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1 © Pearson Education Limited 2006
Instructor’s Manual
Financial Accounting &
Reporting
Tenth edition
Barry Elliott and
Jamie Elliott
For further instructor material please visit:
www.pearsoned.co.uk/elliott
ISBN 0 273 70365 X
Pearson Education Limited 2006 Lecturers adopting the main text are permitted to download the manual as required.
2 © Pearson Education Limited 2006
Pearson Education Limited Edinburgh Gate Harlow Essex CM20 2JE England
and Associated Companies around the world
Visit us on the World Wide Web at: www.pearsoned.co.uk
First published 2006
©Pearson Education 2006 The rights of Barry Elliott and Jamie Elliott to be identified as authors of this Work have been asserted by them in accordance with the Copyright, Designs and Patents Act 1988.
ISBN: 0 273 70365 X
All rights reserved. Permission is hereby given for the material in this publication to be repro-duced for OHP transparencies and student handouts, without express permission of the Publishers, for educational purposes only. In all other cases, no part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise without either the prior written permission of the Publishers or a licence permitting restricted copying in the United Kingdom issued by the Copyright Licensing Agency Ltd, 90 Tottenham Court Road, London W1T 4LP.
Barry Elliott and Jamie Elliott: Financial Accounting and Reporting (tenth edition) – Instructor’s Manual
3 © Pearson Education Limited 2006
Contents Chapter 1 4 Chapter 2 13 Chapter 3 25 Chapter 4 38 Chapter 5 58 Chapter 6 64 Chapter 7 67 Chapter 8 73 Chapter 9 89 Chapter 10 109 Chapter 11 114 Chapter 12 130 Chapter 13 136 Chapter 14 143 Chapter 15 149 Chapter 16 153 Chapter 17 162 Chapter 18 172 Chapter 19 181 Chapter 20 189 Chapter 21 196 Chapter 22 211 Chapter 23 215 Chapter 24 233 Chapter 25 242 Chapter 26 253 Chapter 27 265 Chapter 28 275 Chapter 29 301 Chapter 30 318 Chapter 31 320 Chapter 32 329
Barry Elliott and Jamie Elliott: Financial Accounting and Reporting (tenth edition) – Instructor’s Manual
4 © Pearson Education Limited 2006
C H AP T E R 1
Chapter 1: Question 1 – Jane Parker
(i) Cash budget (£000)
Jan Feb Mar Apr May June Total Initial capital 150.00 82.50 232.50
Customers . . . . 60.00 75.00 135.00
Total receipts 150.00 . . 82.50 60.00 75.00 367.50 Machinery 30.00 30.00
Motor vehicles 24.00 24.00
Premises 75.00 75.00
Drawings 1.20 1.20 1.20 1.20 1.20 1.20 7.20
Suppliers 30.00 48.00 60.00 60.00 60.00 258.00
Rates 1.20 1.20
Wages 2.25 2.25 2.25 2.25 2.25 2.25 13.50
General expenses 0.75 0.75 0.75 0.75 0.75 3.75
Insurance . . . . . 2.10 2.10
Total payments 132.45 35.40 52.20 64.20 64.20 66.30 414.75
Net cash flow 17.55 (35.40) (52.20) 18.30 (4.20) 8.70
Balance b/f – 17.55 (17.85) (70.05) (51.75) (55.95)
Balance c/f 17.55 (17.85) (70.05) (51.75) (55.95) (47.25) (47.25)
(ii) Cash flow summary statement (£000)
Realised operating cash flows for the period ended 30 June 20X1 Receipts from customers 135.00 Payments to:
Suppliers 258.00
Rates 1.20
Wages 13.50
General expenses 3.75
Insurance 2.10
278.55 (143.55)
Barry Elliott and Jamie Elliott: Financial Accounting and Reporting (tenth edition) – Instructor’s Manual
5 © Pearson Education Limited 2006
For information only
Statement of financial position as at 30 June 20X1
£000 Capital – introduced 232.50
– withdrawn (7.20)
Net operating cash flows :Realised (143.55)
:Unrealised (7.80)
73.95
Premises (NRV) 75.00
Vehicles (NRV) 19.20
Machinery (NRV) 27.00
Net cash balance (47.25)
73.95
(iii) Further information re Jane Parker
(a) Nature of business linked to Parker’s business background, technical ability, special skills, know how, existing/terminated business involvement, contacts, associates, related parties.
(b) Type of business unit to be used and rationale for its selection.
(c) Sources of long and short-term capital.
(d) Products’ life cycle, cash flow projections over product life cycle.
(e) Initial investment in fixed assets and their terminal value at the end of the life cycle.
(f) Parker’s attitude to risk and how this affects the choice of discount rate and payback period.
Barry Elliott and Jamie Elliott: Financial Accounting and Reporting (tenth edition) – Instructor’s Manual
6 © Pearson Education Limited 2006
Chapter 1: Question 2 – Mr Norman
(a) Purchases budget (£000)
Jan Feb Mar Apr May June Sales 15.00 20.00 35.00 40.00 40.00 45.00
Gross profit 3.00 4.00 7.00 8.00 8.00 9.00
Purchases 12.00 16.00 28.00 32.00 32.00 36.00
Payments 12.00 16.00 28.00 32.00 32.00
Notes:
• This is a start-up situation.
• Purchases = projected sales less a gross margin on sales at 20%.
• Goods are bought in month of sale; assume stocks remain constant.
(b) Cash flow statement (£000)
Jan Feb Mar Apr May June Total Initial capital 50.00 50.00
Cash Sales 7.50 10.00 17.50 20.00 20.00 22.50 97.50
Credit Sales - 7.50 10.00 17.50 20.00 20.00 75.00
57.50 17.50 27.50 37.50 40.00 42.50 222.50 Premises 80.00 80.00
Rent and rates 2.20 2.20 2.20 2.20 2.20 2.20 13.20
Suppliers 12.00 16.00 28.00 32.00 32.00 120.00
Commission 0.30 0.40 0.70 0.80 0.80 3.00
Wages 0.60 0.60 0.60 0.60 0.60 0.60 3.60
Insurance 3.50 - - - - - 3.50
86.30 15.10 19.20 31.50 35.60 35.60 223.30
Net cash flow (28.80) 2.40 8.30 6.00 4.40 6.90
Balance b/f - (28.80) (26.40) (18.10) (12.10) (7.70)
Balance c/f (28.80) (26.40) (18.10) (12.10) (7.70) (0.80) (0.80)
Barry Elliott and Jamie Elliott: Financial Accounting and Reporting (tenth edition) – Instructor’s Manual
7 © Pearson Education Limited 2006
(c) Statements of operating cash flows and financial position
Realised operating cash flows for the period ended 30 June 20X8 £000 Receipts from customers 172.50
Payments to:
Suppliers 120.00
Rates 13.20
Wages 3.60
Commission 3.00
Insurance 3.50
143.30 29.20
Notes:
• The cash flow statement with summary attached is effectively a six-month cash budget showing the cash received, cash paid each month and the resulting month-end balances.
• It is necessary to separate sales and purchase transactions into cash and on credit and to identify clearly the month of receipt and payment.
• Commission is paid in the month after the sale is made, and all other cash flows are clearly indicated and allocated to specific months.
• Note that the format of the cash flow statement brings out key figures – for management decision and control, e.g.
• Month-end balances – assists in the control of liquidity
• cash deficiencies – identifies how much must be financed
• early warning – allows management to approach appropriate sources
• cash surpluses – identifies amounts to be invested on best terms.
Statement of financial position as at 30 June 20X8 £000
Capital – introduction 50.00
Net operating cash flows :Realised 29.20
:Unrealised (4.00)
75.20
Premises (NRV) 76.00
Net cash balance (0.80)
75.20
Barry Elliott and Jamie Elliott: Financial Accounting and Reporting (tenth edition) – Instructor’s Manual
8 © Pearson Education Limited 2006
Notes:
• This statement shows net assets of £75,200
• make up: premises £76,000 less the negative cash balance £800.
• The negative cash balance indicates need for overdraft arrangements.
• The statement is based on cash flow concept
• it ignores accrual-based figures (£36,900 less £25,250)
• accruals are not regarded as real assets and liabilities
• critics of the cash flow concept would maintain that its utility has therefore been seri-ously diminished.
(d) Letter to bank requesting an overdraft facility should include
• The maximum overdraft facility of £28,800
• required at the end of January
• will be eliminated by July
• Overdraft will fall progressively as per the cash budget.
• It might be practical to request a limit of £30,000
• for the full six-month period
• reducing to £15,000 thereafter to allow for contingencies. The facility only to be called on as required.
• Refer to the Cash Budget to support the request
• confirm that it is based on the most likely scenario
• agree a repayment schedule.
• Specify that collateral security is available in form of premises if it should be required.
• If not an existing customer
• give outline details of business background
• explain future plans.
Barry Elliott and Jamie Elliott: Financial Accounting and Reporting (tenth edition) – Instructor’s Manual
9 © Pearson Education Limited 2006
Chapter 1: Question 3 – Fred and Sally
(i) (a) Decision to close in winter
April May June July Aug Sept Oct Nov Dec Jan Feb March £ £ £ £ £ £ £ £ £ £ £ £ Opening balance 100 12,100 29,860 35,120 40,380 45,640 50,900 45,160 33,660 34,660 35,660 36,660
Sales (Wk1) 14,000 19,760 19,760 19,760 19,760 19,760 5,760
Boards (custom-built) 10,000 10,000 10,000 10,000 10,000 10,000
14,100 31,860 59,620 64,880 70,140 75,400 66,660 55,160 33,660 34,660 35,660 36,660
Salary in Lanzarote: Fred and Sally: income 500 500 500 500 500 500 Staff: income 500 500 500 500 500 500 Purchases 16,000 16,000 16,000 16,000 16,000 16,000 Materials for boards (custom-built)(Wk2) 6,500 6,500 6,500 6,500 6,500 6,500 Wages 1,000 1,000 1,000 1,000 1,000 1,000 Rent 500 500 500 500 500 500 Misc. costs 500 500 500 500 500 500 12,100 29,860 35,120 40,380 45,640 50,900 45,160 33,660 34,660 35,660 36,660 37,660
£ Wk1 (£120,000/6) = 20,000 Wk 2 Under this alternative Per board Total – 6,000 (paid by credit card) Materials £500 14,000 (cash received in month) Sails (not Dryline) 150 + 5,760 (last month’s credit card sales less 4%) 650 × 10 = £6,500 19,760
Barry Elliott and Jamie Elliott: Financial Accounting and Reporting (tenth edition) – Instructor’s Manual
10 © Pearson Education Limited 2006
(i) (b) Decision to remain open in winter and keep Dryline agency
April May June July Aug Sept Oct Nov Dec Jan Feb March £ £ £ £ £ £ £ £ £ £ £ £ Opening balance 100 11,5839,41017,237 24,064 30,891 37,718 32,295 40,528 38,761 37,994 37,227
Sales 14,000 19,76019,76019,760 19,760 5,760 5,760 5,760
576 1,400 1,976 1,976 1,976 1976
Boards 1,000 1,000 10,000 10,000 10,000 10,000 10,000 10,000 1,000 1,000 1,000
1,000
15,676 32,343 40,170 46,997 53,824 60,651 54,878 44,271 42,504 41,737 40,970 40,203
Purchases (Wk3/4) 1,493 14,933 14,933 14,933 14,933 14,933 14,933 1,493 1,493 1,493 1,493 1,493
Boards 600 6,000 6,000 6,000 6,000 6,000 6,000 600 600 600 600 600
Wages 1,000 1,000 1,000 1,000 1,000 1,000 1,000 1,000 1,000 1,000 1,000 1,000
Rent 500 500 500 500 500 500 500 500 500 500 500 500
Misc costs 500 500 500 500 500 500 150 150 150 150 150 150
Closing balance 11,583 9,410 17,237 24,064 30,891 37,718 32,295 40,528 38,761 37,994 37,227 36,460
Wk 3 Wk4
20,000 × 2,000 ×
60% 60%
Non Dryline 12,000 × 1,200 ×
80% 80%
9,600 + 8,000 × 2/3 960 + 800 × 2/3
Dryline 5,333 533
14,933 1,493
Barry Elliott and Jamie Elliott: Financial Accounting and Reporting (tenth edition) – Instructor’s Manual
11 © Pearson Education Limited 2006
Notes supporting (i) (a)
Assuming closure during the winter months means that:
• there are no sales from October to March
• salaries of £1,000 per month are received from October to March
• a start-up situation arises each April with consequential effect on cash from sales of both custom-built and non-custom-built boards.
Cash from sales is calculated as follows:
Non-custom-built (i) 70% received immediately = 14,000 (ii) 30% via credit card finance less 4% (£6,000 – 240) = 5,760
19,760 However, only £14,000 is received in first month and £5,760 in October.
Custom-built Received per month – two months in arrears = £10,000
Cash payments are calculated as follows:
Non-custom-built 80% of the sales value is paid two months after purchase
Custom-built Materials cost £650 each; total £6,500 per month; paid 2 months after purchase
Other fixed costs Wages, rent, miscellaneous costs at uniform monthly rate of £2,000 for 6 months
Projected cash balances show an upward trend to September and then they fall away.
Notes supporting (i) (b)
Cash receipts are calculated as follows:
Non-custom-built Receipts are in two cycles: April to September and October to March. April cash received is £14,576 made up of 70% of £20,000 being the April sales plus 96% of March’s credit card sales (i.e. 96% of £600). From May to September (inclusive) cash receipts will be the same as calculated on the clo-sure assumption i.e. £19,760 per month. October receipts are £7,160 i.e. £5,760 from September plus £1,400 from October sales with £1,976 again for five subsequent months.
Custom-built Cash receipts from June to November will be £10,000 per month as under the closure as-sumption.
Barry Elliott and Jamie Elliott: Financial Accounting and Reporting (tenth edition) – Instructor’s Manual
12 © Pearson Education Limited 2006
In the winter months there will be a further £6,000 except that customers took an unex-plained average of three months in winter, receipts are nil in December.
Cash payments are calculated as follows:
Non-custom-built From May to October purchases are £14,933 and 10% of this for the remaining six months
Custom-built As for closure assumption
Other fixed costs Wages, rent, miscellaneous costs at uniform monthly rate of £2,000 for 6 months
(ii) Additional information required in order to advise
At first glance closing in the winter generates more cash but:
1. What about loss of future earnings from Dryline?
2. Is there any potential damage to customer goodwill?
3. Will this allow competition to creep into market?
Notes relating to part (a):
• This is a start-up situation.
• Purchases = projected sales less a gross margin on sales at 20%.
• Goods are bought in month of sale; assume stocks remain constant.
We need to know more about the business e.g:
• Objectives
• What are Fred/Sally’s objectives?
• Is it a short-term pleasant lifestyle with high income, or long-term market maximisa-tion?
• Demand
• state of market
• whether demand for Dryline sails is expanding or contracting
• possibility of other agencies
• possibility of opening in other areas
• possibility of increasing winter sales
• higher profile for custom-made boards e.g. outline in Lanzarote
• whether or not the custom-made boards are independent of the rest of the business i.e. a different market.
Barry Elliott and Jamie Elliott: Financial Accounting and Reporting (tenth edition) – Instructor’s Manual
13 © Pearson Education Limited 2006
C H AP T E R 2
Chapter 2: Question 1 – Jane Parker
(a) Cash budget (€000)
Jan Feb Mar Apr May June Total Initial capital 150.00 75.00 225.00
Customers 60.00 75.00 75.00 210.00
Total receipts 150.00 60.00 75.00 150.00 435.00 Machinery 30.00 30.00
Motor vehicles 24.00 24.00
Premises 75.00 75.00
Drawings 1.50 1.50 1.50 1.50 1.50 1.50 9.00
Suppliers 30.00 48.00 60.00 60.00 60.00 258.00
Rates
Wages 2.25 2.25 2.25 2.25 2.25 2.25 13.50
General expenses 0.75 0.75 0.75 0.75 0.75 3.75
Insurance 26.40 26.40
132.75 34.50 52.50 64.50 64.50 90.90 439.65 Net cash flow 17.25 (34.50) (52.50) (4.50) 10.50 59.10
Balance b/f – 17.25 (17.25) (69.75) (74.25) (63.75)
Balance c/f 17.25 (17.25) (69.75) (74.25) (63.75) (4.65) (4.65)
All balances are overdrawn except for January 20X1
Feb Mar Apr May June o/d 17.25 69.75 74.25 63.75 4.65
Note: No entries will be made for the 20X0/X1 local taxes that are paid in Feb 20X2 – this situation arose because Jane Parker had assumed that the business would only pay the taxes from the start of the tax year e.g. 1.4.20X1. However, there will be an entry in the profit and loss and balance sheet.
Barry Elliott and Jamie Elliott: Financial Accounting and Reporting (tenth edition) – Instructor’s Manual
14 © Pearson Education Limited 2006
(b) Jane Parker – profit and loss account for six months ended 30.6.20X1
€000 €000
Sales [60.00 + (5 × 75.00)] 435.00
Purchases 378.00
Closing inventory (30.00)
Cost of sales 348.00
Gross profit 87.00
Wages 13.50
General expenses 4.50
Local taxes [1.1.X1 – 30.6.X1] 4.00
Insurance 13.20
Depreciation
– Vehicles 2.40
– Machinery 1.50 39.10
Net profit 47.90
Budgeted balance sheet as at 30 June 20X1
Capital 225.00
Net profit 47.90
Less: Drawings (9.00)
263.90
Non-current assets Premises 75.00
Vehicles 24.00
Less: Depreciation 2.40 21.60
Machinery 30.00
Less: Depreciation 1.50 28.50
Current assets Inventory 30.00
trade receivables [3 × 75.00] 225.00
Insurance 13.20 268.20
Barry Elliott and Jamie Elliott: Financial Accounting and Reporting (tenth edition) – Instructor’s Manual
15 © Pearson Education Limited 2006
Current liabilities Trade payables 120.00
Local taxes [1.1.X1 – 30.6.X1] 4.00
Bank overdraft 4.65
General expenses 0.75 (129.40)
Net current assets 138.80
263.90
(c) Possible action to deal with exceeding agreed overdraft limit
• Approach bank to re-negotiate the overdraft or arrange a loan facility for an agreed term.
• The amount and period that additional facilities are required depends on preparing a pro-jected cash flow statement for a longer period taking into account future plans e.g. owner’s drawings requirement, any additional capital expenditure.
• In particular, consider alternatives such as:
– leasing vehicles and/or machinery
– mortgaging the property
– getting debts in quicker
– introducing more capital
– obtaining or providing loan capital.
Barry Elliott and Jamie Elliott: Financial Accounting and Reporting (tenth edition) – Instructor’s Manual
16 © Pearson Education Limited 2006
Chapter 2: Question 2 – Mr Norman
(a) Purchases budget ($000)
Jan Feb Mar Apr May Jun Sales units 1.65 2.20 3.85 4.40 4.40 4.95
– Closing inventory 0.55 0.96 1.10 1.10 1.24
+ Closing inventory 0.55 0.96 1.10 1.10 1.24 1.38
Purchases units 2.20 2.61 3.99 4.40 4.54 5.09
Purchases Sales $000 $000
Jan (2,200 × 40) 88.00 82.50 (1,650 × 50)
Feb (2,610 × 40) 104.40 110.00 (2,200 × 50)
Mar (3,990 × 40) 159.60 192.50 (3,850 × 50)
Apr (4,400 × 40) 176.00 220.00 (4,400 × 50)
May (4,540 × 40) 181.60 220.00 (4,400 × 50)
Jun (5,090 × 40) 203.60 247.50 (4,950 × 50)
913.20 1,072.50
(b) Cash flow forecast (£000)
Jan Feb Mar Apr May June Total Initial capital 150.00 150.00
Cash Sales 41.25 55.00 96.25 110.00 110.00 123.75 536.25
Credit sales 41.25 55.00 96.25 110.00 110.00 412.50
191.25 96.25 151.25 206.25 220.00 233.75 1098.75 Premises 80.00 80.00
Commission 1.65 2.20 3.85 4.40 4.40 16.50
Suppliers 88.00 104.40 159.60 176.00 181.60 709.60
Administration 8.00 8.00 8.00 8.00 8.00 8.00 48.00
Wages 17.00 17.00 17.00 17.00 17.00 17.00 102.00
Insurance 0.35 0.35
Total payments 105.35 114.65 131.60 188.45 205.40 211.00 956.45
Net cash flow 85.90 (18.40) 19.65 17.80 14.60 22.75
Balance b/f – 85.90 67.50 87.15 104.95 119.55
Balance c/f 85.90 67.50 87.15 104.95 119.55 142.30
Barry Elliott and Jamie Elliott: Financial Accounting and Reporting (tenth edition) – Instructor’s Manual
17 © Pearson Education Limited 2006
(c) Budgeted profit and loss account for six months ended 30 June 20X8
$000 $000 Sales 1072.50
Purchases 913.20
Closing inventory [1,380 units × £40] (55.20)
Cost of sales 858.00
Gross profit 214.50
Wages 102.00
Administration 48.00
Commission [2% of 1072.50] 21.45
Insurance 0.18
Amortisation of lease 8.00
179.63
Net profit 34.87
Budgeted balance sheet as at 30 June 20X8
$000 $000 Capital 150.00
Net profit 34.87
184.87 Non-current assets Leasehold premises 80.00
Less amortisation (8.00)
72.00
Current assets
Inventory 55.20
Trade receivables 123.75
Prepayments – insurance .17
Cash 142.30
321.42
Current liabilities
Trade payables 203.60
Commission 4.95
208.55
Net current assets 112.87
184.87
Barry Elliott and Jamie Elliott: Financial Accounting and Reporting (tenth edition) – Instructor’s Manual
18 © Pearson Education Limited 2006
(d) Investment of surplus funds
• Acid test ratio At the end of the first six months’ trading Norman’s balance sheet shows that the acid test ratio is 1.28:1 (266.22/208.55) – this is higher than the basic 1:1 ratio but it should be com-pared with that of similar businesses in the same industry to establish a norm. It would appear however that the business has surplus funds to invest.
• Amount to invest A projected cash flow statement is required taking into account future plans re owner’s drawing requirements, future capital commitments and working capital criteria e.g. debtor collection and creditor payment terms.
• Period to invest The projected cash flow will give an indication of the period of the investment e.g. it could range from overnight on the money market to term investments.
The important aspect is that the owner should be aware of the projected cash flows so that return on surplus funds can be maximised.
Barry Elliott and Jamie Elliott: Financial Accounting and Reporting (tenth edition) – Instructor’s Manual
19 © Pearson Education Limited 2006
Chapter 2: Question 3 – The Piano Warehouse Company Limited
(a) Conventional profit calculation
(i) (ii) (iii) 4 sold 2 part made 2 repaired/sold £ £ £ £ £ Sales 8,000 3,000
Materials 2,000 900 1,800
Labour 2,800 800 400
Overheads 800 100
Cost of production 5,600 1,800 2,200
Less: inventory – 1,800 – Cost of sales 5,600 2,200
Profit 2,400 800
Comments on profit calculation:
(i) 4 pianos sold: profit is simply sales less cost. (ii) 2 partly completed pianos:
• No profit has been recognised
• Delay recognition until sale to comply with matching concept
• Work-in-progress carried forward.
Match with revenue when sales take place
presumably in the following year. (iii) Rebuilt pianos: profit has been taken in full
• Assumes no default on hire purchase payments.
• An alternative procedure that could be considered would be to
provide for unrealised profit on instalments outstanding
create a provision of £533 [2/3 of £800]
this reduces profit from £800 to £267 [1/3 of £800].
(b) It has been assumed that
• the work-in-progress is held at cost; and
• no profit has been recognised.
• The payment in advance of £900 will be shown as a creditor in the balance sheet.
Barry Elliott and Jamie Elliott: Financial Accounting and Reporting (tenth edition) – Instructor’s Manual
20 © Pearson Education Limited 2006
Given the facts that
• there is an assured market for work-in-progress; and
• the pianos are 50% complete a case could be made out for attributing a % of the total profit of £900 (£4,500 – £ 3,600 estimated cost to produce). Except in the simplest cases, the matching process can be highly subjective.
The conventional approach is to recognise revenue
• at the point of sale or, alternatively
• on completion of production or receipt of payment.
The core determinant is the identification of the completion of the earnings cycle as sig-nalled by a critical event e.g. production, delivery, receipt of payment. Applying these alternatives to The Piano Warehouse Company and assuming the critical event is: (i) On sale/delivery Recognise profit from the sale of 4 pianos (ii) During production Recognise profit from the 50% complete pianos (iii) On receipt of payment Restrict the profit from the 2 rebuilt pianos to the proportion of cash received. A more detailed consideration in IAS 18 relating to the sale of goods suggests the criti-cal event for revenue recognition hinges on 2 conditions:
• There has been a transfer to the buyer of the significant risks and rewards of owner-ship, and
• no significant uncertainty exists concerning the sale price, costs, likelihood of rejec-tion and return.
(c) The significant cost conventions are:
• Accruals for recognising profit
• Matching for associating costs incurred and to be incurred in arriving at a profit fig-ure
• Prudence in attributing/not attributing profit on work-in-progress.
(d) The profit for the year could be increased by the recognition of a proportion of the profit on the two pianos in the course of production with an estimate of the amount earned to date.
The maximum figure would normally be £450 [50% of the estimated total profit] but this would be dependent upon being reasonably certain that the future costs will not ex-ceed the estimate. Conversely, it could be argued that the £800 profit on the rebuilt pianos should be reduced to £267.
Barry Elliott and Jamie Elliott: Financial Accounting and Reporting (tenth edition) – Instructor’s Manual
21 © Pearson Education Limited 2006
Chapter 2: Question 4 – FRRP and Wiggins Group
FRRP membership
The Chairman of the Panel is Richard Sykes QC and the Deputy Chairman Matthew Patient CBE. There are currently 15 other Panel members drawn from a broad spectrum of commerce and the professions. Individual cases are normally dealt with by specially constituted groups of 5 or more members.
FRRP remit
The remit of the Financial Reporting Review Panel is to examine the annual accounts of public and large private companies to see whether they comply with the requirements of the Compa-nies Act 1985. Within this framework a main focus is material departures from accounting standards where such a departure results in the accounts in question not giving a true and fair view as required by the Act.
Action if accounts are defective
Where a company’s accounts are defective the Panel will, wherever possible, endeavour to se-cure their revision by voluntary means, but if this approach fails it is empowered to make an application to the court under section 245B of the Companies Act 1985 for an order compelling their revision. To date no court applications have been made, though in some instances the nec-essary steps have been at an advanced stage.
FRRP is reactive not proactive
The Panel does not itself monitor or actively initiate scrutinies of company accounts for possible defects, but acts on matters drawn to its attention, either directly or indirectly. The Panel’s re-sponsibilities do not extend to the directors’ report, summary financial statements or interim statements.
Wiggins: Revenue recognition
Company policy
It is the company’s accounting policy to recognise revenue in respect of commercial property sales on exchange of contract. In the 1999 accounts however, two sales had been recognised on the basis of non-binding heads of agreement and a third in respect of a contract dated after the end of the 1999 accounting period. In the 2000 accounts, the directors accepted that these treat-ments were not appropriate and adjusted the 1999 comparatives by the £21.5m turnover incorrectly recognised.
Barry Elliott and Jamie Elliott: Financial Accounting and Reporting (tenth edition) – Instructor’s Manual
22 © Pearson Education Limited 2006
FRRP questions raised re contracts
In those accounts, the directors did not address other concerns previously expressed by the Panel in connection with these contracts. One of the contracts was conditional upon the company ob-taining planning permission on terms satisfactory to the purchaser without which he had certain rights not to proceed. A second contract had the appearance of a financing transaction rather than an outright sale which, under FRS 5, should not be recognised until the risks and rewards of ownership pass at a future date. In the particular circumstances, the Panel was of the view that neither contract could be recognised in the 2000 accounts.
The directors have now accepted the Panel’s view and, in the revised accounts, have adjusted for these and other sales in earlier years, applying the same principles.
Revenue recognition
Company policy in 1999 accounts
The 1999 accounts contained an accounting policy for turnover in the following terms: ‘Commercial property sales are recognised at the date of exchange of contract, providing the Group is reasonably assured of the receipt of the sale proceeds.’
FRRP accepted policy in itself was not objectionable
The Panel accepted that this wording was similar to that used by many other companies and was not on the face of it objectionable. In reviewing the company’s 1999 accounts the Panel noted that the turnover and profits recognised under this policy were not reflected in similar inflows of cash; indeed, operating cash flow was negative and the amount receivable within debtors of £46m represented more than the previous two years’ turnover of £44m. As a result, the Panel enquired into the detailed application of the policy.
FRRP enquired into detailed application of the policy where contracts not exchanged
This enquiry established that revenue in respect of the sale of Manston Park and the Northern Grass area of Manston Airport had been recognised at 31 March 1999 on the strength of non-binding Heads of Agreement which were not turned into contracts until 29 July 1999. The enquiry also established that the sale contract for Fairfield had not been signed until 1 April 1999. In the Panel’s view the manner in which these transactions had been accounted for was not in accordance with the stated accounting policy and was unacceptable.
The Panel also expressed its concern that the chairman’s statement for 1999 compounded the error in the accounts by stating that during the year the most important achievements were the exchange of contracts with MEPC for the sale and development of Manston Park and Lon-don Manston Airport when the contract with MEPC for Manston had, in fact, not been exchanged during that year.
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Company response
The company accepted that the 1999 accounts were in error in respect of these transactions and decided to recognise turnover on exchange of contracts in accordance with its stated ac-counting policy which it did in the 2000 accounts by amending the 1999 comparatives.
FRRP enquired into detailed application of the policy where contracts were exchanged
However, the Panel had also questioned whether it would be correct to recognise revenue in respect of two of these transactions even after the contracts had been exchanged in the following year. The contract for the sale of Fairfield, concluded on 1 April 1999, was conditional upon the company’s subsequent fulfilment of a material condition: namely, that planning permis-sion had been obtained on terms satisfactory to the purchaser and without which the purchaser had certain rights not to proceed. Furthermore, the contract for the sale of the Northern Grass area of Manston appeared to have the characteristics of a financing deal rather than an outright sale and, under FRS 5, should not be recognised until the risks and rewards of ownership pass at a future date. The company’s decision to recognise turnover and profit in respect of the conditional Fairfield contract and the Northern Grass transaction in its 2000 accounts was made without discussion with the Panel and in spite of the Panel’s reservations. The directors justified their recognition of revenue from the sale of Fairfield on the basis that they believed the planning permission was ‘virtually certain’ to be obtained in due course. The Panel noted that the company had first recognised revenue in respect of Fairfield in its 1997 and 1998 accounts and had had to reverse those amounts in its original 1999 accounts when the contracts had lapsed. The contracts signed on 1 April 1999 replaced these original contracts. On the principle of reflecting sales of property that are subject to planning permission, the Panel had two main concerns, which are interrelated. The first is that, if the company has still to perform a significant amount of work in order to satisfy the condition, it has not yet com-pleted the earning process sufficiently to entitle it to recognise the revenue at the balance sheet date. The second is that the outcome of a conditional contract is necessarily uncertain, and unless that uncertainty has been reduced to an acceptable level by the time that the accounts have been finalised, in general, the prudent course would be not to recognise the conditional contract until the condition is satisfied. The Panel accepts that there may be specific instances where it might be appropriate to recognise a sale even though it remains conditional; for exam-ple, where all the work required to satisfy the conditions has been performed and the relevant costs have been incurred before the year-end and the relevant conditions satisfied before the ac-counts are issued, it may be reasonable to recognise the sale. Those basic steps had not been effected in the case of Fairfield before the 2000 accounts were issued. The company has now accepted the Panel view. The amount of turnover recognised in the 2000 accounts in error and now to be corrected amounts to £37m.
Revisions required to the accounts – turnover restated
As indicated in its interim statement, the company has also acknowledged that applying these principles, £2.34m turnover included in the 1996 accounts and subsequently reversed in 1997
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and 1998 should not have been recognised in the 1996 accounts. The accounts for 1996 to 1998 are being revised to correct these entries. A similar adjustment is being made by the company to its 1995 accounts.
Revisions required to the accounts – compliance with FRS 5
As to the sale of Northern Grass the Panel considered that the substance of the transaction re-flected a development being financed by the purchaser with the company paying an interest cost on monies received from the purchaser and retaining certain risks and rewards for the time be-ing. Accordingly, in compliance with FRS 5, the transaction should have been treated as a financing arrangement until the interest payments ceased, either on completion of the develop-ment or on 30 January 2002, whichever is the earlier. The company has now accepted the Panel view. The amount of turnover recognised in the 2000 accounts in error and now to be corrected amounts to £5m.
Debtors
The Companies Act 1985 requires the amounts of debtors that are receivable after more than one year to be separately disclosed. In the 1999 accounts £10m of the anticipated proceeds from the sale of Manston Park was wrongly included in debtors due within 12 months. The company agreed to correct this error in the 2000 accounts but in the event recognition of the sale was reversed in its entirety.
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C H AP T E R 3
Chapter 3: Question 1 – Jim Bowater
(a) Refer to Question 2 (a) below for description of underlying theory
(b) Jim Bowater ideal economic income model:
Investment of £36,000, cost of capital 20%
(i) Jim’s economic income (£) for each of the three years is:
31 Dec 20X5 6,828 31 Dec 20X6 6,695 31 Dec 20X7 6,833 (ii) Jim’s economic capital will be preserved at the 1 January 20X5 level of £34,144 provided:
• he reinvests excess actual income of £672 on 31 December 20X5 and £34,107 at 31 De-cember 20X7, generating a return of 20%
• an excess of actual income of £695 at 31 December 20X6 created, in effect, a cumulative injection of capital of (672 – 695) £23
• to maintain his income of 20% p.a. will necessitate an investment of £34,167 from the pro-ceeds of the proposed sale.
Workings
(A) Ideal economic income (i.e. conditions of certainty) Period C Kt Kt–1 Ye C – Ye 20X5 t0 – t1 7,500 33,472 (b) 34,144 (a) 6,828 672
20X6 t1 – t2 6,000 34,167 (c) 33,472 (b) 6,695 (695)
20X7 t2 – t3 41,000 34,167 (c) 6,833 34,167
54,500 20,356 34,144
(a) t0 – t1 7,500 + 6,000 + 41,000 = 34,144
1.2 1.22 1.23
(b) t1 – t2 6,000 + 41,000 = 33,472
1.2 1.22
(c) t2 – t3 41,000 = 34,167
1.2
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(B) Reinvestment under certainty to maintain 20% p.a. income Economic income from: original investment reinvestment total economic income t0 – t1 6,828 – 6,828
t1 – t2 6,695 (20% 672) 133 (approx.) 6,828
t2 – t3 6,833 (20% 23) (5) (approx.) 6,828
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Chapter 3: Question 2 – Hicks’s Concept of Income; Spock
(a) Hick’s economic model of income and capital
Hicks’s economic model of income and capital is based on his concept of ‘welloffness’.
• Welloffness is: the maximum income enjoyed by the individual without depleting that indi-vidual’s capital stock.
• It is based on the precept of consumption which embraces the opportunity for consump-tion as well as actual consumption.
• As an extension of Fisher’s original model: it takes savings into account.
It is an ex ante model in that it usually measures expected income in advance of the time period concerned.
• Measurement of capital is necessitated in order to compute income.
• Income is the difference between opening and closing valuations of capital stock.
• The capital stock is computed by utilising the concept of present values.
• This concept adopts the idea of compound interest in order to compensate for the time ele-ment between cash flows.
Limitations
In the field of accountancy there are serious practical limitations in measuring the accountant’s version of income and capital e.g.
• Subjectivity: the present value factor, often referred to as the discount cash flow element, is subjective.
• It requires the use of an interest rate and, as such, depending upon personal inclinations, it can utilise opportunity cost of capital, or the return on existing capital employed within a business entity, or contemporary short-term interest rates such as that charged on bank overdrafts, or the average rate pertaining in the current economic climate, or a speculative rate as assessed on the basis of perceived risk involved.
• Unrealised and realised flows: the model uses a mix of unrealised and realised cash flows. As a measure it is thus not of practical value in determining taxation liability and dividend policy.
• Financial strategy: attainment of flows as per a financial strategy is an integral part of the calculations. Targets are rarely achieved with precision. Variations from target destroy the model’s accuracy. Predictions are invariably unachievable with absolute accuracy.
• Windfalls: windfall flows cannot be foreseen and consequently cannot be incorporated within the model.
• Balance sheet values: balance sheet valuations of net assets or capital employed concern aggregations of individually valued assets and itemised liabilities.
It is not easy to apply the concept of present values across a range of individual assets and li-abilities for balance sheet discount purposes.
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(b) Calculate Spock’s ideal economic income using Hicks’s theorem
Economic capital value of the business at KO Year Cash Flow DCF Factor PV 1/(1+r)n £ £ K1 400 0.909 364
K2 500 0.826 413
K3 600 0.751 451
400 0.751 300
1,900 1,528
Economic value at X0 i.e. the beginning of the year is £1,528 [Note: initial capital was £1,000 therefore subjective goodwill is £528]
Economic capital value of the business at K1 Year Cash Flow DCF Factor PV 1/(1+r)n £ £ K1 400 1.000 400
K2 500 0.909 455
K3 600 0.826 496
400 0.826 330
1,900 1,681
Economic value at K1 = £1,681. So Y for Y1 = £1,681 – £1,528 = £153
Rate of income return = £153 / £1,528 = 10%
Economic capital value of the business at K2 Year Cash Flow DCF Factor PV 1/(1+r)n £ £ K1 400 1.100 440
K2 500 1.100 500
K3 600 0.909 546
400 0.909 363
1,900 1,849
Economic value at K2 = £1,849. So Y for Y2 = £1,849 – £1,681 = £168
Rate of income return = £168/£1,681 = 10%
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Economic capital value of the business at K3
Year Cash Flow DCF Factor PV 1/(1+r)n £ £ K1 400 1.121 484
K2 500 1.100 550
K3 600 1.000 600
400 1.000 400
1,900 2,034
Economic value at K3 = £2,034. So Y for Y3 = £2,034 – £1,849 = £185
Rate of income return = £185/£1,849 = 10%
Note rate of income return is a constant 10%.
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Chapter 3: Question 3 – Jason
(a) (i) Accounting income for Jason (using historical cost concept and applying conventional accounting by compiling an Income Statement account).
Income statement for the year ended 31 December,20X1 £ £ Opening inventory 10,000 Sales less purchases 36,200
Gross profit c/d 41,700 Closing inventory 15,500
51,700 51,700
Depreciation 5,000 Gross profit b/d 41,700
Net profit 36,700 41,700 41,700
(Note: The Sales less purchases figure of £36,200 is derived from the debtors/creditors account below.)
So accounting profit = £36,700 (assumes traditional concept of going concern).
Workings are shown below in T account form
Cash Book 1 Jan 20X1 Balance 135,000 1.1.20X1 Purchase of business 130,000
Legal costs 5,000
135,000 135,000
20X1 Debtors/creditors 40,000 31 Dec 20X1 Drawings 25,000
Balance 15,000
40,000 40,000
1 Jan 20X2 Bal b/d 15,000
Purchase of business 1 Jan 20X1 Cash 130,000 1 Jan 20X1 Premises 100,000
Stock 10,000
Debtors 4,000
______ Goodwill 16,000
130,000 130,000
Shop premises 1.1.20X1 Purchase of
business 100,000 31 Dec 20X1 Balance 105,000
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Cash
Legal costs capitalised 5,000
105,000 105,000
Depreciation 31 Dec 20X1 Balance c/d 5,000 31 Dec 20X1 P&L a/c 5,000
5,000 5,000
1 Jan 20X2 Balance b/d 5,000
Inventory 1 Jan 20X1 Purchase of
business 10,000 31 Dec 20X1 P&L a/c 10,000
31 Dec 20X1 P&L a/c 15,500
Goodwill 1 Jan 20X1 Purchase of
business 16,000
Capital 31Dec 20X1 Drawings 25,000 1 Jan 20X1 Cash 135,000
Balance c/d 146,700 31 Dec 20X1 P&L a/c 36,700
171,700 171,700
1 Jan 20 × 2 Balance b/d 146,700
Trade receivables/trade payables account
[prepared in order to derive net sales less purchases] 1 Jan 20X1 Purchase of 31 Dec 20X1 Cash balance 40,000
business:
receivables 4,000
20X1 Sales – purchases = balancing figure 36,200 31Dec 20X1 Payables c/d 5,000 31 Dec 20X1 Receivables c/d 5,200
45,200 45,200
1 Jan 20X2 Receivables b/d 5,200 1 Jan 20 × 2 Payables b/d 5,000
Drawings
31 Dec 20X1 Cash 25,000 31 Dec 20X1 Capital a/c 25,000
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Balance sheets
(NA0) (NA1) At 1 Jan 20X1 At 31 Dec 20X1
Premises 100,000 100,000
Add capitalisation
of legal costs 5,000 5,000
105,000 105,000
Less depreciation 5,000
105,000 100,000
Goodwill 16,000 16,000
Inventory 10,000 15,500
Trade receivables 4,000 5,200
Cash 40,000
Less drawings 25,000 15,000
Trade payables (5,000)
135,000 146,700
So profit = NA1 – NA0 + Drawings = 146,700 – 135,000 + 25,000 = £36,700 as confirmed by the profit and loss account above. Comparing the opening and closing balance sheets and allowing for drawings will enable profit to be derived but it is usual for accounting profit to be shown via a profit and loss account.
• It has been assumed that the traditional historical cost concept applies.
• It was intended that the legal costs be capitalised giving a fair value at 1 January 20X1 of £105,000
• Thus depreciation is £5,000 (£105,000 – £100,000)
• Alternatively the £5,000 could have been treated as an expensed cost (i.e. written off in the profit and loss account)
• The net profit would remain as £36,700, the depreciation having been replaced by the legal costs.
• It was assumed that opening balance sheet values represent fair values (i.e. cost) of the indi-vidual assets concerned.
(ii) Realisable income
Y0-1 = Net RV1 – Net RVo + drawings = £136,200 – £135,000 + £25,000 = £26,200
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Workings: Net realisable values At 1 Jan 20X1 At 31 Dec 20X1
Premises 85,000 105,000
Goodwill 16,000 16,000
Inventory 20,000 10,000
Trade receivables 5,200 4,000
Cash 40,000
Less drawings 25,000 15,000
Trade payables (5,000)
Net realisable values 136,200 135,000
Assumptions:
(a) The realisable values are not based on an enforced sale.
(b) Goodwill would possess a realisable value equivalent to its original cost in an enforced sale.
(c) The entity is capable of being sold as a business entity in order to realise goodwill.
Note: Some commentators might dispute the validity of goodwill because the concept of realis-able income contravenes the going concern concept. In this situation the realisable income would be £10,200.
(iii) Economic income ex ante
Ye = C1 + (K1t – Kt – 1)
= 25,000 + (142,361 – 139,467) = £27,894 income for 20X1
Assumptions:
(a) The difference of £4,467 between the actual cost of opening capital of £135,000 and its pre-sent value of £139,467 is to be treated as subjective goodwill.
(b) The anticipated drawings represent expected cash flows.
(c) The discount factor does not vary over the timespan.
(d) The cash flows predicted will materialise.
(e) Only the original capital of a present value of £139,467 needs to be maintained.
(f) All the price levels are constant.
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Workings:
Kt – 1 = capital at 1 January 20X1 ex ante
CF 25,000 25,000 25,000 + 150,000 = ——– = —–—– + —–—– + ––––––––––––––– (1+r)n (1.2) (1.2)2 (1.2)3
= £139,467 K1
t = capital at 31 December 20X1 ex ante
= CF 25,000 25,000 + 150,000 ——– = —–—– + —–—––––––––––
(1+r)n (1.2) (1.2)2
= £142,361
An extension of the tabulated workings might be helpful: Year C1 K1
t Kt –1 Ye W Ye+W C1 – (Ye+W)
Y0–Y1 X1 25,000 142,361 139,467 27,894 27,894 (2,894)
Y1–Y2 X2 35,000 175,000 175,000 35,000 32,639 67,639 (32,639)
Y2–Y3 X3 210,000 175,000 35,000 35,000 175,000
270,000 97,894 130,533 139,467
Workings:
Y1–Y2 20X2 (2) 175,000 175,000 (1) Y2–Y3 20X3 175,000 (2)
35,000 35,000 + 175,000 (1) ––––– + ––––––––––––––– = £175,000
(1.2) (1.2)2
35,000 + 175,000 (2) –––––––––––––––– = £175,000
(1.2)
(iv) Economic income ex post
Ye = C + (Kn – Kn – 1) = 35,000 + (175,000 – 175,000) = £35,000
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Assumptions:
(a) The difference of £40,000 between the actual cost of opening capital of £135,000 and its present value of £175,000 is to be treated as subjective goodwill.
(b) The discount factor is not subject to change.
(c) Price levels are constant.
(d) Cash flows for years following 20X1 will be as predicted.
(e) All flows occur at the year-end.
Workings:
CF 35,000 35,000 35,000 + 175,000 W1 = –––– = –––––– + –––––– + –––––––––––––– (1+r)n (1.2) (1.2)2 (1.2)3
= £175,000
CF 35,000 35,000 + 175,000 W2 = ––––– = ––––– + ––––––––––––––
(1+r)n (1.2) (1.2)2
= £175,000
A tabular extension of the workings might be helpful:
Year C1 Kn Kn – 1 Ye W Ye+W C1 – (Ye+W)
Y0–Y1 35,000 175,000 W2 175,000 W1 35,000 35,000
Y1–Y2 35,000 175,000 W3 175,000 35,000 35,000
Y2–Y3 35,000 -- 175,000 35,000 35,000
175,000 ______
280,000 105,000 _____ ______
35,000 + 175,000 W3 = –––––––––––––– = £175,000
1.2
(b) Evaluation of the income figures
(i) Accounting income (£36,700)
As an indicator of performance
• Based on actual transactions in this respect it is objective.
• However, it also utilises subjective data (e.g. depreciation) which incorporates an ele-ment of estimation into the results for the year.
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• If such subjective data are substantial as a proportion of total costs, then the resultant profit or loss would be of reduced reliability.
• Being based on historical cost it can be misleading as an indicator of real profit in times of changing price levels.
• It ignores unrealised capital gains/losses in pursuit of the going concern concept.
• It could be said therefore that on the one hand the figure is incorrect; but
• on the other it is realistic because there is no intention to realise the net assets.
• The balance sheet is not a valuation statement. Consequently, profit expressed as a return on capital employed may be incorrect as an indicator of performance.
As an aid in decision making
• It is historic and history may not be a guide to the future.
• Circumstances of trade, costs and setting prices may be subject to factors not encoun-tered by the results to date.
• However, historical trends over years may be of considerable assistance.
• It does not enable precise comparisons to be made with the return yield of other businesses as historical costs can mean differing values across trade and industry as inflation develops.
• In general, accounting income has a considerable degree of authenticity because
• of its objective nature
• it is traditional and it is understood
• it can be of assistance as an indicator of performance and as an aid in decision mak-ing if it is used as a base figure capable of amendment in the light of:
• subjective content
• a changing price economy and anticipated future commercial trends regarding costs and sales.
(ii) Realisable income (£26,200)
As an indicator of performance
• It avoids the subjective assessment of depreciation and in this sense its measured income can be said to be realistic, but it embraces unrealised capital gains and losses which can be said to be irrelevant when the intention to sell does not exist.
• If the going concern concept is paramount then as an indicator realisable-value-based profit is unrealistic.
• Realisable values are subjective.
As an aid to decision making
• It can be said to equate asset values with opportunity cost which is relevant when consider-ing the going concern versus the cash realisation potential of disposal.
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(iii) Economic income ex ante (£27,894)
As indicator of performance
• Very subjective figure in terms of future cash flows in respect of amount, timing and dis-count factor. These effects can make it impractical to implement as a system.
• However, it can accommodate inflation by taking account of changing price levels when forecasting the future cash flows
• As an indicator it is predictive and thus windfall gains can occur in this system when antici-pated cash flows are changed by new circumstances.
• It is a guide to prudent conduct as it represents maximum consumption for a defined period without eroding capital.
As an aid to decision making
• By attempting to value a business at different time points it takes account of a strict capital maintenance concept via a time value of money
• thus the possibility of profit distributions being excessive and consequently eroding the capital is restricted
• this is not so with historical cost.
• The adoption of a discounting factor enables cash flows to be adjusted to take account of risk.
• Whilst these two qualities are perhaps too subjective in terms of valuing the entire business entity they can be of considerable assistance when considering investment in the individual asset where choice amongst alternatives or the option of buying or renting exists.
(iv) Economic income ex post (£35,000)
As indicator of performance
• Accuracy is dependent upon the validity of the forecasting cash flows as with the ex ante system.
• However, unlike that model adjustments can be made to past as well as future capital values.
• Thus as an indicator of performance it has the potential to better the ex ante concept.
• By adjusting past as well as future cash flows due to windfall elements it tends to have characteristics akin to traditional accounting. The figure of £35,000 is close to the tradi-tional accounting figure of £36,200.
As an aid to decision making
• Expectations can change over time thereby affecting income and capital calculations.
• Windfall gains and losses can influence the calculations and thus inhibit confidence in the reliability of the measure. Will the profit be £35,000 next year?
• However absolute accuracy is not pretended by the model; as with the ex ante measure its intention is to give guidance only.
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C H AP T E R 4
Chapter 4: Question 1 – Shower Ltd 20X3 HC CPP/PLA RC CoCoA £ £ £P £P £ £ £ (iv) (i) (ii) (iii) (iv) Sales (8,000 units) 20,000 240/120 40,000 20,000 20,000
Inventory (4,000 units) 4,000 240/100 9,600 HC × 150/100 6,000
Purchase (6,000 units) 9,000 240/120 18,000 HC × 150/150 9,000
13,000 27600 15,000
C Inventory (2,000 units) 3,000 10,000 240/120 6,000 21,600 HC × 150/150 3,000 12,000 10,000
10,000 18,400 8,000 10,000
Sundry expenses 5,000 240/120 10,000 HC × 150/150 5,000 5,000
Depn £6,000/5 1,200 240/100 2,880 HC × 200/100 2,400 0,000
3,800 5,520 600 5,000
Monetary gains Realised holding Price variation
gains adjustments
Loan FA FA
(8,000 × 240) – 8,000 2,400–1,200 1,200 6,000–2,000 (4,000)
(100) 11,200 Inventory Inventory
12,000–10,000 2,000 3,000–5,100 2,100
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Monetary Losses Unrealised holding Capital Maintenance
Gains
(6,000 × 240) – 6,000 FA
(120) (6,000) 9,600–4,800 4,800 2,000 × 240
Inventory 100
5,100–3,000 2,100 –2,000 (2,800)
PLA Net Income 10,720 10,700 300
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Balance sheets as at 31 December 20X3
HC CPP/PLA RCA CoCoA
Share capital 2,000 × 240/100 4,800 2,000 2,000
Retained earnings 3,800 PLA 10,720 600 300
Realised holding 3,200
Unrealised holding 6,900
Capital maintenance
reserve 2,000 × 240 2,800
100
–2,000
Loan 8,000 8,000 8,000 8,000
£13,800 £23,520 £20,700 £13,100
Non-current asset 6,000 240/100 14,400 200/100 12,000
Depn 1,200 4,800 240/100 2,880 11,520 200/100 2,400 9,600 NRV 2,000
Inventory 3,000 240/120 6,000 255/150 5,100 NRV 5,100
Cash 6,000 6,000 6,000 6,000
£13,800 £23,520 £20,700 £13,100
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Chapter 4: Question 2 – Toy plc
(a)
1. Cost of sales adjustment
• This is the amount by which the historic cost of goods sold and charged in the historical cost income statement falls short of the replacement cost of those goods as at the date of sale.
• The CCA model requires all costs, assets, revenues and liabilities to be reported at their cur-rent entry value.
• The COSA is therefore an additional charge to the income statement account intended to bring the historical cost of sales to their replacement cost equivalent.
• The COSA is regarded as a realised holding gain in the sense that it is a gain relating to real-ised assets (i.e. sold inventory) and one made during the asset holding period.
2. Additional depreciation
• Is an amount charged to the income statement to make charge for year equate to that related to the replacement cost.
3. MWCA
• This is the gain or loss from holding monetary working capital.
• If prices are rising MWCA will be a gain if net monetary liabilities are held and a charge if net monetary assets are held.
4. Gearing adjustment
• Is an amount that is based on the proportion of the above charges that accrues to ordinary shareholders because there are lenders who bear a proportion of the charges.
5. Accumulated current cost depreciation
• This is to provide sufficient retention of funds to allow for the replacement of the fixed as-set.
6. Current cost reserve
• This is a revaluation reserve where all holding gains (realised as well as unrealised) are credited in order to avoid the distribution of such gains and therefore reserve enough funds to replace assets at their current replacement costs as they are consumed.
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• The composition of the CCA reserve account is likely to include realised items as follows:
• debits: backlog depreciation gearing adjustment
• credits: COSA monetary working capital adjustment.
and the following unrealised items:
• closing inventory revaluation increase
• non-current asset revaluation increase.
(b)
It quantifies cost of sales and depreciation after allowing for changing price levels so that the trading results are free of inflationary elements and provide a clearer picture of management performance.
• Resources are maintained by eliminating the risk of disturbing profits out of real capital.
• Time series and inter firm comparisons are more indicative of management performance.
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Chapter 4: Question 3 – Parkway plc
(a) Monetary working capital
Making and stating assumptions:
• COSA provides for the maintenance of inventory levels in times of inflation.
• There is a view that MWC is also an integral part of daily operating activities and should be treated similarly via a provision out of revenue, from any detrimental impact caused by ris-ing price levels.
• However, a consensus does not exist.
• in that some commentators maintain that MWC is not a part of the operating capital and so should be ignored when considering the operating capital maintenance concept,
• apparently in the belief that investment in such items as debtors is not an essential in-gredient of day-to-day operations.
• Even where critics accept MWC is a part of operating activities, varying views exist as to which assets and liabilities should be included in the MWC calculation. Conflicting views are:
• MWC should embrace monetary assets only; or
• all monetary assets less all monetary liabilities should be taken into account; or
• only short-term monetary liabilities should be accepted into the calculation; that long-term monetary liabilities should be part of the gearing adjustment; or
• even short-term monetary liabilities should be ignored; or
• only monetary assets and liabilities that have been generated by operating activities should be involved and thus these should be segregated from other monetary assets and monetary liabilities.
Usual inclusions:
• In spite of ongoing contentious debate, there is general acceptance to include the following items as part of MWC:
• trade receivables, including prepayments, trade bills receivable and VAT recoverable on trade purchases
• trade payables, including accruals, trade bills payable and VAT payable on turnover; and
• any stock not subject to COSA.
Usual exclusions:
• receivables and trade payables arising from fixed assets sold, bought or under construction or those arising out of any other non-trading activities;
• any cash or bank balances; and
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• certain investments such as long-term and short-term investments. The former will be treated as fixed assets and the latter as cash and bank balances.
Some critics formulate a case for including all or a portion of liquid resources as part of MWC:
• If cash is essential to support day-to-day ordinary operations (e.g. a retail supermarket), then such cash is part of the MWC.
• Similarly if part of a bank balance or overdraft is subject to temporary but material changes as a reaction to fluctuations in levels of stock, trade debtors, trade purchases or sales then it should be treated as MWC.
• Any surplus will become part of the gearing adjustment.
Taking account of the above scenarios the following MWCA calculation involves the assump-tions stated below and corresponding reasons for making them i.e. that:
• MWC is part of day-to-day ordinary operating activities.
• ‘Trade receivables’ are substantial
• at £60,000 this is almost 50% of the capital invested in fixed assets (£126,000)
• they amount to 63% of inventories (after eliminating an average profit content in debt-ors of 16% of sales i.e. £118,000/738,000 × 100 based on the year-end debtors figure of £60,000 i.e. 84% of £60,000/£80,000 × 100) = 63%.
• If COSA is considered necessary in respect of inventories of £80,000 then so too is MWC in respect of trade receivables, inclusive of profit, of £60,000.
• Total inventories of £80,000 are all subject to COSA.
• Trade payables, being also substantial at £90,000, are deemed essential to the entity’s daily operating activities. Trade payables amount to an average 37 days’ credit i.e. [((£80,000 + 70,000)/2) / £738,000] × 365 during 20X8.
• Short-term investments are not essential to MWC, i.e. they do not constitute a provision of finance for, say, imminent investment in trade receivables as part of a marketing strategy to stimulate sales by increasing terms of credit to customers.
• Cash and bank balances, and any part thereof, are essential to day-to-day ordinary activities.
• The rate of credit given and taken remains unchanged over the period.
• Inventories have been charged out on the basis of FIFO and the inventory price level index is appropriate to the MWCA.
• Inventory movements have been evenly spread throughout the year.
Calculation of MWCA
30.6.20X8 1.X.20X7 Change
Trade receivables 60,000 40,000
Trade payables (90,000) (60,000)
(30,000) (20,000) (10,000)
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Adjustment to average price levels:
30,000 × 160 – 20,000 × 160
180 140
= 26,667 – 22,857
= Volume change (3,810)
Reduction in MWC 6,190
(b) Critical evaluation of the influence of MWCA
• The concept of a MWCA acknowledges the existence of the interaction of physical assets and monetary assets by allowing for the protection of MWC against erosion by inflation in the same way that COSA protects capital in stocks consumed.
• The provision for additional MWC supplements the provision for extra depreciation and COSA in maintaining the capital substance of the entity.
• The calculation is not over-prudent as it takes cognisance of the protection granted by credit suppliers in their indirect funding of credit customers.
• The inclusion of monetary assets and trade payables within the inflation protection frame-work reduces the risk of an excess dividend being paid. This could threaten the going concern by overlooking the impact of inflation on the monetary working funds.
• The concept recognises the lag between realising a sale and realising the resultant cash.
• Changes in credit periods between that granted to trade receivables and that given by sup-pliers can be affected by inflation in that impact may otherwise remain hidden if the MWCA were not applied.
• However, a point of criticism is that if trade creditors become unstable in terms of credit given and credit received, the MWCA calculation increases in complexity and may not be so readily understood by the users of the accounts.
• A further criticism lies in the determination of any cash floats and bank balance movements deemed to be part of MWC by some business entities. These may be very subjective and, consequently, inaccurate or prone to abuse by the compilers.
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Chapter 4: Question 4 – Raiders plc
(a) All in £000s
(i) Cost of goods sold
Note: Closing inventory purchased on average on 31 December.
Average index is index at 30.9.X4 i.e. 150
Alternatively calculate the average of indices at 1.4.X4 and 31.3.X5
(138 + 162 ) = 150 ( 2 )
HC ×××× Revaluation = Current ratio cost
Inventory 1.4.X4 9,600 150/133 10,827
Purchases 39,200 150/150 39,200
48,800 50,027
Inventory 31.3.X5 11,300 150/156 10,865
COGS 37,500 39,162
(ii) Inventory figure in balance sheet
Balance sheet value 11,300 162/156 11,735
(iii) Equipment depreciation charge
HC ×××× Revaluation = Current cost ratio 1.4.X4 31.3.X5
Purchased 1.4.X2 16,000 180/145 19,862
1.4.X3 20,000 180/162 22,222
1.4.X4 21,600 180/180 21,600
63,684
× 200/180 70,760
CC depreciation =15% × [63,684 + 70,760] = 10,083
[ 2 ]
Alternatively calculate as: 15% × £70,760 = 10,614
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(iv) Balance sheet value of equipment
Purchase Current cost ×××× 200 Gross CC Accumulated date @ 1.4.X4 180 depreciation
1.4.X2 19,862 22,069 (45%) 9,931
1.4.X3 22,222 24,691 (30%) 7,407
1.4.X4 21,600 24,000 (15%) 3,600
70,760 20,938
Net balance sheet value = 70,760 – 20,938 = £49,822
(b) Evaluation of incremental informational content
Discuss users and their decisions and how current cost number should improve predic-tions and control. Should also refer to recent empirical evidence and may discuss ongoing controversy within (and outside) ASB.
(c) Consider power of providers; cost; economic companies, etc.
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Chapter 4: Question 5 – Smith plc
(i) CPP requires the restatement of the income statement and balance sheet in terms of pur-chasing power of money at the end of the accounting period in units of CPP.
It is rather like translating the historic figures into another currency.
• CPP accounts are derived from the historic accounts by applying the general price index, and are issued as supplementary statements aimed at the shareholders.
The intention is to ensure that shareholders’ capital is maintained in terms of general pur-chasing power and distributions would be restrained during a period of general inflation.
• CPP accounts are objective/factual because they are
• based on HC figures updated to year end values;
• as such can be audited.
They show gains and losses on monetary items not incorporated into basic CCA model.
(ii) (a) Restate the income statement in £CPP
CPP income statement for the year ended 31.12.20X8 HC£000 Index CPP£000
Sales 2,000 236/228 2,070
Cost of sales
Inventory 320 236/216 350
Purchases 1,680 236/228 1,739
2,000 2,089
Closing inventory 280 236/232 (285)
1,720 1,804
Gross profit 280 266
Depreciation 20 236/120 39
Admin. expenses 100 236/228 104
120 143
Net profit 160 123
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(b) Restate the closing balance sheet in £CPP
Balance sheet as at 31.12.20X8 HC£000 Index CPP£000
Non-current assets
Land and buildings 1,180 236/120 2,321
Net current assets
Inventory 280 236/232 284
Trade receivables 160 160
Cash/bank 120 120
560 564
Less Trade payables (140) (140)
420 424
Net total assets 1,600 2,745
Equity 1,600 2,745
(c) Restate the opening balance sheet in £CPP (as at 31.12.20X8 rate)
Balance sheet as at 31.12.20X7 HC£000 Index CPP£000
Non-current assets
Land and buildings (net) 1,200 236/120 2,360
Net current assets
Inventory 320 236/216 350
Trade receivables 80 236/220 86
Cash/bank 40 236/220 43
440 479
Less Trade payables (200) 236/220 (215)
240 264
Net total assets 1,440 2,624
Equity (balancing figure) 1,440 2,624
(d) Calculation of monetary loss as at 31/12/20X8
Equity [balance] at 31.12.20X7 in CPP£000 2,624
Equity [balance] at 31.12.20X8 in CPP£000 2,745
Increase 121
Profit per income statement in CPP£000 123
Monetary loss 2
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(e) Reconciliation of monetary loss as at 31.12.20X8
HC£000 Index CPP£000 Net monetary liabilities at 31.12.20X7 (80) 236/220 (86)
Increase 220 236/228 228
Net monetary assets at 31.12.20X8 140 142
Monetary loss [140 – 142] 2
Net monetary liabilities are made up as follows:
31.12.20X7 31.12.20X8 £000 £000
Trade receivables 80 160
Bank 40 120
Trade payables (200) (140)
(80) 140
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Chapter 4: Question 6 – Aspirations Ltd
Income statement for year ended 31 December 20X1, prepared on RCA basis
Sales 868,425 Purchases 520,125
Less: Inventory at 31.12.X1 24,250
495,875
Add: Cost of sales adjustment (W1) 7,717
Adjusted cost of sales 503,592
Adjusted gross profit 364,833
Expenses 95,750
Depreciation (W2) 33,000
128,750
Operating gain 236,083
Balance sheet as at 31st December 20X1 – RCA Basis
Non-current assets Freehold property (W3) 975,000
Depreciation (W3) 9,750
965,250
Office equipment 465,000
Depreciation 23,250
441,750
Current assets
Inventories at replacement cost 24,250
Trade receivables 253,500
Cash 1,090,300
1,368,050
Less: Current Liabilities
Payable within 1 year 116,250
Net current assets 1,251,800
Less: Non-current liabilities
Payable after 1 year 500,00
751,800
2,158,800
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Issued share capital
1,500,000 ordinary shares at £1 each 1,500,000
Holding gains (W4) 422,717
Retained earnings 236,083
2,158,800
Workings for RCA Model
W1 Cost of sales adjustment (COSA)
HCA Indexed RCA Difference
Initial stock 1.1.X1 34,375 × 130/115 38,859 4,484
Purchases 485,750 × 130/ 130 485,750 –
520,125 524,609 4,484
Closing inventory 31.12.X1 24,250 × 130/ 150 21,017 3,233
495,875 503,592 7,717
The calculation has utilised the device of averaging. The user of an average index assumes that inventory was consumed on average at a price applying midway through the financial period. The increase in the cost of sales due to upward-moving price levels is £7,717. Purchases have been acquired evenly throughout the year, apart from the initial inventory, therefore the histori-cal cost also represents average current cost and thus will not require any amendment. The advantages of averaging are those of speed and convenience.
W2 Depreciation
Depreciation is being based on the year-end replacement cost. HCA Indexed RCA Depn Depn
Property 6,500 × 127/110 7,505
Equipment 18,750 × 145/125 21,750
25,250 29,255
As far as the balance sheet is concerned, however, the cumulative depreciation for one year based on year-end values would still have to be £33,000. The difference of £3,745 (£33,000–29,255) would constitute backlog depreciation for the current year. This is an important aspect of the calculation if average price level movements are used to determine depreciation. At first sight many students find the concept of backlog depreciation for the current year as distinct from previous years more difficult to understand.
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W3 Revaluation of non-monetary items at balance sheet date
HCA Indexed RCA Difference
Freehold property 650,000 × 165/110 975,000 325,000
Office equipment 375,000 × 155/125 465,000 90,000
1,025,000 1,440,000 415,000
Inventory 24,250 × 145/145 24,250
The index of 145/145 used to convert the inventory to RCA is not strictly correct. Inventories of £24,250 were part of purchases for the year and as such were not bought on the last day of the year. However we have assumed that the inventory was bought in the closing days of the year and is tending towards the specific price level measured at 145. If the inventory had been bought much earlier and the amount was material then it would be necessary to ascertain the index at the date of purchase.
W4 Holding gains:
£ On stocks consumed (W1) 7,717
On stocks carried at the year-end nil
On fixed assets (W3) 415,000
422,717
Income statement for year ended 31.12 20X1, GPP basis £ £
Sales (W5) 952,466
Initial inventory (W6) 43,287
Purchases (W6) 532,758
Less: Inventory 31 December (W6) (24,250)
Cost of sales (W6) 551,795
GPP gross 400,671
Expenses (W7) 105,016
Depreciation (W8) 31,796
136,812
GPP net profit before loss on monetary items 263,859
Less: Loss on monetary items (W10) 142,003 GPP net profit after loss on monetary items 121,856
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Balance sheet as at 31st December 20X1, GPP Basis Non-current assets: Cost Depn
Freehold property (W9) 818,518 8,185 810,333
Office equipment (W9) 472,222 23,611 448,611
1,290,740 31,796 1,258,944 Current assets:
Inventories at GPP valuation (W6) 24,250
Trade receivables 253,500
Cash 1,090,300
1,368,050
Less: Current Liabilities
Payable within 1 year 116,250
Net current assets 1,251,800
Less: Non-current liablities
Payable after 1 year 500,000
751,800
2,010,744 Issued share capital
1,500,000 ordinary shares fully paid 1,888,888
Retained earnings 121,856
2,010,744
Workings (W): General or current purchasing power model With the GPP model historic pounds must be converted into general purchasing power pounds as at the end of the financial year. Where sales are generated and costs incurred evenly throughout the year, we may convert the historic pounds by using an average general price in-dex. However, where substantial outlays of cash are involved on a particular day, as in the case of fixed assets and initial acquisition of inventories it will be more precise to utilise the index applying at that date, if available.
HCA Adjustment GPP/CPP
W5 Sales 868,425 × 170 952,466
155
W6 Initial inventory acquired 34,375 × 170 43,287
135
Purchases 485,750 × 170 532,758
155
520,125 576,045
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Closing inventory (24,250) × 170
170 = no change (24,250)
Cost of sales 495,875 551,795
Inventory assumed acquired on or close to December 31
W7 Expenses 95,750 × 170 105,016
155
W8 Depreciation 25,250 × 170 31,796
135
W9 Fixed assets HCA HCA NBV Index CPP CPP cost Depn cost Depn £ £ £ CPP£ CPP£ CPP£
Freehold 650,000 6,500 643,500 × 170/135 818,518 8,185 810,333
Equipment 375,000 18,750 356,250 × 170/135 472,222 23,611 448,611
1,025,000 25,250 999,750 1,290,740 31,796 1,258,944
W10 Gain or loss on monetary items
£ Change in trade receivables during year: 253,500
Change in cash occurring during year:
In hand at 31 December 20X1 1,090,300
Received 1 January 20X1 1,500,000
Less payments – non-current assets (1,025,000)
– inventory (34,375)
In hand at 1 January 20X1 440,625
Change (increase) during year 649,675
Change in payables occurring during year
Trade payables (increase) (116,250)
Other payables – Loans (increase) (500,000)
(616,250)
Change in monetary assets occurring during year 286,925
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So:
Loss on holding net monetary assets during CPP:
year’s inflation
286,925 × (170 – 155)/155 27,767
Add loss on holding cash during the year
i.e. balance at 1 January was held for full year and excluded
from the above calculation:
440,625 × (170 – 135)/135 114,236
142,003
Income statement for year ended 31.12.20X1 – NRV basis £
Sales 868,425
Purchases 520,125
Less: Inventory at 31.12.X1 24,250
Cost of sales 495,875
Gross profit 372,550
Expenses 95,750
Depreciation (W11) 35,000
130,750
Operating gain 241,800
Holding gain (W12) 18,188 259,988
Balance sheet as at 31 December 20X1 – NRV basis
£ £ Non-current assets
Freehold property (W11) 640,000
Equipment (W11) 350,000
Current assets
Inventories at NRV (W12) 42,438
Trade receivables 253,500
Cash 1,090,300
1,386,238
Less: Current Liabilities
Payable within 1 year 116,250
Net current assets 1,269,988
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Less: Non-current liabilities
Payable after 1 year 500,000
769,988
1,759,988
Issued share capital
1,500,000 ordinary shares at £1 each 1,500,000
Retained earnings 259,988
1,759,988
W11 Reduction in value of non-current assets at 31 December 20X1
Freehold Equipment Total £ £ £
HCA 650,000 375,000 1,025,000
Less: NRV at 31.12.X1 640,000 350,000 990,000
10,000 25,000 35,000
The reduction in value is treated as depreciation
W12 Holding gain in inventory at 31 December 20X1
NRV = cost + profit content of 75%
£24,250 + 75% of £24,250 42,438
Less: Cost 24,250
18,188
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C H AP T E R 5
Chapter 5: Question 1 – Membership of FRC, ASB and FRRP
FRC members
The membership of the Council is designed to include wide and balanced representation at the most senior levels of preparers, auditors and users of accounts and others interested in them. The members are:
Chairman
Sir Bryan Nicholson Sir Bryan has been Chairman of the Financial Reporting Council since 2001; Pro-Chancellor and Chair of the Council, Open Uni-versity since 1996; Chairman of Education Development International plc since 2004 and non-executive director of Equi-tas Holdings Ltd since 1996.
Born in 1932, Sir Bryan joined Unilever as a management trainee following National Service as a Second Lieutenant in the Royal Army Service Corps (RASC) and graduated with Second Class Honours from Oriel College, Oxford, where he read Politics, Phi-losophy and Economics (PPE). Having progressed within sales and marketing management at Unilever he moved first to the Jeyes Group as Sales Manager and then to the Remington divi-sion of Sperry Rand in 1964 as Sales Director. In 1966 he became General Manager in Australia and returned to Europe in 1969 as Managing Director for the UK and France. He joined Rank Xerox in 1972 as Director, Operations, Rank Xerox (UK) Limited becoming Chairman in 1979. He also supervised the European Subsidiaries of Rank Xerox.
In 1984 the Government invited him to become Chairman of the Manpower Services Commission (MSC) and he was knighted in 1987 for his work at the MSC. In October 1987 he became Chairman and Chief Executive of the Post Office for five years until the end of December 1992. He was Chairman of BUPA from 1992 to 2001, Chairman of Varity (Europe) Limited from 1992 to 1996 and Chairman of The Cookson Group Plc from 1998 to 2003. Sir Bryan was also Chairman of the Council for National Academic Awards (CNAA) from 1988 to 1991 and of the National Council for Vocational Qualifications (NCVQ) from 1990 until 1993. He was Chancellor of Sheffield Hallam Univer-sity from 1992 to 2001. Sir Bryan was President of the Confederation of British Industry (CBI) from 1994 to 1996. He was a member of the National Economic Development Council (NEDC) from 1985 to 1992. He is a past President of the Oriel
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Society and in 1989 was elected an Honorary Fellow of Oriel in recognition of his services to the College.
Deputy Chair
Barbara Thomas Barbara Thomas received her BA from the University of Penn-sylvania. She then went on to NYU Law School where she received a JD degree with honors. Thereafter she practised cor-porate and securities law in New York, becoming a partner of Kaye, Scholer, Fierman, Hays & Handler in 1978.
In 1980 she was appointed youngest ever Commissioner of US Securities and Exchange Commission and an informal spokes-man for its accounting division. In 1983 she moved to Hong Kong as the first woman main board director of a London mer-chant bank, Samuel Montagu & Co. Ltd. In 1993 she came to the UK as an executive director of News International plc. She sub-sequently led a buy-in of Scotia Haven Food Group and then of Whitworths Food Group.
Currently she is Chairman of Private Equity Investor plc and Deputy Chairman of Friends Provident plc, as well as a non-executive director of Capital Radio plc and Quintain Estates and Development plc, among others. She is also a Trustee of the Royal Academy of Arts and of The Wallace Collection, and a member of the Governing Body of the School of Oriental and African Studies. In addition, she is Chairman of the Professional Standards Advisory Board of the Institute of Directors.
Directors
Sir John Egan President of the CBI
David Illingworth Chairman of the Consultative Committee of Accountancy Bodies and President of the Institute of Chartered Accountants in Eng-land and Wales
Vacancy Investor Community Representative
Members (ex-officio)
Sir John Bourn KCB Chairman, Professional Oversight Board for Accountancy
Richard Fleck Chairman, Auditing Practices Board
Mike Fogden Chairman, Accountancy Investigation and Discipline Board
Mary Keegan Chairman, Accounting Standards Board
Bill Knight Chairman, Financial Reporting Review Panel
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Members
Charles Allen-Jones Formerly Senior Partner, Linklaters & Alliance
Mike Barnes Head of Technical Development, Audit Commission
Scott Bell CBE Formerly Group Managing Director, The Standard Life Assur-ance Company
Sir Victor Blank Chairman, GUS plc and Chairman of Trinity Mirror plc
Sir John Bond Group Chairman, HSBC Holdings plc
Martin Broughton Chairman, British American Tobacco plc
Sir David Clementi Chairman, Prudential plc
Don Cruickshank Formerly Chairman of the London Stock Exchange
Michael Foot CBE Managing Director, Deposit Takers & Markets Directorate, Fi-nancial Services Authority
Stephen Haddrill Director General, Fair Markets Group (Government nominee)
Sir Derek Higgs Senior Adviser in the UK, UBS Warburg
Douglas Kerr Group Finance Director, CPL Industries Ltd
Rory Murphy Joint General Secretary, UNIFI
Paul Myners CBE Chairman, Guardian Media Group plc
Richard Pearson Senior Partner, PKF
Colin Perry Chairman, LTE Scientific Ltd
Ian Plaistowe Formerly Chairman, Auditing Practices Board
Sir Nigel Rudd Chairman, Boots Group plc and Pilkington plc
Vincent Sheridan Chief Executive, VHI Healthcare
Sir Robert Smith Chairman, The Weir Group plc
Rosemary Thorne Group Finance Director, Bradford & Bingley plc
Graham Ward Senior Partner, Global Energy and Utilities, Pricewaterhouse-Coopers
Observers
Sir John Bourn KCB Comptroller & Auditor General, National Audit Office
Peter Brierley Head of Domestic Finance Division, Bank of England (Bank of England nominee)
Sir Andrew Likierman Managing Director, Financial Management, Reporting and Au-dit, HM Treasury, and Head of the Government Accountancy Service
Secretary
Ann Wilks CBE
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ASB members
Membership of the ASB is limited to a maximum of ten, of whom two (the chairman and the technical director) are full-time members and the remainder are part-time members. Appoint-ments to the ASB are made by an Appointments Committee which comprises the FRC chairman and deputy chairman together with three members of council.
Chairman
Mary Keegan On 1 January 2001 Mary Keegan, then head of the Global Corpo-rate Reporting Group of PricewaterhouseCoopers (PwC), succeeded Sir David Tweedie as full-time Chairman of the ASB. She joined Price Waterhouse (now PwC) in 1974, becoming, in 1985, the first woman admitted to partnership as an auditor in the UK firm. In 1991 she took charge of PW’s UK technical function and in 1993 joined the group running the firm’s European audit practice. She formalised the firm’s support for the International Accounting Standards Committee (IASC). She served on the UITF 1993–99 and was a founder-member of IASC’s Standing Interpretations Committee. She served on the Technical Commit-tee of the Hundred Group of Finance Directors 1996–2000. From 1990 she actively contributed to the work of the ICAEW, includ-ing membership of its Council. From 1997 to 2000 she represented the UK accountancy bodies on the Council of the Fédération des Experts Comptables Européens (FEE) and was a vice president of FEE.
Technical Director
Andrew Lennard
Members
Michael Ashley Partner, KPMG
Douglas Flint Group Finance Director, HSBC Holdings plc
Huw Jones Director of Corporate Finance, M&G Investment Management Limited
Roger Marshall Partner, PricewaterhouseCoopers
Isobel Sharp Partner, Deloitte & Touche
John Smith Director of Finance, Property & Business Affairs, British Broad-casting Corporation
Jonathan Symonds Chief Financial Officer, AstraZeneca plc
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Observers
Allan Cook CBE Member of the European Financial Reporting Advisory Group’s Technical Expert Group
Bernadette Kelly Director, Company Law and Investigations, Department of Trade and Industry
Sir Andrew Likierman Managing Director, Financial Management, Reporting and Au-dit, HM Treasury, and Head of the Government Accountancy Service
Professor Geoffrey Liaison member of the International Accounting
Whittington CBE Standards Board
Secretary
Charles Bridge
FRRP members
Chairman
Bill Knight Bill Knight is a solicitor and a former Chairman of the Law Soci-ety’s Company Law Committee. He was senior partner at Simmons & Simmons until 2001. He is currently Deputy Chair-man of Council at Lloyd's of London and Chairman of the Enforcement Committee of the General Insurance Standards Council.
Deputy Chairman
Ian Brindle Ian Brindle BA Econ FCA retired from PricewaterhouseCoopers on 30 June 2001 having been appointed the Senior Partner of Price Waterhouse in 1991, and the Chairman of Pricewater-houseCoopers on the merger in 1998. Before joining the Accounting Standards Board in 1993 he served as a founder member of the Board's Urgent Issues Task Force. He was previ-ously a member of the Auditing Practices Committee, becoming its Chairman in 1990. He was a member of the Council of the In-stitute of Chartered Accountants in England and Wales from 1994 to 1998.
Members
Rupert Beaumont Formerly Partner, Slaughter and May
Sir John Bourn KCB Comptroller & Auditor General, National Audit Office
Stephen Box Formerly Finance Director, The National Grid Group plc
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Michael Brindle QC Barrister
Richard Delbridge Formerly Group Chief Financial Officer, NatWest Group
Martin Eadon Partner, Deloitte
John Grieves Formerly Senior Partner, Freshfields
Gordon Hamilton Partner, Deloitte
Andrew Higginson Finance Director, Tesco plc
Robert Hildyard QC Barrister
Nigel Macdonald Formerly Partner, Ernst & Young
David Mallett Formerly Group Head of Finance, Standard Chartered Bank
Ron Paterson Formerly Partner, Ernst & Young
Andrew Popham Partner, PricewaterhouseCoopers
George Rose Finance Director, BAE Systems plc
Rosemary Thome Group Finance Director Bradford & Bingley plc
Tony Wedgwood Formerly Partner, KPMG
Secretary
Ann Wilks CBE
Director, Panel Operations
Carol Page
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C H AP T E R 6
Chapter 6: Question 1 – Financial Statements from Different Countries
Most companies will begin their accounting policies note with an explanation of the general ac-counting convention (e.g. US GAAP or IASs). The first point that should be considered is whether the overall convention is what might be expected given the origin and/or listing of the company. Secondly, although the companies are based in different countries, they may be using the same overall accounting convention. Students might comment that this is helpful as it al-lows greater comparability. The next stage of the analysis should involve a comparison of the accounting policies for deal-ing with specific accounting items. Things to look out for might include:
• Level of detail – does one country give more than the other? Is this related to the level of regulation or is it down to the individual company?
• Which items are treated in the same way?
• Which items are treated differently?
• What is the effect of the differences?
• Is there a common thread in the differences? For example, might one set of regulations seem to be protecting a particular user group (e.g. creditors) or might there be some other underlying assumption (e.g. earnings should not be volatile)?
Chapter 6: Question 2 – Web Exercise using EDGAR
The approach to this question should probably be similar to that for Question 1. However, this question allows students to measure the relative importance of the differences in policies. Stu-dents will identify the main areas of difference from the numerical reconciliations, but will need to refer to the narrative disclosures to understand the reasons.
This exercise would work well with groups, asking different members of the group to look at particular countries. Tutors may wish to steer students towards particular countries to allow representation of different parts of the world. It is worth remembering that disclosures that sat-isfy the SEC’s requirements need not necessarily be easy for an outsider to follow. If students are studying the book in the order it is presented, then care should be taken that they do not get bogged down with the detail of different methods of accounting at this stage – they will have an opportunity to address this later.
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Chapter 6: Question 3 – Taxation and Financial Reporting
The chapter refers to the relationship between tax and financial reporting fairly briefly. A full answer to this question would probably require some further reading. Suggestions might in-clude: Haller, A. (1992) ‘The relationship of financial and tax accounting in Germany: a major reason
for accounting disharmony in Europe’, International Journal of Accounting, Vol. 27, pp. 310–23.
Hoogendoorn, M.N. (1996) ‘Accounting and taxation in Europe – a comparative overview’, European Accounting Review, Vol. 5 (Supplement), pp. 783–94.
Lamb, M., Nobes, C.W. and Roberts, A.D. (1998) ‘International variations in the connections between tax and financial reporting’, Accounting and Business Research, Vol. 28 (3), pp. 173–89.
Nobes, C.W. (2003) A Conceptual Framework for the Taxable Income of Businesses and How to Apply It under IFRS, Certified Accountants Educational Trust (this can be downloaded from the ACCA website: www.accaglobal.com).
Aisbitt, S. (2002) ‘Tax and accounting rules: some recent developments’, European Business Review, Vol. 14 (2), pp. 92–7.
The question hinges on whether the tax and commercial accounts are (or will be) based on the same figures (congruence). Some advantages and disadvantages of congruence are set out be-low.
Congruence between tax and commercial accounts
Interest group Advantages Disadvantages
(a) Preparers Only one set of information
required
Tax considerations might
drive commercial decisions
(b) Users Clear relationship between
figures in accounts and tax
charge – no need for de-
ferred tax
Accounts do not necessarily
reflect economic reality –
they are prepared so as to
minimise tax liabilities
(c) Tax authorities Clear information that has
been fully audited
May become involved in ac-
counting issues rather than
concentrating on macroeco-
nomic policy issues
If there is (or will be) a high degree of congruence, then tax authorities need to know the extent to which income under IASs will differ from income under current regulations in order to esti-mate their expected share of that income. Further action may be required (e.g. in terms of grants or changes in tax rates) to achieve policy objectives. In the UK, the Inland Revenue is aiming for transition to IASs to be ‘tax neutral’.
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In the longer term international bodies (e.g. the EU) may impose the tax base, e.g. consolidated IAS financial statements. However, the financial reporting lobby (e.g. Nobes, 2003) would op-pose that on the basis that 'tax pollution' of financial statements is undesirable due to the differing needs of the user groups (tax authorities versus investors).
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C H AP T E R 7
Chapter 7: Question 1 – MCRV Ltd
(a) Operations Statement for year ended 31.12.20X8
£ £ Turnover 200 Opening stock at market price 50
Purchases at cost 80
130
Closing stock at market price 66
Charge for goods sold 64 Contribution 136
Salaries 30
Interest paid 9
39
Wealth created by operations 97
(b) Statement of changes in wealth
£
Increase in wealth due to operations 97
Increase in value of fixed assets 40
Decrease in value of long-term loans 20
Realisable increase in net assets 157
Changes in wealth:
• The net assets have increased from 195 to 352.
• Fixed asset values reviewed at net realisable value £270 overall at the end of the year.
• Long-term loan value reviewed at net realisable value £70 at the end of the year due to rise in yields on long-dated stocks.
• Movements are set out in W1 (cash flow) and W2 (worksheet). (c) The value of long-term loans is affected by changes in the prevailing interest rates. In the example the yields have increased. If they had decreased, the value of the loans would have been increased.
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W1: Cash flow statement £
Cash held at start of year 10
Cash flow from operations *66 Long-term loan finance raised 30
106
Fixed assets acquired 30
Cash held at end of year 76
* MCRV does not prescribe the amount of detail which might be shown here. The conclusions of the feasibility study
were that it would be appropriate to report inflows and outflows in the level of detail shown in the following cash book
summary.
Notes on transactions during year
Cash book: £ £ Cash received during year
– credit customers 190
– long-term loans 30
220
Cash paid during year – credit suppliers 85
– fixed assets 30
– salaries 30
– loan interest 9
154
Net increase in cash included in cash flow statement 66
Journal: £ £ DR Debtors 200
CR Sales 200
DR Stock 80
CR Creditors 80
Credit purchases for year
DR Cost of goods sold 70
CR Stock 70
Goods issued for sales
DR Stock 6
CR Cost of goods sold 6
Uplift in closing stock value from cost to net realisable value
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W2: Worksheet for information
Assets and
liabilities at
start of year
Cash
transactions
Journal Changes in
wealth
Operations Assets and
liabilities at
end of year
Fixed assets Stock Debtors Cash Creditors Long-term loan Net assets Sales Cost of sales Salaries Interest paid Operations
Dr Cr 200 50 30 10 35 60 195
Dr Cr 30 190 220 154 85 30 30 9
Dr Cr 86 70 200 80 200 70 6
Inc Dec 40 20 157 97
Dr Cr 200 64 30 9 97
Dr Cr 270 66 40 76 30 70 352
290 290
374 374
356 356
157 157
200 200
452 452
(d) The ratio will differ to the extent that NRV differs from historical costs.
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Chapter 7: Question 2 – Conceptual Framework
(a) Statements of Principles or Financial Reporting which set out the concepts that underlie the preparation and presentation of financial statements for external users have been widely de-veloped. Their primary purpose is to provide a coherent frame of reference for standard setters to use in the development and review of accounting standards. In particular the framework provides a basis for choosing between alternative accounting treatments.
(b) In practice the conceptual framework has provided standard setters with a framework for developing standards rather than providing a frame of reference for practitioners in resolv-ing questions in the absence of a specific promulgated standard. Auditors are under pressure to accept practices which are commercially convenient to the client in the absence of a stan-dard, e.g. selecting favourable revenue recognition criteria, adopting merger accounting where possible, massaging income in times of recession.
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Chapter 7: Question 3 – Fairness
(a) There is an overriding requirement that financial statements should give a true and fair view of the financial position, performance and financial adaptability of an enterprise. In the UK, the ASB considers it to be a dynamic concept whose content will evolve in response to mat-ters such as advances in accounting and changes in business practice. The Board considers that the evolution of the interpretation of the concept will be influenced over time by the accounting standards and other statements that the Board issues.
It is an important concept in the UK because it allows companies to override statutory re-quirements. In such a case the company is required to include a note to the accounts giving particulars of any such departure, the reasons for it and its effect. The use of the override has been considered at various times by the Financial Reporting Review Panel, e.g.
• FRRP Press Notice 42 – Sutton Harbour The Financial Reporting Review Panel considered the 1995 accounts of Sutton Harbour Holdings plc. The Panel accepted the directors’ justification for their departure from the provisions of Statement of Standard Accounting Practice (SSAP) 4 in the particular circum-stances of the company.
• AIM Group The Financial Reporting Review Panel considered the Report and Accounts of AIM Group plc for the year ended 30 April 1998 and discussed them with the company’s directors. The primary matter at issue was the departure from compliance with Financial Reporting Stan-dard (FRS) 7 Fair Values in Acquisition Accounting and the use of the true and fair override following the company’s acquisition of certain of the assets and business of Hunting plc.
(b) This raises the question of the feasibility of general purpose accounts to satisfy the infor-mation needs of non-equity shareholders. Discussion should embrace the interests of each of the user groups and consider the effectiveness of current measurement systems (HC/CPP/RCA/NRVA) and disclosure requirements e.g. socio-economic information, three bottom lines, environmental reporting.
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Chapter 7: Question 4 – Control of Standard Setting
There is no unique answer to this question – it may be approached in a number of ways, e.g.
PRO arguments Technical requirements. These are now so complex as transactions have become more complex, e.g. financial instruments, that accountancy international professional firms are the only profes-sional group with competence in many of the areas that will require standards in the future.
Globalisation. National standard setters do not have the breadth that exists within the interna-tional firms.
Accountability requirements. Standards will be set that are feasible based on current expertise and costs.
Liability. Given that the main liability lies with the professional firms it is important that they are actively involved in formulation of standards.
CON arguments Enforcement. The major requirement is for effective enforcement of existing standards which can only be achieved by making the international firms accountable.
Lack of independence. The firms are too closely allied with the client and are therefore inclined to accept measurement and disclosure practices which do not comply with existing international standards.
Investor confidence. This depends on transparency – the existence of standards; their effective enforcement and adequate monitoring of audit performance.
In practice, this requires the active participation of all parties: the companies preparing accounts, the accounting standard setters, the profession and user groups.
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C H AP T E R 8
Chapter 8: Question 1 – Old NV
(a) Income Statement (internal) for the year ended 31 December 20X1 (€000)
Sales 12,050
Less: returns 350 11,700
Inventory at 1.1. 20X1 825
Purchases 6,263
Carriage on purchases 13
Less: returns (313) 5,963
6,788
Inventory at 31.12.20X1 1,125
5,663
Depreciation of plant 313 5,976
Gross Profit 5,724
Administration:
Wages 738
Administration expenses [286–12] 274
Directors’ remuneration 375
Selling:
Salesmen’s salaries 800
Distribution:
Distribution expenses 290
Depreciation of vehicles 187
Carriage 125
Financial:
Goodwill impairment 177
Audit fee 38
Debenture interest 25
Rent receivable (100) 2,929
2,795
Tax 562
Profit for year 2,233
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(b) Income statement for publication
Income Statement of Old NV for the year ended 31 December 20X1 €000 €000 Sales 11,700
Cost of sales 5,976
Gross profit 5,724
Distribution costs W1 1,402
Administrative expenses W2 1,602
Other operating income (100)
2,904
Trading profit 2,820
Interest payable 25
Profit on ordinary activities before tax 2,795
Income tax 562
Profit on ordinary activities after tax 2,233
W1 Salesmen’s salaries 800
Distribution expenses 290
Depreciation of vehicles 187
Carriage 125 1,402
W2 Wages 738
Administrative expenses 274
Directors’ remuneration 375
Goodwill impairment 177
Audit fee 38 1,602
There will be a disclosure note as follows:
Profit on ordinary activities after tax is after charging
Goodwill impairment 177
Audit fee 38
Depreciation 500
Directors’ remuneration 375
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Balance Sheet of Old NV as at 31 December 20X1 €000 €000
Non-current assets
Intangible assets [1062 – 177] 885
Property, plant and equipment Note 1 1,074
Current assets Inventories 1,125
Receivables 3,875
Cash at bank and in hand 1,750
Prepayments 12
6,762
Current liabilities Payables 738
Provision for income tax 562
Accrued charges 63
Dividends proposed 362
1,725
Net current assets 5,037
Total assets less current liabilities 6,996
Non-current liabilities Debentures 250
6,746 Capital and reserves
Ordinary shares of €1 each 3,125
Preference shares of €1 each 625
Share premium 250
Retained earnings Note 2 2,746
6,746
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Disclosure notes to show make-up of balance sheet items
Note 1: Property, plant and equipment
Property, plant and equipment Motor Plant vehicles Total €000 €000 €000
Cost At 1.1.20X1 1,200 1,125 2,325
Additions 362
Disposals
At 31.12.20X1 1,562 1,125 2,687
Accumulated depreciation At 1.1.20X1 738 375 1,113
Charge for year 313 187 500
At 31.12.20X1 1,051 562 1,613
Net book value At 31.12.20X1 511 563 1,074
At 31.12.20X0 824 750 1,574
Working: Accrued expenses €000
Audit fee 38
Debenture interest 25
Note 2: Movements on reserves €000
Retained earnings at 1.1.20X1 875
Amount transferred from income statement 2,233
Dividends proposed (362)
Balance at 31.12.20X1 2,746
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Chapter 8: Question 2 – HK Ltd
(a) Income Statement for year ended 30 June 20X1
$000 $000 Turnover 381,600
Cost of sales
Per trial balance 318,979
+ Hire 2,400 + depreciation 799
– Insurance 150 + inventory loss 250 3,299 322,278
Gross profit 59,322
Administration expenses
Per trial balance 9,000 + Directors 562 +
Bad Debt 157 + Auditor remuneration 112 9,831
Distribution costs 35,100 44,931
14,391
Profit on disposal of fixed assets 536
Profit before tax and interest 14,927
Interest payable [454 + 151 tax on interest] 605
14,322
Other operating income 17
Profit before tax 14,339
Income tax at 35% 4,887
Tax on profit on disposal 461 5,348
Profit for the year 8,991
Note: Depreciation consists of Buildings 94 + Plant 619 + Fixtures 86
Balance sheet as at 30 June 20X1
(b) Intangible non-current assets
Goodwill 480 Tangible non-currrent assets Freehold land 2,880 Freehold buildings 4,680 Aggregate depreciation 648 4,032 Plant and machinery 3,096 Aggregate depreciation 1,857 1,239 Fixtures and fittings 864 Aggregate depreciation 259 605 Current assets
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Inventory [11,794 – 500 obsolescence] 11,294 Receivables [7,263 + 250 inventory sale + 150 insurance] 7,663 Bank 11,561 30,518 Current liabilities Payables 2,591 Dividends 486 Tax [4,887 + 461] 5,348 8,425 Net current assets 22,093 31,329 Non-current liabilities 9% loan 7,200 24,129 Deferred Income – Government grant (see Note) 68 24,061 Capital Ordinary shares 50c each 3,600 9% preference shares of $1 each 5,400 Reserve for increased cost of plant 310 Retained earnings [6,364 + 780 Revaluation now realised – 310 transfer to Increased Cost of Replacement Reserve + 8,991 profit for the year – 1,074 dividends] 14,751 24,061
Note: The grant could be deducted from the cost of the plant under IAS 20.
(c) The usefulness of the non-current asset schedule
(1) The column headings allow the user to see the type of non-current assets owned by the business. This can give helpful initial indications, for example:
Realisability – intangible assets might be more difficult to sell than property.
Appreciation – land is more likely to appreciate than office equipment.
Depreciation – licences are subject to amortisation and possible fall in value due to com-petion
Security – land and buildings are more likely to be accepted as security for loans and over-drafts than intangible assets.
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(2) The carrying values may be at cost or revaluation. If at cost it may be that the balance sheet gives too low an indication of current market val-ues – this is often an important consideration if existing shareholders are assessing a takeover offer.
(3) The accumulated depreciation figure when related to the cost gives an indication of the age of the assets and possible need for capital outlays to replace with cash flow implications.
(4) Disposals may be an indication that there is replacement occurring which could indicate growth or maintenance of existing capacity. If no replacement then consider implications for future capacity or other reason e.g. change of direction, disposal of non profit making parts of the business.
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Chapter 8: Question 3 – Basalt plc
(a) Income statement for the year ended 31.12.20X0 (£000)
Turnover (962 – 27 returns) 935
Cost of sales Note 1 460
Gross profit 475
Distribution costs Note 2 218
Administrative expenses Note 3 118
139
Other operating income (i.e. rent receivable) 7
Profit on ordinary activities before tax 146
Tax on profit of ordinary activities 58
Profit on ordinary activities after tax 88
Retained profits brought forward 55
143
Proposed ordinary dividend 75
Retained profits carried forward 68
£000
Note 1: Opening inventory 66
Purchases 500
Carriage inwards 9
Returns out (25)
Closing inventory (90)
460
Note 2: Warehouse wages 101
Salesmen’s salaries 64
Distribution expenses 6
Hire of vehicles 19
Depreciation 28 [7/11 of 20% of £220,000]
218
Note 3: Admin. wages 60
Admin. expenses 10
Directors’ remuneration 30
Auditors’ remuneration 2
Depreciation (4/11) 16
118
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Balance Sheet as at 31 December 20X0 (£000) Non-current assets Tangible assets
[cost 220 – Dep’n b/f 49 – Dep’n for year 44] 127
Current assets Inventory 90
Trade receivables 326
Cash at bank 62
478
Liabilities
Amounts falling due within 1 year:
Trade payables 66
Other payables [Audit 2 + Corporation tax 58 +
Dividends 75] 135
201
Net current assets 277
Total assets less current liabilities 404 Capital and reserves
Called-up share capital 300
Share premium a/c 20
General reserve 16
Retained earnings 68
404
(b) (i) Directors’ report must deal with certain matters by law, e.g.
• Proposed dividends
• Likely future developments in the company’s business
• Principal activities of the company
• Political and charitable contributions
• Must be consistent with other statements – reviewed by auditors
(ii) Chairman’s report
• May be highly personalised review of the business, its developments and the environ-ment in which it operates
• Not subject to audit
(iii) Auditors’ report expresses an opinion as to whether the financial statements give a ‘true and fair view’.
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Chapter 8: Question 4 – Raffles Ltd
(a) Income Statement for the year ended 31 December 20X6
$ Revenue 1,628,000
Cost of sales [W1] 1,098,400
Gross profit 529,600
Administration expenses [W2] (71,050)
Distribution expenses (32,800)
Operating profit [2] 425,750
Income from fixed asset investments [5] 6,000
Interest payable and similar charges [6]
[18,000 Deb + 3000] (21,000)
Exceptional costs [7] (150,000)
Profit before tax on ordinary activities 260,750
Tax on ordinary activities [8] 115,750
Profit after tax on ordinary activities 145,000
W1: Cost of sales
$ Per question 1,100,000
Less: Realisable on obsolescent inventory (5,600)
Add: depreciation 14,000
Less: capital item incorrectly posted (10,000)
1,098,400
W2: Administration expenses
Per question 206,300
Less: restructuring expense (150,000)
Less: provision written back (1,500)
Audit: fee 7,000
Goodwill impairment 2,500
Depreciation 6,750
71,050
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Balance sheet as at 31 December 20X6 Non-current assets Intangible [1] 40,000
Property, plant and equipment [2] 341,250
Investments [3] 130,000
511,250
Current assets
Inventory [156,360 + Inventory obsolescence realisable 5,600] 161,950
Receivables [179,830 + 1500 Provision written back] 181,330
343,280
Current liabilities [4] (210,530)
Net current assets 132,750
Total assets less current liabilities 644,000
Non-current liabilities [5] (180,000)
464,000
Share capital 250,000
Revaluation reserve 25,000
Retained earnings [b/f 98,000 + 91,000] 189,000
464,000
(b) Notes to the income statement
1 Accounting policies General Depreciation Exceptional items
2 Operating profit is stated after charging audit fee 7,000
3 Staff costs Purchasing 6 45,000 Distribution 3 22,500 Administration 1 7,500 10 75,000
4 Directors’ emoluments Chairman nil Highest paid director £19,800 Other directors earn salaries in the range of £15,000 – £20,000 £
5 Income from non-current asset investments 6,000
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6 Interest payable and similar charges £ Bank interest 3,000 Debenture interest paid and payable 18,000 21,000
7 Exceptional costs Restructuring 150,000 Less: Tax relief (45,000) 105,000
8 Taxation on ordinary activities Tax on profits [165,000 – 45,000 from Note 7] 120,000 Overprovision (4,250) 115,750
9 Dividends £ Interim at 3.6p 18,000 Proposed at 7.2p 36,000 54,000
Notes to balance sheet
Non-current assets
1 Intangible assets – Goodwill
Cost at 1 January 20X6 50,000
Impairment
At 1 January 20X6 7,500
Charge for year included in Administration expenses 2,500
At 31 December 20X6 10,000
Net book value at 31 December 20X6 40,000 Net book value at 1 January 20X6 42,500
2 Property, plant and equipment
Land/ Plant/ Fixtures Total blgs machinery Cost
At 1.1.20X6 225,000 20,000 78,000 323,000
Additions 90,000 90,000
Disposals (24,000) (24,000)
Revaluation 25,000 25,000
At 31.12.20X6 250,000 110,000 54,000 414,000
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Depreciation
At 1.1.20X6 9,000 16,000 37,500 62,500
Charge 3,000 11,000 6,750 20,750 Disposals (10,500) (10,500)
At 31.12.20X6 12,000 27,000 33,750 72,750
NBV 31.12.20X6 238,000 83,000 20,250 341,250 NBV 1.1. 20X6 220,000 4,000 40,500 260,500
3 Investments
Listed on recognised stock exchange £130,000
Notes relating to Liabilities, Post balance sheet events and Capital
4 Current liabilities
Bank overdraft 12,700
Trade payables 32,830
Taxation 120,000
Dividends 36,000
Accrual – interest 9,000
210,530
5 Non-current liabilities
10% Debentures redeemable 2003 £180,000
(i) Provisions for liabilities – Lawsuit details.
(ii) Post balance sheet events – Details re investment in Diat P’or.
(iii) Share capital
Details of authorized capital
Reserves Revaluation Income
statement
At 1.1.20X6 – 98,000
Movement during year 25,000 145,000
Less dividends (Note 9) (54,000)
At 31.12.20X6 189,000
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Comments
Provision
• is an amount retained from profit
• provides for a loss or liability likely to be incurred but amount is uncertain
• is shown in balance sheet after creditors or deducted from assets e.g. bad debt provision
Reserve
• is a realised or unrealised gain which has not either legally or at the company’s discretion been distributed as dividends, i.e.
• is retained in the business, e.g. retained profits, share premium, revaluation reserve
• is shown in the balance sheet after share capital
Liability
• is an obligation in the future requiring the transfer of assets, e.g. cash payment or provision of services to other entities
• entails a probable future sacrifice
• may also include the amount owed to the owners of the business
• is reported under current or long-term liabilities
Contingent liability
• is a condition that exists at the balance sheet date where the outcome will be determined by a future uncertain event appears as a note to the balance sheet
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Chapter 8: Question 5 – Phoenix plc
(a) Income Statement for year ended 30 June 20X7
£000 Revenue 6,465
Cost of sales [4,165 +280 dep] (4,445)
Gross profit 2,020
Distribution cost (669)
Administration expense [1,126 + 31 dep + 415] (1,572)
Operating loss (221)
Exceptional item:
Gain on disposal of associate 75 Dividend received 80
Loss before taxation (66)
Taxation (96)
Loss after taxation (162)
(b) Balance sheet as at 30 June 20X7
Property, plant and equipment 4,159
Investment 365
Current assets Inventory 1,468
Trade receivables 947
Cash at bank 175
Current liabilities (868)
Net current assets 1,722
6,246
Share capital and reserves
Share capital 4,500
Share premium 500
Revaluation reserve 1,170
Retained earnings 76
6,246
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(c) Statement of Movement of Property, plant and equipment
L&B P&M F&F Total Balance b/f 2,400 1,800 620 4,820 Disposal (150) (150)
Revaluation reserve 160 160
Balance c/f 2,250 1,960 620 4,830
Accumulated depreciation Balance b/f 540 360 900 Revaluation reserve (540) (540)
P&L charge 280 31 311 Balance c/f 280 391 671
WDV at 30.6.20X7 2,250 1,680 22 4,159
Current assets Trade receivables 947
Creditors Trade payables 566
Taxation 122
Dividend proposed 180
868
Balances in revaluation reserve and retained earnings are made up as follows: Revaluation reserve Retained earnings Balance b/f 600 488
Plant and machinery revaluation 700
Transfer on disposal (30) 30
Transfer – additional depreciation (100) 100
Loss for year (162)
Dividends (380)
Balance c/f 1,170 76
(d) Statement of Recognised Gains and Losses
Loss after taxation (162)
Revaluation gain 700
Total recognised gain 538
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C H AP T E R 9
Chapter 9: Question 1 – Springtime Ltd
(a) Income Statement for the year ended 31 March 20X4
Continuing Discontinued operations operations Total Turnover 30,000 5,000 35,000
Cost of sales 19,000 4,000 23,000
Gross profit 11,000 1,000 12,000
Distribution costs (3,065) (425) (3,490)
Administrative costs (1,225) (15) (1,240)
6,710 560 7,270
Closure costs (350) (350)
Operating profit 6,710 210 6,920 Income from fixed asset investment 1,200
8,120
Taxation [3200 – 200 + 150] 3,150
Profit for the year 4,970
Note: Tax: Income Tax 3,200 – Overprovision 200 + Transfer to deferred tax account 150
Workings
Continuing Discontinued Total Distribution costs Delivery costs 900 300 1,200
Dep’n – vans 40 40
Dep’n – stores equip. 50 50
Storeroom costs 1,000 1,000
Delivery staff 700 700
Directors 75 25 100
Storeroom staff 300 100 400
3,065 425 3,490
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Admin. costs Audit 30 30
Depreciation – cars 10 10
Office expenses 800 800
Directors 300 300
Office staff 85 15 100
1,225 15 1,240
Note: as allowed under IFRS 5, disclosures are given on the face of the income statement
(b) IFRS 5 has required companies to disclose in detail activities that are discontinued. This disclosure is both numerical and narrative and provides a full explanation of the activities to be discontinued, when the discontinuance should occur and the financial effect of the dis-continuance.
This information is useful to users in enabling them to interpret the future performance of the enterprise and assessing the performance of management over the period. When consid-ering the future performance of an enterprise only the continuing operations should be considered as it is only these that will continue into future periods. The management per-formance can be assessed to some extent by having knowledge of discontinuing activities because the users will be able to judge whether the management decision to discontinue is a good one.
Users can also get benefits from the disclosure in understanding the future strategic direc-tion of the business. By discontinuing activities the management may be refocusing the business towards more core areas and this would be seen through the disclosures.
(c) Reasons why accounting policy notes are important to users.
• The underlying reason for a change might be more important than the change itself, e.g.
a reduction in the life over which assets are depreciated could indicate a threat from technological changes within the sector; or
a structural change, e.g. repositioning in the market.
• Inter-company comparison requires ideally that two companies should have similar account-ing policies, or that their accounting policies should be amended to make them uniform, e.g. restating all non-current assets at current replacement costs.
• This is important when comparing ROCE, and a policy note about the use of modified his-torical accounts, together with reconciliations to historical cost profit required by some national standards (eg FRS 3 in the UK) might improve the interpretation of differences.
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Chapter 9: Question 2 – Olive A/S
(a) Income Statement for year ended 30 September 20X4
Revenue 3,460
Cost of sales W1 (1,557.1)
Gross profit 1,902.9 Distribution cost W2 (362)
Administration expenses W3 (917.9)
Operating profit 623 Exceptional items: Gain – disposal of fixed assets 6 Dividend received 45
Interest and similar charges (30)
644
Taxation (Sch 1) (197)
Profit for the year 447
(b) Balance Sheet as at 30 September 20X4
Non-current assets Intangible assets 425
Tangible assets (Sch 2) 1,480
Investments 248
Current assets
Inventory [364 + 40] 404
Receivables (Sch 3) 599
Cash and bank 38
Current liabilities (Sch 4) (636)
Net current assets 405 2,558
Non-current liabilities 12% debentures 500
Net capital employed 2,058
Share capital: ordinary shares of £1 each 600
Share premium account 30
Retained earnings (Sch 5) 1,055
Revaluation reserve 373
2,058
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Schedule 1: Taxation charge
Income tax 185
Underprovision 20X3 (140 – 128) 12
197
Schedule 2: Statement of Movement of Non-current Assets Land and Plant and Fixtures Prepay- Buildings Machinery and fittings ments Total Balance b/f 600 520 80 – 1,200
Revaluation 300 – – – 300
Acquisitions – 320 40 60 420
Disposal – (240) – – (240)
Balance c/f 900 600 120 60 1,680
Balance b/f 80 160 26 – 266
Revaluation (80) – – – (80)
Income charge 15 54 11 – 80 Disposal – (66) – – (66)
Balance c/f 15 148 37 – 200
WDV 30.9.X4 885 452 83 60 1,480 WDV 30.9.X3 520 360 54 – 934
Schedule 3: Receivables Trade receivables 584
Prepaid rent 15
599
Schedule4: Current liabilities Trade payables 296
Debenture interest (3 months) 15
20X3 Income tax 140
20X4 Income tax 185
636
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Schedule 5: Statement of Movement of Reserves
Share Revaluation Income premium A/c reserve statement Balance b/f 150 – 661
Formation expenses w/off (120) – –
Profit for the year – – 447
Dividend paid – – (60)
Revaluation gain – 380 –
Transfer – extra depreciation – (7) 7
Balance c/f 30 373 1,055
Notes
1 Expenses charged in the year includes the following: Depreciation written off €80,000 Directors’ emoluments €180,000 Directors’ pension €18,000 €198,000 Audit fees and expenses €65,000
2 Company employs 646 persons, of whom 428 work at the factory and the rest at the head office.
3 Land and Buildings were revalued during the year by Messrs XYZ, Chartered Valuers, at open market value on existing use basis and the surplus recorded in a Revaluation Reserve.
4 Administration expenses includes an exceptional item of €60,000 being the underprovision for a claim that arose in a previous year.
Workings
W1 Cost of Sales Inventory on 1.10.20X3 211
Purchases 925
Carriage inwards 162
Depreciation – Building 9
Depreciation – Machinery [18 + 28 + 8] 54
Salaries [55% of 820] 451
Pension cost [10% of 451] 45.1
Heat and light [80% of 80] 64
Inventory 30.9.20X4 (364)
1557.1
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W2 Distribution cost Advertising 112
Sales commission 92
Bad debts 158
362
W3 Administration expenses Depreciation – Buildings 6
Depreciation – Fixtures and equipment [8 + 3] 11
Underprovision for litigation 60
Salaries 369
Directors’ emoluments 180 549
Pension costs [10% of 549] 54.9
Heat and Light 16
Audit fees and expenses 65
Stationery 28
Other administrative expenses 128
917.9
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Chapter 9: Question 3 – Cryptic plc
(a)
• Company is wise to depreciate buildings because IAS 16 requires the depreciation of all assets with finite life.
• This can be treated as a change in accounting policy; however, the guidance is not clear. If it is a change of policy, the material amount of backlog depreciation up to 30.6.X3 should be treated as a prior period adjustment, and explained in a note to published accounts.
(b)
• The company is not merely permitted, it is encouraged to undertake a periodical review of its estimate of UEL of fixed assets.
Necessary for avoiding situation where assets already fully written off continue in use and assist in earning income.
• The change in the estimate of UEL is not a change in accounting policy and hence the im-pact of the change would not qualify to be treated as prior period adjustment.
• The written-down value of the machinery on 30.6.20X4 of £288,000 should be written off
over the remainder of its revised UEL (of two years)
on the same policy (straight-line method).
the current year’s charge will be £144,000 and this will be included in the figure of Cost of Sale.
• Since the current year’s charge of £144,000 exceeds the normal charge of £48,000 by a sub-stantial amount, the difference may be reported in a note to accounts as an exceptional item.
(c) Statement of Movement of Property, Plant and Equipment
Land and Plant and Furniture, buildings machinery tools etc. Total £000 £000 £000 £000
Balance b/f 600 480 380 1,460
Acquisitions 150 – – 150
Disposals – – (80) (80)
Balance c/f 750 480 300 1,530
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Acc. depreciation
Balance b/f – 192 95 287
Prior period adj 64 – – 64 Income statement charge 9 144 18 171 Disposal – – (9) (9)
Balance c/f 73 336 104 513
WDV on 30.6.20X4 677 144 196 1,017
WDV on 30.6.20X3 600 288 285 1,173
(d) Income Statement for the year ended 30 June 20X5
£000 £000 Revenue 2,285.0
Cost of sales (Note 1) (1,466.2)
Gross profit 818.8
Distribution cost (Note 1) ( 60.6)
Administration expenses (Note 1) (281.2)
Operating Profit: 477.0
Dividend income 24.0
Finance cost (24.0)
Unusual items: Results of discontinued operations (192) Fundamental reorganisation (145) Disposal of fixed assets (7) (344.0) 133.0
Taxation (Note 2) (33.0)
Profit for the year 100.0
Balance Sheet as at 30 June 20X5
Non-current assets Property, plant and equipment (Ans c) 1,017
Non-current asset investments 240
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Current assets Inventory (Sch 3) 590
Receivables 475
Cash and bank balance 29
Current liabilities (Note 3) (497) 597
1,854
Non-current liabilities
Deferred tax (Note 2) (174)
Preference shares @ £1 each (200)
1,480 Share capital
Ordinary shares @ 50p each 1,000
Share premium account 150
Retained earnings 330
1,480 Workings
Cost of sales Distribution Administration Inventory
Raw materials 112
Work-in-progress 76
Finished goods 264
Purchases 1,200
Depreciation
Machinery 144
Buildings 3.6 0.9 4.5
Furniture 18.0
Salaries 288 18 54
Rent 72 18 30
Electricity 3.6 7.2 25.2
Advertising 65
Factory power 48
Stationery 12
Other administration
expenses [468–310] 158
Audit fee 18
Inventory
Raw materials (172)
Work-in-progress (54)
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Finished Goods (364)
1,621.2 109.1 319.7
Less: discontinued operations (155.0) (48.5) (38.5)
1466.2 60.6 281.2
Notes (1) Discontinued operations
The results of discontinued operations are made up from: ‘000 Revenue 215
Cost of sales (155)
Distribution expenses (48.5)
Administrative expenses (38.5)
Costs of cancelling contracts (165)
(192)
(2) Taxation
Income tax 65,000
Overprovision for 20X4 taxation (21,000)
Deferred tax (11,000)
33,000
Deferred tax Balance b/f 185,000
Taxation for the year (11,000)
174,000
(3) Current liabilities
Audit fee 18
Sales tax [(2,875 × 15/115) – (1,380 × 15 /115) – 165] 30
Trade payables 360
Tax 65
Dividend (charged as interest) 24
557
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Items to be disclosed
Expenses charged in the year
Expenses charged in the year includes the following:
Depreciation £171,000
Auditor’s remuneration £18,000
Unusual item:
Depreciation charged on machinery includes an exceptional item of £96,000 arising from the revision of estimated useful life of machinery.
Prior period adjustment
The company has decided to depreciate buildings. The effect of this change in policy of £64,000 has been charged against Retained Earnings b/f.
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Chapter 9: Question 4 – Reporting Financial Performance
(a) Statement of Changes in Equity
The Statement of Changes in Equity is of benefit to both investors and lenders to a company in a number of ways. The statement highlights the way that shareholders’ funds have changed over a period, and also the gains and losses recognised in the financial statements in the period that have not been charged or credited to the income statement.
Investors will use the information in the statement to understand how the financial position of the company has changed. This will help the investors to understand whether the performance of the company has been good or poor.
Investors will also see gains and losses that are not recognised in the income statement. For ex-ample the company could have been holding property that is increasing in value in the period, and this will be seen in the statement if the company has revalued in the period.
Lenders will use the information in the statement to help assess the financial position of the company with a view to lending to it. The recognition of revaluation gains in the statement will help a lender to decide whether a company has a sufficient asset base to give security to loans.
It can be argued that all the information that is in the Statement of Changes in Equity is already available in other disclosures in the financial statements. The statement, however, more clearly presents the information and therefore it is of benefit to users.
Segmental disclosures
Segmental disclosures provide information about the performance and position of an enterprise by reference to its business activities and geographical locations. The disclosures are quite ex-tensive for primary segments and less extensive for secondary segments. The primary segmentation can either be by business activities or geographical location; it is the one that has the biggest impact on business risk.
Investors want to make decisions on whether to buy, sell or hold shares in a company. Investors will need to understand how risky the investment is therefore as the return required will vary depending on the level of risk. Risk can either be financial risk or business risk, and segmental disclosures give information about the business risk that a company faces. If a company oper-ates in a number of different business lines, for example, it will be exposed to less business risk than an enterprise that operates in only one.
Investors can also use segmental disclosures to help to assess the quality of management. The investors will be able to see the performance of management in all of the entity’s trading activi-ties and therefore they will be able to see if the performance is poor in any area. Lenders will use the information in a similar way but to make decisions on whether to lend to the enterprise. The level of business risk to a lender may have an influence on the rate of inter-est that is set by the lender and the other terms of the loan.
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Discontinued activities
IFRS 5 requires companies to present information about their continuing and discontinued ac-tivities separately. This information will often be presented on the face of the income statement although disclosure in the notes is acceptable.
Users (investors, lenders and other users) like to see information about discontinued activities so that they can try to assess the future performance of the enterprise. When assessing the future performance of an enterprise the discontinuing activities should be ignored as these are not pre-sent in the future. If, for example, it can be seen that the discontinuing activities are the poorly performing activities of an enterprise, the enterprise might be a good investment even though overall its performance is not very good.
Also the separate information about discontinued activities will help assess the performance of management. Users will be able to assess if the management is discontinuing unprofitable or profitable business activities. This will help the users decide whether the company is a good or poor investment decision.
Disclosed information about future discontinuances that the company intends to undertake will also be useful to users in assessing the longer-term future potential. Companies must disclose information about discontinued activities as soon as the operations are classified as held for sale, and this could be before the actual discontinuance occurs.
(b) Bedok Ltd
20X9 financial statements
Note to the accounts
On 1 June 20X9 the board of directors announced a plan to dispose of the clothing manufactur-ing segment as this segment is not in line with the core activities of the company. The company is actively seeking a buyer and hopes to have completed the sale by the end of 20Y0. At 31 De-cember 20X9 the carrying amount of the clothing segment assets was £20 million and the liabilities were £4 million. The clothing division had revenue of £65 million, incurred expenses of £50 million, had an operating profit of £14 million and a tax charge of £5 million on the prof-its for the year ended 31 December 20X9. A provision of £1 million has been made in respect of redundancy costs expected when the division is sold.
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20Y0 financial statements
Income statement for 20Y0 Discontinued activities 20Y0 20X9
£000 £000
Turnover 40,000 65,000
Expenses (32,000) (50,000)
Redundancy costs (1,000)
Provision for redundancy costs 1,000 (1,000)
Operating profit 8,000 14,000
Profit on disposal of division 2,000
Taxation (3,000) (5,000)
Please note that 20X9 has been restated to present the results as discontinuing activities.
Note to the accounts
On 10 May 20Y0 the board signed an agreement to sell the clothing division for £20 million. This plan had been announced on 1 June 20X9. The company decided to dispose of the division because its activities were inconsistent with the core activities of Bedok Ltd. Bedok Ltd recog-nised a provision of £1 million in 20X9 for the costs of redundancy of employees, and this provision was released in 20Y0. Actual redundancy costs of £1 million were paid. The process of selling the company was completed on 1 July 20Y0 and the assets of the division at this date were £23 million and liabilities were £5 million. A pre-tax profit of £2 million was made on the disposal.
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Chapter 9: Question 5 – Parnell Ltd
(a) Accounting treatment of items 1–5
Item 1 is an exceptional unusual item
• General rule is to include under format heading to which it relates
In this case distribution costs
No adjustment necessary to the income statement but disclose bad debt by way of note.
Item 2, profit/loss on the sale or termination of an operation should be
• Shown separately on face of the income statement after operating profit and before interest
• Analysed under appropriate heading as continuing or discontinued.
Item 3 enables distinction to be made between continued and discontinued operations
• Improves the comparability of current year with previous and next year.
Item 4 would normally be considered a change of accounting policy and requires
• A depreciation charge of £6m for 2003 and
• A prior year adjustment of £12m in respect of 2001/2002 to be charged against retained profits brought forward.
Item 5 is an exceptional unusual item which should be charged
• As an administrative expense in respect of continuing operations
• No adjustment is required to the income statement but the restructuring costs must be dis-closed by way of note.
(b) Redraft of the income statement for 2003
Continuing Discontinued Total £m £m £m
Sales 463 100 563
Cost of sales 280 30 310
183 70 253
Distribution costs 45 45
Administration expense (W1) 94 00 94
Operating profit 44 70 114
Profit on disposal of asset 10 10
Profit on ordinary activities
before tax 44 80 124
Taxation 45
Retained profit 79
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Reserves
Retained earnings
£m
At beginning of year 101
Prior year adjustment (12)
89
Transfer from income statement 79
At year-end 168
W1 78 per question + 10 being profit on sale of distribution division to be separately disclosed
+ 6 depreciation on offices.
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Chapter 9: Question 6 – Related Party Scenarios
(a) IAS 24 para. 9 states that a related party is a party that can exercise significant influence over another party. Significant influence would normally be assumed if a party owns at least 20% of voting rights.
Arthur is therefore presumed to be a related party.
However, Arthur would not appear to be able to influence the financial and operating poli-cies because of the disagreement.
Further enquiry would be required to establish that this has actually been the effect of the disagreement.
(b) Brenda appears to fall within the definition of key management personnel.
Brenda is therefore presumed to be a related party.
Supporting evidence: Key management is defined as a person in a senior position having au-thority or responsibility for directing or controlling the major activities and resources of the reporting entity. Brenda’s ability to take 30% of the turnover with her would be prima facie evidence of such authority.
(c) Donald and Emma through their relationship with Carrie would be related parties of Z Ltd.
Both would be presumed to be related parties to Z Ltd.
However, Donald is an employee and there would be no requirement to disclose emolu-ments.
Supporting evidence: Emma is not an employee and amounts paid to Emma by Z Ltd would be disclosed.
The disclosure required by para.17 of IAS 24 includes:
(i) description of relationship
(ii) description of the transaction
(iii) the amounts involved
(iv) any additional information required to understand the transaction
(v) amounts due at balance sheet date.
(d) This requires consideration of the difference between common control and common influ-ence.
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• Control brings with it the ability to cause the controlled party to subordinate its separate interests, whereas
• the outcome of the exercise of influence is less certain.
Paragraph 11(a) of IAS 24 states that two entities are not related simply because they have a director in common.
Further enquiry is required to consider whether one or both transacting parties, subject to control and influence from the same source or common influence, have subordinated their own separate interests in entering into that transaction.
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Chapter 9: Question 7 – Maxpool plc
Sale of factory outlet:
• As Bay plc is an investor owning more than 20% of Ching Ltd it is a related party of Ching Ltd.
• Details of the transaction will have to be included in both sets of financial statements for the financial year ending 31 December 20X0.
• Disclosure is required of any elements of the transactions necessary for an understanding of the financial statements.
In this case it means that, as the factory site was sold to a major investor, the financial statements should note that the price was determined by an independent surveyor.
What is position re Maxpool?
• Although both Maxpool plc and Bay plc have an investment in Ching Ltd this does not by itself make these companies related parties. There would appear to be no related party rela-tionship between them and therefore there will be no disclosure in Maxpool plc’s financial statements.
• If Maxpool and Bay fall within IAS 24 para. 9(a) and there is control or influence over Maxpool Group plc they could be related parties.
Evidence of influence would, for example, be presumed if Maxpool plc persuaded Bay to sell the factory at below market value.
What is effect of changes in shareholdings in 20X1?
• Maxpool plc is a related party of Ching Ltd.
• Maxpool plc is presumed to be a related party of Bay plc as Maxpool plc has a holding of more than 20% as per IAS 24 para. 9(b).
• Bay plc is not necessarily a related party of Ching Ltd because there is no presumption that 10% of shareholders have the requisite level of influence.
although Maxpool plc controls Ching and has influence over Bay plc, the relationship between Bay and Ching would not automatically justify their being treated as related parties of each other.
However, one would have to check whether one party has subordinated its interests to the other.
How is the sale of vehicles treated?
• As regards the disclosure of the purchase of the vehicles by Bay plc, as it appears that Bay and Ching are not related parties there is no disclosure required in the financial statements of either company.
• Although Bay plc is not a related party of Ching Ltd it is an associate of Maxpool plc and therefore a related party of Maxpool plc.
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Maxpool plc will have to disclose details of the transaction between a group member and Bay plc in the group financial statements.
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C H AP T E R 1 0
Chapter 10: Question 1 – Distribution Rules
(a) A distribution is every description of distribution of a company’s assets to its members whether in cash or otherwise with the exception of:
• an issue of bonus shares
• redemption of a company’s own shares out of capital
• a reduction in share capital by reducing the outstanding liability on unpaid shares or by paying off paid-up share capital.
• a distribution of assets to shareholders on winding up.
(b) The rules for distribution are made to ensure that losses are properly made good before any dividends are paid ensuring that the capital of the company is not eroded. Before 1980, case law had not made this position clear, thus statute was enacted to clarify the position.
(c) Profits available for distribution are:
• accumulated realised profits less accumulated realised losses in so far as they have not already been distributed or capitalised
• capital and revenue profits are taken together provided they are realised
• unrealised profits are not available for distribution.
The additional rule for a public limited company is that the accumulated realised and unrealised profits must exceed the unrealised and realised losses of a company before a distribution can be made. Net unrealised profits are not distributable.
(d) Other constraint on the company’s ability to distribute may be liquidity i.e. availability of cash to pay a dividend.
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(e) (i) A and B as private companies
A B £000 £000
Profit and loss account is the only distribution profit 90 –
(i) Add back depreciation charged on revalued amount
allowed by companies specifically for distribution 5 10
(ii) Add adjustment to take account of gain now realised
on sale of property – 15
(iii) Take off contingent loss as it is probable. Should
be accrued for and hence in accordance with
general accounting principles be treated as a realised
loss – (13)
Distributable profits for a private limited company 95 12
(ii) A and B as public companies
A B £000 £000
The fixed asset investment is an unrealised loss
take into account (10) (10)
but offset against unrealised profits 40 35
revaluation reserve
therefore no adjustment
to distributable profits
95 12
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Chapter 10: Question 2 – V.R. Confident Ltd
(a) In a private company: accumulated realised profits less accumulated realised losses by the balance sheet date.
For a public company: as above but net unrealised losses also need to be deducted.
(b) Maximum distributable profits
£000 £000 Profit after tax – as per accounts 314.0
Less: (c) Stock 90.0
(e) Bad debts 60.0
150.0
Tax saving at 33% 49.5 (100.5)
213.5
Add: (b) Depreciation 60.0
(a) Asset revaluation reserve 90.0
363.5
Less: Profit and loss a/c brought forward (288.0)
75.5
Add: General reserve 160.0
Maximum available for distribution 235.5
Less: Preference share dividend 18.0
Maximum distribution for ordinary shareholders 217.5
Assumptions:
• Research and development – unrealised
• Profit and loss a/c brought forward – all realised
• General reserve – all realised
No difference here if the company was a public company as no accumulated net unrealised losses.
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Chapter 10: Question 3 – Alpha, Beta and Gamma
(a)(i) Private companies
For a private company the maximum distribution that can be made is
• accumulated realised profits of the company (to the extent that they have not previ-ously been distributed or capitalised) less
• its accumulated realised losses (to the extent that they have not been written off in a reduction or reorganisation of capital).
• Such profits and losses may be revenue or capital in origin.
(ii) Public companies
For a public company the same rules apply subject to the additional restriction that
• IF accumulated unrealised losses exceed accumulated unrealised profits
• THEN the net unrealised loss must be deducted from the amount otherwise avail-able for distribution.
Again profits and losses may be revenue or capital in origin.
(b)(i) Alpha plc
Maximum amount available for distribution at 31 March 20X7:
Realised capital profit 1,600
Realised revenue profit brought forward 800
Realised revenue profit for year 400
2,800
Depreciation relating to revaluation surplus treated
as realised (2,200/50) 44
Maximum distribution 2,844
(ii) Beta plc
Maximum amount available for distribution at 31 March 20X7:
Realised revenue profit brought forward 1,000
Realised revenue loss for year (400)
600
Net unrealised capital loss (revaluation deficit) (400)
Maximum distribution 200
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(iii) Gamma Ltd
Maximum amount available for distribution at 31 March 20X7:
Realised revenue loss brought forward (3,200)
Realised revenue profit for loss 400
(2,800)
No distribution possible – accumulated realised losses exceed accumulated realised profits.
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C H AP T E R 1 1
Chapter 11: Question 1 – Distribution – identifying unrealised and realised profits
(a) (i) Share premium is the amount by which the value at which a company issues its shares exceeds their nominal value.
(ii) Section 130(1) of the Companies Act 1985 requires that
‘where a company issues shares at a value that exceeds their nominal value a sum equal to the difference between the issue value and the nominal value must be transferred to a share premium account’.
Three circumstances in which this is necessary are as follows:
1. Where the company issues its shares for a cash consideration and the total amount it expects to receive in cash exceeds the par value stated on the share certificate.
2. Where shares were forfeited and re-issued thereafter, and the total consideration re-ceived on both transactions exceeded the nominal value.
3. Where the company issues shares for a consideration other than cash (e.g. in rela-tion to an acquisition of business or merger) and the fair value of the shares issued exceeds their fair value.
(iii) Company law seeks to protect any balance in the share premium account from abuse, because:
• it is part of the capital paid up by shareholders and
• it forms the creditors’ buffer that, according to company law, ought to be protected, in the interest of those whose interests are at peril on account of the privilege of limited li-ability.
Company law seeks to protect the balance in share premium from abuse by specifically stating the purpose for which alone such a balance may be applied as follows:
• pay up fully paid bonus shares
• write off preliminary expenses
• write off any expenses of any issue of shares or debentures
• write off commission paid or discount allowed on any issue of shares or debentures
• provide for any premium payable on redemption of debentures and provide for any premium payable on redemption of its own shares under the circumstances specified in answer to question (b)(i) below.
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(b) (i) Depreciation
Depreciation on a fixed asset is a realised expense BUT where the fixed asset has been revalued the depreciation on the revalued portion may be treated as a realised profit which is available for distribution.
(ii) Development Development expenditure capitalised in the balance sheet and subsequently charged to the profit and loss account is a realised loss
• in the year the expense appears in the profit and loss account
• NOT when the cost is incurred.
(iii) Associates The share of profits from an associated company to an investing company which is not included in consolidated financial statements is not considered to be realised profits; only the dividends received are considered realised.
(iv) Profit on disposal The profit on disposal of a fixed asset which has been revalued will be the difference between the proceeds and the valuation of the asset.
• However, the excess of the valuation over net book value will not have been treated as real-ised profit in the year of valuation and so in the year of disposal the whole of the profit (proceeds less net book value) will be treated as realised.
(v) Provisions
• The fact that the provision appears in the balance sheet, and not as a note to the balance sheet concerning a contingent liability, clearly indicates that the directors expect to pay damages.
• This decision is probably based on legal advice and, in accordance with SSAP 2 Disclosure of Accounting Policies, has been provided for in the accounts.
• In these circumstances this would be regarded as a realised loss.
(vi) Revaluation surplus
• Any surplus arising from a revaluation of an asset would be regarded as unrealised.
• It would only be realised when the asset was sold. This is in accordance with SSAP 2 pru-dence concept.
(vii) A provision for bad debts A provision would be realised since it is generally accepted accounting practice to make such provisions in accordance with the prudence concept in SSAP 2.
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Chapter 11: Question 2 – Smith Family Ltd
To: Directors of Smith Family Ltd From: The Auditor Date: August 20X7 Subject: Report on the Proposed Buyback of Ordinary £1 shares held by Mr Otto Smith
Senior
1. Introduction
1.1 Otto Smith Senior wishes to retire from the business and dispose of his holding of 200,000 ordinary £1 shares. These have been valued by independent valuers at £300,000 and the price is not disputed.
1.2 The purpose of this report is to explain:
• whether the company may make the purchase
• the procedure which must be followed
• the rules relating to private companies in respect of the purchase of shares from capital.
1.3 The report will also include illustrative figures and journal entries for the two financing op-tions (internal resources and a combination of internal resources and a new share issue) and will explain the changes to the balance sheet.
(a) 2. Power to purchase own shares
• The Companies Act 1985 permits the purchase whether or not the shares were issued as re-deemable.
• Power to purchase must also be permitted by Smith Family Ltd’s Articles of Association.
(b) 3. Procedure to be followed
• Off market purchase will, therefore, require specific contract approval by special resolution in general meeting.
• Shares bought in from Otto Senior must be cancelled immediately and not reissued. • Permanent capital (share capital and undistributable reserves, e.g. share premium) generally
required to be preserved by Companies Act 1985.
• A transfer must normally be made from distributable profits to undistributable reserves (capital redemption reserve) equivalent to the difference between the proceeds of the new issue (if any) and the nominal value of the shares bought back.
• The premium on redemption (£100,000 in respect of Otto Senior’s shares) must normally be met from distributable reserves (profit and loss)
• although some limited relief may apply if the buyback is partly or wholly financed by a new share issue and Otto Senior’s shares were originally issued at a premium, as indeed they were.
(c) 4. Redemption from capital – private companies
• Smith Family Ltd, as a private company, may be allowed to reduce its permanent capital (share capital and undistributable reserves) where undistributable reserves are insufficient to finance the buyback. The amount of permissible reduction is found by the formula:
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Redemption cost less sum of the distributable reserves and the proceeds of any new issue. This is called the permissible capital payment (PCP).
• Purchase must be permitted by the company and a special resolution is needed.
• Statutory declaration of solvency is required by directors that, immediately after the buy-back and within 1 year of the buyback, the company will be able to pay its debts. The directors may become personally liable for the debts.
• Report from company auditors must be attached to the declaration stating their agreement.
• Dissenting shareholders who did not vote can apply to the courts to have the purchase from capital set aside.
(d) Option 1: Purchase from internal resources
Balance sheet after buyback: Before After
£000 Net assets £000
400 Cash 100 (400 – 300)
850 Other sundry assets 850
1,250 950
Financed by:
1,000 Ordinary £1 shares 800 (1,000 – 200)
100 Share premium 100
– Capital redemption reserve 50 (200 NV–150 PCP)
150 Profit and loss –
1,250 950
Workings: Redemption cost 300,000
Less: Distributable reserves (150,000)
Permissible capital payment (PCP) 150,000
Transfer to capital redemption reserve (CRR)
Nominal value of shares redeemed 200,000
Less: PCP (150,000)
Transfer to CRR 50,000
Journal entries: Dr Cr Ordinary £1 shares 200,000
Purchase of ordinary £1 shares 200,000
Write out of shares to be bought back
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Profit and loss account 100,000
Purchase of ordinary £1 shares 100,000
Premium payable on buyback
Purchase of ordinary £1 shares 300,000
Cash account (or bank) 300,000
Payment to buy back shares
Profit and loss account 50,000
Capital redemption reserve 50,000
Transfer from distributable to undistributable reserves in accordance with the require-
ments of the Companies Act 1985. (Nominal value of shares redeemed 200 less permissible capital payment 150.)
Explanation:
• Distributable reserves (£100,000) are lower than the redemption costs (£300,000), therefore, as a private company, Smith Family Ltd will be permitted to reduce its permanent capital.
• Permissible capital payment (the amount of permitted reduction) is the redemption cost (£300,000) less the distributable reserves (£150,000), that is £150,000 and the permanent capital after the buyback has fallen by this amount from £1,100,000 to £950,000.
• The capital redemption reserve is created because the nominal value of the shares redeemed (£200,000) that is, the amount by which the permanent capital of the company would fall af-ter the buyback, is higher than the permissible capital repayment of £150,000.
• Cash falls by £300,000, the cost of redemption.
• The profit and loss balance (distributable reserves) is wiped out by the premium due on re-demption and the statutory transfer to capital redemption reserve.
• Ordinary shares fall to 800,000 after the buyback.
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Option 2: Partly from internal resources and partly by a new issue of ordi-nary £l share
Balance sheet after buyback: Before After
£000 Net assets £000
400 Cash 200 (400 – 300 + 100)
850 Other sundry assets 850
1,250 1,050
Financed by:
1,000 Ordinary £1 shares 850 (1,000 – 200 + 50)
100 Share premium 110 (100 + 50 – 40)
– Capital redemption reserve 50
150 Profit and loss 40 (150P – 60 (Prem)
– 50 CRR)
1,250 1,050
Workings: PCP £000 £000
Redemption cost 300
Less: Distributable reserves 150
Proceeds of new issue PCP 100 (250)
PCP 50
Transfer to capital redemption reserve:
Nominal value of shares redeemed 200
Less: PCP 50
Proceeds of new issue (to ordinary
shares and share premium) 100 (150)
Transfer to capital redemption reserve 50
Premium on redemption: treatment
Redemption costs partly financed by new issue and Otto Smith Senior’s shares originally issued
at a premium:
Premium on issue 200,000 @ 20p 40,000
Premium on buyback (300 – 200) 100,000
Proceeds of new issue 100,000
Balance on share premium after new issue (100 + 50) 150,000
∴ Write £40,000 of premium due on buyback off against share premium and write balance of
£60,000 off against profit and losses.
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Journal entries:
Dr Cr Ordinary £1 shares 200,000
Purchase of ordinary £1 shares 200,000
Write out of shares to be bought back
Profit and loss account 60,000
Share premium 40,000
Purchase of ordinary £1 shares 100,000
Premium payable on buyback
Purchase of ordinary £1 shares 300,000
Cash account (or bank) 300,000
Payment to buy back shares
The following two entries may be combined:
Cash account 100,000
Application and allotment account 100,000
Proceeds of new issue
Application and allotment account 100,000
Ordinary £1 shares 50,000
Share premium 50,000
Allotment at a premium of £1
Profit and loss account 50,000
Capital redemption reserve 50,000
Statutory transfer from profit and loss to capital redemption reserve: nominal value of shares bought back (£200,000) exceeds the combined total of the permissible capital payment (£50,000) and the proceeds of the new issue (£100,000).
Explanation:
• Distributable reserves and proceeds of new issue are lower than the redemption costs there-fore, as a private company, Smith Family Ltd will be permitted to reduce its permanent capital on the buyback.
• Permissible capital payment is £50,000 and the permanent capital would have fallen by this amount except that part of the premium due on buyback may be financed through share premium, and therefore permanent capital has fallen by £90,000, the combined effect of the PCP (£50,000) and the write-off against share premium (£40,000).
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• Capital redemption reserve is created because the nominal value of the shares redeemed (£200,000) exceeds the combined sum of the PCP (£50,000) and the proceeds of the new is-sue (£100,000).
• Cash falls by £200,000, the net difference between the redemption cost and the proceeds of the new issue.
• Share premium account shows a net increase of £10,000, being the difference between the premium on the new issue of £50,000 and the permitted amount of £40,000 of the premium due on the buyback which has been charged against the share premium.
• Profit and loss falls to £40,000, after charging £60,000 premium due on the buyback and transferring £50,000 to capital redemption reserve.
• Ordinary shares fall to £850,000, showing the net effect of the buyback (£200,000) and the new issue (£50,000).
Conclusions and recommendations
Option 2, partly financed by new share issue, is the more favourable because:
• Company is still left with distributable reserves (£40,000 – profit and loss).
• Share premium, which is a restricted reserve in terms of utilisation, may be used to absorb some of the cost (£40,000) of the premium due on the buyback.
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Chapter 11: Question 3 – Telin plc
(i) Cash and bank
1/10 Balance 5,450,000 28/10 Redemption of
preference shares 8,480,000
4/10 Debentures 2,340,000
12/10 Ord. shares 6,000,000
Share premium 600,000
31/10 P&L a/c 275,000 31/10 Balance c/d 6,185,000
14,665,000 14,665,000
1/11 Balance b/d 6,185,000
10% debentures
4/10 Bank 2,340,000
31/10 Balance c/d 2,400,000 Deb. discount 60,000
1/11 Balance b/d 2,400,000
Discount on debentures
4/10 Debentures 60,000 6/10 Share premium 60,000
Share premium
6/10 Deb. discount 60,000 1/10 Balance 4,000,000
29/10 Premium on
redemption 160,000 12/10 Cash 600,000
31/10 Balance c/d 4,380,000
4,600,000 4,600,000
1/11 Balance b/d 4,380,000
Profit and loss
6/10 Research exp. 1,400,000 1/10 Balance 4,600,000
29/10 Dividends on
pref. shares 80,000 31/10 Cash (profit) 275,000
29/10 Premium on
redemption 240,000
29/10 Capital redemption
reserve 1,400,000
31/10 Balance c/d 1,755,000
4,875,000 4,875,000
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Product development costs
1/10 Balance 1,400,000 6/10 P&L a/c 1,400,000
Ordinary share capital 1/10 Balance 12,000,000
12/10 Bank 6,000,000
30/10 (Bonus issue) CRR 900,000
31/10 Balance c/f 18,900,000 18,900,000
1/11 Balance c/d 18,900,000
12% preference share capital
29/10 Redemption of
shares 8,000,000 1/10 Balance 8,000,000
Redemption of preference shares
29/10 Cash 8,480,000 29/10 Pref. shares 8,000,000
Premium on red. 400,000
P&L a/c 80,000
8,480,000 8,480,000
Premium on redemption
29/10 Redemption a/c 400,000 29/10 Share premium 160,000
P&L a/c 240,000
Capital redemption reserve
30/10 Ordinary share capital 29/10 P&L a/c 1,400,000
bonus issue 900,000
31/10 Balance c/d 500,000
1,400,000 1,400,000
1/11 Bal. b/d 500,000
(ii) Balance sheet as at 31 October 20X5
Ordinary share capital 18,900,000 Sundry assets 32,170,000
Capital redemption Cash at bank 6,185,000
reserve 500,000
Share premium 4,380,000
Retained profits 1,755,000
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10% debentures 2,400,000
Creditors 10,420,000
38,355,000 38,355,000
Note: Advantageous course of action for shareholders is not to reduce distributable profits unless there is no other course of action. Therefore, whenever legally possible, reduction has been made from share premium account.
Bonus issue was made from capital redemption reserve, as this is restricted to bonus issues only whereas share premium can be used for some other purposes also.
(iii) Under the Companies Act 1981:
(a) Premium on redemption of shares can be written off against share premium – maximum allowed being premium received on the issue of shares, which are now being redeemed i.e. 2% of £8,000,000 = £160,000 to share premium.
Balance must be written off against profits.
(b) Transfer to capital redemption reserve is the amount by which the aggregate receipts from specific new issue exceeds the nominal value of shares redeemed.
Nominal value of shares redeemed 8,000,000 Less: total receipts from new issue 6,600,000 To capital redemption reserve 1,400,000 (from distributable profits)
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Chapter 11: Question 4 – Alpha Ltd
(a) Capital reduction and reorganisation account
£000 £000 7¾% notes 50 Ordinary shares 75
Ordinary shares – reissue 15 Ordinary shares 15
Profit and loss account 177 Preference shares 250
Shares in sub. 55 Freehold property 14
Plant 57 ___
354 354
(b) Balance sheet as on 1 July 20X8
£000 £000 Fixed assets
Tangible assets
Freehold property 55
Plant 22
77
Investment
Shares in subsidiary company 45
Loans 40 85
162
Current assets
Inventory 132
Trade receivables 106
Bank 107
345
Payables: Amounts falling due within one year Trade payables 282
Net current assets 63
225
Payables: Amounts falling due after one year 7¾% notes 200
Total assets less liabilities 25
Ordinary share capital 25
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Ordinary share capital
£000 £000 Capital reduction 75 Balance b/f 75
Capital reduction 15 Bank 25
Balance c/f 25 Reissue 15
115 115
Balance 25
Bank
OSC 25 Balance b/f 58
7¾% notes 150 Shares in sub. 10
Balance c/f 107
175 175
Balance b/f 107
7¾% notes
Balance c/f 200 Bank 150
Capital reduction 50
200 200
Balance b/f 200
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Chapter 11: Question 5 – Doxin plc
This question is essentially concerned with the issue and redemption of shares by a plc where there is a trading loss impacting on the cash liquidity position. Part (a) requires students to illustrate the effect on key balance sheet components. Part (b) requires a discussion and evaluation of the effects of applying the Companies Act 1985 capital maintenance rules in circumstances where shares are redeemed partly out of distributable profits.
Opening (i) (iia) (iib) (iii) (iv) (v) Closing BS £000 £000 £000 £000 £000 £000 £000 £000
Ord. shares 800 200 5 1,005
Pref. shares 300 (300) -
Capital red.
Reserve 80 80
Share premium 20 (15) (5) -
Reserves 200 (80) (500) (380)
705
Creditors 400 400
Debentures 400 400
1,700 1,505
Bank 200 220 (315) 360 (500) (35)
Other assets 1,500 1,500
Debenture discount 40 40
1,700 1,505
(i) (a) Premium on redemption
• out of profits or
• lowest of:
• premium received on issue of shares to be redeemed (£75,000)
• balance of share premium account including premium on new issue (£20,000)
• total proceeds of the new issue (£220,000).
(ii) (b) Capital redemption reserve:
• excess of nominal value of shares redeemed over total receipt from new issue (£300,000 – 220,000 = 80,000)
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Comments on Doxin plc
(a) (i) The issue of 200,000 ordinary shares at a premium of 10p each increases the share capital, the share premium and cash balance; note that the issue must be made within specified time limits if it is to be effective in applying the capital maintenance rules which require a transfer to capital redemption reserve.
(ii) On redemption of the preference shares it is necessary to calculate the extent to which the premium on redemption can be charged to the share premium account, and the transfer, if any, to the capital redemption reserve from distributable profits – in this case from the general reserve £200,000.
The full premium on redemption can be charged to the share premium account which was brought into existence by the replacement issue. The limitation imposed by % pre-mium originally received on the shares does not apply.
The preference shares (300,000) disappear from the balance sheets and the share pre-mium account becomes £5,000 with the bank balance reduced by £315,000.
The transfer from general reserve to CRR is always in excess of nominal value re-deemed over the proceeds of other issue (made specifically for redemption).
(iii) The issue of 7% debentures £400,000 valued at 90 results in a long-term liability of £400,000 and a net increase in the bank balance of £360,000 with discount on deben-tures £40,000.
The Companies Act 1985 is silent on treatment of this item apart from the option to write it off against the share premium account. Write-off over the life of the debenture might be the appropriate treatment.
(iv) The use of the share premium balance £5,000 to cover a bonus issue of ordinary shares is reflected by a transfer to the ordinary share capital account as permitted by the Companies Act 1985.
(v) The trade loss £500,000 incurred in the year is recorded as impacting on the bank balance where it creates an overdraft of £35,000.
(b) The interest of creditors is protected by the creation of the CRR £80,000 which is non-distributable and can only be used to issue bonus shares.
However, because of the use of SPA to cover premium on redemption £15,000 the original capi-tal of £1,100,000 is only maintained up to £1,085,000 capital meaning issued share capital plus undistributable reserves.
The effect of this loophole in capital maintenance regulation could be remedied by an additional transfer from distributable profit to CRR – in this case of £15,000.
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Chapter 11: Question 6
(a) The advantages of purchasing and cancelling own shares are:
It is a method of returning surplus cash that a company is unable to invest profitably within the company
It is a method of overcoming a problem as when shares are acquired from a dissenting share-holder so as to remove the nuisance value.
It is a method of providing cash as a help to a shareholder in liquidating their shareholding as where shares have been issued to employees as part of a profit sharing scheme and the employee wishes to convert to cash or they are acquired from the estate of a deceased shareholder
It is a possible method of improving the share price if the directors consider the current share price are undervalued – on cancellation each remaining share has a greater interest in the net assets.
It is taken as a means of increasing the earnings per share.
(b) The advantages of purchasing and holding shares in treasury
It provides a company with greater flexibility in managing its share capital
It allows a company to optimise its gearing by buy back rather than by increasing or decreasing its debt
It reduces the cost of raising new capital if the shares are reissued later through a Broker rather than through a more expensive placing or rights issue.
It can stimulate an inactive market particularly if existing shareholders have been finding it dif-ficult to sell their shares
It can lead to an increase in the earnings per share
Treasury shares can be used to satisfy the exercise of employee share options and may be ac-quired at the date the option is granted and held in treasury.
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C H AP T E R 1 2
Chapter 12: Question 1 – Post Balance Sheet Events
(a) IAS 10 requires that financial statements should be prepared on the basis of conditions ex-isting at the balance sheet date, and therefore lays down the following treatment for events after the balance sheet date.
A material event after the balance sheet date requires changes in the amounts to be included in financial statements where:
• it is an adjusting event (i.e. an event which provides additional evidence of condition exist-ing at the balance sheet date); or
• it indicates that application of the going concern concept to the whole or a material part of the company is not appropriate.
A material event after the balance sheet date should be disclosed where:
• it is a non-adjusting event
i.e. an event which concerns conditions which did not exist at the balance sheet date
of such materiality that its non-disclosure would affect the ability of the users of finan-cial statements to reach a proper understanding of the financial position; or
• it is the reversal or maturity after the year end
of a transaction entered into before the year end
the substance of which was primarily to alter the appearance of the company’s balance sheet.
The purpose of the recommended treatment is:
• To ensure that the financial statements show the true position as it existed at the year end.
• All information available to management at the date that the financial statements are final-ised should be taken into account.
• To the extent that such information relates to the financial year dealt with in the financial statements, they should be adjusted.
• To the extent that material matters relate to the subsequent period the user should be in-formed by way of note so that they are not misled as to the current position of the company. However,
If events subsequent to the year end indicate a need to consider whether the enterprise (or a material part of it) is a going concern they are to be treated as adjusting events
because the use of the going concern basis implies a belief that the company will con-tinue in business for the foreseeable future.
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(b) (i)
• This fraud is an adjusting event, because it has been discovered that the financial statements will not be correct unless they are adjusted for it.
• The £8,000 should therefore be written off in the profit and loss account so that a true and fair view is shown.
(ii)
• As the agreement to purchase this business relates to the period after the year end it is a non-adjusting event.
Knowledge of it in no way affects the position of the company at 31 December 20X6.
Therefore it should be disclosed by way of note.
(iii)
• The rights issue relates entirely to the period after the year end, therefore it is a non-adjusting event.
• It would be wrong to adjust the company’s share capital and cash at 31 December 20X6 because of a subsequent share issue.
• This should be disclosed by way of note.
(iv)
• This is an adjusting event because it provides evidence of conditions existing at the balance sheet date.
• The potential loss of £9,000 should be written off in the income statement and deducted from debtors in the balance sheet.
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Chapter 12: Question 2 – SEAS Ltd
(i) The closure of the Garratt factory is a discontinuance of a business segment, as it was clearly a material and separately identifiable component of the company’s business opera-tions. Under IFRS 5, disclose under discontinuing heading.
(ii) The fraud is an adjusting event under IAS 10, and, as it has been discovered, the financial statements will not show a true and fair view unless they are adjusted for it. The $30,000 should therefore be written off in the income statement.
(iii) This is an exceptional item, because it is material but arises from the ordinary activities of the business. It should be charged in arriving at the profit on ordinary activities, and should be disclosed separately.
(iv) The agreement to purchase this business relates to the period after the year end and is there-fore a non-adjusting event under IAS 10, as knowledge of it does not affect the company’s position at 31 March 20X8. However, disclose the information by way of note.
(v) This is also an exceptional item and should be treated as in (iii) above. It is not a prior year adjustment because it arises from a change in trading conditions and not from a change in accounting policy or a fundamental error.
(vi) Under IAS 10 this is an adjusting event as it provides evidence of conditions existing at the balance sheet date. The potential loss of £30,000 should be written off in the income statement and deducted from the debtors in the balance sheet.
(vii)The rights issue relates entirely to the period after the year end, therefore it is a non-adjusting event under IAS 10. This should be disclosed by way of note.
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Chapter 12: Question 3 – World Wide Nuclear Fuels
(a) Explanation
(i) Need for guidance
Difficulties included:
• Definition – the IASB define provisions as a ‘liability of uncertain timing or amount’.
• Treatment of future operating losses – considered these should be accounted for in the fu-ture.
• Provisions differ from liabilities in that provisions are often subject to disclosure require-ments whereas other creditors are not e.g. statutory requirement to disclose – may however be insufficient detail.
• Adequate level of disclosure of movements is important as these do not go through Income Statement once provision is established.
• Unacceptable practice of big bath provisioning used to absorb expenses incurred in later years.
• Management has been able to control the recognition and timing of movements so that user does not have a clear picture of current year’s performance – smoothing profits.
• There has been inconsistency between the accounting for provisions between different com-panies.
(ii) Recognition
IAS 37 applies Framework approach – provisions are an element of the liabilities and not a separate element of the financial statements. Provisions should therefore be recognised only when:
(i) an enterprise has a present legal or constructive obligation and benefits as a result of past events
(ii) it is probably that an outflow of resources embodying economic benefits will be required to settle the obligation
(iii) a reasonable estimate of the amount required to settle the obligation can be made.
IAS 37 takes a balance sheet perspective by concentrating on liability recognition rather than the recognition of an expense.
Criteria include:
• An obligation exists when the entity has no realistic alternative to making a transfer of eco-nomic benefits – may be legally enforceable or constructive.
• Only recognised if existing at balance sheet date.
• Must have arisen from past events.
• Must exist independently from the company’s future actions.
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• If avoidable by future actions then no provision is recognised.
• No provision should be recognised for future operating losses.
• A constructive obligation for restructuring only exists when the recognition criteria laid out in IAS 37 are satisfied.
• If an enterprise has a contract which is onerous, the present obligation should be recognised and measured as a provision.
(b) Transactions
Although IAS 37 states that no provision should be made for future operation losses, this does not apply if there is an onerous contract. This contract appears to be onerous and so the provi-sion of $135m should remain in the financial statements.
With regard to the provisions for environmental liabilities, the question is whether this is a con-structive obligation. There is no current obligation but it could be argued that there is a ‘constructive obligation’ to provide for the remedial work because the conduct of the company has created a valid expectation that the company will clean up the environment.
We say ‘could be argued’ because there is no clear answer and it may well be determined by the subjective assessment of the directors and auditors as to whether there is a ‘constructive obliga-tion’. The example 2B in IAS 37 would support making a provision.
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Chapter 12: Question 4
The proposal to include the £62.5m and £40m in sales and cost of sales is incorrect. If it were a genuine disposal it should have been treated as the disposal of a non-current asset with the profit included in the income statement, separately disclosed if material.
The substance of this transaction is, however, a secured loan in that the company is going to have the continued use of the equipment for the whole of its economic life.
There should be a charge of 10% in the Income Statement for the three months from 1 October 20x5. In the balance sheet the asset will continue to be shown as a non-current asset and a year’s depreciation charged. There will also be a liability for the amount of the loan less any capital repayment that has been made.
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C H AP T E R 1 3
Chapter 13: Question 1 – DDB AG
Issue of deep discount bond
Charges to income statement and carrying value in BS shown in tabular form
(i) (ii) (iii) Cash Finance charge
Carrying value flows to IS in BS £000 £000 £000 At 1 Apr 1 (2,500–125–100) (2,275) –2,275.000
At 31 Mar 1 (10% of 2,500) (2,250 (12.5% × 2,275) 284.375 –2,309.375
At 31 Mar 2 (10% of 2,500) (2,250 (12.5% × 2,309.375) 288.671 –2,348.046
At 31 Mar 3 (10% of 2,500) (2,250 (12.5% × 2,348.046) 293.506 –2,391.552
At 31 Mar 4 (10% of 2,500) (2,250 (12.5% × 2,391.552) 298.944 –2,440.496
At 31 Mar 5 (2,500 +10% of 2500) (2,750 (12.5% × 2,440.496) 305.062 –
Adj.* 4.442
Net cash flow 1,475 1,475.000
*Adjustment necessitated by rounding of implicit rate to 12.5%
Workings
Implicit rate has been determined by interpolation via formula
t = n Σ = t = 1
The initial cost of 2,275,000 is deducted to arrive at the net present value.
Using 13%
t = n Σ = t = 1
= 221,239 + 195,787 + 173,263 + 153,330 + 1,492,590 – 2,275,000 = –38,791
then using 12%
t = n Σ =
At (1+r)t
250 + 250 + 250 + 250 + 2,750 – 2,275,000 1.131 1.132 1.133 1.134 1.135
223,214 + 199,298 + 177,945 + 158,880 + 1,560,424 – 2,275,000 = 44,761
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[( ])t = 1
Implicit rate = 12% + 44,761 (44,761 + 38,791) × 1% = 12.536 say = 12.5%
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)(
Chapter 13: Question 2 – RPS plc
Redemption of preference shares
The treatment of the finance cost of preference shares follows the pattern of loan debt. IAS 32 requires that redeemable preference shares are presented and treated as debt instruments because they are in substance debt.
Calculation of finance costs and outstanding principal sum (i) (ii) (iii) Cash Finance
Balance flows charge £000 £000 £000
At 1 Oct 1 (100 – 50) (950) – 950
At 30 Sept 1 (Div 5% 1,000) 50 (6.2% × 950) 58.9 958.9
At 30 Sept 2 (Div 5% 1,000) 50 (6.2% × 958.9) 59.5 968.4
At 30 Sept 3 (Div 5% 1,000) 50 (6.2% × 968.4) 60.0 978.4
At 30 Sept 4 (Div 5% 1,000) 50 (6.2% × 978.4) 60.7 989.1
At 30 Sept 5 (1000+div of 5% 1,000)
1050 (6.2% × 989.1) 61.3
Adj.* (0.4)
Net cash flow 300 300.00
*Adjustment caused by rounding in determining implicit rate of 6.2%, namely
t = n Σ = t = 1
For interest, using 6%
t = n Σ = t = 1
= 47.2 + 44.5 + 41.98 + 39.60 + 784.6 – 950 = 7.88
then 7% =
t = n Σ = t = 1
= 46.7 + 43.7 + 40.8 + 38.1 + 748.6 – 950 = 32.1
–1 = 0
50 + 50 + 50 + 50 + 1050 – 950 1.061 1.062 1.063 1.064 1.065
50 + 50 + 50 + 50 + 1050 – 950 1.071 1.072 1.073 1.074 1.075
At (1+r)t
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Interpolation gives rate of 6% + 7.88 × 1% = 6.2% 39.98
Treatment of total finance costs through the life-span of the capital instrument
IAS 32 stipulates that the finance costs of redeemable preference shares are to be shown in the income statement but separately after interest.
Income Statement for year ended 30 September (extracts) Years 1 2 3 4 5
£000 £000 £000 £000 £000 Interest
Finance cost on redeemable
preference shares 58.9 59.5 60.0 60.7 60.9
The balance sheet extracts reveal the impact of the IAS regarding liabilities as follows:
Balance Sheet as at 30 September (extracts)
Years 1 2 3 4 5 £000 £000 £000 £000 £000 Long-term liabilities:
Redeemable preference shares 958.9 968.4 978.4 989.1 –
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Chapter 13: Question 3 – Little Raven
(a) The considerations involved in deciding how to account for the is-sue:
• the issue is made at a substantial discount
• the coupon rate is significantly below market rates
• adopting substance over form, the discount is effectively rolled-up interest and should be accounted for over the period of the borrowing
• the balance sheet should report the obligation to redeem at par and the income statement should report the true cost of the borrowing.
If the borrowing was accumulated for:
(i) As per the question:
DR Cash 4,000
CR Debt 4,000
and each year, DR Income statement 300
CR Cash 300
neither the obligation to repay nor the true cost of the borrowing would be fairly reported.
(ii) Taking advantage of the legal point (available in some countries) that permits discount on issue to be debited to share premium account, the debt could be reported as follows:
DR Cash 4,000
DR Share premium a/c 1,000
CR Debt 5,000
and, each year DR Income statement 300
CR Cash 300
in which case the amount of debt would be fairly reported but not the true cost of the debt.
(iii) Alternatively, DR Cash 4,000
DR Unamortised discount 1,000
CR Debt 5,000
And, each year, DR Income statement 300
CR Cash 300
DR Income statement X
CR Unamortised discount
with amortisation of discount on an appropriate basis over period of debenture.
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At each year-end the debt would be reported as £5,000 less unamortised discount. Such ac-counting achieves the objective of reporting the actual amount repayable and the true cost of the debt but is not the approach adopted by IAS 32.
(iv) Under IAS 32 the approach would be:
• on issue date DR Cash X
CR Debt X
with the net proceeds of issue.
• determine finance costs as total amounts repayable (interest plus redemption) less net pro-ceeds of issue
• allocate finance costs to each period at a constant rate on the carrying amount of the debt by
DR Income statement X
CR Debt X
DR Debt X
CR Cash X
with amounts paid in each period
(b) Carrying Finance Carrying
Period amount at cost Payments amount at y/e beginning (11.476%) end
£000 £000 £000 £000 30.9.X2 4,000 459 (300) 4,159
30.9.X3 4,159 477 (300) 4,336
30.9.X4 4,336 498 (300) 4,534
30.9.X5 4,534 520 (300) 4,754
30.9.X6 4,754 546 (300 + 5,000) –
2,500
(300 x 5 = 1,500 + 5,000 = 6,500 – 4,000 = 2,500)
Revised income statements for the year ended 30 September 20X5 20X4 (restated)
Turnover 6,700 6,300
Cost of sales (3,025) (2,900)
Gross profit 3,675 3,400
Overheads (600) (550)
Interest payable – debenture (520) (498)
– other (75) (50)
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Profit for the financial year 2,480 2,302
Retained profit brought forward,
as previously stated 4,300 1,800
Prior year’s adjustment (336)
[159 + 177]
[159 + 177 + 208] (544)
Retained profit brought forward
restated 3,756 1,464
Retained profit, carried forward 6,236 3,766
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C H AP T E R 1 4
Chapter 14: Question 1 – Kathryn
(a) The original IAS 19 approach to defined benefit pension schemes needed to be reviewed for a number of reasons as follows:
Misleading balance sheet
The original approach to the valuation of the asset or liability for pensions in the balance sheet was potentially misleading to users of the accounts, and did not follow the statement of principles. The income statement charge was ‘smoothed’ out across all the years of ser-vice of the employees. The concept that was being followed in doing this was the accruals concept. Problems for presentation rose when surplus or deficits arose on the pension scheme. For example suppose a company had:
Normal contributions £5m per annum Surplus £10m Average remaining working life of staff 5 years
The actuary recommended a two-year contribution holiday.
The annual income statement account charge would be £3m (the surplus of £10m has been spread over the remaining working lives of 5 years), but in the balance sheet after one year would be a liability of £3m. This liability would grow to £6m in the second year, and would only return to nil by the end of year 5. This balance sheet liability could be understood by users of the financial statements to mean that the company owed the pension fund money. In fact if anything the company had overpaid into the pension scheme.
This approach to pension accounting does not meet the Framework Document in two ways. Firstly the framework prioritises the balance sheet over the income statement whereas the original IAS 19 made the income statement the key statement; and secondly the balance sheet asset or liability does not meet the definition of the item. In the above example for in-stance the liability that is created is not an obligation to transfer economic benefits as a result of past transactions or events.
Internationally inconsistent
The original version of IAS 19 was out of line with the approaches in US GAAP. The re-vised version of the standard is nearer to the requirements to US GAAP as it follows similar valuation principles for assets and obligations, although variations still exist in recognition of gains and losses.
Valuation of pension fund assets and liabilities
The original IAS 19 did not use valuation principles for assets and liabilities that were inter-nationally consistent or the most realistic methods available. Assets were valued at actuarial
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value as opposed to a market value and liabilities of the pension fund were discounted at the expected rate of return on assets, not a realistic discount rate for liabilities.
The amended standard has addressed this by requiring pension scheme assets to be meas-ured at market values and liabilities to be valued using the ‘projected unit credit method’ discounted at an appropriate corporate bond rate.
(b) Income statement
Operating cost
£000 £000 Pension cost – current service cost (W2) (600)
Financing cost
Expected return on assets (W1) 1,155 Interest cost (W2) (1,020) Net return 135
[Under IAS 19 it is not necessary to include the income statement income or expense as op-erating and finance costs, it would all be acceptable under operating costs, however this split is appropriate given the nature of the income and expense items.]
Balance sheet
Pension liability Present value of obligations (10,900) Market value of assets 10,700 (200)
Statement of movement in equity
Actuarial gain on the obligations (W2) 120 Actuarial loss of the assets (W1) (855) Loss in equity (735)
WORKINGS
W1 Assets of the pension fund £000
Market value of assets as at 1 May 2000 10,500 Expected return on assets – 11% 1,155 Contributions 700 Benefits paid (800) Actuarial gains (losses) – bal. fig. (855) Market value of assets as at 30 April 2001 10,700
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W2 Obligations of the pension fund
Present value of the obligations as at 1 May 2000 10,200 Interest cost – 10% 1,020 Current service cost 600 Benefits paid (800) Actuarial (gains) losses – bal. fig. (120) Present value of obligations as at 30 April 2001 10,900
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Chapter 14: Question 2 – Donna
In 2004 the IASB amended IAS 19 Employee Benefits and introduced an extra treatment for actuarial gains and losses. Under the previous version of the standard actuarial gains and losses had to be recognised in the income statement, but only if they exceeded the greater of 10% of the present value of the obligations or 10% of the assets.
In December 2004 an amendment to the standard was issued however that gave an extra treatment. If a company chooses immediate recognition of all gains and losses they can recognise the gains and losses outside the income statement, which would mean in equity. The impact of these approaches is shown below:
Workings
Change in the obligation
2002 2003 2004 Present value of obligation, 1 January 3,500 3,600 3,500 Interest cost 210 180 140 Current service cost 150 160 170 Benefits paid (140) (150) (130) Actuarial (gain)/loss on obligation (120) (290) (480) (balancing figure) Present value of obligation, 31 December 3,600 3,500 3,200
Change in the assets
Fair value of plan assets, 1 January 3,200 3,400 3,600 Expected return on plan assets 320 306 288 Contributions 120 120 130 Benefits paid (140) (150) (130) Actuarial gain/(loss) on plan assets (balancing figure) (100) (76) (288) Fair value of plan assets, 31 December 3,400 3,600 3,600
10% corridor
The limits of the ‘10% corridor’ need to be calculated in order to establish whether actuarial gains or losses exceed the corridor limit and therefore need recognising in the income statement. Actuarial gains and losses are recognised in the income statement if they exceed the 10% corridor, and they are recognised by being amortised over the remaining service lives of employees.
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The limits of the 10% corridor are set (at 1 January each year) at the greater of:
(a) 10% of the present value of the obligation before deducting plan assets; and
(b) 10% of the fair value of plan assets. 2002 2003 2004
Limit of ‘10% corridor’ (at 1 January) 320 340 350
Actuarial gains and losses unrecognised
(1 January) – 20 234
Actuarial gain (loss) recognised over 10 years – – –
Cumulative unrecognised gains (losses) – 20 234
(1 January)
Gains (losses) on the obligation 120 290 480
Gains (losses) on the assets (100) (76) (288)
Cumulative gains (losses) before amortisation 20 234 426
Amortisation in the period – – –
Cumulative unrecognised gains (losses) 20 234 426
(31 December)
There would be some recognition of actuarial gains in 2005 as the unrecognised gains and losses in 2004 exceed the 10% corridor as measured at 31 December 2004.
Accounts presentation
The final step is to work out the balance sheet and income statement position for the company.
Income statement
2002 2003 2004
Current service cost 150 160 170
Interest cost 210 180 140
Expected return on plan assets (320) (306) (288)
Income statement charge 40 34 22
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Balance sheet Present value of obligation, 31 December 3,600 3,500 3,200
Fair value of assets, 31 December (3,400) (3,600) (3,600)
Unrecognised actuarial gains (losses) 20 234 426
Liability in balance sheet 220 134 26
Equity recognition approach
The working will still remain the same, but the recognition of actuarial gains and losses changes.
Income statement
2002 2003 2004 Current service cost 150 160 170
Interest cost 210 180 140
Expected return on plan assets (320) (306) (288)
Income statement charge 40 34 22
Balance sheet
Present value of obligation, 31 December 3,600 3,500 3,200
Fair value of assets, 31 December (3,400) (3,600) (3,600)
Liability (Assets) in balance sheet 200 (100) (400)
Statement of movement in equity
Actuarial gains recognised in the period 20 234 426
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C H AP T E R 1 5
Chapter 15: Question 1 – Notes to Assist in Answering
The Government deliberately sets up special provisions to reduce taxes in order to encourage certain conduct. Examples might be allowance for payments in to pension funds or for capital investment. The running of a company’s affairs to take maximum benefit of items such as these is tax planning. When a company alters its behaviour solely for tax purposes, with no commercial reason, with the intention of saving tax by using the tax system in a way not intended by Parliament, this is called tax avoidance. Tax evasion is when a company illegally hides income from the tax authorities. Tax planning is to be encouraged, and it is for an accountant to point out the opportunities to use it. Tax evasion is illegal, and an accountant is under an obligation to prevent it happening. Tax avoidance is legal; an accountant is under an obligation to ensure that steps are not taken which are illegal and that details are reported accurately to the authorities. In all dealings relating to the tax authorities, an accountant must act honestly and do nothing that might mislead the authori-ties, but he must do all that he can to assist his employer within these criteria.
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Chapter 15: Question 2
(a) Accounts Tax Difference (Depreciation) (capital allowances) (timing) 31/3/20X2 Cost 25,000.00 25,000.00 Depn/allce 2,812.50 4,687.50 1,875.00 22,187.50 20,312.50 1,875.00 31/3/20X3 Depn/allce 3,750.00 5,078.13 1,328.13 18,437.50 15,234.38 3,203.13 31/3/20X4 Depn/allce 3,750.00 3,808.59 58.59 14,687.50 11,425.78 3,261.72 31/3/20X5 Depn/allce 3,750.00 2,856.45 (893.55) 10,937.50 8,569.34 2,368.16 31/3/20X6 Depn/allce 3,750.00 2,142.33 (1,607.67) 7,187.50 6,427.00 760.50
Tax Calculated By Deferral Method Deferred tax Deferred charge in year tax provision 31/3/20X2 1,875.00 20% 375.00 375.00 Balance at 31/3/20X2
31/3/20X3 1,328.13 30% 398.44 773.44 Balance at 31/3/20X3
31/3/20X4 58.59 20% 11.72 785.16 Balance at 31/3/20X4
31/3/20X5 (893.55) 19% (169.77) 615.38 Balance at 31/3/20X5
31/3/20X6 (1,607.67) 19% (302.57) 310.12 Balance at 31/3/20X6
Tax Calculated By Liability Method Difference As at As at As at As at As at As at (timing) 31/3/X2 31/3/X3 31/3/X4 31/3/X5 31/3/X6 Tax rate 20% 30% 20% 19% 19%
31/3/X2 1,875.00
31/3/X3 3203.13
31/3/X4 3261.72
31/3/X5 2368.16
31/3/X6 760.50
--------- -------- --------- -------- ----------
375.00 960.94 652.34 449.95 144.69
(b) Under the liability method the focus is on the balance sheet (the objective being to compute the deferred tax liabilities), whereas the deferral method places the focus on the Profit and Loss Account (the objective being to show the annual effect that has arisen in the year of account).
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Chapter 15: Question 3 – Notes to Assist in Answering
The law has been amended to allow the Inland Revenue to accept accounts drawn up in accor-dance with IFRS, so that two different standards will be acceptable for some years. Therefore the legislation will have to provide for different treatment of specific items under UK GAAP and IFRS. The Finance Act 2004 included legislation which ensured that companies that adopted IFRS to draw up their accounts would receive broadly equivalent tax treatment to companies that con-tinue to use UK GAAP. The clear intention of these provisions is to defer the major tax effects of most transitional adjustments until the tax impact becomes clearer. It remains to be seen whether the taxation effects of any significant changes in profit resulting from the change from UK GAAP to IFRS will be deferred until UK GAAP becomes truly aligned with IFRS. The move towards IFRS is leading to a detailed study of accounting theory and principles, so that the accounting treatment may eventually become the benchmark standard for taxation pur-poses, although this will take several years to reach fruition (if it proves to be attainable).
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Chapter 15: Question 4 – Notes to Assist in Answering
For Discounting:
• Most transactions take place at fair value.
• Rational buyers and sellers will ensure that this fair value reflects the time value of money and the risk associated with the future expected cash flows, which means that market prices generally will reflect such factors.
• To be consistent, these factors need also to be reflected in the other measures that can be used to determine the carrying amount of assets (in other words, value in use and net realis-able value) and the carrying amount of any liabilities measured by reference to expected future cash flows.
• It follows that, when basing carrying amounts on future cash flows, those cash flows will need to be discounted.
Against Discounting:
• The reliable determination of deferred tax assets and liabilities on a discounted basis re-quires detailed scheduling of the timing of the reversal of each temporary difference. In many cases such scheduling is impracticable or highly complex.
• Therefore, it is inappropriate to require discounting of deferred tax assets and liabilities.
• To permit, but not to require, discounting would result in deferred tax assets and liabilities which would not be comparable between enterprises.
• Discounting would result in deferred tax assets and liabilities which would not be compara-ble between enterprises unless there was a set methodology using standard prescribed discount rates.
• In some cases where capital expenditure is uneven, an unexpected effect of discounting could be to turn an eventual liability into an initial asset.
• Discounting is not generally used in financial accounting, so its use for deferred taxation would be an exception to general accounting principles.
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C H AP T E R 1 6
Chapter 16: Question 1 – Universal Entrepreneurs plc
(a) The principles outlined in IAS 16 are that:
• A non-current asset is assessed at the year end to ensure that it has not been impaired.
• Fair charge is made to the income statement each year for the benefit of accruing to that ac-counting period for use of the asset concerned.
• In no way does the IAS address the notion of showing on the balance sheet under the head-ing of ‘Non-current assets’ either the value of the assets to the enterprise or the value at which they might be sold.
• It was this factor that caused property investment companies to feel that they were disadvan-taged by the requirements of IAS 16 to depreciate buildings when these formed the major proportion of their asset structure.
They argued strongly that the assets were not USED in the business but were held, like any other investment, for their income-producing value and potential capital growth.
As a result of these representations the IASC developed IAS 40.
(b) (i) Depreciate on the basis of the rate of extraction of growth over the 10 year period in reviewing annually.
(ii) The cost of the building (£4,000,000) should be depreciated over its useful life. It is not an investment property and the period of the lease granted is irrelevant.
(iii) 20% per annum straight-line. (iv) Depreciate on the basis of actual flying hours. (v) Treat as an investment property, revaluing annually but providing depreciation as it
is a base of less than 20 years.
(c) • The revalued amount of the buildings should be depreciated over the remainder of their
useful lives, taking account of the amounts of depreciation already provided. • Unless the value of the land is being consumed in some way (e.g. by mining) this should
not be depreciated over the remaining period of the bases, again having account of the amounts of amortisation already provided.
• When the valuer is instructed in respect of the freehold properties it must be made clear that interests of land need to be distinguished from those in the buildings thereon.
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Chapter 16: Question 2 – Mercury
(a) Identifying the method
The method of depreciation is the diminishing balance method. The following calculations show that the rate applied at 20%. 20X6 charge = 20% of £80,000 = 16,000 20X7 charge = 20% of £64,000 = 12,800 Cumulative provision = 28,800
(b) How the accumulated depreciation in line (B) was calculated
B/d from (a) above:
20X6 20% of £80,000 = 16,000 20X7 20% of £64,000 = 12,800
20X8 Balance b/f £28,800 Less: 1st disposal 20X6:£15,000 x 20% = £3,000 20X7: £12,000 x 20% = £2,400 (£5,400)
Less: 2nd disposal 20X6: £30,000 x 20% = £6,000
20X7: £24,000 x 20% = £4,800 (£10,800) (16,200) 12,600
20% of (£80,000 – £45,000 disposed of) – £12,600 for accumulated depreciation 4,480 20% of £50,000 replacement for 2nd disposal = 10,000 Depreciation on other asset 1,000 Total given in question 28,080
(c) How the figures for 20X9 are calculated
20X9 Property, plant and equipment Acquired Acquired Acquired Total 20X6 20X7 20X8 20X9 (balancing figure)
£ £ £ £ Cost 35,000 50,000 5,000 90,000 Depreciation to date 17,080 10,000 1,000 28,080 17,920 40,000 4,000 61,920 Charge for 20X9 3,584 8,000 800 12,384 14,336 32,000 3,200 49,536
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(d) Calculation of profit/(loss) on disposal
Plant disposal I £
Cost 15,000 Less: Depreciation (5,400)
Cash (8,000) Loss 1,600
Plant disposal II
Cost 30,000 Less: Depreciation (10,800)
Cash (21,000) Profit 1,800
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Chapter 16: Question 3 – Amy
(a) The figures should be the total cost of making the non-current asset usable, excluding all costs of actually using it. Therefore,
11,000 + 100 + 200 + 400 = £11,700
The additional component is cost of machine as it enhances the revenue-earning capacity of the asset.
The replacement parts are cost of using machine – hence the difference in treatment be-tween the two. Maintenance is obviously a cost of usage.
(b) Depreciation spreads the cost (or value) of an item over its useful life, in appropriate pro-portion to the benefit (usefulness).
It is necessary in accordance with the matching convention – allocating expense against corresponding benefit, as part of the profit calculation.
(c) The straight-line method charges a constant percentage of the cost (or value) each year.
The diminishing balance method charges a constant percentage of the net book value (cost less accumulated depreciation brought forward).
Thus the straight-line method has a constant charge but the diminishing balance method has a charge reducing each year of the asset life.
The two methods therefore make different assumptions about the usefulness, the trend or pattern of benefit, of the fixed asset concerned.
(d) Objectivity implies lack of bias. It removes the need for, and the possibility of, subjectivity, of personal opinion. For an accounting figure to be objective, it must be expected that all accountants would arrive at the same figure.
Clearly the figure stated on an invoice has a high degree of objectivity. However, the cal-culation of depreciation is based on estimates of future life and future usefulness and is therefore highly subjective.
(e) This practice can claim the advantage of greater prudence, as the expense is always the higher of the two possibilities. However, it seems to lack consistency. Perhaps more impor-tantly, it obviously fails to attempt to follow the matching convention. It makes no attempt to make the trend of expenses consistent with the trend of benefit or usefulness.
If the profit figure, or profit trend, is regarded as important, then it seems an unsatisfactory practice.
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Chapter 16: Question 4 – Small Machine Parts Ltd
(a) Year 1 Year 2 Year 3 Year 4 Year 5 £ £ £ £ £
Opening balance 20,000.00 17,085.57 13,733.98 9,879.65 5,447.17 Interest at 15% 3,000.00 2,562.84 2,060.10 1,481.95 817.08
23,000.00 19,648.41 15,794.08 11,361.60 6,264.25 Depreciation 5,914.43 5,914.43 5,914.43 5,914.43 5,914.43
17,085.57 13,733.98 9,879.65 5,447.17 349.82
The income from secondary assets is calculated at 15% of the depreciation charge less the no-tional interest.
Year 1 Year 2 Year 3 Year 4 Year 5 £ £ £ £ £
Depreciation 5,914.43 5,914.43 5,914.43 5,914.43 5,914.43 Interest 3,000.00 2,562.84 2,060.10 1,481.95 817.08
2,914.43 3,351.59 3,854.33 4,432.48 5,097.35 15% 437.16 502.74 578.15 664.87 764.60
437.16 437.16 437.16 437.16 502.74 502.74 502.74 578.15 578.14 664.87 437.16 939.90 1,518.05 2,182.92
Income statement entries Cash flow
Year 1 Year 2 Year 3 Year 4 Year 5 £ £ £ £ £
Operating CF 25,000.00 25,000.00 25,000.00 25,000.00 25,000.00 Depreciation 5,914.43 5,914.43 5,914.43 5,914.43 5,914.43 Operating profit 19,085.57 19,085.57 19,085.57 19,085.57 19,085.57 Income from secondary assets 437.16 939.90 1,518.05 2,182.92
19,085.57 19,522.73 20,025.47 20,603.62 21,268.49 Interest 3,000.00 2,562.84 2,060.10 1,481.85 817.08 Net profit 22,085.57 22,085.57 22,085.57 22,085.57 22,085.57
(b) The annuity method is recommended because it attempts to show the effect of the loss of interest suffered as a result of investing the funds in non-current assets within the organisation. It does this by charging notional interest in addition to the depreciation charge with a reduction for the estimated secondary income on the difference between the depreciation charge and the notional interest. The method suggested of charging the annual average cost is frequently met in practice but is less accurate in that it fails to take account of the opportunity cost of the interest foregone.
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Chapter 16: Question 5 – Calculation of Depreciation
(a)
Year 1
Straight-line (SF800,000 – SF104,000)/4 = SF174,000
Reducing balance 40% of SF696,000 = SF278,400
(b) Comment to include:
• Directors responsible under IAS 16 for selecting an appropriate method.
• Little guidance given as to how to exercise the choice but the following matters may be relevant:
risk of technological change
incidence of repairs
extent to which the asset characteristics favour a particular method, e.g. a lease would be amortised evenly over its life.
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Chapter 16: Question 6 – AB
(a) IAS 36 (i) Indicators (assuming significant in all cases)
• Market value lower than book value
• Lower expected cash flows affecting the value in use
• Rates of return have increased adversely affecting the recoverable amount
• Adverse change in the environment e.g. technological, economic or legal or in physical state of asset e.g. obsolescence or damage
• Adverse change in the use to which asset is put e.g. reorganisation programme
• Evidence that the economic performance of the asset will be worse than expected
• The asset has suffered considerable physical change, or obsolescence or physical damage
• Cost of construction over-run making asset less profitable (ii) Recognition and measurement
IAS 36 Impairment of Assets says that if indicated under the above, then undertake a review to establish the extent of any impairment.
Criteria in HCA model
• An asset should not be valued at an amount greater than its cost or recoverable amount
• The recoverable amount being the higher of net selling price and value in use (net present value of future cash flows).
Criteria in Revaluation model
• Compare the carrying value of the asset with its net selling price or value in use.
• If the net selling price OR value in use exceeds the carrying value, no write-down is necessary
• If the recoverable amount is lower than the carrying value, the asset is impaired and the carrying amount of the asset should be reduced to its recoverable amount.
Recognition
• Any recognition is an impairment loss to be recognised as an expense immediately in the income statement.
What if it is not possible to estimate the recoverable value of an individual asset?
This can occur if the asset does not generate independent cash flows and in such a case, the re-coverable amount of the asset’s cash generating unit should be calculated together with value in use on the same basis.
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An impairment loss is only recognised where its recoverable amount is less than the carrying amounts of the items in that unit.
Allocation of impaired amount where the HCA model is being followed
Any specific impairment of assets should be dealt with initially then allocate first to goodwill, then to intangible assets which have no active market, then to assets whose Net Selling Price is less than their carrying value and finally to other assets on a pro rata basis.
Allocation of impaired amount where the Replacement model is being followed
An impairment loss relating to a revalued asset is treated as a revaluation decrease and therefore charged to revaluation account. Where the impairment loss is greater than the carrying amount of the asset, a liability should only be recognised where it is required by other International Standards. After recognition of an impairment loss, the depreciation charge should be adjusted to allocate the revised carrying amount (less residual value) systematically over its remaining life. An enterprise should review the balance sheet to assess whether a recognised impairment loss still exists or has decreased. Any reversal of an impairment loss should be recognised in the income statement.
(b) AB (i) Impairment of machinery
Indicators are the inventory losses and the taxi business problems.
Procedure: Compare the carrying value ($290,000) with its recoverable amount which has to be calcu-lated. The calculation is to determine the higher of an asset’s net selling price ($120,000) and its value in use. The value in use is $100,000 discounted at 10% for three years, i.e. $248,600 approx.
Thus the recoverable amount would be deemed to be $248,600. AB would therefore write down the asset from $290,000 (carrying value) to $248,600 (its value in use) and recognise the loss of $41,400 in the income statement.
(ii) Impairment of the car taxi business treated as a CGI
Impairment losses should be recognised if the recoverable amount of the cash generating unit is less than the carrying value of the items of that unit.
At 1 February 20X1
1.1.X1 Impairment 1.2.X1 loss $000 $000 $000 Goodwill 40 (15) 25 Intangible assets 30 30 Vehicles 120 (30) 90 Sundry net assets 40 40 230 (45) 185
An impairment loss of $30,000 is recognised first for the specific asset (i.e. the stolen vehi-cles) and the balance ($15,000) is attributed to goodwill.
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At 1 March 20X1 1.2.X1 Impairment 1.3.X1 $000 $000 $000 Goodwill 25 (25) Intangible assets 30 (5) 25 Vehicles 90 90 Sundry net assets 40 40 185 (30) 155
Note the tricky point – that is that the net selling price of the sundry net assets has not fallen. It is therefore not permissible to reduce the sundry net assets.
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C H AP T E R 1 7
Chapter 17: Question 1 – Grabbit plc
(a) PV of future lease payments = £350,000 (cost of asset) The interest rate to apply to the six payments of £92,500 to equate to a PV of £350,000 is 15%. This is calculated as follows:
80,435 + 69,943 + 60,820 + 52,887 + 45,989 + 39,990 = 350,064
Balance sheet
Assets £
Cost of leased asset 350,000
Depreciation for year 43,750
306,250
Liabilities
PV of future lease payments
80,435 + 69,943 + 60,820 + 52,887 + 45,989 = 310,074, say 310,000
Income statement Interest on leasing obligation
(£350,000 × 15%) 52,500
Depreciation on leased asset 43,750
Liability at year end 96,250
(NB 350,000 Cost
52,500 Interest
402,500
(92,500) Payment
310,000 Bal. c/f)
(b) The obligations under a long-term lease are in substance no different from those under a loan but prior to the introduction of the leasing standard they did not appear on the balance sheet. This made the balance sheet unreliable as one could not be confident that there were not undisclosed liabilities such as leases. Further, where a business had essentially the con-trol of an asset for a substantial period of time they had most if not all of the benefits and risks associated with ownership. It was considered a deficiency that these asset rights were not reflected in the balance sheets, even if they were different in nature to outright owner-ship. Therefore the leasing standard attempted to capture the assets and liabilities which occurred when longer-term ownership like contracts were entered into.
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(c) The advantage would be that the obligation would no longer involve the lessee in a long-term commitment although they would probably have long-term access. This would take the relationship out of the financial lease category and put it in as an operating lease. As a con-sequence, under existing standards it would not have to be capitalised but rather would be disclosed under operating leases. The ratios would be better but only if influential investors did not adjust their figures for the long-term obligations that would probably arise.
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Chapter 17: Question 2
(a)
• The ‘title’ to the goods acquired on a hire purchase agreement or lease finance remains le-gally vested in the lessor.
• Yet in commercial substance, at the point of getting custody of the asset the lessee acquires substantially all the risks and rewards of owning the asset.
• Hence accountants have preferred to overlook the legal form and focus more on the com-mercial substance. For example, they have accounted for assets acquired on HP terms or on finance lease terms as if the title passes to the lessee at the date of transfer of the custody of the asset.
• IAS 17, while endorsing the accounting practice, changes the conceptual basis for this ac-counting practice. It emphasises that what the lessor capitalises, at the point of acquiring custody of the leased assets, is not the asset itself (which admittedly he does not own yet), but his own right to use that asset.
The amount at which he capitalises this right is the present value of the minimum lease pay-ments he commits himself to.
(b) In accordance with IAS 17:
• A finance lease is a lease that transfers to the lessee substantially all the risks and rewards of owning an asset.
• All other leases are operating leases.
• The Standard sets out a presumption that a lease transfers substantially all the risks and re-wards of ownership to the lessee IF ‘at the inception of a lease the risks and rewards of ownership are transferred to the lessee’ and if ‘at the inception of a lease the present value of the minimum lease payments, including any initial payment, amounts substantially to all of the fair value of the leased asset’.
Other criteria such as transference of legal title and the right to use the asset for all its life are also considered.
(c) (1) Smarty plc
Machine acquired under a finance lease
1.8.X7 Obligation 15,000
Provision for depreciation on machine
31.3.X8 Depreciation 2,000
31.3.X9 Depreciation 3,000
31.3.X0 Depreciation 3,000
31.3.X1 Depreciation 3,000
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Finance charges account
31.3.X8 Obligation under 31.3.X8 Income statement 1,200
fin. lease 1,200
31.3.X9 Obligation under 31.3.X9 Income statement 1,229
fin. lease 1,229
31.3.Y0 Obligation under 31.3.Y0 Income statement 543
fin. lease 543
31.3.Y1 Obligation under 31.3.Y1 Income statement 28
fin. lease 28
Obligation under finance lease on machinery account
Cash 4,000 1.8.X7 Machinery a/c 15,000
31.3.X8 Balance c/d 12,200 31.3.X8 Finance charges a/c 1,200
16,200 16,200
Cash 6,000 1.4.X8 Balance b/d 12,200
31.3.X9 Balance c/d 7,429 31.3.X9 Finance charges a/c 1,229
13,429 13,429
Cash 6,000 1.4.X9 Balance b/d 7,429
31.3.Y0 Balance c/d 1,972 31.3.Y0 Finance charges a/c 543
7,972 7,972
Cash 2,000 1.4.Y1 Balance b/d 1,972
31.3.Y1 Finance charges a/c 28
2,000 2,000
(2) Income statement entries for y/e 31 March 20X8 extracts:
£ £
Finance charge 1,200
Depreciation 2,000
Balance sheet as at 31 March 20X8 extracts:
Non-current asset 15,000
Depreciation (2,000) 13,000
Liability 12,200
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Chapter 17: Question 3 – The Mission Company Ltd
(a) Income statement
20X6 20X7
£ £
Item Y 20,000 20,000
Item Z 30,000 30,000
As an operating lease each annual payment is simply rent.
(b)
Workings (Item Y) £
Total lease price: 10 × £20,000 = 200,000
Purchase price = 160,000
Finance charge = 40,000
Period of lease: 10 years
Sum of the digits = 10 + 9 + 8 + 7 + 6 + 5 + 4 + 3 + 2 + 1 = 55
Therefore Charge to 20X6 = 4/55 × £40,000
Charge to 20X7 = 3/55 × £40,000
Finance charge to income statement 20X6 20X7
£ £
Item Y 2,909 2,182
Working (Item Z)
Total lease price: 10 × £30,000 = £300,000
Purchase price = £234,000
£ 66,000
Sum of the digits = 55
Therefore Charge to 20X6 = 6/55 × £66,000
Charge to 20X7 = 5/55 × £66,000
Finance charge to income statement
20X6 20X7
£ £
Item Z 7,200 6,000
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Depreciation charge to income statement
20X6 20X7
Item Y 16,000 16,000
Item Z 19,500 19,500
(c) Balance sheet 20X7
Non-current assets Cost Accumulated Dep’n NBV
£ £ £
Item Y 160,000 128,000 32,000
Item Z 234,000 117,000 117,000
Current liabilities £
Item Y 2[20,000 40,000]
55− × 18,545
Item Z 25,200
Non-current liabilities £
Item Y 19,273
Item Z 82,800
Note: Minimum lease commitments at 31 December 20X7 in relation to finance leases were:
Item Y Item Z
£ £
20X8 20,000 30,000
20X9 20,000 30,000
20Y0 30,000
20Y1 30,000
40,000 120,000
Less: Finance charge allocated to future periods 2,182 12,000
37,818 108,000
Workings: to liabilities Item Y
Year B/forward Cost Repayment Interest C/forward
£ £ £ £ £
20X0 160,000 20,000 7,273 147,273
20X1 147,273 20,000 6,545 133,818
20X2 133,818 20,000 5,818 119,636
20X3 119,636 20,000 5,091 104,727
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20X4 104,727 20,000 4,364 89,091
20X5 89,091 20,000 3,636 72,727
20X6 72,727 20,000 2,909 55,636
20X7 55,636 20,000 2,182 37,818
20X8 37,818 20,000 1,455 19,273
20X9 19,273 20,000 727 -
£40,000
Therefore current liability = 20,000 – 1,455 = £18,545
non-current liability = 37,818 – 18,545 = £19,273
Item Z Year B/forward Cost Repayment Interest C/forward
20X2 234,000 30,000 12,000 216,000
20X3 216,000 30,000 10,800 196,800
20X4 196,800 30,000 9,600 176,400
20X5 176,400 30,000 8,400 154,800
20X6 154,800 30,000 7,200 132,000
20X7 132,000 30,000 6,000 108,000
20X8 108,000 30,000 4,800 82,800
20X9 82,800 30,000 3,600 56,400
20Y0 56,400 30,000 2,400 28,800
20Y1 28,800 30,000 1,200 –
£66,000
Therefore current liability = 30,000 – 4,800 = £25,200
non-current liability = 108,000 – 25,200 = £82,800
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Chapter 17: Question 4 – X Ltd
(a) Workings to provide figures for income statement and balance sheet entries
Period Liability Rental Liability Finance Liability
at start payment during charge at end
of period period (4.3535%) of period
1.1.X4 100,000 12,000 88,000 3,831 91,831
1.7.X4 91,831 12,000 79,831 3,475 83,306
1.1.X5 83,306 12,000 71,306 3,104 74,410
1.7.X5 74,410 12,000 62,410 2,717 65,127
1.1.X6 65,127 12,000 53,127 2,313 55,440
1.7.X6 55,440 12,000 43,440 1,891 45,331
1.1.X7 45,331 12,000 33,331 1,451 34,782
1.7.X7 34,782 12,000 22,782 992 23,774
1.1.X8 23,774 12,000 11,774 513 12,287
1.7.X8 12,287 12,000 287 12 299
120,000
Depreciation is over useful economic life, using the historical cost of the leased asset
100,0008
= £12,500 per year
Income statement
Finance Depreciation Total
Charge
20X4 (3,831 + 3,475) 7,306 12,500 19,806
20X5 5,821 12,500 18,321
20X6 4,204 12,500 16,704
20X7 (1,451 + 992) 2,443 12,500 14,943
The balance sheet is as follows: Assets
20X4 20X5 20X6 20X7
Equipment
under finance
lease 100,000 100,000 100,000 100,000
Depreciation 12,500 25,000 32,500 50,000
87,500 75,000 62,500 50,000
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Liabilities Within 2–5 years 65,127 45,331 23,774 299 Within 1 year *18,179 19,796 21,557 23,475
83,306 65,127 45,331 23,774
* The £18,179 = £24,000 – interest (£3,104 + £2,717)
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Chapter 17: Question 5 – Bridge Finance plc
Workings for the lease receivable account
$
1 Jan × 5 Cost 37,200
Direct expense 708
31 Dec × 5 Balance 37,908
10% interest 3,791
Cash –10,000
1 Jan × 6 Balance 31,699
31 Dec × 6 Interest 3,170
Cash –10,000
1 Jan × 7 Balance 24,869
31 Dec × 7 Interest 2,487
Cash –10,000
Balance 17,356
As this is a finance lease the accounts in the lessor’s books would be;
Income Statement
Interest revenue $2,487
Balance sheet
Asset
Lease receivable $17,356 Current 8,265
Non-current 9,091
This can be reconciled as follows:
Gross cashflows receivable $20,000
Less interest 2,644
Net amount 17,356
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C H AP T E R 1 8
Chapter 18: Question 1 – Environmental Engineering plc
(i) Referring to IAS 38 criteria in (ii) below, only (c) might qualify for de-ferral as development expenditure.
(a) is applied research.
(b) is development cost (£1.2m) that has not yet been incorporated into a specific, separate viable project. However, the line between categories is often indistinct in practice, e.g. between development and production costs.
Looked at in general, all three relate to a specific project to which it appears expenditure can be separately allocated. However, the outcome is not reasonably certain as to either technical feasi-bility or commercial viability. We have no idea or projections of sales volume or price/revenue in total and whether it will exceed costs. It is assumed that a plc would have the necessary re-sources to complete the project but there is no evidence of this. Item (c) would not stand out from (a) and (b) and it is recommended that all be written off as expenses. It could be capitalised later when evidence is produced as to criteria for proceeds.
(ii) IAS 38 criteria (para. 45):
(a) Technical feasibility
(b) Intention to complete and use or sell
(c) Ability to use or sell
(d) Asset will generate possible future income – demonstrate existence
(e) of a market, availability of technical, financial and other resources to complete the de-velopment or to use or sell.
(iii)
• Amortisation should begin with the commencement of production.
• Any write-off should be over the period the product is expected to be sold.
This implies that the amortisation costs can be included in stocks being produced for sale.
• Deferred development expenditure should be reviewed at the end of each accounting period and,
to the extent that it is not considered recoverable, it should be written off.
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Chapter 18: Question 2 – Italin NV
IAS 38: Pure and applied research, always written off in period incurred; development expendi-ture may be carried forward in certain circumstances.
Income Statement for the year ended 30 September (extract)
20X1 20X2 20X3 20X4 20X5 20X6 20X7 Research expenditure 200
Development cost – 50 50 50 50 50 50
Depreciation 300 300 300 300 300 300 300
Balance Sheet as at 30 September (extract)
20X1 20X2 20X3 20X4 20X5 20X6 20X7 Intangible fixed assets 300 250 200 150 100 50 –
Tangible fixed assets 2,200 1,900 1,600 1,300 1,000 700 –
Projects must be reviewed each year.
Treatment of fixed assets used in R&D as for any assets.
Disclosure
• Accounting policy
• Consistency and application of IAS 38
amounts written off in the period
pure and applied research is written off
development expenditure is capitalised and written off over six years
• Movement on development costs capitalised
• Fixed assets used are depreciated in the normal way over their useful life of 7 years.
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Chapter 18: Question 3 – Oxlag plc
(i)
Research and Development Costs Account
£000 £000 Capital costs b/f at Capitalised costs c/f
start of year (project C) 200 Project C 500
Costs incurred in year:
Project A 25 Costs written off to
Project C 265 Profit & loss account:
Project D 78 Project A 35
Project D 98 133
Depreciation:
Laboratory:
Project C 20
Equipment:
Project A 10
Project C 15
Project D 20
633 633
Capitalised costs b/f Project C 500
(consists of 200 b/f + 265 costs incurred + 20 laboratory depreciation and 15 equipment depre-ciation)
Fixed Assets: Specialized Laboratory Account
£000 £000 Cost b/f at start of year 500 Depreciation b/f at start of
year 25
Depreciation c/f at end of year 45 Depreciation charge for year20
Cost c/f at end of year 500
545 545
Cost b/f at start of year 500 Depreciation b/f at start of year 45
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Fixed Assets: Specialized Equipment Cost
£000 £000
Cost b/f at start of year: Depreciation b/f at start of year
Project C 75 Project C 15
Project D 50 Project D 10
Additions: Depreciation provided in year:
Project A 50 Project A 10
Project D 50 Project C 15
Project D 20
Depreciation c/f at end of year 70 Cost c/f at end of year 225
295 295
Cost b/f at start of year 225 Depreciation b/f at start of year 70
Market Research Costs Account
£000 £000
Costs b/f at start of year 250 Costs c/f at end of year 325
Costs in year 75
325 325
Costs b/f at start of year 325
Assumption is that this is a contract that will continue in future years.
(ii) Amount to be charged as research costs charged in the income statement for the year ended 31 January 20X2
Fees Fees
Per T a/c Project A: Costs 25
Dep’n 10 35
Project D: Costs 78
Dep’n 20 98
133
(iii) Basis of amortisation:
• Any reasonably systematic basis of amortisation per IAS 38.
• Amount spent and written off reconciled with opening and closing balances in the bal-ance sheets.
• Most likely basis here will be expected sales of the new drug with amortisation being calculated as the proportion of total sales sold during each year.
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Disclosure
• Accounting policy stating basis of capitalisation and basis of write-off
(iv) Balance sheet amounts
Fixed assets £000 Intangible assets:
Deferred development expenditure
(recovery assured by projected future sales) 500
Tangible assets:
Land and buildings: Specialised laboratory 455
Plant and machinery: Specialised laboratory equipment 155
Current assets Inventories:
Long-term work-in-progress 325
(v) Disclosures about new improved drug sales
Identify as non-adjusting post balance sheet event which requires disclosure if material in ac-cordance with IAS 10, having arisen between the end of year 31.1.20X2 and the date of signing the accounts on 14.7.20X2. This does appear to nbe material, therefore the accounts will need to disclose:
• date of new drug going on sale
• success of new drug
• expectation that the sales of the new drug will significantly increase following year’s profits.
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Chapter 18: Question 4 – Goodwill and Intangible Assets
(a) IFRS 3 defines goodwill as ‘any excess of the cost of the acquisition over the acquirer’s interest in the fair value of the identifiable assets, liabilities and contingent liabilities ac-quired at the date of the exchange transaction’ (i.e. the date the assets were acquired).
The cost of the acquisition is the cash or cash equivalent paid or the fair value, at the date of exchange, of the other purchase consideration given in exchange for control over the net assets of the other enterprise plus any costs directly attributable to the acquisition.
Fair value is defined as the amount for which an asset could be exchanged or a liability set-tled between knowledgeable, willing parties in an arm’s length transaction.
The fair value of the assets or liabilities at the date of purchase can include a provision for reorganisation costs, provided a plan has been developed within three months of the date of acquisition. The costs included in the provision can only include costs relating to the ac-quired business for employee redundancy, closing facilities, eliminating product lines and terminating onerous contracts.
(b) IFRS 3 requires an impairment test to be carried out. Unless goodwill is impaired continue to carry at cost.
(a) Total net assets per balance sheet 58,234
(i) No adjustment as no readily ascertainable
market and no information to verify
directors’ estimate (but see (vi) below)
(ii) Valuation 23,000
Other tangible fixed assets 18,000
Total fair value 41,000
Value in balance sheet 38,300
Revaluation 2,700
(iii) Inventories at net realisable value 20,000
(less than replacement cost)
21,600
Loss (1,600)
(iv) Bank loan
Loan at 31.5.09: 12,100×1.13 16,105
Discounted to 31.5.06 at 7% 13,146
Value in balance sheet 12,100
Increase in liability (1,046)
(v) No adjustment required
(as the reorganisation was decided before
acquisition and future losses cannot be
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included in the provision)
(vi) Impairment of brand names (6,020)
Fair value of Yukon at acquisition 52,268
Goodwill:
Cost of acquisition 2.5 × 2.25 × 10,000 × 80% 45,000
Fair value of net assets acquired 80% × 52,268 41,814
Goodwill 3,186
Valuation of goodwill 1,000
Impairment 2,186
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Chapter 18: Question 5 – The Brands Debate
Many of the arguments for including brands in the balance sheet are given in Section 18.12 of Chapter 18. Including brands in the balance sheet increases shareholders’ funds and thus re-duces gearing. A reduction in gearing reduces investors’ and banks’ perception of the risk of the company and it is likely to increase the company’s ability to borrow funds. Also, including brands in the balance sheet shows investors and management the value of the company’s brands, thus providing more information to those users of accounts and enabling them to make more rational decisions.
A brand which has been purchased by a company can be included in the balance sheet. Under IAS 38 Intangible Assets, the brand is included at cost and amortised over its useful life. The ‘allowed alternative treatment’ enables the brand to be revalued and reductions in the brand’s valuation below its original cost are charged to the income statement.
IAS 38 says that internally generated goodwill should not be recognised as an asset (para. 36). However, the cost of developing a brand could be taken as development expenditure and this cost subsequently capitalised in the balance sheet and amortised in the income statement. So, it is possible to capitalise internally generated brands. However, the cost of developing a success-ful brand is likely to be considerably less than its market value (if the brand was purchased, it would be shown in the balance sheet at its market value).
So, the treatment of purchased and internally generated brands is different, and in most situa-tions internally generated brands will not be included in the balance sheet (whereas purchased brands would be included).
It would be possible to include an internally generated brand in the balance sheet at its current market value, provided it was initially included as development expenditure and the ‘allowed alternative treatment’ (of IAS 38) of including the brand at its fair value was included for the balance sheet valuation. However, IAS 38 does require the fair value to be determined by refer-ence to an active market.
On the subject of separability of brands, when a business is acquired, it is likely to be difficult to distinguish between brands and other goodwill. The total amount of goodwill, being the differ-ence between the purchase consideration and the fair value of assets acquired, can be determined. However, dividing this total goodwill between brands and other goodwill will be difficult and is likely to be subjective. Also, in acquiring a company, a number of brand names may be acquired, and it is likely to be very difficult (and subjective) to say how much each of the brands is worth.
On purchased vs home-grown brands, the different accounting treatment has been discussed above. In most situations, purchased brands will be included as an asset in the balance sheet, whereas home-grown brands will not. As both purchased and home-grown brands have value, this different accounting treatment is not consistent. However, this different accounting treat-ment arises because accountants are prepared to include an item in assets when its purchase price is known (as with purchased brands) but are reluctant to include it as an asset when it has been internally generated (and its market value is not certain). For investors, ideally they would like the value of both purchased and home-grown brands to be included in the balance sheet, but this creates the risk that directors may artificially inflate the value of home-grown brands and thus mislead investors.
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As with land and buildings, some companies argue that brands have an infinite life. Current ex-penditure on advertising and marketing the product (e.g. a Mars Bar) maintain the value of the brand, so no amortisation of the brand’s value is justified. IAS 38 says that intangible assets should be amortised over their life, which should not normally exceed 20 years. One can see that some brands have a life of significantly less than 20 years. For instance, a 1 GHz micro-processor has a life of, at most, only a few years as it is superseded by faster processors. Although the brand of ‘Intel’ may have a relatively long life, the company must continue to de-velop its products (i.e. make the microprocessors faster) in order to keep its brand alive.
However, other brands, like the Mars Bar, have a life of significantly more than 20 years – the Mars Bar existed more than 60 years ago. For most brand names, a life of 20 years is a realistic maximum (many brands have a life of less than 20 years), but some brands may have a signifi-cantly longer life. However, although a brand may have had a life of more than 20 years, there is no certainty that it will continue to exist for another 20 years. Many computer companies which were successful 20 years ago no longer exist (e.g. Commodore, Sinclair). How many of today’s well-known brands will no longer exist in 10 or 20 years’ time?
All buildings eventually fall down or are demolished, and all brands will eventually die. So, we would argue that the cost of brands should be amortised in the income statement. It is wrong not to amortise the cost of brands, as eventually they will be worthless.
There is a further argument that even if the brand continues to be reported in the balance sheet at the existing value, the reality is that expenditure has been currently incurred which effectively replaces the original brand value. This means that there has been a substitution of a new brand for the old rather than a maintenance of the old brand.
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C H AP T E R 1 9
Chapter 19: Question 1 – Sunhats Ltd
1. The principle usually followed is to include in the stock valuation only those expenses which relate to the bringing of the product to its present condition and location. In practice, this often entails:
• including factory (or production) expenses
• excluding selling, finance and administration expenses.
2. Sunhats Ltd factory expenses to be included in inventory valuation: Wages of storemen and foremen Salary of production manager Rent and rates, repairs and depreciation; proportion relating to factory and stores would be included e.g. electric power.
3. Expenses to be excluded from inventory valuation:
• Salaries of sales manager and salespeople, advertising and carriage outwards. These ex-penses are excluded as they relate to selling and distributing the goods, not to the production of them.
• Bad debts and bank interest*: these finance charges are excluded as they relate to the business as a whole and not merely to production.
• Salaries of personnel officer*, buyer*, accountant* and company secretary*, and direc-tors’ fees*: these administration expenses are excluded, as they similarly relate to the business as a whole.
• Development expenditure: this is excluded as it is clearly not relevant to the cost of ex-isting stock.
*The items marked with an asterisk are marginal. It can be argued that part of these ex-penses relate to production and should therefore be regarded as factory overheads.
4. It is important to ensure that the overhead expenses included in the inventory valuation are:
• appropriate in the circumstances of the business, and
• included on a consistent basis from year to year.
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Chapter 19: Question 2 – Inventory Valuation Methods
(i) Receipts Issues Balance Date Quantity Rate £ Quantity Rate £ Quantity Rate £
FIFO 1/7 100 10 1,000 100 10 1,000 10/7 80 10 800 20 10 200 12/7 100 9.8 980 100 9.8 980 14/7 20 10 200 20 9.8 196 80 9.8 784 15/7 50 9.6 480 50 9.6 480 20/7 100 9.4 940 100 9.4 940 30/7 20 9.8 196 80 9.4 752 50 9.6 480 20 9.4 188 Cost of goods sold 2,648
LIFO 1/7 100 10 1,000 100 10 1,000
10/7 80 10 800 20 10 200
12/7 100 9.8 980 100 9.8 980
14/7 100 9.8 980 20 10 200
15/7 50 9.6 480 50 9.8 480
20/7 100 9.4 940 100 9.4 940
30/7 90 9.4 846 20 10 200
50 9.6 480
10 9.4 94
Cost of goods sold 2,626
Weighted average 1/7 100 10 1,000 100 10 1,000
10/7 80 10 800 20 10 200
12/7 100 9.8 980 100 9.8 980
14/7 100 9.83 983 120 9.83 1,180
20 9.83 196.7
15/7 50 9.6 480 50 9.6 480
20/7 100 9.4 940 100 9.4 940
30/7 90 9.5 855 170 9.5 1,615
80 9.5 760
Cost of goods sold 2,638
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(ii) Advantages and disadvantages
FIFO
• The movement of some stock follows this pattern in reality e.g. perishables.
• However, the charge to cost of sales will still represent out-of-date prices.
• This means that a distribution policy based on profits calculated using this method will re-duce the operating capital base.
• The balance sheet value will value stock at approaching current values.
LIFO
• The movement of stock does not follow this pattern and detailed records will be required to track costs.
• The charge to cost of sales will represent prices prevalent at date of sale.
• This means that a distribution policy based on profits calculated using this method will tend to maintain the operating capital base.
• However, the balance sheet value will value stock at out-of-date values.
Average cost
• This is a common compromise between the two methods.
• The advantage is that the average represents a compromise between the FIFO and LIFO methods.
• However, there is a disadvantage in that the average cost has to be recalculated after each purchase.
(iii) Effect of a physical shortage of inventory
FIFO Closing inventory
75 @ 9.4 705
Cost of sales increased by
5 @ 9.4 47
LIFO Closing inventory
15 @ 10.0 150
50 @ 9.6 480
10 @ 9.4 9.4
724
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Cost of sales increased by
5 @ 10 50
Weighted average Closing inventory
75 @ 9.5 712.5
Cost of sales increased by
5 @ 9.5 47.5
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Chapter 19: Question 3 – Alpha Ltd
Principles
The basis on which the stocks are valued in this solution is the one which is most commonly used by companies, i.e. the lower of cost and net realisable value. The term ‘cost’ includes those overheads which have been incurred in bringing the stocks to their existing condition, namely manufacturing overheads. Selling and distribution expenses have been excluded from cost as it is assumed that these are not incurred until the units are sold.
Valuation details
Raw materials: 100 tons ×××× cost £140 per ton = £14,000
The net realisable value is assumed to be greater than this amount as the finished units (which incorporate the steel) sell at a profit, as follows
£ Selling price 500
Less: Selling and distribution expenses 60
Net realisable value 440
Manufacturing costs (see workings below) 350
Profit per unit 90
The current replacement price has not been taken, as it is not within the basis of valuation stated above. However, as the replacement price has fallen this is a suitable time to con-sider whether the client should be advised to amend the basis of stock valuation to ‘the lower of cost, replacement price and net realisable value’, which is more conservative. On this basis the stock would be valued at £130 per ton.
Finished units: 100 ×××× cost £350 = £35,000
The cost comprises: Per unit £
Materials 50
Labour 150
Manufacturing overheads – 100% of labour 150
£350
Net realisable value is greater than the cost:
Selling price 500
Less: Selling and distribution expenses 60
Net realisable value £440
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Damaged, finished units: 10 ×××× £240 = £2,400
These units have been valued at cost less the amount of the loss that will be incurred when the units have been rectified, as follows:
Per unit Valuation £ £
Cost of finished units 350 350
Cost to rectify 200
Total cost 550
Less: Net realisable value 440
Loss £110 110
Amount per unit included in the balance sheet £240
Semi-finished units: 40 ×××× cost £250 = £10,000
The cost comprises: Per unit £
Materials 50
Labour 100
Manufacturing overheads – 100% of labour 100
Total cost per unit so far £250
An estimate should be made of the cost required to finish the work. If the total estimated cost exceeds the net realisable value, then the excess must be provided for by deducting it from the £250 cost; this is similar in principle to the treatment of the damaged units. For example:
Per unit
£
Total cost per unit so far (as above) 250
Estimated costs to complete 220
Estimated total costs to completion 470
Less: Net realisable value 440
Estimated loss on completion 30
Valuation:
Total cost per unit so far 250
Less: Estimated loss on completion 30
220
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Chapter 19: Question 4 – Beta Ltd
1. As the raw materials will realise more than cost, they have obviously been valued at the standard cost, namely £30,000.
2. A review of the price variance account shows that, in total, the actual cost of materials has consistently been well above the standard costs.
3. Consequently, the £30,000 standard cost of raw materials in stock is significantly below the actual cost; and, unless the stock figure is adjusted to the actual cost, this year’s profit will be understated. (Moreover, the understatement of stocks this year will result in next year’s profits being artificially inflated.)
4. Therefore, the figure to be included in the balance sheet should not be the standard cost but a figure which is reasonably close to actual cost. This could be done in one of the following ways:
(a) Value each item at the actual cost paid for it, by referring to the purchase invoices con-cerned. However, this may be too laborious, in which case method (b) or (c) should be considered.
(b) If the company has revised the standard costs for use in the following year, then it may be suitable to use these revised costs for valuing the stocks in the balance sheet. (Presumably the revised standards are based on the cost applicable around the year-end.)
(c) If methods (a) and (b) are impracticable, a rough and ready method may be used, as follows: £
Balance on raw materials control account 30,000
This is equal to the goods purchased in October,
November and December, when the price
variances totalled 2,700
Value of raw materials at year-end 32,700
Care is needed in using this method, as the price variances may have arisen over a narrow range of materials, in which case the calculations of the adjustment needed should embrace only those materials.
Conclusion
Standard costs are used mainly as a tool of management control; their use in the valuation of stocks for accounts purposes is merely identical. Standard costs should not be used for stock valuation unless they are reasonably close to actual costs.
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Chapter 19: Question 5 – Bottom
Bottom income statement using FIFO inventory valuation
$000 Revenue 75,000
Cost of sales (37,600)
Gross profit 37,400
Other operating expenses (9,000)
Profit from operations 28,400
Investment income
Finance cost (4,000)
Profit before tax 24,400
Income tax expense (7,000)
Net profit for the period 17,400
The change from LIFO to FIFO would be a change of accounting policy. Under IAS 8 (revised) the effects of such a change should be applied retrospectively and comparative figures restated, with the opening balance of retained profits adjusted.
Working – cost of sales $000 As originally stated 38,000
Increase to opening Inventory 00,500
Increase to closing Inventory (900)
As restated 37,600
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C H AP T E R 2 0
Chapter 20: Question 1 – MACTAR
(£m) M1 M6 M62 Costs to date 2.1 0.3 2.3
Future costs 0.3 1.1 0.8
2.4 1.4 3.1
Contract sum 3.0 2.0 2.75*
Expected profit/(loss) 0.6 0.6 (0.35)
* assumes a 10% increase in contract price is allowed and negotiated.
Recognised profit
Value of work certified 1.8 0.1 1.3
% of work certified to total 60% 5% 47%
So Recognised profit 0.36 Note 1 Note 2
Note 1
Contract M6 is probably at too early a stage of completion to recognise any profit.
Note 2
The anticipated loss on contract M62 must be recognised in full on the grounds of prudence.
£m M1 M6 M62
Recorded as revenue 1.8 0.1 1.3
C of S balance 1.44 0.1 1.65
Profit 0.36 nil (0.35)
Balance sheet work-in-progress
Costs to date 2.1 0.3 2.3
Plus recognised profits 0.36 –
Less: recognised losses (0.35)
Less: progress billings (1.75) (0.1) (1.0)
Closing balance 0.71 0.2 0.95
Receivables
Progress billings 1.75 0.1 1.0
Less: Payment received (1.5) nil (0.75)
Closing balance 0.25 0.1 0.25
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Thus the overall profit on these three contracts is £0.01m (£10,000) for the year. This is of course a prudent view as one of the projects (M6) has only just started, one project is set for a cost over-run (M62) and one contract is very nearly complete (M1).
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Chapter 20: Question 2 – Lytax Ltd
Contract No. 1 2 3 4 5
£000 £000 £000 £000 £000
Contract price 1,100 950 1,400 1,300 1,200
Costs incurred to date 664 535 810 640 1,070
Estimated further cost
to complete 106 75 680 800 165
Estimated cost of post-
completion work 30 10 45 20 5
800 620 1,535 1,460 1,240
Estimated profit/(loss)
On contracts 300 330 (135) (160) (40)
Recognised profit/(loss)
580/800 × 300 218
470/620 × 330 250
(135) (160) (40)
Notes 1 Recognised profit on the profitable contracts is taken as the proportion that costs taken to
revenue bear to total anticipated costs. Other sensible proportions would be acceptable. 2 Losses on unprofitable contracts are recognised in full.
The balance sheet work-in-progress balance will show: 1 2 3 4 5 £000 £000 £000 £000 £000 Costs incurred to date 664 535 810 640 1,070
Recognised profits less 218 250 (135) (160) (40)
foreseeable losses
Progress billings:
Received (615) (680) (615) (385) (722)
Awaited (60) (40) (25) (200) (34)
Retained (75) (80) (60) (65) (84)
Closing balance 132 (15) (25) (170) 190
The positive balances on contracts 1 and 5, totalling £322,000, will be presented as an asset. The negative balances on contracts 2, 3 and 4, totalling £210,000, will be presented as a liability. The difference between total progress billings and total receipts will be shown as a receivable.
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Chapter 20: Question 3 – Beavers Ltd
(a) Contract Account
£ £ Wages 91,000
Materials 36,000
Other costs 18,000
HO costs (see Note) 6,000 Progress billings 150,000
Plant (12/15 × £8,000) 6,400 Materials c/f 3,000
Recognised profit 40,500 WIP c/f 44,900
197,900 197,900
Note
It is assumed that the Head Office costs are associated with the provision of contract-related services that cannot be directly allocated to a specific contract. In these circumstances IAS 11 allows their inclusion in ‘contract costs’. Any apportionment of general Head Office costs would not be permitted under IAS 11.
(b) Balance sheet extract as at 30 June 20X7
Current assets
Inventory – materials 3,000
Long-term contract balance 44,900
(c) Calculation of profit
Contract price 240,000
Costs to date
[157,400 – 3,000 material on site] 154,400
Estimated further costs to complete
[10,000 + 12,000 + 8,000 + 1,600 plant] 31,600
186,000
Estimated profit 54,000
Recognised profit (say)
£180,000/240,000 × 54,000 = £40,500
Amount recoverable on long-term contract (180,000 – 150,000) £30,000
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Chapter 20: Question 4 – Newbild SA
(a) Contract Account
€ € Materials – Stores 13,407 Progress billing 134,800
Materials – Site 73,078 (see Note)
Wages 39,894
Site expenses 4,815
Administration 3,742
Plant – Depreciation 5,160 Materials Bal c/f 5,467
Subtotal 140,096 WIP Bal c/f 22,928
Recognised profit 23,099
163,195 163,195
Note
The progress billing is the amount received from the customer grossed up by the 15% retention.
Calculation of profit Contract price 780,000
Costs to date [140,096 – 5,467] 134,629
Estimated further costs to complete 490,000
Guarantee work [2.5% of 780,000] 19,500
644,129
Estimated profit 135,871
Recognised profit
The work certified as complete has a value of €134,800 ($114,580/0.85). Therefore the contract is around 17% complete (€134,800/$780,000 is 17.28%). Therefore rec-ognised profit could be 17% × €135,871 = €23,099.
(b) Income statement
Revenue 134,800
Cost of sales 111,701
Profit 23,099
Balance sheet extract Current assets
Inventory – materials 5,467
Long-term contract balance 22,928
Receivables – amount recoverable on long-term contract 20,220
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Chapter 20: Question 5 – Good Progress SpA
Note that the contract is 25% complete at the end of 20X0 and 40% complete by the end of 20X1. Therefore 15% of the contract was completed in 20X1.
Income statement entries: 20X1 20X0
€ € Revenue 150,000 250,000
Cost of goods sold
112,500 187,500
Profit [15%/25%] 37,500 62,500
Balance sheet entries 20X1 20X0
Current assets € €
Long-term contracts balance
[117,000 – 112,500] 4,500 [265,000 – 262,500] 2,500
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Chapter 20: Question 6
Solution (a) Water Away
The following extract from the Balfour Beatty 2003 Annual Report deals with such a situation:
Revenue on Aberdeen Environmental Services Limited (AES) is related to the volume and quality of the wastewater processed by the plant. AES therefore takes demand risk and has a fixed asset, which is depreciated over the life of the concession. The revenue is recognised as turnover as it is earned.
Solution (b) Learn A head
The following extract from the Balfour Beatty 2003 Annual Report deals with such a similar situation:
Hospitals and Schools
Balfour Beatty's hospitals and schools concessions receive income based on the avail-ability of the asset, rather than their actual usage. The costs of constructing the asset are therefore accounted for as amounts recoverable on contracts during the course of con-struction and reclassified to contract debtors when construction is complete.
The contract debtor gives rise to an interest income calculation based on an appropriate rate of return for the asset concerned. The income is split into two elements: that relat-ing to the contract debtor, and that relating to the provision of other services such as cleaning and catering. The element of revenue relating to the contract debtor is split be-tween principal repayments, reducing the amount owed to the concession, and interest income, which is credited to the profit and loss account as it is earned. The revenue re-lating to services is recognised as turnover as it is earned, reflecting the continuing provision of services to the concession.
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C H AP T E R 2 1
Chapter 21: Question 1 – Parent Ltd
(a) Parent Ltd balance sheet as at 1 January 20X1
Ordinary Shares of 1 each 40,500
Retained earnings 4,500
45,000
Investment in Daughter Ltd 10,800
Cash[20,000 – 10,800] 9,200
Other net assets 25,000
45,000
Note: The investment is shown as its fair value of 10,800 and the cash has been reduced by consideration.
Consolidated balance sheet as at January 20X1
Parent Daughter Add Eliminate CBS (Dr)/Cr Ordinary shares 40,500 9,000 49,500 (9,000) 40,500
Retained earnings 4,500 1,800 6,300 (1,800) 4,500
55,800 10,800 55,800 45,000
Investment in
Daughter 10,800 10,800 10,800
Cash 9,200 2,000 11,200 11,200
Other net assets 25,000 8,800 33,800 33,800
55,800 10,800 55,800 Q 45.000
Note: Because the cash paid exactly equalled the value of the net assets acquired, there was no difference on consolidation i.e. no positive or negative goodwill.
(b) Parent Ltd balance sheet as at 1 January 20X7
Ordinary Shares of 1 each (40,500+(10,800/2) 45,900
Share premium 5,400
Retained earnings 4,500
55,800
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Investment in Daughter Ltd 10,800
Cash 20,000
Other net assets 25,000
55,800
Note: The investment is shown as its fair value of 10,800 and the shares are issued at their fair value of 5,400 par value and 5,400 premium.
Consolidated balance sheet as at January 20X7
Parent Daughter Add Eliminate CBS (Dr)/Cr
Ordinary shares 45,900 9,000 54,900 (9,000) 40,500
Share premium 5,400 5,400 5,400
Retained earnings 4,500 1,800 6,300 (1,800) 4,500
55,800 10,800 66,600 55,800
Investment in
Daughter 10,800 10,800 10,800
Cash 20,000 20,000 20,000
Other net assets 25,000 10,800 35,800 ___ 35,800
55,800 10,800 66,800 Q 45.000
Note: Because the value of the shares issued exactly equalled the value of the net assets ac-quired, there was no difference on consolidation i.e. no positive or negative goodwill.
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Chapter 21: Question 2 – Parent Ltd
(a) Parent Ltd balance sheet as at 1 January 20X7
Ordinary Shares of 1 each 40,500
Retained earnings 4,500
45,000
Investment in Daughter Ltd 16,200
Cash [20,000 – 16,200] 3,800
Other net assets 25,000
45,000
Note: The investment is shown as its fair value of 16,200 and the cash has been reduced by consideration.
Consolidated balance sheet as at January 20X7
Parent Daughter Add Eliminate CBS (Dr)/Cr
Ordinary shares 40,500 9,000 49,500 (9,000) 40,500
Retained earnings 4,500 1,800 6,300 (1,800) 4,500
55,800 10,800 55,800 45,000
Investment in
Daughter 16,200 16,200 10,800 5,400
Cash 3,800 2,000 5,800 5,800
Other net assets 25,000 8,800 33,800 ___ 33,800
55,800 10,800 55,800 Q 45.000
Note: Because the cash paid exceeded the value of the net assets acquired, there was a difference on consolidation of 5,400 which appears in the consolidated balance sheet as an asset goodwill – this will be reviewed for possible impairment.
(b) Parent Ltd balance sheet as at 1 January 20X7
Ordinary Shares of 1 each (40,500+(16,200/3) 45,900
Share premium 10,800
Retained earnings 4,500 61,200
Investment in Daughter Ltd 16,200
Cash 20,000
Other net assets 25,000
61,200
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Note: The investment is shown as its fair value of 16,200 and the shares are issued at their fair value of 5,400 par value and 10,800 premium.
Consolidated balance sheet as at January 20X7
Parent Daughter Add Eliminate CBS
(Dr)/Cr Ordinary shares 45,900 9,000 54,900 (9,000) 45,900
Share premium 10,800 10,800 10,800
Retained earnings 4,500 1,800 6,300 (1,800) 4,500
61,200 10,800 72,000 61,200
Investment in Daughter 16,200 16,200 10,800 5,400
Cash 20,000 20,000 20,000
Other net assets 25,000 10,800 35,800 ___ 35,800
55,800 10,800 72,000 Q 61,200
Note: Because the value of the shares issued exceeded the value of the net assets acquired, there was a difference on consolidation.
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Chapter 21: Question 3 – Parent Ltd
(a) Parent Ltd balance sheet as at 1 January 20X7
Ordinary Shares of £ 1 each 40,500
Retained earnings 4,500
45,000
Investment in Daughter Ltd 16,200
Cash [20,000 – 16,200] 3,800
Other net assets 25,000
45,000
Note: The investment is shown as its fair value of 16,200 and the cash has been reduced by consideration.
Consolidated balance sheet as at January 20X7
Parent Daughter Add Eliminate CBS (Dr)/Cr
Ordinary shares 40,500 9,000 49,500 (9,000) 40,500
Retained earnings 4,500 1,800 6,300 (1,800) 4,500
55,800 10,800 55,800 45,000
Investment in
Daughter 16,200 16,200 10,800
Revaluation increase (1,200) 4,200
Cash 3,800 2,000 5,800 5,800
Other net assets 25,000 8,800 33,800 1,200 35,000
55,000 10,800 55,800 Q 45.000
Note:
1. The net assets in the CBS will be increased by 1,200.
2. The fair value of the shares issued (16,200) exceeded the fair value of the net assets ac-quired (12,000). This difference on consolidation will be reported as goodwill and reviewed for impairment.
(b) Parent Ltd balance sheet as at 1 January 20X7
Ordinary Shares of 1 each (40,500+(16.200/3) 45,900
Share premium 10,800
Retained earnings 4,500
61,200
Investment in Daughter Ltd 16,200
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Cash 20,000
Other net assets 25,000
61,200
Note: The investment is shown as its fair value of 16,200 and the shares are issued at their fair value of 5,400 par value and 10,800 premium.
Consolidated balance sheet as at January 20X7
Parent Daughter Add Eliminate CBS (Dr)/Cr
Ordinary shares 45,900 9,000 54,900 (9,000) 45,900
Share premium 10,800 10,800 10,800
Retained earnings 4,500 1,800 6,300 (1,800) 4,500
61,200 10,800 72,000 61,200 Investment in
Daughter 16,200 16,200 10,800
Revaluation increase (1,200) 4,200
Cash 20,000 20,000 20,000
Other net assets 25,000 10,800 35,800 1,200 37,000
55,800 10,800 72,000 Q 61,200
Note:
1. The net assets in the CBS will be increased by 1,200.
2. The fair value of the shares issued (16,200) exceeded the fair value of the net assets ac-quired (12,000). This difference on consolidation will be reported as goodwill and reviewed for impairment.
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Chapter 21: Question 4 – Parent Ltd
Parent Ltd balance sheet as at 1 January 20X7
Ordinary Shares of £ 1 each 40,500
Retained earnings 4,500
45,000
Investment in Daughter Ltd 6,000
Cash [20,000 – 6,000] 14,000
Other net assets 25,000
45,000
Note: The investment is shown as its fair value of 6,000 and the cash has been reduced by con-sideration.
Consolidated balance sheet as at January 20X7
Parent Daughter Add Eliminate CBS (Dr)/Cr
Ordinary shares 40,500 9,000 49,500 (9,000) 40,500
Retained earnings 4,500 1,800 6,300 (1,800) 4,500
55,800 10,800 55,800 45,000
Investment in Daughter 6,000 6,000 10,800 (4,800)
Cash 14,000 2,000 16,000 16,000
Other net assets 25,000 8,800 33,800 ___ 33,800
55,800 10,800 55,800 Q 45.000
Note: Because the cash paid was less than the value of the net assets acquired, there was a credit difference on consolidation i.e. negative goodwill which will be credited to the retained earnings.
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Chapter 21: Question 5 – Parent Ltd
Parent Ltd balance sheet as at 1 January 20X7
Ordinary Shares of £ 1 each 40,500
Retained earnings 4,500
45,000
Investment in Daughter Ltd 9,000
Cash [20,000 – 9,000] 11,000
Other net assets 25,000
45,000
Note: The investment is shown as its fair value of 9,000 and the cash has been reduced by con-sideration.
Consolidated balance sheet as at January 20X7
Parent Daughter Add Eliminate CBS (Dr)/Cr
Ordinary shares 40,500 9,000 49,500 (6,750) a
(2,250) b 40,500
Retained earnings 4,500 1,800 6,300 (1,350) a
(450) b 4,500
Minority interest 2,250 b
450 b 2,700 45,000 10,800 55,800 47,700
Investment in
Daughter 9,000 9,000 6,750 a
1,350 a 900
Cash 11,000 2,000 13,000 13,000
Other net assets 25,000 8,800 33,800 ___ 33,800
45,000 10,800 55,800 Q 47,700
Note: Because the cash paid was more than the value of the net assets acquired, there was a debit difference on consolidation of 900.
(a) represents the elimination of the shares and reserves of the company acquired against the invest-ment in the company acquired.
(b) Represents the transfer to the minority shareholders their 25% interest in the net assets of 10,8700 in Daughter Ltd.
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Chapter 21: Question 6
(a) Balance sheet as at 30 June 20X2
Property 43,400
Plant and equipment 12,320 Current assets
Inventory 51,324
Trade receivables 22,829
Cash 63,500
137,713
Current liabilities
Trade payables 63,700
Income tax 6,440
70,140
Net current assets 67,573
123.293 Share capital 56,000
Retained earnings 67,293
123.293
Reserves at date of acquisition
Investment 151,200
Less shares 50,400 Goodwill 100,800
85,680
Reserves 15.120 Step 1: Calculate the % ownership Proposed dividend in CBS 11,760
Proposed dividend in Parent 11,200
Minority dividend 560 10%
Dividend receivable by Parent 5,040 90%
Step 2: Calculate the retained earnings balance Consolidated balance 79,884
Less Parent 35,280
44,604
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Add Profit on stock (4,200 – 3,360) 840
45,444
Add Minority interest (10% of 50,493 or 1/9 of 45,444)) 5,049
Add Pre-acquisition
Parent (90% o £16,800) 15,120
Minority (10% of 16,800) Subsidiary retained earnings 1,680
67,293
Step 3: Reconcile the minority interest Shares 5,600 Retained earnings post-acquisition 5,049
Retained earnings pre-acquisition 1,680
12,329
Worksheet
Non-current assets
Group Parent Subsidiary Adjustment
Property 127,400 84,000 43,400 43,400
Plant 62,720 50,400 12,320 12,320
Current assets
Inventory 121,604 71,120 50,484 840 51,324
Receivables 70,429 51,800 18,629 4,200 22,829
Cash 24,360 24,360 39,200 63,560
Current liabilities
Payables 140,420 80,920 59,500 4,200 63,700
Income tax 27,160 20,720 6,440 6,440
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Chapter 21: Question 7 – Rouge plc
Rouge plc Balance Sheet as at 1 January 20X0
ASSETS £ Million
Non-current assets
Property, plant and equipment [100 + 60] 160
Goodwill [132 – 100] 32
Current assets [80 + 70] 150
342
Common £10 shares 200
Retained earnings 52
Share capital and reserves 252
Current liabilities 90
342
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Chapter 21: Question 8 – Ham plc
(a)
Ham plc Balance sheet as at January 20X0
ASSETS £000
Non-current assets Property, plant and equipment [250 + 100] 350
Goodwill [90 – 110] (20)
Current assets [100 + 70] 170
500
Common £5 shares 200
Retained earnings 160
Share capital and reserves 360
Current liabilities 140
500
(b) See discussion in chapter.
Following recent changes in the treatment of goodwill, negative goodwill will be taken to in-come statement immediately.
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Chapter 21: Question 9 – Berlin plc
Berlin plc Balance sheet as at 1 January 20X0
(a) (b) Cash acquisition Share exchange ASSETS £000 £000 Non-current assets Property, plant and equipment 250 250
Investment in Hanover 100 100
Current assets 50 150
400 500
Common £5 shares 200 250
Additional paid-in capital – 50
Retained earnings 80 80
Share capital and reserves 280 380
Current liabilities 120 120
400 500
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Chapter 21: Question 10 – Bleu plc
Bleu plc Balance sheet as at January 20X0
ASSETS £ Million
Non-current assets Property, plant and equipment [150 + 120] 270
Goodwill [210 – (80% × 180) ] 66
Current assets [108 + 105] 213
549
Common £10 shares 300
Retained earnings 78
Share capital and reserves 378
Minority interest [20% × 180] 36
Current liabilities [90 + 45] 135
549
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Chapter 21: Question 11 – Base plc
Base plc Balance sheet as at January 20X0
ASSETS £000
Non-current assets Property, plant and equipment [250 + 120] 370
Goodwill [90 – (60% × 110) + (40% × 20)] 12
Current assets [100 + 70] 170
Total assets 552
Common £5 shares 200
Retained earnings 160
Share capital and reserves 360
Minority interest [(40% × 110) + (40% × 20)] 52
Current liabilities [80 + 60] 140
Total equity and liabilities 552
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C H AP T E R 2 2
Chapter 22: Question 1 – Sweden
Sweden Balance Sheet as at 31 December 20X1
ASSETS Krm
Non-current assets Property, plant and equipment [264 + 120] 384
Goodwill [200 – (110 + 10 + 70) – 2] 8
Current assets [160 + 140] 300
Total assets 692
Common Kr10 shares 400
Revaluation reserve 20
Retained earnings [104 +10 – 2] 112
Share capital and reserves 532
Current liabilities [100 + 60] 160
Total equity and liabilities 692
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Chapter 22: Question 2 – Summer plc
Summer plc Balance Sheet as at 31 December 20X1
ASSETS £000 Non-current assets Property, plant and equipment [200 + 200] 400
Goodwill [141 – 60% (20 + 35 + 160) – 1] 11
Current assets [100 + 140] 240
651
Common £5 shares 175
Additional paid-in capital 25
Retained earnings [161 + 60% (40 – 35) – 1] 163
Share capital and reserves 363
Minority interest [40% × 220] 88
Current liabilities [80 + 120] 200
651
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Chapter 22: Question 3 – Gold plc
Gold plc Balance Sheet as at 31 December 20X1
ASSETS £
Non-current assets Fixed assets, including land [82,300 + 108,550 + 3,000] 193,850
Goodwill (Note 1) 1,240
Current assets Inventories [23,200 +10,000 – 300] 32,900
Other current assets [5,000 + 7,500] 12,500
Total assets 240,490
Common £10 shares 55,000
Preferred shares 10,000
Additional paid-in capital 5,000
Retained earnings
[(75,000 + 75% (21,200 – 16,000)) – 300 – 310)] 78,290
Share capital and reserves 148,290
Minority interest (Note 2) 26,950
Non-current liabilities [12,500 +14,000] 26,500
Current liabilities Bond interest payable [625 + 700] 1,325
Other current liabilities [18,550 + 18,875] 37,425 38,750
240,490
Note 1: Goodwill £ £
Investment in Silver 46,000
Acquired 75% × 24,000 18,000
30% × 20,000 6,000
20% × 17,500 3,500
27,500
75% × 3,600 2,700
75% × 3,000 2,250
75% × 16,000 12,000 44,450
Goodwill 1,550
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Impairment @ 20% = £310
Goodwill at 31.12.20×1 = £1,550 – 310 = £1,240
Note 2: Minority interest £ 25% × 24,000 6,000
70% × 20,000 14,000
25% × 3,600 900
25% × 3,000 750
25% × 21,200 5,300
26,950
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C H AP T E R 2 3
Chapter 23: Question 1 – Bill plc
Bill SA
Consolidated Income Statement for the year ended 31 December 20X1
£ Sales [300,000 + 180,000 – 12,000] 468,000
Cost of sales [90,000 + 90,000 – 12,000 + 2,000] 170,000
Gross profit 298,000
Expenses [88,623 + 60,000] 148,623
Impairment of goodwill 3,000
Profit before taxation 146,377
Taxation [21,006 + 9,000] 30,006
Profit after taxation 116,371
Minority interest [(20% (21,000 – 4,500)) + (90% x 4,500)] 7,350
Profit attributable to the group 109,021
Dividend paid 60,000
Retained profit for the year 49,021
Retained profit brought forward
[104,004 + 80% (81,000 – 45,000)] 132,804
Retained profit carried forward 181,825
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Chapter 23: Question 2 – Morn Ltd
Morn Ltd Consolidated Income Statement for the year ended 31 December 20X1
£ Gross profit [360,000 + 180,000)] 540,000
Expenses [120,000 + 110,000] 230,000
Profit before taxation 310,000
Taxation [69,000 + 18,000] 87,000
Profit after taxation 223,000
Minority interest [10% × 52,000] 5,200
Profit after taxation belonging to the group 217,800
Dividends paid 120,000
Retained profit for the year 97,800
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Chapter 23: Question 3 – River plc
River A/S
Consolidated Income Statement for the year ended 31 December 20X1 £ Sales [100,000 + [(9/12 × 60,000)] 145,000
Cost of sales [30,000 +[(9/12 × 30,000]) 52,500
Gross profit 92,500
Expenses [20,541 + (9/12 × 15,000)] 31,791
Interest payable on 5% bonds [9/12 × (5,000 – 500)] 3,375
Impairment of goodwill 4,000
Profit before taxation 53,334
Taxation [7,002 + (9/12 × 3,000)] 9,252
Profit after taxation 44,082
Minority Interest [10% × 7,000 × 9/12] 525
Profit after taxation belonging to the group 43,557
Dividends paid 20,000
23,557
Profit and loss account balance
brought forward from previous years
34,668
58,225
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Chapter 23: Question 4 – Mars plc
Balance Sheet as at 31 December 20X2
Assets £ £ Non-current assets [330,000 + 157,500] 487,500
Goodwill 37,100 Current assets Inventories [(225,000 + 67,500) – 3,000] 289,500
Trade receivables [180,000 + 90,000] 270,000
Bank [36,000 + 18,000] 54,000 613,500
Total assets 1,138,100
Equity and liabilities
Capital and reserves Issued capital 196,000
General reserve [245,000 + 10,800] 255,800
Retained earnings [222,000 + 44,000] 266,000
717,800
Minority interest 51,300
Current liabilities Trade payables [283,500 + 40,500] 324,000
Taxation [31,500 + 13,500] 45,000
369,000
1,138,100
W1: Cancel inter-company balances
• Current accounts of £22,500
• Dividends receivable in Mars of £9,000 cancels with £9,000 of the dividends payable in Jupiter, leaving £2,250 payable to the minority interest.
Consolidated Income Statement for the year ending 31 December 20X2
£ Sales [1,440,000 + 270,000 – 18,000] 1,692,000
Cost of sales [1,045,000 + 135,000 – 18,000 + 3,000] 1,165,000
Gross profit 527,000
Expenses [123,500 + 90,000] 213,500
Profit before tax 313,500
Taxation [31,500 + 13,500] 45,000
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Profit after tax 268,500
Minority interest [20% × 31,500] 6,300
262,200
Dividend paid 180,000
Retained profit 82,200
Accumulated profit brought forward
[(156,000 + 80% (114,750 – 80,000)) 183,800
266,000
W2: Goodwill
£ £ Investment in Jupiter 187,500
£1 Ordinary shares [80% × 90,000] 72,000
Accumulated profits [80% × 80,000] 64,000
General Reserve [80% × 18,000] 14,400
150,400
Goodwill 37,100
W3: Unrealised profit on inter-company sales
50/150 × 18,000 = 6,000. Only half the stock is unsold at the year end so 6,000/2 is the provi-sion required against the closing stock figure.
W4: The income statement of Jupiter
£ £ Balance at 31/12/20X2 as per the balance sheet 135,000
Pre-acquisition profit held by Mars 64,000
Minority interest [20% × 135,000] 27,000 91,000
44,000
W5: The income statement of Mars
£ Balance at 31/12/20X2 as per the balance sheet 225,000
Less: Provision for unrealised profit 3,000
222,000
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W6: The minority interest
£ 20% × 90,000 Shares 18,000
20% × 31,500 General reserve 6,300
20% × 135,000 27,000
51,300
W7: Jupiter general reserve
£ Balance at 31/12/20X2 as per balance sheet 31,500
Less:
Mars share of pre-acquisition 80% × 18,000 = (14,400)
Minority interest 20% × 31,500 (6,300)
10,800
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Chapter 23: Question 5 – Red Ltd
Consolidated Balance Sheet as at 31 December X2
Assets $ $ Non-current assets Tangible [120,000 + 70,000] 190,000
Intangible – Goodwill (W1) 51,500
Current assets
Inventories [100,000 + 30,000 – 1,500] (W2) 128,500
Trade receivables [80,000 + 40,000] 120,000
Bank [16,000 + 8,000] 24,000 272,500
Total assets 514,000
Equity and liabilities Capital and reserves Issued capital 176,000
General reserve [20,000 + (75% × (14,000 – 8,000))] 24,500
Retained earnings [(100,000 + (75% × (60,000 – 30,000)
– 1,500))] 121,375
321,875
Minority interest 25% × (114,000 – 1,500) 28,125
Current liabilities
Creditors [125,996 + 18,000] 143,996
Taxation [14,004 + 6,000] 20,004 164,000
514,000
Income Statement for the year ending 31 December X2
£ Sales [200,000 + 120,000 –12,000] 308,000
Cost of sales [60,000 + 60,000 –12,000 + 1,500 109,500
Gross profit 198,500
Expenses [59,082 + 40,000] (99,082)
Profit before tax 99,418
Taxation [14,004 + 6,000] 20,004
Profit after tax 79,414
Minority interest [25% × (14,000 – 1,500] 3,125
76,289
Dividend paid 40,000
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Retained profit 36,289
Accumulated profit brought forward (W3) 85,086
121,375
W1: Goodwill
$
Investment in Pink 110,000
$1 Common shares [75% × 40,000] 30,000
Accumulated profits [75% × 30,000] 22,500
General Reserve [75% × 8,000] 6,000
58,500
Goodwill 51,500
W2: Unrealised profit on inter-company sales
Mark-up = 9,000 × 1/3 = $3,000 Only half the stock is unsold at the year end so $3,000/2 is the provision required against the closing stock figure = $1,500 W3: Red 69,336
Pink [75% × (51,000 – 30,000)] 15,750
85,086
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Chapter 23: Question 6 – Try plc
Try Hard CPL £000 £000 £000 Profit before tax 80 56 136.00
Tax 42 28.60 70.60
38 27.40 65.40
Minority interest [25%] 6.85 6.85
38 20.55 58.55
Dividends 20 . 20.00
Carried forward 18 20.55 38.55
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Chapter 23: Question 7 – Mother plc
(a) Consolidated income statement for the year ended 31 December 20x6 Mother Daughter CPL
000 000 000
Profit before tax 300 100 400
Less Intra-company dividend (20) (20)
Income tax (120) (30) (150)
Profit after tax 160 70 230
Intra-group dividend 20 (20)
180 50 230
Transfer to general reserve (30) (20) (50)
Dividends (50) (50)
Retained 100 30 130
Balance b/f at 1.1.20x6 50 10 60
150 40 190
Consolidated balance sheet as at 31 December 20x6
Mother Daughter CBS
000 000 000
Non-current assets 300 150 450
Investment in Daughter plc 200
Net current assets 280 110 390
780 260 840
Share capital 500 200 500
General reserve 130 20 150
Retained earnings 150 40 190
780 260 840
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(b) The consolidated balance sheet:
• The parent company has 100% control of the subsidiary.
• The subsidiary was acquired at the date of incorporation when the net assets were equal to share capital with both stated at £200,000, there was therefore no goodwill.
• The CBS is formed by the aggregation of the assets and the reserves. Only the share capital of the parent company is included.
The consolidated income statement:
• Items are aggregated except for dividend.
• Intra-group dividends are cancelled.
• Only the dividend of the parent company is shown.
• Reserves are aggregated because they are post-acquisition
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Chapter 23: Question 8 – Mother plc
(a) Consolidated income statement for the year ended 31 December 20x6 Mother Daughter CPL
000 000 000
Profit before tax 300 100 400
Less Intra-company dividend (16) (16)
Income tax (120) (30) (150)
Profit after tax 164 70 234
Less minority interest 20% of 70 (14) (14)
164 56 220
Intra-group dividend 16 (16)
180 50 220
Transfer to general reserve (30) 80% of 20 (16) (46)
Dividends (50) (50)
Retained 100 24 124
Balance b/f at 1.1.20x6 50 80% of 10 8 58
150 80% of 40 32 182
Consolidated balance sheet as at 31 December 20x6
Mother Daughter CBS
000 000 000
Non-current assets 300 150 450
Goodwill (200,000-160,000) 40
Investment in Daughter plc 200
Net current assets 280 110 390
780 260 880
Share capital 500 200 500
General reserve 130 20 146
Retained earnings 150 40 182
Minority interest 20% of 260,000 52
780 260 880
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(b) The consolidated balance sheet:
• The parent company holds 80% of the shares • There is a 20% minority interest
• In CPL it is 20% of post tax profit
• In the CBS it is 20% of the closing net assets of 260,000
• The intragroup dividend is 80% of the Daughter plc dividend i.e. 80% of 20,000
• The retained earnings is then 80% of the closing balance i.e. 80% of 40,000.
• Goodwill has arisen because Mother paid more than the fair value of the net assets i.e. 200,000 for net assets of 160,000.
• The CBS is formed by the aggregation of the assets and the reserves. Only the share capital of the parent company is included.
The consolidated income statement:
• Items are aggregated except for dividend.
• Intra-group dividends are cancelled.
• Only the dividend of the parent company is shown.
• Reserves are aggregated because they are post-acquisition
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Chapter 23: Question 9 – Mother plc
(a) Consolidated income statement for the year ended 31 December 20X6
Mother Daughter CPL 000 000 000
Retained 150 30 130
Balance b/f at 1.1.20X6 50 5 55
150 (Note 1) 35 185
Consolidated balance sheet as at 31 December 20X6
000
Non-current assets 450
Net current assets 390
840
Share capital 500
Negative goodwill
[Cost £200,000 - net assets £220,000] 20 (Note 2)
General reserve 135 [only includes post-acquisition]
Retained earnings 185
840
(b)
Note 1. The group share of Daughter's retained profit is 100% of the post-acquisition profits i.e. 100% of 40,000 – 5,000 that existed at 1.1.20X2.
Note 2. The price paid is less than the fair value of the net assets. This can be attributed either to a bargain purchase perhaps because the vendor needs to achieve a quick sale or to expectation of future losses whereby the purchase price has been reduced to take account of future costs, such as reorganisation costs, or losses that do not represent identifiable liabilities at the balance sheet date.
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Chapter 23: Question 10 – Mother plc
(a) Consolidated income statement for the year ended 31 December 20X6
Mother Daughter CPL £000 £000 £000
Retained 100 24 124
Bal b/f at 1.1.20X6 50 [80% × 5] 4 54
150 (Note 1) 28 178
Note 1. The group share of Daughter's retained profit is 80% of the post-acquisition profits i.e.
80% of 40,000 – 5,000 that existed at 1.1.20X2.
Consolidated balance sheet as at 31 December 20X6
000
Goodwill
[200,000 – 80% of 220,000] 24
Non-current assets 450
Net current assets 390
864
Share capital 500
General reserve [130,000 + 80% of 5,000] 134
Income statement 178
Minority interest [20% of 260,000] 52
864
(b) In this case a minority interest is recorded representing the minority's 20% interest in the net assets at the balance sheet date which are under the control of the majority shareholder.
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Chapter 23: Question 11 – Tailor Ltd
Plant [207,900–184,900] 23,000
Depreciation [44,000–32,000] 12,000 11,000
Inventory [70,000 – 63,000 + 300 unrealised profit] 7,300
Receivables [25,000–23,000] 2,000 9,300
20,300
Less:
Payables [58,000 – 56,000] 2,000
Overdraft [6,000–0] 6,000 8,000
12.300
Capital 7,000
Reserves 5,300
12,300
Reconcile the reserves: (1) Cost of control Cash for investment - per balance sheet 9,100
Capital reserve - per Note 2 in question 800
Less: 9,900
Shares (6,300)
Reserves as the difference 3.600
Reserves of 3,600 is a 90% interest (i.e. 6300/7000 × 100)
Therefore 100% interest was 4,000
(2) Calculate distributable profits
Minority interest per consolidated balance sheet 1,200
Less Shares (700)
Post-dividend reserve 500
Dividend (1/9 of 900 in parent balance sheet) 100
Pre dividend reserve 600
Less Pre-acquisition (1/9 of 3,600 from Working 1 above) (400)
200
10% is £200, therefore 100% is £2,000
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(3) Calculate the reserve of subsidiary
Profits were from (2) above 2,000
Add profit on stock (inter-group) 300
2,300
Less dividend (1,000)
Retained 1,300
Balance b/f 4,000
Balance c/f 5.300 (4) Treatment of reserves on consolidation
Balance 5,300
Less:
Inventory adjustment 300
Minority interest 500
Pre-acquisition 3,600
Post-acquisition 900
5.300
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Chapter 23: Question 12 – H and S Ltd
(a) % of S Ltd owned by H Ltd = 75% Derived from the minority interest figures
Income statement 170/680 × 100 = 25% Balance sheet 555/2,220 × 100 = 25%
(b) Inter-company sales = 500 The amount eliminated in the Income Statement Parent 4,000 + subsidiary 2,200 - group 5,700
(c) Inventory unrealised profit = 45 Parent 410 + subsidiary 420 - group 785
(d) Inter-company receivables and payables offset/eliminated Receivables: Parent 535 + subsidiary 220 - group 595 = 160 Payables: Parent (300) + subsidiary (260) - group 355 = 225
(e) S Ltd – retained earnings on acquisition = 960 Comprising: Cost 1,700
Less Share capital 570 Goodwill 410 980
Reserves attributable to 75% 720 Total reserves 720/75 × 100 960
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C H AP T E R 2 4
Chapter 24: Question 1 – Swish
(a) Income Statement for the year ended 31 December 20X3
£ Sales [300,000 + 160,000 – 16,000] 444,000
Cost of Sales [90,000 + 80,000 – 16,000 + 3,200] 157,200
286,800
Expenses [95,000 + 50,000] 145,000
Group profit before taxation 141,800
Share of Associated Company
profits [25% × 30,000] 7,500
Profit before taxation 149,300
Taxation – Group [30,000 + 7,000] 37,000
– Associate [25% × 8,000] 2,000 39,000
110,300
Minority Interest (10% × 23,000) 2,300
108,000
Dividends paid 40,000
Retained profit for the year 68,000
Retained earnings brought forward
[94,000 + ( 90% × 47,000) + (25% × 6,000)] 137,800
205,800
(b) Consolidated Balance Sheet as at 31 December 20X3
Cost Dep’n Net Non-current assets £ £ £ Intangible: Goodwill in subsidiary 17,600
Tangible [120,000 + 110,000] 500,000 270,000 230,000
Investment in Associate [18,000 + 28,000] 46,000
293,600
Current Assets Inventories [120,000 + (60,000 – 3,200)] 176,800
Trade receivables [130,000 + 70,000] 200,000
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Current account – Handle (Note 1) 3,000
Bank [24,000 + 7,000] 31,000
410,800
Current liabilities Trade payables [132,000 + 25,000] 157,000
Taxation payable 37,000
194,000 216,800
510,400
Financed by £1 Common shares 250,000
General reserve [30,000 + 3,600 + (25% × 4,000] (Note 2) 34,600
Retained earnings
[150,000 – 3,200 + 54,000 + (25% × 20,000) (Note 2) 205,800
490,400
Minority interest 20,000
510,400
Notes 1. The inter-company current account balance with the associated company has not been can-
celled because the associated company is not a member of the group.
2. The group’s share of the retained earnings and general reserve is calculated on the post-acquisition accumulated profits and general reserve of Handle, i.e.
General reserve per Handle balance sheet is 12,000
Pre-acquisition (see question) 8,000
Post-acquisition 4,000
Retained earnings per Handle balance sheet 50,000
Pre-acquisition (see question) 30,000
Post-acquisition 20,000
3. Goodwill in Broom
Cost of investment 140,000
Less 90% of share capital 60,000
General reserve 16,000
Retained earnings 60,000
136,000
90% 122,400
Goodwill 17,600
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4. Unrealised profit in Inventory
Swish sold Broom 16,000
Remaining unsold at year end 12,800
Profit element 25% 3,200
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Chapter 24: Question 2 – Stop Group
(a) Consolidated income statement for year to 31 December 20X1
£ Sales 375,000
Cost of sales 125,000
250,000
Expenses 149,750
100,250
Share of profits of Associate [43,750 × 30% × 0.75] 9,844
110,094
Taxation – Group 25,000
– Associate [11,250 × 30% × 0.75] 2,531
27,531
82,563
Dividends paid 50,000
Retained profit for the year 32,563
Balance brought forward 112,500
145,063
(b) Consolidated Balance Sheet at 31 December 20X1
£ Fixed assets at cost 375,000
Depreciation 125,000
250,000
Goodwill 7,000
Investment in Start Ltd [204,375 × 30%] 61,313
Current assets
Inventory 160,000
Trade receivables 165,000
Current a/c Start Ltd 15,000
Bank 12,500
352,500
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Current liabilities
Trade payables 187,500
Taxation 25,000
212,500
140,000
458,313
Financed by
Ordinary shares of £1 281,000
General reserves [31,500 + (2,500 × 30%)] 32,250
Retained earnings 145,063
458,313
Working 1 Investment in Start [63,250 – 750] (see Note) 62,500
Shares acquired 18,750
Retained earnings [102,500 × 30%] 30,750
General reserve [20,000 × 30%] 6,000
55,500
Goodwill 7,000
Note: The £750 which has correctly been credited to Stop’s investment in Start represents the share of the dividend receivable out of the profits of Start before it became an associate i.e. £10,000 × 30% × 3/12 = 750. This amount is not a profit made by the group and must not there-fore be in the group profit and loss. In effect this adjustment restores the net assets purchased on acquisition to their full amount.
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Chapter 24: Question 3 – Ant Co
(a) Consolidated Income Statement for the year ended 31 December 20X9
$ Sales [225,000 + 120,000 – 12,000] 333,000
Cost of sales [67,500 + 60,000
– 12,000 + 2,700] 118,200
214,800
Expenses [70,500 + 37,500] 108,000
Group profit before taxation 106,800
Share of Associated Company
profits [25% × 22,500] 5,625
Profit before taxation 112,425
Taxation – Group [22,500 + 5,250] 27,750
– Associate [25% × 6,000] 1,500 29,250
83,175
Minority interest [20% × 17,250] 3,450
79,725
Dividends paid 30,000
Retained profit for the year 49,725
Retained earnings brought forward
[70,500 + (80% × 35,250*) + (25% × 4,500*) 99,825
149,550
* Post-acquisition profits brought forward
(b) Consolidated Balance Sheet as at 31 December 20X9
Cost Dep’n Net $ $ $ Non-current assets Intangible: Goodwill in subsidiary 8,400
Tangible: [90,000 + 82,500] 375,000 202,500 172,500
Investment in Associate [21,000 + 13,500] 34,500
215,400
Current assets Inventories [105,000 + 45,000 – 2,700] 147,300
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Trade receivables [98,250 + 52,500] 150,750
Current account – Nit (Note 1) 2,250
Bank [17,750 + 5,250] 22,500
322,800
Current liabilities Trade payables [99,000 + 18,750] 117,750
Taxation payable 27,750
145,500 177,300
392,700
Financed by $1 common shares 187,500
General reserve [22,500 + 2,400 + (25% × 3,000)] (Note 2) 25,650
Retained earnings 149,550
362,700
Minority interest (20% × 150,000) 30,000
392,700
Notes 1. The inter-company current account balance with the Associated company has not been can-
celled because the Associated company is not a member of the group.
2. The group’s share of the Associated retained earnings and General Reserve is calculated on the post-acquisition retained earnings and General reserve of Nit, i.e.
General reserve per Nit balance sheet is 9,000
Pre-acquisition (see question) 6,000
Post-acquisition 3,000
Retained earnings per Nit balance sheet 37,500
Pre-acquisition (see question) 22,500
Post-acquisition 15,000
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Chapter 24: Question 4 – Twist plc
(a) Consolidated Income Statement for year to 31 December 20X3
£ Sales 450,000
Cost of sales 150,000
300,000
Expenses 171,000
129,000
Share of profits of Associate [74,000 × 30% × 0.25] 5,550
134,550
Taxation – Group 30,000
– Associate [14,000 × 30% × 0.25] 1,050
31,050
103,500
Minority interest 10,000
Attributable to the shareholders of the parent 93,500
Dividends paid 60,000
33,500
Retained earnings brought forward 136,000
169,500
(b) Consolidated Balance Sheet at 31 December 20X3
£ Property, plant and equipment 450,000
Depreciation 150,000
300,000
Investment in Turn [(244,000 × 30%) + 3,300] (W1) 76,500
Current assets
Inventories 180,000
Trade receivables 207,000
Current a/c Turn 18,000
Bank 18,000
423,000
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Current liabilities
Trade payables 225,000
Taxation 30,000
255,000
168,000
544,500
Financed by
Common shares of £1 each 200,000
General reserve 37,000
Retained earnings [168,000 + (20,000 × 25% × 30%)] 169,500
406,500
Minority interest 138,000
544,500
Working 1
Investment in Turn 75,000
Shares acquired 21,000
Retained earnings [137,000 × 30%] 41,100
General reserve [32,000 × 30%] 9,600
71,700
Goodwill 3,300
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C H AP T E R 2 5
Chapter 25: Question 1 – Fry Ltd
The profit or loss on foreign exchange in these cases will be as follows:
American Dollar Name of account: Texas Inc Alamos Inc Chicago Inc bank bank account Payable Receivable Creditor Loan creditor
Foreign currency $40,000 $60,000 $100,000 $90,000 $90,000
at exchange rate on 2.60 2.60 2.40 2.40 2.40
date of initial transaction
£15,385 £23,077 £41,667 £37,500 £37,500
Foreign currency $40,000 $30,000 $80,000
at exchange rate on 2.40 2.40 2.30
date of settlement £16,667 £12,500 £34,783
Foreign currency $30,000 $20,000 $90,000 $90,000
at exchange rate on 2.10 2.10 2.10 2.10
date of balance sheet 000 000 £14,286 £9,524 £42,847 £42,857
Profit/(loss)
on foreign exchange (£1,282) £3,709 (£2,640) (£5,357) £5,357
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Chapter 25: Question 2 – Walpole Ltd
(a) Translate the financial statements of Paris SA into sterling
Income statement
Paris SA Exchange rate Translated €000 £000 Sales 200,000
Purchases (90,000)
Other expenses (7,000)
Interest (3,000)
Taxation (15,000)
85,000 3.0 28,333 Note 1
Opening inventories (22,000) 2.5 (8,800) Note 2
Closing inventories 12,000 4.5 2,667 Depreciation (30,000) 3.5 (8,571) Note 3
Dividend paid (10,000) 5.0 (2,000) Note 4
Net profit carried forward 35,000 11,629
Notes
1 Sales, purchases and expenses have been translated at an average which is an approxima-tion of the rate when they were originally recorded. This requirement of the IAS has been rather more loosely interpreted in the case of interest and taxation, which have been trans-lated at the rates or approximate rates when they originally accrued. Under the wording of the IAS it might be more strictly correct if the taxation and interest were translated at the date they were first recorded in the books.
2 Translated at the actual date of acquiring the inventories.
3 The rate is that applicable to the date of revaluation rather than that at the date of acquiring the fixed assets.
4 The closing rate has been taken as the actual rate in this case.
Balance sheet
Non-current assets 150,000 3.5 42,857 Note 3 Current assets
Inventories 12,000 4.5 2,667 Note 5
Receivables 40,000 5.0 8,000 Note 6
Cash 11,000 5.0 2,200
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Current liabilities Payables (18,000) 5.0 (3,600)
Walpole Ltd (12,000) 5.0 (2,400)
Taxation (15,000) 5.0 (3,000)
Non-current assets – bonds (10,000) 5.0 (2,000)
Total assets less liabilities 158,000 44,724
Equity Share capital 60,000 2.0 30,000 Note 7
Additional paid-in capital 20,000 2.0 10,000 Note 8
Accumulated
Profit [66,000 – 35,000] 31,000 Balancing figure 30,229 Note 9
111,000 70,229 Note 10
Revaluation reserve 12,000 3.5 3,428 Note 11
Profit for the year 35,000 see above 11,629 Note 12
Loss on exchange (40,562) Note 13
Total equity 158,000 44,724
Notes
5 As inventories are non-monetary assets they are translated at actual.
6 The receivables and all the following assets in the balance sheet are monetary items and therefore retranslated at the closing rate.
7 Share capital issued should be translated at the date of acquiring the subsidiary or at the date of issue if later. At this stage of the process we are attempting to find the figure of profit or loss on exchange differences up to the beginning of the current year so that we can isolate the profit or loss on exchange in the current year. One way to do this is to split the share capital and reserves into the amount arising this year and the balance at the end of the previ-ous year. In this question the balance at the end of the previous year can be calculated as €111,000 (see Note 10). The rest (profit for the year 35,000 and revaluation reserve 12,000) arose in the present year. If we can then translate the 111,000 into pounds sterling at the end of the previous year, we can eventually find this year’s profit or loss on exchange. In practice we could obtain the sterling equivalent of the €111,000 from the workings for the previous year’s consolidated accounts.
8 The additional paid-in capital (share premium) is translated at the same rate as the shares to which it relates.
9 The accumulated profit at the end of the previous year can be taken as the balancing figure after translating the €111,000. The accumulated profit will have been translated at many dif-ferent rates over the years. In practice the translated figure would be available from the previous years’ consolidated accounts.
10 The 111,000 represents a mixture of monetary and non-monetary assets. The amount can be translated by applying the exchange rates used in the balance sheet in the previous year. This is calculated as follows:
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Non-current assets 150,000
Depreciation 30,000
180,000
Revaluation (12,000)
168,000 2.0 84,000
Opening inventory 22,000 2.5 8,800
190,000 92,800
Balance = Monetary
Liabilities at 31/12/20X1 (79,000) 3.5 (22,571)
Net assets at 31/12/20X1 111,000 70,229
11 The revaluation reserve is translated at the rate when the revaluation took place in the cur-rent year.
12 The income statement was translated to give the profit figure in sterling.
13 The loss on exchange differences is the balancing figure but can be found directly, as shown below.
Calculating the exchange difference for the year
(i) The monetary net liabilities at the beginning of the year of €79,000 (see Note 10 above) have been retranslated into sterling at 31 December 20X2 and a gain of £6,771 has been made since translation at the end of the previous year. £ Opening net monetary liabilities: €79,000 @ opening rate 3.5 = 22,571
Opening net monetary liabilities: €79,000 @ closing rate 5.0 = 15,800
Gain 6,771
(ii) Any profit made during the year initially goes into monetary net assets. The translation of these at the year-end rate will give a profit in this case of the difference between the actual or average rate (as an approximation of the actual rate) used for translating the income statement items and the year-end rate used for translating monetary items in the balance sheet. £
Translated – at average rate 85,000 @ 3.0 = 28,333
– at closing rate 85,000 @ 5.0 = 17,000
Loss 11,333
(iii) The fixed assets were acquired when the rate of exchange was 2 euros to the £ and this was the rate applied to them at 31 December 20X1. On 1 January 20X2 the fixed assets were revalued when the rate was 3.5 euros to the £ and this was therefore the rate applied to these fixed assets at 31 December 20X2. This produced a loss of £36,000 being (£168,000/2.0) – (£168,000/3.5).
Total loss on changing exchange rates (11,333 + 36,000 – 6,771) = £(40,562)
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(b) Prepare consolidated accounts – Walpole
Balance Sheet as at 31 December 20X2
ASSETS £000
Non-current assets
Goodwill (W1) 550
Other [94,950 + 42,857] 137,807
138,357
Current assets (W2) Inventories [60,000 + 2,667] 62,667
Receivables [59,600 + 8,000] 67,600
Bank [11,000 + 2,200] 13,200
143,467
Total assets 281,824
Equity and liabilities
Common share capital 80,000
Additional paid-in capital 6,000
Revaluation reserve [10,000 + 3,085] (W3) 13,085
Retained earnings [67,000 – 3,334] (W4) 63,666
162,751
Minority interest (W5) 4,473
Non-current liabilities (W2)
Bonds [40,000 + 2,000] 42,000
Current liabilities Payables [45,000 + 3,600] 48,600
Taxation [21,000 + 3,000] 24,000
114,600
Total equity and liabilities 281,824
W1: Goodwill £000 £000
Investment in Paris 41,050 Common share in Paris [90% × 30,000] 27,000 Retained earnings [90% × 5,000*] 4,500 Additional paid-in capital [90% × 10,000*] 9,000 40,500 Goodwill 550
* Pre-acquisition retained earnings translated at the exchange rate on the day of acquisition (£1
= €2)
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W2: Cancel inter-company balances
Current accounts of 2,400
W3: Paris SA revaluation reserve £000 Balance at 31/12/20X2 as per balance sheet 3,428
Minority interest 10% × 3,428 343
Consolidated balance sheet 3,085
W4: Retained earnings of Paris £000
Balance at 31/12/20X2 as per the balance sheet
[11,629 + 30,229 – 40,562 loss on exchange] 1,296
Pre-acquisition profit 4,500
Minority interest [10% × 1,296] 130 4,630 (3,334)
W5: The minority interest £000
Common shares [10% × 30,000] 3,000
Retained earnings [10% × 1,296] 130
Additional paid-in capital [10% × (9,800 +10,000)] 1,000
Revaluation reserve [10% × 3,429] 343
4,473
The consolidated income statement for the year ended 31/12/20X2 includes the subsidiary fig-ures using the exchange rates as shown in the question.
£ Sales [317,200 + (200,000/3)] 383,867
Cost of sales [170,000 + (8,800 + 90,000/3 – 2,667)] (206,133)
Gross profit 177,734
Depreciation [30,000 + 8,571] (38,571)
Expenses [15,000 + 7,000/3] (17,334)
Loss on foreign exchange (40,562)
Interest [6,000 + 3000/3] (7,000)
Profit before tax 74,267
Taxation [21,000 + 15,000/3] 26,000
Profit after tax 48,267
Minority interest [10% × (11,629 + Div 2,000 – 40,562)] 2,693
Net profit for the year 50,960
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Dividend paid (20,000)
Retained profit 30,960
Retained earnings brought forward (W6) 32,706
63,666
Group statement of changes in equity for the year ended 31/12/20X2
This statement will appear as follows: £ Retained earnings brought forward (W6) 32,706
Net profit for the year 50,960
Dividend paid (20,000)
Accumulated profit carried forward 63,666
W6: Group retained earnings brought forward at 1/1/20X2
£ Walpole [67,000 – this year 57,000] 10,000
Paris [90% × (30,229 – Pre-acquisition 5,000 (W1))] (22,706)
32,706
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Chapter 25: Question 3 – Paris SA
Walpole Question 3
(a) Income statement
Paris SA Exchange rate Translated
As in solution 2 35,000 See sol to Qn 2 11,629
Balance sheet
Net assets 158,000 5.0 31,600
Share capital 60,000 2.0 30,000
Additional paid in capital 20,000 2.0 10,000
Retained earnings (66,000–
35,000)
31,000
Balancing figure
(8,286)
111,000 3.5 31,714
Revaluation reserve 12,000 3.5 3,428
Profit for the year 35,000 See above 11,629
Loss on exchange (15,171)
Total equity 158,000 31,600
Proof of the loss on translation
£ (i) Opening net assets €111,000 @ opening rate 3.5 = 31,714
Closing net assets €111,000 @ closing rate 5.0 = 22,200
Loss (9,514)
(ii) Income statement €85,000 @ average rate 3.0 = 28,333
@ closing rate 5.0 = 17,000
Loss (11,333)
(iii) Opening inventories €22,000 @ 2.5 = 8,800
@ 5.0 = 4,400
Profit 4,400
(iv) Closing inventories €12,000 @ 4.5 = 2,667
@ 5.0 = 2,400
Loss (267)
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(v) Depreciation €30,000 @ 3.5 = 8,571
@ 5.0 = 6,000
Profit 2,571
(vi) Revaluation Reserve €12,000 @ 3.5 = 3,428
@ 5.0 = 2,400
Loss (1,028)
Total loss [ (9,514) + (11,333) +(267) + (1,028) – 2,571 – 4,400] = (15,171)
Add loss on retranslation of goodwill 550 (@2) – 220 (@5) = (330)
(b) Prepare consolidated accounts – Walpole
Balance sheet as at 31 December 20x2
Non-current assets £ £ Goodwill (W1) 220
Other (94,950 + 150,000/5) 124,950
125,170
Current assets (W2)
Inventories (60,000 + 12,000/5) 62,400
Receivables (59,600 + 8,000) 67,600
Bank (11,000 + 2,200) 13,200
143,200
Total assets 268,370
Equity and liabilities
Common share capital 80,000
Additional paid in capital 6,000
Revaluation reserve (10,000 + 3,085) (W3) 13,085
Retained earnings (67,000 – 15,475) (W4) 51,525
150,610
Minority interest (W5) 3,160
Non-current liabilities (W2)
Bonds (40,000+2,000) 42,000
Current liabilities
Payables (45,000 + 3,600) 48,600
Taxation (21,000 + 3,000) 24,000
114,600
Total equity and liabilities 268,370
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W1 Goodwill
£ £ Investment in Paris 41,050
Common shares in Paris (90% of 30,000) 27,000
Retained earnings (90% of 5,000) 4,500
Additional paid in capital (90% of 10,000* 9,000 40,500
Goodwill 550
• Pre-acquisition retained earnings translated at the exchange rate on the day of acquisition (£1 = €2) Restated at the rate on 31/12/20X2 as goodwill is treated as the asset of the sub-sidiary. Restated at 5.0 = £330.
W2 Cancel inter-company balances Current accounts of 2,400
W3 Paris SA revaluation reserve
£000 Balance at 31.12.20x2 per balance sheet 3,428
Minority interest 10% of 3,428 343
Consolidated balance sheet 3,085 W4 Retained earnings of Paris
£000 £000 Balance at 31.12.20x2 per the balance sheet
(11,629 – 8,286 – 15,171) (11,828)
Pre-acquisition profit 4,500
Minority interest 10% of (11,829) (1,183) (3317)
(15,145)
Loss on restatement of goodwill (330)
(15,475) W5 The minority interest
£000 Common shares (10% of 30,000) 3,000
Retained earnings (W4) (1,183)
Additional paid in capital (10% of 10,000) 1,000
Revaluation reserve (10% of 3,428) 343
3,160 The consolidated income statement for the year ended 31.12.20x2 includes the subsidiary fig-ures using the exchange rates as shown in the question
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£ £ Sales (317,200 + (200,000/3) 383,867
Cost of sales [170,000 + (8,800 + 0,000/3 – 2,667)] (206,133)
Gross profit 177,734
Depreciation (30,000 + 8,571) (38,571)
Expenses (15,000 + 7,000/3) (17,333)
Interest (6,000 + 3,000/3) (7,000)
Profit before tax 114,830
Taxation (21,000 + 15,000/3) 26,000
Profit after tax 88,830
Minority interest [10% of (11,629 + Div 2,000)] (1,363)
Net profit for the year 87,467
Dividend paid (20,000)
Retained profit 67,467
Group statement of changes in equity for the year ended 31.12.20x2 £ Retained earnings brought forward (W6) (1,957)
Net profit for the year 87,467
Dividend paid (20,000)
65,510
Loss on translation (90% of 15,171) (13,655)
Loss on restatement of goodwill (330)
Retained earnings carried forward 51,525 W6 Group retained earnings brought forward at 1.1.20x2
£ £ Walpole (67,000 – this year 57,000) 10,000
Paris [90% of ( (8,286) – pre-acquisition 5,000 (W1)] (11,957)
(1,957)
Note that in this example the loss on translation has been taken to retained earnings. In practice such gains or losses might be taken to a separate foreign currency reserve.
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C H AP T E R 2 6
Chapter 26: Question 1 – Alpha plc
(i)
Step 1 Theoretical ex-rights calculation
The shareholders get an element of bonus at the same time as the company receives additional capital. The bonus element may be quantified by the calculation of a theoretical ex-rights price, which is compared with the last market price prior to the issue; the difference is a bonus. The theoretical ex-rights price is calculated as follows: £ 4 shares at fair value of £1 each prior to rights issue = 4.00
1 share at discounted rights issue price of 80p each = 0.80
∴5 shares at fair value after issue (i.e. ex-rights) = 4.80
The theoretical ex-rights price is £4.80/5shares = 0.96
The bonus element is fair value £1 less 96p = 0.04
Step 2 The time-weighted average number of shares is calculated for the current year
No. of shares Shares to date of rights issue
Shares × Increase by bonus fraction × Time adjustment
2,000,000 × 9/12 = 1,500,000
Bonus : ((2,000,000 × 100/96) – 2,000,000) × 9/12 = 62,500
Shares from date of issue
2,500,000 × × 3/12 = 625,000
Weighted average number of shares 2,187,500
Step 3 Calculate BEPS for current year
BEPS for 20X1 is then calculated as £5,000,000/2,187,500 shares = £2.29
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(ii)
Step 4 Adjusting the previous year’s BEPS for the bonus element of a rights is-sue
This bonus element will affect the comparison with the previous year’s BEPS which will need to be reduced to ensure comparability. The approach is to reduce the prior year by multiplying it by:
Theoretical ex-rights fair value per share = £0.96 Fair value per share immediately before the exercise of rights £1.00
Assuming that the earnings for 20X0 and 20X1 were £4.5m and £5m respectively, the 20X0 BEPS figures will be reported as follows:
As reported in the 20X0 accounts £4.5m/2m = £2.25 As restated in the 20X1 accounts (£4.5m/2m) × (0.96/1.00) = £2.16
The same effect is achieved by increasing the number of shares in the denominator by 100/96 for 20X0:
Earnings/(Number of shares × Bonus fraction ) £4,500,000 / (2,000,000 × (100/96) = £2.16
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Chapter 26: Question 2 – Beta Ltd
Beta Ltd weighted average number of shares
Time Bonus Bonus element apportion adjustment in rights issue 1 January – 31 March
1,000,000 × 3/12 × 3/2 × 7/6 = 437,500
1 April – 30 April
1,500,000 × 1/12 × 3/2 × 7/6 = 218,750
1 May – 31 August
2,250,000 × 4/12 × × 7/6 = 875,000
1 September – 31 October
3,250,000 × 2/12 × × 7/6 = 631,944
1 November – 31 December
4,333,333 × 2/12 × = 722,222
Weighted average number of shares 2,885,416
Note: bonus element in rights issue calculated as follows:
3 shares at $5.60 = 16.80
1 share at $2.40 = 2.40
Fair value of 4 shares 19.20
Theoretical ex-rights price $4.80
Fair value $5.60
Bonus factor = 5.6/4.8 = 7/6
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Chapter 26: Question 3 – Nottingham Industries plc
(a) EPS complying with IAS 33 definition of earnings:
Earnings for EPS calculation is ‘profit of the period after tax, minority interests and extraordi-nary items and after preference dividends’.
Basic EPS calculation: £000
Equity earnings:
Profit after tax and extraordinary items 580
Preference dividend [10% of £1,000,000] (100)
480
Weighted average number of ordinary shares (25p)
Actual no. Weight Bonus Weighted time factor average
1.4.X5 in issue 16,000,000 3/12 6/5 4,800,000
1.7.X5 bonus issue 3,200,000
19,200,000 3/12 4,800,000
1.10.X5 Purchase (500,000)
31.3.X6 in issue 18,700,000 6/12 9,350,000
18,950,000
Basic EPS for 20X6 £480,000/18,950,000 = £0.0253
Comparative for 20X5 = £0.022 × 5/6 = £0.0183
(b) Diluted EPS calculation
Equity earnings: £000 As for Basic EPS 480
The computation of Basic and Diluted EPS is as follows:
Per share Earnings Shares Net profit for 20X6 £480,000
Weighted average shares during 20X6 18,950,000
Basic EPS (£480,000/18,950,000) £0.02533
Number of shares under option 200,000
Number that would have been issued
At fair value (200,000 × £1.00)/ £1.10 (181,818)
Diluted EPS £0.0253 £480,000 18,968,182
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(c) Usefulness of EPS figures
It is helpful to users to have a standardised EPS figure. This is provided by applying the IIMR calculation as follows.
IIMR headline EPS
Headline earnings per share are based upon the headline earnings figure stated in accordance with the Institute of Investment Management and Research Statement of Practice No. 1 The Definition of Headline Earnings and accordingly exclude profit on sale of the major operation. £000 Equity earnings:
Profit after tax and extraordinary items 580
Exclude capital items such as profit on sale of a major operation:
£120,000 less tax £38,000 (82)
IIMR Headline EPS 498
Less: preference dividend (100)
398
Even when standardised the ASB considers that there is too much emphasis on a single profit figure and encourages users to refer to the information set as a whole when appraising perform-ance and predicting future earnings. Nevertheless, the EPS figure has remained an important figure in the eyes of many investors and analysts.
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Chapter 26: Question 4 – Simrin plc
(a) Calculation of Basic EPS
As per IAS 33:
Profit after tax, Minority interest, EPS = Preference dividends and extraordinary items
Number of ordinary shares
= £79,000 – £9,000 100,000
Basic Earnings per Share = 70p per share
(b) Calculation of the Diluted EPS
£ Subscription monies received = £1.28 × 50,000
= 64,000
Notional number at fair value:
£64,000/£1.1 (fair value of a share) = 58,182
Notional number at no value = 5,818
64,000
Profit after tax and preference dividend
MI & extraordinary items 70,000
Number of shares: At 1 January 20X0 100,000
From warrants at no value 5,818
Total number of shares 105,818
Diluted EPS = £70,000/105,818 = 66.15p per share
(c) (i) Need to disclose DEPS
• Company able to finance projects using convertible securities which carried fixed interest rate and also future benefits causing dilution of shares in the future on conversion.
• Trend revealed by diluted EPS is more meaningful to shareholders as it enables them to identify the final effect on company’s EPS by using convertible debt.
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(ii) Relevance to shareholders
• Relevance is questionable.
• It shows dilution of future earnings per share and it is reasonable that existing shareholders should be given a warning of the potential dilution.
(d) Reliance on EPS as single most important indicator of financial per-formance
• There is no one correct answer for this, but discussion of the Institute of Investment Man-agement and Research headline figure is required.
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Chapter 26: Question 5 – Gamma Ltd
There are two steps in arriving at the Diluted EPS, namely:
Step 1 Determine the increase in earnings attributable to ordinary shareholders on conversion of potential ordinary shares
Step 2 Determine the potential ordinary shares to include in the Diluted Earnings per Share
(a) Convertible preference shares receive a dividend of £2.50
Step 1 Determine the increase in earnings attributable to ordinary shareholders on conversion of potential ordinary shares
Increase in Increase in number Earnings per earnings of ordinary shares incremental share Convertible preference shares Increase in net profit
50,000 shares × £2.50 125,000
Incremental shares
50,000/1 50,000 2.50
10% Convertible bond Increase in net profit
£250,000 × 0.10 × (1 – 0.4) 15,000
Incremental shares
250,000/1000 × 500 125,000 0.12
Step 2 Determine the potential ordinary shares to include in the computation of diluted earnings per share
Net profit attributable to Ordinary continuing operations shares Per share As reported 5,000,000 1,000,000 5.00
10% Convertible loan 15,000 125,000
5,015,000 1,125,000 4.46 dilutive
Convertible preference shares 125,000 50,000
5,140,000 1,175,000 4.37 dilutive
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(b) Convertible preference shares receive a dividend of £6 per share.
Step 1 Determine the increase in earnings attributable to ordinary shareholders on conversion of potential ordinary shares
Earnings per Increase in Increase in number incremental earnings of ordinary shares share Convertible preference shares Increase in net profit
50,000 shares × £6.00 300,000
Incremental shares 50,000/1 50,000 6.00
10% Convertible bond Increase in net profit
£250,000 × 0.10 × (1 – 0.4) 15,000
Incremental shares
250,000/1000 × 500 125,000 0.12
Step 2 Determine the potential ordinary shares to include in the computation of diluted earnings per share
Net profit attributable to Ordinary Per share continuing operations shares As reported 5,000,000 1,000,000 5.00
10% convertible loan 15,000 125,000
5,015,000 1,125,000 4.46 dilutive
Convertible preference shares 300,000 50,000
5,315,000 1,175,000 4.52 anti-dilutive
• Since the Diluted EPS is increased when taking the convertible preference shares into ac-count (from 4.46p to 4.52p) , the convertible preference shares are anti-dilutive and are ignored in the calculation of Diluted EPS.
• The lowest figure is selected and the Diluted EPS will, therefore, be disclosed as 4.46p.
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Chapter 26: Question 6 – Delta NV
(a) Calculate theoretical ex-rights value of a share
Market value of a share prior to rights issue was €1.10.
4 shares at €1.10 per share = 4.40 1 share at 60p = .60 5 shares = 5.00 Theoretical ex-rights value = 1.00
(b) Bonus issue factor =110/100
(c) BEPS 20X8
440,000/(4,000,000 × 11/10) = €0.10
previously calculated as:
440,000/4,000,000 = €0.11
(d) BEPS 20X9
Uplift shares prior to issue by 110/100 4,000,000 × (110/100) × 6/12 months = 2,200,000
Weight shares after issue: 5,000,000 × 6/12 months = 2,500,000 Total shares for BEPS calculation = 4,700,000
BEPS = €500,000/4,700,000 = €0.106
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Chapter 26: Question 7 – X Ltd
(a) Ordinary shares Profit EPS Effect Net profit after tax 18,160
Less preference dividend (160)
40,000 18,000 45p
Options (W1) 400 40,400 18,000 44.6p dilutive
Convertible preference shares 3,200 160
43,600 18,160 41.7p dilutive
Convertible loan stock Interest [6% × £20m ×s 0 .67] 804 Discount 200 Shares converted [(20m/200) × 23] 2,300 _____ 45,900 19,164 41.8p anti-dilutive
• Since the loan stock is anti-dilutive it is ignored in the calculation of Diluted Earnings per Share
• Diluted EPS will be reported as 41.7p.
W1 Fair value of one ordinary share £1.50
Number of options 2,000,000
Exercise price £1.20
Proceeds from exercise of options £2,400,000
Number of shares assumed to be issued at fair value 1,600,000
Number of shares issued for no consideration (2m – 1.6m) = 400,000
(b)
• An option is treated as if – there was an issue of shares for full market value/fair value; and – an issue for no consideration (a bonus issue). – The bonus element is treated as being the dilutive effect.
• IAS 33 is saying that by issuing options to directors/employees the company is making a bonus issue of shares plus a full issue of shares, the latter being as-sumed not to have a dilutive effect.
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• Only potential ordinary shares that would dilute EPS should be taken into account and any anti-dilutive potential ordinary shares will be ignored.
• This procedure essentially means that certain categories of potential
• ordinary shares will not be used in the calculation.
• Thus the calculation will be based on the concept of prudence rather than on the substance of what is realistically going to occur. All items of income or expense that would cease on conversion are to be added back.
• Prudent disclosure.
As regards the ranking of potential ordinary shares from most to least dilutive and the subse-quent calculations, an alternative solution would be to disclose both the fully diluted EPS and the maximum dilution of EPS. This would essentially mean that the more realistic calculation and the prudent calculation of IAS 33 would be disclosed.
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C H AP T E R 2 7
Chapter 27: Question 1 – Example Ltd
£000 £000 Cash flows from operating activities Net profit before tax 500
Adjustments for:
Depreciation 102
Profit on sale of plant (13)
Interest expense 20
Operating profit before working capital changes 609
Increase in trade and other receivables (260)
Increase in inventories (400)
Decrease in trade payables (40)
Cash generated from operations (91)
Interest paid (20)
Income taxes paid (220)
Net cash used in operating activities (331)
Cash flows from investing activities Purchase of property, plant and equipment (560)
Proceeds from sale of equipment 241
Payment to acquire government securities (20)
Net cash used in investing activities (339)
Cash flows from financing activities Proceeds from issuance of share capital 300
Redemption of debentures (50)
Dividends paid (120)
Net cash from financing activities 130
Net increase in cash and cash equivalents (540) Cash and cash equivalents at the beginning of the period 72
Cash and cash equivalents at the end of the period (468)
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Chapter 27: Question 2 – Martel plc
(a) £000 £000
Cash flows from operating activities Net profit before tax 427
Adjustments for:
Depreciation 292
Profit on sale of plant (8)
Interest expense 52
Operating profit before working capital changes 763 Increase in trade and other receivables (132)
Increase in inventories (174)
Increase in trade payables 46
Cash generated from operations 503
Interest paid (52)
Taxes paid (79)
Net cash used in operating activities 372
Cash flows from investing activities Purchase of property, plant and equipment (714)
Proceeds from sale of equipment 20
Purchase of government securities (40)
Net cash used in investing activities (734)
Cash flows from financing activities Proceeds from issuance of share capital 150
Proceeds from 9% debenture issue 82
Dividends paid (76)
Net cash from financing activities 156
Net increase in cash and cash equivalents (206) Cash and cash equivalents at the beginning of the period 22
Cash and cash equivalents at the end of the period (184)
Note 1: Cash and cash equivalents 20X1 20X0 Bank – 22
Overdraft (184) –
Cash and cash equivalents (184) 22
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(b) Martel plc has invested heavily in fixed assets during the year and although it has raised addi-tional capital it has had to rely on a bank overdraft. The acid test ratio is lower in the current year (304 : 642).
However, we do not have information on the projected cash flows that supported the capital in-vestment decisions – this is where narrative information within the annual report could be helpful in identifying the company’s strategic planning for future years, e.g. new markets, new products, greater productive efficiency.
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Chapter 27: Question 3 – Flow Ltd
Cash flow Statement for the year ended 31 December 20x6 for Flow Ltd
Net cash inflow from operating activities 191,025 Cash flows from investing activities
Payment to acquire non-current assets (265,500)
[1,983,750 + 25,500–1,743,750]
Receipts from sale of non–current assets 6,225
Net cash paid on investing activities (259,275) Cash flows from financing activities
Issue of common shares 180,000
Dividends paid
(could be shown as operating cash flow) (45,000)
Net cash inflow from financing activities 135,000 Net increase in cash and cash equivalents
[75,000–8,250] 66,750 Net cash inflow from operating activities:
Profit (176,625 –(387,000–300,000–45,000)) 134,625
Non cash items
Depreciation [619,125–551,250 +(25,500–9,375)] 84,000
Loss on disposal [9,375–6,225] 3,150 Changes in working capital
Decrease in inventory 15,750
Increase in trade receivables (22,500)
Decrease in trade payables (24,000)
Net cash inflow from operating activities 191,025
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Chapter 27: Question 4 – Blue Ting plc
(a) Cash Flow Statement for the year ended 31 May 20X5 £m £m Cash flows from operating activities Profit before tax 96
Adjustments for:
Depreciation expense 37
Amortisation of development expenditure 1
Interest income (3)
Interest expense 7
Loss (gain) on disposal of property, plant and equipment (2)
Operating profit (loss) before working capital changes 136 Increase in accounts receivable (20)
Decrease in inventories 15
Increase in payables 89
Cash generated from (used in) operations 220 Interest paid (4)
Interest income 3
Interest element in finance lease rental payment (3)
Tax paid [10 + 22 – 16] (16)
Dividends paid [12 + 8] (20)
Net cash from operating activities 180
Cash flows from investing activities: Proceeds from disposal of property, plant and equipment 21
Purchase of property, plant and equipment (104)
Net cash used in investing activities (83)
Cash flows from financing activities: Proceeds from issuing shares 14
Share issue costs (1)
Purchase of own shares (12)
Capital repayments under finance leases (7)
Net cash used in financing activities (6)
Net increase (decrease) in cash and cash equivalents 91 Cash and cash equivalents at beginning of year 3 Cash and cash equivalents at end of year 94
(Note: Dividends paid have been treated in their optional position in operating activities and the cash and liquid resources have been assumed to be cash and cash equivalents.)
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(b) Published forecast cash flow information: advantages and disadvantages to users
Advantages
• Provides the benefit of: management’s knowledge of future cash flow their views as to future cash flows committing management to future planning committing to considering going concern issues.
• Reduces the benefits of insider dealing as information would be in the public domain.
• Makes it more possible to evaluate managerial performance
• Aids investors and creditors to assess the ability of the company to meet its obligations in the future.
Disadvantages
• They are uncertain.
• They are subjective as based on the opinions of management.
• They can be manipulated by management although a poor history of accuracy will become apparent over time.
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Chapter 27: Question 5 – Carver plc
Cash Flow from Operations for the year ended 30 September 20X4
£000 £000 Profit before tax
1,985
Adjustments for:
Depreciation W1 325
Investment income (155)
Interest payable 150
Share of profit of associate (495)
Profit on sale of machinery (100)
Operating profit before working capital changes 1,710 Increase in inventory W2 (943)
Increase in trade receivables W3 (547)
Increase in trade payables W4 152
Cash generated from operations 372 Interest paid (100)
Taxes paid W5 (250)
Net cash from operating activities 22
Cash from investing activities Purchase of machinery W6 (1,085)
Sale of machinery 500
Purchase of subsidiary W7 98
Dividends received from associate W8 250
Dividends received from fixed asset investments 155
Cash used in investing activities (82)
Cash flow from financing Proceeds from the issue of share capital W9 2,453
Issue of loan stock W10 920
Capital payments under finance leases W11 (270)
Dividends paid to group shareholders (300)
Dividends paid to minority interests W12 (48)
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Cash flow from financing 2,755 Increase in cash and cash equivalents 2,695
Cash and cash equivalents brought forward 1,820
Cash and cash equivalents carried forward 4,515
Workings
W1: Depreciation charge Buildings 125
Machinery
Closing aggregate amount 1,200
Less: Opening aggregate amount(1,100)
100
Add: depreciation on disposal 100 200
325
W2: Inventory Closing balance 1,975
Less: Opening balance 1,000
Arising on acquisition 32 (1,032)
943
W3: Trade receivables Closing balance 1,850
Less: Opening balance 1,275
Arising on acquisition 28 (1,303)
547
W4: Trade payables Closing balance 500
Less: Opening balance 280
Arising on acquisition 68 (348)
152
W5: Tax
Opening balances
Income tax 217
Deferred tax 13
Transfer from profit and loss account 495
Closing balances
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Income tax (462)
Deferred tax (30)
233
Acquisition tax 17
250
W6: Investment in machinery Cost at 30.9.20X4 3,000
Less: Cost at 1.10.20X3 (1,400)
1,600
Add: Disposal 500
2,100
Less: Arising from acquisition (165)
Leased (850)
Cash outflow 1,085
W7: Cash Cash acquired from acquisition 112
Less: Cash consideration (14)
Cash inflow 98
W8: Dividends received from associate Opening balance 1,000
Add: Share of profit 495
Less: Tax (145) 350
1,350
Closing balance (1,100)
Cash inflow 250
W9: Shares
Closing balances
Shares 3,940
Premium 2,883
6,823
Less: Opening balances
Shares (2,000)
Premium (2,095)
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Non-cash consideration
Shares (220)
Premium (55)
Cash inflow 2,453
W10: Loans Closing balance 1,460
Less: Opening balance (500)
960
Less: Increase finance cost (40)
Cash inflow 920
W11: Lease – capital payments Opening balances [200 + 170] 370
Add: new lease commitment 850
1,220
Less: Closing balances [240 + 710] (950)
Cash outflow 270
W12: Minority interests Opening balance –
Add: Profit for year 100
Arising from acquisition 63
163
Closing balance (115)
Cash inflow 48
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C H AP T E R 2 8
Chapter 28: Question 1 – Saddam Ltd
(a) Profitability – ROCE
• Camel Ltd is the most profitable of the three companies.
• An inspection of the secondary ratios shows that this is due to efficient utilisation of assets since its net profit ratio is well below that of the other two companies.
• Examination of gross profit percentages confirms the observation that Camel Ltd seems a high volume, low margin business compared with the others.
Liquidity
• Ali Ltd has a current ratio which is out of line with the other two, being very much higher suggesting surplus investment in working capital.
• The acid test ratio reinforces this view and also indicates that Baba Ltd appears to have a liquidity problem with current liabilities considerably greater than cash and debtors (de-spite having the greatest number of weeks’ debtors outstanding of the three companies).
• Baba Ltd also has considerably more weeks of stock outstanding than the other two com-panies which may be linked with the high level of creditors.
• Ali Ltd also has stock levels well in excess of Camel Ltd explaining in part at least the high current ratio.
Dividends
Camel Ltd is paying a higher proportion of profits out in dividends, which may have the effect of raising shareholder loyalty and the bid price.
Conclusion
• Baba Ltd appears to have considerable liquidity problems arising out of excess investment in stock.
• Camel Ltd is a lean enterprise able to survive on a lower gross profit margin due to superior asset utilisation. Why is the gross profit margin low?
Before a final decision is made the absolute figures in the financial statements should be studied and questions raised such as:
• Are the activities of the firms really the same?
• What are the relative turnovers?
• What is the growth over a period of years?
• What are the trends of all the ratios?
• How old are the assets?
• Are asset ages distorting ROCE comparisons between the companies?
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Also need to assess managerial skills, product potential etc. which are not shown in the financial statements.
(b) Why balance sheet is unlikely to show the true market value of the business
The accounting policy in the UK is to state fixed assets at cost less depreciation or at historical cost modified by revaluation of all or selected classes of fixed assets.
The true market value of a listed company is available from the market capitalisation figure based on current share prices.
The true market value of an unquoted company is not readily available and would require the future cash flows to be evaluated.
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Chapter 28: Question 2 – Esrever Ltd
Forecast profit and loss account for year ended 30 June 20X1
£ £ Turnover [87,007 × 100/32] (S3) 271,897
Opening stock 22,040
Purchases (S5) 194,205
216,245
Closing stock [184,890 × 61.9/365] (S5) 31,355
Cost of sales [271,897 × 68%] (S4) 184,890
Gross profit [20,290 × 100/23.32] (S2) 87,007
Depreciation
– buildings [132,000 × 2%] (S6) 2,640
– fixtures etc. [96,750 × 20%] (S6) 19,350
Loan interest [50,000 × 12%] (S7) 6,000
Credit expenses (balancing figure) (S8) 33,655
61,645
Profit before tax 25,362
Corporation tax [20,290 × 20/80] (S9) 5,072
Profit after tax [181,808 × 11.16%] (S1) 20,290
Dividends [200,000 × 2.5p] (S10) 5,000
Profit retained (S11) 15,290
Profit retained b/f (S12) 66,518
Retained profit c/f (S13) 81,808
Forecast balance sheet as at 30 June 20X1
£ £ Fixed assets (NBV)
Land and buildings [132,000 – 2,640] 129,360
Fixtures, fittings [96,750 – 19,350] 77,400
(S14) 206,760
Current assets Stock (S15) 31,355
Debtors [(271,897 × 42.6/365) × 1.15] (S16) 36,494
67,849
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Creditors: amounts falling due in less than one year Bank overdraft (a balance figure based on note 2) (S20) 9,756
Creditors [(194,205 + 33,655) × (29.7/365) × 115%] (S17) 21,321
Other creditors [5,072 tax + 5,000 dividends
+ 1,652 VAT] (S18, S19) 11,724
42,801
Net current assets 25,048
Total assets less current liabilities (per Note 3) 231,808
Creditors: amounts falling due in more than one year 12% loan (S23) 50,000
181,808
Ordinary shares (S21) 100,000
Profit and loss account (balancing figure) (S22) 81,808
181,808
VAT: Output tax [271,897 × 15%] 40,785
Input tax [(194,205 + 33,655) × 15%] 34,179
Net amount for year 6,606
6,606 × 0.25 1,652
Approach to Esrever profit and loss account
(S1) Start with post-tax profit i.e. 11.16% of (231,808 – 50,000) per notes 3 & 4 = £20,290 (S2) From post-tax profit 20,290 derive gross profit as 100/23.32 × 20,292 based on Note 4 = £87,007 (S3) Next, derive turnover as 100/32 × 87,007 based on Note 6.
Cost of goods sold = 68% of turnover. Therefore turnover = 100/32 × gross profit = £271,897
(S4) From sales and gross profit derive cost of goods sold as 271,897 – 87,007 = £184,890
(S5) You can now find components of cost of sales (£184,890) as: £
(a) Opening stock 22,040 (given in question) (b) Purchases 194,205 (balance figure)
216,245 (c) Closing stock (31,355) (61.9 × 184,890)
365 Total costs of goods sold 184,890
Note: Start with closing stock 61.9 days based on Note 7; all other figures are derived and the opening stock is given as £22,040.
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(S6) Depreciation: 2% × 132,000 for buildings = £2,640 20% × 96,750 for fixtures etc. = £19,350
based on Note 1 and opening asset given (S7) Loan interest is 12% of 50,000 = 6,000 (S8) Expenses – this is a balancing figure as we already have all the other figures in the profit
and loss account = 33,655 (S9) Taxation charge is 20/80 × 20,290 based on Note 5 = 5,072 (S10) Dividend – see Note 9 (200,000 × 2.5p) = 5,000 (S11) Retained profit = 15,290
(S12) Retained profit b/forward is a balancing figure = 66,518
(S13) Retained profit c/down (see S22 below) = 81,808
Approach to Esrever balance sheet
Projected balance sheet as at 30/6/20X1 is built up as follows:
(S14) Fixed assets are derived from the opening figure less depreciation = 206,760
(S15) Stock has already been computed at = 31,355 (S16) Debtors, based on Note 10, assuming 42.6 days’
credit, are 42.6/365 × 271,897 = 31,734 × 1.15 to cover VAT = 36,494
(S17) Creditors, assuming credit of 29.7 days, are 29.7/365 × 227,860 × 1.15 = (21,321)
(S18) Other creditors (dividends 5,000 + tax 5,072) = (10,072) (S19) VAT 15% net of sales – purchases and expenses is
15% (271,897 – 194,205 – 33,655) x 0.25 = (1,652) (11,724)
(S20) Overdraft is balancing figure based on Note 2 = (9,756) Current liabilities 42,801
Total assets less current liabilities per Note 3 231,808 (S21) Share capital given in question 100,000 (S22) Retained profit (balancing figure) 81,808 (S23) 12% loan 50,000
231,808 Note: Retained profit is the balancing figure to make up £231,808. The bank overdraft of £9,756 is the overall balance sheet balancing figure.
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Chapter 28: Question 3 – Amalgamated Engineering plc
(a) Cash flow statement for year ended 31 December 20X6
£000 £000 Net cash inflow from operating activities 495
Returns on investing and servicing of finance
Interest paid 195
Net cash outflow 195
300
Taxation
Tax paid 375
(75)
Capital expenditure
Payment to acquire plant (450)
Receipt from sale of investments 300
(150)
Equity dividends paid (225)
Net cash outflow before financing (450)
Financing -
Increase in overdraft (450)
Reconciliation of operating profit to net cash inflow from operating activities
Operating profit 795
Depreciation 300
Increase in stocks (375)
Increase in debtors (300)
Increase in creditors 75
495
(b) 20X5 20X6
Liquid ratio
Current assets – inventory 1,125 1,125
Current liabilities 1,125 1,575
= 1 = 0.71
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Interest cover Profit before interest 885 795
Interest charge 135 195
= 6.56 times = 4.08 times
Return on average shareholders’ funds Profit after tax …….375 …………..300
Av. shareholders funds (4,575 + 4,425) / 2 (4,650 + 4,575) / 2
(Could revalue property) = 8.3% = 6.5%
Gearing ratio Long-term loans 1,500 1,500
Shareholders’ funds 4,575 4,650
= 32.8% = 32.3%
or
Long-term loans 1,500 1,500
Long-term loans and shareholders’ (1,500 + 4,575) (1,500 + 4,650)
funds
= 24.7% = 24.4%
Stock turnover ratio Cost of sales 4,410 4,680
Inventory 1,125 1,500
= 3.92 times = 3.12 times
(c) Main points in report should cover the following. Most important points are with an asterisk.
Profitability *(1) Given unchanged sales volume (NB cannot tell from historical cost accounts without
date on specific price movements), price rises have been below the level of general in-flation (4.8%). Is this deliberate policy or just poor management? If deliberate appears not to have improved sales.
(2) Cost of materials and labour also increased below level of inflation (5% and 5.6% respec-tively).
More efficient use? (3) Overheads increased 10% – in line with inflation (both production and administrative) – led
to falling margins (gross and net). (Further information by product might help see if one particular area is a problem – or if it is right across the board.)
(4) Increased interest has caused profit before tax to fall 20% although interest cover still looks OK. (NB Is this relevant? Interest is paid from cash.)
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*(5) Trends are worrying – falling margins and rising interest seem to indicate problems soon. How long can firm continue to hold the dividend? (Need more years’ data – long-term picture. Is this a recent trend or not?)
Solvency/liquidity (6) Working capital rising – trade receivables and inventories are up a lot.
*(7) Reflected in worsening liquid ratio – quite a large fall. (Again, need more years’ data. What is norm?)
*(8) Inventory turnover is getting worse – 3.85 months’ inventory on hand (20X5 3.06). Need more information here – slow-moving inventory? Or is it just poor management of working capital?
*(9) Trade receivables’ turnover ratio has got worse (20X5 7.64; 20X6 5.87). In their state they need to be collecting more quickly. Is there one or a few debts causing this, or is it general sloppiness?
(10) Flow of funds – company is investing in new equipment so is presumably not contract-ing operations. Need information as to use equipment is being put to, and future capital expenditure plans.
*Purchases of assets (+ payment of tax + dividend) have been partly paid for by selling off short-term investments. This is a one-off – bad sign.
Could use previous 5 years’ funds flow statements – trends quite important.
*(11) The increased overdraft is financing the increased stocks and debtors. (12) Gearing ratio is OK – but the problem is one of liquidity at the moment.
Could argue the overdraft appears to be a permanent feature of this firm. The gearing ra-tio looks worse if the overdraft is included (+ an overdraft of 1,500,000 makes it look even more unhealthy). (Gearing ratios calculated using book values may not be too use-ful – could recalculate using market values of debt and equity, where quoted.)
General points *(13) Why does firm want to increase the overdraft? Seems to be to finance working capital.
Could be risk for the bank if the firm’s profitability is in a long-term decline (Does not mean don’t lend – could charge more interest.)
*(14) Or could secure the overdraft – market value of the land and buildings is well in excess of the debentures.
*(15) How will firm pay off the overdraft? Need to ask for cash forecasts for next few years (firm should have – if not, poor management). (NB Historical cost accounts generally of little help with respect to forward-looking data.)
(16) More data on management. Old, young? Likely to let firm stagnate? Also need to see strategic plans – in what direction is firm going? Do they know?
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(d) Response to director
(i) Debt Service Coverage Ratio
• This ratio requires the figures for interest, tax, depreciation and amortisation charge to cal-culate EBITDA.
• The ratio gives the bank an indication of the company’s ability to meet its capital debt re-payments as well as annual interest payments from its cash flow from operations.
(ii) Cash flow from operations to current liabilities
• This ratio requires the cash flow from operations figure in the cash flow statement.
• The ratio gives additional information to the current and acid test ratios which are static in the sense that both the numerators and denominators are based on year-end figures which are capable of manipulation or management e.g. running down stocks or exceptional cash receipts at the year-end.
(iii) Cash recovery ratio
• This ratio requires the figures for cash flow from operations and proceeds of sale of fixed assets from the cash flow statement.
• The ratio gives an indication of the payback time i.e. how quickly the company will recoup its investment in fixed assets from its cash flow. The manager would naturally regard a shorter period as less risky.
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Chapter 28: Question 4 – Sally Gorden
(a) EPS Ruby Sapphire
Earnings: Profit £280,000
Pref. div. (90,000)
190,000 Number of shares:
1.7.X3 – 30.9.X3: 1,500,000 × 3/12 = 375,000
1.10.X3 – 31.6.X4: 2,000,000 × 9/12 = 1,500,000
1,875,000
£190,000 / 1,875,000 × 100 = 10.13p
£240,000 / 3,000,000 × 100 = 8p
(b) Price/earnings ratio
475/10.13 = 47 times 480/8 60 times
(c) PE ratio of Sapphire plc is almost twice that of Ruby plc.
• This would reveal that there is much higher demand for shares in Sapphire.
• This in turn indicates greater confidence the investing public has in that company.
• This confidence may be based on
• the type of industry
• growth potential, growth rate
• track record of past performance
• diversity of its products
• quality of management
• customer attachment and so on.
(d) Other matters that should be considered
(i) What Sapphire’s EPS would have been if there had
been no bonus issue: 240,000/2,000,000 × 100 12p Sapphire appears better than Ruby
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(ii) Return on capital employed (ROCE)
PBIT/capital employed × 100 588,000 / 2,710,000 × 100 = 21.7% 445,000 / 2,450,000 × 100 = 18.2%
(iii) Return on equity capital (ROEC)
PBT less pref. Div./equity cap + reserves 354,000/1,310,000 × 100 = 27% 385,000/1,950,000 × 100 = 19.7% • Ruby provides a better return on equity • but its EPS is not quite so favourable • it is more geared, and • had borrowed at a significantly higher cost than Sapphire.
(iv) Gearing ratio
Prior charge capital/total CE × 100 1,400,000/2,710,000 × 100 = 51.66% 500,000/2,450,000 × 100 = 20.4%
• Though both companies are geared, Ruby is highly geared. This means that any fall in profit will affect equity shares more than in proportion.
(e) Advantages of gearing
• Equity shareholders benefit if the return on investment exceeds the cost of borrowing.
• There is no dilution of the existing shareholders’ interest if funds are raised by borrowing rather than by an issue to new shareholders.
• Loan interest is allowable for tax relief.
• Lenders normally obtain some form of security in the form of either a charge on assets or prior rights on liquidation. This means that their risk is lower and therefore their required rate of interest is lower.
Disadvantages of gearing
• Impact on company’s funding if loan covenants are breached e.g. may be required to rene-gotiate the loan at a higher rate of interest or even by issuing additional ordinary shares to the lenders in recognition of their increased risk.
• Impact on company’s funding if equity shareholders perceive that there is a greater risk to equity funds if there is high gearing and as a result require a higher return on their invest-ment.
• Adverse impact on amount available for distribution to shareholders if profits fall.
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Chapter 28: Question 5 – Segmental Reporting
(i) The case for segmental reporting – two arguments for
• It will reveal in more detail how well management has performed.
• Management will not be able to hide its failures behinds its successes.
• Both will be disclosed and shareholders will be better able to judge the performance of di-rectors.
• In addition, disclosure of segment results may encourage management to exercise greater care when making investment decisions and be more positive in correcting any mistakes.
• The first argument is, then, that segmental reporting will result in improved managerial per-formance.
• The data provided by segmental reporting will be more useful for the investors.
• This is because many financial statement users have said that consolidated financial infor-mation, while important, would be more useful if supplemented with disaggregated information to assist them in assessing those uncertainties that surround the timing and amount of expected cash flows.
• This would allow them, therefore, to assess the risks related to a personal investment in or a loan to an enterprise that may well operate in different industries or in different areas of work.
• The results of a diversified enterprise are composed of the results of its parts and the finan-cial users consequently regard financial information on a segmental basis as also important.
(ii) The case against segmental reporting
• The case against segmental reporting arises from a consideration of cost and reliability.
• An important consideration in assessing the desirability of disclosing segmental data is a comparison of the benefits arising from and the costs incurred by any such disclosure.
• If the benefits exceed the costs, then the disclosure is desirable.
• This comparison is difficult to make in practice because the benefits are enjoyed by the us-ers while the costs are incurred by the statement providers.
• It is not surprising that users express a need for segmental data because it costs them noth-ing.
• Equally, it is not surprising that the statement providers do not want to incur the costs of disclosing segmental data because
• they are unlikely to receive any benefits and,
• even worse, they run the risk of their managerial deficiencies being revealed.
• The costs that may be incurred by the statement providers include
• the costs of collecting and processing the information,
• the costs of audit,
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• the costs of disseminating it to those who must receive it and
• the costs of disclosure in the form of a loss of competitive advantage vis-à-vis trade competitors or trade unions with a consequent effect on wage demands.
• It follows that a comparison of the private costs incurred by the providers and the private benefits enjoyed by the users is likely to be inconclusive.
• A more fruitful, but again difficult, approach would be to compare the social costs with the social benefits. The social costs would be the resources consumed in the gathering, process-ing and publication of the segmental data. The social benefits would be the improved allocation and more efficient use of resources.
• The second major objection to the provision of segmental data is their reliability.
• It is argued that segmental data are not sufficiently reliable to justify disclosure. If this is true the unreliable data may be just as misleading as no segmental data at all.
• The unreliability is due to the fact that there is the necessity to make arbitrary allocations of both costs and revenues amongst the various segments of the business.
• The degree of arbitrariness will depend upon the nature and size of the reporting segments and the amount of detail disclosed for each segment.
There are other specific objections to the disclosure of segmental data that may be made. These include:
Investors invest in a company and not its individual segments. Whilst this is correct it cannot be denied that data about the operations of individual segments may permit investors to make better informed decisions about investments.
The data are difficult to interpret and may confuse readers or be misunderstood with inappropriate inferences being drawn. It is usually assumed, however, that the statement users are technically competent and able to understand accounting data.
Segmental data cannot be prepared with sufficient reliability and it is beyond the scope of external financial reporting to provide such analytical or interpretive data. It is true then that there are reliability problems with producers of segmental data, but whether those problems are sufficient to warrant non-disclosure of the data is a matter of judgement. It is sometimes maintained that the disclosure of segmental data constitutes analysis and interpretation and is, therefore, beyond the scope of financial reporting. However, this is a matter of opinion. Whilst analysis and interpretation do usually involve the study or reordering of existing published data, segmental reporting provides additional data not otherwise available. It is difficult to argue, therefore, that the provision of segmental data constitutes analysis and interpretation.
There may be a negative impact on corporate innovation and experimentation. If mistakes are disclosed, management may be inclined to minimise risk to avoid mis-takes, and innovation may suffer. This argument is difficult to assess. In the long run, of course, a lack of innovation will lead to poor performance and dissatisfaction with man-agement. It seems likely that investors will be sufficiently sophisticated to realise that continued success requires innovation, which means that some risks must be taken. The costs of providing segmental information are too high.
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The objection relates primarily to a fear that disclosure of segmental data may weaken the firm’s competitive position. This objection has been fairly widely researched and the general conclusion seems to be that researchers found that companies rarely ‘if ever, en-counter(ed) any real loss of competitive advantage as a result of segment reporting’.
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(b) Chapter 28: Question 6 – Filios Products plc
(a) Refer to Chapter 28: Question 5.
(b) Segmental statement (£m)
Classes of business Beer & pub Hotel Other drinks Total business & leisure operations Turnover
Turnover 508 152 368 1,028
Profit
Segment profit (W1) 85 45 18 148
Common costs 15
Operating profit 133
Interest 14
Published net profit 119
Net assets
Segment net assets (W2) 1,127 391 403 1,921
Unallocated assets (W2) 82
Published net assets 1,839
Workings
W1 Sales 508 152 368
Cost of sales 316 81 287
Administration 43 14 18
Distribution costs 64 12 25
423 107 350
Segment profit 85* 45 18
W2 Net assets Fixed assets book value 890 332 364 77
Stocks and debtors 230 84 67
Bank 73 15 28 12
303 99 95 12
Less Current liabilities 66 40 56 31
Net current assets 237 59 39 (19)
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10% Debentures (140)
Net assets 1,127* 391 403 (82)
* Excluding interest and interest bearing loans as appropriate
(c) Analysis calculations
Accounting ratios: Operating divisions Competitors Beer & Hotel Other Dean Clarke Pub business % % % % % Operating profit % 16.7 29.6 4.9 13.3 40.0
Asset turnover 45.1 38.9 91 46.0 50.0
Return on assets 7.5 11.5 4.5 6.2 20.0
(i) Possible comments:
• The best performing segment, based on the primary accounting ratio, the return on assets, is the hotel division.
• The superior performance of the hotel division is attributable to the fact that it is able to generate higher operating margins than either of the other segments, and this outweighs the fact that it has the lowest asset turnover.
• It would appear that Filios’ beer and pub division pursues a policy of higher selling prices and margins while also endeavouring to maintain asset turnover.
• It would appear that the hotel business division is performing poorly both in terms of cost control and use of assets, and each of these areas requires detailed investigation.
• The third division – other drinks and leisure – is making a contribution to profit of £18m but performance is mediocre by all measures, including a return on net assets of just 4.5%.
(ii)
• In order to interpret effectively the performance of the company, the results achieved by each division need to be compared with its direct competitor.
• The beer and pub division achieved a return on assets higher than that of its competitor, Dean. The beer and pub division has achieved a far higher profit margin that has more than compensated for the marginally inferior asset turnover.
• Filios’ hotel business division performs poorly compared with its competitor, producing a return on assets of not much more than half of that achieved by Clarke. The division’s profit margin and rate of asset turnover are both lower than those of its competitor.
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• The performance of each of the two divisions for which competitor information is available is not encouraging. The position is even worse when it is recognised that there are unallo-cated common costs of £15m and interest of £14 million. All the indications are that Filios is not being managed in the most effective manner.
• The rate of return on assets earned by Filios Products as a whole (6.5%) is marginally better than that achieved by its competitor Dean, but far below that of Clarke.
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Chapter 28: Question 7 – Chaldon District Council
Report To Client Services Committee From Accountant Date Subject Roofing Contract: Financial Appraisal of Tenderers
1 Introduction
1.1 Four tenderers, including CDS, have been short-listed for appraisal. The ten-ders have been submitted by:
Tender Name A Nutfield & Sons B Chaldon Direct Services (CDS) C Tandridge Tilers Limited D Redhill Roofing Contractors plc
Objective – to determine to whom the roofing contract should be awarded.
Basis of appraisal Tenderers will be appraised on financial and qualitative grounds. Accounting ratios will be em-ployed to assess profitability, solvency (long and short term), speed of cash collection and payment. Details are provided in Appendix A.
Reference to limitations of approach:
• analysis is indicative only, not definitive
• analysis is based on historical information
• need for several years’ figures in order to consider trends.
2 Interpretation of ratios
2.1 Profitability
Despite having the lowest profit margin, A’s ROCE is the highest at 77% due to its very high asset turnover of 13 times per annum. This is probably a reflection of the nature of the business – a small family concern; this probably also accounts for the firm’s relatively low stockholding. The asset turnover of the other two companies is similar, and C’s higher ROCE is due to its higher margins. D’s stock turnover is considerably higher than its competitors’ which could be a cause for concern.
2.2 Long-term security
A has no long-term debt and, therefore, does not bear any interest charges. The other two com-panies are highly geared with C’s long-term debt being equivalent to its equity finance which is a cause for concern.
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2.3 Short-term security
D has the best current ratio, although the quick ratio of the three businesses is similar, C having the lowest. Interest cover is only relevant for C & D and does not appear problematic in either given current profit levels.
2.4 Cash flow ratios
A takes longer to settle its creditors and collect from its debtors than the other two companies whose ratios are similar.
3 Other factors
3.1 An analysis of the make-up of the tenders is as follows
Labour Materials Overheads % % %
A 59 35 6
B 63 25 12
C 75 20 5
D 57 34 9
The variation between the components of the various tenders does not provide for any meaning-ful comparison, although CDS (B) does have the highest proportion of its bid for overheads and profit.
Nutfield and Sons (A) have been employed by the Council for small contracts which they have performed satisfactorily. However, this contract is substantially larger than others they have won and, given a workforce of only six, they may not be able to fulfil a contract of this scale.
CDS (B) is obviously well known to the authority and its management have striven to improve its financial position recently in order to achieve a satisfactory rate of return this year.
Tandridge Tilers Limited (C) have not performed satisfactorily on other contracts that they have carried out for the Council.
Redhill Roofing Contractors plc have not been employed by this authority and the standard of their work is not known.
4 Conclusions
Although the financial standing of Nutfield and Sons (A) does not give cause for concern, and although it has submitted the lowest tender bid, there are doubts as to whether it is capable of carrying out a contract of this scale.
Include a comparison of uses in private and public sector.
Main points should include:
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Private sector
• Weaknesses of historical cost (HC) accounts in times of high inflation; undervaluing assets; overstating profits; not providing for maintenance of capital.
• Can give a better indication of actual profits earned, separates holding gains from earned profits.
• Can give better indication of value of individual assets to the business.
• Based on concept of providing useful information for users of accounts. Not accepted in public sector; accountants not able to agree on bases and methods of adjustments required, or capital maintenance to use.
Public Sector Need to show effective use of public assets. Real-terms measure seen as more appropriate:
• Many public sector organisations have very long lived assets, HC is particularly misleading as result.
• Financial objectives of many public sector bodies are stated in real terms and test discount rates used to evaluate capital projects based on real rates of inflation.
HC is objective and services stewardship function. HC can provide information to enable users of accounts to make their own adjustments, comparisons etc., but fuller disclosure of informa-tion would be required.
There is a wide range of external information available to users of private sector company ac-counts. This is not the case with many public sector bodies.
CCA-adjusted figures argued to be more useful bases of assessing performance.
Does this imply the government views performance evaluation as more important for public sector bodies than investors do for private companies?
CDS (B) submitted the second lowest tender. There is no reason to suspect that it will not be able to deliver the contract to the appropriate standard.
The longer-term financial security (gearing) of Tandridge Tilers Limited (C), the second highest tenderer, and the quality of its work give major causes for concern.
The highest bid was submitted by Redhill Roofing Contractors plc and, although its financial standing does not cause concern, its quality is unknown.
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5 Recommendation
5.1 It is recommended that the contract be awarded to CDS.
Appendix A: Accounting ratios
Profitability A B C Return on capital employed (%) (ROCE) 77.1 21.2 16.5
Profit margin (%)(PM) 6.0 19.5 17.3
Asset turnover (times p.a.)(AT) 12.8 1.1 1.0
Stock turnover (days) (ST) 17 46 94
Long-term solvency Gearing (%) 0.0 50.0 37.0
Short-term solvency Interest cover (times) n/a 4.0 5.6
Current ratio 0.9:1 1.3:1 1.9:1
Quick ratio 0.7:1 0.6:1 0.7:1
Cash flow ratios
Creditors’ settlement period (days) 59 37 40
Debtors’ settlement period (days) 41 27 29
Notes ROCE = (Operating profit/net assets) × 100 PM = (Operating profit/sales) × 100 AT = (Sales/net assets) ST = (Stock and WIP × 365)/direct costs Gearing = (Non-equity finance/equity finance and non-equity finance) × 100 Interest cover = Net profit before tax and interest/interest payable Current ratio = Current assets: current liabilities Quick ratio = (Current assets – stock and WIP): current liabilities Creditors’ settlement period = (Creditors × 365)/operating costs Debtors’ settlement period = (Debtors × 365/sales)
A C D £000 £000 £000
Turnover 612 1,741 3,080
Operating profit 37 339 534
Net assets (total assets less
Current liabilities) 48 1,600 3,241
Non-equity finance – 800 1,200
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Equity and non-equity finance 48 1,600 3,241
Interest payable – 85 96
Direct costs 410 1,191 1,735
Stock and WIP 27 149 449
Operating costs 575 1,402 2,546
Current assets 96 290 690
Current liabilities 104 232 356
Current assets excl. stock 69 141 241
Creditors 93 141 280
Debtors 69 131 241
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Chapter 28: Question 8 – Chelsea plc
(a)
Profitability: ROCE
• Wimbledon outperformed: the industry by 8% and Kensington by 6%. Profit margins:
• Wimbledon follows a high volume/low profit pricing policy
• Low profit evidenced by extremely low profit margin.
• High volume evidenced by the asset turnover figures of 12 and 4 for fixed assets and total assets.
• Kensington and the industry, in contrast, have achieved 2.3 and 1.5; and 5.1 and 2.5 re-spectively. Kensington perhaps moving up market with lower volume/ higher margin.
Cost control:
• Wimbledon’s 7% (12 – 5) shows lower overhead costs as a percentage of sales compared with Kensington and industry averages of 14% and 13%.
Liquidity:
• Wimbledon has a lower debtor collection period and stockholding period – suggests better working capital management than in Kensington.
• Kensington’s acid test ratio of 0.5 appears low compared with 0.9 in Wimbledon and the industry average of 1.3. This appears dangerously low when taking into account the long debtor collection period.
Overall, Wimbledon appears the better investment:
• making better use of assets
• better cost control
• well managed working capital
• potential for borrowing to gear up
• return on equity is healthy.
(b) Matters to be investigated before a final decision can be made:
• Check if activities of companies are actually similar.
• Obtain the absolute figures (£) for turnover, profits, assets etc.
• Determine unexpired economic lives of fixed assets in each company.
• Check quality of management and confirm whether likely to remain.
• Confirm management’s strategy – increased markets or diversification.
• Obtain details of date of redemption of debt.
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Chapter 28: Question 9
(a) North is achieving a higher profit margin than South or East, with East achieving the lowest margin at 3%.
North South East
(i) Profit/Sales × 100 5% 4% 3%
(ii) Asset turnover 5 times 3 times 4 times
ROCE (i) × (ii) 25% 12% 12%
Whilst North has the highest profit to sales, the effect of the differences in the rate of asset turnover on the comparative performance of South and East means that their ROCE is the same at 12%. The ROCE indicates that North is performing better than South and East which have the same return of 12%. However, there are different levels of gearing as shown by the financial multiplier and when this is taken into account the position is as follows:
North South East
(i) Profit/Sales × 100 5% 4% 3%
(ii) Asset turnover 5 times 3 times 4 times
ROCE (i) × (ii) 25% 12% 12%
Financial leverage 2 4 5
ROE 50% 48% 60%
For a lender North has the lowest gearing and less risk (assuming that there are no other con-tra-indications such a s solvency or liquidity problems), for a minority investor East shows the highest ROE. However, as a measure of management performance, although East has the highest ROE it is underperforming at an operational level. If it were to achieve North’s performance (perhaps under new management) then its ROE would increase to 175% (5% margin × 5 times asset turnover × 5 times financial multiplier).
(b) Decision usefulness of consolidated accounts
Pros:
• Consolidated accounts give an overview of the group’s results and financial position.
• Shareholders in parent company can see how their funds have been invested:
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• How much of the net assets belongs to the minority shareholders.
• The amount of profit attributable to their shareholding.
• The amount of profit expressed as EPS with implication for share price movements.
• Impossible for a shareholder in parent of a complex group to obtain such information with-out group accounts which are prepared:
• using uniform accounting policies across all group companies
• eliminating inter-group transactions.
Cons:
• Group accounts might combine very disparate companies with different levels of profitabil-ity, liquidity and risk profiles.
• Detailed information on an individual company may be disguised e.g. excessive gearing.
• Some group companies may be making losses – this will only become apparent if the parent decides to sell the loss-making subsidiary and it is reported under discontinued operations.
• Also not possible to identify any extremely profitable subsidiary although this might be-come apparent from the segmental report.
• The volume of intra-group trading and intra-group indebtedness by each company will not be apparent.
• Where there is a minority interest, unrealised profit on intra-group sales will be eliminated 100% although it could be considered that the proportion relating to the minority interest has been realised.
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Chapter 28: Question 10
PROFILE 31/07/2004 31/07/2003 31/07/2002 31/07/2001
12 months 12 months 12 months 12 months
Turnover 787,126 730,913 601,295 483,968
Profit (Loss) before Taxation
46,316 56,139 53,568 44,317
Net Tangible Assets (Liab.)
677,710 680,989 660,447 575,223
Shareholders Funds
288,954 318,628 310,133 273,839
Profit Margin (%) 5.88 7.68 8.91 9.16
Return on Share-holders Funds (%)
16.03 17.62 17.27 16.18
Return on Capital Employed (%)
6.83 8.24 8.11 7.70
Liquidity Ratio 0.22 0.24 0.24 0.29
Gearing Ratio (%) 143.19 121.51 120.96 110.06
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C H AP T E R 2 9
Chapter 29: Question 1 – Wandafood Products plc
• Profit to sales was low in 20×7.
• Decline in return on assets in 20×7.
• Consider the profit to turnover and asset turnover movements.
• Interest and dividend cover is falling from 20×6.
• Further decline could create problems.
• There is an upward move in the level of borrowings.
• Debt to equity as indicated by the relationship between the net borrowings and the sum of net borrowings and shareholders’ funds is 1:10 in 20×6 and 1:2.5 in 20×9 indicating in-creased borrowing.
• Liquidity as indicated by the trend in the liquid and current ratios is levelling out.
Asset ratios
• Sales to working capital ratio shows a steadily increasing trend. May indicate more efficient use of working capital.
• Assets per share are increasing indicating that the company is ploughing back profits.
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Chapter 29: Question 2 – Bouncy plc
(a) Ratios for a potential shareholder
20×6 20×5
(i) Return on equity Profit after tax and Preference divi-
dends /Ordinary share capital +
Reserves
1,300/6,700
= 19.4%
900/5,650
= 15.9%
(ii) Earnings per
share
Profit after tax and Preference divi-
dends/No.of Ordinary shares
1,300/6000
= 21.67p
900/6,000
= 15p
(iii) Dividend cover Equity profits/Proposed dividend 1,300/250
= 5.2 times
900/250
= 3.6 times
(iv) Gearing Debt capital/Debt + Equity 1,500/8,200
= 18.3%
1,500/7,150
= 21.0%
(b) Solvency ratios for a potential lender
(i) Debt equity Debt:Equity 1,500:6,700 = 1:4.5
1,500:5,650 = 1:3.8
(ii) Solvency Current assets:Current liabilities 3,810:1,960 = 1.9:1
3,610:2,060 = 1.8:1
(iii) Interest cover Profit before interest:Interest 2,200/170 = 13 times
1,570/150 = 10 times
(iv) Liquidity Current assets – Stock:Current li-abilities
1,710:1,960 = 0.87:1
1,540:2,060 = 0.75:1
(c) Comments from potential shareholder’s viewpoint
The return on equity has improved by approximately 25%. The dividend is well covered and has improved in 20×6 from 3.6 in 20×5 to 5.2 in current year. The EPS figure is in line with the re-turn on equity and is acceptable. The gearing is low at 18.3% so that the business enjoys lower earnings risk.
Comments from viewpoint of lender
The current ratio at 1.9 and acid test ratio at 0.87 are both improving and interest is well covered at 13 times. Gearing is low and coupled with the improving return on equity and sound interest cover means that the company is able to increase its long-term borrowing.
The increase in the share price over the last three years is understandable given the picture pre-sented by the ratios.
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(d) Advising on scheme to choose
It is interesting to assess the schemes from their impact on earnings per share and return on equity. Assuming a rights issue £000 £000 Profit before interest and tax 2200
Interest expense currently (170)
Less: Debenture interest (10% of £1.5m) 150
Bank charge interest (20)
2180
Taxation (730)
Loss of interest allowance 40% of 150,000 (60)
(790)
Revised profit after tax 1390
Earnings per share:
Shares in issue £3,000,000/£0.5 = 6,000,000
New shares £6,000,000/£1.5 = 4,000,000
10,000,000
EPS = £1,390,000/10,000,000 = 13.9p
Return on Equity = 1,390/(6,700+6,000) × 100 = 11%
13% Debentures
£000 £000 Profit before interest and tax 2,200
Interest expense (6,000 × 13%) (780)
1,420
Taxation 730
Less tax savings on loan interest (780 – 170) × 40% (244)
486
Revised profit 934
EPS = 934/6,000 = 15.6p
Return on Equity = (934/6,700) × 100 = 14%
The decision based on EPS and return on equity supports the loan funding scheme.
Other factors to be taken into account:
Consider the increase in gearing from 18.3% to 47.2% (6,000/12,700)
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Chapter 29: Question 3 – Liz Collier
(a) Option 1 Year 1 Year 2
£ £ Profit [21,000 × 140/100] 29,400 29,400
Less interest at 10% per annum 1,000 1,000
28,400 28,400
Comments:
(i) The loan of £10,000 is paid out of incremental cash flow generated by profit in 14.5 months.
(ii) It is likely that some benefit will continue after the end of year 2 and marginally improve her lifestyle.
(iii) It is assumed that the 40% increase is a reasonable and feasible forecast.
Option 2 Year 1 Year 2
£ £ Partnership profit 39,600 39,600
[profit is £33,000 × 120/100]
Less cost of amalgamation (6,870)
Less salaries
Liz – 2% of £126,000 (2,520) (2,520)
Joan – 2% of £72,000 (1,440) (1,440)
28,770 35,640
Profit share:
Liz 3/5 (17,262) (21,384)
Joan 2/5 (11,508) (14,256)
Comment:
(i) Liz will receive
Salary 2,520 2,520
Profit share 17,262 21,384
19,782 23,904
Liz is worse off in year 1 by £1,218 [21,000 – 19,782] and better off by £2,904 in year 2. Her share of the initial investment is £4,122 i.e. 3/5 of £6,870. This investment will be repaid in 2.5 years and the benefit will accrue in perpetuity. From year 2 onwards it generates a ROCE of 70% i.e. £2,904/£4,122. It seems a good proposal assuming the figures are reliable and that the partners are able to work in harmony. There is potential for expansion with synergy effect.
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Joan will derive a benefit in year 1 and a higher return in subsequent years i.e. £3,696/£2,748 × 100 = 134% in year 2. This might indicate that the profit-sharing ratio is unfair to Liz and should be reviewed if this option is selected. Option 3 Year 1 Year 2 Profit [£21,000 × 8/10] 16,800 16,800
Franchise profit 15,000 17,250
Less interest @ 10% per annum (8,000) (8,000)
Total profit 23,800 26,050
Comments:
(i) Incremental profit compared with
present position is: £2,800 £5,050
(ii) Franchise projected profit:
Year 3: £19,838; Year 4: £22,813; Year 5: £22,813
It will take 6 to 7 years to repay £80,000 from incremental cash flows. After year 8 it could be a very profitable proposition.
(b) Option 1 gives a 40% increase over two years. It is unlikely that this increase can be main-tained in year 3 and subsequent years without additional expense on advertising etc. The initial outlay is moderate and is repaid quickly from additional cash flow. Liz will maintain her inde-pendence and improve somewhat her standard of living/lifestyle.
Option 2 shows a reduction in profit in year 1 compared with the present and a £2,900 increase thereafter in year 2 and subsequently. The initial outlay is moderate and there may be longer-term prospects without additional expense after year 3. There is however a loss of independ-ence as a partner. There may be hidden costs not provided for and high opportunity costs.
Option 3 requires substantial investment of £80,000 which may be repaid until about year 7 out of incremental cash flows.
(c) Reservations
Option 1
• The ability to increase turnover by 40% and the maintenance of the level of sales after year 2.
Option 2
• The ability to work amicably with Joan in the partnership.
• Risk of poor decisions by the other partner which then bind the firm.
• Possibility of administration costs not included in the estimates given.
• Basis of profit-sharing ratio seems to be biased in favour of Joan.
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Option 3
• Need to reduce existing sales.
• Involvement with franchise constitutes a refocusing of the business with attendant risks.
• Reliability of the estimates particularly after the first 2 years.
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Chapter 29: Question 4 – Chekani plc
(a) Principles of share valuation:
• No one method of valuing shares.
• Accounting values only a guide as to starting point and/or maximum value for negotiating between parties.
• Share value is the amount that the buyer is willing to pay and the vendor willing to accept.
Methods or bases of valuation:
• Dividend yield basis.
• Price/earnings ratio.
• Net asset value based on a going concern or break-up value.
• Valuation of an unlisted company of this type needs to take account of the difficulty associ-ated with selling the shares and the increased risk of the investment, by adjusting quoted company yields or PE ratio.
• Minority holdings usually valued on dividend yield basis, which is not appropriate for ma-jority holdings of this type.
• Majority holdings valued on PE basis, using adjusted quoted company PEs; the net asset value, as a going concern, gives a minimum valuation.
(b) Alternative valuations (see appendix for calculations)
Dividend yield basis.
For calculations, see appendix. Discussion of investor’s required rate of return, quoted com-pany yields and possible uplift % for an unlisted company.
Appendix shows £1.28 (with 30% adjustment for unquoted status). Method not appropriate here.
Net asset basis
For calculations, see appendix. Discussion of treatment of:
• contingent liability
• purchased goodwill unamortised
• book value v current market value of assets
• relating goodwill and current market values.
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Preference shares
• These could be deducted at their nominal value as the liability due to outside interests.
• Alternatively, the better student could argue that the approach to be adopted should be to value the company as a whole, e.g. Gross asset value, the amount Chekani would pay for the whole enterprise, including the preference shares, and then to deduct the value of the prefer-ence shares, i.e. total value less the amount that will not be acquired.
Debentures
• Either the premium is an extra cost to Chekani and is ignored in the valuation,
• or it is included on the basis that it is part of the value of the company’s net assets.
Earnings basis
Calculations per appendix
• Comment on use of P/E ratios for quoted companies and discount rate applied.
• Treatment of exceptional item, maintainable earnings.
(c) Appropriate strategy
• Normally do not sell below net asset value, based on revalued amounts. This is the highest price here, £3.02, and may not be acceptable to the purchaser due to factors such as:
• falling profits over last three years, return on investment may be more important than asset value
• value includes estimate of current values which may not be realisable
• future prospects and forecasts are not given and cannot be taken into account, but they could provide evidence to support a higher (upturn in prospects expected) or lower (no improvement or downturn forecast) price.
• The final price is likely to be between the two net asset basis prices, the revalued asset basis figure £3.02 and the value based on net assets per balance sheet, £2.175.
• Opening bid should be around the higher figure, say £3.00, leaving room to negotiate downwards, possibly with a view to agreeing a final price around £2.60.
Appendix
Dividend yield
Net dividend on ordinary shares £3m
Dividend per share £3 million/40 million 7.5 pence
Investors’ required rate of return, based on average gross yield of the two quoted companies given, (4.9 + 4.1)/2 = 4.5%
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Value per share: No allowance for different risk (£1 × 7.5/4.5) = £1.67 per share Adjusted yields, allowing for increased risk of unquoted share, using 30% (Note: other adjust-ment % are permissible), (4.5% × 1.3) = 5.85%, so £1 × 7.5/5.85 = £1.28 per share.
Asset valuation basis Assets at balance Assets revalued/
sheet values goodwill written off etc. Goodwill 15,000 0
Property 30,000 56,250
Plant 60,000 60,000
Investments 15,000 22,500
Net current assets 12,000 12,000
Contingent liabilities (3,000) (3,000)
10% Debentures (30,000) (33,000)
Preference shares (12,000) (10,800)
87,000 103,950
Value per share 87,000/40,000 = £2.175 103,950/40,000 = £2.60
Other variations could be: Goodwill not written off 103,950 + 15,000 = 118,950
118,950/40,000 = £2.97
Debentures and preference shares 103,950 + 1,800 = 105,750
at nominal value 105,750/40,000 = £2.64
Goodwill not written off and 103,950 + 15,000 + 1,800 = 120,750
debenture/preference at nominal 120,750/40,000 = £3.02
value (maximum valuation of assets)
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Valuation on an earnings basis Capitalised using PE ratio of similar listed companies:
Average of 11.3 and 8.2 = 9.75 Discount at 30% = 6.825
Earnings:
Profit before interest and tax 21,000
Interest (3,000)
18,000
Tax 5,550
12,450
Preference dividends 840
11,610
EPS = 11,610/40,000 = 29.025 pence per share
29.025 × 9.75/100 = £2.83
Discounted
29.025 × 6.825/100 = £1.98
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Chapter 29: Question 5 – Johnson Products Ltd
(a) (i) Sale of shares to Sonar Products Ltd
The 75% holding constitutes a controlling interest and can be valued on an earnings basis to in-dicate the amount that the buyer could offer and reasonably assume would be acceptable to the seller.
A valuation on an earnings basis gives a value of approximately £300,000 or 37p per share. The value is computed using the following formula:
Value = Earnings/% earnings yield required
For this part of the question we need to estimate the amount of the earnings that are to be capi-talised and the percentage earnings yield required from the information given in the question. The earnings could be based on the final year figure or perhaps a weighted average. For the purpose of illustration the weighted average is being used in this solution, calculated as follows:
Earnings Weight Product £ £ 79,400
(27,600)
56,500 1 56,500
88,300 2 176,600
97,200 3 291,600
6 524,700
Average earnings = £524,700/6 = £87,450
Note that in part (c) of the question there is a further discussion required of the principal matters that need to be taken into account when assessing future maintainable earnings.
The percentage earnings yield required is based on the information provided in the question about the three other companies:
Gross dividend Retention Earnings % yield % % yield Eastron 15 25 20
Westron 10.5 16 12.5
Northron 13.4 20 16.75
The average percentage earnings yield = (20 + 12.5 + 16.75)/3 = 16.4%.
Based on the estimated average earnings which are regarded as maintainable and the estimated percentage earnings yield required, the valuation of the 75% shareholding is as follows:
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Value of company = £87,450 × 100/16.4 = £533,232
Value of 75% = £533,232 × 75/100 = £399,924
Less say 25% for lack of marketability £99,981
£299,943
This value is an estimate of the amount that would be acceptable to R. Johnson.
(ii) Sale of shares to the staff
• The possible sale to the staff would result in a widely held share capital with no single person holding in excess of 4% of the share capital.
• Consequently it is felt that the shares should be valued on a dividend basis using the formula that the value of a share would be the dividend divided by the percentage dividend yield required less 25% for lack of marketability.
• The dividend is assumed to be 5p per share and the percentage dividend yield re-quired is estimated at 12.97 being the average of the yields for the three comparator companies.
The value of a share = 5/12.97 × 100 = 38.55p
Less 25% 9.64
Value per share 28.91
Value of 810,000 shares £234,171.00
(iii) Sale to Divest plc
The realisable value of the business is:
Land 480,000
Premises 630,000
Equipment 150,000
Stock 98,000
Debtors 168,000
Cash 70,000
Creditors (335,000)
Non-current creditors (158,000)
Realisable value 1,103,000
Less 16.7% (based on the need to obtain 20% return) 183,833
Value of business 919,167
Value of 75% 689,375
The three values are therefore:
(i) Sale to Sonar Products Ltd £299,943
(ii) Sale to minority interests £234,171
(iii) Sale to Divest plc £689,375
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(b) Maximum that would be offered by Sonar Products Ltd on basis of information provided in the question
The valuation would be calculated on a return on capital basis to indicate the maximum amount the buyer would be prepared to offer.
The maximum that Sonar Products would be prepared to pay may be estimated by reference to the rate of return that they presently achieve. Given that they currently achieve a rate of return on capital employed of 12.5% the amount they would regard as maximum is £524,700 calcu-lated as follows:
Average Capitalised at % Holding Maximum earnings % return on value capital
£87,450 × (100/12.5) × (75/100) = £524,700
(c) Principal matters to take into account when estimating future main-tainable earnings
There are a number of matters that could be mentioned and in this answer a selection of relevant matters is given. There are others that could be put forward as satisfactory replies to this ques-tion.
(i) Past performance
• Past performance, i.e. past earnings, is the main indicator of future potential.
• One cannot merely carry out an extrapolation of the past three to five years
• But it is an indication of how well the company has operated in the past in comparison with other companies within the same industry.
• This means that one would need to obtain information about the earnings of the three com-parator companies over say the past three to five years and assess how well Johnson Products Ltd has fared in comparison with these.
• One could pay attention to the compound annual growth rates in sales and operating profits and profits for the year, and look at the implication of financial and operating gearing.
(ii) Forecast for the industry
• It is important to form a view on the possible growth or decline within the industry sector in the future.
• Although the past earnings are the base from which accountants start, they also needs to have regard to the expected movements within the industry in the future.
• We are attempting to estimate future maintainable earnings and clearly the rate of growth in the industry is important.
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(iii) Changes in the activities undertaken
• The activities that generated the past earnings will be known.
• It is important to identify the extent to which these will be varied.
• There are various indicators that will be apparent from an examination of the accounts themselves, such as
• research and development expenditure
• new fixed assets
• capital investment contracts outstanding at the balance sheet date, and even
• surplus funds that are not currently invested within the business because they indicate the capacity to move into new activities or to expand the level of existing operations.
(iv) Rationalisation
• Consideration needs to be given to the likelihood of the acquirer selling off parts of the ac-quired company in order
• to improve performance or
• to release cash for the payment of interest or for other purposes.
(v) Management and staff
• These are an important component for success in any business.
• It is possible to gain an impression from the accounts and filed documents of average wage levels and the stability of the board.
• However, to obtain more detailed information, it would be necessary to have the co-operation of the company because one would be seeking more detailed information on
• service contracts
• performance-related pay
• the rate of labour turnover.
• It is clearly more fruitful if it is possible to obtain the co-operation of management to obtain these data.
(vi) Accounting policies
• If it is assumed that the new owners will be able to control the accounting policies then clearly it is of interest to identify how the past policies will be varied. For example, there are the areas such as depreciation and long-term contracts where the company might follow a more or less conservative accounting policy.
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(vii) nterim accounts
• If it is possible to obtain access then the interim accounts, management accounts, budgets and forecasts will give an indication of the company’s strategy and its success over the im-mediate past few months.
• This could give a more current feel for the company’s progress.
(viii) Ratio analysis of balance sheet
• The matters referred to in paras (ii)–(vii) are specifically towards the future.
• Whilst the emphasis is on the future we also need to refer to the last balance sheet to pick up items such as
• high gearing,
• poor liquidity
• references to post balance sheet events, or
• contingent liabilities that might impact on the future prospects of the company.
• In conclusion therefore the question is looking for a recognition that the valuer needs to be forward looking, identifying as clearly as possible the future maintainable earnings.
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Chapter 29: Question 6 – Business Risk Management
(a) Identification and prioritisation of risks
All types of risk are relevant to an existing or potential shareholder including both downside risks (possible losses) and volatility risks (possible gains or losses). Shareholders are not pro-tected if they only receive details of downside risks and sell their shares inappropriately.
Developments to date have been aimed at addressing a particular problem e.g. SSAP 25 Seg-mental Reporting. This has meant that companies have had prescriptive requirements which might not have reflected the actual risks which are relevant to their company.
Risk that may be relevant include:
• product or service failure
• new regulations
• product development with heavy R&D costs before cash flows in.
Internal risks include:
• process risks e.g. arising from employees such as risk of losing key staff, suppliers and manufacturing process whereby products are not delivered on time or to correct specifica-tion.
• financial risks e.g. price, liquidity and credit risks.
External risks include:
• social, political and economic forces, e.g. risk of new employee protection regulations
• financial risks, e.g. exchange rate movements.
Risk prioritisation
The normal materiality criterion applies and attention should be drawn to risks in accordance with their significance.
(b) Managing risk
There are different views on the nature of the disclosure. One view is that it is sufficient to con-firm that the company has complied with the Combined Code.
There is also the view that there should be detailed disclosure of particular steps taken e.g. in-surance, hedging, outsourcing.
(c) Measuring risk
There is a wide range of measures that could be applied to measuring risk and it is important not to concentrate only on deterministic data e.g. potential losses on exchange, but also to consider how to report on strategic risks.
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Accounting measures already exist internally, e.g. reporting provisions and contingencies and producing ratios such as gearing and liquidity, trend analysis and benchmarking.
Accounting measures also exist externally, e.g. bond rating by credit agencies, benchmarking.
Non-accounting measures are also important, e.g. price competitiveness, delivery times, level of warranty claims.
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C H AP T E R 3 0
Chapter 30: Question 1
The IFRS Taxonomy has the element Inventories identified as bearing the name of Inventories, being of the type monetaryItemType and that it is expected to have a debit balance <element id="ifrs-gp_Inventories" name="Inventories" type="xbrli:monetaryItemType" substitutionGroup="xbrli:item" xbrli:periodType="instant" xbrli:balance="debit" nillable="true" /> As the explanations in this text do not go in detail as to the different structures of all the files used in XBRL, it is not expected that students would be able to reproduce this type of coding. Students may have visited the example at http://www.xbrl.org/Example1/ and come up with the following: <ifrs-gp:Inventories ContextRef=”Current_AsOf” UnitRef=”U-Euros” Decimals=”0”>100000</ofrs-gp:Inventories> Although this is an example of XBRL works, the coding really is from an Instance Document and not from the underlying schemas etc. If the students followed the naming conventions used (see http://xbrl.org.au/training/ XBRLNamingConventions.pdf) then it is probably more likely that students come up with: CurrentAssets Inventory Or: CurrentAssets CashAndCashEquivalents Inventory The placement of Inventory depends thus on the standard’s position as to Inventory belonging to the class of Cash and Cash Equivalents or to Other Current Assets. Agricultural assets may well be split between Current and Non Current (Timber Trees or planta-tions) Another good overview example of the application of the IFRS can be found at http://xbrl.iasb.org/int/fr/ifrs/gp/2005-01-15/Samples.htm
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Chapter 30: Question 2
List the steps in the approval process for a taxonomy to be considered to have ‘final’ status. (Hint: look at www.xbrl.org ) Students would have looked at http://www.xbrl.org/FormingAJurisdiction/ and perused the zip file and found that there are 2 different classifications for Jurisdictions as listed in the table below: Established Jurisdiction A non-profit organisation, involved in business reporting, that col-
lects dues from ten or more members and pays dues to XBRL
International.
Provisional Jurisdiction A non-profit organisation involved in business reporting that has a
group of individuals (often called a working party) creating an
XBRL Taxonomy or other XBRL work products, and that pays dues
to XBRL International.
Jurisdictions are normally established within a country where a particular accounting standard is applicable. Should a country adapt the IFRS then, technically, it may not need to form a jurisdiction. Should there be a need to adapt (XBRL refers to this as ‘extend’) then there will be a need if the country needs to use XBRL.
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C H AP T E R 3 1
Chapter 31: Question 1 – BC
(a) Provision at 31.12.×0 = no. of shares × option price × probability of achieving the option × 1/3 = 1,000,000 × 0.05 × 0.6 × 1/3 = 10,000
Provision at 31.12.×1 = no. of shares × option price × probability of achieving the option × 2/3 = 1,000,000 × 0.10 × 0.7 × 2/3 = 46,667
Provision at 31.12.×2 = no. of shares × option price × probability of achieving the option = 1,000,000 × 0.15 × 0.85 = 127,500
Provision at 31.12.×3 = no. of shares × option price × probability of achieving the option = 1,000,000 × 0.30 × 1.0 = 300,000
Final cost at 30.6.×4 = no. of shares × option price × probability of achieving the option = 1,000,000 × 0.35 × 1.0 = 350,000
Year ended Provision P&L a/c charge 31 Dec 20×0 10,000 10,000
31 Dec 20×1 46,667 36,667
31 Dec 20×2 127,500 80,833
31 Dec 20×3 300,000 172,500
31 Dec 20×4 50,000
Total charge 350,000
There will be no provision in the financial statements for the year ended 31 December 20×4, as the option will have been awarded to the director. The total cost of the option at 30 June 20×4 will be charged as directors’ remuneration and credited to the share premium account.
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(b) The total cost of the share option using the different methods will be: Method Total cost IAS 37 £350,000
US FAS123 & IFRS 2 £30,000
UK recommendation £300,000
(c) (i) The IAS 37 method gives a cost for the option which is consistent with the International Accounting Standard and the IASC’s Framework for the Preparation and Presentation of Financial statements. Taking the value of the option and the probability of the option being granted tends to give an uneven charge for the option, with a higher charge in later years. This example tends to exaggerate this uneven charge, but the charge will tend to be higher in later years because the probability of the option being granted is higher near the end of the option entitlement period (and less in earlier years). Also, there is an element of discounting in determining the option price, so the option price will be lower in earlier years than later ones. In addition, the option price will be lower in earlier years as it is less certain that the share price will be above the option price in earlier years than later ones.
(ii) In this example, FAS 123/IFRS 2 gives a charge to the profit and loss account of only 8.6% of the cost of the IAS 37 method (and only 10% of the UK recommendation). This charge occurs in the year ended 31 December 20×0, and there is no subsequent charge in the profit and loss account.
(iii) The UK recommendation gives a charge of 86% of the IAS 37 method, which is a more realistic figure than using the second method. However, the charge only occurs at 31 December 20×3, which is 3 years after the option was granted to the director. It would seem more appropriate if the charge was made during the period the director earned the entitlement to the share option.
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Chapter 31: Question 2 – Rolls Royce
(a) The composition of the Remuneration Committee is appropriate as it comprises entirely non-executive directors. It is good that they meet regularly and receive appropriate profes-sional advice. However, the statement that they ‘meet regularly’ is vague and could be more specific, stating the number of meetings held in the year ended 31 December 1999.
There appears to be a slight conflict in that the Chairman and Chief Executive attend the meetings. They are virtually members of the Remuneration Committee. However, the Re-muneration Committee need relevant information on the performance of the executive directors, and one good way of obtaining this is from the Chairman and Chief Executive. Also, the Chairman and Chief Executive may have relevant information on comparable salaries for directors in other similar companies.
However, there may be problems with the Chairman and Chief Executive attending the meeting, as the Remuneration Committee may want to discuss information provided by the Chairman and Chief Executive but with both the Chairman and Chief Executive being ab-sent from the meeting. For instance, it would not be possible for the non-executive directors to discuss the point ‘do we believe what the Chairman and Chief Executive are saying’ when those people are present at the meeting. Thus, the non-executive directors should have the opportunity to discuss matters alone. The note to the financial statements suggests that either the Chairman or Chief Executive would be present at the meeting. The likely close relationship between the Chairman and Chief Executive could result in the Chairman disclosing to the Chief Executive confidential matters relating discussions by the Remunera-tion Committee on the Chief Executive’s performance and remuneration.
One would be more confident about the independence of the Remuneration Committee if the financial statements disclosed that the non-executive directors of the Remuneration Committee have the right to discuss matters without the Chairman and Chief Executive be-ing present.
(b) Like Diageo plc, the statement about ‘Base Salary’ is qualitative rather than quantitative. It appears that the ‘median-level base salary’ would be given even if the performance of the directors is poor. Also, mention of ‘performance-related schemes’ does not seem relevant and appropriate in a section discussing ‘Base Salary’.
As explained in the main body of the Chapter, it is difficult to determine the effectiveness of directors’ performance. The financial performance of a company may be poor because the directors’ performance is poor, or the performance may be poor because of a recession in the market for the company’s products. Also, directors may work very hard when the com-pany is performing poorly to overcome the problems it is experiencing. Directors should be paid on how hard and effectively they work, and financial performance may be a poor measure of their performance.
(c) This paragraph explains that the annual performance award scheme gives a performance award of up to 60% of basic salary. It talks about a ‘reducing scale of maximum percent-ages for senior employees’ - are these non-directors or do they include directors? It is unclear about whether the performance award is graduated, so that the achievement of the full performance requirement obtains 60% of salary, with reducing figures for lower achievement of the performance. Also, at what point is no performance award made?
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On the award itself, it says that a third of the award is paid in Rolls-Royce shares. How and when is the charge for these shares made in the financial statements? It would appear that the charge should be made when the shares are purchased. However, the charge could be avoided at that stage by including the shares at cost in the balance sheet. If a third of the award is made in shares, then two-thirds must be made in ‘cash’. When is the charge for the cash part of the award made? This charge is probably when the payment is made, whereas it would be better to make the charge during the period when the director works to achieve the performance target.
The final statement in this paragraph says the performance award ‘provides a culture of share ownership amongst the Group’s senior management’. From the company’s financial statements, it is very difficult to see whether this is happening. The directors held more (or the same number of) shares at 31 December 1999 than they did a year earlier, but there was no information on the number of shares issued to directors in that period.
(d) Once again, the directors can obtain an award of 60% of salary under the LTIP. This seems like ‘double counting’ as they can also obtain 60% of their salary from the annual perform-ance award scheme (APAS). This gives a total possible bonus of 120% of the base salary.
The wording of the paragraph is very similar to that for the APAS, so the comments are similar. There is maximum award of 60% of salary, but is this proportionally reduced when the full target is not met?
There is some explanation of how the award is calculated, and no award is made if the com-pany’s performance is below average (i.e. 10th out of 19 or below). The timing of the charge for the LTIP to the profit and loss account is uncertain, in a similar way to the APAS. It is probable that the cost is charged when the shares are purchased, but the cash portion is only charged when the payment is made to the director, rather than during the pe-riod when the director is working to achieve the target.
The last paragraph is clear in explaining that no award was made in the year ended 31 De-cember 1999, and none was realised (i.e. paid).
(e) The ‘Combined Code’ recommends that rolling contracts should be no more than a year, whereas the company is providing a rolling contract of two years to most of its executive di-rectors. The ‘rolling contract’ means that if a director is dismissed, he/she is paid one (or two) years’ salary on termination.
One would have to look at the financial statements of other companies to see if they are us-ing a one-year rolling contract for directors, or a longer period. It appears that most companies now comply with the one-year term of the ‘Combined Code’, so Rolls-Royce’s terms are generous to its directors.
On new directors who are initially given a two-year rolling contract, there is no explanation of the ‘initial period’ after which the contract is reduced to one year.
(f) The first paragraph under ‘Compensation and mitigation’ seems reasonable, as it appears to prevent incompetent directors from receiving a large termination payment. Also, if a direc-tor was close to the retirement age it would be unreasonable to give the director a termination payment which extends beyond the retirement age. For example, if the director was exactly 64 and the retirement age was 65, then the termination payment should be lim-ited to 1 year, so it only covers the period until he is 65. So, the first paragraph seems reasonable.
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The second paragraph gives an example of the application of the first paragraph. The com-pensation paid to the director seems generous and there are many unanswered questions. Although the individual was a director until the company’s year end of 31 December 1999, he is not included in the list of directors and their biographies. So, there is no disclosure of the age of the director at 31 December 1999 and his position in the company. One would have to look at the previous year’s financial statements for this information, and, like many other shareholders, I have thrown away the 1998 financial statements! Thus, the financial statements should give biographical details of all directors who served the company during the year. There is a need for such a requirement under the Companies Acts or Stock Ex-change codes.
The other unanswered question is ‘why did the director retire early?’ The Chairman’s statement only thanks the retiring director for his services, and the only other information on this payment is given in this question. How long had the director served the company and in what positions?
In practice, it is unlikely that companies will disclose reasons why directors leave the com-pany or retire early. Sometimes, they express appreciation for the director’s contribution to the company. However, there may have been heated disagreements between the directors with the losing directors leaving the company. These ‘losing directors’ may be given a gen-erous termination payment on the understanding they will ‘keep quiet’ about the dispute. There is likely to be little or no mention of these problems in the company’s financial state-ments. Also, full disclosure of the problems by the company is likely to lead to expensive legal action by the ‘losing directors’ against the company.
It is probably much better to obtain information about the director’s resignation from the fi-nancial press than from the company’s annual financial statements.
From the figures given in the question, it is apparent that the retiring director has been given two years’ basic salary in compensation payment. This is very generous. Also, there is al-most no disclosure of information about the director in the financial statements, so it is impossible to determine whether there should be any reduction in the termination payment, using the rules in the first paragraph of the statement.
It appears that many UK companies are very generous in their termination payments to di-rectors. Very few UK employees who are not directors are given two years’ termination payment when they retire early.
Some directors can earn large sums from termination payments. For instance, a director working for company A may obtain a job at company B in six months’ time. Then, he makes a nuisance of himself at company A which results in him being dismissed from com-pany A with a generous compensation payment. He then moves on to company B, obtains a job at company C, makes a nuisance of himself at company B and is dismissed and so on!
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Chapter 31: Question 3 – Risk-Averse Auditors
Explanations of why auditors perform more work than is necessary include:
(d) being sued involves a lot of scarce senior management time
(e) it is very worrying to be sued, so auditors would want to keep the number of claims to a minimum
(f) being sued damages the reputation of the audit firm, which is likely to reduce the number of new audits acquired and losing some existing audits
(g) if the auditor is found to be negligent, he/she will have to pay out damages. Most of this would be covered by Professional Indemnity Insurance (PII insurance). If there are many claims, the PII insurance company is likely to increase the insurance premiums
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Chapter 31: Question 4 – Audit Firms and Consultancy
(a) An audit firm can provide significant help to the audit client through consultancy work. The audit firm will know the audit client from the audit, so this will reduce the learning time when carrying out consultancy work, thus reducing its cost. Also, audit firms have knowl-edge in specialised areas, which would benefit the audit client. Audit firms have been developing financial and related business services as part of their consultancy business, so there are many areas where the audit firm can help the audit client. The audit firms have specialised skills in information and computer systems, and E-commerce and Internet appli-cations. Also, audit firms have always had specialists who deal with company and personal taxation, and accountants’ skills in this area are probably better than those of any other business.
So, it can be seen that auditors can provide high quality services to audit clients, often at a lower cost than could be provided by other consultants.
(b) The provision of consultancy services creates independence problems for the audit firm:
(i) The auditor may be reporting on his/her own work, such as when reporting on financial statements prepared by the auditor, or accounting systems which have been recom-mended by the audit firm. If the auditor both prepares and audits the financial statements, the quality of the audit will be less than if these two functions were under-taken by different people. This is because one is poor at checking the accuracy of one’s own work. An independent person is much better at detecting errors in another person’s work. Also, if the auditor finds errors in work carried out by the firm, he/she will be reluctant to highlight these errors, as they could be a sign to the audit client of the low quality of the audit firm’s work. So, the audit firm may give an unqualified audit report when the audit report should have been qualified (modified) because of material errors in the financial statements.
(ii) the second problem is that with the higher fee from the combined audit and consultancy work, the auditor will be reluctant to qualify the audit report, as this could result in a loss of both the statutory audit and the consultancy work. The profitability of the non-audit work for the FTSE 100 listed companies is six times the profits from audit work.
(iii) The ethical rules of most of the accounting bodies, the IFAC and the US SEC say the auditor should avoid making management decisions when performing consultancy work. However, there are problems in defining the situations when the auditor would be making management decisions, and it is difficult for third parties and regulators to detect whether audit firms are carrying out management decisions for the client com-pany. The easiest solution to this problem is to prohibit auditors from carrying out consultancy work for audit clients.
(c) Audit firms want to continue to perform consultancy work because of the high profits from this work. If an audit firm has acquired a new audit, it is both a regular annual income stream from the audit, and, being auditor, the firm has a greater chance of being selected for consultancy work than competitor consultants. This is because the audit firm’s consultants will be able to avoid some of the learning costs and the audit client will know the audit firm (and probably have a good relationship with the audit firm) so they will feel more confident in awarding the consultancy work to the audit firm than to a consultant who they have no experience of.
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Chapter 31: Question 5 – Auditor Accountability
(a) Where the auditor reports to shareholders, the work the auditor carries out is determined by the information required by the shareholders. In a statutory audit (i.e. one governed by the country’s legislation) the work the auditor needs to carry out is determined by the informa-tion the country’s law requires the auditor to report on. In addition, it is common for the statutes to give the auditor the right of access to the company’s accounting records and to obtain explanations from the company’s staff, including the directors. In this situation, it is the shareholders or the country’s statutes which determine the work the auditor is required to carry out. In this situation, the directors cannot limit the work the auditor is required to carry out. This is quite different from situation (b).
(b) Where the auditor is providing consultancy services for the client company, the directors specify the work the audit firm is required to carry out. Thus, the audit firm’s responsibility is to the directors of the company. For consultancy work, the directors can prevent the audit firm from looking at parts of the company’s business. This limitation of the auditor’s work is not allowed for the statutory audit. So, for consultancy work, the auditor’s work is con-trolled by the directors. For the audit, the auditor’s work is determined by statute (or the shareholders) and it cannot be limited by the directors.
If the directors tried to limit the auditor’s work in carrying out an audit, the auditor would probably give a qualified (modified) report on the financial statements, stating the way the directors have restricted the auditor’s work and its possible effects on the financial state-ments.
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Chapter 31: Question 6 – Auditors as Shareholders
There is a concern that auditors should be impartial and also be seen to be impartial in carrying out their duties as auditors. This means that they should have no personal pressure to influence the reported income of the business. Whilst it is of course possible for an independent auditor to ignore the personal implication of the shareholding and to act professionally and objectively, the public might well take a critical view. Consequently the professional bodies prohibit an auditor from holding shares in a client company.
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C H AP T E R 3 2
Chapter 32: Question 1 – Plus Factors Group plc
(a) Value added statement for year ended 30 September 20X9
20X9 20X8
£000 % £000 %
Turnover 8,613.6 7,560.1
Bought-in materials and services 4,815.4 4,096.4
Value added by group 3,798.2 3,463.7
Share of profits of Associate 10.9 - 10.7 -
3,809.1 100.0 3,474.4 100.0
Applied the following ways:
To employees 2,193.5 57.6 2,153.6 62.0
To providers of capital 735.7 19.3 566.5 16.3
To government 464.7 12.2 527.9 15.2
For asset maintenance and expansion 415.2 10.9 226.4 6.5
3,809.1 100.0 3,474.4 100.0
(b)
20X9 20X8
£ £
Sales per employee 43,974 37,612
Value added per employee 20,379 17,232
Average remuneration per employee 11,201 10,714
(c) Problems arise because there is no standard defining the terms e.g. turnover gross or net of VAT, treatment of minority interests, should VAT appear in the government section?
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Working
20X9 20X8
£000 £000
Turnover Sales including VAT 9,905.6 8,694.1
VAT at 15% 1,292.0 1,134.0
8,613.6 7,560.1
Bought-in materials and services Cost of materials
Creditors at end of year 1,244.2 1,109.1
Add: Payments in year 3,622.9 2,971.4
4,867.1 4,080.5
Less: Creditors at start of year 1,109.1 987.2
Materials purchased in year 3,758.0 3,093.3 Add opening stock 804.1 689.7
Less closing stock (837.8) (804.1)
Add: Bought-in services
Auditors’ remuneration 12.2 11.9
Hire charges 66.5 367.3
Other overheads 1,012.4 738.3
4,815.4 4,096.4
Employees £ £
Benefits 109.9 68.4
Pensions 319.8 222.2
Salaries and wages 1,763.8 1,863.0
2,193.5 2,153.6
Providers of capital Debenture interest [11% of £600,000] 66.0
Debenture interest [11% of £550,000] 60.5
Discount on debentures 4.0
Dividends
Preference [7% of £200,000] 14.0
Preference [7% of £500,000] 35.0
Ordinary [8m at 4.28p] 342.4
Ordinary [10m at 4.69p] 469.0
Minority interest 167.2 144.1
735.7 566.5
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Maintenance and expansion of assets Profit before tax 1,437.4 1,156.4
Less: Taxation 464.7 527.9
Minority interest 167.2 144.1
Dividends 504.0 356.4
Retained profits 301.5 128.0
Depreciation 113.7 98.4
415.2 226.4
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Chapter 32: Question 2 – David Mark
(a) Your proposal to close the branch is ill advised. Apart from the so-cial implications of closure referred to below, the loss accruing to your organisation based on 20X4 figures would be approximately £2,800 made up as follows:
£ £ Contributions/gross profit lost 95,700
Expenses/costs save:
Salaries and wages (all) 78,540
Rates (all) 2,865
Advertising (specified) 1,320
Delivery van expenses (all) 5,280
General expenses assuming all relate to branch 1,188
Telephone (specified) 1,056
Wrapping materials 2,640 92,889
Loss if closed 2,811
(b) Increased turnover if Peter’s suggestion is followed
To cover £125,500 expenses (including presumably the extra staff required) will need additional gross profit of (125,500 – 111,237) £14,263 thus requiring
£ Sales (14,263 × 4) of 57,052
But current expenses of £111,237 are not
covered by currently generated gross profit
because a loss of £15,537 occurs. If this is
to be absorbed then additional turnover is
necessary (15,537 × 4) 62,148
Total additional turnover 119,200
This assumes that the branch will be expected to absorb existing fixed charges i.e. salary of D. Mark £10,560, advertising £1,320 and telephone of (1,584 – 1,056) £528 and, if demanded, the delivery charge attributable to Arton of £5,280.
[Total costs estimated of £125,500 have presumably allowed for additional wages and the van charge; or additional wages, having deducted the van charge. One way or the other the wages figure will have compensated for the van be it a plus or minus. If van is included then wage fig-ure will be incorrectly budgeted in the data of the question, because it should have been excluded.]
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Extra part-time workers necessary per formula = 119,200 = 4
30,000
If figures are to be based on costs specific to the branch of £92,889 then the additional turnover will still be £119,200 because Peter’s expenses of £125,500 remain unadjustable for fixed ex-penses, be they included or excluded, in this solution. i.e. (125,500 – 92,889) × 4 = 130,444
But the 92,889 already includes a contribution
of 2,811 via sales (×4) of 11,244
So extra turnover is: 119,200
Or required turnover of 25% gross profit content
to generate absorption of Peter’s estimated costs
of £125,500 = × 4 = £502,000
Current level per accounts = £382,800
Additional turnover = £119,200
(c) Comments on social implications of closure
1. Loss of a local shopping amenity in village. 2. Inconvenience to local residents travelling to nearest supermarket. 3. Loss of employment for 8 people and loss of the benefit of their disposable income if they
are local residents. 4. Impact on family life with parents having to work.
Comments on social implications of Peter’s recommendation. This would avoid the prob-lems referred to above.
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Chapter 32: Question 3 – Hythe plc
(a) Value added statement – year ended 31 December 20X6
20X6 20X5
£000 % £000 %
Turnover 5,124 4,604
Bought-in materials and services (W1) 3,275 2,770 ___
Value added 1,849 100 1,834 100
Applied in the following way:
To pay employees
Wages and salaries (W2) 810 43.8 796 43.4
To pay providers of capital
Interest on loans 168 9.1 151 8.2
Preference shareholders’ dividend 24 1.3 24 1.3
Equity shareholders’ dividend 288 15.6 256 14.0
480 431
To pay government
Corporation tax 402 21.7 393 21.4
To provide for maintenance and expansion
of assets
Depreciation 155 8.4 144 7.9
Retained profits 2 0.1 70 3.8
157 214
£1,849 100.0 £1,834 100.0
Value added per employee 46,225 43,667
Sales per employee 128,100 109,619
Average earnings per employee 20,250 18,952
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20X620X5
Workings £000 £000
(1) Bought-in materials and services
Materials consumed 2,934 2,482
Fuel consumed 290 242
Hire of plant and machinery 41 38
Auditors’ remuneration 10 8
3,275 2,770
(2) Wages and salaries
Wages 607 598
Salaries 203 198
810 796
(b) A value added statement is a measure of the wealth created by a business. It is the amount of value added by manufacturing, distribution and other businesses to the cost of raw materials, products and services purchased. It shows the total wealth created and how it was distributed, taking into account the amounts retained and reinvested in the group for the replacement of as-sets and development of operations.
Financial statements have been regarded as primarily intended for equity investors whose inter-est has been focused on profitability, capacity to adapt and solvency. The value added statement has perhaps been seen as of more interest to staff who have had little recognition by standard setters. Even in 2004 when there is a growing interest in social, environmental and ethical issues there is no financial reporting standard relating to human asset accounting in the balance sheet or value added statements.
There is a further argument that the data already appears within the existing primary reporting statements and that there is consequently little point in producing yet another statement.
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Chapter 32: Question 4 – Gettry Doffit
1 Quantities of chemicals received by the company for disposal on site represent a liability for costs of disposal at the year-end. The work would be undertaken by Gettry Doffit plc on a con-tractual basis and, clearly, income from contracts (short-term as defined in the original SSAP 9) should not be credited to profit and loss account until the work has been completed i.e. on the completion of the contract. Therefore, it would appear that such quantities should be carried in the balance sheet as a liability at the higher of:
(i) invoice cost to the customer or
(ii) estimated cost of disposal.
Applying these principles to (A) axylotl peroxide and (B) pterodactyl chlorate:
Re (A) This contract will give rise to certain revenue of £87,179 i.e. 170 million won @ 1,950 to the £. This is because the invoice value in won has been ‘sold forward’ at the stated rate of the forward contract. It is therefore appropriate, and permissible per SSAP 20, to use the forward rate as the transaction value in the books at all dates, and given such treatment, no exchange differences will arise.
There should be a debtor and creditor for this amount in the balance sheet i.e. the debtor for the certain amount receivable should not be dealt with as income until the contract is completed. Any profit arising would be dealt with in the year to 31 March 20X6.
Dr Debtors £87,179
Cr Creditors – accruals and deferred income £87,179
It is possible that the company could choose as a matter of accounting policy to use rates on the date of the transaction and then retranslate on settlement/balance sheet date giving rise to ex-change differences. The alternative numbers arising are dealt with below. The costs incurred up to the year-end will be dealt with as follows
Dr Creditors £60,000
Cr Bank £60,000
The creditor balance would be debited with the estimated further costs to completion of £15,000 in 20X5/X6 leaving the company with profit of £12,179 in 20X5/X6.
Also in 20X5/X6 – 1.5.X5 – the company would receive 170 million won and realise, per the terms of the forward contract, £87,179, thus eliminating the debtor. Had actual rates been used:
Dr Debtors 170 million won @ 1,900 = £89,473
Cr Creditors £89,473
The balance on creditors in 20X5/X6 will then be a profit of £14,473. However, the debtor would have to be retranslated at the 20X5 year-end – 170 million won @ 2,000 to the £ = £85,000 giving rise to a loss in that year of £4,473. On settlement the debtor will realise £87,179 giving rise to a gain of £2,179.
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In total, £14,473 plus £2,179 less £4,473 = £12,179 (as when the forward rate was used to start with) would be credited to profit and loss account, though in this case partly in 20X4/X5 and partly in 20X5/X6.
Re (B) As this is disposed of per the terms of this contract, neither a debtor nor a liability arises. The point where revenue should be recognised is the date of processing, and it is clear per the terms of the contract that no loss can arise. The costs of the break-down should therefore be carried forward as work-in-progress, perhaps reduced for the worth of the by-products.
2 The won forward contract has been exhaustively dealt with above. As the contract to buy dollars is to be used to finance trade purchases overseas, the transaction poses no problems pro-vided the dollars will be used to purchase stocks whose realisable amount is greater than (70,000 @ 1.60) = £43,750. Indeed, it would make sense not to reflect such a contract in the accounts, it being more appropriate to disclose the detail under commitments. There are, how-ever, other pertinent points to be made.
If the dollars are not to be applied towards a trade purchase, the company would have surplus dollars which may only be converted back to sterling at a loss. Such a loss should be recognised in accordance with the prudence concept, although there may be mitigating factors such as an alternative use for dollars.
3 Given the raising of the irrevocable letter of credit, all that the Nigerian supplier has to do is to ship the goods specified in the letter, present the bill of lading as proof of shipment, and await payment. Thus, the company must pay for goods supplied in accordance with the contract terms, and cannot cancel. Therefore, a liability of (130 – 90)/130 × £65,000 = £20,000 should be recog-nised immediately, unless a variation can be negotiated with the supplier or an alternative use found for the chemical.
4 The spillage is a post balance sheet event. No liability should be recognised in the accounts unless the going concern concept is threatened.
However, the potential liability is so material as to require disclosure under SSAP 17.
• In a normal joint venture the companies trade as partners, with joint and several liability.
• The precise apportionment of the liability may require a contribution from Dumpet Andrunn plc.
• If they cannot pay, it is likely that Gettry Doffit plc will have to.
• The likelihood of a liability crystallising, the likely amount, and any recovery from Dumpet Andrunn plc, must be assessed, and full details given in the notes to the accounts and re-ferred to in the directors’ report.
• As it is likely that the company will resist the claim, the maximum payable should probably be disclosed as a contingent liability.
• The possibility of an insurance recovery should also be examined.