F7 Lecture
F7 Lecture
F7 Lecture
1
Contents
LESSON 1: THE CONCEPTUAL FRAMEWORK 3
LESSON 2: THE REGULATORY FRAMEWORK 12
LESSON 3: TANGIBLE NON-CURRENT ASSETS 17
LESSON 4: INTANGIBLE ASSETS 39
LESSON 5: IMPAIRMENT OF ASSETS 50
LESSON 6: REVENUE – IFRS 15 57
LESSON 7: INTRODUCTION TO GROUPS 77
LESSON 8: THE CONSOLIDATED STATEMENT OF FINANCIAL POSITION 81
LESSON 9: THE CONSOLIDATED STATEMENT OF PROFIT AND LOSS AND OTHER COMPREHENSIVE
INCOME 98
LESSON 10: INVESTMENTS IN ASSOCIATES 110
LESSON 11: FINANCIAL INSTRUMENTS 119
LESSON 12: LEASING 132
LESSON 13: PROVISIONS AND EVENTS AFTER THE REPORTING PERIOD 144
LESSON 14: INVENTORIES AND BIOLGICAL ASSETS 153
LESSON 15: TAXATION 157
LESSON 16: PRESENTATION OF PUBLISHED FINANCIAL STATEMENTS 170
LESSON 17: REPORTING FINANCIAL PERFORMANCE 180
LESSON 18: EARNINGS PER SHARE 193
LESSON 19: CALCULATION AND INTERPRETATION OF ACCOUNTING RATIOS AND TRENDS 204
LESSON 20: LIMITATION OF FINANCIAL STATEMENTS AND INTERPRETATION TECHNIQUES 222
LESSON 21. STATEMENT OF CASH FLOWS 226
LESSON 22: ACCOUNTING FOR INFLATION 243
LESSON 23: SPECIALIZED, NOT-FOR-PROFIT AND PUBLIC SECTOR ENTITIES 248
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LESSON 1: THE CONCEPTUAL FRAMEWORK
LEARNING OUTCOMES:
I. Conceptual framework
1. Conceptual framework and GAAP
b. GAAP
B. Financial reporting
a. The elements of FS
- Financial position: Asset, Liability, Equity
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A. THE CONCEPTUAL FRAMEWORK
I. Conceptual framework
CONCEPTUAL
FRAMEWORK (CF)
ADVANTAGES DISADVANTAGES
4
GAAP IFRS
5
b. Users and their information needs
Customers
▪ Continuance
B. FINANCIAL REPORTING
1. The objective of general-purpose financial reporting
OBJECTIVE
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▪ Those information should be prepared on an accruals basis.
Accruals basis. The effects of transactions and other events are:
▪ recognized when they occur (and not as cash or its equivalent is received or
paid);
▪ recorded in the accounting records and reported in the FSs of the periods to
which they relate.
2. Underlying assumption:
▪ There is only one “underlying assumption” of FSs: Going concern
Going concern. An entity will continue in operation for the foreseeable future.
▪ It is assumed that the entity has no intention to liquidate or curtail major operations. If it
did, then the FSs would be prepare on a different (disclosed) basis.
3. Qualitative characteristics of useful financial information: Relevance, Faithful
representation
According to the Conceptual Framework, financial information is useful when it
is relevant and represents faithfully what it purports to represent.
QUALITATIVE
CHARACTERISTICS
Nature alone may Information is Free from bias. Adequate or Free from error.
be sufficient to material if it is full disclosure
determine significant enough of all necessary
relevance. to influence the information.
decision of users.
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4. Enhancing qualitative characteristics: Comparability, Verifiability, Timeliness,
Understandability
The usefulness of financial information is enhanced if it is comparable, verifiable, timely and
understandable.
ENHANCING
QUALITATIVE
CHARACTERISTICS
Elements of FSs
FINANCIAL POSITION
8
PERFORMANCE
INCOME EXPENSES
RECOGNITION
ASSET SoFP It is probable that the future economic benefits will flow to the entity and
the asset has a cost or value that can be measured reliably.
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c. Measurement of the elements of FS
Measurement. The process of determining the monetary amounts at which the elements
of the financial statements are to be recognized and carried in the SoFP and SoPL.
Basis of measurement includes:
• Historical cost • Realizable value / Settlement value
• Current cost • Present value
10
Example:
A machine was purchased on 1 January 20X8 for $3m. That was its original cost/historical
cost.
It has a useful life of 10 years and under the historical cost convention it will be carried at
original cost less accumulated depreciation. So in the FSs at 31 December 20X9 it will be
carried at: $3m – (0.3 x 2) = $2.4m.
The current cost of the machine, which will probably also be its fair value, will be fairly easy
to ascertain if it is not too specialized. For instance, two-year-old machines like this one
may currently be changing hands for $2.5m, so that will be an appropriate fair value.
The net realizable value (NRV) of the machine will be the amount that could be obtained
from selling it, less any costs involved in making the sale. If the machine had to be
dismantled and transported to the buyer's premises at a cost of $200,000, the NRV would
be $2.3m.
The replacement cost of the machine will be the cost of a new model less two-year's
depreciation. The cost of a new machine may now be $3.5m. Assuming a ten-year life, the
replacement cost will therefore be $2.8m.
The present value of the machine will be the discounted value of the future cash flows that
it is expected to generate. If the machine is expected to generate $500,000 per annum for
the remaining 8 years of its life and if the company's cost of capital is 10%, present value
will be calculated as: $500,000 x 5.335* = $2667,500.
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LESSON 2: THE REGULATORY FRAMEWORK
LEARNING OUTCOME:
2. Current IFRS/IAS
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I. The need for a regulatory framework
✓ Because IFRSs are based on The Conceptual Framework for Financial Reporting, they are
often regarded as being a principles-based system.
IFRS
Advantages Disadvantages
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The IASB benefits from working NSS benefit by:
with NSS through their:
2. Current IFRS/IAS
The current list is as follows.
Date of
International Accounting Standards
issue/revision
IAS 1
Presentation of FSs Sep 2007
(revised)
IAS 2 Inventories Dec 2003
IAS 7 Statements of cash flows Dec 1992
Accounting policies, changes in accounting estimates and
IAS 8 Dec 2003
errors
IAS 10 Events after the reporting period Dec 2003
IAS 12 Income taxes Nov 2000
IAS 16 Property, plant and equipment Dec 2003
IAS 19* Employee benefits Dec 2004
Government grants and disclosure of government
IAS 20 Jan 1995
assistance
IAS 21* The effects of changes in foreign exchange rates Dec 2003
IAS 23
Borrowing costs Jan 2008
(revised)
IAS 24* Related party disclosures Dec 2003
IAS 26* Accounting and reporting be retirement benefit plans Jan 2995
IAS 27
Separate FSs May 2011
(revised)
IAS 28 Investments in associates and joint ventures** Dec 2003
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IAS 29* Financial reporting in hyperinflationary economies Jan 1995
Disclosure in the FSs of banks and similar financial
IAS 30* Jan 1995
institutions (not examinable)
IAS 32 Financial instruments: presentation Dec 2003
IAS 33 Earnings per share Dec 2003
IAS 34* Interim financial reporting Feb 1998
IAS 36 Impairment of assets Mar 2004
IAS 37 Provisions, contingent liabilities and contingent assets Sep 1998
IAS 38 Intangible assets Mar 2004
IAS 40 Investment property Dec 2003
IAS 41 Agriculture Feb 2001
IFRS 1* First time adoption of IFRSs Jun 2003
IFRS 2* Share-based payment Feb 2004
IFRS 3
Business combinations Jan 2008
(revised)
IFRS 4* Insurance contracts Mar 2004
Non-current assets held for sale and discontinued
IFRS 5 Mar 2004
operations
IFRS 6* Exploration for and evaluation of mineral resources Dec 2004
IFRS 7 Financial instruments: disclosures Aug 2005
IFRS 8* Operating segments Nov 2006
IFRS 9 Financial instruments Jul 2014
IFRS 10 Consolidated financial statements May 2011
IFRS 11* Joint arrangements May 2011
IFRS 12* Disclosures of interests in other entities May 2011
IFRS 13 Fair value measurement May 2011
IFRS 14* Regulatory deferral accounts Jan 2014
IFRS 15 Revenue from contracts with customers May 2014
IFRS 16 Leases Jan 2016
IFRS 17* Insurance contracts May 2017
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o They oblige companies to disclose the accounting policies used in the preparation of
accounts.
o They are a less rigid alternative to enforcing conformity by means of legislation.
o They have obliged companies to disclose more accounting information than they
would otherwise have done if accounting standards did not exist, for example IAS 33
Earnings per share.
Many companies are reluctant to disclose information which is not required by national
legislation. However, the following arguments may be put forward against standardization
and in favor of choice.
o A set of rules which give backing to one method of preparing accounts might be
inappropriate in some circumstances. i.e. IAS 16 on depreciation is inappropriate for
investment properties, which are covered by IAS 40 on investment property.
o Standards may be subject to lobbying or government pressure. i.e. In the US, the
accounting standard FAS 19 on the accounts of oil and gas companies led to a
powerful lobby of oil companies, which persuaded the SEC to step in. FAS 19 was then
suspended.
o Many national standards are not based on a conceptual framework of accounting,
although IFRSs are.
o There may be a trend towards rigidty, and away from flexibility in applying the rules.
b. Political problems
Any international body, whatever its purpose or activity, faces enormous political difficulties
in attempting to gain international consensus and the IASB is no exception to this.
You must keep up to date with the IASB’s progress and the problems it encounters in the
financial press. You should also be able to discuss:
o Due process of the IASB
o Use and application of IFRSs
o Future work of the IASB
o Criticisms of the IASB
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LESSON 3: TANGIBLE NON-CURRENT ASSETS
MEASUREMENT
(IAS 16)
Basic concepts
Held for use in the production or supply
of goods or services, for rental to others, Property, plant and Are expected to be used during
or for administrative purposes equipment (PPE) more than one period
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Accounting for property, plant and equipment
Initial costs Capitalise all costs to bring an asset to its present location and condition for its intented use
All other subsequent costs should be recognised as an expense in the period that they are incurred
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Such as:
• cost of site preparation
• initial delivery and handling costs
• installation and testing costs
• professional fees
Subsequent OR
measurement
Revaluation
* FAIR VALUE at the Subsequent accumulated Subsequent accumulated
Available only if the Fair Value of model revaluation date depreciation impairment losses
the item can be measured reliably.
Applied to all assets in the entire category. The revalued amount should be depreciated
(ie if you revalue a building, you must revalue Depreciation over the assets remaining useful life.
all land and buildings in that class of asset).
Reserves The depreciation charge on the revalued asset will be different to the
Revaluations must be carried transfer one on the historical cost of the asset => A transfer is made to the excess
out with sufficient regularity. depreciation from the revaluation reserve to retained earnings.
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4. Depreciation Depreciable
HOW MUCH to depreciate COST Residual Value
Amount
Period
Is the
allocation of Useful life HOW LONG
Depreciable to depreciate
Number
Amount over of units
its Useful Life ▪ % on cost, or
on Systematic ▪ Cost – residual value
Basis HOW / IN WHAT Straight line method divided by useful life
Systematic
MANNER to depreciate
Basis
(Depreciation Method)
Reducing balance ▪ % on carrying amount
Component If an asset comprises two or more major components with different useful lives, then each component
depreciation should be accounted for separately for depreciation purposes and depreciated over its own useful life.
On disposal
When
5. Derecognition Gain or loss = Net disposal proceeds – Carrying Amount => P&L
No future
economic expected
Disposal proceeds > CA => Profit
Disposal proceeds < CA => Loss
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Example 1. Initial recognition
On 1 March 20X0 Yucca Co acquired a machine from Plant Co under the following terms:
$000 The store was completed on 1 January 20X2 and brought into use following its grant
opening on the 1 April 20X2. Ham Co issued a $25m unsecured loan on 1 April 20X1 to aid
Freehold land 4,500
construction of the new store (which meets the definition of a qualifying asset per IAS 23).
Architect fees 620
The loan carried an interest rate of 8% per annum and is repayable on 1 April 20X4.
Site preparation 1,650
Materials 7,800 Required
Direct labour costs 11,200
Calculate the amount to be included as property, plant and equipment in respect of the
Legal fees 2,400
General overheads 940 new store and state what impact the beside information would have on the statement of
profit or loss (if any) for the year ended 31 March X2.
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On 1 March 20X2 Yucca Co purchased an upgrade package from Plant Co at a cost of $18,000 for the machine it originally purchased in 20X0
(Example 1). The upgrade took a total of two days where new components were added to the machine. Yucca agreed to purchase the package
as the new components would lead to a reduction in production time per unit of 15%. This will enable Yucca to increase production without
the need to purchase a new machine.
Should the additional expenditure be capitalised or expensed?
Example 4. Depreciation
An item of plant was purchased on 1 April 20X0 for $200,000 and its being depreciated at 25% on a reducing balance basis.
Prepare the extracts of the financial statements for the year ended 31 March 20X2.
Calculate the annual depreciation charge for the property for the year ended 31 March 20X2.
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Example 7. Revaluation gains
A company purchased a building on 1 April 20X1 for $100,000. The asset had a useful life at that date of 40 years. On 1 April 20X3 the company
revalued the building to its current fair value of $120,000. What is the double entry to record the revaluation?
The carrying amount of Zen Co’s property at the end of the year amounted to $108,000. On this date the property was revalued and was deemed
to have a fair value of $95,000. The balance on the revaluation surplus relating to the original gain of the property was $10,000. What is the
double entry to record the revaluation?
A company revalued its property on 1 April 20X1 to $20m ($8m for the land). The property originally cost $10m ($2m for the la nd) 10 years
ago. The original useful life of 40 years is unchanged. The company’s policy is to make a transfer to realised profits in respect of excess
depreciation. How will the property be accounted for in the year ended 31 March 20X2?
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✓ Exam focus: Example 10. Revaluation date 01
A company purchased a building on 1 April 20X1 for $100,000 at which point it was considered to have a useful life of 40 year s. At the year end
31 March 20X6 the company decided to revalue the building to its current value of $98,000. How will the building be accounted for in the year
ended 31 March 20X6?
At 1 April 20X1 HD Co carried its office block in its financial statements at its original cost of $2 million less depreciati on of $400,000 (based on
its original life of 50 years). HD Co decided to revalue the office block on 1 October 20X1 to its current value of $2.2m. The useful l ife remaining
was reassessed at the time of valuation and is considered to be 40 years at this date. It is the company’s policy to charge depreciation
proportionally. How will the office block be accounted for in the year ended 31 March 20X2?
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2 – IAS 40 Investment property
Objective To prescribe the accounting treatment and disclosures for Investment Property
Property (land or buildings, or part thereof) held to earn rentals or for capital appreciation or both IAS 40
Investment
Property (IP) Production or supply of goods/services
IAS 16
Not Administrative purposes
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On disposal
Recognition All borrowing costs that relate to a qualifying asset must be capitalised
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IAS 20
GOVERNMENT Definition Governments often provide money or incentives to companies to export their goods or to promote local employment.
GRANTS
Grants should not be recognised until the conditions for receipt have been
General principles Prudence complied with and there is reasonable assurance the grant will be received.
Accruals Grants should be matched with the expenditure towards which they were intended to contribute.
If the grant is paid when evidence is produced that certain expenditure has
Revenue grants Recognition been incurred, the grant should be matched with that expenditure.
If the grant is paid on a different basis, e.g. achievement of a non-financial objective, the
grant should be matched with the identifiable costs of achieving that objective.
Capital grants Treatment Write off against the cost of the non-current asset and depreciate the reduced cost.
Repayment of grants In some cases, when the conditions of the grant are breached.
If there is an obligation to repay the grant and the repayment is probable => IAS 37
If the deferred income method (capital grants) has been used => repaid the remaining grants to the government.
Any amounts released to P or L may also be reserved, depending on the level of repayment required.
If the netting-off method (capital grants) has been used => increase the cost of asset to recognise full cost of
asset without the grants. A liability will be set up for the grant repayment.
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Iilustration 1. Revenue grants Iilustration 2. Capital grants
An entity is given $300,000 on 1 January 20X1 to keep staff Grants for purchases of non-current assets should be recognised
employed within a deprived area. The entity must not make over the expected useful lives of the related assets.
redundancies for the next three years, or the grant will need to be
repaid. IAS 20 permits two treatments. Both treatments are equally
acceptable and capable of giving a fair presentation.
By 31 December 20X1, no redundancies have taken place and none
are planned. Method 1.
On initial recognition, deduct the grant from the cost of the non-
The grant should be released over three years, meaning that current asset and depreciate the reducted cost.
$100,000 is taken to the statement of profit or loss each year.
This can be shown as a separate line in the statement of profit or Method 2.
loss or deducted from administrative expenses (or wherever the Recognise the grant initially as deferred income and transfer a
staff costs are charged). portion to revenue each year, so offsetting the higher depreciation
charge based on the original cost.
As $100,000 has been released to the statement of profit or loss,
the remaining $200,000 will be held in deferred income, to be Method 1 is obviously far simpler to operate. Method 2, however,
recognised over the next two years. has the advantage of ensuring that assets acquired at different
times and in different locations are recorded on a uniform basis,
Of this, $100,000 will be released within the next year, so will be regardless of changes in government policy.
held within current liabilities. The remaining $100,000 will be held
as a non-current liability.
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ANSWERS
ANSWER 1. Initial recognition
In accordance with IAS 16, all costs required to bring an asset to its present location and condition for its intended use should be capitalised.
Therefore, the initial purchase price of the asset should be:
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Property, plant and equipment
Store:
$000
Freehold land 4,500
Architect fees 620
Site preparation 1,650
Materials 7,800
Direct labour costs 11,200
Legal fees 2,400
Borrowing costs
1,500
(25,000 x 8%) x 9/12
Total to be capitalised 29,670
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ANSWER 4. Depreciation
Income statement extract Working for depreciation:
Depreciation expense 31/03/09 Cost 200,000
$37,500 Depreciation – 25% (50,000)
Carrying value 150,000
31 March 2008 At the date of acquisition the cost of the asset of $120,000 would be capitalised. The asset should then be depreciated for the
years to 31 March 2008/2009 as:
31 March 2009
Income statement extract 2009
Depreciation $10,000
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Statement of financial position extract 2009
Machine (120,000 – 20,000) $100,000
31 March 2010
As the residual value and useful economic life estimates have changed during the year ended 2010, the depreciation charge wil l need to be
recalculated. The carrying value will now be spread according to the revised estimates.
Depreciation charge:
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ANSWER 7. Revaluation gains
Gain on revaluation: Double entry:
Carrying value of asset at revaluation date: 95,000 Dr Building cost 20,000
(100,000 – 100,000 / 40 years x 2 years) (120,000 – 100,000)
Valuation: 120,000 Dr Accumulated depreciation 5,000
(100,000 / 40 years x 2 years)
Gain on revaluation: 25,000 Cr Revaluation reserve 25,000
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$000
Non-current assets
Property (20,000 – 400) 19,600
Equity
Revaluation reserve (12,000 – 200) 11,800
Workings:
Gain on revaluation: Double entry:
$000 $000
Carrying value of non-current asset at revaluation date
8,000 Dr Property (20,000 – 10,000) 10,000
(10,000 – ((10,000 – 2,000)/40 years x 10 years))
Dr Accumulated depreciation
Valuation 20,000 2,000
((10,000 – 2,000)/40 years x 10 years)
Gain on revaluation 12,000 Cr Revaluation reserve 12,000
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✓ ANSWER 10. Revaluation date 01
Statement of comprehensive income extract 31 March 2010 Working paper:
Depreciation charge 2,500 Note: Revaluation takes place at year end, therefore a full year of depreciation
must first be charged.
Other comprehensive income:
Revaluation gain 10,500 (W1) Depreciation year ended 31 March 2010
100,000
= $2,500
40 𝑦𝑒𝑎𝑟𝑠
Statement of financial position extract 31 March 2010 (W2) Revaluation
Building at valuation 98,000 The carrying value of the asset at 31 March 2010 can now be found and revalued.
Carrying value of non-current asset at revaluation date 87,500
(100,000 – (100,000/40 years x 5 years))
Statement of changes in equity extract Valuation of non-current asset 98,000
Revaluation
Gain or loss on revaluation 10,500
reserve
Revaluation gain 10,500
Double entry:
Dr Accumulated depreciation 12,500
Cr NCA cost 2,500
Cr Revaluation reserve 10,000
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ANSWER 11. Revaluation date 02
Statement of comprehensive income extract 31 March 2010 Working paper:
Depreciation charge 47,500 Note: Revaluation takes place part way through the year and therefore
(20,000 (W1) + 27,500 (W2)) depreciation must first be charged for the period 1 April 09 – 30 September 09,
then the revaluation can be recorded and then depreciation needs to be charged
for the period 1 October 2009 – 31 March 2010.
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LESSON 4: INTANGIBLE ASSETS
Intangible assets are defined by IAS 38 as non-monetary assets without physical substance
Objectives of the standard
• To establish the criteria for when an intangible asset may or should be recognized
• To specify how intangible assets should be measured
• To specify the disclosure requirements for intangible assets (IA)
2. Recognition of Intangible assets • Intangible asset is acquired separately through purchase => transfer of a legal right
that would help to make an asset identifiable.
• An intangible asset may be identifiable if it is separable, ie if it could be rented or sold
an identifiable non-monetary asset
What is separately. However, 'separability' is not an essential feature of an intangible asset.
without physical substance
identifiable?
IA is acquired separately
recognised at cost
value
IA is acquired as part of a business combination
the cost of the IA is its fair value at the date of the acquisition
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• = cost – (amortisation + impairment losses) IA with a finite useful life must be amortised over
• more commonly used in practice that life, normally using the straight-line method
Cost model • Amortisation should start when the asset is with a zero residual value
available for use and cease at the earlier of
the date that the asset is classified as held IA with an indefinite useful life:
for sale and the date that the asset is • should not be amortised
derecognised • should be tested for impairment annually, and
• Amortisation charge for each period should more often if there is an actual indication of possible
Subsequent normally be recognised in profit or loss impairment
measure
• = Fair value (FV) at the date of revaluation – ( accumulated amortisation + accumulated impairment losses)
• The fair value must be able to be measured reliably with reference to an active market
• The entire class of intangible assets of that type must be revalued at the same time (to prevent
Revaluation model selective revaluations).
• If an IA in a class of revalued intangible assets cannot be revalued because there is no active market for this
asset, the asset should be carried at cost model
• Revaluations should be made with such regularity that the carrying amount does not differ from that which
would be determined using fair value at the end of the reporting period
• An IA should be eliminated from the statement of financial position when it is disposed of or when there is no further expected
Disposals/retire economic benefit from its future use.
ments • On disposal the gain or loss arising from the difference between the net disposal proceeds and the carrying amount of the asset
should be taken to profit or loss as a gain or loss on disposal (ie treated as income or expense)
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NOTE: Internally-generated goodwill and internally-generated intangible assets
Generally, internally-generated goodwill cannot be capitalised, as the costs associated with
these cannot be identified separately from the costs associated with running the business.
Example of Internally-generated goodwill:
• brands
• mastheads
• publishing titles
• customer lists
Internally-generated intangible assets:
• Initially be measured at cost (sum of the expenditure incurred from the date when the
intangible asset first meets the recognition criteria
• Subsequently measured at cost or at a revalued amount.
Question:
An intangible asset is measured by a company at fair value. The asset was revalued by $400
in 20X3, and
there is a revaluation surplus of $400 in the statement of financial position. At the end of
20X4, the asset
is valued again, and a downward valuation of $500 is required.
Required
State the accounting treatment for the downward revaluation.
Answer:
In this example, the downward valuation of $500 can first be set against the revaluation
surplus of $400.
The revaluation surplus will be reduced to $nil and a charge of $100 made as an expense in
20X4.
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• Activities aimed at obtaining new knowledge
• The search for, evaluation and final selection of, application of
II. Research and development research findings or other knowledge
• The search for alternatives for materials, devices, products,
processes, systems or services
Example
• The formulation, design evaluation and final selection of possible
alternatives for new or improved materials, devices, products,
systems or services
Research
• Not meet the criteria for recognition under IAS 38 because, at the
Treatment research stage of a project, it cannot be certain that future
economic benefits will probably flow to the entity from the project.
• Research costs should therefore be written off as an expense as
they are incurred
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All expenditure related to an intangible which does not meet the criteria for recognition
either as an identifiable intangible asset or as goodwill arising on an acquisition should be
expensed as incurred. The IAS gives examples of such expenditure:
• Start up costs
• Training costs
• Advertising costs
• Business relocation costs
Prepaid costs for services, for example advertising or marketing costs for campaigns that
have been prepared but not launched, can still be recognised as a prepayment.
EXAMPLE 1:
An entity has incurred the following expenditure during the current year:
(a) $100,000 spent on the initial design work of a new product – it is anticipated that this
design will be taken forward over the next two year period to be developed and tested with
a view to production in three years' time.
(b) $500,000 spent on the testing of a new production system which has been designed
internally and which will be in operation during the following accounting year. This new
system should reduce the costs of production by 20%.
How should each of these costs be treated in the financial statements of the entity?
EXAMPLE 2:
An entity has incurred the following expenditure during the current year:
(i) A brand name relating to a specific range of chocolate bars, purchased for $200,000. By
the year end, a brand specialist had valued this at $250,000.
(ii) $500,000 spent on developing a new line of confectionery, including $150,000 spent on
researching the product before management gave approval to fully fund the project.
(iii) Training costs for staff to use a new manufacturing process. The total training costs
amounted to $100,000 and staff are expected to remain for an average of 5 years.
Explain the accounting treatment for the above issues.
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III. GOODWILL
Goodwill is created by good relationships between a business and its customers.
What is Goodwill • By building up a reputation (by word of mouth perhaps) for high quality products or high standards of service
• By responding promptly and helpfully to queries and complaints from customers
• Through the personality of the staff and their attitudes to customers
• There is one exception to the general rule that goodwill has no obje ctive valuation. This is when a business is sold
Purchased goodwill
• Purchased goodwill is shown in the statement of financial position because it has been paid for. It has no tangible
substance, and so it is an intangible non-current asset.
• The seller and buyer agree on a price for the business without specifically quantifying the goodwill. The purchased
goodwill will then be the difference between the price agreed and the value of the identifiable net assets in the books of
Value of goodwill the new business (B agrees to pay $61,000 for the business but values the net assets at only $38,000, then th e goodwill
in B's books will be $61,000 – $38,000 = $23,000)
• However, the calculation of goodwill often precedes the fixing of the purchase price and becomes a central element of
negotiation. There are many ways of arriving at a value for goodwill and most of them are related to the profit record of
the business in question (If A values his net assets at $40,000, goodwill is agreed at $21,000 and B agrees to pay $61,000
for the business
• Goodwill acquired in a business combination is recognised as an asset and is initially measured at cost and
subsequently measured at cost less any accumulated impairment losses. It is not amortised, but to tested for
impairment at least annually
• Negative goodwill (gain on a bargain purchase)arises when the acquirer's interest in the net fair value of
Treatment of goodwill
the acquiree's identifiable assets, liabilities and contingent liabilities exceeds the cost of the business
combination. Negative goodwill can arise as the result of errors in measuring the fair value of either the cost of the
combination or the acquiree's identifiable net assets, so:
o An entity should first reassess the amounts at which it has been measured both the cost of the combination and the
acquiree’s identifiable net assets. This exercise should identify any error
o Any excess remaining should be recognized immediately in profit or loss
44
EXAMPLE 3:
Cowper plc has spent $20,000 researching new cleaning chemicals in the year ended 31
December 20X0. They have also spent $40,000 developing a new cleaning product which
will not go into commercial production until next year. The development project meets
the criteria laid down in IAS 38 Intangible Assets.
1. How should these costs be treated in the financial statements of Cowper plc for the
year ended 31 December 20X0?
A. $60,000 should be capitalised as an intangible asset on the statement of financial
position.
B. $40,000 should be capitalised as an intangible asset and should be amortised; $20,000
should be written off to the of profit or loss.
C. $40,000 should be capitalised as an intangible asset and should not be amortised;
$20,000 should be written off to the statement of profit or loss.
2. Which TWO of the following items below could potentially be classified as intangible
assets?
B. training of staff
C. internally generated brand
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B. Reduce profit by $150,000 and increase non-current assets by $100,000
$ __________
46
7. Which TWO of the following criteria must be met before expenditure is capitalised
according to IAS 38 Intangible Assets?
8. For each issue, identify the correct accounting treatment in Madeira's financial
statements: Capitalise as intangible or Expense?
(i) $400,000 developing a new process which will bring in no revenue but is expected to
bring significant cost savings
(ii) $400,000 developing a new product. During development a competitor launched a
rival product and now Madeira is hesitant to commit further funds to the process
(iii) $400,000 spent on marketing a new product which has led to increased sales of
$800,000
(iv) $400,000 spent on designing a new corporate logo for the business
47
ANSWERS
Example 1:
(a) These are research costs as they are only in the early design stage and therefore
should be written off to the statement of profit or loss in the period.
(b) These would appear to be development stage costs as the new production system is
due to be in place fairly soon and will produce economic benefits in the shape of
reduced costs. Therefore these should be capitalised as development costs.
Example 2:
(i) The brand name is a purchased intangible asset, so can be capitalised at the cost of
$200,000.
Intangible assets can only be revalued if an active market exists. This is unlikely here, as
the brand name will not be a homogeneous item. Therefore the item should be held
under the cost model.
The brand should be written off over its expected useful life. If this has an indefinite
useful life then no amortisation is charged. However, an annual impairment review
would be required.
(ii) The $500,000 relates to research and development. Of the total, $150,000 should be
expensed to the statement of profit or loss, as
management had not displayed either the intention to complete, or the release of the
resources to complete.
Example 3:
1. C – $20,000 is research and should be written off as incurred. $40,000 should be
capitalised as a development asset, but is not amortised until commercial production
begins.
2. A and D – Training cannot be capitalised as a firm cannot control the future economic
benefits by limiting the access of others to the staff. Internally generated brands cannot
be capitalised.
3. B – The expenditure in relation to projects A and B should be written off. Project C
should be capitalised and will therefore increase the value of non-current assets.
4. D – All of the statements are true.
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5. D – Internally generated intangible assets cannot be recognised, and research costs
are written off as incurred.
6. $215,000 – The development costs of $200,000 can be capitalised, as can the
depreciation on the asset while the project is being developed. The asset is used for a
year on the project, so the depreciation for the first year ($60,000/4 years = $15,000)
can be added to intangible assets. The $40,000 is an internally generated brand and
cannot be capitalised.
7. A and C – There is no need for revenue, there needs to be probable economic
benefits which may come in the form of cost savings as well as revenue.
49
LESSON 5: IMPAIRMENT OF ASSETS
I. IAS 36 IMPAIRMENT OF ASSETS
1. Scope
Scope: All assets, except: inventories, construction contracts, deferred tax assets,
employee benefits, financial assets, investment property, biological assets, insurance
contract assets, and assets held for sale.
INDIVIDUAL ASSETS
ASSETS TO BE
REVIEWED
CASH-GENERATING UNITS (CGUs)
50
A fall in the asset's market value that is more significant than
would normally be expected from passage of time over normal
use
A significant change in the technological, market, legal or
2. IDENTIFYING A POTENTIALLY IMPAIRED ASSET economic environment of the business in which the assets are
employed
External indicators An increase in market interest rates or market rates of return on
investments likely to affect the discount rate used in calculating
value in use
When to test for The carrying amount of the entity's net assets being more than
impairment? its market capitalisation
ANNUAL IMPAIRMENT
Compulsory for:
TESTS • Intangible assets with an indefinite useful life
• Intangible assets not yet available for use
• CGUs to which goodwill has been allocated.
WHEN TO REVERSE
The recoverable amount of an asset that has previously
IMPAIRMENT? been impaired turns out to be higher than the asset's
current carrying amount
Recoverable amount
higher
What should be the value of the drilling platform in the statement of financial position, and
what, if anything, is the impairment loss?
Solution
Fair value less costs of disposal = $2.8m
Value in use = PV of cash flows from use less the carrying
amount of the provision/liability = $3.3m – $0.6m
Recoverable amount = = $2.7m
Carrying value = Higher of these two amounts, ie $2.8m
Impairment loss = $3m
$0.2m
The carrying value should be reduced to $2.8m.
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$3.1m.
Solution
There has been an impairment loss of $1.4m ($4.5m – $3.1m).
The impairment loss will be recognised in profit or loss. The loss will be allocated between
the assets in the cash-generating unit as follows.
A loss of $1m can be attributed directly to the uninsured asset that has been
(a)
destroyed.
(b)
The remaining loss of $0.4m should be allocated to goodwill.
The carrying value of the assets will now be $3m for tangible assets and $0.1m for goodwill.
Minimart belongs to a retail store chain Maximart. Minimart makes all its retail purchases
through Maximart's purchasing centre. Pricing, marketing, advertising and human resources
policies (except for hiring Minimart's cashiers and salesmen) are decided by Maximart.
Maximart also owns five other stores in the same city as Minimart (although in different
neighbourhoods) and 20 other stores in other cities. All stores are managed in the same way
as Minimart. Minimart and four other stores were purchased five years ago and goodwill
was recognized.
All Maximart's stores are in different neighbourhoods and probably have different customer
managed at a corporate level, Minimart generates cash inflows that are largely independent
from those of Maximart's other stores. Therefore, it is likely that Minimart is a cash-
generating unit.
54
ABC is currently undertaking an impairment review. One of its monitered CGU, X, contains
an allocated goodwill of $5m in accordance with IAS 36 for the purpose of impairment
testing. The required annual impairment test was conducted on 31 December 20X6. The
following is relevant to the individual assets of CGU X under review:
Dr Impairment loss 14
Cr Goodwill 5
Cr A 2
Cr B 3
Cr C 4
2. Assuming that the recoverable amount of CGU X is assessed at $83 million and the fair
value less cost to sell asset A is estimated at $22 million.
Dr Impairment loss 12
Cr Goodwill 5
Cr B 3
Cr C 4
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3. Assuming that the recoverable amount of CGU X is assessed at $82 million and the fair
value less cost to sell asset A is estimated at $19 million.
Dr Impairment loss 13
Cr Goodwill 5
Cr A 1
Cr B 3
Cr C 4
56
LESSON 6: REVENUE – IFRS 15
1. Scope
57
2. Basic concepts
An agreement that
Contract creates enforceable
rights and obligations
The amount of
consideration exchanged
Transaction price
for transfer of goods or
services
Revenue Income arising in the
course of an entity’s
Promise to transfer
distinct goods or service ordinary activities.
(or bundle) or a series of Performance
goods or services obligation
A right to consideration
Contract asset for goods or services
transferred
An obligation to transfer
goods or services for
consideration received or Contract liability
receivable The price at which
an entity would sell a
The price which would be Stand-alone promised good or service
received to sell an asset selling price separately to a customer
or paid to transfer a
liability in an orderly
transaction between
market participant at the Fair value
measurement date.
58
3. Criteria to recognize a revenue
According to the IFRS criteria, for revenue to be recognized, the following conditions must
be satisfied:
• Risks and rewards of ownership have been transferred from the seller to the buyer.
• The seller does not have control any longer over the goods sold.
• The collection of payment from goods or services is reasonably assured.
• The amount of revenue can be reasonably measured.
• Costs of revenue can be reasonably measured.
Conditions (1) and (2) are referred to as Performance. Regarding performance, it occurs
when the seller has done what is to be expected to be entitled to payment.
Condition (3) is referred to as Collectability. The seller must have a reasonable expectation
that he or she will be paid for the performance.
Conditions (4) and (5) are referred to as Measurability. Due to the accounting guideline of
the matching principle, the seller must be able to match the revenues to the expenses.
Hence, both revenues and expenses should be able to be reasonably measured.
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• Normally when customer gains control;
• May be over time or at a point in time.
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4.1. Example 1 – The five steps
On 1 December 20X1, Wade receives an order from a customer for a computer as well as 12
months of technical support. Wade delivers the computer (and transfers its legal title) to the
customer on the same day.
The customer paid $420 on 1 December 20X1. The computer normally sells for $300 and the
technical support for $120.
Step 4 – Allocate the transaction price to the performance obligations in the contract
Based on stand-alone sales prices, $300 should be allocated to the sale of the computer and
$120 should be allocated to the sale of technical support.
Step 5 – Recognise revenue when (or as) a performance obligation is satisfied
Control over the computer has been passed to the customer so the full goods revenue of
$300 should be recognised on 1 December 20X1.
The technical support is provided over time, so revenue from this should be recognised over
time. In the year ended 31 December 20X1, revenue of $10 (1/12 x $120) should be
recognised from the provision of technical support.
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Office Solutions Co is not the only company able to install CommSoft, and the technical
support can also be provided by other companies. The software can function without the
updates and technical support.
Required
Explain whether the goods or services provided to Logisticity Co are distinct in accordance
with IFRS 15 Revenue from contracts with customers.
Solution
CommSoft Co was delivered before the other goods or services and remains functional
without the updates and the technical support. It may be concluded that Logisticity Co can
benefit from each of the goods and services either on their own or together with the other
goods and services that are readily available.
The promises to transfer each food and service to the customer are separately identifiable.
In particular, the installation service does not significantly modify the software itself and, as
such, the software and the installation service are separate outputs promised by Office
Solutions Co rather than inputs used to produce a combined output.
In conclusion, the goods and services are distinct and amount to four performance
obligations in the contract under IFRS 15.
(a) As at 30 September 20X5, TrillCo had bought 70 laptops from Taplop. Taplop
Co therefore estimated that TrillCo’s purchases would not exceed 500 in the
year to 30 June 20X6, and TrillCo would therefore not be entitled to the
volume discount.
(b) During the quarter ended 31 December 20X5, TrillCo expanded rapidly as a
result of a substantial acquisition, and purchased an additional 250 laptops
from Taplop Co. Taplop Co then estimated that TrillCo’s purchases would
exceed the threshold for the volume discount in the year to 30 June 20X6.
Require
Calculate the revenue Taplop Co would recognise in:
Solution
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(a) Applying the requirements of IFRS 15 to TrillCo’s purchasing pattern at 30
September 20X5, Taplop should conclude that it was highly probable that a
significant reversal in the cumulative amount of revenue recognised ($500 per
laptop) would not occur when the uncertainly was resolved, that is when the
total amount of purchases was known.
(b) In the quarter ended 31 December 20X5, TrillCo’s purchasing pattern changed
such that it would be legitimate for Taplop Co to conclude that TrillCo’s
purchases would exceed the threshold for the volume discount in the year to
30 June 20X6, and therefore that it was appropriate to reduce the price to
$450 per laptop.
As the total receipts are $480, this is the amount which must be allocated to the separate
performance obligations. Revenue will be recognised as follows (rounded to nearest $).
$
Year 1
Handset (480 x 17%) 82
Contract (480 – 82)/2 199
281
63
Year 2
Contract as above 199
EXAMPLE:
Background:
• WatchCo uses a wholesale network to supply its products to end-customers.
• WatchCo sells 100 watches to a retailer for €50 each. The cost of each watch is €10.
• WatchCo estimates, based on the expected value method, that 6% of watches sold
will be returned, and it is highly probable that returns will not be higher than 6%.
• WatchCo has no further obligations after transferring control of the watches.
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Situation A – Retailer has a contractual right to return the watches for a full refund for a
contractually defined period.
Situation B – Retailer has no contractual right, but WatchCo has a customary business
practice where returns have been made and accepted.
Situation B:
WatchCo has a customary business practice of accepting returns which should be
considered part of the terms of the contracts with its customers.
5.2. Warrenties
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Question
Manufacturer A sells laptop computers with a 12-month warranty which assures that the
laptops will work as intended for 12 months. The warranty is not sold separately. How
should Manufacturer A account for the warranty?
Answer
Because the warranty provides the customer with the assurance that the laptop will work as
intended for one year, Manufacturer A will account for this ‘assurance-type’ warranty in
accordance with IAS 37 Provisions, Contingent Liabilities and Contingent Assets, i.e. a
provision is raised for the expected cost of repairing the product in the next 12 months.
Assurance-type warranties do not result in a change to current practice re the recognition of
revenue, i.e. this does not represent a separate performance obligation.
EXAMPLE – Providing a free extended warranty
Question
On 29 June 2018, Retailer C is running a special promotion on its washing machines. The
selling price of the washing machine is $1,000. Customers will receive a free 24-month
extended warranty, in addition to the 12-month standard warranty. The same 24-month
extended warranty can be purchased from the manufacturer for $200. How should Retailer
C account for the sale? Assume that the standalone selling price of the washing machine is
$1,000.
Answer
A portion of the selling price needs to be allocated to the extended warranty based on the
relative standalone selling price.
Contract components Standalone selling price Revenue
Washing machine $1,000 $833
($1,000x($1,000/$1,200))
Extended warranty $200 $167 ($1,000x($200/$1,200))
$1,200 $1,000
Retailer C will recognise $833 when the washing machine is sold. $167 is deferred until the
warranty obligation is satisfied.
The common practice today is to recognise $1,000 as revenue, and a provision under IAS 37.
30 June 30 June
30 June 2020 Total
2018 2019
IFRS 15
Washing machine $833 - - $833
2 year extended $84 $84 $167
warranty
Total $833 $84 $84 $1,000
IAS 18
Washing machine $1,000 - - $1,000
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Practical implications on systems and processes
Some of the practical implications on systems and processes for Retailer C include:
Agent Principal
▪ Its performance obligation is to ▪ It controls the promised good
arrange for the provision of goods or service before it is
or services by another party. transferred to the customer.
Indicators
(b) The entity does not have inventory risk before or after the goods have been ordered by a customer, during
shipping or on return.
(c) The entity does not have discretion in establishing prices for the other party’s goods or services and, therefore,
the benefit that the entity can receive from those goods or services is limited .
(e) The entity is not exposed to credit risk for the amount receivable from a customer in exchange for the other
party’s goods or services.
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Is the entity a principal or an agent?
(d) The entity does not establish prices and bears no credit risk.
The entity would therefore conclude that it is acting as an agent and that the only revenue
to be recognised is the amounts received as commission.
Repurchase
agreements
If an asset has
Solution
• Yorrick faces the risk of falling property prices.
• Xavier continues to insure and maintain the property.
• Xavier will benefit from a rising property price.
• Xavier has the benefit of use of the property.
Xavier should continue to recognise the head office as an asset in the statement of financial
position. This is a secured loan with effective interest of $2 million ($12 million – $10
million) over the four-year period.
“Consignment arrangements” –
the customer (dealer) does not
obtain control of the product at
that point in time
Indicators
The product is controlled by the The entity can require the The customer
entity until a specified event return of the product, or (dealer/distributor) does not
occurs, such as the product is sold transfer it to another party. have an unconditional obligation
on, or a specified period expires. to pay for the product.
EXAMPLE:
• GardenfurnishingsCo provides teak furniture to a garden centre on a
consignment basis. The products are immediately proposed for sale in the
garden centre.
• GardenfurnishingsCo retains title to the products until they are sold to the end-
customer.
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• The garden centre does not have an obligation to pay GardenfurnishingsCo until
a sale occurs, and any unsold products can be returned to GardenfurnishingsCo.
• GardenfurnishingsCo also retains the right to take back any unsold products, or
to transfer unsold products to another retailer.
• Once the garden centre sells the products to the end-customer,
GardenfurnishingsCo has no further obligations, and the retailer has no further
return rights.
SOLUTION:
GardenfurnishingsCo should recognise revenue once the garden centre sells the product to
the end-customer. Although the garden centre has physical possession of the products, it
does not take title, only a right to sell, and it does not have an unconditional obligation to
pay GardenfurnishingsCo. GardenfurnishingsCo retains the right to call back the products.
Therefore, revenue is not recognised when the goods are delivered to the garden centre in
accordance with the guidance in paragraphs B77 and B78 of IFRS 15.
GardenfurnishingsCo should also assess whether it is the principal to the transaction with
the end-customer. If this is the case, it would recognise revenue in the amount that was
received from the end-customer, and the amount retained by the garden centre would be
recognised as commission expense (see also Section VI).
(a) The reason for (b) The product (d) The entity cannot
(c) The product
the bill-and-hold must be separately have the ability to use
must be ready for
must be substantive identified as70 the product or to
physical transfer
belonging to the transfer it to another
(e.g. requested by to the customer.
customer customer.
the customer)
EXAMPLE:
• Consoles AG, a video game company, enters into a contract to supply 100,000 video
game consoles to a retailer, Durbin, branded with Durbin’s logo, to be delivered by the
end of the year.
• The contract contains specific instructions from the retailer about where the consoles
should be delivered.
• The retailer expects to have sufficient shelf space at the time of delivery.
• As of year-end, Consoles AG has shipped 60,000 units and the remaining 40,000
inventory of Durbin-branded consoles have been produced, packed and are ready for
transport. However, the retailer asks for the shipment to be held, due to lack of shelf
space.
When should Consoles AG recognise revenue for the 100,000 units to be delivered to the
retailer?
SOLUTION:
At the year-end, Consoles AG should recognise revenue for all 100,000 units, because all of
the criteria exist for the control of the units to have transferred to Durbin. Since the goods
are branded, they can not be directed to another customer, they are clearly identified as
belonging to Durbin, and the reason for entering into the transaction is substantive (that is,
lack of shelf space).
6. Long-term contract
IFRS 15 is not prescriptive about the treatment of contract assets/liabilities.
As alternatives to the term 'contract asset', IFRS 15 also allows the terms receivable and
work-in-progress to be used.
71
% completion = contract costs incurred to date ÷ total expected costs
x 100
Output method – based on performance completed to date.
% completion = the value of the work certified to date ÷ the total
contract price x 100
NOTE: If revenue is earned equally over time (e.g. providing a
monthly payroll service), then revenue would be recognised on a
straight line basis over that period.
Where Revenue should be recognised only to the extent of contract costs
progress incurred that will probably be recoverable.
cannot be
measured
STEP 2 – Determining Revenue in the period
Revenue = Total contract price × % completion
STEP 3 – Determining Total contract Profit
Total contract Profit = Total contract price – Total costs
NOTE: There are 2 cases: Total contract profit > 0 or < 0
STEP 4 – Determining Profit and COGS in the period
CASE 1 Total profit contract > 0
COGS = Total costs × % completion
Profit = Total contract profit × % completion
CASE 2 Total profit contract < 0 → Loss
NOTE: Recognised all loss in this period
COGS = Revenue – Loss
STEP 5 – Determining contract asset/liabilities
X = Cost incurred + Profit recognised – Amount invoiced
If X > 0 => contract asset
If X < 0 => contract liability
EXAMPLE 1:
On 1 January 20X1, Baker entered into a contract with a customer to construct a specialised
building for consideration of $2m plus a bonus of $0.4m if the building is completed within
18 months. Estimated costs to construct the building were $1.5m. If the contract is
terminated by the customer, Baker can demand payment for the costs incurred to date plus
a mark-up of 30%. On 1 January 20X1, as a result of factors outside of its control, Baker was
not sure whether the bonus would be achieved. At 31 December 20X1 Baker had incurred
costs of $1m. They were still unsure as to whether the bonus target would be met. Baker
measures progress towards completion based on costs incurred. At 31 December 20X1
Baker had received $1 million from the customer.
Required: How should this transaction be accounted for in the year ended 31 December
20X1?
SOLUTION:
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Constructing the building is a single performance obligation. The bonus is variable
consideration. It is excluded from the transaction price because it is not highly probable that
a significant reversal in the amount of cumulative revenue recognised will not occur.
The construction of the building should be accounted for as an obligation settled over time.
Baker should recognise revenue based on progress towards satisfaction of the construction
of the building.
1. Overall contract
$000
Price 2,000
Costs to date (1,000)
Costs to complete (500)
–––––
Overall profit 500
–––––
2. Progress
An input method is used to calculate the progress, being costs to date compared to total
costs. 1,000/1,500 = 66.7% (or 2/3)
3. Statement of profit or loss
$000
Revenue (2,000 × 2/3) 1,333
Cost of sales (1,500 × 2/3) (1,000)
–––––
Profit 333
–––––
$000
Costs to date 1,000
Profit to date 333
Less: Billed to date (1,000)
–––––
Contract asset 333
–––––
EXAMPLE 2:
On 1 January 20X1, Castle entered into a contract with a customer to construct a specialised
building for consideration of $10m. Castle is not able to use the building themselves at any
point during the construction. At 31 December 20X1, Castle had incurred costs of $6m.
Costs to complete are estimated at $6m. Castle measures progress towards completion
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based on costs incurred. At 31 December 20X1 Castle had received $3 million from the
customer.
Required: How should this transaction be accounted for in the year ended 31 December
20X1?
SOLUTION:
The construction of the building should be accounted for as an obligation settled over time.
Castle should recognise revenue based on progress towards satisfaction of the construction
of the building.
1. Overall contract
$000
Price 10,000
Costs to date (6,000)
Costs to complete (6,000)
–––––
Overall loss (2,000)
–––––
As the contract is loss making, Castle must provide for the full loss immediately.
2. Progress
An input method is used to calculate the progress, being costs to date compared to total
costs. 6,000/12,000 = 50%
Revenue and expenses should be recorded based on the progress to date. However, doing
this would only recognise 50% of the loss. Therefore a provision is made in order to
recognise the full loss of $2 million immediately.
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EXAMPLE 3:
On 1 January 20X1 Amir entered into a contract with a customer to construct a stadium for
consideration of $100m. The contract was expected to take 2 years to complete.
At 31 December 20X1 Amir had incurred costs of $24m. Costs to complete are estimated at
$20m. In addition to these costs, Amir purchased plant to be used on the contract at a cost
of $16m. This plant was purchased on 1 January 20X1 and will have no residual value at the
end of the 2 year contract. Depreciation on the plant is to be allocated on a straight line
basis across the contract.
Amir measures progress on contracts using an output method, based on the value of work
certified to date.
At 31 December 20X1, the value of the work certified was $45 million, and the customer had
paid $11.4m.
Required:
How should this transaction be accounted for in the year ended 31 December 20X1?
SOLUTION:
1. Overall contract
$000
Price 100,000
Costs to date (24,000)
Costs to complete (20,000)
Plant cost (16,000)
–––––
Overall profit 40,000
–––––
As the contract is loss making, Castle must provide for the full loss immediately.
2. Progress
An output method is used to calculate the progress, being workcertified to date compared
to the total contract price.
45,000/100,000 = 45%
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$000
Non-current assets
Property, plant & equipment 8,000 (W1)
Current assets
Contract asset 38,600 (W2)
Alternatively, the current asset could be split between receivables and inventory, rather
than being held as a contract asset:
Current assets
Inventory (work-in-progress) 5,000 (W3)
Trade receivable 33,600 (45,000 revenue less 11,400 cash
received (W4))
Workings:
(W1) Property, plant & equipment
The plant cost $16 million and should be depreciated over the 2 year period.
Therefore by the year end, the depreciation is $8 million, and the carrying amount
is also $8 million.
(W2) Contract asset
$000
Costs to date ($24m + $8m depreciation) 32,000
Profit to date 18,000
Less: Amount billed to date (11,400)
––––––
Contract asset 38,600
––––––
(W3) Inventory
As the costs to date (costs spent to date plus depreciation to date) exceed the cost
of sales, the difference will be treated as work-in-progress within inventory.
Costs to date: $24m + $8m depreciation = $32m
Cost of sales: $27m
Therefore WIP = $32m – $27m = $5m.
(W4) Receivable
Revenue – $45 million. Cash received = $11.4 million.
Therefore receivable = $33.6 million
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LESSON 7: INTRODUCTION TO GROUPS
1. Overview of group accounts and treatment
1.1. Introduction to business combination
Business combination: a transaction or other event in which the acquirer obtains control of
one or more businesses (True mergers/ Mergers of equals).
77
1.3. Types of relationship with criterion and required treatment
78
b. Rationale
• Users of the financial statements of a parent are usually concerned with, and need to
be informed about, the financial position, results of operations and changes in
financial position of the group as a whole.
• This need is served by consolidated financial statements, which present financial
information about the group as that of a single entity without regard for the legal
boundaries of the separate legal entities.
• A parent which is wholly owned by another entity may not always present
consolidated financial statements because such statements may not be required by
its parent, and the needs of other users may be best served by the consolidated
financial statements of the ultimate parent.
Note:
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3. Content of group accounts and group structure
3.1. Group accounts
Adjustment
Group accounts/
Consolidated accounts
S2,3,4: Partly
100% 80% 75% 90%
owned
S1 S2 S3 S4 subsidiaries
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LESSON 8: THE CONSOLIDATED STATEMENT OF FINANCIAL POSITION
acquired
P 60% of S 40% of S
The amount Parent paid to acquire share is called “Consideration transferred” (CT), and
would be presented “investments in subsidiary” in separate FS of parent.
Types of consideration transferred
- Cash paid immediately
- Deferred cash payment (paid after period of time, ie: 2 years)
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- Share exchange (issued new share of parent in exchange share of subsidiary). After
share exchange, shareholders of subsidiary (Mr A, Mr B, Mr C above) would not only
receive cash, but also receive new share of Parent, then become shareholders of parent;
while parent become shareholders of subsidiary, so this transaction is called “share
exchange”.
3. Procedures in preparing the consolidated statement of financial position
Different reporting
dates
Asset Liabilities
83
EXAMPLE 1:
As at 31 December 2014
Parent Subsidiary
Non-current assets:
Tangibles 2,000 500
5,000 1,000
5,000 1,000
Further information:
Parent bought 100% of Subsidiary on 31 December 2014.
Features to note:
1. The issued capital of the group is the issued capital of Parent. This is always the case.
2. The cost of investment is to disappear. It is "replaced".
3. The assets and liabilities of the group are simply a line-by-line cross cast of those of
Parent and
Subsidiary. Parent controls 100% of Subsidiary's net assets. This is always the case.
Required: Prepare the consolidated statement of financial position
84
ANSWER:
Non-current assets:
1,000 1,000
(2) Goodwill
Cost 1,000
Non-controlling interest –
Share of Subsidiary –
4,500
85
EXAMPLE 2:
As at 31 December 2014
Parent Subsidiary
Non-current assets:
3,300 1,600
Further information:
1. Parent bought 100% of Subsidiary on 31 December 2014. 1. Parent bought 100% of
Subsidiary two years ago.
2. Subsidiary's reserves were $100 at the date of acquisition.
3. Goodwill has been impaired by $80 since the date of acquisition.
Features to note:
1-3: As before
4. As before, part of the cost is goodwill. This must be separately identified as an asset
to help
replace the cost of investment.
5. Parent's share of the post-acquisition profits of Subsidiary is included in the
consolidated
6. retained earnings.
86
ANSWER:
87
EXAMPLE 3: NCI with Proportionate Share
As at 31 December 2014
Parent Subsidiary
Non-current assets:
Tangibles 1,000 600
2,700 1,200
Issued capital 100 50
2,700 1,200
Further information:
1. Parent bought 80% of Subsidiary two years ago.
2. Subsidiary's reserves are $150 at the date of acquisition.
3. Goodwill has been impaired by $200 since the date of acquisition
4. Non-controlling interest is valued at the proportionate share of the subsidiary's
identifiable
5. net assets; it is not credited with its share of goodwill.
Features to note:
1-2: As before
3. As before, the assets and liabilities of the group are simply a cross cast of those of
Parent
and Subsidiary. Parent's share of Subsidiary's net assets is 100% on a line-by-line basis.
That part which does not belong to the parent is called "non-controlling interest". It is
shown as a credit balance, within equity, in the statement of financial position. This example
values non-controlling interest without including any value for goodwill.
4. As before, only this time goodwill is impaired by $200.
5. As before, Parent's share of the post-acquisition profits of Subsidiary is included in
the
consolidated retained earnings
88
ANSWER:
Consolidated statement of financial position
$
Non-current assets:
Goodwill (W2) 840
Tangibles 1,600
Net current assets 1,100
3,540
89
EXAMPLE 4: NCI with Fair Value
As at 31 December 2014
Parent Subsidiary
Non-current assets:
2,700 1,200
Further information:
1. Parent bought 80% of Subsidiary two years ago.
2. Subsidiary's reserves are $150 at the date of acquisition.
3. Goodwill has been impaired by $200 since the date of acquisition.
4. Non-controlling interest is valued at fair value on acquisition; it is credited with its
share of
goodwill. The market price of a share in the subsidiary at the date of acquisition was $29.60.
Features to note:
1-2: As before
3. As before, the assets and liabilities of the group are simply a cross cast of those of
Parent
and Subsidiary. Parent's share of Subsidiary's net assets is 100% on a line-by-line basis.
That part which does not belong to the parent is called "non-controlling interest". It is
shown as a credit balance, within equity, in the statement of financial position. This example
values non-controlling interest without including any value for goodwill.
4. As before, only this time goodwill is impaired by $200.
5. As before, Parent's share of the post-acquisition profits of Subsidiary is included in
the
consolidated retained earnings
90
ANSWER:
Consolidated statement of financial position
$
Non-current assets:
Goodwill (W2) 1,096
Tangibles 1,600
Net current assets 1,100
3,796
91
7. Step 4: Eliminating inter-company transaction
Current assets:
Inventories 16,000 12,000
Trade receivables: Suyin Co 2,000 _
Other 6,000 9,000
Cash and cash equivalents 1,000 ______
Total assets 100,000 66,000
92
EQUITY AND LIABILITIES
Equity
40,000 $1 ordinary shares _ 40,000
70,000 $1 ordinary shares 70,000 _
Retained earnings 16,000 19,000
86,000 59,000
Current liabilities
Bank overdraft 3,000
Trade and other payables: Park Co 2,000
Trade and other payables: Other 14,000 2,000
Total equity and liabilities 100,000 66,000
Current assets:
Inventories 28,000
Trade receivables: 15,000
Cash and cash equivalents 1,000
Total assets 44,000
124,000
93
Bank overdraft 3,000
Trade and other payables 16,000
19,000
Total equity and liabilities 124,000
Notes:
1. Park Co’s bank balance is not netted of with Suyin Co’s bank overdraft. To offer one
against the other would be less informative and would conflict with the principle
that assets and liabilities should not be netted off
2. The share capital in the consolidated statement of financial position is the share
capital of the parent company alone. This must always be the case, no matter how
complex the consolidation, because the share capital of subsidiary companies must
always be wholly canceling items
Adjustments for
selling company
▪ Inventory and non-current assets transfer are two typical inter-company trading within
a group which leads to unrealized profit
94
7.2.1. Inventory
▪ Value recognition to a group:
Cost
Lower between
Inventory value
▪ The group needs to eliminate profit made by the selling company if inventory is still held
by the group at the year end, as the group has not yet realised this profit.
(2) Parent owns 80% of Subsidiary. During the current accounting period, Subsidiary sold
goods to Parent for $18,000, which gave Subsidiary a profit of $6,000. At the end of the
reporting period, half of these goods are included in Parent's inventory. At the end of the
reporting period, Parent's accounts showed retained profits of $100,000, and Subsidiary's
accounts showed net assets of $75,000, including retained profits of $65,000. Subsidiary
had retained profits of $20,000 at acquisition. Ignore goodwill
95
ANSWER:
(1) Dr Retained Earnings: 1,000
Cr Inventory: 1,000
96
years. Full allowance is made for depreciation in the year of purchase and none in the year of
sale.
Required: Calculate the adjustments for the consolidated financial statements at 31
December 2014.
ANSWER:
Amounts in the Amounts if no Adjustment
accounts transfer had
occurred
$ $ $
Cost 15,000 20,000
Accumulated depreciation (5,000) *(12,000)
(15,000/3 years) 10,000 8,000 2,000
Profit on disposal
Proceeds 15,000
NBV (20 – 8) (12,000)
3,000 – 3,000
(*) Accumulated depreciation of $12,000 is calculated as 3 years @ 20% per annum based
on the original cost of $20,000.
97
LESSON 9: THE CONSOLIDATED STATEMENT OF PROFIT AND LOSS AND
OTHER COMPREHENSIVE INCOME
1. Rationale and process of making consolidated statement of profit and loss and other
comprehensive income
1.1. Rationale
Criterion Explanation
Purpose Shows a true and fair view of the group’s activities since acquisition
of any subsidiaries as if it were a single entity
Components
Top Shows:
• Income
• Expenses
• Profit
• Other comprehensive income by the group
Bottom Reconciliation shows the ownership of those profit and total
comprehensive income
1.2. Process
Making consolidated statement Step 1: Draw up the group structure and where
of profit and loss and other subsidiaries/ associates are acquired in
comprehensive income the year identify the proportion to
consolidate (Use timeline)
98
2. Step 1: Draw up the group structure (W1)
P
This indicates that P owns 80% of the ordinary shares of S and when they were acquired.
This drawing will show how much of subsidiary owned by P and how long P control over S.
100% (Parent + Subsidiary) × Time apportioned × X/12 Omit the amount from subsidiary
99
5. Step 4: Calculate necessary adjustments
Necessary adjustments
EXAMPLE 1:
Whales owns 75% of Porpoise. The trading account for each company for the year ended 31
March is as follows:
Whales Porpoise
$ $
Revenue 120,000 70,000
Cost of sales (80,000) (50,000)
Gross profit 40,000 20,000
During the year, Porpoise made sales to Whales amounting to $30,000. Of these sales,
$15,000 was in inventory at the year end. Profit made on the year-end inventory items
amounted to $2,000.
Required: Calculate group revenue, cost of sales and gross profit.
100
ANSWER:
Whales Porpoise Adjustment Consolidated
$ $ $ $
Revenue 120,000 70,000 (30,000) 160,000
Cost of sales — per question (80,000) (50,000) 30,000
— unrealised profit _______ _______ (2,000) (102,000)
Gross profit 40,000 18,000 _______ 58,000
Non-controlling interest (4,500)
(25% × 18,000)
EXAMPLE 2:
Parent owns 80% of Subsidiary. Parent transferred a non-current asset to Subsidiary on 1
January 2014 at a value of $15,000. The asset originally cost Parent $20,000 and
depreciation to the date of transfer was $8,000. The asset had a useful life of five years
when originally acquired, with a residual value of zero. The useful life at the date of transfer
remains at three years. Both companies depreciate their assets at 20% per annum on cost,
making a full year's depreciation charge in the year of acquisition and
none in the year of disposal. Total depreciation for 2014 was $700,000 for Parent and
$500,000 for Subsidiary.
Required: Show the adjustments required for the above transaction in the consolidated
statement of profit or loss for the year ended 31 December 2014.
ANSWER:
Parent Subsidiary Adjustment Consolidated
$ $ $ $
Per question 700,000 500,000 1,200,000
Asset unrealised profit 3,000 3,000
[15,000 − (20,000 −
8,000)]
Depreciation adjustment* (1,000) (1,000)
(15,000 ÷ 3 years) − 4,000
1,202,000
5.2. Dividends
Dividend from S must be removed
On consolidated
financial statement
Dividend from P’s own shareholders is kept
101
5.3. Further adjustments
5.3.1. Impairment of goodwill
▪ Cost of impairment is considered operating expense in the CSPL statement
▪ This impairment will lead to the removal of impairment expense from the NCI’s share of
profit if the NCI have been valued at fair value
EXAMPLE 3:
Pathfinder owns 75% of Sultan. Statements of profit or loss for the two companies for the
year ending 30 June are as follows:
Pathfinder Sultan
$ $
Revenue 100,000 50,000
Cost of sales (60,000) (30,000)
Gross profit 40,000 20,000
Expenses (20,000) (10,000)
Profit for the period 20,000 10,000
During the year, Pathfinder sold goods to Sultan for $20,000, at a gross profit margin of
40%. Half of the goods remained in inventory at the year end. Non-controlling interest is
valued at fair value on acquisition. Goodwill has been impaired by $4,000 in the year ended
30 June.
Required: Prepare the consolidated statement of profit or loss of the group for the year
ended 30 June.
ANSWER:
Consolidated statement of profit or loss for the year ended 30 June:
$
Revenue 130,000
Cost of sales (74,000)
Gross profit 56,000
Expenses (30,000)
Goodwill (4,000)
Profit 22,000
Non-controlling interest (W3) (1,500)
Profit for the period 20,500
Workings:
(1) Group structure:
Pathfinder
75%
Sultan
102
(2) Consolidation schedule
Whales Porpoise Adjustment Consolidated
$ $ $ $
Revenue 100,000 50,000 (20,000) 130,000
Cost of sales — per (60,000) (30,000) 20,000
question
— unrealised profit (4,000) (74,000)
(W4)
Expenses (20,000) (10,000) (30,000)
Goodwill (4,000) (4,000)
Profit 22,000
% $
Selling price 100 20,000
Cost (60) (12,000)
Gross profit 40 8,000 x ½ = 4,000
EXAMPLE 4:
Parent acquired 75% of Subsidiary during the year on 1 April. Extracts from the companies'
statements of profit or loss for the year ended 31 December are:
103
Parent Subsidiary
$ $
Revenue 100,000 75,000
Cost of sales (70,000) (60,000)
Gross profit 30,000 15,000
Since acquisition, the Parent has made sales to the Subsidiary of $15,000. None of these
goods remain in inventories at the year end.
Required: Calculate revenue, cost of sales and gross profit for the group for the year ending
ANSWER:
Consolidated statement of profit or loss for the year ending 31 December:
5.3.4. Disposals
▪ Disposal refers to the situation that parent sells its share in subsidiary and stop
consolidation (deconsolidation). In this situation, the parent must:
o Derecognize all assets and liabilities of the subsidiary at the date when control is
lost;
o Derecognize any non-controlling interest in the lost subsidiary;
o Recognize fair value of consideration received from the transaction,
o Recognize any resulting gain or loss in profit or loss attributable to the parent.
▪ When a subsidiary is disposed of, this must be accounted for in both the parent's
separate financial statements and the consolidated financial statements.
Parent’s separate FS
$
Fair value of consideration received X
Less carrying amount of investment disposed of (X)
Profit/(loss) on disposal X/(X)
Disposal
Group FS
treatment
▪ Statement of financial position: There will be no non-
controlling interest and no consolidation as there is no
subsidiary at the date the statement of financial position is
being prepared.
▪ Statement of profit or loss and other comprehensive income:
104
o Consolidate results and non-controlling interest to the
date of disposal.
o Show the group profit or loss on disposal.
▪ Details into group statement of profit or loss on disposal:
$ $
Fair value of consideration received X
Less: share of consolidated carrying amount at date of
disposal
net assets X
goodwill X
less non-controlling interests (X)
(X)
Profit/(loss) on disposal X/(X)
EXAMPLE 5:
Horse Co bought 80% of the share capital of Hoof Co for $648,000 on 1 October 20X5. At that
date Hoof Co's retained earnings balance stood at $360,000. The statements of financial
position at 30 September 20X8 and the summarised statements of profit or loss to that date
are given below. (There is no other comprehensive income.)
Horse Co Hoof Co
$ $
Non-current assets 720 540
Investment in Hoof Co 648 –
Current assets 740 740
2,108 1,280
Equity
$1 ordinary shares 1,080 360
Retained earnings 828 720
Current liabilities 200 200
2,108 1,280
Assume that profits accrue evenly throughout the year and no dividends have been paid. It is
the group's policy to value the non-controlling interest at its proportionate share of the fair
value of the subsidiary's identifiable net assets. Ignore taxation.
Required: Prepare the consolidated statement of financial position and statement of profit
or loss at 30 September 20X8 assuming that Horse Co sells its entire holding in Hoof Co for
$1,300,000 on 30 September 20X8. (Assume no impairment of goodwill.)
105
ANSWER:
CONSOLIDATED STATEMENT OF FINANCIAL POSITION AS AT 30 SEPTEMBER 20X8
$'000
Non-current assets 720
Current assets ( 740 + 1,300) 2,040
2,760
Equity
$1 ordinary shares 1,080
Retained earnings (W4) 1,480
Current liabilities 200
2,760
1. Timeline
1.10.X7 30.9.X8
106
__(936)
Profit/(loss) on disposal ___364
3. Goodwill
$'000
Consideration transferred 648
NCI at acquisition (720 × 20%) 144
Less: net assets at acquisition (360 + 360) (720)
72
4. Retained earnings carried forward
Horse Hoof
$'000 $'000
Per question/date of disposal 828 720
Add group gain on disposal (W2) 364 _
Reserves at acquisition _ __(360)
▪ With mid-year disposal: The treatment is the same as disposal at the end of period, with
the timeline in subsidiary to set up the P/L is for 6 months only
Both the associate’s profit or loss and other comprehensive income are calculated based on
tax figures
107
7. Step 6: Complete non-controlling interest in subsidiary’s PFY and TCI
PFY/TCI per question (time-apportioned (x/12 X
Any group impairment loss on associate in the period (X)
X
Shown before group profit before tax
EXAMPLE 6:
On 1 July 20X8 Crystal acquired 60,000 of the 100,000 shares in Pebble, its only subsidiary.
The draft statements of profit or loss and other comprehensive income of both companies at
31 December 20X8 are shown below:
Crystal Pebble
$’000 $’000
Revenue 43,000 26,000
Cost of sales (28,000) (18,000)
Gross profit 15,000 8,000
Other income – dividend received from 2,000 –
Pebble
Distribution costs (2,000) (800)
Administrative expenses (4,000) (2,200)
Finance costs (500) (300)
Profit before tax 10,500 4,700
Income tax expense (1,400) (900)
Profit for the year 9,100 3,800
Other comprehensive income:
Gain on property revaluation (Note (i)) – 2,000
Investment in equity instrument 200 –
Total comprehensive income for the year 9,300 5,800
Additional information:
a) At the date of acquisition, the fair values of Pebble's assets were equal to their carrying
amounts with the exception of a building which had a fair value $1m in excess of its
carrying amount. At the date of acquisition, the building had a remaining useful life of
20 years. Building depreciation is charged to administrative expenses. The building
was revalued again at 31 December 20X8 and its fair value had increased by an
additional $1m.
b) Sales from Crystal to Pebble were $6m during the post-acquisition period. All of these
goods are still held in inventory by Pebble. Crystal marks up all sales by 20%.
c) Despite the property revaluation, Crystal has concluded that goodwill in Pebble has
been impaired by $500,000.
d) It is Crystal's policy to value the non-controlling interest at full (fair) value.
108
e) Income and expenses can be assumed to have arisen evenly throughout the year.
Required: Prepare the consolidated statement of profit or loss and other comprehensive
income for the year ended 31 December 20X8.
109
LESSON 10: INVESTMENTS IN ASSOCIATES
Investments in associates
110
1.2.1. Separate financial statement of investor
One of the following:
Exemption:
111
▪ Investor share the losses at the maximum amount (equivalent to the interest in associate).
When the investment is reported to be nil value, the investor should discontinue sharing
the losses unless the investor has incurred obligations or made payments on behalf of the
associate (for example, if it has guaranteed amounts owed to third parties by the
associate).
2.2. Basic rule
Criterion Explanation
Cost of the investment ▪ Increase or decrease with the parent’s share of the associate's
post- acquisition profits or losses.
▪ This carrying amount of the investment in the associate
Carrying amount of the ▪ Is included as a single line entry in the consolidated statement
cost of investment of financial position.
▪ Decreased when the parent receives distribution
▪ Needs to be adjusted when there is a change in the investor's
proportionate interest in the associate arising from items
which have not been recognized in the profit or loss
(revaluation of PPE, foreign exchange translation differences)
Share of current year’s ▪ Recognize in the investor’s profit or loss
profit or loss
Group share of the ▪ Is included in the consolidated statement of financial position
associate's net assets in one line
Share of profit (after ▪ Is included in the consolidated statement of profit or loss in
tax) one line.
The way of presenting group share of associate’s net assets and share of profit (after tax) in
one line in consolidated financial statements rather than consolidating line by line due to
the fact that associate does not belong to group and it is not controlled by parent.
3. Application in preparing consolidated financial statements
3.1. In a consolidated statement of financial position
Components Requirement
Investment in Equals:
associates account Cost of investment
+/-
Parent’s share of associates post-acquisition profits (loss)
-
Impairment of the investment
Goodwill ▪ Included in the carrying amount of the investment instead of
being separately presented
▪ Is calculated by using the fair values of the associate’s assets
and liabilities
Asset ▪ Do not consolidate the associate's net assets line-by-line
▪ The net asset of associate is not controlled by parent
Group reserve ▪ The parent’s share of the associate’s post-acquisition
reserves is included
112
Adjustment ▪ Fair value adjustments can lead to the change in reserves,
depreciation charges…
Income to determine ▪ The difference between the share of the associate’s net
the investor’s share of assets acquired at fair value and the cost of the investment
the associate’s profit
and loss
EXAMPLE 1:
P owns 80% of S and 40% of A. Statements of financial position of the three companies at 31
December 2014 are:
P S A
$ $ $
Investment: shares 800 - -
in S
Investment: shares 600 - -
in A
Other non-current 1,600 800 1,400
assets
Current assets 2,200 3,300 3,250
5,200 4,100 4,650
Issued capital – $1 1,000 400 800
ordinary shares
Retained earnings 4,000 3,400 3,600
Liabilities 200 300 250
5,200 4,100 4,650
P acquired its shares in S seven years ago when S's retained earnings were $520 and P
acquired its shares in A on 1 January 2014 when A's retained earnings were $400. Non-
controlling interest is not credited with goodwill which had been written off after five years.
There were no indications during the year that the investment in A was impaired.
ANSWER:
113
Liabilities 500
9,780
Working:
S
(2) Net assets working
(3) Goodwill
S
$
Cost of investment 800
Net assets acquired (80% × 920 (736)
(W2))
64
114
Share of post-acquisition profits 1,280
Less: Impairment loss)] 0
1,880
Components Requirement
Group share of the ▪ Included in consolidated profit or loss
associate’s profits ▪ Replaces dividend income in the investor’s separate profit or
after tax loss statement
Revenue and expenses ▪ Do not add line by line
Adjustment ▪ Acquisition at mid-year should lead to adjustment by
apportioning time in the associate’s results
EXAMPLE 2:
P has owned 80% of S and 40% of A for several years. Statements of profit or loss for the
year ended 31 December are:
P S A
$ $ $
Revenue 14,000 12,000 10,000
Cost of sales (9,000) (4,000) (3,000)
Gross profit 5,000 8,000 7,000
Administrative expenses (2,000) (6,000) (3,000)
3,000 2,000 4,000
Dividend from associate 400 – –
Profit before taxation 3,400 2,000 4,000
Income taxes (1,000) (1,200) (2,000)
Profit after taxation 2,400 800 2,000
Dividends (paid) (1,000) – (1,000)
Retained earnings for the 1,400 800 1,000
period
Non-controlling interest is not credited with goodwill, which was fully written off three
years ago.
Required: Prepare the consolidated statement of profit or loss for the year ended 31
December.
ANSWER: Consolidated statement of profit or loss for the year ending 31 December
$
Revenue 26,000
Cost of sales (13,000)
Gross profit 13,000
Administrative expenses (8,000)
Operating profit 5,000
115
Income from associate 800
Profit before taxation 5,800
Income taxes (2,200)
Profit after taxation 3,600
Non-controlling interest (W3) (160)
Profit for the year 3,440
S
(2) Consolidation schedule
$
S only 20% × 800 160
4.2. Dividends
117
▪ To eliminate unrealized profit, deduct the profit from the associate's profit before tax and
retained earnings in the net assets working before equity accounting for associate,
irrespective of whether the sale is from the associate to the parent or vice versa
EXAMPLE 3:
Parent sells goods to associate for $150 which originally cost parent $100. The goods are still
in associate's inventory at the year end.
Required: State how the unrealized profit will be dealt with in the consolidated accounts.
ANSWER:
118
LESSON 11: FINANCIAL INSTRUMENTS
Financial market
To help you to get a deep understanding of financial instrument, we should have an overview
of financial market, where financial instrument is created and traded.
The components of financial market are illustrated in the graph below.
Financial market includes money market and capital market. Money market includes the
short-term debt and investments (high degree of liquidity, safety and low return in interest).
The financial instrument in this market is debenture, bond, mortgage, treasur y bill,
commercial paper (paper to fund the short-term need such as payment of accounts
receivable) …
Capital market refers to long-term debt and investments, which can be divided into debt
market, equity market and derivative market. Debt market (also called bond market) has
financial instruments such as bonds, debentures, leases, certificates, bills of exchanges…
Equity market (also called stock market) includes financial instruments such as equity and
preference share. Derivative market, which supports for two market above includes types of
instruments such as forwards, futures, option and swaps…
In this lesson, we will learn these types of financial instruments in accounting aspect to
understand how they are recorded, treated in financial statements.
Contract
Entity 1 Entity 2
Or
Financial asset Financial liability Equity instrument
increases increases increases
119
▪ The term should be focused is contract. This will decide whether one item treated as
financial instruments or not. Contract here can be not in written form, but must have
“clear economic consequences” that are unavoidable (normally due to the enforcement
by law)
▪ Therefore, items are not financial instruments include (according to IAS 32):
o Physical asset (inventories, property, PPE, leased assets)
o Intangible assets (patents, trademarks)
o Prepaid expense
o Liabilities and assets which does not have contractual nature
▪ Fair value: The price that would be received to sell an asset or paid to transfer a liability
in an orderly transaction between participants at the measurement date
▪ Entity can be individual, partnership or incorporated body or government agency
▪ Rationale: Asset = Liability + Equity
DISCUSSION: Why physical assets and prepaid expenses are not considered financial
instruments?
Answer:
▪ Physical asset does not give rise to a present right to receive cash or another financial
asset
▪ Prepaid expense is the future economic benefit of receipt of good/services rather than
right to receive cash or another financial instrument
120
1.2. Relevant accounting standards
Classification between IAS 32: Financial instruments presentation
liabilities and equity
Measurement
IFRS 9: Financial instruments
Impairment
1
Hedging accounting
IFRS 7 Financial
Disclosure instruments:
Disclosure
Presentation &
Disclosure
Presentation
a. Liabilities or equity?
As mentioned above, the increase on financial asset of one entity will make a rise of financial
liability OR instrument equity of another. IAS 32 classify liability or equity based on substance,
not merely legal form.
1 An accounting principles for recording hedging (reducing risk of financial instrument) activities of company
121
Work flow: Not financial instruments
No
Yes No
DISCUSSION: Entities which issues preference shares which must be redeemed by the issuer
for a fixed amount at a fixed future date. Alternatively, the holder may have the right to
require the issuer to redeem the shares at or after a certain date for a fixed amount. Classify
the item in this case?
Answer:
▪ The issuer has obligation
▪ The obligation is to deliver fixed amount at fixed date
Financial liability
b. Mix between liabilities and equity
Liability element
Instrument Contains
Equity element
122
Example: The convertible bond is classified by issuer as mixed instrument because:
▪ Liability element: The bond issuer has the liability obligation to the buyer
▪ Equity element: The bond buyer/holder has the right to convert it into equity instrument
(ordinary shares)
Issuing convertible bond = Issuing debt + Warrant shares acquisition right in
the future
Valuation:
The value of the mixed instrument = Value of liability component + Value of equity component
(residual amount)
Example 1: Rathbone Co issues 2,000 convertible bonds at the start of 20X2. The bonds have
a three year term, and are issued at par with a face value of $1,000 per bond, giving total
proceeds of $2,000,000. Interest is payable annually in arrears at a nominal annual interest
rate of 6%. Each bond is convertible at any time up to maturity into 250 ordinary shares.
When the bonds are issued, the prevailing market interest rate for similar debt without
conversion options
is 9%.
Required
What is the value of the equity component in the bond?
Solution
The liability component is valued first, and the difference between the proceeds of the bond
issue and the fair value of the liability is assigned to the equity component. The present
value of the liability component is calculated using a discount rate of 9%, the market
interest rate for similar bonds having no conversion rights.
$
Present value of the principal: $2,000,000 payable at the end of three years 1,544,367
($ 2m * 0.772183)
Present value of the interest: $120,000 payable annually in arrears for three 303,755
years
($120,000 2.5313)
Total liability component 1,848,122
Equity component (balancing figure) 151,878
Proceeds of the bond issue 2,000,000
Example 2: A company issues $20m of 4% convertible loan notes at par on 1 January 2009.
The loan notes are redeemable for cash or convertible into equity shares on the basis of 20
shares per $100 of debt at the option of the loan note holder on 31 December 2011. Similar
but non-convertible loan notes carry an interest rate of 9%.
The present value of $1 receivable at the end of the year based on discount rates of 4% and
9% can be
taken as:
4% 9%
$ $
End of year 1 0.96 0.92
2 0.93 0.84
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3 0.89 0.77
Cumulative 2.78 2.53
Required
Show how these loan notes should be accounted for in the financial statements at 31
December 2009.
ANSWER
Workings
1 Equity and liability elements $’000
3 year interest (20,000 * 4% * 2.53) 2,024
Redemption (20,000 * 0.77) 15,400
Liability element 17,424
Equity element 2,576
Proceeds of loan note 20,000
2 Loan note balance
Liability (W1) 17,424
Interest of the year at 9% 1,568
Less interest paid (20,000 * 4%) (800)
Carrying value at 31/12/2009 18,192
Element Treatment
Interests, dividends, losses and gains Income/Expense in profit or loss
related to financial liability
Dividends to ordinary shareholder related Debit in equity by the issuer in statement of
to equity instrument changes in equity
Transaction costs of equity transaction Debit to share premium account
3.1. Scope
▪ All financial instruments excluding investments in subsidiaries, associates, joint ventures
and other joint arrangements
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3.3. De-recognition
a. Financial asset
125
Fair value For all other financial assets (including derivatives)
through profit
or loss
➔ equity investments may not be classified as measured at amortised cost and must
be measured at fair value.
➔ A debt instrument may be classified as measured at either amortised cost or fair
value depending on whether it meets the criteria above.
Debt instruments that pass the cash flow test for measurement at amortised cost but are
also held for trading to be carried at fair value through other comprehensive income:
▪ Fair value changes go through OCI
▪ Interest charges measured at amortized cost and go throung profit or loss.
Summary
126
Example: Investment in convertible loan is not qualified to be measured at amortised
cost because the inclusion of the conversion option which is not deemed to represent
payments of principal and interest.
b. Financial liability
127
▪ Accrue the interest of the factor’s
charges
▪ Accrue other interest charges in profit or
loss
3.6. Re-classification on recognition
If financial instruments are designated as fair value through profit or loss, then measured at
cost only at fair value. Transaction cost is recognised as expense in SOPL.
B – Subsequent measurement of Financial Asset
Classification Conditions
Amortised - Collect contractual cash flows
cost (both - The financial asset makes change in cash flow (solely due to
conditions) paying principal and interest) at one specific date
FVOCI
FVTPL (1 of - Held for trading
conditions) - designated by the entity as at fair value through profit or loss
Solution:
Abacus Co will receive interest of $59 (1,250 4.72%) each year and $1,250 when the
instrument matures.
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Abacus must allocate the discount of $250 and the interest receivable over the five year term
at a constant rate on the carrying amount of the debt. To do this, it must apply the effective
interest rate of 10%.
Year Amortised cost Profit or loss Interest Amortised cost
at beginning of (10%) received (cash at end of year
year inflow)
20X1 1,000 100 (59) 1,041
20X2 1,041 104 (59) 1,086
20X3 1,086 109 (59) 1,136
20X4 1,136 113 (59) 1,190
20X5 1,190 119 (59 + 1250) -
If Abacus was also holding this instrument for trading, the IFRS 9 business model would allow
it to be carried at fair value through other comprehensive income.
For instance, if at 1 January 20X2 the fair value of the debt instrument was $1,080, the
difference of $39 (1,080 – 1,041) would go to OCI and the asset would be shown in the
statement of financial position at $1,080.
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ANSWER
(a)
Statement of profit or loss $
Investment income (20,000 * (5.5-4.0)) 30,000
Dividend income (20,000 *2c) 4,000
Transaction cost (2,000)
Statement of financial position
Investment in equity instrument 110,000
(20,000 *5)
(b)
Statement of profit or loss $
Dividend income 4,000
Other comprehensive income
Gain on investment in equity instruments 28,000
(20,000 * 5.5) – (20,000 * 4 + 2,000)
Statement of financial position
Investments in equity instruments 110,000
(20,000 * 5.5)
- Financial liabilities
After initial recognition all financial liabilities should be measured at
+ amortised cost
+ fair value through profit or loss
3.8. Own credit
Financial liabilities which are designated as measured at fair value through profit or loss
are treated differently. In this case the gain or loss in a period must be classified into:
Gain or loss resulting from credit risk, and
Other gain or loss.
IFRS 9 requires the gain or loss as a result of credit risk to be recognised in other
comprehensive income.
The other gain or loss (not the result of credit risk) is recognised in profit or loss.
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Financial instruments carried at amortised cost: gains and losses are recognised in
profit or loss as a result of the amortisation process and when the asset is
derecognised.
Financial assets held within a business model whose objective is achieved by both
collecting contractual cash flows and selling financial assets must be measured at fair value
with gains and losses recognised in other comprehensive income.
131
LESSON 12: LEASING
LEARNING OUTCOMES:
1. Definition
2. Identify a lease
3. Accounting treatment
4. Short-life and low value assets
132
1. Definition
Lease: A contract, or part of a contract, that conveys the right to use an asset (the
underlying asset) for a period of time in exchange for consideration.”
Lessor Lessee
Provides the right to use an underlying asset
Commencement date of the lease: The date on which a lessor makes an underlying asset
available for use by a lessee
Inception date of the lease: The earlier of the date of a lease agreement and the date of
commitment by the parties to the principal terms and conditions of the lease.
Underlying asset: An asset that is the subject of a lease, for which the right to use that asset
has been provided by a lessor to a lessee.
Right-of-use asset: An asset that represents a lessee’s right to use an underlying asset for
the lease term.
▪ Lease payments. Payments made by a lessee to a lessor relating to the right to use an
underlying asset during the lease term, comprising:
a. Fixed payments, less any lease incentives
b. Variable lease payments that depend on an index or rate
c. The exercise price of a purchase option if the lessee is reasonably certain to exercise
that option
d. Payment of lease termination penalties if applicable
▪ Interest rate implicit in the lease
The discount rate that, at the inception of the lease, causes the aggregate present value
of:
a. The lease payments, and
b. The unguaranteed residual value
to be equal to the sum of:
a. The fair value of the underlying asset, and
b. Any initial direct costs
Lessee's incremental borrowing rate: The rate of interest that a lessee would have to pay to
borrow over a similar term, and with a similar security, the funds necessary to obtain an
asset of similar value to the right of use asset in a similar economic environment.
Unguaranteed residual value: That portion of the residual value of the underlying asset, the
133
2. Identifying a lease
No
Is there an identified asset?
Yes
Yes
No
134
Example 1: Is this a lease?
A Council has entered into 5 year contract with B Co, under which D Co supplies the council
with ten vehicles for the purposes of community transport. D Co owns the relevant vehicle,
all ten of which are specified in the contract. A Council determines the routes taken for
community transport and the charges and eligibility for discounts. The council can choose to
use the vehicle for purpose other than community transport. When the vehicle are not
being used, they are kept at the council’s office and cannot be retrieved by D Co unless A
Council defaults on payment. If a vehicle needs to be serviced or repaired, D Co is obliged to
provide a temporary replacement vehicle of the same type.
Conclusion: This is a lease. There is an identifiable asset. A has the right to use the vehicle
for the period of contract. D Co does not have the right to substitute any of the vehicles
unless they are being serviced or repaired.
Example 2: Is it a lease?
B Council has recently made substantial cuts to its community transport service. It will now
provide such services only in cases of great need, assessed on a case by case basis. It has
entered into 2 year contract with F Co for the use of its minibuses for this purpose. The
minibus must seat ten people, but F Co can use any of its ten-seater minibus when required.
The minibuses are held on F Co’s premises and are only made available to B Council on
request.
Conclusion: This is not a lease. There is no identifiable asset. F Co can exchange one
minibus for another. B Council should account for the rental payments as an expense in
P&L.
Example 3: Is it a lease?
K Co enters into a 10 year contract with a utilities company (T Co) for the right to use 3
specified, physically distinct dark fibres within a larger fibre-optic cable connecting N Town
to S Town. K Co makes the decision about the use of the fibres by connecting each end of
fibres to its electronic equipment (ie K Co “lights” the fibres and decides what data, and how
much date, those fibres will transport). If the fibres are damaged, T Co is responsible for the
repair and maintenance. T Co owns extra fibres, but can substitute those of K Co’s fibres
only for the reason of repairs, maintenance or malfunction (and is obliged to substitute the
fibres in these cases).
Conclusion: This is a lease. There are 3 identifiable fibres. The fibres are explicitly specified
in the contract and are physical distinct from other fibres within the cable. T Co cannot
substitute the fibres other than for the reasons of repairs, maintenance or malfunction.
3. Recognition exemption
Instead of applying the recognition requirements of IFRS 16 described, a lessee may elect to
account for lease payments as an expense on a straight-line basis over the lease term or
another systematic basis for the following two types of leases
135
a. Short-term leases. These are leases with a lease term of twelve months or less. This
election is made by class of underlying asset. A lease that contains a purchase option
cannot be a short-term lease.
b. Low value leases. These are leases where the underlying asset has a low value when new
(such as tablet personal computers or small items of office furniture and telephones). This
election can be made on a lease-by-lease basis. An underlying asset qualifies as low value
only if two conditions apply:
i. The lessee can benefit from using the underlying asset.
ii. The underlying asset is not highly dependent on, or highly interrelated with, other
assets.
136
the end, the finance lease will be depreciated over the useful life of the
be smaller. underlying asset.
- If there is no transfer of ownership and no
purchase option, the right-of-use asset should be
depreciated from the commencement date to the
earlier of the end of the useful life and the end of
the lease term.
The liability
The carrying amount of the lease liability is increased by the interest charge, calculated as
the outstanding liability multiplied by the discount rate of interest.
To work out the interest and year end liabilities, a lease liability table is often used (see
illustration below). The layout of the table will depend on whether payments are made at
the end of the year (in arrears) or at the start of the year (in advance).
Payments in arrears
Year Balance b/f Interest Payment Balance c/f
1 X X (X) X
2 X X (X) X
(NCL)
Payments in advance
Year Balance b/f Payment Subtotal Interest Balance c/f
1 X (X) X X X
2 X (X) X X X
(NCL)
On the statement of financial position the total liability at the end of year 1 is split between
its non-current and current elements. For payments made in advance or arrears the non-
current liability (NCL) is represented by the balance outstanding immediately after the
payment in year 2. The difference between the total liability at the year-end and the non-
current liability will be the current liability. Note that where payments are made in advance
the non-current liability is not the balance outstanding at the end of year 2, as this includes
the interest charge for year 2.
EXAMPLE 1:
137
Riyad enters into an agreement to lease an asset. The terms of the lease are as follows.
1. Primary period is for four years from 1 January 20X2 with a rental of $2,000 pa payable
on 31 December each year.
2. The present value of the lease payments is $5,710
3. The interest rate implicit in the lease is 15%.
What figures will be shown in the financial statements for the year ended 31 December
20X2?
ANSWER:
$
Depreciation (1,428)
Finance cost (857)
Non-current liabilities
Lease 3,252
138
Current liabilities
Lease 1,315
If a company enters into a lease part-way through the year, the depreciation and interest
will need to be time-apportioned.
The liability table is likely to need extra columns to split the table between pre and post-
payment.
EXAMPLE 2:
Shaeen Ltd entered into an agreement to lease an item of plant on 1 October 20X8. The
lease required four annual payments of $200,000 each, commencing on 1 October 20X8.
The plant has a useful life of four years and is to be scrapped at the end of this period. The
present value of the lease payments is $700,000. The implicit interest rate within the lease
is 10%.
Prepare extracts of the financial statements in respect of the leased asset for the year
ended 31 March 20X9.
ANSWER:
Working 1: Depreciation expense = 700,000/4 * 6/12 = 87,500
Working 2: Lease
Interest Interest
Year – Initial Balance
Bal b/f @10% Paid @10% Bal c/f
end balance @1 Oct
*6/12 *6/12
31.3.X9 0 700,000 (200,000) 500,000 25,000 525,000
31.3.Y0 525.000 25,000 (200,000) 350,000
Non-current liabilities
Lease 350,000
139
Current liabilities
Lease (525,000 – 350,000) 175,000
d. Presentation
In the statement of financial position right-of use assets can be presented on a separate line
under noncurrent assets or they can be included in the total of corresponding underlying
assets and disclosed in the notes.
Lease liabilities should be either presented separately from other liabilities or disclosed in
the notes
IFRS 16 does not specify that lease liabilities should be split between non-current and
current liabilities, but this should be done as best practice.
Note: If the proceeds are less than the fair value of the asset or the lease payments are less
than market rental, the following adjustments to sales proceeds apply:
▪ Any below – market terms should be accounted for as a prepayment of the lease payment
▪ Any above – market terms should be accounted for as additional financing provided to the
lessee
a. Transfer is a sale
Right-of-use asset rising from the leaseback measured by lessee:
Discounted lease payments
Carrying amount x Fair value
140
Gains on rights transferred is only recognized on the sale that relates to the right
transferred to the buyer, which is calculated as followed:
▪ Stage 1: Calculate the total gain: Total gain = Fair value – Carrying amount
▪ Stage 2: Calculate the gain that relates to the right retained:
Discounted lease payments
Gain relating to rights retained = Gain x Fair value
EXAMPLE:
On 1 April 20X2, Witon Co bought an injection moulding machine for $600,000. The carrying
amount of the machine as at 31 March 20X3 was $500,000. On 1 April 20X3, Wigton Co sold
it to Whitehaven Co for $740,000, its fair value. Wigton Co immediately leased the machine
back for five years, the remainder of its useful life, at $160,000 per annum payable arrears.
The present value of the annual lease payments is $700,000 and the transaction satisfies the
IFRS 15 criteria to be recognized as a sale.
Required: What gain should Wigton Co recognize for the year ended 31 March 20X4 as a
result of the sale and leaseback?
ANSWER:
= ($240,000 x 700,000/740,000)
= $227,027
Stage 3: Gain relating the rights transferred = Total gain – Gain on rights retained
141
Bungle Co sells a building to the Zippy Co for $800,000 cash. The carrying amount of the
building prior to the sale was $600,000. Bungle Co arranges to lease the building back for
five years at $120,000 per annum, payable in arrears. The remaining useful life Is 15 years.
At the date of sale, the fair value of the building was $750,000 and the interest rate implicit
in the lease is 4.5%.
The transaction satisfies the performance obligations in IFRS 15, so will be accounted for as
a sale and leaseback.
At the date of sale, the fair value of the building was $750,000, so the excess $50,000 paid
by Zippy Co is recognized as additional financing provided by Bungle Co.
ANSWER:
This is calculated as
Right-of-use asset (arising from leaseback) = carrying amount x discounted lease
payments/fair value.
Bungle Co only recognizes the amount of gain that relate to the rights transferred:
142
Stage 1: Total gain on the sale = fair value – carrying amount
= $750,000 - $600,000
= $150,000
= $(150,000 x 476,797/750,000)
= $95,360
Stage 3: Gain relating to the rights transferred = total gain – gain on rights retained
= $150,000 - $95,360
= $54,640
The right-of-use asset will be depreciated over five years, the gain will be recognized in
profit or loss and the financial liability will be increased each year by the interest charge and
reduced by the lease payments.
143
LESSON 13: PROVISIONS AND EVENTS AFTER THE REPORTING PERIOD
Legal/contractual
An entity has a present obligation as a result of a past event (1) Constructive: the company establish a valid
expectation through a course of past practice,
regardless of whether there is a legal requirement
to perform the task or not.
Required
What is the provision required?
ANSWER
The cost is found using 'expected values' (75% $nil) + (20% $1.0m) + (5% $4.0m) =
$400,000
*** Note.
1. Provision with time value of money
Where the effect of the time value of money is material, the amount of a provision
should be the present value of the expenditure required to settle the obligation. An
appropriate discount rate should be used.
The discount rate should be
• A pre-tax rate
• Reflect current market assessments of the time value of money.
• Should not reflect risks for which future cash flow estimates have been adjusted.
145
SOLUTION:
$5m 0.62092*
3,104,600
*The discount rate for five years at 10%
The following year the provision will be:
$5m 0.68301** 3,415,050
310,540
The discount rate for four years at 10%
The increase in the second year of $310,450 will be charged to profit or loss. It is referred to
as the
unwinding of the discount. This is accounted for as a finance cost. The original provision of
$3,104,600
will be added to the cost of the assets involved in the operation and depreciated over five
years.
2. Use of provision:
Provisions should be reviewed at the end of each reporting period and adjusted to
reflect the current best estimate
If it is no longer probable that a transfer of resources will be required to settle the
obligation, the provision should be reversed.
3. Change in provision
A provision should be used only for expenditures for which the provision was originally
recognised.
146
EXAMPLES OF POSSIBLE PROVISION:
147
or if the company has broken current environmental
legislation then a provision for environmental damage must
be made.
• This will be discounted to present value at a pre-tax market
rate.
5 Decommissioning • When an oil company initially purchases an oilfield it is
or abandonment put under a legal obligation to decommission the site at the
costs end of its life.
• IAS 37 insists that a legal obligation exists on the initial
expenditure on the field and therefore a liability exists
immediately. This would appear to result in a large charge
to profit and loss in the first year of operation of the field.
However, the IAS takes the view that the cost of purchasing
the field in the first place is not only the cost of the field
itself but also the costs of putting it right again. Thus all the
costs of decommissioning may be cap
6 Restructuring Definition:
provisions • A programme that is planned and is controlled by
management and materially changes one of two things.
o The scope of a business undertaken by an entity
o The manner in which that business is conducted
Examples:
• The sale or termination of a line of business
The closure of business locations in a country or region or
the relocation of business activities from one country
region to another
• Changes in management structure, for example, the
elimination of a layer of management
• Fundamental reorganisations that have a material effect on
the nature and focus of the entity's operations
When to provide provision:
• An entity must have a detailed formal plan for the
restructuring.
• It must have raised a valid expectation in those affected
that it will carry out the restructuring by starting to
implement that plan or announcing its main features to
those affected by it
Costs to be included within a restructuring provision
• Necessarily entailed by the restructuring; and
Not associated with the ongoing activities of the entity.
Costs not to be included within a restructuring provision
• Retraining or relocating continuing staff
• Marketing
• Investment in new systems and distribution networks
Disclosures
148
• Disclosure of details of the change in carrying value of a
provision from the beginning to the end of the year
• Disclosure of the background to the making of the
provision and the uncertainties affecting its outcome
Note: Future operating losses/future repairs are not provision because they arise in the
future and can be avoided (close the division that is making losses or sell the asset that may
need repair) => no obligation exists.
SOLUTION:
(a) No provision would be recognised as the decision has not been communicated.
(b) A provision would be made in the 20X9 financial statements.
(c) A provision for such costs is appropriate.
(d) No present obligation exists and under IAS 37 no provision would be appropriate. This is
because
the entity could avoid the future expenditure by its future actions, maybe by changing its
method of operation.
149
2. Contingent liabilities
Treatment Contingent liabilities should not be recognised in financial statements but they should be
disclosed
3. Contingent assets
• A possible asset that arises from past events and whose existence will be
Definition confirmed by the occurrence or
• Non-occurrence of one or more uncertain future events not wholly within
control of the entity.
A contingent asset must not be recognised. Only when the realisation of the related
Treatment economic benefits is virtually certain should recognition take place. At that point, the
asset is no longer a contingent asset
Contingent assets must only be disclosed in the notes if they are probable. Information
Disclosures to be disclosed: a brief description of the contingent asset should be provided along with
an estimate of its likely financial effect.
150
***Let out
IAS 37 permits reporting entities to avoid disclosure requirements relating to provisions,
contingent
liabilities and contingent assets if they would be expected to seriously prejudice the
position of the entity in dispute with other parties.
4. Summary
151
II. IAS 10 EVENTS AFTER THE REPORTING PERIOD
Those that provide evidence of conditions that existed at the Those that provide evidence of conditions that existed at the
end of the reporting period – adjusting end of the reporting period – adjusting
Examples: Examples:
• Evidence of a permanent diminution in property value • Acquisition of, or disposal of, a subsidiary after the year
prior to the year end end
• Sale of inventory after the reporting period for less than its • Announcement of a plan to discontinue an operation
carrying value at the year end • Major purchases and disposals of assets
• Insolvency of a customer with a balance owing at the year • Destruction of a production plant by fire after the reporting
end period
• Amounts received or paid in respect of legal or insurance • Announcement or commencing implementation of a major
claims which were in negotiation at the year end restructuring
• Determination after the year end of the sale or purchase • Share transactions after the reporting period
price of assets sold or purchased before the year end • Litigation commenced after the reporting period
• Evidence of a permanent diminution in the value of a long- • Dividends that are declared after reporting date
term investment prior to the year end
• Discovery of error or fraud which shows that the financial
statements were incorrect
***In relation to going concern, where operating results and Treatment:
the financial position have deteriorated after the reporting Disclose for each material category of non-adjusting events:
period, it may be necessary to reconsider whether the going • The nature of the event
concern assumption is appropriate in the preparation of the • An estimate of its financial effect or the statement that such
financial statements. estimate cannot be made.
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LESSON 14: INVENTORIES AND BIOLGICAL ASSETS
I. IAS 2 Inventories
1. Inventory and IAS 2
Include
Goods purchased and held for resale, eg
land and buildings held for resale
Raw materials
153
2. INVENTORIES ARE MEASURED AT LOWER OF COST AND NET REALIABLE VALUE (NRV) – Exam focus point
Purchase price
Overheads costs
lower Other costs incurred in bringing the inventories to their present location and condition
INVENTORIES
How to measure cost: Costs which would not include in the cost of inventories, but recognized
as expense
• Standard cost: normal used
• Retail method: • Abnormal amounts of wasted materials, labour or other production
o Used in retail industry when there costs
• Storage costs (except costs which are necessary in the production
is a large turnover of inventories
process)
items have similar profit margin
• Administrative overheads not incurred to bring inventories to their
o Inventories cost = total selling present location and conditions
price – overall average profit • Selling costs
margin
NRV = estimated selling price - the estimated costs of completion and costs necessary to make the sale.
QUESTION:
A company has inventory on hand at the end of the reporting period as follows:
ANSWER:
a. Villandry's inventory includes three items for which the following details are
available
Supplier’s list price Net reliable value
$ $
Product A 3,600 5,100
Product B 2,900 2,800
Product C 4,200 4,100
The company receives a 2½% trade discount from its suppliers and it also takes
advantage of a 2% discount for prompt payment.
Required
155
Calculate the total value of products A, B and C which should be shown in inventory in
the statement of financial position.
b. Explain the difference that changing from weighted average to FIFO method of
inventory valuation is likely to have on an entity’s profit or loss
ANSWER:
a.
156
LESSON 15: TAXATION
TAXATION
DIFFERENCE BETWEEN
TERMINOLOGY
MEASUREMENT AND
• Taxable temporary
• Current tax RECOGNITION AND OTHER
differences
• Deffered tax ACCOUNTING TREATMENTS
• Deductible temporary
differences
• Carrying amount
• Business combination
1. Overview
Difference
between
157
1.2. Terminology
▪ Accounting profit: Net profit or loss for a period before deducting tax expense
▪ Taxable profit (tax loss): The profit (loss) for a period, determined in accordance with the
rules established by the taxation authorities, upon which income taxes are payable
(recoverable)
▪ Tax expense (tax income): The aggregate amount included in the determination of net
profit or loss for the period in respect of current tax and deferred tax
Tax expense (income) = Current tax expense (income) + Deferred tax expense (income)
▪ Current tax: The amount actually payable to the tax authorities in relation to the trading
activities of the entity during the period
▪ Deferred tax is an accounting measure, used to match the tax effects of transactions with
their accounting impact and thereby produce less distorted results
2. Current tax
Entry
Treatment
Be off-set against the amount of tax payment of the following year
158
is already underway. Therefore, any under or over provision related to previous year are
adjusted in current year’s provision in the income statement. The adjustment of over/under
provision however, has no effect on current year’s provision in the statement of financial
position.
▪ Previous year’s under provision increases current year’s tax charge in the income
statement.
▪ Previous year’s over provision decreases current year’s tax charge in the income
statement.
Answer:
a.
$
Tax due on 20X8 profits ($120,000 x 30%) 36,000
Underpayment for 20X7 5,000
Tax charge and liability 41,000
b.
$
Tax due on 20X8 profits (as above) 36,000
Overpayment for 20X7 (5,000)
Tax charge and liability 31,000
159
IAS 12 also requires recognition as an asset of the benefit relating to any tax loss
that can be carried back to recover current tax of a previous period.
Example 2:
In 20X7 Eramu Co paid $50,000 in tax on its profits. In 20X8 the company made tax losses of
$24,000. The local tax authority rules allow losses to be carried back to offset against current
tax of prior years. The tax rate is 30%. Show the tax charge and tax liability for 20X8.
Answer:
▪ Current tax > Deferred tax • Current tax < Deferred tax
▪ Due to:
o Deductible temporary • Due to:
differences o Taxable temporary differences
o Carry forward of unused tax
losses
o Carry forward of unused tax
credits
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3.2. Differences reason between accounting profits and taxable profit
Differences reason
Example: Example:
▪ One-off differences by certain items • Certain types of incomes and
▪ Differences impact on tax computation expenditures taxed on cash (but not in
of one period accrual basis): some provisions
▪ Differences with no deferred tax
consequences whatever • Dif. Between non-current asset’s
depreciation charged and allowances
(most common type)
In the long run, the total taxable profits and total accounting profits will be the same (except
for permanent differences) so that timing differences originate in one period and are capable
of reversal in one or more subsequent periods.
The tax base of an asset is the amount that will be deductible for tax purposes against any
taxable economic benefits that will flow to the entity when it recovers the carrying amount
of the asset.
Example 3: State the tax base of each following assets and any temporary difference arising
(a) A machine cost $10,000 and has a carrying amount of $8,000. For tax purposes,
depreciation of $3,000 has already been deducted in the current and prior periods and
the remaining cost will be deductible in future periods, either the depreciation or through
a deduction on disposal. Revenue generated by using the machine is taxable, any gain on
disposal of the machine will be taxble and any loss on disposal will be deductible for tax
purposes.
(b) Interest receivable has a carrying amount of $1,000. The related interest revenue will be
taxed on a cash basis.
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(c) Trade receivable has a carrying amount of $1.000. The related revenue has already been
included in taxable profit (tax loss).
(d) A loan receivable has a carrying amount of $1m. The repayment of the loan will have no
tax consequences.
ANSWER
(a) The tax base of the machine is $7.000. The temporary differences is $1.000
(b) The tax base of the interest receivable is nil. The temporary difference is $1.000
(c) The tax base of the trade receivable is $10.000. No temporary difference.
(d) The tax base of the loan is $1m. No temporary difference.
In case of liability, the tax base will be its carrying amount, less any amount that will be
deducted for tax purposes in relation to the liability in future periods.
Example 4: State the tax base of each following liabilities and any temporary difference
arising
(a) Current liabilities include accrued expenses with a carrying amount of $1.000. The related
expense will be deducted for tax purposes on a cash basis.
(b) Current liabilities include interest revenue received in advance, with a carrying amount of
$10.000. The related interest revenue was taxed on a cash basis.
(c) Current liabilities include accrued expenses with a carrying amount of $2,000. The related
expense has already been deducted for tax purposes.
(d) Current liabilities include accrued fines and penalties with a carrying amount of $100.
Fines and penalties are not deductible for tax purposes.
(e) A loan payable has a carrying amount of $1m. The repayment of the loan will have no tax
consequences.
ANSWER
(a) The tax base of accrued expense is nil. The temporary difference is $1,000
(b) The tax base of interest received in advance is nil. The temporary difference is $10,000.
(c) The tax base of the accrued expense is $2,000. No temporary difference.
(d) The tax base of the accrued fines and penalties is $100. No temporary difference.
(e) The tax base of the loan is $1m. No temporary difference.
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3.4. Temporary differences reason in details
Definition: Deferred tax assets and liabilities arise from taxable and deductible temporary
differences.
The rule to remember here is that: “All taxable temporary differences give rise to a deferred
tax liability.”
Some examples of circumstances that give rise to taxable temporary differences. They will all
result in a higher tax charge in one or more future periods.
▪ Transactions that affect the statement of profit or loss: Interest revenue, Sale of goods
revenue, Depreciation, Development costs, Prepaid expenses etc.
▪ Transactions that affect the statement of financial position: Accounting depreciation
of an asset, a borrower records a loan at proceeds received (amount due at maturity)
less transaction costs, …
▪ Fair value adjustments and revaluations: The exceeds cost arisen from change in fair
value of current investments or financial instruments, the difference between the
carrying amount of a revalued asset and its tax base.
In these cases, the deferred tax provision recognizes that additional profit will be realized on
the use or eventual disposal of these assets, leading to a higher tax charge.
Reasoning behind the recognition of deferred tax liabilities on taxable temporary
differences.
▪ When an asset is recognized, it is expected that its carrying amount will be recovered
in the form of economic benefits that flow to the entity in future periods.
▪ If the carrying amount of the asset is greater than its tax base, then taxable economic
benefits will also be greater than the amount that will be allowed as a deduction for
tax purposes.
▪ The difference is therefore a taxable temporary difference and the obligation to pay
the resulting income taxes in future periods is a deferred tax liability.
▪ As the entity recovers the carrying amount of the asset, the taxable temporary
difference will reverse and the entity will have taxable profit.
▪ It is then probable that economic benefits will flow from the entity in the form of tax
payments, and so the recognition of deferred tax liabilities is required by IAS 12.
Example 5:
A company purchased an asset costing $1,500. At the end of 20X8 the carrying amount is
$1,000. The cumulative depreciation for tax purposes is $900 and the current tax rate is 25%.
Calculate the deferred tax liability for the asset.
Answer:
Firstly, what is the tax base of the asset? It is $1,500 – $900 = $600.
In order to recover the carrying amount of $1,000, the entity must earn taxable income of
$1,000, but it will only be able to deduct $600 as a taxable expense. The entity must therefore
pay income tax of $400 * 25% = $100 when the carrying amount of the asset is recovered.
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The entity must therefore recognize a deferred tax liability of $400 * 25% = $100, recognizing
the difference between the carrying amount of $1,000 and the tax base of $600 as a taxable
temporary difference.
Many taxable temporary differences are timing differences. Timing differences arise when
income or an expense is included in accounting profit in one period, but in taxable profit in a
different period, such as: Interest received, Accelerated depreciation, Development costs …
Example 6:
Jonquil Co buys equipment for $50,000 on 1 January 20X1 and depreciates it on a straight-
line basis over its expected useful life of five years. It has no other non-current assets. For tax
purposes, the equipment is depreciated at 25% per annum on a straight-line basis.
Accounting profit before tax for the years 20X1 to 20X5 is $20,000 per annum. The tax rate is
40%.
Required: Show the calculations of current and deferred tax for the years 20X1 to 20X5.
Answer:
The differences between accounting and tax depreciation on the equipment will be:
Note that the taxable difference reverses in 20X5, when the equipment is fully depreciated
for tax purposes.
This will give the following differences between the carrying amount and the tax base of the
asset at the end of each year.
20X1 20X2 20X3 20X4 20X5
$ $ $ $ $
Carrying amount at Y/E 40,000 30,000 20,000 10,000 -
Tax base at Y/E 37,500 25,000 12,500 - -
Cumulative difference 2,500 5,000 7,500 10,000 -
Deferred tax 40% 1,000 2,000 3,000 4,000 -
The tax charge to profit or loss will be as follows:
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Tax charge 40% 7,000 7,000 7,000 7,000 12,000
Deferred tax adjustment 1,000 1,000 1,000 1,000 (4,000)
Tax charge in profit or loss 8,000 8,000 8,000 8,000 8,000
The effect of the deferred tax adjustment is to recognize the additional tax which will be due
in 20X5 evenly over years 20X1 to 20X5.
At the end of 20X5 there will be no remaining temporary difference and the balance on the
deferred tax account in the statement of financial position will be credited back to profit or
loss.
The SOFP will show:
▪ When a liability is recognized, it is assumed that its carrying amount will be settled in
the form of outflows of economic benefits from the entity in future periods.
▪ When these resources flow from the entity, part or all may be deductible in
determining taxable profits of a period later than that in which the liability is
recognized.
▪ A temporary tax difference then exists between the carrying amount of the liability
and its tax base.
▪ A deferred tax asset therefore arises, representing the income taxes that will be
recoverable in future periods when that part of the liability is allowed as a deduction
from taxable profit.
▪ Similarly, when the carrying amount of an asset is less than its tax base, the difference
gives rise to a deferred tax asset in respect of the income taxes that will be recoverable
in future periods.
Deferred tax assets can only be recognized when sufficient future taxable profits exist
against which they can be utilised.
Example 7:
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Pargatha Co recognises a liability of $10,000 for accrued product warranty costs on 31
December 20X7. These product warranty costs will not be deductible for tax purposes until
the entity pays claims. The tax rate is 25%.
Example 8:
Ginger Co has an asset with a carrying amount of $80,000 and a tax base of $50,000. The
current tax rate is 30% and the rate is being reduced to 25% in the next tax year. Ginger Co
plans to dispose of the asset for its carrying amount and will do so after the tax rate falls.
The deferred tax on the temporary difference is therefore $30,000 x 25% = 7,500.
4.2. Discounting
IAS 12 states that DTA and DTL should not be discounted because of complexities and
difficulties involved.
4.3. Recognition
Deferred tax normally be recognised as income or expense in SOPL.
The exception is where the tax arises from a transaction or event which is recognised directly
on equity such as a revaluation where the surplus is credited to the revaluation surplus.
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Examples 9:
Zebre Co owns a property which has a carrying amount at the beginning of 20X9 of
$1,500,000. At the year end it has entered into contract to sell the property for $1,800,000.
The tax rate is 30%. How will this be shown in the FS?
Solution
SOCI
$’000
Profit for the year
Other comprehensive income
Gains on property revaluation 300
Income tax relating to components of OCI (90)
OCI for the year net of tax 210
The amount will be posted as follow:
▪
Income tax on taxable profits;
▪
Transfers to or from deferred taxation;
▪
Any underprovision or overprovision of income tax on profits of previous years.
When income tax on profits is calculated, the calculation is only an estimate of what the
company thinks its tax liability will be. In subsequent dealings with the tax authorities, a
different income tax charge might eventually be agreed.
The difference between the estimated tax on profits for one year and the actual tax charge
finally agreed for the year is made as an adjustment to taxation on profits in the following
year, resulting in the disclosure of either an underprovision or an overprovision of tax.
Example 10:
In the accounting year to 31 December 20X3, Neil Down Co made an operating profit before
taxation of $110,000.
Income tax on the operating profit has been estimated as $45,000. In the previous year (20X2)
income tax on 20X2 profits had been estimated as $38,000 but it was subsequently agreed at
$40,500.
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A transfer to the credit of the deferred taxation account of $16,000 will be made in 20X3
Required:
i. Calculate the tax on profits for 20X3 for disclosure in the accounts.
ii. Calculate the amount of tax payable
ANSWER
(a) $
Income tax on profit (liability on SOFP) 45,000
Deferred taxation 16,000
Underprovision of tax in previous year 2,500
Tax on profit for 20X3 (profit or loss 63,500
charge)
(b)
Taxable on 20X3 profit (liability) 45,000
If no tax is payable (or very little), then there might be an income tax recoverable asset
disclosed in current assets (income tax is normally recovered by offset against the tax liability
for the year). There will usually be a liability for tax assessed as due for the current year.
We may also find a liability on the deferred taxation account. Deferred taxation is shown
under 'non-current liabilities' in the statement of financial position.
Example 11:
For the year ended 31 July 20X4 Norman Kronkest Co made taxable trading profits of
$1,200,000 on which income tax is payable at 30%.
A transfer of $20,000 will be made to the deferred taxation account. The balance on this
account was $100,000 before making any adjustments for items listed in this paragraph.
The estimated tax on profits for the year ended 31 July 20X3 was $80,000, but tax has now
been agreed at $84,000 and fully paid.
Tax on profits for the year to 31 July 20X4 is payable on 1 May 20X5.
In the year to 31 July 20X4 the company made a capital gain of $60,000 on the sale of some
property. This gain is taxable at a rate of 30%.
Required:
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(a) Tax charge for the year
$
(i) Tax on trading profit (30% of 360,000
1,200,000)
Tax on capital gain (30% of 60,000) 18,000
Deferred taxation 20,000
398,000
Underprovision of taxation in previous 4,000
years
Tax charge on profit for the period 402,000
(ii) The statement of profit or loss will
show:
Profit before tax (1,200,000 + 60,000) 1,260,000
Income tax expense (402,000)
Profit for the year 858,000
(b)
Deferred taxation $
Balance brought forward 100,000
Transfer from profit or loss 20,000
Deferred taxation in SOFP 120,000
The tax liability is as follow
Payable on 1 May 20X5
Tax on profits 360,000
Tax on capital gain 18,000
Due on 1 May 20X5 378,000
Summary
Current liabilities
Tax payable on 1 May 20X5 378,000
Non current liabilities
Deferred taxation 120,000
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LESSON 16: PRESENTATION OF PUBLISHED FINANCIAL STATEMENTS
LEARNING OUTCOMES:
3. Statement of profit
or loss and other
comprehensive
income 4. Revision of basic
3.1. Format accounts
3.2. Information
presented in the
statement of profit or
loss
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1. IAS 1 Presentation of financial statements
To prescribe the content of general purpose FSs To achieve this the standard sets out:
to ensure comparability with:
▪ Overall considerations for the presentation;
▪ The entity’s own financial statements; and OBJECTIVE ▪ Guidelines for the structure; and
▪ Financial statements of other entities. ▪ Minimum requirements for content of FSs.
1.1.2. Components
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1.2.2. Identification of financial statements
IAS 1 (revised) specifies various items which must appear on the face of the SoFP as a
minimum disclosure.
(a) Property, plant and equipment
(b) Investment property
(c) Intangible assets
(d) Financial assets (excluding amounts shown under (e), (h) and (i))
(e) Investments accounted for using the equity method
(f) Biological assets
(g) Inventories
(h) Trade and other receivables
(i) Cash and cash equivalents
(j) Assets classified as held for sale under IFRS 5
(k) Trade and other payables
(l) Provisions
(m) Financial liabilities (other than (j) and (k))
(n) Current tax liabilities and assets as in IAS 12
(o) Deferred tax liabilities and assets
(p) Liabilities included in disposal groups under IFRS 5
(q) Non-controlling interests
(r) Issued capital and reserves
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2.2. The current/non-current distinction
An asset is classified as
“current” when it
satisfies one of the
following criteria:
A liability is classified as
“current” when:
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3. Statement of profit or loss and other comprehensive income
3.1. Format
The allocated amounts must not be presented as items of income or expense. (These relate
to group accounts, covered later in this text.)
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4. Revision of basic accounts
The Study Guide requires you to be able to prepare a basic set of company accounts from a
trial balance.
Land 100
Buildings 120
Plant and machinery 170
Depreciation provision 120
Ordinary shares of $1 100
Retained earnings brought forward 380
Trade accounts receivable 200
Trade accounts payable 110
Inventory 190
Profit before tax 80
Allowance for receivables 3
Bank balance (asset) 12
Suspense 1
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a. Prepare journal entries to cover items in notes (i) to (v) above. You are not to open any
new accounts and may use only those accounts included in the list of account balances
as given.
b. Prepare final accounts for internal use within the limits of the available information. For
presentation purposes all the items arising from notes (i) to (v) above should be
regarded as material.
Answer:
176
Bank (12 + 2 – 1) 13,000
389,140
Total assets 659,140
Equity and liabilities
Equity
Share capital 100,000
Retained earnings (see profit or loss) 459,140
559,140
Current liabilities
Accounts payable (110 – 10) 100,000
Total equity and liabilities 659,140
FIDDLES CO
STATEMENT OF PROFIT OR LOSS (This is not as per IAS 1, it is purely for internal purposes)
$
Profit before tax (W2) 80,140
Retained earnings brought forward ($380,000 – 1,000) 379,000
Retained earnings carried forward 459,140
Workings
$
1. Accounts receivable
Per opening trial balance 200,000
Contra (10,000)
Miscasting (1,000)
Standing order (2,000)
Written off (1,000)
186,000
Allowance b/f 3,000
Allowance required 1,860
Journal 1,140
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This question dealt with accounts for internal purposes. In accounts produced for
publication the statement of profit or loss would comply with the IAS 1 format. In the
following chapter we will be dealing with all the issues involved in producing financial
statements for publication.
5.1. Structure
The notes to the financial
statements should perform the
following functions.
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Notes to the financial statements
will amplify the information shown
therein by giving the following.
Contingent
liabilities,
commitments Non-financial
and other disclosures
financial
disclosures
The order of specific items may have to be varied occasionally, but a systematic structure is
still required.
ACCOUNTING POLICIES
Definition:
Accounting policies are the specific principles, bases, conventions, rules and practices adopted by an entity in
preparing and presenting financial statements.
Principle
Consistency of accounting policies:
If change is due to new standard / interpretation, apply
Policies should be consistent for similar transactions,
transitional provisions.
events or conditions.
If no transitional provisions, apply RETROSPECTIVELY
(Retrospective application means that the new accounting
policy is applied to transactions and events as if it had
always been in use)
Disclose:
Revenue 869
Cost of sales:
Opening inventory 135
Purchases 246
Closing inventory (174) (207)
Gross profit 662
In order to prepare comparative figures for 20X8 showing the change of accounting policy, it
is necessary to recalculate the amounts for 20X7, so that the opening inventory for 20X8 is
valued on a weighted average basis.
It is established that opening inventory for 20X8 based on the weighted average method
would be $122,000 and closing inventory would be $143,000. So the 20X8 gross profit now
becomes:
$'000
Revenue 869
Cost of sales:
Opening inventory 122
Purchases 246
644
This shows $18,000 lower gross profit for 20X8 which will reduce net profit and retained
earnings by the same amount. The opening inventory for 20X9 will be $143,000 rather than
$174,000 and the statement of changes in equity for 20X9 will show an $18,000 adjustment
to opening retained earnings.
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2. Changes in accounting estimates
Definition:
A change in accounting estimate is an adjustment of the carrying amount of an asset or a liability or the amount of the
periodic consumption of an asset, that results from the assessment of the present status of, and expected future
benefits and obligations associated with, assets and liabilities
Example:
Principle
Recognise the change prospectively in profit or loss in:
• Period of change, if it only affects that period only
• Period of change and future periods, if the change affects both
Disclosure
• Nature and amount of change that has an effect in the current period (or expected to have in future)
• Fact that the effect of future periods is not disclosed because of impracticality
Example:
Which of the following is a change in accounting policy as opposed to a change in estimation
technique?
1. An entity has previously charged interest incurred in connection with the construction
of tangible non-current assets to the statement of profit or loss. Following the revision
of IAS 23 Borrowing Costs, and in accordance with the revised requirements of that
standard, it now capitalises this interest.
2. An entity has previously depreciated vehicles using the reducing balance method at
40% pa. It now uses the straight-line method over a period of five years.
3. An entity has previously shown certain overheads within cost of sales. It now shows
those overheads within administrative expenses.
4. An entity has previously measured inventory at weighted average cost. It now measures
inventory using the first in first out (FIFO) method.
Solution
For each of the items, ask whether this involves a change to:
• recognition
• presentation
• measurement basis
If the answer to any of these is yes, the change is a change in accounting policy.
1. This is a change in recognition and presentation. Therefore this is a change in
accounting policy.
2. The answer to all three questions is no. This is only a change in estimation technique.
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3. This is a change in presentation and therefore a change in accounting policy.
4. This is a change in measurement basis and therefore a change in accounting policy.
3. Errors
PRIOR PERIOD ERRORS
Definition:
Prior period errors are omissions from, and misstatements in, the entity's financial statements for
one or more prior periods arising from a failure to use, or misuse of, reliable information that:
– Was available when financial statements for those periods were authorised for issue
– Could reasonably be expected to have been obtained and taken into account in the preparation
and presentation of those financial statements
Including:
• Mathematical mistakes
• Mistakes in the application of accounting policies
• Misinterpretation of facts
• Oversights
• Fraud
Principle
Correct RETROSPECTIVELY as if the error had never occurred.
• Either restating the comparative amounts for the prior period(s) in which the error
occurred, or
• When the error occurred before the earliest prior period presented, restating the opening
balances of assets, liabilities and equity for that period
Only where it is impracticable to determine the cumulative effect of an error on prior periods can
an entity correct an error prospectively
Disclosure
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II. IFRS 5 Non-current assets held for sales and discontinued operations Management must be committed
to a plan to sell the asset
IFRS 5 does not apply to certain assets covered by other accounting standards:
There must be an active
• Deferred tax assets (IAS 12) • Investment properties accounted for in accordance with the programme to locate a buyer.
• Assets arising from employee fair value model (IAS 40)
benefits (IAS 19) • Agricultural and biological assets (IAS 41) Sale at a price that is reasonable
• Financial assets (IFRS 9) • Insurance contracts (IFRS 4) Its sale must be highly
in relation to its current fair value
1. Non-current assets held for sales probable
The sale should be expected to
2. take place within one year from
Criteria the date of classification(2)
A non-current asset (or disposal The asset must be
group) should be classified as held available for immediate It is unlikely that significant
Classification for sale if its carrying amount will sale in its present condition changes to the plan will be made
be recovered principally through a or that the plan will be
sale transaction rather than withdrawn
through continuing use (1)
If recoverable amount is lower
Carrying amount than its carrying value => An
Non-current assets Lower of
impairment loss on an asset held
held-for-sale for sales is charged to profit or
Fair value (3) less costs of disposal(4)
Non-current assets Measurement loss
held for sales Non-current assets held for sale
Its carrying amount before it was should not be depreciated
classified as held for sale, adjusted for
any depreciation that would have been
charged
Non-current assets no Lower of
longer classified as
held-for-sale Its recoverable amount at the date of
the decision not to sell
Non-current assets and disposal groups classified as held for sale should be presented separately from other assets
in the statement of financial position. The liabilities of a disposal group should be presented separately from other
Presentation(5) liabilities in the statement of financial position.
(a) Assets and liabilities held for sale should not be offset.
The major classes of assets and liabilities held for sale should be separately disclosed either on the face of the
(b)
statement of financial184
position or in the notes.
IFRS 5 requires non-current assets or disposal groups held for sale to be shown as a separate component of
(c)
current assets/current liabilities.
(1) An asset that is to be abandoned should not be classified as held for sale. This is because
its carrying amount will be recovered principally through continuing use. However, a
disposal group to be abandoned may meet the definition of a discontinued operation and
therefore separate disclosure may be required
(2) An asset (or disposal group) can still be classified as held for sale, even if the sale has not
actually taken place within one year. However, the delay must have been caused by
events or circumstances beyond the entity's control and there must be sufficient evidence
that the entity is still committed to sell the asset or disposal group. Otherwise the entity
must cease to classify the asset as held for sale.
(3) Fair value. The price that would be received to sell an asset or paid to transfer a liability in
an orderly transaction between market participants at the measurement date.
(4) Costs of disposal. The incremental costs directly attributable to the disposal of an asset (or
disposal group), excluding finance costs and income tax expense.
(5) In the period in which a non-current asset (or disposal group) has been either classified as
held for sale or sold the following should be disclosed.
A description of the non-current asset (or disposal group)
(a)
A description of the facts and circumstances of the disposal
(b)
Any gain or loss recognised when the item was classified as
(c)
held for sale
185
3. Presenting discontinued operations
Discontinued operation. A component of an entity that has either been disposed of, or is
classified as held for sale, and:
• Represents a separate major line of business or geographical area of operations
• Is part of a single co-ordinated plan to dispose of a separate major line of business or
geographical area of operations, or
• Is a subsidiary acquired exclusively with a view to resale.
Component of an entity. Operations and cash flows that can be clearly distinguished,
operationally and for financial reporting purposes, from the rest of the entity.
An entity should disclose a single amount in the statement of profit or loss comprising the
total of:
• The post-tax profit or loss of discontinued operations
• The post-tax gain or loss recognised on the measurement to fair value less costs of
disposal or on the disposal of the assets or disposal group(s) constituting the discontinued
operation
An entity should also disclose an analysis of this single amount into:
• The revenue, expenses and pre-tax profit or loss of discontinued operations
• The related income tax expense
• The gain or loss recognised on the measurement to fair value less costs of disposal or on
the disposal of the assets of the discontinued operation
• The related income tax expense
EXAMPLE:
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III. Foreign currency transactions
1. Definition
EXAMPLE OF CONVERSION:
Suppose a US company buys a consignment of goods from a supplier in Germany. The order
is placed on 1 May and the agreed price is €124,250. At the time of delivery the rate of
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foreign exchange was €2 to $1.
The local company would record the amount owed in its books as follows.
DEBIT Purchases (124,250 ÷ 2) $62,125
CREDIT Payables $62,125
When the US company comes to pay the supplier, it needs to obtain some foreign currency.
By this time, however, if the rate of exchange has altered to €2.05 to $1, the cost of raising
€124,250 would be (÷ 2.05) $60,610. The company would need to spend only $60,610 to
settle a debt for inventories 'costing' $62,125. The US company will record a profit on
conversion (or exchange gain) of $1,515.
DEBIT Payables $62,125
CREDIT Cash $60,610
CREDIT Profit on conversion $1,515
Profits (or losses) on conversion would be included in profit or loss for the year in which
conversion (whether payment or receipt) takes place.
Suppose that another US company sells goods to a Mexican company, and it is agreed that
payment should be made in Mexican pesos at a price of MXN116,000. We will further assume
that the exchange rate at the time of sale is MXN17.2 to $1, but when the debt is eventually
paid, the rate has altered to MXN 18.1 to $1. The company would record the sale as follows.
DEBIT Receivables (116,000 ÷ 17.2) $6,744
CREDIT Revenue $6,744
When the MXN116,000 are paid, the US company will convert them into $, to obtain (÷ 18.1)
$6,409. In this example, there has been a loss on conversion of $335 which will be written off
to profit of loss for the
year:
DEBIT Cash $6,409
DEBIT Loss on conversion $335
CREDIT Receivables $6,744
EXAMPLE OF TRANSLATION
Suppose, for example, that a Belgian subsidiary purchases a piece of property for €2,100,000
on 31 December 20X7. The rate of exchange at this time was €70 to $1. During 20X8, the
subsidiary charged depreciation on the building of €16,800, so that at 31 December 20X8, the
subsidiary recorded the asset as follows.
€€€€
Property at cost 2,100,000
Less accumulated depreciation 16,800
Carrying amount 2,083,200
At this date, the rate of exchange has changed to €60 to $1.
The local holding company must translate the asset's value into $, but there is a choice of
188
exchange rates.
(a) Should the rate of exchange for translation be the rate which existed at the date of
purchase, which would give a carrying amount of 2,083,200 ÷ 70 = $29,760?
(b) Should the rate of exchange for translation be the rate existing at the end of 20X8 (the
closing rate of €60 to $1)? This would give a carrying amount of $34,720.
Similarly, should depreciation be charged to group profit or loss at the rate of €70 to $1 (the
historical rate), €60 to $1 (the closing rate), or at an average rate for the year (say, €64 to
$1)?
189
2. Foreign currency transactions
Non-monetary items that are held at cost are initially translated at the historic rate and carried forward at this value . They are not
retranslated. The diagram below shows the treatment for monetary items
Subsequent measure
• If a transaction is still unsettled at the reporting date, there will be an outstanding asset or
liability on the statement of financial position.
Unsettled transactions • If the asset/liability is a monetary item it should be retranslated at the closing rate.
• If the asset/liability is a non-monetary item it should remain at the historic rate.
• Exchange differences will arise on the retranslation of the monetary items, and these are also
posted to the statement of profit or loss.
• If the exchange difference relates to trading transactions it is disclosed within other operating income/operating
Treatment of expenses.
exchange differences • If the exchange difference relates to non-trading transactions it is disclosed within interest receivable and similar
income/finance costs.
190
Example for settled transactions
On 1 April 20X8 Collins Co, a company that uses the dollar ($) as itsfunctional currency, buys
goods from an overseas supplier, who uses Kromits (Kr) as its functional currency. The goods
are priced at Kr54,000. Payment is made 2 months later on 31 May 20X8.
The prevailing exchange rates are:
1 April 20X8 Kr1.80 : $1
31 May 20X8 Kr1.75 : $1
Required:
Record the journal entries for these transactions
Solution:
Initial transaction
Translate at historic rate on 1 April, Kr54,000/1.8 = $30,000
Dr Purchases $30,000
Cr Payables $30,000
On settlement
Translate at historic rate on 31 May, Kr54,000/1.75 = $30,857
Dr Payables $30,000
Dr SPL – foreign exchange loss $857
Cr Cash $30,857
Solution:
Initial transaction
Translate at historic rate on 1 April, Kr54,000/1.8 = $30,000
Dr Purchases $30,000
Cr Payables $30,000
At the reporting date
Payables are monetary items, so retranslate at the closing rate on 30 June, Kr54,000/1.70
= $31,765
Dr SPL $1,765 ($31,765 – $30,000)
Cr Payables $1,765
At the reporting date
Leave closing inventory at the original cost, as inventory is a non-monetary item
191
Dr Inventory $30,000
Cr Cost of sales $30,000
Solution:
192
LESSON 18: EARNINGS PER SHARE
I. IAS 33 Earnings per shares
1. Definitions
2. Scope
• Only companies with (potential) ordinary shares which are publicly traded need to
present EPS
(including companies in the process of being listed).
• EPS need only be presented on the basis of consolidated results where the parent's
results are
shown as well.
193
II. Basic EPS
𝑬𝒂𝒓𝒏𝒊𝒏𝒈𝒔
EPS = 𝑺𝒉𝒂𝒓𝒆𝒔
194
Basic EPS
Characteristics: Characteristics:
• Not provide additional resources to the issuer • Contribute additional resources
• Shareholder owns the same proportion of the • Priced below full market price
business before and after the issue
• In the current year, the bonus shares are • Adjust for bonus element in rights issue, by
Taking account of the date any new deemed to have been issued at the start of multiplying capital in issue before the rights
shares are issued during the year the year issue by the following fraction:
• Comparative figures are restated to allow for Market price before issue
the proportional increase in share capital Theoretical ex rights price
caused by the bonus issue. • Calculate the weighted average share capital
195
ANSWER:
Calculation of EPS
$460,000
20X7 EPS = 800,000 = $0.575
Issue at full market price
Date Actual number of Fraction of year Total
shares
1 Jan 20X8 b/f 800,000 6/12 400,000
1 July 20X8 Issue 200,000
1 July 20X8 c/f 1,000,000 6/12 500,000
Number of shares in EPS calculation 900,000
$550,000
20X8 EPS = = $0.611
900,000
Note:
Since the 200,000 shares have only generated additional resources towards the earning of
profits for half a year, the number of new shares is adjusted proportionately. Note that the
approach is to use the earnings figure for the period without adjustment, but divide by the
average number of shares weighted on a time basis.
SOLUTION
In the 20X7 accounts, the EPS for the year would have appeared as 46¢ ($460,000 ÷
1,000,000). In the example above, the computation has been reworked in full. However, to
make the changes required it would be simpler to adjust the original EPS figure.
Since the old calculation was based on dividing by 1,000,000 while the new is determined by
using 1,200,000, it would be necessary to multiply the EPS by the first and divide by the
second.
1,000 ,000 5
The fraction to apply is, therefore: or
1,200 ,000 6
5
Consequently: 0.46 x = 0.383
6
196
EXAMPLE FOR BONUS AND MARKET ISSUES COMBINED
NOTE:
If a question gives both a bonus issue and an issue of shares at full price:
• Apply the bonus fraction from the start of the year up until the date of the bonus issue
• Time apportion the number of shares to reflect the cash being received from the market
issue.
QUESTION:
An entity had 1 million shares in issue on 1 January 20X1. They issued 200,000 shares at
market value on 1 April 20X1, followed by a 1 for 5 bonus issue on 1 August 20X1, with a
further 300,000 issued at market value on 1 October 20X1.
If profit for the year ending 31 December 20X1 is $220,000, what is the basic earnings per
share?
ANSWER:
Date Number of Bonus fraction Fraction of year Total
shares
1 Jan b/f 1,000,000 6/5 3/12 300,000
Issue 200,000
1 Apr b/f 1,200,000 6/5 4/12 480,000
1 for 5 bonus 240,000
1 Aug b/f 1,440,000 2/12 240,000
Issue 300,000
1 Oct b/f 1,740,000 3/12 435,000
1,455,000
$220,000
The earnings per share for 20X1 would now be calculated as: 1,455,000 = $0.151
197
ANSWER:
Note As per example
Step 1 – Calculate theoretical ex-rights price (TERP)
Start with the number of shares previously No. of Price Value
held by an individual at their market price. shares $ $
Then add in the number of new shares Prior to 2 3 6
purchased at the rights price. You can then rights
find the TERP by dividing the total value of issue
these shares by the Taking 1 1.5 1.5
number held. up rights
7.5
TERP = $7.5/3 = $2.5
198
III. Diluted EPS
Equity share capital may increase in the future due to circumstances which exist now.
When it occurs, this increase in shares will reduce, or dilute, the earnings per share. The
provision of a diluted EPS figure attempts to alert shareholders to the potential impact
on EPS of these additional shares.
Examples of dilutive factors are:
• the conversion terms for convertible bonds/convertible loans etc.
• the exercise price for options and the subscription price for warrants. An option or
warrant gives the holder the right to buy shares at some time in the future at a
predetermined price.
Diluted EPS is calculated by adjusting the net profit due to continuing operations
attributable to ordinary shareholders and the weighted average number of shares
outstanding for the effects of all dilutive potential ordinary shares.
Formulae:
Earnings + notional extra earnings (1)
𝐃𝐄𝐏𝐒 =
Number of shares + notional extra shares(2)
Note The earnings calculated for basic EPS should be based on continuing operations
1 and adjusted by the post-tax (including deferred tax) effect of:
Any dividends on dilutive potential ordinary shares that were deducted
(a)
to arrive at earnings for basic EPS
Interest recognised in the period for the dilutive potential ordinary
(b)
shares (convertible debt)
ST Any other changes in income or expenses (fees or discount) that would
RWA(c) result from the conversion of the dilutive potential ordinary shares
Note It should be assumed that dilutive ordinary shares were converted into ordinary
2 shares at the beginning of the period or, if later, at the actual date of issue.
There are two other points:
The computation assumes the most advantageous conversion rate or
(a) exercise rate from the standpoint of the holder of the potential ordinary
shares.
199
DEPS
The total number of shares issued on the exercise of the option or warrant is split
into two:
If the convertible bonds/preference shares • the number of shares that would have been issued if the cash received had been
had been converted: used to buy shares at fair value (using the average price of the shares during the
• the interest/dividend would be saved period)
therefore earnings would be higher • the remainder, which are treated like a bonus issue (i.e. as having been issued for
• the additional earnings would be subject to no consideration).
tax The number of shares issued for no consideration is added to the number of shares
• the number of shares would increase. when calculating the DEPS.
Fair value – exercise price
Number of free shares = No. of options × Fair value
200
EXAMPLE FOR CONVERTIBLE INSTRUMENTS
A company had 8.28 million shares in issue at the start of the year and made no new issue
of shares during the year ended 31 December 20X4, but on that date it had in issue
$2,300,000 convertible loan stock 20X6- 20X9. The loan stock carries an effective rate of
10%. Assume an income tax rate of 30%. The earnings for the year were $2,208,000.
This loan stock will be convertible into ordinary $1 shares as follows.
20X6 90 $1 shares for $100 nominal value loan stock
20X7 85 $1 shares for $100 nominal value loan stock
20X8 80 $1 shares for $100 nominal value loan stock
20X9 75 $1 shares for $100 nominal value loan stock
Calculate the diluted earnings per share for the year ended 31 December 20X4.
SOLUTION:
If this loan stock was converted to shares the impact on earnings would be as follows.
$ $
Basic earnings 2,208,000
Add notional interest saved ($2,300,000 × 10%) 230,000
Less: Tax relief $230,000 × 30% (69,000)
161,000
Revised earnings 2,369,000
Number of shares if loan converted
Basic number of shares 8,280,000
90
Maximum notional extra shares 2,300,000 x 2,070,000
100
Revised number of shares 10,350,000
ANSWER:
$500,000
Basic EPS = = $0.125
4,000,000
Options or warrants
$
Earnings 500,000
Number of shares
Basic 4,000,000
Options (W1) 333,333
4,333,333
$500,000
The DEPS is therefore = $0.115
4,333 ,333
201
(W1) Number of shares at option price
Options = 1,000,000 × $2
= $2,000,000
$2,000,000
At fair value $3
= 666,667
Number issued free = 1,000,000 – 666,667 = 333,333
Or, using formula, number of free shares:
1,0000 × (3 – 2)/3 = 333,333
4. Significance of EPS
• The EPS figure is used to compute the major stock market indicator of performance,
𝑀𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑠ℎ𝑎𝑟𝑒
the price earnings ratio (P/E ratio). The calculation is: P/E ratio =
𝐸𝑃𝑆
• Although EPS is based on profit on ordinary activities after taxation, the trend in EPS
may be a more accurate performance indicator than the trend in profit.
• EPS measures performance from the perspective of investors and potential investors
and shows the amount of earnings available to each ordinary shareholder, so that it
indicates the potential return on individual investments.
5. Limitations of EPS
202
• Management knows investors rely on using EPS as a guidance for company
performance so they’ll naturally want the EPS figure to appear as high as possible in
the short term. They may make decisions to maximise the EPS figure in the short
term, which may damage the entity’s prospects in the long term.
• EPS also doesn’t consider cash flow. Management may focus so much on increasing
the earnings figure, they start selling to bad customers who don’t pay or sell at lower
margins. If the company can’t earn cash to pay its bills, no matter how large the
earnings are, it may be insolvent.
• EPS also ignores inflation, the price of goods and services generally may be
increasing, so this could be contributing to the good EPS figure, but this growth
might be misleading if the company can’t buy as many goods this year as it could last
year.
• Also, each company has different accounting policies; this makes it harder to
compare individual companies on a like for like basis.
203
LESSON 19: CALCULATION AND INTERPRETATION OF ACCOUNTING RATIOS
AND TRENDS
Ratio analysis is a technique whereby complicated information is summarised to a common
denominator so that a meaningful comparison of the company’s performance and financial
position can be made, or comparison be made with another similar company.
ANALYSIS AND INTERPRETATION
Explanation of ratios to
Calculation of key ratios from
establish strengths and
financial statements
weaknesses
PURPOSE
Depends on USER
LIMITATIONS
204
3. Historical cost accounts do not take into account the impact of inflation
DIVISION OF RATIOS
Exam technique:
• RATIO ANALYSIS ------------ use appendices to show calculations / always show formula
used
• COMMENTS (cause) & CONSEQUENCES (effect)
3 steps
- The gearing ratio has moved from…….
- The gearing ratio measures………………. What is the overall picture?
- The move may be due to………………….
205
1. Performance ratios
Profitability and asset
utilization
Return on Capital Employed
Primary ratio
(ROCE)
PBIT
𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝑒𝑚𝑝𝑙𝑜𝑦𝑒𝑑
Comments on how
Capital = Shareholders’ + NCL efficiently capital has
Employed equity been employed by
management
= Total – Current
assets liabilities
Measures performance
Comments on how profitable
of company in
are sales and control of
generating sales from
operating costs
assets at their disposal
Non-current asset
Gross profit margin Tertiary ratios
utilization
Operating cost margin Return on equity capital (ROE) Net profit margin
𝑃𝐴𝑇
𝐷𝑖𝑠𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 / 𝐴𝑑𝑚𝑖𝑛𝑖𝑠𝑡𝑟𝑎𝑡𝑖𝑜𝑛 𝑃𝐴𝑇 𝑎𝑛𝑑 𝑝𝑟𝑒𝑓𝑒𝑟𝑒𝑛𝑐𝑒 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠
𝑆𝑎𝑙𝑒𝑠
𝑆𝑎𝑙𝑒𝑠 𝐸𝑞𝑢𝑖𝑡𝑦 𝑠ℎ𝑎𝑟𝑒ℎ𝑜𝑙𝑑𝑒𝑟𝑠′ 𝑓𝑢𝑛𝑑
206
2. Liquidity ratios
Can business pay its creditors / employees on time and service its assets
𝑁𝐶𝐿 𝐸𝑞𝑢𝑖𝑡𝑦
𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝑒𝑚𝑝𝑙𝑜𝑦𝑒𝑑 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝑒𝑚𝑝𝑙𝑜𝑦𝑒𝑑
207
3. Efficiency ratios (Turnover ratios)
Working capital
management / efficiency
Inventory and credit
control
208
𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠 𝑝𝑎𝑖𝑑 𝑓𝑜𝑟 𝑜𝑟𝑑𝑖𝑛𝑎𝑟𝑦 𝑠ℎ𝑎𝑟𝑒𝑠 stable & the management
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑜𝑟𝑑𝑖𝑛𝑎𝑟𝑦 𝑠ℎ𝑎𝑟𝑒𝑠 team is confident in the
company’s future prodits.
Price earnings ratio (P/E)
Measures of a company’s
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑚𝑎𝑟𝑘𝑒𝑡 𝑝𝑟𝑖𝑐𝑒 (𝑒𝑥 𝑑𝑖𝑣) market rating; higher the
𝐸𝑃𝑆 PER, the higher the market’s
confidence in company’s
future prospects.
209
5. Test your understanding Example
EXAMPLE 1
Statements of financial position and statements of profit or loss for Ocean Motors are set out
below.
20X2 20X1
$000 $000 $000 $000
Non-current assets:
Land and buildings
Cost 1,600 1,450
Depreciation (200) (150)
1,400 1,300
Plant and machinery:
Cost 600 400
Depreciation (120) (100)
480 300
1,880 1,600
Current assets:
Inventory 300 100
Receivables 400 100
700 200
Total assets 2,580 1,800
Equity:
Share capital –
$1 ordinary shares 1,200 1,200
Retained earnings 310 220
1,510 1,420
Current liabilities:
Bank overdraft 590 210
Payables and accruals 370 70
Taxation 110 100
1,070 300
2,580 1,800
210
Administration and distribution expenses (400) (360)
The dividend for 20X1 was $100,000 and for 20X2 was $110,000.
Calculate the following ratios for Ocean Motors and briefly comment upon what they indicate:
Profitability ratios:
• Gross profit margin
• Operating profit margin
• ROCE
• Net asset turnover
Liquidity and working capital ratios:
• Current ratio
• Quick ratio
• Inventory collection period
• Accounts receivable collection period
• Accounts payable payment period
SOLUTION
Profitability ratios
20X2 20X1
ROCE 400/1,510 = 26.5% 340/1,420 = 23.9%
Gross profit margin 800/1,500 = 53.3% 700/1,000 = 70.0%
Operating profit margin 400/1,500 = 26.7% 340/1,000 = 34.0%
Asset turnover 1,500/1,510 = 0.99 1,000/1,420 = 0.70
Comment
Key factors:
• Revenue has increased by 50%
• Gross profit margin significantly decreased, maybe due to lowering of selling prices in
order to increase market share and sales revenue
• Operating profit margin has decreased in line with gross profit margin
• ROCE has increased, which must be due to the improvement in asset turnover.
20X2 20X1
Current ratio 700/1,070 = 0.65 : 1 200/380 = 0.53 : 1
Quick ratio 400/1,070 = 0.37 : 1 100/380 = 0.26 : 1
Inventory holding 300/700 x 365 = 165 days 100/300 x 365 = 122 days
period
211
Accounts receivable 400/1,500 x 365 = 97 days 100/1,000 x 365 = 36.5
collection period days
Accounts payable 370/700 x 365 = 193 days 70/300 x 365 = 85 days
payment period
Comment
Overall the liquidity of the company would appear to be in some doubt:
• Both the current ratio and quick ratio appear very low although they have improved
since the previous year.
• We do not know anything about the type of business, so it is difficult to comment on
these absolute levels of liquidity.
• Inventory holding period indicates that inventory is held for a considerable time and that
this period is increasing.
• Accounts receivable collection period has deteriorated rapidly although given the
increase in revenue this may be due to a conscious policy of offering extended credit
terms in order to attract new custom.
• Accounts payable payment period has also more than doubled and is even longer than
the period of credit taken by customers.
• Clearly the business is heavily dependent upon its overdraft finance.
EXAMPLE 2
Interpretation of financial statements
Neville is a company that manufactures and retails office products. Their summarised
financial statements for the years ended 30 June 20X4 and 20X5 are given below:
20X5 20X4
$000 $000
Revenue 1,391,820 1,159,850
Cost of Sales (1,050,825) (753,450)
212
Statements of financial position as at 30 June
20X5 20X4
$000 $000
Non-current assets 509,590 341,400
Current assets
Inventory 109,400 88,760
Receivables 419,455 206,550
Bank – 95,400
1,038,445 732,110
Share capital 100,000 100,000
Share premium 20,000 20,000
Revaluation reserve 50,000 –
Retained earnings 376,165 287,420
546,165 407,420
Non-current liabilities 61,600 83,100
Current liabilities
Payables 295,480 179,590
Overdraft 80,200 –
Tax 55,000 62,000
1,038,445 732,110
The directors concluded that their revenue for the year ended 30 June 20X4 fell below
budget and introduced measures in the year end 30 June 20X5 to improve the situation.
These included:
• Cutting prices
• Extending credit facilities to customers
• Purchasing additional machinery in order to be able to manufacture more
products.
The directors are now reviewing te results for the year ended 30 June 20X5 and have
asked for your advice, as an external business consultant, as to whether or not the above
strategies have been successful.
Required:
Prepare a report to the directors of Neville assessing the performance and position of the
company in the year ended 30 June 20X5 compared to the previous year and advise them
on whether or not you believe that their strategies have been successful.
SOLUTION
Neville
Report
To: Directors of Neville
From: Business Consultant
Date: XX.XX.XX
Subject: Performance of Neville
213
Introduction
As requested I have analysed the financial statements of Neville for the year ended 30
June 20X5 compared to the previous year to assess the performance and postion of the
entity and to determine whether the strategies that you have implemented have been
successful. The ratios that I have calculated are shown in an appendix to this report.
Performance
Profitability
The revenue of the entity has increased by 20% on last year. It would therefore appear
that the strategy of cutting prices and extending credit facilities has attracted customers
and generated an increase in revenue. Whether or not the revenue is now above budget,
as was the directors’ aim, is unknown.
Despite this increase however, the profitability of the company has worsened, with both
gross profit and operating profit margin has declined from 20.3% to 12.9%. There are
likely to be several reasons behind this deterioration.
The reduction in sale prices will have contributed to the worsening gross profit. To rectify
this, Neville may consider approaching their suppliers for some bulk-buying discounts, as
since they are selling more items they will now be purchasing more material from
suppliers.
The move of purchasing additional machinery may also have contributed to the lower
profitability, with an impact on depreciation expense.
The return on capital employed has dropped significantly from 48% to 29.5%. This is
mainly due to the lower operating profit margins and reasons discussed above, as
opposed to a decline in the efficient use of assets since the asset utilisation has suffered
only a slight fall.
The revaluation of non-current assets will also have contributed to the fall in the return
on capital employed and would explain why the asset utilisation has fallen slightly.
The revaluation may have caused additional depreciation charges in the statement of
profit or loss if the assets were revalued at the start of the year. This may therefore be
another factor in the worsening profits.
The additional machinery purchased furing the year may not have been fully operational
in the current year, and so would also explain the lower returns. The higher depreciation
charges will also have contributed to lower profits.
Position
Liquidity
214
Again, the company’s results are showing a worsening position in this area with the
current ratio declining from 1.62 to 1.23.
The cause for this would seem to be the extension of credit facilities to customers.
Receivables days have increased from what seems to be an acceptable level of 65 days to
110 days. Although the benefits of this strategy have been shown by the increase in
revenue, it would seem that Neville have now allowed customers too much credit. It
would be recommended that receivables days should be reduced to closer to 90 days as a
first step.
As a result of the increase in the receivables collection period, Neville have been taking
longer to pay their suppliers. Their payables days are now at an unacceptably high level of
102 days. This is likely to be causing dissatisfaction with suppliers and would reduce the
ability of Neville being able to negotiate discounts as discussed above.
Inventory holding days have decreased from 43 to 38. Although this increase in efficiency
is to be welcomed, it may be caused by supply problems from dissatisfied suppliers.
As a consequence of these factors, by the end of the year Neville are operating a
significant overdraft.
Gearing
The gearing ratio has fallen from 16.9% to 10.1% as a result of the reduction in non-
current liabilities. Assuming that these are loans, it would appear that Neville have further
utilised their cash resources to repay these loans. This does not seem to have been a
sensible move given their poor liquidity position.
The revaluation of non-current assets and subsequent increase in equity would also have
contributed to the lowering of this ratio.
Further, the gearing ratio last year does not seem particularly high, although comparison
with an industry average would confirm this, and the company had a significant level of
profits covering their finance costs.
Hence it would have seemed appropriate to have increased the longer term debt of the
company to finance the growth rather than increasing their current liabilities.
It was identified above that Neville purchased additional non-current assets. Given the
gearing and liquidity positions, it would seem that these have been financed from short-
term sources rather than more appropriate long-term sources.
Summary
215
Although the directors’ initial aim of improving revenue has been achieved with the
measures taken, the strategies do not appear to have been successful overall. The cutting
of prices has caused lowering profit margins and, combined with additional depreciation
charges, has resulted in a worsening profit situation overall.
The extension of credit periods has again been successful to the extent that it has helped
increase revenue but has caused a poor liquiditu position.
To recify the situation it would seem appropriate to increase the long-term debt of the
company as a matter of priority.
Appendix
20X4 20X5
Revenue 1,159,850 1,391,820 +20%
Gross profit 406,400 340,995 – 16.1%
Operating profit 235,450 179,545 – 23.7%
216
Gearing 83,100 61,600
= 16.9% = 10.1%
490,520 607,765
EXAMPLE 3
Comparator assembles computer equipment from bought-in components and distributes
them to various wholesalers and retailers. It has recently subscribed to an inter-firm
comparison service. Members submit accounting ratios as specified by the operator of
the service, and in return, members receive the average figures for each of the specified
ratios taken from all subscribing entities in the same sector. The specified ratios and the
average figures for Comparator’s sector are shown below.
Ratios of companies reporting a full year’s results for period ending between 1 July 20X3
and 30 September 20X3:
Return on capital employed 22.1%
Net asset turnover 1.8 times
Gross profit margin 30%
Net profit (before tax) margin 12.5%
Current ratio 1.6 : 1
Quick ratio 0.9 : 1
Inventory days 46 days
Receivables days 45 days
Payables days 55 days
Debt to equity 40%
Dividend yield 6%
Dividend cover 3 times
Comparator’s financial statements for the year to 30 September 20X3 are set out below:
217
Profit for the year 96
Notes:
(i) The details of non-current assets are:
218
Required:
(a) Calculate the ratios for Comparator equivalent to those provided by the inter -
firm comparison service.
(b) Write a report analysing the financial performance of Comparator based on a
comparison with the sector averages.
ANSWER
(a) Calculation of specified ratios
Comparator Sector
average
Return on capital employed
34.6% 22.1%
(186 + 34 loan interest/(335 + 300))
Net asset turnover
3.8 times 1.8 times
(2,425/(335 + 300))
Gross profit margin
22.9% 30%
(555/2,425 x 100)
Net profit (before tax) margin
7.7% 12.5%
(186/2,425 x 100)
Current ratio (595/500) 1.19 : 1 1.6 : 1
Quick ratio (320/500) 0.64 : 1 0.9 : 1
Inventory days (275/1,870 x 365) 54 days 46 days
Receivables days (320/2,425 x 365) 48 days 45 days
Payables days (350/1,870 x 365)
68 days 55 days
(based on cost of sales)
Debt to equity (300/335 x 100) 90% 40%
Dividend yield (see below) 2.5% 6%
Dividend cover (96/90) 1,07 times 3 times
(The workings are in $000 and are for Comparator’s ratios.)
The dividend yield is calculated from a dividend per share figure of 15c
($90,000/150,000 x 4) and a share price of $6.00. Thus the yield is 2.5%
(15c/$6.00 x 100%).
(b) REPORT
Operating performance
219
exceptionals are treated as one-off costs and excluded, Comparator’s margins are
very similar to the sector average.
This short analysis seems to imply that Comparator’s superior return on capital
employed is due entirely to an efficient asset turnover i.e. Comparator is making
its assets work twice as efficiently as its competitors. A closer inspection of the
underlying figures may explain why its asset turnover is so high. It can be seen
from the note to the statement of financial position that Comparator’s non-
current assets appear to be quite old. Their carrying amount is only 15% of their
original cost. This has at least two implications. Firstly these assets will need
replacing in the near future and the company is already struggling for funding,
and secondly their low carrying amount produces a high figure for asset turnover.
Unless Comparator has underestimated the life of its assets in its depreciation
calculations, its non-current assets will need replacing in the near future. When
this occurs its asset turnover and return on capital employed figures will be much
lower.
This aspect of ratio analysis often causes problems and to counter this anormaly
some companies calculate the asset turnover using the cost of non-current assets
rather than their carrying amount as this gives a more reliable trend.
A further issue is which of the two calculated margins should be compared to the
sector average (i.e. including or excluding the effects of the exceptionals). The
gross profit margin of Comparator is much lower than the sector average. If the
exceptional losses were taken in at trading account level, which they should be as
they relate to obsolete inventory, Comparator’s gross margin would be even
worse. As Comparator’s net margin is similar to the sector average, it would
appear that Comparator has better control over its operating costs. This is
especially true as the other element of the net profit calculation is finance costs
and as Comparator has much higher gearing than the sector average, one would
expect Comparator’s interest to be higher than the sector average.
Liquidity
Here Comparator shows real cause for concern. Its current and quick ratios are
much worse than the sector average, and indeed far below expected norms.
Current liquidity problems appear due to high levels of accounts payable and a
high bank overdraft. The high levels of inventory contribute to the poor quick
ratio and may be indicative of further obsolete inventory, as the exceptional item
is due to obsolete inventory.
220
Gearing
Investment ratios
Summary
The company compares favourably with the sector average figures for
profitability. However the company’s liquidity and gearing position is quite poor
and gives cause for concern. If it is to replace its old assets in the near future, it
will need to raise further finance. With already high levels of borrowing and poor
dividend yields, this may be a serious problem for Comparator.
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LESSON 20: LIMITATION OF FINANCIAL STATEMENTS AND INTERPRETATION
TECHNIQUES
LEARNING OUTCOMES:
1. Limitation of financial statements:
- Problems of historical cost information
- Creative accounting
- Intragroup transactions
- Seasonal trading
- Asset Acquisitions
- Acquisitions and disposals
2. Limitation of ratio analysis:
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A. LIMITATION OF FINANCIAL STATEMENTS:
b) Creative accounting:
A number of creative accounting measures are aimed at reducing gearing, but
regulation is increasingly catching up with these measures. In the past, parent
companies could find reasons to exclude highly-geared subsidiaries from the
consolidation and could obtain loans in the first place via such “ quasi subsidiaries”
so that the loan never appeared in the consolidated statement of financial position
(this loophole was effectively closed by IAS 27). Assets could be “sold” under a sale
and leaseback agreement, which is in effect a disguised loan, or leased under an
operating lease rather than a finance lease, in order to keep the liability off the
balance sheet (IFRS 16, the new leasing standard, now make it very difficult to keep
the liability off the balance sheet). In all else fails, a last minute piece of “ window
dressing” can be undertaken.
c) Intragroup transactions:
It is common for entities to carry on activities with or through subsidiaries and
associates, or occasionally to engage in transactions with directors or their families.
The point is that such transactions cannot be assumed to have been engaged in “ at
223
arm’s length” or the best interest of the entity itself, which is why investors and
potential investors need to be made aware of them. Transfer pricing can be used to
transfer profit from one company to another and inter-company loans and transfers
of non-current assets can also be used in the same way.
d) Seasonal trading:
Many companies whose trade is seasonal position their yearend after their busy
period, to minimise time spent on the inventory count. At this point in time, the
statement of financial position will show a healthy level of cash and/or receivables
and a low level trade payables, assuming most of them have been paid. Thus, the
position is reported at the moment when the company is at its most solvent. A
statement of financial position drawn up a few months earlier, or even perhaps a
few months later, when trade is still slack but fixed costs still have to be paid, may
give a very different picture.
e) Asset acquisitions:
Major asset acquisitions just before the end of an accounting period can also distort
results. The statement of financial position will show an increased level of assets and
corresponding liabilities (probably a loan or lease payable), but the income which
will be earned from utilisation of the asset will not yet have materialised. This will
adversely affect the company’s return on capital employed.
B. ACCOUNTING POLICIES:
a) The effect of choice of accounting policies:
Where accounting standard allow alternative treatment of items in the accounts,
then the accounting policy note should declare which policy has been chosen. It
should then be applied consistently.
b) Changes in accounting policy:
The accounting policy for any item in the accounts could only be changed once in
quite a long period of time. Auditors would not allow another change, even back to
the old policy, unless there was a wholly exceptional reason.
The managers of a company can choose accounting policies initially to suit the
company or the type of results they want to get. Any changes in accounting policy
must be justified, but some managers might try to change accounting policies just to
manipulate the results.
224
C. LIMITATION OF RATIO ANALYSIS:
The consideration of how accounting policies may be used to manipulate company results
leads us to some of the other limitations of ratio analysis.
225
LESSON 21. STATEMENT OF CASH FLOWS
LEARNING OUTCOMES:
1. IAS 7
1.1. Objective
1.2. Scope
1.3. Importance of Cash Flows
1.4. Benefits of Cash Flow Information
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1. IAS 7 – Statement of Cash Flows
1.1. Objective
1.2. Scope
• To conduct •
• To pay To provide
operations; returns to
obligations;
and investors.
(a) Not all profitable companies are (b) Profit or loss is based on the accruals
successful; many fail due to a lack of concept and also includes non-cash
cash. items (e.g. depreciation).
(c) A major function of SoCF is to inform (d) SoCF also helps to identify the
the users of accounts whether or not availability of cash to:
the reported profits are being realized • Pay dividends;
(e.g. that trade receivables are being • Finance further investment
covered). (which will generate more cash).
227
1.4. Benefits of Cash Flow Information
2.1. Classification
228
2.2. Examples
229
2.3. Operating activities
Cash flows from operating activities can be reported using direct method or indirect
method
230
2.3.1. Direct Method (familiar with F3)
Technique Formula
1. Cash receipts from customers. Cash receipts from customers
2. Deduct cash paid to suppliers and - Cash paid to suppliers
employees. - Cash paid to employees
Cash generated from operations Cash generated from operations
3. Payments for interest and income - Payments for interest
taxes. - Income taxes paid
Net cash from operating activities Net cash from operating activities
2.3.2. Indirect Method (easier from the point of view of the preparer of SoCF – IAS 7 focus
on Indirect Method)
Technique Formula
1. Start with profit before tax. Profit before tax
2. Adjust for non-cash items, investing + non-cash expenses/losses
items and financing items - non-cash income/gains
accounted for on the accruals basis
(e.g. interest).
Operating profit before working Operating profit before working
capital changes capital changes
3. Make working capital changes. + increases (decreases) in operating
liabilities (assets)
+ increases (decreases) in operating
assets (liabilities)
Cash generated from operations Cash generated from operations
231
2.4. Investing and Financing activities
232
3. Disclosure of some items
• As a financing CF;
• As a component of
CF from operating
activities.
3. Preparing of SoCF
4. Preparing a SoCF
4.1. Introduction
Note that the following items are treated in a way that might seem confusing, but the
treatment is logical if you think in terms of cash.
(a) Increase in inventory is treated as negative (in bracklets). This is because it represents a
cash outflow; cash is being spent on inventory.
(b) An increase in receivables would be treated as negative for the same reasons; more
receivables means less cash.
233
4.2. Example: preparation of a SoCF
Kane Co’s SoPL for the year ended 31/12/20X2 and SoFP at 31/12/20X1 and 31/12/20X2 were:
STATEMENT OF PROFIT OR LOSS FOR THE YEAR ENDED 31 DECEMBER 20X2
$’000 $’000
Revenue 720
Raw materials consumed 70
Staff costs 94
Depreciation 118
Loss on disposal of non-current asset 18
300
Operating profit 420
Interest payable 28
Profit before tax 392
Taxation 124
Profit for the year 268
234
Additional information
Required
Prepare a SoCF for Kane Co for the year ended 31/12/20X2 in accordance with the
requirements IAS 7, using the indirect method.
SOLUTION
Calculate the cash flows figures for purchase or sale of non-current assets,
STEP 3
issue of shares and repayment of loans if these are not given
KANE CO
STATEMENT OF CASH FLOWS FOR THE YEAR ENDED 31 DECEMBER 20X2
$’000 $’000
Cash flows from operating activities
Profits before tax 392
Depreciation charges 118
Loss on sale of tangible non-current assets 18
Interest expense 28
Increase in inventories (W4) (4)
Increase in trade receivables (W4) (18)
Increase in trade and other payables (W4) 6
Cash generated from operations 540
Interest paid (28)
Dividends paid (66)
Tax paid (108)
Net cash from operating activities 338
Cash flows from investing activities
Payments to acquire tangible non-current assets (90)
Receipts from sales of tangible non-current assets (W1) 12
Net cash used in financing activities (78)
Cash flows from financing activities
235
Issues of share capital 32
Long-term loans repaid (W3) (300)
Net cash used in financing activities (268)
Decrease in cash and cash equivalents (8)
Cash and cash equivalents at 1.1.X2 56
Cash and cash equivalents at 31.12.X2 48
Workings
1 – Assets
Non-current assets
$’000
B/d 1,336
Addition 90
Depreciation charge (118)
Disposal carrying amount (54 – 24) (30)
C/d 1,278
Disposal proceeds = (30 – 18) = 12
2 – Equity
Share Share Retained
capital premium earnings
$’00 $’00 $’000
0 0
B/d 340 24 514
Share issue 20 12
SPL 268
Dividends paid (per Q) - - (66)
360 36 716
3 – Liabilities
Long-term loans Taxation
$’000 $’000
B/d 500 86
SPL 124
Cash paid (300) (108)
C/d 200 102
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B/d 20 58 6
Increase (decrease) 4 18 6
C/d 24 76 12
5. Interpretation of SoCF
5.1. Introduction
Some of the main areas where SoCF should provide
Other relationship can be examined:
information not found elsewhere in the FSs are:
Equity
Share capital ($1 each) 6,000 6,000
Reverse:
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Revaluation (Note (ii)) nil 1,600
Retained earnings 2,550 850
2,550 2,450
8,550 8,450
Non-current liabilities
Lease obligations (Note (ii)) 2,000 1,700
6% loan notes 600 nil
10% loan notes nil 4,000
Deferred tax 200 500
Government grants (Note (ii)) 1,400 900
4,400 7,100
Current liabilities
During the year Tabba Co sold its factory for its fair value $12m. At the date of sale it had a
carrying value of $7.4m based on a previous revaluation to $8.6m less depreciation of $1.2m
since the revaluation. The profit on the sale of the factory has been included in operating
profit. The revaluation surplus related entirely to the factory. No other disposals of non-
current assets were made during the year.
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Plant acquired under leases during the year gave rise to right-of-use assets of $1.5m. Other
purchases of plant during the year qualified for government grants of $950,000.
Required
(a) Prepare a statement of cash flows using the indirect method for Tabba Co in
accordance with IAS 7 Statement of Cash Flows for the year ended 30 September
20X5
(b) Using the information in the question and your statement of cash flows, comment
on the change in the financial position of Tabba during the year ended 30
September 20X5.
SOLUTION
(a) TABBA CO: STATEMENT OF CASH FLOWS FOR THE YEAR ENDED 30 SEPTEMBER 20X5
$’000 $’000
Cash flows from operating activities
Profit before taxation 50
Adjustments for:
Depreciation (W1) 2,200
Profit on disposal of PPE (W1) (4,600)
Release of grant (W3) (250)
Increase in insurance claim receivable (1,500 – (300)
1,200)
Interest expense 260
Investment income (40)
(2,680)
(Increase) decrease in inventories (W4) (700)
(Increase) decrease in trade & other receivables (W4) (500)
Increase (decrease) in trade payables (W4) 1,100
Cash used in operations (2,780)
Interest paid (260)
Income taxes paid (W3) (1,350)
Net cash outflow from operating activities (4,390)
239
Net cash from investing activities 10,090
Cash flows from financing activities
Proceeds of loan (6% loan received) 800
Repayment of loan (10% loan repaid) (4,000)
Payments under leases (W3) (1,100)
Net cash used in financing activities (4,300)
Workings
2 Equity
Share Revaluation Retained
capital surplus earnings
B/d 6,000 850
Factory sale, surplus realised (1,600) 1,600
SPL - - 100
C/d 6,000 - 2,550
3 Liabilities
Government
Leases Grant Taxation
$’000 $’000 $’000
B/f – non-current 1,700 900 500
– current 800 400 1,200
New leases 1,500
Grant received 950
Profit or loss credit (50)
Cash paid/movement (ß) (1,100) (250) (1,350)
C/f (non-current + 2,900 2,000 300
current)
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In the case of the leases and tax the movement represents cash paid, in the case of the
government grant it represents grant amount released.
4 Working capital
changes
Inventories Trade Trade payables
receivables
$’000 $’000 $’000
b/d 1,850 2,600 2,950
Increase / (decrease) 700 500 1,100
c/d 2,550 3,100 4,050
To survive and thrive businesses must generate cash from their operations; but
Tabba Co has absorbed $2.68m. Whereas most companies report higher operating
cash inflows than profits, Tabba Co has reported the reverse. The only reason Tabba
Co was able to report a profit was because of the one-off $4.6m surplus on disposal.
There were two other items that inflated profits without generating cash; a $300,000
increase in the insurance claim receivable and a $250,000 release of a government
grant. Without these three items Tabba Co would have reported a $5.1m loss before
tax.
Were it not for the disposal proceeds Tabba Co would be reporting a $10.6m net
decrease in cash. Tabba Co has no other major assets to sell and so the coming year
will see a large outflow of cash unless Tabba Co’s trading position improves.
The high tax bill for the previous year suggests that Tabba Co’s fall from profitability
has been swift and sleep. Dispite this downturn in trade Tabba Co’s inventories and
receivables have increased, suggesting poor financial management. This in turn
damages cash flow, which is indicated by the increase in the level of payables.
There are some good signs though. Investment in non-current assets has continued,
although $1.5m of this was on leases which are often a sign of cash shortages. Some
of the disposal proceeds have been used to redeem the expensive $4m 10% loan and
replace it with a smaller and cheaper $800,000 6% loan. This will save $352,000 per
annum.
Tabba Co’s recovery may depend on whether the circumstances causing the slump in
profits and cash flow will either disappear of their own accord or whether Tabba Co
can learn to live with them. The SoCF has however highlighted some serious issues
for the shareholders to discuss with the directors at the annual general meeting.
241
Exam focus point
A SoCF is very likely to come up in your exam, in one of the long questions, or at least in a
couple of MCQs. In this chapter we give you the basics, but you should also do as many as
possible of the SoCF questions in the Practice and Revision Kit. These will give you
practice at the various items that you may have to deal with in a cash flow question
242
LESSON 22: ACCOUNTING FOR INFLATION
I. Historical cost accounting and current value accounting
1. Historical cost
1.1 Definition
A historical cost is a measure of value used in accounting in which the value of an asset on
the balance sheet is recorded at its original cost when acquired by the company.
1.2 Advantages and disadvantages of historical cost accounting
Advantages of historical cost accounting Disadvantages of historical cost accounting
IFRS now allows entities to revalue non-current assets (land, building...) in line with market
value and financial assets and liabilities (securities and investments) can be carried at fair
value.
Under current value accounting, the original cost of an asset would be replaced with its
discounted present value of inflows and outflows using an interest rate. This is obviously
suitable for monetary items such as receivables and payables.
Investment analysts have argued that historical cost information is out of date and not
relevant and that fair value information, where based on active market prices, is the best
available measure of future cashflows which an asset can be expected to generate. Two
alternative systems are current purchasing power (CPP) and current cost accounting (CCA).
II. Concepts of capital and capital maintenance
Capital: Under a financial concept of capital (invested money or purchasing power), capital
is net assets or equity of the equity. Under a physical concept of capital, such as operating
capability, capital is the productive capacity of the entity based on, for example, units of
output per day.
243
Profit: The residual amount that remains after expense (including capital maintenance
adjustments, where appropriate) have been deducted from income. Any amount over and
above that required to maintain the capital at the beginning of the period is profit.
The main difference between the two concepts of capital maintenance is the treatment of
the effects of changes in the prices of assets and liabilities of the entity
Profit is the increase in normal money Profit is the increase in the physical
capital over the period productive capacity over the period
Profit can be measured as the difference between how wealthy a company is at the
beginning and at the end of an accounting period during a period of rising prices.
▪ This wealth can be expressed in terms of the capital of a company as shown in its
opening and closing statements of financial position
▪ A business which maintains its capital unchanged during an accounting period can be
said to have broken even
▪ Once capital has been maintained, anything achieved in excess represents profit.
In conventional historical cost accounts, capital is simply the difference between assets and
liabilities.
III. Current purchasing power (CPP)
CPP accounting is a method for general (not specific) inflation. It does so by expressing asset
values in a stable monetary unit, the $ of current purchasing power.
Another way to tackle the problems of capital maintenance in times of rising prices is to look
at the unit of measurement in which accounting values are expressed.
For example:
If money values are stable, $1 at the start of the financial year has the same value as $1 at
the end of that year.
If prices are rising, $1 at the end of the year has less value (less purchasing power) than it
had one year previously.
244
2. Specific and general price changes
When prices are rising, it is likely that the current value of assets will also rise.
▪ The specific price inflation measures price changes over time for a specific asset or
group of assets.
▪ The general price inflation is the average rate of inflation which reduces the general
purchasing power of money.
CPP measures profits as the increase in the current purchasing power of equity. Profits are
therefore stated after allowing for the declining purchasing power of money due to price
inflation.
During a period of inflation, borrowers benefit at the expense of lenders. A sum borrowed
at the beginning of the year will cost less to repay at the end of the year (although lenders
will seek to allow for this in higher interest charges).
Monetary items (cash, receivables, payables) cannot be restated as their amount is fixed.
Nonmonetary items (non-current assets and inventories) are restated in line with the
general price index and the balancing figure is equity.
Advantages Disadvantages
245
IV. Current cost accounting (CCA)
The conceptual basis of CCA is that the value of assets consumed or sold, and the value of
assets in the statement of financial position, should be stated at their value to the business.
The deprival value of an asset is the loss which a business entity would suffer if it were
deprived of the use of the asset.
Value to the business or deprival value can be any of the following values:
▪ Replacement cost: in the case of non-current assets, replacement cost of an asset
would be its net replacement cost (NRC)
▪ Net realizable value (NRV): what the asset could be sold for, net of any disposal
costs
▪ Economic value (EV) or value in use: what the existing asset will be worth to the
company over the rest of its useful life.
Deprival value is the lower of:
▪ Net replacement cost (NRC)
▪ The higher of net realizable value and economic value
The deprival value of assets is reflected in the CCA statement of profit or loss:
▪ Depreciation: is charged on NCA on the basis of gross replacement cost of the asset
▪ Where NRV and EV is the deprival value, the charge against CCA profits will be the
loss in value of the asset.
▪ Goods sold are charged at their replacement cost.
246
3. The advantages and disadvantages of current cost accounting
Advantages Disadvantages
▪ Reducing the operating capability of ▪ It is impossible to make valuations of EV
the business by excluding holding gains and NRV without subjective
from profit. judgements.
▪ Guiding management in deciding ▪ There are several problems to be
whether to hold or sell assets after overcome in deciding how to provide
considering the opportunity cost of an estimate of replacement costs for
holding assets. NCA.
▪ It is relevant to the needs of ▪ It is arguable that the total assets will,
information users in therefore, have an aggregate value
− Assessing the stability and the which is not particularly meaningful.
vulnerable or the liquidity of the ▪ It can be argued that “deprival value” is
business an unrealistic concept.
− Evaluating the performance of
management in maintaining and
increasing the business substance.
− Judging future prospects.
▪ Being implemented fairly easily in
practice by making adjustments to the
historical cost accounting profits
247
LESSON 23: SPECIALIZED, NOT-FOR-PROFIT AND PUBLIC SECTOR ENTITIES
I. Primary aims
The accounting requirements for not-for-profit and public sector entities are moving closer
to those required for profit – making entities. However, they do have different goals and
purposes.
Some example about organization:
Some of the issues that arise in considering financial reporting by not-for-profit entities are:
▪ Insufficient emphasis on accountability/ stewardship.
▪ A need to broaden the definition of users and user groups.
▪ The emphasis on future cash flows is inappropriate to not-for-profit entities.
▪ Insufficient emphasis on budgeting.
2. Accountability/ stewardship
Not-for-profit entities are not reporting to shareholder, but it is very important that they
can account for funds received and show they have been spent.
248
Regulation of public not-for-profit entities, principally local and national governments and
governmental agencies, is by the International Public Sector Accounting Standards Board
(IPSAB).
The IPSAB is developing a set of International Public Sector Accounting Standards (IPSASs),
based on IFRSs, which includes:
1. Presentation of Financial Statements
2. Cashflow Statements
3. Net Surplus of Deficit for the Period, Fundamental Errors and Changes in Accounting
Policies
4. The Effect of Changes in Foreign Exchange Rates
5. Borrowing Costs
6. Consolidated Financial Statements and Accounting for Controlled Entities
7. Accounting for Investments in Associate
8. Financial Reporting of Interests in Joint Ventures
9. Revenue from Exchange Transactions
10. Financial Reporting in Hyperinflationary Economies
11. Construction Contracts
12. Inventories
13. Leases
14. Events After the Reporting Date
15. Financial instruments: Disclosure and Presentation
16. Investment Property
17. Property, Plant and Equipment
18. Segment Reporting
19. Provisions, Contingent Liabilities and Contingent Assets
20. Related Party Disclosures
21. Impairment of Non-Cash-Generating Assets
22. Disclosure of financial information about the central government
23. Revenue from non-exchange transactions
24. Presentation of budget information in the financial statements
25. Employee benefits
26. Impairment of cash-generating assets
27. Agriculture
28. Financial instrument (presentation)
29. Financial instrument (recognition and measurement)
30. Financial instruments (disclosure)
31. Intangible assets
32. Service concession arrangements
33. First time adoption of accrual basis IPSASs
249
2. Characteristics of Not-for-profit Entities
The capital Be acquired and held to deliver Be acquired and held to deliver
assets services without the intention of services without the intention of
earning a return on them. earning a return on them.
Not-for profit and public sector entities produce financial statements in the same way as
profit-making entities do but their performance cannot be measured simply by the bottom
line while they are expected to remain solvent.
They are not expected to have profit or underspend its budget. Because whenever they are
underspent its budget, next year’s allocation will be correspondingly reduced. This leads to a
rash of digging up or other expenditure just before year end in order to spend the
remaining funds.
The government will lay down the performance of those entities on economy, efficiency and
effectiveness. It will be based on Key Performance Indicators (KPIs).
250
For example:
▪ Number of homeless people rehoused
▪ % of rubbish collections made on time
▪ Number of children in care adopted
Public sector entities use the services of outside contractors for a variety of functions. Then
they have to be able to show that they have obtained the best possible value for what they
have spent on outside services. This principle is usually referred to as Value For Money
(VFM). In UK, this system is called Best Value.
251
LESSON 24: FOREIGN CURRENCY
Initial treatment
Settled transactions
Unsettled transactions
Asset and Monetary items: items that can be easily converted into cash, e.g. receivables, payables, loans.
liabilities
Non-monetary items: items that give no right to receive or deliver cash, e.g. inventory, plant and machinery.
Entity can
choose it Presentation currency: 'the currency in which the financial statements are presented'
Currency
Functional currency: 'the currency of the primary economic environment in which an entity operates'
Entity needs to
determine it
253
2. Translating transactions
Mechanics of translation
Non-monetary Items:
254
• Cost model
Non-monetary items that are
held at cost are initially
translated at the historic rate
and carried forward at this
value. They are not
retranslated.
EXAMPLE
1. On 1 April 20X8 Collins Co, a company that uses the dollar ($) as Initial transaction
its Translate at historic rate on 1 April, Kr54,000/1.8 = $30,000
functional currency, buys goods from an overseas supplier, who uses Dr Purchases $30,000
Kromits (Kr) as its functional currency. The goods are priced at Cr Payables $30,000
Kr54,000.
Payment is made 2 months later on 31 May 20X8. On settlement
The prevailing exchange rates are: Translate at historic rate on 31 May, Kr54,000/1.75 = $30,857
1 April 20X8 Kr1.80 : $1 Dr Payables $30,000
31 May 20X8 Kr1.75 : $1 Dr SPL – foreign exchange loss $857
Cr Cash $30,857
Required:
Record the journal entries for these transactions.
255
Initial transaction
2. On 1 April 20X8 Collins Co, a company that uses the dollar ($) as Translate at historic rate on 1 April, Kr54,000/1.8 = $30,000
its Dr Purchases $30,000
functional currency, buys goods from an overseas supplier, who uses Cr Payables $30,000
Kromits (Kr) as its functional currency. The goods are priced at
Kr54,000. Payment is still outstanding at the reporting date of 30 At the reporting date
June Payables are monetary items, so retranslate at the closing rate
20X8. on
The prevailing exchange rates are: 30 June, Kr54,000/1.70 = $31,765
1 April 20X8 Kr1.80 : $1 Dr SPL $1,765 ($31,765 – $30,000)
30 June 20X8 Kr1.70 : $1 Cr Payables $1,765
3. ABC Co has a year end of 31 December 20X1 and uses the dollar (a) Original transaction
($) as 25 October 20X1 Value = 286,000/11.16 = $25,627
its functional currency. Dr Purchases 25,627
On 25 October 20X1 ABC Co buys goods from a Swedish supplier for Cr Payables 25,627
Swedish Krona (SWK) 286,000. 16 November 20X1 Payment 286,000/10.87 = $26,311
Rates of exchange: Dr Payables 25,627
25 October 20X1 $1 = SWK 11.16 Dr SPL 684 (Balancing figure, 26,311 – 25,627)
16 November 20X1 $1 = SWK 10.87 Cr Cash 26,311
31 December 20X1 $1 = SWK 11.02
Required: (b) If the amount remains outstanding:
Show the accounting treatment for the above transactions if: 31 December 20X1 Retranslate payable 286,000/11.02 = $25,953
(a) A payment of SWK286,000 is made on 16 November 20X1. Dr SPL 326 (25,953 – 25,627)
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(b) The amount owed remains outstanding at the year-end date. Cr Payables 326
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supplier. The exchange rate at the year-end was 1Kr/$0.92. For tutorial purposes the journal entry would be as follows: Loss
Which THREE of the following amounts would be recorded in the on
financial statements at year end? translation = $307,692 – $266,667= $41,025
A Property, plant and equipment $85,000 Cr Receivables 41,025
B Trade payable $85,000 Dr SPL 41,025
C Foreign exchange loss $7,000
D Property, plant and equipment $92,000 7. $307,692. At the reporting date:
E Trade payable $92,000
F Foreign exchange loss $Nil No adjustment will be made at year-end to the inventory
because
inventory is a non-monetary item.
Purchase:
Translate the sale at the spot rate prevailing on the transaction
date.
Kr200,000/0.65 = $307,692 (Dr Purchases, Cr Payables)
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8. A, C, E
At acquisition:
Kr100,000 × 0.85 = $85,000
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