortised cost would create a measurement mismatch, as the interest rate swap would be held at FVTPL. In this casethe loan receivable could be designated at FVTPL under the fair value option to reduce the accounting mismatch thatarises from measuring the loan at amortised cost.
All equity investments within the scope of IFRS 9 are to be measured in the statement of financial position at fair valuewith the default recognition of gains and losses in profit or loss. Only if the equity investment is not held for trading canan irrevocable election be made at initial recognition to measure it at fair value through other comprehensive income(FVTOCI) with only dividend income recognised in profit or loss. The amounts recognised in OCI are not recycled to profitor loss on disposal of the investment although they may be reclassified in equity.
The standard eliminates the exemption allowing some unquoted equity instruments and related derivative assets to bemeasured at cost. However, it includes guidance on the rare circumstances where the cost of such an instrument maybe appropriate estimate of fair value.
The classification of an instrument is determined on initial recognition and reclassifications are only permitted on thechange of an entity’s business model and are expected to occur only infrequently. An example of where reclassification
18
from amortised cost to fair value might be required would be when an entity decides to close its mortgage business, nolonger accepting new business, and is actively marketing its mortgage portfolio for sale. When a reclassification isrequired it is applied from the first day of the first reporting period following the change in business model.
All derivatives within the scope of IFRS 9 are required to be measured at fair value. IFRS 9 does not retain IAS 39’sapproach to accounting for embedded derivatives. Consequently, embedded derivatives that would have been separatelyaccounted for at FVTPL under IAS 39 because they were not closely related to the financial asset host will no longer beseparated. Instead, the contractual cash flows of the financial asset are assessed as a whole and are measured at FVTPLif any of its cash flows do not represent payments of principal and interest.
One of the most significant changes will be the ability to measure some debt instruments, for example investments ingovernment and corporate bonds at amortised cost. Many available-for-sale debt instruments currently measured at fairvalue will qualify for amortised cost accounting.
Many loans and receivables and held-to-maturity investments will continue to be measured at amortised cost but somewill have to be measured instead at FVTPL. For example some instruments, such as cash-collateralised debt obligations,that may under IAS 39 have been measured entirely at amortised cost or as available-for-sale will more likely bemeasured at FVTPL. Some financial assets that are currently disaggregated into host financial assets that are not atFVTPL will instead by measured at FVTPL in their entirety.
IFRS 9 may result in more financial assets being measured at fair value. It will depend on the circumstances of eachentity in terms of the way it manages the instruments it holds, the nature of those instruments and the classificationelections it makes.
Assets that are currently classified as held-to-maturity are likely to continue to be measured at amortised cost as theyare held to collect the contractual cash flows and often give rise to only payments of principal and interest.
IFRS 9 does not directly address impairment. However, as IFRS 9 eliminates the available-for-sale (AFS) category, it alsoeliminates the AFS impairment rules. Under IAS 39 measuring impairment losses on debt securities in illiquid marketsbased on fair value often led to reporting an impairment loss that exceeded the credit loss that management expected.Additionally, impairment losses on AFS equity investments cannot be reversed within the income statement section ofthe statement of comprehensive income under IAS 39 if the fair value of the investment increases. Under IFRS 9, debtsecurities that qualify for the amortised cost model are measured under that model and declines in equity investmentsmeasured at FVTPL are recognised in profit or loss and reversed through profit or loss if the fair value increases.
(ii) Under the general rules of retrospective application of IAS 8, the financial statements for the year ended 30 April 2011would have an opening adjustment to equity of $1,500 credit as at 1 May 2010 ($106,500 minus $105,000). Thefair value of the asset was $106,500 on 30 April 2010 and $111,000 on 30 April 2011 and therefore $4,500 willbe credited to profit or loss for the year ended 30 April 2011.
(b) (i) The expected loss model is more subjective in nature compared to the incurred loss model, since it relies significantlyon the cash flow estimates prepared by the reporting entity which are inherently subjective. Therefore safeguards areneeded to be built into the process such as disclosures of methods applied. The expected loss model would involvesignificant operational challenges notably it is onerous in data collection since data needs to be collected for the wholeportfolio of financial assets measured at amortised cost held by a reporting entity. This means that data is not onlyrequired for impaired financial assets but it also requires having historical loss data for all financial assets held atamortised cost. Entities do not always have historical loss data for financial assets, particularly for some types of financialasset or some types of markets. The historical loss data often does not reflect the losses to maturity or the historical dataare not relevant due to significant changes in circumstances.
(ii) Incurred loss model per IAS 39
Date Loan asset Interest Cash flow Loss (C) Loan asset Return(A) at 16% (B) (B – C)/A%
Date Loan asset Interest Cash flow Loan asset Return(A) at 9·07% (B) B/A%
$000 $000 $000 $000y/e 30 April 11 5,000 453·5 (800) 4,653·5 9·07%y/e 30 April 12 4,653·5 422·1 (800) 4,275·6 9·07%y/e 30 April 13 4,275·6 387·8 (728) 3,935·4 9·07%
being 800 x 91%
19
The expected loss model matches the credit loss on the same basis as interest revenue recognised from the financialasset. Under an expected loss model revenue is set aside to cover expected future credit losses. The expected loss modelhas the effect of smoothing the reported income for cash flows that are not expected to accrue evenly over the life of theportfolio as impairment is recognised earlier. The IAS 39 model is based on the perspective of matching a credit loss tothe period in which that loss was incurred. This results in loan loss expenses being recognised later in the life of theinstrument. Interest income is recognised in full without considering expected credit losses until they have actually beenincurred. This model is therefore characterised by higher revenues due to the period immediately after initial recognition,followed by lower net income if credit losses are incurred.
20
Professional Level – Essentials Module, Paper P2 (UK)Corporate Reporting (United Kingdom) June 2011 Marking Scheme
Marks1 (a) (i) 1 mark per point up to maximum 6
(ii) Amortisation of patent 1Acquisition of further interest 5Stem – translation and calculation of goodwill 7Retained earnings and other equity including exchange reserve 8Non-controlling interest 3Property, plant and equipment 6Non-current liabilities 1Employee bonus scheme 4
–––35
(b) UK GAAP v IFRS 5Ethical considerations 2
Professional marks 2–––50–––
2 (a) 1 mark per point maximum 6
(b) 1 mark per point maximum 6
(c) 1 mark per point maximum 6
(d) 1 mark per point maximum 5
Professional marks 2–––25–––
3 (a) 1 mark per point up to maximum 6
(b) 1 mark per point up to maximum 5
(c) 1 mark per point up to maximum 5
(d) 1 mark per point up to maximum 7
Professional marks 2–––25–––
4 (a) (i) 1 mark per point maximum 11
(ii) IAS 8 1$1,500 credit to equity 1$4,500 will be credited to profit or loss 2
–––4
(b) (i) 1 mark per point up to 4
(ii) Calculations 4
Professional marks 2–––25–––
21
Professional Level – Essentials Module
Time allowedReading and planning: 15 minutesWriting: 3 hours
This paper is divided into two sections:
Section A – This ONE question is compulsory and MUST be attempted
Section B – TWO questions ONLY to be attempted
Do NOT open this paper until instructed by the supervisor.
During reading and planning time only the question paper may be annotated. You must NOT write in your answer booklet untilinstructed by the supervisor.
This question paper must not be removed from the examination hall.
Pape
r P2 (
UK
)
Corporate Reporting(United Kingdom)
Tuesday 19 June 2012
The Association of Chartered Certified Accountants
Section A – THIS ONE question is compulsory and MUST be attempted
1 The following draft statements of financial position relate to Robby, Hail and Zinc, all public limited companies, as at31 May 2012:
Robby Hail Zinc$m $m $m
AssetsNon-current assets:Property, plant and equipment 112 60 26Investment in Hail 55Investment in Zinc 19Financial assets 9 6 14Jointly controlled operation 6Current assets 5 7 12
–––– ––– –––Total assets 206 73 52
–––– ––– –––Equity and LiabilitiesOrdinary shares 25 20 10Other components of equity 11 – –Retained earnings 70 27 19
–––– ––– –––Total equity and liabilities 206 73 52
–––– ––– –––
The following information needs to be taken into account in the preparation of the group financial statements of Robby:
(i) On 1 June 2010, Robby acquired 80% of the equity interests of Hail. The purchase consideration comprisedcash of $50 million. Robby has treated the investment in Hail at fair value through other comprehensive income(OCI).
A dividend received from Hail on 1 January 2012 of $2 million has similarly been credited to OCI.
It is Robby’s policy to measure the non-controlling interest at fair value and this was $15 million on 1 June 2010.
On 1 June 2010, the fair value of the identifiable net assets of Hail were $60 million and the retained earningsof Hail were $16 million. The excess of the fair value of the net assets is due to an increase in the value of non-depreciable land.
(ii) On 1 June 2009, Robby acquired 5% of the ordinary shares of Zinc. Robby had treated this investment at fairvalue through profit or loss in the financial statements to 31 May 2011.
On 1 December 2011, Robby acquired a further 55% of the ordinary shares of Zinc and gained control of thecompany.
The consideration for the acquisitions was as follows:
Shareholding Consideration$m
1 June 2009 5% 21 December 2011 55% 16
–––– –––60% 18–––– –––
At 1 December 2011, the fair value of the equity interest in Zinc held by Robby before the business combinationwas $5 million.
It is Robby’s policy to measure the non-controlling interest at fair value and this was $9 million on 1 December2011.
2
The fair value of the identifiable net assets at 1 December 2011 of Zinc was $26 million, and the retainedearnings were $15 million. The excess of the fair value of the net assets is due to an increase in the value ofproperty, plant and equipment (PPE), which was provisional pending receipt of the final valuations. Thesevaluations were received on 1 March 2012 and resulted in an additional increase of $3 million in the fair valueof PPE at the date of acquisition. This increase does not affect the fair value of the non-controlling interest atacquisition. PPE is to be depreciated on the straight-line basis over a remaining period of five years.
(iii) Robby has a 40% share of a joint operation, a natural gas station. Assets, liabilities, revenue and costs areapportioned on the basis of shareholding.
The following information relates to the joint arrangement activities:
– The natural gas station cost $15 million to construct and was completed on 1 June 2011 and is to bedismantled at the end of its life of 10 years. The present value of this dismantling cost to the jointarrangement at 1 June 2011, using a discount rate of 5%, was $2 million.
– In the year, gas with a direct cost of $16 million was sold for $20 million. Additionally, the joint arrangementincurred operating costs of $0·5 million during the year.
Robby has only contributed and accounted for its share of the construction cost, paying $6 million. The revenueand costs are receivable and payable by the other joint operator who settles amounts outstanding with Robbyafter the year end.
(iv) Robby purchased PPE for $10 million on 1 June 2009. It has an expected useful life of 20 years and isdepreciated on the straight-line method. On 31 May 2011, the PPE was revalued to $11 million. At 31 May2012, impairment indicators triggered an impairment review of the PPE. The recoverable amount of the PPE was$7·8 million. The only accounting entry posted for the year to 31 May 2012 was to account for the depreciationbased on the revalued amount as at 31 May 2011. Robby’s accounting policy is to make a transfer of the excessdepreciation arising on the revaluation of PPE.
(v) Robby held a portfolio of trade receivables with a carrying amount of $4 million at 31 May 2012. At that date,the entity entered into a factoring agreement with a bank, whereby it transfers the receivables in exchange for$3·6 million in cash. Robby has agreed to reimburse the factor for any shortfall between the amount collectedand $3·6 million. Once the receivables have been collected, any amounts above $3·6 million, less interest onthis amount, will be repaid to Robby. Robby has derecognised the receivables and charged $0·4 million as a lossto profit or loss.
(vi) Immediately prior to the year end, Robby sold land to a third party at a price of $16 million with an option topurchase the land back on 1 July 2012 for $16 million plus a premium of 3%. The market value of the land is$25 million on 31 May 2012 and the carrying amount was $12 million. Robby accounted for the sale,consequently eliminating the bank overdraft at 31 May 2012.
Required:
(a) Prepare a consolidated statement of financial position of the Robby Group at 31 May 2012 in accordancewith International Financial Reporting Standards. (35 marks)
3 [P.T.O.
(b) (i) In the above scenario (information point (iii)), Robby has entered into an agreement with another entity andowns a 40% share in a natural gas station. Robby allocates assets, liabilities, revenue and costs on thisbasis. UK GAAP would treat this arrangement under FRS 9 Associates and Joint Ventures whereas IFRS 11Joint Arrangements would be used to account for the transaction under International Financial ReportingStandards.
Discuss the differences between the definitions and accounting treatments of the different types of jointarrangements under UK GAAP and IFRS, concluding as to whether there would be any difference indefinition and accounting treatment of the natural gas station under UK GAAP. (9 marks)
(ii) Discuss the legitimacy of Robby selling land just prior to the year end in order to show a better liquidityposition for the group and whether this transaction is consistent with an accountant’s responsibilities tousers of financial statements.
Note: Your answer should include reference to the above scenario. (6 marks)
(50 marks)
4
Section B – TWO questions ONLY to be attempted
2 William is a public limited company and would like advice in relation to the following transactions.
(a) William owned a building on which it raised finance. William sold the building for $5 million to a financecompany on 1 June 2011 when the carrying amount was $3·5 million. The same building was leased back fromthe finance company for a period of 20 years, which was felt to be equivalent to the majority of the asset’seconomic life. The lease rentals for the period are $441,000 payable annually in arrears. The interest rate implicitin the lease is 7%. The present value of the minimum lease payments is the same as the sale proceeds.
William wishes to know how to account for the above transaction for the year ended 31 May 2012.(7 marks)
(b) William operates a defined benefit scheme for its employees. At June 2011, the net pension liability recognisedin the statement of financial position was $18 million, excluding an unrecognised actuarial gain of $15 millionwhich William wishes to spread over the remaining working lives of the employees. The scheme was revised on1 June 2011. This resulted in the benefits being enhanced for some members of the plan and because benefitsdo not vest for these members for five years, William wishes to spread the increased cost over that period.However, part of the scheme was to be closed, without any redundancy of employees.
William requires advice on how to account for the above scheme under IAS 19 Employee Benefits including thepresentation and measurement of the pension expense. (7 marks)
(c) On 1 June 2009, William granted 500 share appreciation rights to each of its 20 managers. All of the rights vestafter two years service and they can be exercised during the following two years up to 31 May 2013. The fairvalue of the right at the grant date was $20. It was thought that three managers would leave over the initial two-year period and they did so. The fair value of each right was as follows:
Year Fair value at year end $31 May 2010 2331 May 2011 1431 May 2012 24
On 31 May 2012, seven managers exercised their rights when the intrinsic value of the right was $21.
William wishes to know what the liability and expense will be at 31 May 2012. (5 marks)
(d) William acquired another entity, Chrissy, on 1 May 2012. At the time of the acquisition, Chrissy was being suedas there is an alleged mis-selling case potentially implicating the entity. The claimants are suing for damages of $10 million. William estimates that the fair value of any contingent liability is $4 million and feels that it is morelikely than not that no outflow of funds will occur.
William wishes to know how to account for this potential liability in Chrissy’s entity financial statements andwhether the treatment would be the same in the consolidated financial statements. (4 marks)
Required:
Discuss, with suitable computations, the advice that should be given to William in accounting for the aboveevents.
Note: The mark allocation is shown against each of the four events above.
Professional marks will be awarded in question 2 for the quality of the discussion. (2 marks)
(25 marks)
5 [P.T.O.
3 Ethan, a public limited company, develops, operates and sells investment properties.
(a) (i) Ethan focuses mainly on acquiring properties where it foresees growth potential, through rental income aswell as value appreciation. The acquisition of an investment property is usually realised through theacquisition of the entity, which holds the property.
In Ethan’s consolidated financial statements, investment properties acquired through business combinationsare recognised at fair value, using a discounted cash flow model as approximation to fair value. There iscurrently an active market for this type of property. The difference between the fair value of the investmentproperty as determined under the accounting policy, and the value of the investment property for taxpurposes results in a deferred tax liability.
Goodwill arising on business combinations is determined using the measurement principles for theinvestment properties as outlined above. Goodwill is only considered impaired if and when the deferred taxliability is reduced below the amount at which it was first recognised. This reduction can be caused both bya reduction in the value of the real estate or a change in local tax regulations. As long as the deferred taxliability is equal to, or larger than, the prior year, no impairment is charged to goodwill. Ethan explained itsaccounting treatment by confirming that almost all of its goodwill is due to the deferred tax liability and thatit is normal in the industry to account for goodwill in this way. (5 marks)
(ii) Ethan wishes to apply the fair value option rules of IFRS 9 Financial Instruments to debt issued to financeits investment properties. Ethan’s argument for applying the fair value option was based upon the fact thatthe recognition of gains and losses on its investment properties and the related debt would otherwise beinconsistent. Ethan argued that there is a specific financial correlation between the factors, such as interestrates, that form the basis for determining the fair value of both Ethan’s investment properties and the relateddebt. (7 marks)
(iii) Ethan has an operating subsidiary, which has in issue A and B shares, both of which have voting rights.Ethan holds 70% of the A and B shares and the remainder are held by shareholders external to the group.The subsidiary is obliged to pay an annual dividend of 5% on the B shares. The dividend payment iscumulative even if the subsidiary does not have sufficient legally distributable profit at the time the paymentis due.
In Ethan’s consolidated statement of financial position, the B shares of the subsidiary were accounted for inthe same way as equity instruments would be, with the B shares owned by external parties reported as a non-controlling interest. (5 marks)
Required:
Discuss how the above transactions and events should be recorded in the consolidated financial statementsof Ethan.
Note: The mark allocation is shown against each of the three transactions and events above.
(b) Differences in accounting for investment properties by Ethan and the tax authorities has created a deferred taxprovision. Further, there are accounting treatment differences between UK GAAP and International FinancialReporting Standards (IFRS) in respect of deferred taxation.
Required:
Discuss the key differences in the accounting treatment of deferred taxation under UK GAAP and IFRS, andwhether deferred taxation would arise under UK GAAP on investment properties carried at fair value.
(6 marks)
Professional marks will be awarded in question 3 for the quality of the discussion. (2 marks)
(25 marks)
6
4 (a) The existing standard dealing with provisions IAS 37, Provisions, Contingent Liabilities and Contingent Assets,has been in place for many years and is sufficiently well understood and consistently applied in most areas. TheIASB feels it is time for a fundamental change in the underlying principles for the recognition and measurementof non-financial liabilities. To this end, the Board has issued an Exposure Draft, ‘Measurement of Liabilities in IAS 37 – Proposed amendments to IAS 37’.
Required:
(i) Discuss the existing guidance in IAS 37 as regards the recognition and measurement of provisions andwhy the IASB feels the need to replace this guidance; (9 marks)
(ii) Describe the new proposals that the IASB has outlined in the Exposure Draft. (7 marks)
(b) Royan, a public limited company, extracts oil and has a present obligation to dismantle an oil platform at the endof the platform’s life, which is 10 years. Royan cannot cancel this obligation or transfer it. Royan intends to carryout the dismantling work itself and estimates the cost of the work to be $150 million in 10 years time. Thepresent value of the work is $105 million.
A market exists for the dismantling of an oil platform and Royan could hire a third party contractor to carry outthe work. The entity feels that if no risk or probability adjustment were needed then the cost of the externalcontractor would be $180 million in ten years time. The present value of this cost is $129 million. If risk andprobability are taken into account, then there is a probability of 40% that the present value will be $129 millionand 60% probability that it would be $140 million, and there is a risk that the costs may increase by $5 million.
Required:
Describe the accounting treatment of the above events under IAS 37 and the possible outcomes under theproposed amendments in the Exposure Draft. (7 marks)
Professional marks will be awarded in question 4 for the quality of the discussion. (2 marks)
(25 marks)
End of Question Paper
7
Answers
Professional Level – Essentials Module, Paper P2 (UK)Corporate Reporting (United Kingdom) June 2012 Answers
1 (a) Robby Consolidated Statement of Financial Position at 31 May 2012
$mAssetsNon-current assets:Property, plant and equipment (W8) 241·13Goodwill (5 + 1) (W1 and W2) 6·00Financial assets 29·00Current assets (W9) 36·00
–––––––Total assets 312·13
–––––––Equity and LiabilitiesOrdinary shares 25·00Other components of equity (W3) 2·00Retained earnings (W3) 81·45
$mFair value of consideration for 80% interest 50·00Fair value of non-controlling interest 15·00
––––––65·00
Fair value of identifiable net assets acquired (60·00)––––––
Goodwill 5·00––––––
On consolidation, there will be a reversal of the fair value adjustments to the investment held at fair value through profit andloss. Further, the dividend income on investment should be taken to profit or loss and not other comprehensive income.Therefore the adjustments required are:
Dr Other comprehensive income 5·00Cr Investment in Hail 5·00Dr Other comprehensive income 2·00Cr Retained earnings 2·00
Working 2
Zinc
$mConsideration: at 1 June 2009 2·00
at 1 June 2011 16·00Increase in fair value to 31 May 2011 1·00
––––––Investment in Zinc in Robby’s financial statements 19·00Increase in fair value of equity interest (5·00 – 2·00 – 1·00) 2·00
––––––Fair value of consideration 21·00Fair value of non-controlling interest 9·00
––––––30·00
Fair value of identifiable net assets (26·00)Increase in value (3·00)
––––––Goodwill 1·00
––––––
11
Working 3
Retained earnings
$mRobby:Balance at 31 May 2012 70·00Dividend from Hail 2·00
––––––Increase in fair value of equity interest – Zinc 2·00Post-acquisition reserves: Hail 8·80
Zinc 2·16Joint operation 0·68Impairment loss (0·70)Transfer from OCE 0·11Factoring trade receivables 0·40Reversal of disposal profit on land under option (4·00)
––––––81·45
––––––
Hail:Group reserves – 80% of 11 8·80NCI – 20% of 11 2·20
Group reserves – 60% of 3·60 2·16NCI – 40% of 3·60 1·44
––––––3·60
––––––
Other components of equity
$mRobby:Balance at 31 May 2012 11·00Dividend to retained earnings (2·00)Profit on revaluation of investment in Hail (5·00)Impairment loss (1·89)Transfer to retained earnings (0·11)
Robby has transferred its rights to receive cash flows and its maximum exposure is to repay $3·6 million. This is unlikely, butRobby has guaranteed that it will compensate the bank for all credit losses. Additionally, Robby receives the benefit ofamounts received above $3·6 million and therefore retains both the credit risk and late payment risk. Substantially, all therisks and rewards remain with Robby and therefore the receivables should still be recognised.
Any impairment loss on a revalued asset is charged to other comprehensive income to the extent of the amount relating tothat asset in the revaluation surplus and thereafter in profit or loss.
PPE Depreciated historical cost Revalued carrying amount$m $m
31 May 2011 9·00 9·00Revaluation 2·00
––––– ––––––Total 9·00 11·00Depreciation to 31 May 2012 (0·50) (0·61)
––––– ––––––Balance 31 May 2012 8·50 10·39Impairment loss (0·70) (2·59)
––––– ––––––31 May 2012 after impairment loss 7·80 7·80
––––– ––––––
There will have been a transfer of $0·11 (0·61 – 0·50) million from the revaluation surplus to retained earnings for the excessdepreciation charged in the year so the remaining amount in the revaluation surplus is $1·89m (2·00 – 0·11). $1·89m ofthe impairment will be recognised in other comprehensive income and the remaining $0·7m in profit or loss.
Working 7
Joint operation
SOFP 1 June Dismantling Depreciation Unwinding 31 May 2011 cost of discount 2012 $m $m $m $m $m
PPE 6 2 x 40% (6·8 x 1/10) 6·12Trade receivables 8Trade payables (0·2 + 6·4) 6·6Provision 0·8 0·04 0·84
Income statementRevenue (20·00 x 40%) 8Cost of sales (16·00 x 40%) (6·4)Operating cost (0·50 x 40%) (0·2)Depreciation (0·68)Finance expense (0·04)
–––––Net profit 0·68
–––––
Working 8
Property, plant and equipment
$m $mRobby 112·00Hail 60·00Zinc 26·00
–––––––198·00
Increase in value of land – Hail (60 – 20 – 16) 24·00Increase in value of PPE – Zinc (26 – 10 – 15) 1·00Further increase in value of PPE at acquisition 3·00Less: increased depreciation (1 + 3)/5 x 6/12 (0·40)Impairment loss (2·59)Joint operation (W7) 6·12Land – option to repurchase 12·00
–––––––241·13–––––––
The sale of land should not be recognised in the financial statements as the risks and rewards of ownership have not beentransferred. The land can be repurchased at the sale price plus a premium, which represents effectively an interest payment.It is effectively manipulating the financial statements in order to show a better cash position. The land should be reinstatedat its carrying amount before the transaction, so $12 million, a current liability recognised of $16 million and the profit ondisposal of $4 million that was recorded reversed.
(b) (i) FRS 9 Associates and Joint Ventures defines a joint venture as an entity in which the reporting entity holds an intereston a long-term basis and is jointly controlled by the reporting entity and one or more other venturers under a contractualarrangement.
FRS 9 also contains guidance for joint arrangements that are not entities (JANEs). A JANE is a contractual arrangementunder which the participants engage in joint activities that do not create an entity because it would not be carrying ona trade or business of its own. A contractual arrangement where all significant matters of operating and financial policyare predetermined does not create an entity because the policies are those of its participants, not of a separate entity.
In this instance, the natural gas station is a JANE under FRS 9 as the gas station does not operate with any degree ofindependence as construction, revenues and expenditures are being determined by the venturers.
IFRS 11 Joint Arrangements focuses on the rights and obligations of the arrangement. A joint arrangement is definedas being an arrangement where two or more parties contractually agree to share control. Joint control exists only whenthe decisions about activities that significantly affect the returns of an arrangement require the unanimous consent ofthe parties sharing control. All parties to a joint arrangement should recognise their rights and obligations arising fromthe arrangement. Joint arrangements are either joint operations or joint ventures.
Under IFRS, a joint arrangement is a joint venture whereby the parties only have rights over the net assets and not theindividual components comprising the net assets.
Further, a joint arrangement is a joint operation whereby the parties to the arrangement have direct rights/obligationrelating to the assets, liabilities, revenues and costs of the arrangement. Those parties are called joint operators. A jointoperator will recognise its interest based on its direct rights and obligations rather than on its participation interest. Inthis instance the joint arrangement is a joint operation as indicated within the scenario.
Under FRS 9 the consolidated financial statements should include joint ventures using the gross equity method. This isthe same as the equity method under IFRS, except that:
– in the consolidated profit and loss account the investor’s share of its joint ventures’ turnover should be shown, butnot as part of group turnover;
– in the consolidated balance sheet the investor’s share of the gross assets and liabilities underlying the net equityamount included for joint ventures should be shown in amplification of that net amount.
14
Under FRS 9, participants in a JANE should account for their own assets, liabilities and cash flows, measured accordingto the terms of the agreement governing the arrangement
Under IFRS 11 a joint venturer recognises its interest in a joint venture as an investment and accounts for thatinvestment using the equity method in accordance with IAS 28 Investments in Associates and Joint Ventures, unlessthe entity is exempted from applying the equity method. A party that participates in, but does not have joint control of,a joint venture accounts for its interest in the arrangement in accordance with IFRS 9 Financial Instruments unless ithas significant influence over the joint venture, in which case it accounts for it in accordance with IAS 28.
The IFRS states that a joint operator of a joint operation (and not joint venture entities) recognises:
its assets, including its share of any assets held jointly; its liabilities, including its share of any liabilities incurred jointly; its revenue from the sale of its share of the output of the joint operation; its share of the revenue from the sale of the output by the joint operation; and its expenses, including its share of any expenses incurred jointly.
In conclusion there are differences in the definitions and accounting between UK GAAP and IFRS. In the case of Robby,the natural gas station would be treated as a JANE under UK GAAP and as a joint operation under IFRS and not a jointventure entity under either standard. The accounting treatment would be the same under both sets of standards.
(ii) Manipulation of financial statements often does not involve breaking rules, but the purpose of financial statements is topresent a fair representation of the company’s or group’s position, and if the financial statements are misrepresented onpurpose then this could be deemed unethical. The financial statements in this case are being manipulated to hide thefact that the group has liquidity problems. The Robby Group has severe problems with a current ratio of 0·44($36m/$81·2m) and a gearing ratio of 0·83 ($53 + 20 + 21 + factored receivables 3·6 + land option 16 =113·6/equity interest including NCI $136·09m). The sale and repurchase of the land would make little difference to theoverall position of the company, but would maybe stave off proceedings by the bank if the overdraft were eliminated.Robby has considerable PPE, which may be undervalued if the sale of the land is indicative of the value of all of thePPE.
Accountants have the responsibility to issue financial statements that do not mislead users as they assume that suchprofessionals are acting in an ethical capacity, thus giving the financial statements credibility. Accountants should seekto promote or preserve the public interest. If the idea of a profession is to have any significance, then it must have thetrust of users. Accountants should present financial statements that meet the qualitative characteristics set out in theFramework. Faithful representation and verifiability are two such concepts and it is critical that these concepts areapplied in the preparation and disclosure of financial information.
2 (a) A lease is classified as a finance lease if it transfers substantially the entire risks and rewards incident to ownership. All otherleases are classified as operating leases. Classification is made at the inception of the lease. Whether a lease is a financelease or an operating lease depends on the substance of the transaction rather than the form. Situations that would normallylead to a lease being classified as a finance lease include the following:
– the lease transfers ownership of the asset to the lessee by the end of the lease term;
– the lessee has the option to purchase the asset at a price which is expected to be sufficiently lower than fair value atthe date the option becomes exercisable that, at the inception of the lease, it is reasonably certain that the option willbe exercised;
– the lease term is for the major part of the economic life of the asset, even if title is not transferred;
– at the inception of the lease, the present value of the minimum lease payments amounts to at least substantially all ofthe fair value of the leased asset;
– the lease assets are of a specialised nature such that only the lessee can use them without major modifications beingmade.
In this case the lease back of the building is for the major part of the building’s economic life and the present value of theminimum lease payments amounts to all of the fair value of the leased asset. Therefore the lease should be recorded as afinance lease.
The building is derecognised at its carrying amount and then reinstated at its fair value with any disposal gain, in this instance$1·5 million ($5m – $3·5m) being deferred over the new lease term. The building is depreciated over the shorter of the leaseterm and useful economic life, so 20 years. Finance lease accounting results in a liability being created, finance chargeaccruing at the implicit rate within the lease, in this case 7%, and the payment reducing the lease liability in arriving at theyear-end balance. The associated double entry for the lease is as follows:
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$000 $000Sale of buildingDr cash 5,000Cr building 3,500
deferred income 1,500Leased asset and liabilityDr asset – finance lease 5,000Cr finance lease creditor 5,000Deferred income releaseDr deferred income 75Cr profit or loss 75Depreciation of assetDr depreciation 250Cr assets under finance lease 250Rentals paidDr interest 350
finance lease creditor 91Cr cash 441
(b) Under IAS 19 Employee Benefits, the accounting procedures would be:
Recognition of actuarial gains and losses (remeasurements):
Actuarial gains and losses are renamed ‘remeasurements’ and will be recognised immediately in ‘other comprehensiveincome’ (OCI). Actuarial gains and losses cannot be deferred or recognised in profit or loss; this is likely to increase volatilityin the statement of financial position and OCI. Remeasurements recognised in OCI cannot be recycled through profit or lossin subsequent periods. Thus William will not be able to spread these gains and losses over the remaining working life of theemployees.
Recognition of past service cost:
Past-service costs are recognised in the period of a plan amendment; unvested benefits cannot be spread over a future-serviceperiod. The plan benefits which were enhanced on 1 June 2011 would have to be immediately recognised and the unvestedbenefits would not be spread over five years from that date. A curtailment occurs only when an entity reduces significantlythe number of employees. Curtailment gains/losses are accounted for as past-service costs. Thus William will need to realisethat any curtailment is only recognised in these circumstances and will result in immediate recognition of any gain or loss.
Measurement of pension expense:
Annual expense for a funded benefit plan will include net interest expense or income, calculated by applying the discount rateto the net defined benefit asset or liability. The discount rate used is a high-quality corporate bond rate where there is a deepmarket in such bonds, and a government bond rate in other markets.
Presentation in the income statement:
The benefit cost will be split between (i) the cost of benefits accrued in the current period (service cost) and benefit changes(past-service cost, settlements and curtailments); and (ii) finance expense or income. This analysis can be in the incomestatement or in the notes.
(c) Expenses in respect of cash-settled share-based payment transactions should be recognised over the period during whichgoods are received or services are rendered, and measured at the fair value of the liability. The fair value of the liability shouldbe remeasured at each reporting date until settled. Changes in fair value are recognised in the statement of comprehensiveincome.
The credit entry in respect of a cash-settled share-based payment transaction is presented as a liability. The fair value of eachshare appreciation right (SAR) is made up of an intrinsic value and its time value. The time value reflects the fact that theholders of each SAR have the right to participate in future gains. At 31 May 2012, the expense will comprise any increasein the liability plus the cash paid based on the intrinsic value of the SAR.
Liability 31 May 2012 (10 x 500 x $24) $120,000Liability 31 May 2011 (17 x 500 x $14) ($119,000)Cash paid (7 x 500 x $21) $73,500Expense year ending 31 May 2012 $74,500
Therefore the expense for the year is $74,500 and the liability at the year end is $120,000.
(d) IAS 37 Provisions, Contingent Liabilities and Contingent Assets describes contingent liabilities in two ways. Firstly, as reliablypossible obligations whose existence will be confirmed only on the occurrence or non-occurrence of uncertain future eventsoutside the entity’s control, or secondly, as present obligations that are not recognised because: (a) it is not probable that anoutflow of economic benefits will be required to settle the obligation; or (b) the amount cannot be measured reliably.
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In Chrissy’s financial statements contingent liabilities are not recognised but are disclosed and described in the notes to thefinancial statements, including an estimate of their potential financial effect and uncertainties relating to the amount or timingof any outflow, unless the possibility of settlement is remote.
However, in a business combination, a contingent liability is recognised if it meets the definition of a liability and if it can bemeasured. The first type of contingent liability above under IAS 37 is not recognised in a business combination. However, thesecond type of contingency is recognised whether or not it is probable that an outflow of economic benefits takes place butonly if it can be measured reliably. This means William would recognise a liability of $4 million in the consolidated accounts.Contingent liabilities are an exception to the recognition principle because of the reliable measurement criteria.
3 (a) (i) The fair value model in IAS 40 Investment Property defines fair value as the amount for which an asset could beexchanged between knowledgeable, willing parties in an arm’s length transaction. Fair value should reflect marketconditions at the date of the statement of financial position. The standard gives a considerable amount of guidance ondetermining fair value; in particular, that the best evidence of fair value is given by current prices on an active marketfor similar property in the same location and condition and subject to similar lease and other constraints. Thereforeinvestment properties are not being valued in accordance with the best possible method. This means that goodwillrecognised on the acquisition of an investment property through a business combination of real estate investmentcompanies is different as compared to what it should be under IFRS 3 Business Combination valuation principles. Inreality, the fair value of both the property and the deferred tax liability are reflected in the purchase price of the businesscombination. The difference between this purchase price and the net assets recognised according to IFRS 3, upon whichdeferred tax is based, is recognised as goodwill in the consolidated statement of financial position.
Ethan’s methods for determining whether goodwill is impaired, and the amount it is impaired by, is not in accordancewith IAS 36 Impairment of Assets. The standard requires assets (or cash generating units (CGU) if not possible toconduct the review on an asset by asset basis) to be stated at the lower of carrying amount and recoverable amount.The recoverable amount is the higher of fair value less costs to sell and value in use. Fair value less costs to sell is apost-tax valuation taking account of deferred taxes. According to IAS 36, the deferred tax liability should be included incalculating the carrying amount of the CGU, since the transaction price also includes the effect of the deferred tax andthe purchaser assumes the tax risk. Therefore, the impairment testing of goodwill should be based on recoverableamount, rather than on the relationship between the goodwill and the deferred tax liability as assessed by Ethan.
Ethan should disclose both the methodology by which the recoverable amount of the CGU, and therefore goodwill, isdetermined and the assumptions underlying that methodology under the requirements of IAS 36. The standard requiresEthan to state the basis on which recoverable amount has been determined and to disclose the key assumptions onwhich it is based.
In accordance with IAS 36, where impairment testing takes place, goodwill is allocated to each individual real estateinvestment identified as a cash-generating unit (CGU). Periodically, but at least annually, the recoverable amount of theCGU is compared with its carrying amount. If this comparison results in the carrying amount being greater than therecoverable amount, the impairment is first allocated to the goodwill. Any further difference is subsequently allocatedagainst the value of the investment property.
(ii) Normally debt issued to finance Ethan’s investment properties would be accounted for using amortised cost model.However, Ethan may apply the fair value option in IFRS 9 Financial Instruments as such application would eliminate orsignificantly reduce a measurement or recognition inconsistency between the debt liabilities and the investmentproperties to which they are related. The provision requires there to be a measurement or recognition inconsistency thatwould otherwise arise from measuring assets or liabilities or recognising the gains and losses on them on different bases.The option is not restricted to financial assets and financial liabilities. The IASB concludes that accounting mismatchesmay occur in a wide variety of circumstances and that financial reporting is best served by providing entities with theopportunity of eliminating such mismatches where that results in more relevant information. Ethan supported theapplication of the fair value option with the argument that there is a specific financial correlation between the factorsthat form the basis of the measurement of the fair value of the investment properties and the related debt. Particularimportance was placed on the role played by interest rates, although it is acknowledged that the value of investmentproperties will also depend, to some extent, on rent, location and maintenance and other factors. For some investmentproperties, however, the value of the properties will be dependent on the movement in interest rates.
Under IFRS 9, entities with financial liabilities designated as FVTPL recognise changes in the fair value due to changesin the liability’s credit risk directly in other comprehensive income (OCI). There is no subsequent recycling of theamounts in OCI to profit or loss, but accumulated gains or losses may be transferred within equity. The movement infair value due to other factors would be recognised within profit or loss. However, if presenting the change in fair valueattributable to the credit risk of the liability in OCI would create or enlarge an accounting mismatch in profit or loss, allfair value movements are recognised in profit or loss. An entity is required to determine whether an accounting mismatchis created when the financial liability is first recognised, and this determination is not reassessed. The mismatch mustarise due to an economic relationship between the financial liability and the associated asset that results in the liability’scredit risk being offset by a change in the fair value of the asset. Financial liabilities that are required to be measured atFVTPL (as distinct from those that the entity has designated at FVTPL), including financial guarantees and loancommitments measured at FVTPL, have all fair value movement recognised in profit or loss. IFRS 9 retains the flexibilitythat existed in IFRS 7 Financial Instruments: Disclosures to determine the amount of fair value change that relates tochanges in the credit risk of the liability.
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(iii) Ethan’s classification of the B shares as equity instruments does not comply with IAS 32 Financial Instruments:Presentation. IAS 32 paragraph 11 defines a financial liability to include, amongst others, any liability that includes acontractual obligation to deliver cash or financial assets to another entity. The criteria for classification of a financialinstrument as equity rather than liability are provided in IAS 32 paragraph 16. This states that the instrument is anequity instrument rather than a financial liability if, and only if, the instrument does not include a contractual obligationeither to deliver cash or another financial asset to the entity or to exchange financial assets or liabilities with anotherentity under conditions that are potentially unfavourable to Ethan. IAS 32 paragraph AG29 explains that when classifyinga financial instrument in consolidated financial statements, an entity should consider all the terms and conditions agreedbetween members of a group and holders of the instrument, in determining whether the group as a whole has anobligation to deliver cash or another financial instrument in respect of the instrument or to settle it in a manner thatresults in classification as a liability. Therefore, since the operating subsidiary is obliged to pay an annual cumulativedividend on the B shares and does not have discretion over the distribution of such dividend, the shares held by Ethan’sexternal shareholders should be classified as a financial liability in Ethan’s consolidated financial statements and notnon-controlling interest. The shares being held by Ethan will be eliminated on consolidation as intercompany.
(b) In respect of deferred tax, IAS 12 Income Taxes is conceptually different from FRS 19 Deferred Tax. There are significantdifferences between the two standards. UK standard setters do not agree with the conceptual arguments underpinning therequirements of IAS 12, which it believes lead to companies making excessive provisions. They have therefore taken adifferent conceptual approach. The most important practical consequence is that, unlike IAS 12, the FRS does not in generalrequire deferred tax to be provided for when non-monetary assets are revalued or when they are adjusted to their fair valueson the acquisition of a business.
FRS 19 Deferred Tax requires full provision to be made for deferred tax assets and liabilities arising from timing differencesbetween the recognition of gains and losses in the financial statements and their recognition in a tax computation. The generalprinciple underlying the requirements is that deferred tax should be recognised as a liability or asset if the transactions orevents that give the entity an obligation to pay more tax in future or a right to pay less tax in future have occurred by thebalance sheet date. FRS 19 requires recognition of a provision for deferred tax using an incremental liability approach on thebasis of timing differences that have been originated but not reversed at the balance sheet date. Timing differences originatein one period and can be reversed in one or subsequent periods.
Instead of accounting for timing differences which is the basis used in FRS 19, IAS 12 uses a balance sheet concept oftemporary differences which are differences between the carrying amount of assets, liabilities, income and expenditure andtheir tax base. Temporary differences include not only timing differences, but other differences between the accounting andtax bases of assets, liabilities, income and expenditure that are not timing differences, for example, revaluation of assets forwhich no equivalent adjustment is made for tax purposes. Under IAS 12, deferred tax is always recognised on revaluationgains. Under FRS 19, deferred tax on revaluation gains is only recognised if there is a binding agreement to sell the revaluedasset and the gain expected to arise on sale has been recognised or where an asset is continuously revalued to fair value withchanges in fair value being recognised in the profit and loss account. It would not apply to a single and one off revaluationof an asset which is above historical cost but which is caused by a clear consumption of economic benefits.
Another significant difference is that FRS 19 allows, but does not require, deferred tax liabilities that will not be settled forsome time to be discounted to reflect the time value of money. In contrast, IAS 12 prohibits discounting.
SSAP 19 Investment Property requires investment properties to be carried at open market value and does not permit suchproperty to be carried at depreciated historical cost. If the value of investment properties changes, it should not be taken tothe profit and loss account but should be taken to the investment revaluation reserve unless a deficit on an individual propertyis expected to be permanent. Thus although investment property is continuously revalued, the changes in value do not go tothe profit and loss account, and no deferred taxation would be provided under UK GAAP on investment property.
4 (a) (i) The existing guidance requires a provision to be recognised when: (a) it is probable that an obligation exists; (b) it isprobable that an outflow of resources will be required to settle that obligation; and (c) the obligation can be measuredreliably. The amount recognised as a provision should be the best estimate of the expenditure required to settle thepresent obligation at the balance sheet date, that is, the amount that an entity would rationally pay to settle the obligationat the balance sheet date or to transfer it to a third party. This guidance, when applied consistently, provides useful,predictive information about non-financial liabilities and the expected future cash flows, and is consistent with therecognition criteria in the Framework. The IASB has initiated a project to replace IAS 37 for three main reasons:
1. To address inconsistencies with other IFRSs. IAS 37 Provisions, Contingent Liabilities and Contingent Assetsrequires an entity to record an obligation as a liability only if it is probable (i.e. more than 50% likely) that theobligation will result in an outflow of cash or other resources from the entity. Other standards, such as IFRS 3Business Combinations and IFRS 9 Financial Instruments, do not apply this ‘probability of outflows’ criterion toliabilities.
2. To achieve global convergence of accounting standards. The IASB is seeking to eliminate differences between IFRSsand US generally accepted accounting principles (US GAAP). At present, IFRSs and US GAAP differ in how theytreat the costs of restructuring a business. IAS 37 requires an entity to record a liability for the total costs ofrestructuring a business when it announces or starts to implement a restructuring plan. In contrast, US GAAPrequires an entity to record a liability for individual costs of a restructuring only when the entity has incurred thatparticular cost.
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3. To improve measurement of liabilities in IAS 37. The requirements in IAS 37 for measuring liabilities are unclear.As a result, entities use different measures, making it difficult for analysts and investors to compare their financialstatements. Two aspects of IAS 37 are particularly unclear. IAS 37 requires entities to measure liabilities at the‘best estimate’ of the expenditure required to settle the obligation. In practice, there are different interpretations ofwhat ‘best estimate’ means: the most likely outcome, the weighted average of all possible outcomes or even theminimum or maximum amount in the range of possible outcomes. IAS 37 does not specify the costs that entitiesshould include in the measurement of a liability. In practice, entities include different costs. Some entities includeonly incremental costs while others include all direct costs, plus indirect costs and overheads, or use the pricesthey would pay contractors to fulfil the obligation on their behalf.
(ii) The IASB has decided that the new IFRS will not include the ‘probability of outflows’ criterion. Instead, an entity shouldaccount for uncertainty about the amount and timing of outflows by using a measurement that reflects their expectedvalue, i.e. the probability-weighted average of the outflows for the range of possible outcomes. Removal of this criterionfocuses attention on the definition of a liability in the Framework, which is a present obligation of an entity arising frompast events, the settlement of which is expected to result in an outflow from the entity of resources embodying economicbenefits. Furthermore, the new IFRS will require an entity to record a liability for each individual cost of a restructuringonly when the entity incurs that particular cost.
The exposure draft proposes that the measurement should be the amount that the entity would rationally pay at themeasurement date to be relieved of the liability. Normally, this amount would be an estimate of the present value of theresources required to fulfil the liability. It could also be the amount that the entity would pay to cancel or fulfil theobligation, whichever is the lowest. The estimate would take into account the expected outflows of resources, the timevalue of money and the risk that the actual outflows might ultimately differ from the expected outflows.
If the liability is to pay cash to a counterparty (for example to settle a legal dispute), the outflows would be the expectedcash payments plus any associated costs, such as legal fees. If the liability is to undertake a service, for example todecommission plant at a future date, the outflows would be the amounts that the entity estimates it would pay acontractor at the future date to undertake the service on its behalf. Obligations involving services are to be measured byreference to the price that a contractor would charge to undertake the service, irrespective of whether the entity iscarrying out the work internally or externally.
(b) Under IAS 37, a provision of $105 million would be recognised since this is the estimate of the present obligation. There willbe no profit or loss impact other than the adjustment of the present value of the obligation to reflect the time value of moneyby unwinding the discount.
Under the proposed approach there are a number of different outcomes:
– with no risk and probability adjustment, the initial liability would be recognised at $129 million which is the presentvalue of the resources required to fulfil the obligation based upon third-party prices. This means that in 10 years theprovision would have unwound to $180 million, the entity will spend $150 million in decommission costs and a profitof $30 million would be recognised. If there were no market for the dismantling of the platform, then Royan wouldrecognise a liability by estimating the price that it would charge another party to carry out the service.
– With risk and probability being taken into account, then the expected value would be (40% x $129m + 60% x $140m),i.e. $135·6m plus the risk adjustment of $5 million, which totals $140·6 million.
– $105 million being the present value of the future cashflows discounted.
The ED suggests within paragraph 36B that the entity should take the lower of:
(a) the present value of the resources required to fulfil the obligation, i.e. $105 million;
(b) the amount that the entity would have to pay to cancel the obligation, for which information is not available here; and
(c) the amount that the entity would have to pay to transfer the obligation to a third party, i.e. $129 million without risk or$140·6 million incorporating risk.
Therefore $105 million should be provided.
The ED makes specific reference to provisions relating to services such as decommissioning where it suggests that the amountto transfer to a third party would be the required liability, so $140·6 million would be provided.
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Professional Level – Essentials Module, Paper P2 (UK)Corporate Reporting (United Kingdom) June 2012 Marking Scheme
4 Existing guidance and critique 9New proposals 7IAS 37 and ED 7Communication skills 2
–––25–––
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Professional Level – Essentials Module
Time allowedReading and planning: 15 minutesWriting: 3 hours
This paper is divided into two sections:
Section A – This ONE question is compulsory and MUST be attempted
Section B – TWO questions ONLY to be attempted
Do NOT open this paper until instructed by the supervisor.
During reading and planning time only the question paper may be annotated. You must NOT write in your answer booklet untilinstructed by the supervisor.
This question paper must not be removed from the examination hall.
Pape
r P2 (
UK
)
Corporate Reporting(United Kingdom)
Tuesday 11 June 2013
The Association of Chartered Certified Accountants
Section A – THIS ONE question is compulsory and MUST be attempted
1 (a) Trailer, a public limited company, operates in the manufacturing sector. Trailer has investments in two othercompanies. The draft statements of financial position at 31 May 2013 are as follows:
Trailer Park Caller$m $m $m
Assets:Non-current assetsProperty, plant and equipment 1,440 1,100 1,300Investments in subsidiariesPark 1,250Caller 310 1,270Financial assets 320 21 141
–––––– –––––– ––––––Total equity and liabilities 4,215 3,072 1,591
–––––– –––––– ––––––
The following information is relevant to the preparation of the group financial statements:
1. On 1 June 2011, Trailer acquired 14% of the equity interests of Caller for a cash consideration of $260 million and Park acquired 70% of the equity interests of Caller for a cash consideration of $1,270 million. At 1 June 2011, the identifiable net assets of Caller had a fair value of $990 million,retained earnings were $190 million and other components of equity were $52 million. At 1 June 2012,the identifiable net assets of Caller had a fair value of $1,150 million, retained earnings were $240 millionand other components of equity were $70 million. The excess in fair value is due to non-depreciable land.
The fair value of the 14% holding of Trailer in Caller was $280 million at 31 May 2012 and $310 millionat 31 May 2013. The fair value of Park’s interest in Caller had not changed since acquisition.
2. On 1 June 2012, Trailer acquired 60% of the equity interests of Park, a public limited company. Thepurchase consideration comprised cash of $1,250 million. On 1 June 2012, the fair value of the identifiablenet assets acquired was $1,950 million and retained earnings of Park were $650 million and othercomponents of equity were $55 million. The excess in fair value is due to non-depreciable land.
It is the group’s policy to measure the non-controlling interest at acquisition at its proportionate share of thefair value of the subsidiary’s net assets.
3. Goodwill of Park and Caller was impairment tested at 31 May 2013. There was no impairment relating toCaller. The recoverable amount of the net assets of Park was $2,088 million. There was no impairment ofthe net assets of Park before this date and any impairment loss has been determined to relate to goodwilland property, plant and equipment.
4. Trailer has made a loan of $50 million to a charitable organisation for the building of new sporting facilities.The loan was made on 1 June 2012 and is repayable on maturity in three years’ time. Interest is to be
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charged one year in arrears at 3%, but Trailer assesses that an unsubsidised rate for such a loan would havebeen 6%. The only accounting entries which have been made for the year ended 31 May 2013 are the cashentries which have resulted in a balance of $48·5 million being shown as a financial asset.
5. On 1 June 2011, Trailer acquired office accommodation at a cost of $90 million with a 30-year estimateduseful life. During the year, the property market in the area slumped and the fair value of the accommodationfell to $75 million at 31 May 2012 and this was reflected in the financial statements. However, the marketrecovered unexpectedly quickly due to the announcement of major government investment in the area’stransport infrastructure. On 31 May 2013, the valuer advised Trailer that the offices should now be valuedat $105 million. Trailer has charged depreciation for the year but has not taken account of the upwardvaluation of the offices. Trailer uses the revaluation model and records any valuation change when advisedto do so.
6. Trailer has announced two major restructuring plans. The first plan is to reduce its capacity by the closureof some of its smaller factories, which have already been identified. This will lead to the redundancy of 500employees, who have all individually been selected and communicated with. The costs of this plan are $9 million in redundancy costs, $4 million in retraining costs and $5 million in lease termination costs. Thesecond plan is to re-organise the finance and information technology department over a one-year period butit does not commence for two years. The plan results in 20% of finance staff losing their jobs during therestructuring. The costs of this plan are $10 million in redundancy costs, $6 million in retraining costs and$7 million in equipment lease termination costs. No entries have been made in the financial statements forthe above plans.
7. The following information relates to the group pension plan of Trailer:
1 June 2012 ($m) 31 May 2013 ($m)Fair value of plan assets 28 29Actuarial value of defined benefit obligation 30 35
The contributions for the period received by the fund were $2 million and the employee benefits paid in theyear amounted to $3 million. The discount rate to be used in any calculation is 5%. The current service costfor the period based on actuarial calculations is $1 million. The above figures have not been taken intoaccount for the year ended 31 May 2013 except for the contributions paid which have been entered in cashand the defined benefit obligation.
Required:
Prepare the group consolidated statement of financial position of Trailer as at 31 May 2013. (35 marks)
(b) Trailer is considering purchasing a local entity that currently uses UK Generally Accepted Accounting Practice(GAAP). The entity has several subsidiaries, which operate in the UK. Trailer feels that the use of UK GAAP willhave had a major impact on the financial statements of the entity. Before continuing with the purchase of theentity, Trailer wishes to know whether there are any significant differences between UK GAAP and InternationalFinancial Reporting Standards (IFRS) regarding business combinations and accounting for subsidiaryundertakings. It is particularly interested in the differences between IFRS 10 Consolidated Financial Statements,IFRS 3 Business Combinations and FRS 2 Accounting for Subsidiary Undertakings, FRS 10 Goodwill andIntangible Assets and FRS 7 Fair Values in Acquisition Accounting.
Required:
Discuss whether there are any key differences between UK GAAP and IFRS regarding business combinationsand accounting for subsidiary undertakings. (9 marks)
3 [P.T.O.
(c) The directors of Trailer are involved in takeover talks with another entity. In the discussions, one of the directorsstated that there was no point in an accountant studying ethics because every accountant already has a set ofmoral beliefs that are followed and these are created by simply following generally accepted accounting practice.He further stated that in adopting a defensive approach to the takeover, there was no ethical issue in falselydeclaring Trailer’s profits in the financial statements used for the discussions because, in his opinion, the takeoverdid not benefit the company, its executives or society as a whole.
Required:
Discuss the above views of the director regarding the fact that there is no point in an accountant studyingethics and that there was no ethical issue in the false disclosure of accounting profits. (6 marks)
(50 marks)
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This is a blank page.Question 2 begins on page 6.
5 [P.T.O.
Section B – TWO questions ONLY to be attempted
2 (a) In its annual financial statements for the year ended 31 March 2013, Verge, a public limited company, hadidentified the following operating segments:
(i) Segment 1 local train operations (ii) Segment 2 inter-city train operations (iii) Segment 3 railway constructions
The company disclosed two reportable segments. Segments 1 and 2 were aggregated into a single reportableoperating segment. Operating segments 1 and 2 have been aggregated on the basis of their similar businesscharacteristics, and the nature of their products and services. In the local train market, it is the local transportauthority which awards the contract and pays Verge for its services. In the local train market, contracts areawarded following a competitive tender process, and the ticket prices paid by passengers are set by and paid tothe transport authority. In the inter-city train market, ticket prices are set by Verge and the passengers pay Vergefor the service provided. (5 marks)
(b) Verge entered into a contract with a government body on 1 April 2011 to undertake maintenance services on anew railway line. The total revenue from the contract is $5 million over a three-year period. The contract statesthat $1 million will be paid at the commencement of the contract but although invoices will be subsequently sentat the end of each year, the government authority will only settle the subsequent amounts owing when thecontract is completed. The invoices sent by Verge to date (including $1 million above) were as follows:
Year ended 31 March 2012 $2·8 millionYear ended 31 March 2013 $1·2 million
The balance will be invoiced on 31 March 2014. Verge has only accounted for the initial payment in the financialstatements to 31 March 2012 as no subsequent amounts are to be paid until 31 March 2014. The amounts ofthe invoices reflect the work undertaken in the period. Verge wishes to know how to account for the contract todate.
Market interest rates are currently at 6%. (6 marks)
(c) In February 2012, an inter-city train did what appeared to be superficial damage to a storage facility of a localcompany. The directors of the company expressed an intention to sue Verge but in the absence of legalproceedings, Verge had not recognised a provision in its financial statements to 31 March 2012. In July 2012,Verge received notification for damages of $1·2m, which was based upon the estimated cost to repair thebuilding. The local company claimed that the building was much more than a storage facility as it was a valuablepiece of architecture which had been damaged to a greater extent than was originally thought. The head of legalservices advised Verge that the company was clearly negligent but the view obtained from an expert was that thevalue of the building was $800,000. Verge had an insurance policy that would cover the first $200,000 of suchclaims. After the financial statements for the year ended 31 March 2013 were authorised, the case came to courtand the judge determined that the storage facility actually was a valuable piece of architecture. The court ruledthat Verge was negligent and awarded $300,000 for the damage to the fabric of the facility. (6 marks)
(d) Verge was given a building by a private individual in February 2012. The benefactor included a condition that itmust be brought into use as a train museum in the interests of the local community or the asset (or a sumequivalent to the fair value of the asset) must be returned. The fair value of the asset was $1·5 million in February2012. Verge took possession of the building in May 2012. However, it could not utilise the building inaccordance with the condition until February 2013 as the building needed some refurbishment and adaptationand in order to fulfil the condition, Verge spent $1 million on refurbishment and adaptation.
On 1 July 2012, Verge obtained a cash grant of $250,000 from the government. Part of the grant related to thecreation of 20 jobs at the train museum by providing a subsidy of $5,000 per job created. The remainder of thegrant related to capital expenditure on the project. At 31 March 2013, all of the new jobs had been created.
(6 marks)
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Required:
Advise Verge on how the above accounting issues should be dealt with in its financial statements for the yearsending 31 March 2012 (where applicable) and 31 March 2013.
Note: The mark allocation is shown against each of the four issues above.
Professional marks will be awarded in question 2 for clarity and quality of presentation. (2 marks)
(25 marks)
7 [P.T.O.
3 (a) (i) Janne is a real estate company, which specialises in industrial property. Investment properties includingthose held for sale constitute more than 80% of its total assets.
It is considering leasing land from Maret for a term of 30 years. Janne plans to use the land for its own officedevelopment but may hold the land for capital gain. The title will remain with Maret at the end of the initiallease term but Janne can lease the land indefinitely at an immaterial rent at the end of the lease or maypurchase the land at a 90% discount to the market value after the initial lease term. Janne is to pay Mareta premium of $3 million at the commencement of the lease, which equates to 70% of the value of the land.Additionally, an annual rental payment is to be made based upon 4% of the market value of the land at thecommencement of the lease, with a market rent review every five years. The rent review sets the rent at thehigher of the current rent or 4% of the current value of the land. Land values have been rising for manyyears.
Additionally, Janne is considering a suggestion by Maret to incorporate a clean break clause in the leasewhich will provide Janne with an option of terminating the agreement after 25 years without any furtherpayment and also to include an early termination clause after 10 years that would require Janne to make atermination payment which would recover the lessor’s remaining investment. (11 marks)
(ii) Janne operates through several subsidiaries and reported a subsidiary as held for sale in its annual financialstatements for both 2012 and 2013. On 1 January 2012, the shareholders had, at a general meeting ofthe company, authorised management to sell all of its holding of shares in the subsidiary within the year.Janne had shown the subsidiary as an asset held for sale and presented it as a discontinued operation inthe financial statements at 31 May 2012. This accounting treatment had been continued in Janne’s 2013financial statements.
Janne had made certain organisational changes during the year to 31 May 2013, which resulted inadditional activities being transferred to the subsidiary. Also during the year to 31 May 2013, there had beendraft agreements and some correspondence with investment bankers, which showed in principle only thatthe subsidiary was still for sale. (6 marks)
Required:
Advise Janne on how the above accounting issues should be dealt with in its financial statements underInternational Financial Reporting Standards.
Note: The mark allocation is shown against each of the two issues above.
(b) Discuss the main differences in accounting for leases under UK GAAP that could affect the treatment of thelease held by Janne. (6 marks)
Professional marks will be awarded in question 3 for clarity and quality of presentation. (2 marks)
(25 marks)
8
4 (a) Developing a framework for disclosure is at the forefront of current debate and there are many bodies around theworld attempting to establish an overarching framework to make financial statement disclosures more effective,coordinated and less redundant. It has been argued that instead of focusing on raising the quality of disclosures,these efforts have placed their emphasis almost exclusively on reducing the quantity of information. The belief isthat excessive disclosure is burdensome and can overwhelm users. However, it could be argued that there is nosuch thing as too much ‘useful’ information for users.
Required:
(i) Discuss why it is important to ensure the optimal level of disclosure in annual reports, describing thereasons why users of annual reports may have found disclosure to be excessive in recent years.
(9 marks)
(ii) Describe the barriers, which may exist, to reducing excessive disclosure in annual reports. (6 marks)
(b) The directors of Lizzer, a public limited company, have read various reports on excessive disclosure in the annualreport. They have decided to take action and do not wish to disclose any further detail concerning the twoinstances below.
(i) Lizzer is a debt issuer whose business is the securitisation of a portfolio of underlying investments andfinancing their purchase through the issuing of listed, limited recourse debt. The repayment of the debt isdependent upon the performance of the underlying investments. Debt-holders bear the ultimate risks andrewards of ownership of the underlying investments. Given the debt specific nature of the underlyinginvestments, the risk profile of individual debt may differ.
Lizzer does not consider its debt-holders as being amongst the primary users of the financial statements and,accordingly, does not wish to provide disclosure of the debt-holders’ exposure to risks in the financialstatements, as distinct from the risks faced by the company’s shareholders, in accordance with IFRS 7Financial Instruments: Disclosures. (4 marks)
(ii) At the date of the financial statements, 31 January 2013, Lizzer’s liquidity position was quite poor, suchthat the directors described it as ‘unsatisfactory’ in the management report. During the first quarter of 2013,the situation worsened with the result that Lizzer was in breach of certain loan covenants at 31 March 2013.The financial statements were authorised for issue at the end of April 2013. The directors’ and auditor’sreports both emphasised the considerable risk of not being able to continue as a going concern.
The notes to the financial statements indicated that there was ‘ample’ compliance with all loan covenantsas at the date of the financial statements. No additional information about the loan covenants was includedin the financial statements. Lizzer had been close to breaching the loan covenants in respect of free cash flows and equity ratio requirements at 31 January 2013.
The directors of Lizzer felt that, given the existing information in the financial statements, any furtherdisclosure would be excessive and confusing to users. (4 marks)
Required:
Discuss the directors’ view that no further information regarding the two instances above should be disclosedin the financial statements because it would be ‘excessive’.
Note: The mark allocation is shown against each of the two instances above.
Professional marks will be awarded in question 4 for clarity and quality of presentation. (2 marks)
(25 marks)
End of Question Paper
9
Answers
Professional Level – Essentials Module, Paper P2 (UK)Corporate Reporting (United Kingdom) June 2013 Answers
1 (a) Trailer plc
Consolidated Statement of Financial Position at 31 May 2013
Equity and liabilitiesEquity attributable to owners of parentShare capital 1,750Retained earnings (W4) 1,254·65Other components of equity (W5) 170·1
–––––––––3,174·75–––––––––
Non-controlling interest (W7) 892·6–––––––––
Total non-current liabilities (W10) 1,906–––––––––
Current liabilities (W6) 412–––––––––
Total liabilities 2,318–––––––––
Total equity and liabilities 6,385·35–––––––––
Working 1
Park
$m $mFair value of consideration for 60% interest 1,250Fair value of identifiable net assets acquired:Share capital 1,210Retained earnings 650OCE 55FV adjustment – land (balance) 35
–––––1,950 x 60% (1,170)
–––––Goodwill 80
–––––
NCI at acquisition is 40% x $1,950m, i.e. $780m
Working 2
Caller comes under the control of Park on 1 June 2011. The investments occurred on the same day and therefore only onegoodwill calculation is required. However, the calculation will occur at the date when Trailer gains control of Park, that is 1 June 2012. The effective interest in Caller by Trailer is 14% plus (60% of 70%), i.e. 56%. The NCI will be 44%.
Caller
$m $mPurchase consideration – Trailer 280Park – 60% of $1,270m 762Less fair value of identifiable net assets:Share capital 800Retained earnings 240OCE 70FV adjustment – land 40
–––––1,150 x 56% (644)
–––––Goodwill 398
–––––
NCI at acquisition is $1,150m x 44%, i.e. $506m
13
The equity interest in Caller held by Trailer has been revalued at 31 May 2013 from $280 million to $310 million and theprofit will have been recognised in profit or loss and hence in retained earnings. This needs to be reversed on consolidation($30m). The gain of $20 million recognised before Trailer took control of Park remains as the original investment is treatedat fair value at the acquisition date as part of the consideration for the control of Caller.
Working 3
Impairment of goodwill
Park
$m $mGoodwill 80Unrecognised non-controlling interest (40%/60% of $80m) 53·3Identifiable net assets Net assets 2,220FV adjustment – land 35
––––––2,255
––––––––Total 2,388·3Recoverable amount (2,088)
––––––––Impairment 300·3Less notional goodwill on NCI (53·3)
––––––––Impairment loss to be allocated 247
––––––––
Allocated toGoodwill 80PPE 167
––––––––Total 247
––––––––
Total goodwill is therefore only that of Caller, i.e. $398m. The impairment loss relating to the PPE is split between NCI($66·8m) and retained earnings ($100·2m). As the goodwill relating to the NCI is not recognised, no impairment of goodwillis allocated to the NCI. Thus retained earnings are charged with ($80m + $100·2m), i.e. $180·2m. It is assumed that therecoverable amount includes the investment in Caller.
Working 4
Retained earnings
$mTrailer:Balance at 31 May 2013 1,240Reversal of gain on revaluation of investment (30)Impairment loss (W3) (180·2)Interest charge (W8) (3·99)Interest credit (W8) 2·76Reversal of revaluation loss (W9) 11·58Provision for restructuring (W11) (14)Pension plan (W12) (1·1)Post-acquisition reserves: Park (60% of (930 – 650)) 168
Caller (56% of (350 – 240)) 61·6–––––––––1,254·65–––––––––
Working 5
Other components of equity
$mBalance at 31 May 2013 – Trailer 125Revaluation gain (W9) 21Pension plan remeasurements (W12) (4·9)Park post acquisition (60% of 80 – 55) 15Caller (56% x (95 – 70)) 14
––––––170·1––––––
14
Working 6
Current liabilities
$mBalance at 31 May 2013Trailer 115Park 87Caller 196Provision for restructuring (W11) 14
––––412––––
Working 7
Non-controlling interest
$mPark (W1) 780Caller (W2) 506Post-acquisition retained earnings – Park (40% of 930 – 650) 112Post-acquisition retained earnings – Caller (44% of 350 – 240) 48·4OCE – post acquisition – Park (40% of 80 – 55) 10OCE – post acquisition – Caller (44% of 95 – 70) 11Less impairment in Park (W3) (66·8)Less NCI share of Park’s investment in Caller (40% of $1,270m) (508)
––––––892·6––––––
Working 8
The discounted interest rate should be recognised as a reduction in the fair value of the asset when measured for the firsttime. The treatment reflects the economic substance of the transaction, i.e. Trailer is locking itself into an arrangement whereit will incur an effective loss on interest receivable over the life of the instrument. This loss will be anticipated by calculatingthe present value of all future cash receipts using the prevailing market interest rate for a similar instrument. This will resultin a lower figure for fair value than the amount advanced, the difference being required to be debited to profit or loss.
The initial fair value of the loan is calculated by scheduling the cash flows due to take place over the life of the loan (afterthe advance has been made) and discounting them to present value using the unsubsidised rate of interest. The making ofthe loan would be accounted for by:
Dr Financial assets $46·01mCr Cash $50mDr Profit or loss $3·99m
The accounting entries should be for the year ended 31 May 2013:
Financial assets
Amortised cost Interest Cash Amortised costat 1 June 2012 credit paid at 31 May 2013
Increase in value of land – Park (W1) 35Increase in value of land – Caller (W2) 40Impairment (W3) (167)Increase in value of offices 32·58
–––––––––3,780·58–––––––––
In 2012, Trailer would have charged $3m for depreciation ($90m divided by 30). Trailer would then have accounted for theremaining $12m of the $15m fall in value as a revaluation loss and charged this to profit or loss.
In 2013, Trailer should charge depreciation of $2·58m ($75m divided by 29 years – the remaining useful life), reducing thecarrying amount of the asset to $72·42m. In order to bring the asset up to its current value of $105m at the end of the year,a revaluation gain of $32·58m needs to be recognised.
The entries will be:
Dr Property, plant and equipment $32·58mCr Profit or loss $11·58mCr Revaluation reserve $21m
The credit to profit or loss is made up of a reversal of $12m impairment loss charged in 2012, less $0·42m for thedepreciation that would have been charged if the asset had not been devalued ($12m divided by 29). This leaves $21m ofthe upward valuation to be credited to the revaluation reserve.
Only those costs that result directly from and are necessarily entailed by the restructuring may be included, such as employeeredundancy costs or lease termination costs. Expenses that relate to ongoing activities, such as relocation and retraining areexcluded. With regard to the service reduction, a provision should be recognised for the redundancy and lease terminationcosts of $14 million. The sites and details of the redundancy costs have been identified.
In contrast, Trailer should not recognise a provision for the finance and IT department’s re-organisation. The re-organisationis not due to start for two years. External parties are unlikely to have a valid expectation that management is committed tothe re-organisation as the time frame allows significant opportunities for management to change the details of the plan oreven to decide not to proceed with it. Additionally, the degree of identification of the staff to lose their jobs is not sufficientlydetailed to support the recognising of a redundancy provision.
16
Working 12
Pension plan
$mFair value at 1 June 2012 28Return on plan assets (5% of $28m) 1·4Contributions for period 2Benefits paid (3)
–––––Expected fair value at 31 May 2013 28·4Actual fair value 29
–––––Remeasurements – gain recognised in OCI 0·6
–––––
Obligation at 1 June 2012 30Interest cost (5% of $30m) 1·5Current service cost 1Benefits paid (3)
–––––Expected obligation 29·5Obligation at 31 May 2013 35
–––––Remeasurements – loss recognised in OCI 5·5
–––––
The liability recognised in the financial statements will be ($35 – $29m), i.e. $6 million.
$mNet obligation at 1 June 2012 ($30m – $28m) 2Net interest cost ($1·5m – $1·4m) 0·1Contributions (2)Current service cost 1Remeasurement loss ($5·5m – $0·6m) 4·9
––––Net obligation at 31 May 2013 ($35m – $29m) 6
––––
The current service cost and net interest cost will be charged to profit or loss ($1·1m) and the remeasurements to OCI($4·9m). There will be no adjustment for the contributions, which have already been taken into account. Therefore theobligation will be credited with $6m.
Working 13
Current assets
$mTrailer 895Park 681Caller 150
––––––1,726
––––––
(b) IFRS 10 Consolidated Financial Statements and FRS 2 Accounting for Subsidiary Undertakings provide similar guidance onthe preparation of consolidated financial statements. While the detailed conditions for exemption from preparing consolidatedfinancial statements differ between FRS 2 (which is based on the Companies Act 2006) and IFRS 10, for companiespreparing financial statements under EU-adopted IFRS (rather than as issued by the IASB) the requirements to prepareconsolidated financial statements are as set out in company law. The determination of whether or not entities are consolidatedby a reporting entity is based on control, although some differences exist in the definition of control. This difference indefinition will often not result in a practical effect.
Under both IFRS 10 and FRS 2, a subsidiary’s financial statements should be prepared using consistent accounting policiesand as of the same date as the financial statements of the parent unless it is impracticable to do so. The basic consolidationprocedures are also similar under the two standards.
The policy adopted by an entity on initial recognition of NCI is either to fair value the NCI interests or account for the NCI’sproportionate share of the fair value of the identifiable net assets. The choice is made on a transaction-by-transaction basis.Under UK GAAP, there is no option to fair value NCI (minority interest) at the time of acquisition and changes in equityallocated to NCI are determined based on present ownership interest.
Under IFRS, where there is a reduction in the ownership without losing control, the carrying amounts of the controlling andNCI are adjusted to reflect the changes in their relative ownership interests in the subsidiary. Any difference between suchamount and the fair value of the consideration paid or received is recognised directly in equity and attributed to the ownersof the parent. Under UK GAAP, the difference between the carrying amount of the subsidiary’s net assets (including anyunamortised goodwill) attributable to the group’s interest before and after the reduction, together with any proceeds received,are recognised in the group profit or loss.
17
Under IFRS, where there is a loss of control in the subsidiary, a gain or loss is recognised as the net effect of:
(i) The carrying amount of the subsidiary’s net assets including goodwill;(ii) The carrying amount of any non-controlling interest;(iii) Fair value of any investment retained as at date of loss of control; and(iv) Any gains and losses reclassified to profit or loss from OCI (including exchange differences).
Under UK GAAP, the gain or loss on disposal is calculated by comparing the carrying amount of the group’s share of the netassets of the subsidiary undertaking (including unamortised goodwill and goodwill previously eliminated against reserves)before disposal with any remaining carrying amount attributable to the group’s interest after the cessation, together with anyproceeds received.
IFRS 3 Business Combinations and FRS 7 Fair Values in Acquisition Accounting provide guidance on how the fair values ofassets acquired and liabilities assumed should be determined, although these are not the same. One of the key principles ofUK GAAP and the Companies Act 2006 is that intangible assets must be separable in the context of identifiable assets andliabilities. Additionally under FRS 10 Goodwill and Intangible Assets, goodwill should be capitalised and amortised usuallyover a period not exceeding 20 years with impairment reviews to confirm the current value. Amortisation, in this way, is notpermitted under IFRS.
Both UK GAAP and IFRS permit an investigation period before the fair value exercise must be finalised, although the lengthdiffers, as does the treatment of changes to fair values of assets and liabilities.
Under IFRS, contingent consideration is initially measured at fair value and any subsequent changes are recognised in eitherprofit or loss, or OCI currently. Contingent consideration meeting the definition of equity is not remeasured. Under UK GAAP,contingent consideration is measured at fair value with any subsequent adjustments made against goodwill.
Under IFRS, an acquirer must expense acquisition-related costs in the periods in which the costs are incurred, except for coststo issue debt or equity securities. Under UK GAAP, all fees and similar incremental costs incurred directly in making anacquisition (except for the issue costs of shares or other securities) are included in the cost of acquisition.
The recognition of a bargain purchase is different under the two GAAPs. Under IFRS, the excess of the fair value of identifiableassets, liabilities and contingent liabilities over the consideration (i.e. negative goodwill) is recognised immediately throughprofit or loss. Under UK GAAP, negative goodwill is capitalised and recognised in profit or loss in the periods in which thenon-monetary assets are recovered through depreciation and sale. Negative goodwill in excess of the fair value of the non-monetary assets is recognised in the periods expected to benefit. Where the acquisition is achieved in stages, the acquirerremeasures its previously held equity interest in the acquiree at its acquisition-date fair value and recognises the resulting gainor loss, if any, in profit or loss. Any amounts previously recognised through OCI are recognised on the same basis as wouldbe required if the acquirer had disposed directly of the previously held equity interest. Under UK GAAP, the cost of acquisitionis the total of the costs of the interests acquired, determined as at the date of each transaction. Where the fair values ofidentifiable assets and liabilities recognised as part of the earlier transaction are reassessed compared to their carryingamounts, a revaluation gain is recognised in the STRGL.
(c) There are several reasons why an accountant should study ethics. The moral beliefs that an individual holds may not besufficient because often these are simple beliefs about complex issues. The study of ethics can sort out these complex issuesby teaching the principles that are operating in these cases. Often there may be ethical principles which conflict and it maybe difficult to decide on a course of action. The study of ethics can help by developing ethical reasoning in accountants byproviding insight into how to deal with conflicting principles and why a certain course of action is desirable. Individuals mayhold inadequate beliefs or hold on to inadequate ethical values. For example, it may be thought that it is acceptable to holdshares in client companies for business reasons, which, of course, is contrary to ethical guidance. Additionally, compliancewith GAAP could be thought to be sufficient to meet the duty of an accountant. However, it can be argued that an accountanthas an ethical obligation to encourage a more realistic financial picture by applying ethical judgement to the provisions ofGAAP.
Another important reason to study ethics is to understand the nature of one’s own opinion and ethical values. Ethicalprinciples should be compatible with other values in life. For example, one’s reaction to the following circumstances: thechoice between keeping your job and violating professional and ethical responsibilities, the resolution of conflicts of interestif they involve family.
Finally, a good reason for studying ethics is to identify the basic ethical principles that should be applied. This will involve notonly code-based decisions but also the application of principles that should enable the determination of what should be donein a given situation. The ethical guidance gives a checklist to be applied so that the outcome can be determined. Ethical issuesare becoming more and more complex and it is critical to have knowledge of the underlying structure of ethical reasoning.Professional ethics is an inherent part of the profession. ACCA’s Code of Ethics and Conduct requires its members to adhereto a set of fundamental principles in the course of their professional duty, such as confidentiality, objectivity, professionalbehaviour, integrity and professional competence and due care. The main aim of professional ethics is to serve as a moralguideline for professional accountants. By referring back to the set of ethical guidelines, the accountant is able to decide onthe most appropriate course of action, which will be in line with the professional body’s stance on ethics. The presence of acode of ethics is a form of declaration by the professional body to the public that it is committed to ensuring the highest levelof professionalism amongst its members.
Although the takeover does not benefit the company, its executives or society as a whole, the action is deceptive, unethicaland hence unfair. It violates the relationship of trust, which the company has with society and the professional code of ethics.There are nothing but good reasons against the false disclosure of profits.
18
2 (a) IFRS 8 Operating Segments states that reportable segments are those operating segments or aggregations of operatingsegments for which segment information must be separately reported. Aggregation of one or more operating segments into asingle reportable segment is permitted (but not required) where certain conditions are met, the principal condition being thatthe operating segments should have similar economic characteristics. The segments must be similar in each of the followingrespects:
– the nature of the products and services– the nature of the production processes– the type or class of customer– the methods used to distribute their products or provide their services– the nature of the regulatory environment.
Segments 1 and 2 have different customers. In view of the fact that the segments have different customers, the two segmentsdo not satisfy one of the aggregation criteria above. The decision to award or withdraw a local train contract rests with thetransport authority and not with the end customer, the passenger. In contrast, the decision to withdraw from a route in theinter-city train market would normally rest with Verge but would be largely influenced by the passengers’ actions that wouldlead to the route becoming economically unviable.
In the local train market, contracts are awarded following a competitive tender process, and, consequently, there is noexposure to passenger revenue risk. The ticket prices paid by passengers are set by a transport authority and not Verge. Bycontrast, in the inter-city train market, ticket prices are set by Verge and its revenues are, therefore, the fares paid by thepassengers travelling on the trains. In this set of circumstances, the company is exposed to passenger revenue risk. This riskwould affect the two segments in different ways but generally through the action of the operating segment’s customer.Therefore the economic characteristics of the two segments are different and should be reported as separate segments.
(b) Revenue should be measured at the fair value of the consideration received or receivable under IAS 18 Revenue. Where theinflow of cash or cash equivalents is deferred, the fair value of the consideration receivable is less than the nominal amountof cash and cash equivalents to be received, and discounting is appropriate. This would occur in this instance as, effectively,Verge is providing interest-free credit to the buyer. Interest must be imputed based on market rates, which in this case is 6%.Recognition, as defined in the IASB Framework, means incorporating an item that meets the definition of revenue in thestatement of profit or loss when it meets the following criteria:
– it is probable that any future economic benefit associated with the item of revenue will flow to the entity, and– the amount of revenue can be measured with reliability.
Thus Verge must recognise revenue as work is performed throughout the contract life. Discounting the revenue to reflect thedelay in receipt of cash from the customer ensures that the revenue is reported at its fair value. The difference between thediscounted revenue and the payment received should be recognised as interest income.
The calculation of the revenue’s fair value is as follows:
In the year ended 31 March 2012, Verge should have recorded revenue of $1·8 million/1·06/1·06, i.e. $1·6 million plus $1 million, i.e. $2·6 million. In the year ended 31 March 2013, revenue should be recorded of $1·2 million/1·06, i.e. $1·13 million. In addition, there will be an interest income of $1·6 million x 6%, i.e. $96,000 recorded in the year to 31 March 2013 which is the unwinding of the discount on the recognised revenue for the year ended 31 March 2012.
Prior period errors are omissions from, and misstatements in, the entity’s financial statements for one or more prior periodsarising from a failure to use, or misuse of, reliable information that:
– was available when financial statements for those periods were authorised for issue; and– could reasonably be expected to have been obtained and taken into account in the preparation and presentation of those
financial statements.
Such errors include the effects of mathematical mistakes, mistakes in applying accounting policies, oversights ormisinterpretations of facts and fraud. The fact that Verge only included $1 million of the revenue in the financial statementsfor the year ended 31 March 2012 is a prior period error.
Verge should correct the prior period errors retrospectively in the financial statements for the year ended 31 March 2013 byrestating the comparative amounts for the prior period presented in which the error occurred.
(c) Under IAS 37 Provisions, Contingent Liabilities and Contingent Assets, an entity must recognise a provision if, and only:
– if a present obligation (legal or constructive) has arisen as a result of a past event (the obligating event), – payment is probable (‘more likely than not’), and – the amount can be estimated reliably.
An obligating event is an event that creates a legal or constructive obligation and, therefore, results in an entity having norealistic alternative but to settle the obligation. The obligating event took place in the year to 31 March 2012. A provisionshould be made on the date of the obligating event, which is the date on which the event takes place that results in an entityhaving no realistic alternative to settling the legal or constructive obligation. Even in the absence of legal proceedings, Vergeshould prudently recognise an obligation to pay damages, but it is reasonable at 31 March 2012 to assess the need for aprovision to be immaterial as no legal proceedings have been started and the damage to the building seemed superficial.Provisions should represent the best estimate at the financial statement date of the expenditure required to settle the presentobligation and this measurement should take into account the risks and uncertainties of circumstances relevant to theobligation.
19
In the year to 31 March 2013, as a result of the legal arguments supporting the action, Verge will have to reassess its estimateof the likely damages and a provision is needed, based on the advice that it has regarding the likely settlement. Provisionsshould be reviewed at each year end for material changes to the best estimate.
Dr Profit or loss $800,000Cr Provision for damages $800,000
The potential for reimbursements (e.g. insurance payments) to cover some of the expenditure required to settle a provisioncan be recognised, but only if receipt is virtually certain if the entity settles the obligation. IAS 37 requires that thereimbursement be treated as a separate asset. The amount recognised for the reimbursement cannot exceed the amount ofthe provision. IAS 37 permits the expense relating to a provision to be presented net of the amount. The company seemsconfident that it will satisfy the terms of the insurance policy and should accrue for the reimbursement:
Dr Trade receivables $200,000Cr Profit or loss $200,000
The court case was found against Verge but as this was after the authorisation of the financial statements, there is noadjustment of the provision at 31 March 2013. It is not an adjusting event.
(d) In accordance with IAS 1 Presentation of Financial Statements, all items of income and expense recognised in a period shouldbe included in profit or loss for the period unless a standard or interpretation requires or permits otherwise.
IAS 16 Property, Plant and Equipment states that the recognition criteria for PPE are based on the probability that futurebenefits will flow to the entity from the asset and that cost can be measured reliably. The above normally occurs when therisks and rewards of the asset have passed to the entity. Normally the risks and rewards are assumed to transfer when anunconditional and irrevocable contract is put in place.
Therefore at 31 March 2012, the building would not be recognised as the ‘contract’ is not unconditional and possession ofthe building has not been taken by Verge.
Once the conditions of the donated asset have been met in February 2013, the income of $1·5 million is recognised in thestatement of profit or loss and other comprehensive income. The following transactions need to be made to recognise theasset in the entity’s statement of financial position as of 31 March 2013.
Dr Property, plant and equipment $2·5mCr Profit or loss $1·5mCr Cash/trade payable $1m
Depreciation of the building should also be charged for the period according to Verge’s accounting policy.
IAS 20 Accounting for Government Grants and Disclosure of Government Assistance states that a government grant isrecognised only when there is reasonable assurance that (a) the entity will comply with any conditions attached to the grantand (b) the grant will be received. Thus in this case the grant will be recognised.
The grant is recognised as income over the period necessary to match it with the related costs, for which it is intended tocompensate, on a systematic basis. A grant receivable as compensation for costs already incurred or for immediate financialsupport, with no future related costs, should be recognised as income in the period in which it is receivable.
A grant relating to assets (capital based grant) may be presented in one of two ways:
– either as deferred income, or – by deducting the grant from the asset’s carrying amount.
The grant of $250,000 relates to capital expenditure and revenue. It seems appropriate to account for the grant on the basisof matching the grant to the expenditure. Therefore $100,000 (20 x $5,000) should be taken to income and the remainder($150,000) should be recognised as a capital based grant. The double entry would be:
Dr Cash $250,000Cr Profit or loss $100,000Cr Deferred income or PPE (depending on accounting policy) $150,000
3 (a) (i) The lease of the land is subject to the general lease classification criteria of IAS 17 Leases and the fact that land normallyhas an indefinite economic life is an important consideration. Thus, if the lease of land transfers substantially all therisks and rewards incidental to ownership to the lessee, then the lease is a finance lease, otherwise it is an operatinglease. A lease of land with a long term may be classified as a finance lease even if the title does not pass to the lessee.Situations set out in IAS 17 that would normally lead to a lease being classified as a finance lease include the following:
(1) the lease transfers ownership of the asset to the lessee by the end of the lease term
(2) the lease term is for the major part of the economic life of the asset, even if title is not transferred
(3) at the inception of the lease, the present value of the minimum lease payments amounts to at least substantiallyall of the fair value of the leased asset
(4) the lessee has the ability to continue to lease for a secondary period at a rent that is substantially lower than marketrent.
20
A contingent rent is an amount that is paid as part of the lease payments but is not fixed or agreed in advance at theinception of the lease, rather the amount to be paid is dependent on some future event. However, it is not an interestpayment, as it is not connected with the passage of time, therefore time value of money is not an issue. Under IAS 17,contingent rents are excluded from minimum lease payments and are accounted as expense/income in the period inwhich they are incurred/earned. Contingent rents may indicate that a lease is an operating lease if the nature of thecontingency provides evidence that the lessor has not transferred substantially all of the risks and rewards of ownershipof the land. However, other factors have to be taken into account besides the contingent rental.
The presence of an option to extend the lease at substantially less than a market rent or purchase it at a discount of90% on the market value implies that the lessor expects to achieve its return on investment mainly through the leasepayments and therefore is content to continue the lease for a secondary period at an immaterial rental or sell it at asubstantial discount to the market value. This is an indicator of a finance lease. It is reasonable to assume that the lesseewill extend the lease in these circumstances. However, an option to extend it at a market rental without the purchaseprovision may indicate that the lessor has not achieved its return on investment through the lease rentals and thereforeis relying on a subsequent lease or sale to do so. This is an indicator of an operating lease as there will be no compellingcommercial reason why the lessee should extend the agreement. In this case, the lease term is not for the major part ofthe economic life of the asset as the asset is land. However, it would appear that the minimum lease payments wouldequate to the fair value of the asset, given the fact that the lease premium is 70% of the current fair value and the rentis 4% of the fair value for 30 years. Additionally, if land values rise, then there is a revision of the rental every five yearsto ensure that the lessor achieves the return on the investment. As a result of the above, it would appear that the leaseis a finance lease. The upfront premium plus the present value of the annual payments at the commencement of thelease would be capitalised as property, plant and equipment and the annual lease payments would be shown as aliability. The interest expense would be recognised over the lease term so as to produce a constant periodic rate of intereston the remaining balance of the liability.
Additionally, Janne plans to use the land in its business but may hold the land for capital gain. Thus the lease may meetthe definition of an investment property if it is to be held for capital gain. In the latter case, IAS 40 Investment Propertyshould be used to account for the land with the lessee’s chosen model used to account for it.
If a lease contains a clean break clause, where the lessee is free to walk away from the lease agreement after a certaintime without penalty, then the lease term for accounting purposes will normally be the period between thecommencement of the lease and the earliest point at which the break option is exercisable by the lessee. If a leasecontains an early termination clause that requires the lessee to make a termination payment to compensate the lessorsuch that the recovery of the lessor’s remaining investment in the lease is assured, then the termination clause wouldnormally be disregarded in determining the lease term. However, the suggestions made by Maret do add substance tothe conclusion that the lease is a finance lease, as the early termination clause requires a payment which recovers thelessor’s investment and it would appear that Maret is happy to allow the termination of the agreement after 25 yearswhich would imply that the lessor’s return would have been achieved after that period of time.
(ii) Under IFRS 5 Non-current Assets Held for Sale and Discontinued Operations, a disposal group is classified as held forsale where its carrying amount will be recovered principally through sale rather than continuing use. The sale should beexpected to be complete within one year from the date of classification. A disposal group can, exceptionally, be classifiedas held for sale/discontinued after a period of 12 months if it meets certain criteria. These are: that during the initialone-year period, circumstances arose that were previously considered unlikely and, as a result, a disposal grouppreviously classified as held for sale is not sold by the end of that period. Also during the initial one-year period, theentity took action necessary to respond to the change in circumstances such that the non-current asset (or disposalgroup) is being actively marketed at a price that is reasonable, given the change in circumstances, and the criteria forclassification as held for sale are met.
The draft agreements with investment bankers appear not to be sufficiently detailed to prove that the subsidiary met thecriteria at the point of classification as required by IFRS 5. This requires the disposal group to be available for immediatesale in its present condition subject only to terms that are usual and customary for sales of such disposal groups. Also,Janne had made certain organisational changes during the year to 31 May 2013, which resulted in additional activitiesbeing transferred to the subsidiary. This confirms that the subsidiary was not available for sale in its present conditionas at the point of classification. Also, the shareholders’ authorisation to sell the subsidiary was only granted for one yearand there is no indication that this was extended by the subsequent shareholders’ meeting in 2013. The subsidiaryshould have been treated as a continuing operation in the financial statements for both years ended 31 May 2012 and31 May 2013.
(b) UK GAAP would consider a similar list of indicators for the determination of a finance lease, but has a rebuttable presumptionthat transfer of risks and rewards occurs, if the present value of the minimum lease payments discounted at the interest rateimplicit in the lease amounts to substantially all (normally 90% or more) of the fair value of the leased asset. IAS 17 Leasesincludes a number of situations that individually or in combination would lead to a lease being classified as a finance leasebut there is no 90% test rule.
Lease classification, under IAS 17, is made at the inception of the lease, which is the earlier of the date of the lease agreementand the date of commitment by the parties to the principal provisions of the lease. Under UK GAAP, inception is the earlierof the time the asset is brought into use and the date from which rentals first accrue.
21
A leased asset, under IAS 17, is recognised at the lower of the fair value of the asset or the present value of the minimumlease payments, discounted at the interest rate implicit in the lease or, if this is not available, the entity’s incrementalborrowing rate. A leased asset, under UK GAAP, is recognised at the present value of the minimum lease payments,discounted at the interest rate implicit in the lease (or at the borrowing rate on a similar lease), or at the fair value of the assetif it is a sufficiently close approximation of the present value of the minimum lease payments. There is no guidance ontreatment of contingent rent under UK GAAP and the interest rate implicit in the lease excludes the impact of initial directcosts of the lessor but under IAS 17 it includes these costs.
There are no detailed rules regarding the allocation between land and buildings elements under UK GAAP but, in the contextof the UK property market, only those leases of land and buildings that are of such length that they allow the lessee toredevelop the site are likely to include a significant value for the land element. Under IAS 17, when a lease includes landand buildings elements, the classification of each element as a finance or operating lease is assessed separately. An importantconsideration is that land normally has an indefinite economic life. The minimum lease payments are allocated between landand buildings in proportion to the relative fair values of the interests in each element. As Janne is only leasing the land, thedifference in treatment should not affect the accounting for the lease.
4 (a) (i) Excessive disclosure can obscure relevant information and make it harder for users to find the key points about theperformance of the business and its prospects for long-term success. It is important that financial statements arerelevant, reliable and can be understood. Additionally, it is important for the efficient operation of the capital marketsthat annual reports do not contain unnecessary information. However, it is equally important that useful information ispresented in a coherent way so that users can find what they are looking for and gain an understanding of the company’sbusiness and the opportunities, risks and constraints that it faces. A company, however, must treat all of its shareholdersequally in the provision of information. It is for each shareholder to decide whether they wish to make use of thatinformation. It is not for a company to pre-empt a shareholder’s rights in this regard by withholding the information.
A significant cause of excessive disclosure in annual reports is the vast array of requirements imposed by laws,regulations and financial reporting standards. Regulators and standard setters have a key role to play in cutting clutter,both by cutting the requirements that they themselves already impose and by guarding against the imposition ofunnecessary new disclosures. A listed company may have to comply with listing rules, company law, internationalfinancial reporting standards, the corporate governance codes and, if it has an overseas listing, any local requirements,such as those of the SEC in the US. Thus a major source of excessive disclosure is the fact that different parties requirediffering disclosures for the same matter. For example, an international bank in the UK may have to disclose credit riskunder IFRS 7 Financial Instruments: Disclosures, the Companies Acts and the Disclosure and Transparency Rules, theSEC rules and Industry Guide 3 as well as the requirements of Basel II Pillar 3. A problem is that different regulatorshave different audiences in mind for the requirements they impose on annual reports. Regulators attempt to reach widerranges of actual or potential users and this can lead to a loss of focus and structure in reports.
Shareholders are increasingly unhappy with the substantial increase in the length of reports that has occurred in recentyears. This, often, has not resulted in better information but more confusion as to the reason for the disclosure. A reviewof companies’ published accounts will show that large sections such as ‘Statement of Directors Responsibilities’ and‘Audit Committee report’ can be almost identical.
Preparers now have to consider many other stakeholders including employees, unions, environmentalists, suppliers,customers, etc. The disclosures required to meet the needs of this wider audience have contributed to the increasedvolume of disclosure. The growth of previous initiatives on going concern, sustainability, risk, the business model andothers that have been identified by regulators as ‘key’ has also expanded the annual report size.
A problem that seems to exist is that disclosures are being made because a disclosure checklist suggests it may needto be made, without assessing whether the disclosure is necessary in a company’s particular circumstances. It isinherent in these checklists that they include all possible disclosures that could be material.
The length of the annual report is not necessarily the problem but the way in which it is organised. The inclusion of‘immaterial’ disclosures will usually make this problem worse but, in a well organised annual report, users will often beable to bypass much of the information they consider unimportant especially if the report is online. It is not the lengthof the accounting policies disclosure that is itself problematic, but the fact that new or amended policies can be obscuredin a long note running over several pages. A further problem is that accounting policy disclosure is often ‘boilerplate’,providing little specific detail of how companies apply their general policies to particular transactions. Many disclosurerequirements have been introduced in new or revised international accounting standards over the last ten years withoutany review of their overall impact on the length or usefulness of the resulting financial statements.
(ii) There are behavioural barriers to reducing disclosure. It may be that the threat of criticism or litigation could be aconsiderable limitation on the ability to cut disclosure. The threat of future litigation may outweigh any benefits to beobtained from eliminating ‘catch-all’ disclosures. Preparers of annual reports are likely to err on the side of caution andinclude more detailed disclosures than are strictly necessary to avoid challenge from auditors and regulators. Removingdisclosures is perceived as creating a risk of adverse comment and regulatory challenge. Disclosure is the safest optionand is therefore often the default position. Preparers and auditors may be reluctant to change from the current positionunless the risk of regulatory challenge is reduced. The prospect of internal firm review and/or external review can induceauditors to take a ‘tick-box’ compliance approach to avoid challenge and adverse publicity. Companies have a tendency
22
to repeat disclosures because they were there last year. Preparers wish to present balanced and sufficiently informativedisclosures and may be unwilling to change.
A reassessment of the whole model will take time and may necessitate changes to law and other requirements. TheIASB has recently issued a request for views regarding its forward agenda in which it acknowledges that stakeholdershave said that disclosure requirements are too voluminous and not always focused in the right areas. The drive by theIASB has very much been to increase the use of disclosure to address comparability between companies and, in theshort to medium term, a reduction in the volume of accounting disclosures does not look feasible although this is anarea to be considered by the IASB for its post-2012 agenda.
(b) (i) Lizzer’s perception of who could reasonably be considered to be among the users of its financial statements is toonarrow, being limited to the company’s shareholders rather than including debt-holders; and the risk disclosures requiredby IFRS 7 should be enhanced to include those relating to the debt-holders, by individual series of debt wherepracticable, so as to ensure that significant differences between the various series of debt are not obscured. IAS 1 statesthat the objective of financial statements is to provide information about the financial position, financial performance andcash flows of an entity that is useful to a wide range of users in making economic decisions. The standard also statesthat omissions or misstatements of items are material if they could, individually or collectively, influence the economicdecisions that users make on the basis of the financial statements.
The objective of IFRS 7 is to require entities to provide disclosures in their financial statements that enable users toevaluate the significance of financial instruments for the entity’s financial position and performance. IFRS 7 states that,amongst other matters, for each type of risk arising from financial instruments, an entity shall disclose:
(a) the exposures to risk and how they arise; (b) its objectives, policies and processes for managing the risk and the methods used to measure the risk.
Thus the risks attached to the debt should be disclosed.
(ii) Lizzer should have disclosed additional information about the covenants relating to each loan or group of loans, includingthe amount of headroom, as deemed appropriate under IFRS 7. The subsequent breach of the covenants represented amaterial event after the reporting period and should have given rise to relevant disclosures required by IAS 10 EventsAfter the Reporting Period in relation to material non-adjusting events after the reporting period.
According to IFRS 7, an entity should disclose information that enables users of its financial statements to evaluate thenature and extent of risks arising from financial instruments to which the entity is exposed at the end of the reportingperiod. Disclosure of information about covenants is necessary to a greater extent in situations where the entity is closeto breaching its covenants, and in situations where uncertainty is expressed in relation to the going concern assumption.Given the fact that, at 31 January 2013, there was a considerable risk of breach of covenants in the near future, Lizzershould have given additional information relating to the conditions attached to its loans, including details on how closethe entity was to breaching the covenants.
A breach of covenants after the date of the financial statements, but before the financial statements were authorised forissue, constitutes a material non-adjusting event after the end of the reporting period which requires further disclosurein accordance with IAS 10. Additionally, there appears to be an apparent inconsistency between the informationprovided in the directors’ and auditors’ reports and that which is included in the financial statements. If balances areaffected in the SOFP, then there would need to be some adjustment.
23
Professional Level – Essentials Module, Paper P2 (UK)Corporate Reporting (United Kingdom) June 2013 Marking Scheme
(c) Subjective assessment – 1 mark per point 6–––50
–––
2 (a) Segment explanation up to 5
(b) IAS 18 explanation and calculation 6
(c) IAS 37 explanation and calculation 6
(d) IAS 1/16/20 explanation and calculation 6
Professional marks 2–––25
–––
3 (a) (i) Leases explanation up to 11
(ii) IFRS 5 explanation 6
(b) Explanation of differences – 2 marks per valid point 6
Professional marks 2–––25
–––
4 (a) Subjective disclosure 9barriers 6
(b) Subjective 8
Professional marks 2–––25
–––
25
Professional Level – Essentials Module
Time allowedReading and planning: 15 minutesWriting: 3 hours
This paper is divided into two sections:
Section A – This ONE question is compulsory and MUST be attempted
Section B – TWO questions ONLY to be attempted
Do NOT open this paper until instructed by the supervisor.
During reading and planning time only the question paper may be annotated. You must NOT write in your answer booklet untilinstructed by the supervisor.
This question paper must not be removed from the examination hall.
Pape
r P
2 (
UK
)
Corporate Reporting(United Kingdom)
Tuesday 10 June 2014
The Association of Chartered Certified Accountants
Section A – THIS ONE question is compulsory and MUST be attempted
1 The following draft financial statements relate to Marchant, a public limited company.
Marchant Group: Draft statements of profit or loss and other comprehensive income for the year ended 30 April 2014.
–––– –––– –––Other comprehensive income – revaluation surplus 10
–––– –––– –––Total comprehensive income for year 51 19 15
–––– –––– –––
The following information is relevant to the preparation of the group statement of profit or loss and othercomprehensive income:
1. On 1 May 2012, Marchant acquired 60% of the equity interests of Nathan, a public limited company. Thepurchase consideration comprised cash of $80 million and the fair value of the identifiable net assets acquiredwas $110 million at that date. The fair value of the non-controlling interest (NCI) in Nathan was $45 million on1 May 2012. Marchant wishes to use the ‘full goodwill’ method for all acquisitions. The share capital andretained earnings of Nathan were $25 million and $65 million respectively and other components of equity were$6 million at the date of acquisition. The excess of the fair value of the identifiable net assets at acquisition isdue to non-depreciable land.
Goodwill has been impairment tested annually and as at 30 April 2013 had reduced in value by 20%. Howeverat 30 April 2014, the impairment of goodwill had reversed and goodwill was valued at $2 million above itsoriginal value. This upward change in value has already been included in above draft financial statements ofMarchant prior to the preparation of the group accounts.
2. Marchant disposed of an 8% equity interest in Nathan on 30 April 2014 for a cash consideration of $18 millionand had accounted for the gain or loss in other income. The carrying value of the net assets of Nathan at 30 April 2014 was $120 million before any adjustments on consolidation. Marchant accounts for investmentsin subsidiaries using IFRS 9 Financial Instruments and has made an election to show gains and losses in othercomprehensive income. The carrying value of the investment in Nathan was $90 million at 30 April 2013 and$95 million at 30 April 2014 before the disposal of the equity interest.
3. Marchant acquired 60% of the equity interests of Option, a public limited company, on 30 April 2012. Thepurchase consideration was cash of $70 million. Option’s identifiable net assets were fair valued at $86 millionand the NCI had a fair value of $28 million at that date. On 1 November 2013, Marchant disposed of a 40%equity interest in Option for a consideration of $50 million. Option’s identifiable net assets were $90 million andthe value of the NCI was $34 million at the date of disposal. The remaining equity interest was fair valued at$40 million. After the disposal, Marchant exerts significant influence. Any increase in net assets since acquisitionhas been reported in profit or loss and the carrying value of the investment in Option had not changed sinceacquisition. Goodwill had been impairment tested and no impairment was required. No entries had been madein the financial statements of Marchant for this transaction other than for cash received.
2
4. Marchant sold inventory to Nathan for $12 million at fair value. Marchant made a loss on the transaction of $2 million and Nathan still holds $8 million in inventory at the year end.
5. The following information relates to Marchant’s pension scheme:
$mPlan assets at 1 May 2013 48Defined benefit obligation at 1 May 2013 50Service cost for year ended 30 April 2014 4Discount rate at 1 May 2013 10%Re-measurement loss in year ended 30 April 2014 2Past service cost 1 May 2013 3
The pension costs have not been accounted for in total comprehensive income.
6. On 1 May 2012, Marchant purchased an item of property, plant and equipment for $12 million and this is beingdepreciated using the straight line basis over 10 years with a zero residual value. At 30 April 2013, the assetwas revalued to $13 million but at 30 April 2014, the value of the asset had fallen to $7 million. Marchant usesthe revaluation model to value its non-current assets. The effect of the revaluation at 30 April 2014 had not beentaken into account in total comprehensive income but depreciation for the year had been charged.
7. On 1 May 2012, Marchant made an award of 8,000 share options to each of its seven directors. The conditionattached to the award is that the directors must remain employed by Marchant for three years. The fair value ofeach option at the grant date was $100 and the fair value of each option at 30 April 2014 was $110. At 30 April 2013, it was estimated that three directors would leave before the end of three years. Due to aneconomic downturn, the estimate of directors who were going to leave was revised to one director at 30 April2014. The expense for the year as regards the share options had not been included in profit or loss for the currentyear and no directors had left by 30 April 2014.
8. A loss on an effective cash flow hedge of Nathan of $3 million has been included in the subsidiary’s financecosts.
9. Ignore the taxation effects of the above adjustments unless specified. Any expense adjustments should beamended in other expenses.
Required:
(a) (i) Prepare a consolidated statement of profit or loss and other comprehensive income for the year ended30 April 2014 for the Marchant Group. (30 marks)
(ii) Explain, with suitable calculations, how the sale of the 8% interest in Nathan should be dealt with inthe group statement of financial position at 30 April 2014. (5 marks)
(b) Marchant has carried out impairment reviews of goodwill annually and has recorded the reversal of theimpairment of goodwill, reflecting this in profit or loss. Two of the directors of Marchant are qualified accountantswho were trained in the use of UK GAAP and are still finding it difficult to understand the key differences betweenUK GAAP and IFRS, particularly in this area.
Required:
Explain the key differences between UK GAAP and IFRS as regards (i) the recognition of reversals ofimpairments of intangible assets and (ii) the recognition of intangible assets generally. (9 marks)
3 [P.T.O.
(c) Marchant plans to update its production process and the directors feel that technology-led production is the onlyfeasible way in which the company can remain competitive. Marchant operates from a leased property and theleasing arrangement was established in order to maximise taxation benefits. However, the financial statementshave not shown a lease asset or liability to date.
A new financial controller joined Marchant just after the financial year end of 30 April 2014 and is presentlyreviewing the financial statements to prepare for the upcoming audit and to begin making a loan application tofinance the new technology. The financial controller feels that the lease relating to both the land and buildingsshould be treated as a finance lease but the finance director disagrees. The finance director does not wish torecognise the lease in the statement of financial position and therefore wishes to continue to treat it as anoperating lease. The finance director feels that the lease does not meet the criteria for a finance lease and it wasmade clear by the finance director that showing the lease as a finance lease could jeopardise the loan application.
Required:
Discuss the ethical and professional issues which face the financial controller in the above situation.(6 marks)
(50 marks)
4
Section B – TWO questions ONLY to be attempted
2 Aspire, a public limited company, operates many of its activities overseas. The directors have asked for advice on thecorrect accounting treatment of several aspects of Aspire’s overseas operations. Aspire’s functional currency is thedollar.
(a) Aspire has created a new subsidiary, which is incorporated in the same country as Aspire. The subsidiary hasissued 2 million dinars of equity capital to Aspire, which paid for these shares in dinars. The subsidiary has alsoraised 100,000 dinars of equity capital from external sources and has deposited the whole of the capital with abank in an overseas country whose currency is the dinar. The capital is to be invested in dinar denominatedbonds. The subsidiary has a small number of staff and its operating expenses, which are low, are incurred indollars. The profits are under the control of Aspire. Any income from the investment is either passed on to Aspirein the form of a dividend or reinvested under instruction from Aspire. The subsidiary does not make any decisionsas to where to place the investments.
Aspire would like advice on how to determine the functional currency of the subsidiary. (7 marks)
(b) Aspire has a foreign branch which has the same functional currency as Aspire. The branch’s taxable profits aredetermined in dinars. On 1 May 2013, the branch acquired a property for 6 million dinars. The property had anexpected useful life of 12 years with a zero residual value. The asset is written off for tax purposes over eightyears. The tax rate in Aspire’s jurisdiction is 30% and in the branch’s jurisdiction is 20%. The foreign branchuses the cost model for valuing its property and measures the tax base at the exchange rate at the reporting date.
Aspire would like an explanation (including a calculation) as to why a deferred tax charge relating to the assetarises in the group financial statements for the year ended 30 April 2014 and the impact on the financialstatements if the tax base had been translated at the historical rate. (6 marks)
(c) On 1 May 2013, Aspire purchased 70% of a multi-national group whose functional currency was the dinar. Thepurchase consideration was $200 million. At acquisition, the net assets at cost were 1,000 million dinars. Thefair values of the net assets were 1,100 million dinars and the fair value of the non-controlling interest was 250 million dinars. Aspire uses the full goodwill method.
Aspire wishes to know how to deal with goodwill arising on the above acquisition in the group financialstatements for the year ended 30 April 2014. (5 marks)
(d) Aspire took out a foreign currency loan of 5 million dinars at a fixed interest rate of 8% on 1 May 2013. Theinterest is paid at the end of each year. The loan will be repaid after two years on 30 April 2015. The interestrate is the current market rate for similar two-year fixed interest loans.
Aspire requires advice on how to account for the loan and interest in the financial statements for the year ended30 April 2014. (5 marks)
Aspire has a financial statement year end of 30 April 2014 and the average currency exchange rate for the year isnot materially different from the actual rate.
Exchange rates $1 = dinars1 May 2013 530 April 2014 6Average exchange rate for year ended 30 April 2014 5·6
Required:
Advise the directors of Aspire on their various requests above, showing suitable calculations where necessary.
Note: The mark allocation is shown against each of the four issues above.
Professional marks will be awarded in question 2 for clarity and quality of presentation. (2 marks)
(25 marks)
5 [P.T.O.
3 (a) Minco is a major property developer which buys land for the construction of housing. One aspect of its businessis to provide low-cost homes through the establishment of a separate entity, known as a housing association.Minco purchases land and transfers ownership to the housing association before construction starts. Minco sellsrights to occupy the housing units to members of the public but the housing association is the legal owner of thebuilding. The housing association enters into loan agreements with the bank to cover the costs of building thehomes. However, Minco negotiates and acts as guarantor for the loan, and bears the risk of increases in the loan’sinterest rate above a specified rate. Currently, the housing rights are normally all sold on completion of a project.
Minco enters into discussions with a housing contractor regarding the construction of the housing units but theagreement is between the housing association and the contractor. Minco is responsible for any construction costsin excess of the amount stated in the contract and is responsible for paying the maintenance costs for any unitsnot sold. Minco sets up the board of the housing association, which comprises one person representing Mincoand two independent board members.
Minco recognises income for the entire project when the land is transferred to the housing association. Theincome recognised is the difference between the total sales price for the finished housing units and the totalestimated costs for construction of the units. Minco argues that the transfer of land represents a sale of goodswhich fulfils the revenue recognition criteria in IAS 18 Revenue. (7 marks)
(b) Minco often sponsors professional tennis players in an attempt to improve its brand image. At the moment, ithas a three-year agreement with a tennis player who is currently ranked in the world’s top ten players. Theagreement is that the player receives a signing bonus of $20,000 and earns an annual amount of $50,000, paidat the end of each year for three years, provided that the player has competed in all the specified tournamentsfor each year. If the player wins a major tournament, she receives a bonus of 20% of the prize money won atthe tournament. In return, the player is required to wear advertising logos on tennis apparel, play a specifiednumber of tournaments and attend photo/film sessions for advertising purposes. The different payments are notinterrelated. (5 marks)
(c) Minco leased its head office during the current accounting period and the agreement terminates in six years’ time.There is a clause in the operating lease relating to the internal condition of the property at the termination of thelease. The clause states that the internal condition of the property should be identical to that at the outset of thelease. Minco has improved the building by adding another floor to part of the building during the currentaccounting period. There is also a clause which enables the landlord to recharge Minco for costs relating to thegeneral disrepair of the building at the end of the lease. In addition, the landlord can recharge any costs of therepairing the roof immediately. The landlord intends to replace part of the roof of the building during the currentperiod. (5 marks)
(d) Minco acquired a property for $4 million and annual depreciation of $300,000 is charged on the straight linebasis. At the end of the previous financial year of 31 May 2013, when accumulated depreciation was $1 million,a further amount relating to an impairment loss of $350,000 was recognised, which resulted in the propertybeing valued at its estimated value in use. On 1 October 2013, as a consequence of a proposed move to newpremises, the property was classified as held for sale. At the time of classification as held for sale, the fair valueless costs to sell was $2·4 million. At the date of the published interim financial statements, 1 December 2013,the property market had improved and the fair value less costs to sell was reassessed at $2·52 million and atthe year end on 31 May 2014 it had improved even further, so that the fair value less costs to sell was $2·95 million. The property was sold on 5 June 2014 for $3 million. (6 marks)
Required:
Discuss how the above items should be dealt with in the financial statements of Minco.
Note: The mark allocation is shown against each of the four issues above.
Professional marks will be awarded in question 3 for clarity and quality of presentation. (2 marks)
(25 marks)
6
4 (a) The difference between debt and equity in an entity’s statement of financial position is not easily distinguishablefor preparers of financial statements. Some financial instruments may have both features, which can lead toinconsistency of reporting. The International Accounting Standards Board (IASB) has agreed that greater claritymay be required in its definitions of assets and liabilities for debt instruments. It is thought that defining the natureof liabilities would help the IASB’s thinking on the difference between financial instruments classified as equityand liabilities.
Required:
(i) Discuss the key classification differences between debt and equity under International FinancialReporting Standards.
Note: Examples should be given to illustrate your answer. (9 marks)
(ii) Explain why it is important for entities to understand the impact of the classification of a financialinstrument as debt or equity in the financial statements. (5 marks)
(b) The directors of Avco, a public limited company, are reviewing the financial statements of two entities which areacquisition targets, Cavor and Lidan.They have asked for clarification on the treatment of the following financialinstruments within the financial statements of the entities.
Cavor has two classes of shares: A and B shares. A shares are Cavor’s ordinary shares and are correctly classedas equity. B shares are not mandatorily redeemable shares but contain a call option allowing Cavor to repurchasethem. Dividends are payable on the B shares if, and only if, dividends have been paid on the A ordinary shares.The terms of the B shares are such that dividends are initially payable at a rate equal to that of the A ordinaryshares. Additionally, Cavor has also issued share options which give the counterparty rights to buy a fixed numberof its B shares for a fixed amount of $10 million. The contract can be settled only by the issuance of shares forcash by Cavor.
Lidan has in issue two classes of shares: A shares and B shares. A shares are correctly classified as equity. Two million B shares of nominal value of $1 each are in issue. The B shares are redeemable in two years’ timeat the option of Lidan. Lidan has a choice as to the method of redemption of the B shares. It may either redeemthe B shares for cash at their nominal value or it may issue one million A shares in settlement. A shares arecurrently valued at $10 per share. The lowest price for Lidan’s A shares since its formation has been $5 pershare.
Required:
Discuss whether the above arrangements regarding the B shares of each of Cavor and Lidan should betreated as liabilities or equity in the financial statements of the respective issuing companies. (9 marks)
Professional marks will be awarded in question 4 for clarity and quality of presentation. (2 marks)
(25 marks)
End of Question Paper
7
Answers
Professional Level – Essentials Module, Paper P2 (UK)Corporate Reporting (United Kingdom) June 2014 Answers
1 (a) (i) Marchant Group: Statement of profit or loss and other comprehensive income for the year ended 30 April 2014
$mRevenue 538Cost of sales (383)
––––––Gross profit 155Other income 45·7Administrative costs (30)Other expenses (74·69)Share of profits of associates 1·5
––––––Operating profit 97·51Finance costs (10)Finance income 15
––––––Profit before tax 102·51Income tax expense (30·5)
––––––Profit for the year 72·01
––––––––––––
Other comprehensive income: Items which will not be reclassified to profit or lossChanges in revaluation surplus 2·8Remeasurements – defined benefit plan (2)
––––––Total items which will not be reclassified subsequently to profit or loss 0·8Items which may be reclassified subsequently to profit or lossLosses on cash flow hedge (3)
––––––Other comprehensive loss for the year (2·2)
––––––Total comprehensive income for the year 69·81
––––––––––––
Profit/loss attributable to: (W7)Owners of the parent 60·21Non-controlling interest 11·8
––––––72·01
––––––
Total comprehensive income attributable to:
$mOwners of the parent 59·21Non-controlling interest 10·6
––––––69·81
––––––
11
Working 1
(Note that this is purely a working and does not purport to show necessarily what would be reported in the individualaccounts)
–––––– ––– –––– ––––––Profit for the year 42·51 22 7·5 72·01
–––––– ––– –––– –––––––––––– ––– –––– ––––––
Other comprehensive incomeRemeasurements defined benefit plan (2) (2)Revaluation surplus($10m – $5m (W2)) 5 5Revaluation adjustment (2·2) (2·2)Cash flow hedge (finance costs reduced by same amount) (3) (3)
–––––– ––– –––– ––––––Other comprehensive income/loss for year 0·8 (3) (2·2)
–––––– ––– –––– ––––––Total comprehensive income for year 43·31 19 7·5 69·81
–––––– ––– –––– –––––––––––– ––– –––– ––––––
Note that the share of the associates’ profit should be disclosed on the face of the statement of profit or loss. Thereforeother expenses will be $73·19m plus $1·5m, i.e. $74·69m.
Working 2 Nathan
$m $mFair value of consideration for 60% interest 80Fair value of non-controlling interest 45 125
–––Fair value of identifiable net assets acquired (110)
––––Goodwill 15
––––
Goodwill impairment
After goodwill has been impaired (20% of $15m, i.e. $3m), any subsequent increase in the recoverable amount is likelyto be internally generated goodwill rather than a reversal of purchased goodwill impairment. IAS 38 Intangible Assetsprohibits the recognition of internally generated goodwill, thus any reversal of impairment is not recognised.
Hence $5 million needs to be charged to profit or loss to undo the reversal.
Total impairment is still $3 million.
The gains recorded regarding the investment in Nathan will be follows:
Gain on investment in Nathan ($95m – $90m) $5mGain on sale of holding in Nathan ($18 – (8%/60% of $95m)) $5·3m
No gain or loss is recognised in profit or loss on the sale of Nathan in the group accounts as the sale is shown as amovement in equity. Therefore it is eliminated. Additionally, the gain on the revaluation of the investment in Nathan willalso be eliminated on consolidation as the calculation of goodwill will be based on the fair value of the consideration atthe date of acquisition and not at the date of the current financial statements.
12
Working 3 Option
$m $mFair value of consideration for 60% interest 70Fair value of non-controlling interest 28 98
–––Fair value of identifiable net assets acquired (86)
–––Goodwill 12
–––
As Marchant has sold a controlling interest in Option, a gain or loss on disposal should be calculated. Additionally, theresults of Option should only be consolidated in the statement of profit or loss and other comprehensive income for thesix months to 1 November 2013. Thereafter Option should be equity accounted.
The gain recognised in profit or loss would be as follows:
$mFair value of consideration 50Fair value of residual interest to be recognised as an associate 40Value of NCI 34
––––124
Less: net assets and goodwill derecognised net assets (90)goodwill (12)
––––Gain on disposal to profit or loss 22
––––
The share of the profits of the associate would be 20% of a half year’s profit ($15m/2), i.e. $1·5 million.
Working 4 Defined benefit plan
Pension cost recognised for the year would be $mCurrent service cost 4Net interest cost (10% of $50m – $48m) 0·2Past service cost 3
–––Net service cost recognised in profit or loss 7·2Remeasurements in OCI 2
–––Net cost for year recognised in total comprehensive income 9·2
–––
IAS 19 does not specify where service cost and net interest cost should be presented. Therefore it is acceptable toinclude the net interest cost in finance costs. IAS 19 states that past service cost should be recognised immediately andthe past service cost will be included in the defined benefit obligation at 1 May 2013. Therefore there is no need tocalculate an interest cost on the past service cost.
Working 5 Property, plant and equipment
$mCarrying amount at 1 May 2013 13Depreciation for year ($13m/9) (1·44)
–––––Carrying amount at 30 April 2014 11·56Fall in value charged to revaluation surplus ($13m – ($12m – ($12m/10))) (2·2)Fall in value charged to profit or loss (2·36)
–––––Carrying amount after revaluation 30 April 2014 7
–––––
Working 6 Share options
Year Expense for year Cumulative expense Calculation$m $m
30 April 2013 1·07 1·07 4 directors x $100 x 8,000 x 1/330 April 2014 2·13 3·2 6 directors x $100 x 8,000 x 2/3
Working 7 Non-controlling interest (NCI)
NCI in profits for year is (40% of $22m + 40% of $15 million/2) = $11·8 millionNCI in TCI (40% of 19 + 40% of $15 million/2) = $10·6 million
Working 8
The loss on the sale of the inventory is not eliminated from group profit or loss. Because the sale is at fair value, theinventory value must have been impaired and therefore the loss on sale must remain realised. However, the revenueand cost of sales of $12 million will be eliminated.
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(ii) Once control has been achieved, further transactions whereby the parent entity acquires further equity interests fromnon-controlling interests, or disposes of equity interests but without losing control, are accounted for as equitytransactions, that is transactions with owners in their capacity as owners. Thus it follows that:
– the carrying amounts of the controlling and non-controlling interests are adjusted to reflect the changes in theirrelative interests in the subsidiary;
– any difference between the amount by which the non-controlling interests is adjusted and the fair value of theconsideration paid or received is recognised directly in equity and attributed to the owners of the parent; and
– there is no consequential adjustment to the carrying amount of goodwill, and no gain or loss is recognised in profitor loss.
Sale of equity interest in Nathan
$mFair value of consideration received 18Amount recognised as non-controlling interest (net assets per question at year end($120m + fair value adjustment PPE at acquisition $14m + goodwill (15 – 3)) x 8%) (11·7)
–––––Positive movement in parent equity 6·3
–––––
The fair value adjustment is $110m – ($25m + $65m + $6m). The income should be shown as a movement in equitynot in income. Hence it does not affect the consolidated statement of profit or loss and other comprehensive income.
(b) Under IFRS, an impairment loss is only reversed if there has been a change in the estimates used to determine the recoverableamount as a result of a reversal of the factors which caused the original impairment. Reversal of goodwill impairment lossesis not permitted. For assets other than goodwill, the reversal of an impairment loss is recognised as a gain in profit or lossunless the asset is carried at a revalued amount in accordance with another standard, in which case it is treated as arevaluation increase in accordance with that standard. The reversal is allocated pro-rata to the assets, other than goodwill.
Under UK GAAP, impairment losses on goodwill and intangible fixed assets are reversed if, and only if, there is an externalevent reversing the impairment in an unforeseen way or the loss arose on an intangible asset with a readily ascertainablemarket value. If the recoverable amount of an asset increases because of a change in economic conditions or expected useof the asset, the reversal of impairment is recognised in profit or loss to the extent that the original impairment loss (adjustedfor subsequent depreciation) was recognised in profit or loss. For a revalued asset, any remaining balance of a reversal isrecognised in the STRGL.
Under IFRS, the criteria for recognition of intangible assets do not require the asset to be separable. An asset is identifiableif it is separable or it arises from contractual or legal rights. An asset must be controlled. While it is more difficult in theabsence of legal rights, legal enforceability is not a necessary condition for control. Under UK GAAP, to be recognised as anintangible asset, an asset must be identifiable, i.e. capable of being disposed of separately, without disposing of a businessof the entity, and controlled by the entity through custody or legal rights.
Under IFRS, an intangible asset arising from the development phase of an internal project must be capitalised if certain criteriaare met. Under UK GAAP, where certain criteria (similar, but not identical to IFRS criteria) are met, an entity may capitalisedevelopment expenditure.
Under IFRS, amortisation of goodwill is not permitted; instead annual impairment testing is required. Under UK GAAP,goodwill is normally amortised over its useful economic life, with a rebuttable presumption of a maximum useful life of 20 years. Annual impairment reviews are required where the useful economic life of goodwill exceeds 20 years or is indefinite.
(c) A lease is classified as a finance lease if it transfers substantially all the risks and rewards incident to ownership. All otherleases are classified as operating leases and classification is made at the inception of the lease. Whether a lease is a financelease or an operating lease depends on the substance of the transaction rather than the legal form. Thus in manycircumstances, the classification of a lease can be quite subjective. In the case of a lease of land, this is particularly subjectiveas the title to the land may not pass to the lessee at the end of the agreement but the lease may still be classed as a financelease where the present value of the residual value of the land is negligible and the risks and rewards pass to the lessee.Thus, it appears that at first sight this is a difference in a professional opinion, which can be solved by the financial controllerseeking advice.
If the features of the lease appear to meet IAS 17 Leases criteria for classification as a finance lease and the treatment usedis part of a strategy to understate the liabilities of the entity in order to raise a loan, then an ethical dilemma arises.Professional accountants are capable of making judgements, applying their skills and reaching informed decisions insituations where the general public cannot. The judgements made by professional accountants should be independent andnot affected by business pressures. The code of ethics is very important because it sets out boundaries outside whichaccountants should not stray. The financial director should not place the financial controller under undue pressure in order toinfluence his decisions. If the financial controller is convinced that the lease is a finance lease, then disclosure of this factshould be made to the internal governance authority. The financial controller will have the knowledge that his actions wereethical.
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2 (a) The functional currency is the currency of the primary economic environment in which the entity operates, which is normallythe one in which it primarily generates and expends cash. An entity’s management considers the following primary indicatorsin determining its functional currency:
(a) the currency which mainly influences sales prices for goods and services;(b) the currency of the country whose competitive forces and regulations mainly determine the sales prices of goods and
services; and(c) the currency which mainly influences labour, material and other costs of providing goods and services.
Further secondary indicators which may also provide evidence of an entity’s functional currency are the currency in whichfunds from financing activities are generated and in which receipts from operating activities are retained.
Additional factors are considered in determining the functional currency of a foreign operation and whether its functionalcurrency is the same as that of the reporting entity. These are:
(a) the autonomy of a foreign operation from the reporting entity;(b) the level of transactions between the two; (c) whether the foreign operation generates sufficient cash flows to meet its cash needs; and(d) whether its cash flows directly affect those of the reporting entity.
When the functional currency is not obvious, management uses its judgement to determine the functional currency whichmost faithfully represents the economic effects of the underlying transactions, events and conditions.
In the case of Aspire, the subsidiary does not make any decisions as to the investment of funds, and consideration of thecurrency which influences sales and costs is not relevant. Although the costs are incurred in dollars, they are not material toany decision as to the functional currency. Therefore it is important to look at other factors to determine the functionalcurrency. The subsidiary has issued 2 million dinars of equity capital to Aspire, which is a different currency to that of Aspire,but the proceeds have been invested in dinar denominated bonds at the request of Aspire. The subsidiary has also raised100,000 dinars of equity capital from external sources but this amount is insignificant compared to the equity issued toAspire. The income from investments is either remitted to Aspire or reinvested on instruction from Aspire. The subsidiary hasa minimum number of staff and does not have any independent management. The subsidiary is simply a vehicle for theparent entity to invest in dinar related investments. Aspire may have set up the entity so that any exposure to the dinar/dollarexchange rate will be reported in other comprehensive income through the translation of the net investment in the subsidiary.There does not seem to be any degree of autonomy as the subsidiary is merely an extension of Aspire’s activities. Thereforethe functional currency would appear to be the dollar.
In contrast, the dinar represents the currency in which the economic activities of the subsidiary are primarily carried out asis the case regarding the financing of operations and retention of any income not remitted. However, the investment of fundscould have been carried out directly by Aspire and therefore the parent’s functional currency should determine that of thesubsidiary.
(b) Where a foreign branch’s taxable profit is determined in a foreign currency, changes in exchange rates may give rise totemporary differences. This can arise where the carrying amounts of the non-monetary assets are translated at historical ratesand the tax base of those assets is translated at the rate at the reporting date. An entity may translate the tax base at the year-end rate as this rate gives the best measure of the amount which will be deductible in future periods. The resultingdeferred tax is charged or credited to profit or loss.
Property Dinars (000) Exchange rate Dollars (000)Cost 6,000 5 1,200Depreciation for year (500) (100)
–––––– ––––––Net book amount 5,500 1,100
Tax base Cost 6,000Tax depreciation (750)
––––––5,250 6 875
Temporary difference 225
Deferred tax at 20% 45
The deferred tax arising will be calculated using the tax rate in the overseas country. The deferred tax arising is therefore$45,000, which will increase the tax charge in profit or loss. If the historical rate had been used, the tax base would havebeen $1·05 million ($5·25m/5) which would have led to a temporary difference of $50,000 and a deferred tax liability of$10,000, which is significantly lower than when the closing rate is used.
(c) The goodwill arising when a parent acquires a multinational operation with several currencies is allocated to each level offunctional currency. Goodwill arising on acquisition of foreign operations and any fair value adjustments are both treated asthe foreign operation’s assets and liabilities. They are expressed in the foreign operation’s functional currency and translatedat the closing rate. Exchange differences arising on the retranslation of foreign entities’ financial statements are recognised inother comprehensive income and accumulated as a separate component of equity.
15
Exchange rate at 1 May 2013 $1= 5 dinarsExchange rate at 30 April 2014 $1 =6 dinars
Net assets at fair value 1,100m dinarsTranslated at 1 May 2013 $220mPurchase consideration $200mNCI (250m dinars/5) $50mGoodwill $30mGoodwill treated as foreign currency asset at 1 May 2013 (30m x 5) 150m dinarsGoodwill translated at closing rate at 30 April 2014 (150m dinars/6) $25m
Translation adjustment for goodwill in equity ($5m)
An exchange loss of $5 million will be charged in other comprehensive income together with any gain or loss on theretranslation of the net assets of the operations.
(d) The loan balance, as a monetary item, is translated at the spot exchange rate at the year-end date. Interest is translated atthe average rate because it approximates to the actual rate. Because the interest is at a market rate for a similar two-yearloan, Aspire measures the loan on initial recognition at the transaction price translated into the functional currency. Becausethere are no transaction costs, the effective interest rate is 8%.
On 1 May 2013, the loan is recorded on initial recognition as follows:
Dr Cash $1 millionCr Loan payable – financial liability $1 million
Year ended 30 April 2014Aspire records the interest expense as follows:
Dr Profit or loss – interest expense $71,429Cr Loan payable – financial liability $71,429
To recognise interest on loan payable for the year ended 30 April 2014 (0·4 million dinars/5·6).
On 30 April 2014 the interest is paid and the following entry is made:
Dr Loan payable – financial liability $66,666Cr Cash $66,666
To recognise the payment of 2014 interest on financial liability (0·4 million dinars/6).
At 30 April 2014 the loan is recorded at 5 million dinars/6, i.e. $833,333, which gives rise to an exchange gain of$166,667. In addition to this, a further exchange gain of $4,763 arises on the translation of the interest paid ($71,429 –$66,666). The total exchange gain is therefore $171,430.
3 (a) Minco needs to consider whether its revenue recognition policy is in compliance with IAS 18 Revenue. The criteria for revenuerecognition required by paragraph 14 of IAS 18 do not appear to be met, and no revenue should be accounted for as of thedate of the transfer of land to the housing association. Revenue arising from the sale of goods should be recognised when allof the following criteria have been satisfied (IAS 18.14):
(a) the seller has transferred to the buyer the significant risks and rewards of ownership;(b) the seller retains neither continuing managerial involvement to the degree usually associated with ownership nor effective
control over the goods sold;(c) the amount of revenue can be measured reliably;(d) it is probable that the economic benefits associated with the transaction will flow to the seller; and(e) the costs incurred or to be incurred in respect of the transaction can be measured reliably.
It is important to consider whether the risks for the project have been transferred to the association and whether Minco hascontrol over the project during the construction period. Even if the risk associated with the land is different to the riskassociated with the project directly, Minco should assess the risks for the entire project since it is exposed to material risksduring the construction period. Minco provides a guarantee as regards the maintenance costs, is liable for certain increasesin the interest rate over expectations, and is responsible for financing variations in the procurement and construction contractwhich the contractor would not cover. Further, Minco guarantees the payment for the housing association’s debt on thebuilding loan. Minco is exposed to risk as if it had built the housing units itself because it gives guarantees in respect of theconstruction process.
Minco also determines the membership of the board of the housing association and thus there is a question mark overwhether the board is independent from Minco. Minco guarantees that the housing association would not be liable if budgetedconstruction costs are exceeded, so the entity is exposed to financial risk in the construction process.
Minco has retained the significant risks and had effective control of the land it had sold and also the entire constructionprocess. Consequently, the revenue recognition criteria in paragraph 14 of IAS 18 are not met on the transfer of the land andMinco should account for the whole project as if it had built the housing units itself. Accordingly, revenue should be recognisedwhen the housing units are finished and delivered to the buyer of the rights in accordance with IAS 18, which appears to bewhen the project has been completed.
16
(b) The different payments to the tennis player are not interrelated. Therefore, any interdependencies and interrelations betweendifferent forms of payments or specific services and payments need not be examined in order to determine an appropriateexpense recognition pattern. The contract relates to advertising and promotional expenditure to improve Minco’s brand imageby the tennis player. Therefore, in accordance with IAS 38 Intangible Assets, the costs must be expensed when the entityhas received the service. Any amounts paid in advance of the service being received are recognised as prepayments andexpensed when that service is received. The signing bonus of $20,000 is paid to the player on commencement of thecontract. In return, the player is obliged to advertise Minco and take part in photo/film sessions. The signing bonus relates tothe full contract term and a prepayment of $20,000 is recognised on commencement and is expensed on a straight line basisover the three-year contract period. However, if, from the terms of the contract, separate services can be identified andmeasured reliably, Minco should allocate the costs and recognise expenses once the separate service is rendered. If thecontract is terminated prior to the end of the contract period, any amount not recovered from the player would be expensedimmediately.
The player receives the annual retainer at the end of each year, provided she has competed in all of the specified tournamentsfor that year. Minco has a contractual obligation to deliver cash to the player and, hence, recognises a financial liability duringthe period, which must be accounted for in accordance with IFRS 9 Financial Instruments. The liability is recognised at thepoint where Minco has an obligation which arises on the date when the player has competed in all the specified tournaments.The financial liability is recognised at the present value of the expected cash flows.
The player also receives additional performance-related payments for success in the tournaments. As these payments relateto specific events, they are treated as executory contracts. They are accrued and expensed when the player has won atournament.
(c) As regards the improvements to the building through adding an extra floor, Minco should capitalise the costs of the floor inaccordance with IAS 16 Property, Plant and Equipment and amortise these costs over the six years of the lease. However,Minco has an obligation to remove the floor at the end of the lease. The obligation arises because the completion of the floorcreates an obligation event. A provision should be made for the present value of the cost of removal of the floor in six years’time. At the same time an asset should be recognised for the cost. The cost should be recovered from the benefits generatedby the new floor over the remainder of the lease. The asset should be amortised over the six-year period. In effect, this is insubstance a decommissioning activity.
As regards the disrepairs of the building, the estimated costs should be spread over the six years of the agreement. IAS 37Provisions, Contingent Liabilities and Contingent Assets would indicate that Minco has a present obligation arising from thelease agreement because the landlord can recharge the costs of any repair to Minco. The obligating event is the wear andtear to the building which will arise gradually over the tenancy period and its repair can be enforced through the legalagreement. The obligation relates to wear and tear and is not related to future operating costs. The wear and tear will resultin an outflow of economic benefits and a reliable estimate of the yearly obligation arising from this will be made, although itwill not necessarily equate to one sixth per year. As regards the roof repair, it is clear from the lease that an obligation existsand therefore a provision should be made for the whole of the rectification work when the damage was identified.
(d) IAS 34 Interim Financial Reporting requires an entity to apply the same accounting policies in its interim financial statementsas are applied in its annual financial statements. Measurements should be made on a ‘year to date’ basis. In valuing theproperty, Minco should use the provisions of IFRS 5 Assets held for Sale and Discontinued Operations. Immediately beforethe initial classification of the asset as held for sale, the carrying amount of the asset should be measured in accordance withapplicable IFRSs. After classification as held for sale, the property should be measured at the lower of carrying amount andfair value less costs to sell. Impairment must be considered both at the time of classification as held for sale and subsequentlyin accordance with the applicable IFRSs. Any impairment loss is recognised in profit or loss unless the asset has previouslybeen measured at a revalued amount under IAS 16 or IAS 38, in which case the impairment is treated as a revaluationdecrease. A gain for any subsequent increase in fair value less costs to sell of an asset is recognised in the profit or loss tothe extent that it is not in excess of the cumulative impairment loss which has been recognised in accordance with IFRS 5or previously in accordance with IAS 36.
At the time of classification as held for sale, depreciation needs to be charged for the four months to 1 October 2013. Thiswill be based upon the year end value at 31 May 2013 of $2·65 million. The property has 10 years life remaining basedupon the depreciation to date and assuming a zero residual value, the depreciation for the four months will be approximately $0·1 million. Thus, at the time of classification as held for sale, after charging depreciation for the four months of $0·1 million, the carrying amount is $2·55 million ($4m – $1 – $0·1m – $0·35m) and fair value less costs to sell is assessedat $2·4 million. Accordingly, the initial write-down on classification as held for sale is $150,000 and the property is carriedat $2·4 million. On 1 December 2013 in the interim financial statements, the property market has improved and fair valueless costs to sell is reassessed at $2·52 million. The gain of $120,000 is less than the cumulative impairment lossesrecognised to date ($350,000 plus $150,000, i.e. $500,000). Accordingly, it is credited in profit or loss and the propertyis carried at $2·52 million. On 31 May 2014, the property market has continued to improve, and fair value less costs to sellis now assessed at $2·95 million. The further gain of $430,000 is, however, in excess of the cumulative impairment lossesrecognised to date ($350,000 plus $150,000 – $120,000 – $430,000, i.e. $50,000). Accordingly, a restricted gain of$380,000 is credited in profit or loss and the property is carried at $2·9 million. Subsequently, the property is sold for $3 million at which point a gain of $100,000 is recognised. This sale would be a non-adjusting event under IAS 10 Eventsafter the Reporting Period if deemed to be material.
17
4 (a) (i) IAS 32 Financial Instruments: Presentation establishes principles for presenting financial instruments as liabilities orequity. To determine whether a financial instrument should be classified as debt or equity, IAS 32 uses principles-baseddefinitions of a financial liability and of equity. In contrast to the requirements of generally accepted accounting practicein many jurisdictions around the world, IAS 32 does not classify a financial instrument as equity or financial liability onthe basis of its legal form. The key feature of debt is that the issuer is obliged to deliver either cash or another financialasset to the holder. The contractual obligation may arise from a requirement to repay principal or interest or dividends.Such a contractual obligation may be established explicitly or indirectly through the terms of the agreement. For example,a bond which requires the issuer to make interest payments and redeem the bond for cash is classified as debt. Incontrast, equity is any contract which evidences a residual interest in the entity’s assets after deducting all of itsliabilities. A financial instrument is an equity instrument only if the instrument includes no contractual obligation todeliver cash or another financial asset to another entity and if the instrument will or may be settled in the issuer’s ownequity instruments. For example, ordinary shares, where all the payments are at the discretion of the issuer, are classifiedas equity of the issuer. The classification is not quite as simple as it seems. For example, preference shares required tobe converted into a fixed number of ordinary shares on a fixed date or on the occurrence of an event which is certainto occur, should be classified as equity.
A contract is not an equity instrument solely because it may result in the receipt or delivery of the entity’s own equityinstruments. The classification of this type of contract is dependent on whether there is variability in either the numberof equity shares delivered or variability in the amount of cash or financial assets received. A contract which will be settledby the entity receiving or delivering a fixed number of its own equity instruments in exchange for a fixed amount of cashor another financial asset is an equity instrument. However, if there is any variability in the amount of cash or own equityinstruments which will be delivered or received, then such a contract is a financial asset or liability as applicable.
For example, where a contract requires the entity to deliver as many of the entity’s own equity instruments as are equalin value to a certain amount of cash, the holder of the contract would be indifferent whether it received cash or sharesto the value of that amount. Thus this contract would be treated as debt.
Other factors, which may result in an instrument being classified as debt, are:
– redemption is at the option of the instrument holder– there is a limited life to the instrument– redemption is triggered by a future uncertain event which is beyond the control of both the holder and issuer of the
instrument– dividends are non-discretionary
Similarly, other factors, which may result in the instrument being classified as equity, are whether the shares are non-redeemable, whether there is no liquidation date or where the dividends are discretionary.
(ii) The classification of a financial instrument by the issuer as either debt or equity can have a significant impact on theentity’s gearing ratio, reported earnings, and debt covenants. Equity classification can avoid such impact but may beperceived negatively if it is seen as diluting existing equity interests. The distinction between debt and equity is alsorelevant where an entity issues financial instruments to raise funds to settle a business combination using cash or aspart consideration in a business combination. Understanding the nature of the classification rules and potential effectsis critical for management and must borne in mind when evaluating alternative financing options. Liability classificationnormally results in any payments being treated as interest and charged to profit or loss, which may affect the entity’sability to pay dividends on its equity shares.
(b) Cavor
An obligation must be established through the terms and conditions of the financial instrument. IAS 32 uses principles-baseddefinitions of a financial liability and of equity. IAS 32 uses substance over form as a principle to classify a financial instrumentbetween equity and financial liability. IAS 32 restricts the role of ‘substance’ to consideration of the contractual terms of aninstrument. Anything outside the contractual terms is not therefore relevant to the classification process under IAS 32. The B shares of Cavor should be classified as equity as there is no contractual obligation to pay the dividends or to call theinstrument. Dividends can only be paid on the B shares if dividends have been declared on the A shares and they are payableat the same rate as the A shares which will be variable. There is no contractual obligation to declare A share dividends.
The classification of the B share options in Cavor is dependent on whether there is variability in either the number of equityshares delivered or variability in the amount of cash or financial assets received. As there is no variability and the contractwill be settled by the entity issuing a fixed number of its own equity instruments in exchange for a fixed amount of cash, thenthe share options are classified as an equity instrument.
Lidan
The contractual obligation may arise from a requirement to repay principal or interest or dividends. Such a contractualobligation need not be explicit. It may instead be established indirectly through the terms and conditions of the financialinstrument and the liability classification is not avoided by a share settlement alternative which is uneconomic in comparisonto the cash obligation. The B shares of Lidan will be classified as a liability. This is because the value of the own sharesettlement alternative substantially exceeds that of the cash settlement option, meaning that the entity is implicitly obliged toredeem the option for a cash amount of $1 per share. Additionally, IAS 32 also states that where a derivative contract hassettlement options, it is a financial asset or liability unless all of the settlement alternatives result in it being an equityinstrument. This would also lead to the conclusion that the B shares are a financial liability.
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Professional Level – Essentials Module, Paper P2 (UK)Corporate Reporting (United Kingdom) June 2014 Marking Scheme
Marks1 (a) Impairment adjustment 4
Nathan 6Option 6Inventory 1Share options 4PPE 3Employee benefits 4NCI 2Sale of equity interest in Nathan 5
–––35–––
(b) 1 mark per point up to maximum 9
(c) 1 mark per point up to maximum 6–––50–––
2 (a) 1 mark per point up to maximum 7
(b) 1 mark per point up to maximum 6
(c) 1 mark per point up to maximum 5
(d) 1 mark per point up to maximum 5
Professional marks 2–––25–––
3 (a) 1 mark per point up to maximum 7
(b) 1 mark per point up to maximum 5
(c) 1 mark per point up to maximum 5
(d) 1 mark per point up to maximum 6
Professional marks 2–––25–––
4 (a) (i) 1 mark per point up to maximum 9
(ii) Effects 5
(b) 1 mark per point up to maximum 9Professional marks 2
