F7 Lecture

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The document covers various topics related to accounting standards and preparation of financial statements.

The main topics covered include conceptual framework, regulatory framework, accounting for different types of transactions and items, preparation and analysis of financial statements.

Some of the key lessons discussed are tangible and intangible assets, impairment of assets, revenue recognition, groups and consolidated financial statements, investments in associates, financial instruments and leasing.

A.

CONCEPTUAL AND REGULATORY FRAMEWORK FOR FINANCIAL


STATEMENTS

B. ACCOUNTING FOR TRANSACTIONS IN C. PREPARATION OF FINANCIAL STATEMENTS D. ANALYSIS AND INTERPRETATION OF


FS FINANCIAL STATEMENTS
• Presentation of published financial
• Tangible non-current assets statements • Calculation and interpretation of
• Intangible non-current assets • Accounting policies, changes in accounting ratios and trends
• Impairment of assets accounting estimates and errors • Limitation of financial statements
• Non-current assets held-for-sale and • Events after the reporting period and interpretation techniques
discontinued operation • Accounting for groups
• Inventories and biological assets • Consolidated statement of financial
• Government grants position
• Provisions • Consolidated statement of profit or
• Revenue loss and other comprehensive income
• Taxation • Accounting for associates
• Leasing • Statement of cash flows
• Financial instruments E. SUPPORTING SECTIONS
• Foreign currency transactions • Accounting for inflation
• Specialized, not-for-profit and
public sector entities

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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:

A. The conceptual framework

I. Conceptual framework
1. Conceptual framework and GAAP

a. Advantages and disadvantages of conceptual framework

b. GAAP

2. Purpose and status


a. Scope of conceptual framework

b. Users and their information needs

B. Financial reporting

1. The objective of general-purpose financial reporting


2. Underlying assumption: Going concern
3. Qualitative characteristics of useful financial information: Relevance, Faithful
representation
4. Enhancing qualitative characteristics: Comparability, Verifiability, Timeliness,
Understandability

5. Financial statements (FS)

a. The elements of FS
- Financial position: Asset, Liability, Equity

- Performance: Income, Expense

b. Recognition of the elements of FS


c. Measurement of the elements of FS

6. Fair presentation and compliance with IFRS

3
A. THE CONCEPTUAL FRAMEWORK

I. Conceptual framework

A conceptual framework: is a statement of generally accepted theoretical principles which


form the frame of reference for financial reporting.

1. Conceptual framework and GAAP

a. Advantages and disadvantages of conceptual framework

CONCEPTUAL
FRAMEWORK (CF)

ADVANTAGES DISADVANTAGES

1. Assist preparers, 2. Help reduce:


auditors and users of 3. Financial 2. The framework
1. FSs are
FSs to understand: - the influence of statements (FSs) is not complete.
intended for a
personal bias on are:
variety of users,
- the approach to standard-setting
standard setting; - internally and it is not
decisions;
consistent; certain that a
- the nature and - political pressures single CF can suit
function of the in making - more consistent all the users.
financial information accounting with each other.
reported. judgments.

b. Generally Accepted Accounting Practice (GAAP)


▪ GAAP:
o is a general term for a set of financial accounting standards and reporting
guidelines used to prepare accounts in a given environment;
o e.g. US GAAP: adopted by the Securities and Exchange Commission (SEC) in the U.S.
▪ GAAP is used by organizations to:
o Properly organize their financial information into accounting records;
o Summarize the accounting records into financial statements; and
o Disclose certain supporting information.
▪ GAAP vs. IFRS (International Financial Reporting Standards)

4
GAAP IFRS

GAAP is used primarily by IFRS (International Financial


businesses reporting their Reporting Standards), is the
financial results in the US. accounting framework used in
most other countries.

GAAP is much more rules-based IFRS focuses more on general


than IFRS. principles than GAAP.

Since IFRS is still being IFRS body of work much smaller,


constructed, GAAP is considered cleaner, and easier to
to be the more comprehensive. understand than GAAP.

2. Purpose and status


a. Scope of conceptual framework
▪ The Conceptual framework deals with:
o Objective of FSs.
o Underlying assumption.
o Qualitative characteristics of useful information.
o Definition, recognition and measurement of the elements in FSs.
o Concepts of capital and capital maintenance.

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b. Users and their information needs

USERS THEIR INFORMATION NEEDS

Investors and their ▪ Risk and return of investment


advisers

▪ Stability and profitability of employers.


Employees and their ▪ Ability to provide remuneration, retirement
representatives benefits and employment opportunities.

Lenders ▪ Whether loans and interest will be paid when


due.

Suppliers and other ▪ Whether amounts owing will be paid when


trade creditors due.

Customers
▪ Continuance

▪ Allocation of resources and, therefore,


Governments and activities of entities.
their agencies

▪ Contribution to the local economy, including


Public the number of employees and the patronage
II. Financial reporting of local suppliers.

B. FINANCIAL REPORTING
1. The objective of general-purpose financial reporting

OBJECTIVE

▪ To show the results ▪ To provide information of a


of management’s reporting entity that is useful to a
stewardship wide range of users in making
economic decisions.

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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

RELEVANCE FAITHFUL REPRESENTATION


This quality concerns the decision-making needs of Useful information must represent faithfully what
users. Relevance help users: it purports to represent (or could be reasonably
expected to represent).
▪ To evaluate past, present or future events;
▪ To confirm or correct their past evaluations. Three characteristics of faithful representation:
Relevance of information is affected by:

Its nature Materiality Neutrality Completeness Accuracy

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

Comparability Verifiability Timeliness Understandability

- Comparable - Financial information Information needs to Financial information


information enables is supported by be available in time for needs to be
comparisons within evidence and; users to make comprehensible to
the entity and across decisions. users.
- can check to see
entities.
whether such
information is
faithfully represented.

5. Financial statements (FS)


a. The elements of FS

Elements of FSs

FINANCIAL POSITION PERFORMANCE

FINANCIAL POSITION

ASSET LIABILITY EQUITY


- A resource controlled by the - A present obligation of the entity; - The residual interest;
entity;
- arising from past events; - in the assets of the entity;
- as a result of past event;
- settlement of which is expected to - after deducting all its liabilities.
- from which future economic result in an outflow of resources
benefits are expected to flow. embodying economic benefits.

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PERFORMANCE

INCOME EXPENSES

- Increases in economic benefits during - Decreases in economic benefits during


the accounting period; the accounting period;

- in the form of inflows (or - in the form of outflows (or depletions) of


enhancements) of assets or decreases of assets or incurrences of liabilities;
liabilities;
- which result in decreases in equity;
- which result in increases in equity;
- other than those relating to distributions
other than those relating to contributions to equity participants.
to equity participants.

b. Recognition of the elements of FS

RECOGNITION

Definition Recognition criteria


- The process of incorporating in the SoFP or SoPL o Items are recognized when it is probable
an item that meets the definition of an element that any future economic benefit associated
and satisfies the criteria for recognition. with the item will flow to or from the entity;
- One factor to consider in assessing whether an and
item meets a definition of an element is “substance o The item has a cost or value that can be
over form”. measured with reliability.

ITEMS Recognized in WHEN

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.

It is probable that an outflow of resources embodying economic benefits


LIABILITY SoFP will result from the settlement of a present obligation and the amount at
which the settlement will take place can be measured reliably.

INCOME SoFL An increase in future economic benefits related to an increase in an asset


or a decrease of a liability has arisen that can be measured reliably.

EXPENSE SoFL A decrease in future economic benefits related to a decrease in an asset


or an increase of a liability has arisen 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

Measurement bases Assets are recorded/carried at Liabilities are


recorded/carried at

The amount paid (or the fair


value of the consideration given) The amount received in exchange
Historical cost
to acquire them at the time of for the obligation.
their acquisition.

The amount which would have The undiscounted amount which


Current cost to be paid if the same or an would be required to settle the
equivalent asset were acquired obligation currently.
currently.

The amount which could


Realizable At settlement values.
currently be obtained by selling
(Settlement)
the asset in an orderly disposal.
value

Present discounted value of the Present discounted value of the


future net cash inflows (NCI) future net cash outflows (NCO)
Present value which the item is expected to which are expected to be
generate in the normal course required to settle the liabilities in
of business. the normal course of business.

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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.

* Cumulative present of $1 per annum for 8 years discounted at 10%.

6. Fair presentation and compliance with IFRSs


▪ FSs should “present fairly”:
o financial position;
o financial performance; and
o cash flows.
▪ Achieved by appropriate application of IFRSs (and any necessary additional
disclosures).
▪ Inappropriate accounting treatments are not rectified by;
o disclosure of accounting polices used; or
o notes or explanatory material.

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LESSON 2: THE REGULATORY FRAMEWORK

LEARNING OUTCOME:

I. The need for a regulatory framework

1. Principles-based vs. rules-based systems


2. IFRS: advantages and disadvantages

II. Setting of International Financial Reporting Standards (IFRS)

1. Co-ordination with national standard setters

2. Current IFRS/IAS

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I. The need for a regulatory framework

1. Principles-based vs. rules-based systems

Principles-based accounting system Rules-based accounting system

▪ It relies on GAAP that are conceptually


▪ Likely to be very descriptive.
based and are normally underpinned by a
▪ Relies on a series of detailed rules or
set of key objectives.
accounting requirements that prescribe
▪ More flexible than a rules-based system.
how FSs should be prepared.
▪ Require judgement and interpretation
▪ Considered less flexible, but often more
which could lead to inconsistencies
comparable and consistent, than a
between reporting entities and can
principles-based system.
sometimes lead to the manipulation of
▪ Can lead to looking for ‘loopholes’.
FSs.

✓ Because IFRSs are based on The Conceptual Framework for Financial Reporting, they are
often regarded as being a principles-based system.

2. IFRS: advantages and disadvantages

IFRS

Advantages Disadvantages

▪ One international model for all.


▪ Improved quality and credibility ▪ Cost to convert from local GAAP.
provides access to global funds. ▪ Reluctance to change.
▪ Reduces training costs; accountants ▪ May be a requirement for both
only need to learn one model. statutory and IFRS accounts.
▪ Recognized globally. ▪ Perception of difficulty.

II. Setting of International Financial Reporting Standards (IFRS)

1. Co-ordination with national standard setters

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The IASB benefits from working NSS benefit by:
with NSS through their:

• knowledge of local financial reporting • influencing the development of


and legal requirements; global accounting standards;
• relationships with key stakeholders; • representing their stakeholders to
the IASB and in the international
• experience in standard-setting and
debate;
technical accounting capabilities; and
• sharing information and ideas with
• role in the endorsement of new
other NSS.
Standards.

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

* These standards are not examinable at Financial Reporting.


** Associates are examinable at Financial Reporting; joint ventures are not.
3. Criticisms of the IASB

a. Accounting standards and choice


It is sometimes argued that companies should be given a choice in matters of financial
reporting on the grounds that accounting standards are detrimental to the quality of such
reporting. There are arguments on both sides:
In favor of accounting standards (both national and international), the following points can be
made.
o They reduce or eliminate confusing variations in the methods used to prepare
accounts.
o They provide a focal point for debate and discussions about accounting practice.

15
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

INVESTMENT TANGIBLE NON-


PROPERTIES CURRENT ASSETS
(IAS 40)

MEASUREMENT
(IAS 16)

DEPRECIATION REVALUATION BORROWING GOVERNMENT


(IAS 16) (IAS 16) COSTS (IAS 23) GRANTS (IAS 20)

CHANGE IN ACCOUNTING FOR


METHOD REVALUATION REVENUE
GRANTS
CHANGE IN DEPRECIATION
ESTIMATES OF REVALUED
ASSET
CAPITAL
COMPONENTS GRANTS
AND OVERHAUL DISPOSAL OF
COSTS REVALUED
ASSET 17
1 – IAS 16 Property, plant and equipment

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

Is the amount of cash or cash equivalents


paid or the fair value of the other
Cost
consideration given to acquire an asset at
the time of its acquisition or construction.
Is the net amount which the entity
expects to obtain for an asset at the
Residual value
end of its useful life after deducting
the expected costs of disposal.
Measurement-date price received to sell
and asset, or paid to transfer a liability, in Fair value
an orderly transaction between market
participants. (IFRS 13) Is the amount at which an asset is
recognised in the SoFP after deducting
Carrying amount
any accumulated depreciation and
accumulated impairment losses.
Is the amount by which the carrying
amount of an asset exceeds its Impairment loss
recoverable amount.

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Accounting for property, plant and equipment

1. Scope Biological assets (IAS 41), apart from bearer


Except
biological assets
Mineral rights and mineral reserves (IFRS 6)

Initial costs Capitalise all costs to bring an asset to its present location and condition for its intented use

2. Recognition Future economic benefit Indirectly future economic benefit


Capitalise if
Subsequent costs
IAS 16 - PPE Cost reliably measurable Eg. PPE necessary for environmental & safety
reasons

Eg. Major inspections, overhauling, replacement of parts

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

Purchase price Initial estimate


Directly Borrowing
Initial measurement less any trade of dismantling,
COST attributable costs (IAS
at cost discount or removing,
costs 23)
rebate restoring costs
3. Measurement

Cost model COST Accumulated depreciation Accumulated impairment loss

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.

20 if the examiner indicates that it is company policy to make a transfer


NOTE: 1. Be careful, in the exam a reserves transfer is only required Double entry:
to realised profits in respect of excess depreciation on revalued assets. If this is not the case then a reserves transfer is not necessary. • Dr Revaluation reserve
2. This movement in reserves should also be disclosed in the statement of changes in equity. • Cr Retained earnings
* Accounting for Revaluation - The initial revaluation
Carrying amount of NCA at revaluation date X
Valuation of NCA X
Difference = Gain or loss revaluation X
Revaluation gains
A gain on revaluation is always recognised in equity, under a revaluation Revaluation losses
reserve (unless the gain reverse’s revaluation losses on the same asset that A revaluation loss should be charged against any related revaluation surplus
were previously recognised in the income statement – in this instance the to the extent that the decrease does not exceed the amount held in the
gain is to be shown in the income statement). The revaluation gain is known revaluation surplus in respect of the same asset. Any additional loss must be
as an unrealised gain which later becomes realised when the asset is charged as an expense in the statement of profit or loss.
disposed of (derecognised).
• Dr Revaluation reserve (to maximum of original gain)
Dr NCA cost (difference between valuation and original cost/valuation)
• Dr Income statement (any residual loss)
Dr Accumulated depreciation (with any historical cost accumulated • Cr Non-current asset (loss on revaluation)
depreciation)
NOTE: The revaluation gain or loss must be disclosed in both the statement
Cr Revaluation reserve (gain on revaluation) of changes in equity and in other comprehensive income.

✓ Exam focus: revaluation date


At the start of The revaluation should be accounted for Mid-way ▪ The carrying amount would need to be found at the date
the year immediately and depreciation should be through of revaluation.
charged in accordance with the rule above. the year ▪ The asset would be depreciated based on the original
At the year- The asset would be depreciated for a full 12 depreciation for the period up until revaluation.
end months first based on the original ▪ The revaluation will take place and be accounted for.
depreciation of that asset. This will enable Once the asset has been revalued you will need to consider the
the carrying amount of the asset to be known last period of depreciation. This will be found based upon the
at the revaluation date, at which point the revaluation rules (depreciate the revalued amount over
revaluation can be accounted for. remaining useful life).

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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:

$ In addition to the beside information, Yucca Co was granted a trade discount of


List price of machine 82,000 10% on the initial list price of the asset and a settlement discount of 5% if
Import duty 1,500 payment for the machine was received within one month of purchase. Yucca Co
Delivery fees 2,050 paid for the plant on 25 March 20X0.
Electrical installation costs 9,500
How should the above information be accounted for in the financial statements?
Pre-production testing 4,900
Purchase of a five-year maintenance
7,000
contract with Plant

Example 2. Self-constructed asset


Constuction of Ham Co's new store began on 1 April 20X1. The following costs were incurred on the construction:

$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.

Example 3. Subsequent costs

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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.

Example 5. Useful life and residual value


A machine was purchased on 1 April 20X0 for $120,000. It was estimated that the asset had a residual value of $20,000 and a useful life of 10 years at this
date. On 1 April 20X2 (two years later) the residual value was reassessed as being only $15,000 and the useful life remaining was considered to be only five
years.
How should the asset be accounted for in the years ending 31 March 20X1/20X2/20X3?

Example 6. Component depreciation


A company purchased a property with an overall cost of $100m on 1 April 20X1. The property elements are made up as follows:
$000 Estimated life
Land and buildings (Land element $20,000) 65,000 50 years
Fixtures and fittings 24,000 10 years
Lifts 11,000 20 years
100,000

Calculate the annual depreciation charge for the property for the year ended 31 March 20X2.

24
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?

Example 8. Revaluation loss

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?

Example 9. Depreciation after revaluation & Reserves transfer

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?

25
✓ 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?

✓ Exam focus: Example 11. Revaluation date 02

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?

26
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

Sale in ordinary course of business IAS 2

Initial Cost model (IAS 16) –


measurement includes transaction costs
IP is re-measured to FV (IFRS 13)
Recognition &
Dr P/L: Loss from FV change
measurement
Fair value model (differ Gain/loss from re-measurement => P&L
Subsequent from revaluation model Cr Investment property
measurement in IAS 16) No depreciation charged

If unable to measure FV reliably

Cost model (IAS 16) – Is IP under construction?


If classified as held for sale (or includes transaction NO YES At cost
disposal group) => IFRS 5 costs

Transfers Only when there is a change in use

27
On disposal

Gain or loss = Net disposal proceeds – Carrying amount => P&L


Derecognition
When permanently
withdrawn from use

3 – IAS 23 Borrowing costs

Effective interest (IFRS 9)

Interest and other costs


Definition incurred in connection with the Finance costs in respect of leases (IFRS 16)
borrowing of funds. Inculde:
Exchange differences on foreign currency borrowings (IAS 21)

Dividends on preference shares classified as debt

Recognition All borrowing costs that relate to a qualifying asset must be capitalised

All borrowing costs will be expensed when incurred

28
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.

Presentation Presented as a credit in the statement of profit or loss, or

Deducted from the related expense.

Capital grants Treatment Write off against the cost of the non-current asset and depreciate the reduced cost.

Treat as a deferred credit and transfer a portion to revenue each year,


so offsetting the higher depreciation charge on the original 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.
29
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.

30
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:

$ The maintenance contract of $7,000 is an expense and therefore should


List price of machine 82,000 be spread over a five-year period in accordance with the accruals
Less: trade discount (10%) 8,200 concept and taken to the income statement. If the $7,000 has been paid
73,800 in full, then some of this cost will represent a prepayment.
Import duty 1,500
Delivery fees 2,050 In addition the settlement discount received of $3,690 ($73,800 x 5%) is
Electrical installation costs 9,500 to be shown as other income in the income statement.
Pre-production testing 4,900
Total amount to be capitalised at 1 March 91,750

ANSWER 2. Self-constructed asset


All costs to get the store to its present location and condition for its intended use should be capitalised. All of the expenditure listed in the
question, with the exception of general overheads would qualify for capitalisation.
The interest on the loan should also be capitalised frm 1 April 2009 as in accordance with IAS 23 it meets the definition of a qualifying asset.
The recognition criteria for capitalisation appears to be met ie activities to prepare the asset for its intended use are in progress, expenditure
for the asset is being incurred and borrowing costs are being incurred. Capitalisation of the interest on the loan must ce ase when the asset is
ready for use, ie 1 January 2010. At this point any remaining interest for the period should be charged as a finance cost in P&L.

31
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

Income Statement impact


With regards to the income statement this should be charged with:
▪ General overheads of $940,000
▪ Remaining interest for Jan-Mar which is now an expense $500,000 (25,000 x 8% x 3/12) and;
▪ Depreciation of the store. (Even thought the asset has not yet been brought into use, IAS 16 states depreciation of an asset begins
when it is available for use, ie when it is in the location and condition necessary for it to be capable of operating in the manne r
intended be management.)
Note: Depreciation cannot be calculated in this question as information surrounding useful economic life has not been provided.

ANSWER 3. Subsequent costs


The $18,000 should be capotalised as part of the cost of the asset as the revenue earning capacity of the machine has signifi cantly increased,
which could in turn lead to the inflow of additional economic benefit and the cost of the upgrade can be reliably measured.

32
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

Statement of financial position extract 31/03/10 Carrying value 150,000


Plant (200,000 – 50,000 – 37,500) Depreciation – 25% (37,500)
$112,500 Carrying value 112,500

ANSWER 5. Useful life and residual value

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:

𝐶𝑜𝑠𝑡 − 𝑟𝑒𝑠𝑖𝑑𝑢𝑎𝑙 𝑣𝑎𝑙𝑢𝑒 120,000 − 20,000


= = $10,000 𝑝𝑒𝑟 𝑎𝑛𝑛𝑢𝑚
𝑈𝑠𝑒𝑓𝑢𝑙 𝑒𝑐𝑜𝑛𝑜𝑚𝑖𝑐 𝑙𝑖𝑓𝑒 10 𝑦𝑒𝑎𝑟𝑠

Income statement extract 2008


Depreciation $10,000
Statement of financial position extract 2008
Machine (120,000 – 10,000) $110,000

31 March 2009
Income statement extract 2009
Depreciation $10,000

33
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:

𝐶𝑜𝑠𝑡 − 𝑟𝑒𝑠𝑖𝑑𝑢𝑎𝑙 𝑣𝑎𝑙𝑢𝑒 100,000 − 15,000


= = $17,000 𝑝𝑒𝑟 𝑎𝑛𝑛𝑢𝑚
𝑈𝑠𝑒𝑓𝑢𝑙 𝑒𝑐𝑜𝑛𝑜𝑚𝑖𝑐 𝑙𝑖𝑓𝑒 5 𝑦𝑒𝑎𝑟𝑠
Income statement extract 2008
Depreciation $17,000
Statement of financial position extract 2008
Machine (100,000 – 17,000) $83,000

ANSWER 6. Component depreciation


$000
Land and buildings
900
(65,000 – 20,000)/50 years
Fixtures and fittings
2,400
(24,000/10 years)
Lifts
550
(11,000/20 years)
Total property depreciation 3,850

34
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

ANSWER 8. Revaluation loss


Loss on revaluation: Double entry:
Carrying value of NCA at revaluation date: 108,000 Dr Revaluation reserve 10,000
(to maximum of original gain)
Valuation: 95,000 Dr Income statement 3,000
Loss on revaluation: 13,000 Cr NCA 13,000

ANSWER 9. Depreciation after revaluation & Reserves transfer


Statement of comprehensive income extract for the year ended 31
Statement of changes in equity extracts
March 2010
$000 Revaluation Retained
Depreciation expense 400 reserve earnings
Other comprehensive income: $000 $000
Revaluation gain 12,000 Revaluation gain 12,000
Reserves transfer (200) 200
Statement of financial position extract as at 31 March 2010

35
$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

Depreciation charge for year to 31 March 2010: Reserves transfer:


Dr depreciation expense ((20,000 – 8,000)/30 years) 400 Historical cost depreciation charge 200
((10,000 – 2,000)/40 years)
Cr Accumulated depreciation 400 Revaluation depreciation charge 400
Excess depreciation to be transferred 200

Dr Revaluation reserve 200


Cr Retained earnings 200

36
✓ 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

37
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.

Other comprehensive income: (W1) Depreciation 1 April–30 September 2009


Revaluation gain 620,000 2,000,000
𝑥 6 / 12 = $20,000
50 𝑦𝑒𝑎𝑟𝑠

Statement of financial position extract 31 March 2010 (W2) Revaluation


Office block (carrying value at 31 March): The carrying value of the asset at 1 October 2009 can now be found and revalued.
Valuation 2,200,000
Depreciation (27,500) Carrying value of non-current asset at revaluation date
1,580,000
(2,000,000 – (400,000 – 20,000))
Carrying value 2,172,500 Valuation of non-current asset 2,200,000
Gain on revaluation 620,000
Statement of changes in equity extract
Revaluation
Double entry:
reserve
Revaluation gain 620,000 Dr NCA cost (2,200,000 – 2,000,000) 200,000
Dr Accumulated depreciation 420,000
Cr Revaluation reserve 620,000

(W3) Depreciation 1 October – 31 March 2010


2,200,000
𝑥 6 / 12 = $27,500
40 𝑦𝑒𝑎𝑟𝑠

38
LESSON 4: INTANGIBLE ASSETS

I. IAS 38 and recognition of Intangible assets


1. IAS 38 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?

• A legally enforceable right is usually (not always) evidence of such control


Controlled by the entity as a result NOTE • Control over technical knowledge or know-how only exists if it is protected by a legal right.
Definition of events in the past • The skill of employees, arising out of the benefits of training costs, are most unlikely to be
recognisable as an intangible asset, because an entity does not control the future actions of its staff.
• Market share and customer loyalty cannot normally be intangible assets, since an entity cannot
Something from which the entity expects control the actions of its customers
future economic benefits to flow

Recognized if satisfy both 2 conditions


• It is probable that the future economic benefits that are attributable to the asset will flow to the entity
Initial measure • The cost can be measured reliably

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
39
• = 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)

40
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.

41
• 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

• The design, construction and testing of pre-production or pre-use


prototypes and models
• The design of tools, jigs, moulds and dies involving new
technology
Example • The design, construction and operation of a pilot plant that is not
of a scale economically feasible for commercial production
• The design, construction and testing of a chosen alternative for
new or improved materials devices, products, processes, systems
or services

Development • The technical feasibility of completing the intangible asset so


that it will be available for use or sale
• Its intention to complete the intangible asset and use or sell it
• Its ability to use or sell the intangible asset
• How the intangible asset will generate probable future economic
benefits. Among other things, the
Treatment
entity should demonstrate the existence of a market for the
output of the intangible asset or the
intangible asset itself or, if it is to be used internally, the
usefulness of the intangible asset
• Its ability to measure the expenditure attributable to the
intangible asset during its development reliably

NOTE:

Conditions for capitalzing development:

1. Probable future economic benefits,


2. Intention to complete and use or sell the asset,
3. Resources adequate and available to complete and use or sell the asset,
4. Ability to use or sell the asset,
5. Technical feasibility,
6. Expenditures can be reliably measured.

42
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.

43
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.

Two methods of valuation:

• 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.

D. $60,000 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?

A. purchased brand name

B. training of staff
C. internally generated brand

D. licences and quotas

3. Sam Co has provided the following information as at 31 December 20X6:


(i) Project A – $50,000 has been spent on the research phase of this project during the
year.
(ii) Project B – $80,000 had been spent on this project in the previous year and $20,000
this year. The project was capitalised in the previous year however, it has been decided
to abandon this project at the end of the year.
(iii) Project C – $100,000 was spent on this project this year. The project meets the
criteria of IAS 38 and is to be capitalised.
Which of the following adjustments will be made in the financial statements as at 31
December 20X6?

A. Reduce profit by $70,000 and increase non-current assets by $100,000

45
B. Reduce profit by $150,000 and increase non-current assets by $100,000

C. Reduce profit by $130,000 and increase non-current assets by $180,000


D. Reduce profit by $130,000 and increase non-current assets by $100,000

4 Which of the following statements concerning the accounting treatment of research


and development expenditure are true, according to IAS 38 Intangible Assets?
(i) Research is original and planned investigation undertaken with the prospect of
gaining new knowledge and understanding.

(ii) Development is the application of research findings.


(iii) Depreciation of plant used specifically on developing a new product can be
capitalised as part of development costs.

(iv) Expenditure once treated as an expense cannot be reinstated as an asset.


A. (i), (ii) and (iii)

B. (i), (ii) and (iv)


C. (ii), (iii) and (iv)

D. All of the above

5. Which of the following should be included in a company’s statement of financial


position as an intangible asset under IAS 38 Intangible Assets?
A. Internally developed brands

B. Internally generated goodwill

C. Expenditure on completed research

D. Payments made on the successful registration of a patent.

6. During the year to 31 December 20X8 X Co incurred $200,000 of development costs


for a new product. In addition, X Co spent $60,000 on 1 January 20X8 on machinery
specifically used to help develop the new product and $40,000 on building the brand
identity. Commercial production is expected to start during 20X9. The machinery is
expected to last 4 years with no residual value.
What value should be included within Intangible Assets in respect of the above in X Co’s
Statement of Financial Position as at 31 December 20X8?

$ __________

46
7. Which TWO of the following criteria must be met before expenditure is capitalised
according to IAS 38 Intangible Assets?

A. the technical feasibility of completing the intangible asset


B. future revenue is expected

C. the intention to complete and use or sell the intangible asset

D. there is no need for reliable measurement of expenditure

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.

Therefore $350,000 can be capitalised as an intangible asset as development costs.


(iii) The training costs must be expensed in the statement of profit or loss. The
movement of staff cannot be controlled, and therefore
there is no way of restricting the economic benefits. If the staff leave, the company
receives no benefit.

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.

48
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.

8. Capitalize as Intangle: (i)


Expense: (ii), (iii), (iv)

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)

CGU: the smallest identifiable group of assets for which


independent cash flows can be identified and measured.

EXAMPLE FOR CASH-GENERATING UNIT


a. A mining company owns a private railway that it uses to transport output from one of
its mines. The railway now has no market value other than as scrap, and it is impossible
to identify any separate cash inflows with the use of the railway itself. Consequently,
if the mining company suspects an impairment in the value of the railway, it should
treat the mine as a whole as a cash generating unit and measure the recoverable
amount of the mine as a whole.
b. A bus company has an arrangement with a town's authorities to run a bus service on
four routes in the town. Separately identifiable assets are allocated to each of the bus
routes, and cash inflows and outflows can be attributed to each individual route. Three
routes are running at a profit and one is running at a loss. The bus company suspects
that there is an impairment of assets on the lossmaking route. However, the company
will be unable to close the loss-making route, because it is under an obligation to
operate all four routes, as part of its contract with the local authority. Consequently,
the company should treat all four bus routes together as a cash generating unit and
calculate the recoverable amount for the unit as a whole.

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

Internal indicators Evidence of obsolescence or physical damage


Adverse changes in the use to which the asset is put
Adverse changes in the asset's economic performance

When there is an indicator of impairment.


Indicators are assessed at each reporting date.

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

• The reversal of the impairment loss should be


recognised immediately as income in profit or loss for
HOW TO REVERSE
the year
IMPAIRMENT? • The carrying amount of the asset should be increased
51 to its new recoverable amount
3. MEASURING RECOVERABLE AMOUNT OF THE ASSET AND ACCOUNTING TREATMENT OF IMPAIRMENT LOSS
Impairment: Carrying amount > recoverable amount

Recoverable amount

higher

The asset’s fair value - cost of disposal Its value in use

Fair value (FV) Present value of the


future cash flows
• Active market: FV = market price/ price of the recent transactions in similar assets
expected to be derived
• No active market: estimate FV based on what market participants might pay in an from an
orderly transaction asset or cash-generating
Cost of disposal: eg legal expenses unit

First, to any assets that are obviously damaged or destroyed


Next, to the goodwill allocated to the CGU
the loss should be allocated between the Then to all other assets in the cash-generating unit, on a pro rata basis
assets in the unit in the following order

In allocating an impairment loss, the carrying amount of an asset should


not be reduced below the highest of: 52
• Its fair value less costs of disposal
• Its value in use (if determinable)
• Zero
Example 1: Impairment loss
• A company that extracts natural gas and oil has a drilling platform in the Caspian
Sea. It is required by legislation of the country concerned to remove and dismantle
the platform at the end of its useful life.
• Accordingly, the company has included an amount in its accounts for removal and
dismantling costs, and is depreciating this amount over the platform's expected life.
• The company is carrying out an exercise to establish whether there has been an
impairment of the platform.

(a) Its carrying amount in the statement of financial position is $3m.


The company has received an offer of $2.8m for the platform from another oil
(b) company. The bidder would take over the responsibility (and costs) for dismantling
and removing the platform at the end of its life.
The present value of the estimated cash flows from the platform's continued use is
(c)
$3.3m (before adjusting for dismantling costs).
The carrying amount in the statement of financial position for the provision for
(d) dismantling and
removal is currently $0.6m.

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.

Example 2: Impairment loss


A company has acquired another business for $4.5m: tangible assets are valued at $4.0m
and goodwill at $0.5m.
An asset with a carrying value of $1m is destroyed in a terrorist attack. The asset was not
insured. The loss of the asset, without insurance, has prompted the company to assess
whether there has been an impairment of assets in the acquired business and what the
amount of any such loss is.
The recoverable amount of the business (a single cash-generating unit) is measured as

53
$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.

Example 3: Recognition and measurement of an impairment loss


The impairment loss should be charged as an expense in profit or loss.

VIU FVLC RA CV Impairment


1 80 85 85 80 Nil
2 76 70 76 80 4
3 73 75 75 80 5

Example 4: Cash generating units


a. Definitions

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.

In identifying Minimart's cash-generating unit, an entity considers whether, for example:

• Internal management reporting is organised to measure performance on a store-by-


store basis.
• The business is run on a store-by-store profit basis or on a region/city basis.

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.

b. Accounting treatment for impairment test of CGU

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:

1. Assuming that CGU X’s recoverable amount is assessed at $81 million

Before impairment Allocation of After impairment


impairment loss
$m $m $m
Goodwill 5 5 Nil
Asset A 20 2 18
Asset B 30 3 = 9x20/90 27
Asset C 40 4 = 9x30/90 36
Carrying value 95 14 = 9x40/90 81

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.

Before impairment Allocation of After impairment


impairment loss
$m $m $m
Goodwill 5 5 Nil
Asset A 20 Nil 20
Asset B 30 3 = 7x30/70 27
Asset C 40 4 = 7x40/70 36
Carrying value 95 12 83

Dr Impairment loss 12
Cr Goodwill 5
Cr B 3
Cr C 4

55
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.

Before impairment Allocation of After impairment


impairment loss
$m $m $m
Goodwill 5 5 Nil
Asset A 20 1 19
Asset B 30 3 = 7x30/70 27
Asset C 40 4 = 7x40/70 36
Carrying value 95 13 82

Dr Impairment loss 13
Cr Goodwill 5
Cr A 1
Cr B 3
Cr C 4

56
LESSON 6: REVENUE – IFRS 15

1. Scope

IFRS 15 applies to all contracts


with customers except:

Leases within the Insurance contracts Financial instruments and Non-monetory


scope of IFRS 16 within the scope of other contractual rights exchanges between
IFRS 4 and obligations within the entities in the same
scope of IFRS 9, IFRS 10, line of business
IFRS 11, IAS 27 or IAS 28

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.

4. The 5 – step model for revenue recognition

STEP 1 Identify the contracts with the customers


✓ Contract must meet five criteria:
• Approved contract;
• Rights and obligations identified;
• Payment terms identified;
• Commercial substance; and
• Probable collection of consideration due.

STEP 2 Identify the separate performance obligations


✓ May require unbundling of a contract (mobile phone)

STEP 3 Determine the transaction price


✓ Ignore sales tax (VAT)
✓ Allow for time value of money, if relevant
✓ Include fair value of non-cash component
✓ Deduct consideration payable to customer

STEP 4 Allocate the transaction price to the performance obligations


✓ To all separate performance obligations in proportion to stand-alone
selling prices
✓ Estimate stand-alone price if not observable
STEP 5 Recognise revenue when (or as) a performance obligation is satisfied
✓ When performance obligation is satisfied by transfer to customer

59
• Normally when customer gains control;
• May be over time or at a point in time.

❖ Recognise revenue over time vs. at a point in time’

Licensing (of an entity’s


intellectual property (IP))

If the license is not If the license is


distinct from other distinct from other
goods or services goods or services
when or

It is an integral The customer can


component to the only benefit from
It is accounted for as
functionality of a the licence in a single performance
tangible good, or conjuntion with a obligation
related service

OVER TIME AT A POINT


IN TIME

It is accounted for together with If the criteria for recognition


other promised goods or services as If and only if:
over time are not met.
a single performance obligation (a) The entity (is reasonably
expected to) undertakes
activities that will
significantly affect the IP to ▪ The right is over the IP
which the customer has in its form and
rights functionality at the
(b) The customer’s rights to point at which the
the IP expose it to the licence is granted to
positive/negative effects or the customer.
the activities that the entity ▪ Revenue is recognised
undertakes in (a) at the point in time at
which control of the
(c) No goods or services are licence is transferred
transferred to customer as to the customer.
the entity undertakes
activities in (a)

60
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.

The 5 steps would be applied to this transaction as follows:

Step 1 – Identify the contract


There is an agreement between Wade and its customer for the provision of goods (the
computer) and services (the technical support).
Step 2 – Identify the separate performance obligations within a contract

There are two performance obligations within the contract:

• The supply of a computer


• The supply of technical support
Step 3 – Determine the transaction price

The total transaction price is $420.

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.

4.2. Example 2 – STEP 2 : Identifying the separate performance obligations


Office Solutions Co, a limited compay, has developed a communications software package
called CommSoft. Office Solutions Co has entered into a contract with Logisticity Co to
supply the following:

(a) Licence to use CommSoft


(b) Installation service. This may require an upgrade to the computer operating
system, but the software package does not need to be customised.
(c) Technical support for three years
(d) Three years of updates for Commsoft

61
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.

4.3. Example 3 – STEP 3 : Determining the transaction price


Taplop Co supplies laptop computers to large businesses. On 1 July 20X5, Taplop Co entered
into a contract with TrillCo, under which TrillCo was to purchase laptops at $500 per unit.
The contract states that if TrillCo purchases more than 500 laptops in a year, the price per
unit is reduced retrospectively to $450 per unit. Taplop’s year end is 30 June.

(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:

(a) Quarter ended 30 September 20X5


(b) Quarter ended 31 December 20X5
We need to apply the principles of IFRS 15 Revenue from contracts with customers.

Solution

62
(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.

Consequently, Taplop Co should recognise revenue of 70 x $500 = $35,000 for


the first quarter ended 30 September 20X5.

(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.

Taplop Co should therefore recognise revenue of $109,000 for the quarter


ended 31 December 20X5. The amount is calculated as from $112,500 (250
laptops x $450 ) less the change in transaction price of $3,500 (70 laptops x
$50 price reduction) for the reduction of the price of the laptops sold in the
quarter ended 30 September 20X5.

4.4. Example 4 – STEP 4 : Allocating the transaction price


A mobile phone company, Deltawave Co, gives customers a free handset when they sign a
two-year contract for provision of network services. The handset has a stand-alone price of
$100 and the contract is for $20 per month.
Prior to IFRS 15, Deltawave Co would recognise no revenue in relation to the handset and a
total of $240 per annum in relation to the contract.
Under IFRS 15, revenue must be allocated to the handset because delivery of the handset
constitutes a performance obligation. This will be calculated as follows:
$ %
Handset 100 17
Contract – two years 480 83
Total value 580 100

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

So application of IFRS 15 has moved revenue of $41 from Year 2 to Year 1.

5. Common types of transaction

Warranties Repurchase Bill-and-hold


agreements agreements

A right Principal Consignment


of return vs. agent arrangements

5.1. A right of return

A right to return as a right that


enables a customer to receive:

1. A full or partial 2. A credit that 3. A different 4. Any


refund of any can be applied product in combination of
consideration against other exchange, or the above.
paid amounts owed,
or that will be
owed, to the
vendor by the
customer

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.

64
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.

How should WatchCo recognise revenue in accordance with IFRS15?


SOLUTION:
Situation A: Revenue is recognised when the watches are delivered and a liability deducted
from revenue for expected returns.
Simultaneously, an asset is recognised for the watches expected to be returned, reducing
the cost of sales. Recognition occurs on transfer of control to the wholesaler.
The returns asset will be presented and assessed for impairment separately from the refund
liability. WatchCo will need to assess the returns asset for impairment, and adjust the value
of the asset if it is impaired.
Revenue: Sales price per unit × units (excluding those expected to be returned) €50 × 100*(1
− 0.06) watches = €4,700
Cost of sales: Cost × units (excluding those expected to be returned) €10 × 94 watches =
€940 Asset: Former carrying amount x units expected to be returned €10 × 6 watches = €60
Liability: Return ratio x units sold x sales price per unit 6% x 100 watches × €50 = €300 for
the refund obligation.

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.

The right of return is accounted for in the same manner as in situation A.

5.2. Warrenties

Does it has “A separate


performance obligation”?
NO YES

Assurance type Service type


(apply IAS 37) (IFRS 15)

EXAMPLE – Assurance type warranties

65
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

66
Practical implications on systems and processes
Some of the practical implications on systems and processes for Retailer C include:

• Processes to identify that there are two performance obligations


• Working out the standalone selling price of the extended warranty. Use one of the
following methods to determine standalone selling prices:
o How much competitors are selling the service for
o Estimate the price customers would be willing to pay
o Use an expected cost + appropriate margin approach
• System to be able to split revenue at point of sale
• Systems to apportion and defer revenue.

5.3. Principal vs. agent


Agent agreements

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

(a) Another party is primarily responsible for fulfilling the contract.

(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 .

(d) The entity’s consideration is in the form of a commission.

(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.

EXAMPLE: This example is taken from the standard.


An entity operates a website that enables customers to purchase goods from a range of
suppliers. The suppliers deliver directly to the customers, who have paid in advance, and the
entity receives a commission of 10% of the sales price.
The entity’s website also processes payments from the customer to the supplier at prices
set by the supplier. The entity has no further obligation to the customer after arranging for
the products to be supplied.

67
Is the entity a principal or an agent?

The following points are relevant:


(a) Goods are supplied directly from the supplier to the customer, so the entity does not
obtain control of the goods.
(b) The supplier is primarily responsible for fullfilling the contract.

(c) The entity’s consideration is in the form of commission.

(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.

5.4. Repurchase agreements

Repurchase
agreements

A forward A call option A put option


contract

An entity has An entity An entity must


an obligation has the right to repurchase the
to repurchase repurchase the asset if requested
the asset asset to do so by the
customer

If an asset has

The repurchase price < The repurchase price >


The original selling price The original selling price
Account as

✓ A forward contract ✓ A put option Financial


✓ A call option
instruments
(IFRS 9)
Account as

A lease in ▪ “Lease” (IFRS 16) if customer exercise option.


accordance ▪ Sale with a right of return (IFRS 15) if customer
with IFRS 16 not exercise option
68
EXAMPLE:
Xavier sells its head office, which cost $10 million, to Yorrick, a bank, for $10 million on 1
January 20X2. Xavier has the option to repurchase the property on 31 December 20X5, four
years later, at $12 million. Xavier will continue to use the property as normal throughout the
period and so is responsible for its maintenance and insurance. The head office was valued
at transfer on 1 January 20X2 at $18 million and is expected to rise in value throughout the
four-year period.
Giving reasons, show how Xavier should record the above during the first year following
transfer.

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.

5.5. Consignment arrangements

“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.

69
• 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.

When does GardenfurnishingsCo recognise revenue in accordance with IFRS 15?

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).

5.6. Bill-and-hold agreements

Under a bill-and-hold arrangement goods


are sold but remain in the possession of
the seller for a specified period (e.g.
customer lacks storage facilities)

The entity will need to determine at what


point the customer obtains control of the
product to recognise revenue.

A customer has obtained control of a


product in a bill and hold arrangement
when all the following criteria are met:

(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.

If revenue exceeds If costs to date If the cash received If a contract is loss-


cash received, this exceed cost of sales, exceeds the revenue making, there will
could be included this could be recognised to date, be a provision
within trade included within there will be a recorded to
receivables. inventory, as work- contract liability recognise the full
in-progress. (effectively deferring loss under the
the income). onerous contract, as
per IAS 37. This can
either be termed as
a contract liability or
a provision.

*5 STEPS to identify revenue, COGS and profit:


STEP 1 – Determining the progress of a contract: Choose between 2
methods:
Input method – based on the inputs 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:

72
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
–––––

4. Statement of financial position

$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

73
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%

3. Statement of profit or loss


$000
Revenue (10,000 × 50%) 5,000
Cost of sales (12,000 × 50%) (6,000)
Cost of sales (provision to recognise the full loss) (1,000)
–––––
Loss (2,000)
–––––

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.

4. Statement of financial position


$000
Costs to date 6,000
Loss to date (2,000)
Less: Billed to date (3,000)
Contract asset 1,000

74
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%

3. Statement of profit or loss


$000
Revenue (100,000 × 45%) 45,000
Cost of sales (Total costs of $60,000 × 45%) (27,000)
–––––
Profit (18,000)
–––––

4. Statement of financial position

75
$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

76
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).

Business combinations methods

Direct acquisition Indirect acquisition


Others
Investor acquires the assets and Investor acquires shares in another
liabilities of one or more business entity and obtains control

1.2. Types of relationships established by a company with other entities


Company

Control Associate Joint Control

Wholly owned Partially owned Joint venture Joint operation


subsidiary subsidiary

• Group: a parent and its subsidiaries.


• Parent: an entity with controls one or more entities.
• Subsidiary: An entity that is controlled by Parent
o Control: An investor controls an investee when the investor is exposed, or has
rights to, variable returns from its involvement with the investee and has the
ability to affect those returns through power over the investee
• Associate: An entity in which an investor has significant influence and neither a
subsidiary nor a joint venture of the investor
o Significant influence: the power to participate in the financial and operating
policy decisions of an economic activity but not control or joint control over
those policies

77
1.3. Types of relationship with criterion and required treatment

Investment Criteria Required treatment in group


accounts
Subsidiary Control (>50% rule) Full consolidation (IFRS 10)
Associate Significant influence Equity accounting (IAS 28)
(20%+ rule)
Investment which is Assets held for accretion As for single entity accounts (IFRS
none of the above of wealth 9)
• 50% rule refers to the fact that an investor has control over the investee when it
holds more than 50% of the equity interests that carry voting rights in the investee
• 20% + rule refers to the fact that an investor has significant influence over the
investee when it holds more than 20% of voting power of the investee.

2. Consolidated financial statements to groups – Overview


2.1. Inclusions in consolidated financial statement
• Consolidated financial statements: the financial statements of a group in which the
assets, liabilities, equity, income, expenses and cash flows of the parent and its
subsidiaries are presented as those of a single economic entity.
 Parent should consolidate all subsidiaries, both foreign and domestic in
consolidated financial statements

• Besides, in the parents own single company financial statements, investments in


subsidiaries and associates should be recognized according to one of the following:
a) Accounted at cost
b) In accordance with IFRS 9
c) Using equity method (IAS 28)

2.2. Exemption of preparing the consolidated financial statements


a. Rule • Is wholly-owned subsidiary or
partially owned subsidiary
• Does not trade securities
publicly
• Is not in the process of
Exemption of preparing Meetings all of the conditions issuing securities in public
consolidated FS for parent securities markets
• The ultimate (or
intermediate) parent
presents consolidated
financial statements in
accordance with IFRSs.

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.

2.3. Exclusion of preparing the consolidated financial statements


Subsidiaries held for sale must be accounted for in accordance with IFRS 5. No exclusions
are permitted in IFRS 10.

2.4. Consolidated financial statements package


Consolidated FS prepared by parents

Separate FS of parent company Consolidated FS

• Statement of financial position • Consolidated statement of


• Statement of profit or loss and financial position
other comprehensive income • Consolidated statement of profit
• Statement of cash flow or loss and other comprehensive
• Statement of change and equity income
• Consolidated statement of cash
flow

Note:

• In separate financial statement of financial position of the parent company, “Investment


in subsidiary undertakings is presented as asset
• In separate of the parent company, “Income for subsidiaries” is presented as dividend
2.5. Adjustment on the consolidated financial statements

Adjustment should be made in case of:

• Different reporting dates between subsidiaries and parents or among subsidiaries


• Different accounting policies used by member of a group

79
3. Content of group accounts and group structure
3.1. Group accounts

Parent’s account Subsidiaries’ accounts

Assets, liabilities: Add together


Equity: Separate the parent shareholders’ and non-controlling interest’ equity

Adjustment

Group accounts/
Consolidated accounts

• Non-controlling interest: the equity in a subsidiary which is not attributable, directly


or indirectly, to a parent.

3.2. Group structure: 2 common types

Group structure type Illustration Explanation


Direct interest P S1: Wholly owned
subsidiary

S2,3,4: Partly
100% 80% 75% 90%
owned
S1 S2 S3 S4 subsidiaries

Indirect holding P S: Subsidiary of P


SS: Subsidiary of S
51% P: Ultimate
parent to SS
S
Interest of P in
51% SS: 51% x 51% =
26.01% (Chain of
SS control despite
low interest in
asset)

80
LESSON 8: THE CONSOLIDATED STATEMENT OF FINANCIAL POSITION

1. Basic principles and Method of preparing a consolidated SOFP


A. Basic principles
- The basic principle of a consolidated statement of financial position is that it shows all
assets and liabilities of the parent and subsidiary.
- Intra-group items are excluded, e.g. receivables and payables shown in the consolidated
statement of financial position only include amounts owed from/to third parties.
B. Method of preparing a consolidated statement of financial position
The investment in the subsidiary (S) shown in the parent’s (P’s) statement of financial
position is replaced by the net assets of S.
The cost of the investment in S is effectively cancelled with the ordinary share capital and
reserves of the subsidiary, leaving goodwill as a balance.
This produces a consolidated statement of financial position showing:
- The net assets of the whole group (P + S)
- The share capital of the group which always equals the share capital of P only and
- The retained earnings, comprising profits earned by the group (i.e. all of P’s historical
profits + post-acquisition profits made by S).

2. Transaction at the acquisition date


At the acquisition date, Parent acquires share from other shareholders of Subsidiary, so
it’s transaction between shareholders of Subsidiary in secondary market, and not affect
any items in FS of Subsidiary. After this transaction, Parent becomes controlling
shareholder of subsidiary (controlling interest), and other shareholders of subsidiary
becomes non – controlling interes (NCI). As example below when Parent acquired 60%
share of Subsidiary:
Non-controlling interest (NCI)

acquired
P 60% of S 40% of S

Mr.A Mr.B Mr.C


P paid Mr.A, Mr.B, Mr.C, not paid 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)

81
- 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

Step 1: Take individual accounts of parent and each


subsidiaries and adjust if they are not prepared in the
common basis in term of:

Preparing the consolidated Accounting policies


statement of financial position Reporting period ending dates

Step 2: Combine items of assets, liabilities of parents with


subsidiaries

Step 3: Do the consolidation adjustments by eliminating:

The carrying amount of parent’s investment in each


subsidiary and

Parent’s portion of equity of each subsidiary

Step 4: Eliminate full intragroup assets, liabilities, equity,


income, expenses relating to the transactions between
entities of the group.

4. Step 1: Adjust according to common basis


4.1. Accounting policies

Different accounting Adjust Same accounting


policies policies

4.2. Reporting period ending dates

Use the old statements

Different reporting
dates

Adjust and use new statements


82
5. Step 2: Asset and liabilities combination

Asset Liabilities

100% (Parent + Subsidiary)

6. Step 3: Consolidation adjustments


● NCI is Equity participant in the group
● NCI entitled to the respective proportionate interest in equity of subsidiary after making
adjustment for unrealized profits and losses of subsidiary arising from intra group
transaction

Components in consolidated statement of financial position

Share Retained earnings Non-controlling Goodwill


capital interest

Parent only 100% Parent Pre-acquisition NCI Goodwill


+ NCI is valued at =
Group share of post- 1) proportionate share Fair value of consideration
acquisition retained of subsidiary’s (Investment in subsidiary)
reserves of Subsidiary identifiable net assets +
or 2) Fair value NCI


Consolidation
Fair value of net assets
adjustments Post-acquisition NCI at acquisition
Proportionate share of
subsidiary’s net assets
after acquisition date

83
EXAMPLE 1:
As at 31 December 2014

Parent Subsidiary

Non-current assets:
Tangibles 2,000 500

Investment in Subsidiary 1,000

Net current assets 2,000 500

5,000 1,000

Issued capital 500 1,000

Retained earnings 4,500 __

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:

Consolidated statement of financial position


$

Non-current assets:

Tangibles ((2,000 + 500) 2,500


<- Cost of investment has
disappeared

Net current assets (2,000 + 500) 2,500


Total assets 5,000

Issued capital 500 <- Issued capital of Parent

Retained earnings (W3) 4,500


Total Equities and liabilities 5,000

WORKINGS Reporting date Acquisition

(1) Subsidiary's net assets $ $


Issued capital 1,000
1,000
Retained earnings 0 0

1,000 1,000

(2) Goodwill

Cost 1,000
Non-controlling interest –

Less: Net assets (W1) (1,000)

(3) Retained earnings


Parent (as given) 4,500

Share of Subsidiary –

4,500

85
EXAMPLE 2:

As at 31 December 2014
Parent Subsidiary

Non-current assets:

Tangibles 1,400 1,000

Investment in Subsidiary 1,200


Net current assets 700 600

3,300 1,600

Issued capital 100 900

Retained earnings 3,200 700


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.

Required: Prepare the consolidated statement of financial position

86
ANSWER:

Consolidated statement of financial position


$
Non-current assets:
Goodwill (W2) 120
Tangibles 2,400
Net current assets 1,300
3,820

Issued capital 100


Retained earnings (W3) 3,720
3,820

WORKINGS Reporting date Acquisition


(1) Subsidiary's net assets $ $
Issued capital 900 900
Retained earnings 700 100
1,600 1,000
(2) Goodwill
Cost 1,200
Non-controlling interest –
Less: Net assets (100% × 1,000) (1,000)
200
Impaired 80
As an asset 120

(3) Retained earnings


Parent (as given) 3,200
Share of Subsidiary (W1) 100% (700 – 600
100)
Goodwill written off (W2) (80)
3,720

87
EXAMPLE 3: NCI with Proportionate Share
As at 31 December 2014

Parent Subsidiary

Non-current assets:
Tangibles 1,000 600

Investment in Subsidiary 1,200

Net current assets 500 600

2,700 1,200
Issued capital 100 50

Retained earnings 2,600 1,150

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

Required: Prepare the consolidated statement of financial position

88
ANSWER:
Consolidated statement of financial position
$
Non-current assets:
Goodwill (W2) 840
Tangibles 1,600
Net current assets 1,100
3,540

Issued capital 100


Retained earnings (W4) 3,200
Non-controlling interest (W3) 240
3,540

WORKINGS Reporting date Acquisition


(1) Subsidiary's net assets $ $
Issued capital 50 50
Retained earnings 1,150 150
1,200 200
(2) Goodwill
Cost 1,200
Share of net assets (80% × 200) (160)
1,040
To retained earnings (impaired) 200
Asset recognized 840

(3) Non-controlling interests


Share of net assets (20 × 1,200 (W1)) 240

(3) Retained earnings


Parent (as given) 2,600
Share of Subsidiary 80% × (1,150 – 800
150) (W1)
Goodwill impairment (200)
3,200

89
EXAMPLE 4: NCI with Fair Value

As at 31 December 2014
Parent Subsidiary

Non-current assets:

Tangibles 1,000 600

Investment in Subsidiary 1,200 _


Net current assets 500 600

2,700 1,200

Issued capital 100 50

Retained earnings 2,600 1,150


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

Required: Prepare the consolidated statement of financial position

90
ANSWER:
Consolidated statement of financial position
$
Non-current assets:
Goodwill (W2) 1,096
Tangibles 1,600
Net current assets 1,100
3,796

Issued capital 100


Retained earnings (W4) 3,240
Non-controlling interest (W3) 456
3,796

WORKINGS Reporting date Acquisition


(1) Subsidiary's net assets $ $
Issued capital 50 50
Retained earnings 1,150 150
1,200 200
(2) Goodwill
Cost 1,200
Share of net assets (10 × $29.60) 296
Less: Net assets on acquisition (100%) (200)
1,296
Impaired* 200
Goodwill recognised 1,096

(3) Non-controlling interests


Fair value on acquisition (W2) 296
Share of post-acquisition profits (1,000 200
× 20%)
Less: Share of goodwill impaired (200 (40)
× 20%)
456
(3) Retained earnings
Parent (as given) 2,600
Share of Subsidiary 80% × (1,150 – 800
150) (W1)
Goodwill impairment (200 × 80%) (200)
3,240

91
7. Step 4: Eliminating inter-company transaction

Inter-company transactions elimination

Inter-company balances Unrealized profit

Inventory Non-current asset transfers

Inter-company transactions elimination includes inter-company balances and unrealized


profit. Inter-company balances exist in the individuals’ financial statements, which are needed
to be eliminated in the consolidated financial statements. Unrealized profit is recognized only
when individuals’ accounts consolidated, then is adjusted by removing.
The reason why all inter-company transaction should be eliminated is that the position and
performance of a group of company will be consolidated, as if they were a single company.
The details can be found below.
7.1. Inter-company balances
▪ Inter-company balances are cancelled when members of the group trade with each
other, including:
o Receivables and payables (in the statement of financial position)
o Income and expense (in the statement of comprehensive income)

EXAMPLE 5: CANCEL THE INTER-COMPANY BALANCES


Park Co regularly sells good to its one subsidiary company, Suyin Co, which it has owned since
Suyin Co’s incorporation. The statement of financial position of the two company on 31
December 20X6 are given below:
STATEMENT OF FINANCIAL POSITION AS AT 31 DECEMBER 20X6
Park Co ($) Suyin Co ($)
ASSETS
Non-current assets:
Property, plant and equipment 35,000 45,000
Investment in 40,000 $1 share in S Co at cost 40,000
75,000

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

Required: Prepare the consolidated statement of financial position of Park Co at 31


December 20X6
ANSWER:

The canceling items are:


(a) Park Co’s asset ‘investment in shares of Suyin Co’ ($40,000) cancels with Suyin Co’s
liability ‘share capital’ ($40,000)
(b) Park Co’s asset’ trade receivables: Suyin Co’ ($2,000) cancles with Suyin Co’s liability
‘Trade and other payables: Park Co’ ($2,000)
The remaining assets and liabilities are added together to procedure the following
consolidated financial statement of financial position.
Consolidated statement of financial position of Park Co
$ $
ASSETS
Non-current assets:
Property, plant and equipment 80,000

Current assets:
Inventories 28,000
Trade receivables: 15,000
Cash and cash equivalents 1,000
Total assets 44,000
124,000

EQUITY AND LIABILITIES


Equity
70,000 $1 ordinary shares 70,000
Retained earnings 35,000
105,000
Current liabilities

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

7.2. Unrealized profit


▪ Unrealized profit happens when a member of a group sells inventory, at a profit, to
other member in group and that inventory is still held by the buying company at the
year end. The entry made in individual financial statement is as followed:
o Seller: Recognize profit
o Buyer: Recognize inventory as cost
▪ In the group’s view, the profit is unrealized => Should be adjusted
▪ Adjusted by eliminating unrealized profit from inventory value by:
o Adjusting entire profit from parents’ shareholders
o Apportion between parents’ shareholders and non-controlling interest

In statement of Seller is parent: Adjustment to retained


financial position earnings
Seller is subsidiary: Adjustment to net assets

Adjustments for
selling company

In statement of Unrealized profit is added to the costs


profit and loss of 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

Net realizable value to group

▪ 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.

If the seller is the Dr Group Retained Earnings (only to parent,


parent → the not NCI)
profit included in
Cr Group Inventory
parent’s retained
Consolidation
earnings
adjustments for
7.3. inventory If the seller is the Dr Subsidiary retained earnings (then share
subsidiary → the between the parent and NCI)
profit included in
Cr Group Inventory
subsidiary’s
retained earnings

EXAMPLE 6: UNREALIZED PROFIT


(1) Parent owns 80% of Subsidiary. During the current accounting period, Parent transferred
goods to Subsidiary for $4,000, which gave Parent a profit of $1,000. These goods were
included in the inventory of Subsidiary at the end of the reporting period.
Required: Calculate the adjustment in the consolidated statement of financial position.

(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

Required: Show the adjustment to eliminate unrealised profits in the consolidation


workings for Parent.

95
ANSWER:
(1) Dr Retained Earnings: 1,000
Cr Inventory: 1,000

(2) Dr Retained Earnings (1/2 * 6,000): 3,000


Cr Inventory: 3,000
WORKINGS Reporting date Acquisition
(1) Subsidiary's net assets $ $
Issued capital 10,000 10,000
Retained earnings
As given 65,000 20,000
Unrealized profit (3,000) 62,000 ______
72,000 30,000
(2) Non-controlling interests
Share of net assets (including the unrealised
profit)
(20% × 72,000) 14,400

(3) Retained earnings


Parent (as given) 100,000
Share of Subsidary (including the unrealised
profit) 33,600
80% × (62,000 – 20,000)
133,600

7.2.2 Non-current asset transfer


▪ The intra-group trading may include the non-current asset, which is used by the entity
rather than being sold onwards.
▪ Adjustment is taken by assuming that no transfer has been made.

Eliminate the profit

Consolidation adjustments for non-


current asset transfer

Adjust the depreciation


charge7777777777777

EXAMPLE 7: TRANSFER OF NON-CURRENT ASSET


Parent owns 80% of Subsidiary. Parent transferred an asset to Subsidiary at a value of $15,000
on 1 January 2014. The original cost to Parent was $20,000 and the accumulated depreciation
at 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

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

Charge for the year 5,000 4,000 1,000

Profit on disposal
Proceeds 15,000
NBV (20 – 8) (12,000)
3,000 – 3,000

Dr "P" profit or loss – profit on 3,000


disposal
Cr Non-current assets 3,000
And
Dr Non-current assets 1,000
Cr "S" Profit or loss – depreciation 1,000

(*) 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)

Step 2: Draw up the pro-forma statement

Step 3: Calculate income/expenses, subsidiary’s


profit for the year (PFY), total
comprehensive income (TCI), associate’s
PFY and other comprehensive income (OCI)

Step 4: Calculate necessary adjustments

Step 4: Calculate ‘Share of profit of associate’ and


‘Share of other comprehensive income of
associate’

Step 5: Complete non-controlling interest in


subsidiary’s PFY and TCI

98
2. Step 1: Draw up the group structure (W1)
P

Date of acquisition 80%

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.

3. Step 2: Draw up pro-forma statement


Sample of Liberty Cleaning Company:

4. Step 3: Calculate income, expenses, PFY, TCI and OCI

Income and expense Dividends receivable

100% (Parent + Subsidiary) × Time apportioned × X/12 Omit the amount from subsidiary

99
5. Step 4: Calculate necessary adjustments
Necessary adjustments

Intra-group trading Dividends Further adjustments

▪ Sales ▪ Impairment of goodwill


▪ Interest ▪ Fair values
▪ Non-current asset transfers ▪ Mid-year acquisitions
▪ Inventory ▪ Disposal

5.1. Intra-group trading


▪ Consolidated sales revenue = P’s revenue + S’s
Sales revenue – Intra-group revenue
▪ Consolidated cost of sales (COS)= P’s COS + S’s COS –
Intra-group COS

Intra-group Interest Loan and interest from outstanding loan between group
trading entities must be eliminated in the consolidated FS

▪ Remove profit or loss on transfer of NCA


Non-current
asset transfer ▪ Adjust the depreciation charge based on the cost of
asset to the group

▪ Value of goods sold intra-group included in closing


inventory must be added to cost to the group
Inventory
▪ Reduce NCI based on the unrealized profit from
inventory

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

(3) Non-controlling interest


$
Sultan (W2) (6,000 x 25%) 1,500

(4) Unrealised profit

% $
Selling price 100 20,000
Cost (60) (12,000)
Gross profit 40 8,000 x ½ = 4,000

5.3.2. Fair values


▪ If the value of Subsidiary’s non-current assets has been subjected to a fair value uplift,
then any additional depreciation must be charged to profit or loss
▪ The depreciation charge of the asset included in the CSPL statement must be based on
fair value.
▪ Extra depreciation must be calculated and charged to appropriate cost (cost of sales
usually)

5.3.3. Mid-year acquisitions


▪ If mid-year acquisitions happened, the subsidiary’s results should be consolidated from
the date of acquisition only
▪ Other procedures to consolidate is the same as other time for acquisition

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:

Parent Subsidiary Adjustment Consolidated


(9/12)
$ $ $ $
Revenue 100,000 56,250 (15,000) 141,250
Cost of sales (70,000) (45,000) 15,000 (100,000)
Gross Profit 11,250 0 41,250
30,000

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

Profit before tax 306 252


Tax (90) (72)
Profit for the year 216 180

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

CONSOLIDATED STATEMENT OF PROFIT OR LOSS FOR THE YEAR ENDED 30 SEPTEMBER


20X8
$'000
Profit before tax (306 + 252) 558
Profit on disposal (W2) 364
Tax (90 + 72) __(162)
_-_760
Profit attributable to:
Owners of the parent 724
Non-controlling interest (20% x 180) ____36
___760
Workings:

1. Timeline
1.10.X7 30.9.X8

P/L Subsidiary – all year

Group gain on disposal


not sub at y/e

2. Profit on disposal of Hoof Co


$'000 $'000
Fair value of consideration received 1,300
Less: share of consolidated carrying amount at date of
disposal
net assets (360+720) 1,080
Goodwill (W3) 72
less non-controlling interests __(216)

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)

Share of post-acq'n reserves up to the disposal 288


__1,480

▪ 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

6. Step 5: Calculate ‘Share of profit of associate’ and ‘Share of other


comprehensive income of associate’
A’s profit for the year (PFY) x Group % X
Any group impairment loss on associate in the period (X)
X
Shown before group profit before tax

A’s other comprehensive income (OCI) x Group% X

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

A’s other comprehensive income (OCI) x Group% X

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.

ANSWER: CONSOLIDATED STATEMENT OF PROFIT OR LOSS AND OTHER COMPREHENSIVE INCOME


$
Revenue (43,000 + (26,000 x 6/12) – 6,000 (W1)) 50,000
Cost of sales (28,000 + (18,000 x 6/12) – 6,000 + 1,000 (W1)) (32,000)
Gross profit 18,000
Distribution costs (2,000 + (800 x 6/12)) (2,400)
Administrative expenses (4,000 + (2,200 x 6/12) + 25 (W2) + 500 (5,625)
impairment)
Finance costs (500 + (300 x 6/12)) __ _(650)
Profit before tax 9,325
Income tax expense (1,400 + (900 x 6/12)) __(1,850)
Profit for the year 7,475
Other comprehensive income:
Gain on property revaluation(post-acquisition) 1,000
Investment in equity instrument __ _200
Total comprehensive income for the year 8,675
Profit attributable to:
Owners of the parent 6,925
Non-controlling interest (W3) __ _550
7,475
Total comprehensive income attributable to:
Owners of the parent 7,725
Non-controlling interest (550 + (1,000 x 40%) ___ _950
___8,675
Workings:
1 Unrealised profit
Remove intercompany trading
DR Revenye $6m/ CR Cost of sales $6m
Unrealised profit = 6,000 x 20/120 = 1,000 – add to cost of sales

2 Movement on fair value adjustment


The fair value adjustment of $1m will be depreciated over the remaining life of the
building. The amount to be charged at 31 December is:
1,000,000/20 x 6/12 = 25,000
40% of this (10,000) will be charged to the NCI

3 Non-controlling interest – share of profit for the year


$'000
Share of post-acquisition profit (3,800 x 6/12 x 40%) 760
Movement on fair value adjustment (25 x 40%) (10)
Share of goodwill impairment (500 x 40%) __(200)
___550

109
LESSON 10: INVESTMENTS IN ASSOCIATES

Investments in associates

Terms revision Base for preparing in Application in preparing consolidated FS


consolidated FS

• Associate Consolidated Consolidated


• Significant statement of statement of
influence financial comprehensive
• Requirements position income
• Exemption
• Accounting
method used Necessary adjustments in FS

1. Investments in associates overview


1.1. Key terms

Key terms are revised from the “Introduction to groups” lesson:


▪ Associate. An entity, including an unincorporated entity such as a partnership, over which
an investor has significant influence and which is neither a subsidiary nor an interest in a
joint venture.
▪ Significant influence. The power to participate in the financial and operating policy
decisions of the investee but it is not control or joint control over those policies.
▪ An investor has significant influence over the investee when it holds more than 20% of
voting power of the investee.

1.2. Accounting treatment requirements


In this lesson, investments in associates concerns with the accounting treatment in:
▪ Separate financial statement of the investor
▪ Consolidated financial statement of the investor
This requirement can be viewed in details in IAS 28: Investments in Associates and Joint
Ventures (2011)

110
1.2.1. Separate financial statement of investor
One of the following:

▪ Accounted for at cost


▪ Using equity method
▪ In accordance with IFRS 9 (fair
Treatment of value)
investment in
an associate
One of the following:

• Accounted for at cost

• In accordance with IFRS 9 (fair


1.2.2. Consolidated financial statement of the investor
▪ All investments in associates to be accounted for in the consolidated accounts using the
equity method
▪ The use of the equity method should be discontinued from the date that the investor
ceases to have
significant influence.

Exemption:

Nature of the investment Nature of the investor


The investment is ▪ The investor is a wholly-owned subsidiary or it is a partially
classified as 'held for sale' owned subsidiary of another entity including those not
in accordance with IFRS 5 otherwise entitled to vote, have been informed about, and
do not object to, the investor not applying the equity
method
▪ The investor's securities are not publicly traded
▪ It is not in the process of issuing securities in public
securities markets
▪ The ultimate or intermediate parent publishes
consolidated financial statements that comply with
International Financial Reporting Standards

2. Base for preparing consolidated financial statements


As mentioned in the previous part, equity method is the base for accounting for
investments in associates in consolidated financial statements
2.1. Rationale
▪ Accounting for associates is different from accounting for subsidiaries because an
associate is not a part of a group (not controlled by group)
▪ Accounting for associates must concern with the change in the investee’s equity that will
impact on the carrying amount of the investment because the investor has significant
influence over the associates and the investor is entitled with the performance of the
associate

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

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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.

Required: Prepare the consolidated statement of financial position at 31 December 2014.

ANSWER:

Consolidated statement of financial position as at 31 December 2014


$
Investment in associate (W6) 1,880
Non-current assets (1,600 + 800) 2,400
Current assets (2,200 + 3,300) 5,500
9,780
Issued capital 1,000
Retained earnings (W5) 7,520
8,520
Non-controlling interest (W4) 760

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Liabilities 500
9,780

Working:

(1) Group structure


P
40%
GROUP
80%
A

S
(2) Net assets working

S Reporting date Acquisition


$ $
Issued capital 400 400
Retained earnings 3,400 520
3,800 920

(3) Goodwill
S
$
Cost of investment 800
Net assets acquired (80% × 920 (736)
(W2))
64

(4) Non-controlling interest


$
S only (20% × 3,800) 760

(5) Retained earnings


$
P – from question 4,000
Share of S [80% × (3,400 – 520) (2,304)
(W2)]
Share of A [40% × (3,600 – 400)] 1,280
Less: Goodwill impairment (W3) (64)
7,520

(6) Investment in associate


$
Cost of investment 600

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Share of post-acquisition profits 1,280
Less: Impairment loss)] 0
1,880

3.2. In a consolidated statement of comprehensive income

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

Statement of Changes in Equity


Dividends paid 1,000
Working:

(1) Group structure


P
40%
GROUP
80%
A

S
(2) Consolidation schedule

P S A (40%) Adjustment Consolidati


* on
$ $ $ $ $
Revenue 14,000 12,000 26,000
Cost of sales (9,000) (4,000) (13,000)
Administration (2,000) (6,000) (8,000)
expenses
Income from associate 800 800
40% × 2,000
Tax – group (1,000) (1,200) (2,200)
Profit after tax 800

(3) Non-controlling interest

$
S only 20% × 800 160

4. Necessary adjustments related to investment in associates in consolidated financial


statements
Investment in associates related adjustments

Inter-company trading adjustments

Inter-company balances Dividends Unrealized profit


116
The inter-company transactions refer to the transactions between members of group with
associate, which may come under two types: downstream and upstream transaction.
▪ Downstream: transaction from associate to investor
▪ Upstream: transaction from investor to associate

Three typical intercompany trading adjustments include: inter-company balances, dividends


and unrealized profit. Sales and purchase between group member with associate may lead to
inter-company balances and unrealized profit in some cases

4.1. Inter-company balances


▪ Inter-company trading may result in the recognition of receivables and payables in the
individual company accounts
▪ Treatment:

Types of consolidated FS Treatment


Financial position ▪ Do not cancel inter-company balances
▪ Show separately with other receivables/payables balances
Statement of profit/loss ▪ Do not adjust sales and cost of sales for trading with
associate
▪ Show amounts owed to the group by the associate as
assets and amounts owed to the associate by the group as
liabilities

4.2. Dividends

Types of consolidated FS Treatment


Financial position ▪ Do not cancel inter-company balances for dividends
▪ Include receivable in the consolidated statement of
financial position for dividends due to the group from
associates.
Statement of profit/loss ▪ Do not include dividends from an associate in the
consolidated statement of profit or loss.
▪ Show the parent's share of the associate's profit after tax
(before dividends) in the income from associate

4.3. Unrealized profits


▪ Unrealized profits should be eliminated to the extent of the investor's interest in the
associate
▪ Unrealized losses should not be eliminated if the transaction provides evidence of
impairment in value of the asset which has been transferred.

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:

To eliminate unrealized profit:


▪ Deduct $50 from the associate's profit before tax in the statement of profit or loss, to
deal with the effect on profit or loss.
▪ Deducted $20 (50 x 40%) from the carrying amount of the associate, to deal with the
effect on the consolidated statement of financial position.

118
LESSON 11: FINANCIAL INSTRUMENTS

1. Overview of financial instrument

Financial market

Money market Capital market

Debt market Equity market Derivative 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.

1.1. Term and definition


▪ Financial instrument: Any contract that gives rise to both a financial asset of one entity
and a financial liability or equity instrument of another entity.
▪ In terms of finance, financial instrument can be regarded as a financial contract that
can be traded in the market. This contract will represent

Contract
Entity 1 Entity 2

Or
Financial asset Financial liability Equity instrument
increases increases increases
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▪ 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

Financial instrument element Example


Financial ▪ Cash ▪ Cash and cash
Asset equivalents
▪ An equity instrument of another entity ▪ Stock/share
▪ A contractual right to receive cash or ▪ Trade/Loan
another financial asset from another receivable
entity/ exchange financial instruments with ▪ Option
another entity under favorable conditions
Financial Contractual obligation to: ▪ Trade payable
Liability ▪ Deliver cash or another financial asset to ▪ Debenture loans
other entity payable
▪ Exchange financial instruments with ▪ Redeemable
another entity under condition that are preference share
under potentially unfavorable conditions

Equity Contractual that: ▪ Shares traded on a


instrument ▪ Evidences a residual interest in assets of securities exchange
another entity after deducting all of its
liabilities

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

Recognition and de-recognition

Measurement
IFRS 9: Financial instruments

Impairment

1
Hedging accounting

IFRS 7 Financial
Disclosure instruments:
Disclosure
Presentation &
Disclosure
Presentation

2. IAS 32: Financial instruments presentation (Classification and presentation)

2.1. Classification between liabilities and equity

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.

Substance of contractual agreement


Liabilities or Based on
equity?
Definitions of financial liability and equity instrument

In the case of financial liability:


▪ Substance of contractual agreement: obligation to transfer economic result
▪ Definition of financial liability: Contractual obligation to deliver cash or another financial
asset to other entity or exchange financial instruments with another entity under
condition that are under potentially unfavorable conditions]

1 An accounting principles for recording hedging (reducing risk of financial instrument) activities of company

121
Work flow: Not financial instruments
No

Is there any contractual obligation?

Is the obligation delivering cash or


Yes
another financial asset to other entity
or exchange financial instruments
with another entity under condition
that are under potentially
unfavorable conditions?

Yes No

Financial liability Equity instrument

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

Must be classified separately

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

123
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

Statement of profit or loss $


Finance cost (W2) 1,568
Statement of financial position $
Equity – option to convert (W1) 2,576
Non-current liabilities
4% convertible loan notes (W2) 18,192

2.2. Presentation of financial instruments: Interest, dividend, loss and gain

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. IFRS 9: Financial instrument (Recognition, measurement and related issue)

3.1. Scope
▪ All financial instruments excluding investments in subsidiaries, associates, joint ventures
and other joint arrangements

3.2. Initial recognition

Normal accounting transaction Financial instrument


▪ Record when there is probable inflow ▪ Record when the reporting entity
or outflow benefit becomes a party to the contractual
▪ Cost or value can be measured reliably provisions of instruments

124
3.3. De-recognition

De-recognition Financial instrument


Definition ▪ Remove previously recognized financial instrument from
financial position fully or partly

When ▪ Financial asset should be de-recognized when an entity losses


control of the economic benefits due to either expiry of the
contract or transfer the economic benefit
▪ Financial liabilities should be de-recognized when the obligation
is extinguished

Impact on net Carrying amount of full/part of financial instrument transferred


profit or loss X

Proceeds received/paid
(X)

Difference to profit or loss


X

3.4. Classification on recognition


Subsequent to initial recognition, the classification of financial assets and financial liability
will affect how these assets and liabilities measured.

a. Financial asset

The classification is based on two elements:


▪ Entity’s business model for managing financial asset
▪ Contractual cash flow characteristics of the financial asset

Three treatments are:


▪ Amortized cost
▪ Fair value through other comprehensive income (OCI)
▪ Fair value through profit or loss
Treatment Objective of managing the asset Contractual cash flow
characteristics
Amortized cost ▪ Collect contractual cash ▪ The financial asset makes
flows change in cash flow (solely due
to paying principal and interest -
SPPI) at one specific date
Fair value ▪ Collect contractual cash ▪ The financial asset makes
through OCI flows and change in cash flow (solely due
▪ For sale to paying principal and interest)
at one specific date

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

1.PwC - Understanding the basis of IFRS09

Business model test in details


▪ The assessment should not be at an individual financial instrument level
▪ The assessment should be based on how key personnel actually manage the
business, rather than management’s intention for specific financial assets.
▪ Entity with more than one business model for different type of portfolio of financial
asset can have the assessment for classification purposes at portfolio level, rather
than entity level.
▪ An entity’s business model can be to hold financial assets to collect contractual cash
flows even when sales of financial assets occur

Contractual cash flow test in details


Only instruments with contractual cash flows of principal and interest on principal may
qualify for amortized cost measurement

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

Two treatments are:


▪ Amortized cost
▪ Fair value through profit or loss
Treatment Liability with
FVTPL Management objectives:
▪ Held for trading
▪ Designated at fair value through profit or loss upon initial
recognition
Derivatives are always measured at fair value through profit or loss.
3.5. Factoring of receivables
Where debts or receivables are factored, the original creditor sells the debts to the factor.
If the significant risks and rewards are transferred from the entity, resulting in the original
receivable being derecognised, the entity is not holding these receivables to collect the
contractual cash flows but to sell them.
If the significant risks and rewards of these receivables are not transferred from the entity,
and the receivables do not therefore qualify for derecognition, the entity's business objective
is to hold the assets to collect contractual cash flows.
Indications that the debts are not an asset Indications that the debts are an asset of
of the seller the seller
▪ Transfer is for single non-returnable ▪ Finance cost varies with speed of
fixed sum collection of debts by adjustment to
▪ There is no recourse to the seller for the consideration for original transfer or
losses subsequent transfers priced to recover
▪ Factor is paid all amounts received from costs of earlier transfers
the factored debts (and no more). Seller ▪ There is full recourse to seller for the
has no rights to further sums from the losses
factor ▪ Seller is required to repay amounts
received from the factor on or before a
set date, regardless of timing or
amounts collected
Treatment: Treatment:
▪ Remove the receivables and liability in ▪ Gross amount of receivables should be
respect of the proceeds received from in balance sheet of the seller
the factor in balance sheet ▪ Liability in respect of the proceeds
received from the factor should be
shown within liabilities

127
▪ Accrue the interest of the factor’s
charges
▪ Accrue other interest charges in profit or
loss
3.6. Re-classification on recognition

In some cases, financial assets should be re-classified due to:


▪ Change in business model for managing financial assets
▪ Applied for only debt instruments
3.7. Measurement
A – Initial measurement
If financial instrument are designated as amortised cost or Fair value through other
comprehesive income, then:

Financial asset Measured at Cost = Fair value + Transaction costs

Financial liability Measured at Cost = Fair value - Transaction costs

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

- Financial Asset at amortised cost


Financial Asset = Initial Measurement – Principal Repayment + Cumulative amortisation -
Impairment
Example 3 : On 1 January 20X1 Abacus Co purchases a debt instrument for its fair value of
$1,000. The debt instrument is due to mature on 31 December 20X5. The instrument has a
principal amount of $1,250 and the instrument carries fixed interest at 4.72% that is pa id
annually. The effective rate of interest is 10%.
How should Abacus Co account for the debt instrument over its five year term?

Solution:
Abacus Co will receive interest of $59 (1,250 4.72%) each year and $1,250 when the
instrument matures.

128
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.

- Financial asset as Equity instrument


After initial recognition equity instruments are measured at either fair value through
profit or loss (FVTPL) or fair value through other comprehensive income (FVTOCI).
Equity instruments can be held at FVTOCI if:
(a) They are not held for trading (ie the intention is to hold them for the long term to
collect dividend income)
(b) An irrevocable election is made at initial recognition to measure the investment at
FVTOCI.
If the investment is held at FVTOCI, all changes in fair value go through other
comprehensive income. Only dividend income will appear in profit or loss.
If equity instruments are held at FVTPL no transaction costs are included in the carrying
amount.
Example 4: In February 20X8 a company purchased 20,000 $1 listed equity shares at a price
of $4 per share.
Transaction costs were $2,000. At the year end of 31 December 20X8, these shares were
trading at $5.50.
A dividend of 20c per share was received on 30 September 20X8.
Show the financial statement extracts at 31 December 20X8 relating to this investment on the
basis that:
(a) The shares were bought for trading (conditions for FVTOCI have not been met)
(b) Conditions for FVTOCI have been met

129
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.

3.9. Gain or loss


Instruments at fair value through profit or loss: gains and losses are recognised in profit
or loss.
If financial asset is an equity instrument and the entity made an election upon initial
recognition to present gains and losses directly in equity through other comprehensive
income. Dividends from the investment will be recognised in profit or loss.
When an investment held at FVTOCI is sold, any gain or loss on disposal will also go
through OCI and be held in reserves. At disposal entities are permitted to transfer the
total gains and/or losses on the investment to retained earnings, but these amounts
will not appear in any statement of 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.

3.10. Impairment and uncollectability of financial asset


IFRS 9 is based on providing for expected losses (rather than dealing with losses after they
have arisen) and applies to financial assets held at amortised cost and FVTOCI.
On initial recognition of the asset the entity creates a credit loss allowance equal to 12
months' expected credit losses.
If credit risk increases significantly subsequent to initial recognition, the allowance
recorded to represent 12 months' expected credit losses is replaced by an allowance for
lifetime expected credit losses.

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LESSON 12: LEASING

LEARNING OUTCOMES:

1. Definition

2. Identify a lease

3. Accounting treatment
4. Short-life and low value assets

5. Sale and leaseback

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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

realization of which by the lessor is not assured


Lease incentives: Payment made by the lessor to the lessee, or the reimbursement or
assumption by the lessor of costs of the lessee.

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2. Identifying a lease

No
Is there an identified asset?

Yes

Does the customer have the right to obtain


substantially all of the economic benefits No
from use of the asset throughout the period
of uses?

Yes

Customer Does the customer, the supplier or neither Supplier


party have the right to direct how and for
what purpose the asset is used throughout
the period of use?

Neither; how and for what


purpose the asset will be
used is predetermined

Does the customer have the right to operate


Yes the asset throughout the period of use,
without the supplier having the right to
change those operating instructions?

No

Did the customer design the asset in a way


No
that predetermines how and for what
purpose the asset will be used throughout
the period of use?

The contract contains a lease The contract does not


contain a lease

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.

4. Accounting treatment – Lessees


a. Basic principle
At the commencement, the lessee should recognize

Lease liability Right-of-use asset

b. Initial measurement (At the commencement date)


Lease liability Right-of-use asset
The liability: is initially A lessee recognizes a right-of-use asset at cost
measured at the present value The right-of-use asset at cost includes:
of the future lease payments, ▪ The amount of the initial measurement of the lease
discounted at the interest rate liability
implicit in the lease. If that rate
▪ Any lease payments made before the
cannot be determined, the
commencement date, less any lease incentives
lessee’s incremental
borrowing rate should be used. received
▪ Any initial direct costs incurred
▪ Any costs which the lessee will incur for dismantling
and removing the underlying asset or restoring the
site at the end of the lease terms
c. Subsequent measurement (After commencement date)
Lease liability Right-of-use asset
The carrying amount of the - The right-of-use asset should be measured using
lease liability is increased by the cost model in IAS 16, unless it is an investment
interest charges on the
property or belongs to class of assets to which the
outstanding liability and
reduced by lease payment revaluation model applies.
made. - If the lease transfers ownership of the underlying
At the start, the finance charge asset at the end of the lease term or if the cost
will be large as the outstanding reflects a purchase option which the lessee is
lease liability is large. Toward expected to exercise, the right-of-use asset should

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.

This interest is also recorded in the statement of profit or loss:


Dr Finance costs (SPL) X
Cr Lease liability (SFP) X

The carrying amount of the lease liability is reduced by cash repayments:


Dr Lease liability X
Cr Cash X

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:

A non-current right-of-use asset is recorded at an initial value of $5,710.

Annual depreciation charge = 1/4 × $5,710 = $1,428.


A liability is initially recorded at $5,710.
The total finance charge for the lease is calculated as the difference between the total
payments of $8,000 and the initial value of $5,710 = $2,290. The allocation of this to each
rental period is calculated using the implicit interest rate on a lease liability table as follows:

Period Liability b/f Interest @ 15% Payment Liability

20X2 5,710 857 (2,000) 4,567


20X3 4,567 685 (2,000) 3,252
20X4 3,252 488 (2,000) 1,740
20X5 1,740 260 (2,000) _
2,290 8,000

Extracts from financial statements for the year to 31 December 20X2


Statement of profit or loss

$
Depreciation (1,428)
Finance cost (857)

Statement of financial position


$
Non-current assets
Right-of-use asset (5,710 – 1,428) 4,282

Non-current liabilities
Lease 3,252

138
Current liabilities
Lease 1,315

Mid-year entry into a lease

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

Extracts from financial statements for the year to 31 March 20X9

Statement of profit or loss


$
Depreciation (87,500)
Finance cost (25,000)

Statement of financial position


$
Non-current assets
Right-of-use asset (700,000 – 87,500) 612,500

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.

5. Sale and leaseback transactions


Transfer is a sale Transfer is not a sale
▪ Derecognise the asset ▪ The asset continues to be recognised and
▪ Recognize the sale at fair value a financial liability is recognised equal to
▪ Recognize lease liability (PV of lease the proceeds transferred
rentals) ▪ The financial liability is accounted for in
▪ Recognize a right-of-use asset, in accordance with IFRS 9
proportion to the previous carrying
amount of the asset that relates to the
right of use retained
▪ Gains and losses are limited to the
amount relating to the rights transferred

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

▪ Stage 3: The gain relating to rights transferred:


Gain on rights transferred = Total gain – Gain on rights retained

The right-of-use asset continue to be depreciated as normal.

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:

Stage 1: Total gain on the sale = Fair value – Carrying amount


= $740,000 - $500,000 = $240,000
Discounted lease payments
Stage 2: Gain relating to the rights retained = Gain x Fair value

= ($240,000 x 700,000/740,000)

= $227,027

Stage 3: Gain relating the rights transferred = Total gain – Gain on rights retained

= $240,000 - $227,027 = $12,973


b. Transfer is not a sale
If the transfer does not satisfy the IFRS 15 requirements to be accounted for as a sale, the
seller continues to recognize the transferred asset and the transfer proceeds are treated as
a financial liability, accounted for in accordance with IFRS 9. The transaction is more in the
nature of a secured loan.

c. Example: Sale and lease back not an market terms


EXAMPLE:

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:

Step 1: The lease liability must be calculated


The interest rate implicit in the lease is 4.5% therefore the present value of the annual
payments is calculated as follows:
120,000/1,045 114,883
120,000/1,0452 109,888
120,000/1,0453 105,155
120,000/1,0454 100,627
120,000/1,0455 96,294
526,797
Of this, $467,797 ($526,797 - $50,000) related to the lease and $50,000 relates to the
additional financing

Step 2: The right-of-use assets must be measured


At the commencement date, Bungle Co measures the right-of-use asset arising from the
leaseback of the building at the proportion of the previous carrying amount of the building
that relates to the right-of-use retained.

This is calculated as
Right-of-use asset (arising from leaseback) = carrying amount x discounted lease
payments/fair value.

Therefore: $600,000 x 476,797/750.000 = $381,437


The right-of-use asset will be depreciated over five years, being the shorter of the lease
term and the useful life of the asset.

Step 3: The gain on the sale and leaseback must be calculated

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

𝐷𝑖𝑠𝑐𝑜𝑢𝑛𝑡𝑒𝑑 𝑙𝑒𝑎𝑠𝑒 𝑝𝑎𝑦𝑚𝑒𝑛𝑡𝑠


Stage 2: Gain relating to the rights retained = Gain x 𝐹𝑎𝑖𝑟 𝑣𝑎𝑙𝑢𝑒

= $(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

Step 4: The transaction must be recorded in Bungle Co’s accounts

At the commencement date the transaction is recorded as follows:


Debit Credit
$ $
Cash 800,000
Right-of use asset 381,437
Building 600,000
Financial liability 526,797
Gain on rights transferred 54,640
1,181,437 1,181,437

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

I. IAS 37 PROVISIONS, CONTINGENT LIABILITIES AND CONTINGENT ASSETS


The objective of IAS 37 Provisions, Contingent Liabilities and Contingent Assets is to ensure that:
• appropriate recognition criteria and measurement bases are applied to provisions, contingent liabilities and contingent assets, and
• sufficient information is disclosed in the notes to the financial statements to enable users to understand their nature, timing and amount.
1. Provisions

• A provision is a liability of uncertain timing or amount.


Definition • A liability is a present obligation of the entity arising from past events, the settlement of which is expected to result in an
outflow from the entity of resources embodying economic benefits

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.

Probability of more than 50%

It is probable that an outflow of resources embodying


Recognition economic benefits will be required to settle (2) Where there is a number of similar obligations the
the obligation probability should be based on considering the
population as a whole

Provision relates to one event (e.g court case):


measured using the most likely outcome
A reliable estimate can be made of the amount of the
obligation (3)
Provision is made up of numerous events (e.g a
144 provision to make repairs on goods within a year of
sale) then the provision should be measured using
expected values
EXAMPLE FOR PROVISION MADE UP OF NUMEROUS EVENTS
Parker Co sells goods with a warranty under which customers are covered for the cost of
repairs of any manufacturing defect that becomes apparent within the first six months of
purchase. The company's past experience and future expectations indicate the following
pattern of likely repairs.

Cost of repairs if all items


suffered from these defects
% of goods sold Defects
$m

75 None -
20 Minor 1.0
5 Major 4.0

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.

(You will be given any relevant discount rates in the exam)


EXAMPLE FOR PROVISION TAKING ACCOUNT FOR TIME VALUE OF MONEY
A company knows that when it ceases a certain operation in five years' time it will have to
pay
environmental cleanup costs of $5m. The provision to be made now will be the present
value of $5m in five years' time. The relevant discount rate in this case is 10%.

145
SOLUTION:

Therefore a provision will be made for:


$

$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:

No. Provision Definition and estimate method


1 Warranty • Common in manufacturing and retailing businesses.
• There is either a legal or constructive obligation to make
good or replace faulty products.
• A provision is required at the time of the sale rather than
the time of the repair/replacement as the making of the
sale is the past event which gives rise to an obligation.
• This requires the seller to analyse past experience so that
they can estimate:
o how many claims will be made – if manufacturing
techniques
improve, there may be fewer claims in the future than
there have
been in the past
o how much each repair will cost – as technology becomes
more
complex, each repair may cost more.
• The provision set up at the time of sale:
o is the number of repairs expected in the future
multiplied by the
expected cost of each repair
o should be reviewed at the end of each accounting period
in the light of further experience.
2 Guarantees • In some instances (particularly in groups) one entity will
make a guarantee on behalf of another to pay off a loan,
etc. if the other entity is unable to do so.
• A provision should be made for this guarantee if it is
probable that the payment will have to be made.
• It may otherwise require disclosure as a contingent liability.
3 Onerous • 'An onerous contract is a contract in which the unavoidable
contracts costs of meeting the obligations under the contract exceed
the economic benefits expected to be received under it'
• The signing of the contract is the past event giving rise to
the obligation to make the payments and those payments,
discounted if the effect is material, will be the measure of
the excess of cost over the benefits.
• A provision for this net cost should be recognised as an
expense in the statement of profit or loss in the period
when the contract becomes onerous. In subsequent periods,
this provision will be increased by the unwinding of the
discount (recognised as a finance charge) and reduced by
any payments made.
4 Environmental • If the company has an environmental policy such that other
provisions parties
would expect the company to clean up any contamination

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.

Example of provision for restructure


In which of the following circumstances might a provision be recognised?
On 13 December 20X9 the board of an entity decided to close down a division.
The accounting date of the company is 31 December. Before 31 December 20X9
(a)
the decision was not communicated to any of those affected and no other steps
were taken to implement the decision.
The board agreed a detailed closure plan on 20 December 20X9 and details were
(b) given to
customers and employees.
A company is obliged to incur clean up costs for environmental damage (that has
(c) already been
caused).
A company intends to carry out future expenditure to operate in a particular way
(d)
in the future.

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

• A possible obligation that arises from past events and whose


existence will be confirmed only by the occurrence or nonoccurrence of one or
more uncertain future events not wholly within the control of the entity, or
• A present obligation that arises from past events but is not recognised because:
Definition
o it is not probable that an outflow of resources embodying economic
benefits will be required to settle the obligation, or
o the amount of the obligation cannot be measured with sufficient
reliability'

Treatment Contingent liabilities should not be recognised in financial statements but they should be
disclosed

The required disclosures are:

Disclosures • A brief description of the nature of the contingent liability


• An estimate of its financial effect
• An indication of the uncertainties that exist
• The possibility of any reimbursement

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.

However, this should only be employed in extremely rare cases.


Details of the general nature of the provision/contingencies must still be provided, together
with an explanation of why it has not been disclosed.
Example of contingent liabilities and contingent assets
A company is engaged in a legal dispute. The outcome is not yet known. A number of
possibilities arise:
• It expects to have to pay about $100,000. A provision is recognised.
• Possible damages are $100,000 but it is not expected to have to pay them. A contingent
liability is
disclosed.
• The company expects to have to pay damages but is unable to estimate the amount. A
contingent
liability is disclosed.
• The company expects to receive damages of $100,000 and this is virtually certain. An asset
is
recognised.
• The company expects to probably receive damages of $100,000. A contingent asset is
disclosed.
• The company thinks it may receive damages, but it is not probable. No disclosure

4. Summary

Degree of Outflow Inflow


probability
Virtually certain Recognise liability Recognise asset
Probable Recognise provision Disclose contingent asset
Possible Disclose contingent liability Ignore
Remote Ignore Ignore

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II. IAS 10 EVENTS AFTER THE REPORTING PERIOD

EVENTS AFTER THE REPORTING PERIOD


events, both favourable and unfavourable, that occur between the end of the reporting period and
the date on which the financial statements are authorised for issue

ADJUSTING EVENTS NON-ADJUSTING EVENTS

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

IAS 2 Inventories are assets:


• Lay out required accounting treatment for inventories • Held for sale in the ordinary course of business;
• Not include: • In the process of production for such sale; or
▪ Work in progress under long-term contracts
• In the form of materials or supplies to be consumed in
▪ Financial instruments (ie shares, bonds) the production process or in the rendering of services.
▪ Biological assets

Include
Goods purchased and held for resale, eg
land and buildings held for resale

Finished goods produced

Work in progress being produced

Raw materials

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2. INVENTORIES ARE MEASURED AT LOWER OF COST AND NET REALIABLE VALUE (NRV) – Exam focus point
Purchase price

Import duties and other taxes


Purchase
Transport, handling and any other cost directly attributable to the acquisition of Inventories

Trade discounts, rebates and other similar amounts


COST

Costs of conversion Direct costs

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.

Reasons for the fact that NRV is less than cost:


• An increase in costs or a fall in selling price
NRV
• A physical deterioration in the condition
154 of inventory
• Obsolescence of products
• A decision as part of the company's marketing strategy to manufacture and sell products at a loss
• Errors in production or purchasing
3. Consistency – different cost formulas for inventories
AS 2 allows two cost formulas (FIFO or weighted average cost) for inventories that are
ordinarily
interchangeable or are not produced and segregated for specific projects.
IAS 2 provides that an entity should use the same cost formula for all inventories having
similar nature
and use to the entity. For inventories with different nature or use (for example, certain
commodities used in one business segment and the same type of commodities used in
another business segment), different cost formulas may be justified. A difference in
geographical location of inventories (and in the respective tax rules), by itself, is not
sufficient to justify the use of different cost formulas

QUESTION:

A company has inventory on hand at the end of the reporting period as follows:

Units Raw Attributable Attributable Expected


material cost production Selling costs Selling
$ Overheads $ $
$
Item A 300 160 15 12 185
Item B 250 50 10 10 75
At what amount will inventories be stated in the statement of financial position in
accordance with IAS 2?

ANSWER:

Units cost NRV Lower Total


$ $ $ $
Item A 300 175 173 173 51,900
Item B 250 60 65 60 15,000
66,900

CASE STUDY – VILLANDRY

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

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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.

Cost less 2½% trade NRV Valuation


discount $ $
$
Product A 3,510 5,100 3,510
Product B 2,827.5 2,800 2,800
Product C 4,095 4,100 3,510.00
10,405.00
b. The weighted average method values items withdrawn from inventory at the
average price of all
goods held in inventory at the time. Thus, it smooths out any fluctuations due to
rising or falling
prices.
The FIFO method of inventory valuation assumes that items sold are the oldest ones
received from suppliers. Thus, any goods held at the year end will be assumed to
have been purchased recently.
Thus, changing from weighted average to FIFO (assuming inventory purchase prices
are rising over time) is likely to increase the value of closing inventory (from
historical to current price levels). This would reduce the cost of sales figure in profit
or loss and increase the reported profit figure.
Bearer biological is a living plant that:
assets • is used in the production or supply of agricultural produce;
• is expected to bear fruit for more than one period; and
• has a remote likelihood of being sold as agricultural
produce, except for incidental scrap sales
Agricultural harvested product of an entity's biological assets
produce
Harvest the detachment of produce from a biological asset or the
cessation of a biological asset's life processes

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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

• Difference between accounting treatment and tax treatment

• Business combination

• Other stated in IAS 12

1. Overview

1.1. Introduction to income taxes


Individual
s
Paid by
Income tax Based on Tax rates and tax laws
of relevant jurisdiction
Entities

Treatment according to Calculation of tax expense Comprehensive


IAS 12
assets and liabilities balance sheet method

Difference
between

Carrying amounts Underlying tax base


recognized in the according to tax
financial statement jurisdiction

Deferred tax Current tax

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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

2.1. Overview and treatment


CURRENT TAX

The amount payable to the tax authorities in relation to trading


activities of the period

Entry

Dr: Tax charge (statement of profit or loss)

Cr: Tax liability (statement of financial position)

Current tax assets Current tax liabilities


Unpaid tax in respect of the current or Excess tax paid in respect of current
prior periods or prior periods over what is due

Treatment
Be off-set against the amount of tax payment of the following year

2.2. Provision for income tax


Provision for income taxes is the estimated amount that a business or individual taxpayer
expects to pay in income taxes for the current year.
The under/over provision is determinable only after the actual payment is usually made when
the financial statements of the relevant year are already published and the subsequent year

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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.

2.3. Taxation account

Taxation account has two entries in one year:


▪ Balance brought forward
▪ Payment
Treatment to the payment:
▪ If balance brought forward equals payment => Balance on trial balance equals zero
▪ Debit balance => Charge to SOPL
▪ Credit balance => Credited to SOPL
Example 1: In 20X8 Darton Co had taxable profits of $120,000. In the previous year (20X7)
income tax on 20X7 profits had been estimated as $30,000. The corporate income tax rate is
30%.
Required: Calculate tax payable and the charge for 20X8 if the tax due on 20X7 profits was
subsequently agreed with the tax authorities as:
a. $35,000; or
b. $25,000.
Any under or over payments are not settled until the following year's tax payment is due.

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

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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:

Tax repayment due on tax losses = 30% x $24,000 = $7,200.

The double entry will be:

DR Tax receivabl e (statement of financial positi on) $7,200


Tax repaymen t (statem ent of profit or
CR loss) $7,200
The tax receivable will be shown as an asset until the repayment is received from the tax
authorities.
3. Deferred tax
3.1. Overview and treatment
The difference between tax compliance and accounting standards

The differences between current tax and deferred tax

Deferred tax assets Deferred tax liabilities

▪ 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

Recoverable in the future Payable in the future

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3.2. Differences reason between accounting profits and taxable profit

Differences reason

Permanent differences Temporary differences

Due to certain items of revenue or Due to certain items of revenue or


expenses are excluded from taxable profits expenses are included in both
computation computations but different accounting

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.

Deferred tax is the tax attributable to temporary differences.


3.3. Tax base

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.

163
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:

20X1 20X2 20X3 20X4 20X5


$ $ $ $ $
Accounting depreciation 10,000 10,000 10,000 10,000 10,000
Tax depreciation 12,500 12,500 12,500 12,500 -
Taxable difference 2,500 2,500 2,500 2,500 (10,000)
Cumulative difference 2,500 5,000 7,500 10,000 -

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:

20X1 20X2 20X3 20X4 20X5


$ $ $ $ $
Profit for the year 20,000 20,000 20,000 20,000 20,000
Add back depreciation 10,000 10,000 10,000 10,000 10,000
Deduct tax depreciation (12,500) (12,500) (12,500) (12,500) -
Taxable amount 17,500 17,500 17,500 17,500 30,000

164
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:

20X1 20X2 20X3 20X4 20X5


$ $ $ $ $
Non-current liabilities
Deferred tax 1,000 2,000 3,000 4,000 -
Current liabilities
Income tax payable 7,000 7,000 7,000 7,000 12,000

3.5. Deductible temporary differences reason in details


The rule to remember here is that: “All deductible temporary differences give rise to a
deferred tax asset”.
The reasoning behind the recognition of deferred tax assets arising from deductible
temporary differences.

▪ 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:

165
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%.

Required: State the deferred tax implications of this situation.


Answer
What is the tax base of the liability? It is nil (carrying amount of $10,000 less the amount that
will be deductible for tax purposes in respect of the liability in future periods).
When the liability is settled for its carrying amount, the entity's future taxable profit will be
reduced by $10,000 and so its future tax payments by $10,000 * 25% = $2,500.
The difference of $10,000 between the carrying amount ($10,000) and the tax base (nil) is a
deductible temporary difference. The entity should therefore recognise a deferred tax asset
of $10,000 x 25% = $2,500 provided that it is probable that the entity will earn sufficient
taxable profits in future periods to benefit from a reduction in tax payments.
4. Measurement and recognition
4.1. Changes in tax rate
Where the corporate rate of income tax fluctuates from one year to another, IAS requires
DTA and DTL to be measures at the tax rates expected to apply in the period when the asset
is realised or liabilitiy setteled, based on tax rates and laws enacted (or substaintively enacted)
at the end of the reporting period.

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.

(a) Revaluation of PPE (IAS 16)


(b) The effect of a change in accounting policy (applied retrospectively) or correction of a
material error.
Revaluation will appear under OCI in SOCI and the tax element will be shown seperately as
“income tax relating to components of OCI”

166
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:

Debit PPE 300


Credit Deferred tax 90
Revaluation surplus 210
5. Taxation in company accounts
In the statement of financial position, the liability for tax payable is the tax on the current
year profits. In the statement of profit or loss the tax on the current year profits is adjusted
for transfers to or from the deferred tax balance and for prior year under- or overprovisions.

5.1. Taxation in the statement of profit or loss


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.

167
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

5.2 Taxation in the statement of financial position


In the statement of financial position, there are several items which we might expect to find.
Amounts underprovided/overprovided in the prior year. These will appear as debits/credits
to the tax payable account.

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:

Calculate the tax charge for the year to 31 July 20X4.


Calculate the tax liabilities in the statement of financial position of Norman Kronkest as at 31
July 20X4.
Answer:

168
(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

Journal entries for these items

Debit Tax charge (SOPL) 402,000


Credit Tax payable 382,000
Deferred tax 20,000

169
LESSON 16: PRESENTATION OF PUBLISHED FINANCIAL STATEMENTS

LEARNING OUTCOMES:

2. Statement of 1. IAS 1 Presentation of financial statements


financial position
1.1. Objectives and components
2.1. Statement of 5. Notes to the
financial position 1.1.1. Objectives financial statements

2.2. The current/non- 1.1.2. Components 5.1. Structure


current distinction
1.2. Structure and content 5.2. Presentation of
2.2.1. Current assets accounting policies
1.2.1. How items are disclosed
2.2.2. Current
1.2.2. Identification of financial statements
liabilities

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

170
1. IAS 1 Presentation of financial statements

1.1. Objectives and components


1.1.1. Objectives

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

A complete set of FSs includes:

Statement of Statement of Statement of Notes to the


profit or loss and Statement of
financial changes in financial
other cash flows;
position; equity; statements.
comprehensive
income;

1.2. Structure and content

1.2.1. How items are disclosed

IAS 1 specifies disclosures of certain


items in certain ways:

Some items must Other items can


appear on SoFP appear in Notes
or SoPL. to the FSs.

Recommended formats are


given which entities may or
may not follow, depending on
their circumstances.

171
1.2.2. Identification of financial statements

FSs should be clearly


Name of the identified and distinguished The level of
reporting entity from other information in the rounding used in
(or other means same published document: presenting
of identification). amounts in the
FSs.

Whether the The date of the


accounts cover end of the The presentation
the single entity reporting period currency.
only or a group or the period
of entities. covered by FSs.

2. Statement of financial position

2.1. Statement of financial position

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

172
2.2. The current/non-current distinction

2.2.1. Current assets

An asset is classified as
“current” when it
satisfies one of the
following criteria:

It is expected to It is held primarily It is expected to It is cash or cash


be realized, or is for trading be realized within equivalent which
intended for sale purposes; 12 months of the is not restricted in
or consumption, end of the use.
in the normal reporting period;
course of the or
operating cycle;
or

▪ All other assets are classified as “non-current”.

2.2.2. Current liabilities

A liability is classified as
“current” when:

It is expected to It is held primarily It is due to be The entity does


be settled in the for the use of settled within 12 not have an
normal course of being traded; months of the end unconditional
the operating of the reporting right to defer
cycle; period; and settlement for at
least 12 months
after the end of
the reporting
period.

173
3. Statement of profit or loss and other comprehensive income

3.1. Format

IAS 1 (revised) allows income


and expense items to be
presented either:

In a single statement of P&L In two statements: a separate


and other comprehensive statement of P&L and statement
income; or of other comprehensive income

3.2. Information presented in the statement of profit or loss

The standard lists the


following as the minimum to
be disclosed on the face of the
statement of profit or loss.

Share of profits Pre-tax gain or loss


and losses of recognized on the
associates and disposal of assets
Finance Tax Profit
Revenue joint ventures or settlement of
costs expense or loss
liabilities
accounted for
attributable to
using the equity
discontinued
method. operations.

The following items must be


disclosed as allocations of profit
or loss for the period.

Profit or loss Profit or loss


attributable to non- attributable to owners
controlling interest of the parent

The allocated amounts must not be presented as items of income or expense. (These relate
to group accounts, covered later in this text.)
174
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.

Question: Company financial statements


The accountant of Fiddles Co, a limited liability company, has begun preparing final accounts
but the work is not yet complete. At this stage the items included in the list of account
balances are as follows:

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

Notes i to v below are to be taken into account:


i. The accounts receivable control account figure, which is used in the list of account
balances, does not agree with the total of the sales ledger. A contra of $5,000 has
been entered correctly in the individual ledger accounts but has been entered on the
wrong side of both control accounts.
A batch total of sales of $12,345 had been entered in the double entry system as
$13,345, although the individual ledger accounts entries for these sales were correct.
The balance of $4,000 on the sales returns account has inadvertently been omitted
from the trial balance though correctly entered in the ledger records.
ii. A standing order of receipt from a regular customer for $2,000, and bank charges of
$1,000, have been completely omitted from the records.
iii. A receivable for $1,000 is to be written off. The allowance for receivables balance is
to be adjusted to 1% of receivables.
iv. The opening inventory figure had been overstated by $1,000 and the closing
inventory figure had been understated by $2,000.
v. Any remaining balance on the suspense account should be treated as purchases if a
debit balance and as sales if a credit balance.
Required:

175
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:

a. JOURNAL ENTRIES FOR ADJUSTMENTS


Debit Credit
$ $
(i) Trade accounts payable 10,000
Trade accounts receivable 10,000
Profit before tax 1,000
Trade accounts receivable 1,000
Profit before tax 4,000
Suspense 4,000
(ii) Bank 2,000
Trade accounts receivable 2,000
Profit before tax 1,000
Bank 1,000
(iii) Profit before tax 1,000
Trade accounts receivable 1,000
Allowance for receivables (W1) 1,140
Profit before tax 1,140
(iv) Inventories 2,000
Profit before tax 2,000
Retained earnings brought forward 1,000
Profit before tax 1,000
(v) Suspense 3,000
Profit before tax 3,000

b. STATEMENT OF FINANCIAL POSITION


$ $ $
Assets
Non-current assets
Land and buildings 220,000
Plant and machinery 170,000
Depreciation (120,000)
270,000
Current assets
Inventories (190 + 2) 192,000
Accounts receivable (W1) 186,000
Less allowance (1,860)
184,140

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

2. Profit before tax


Per question 80,000
Wrong batch total (1,000)
Returns (4,000)
Bank charges (1,000)
Irrecoverable debt (1,000)
Allowance for receivables 1,140
Inventory (2,000 + 1,000) 3,000
Suspense (sales) 3,000
80,140

177
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. Notes to the financial statements

5.1. Structure
The notes to the financial
statements should perform the
following functions.

Provide information about the Show any additional


basis on which the financial Disclose any information,
information that is relevant
statements were prepared and not shown elsewhere in the
to understanding which is
which specific accounting financial statements, which
not shown elsewhere in the
policies were chosen and applied is required by IFRSs
to significant transactions/events
financial statements

178
Notes to the financial statements
will amplify the information shown
therein by giving the following.

More detailed analysis or Narrative information Additional information, eg.


breakdowns of figures in the explaining figures in the contingent liabilities and
statements statements commitments

IAS 1 suggests a certain order for notes


to the financial statements. This will
assist users when comparing the
statements of different entities.

Supporting information for


Statement of the
Statement of items presented in each Other
measurement basis
compliance financial statement in the same disclosures,
(bases) and accounting
with IFRSs order as each line item and each eg:
policies applied
financial statement is presented

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.

5.2. Presentation of accounting policies

The accounting policies section


should describe the following.

The other accounting policies


The measurement basis (or
used, as required for a proper
bases) used in preparing the
understanding of the financial
financial statements
179 statements
LESSON 17: REPORTING FINANCIAL PERFORMANCE
I. IAS 8 Accounting policies, changes in accounting estimates and errors
1. Changes in Accounting policies

ACCOUNTING POLICIES

Definition:
Accounting policies are the specific principles, bases, conventions, rules and practices adopted by an entity in
preparing and presenting financial statements.

How to determine accounting policy Change in accounting policy

Selection and application of accounting policies: Only change if the change:


• If there is a relevant IFRS, use that standard or • is required by an IFRS Standard or
interpretation • results in the financial statements providing reliable and
• Where there is no applicable IFRS or Interpretation, more relevant information
management should use its judgement in developing
and applying an accounting policy that results in
Occurs if there has been a change in:
information that is relevant and reliable.
• recognition, e.g. an expense is now recognised rather
Management should refer to:
than an asset
• The requirements and guidance in IFRSs dealing • presentation, e.g. depreciation is now included in cost
of sales rather than administrative expenses
with similar and related issues
• measurement basis, e.g. stating assets at replacement
• The definitions, recognition criteria and
cost rather than historical cost.
measurement concepts for assets, liabilities and
expenses in the Conceptual Framework

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:

Reasons for the change/nature of change


Reasons why new policy provides more relevant/reliable
information
Amount of the adjustment for the current period and for
each period presented
Amount of the adjustment relating to periods prior to those
included in the comparative information
The fact that comparative information has been restated or
180 that it is impracticable to do so
WORKED EXAMPLE: CHANGE OF ACCOUNTING POLICY
A company has always valued inventory on a FIFO (first in, first out) basis. In 20X9 it decides
to switch to the weighted average method of valuation. Gross profit in the 20X8 financial
statements was calculated as follows.
$'000

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

Closing inventory (143) (225)

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.

181
2. Changes in accounting estimates

CHANGE IN ACCOUNTING ESTIMATE

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:

• A necessary irrecoverable debt allowance


• Useful lives of depreciable assets
• Provision for obsolescence of inventory

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.

182
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

• Nature of the prior period error


• For each prior period, to the extent practicable, the amount of the correction:
o For each financial statement line item affected
o If IAS 33 applies, for basic and diluted earnings per share
• The amount of the correction at the beginning of the earliest prior period presented
• If retrospective restatement is impracticable for a particular prior period, the circumstances
that led to the existence of that condition and a description of how and from when the error
has been corrected. Subsequent periods need not repeat these disclosures

183
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

EXAMPLE FOR PRESENTATION OF ASSETS HELD FOR SALES

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:

186
III. Foreign currency transactions
1. Definition

Historic rate rate in place at the date the transaction takes


place, sometimes referred to as the spot rate.
Exchange rates
Closing rate rate at the reporting date
Average rate average rate throughout the accounting period
Monetary items that can be easily converted into cash,
Assets and items e.g. receivables, payables, loans.
liabilities Non-monetary items that give no right to receive or deliver cash,
items e.g. inventory, plant and machinery
Functional The currency of the primary economic
currency environment in which an entity operates
An entity should consider the following primary
factors when determining its functional currency:
• the currency that mainly influences sales
prices for goods and services
• the currency of the country whose
competitive forces and regulations mainly
determine the sales price of goods and
services
• the currency that mainly influences labour,
Currency materials and other costs of providing
goods and services.
If the primary factors are inconclusive then the
following secondary factors should also be
considered:
• the currency in which funds from financing
activities are generated
• the currency in which receipts from
operating activities are retained.

Presentation the currency in which the financial statements are


currency presented
Foreign currency Conversion Conversion is the process of exchanging amounts
transactions of one foreign currency for another
Translation Translation is required at the end of an accounting
period when a company still holds assets or
liabilities in its statement of financial position
which were obtained or incurred in a foreign
currency

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

187
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

• Translate using the historic rate prevailing at the transaction date.


Initial transactions • The average rate can also be used if it does not fluctuate significantly during the accounting period.

If a transaction is settled (payment or receipt occurs) during the accounting period:


• Translate at the date of payment / receipt using the historic rate prevailing at that date.
Settled transactions
• As this may be different to the initial transaction an exchange difference may arise, this is
posted to the statement of profit or loss

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

Example for unsettled transactions


On 1 April 20X8 Collins Co, a company that uses the dollar ($) as its functional currency, buys
goods from an overseas supplier, who uses Kromits (Kr) as its functional currency. The goods
are priced at Kr54,000. Payment is still outstanding at the reporting date of 30 June 20X8.
The prevailing exchange rates are:
1 April 20X8 Kr1.80 : $1
30 June 20X8 Kr1.70 : $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
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

Example for treatment of exchange difference


ABC Co has a year end of 31 December 20X1 and uses the dollar ($) as its functional
currency.
On 25 October 20X1 ABC Co buys goods from a Swedish supplier for Swedish Krona (SWK)
286,000.
Rates of exchange:
25 October 20X1 $1 = SWK 11.16
16 November 20X1 $1 = SWK 10.87
31 December 20X1 $1 = SWK 11.02
Required:
Show the accounting treatment for the above transactions if:
(a) A payment of SWK286,000 is made on 16 November 20X1.
(b) The amount owed remains outstanding at the year-end date.

Solution:

(a) Original transaction


25 October 20X1 Value = 286,000/11.16 = $25,627
Dr Purchases 25,627
Cr Payables 25,627
16 November 20X1 Payment 286,000/10.87 = $26,311
Dr Payables 25,627
Dr SPL 684 (Balancing figure, 26,311 – 25,627)
Cr Cash 26,311

(b) If the amount remains outstanding:


31 December 20X1 Retranslate payable 286,000/11.02 = $25,953
Dr SPL 326 (25,953 – 25,627)
Cr Payables 326
Note: The inventory would not be restated and would remain at the original transaction
price of $25,627

192
LESSON 18: EARNINGS PER SHARE
I. IAS 33 Earnings per shares
1. Definitions

No. Term Definition


An equity instrument that is subordinate to all other
1 Ordinary shares
classes of equity instruments.
A financial instrument or other contract that may entitle its
holder to
ordinary shares. Some examples of potential ordinary
shares are:
• Debt or equity instruments, including preference
shares, that are convertible into ordinary shares
Potential ordinary • Share warrants and options
2
share • Employee plans that allow employees to receive
ordinary shares as part of their remuneration and
other share purchase plans
• Shares that would be issued upon the satisfaction
of certain conditions resulting from contractual
arrangements, such as the purchase of a business
or other assets
Options, warrants
Financial instruments that give the holder the right to
3 and their
purchase ordinary shares
equivalents
Any contract that gives rise to both a financial asset of one
Financial
4 entity and a
instrument
financial liability or equity instrument of another entity
Any contract that evidences a residual interest in the
5 Equity instrument
assets of an entity after deducting all of its liabilities

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

• Earnings = group profit after tax - non-controlling interests - preference share


dividends.
• Shares: weighted average number of ordinary shares in issue during the
period:
o Time weighted average number of shares issued from date consideration
receivable
o For additional shares where no consideration received – time weighted
average number of shares from beginning of year / date of issue of shares
with consideration (e.g. bonus issue)
o Restate comparatives.

194
Basic EPS

Bonus issue Right issue


Issue of shares at full market price

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

EXAMPLE FOR ISSUE OF SHARES AT FULL MARKET PRICE


An entity, with a year-end of 31 December 20X8, issued 200,000 shares at full market price of $3 on 1 July 20X8.
Relevant information
20X8 20X7
Profit attributable to the ordinary shareholders for the year ending 31 $550,000 $460,000
December
Number of ordinary shares in issue at 31 December 1,000,000 800,000
Required: Calculate the EPS for each of the year

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.

EXAMPLE FOR BONUS ISSUE


An entity makes a bonus issue of one new share for every five existing shares held on 1 July
20X8.
20X8 20X7
Profit attributable to the ordinary shareholders $550,000 $460,000
for the year ending 31 December
Number of ordinary shares in issue at 31 1,200,000 1,000,000
December
Calculate the EPS in 20X8 accounts

SOLUTION

Calculation of EPS in 20X8 accounts.


$460,000
20X7 comparative = $0.383
1,200 ,000
$550,000
20X8 = $0.458
1,200 ,000

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

EXAMPLE FOR RIGHT ISSUE:


An entity issued one new share for every two existing shares held by way of a rights issue at
$1.50 per share on 1 July 20X8. Pre-issue market price was $3 per share.
Relevant information
20X8 20X7
Profit attributable to the ordinary shareholders $550,000 $460,000
for the year ending 31 December
Number of ordinary shares in issue at 1,200,000 800,000
31 December

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

Step 2 – Bonus fraction

𝑀𝑎𝑟𝑘𝑒𝑡 𝑝𝑟𝑖𝑐𝑒 𝑏𝑒𝑓𝑜𝑟𝑒 𝑖𝑠𝑠𝑢𝑒


Bonus fraction = Market price before issue/TERP = $3/$2.5
𝑇ℎ𝑒𝑜𝑟𝑒𝑡𝑖𝑐𝑎𝑙 𝑒𝑥 𝑟𝑖𝑔ℎ𝑡𝑠 𝑝𝑟𝑖𝑐𝑒

Step 3 – Weighted average number of shares


Draw up the usual table to calculate the No. Bonus Time Shares
weighted average number of shares. fraction
When doing this, the bonus fraction would 1 800,000 3/2.5 6/12 480,000
be applied from the start of the year up to January
the date of the rights issue, but not 20X8
afterwards. b/f
Rights 400,000
issue
1 July 1,200,000 6/12 600,000
1,080,000

Step 4 – Earnings per share (EPS)


20X8 EPS
𝑃𝑟𝑜𝑓𝑖𝑡 𝑎𝑓𝑡𝑒𝑟 𝑡𝑎𝑥
EPS = 𝑊𝑒𝑖𝑔ℎ𝑡𝑒𝑑 𝑎𝑣𝑒𝑟𝑎𝑔𝑒 𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑠ℎ𝑎𝑟𝑒𝑠 $500,000
EPS = = $0.509 per share
1,080 ,000
if you are asked to restate the prior year
EPS, then this is simply the prior year's EPS 20X7 EPS
multiplied by the inverse of the bonus Last year, reported EPS: $460,000 ÷ 800,000 =
fraction $0.575
20X7 Restated EPS: 57.5¢ × 2.5/3 = $0.479

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.

Contingently issuable (potential) ordinary shares are treated as for basic


EPS; if the conditions have not been met, the number of contingently
issuable shares included in the computation is based on the number of
(b)
shares that would be issuable if the end of the reporting period was the
end of the contingency period. Restatement is not allowed if the
conditions are not met when the contingency period expires.

199
DEPS

Convertible Option and warrants to


instruments subscribe for shares

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

EXAMPLE FOR OPTION AND WARRANTS TO SUBSCRIBE FOR SHARES


On 1 January 20X7, a company has 4 million ordinary shares in issue and issues options for a
further million shares. The profit for the year is $500,000.
During the year to 31 December 20X7 the average fair value of one ordinary share was $3
and the exercise price for the shares under option was $2.
Calculate basic EPS and DEPS for the year ended 31 December 20X7.

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

IV. Presentation, disclosure and other matters


1. Presentation
• Basic and diluted EPS should be presented by an entity in the statement of profit or
loss and other comprehensive income for each class of ordinary share that has a
different right to share in the net profit for the period.
• The basic and diluted EPS should be presented with equal prominence for all periods
presented.
• Disclosure must still be made where the EPS figures (basic and/or diluted) are
negative (ie a loss per share).
2. Disclosure
An entity should disclose the following.
• The amounts used as the numerators in calculating basic and diluted EPS, and a
reconciliation of those amounts to the net profit or loss for the period
• The weighted average number of ordinary shares used as the denominator in
calculating basic and diluted EPS, and a reconciliation of these denominators to
each other

3. Alternative EPS figures


An entity may present alternative EPS figures if it wishes. However, IAS 33 lays out certain
rules where
this takes place.
• The weighted average number of shares as calculated under IAS 33 must be used.
• A reconciliation must be given if necessary between the component of profit used
in the alternative EPS and the line item for profit reported in the statement of
profit or loss and other comprehensive income.
• Basic and diluted EPS must be shown with equal prominence.

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

Management Lender / Analyst Investors / Analyst


Cost control Lending
Buy / Hold / Sell shares
Profitability analysis Security
Quality of management
Investment decisions Credit worthiness

Comparison required with:


Previous years
Predetermined forecasts
Industry averages

LIMITATIONS

Availability of information Consistency Historic cost accounting


Changes in accounting
policies between years
Cost / difficulty of obtaining Inherent limitations of HCA in
information periods of price level changes
Different policies used by
different companies

LIMITATIONS OF RATIO ANALYSIS


1. It is an oversimplification of a harsh business world

2. Ratios are based on highly subjective accounting figures

204
3. Historical cost accounts do not take into account the impact of inflation

4. Ratios do not make allowances for external factors: economic or political


5. Users are more interested in future prospects rather than past events

DIVISION OF RATIOS

PERFORMANCE LIQUIDITY STOCK MARKET


EFFICIENCY
(Profitability & (Solvency & (Shareholders
(Turnover ratios)
Return) stability) investment ratios)

ROCE% • SHORT TERM Stock t/o in days EPS


Profit margin% Cash cycle
Debtors t/o in
Current ratio Dividend per share
days
Gross profit% Quick ratio
Creditors t/o in
Dividend cover
days
Net profit% • LONG TERM
Debt ratio Dividend yield
ROE% Gearing ratio
Equity to assets PE ratio
ratio
Asset turnover
Interest cover
Cash flow ratio

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

Profitability Asset utilization

Profit margin Secondary ratios Asset turnover

𝑃𝐵𝐼𝑇 𝑷𝒓𝒐𝒇𝒊𝒕 𝒎𝒂𝒓𝒈𝒊𝒏 𝒙 𝑨𝒔𝒔𝒆𝒕 𝒕𝒖𝒓𝒏𝒐𝒗𝒆𝒓 𝑆𝑎𝑙𝑒𝑠


= 𝑹𝑶𝑪𝑬
𝑆𝑎𝑙𝑒𝑠 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝑒𝑚𝑝𝑙𝑜𝑦𝑒𝑑

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

𝐺𝑟𝑜𝑠𝑠 𝑝𝑟𝑜𝑓𝑖𝑡 𝑆𝑎𝑙𝑒𝑠


𝑆𝑎𝑙𝑒𝑠 𝑁𝐶𝐴 (𝑒𝑥 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡𝑠)

Operating cost margin Return on equity capital (ROE) Net profit margin
𝑃𝐴𝑇
𝐷𝑖𝑠𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 / 𝐴𝑑𝑚𝑖𝑛𝑖𝑠𝑡𝑟𝑎𝑡𝑖𝑜𝑛 𝑃𝐴𝑇 𝑎𝑛𝑑 𝑝𝑟𝑒𝑓𝑒𝑟𝑒𝑛𝑐𝑒 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠
𝑆𝑎𝑙𝑒𝑠
𝑆𝑎𝑙𝑒𝑠 𝐸𝑞𝑢𝑖𝑡𝑦 𝑠ℎ𝑎𝑟𝑒ℎ𝑜𝑙𝑑𝑒𝑟𝑠′ 𝑓𝑢𝑛𝑑

Indicates whether costs are Indicates how efficiently company


being controlled is employing funds provided by
equity shareholders

206
2. Liquidity ratios

2.1. Short term solvency, working capital management and gearing

Short term solvency

Cash cycle = Inventory days + Receivable days – Payable days

Can business pay its creditors / employees on time and service its assets

Current ratio Acid ratio (quick ratio)

𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑎𝑠𝑠𝑒𝑡𝑠 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑎𝑠𝑠𝑒𝑡𝑠 − 𝑖𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦


𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠

Indicates any potential Indicates real short-term liquidity


liquidity problems

2.2. Long-term ratios

Gearing and long term financial strength


Risk business takes from using debt
capital

Debt ratio Interest cover (Times)

𝑇𝑜𝑡𝑎𝑙 𝑑𝑒𝑏𝑡𝑠 𝑃𝐵𝐼𝑇


𝑇𝑜𝑡𝑎𝑙 𝑎𝑠𝑠𝑒𝑡𝑠 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑐ℎ𝑎𝑟𝑔𝑒𝑠

Indicates safety of interest


payments

Gearing ratio (%) (Leverage ratio) Equity to assets ratio (%)

𝑁𝐶𝐿 𝐸𝑞𝑢𝑖𝑡𝑦
𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝑒𝑚𝑝𝑙𝑜𝑦𝑒𝑑 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝑒𝑚𝑝𝑙𝑜𝑦𝑒𝑑

Indicates how vulnerable company is Measures the proportion of


to lenders of long term finance or assets invested in a business that
how reliant it is on external finance are financed by equity

Cash flow ratio


The higher the ratio, the better the firm’s financial
𝑁𝑒𝑡 𝑐𝑎𝑠ℎ 𝑖𝑛𝑓𝑙𝑜𝑤 flexibility and its ability to pay its debts
𝑇𝑜𝑡𝑎𝑙 𝑑𝑒𝑏𝑡𝑠

207
3. Efficiency ratios (Turnover ratios)

Working capital
management / efficiency
Inventory and credit
control

Stock control Credit control

Raw materials: Inventory turnover period: Debtors turnover in days:

𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑅𝑀 𝑠𝑡𝑜𝑐𝑘 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝐴𝑅


𝑥 365 𝑥 365 𝑥 365
𝑅𝑀 𝑐𝑜𝑛𝑠𝑢𝑚𝑝𝑡𝑖𝑜𝑛 𝐶𝑂𝑆 𝐶𝑟𝑒𝑑𝑖𝑡 𝑠𝑎𝑙𝑒𝑠

• Indicates inventory • How many days a • Indicates number of


holding policy firm averagely days taken to collect
needs to turn its debts
Work-in-progess: inventory into sales
Creditors turnover in days:
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 Inventory turnover:
𝑥 365 𝐴𝑃
𝐶𝑜𝑠𝑡 𝑜𝑓 𝑝𝑟𝑜𝑑𝑢𝑐𝑡𝑖𝑜𝑛 𝑥 365
𝐶𝑂𝑆 𝐶𝑟𝑒𝑑𝑖𝑡 𝑝𝑢𝑟𝑐ℎ𝑎𝑠𝑒𝑠
• Indicates production 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦
cycle • Indicates number of
• How many times a days to pay debts
Finished goods: company has sold
and replaced
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐹𝐺 inventory during a
𝑥 365 given period
𝐶𝑜𝑠𝑡 𝑜𝑓 𝑠𝑎𝑙𝑒𝑠

• Indicates shelf life

4. Stock market / investor ratios

Earnings per share (EPS)


Used as measure of
𝑃𝑟𝑜𝑓𝑖𝑡𝑠 𝑎𝑡𝑡𝑟𝑖𝑏𝑢𝑡𝑎𝑏𝑙𝑒 𝑡𝑜 𝑜𝑟𝑑𝑖𝑛𝑎𝑟𝑦 𝑠ℎ𝑎𝑟𝑒ℎ𝑜𝑙𝑑𝑒𝑟𝑠 ∗ profitability; higher the EPS,
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑜𝑟𝑑𝑖𝑛𝑎𝑟𝑦 𝑠ℎ𝑎𝑟𝑒𝑠 the higher the shareholders
expectation dividend
*Profits after tax & preference share dividends payout.

Dividend per share (DPS)


An increase in DPS signals
the company is financially

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.

Dividend cover (times)


Indicates how
𝐸𝑃𝑆/𝑇𝑜𝑡𝑎𝑙 𝑒𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑎𝑡𝑡𝑟𝑖𝑏𝑢𝑡𝑎𝑏𝑙𝑒 𝑡𝑜 𝑜𝑟𝑑𝑖𝑛𝑎𝑟𝑦 𝑠ℎ𝑎𝑟𝑒ℎ𝑜𝑙𝑑𝑒𝑟𝑠 many times
𝐷𝑃𝑆/𝑇𝑜𝑡𝑎𝑙 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠 𝑝𝑎𝑖𝑑 𝑡𝑜 𝑜𝑟𝑑𝑖𝑛𝑎𝑟𝑦 𝑠ℎ𝑎𝑟𝑒ℎ𝑜𝑙𝑑𝑒𝑟𝑠 current year’s
profit covers
dividends
appropriated, and
retention policy.

Dividend yield (%)


Measure of return
𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒 on investment.
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑚𝑎𝑟𝑘𝑒𝑡 𝑝𝑟𝑖𝑐𝑒 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒 (𝑒𝑥. 𝑑𝑖𝑣)

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.

Ocean Motors statement of financial position

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

Ocean Motors statement of profit or loss


20X2 20X1
$000 $000
Sales revenue 1,500 1,000
Cost of sales (700) (300)

Gross profit 800 700

210
Administration and distribution expenses (400) (360)

Profit before tax 400 340


Income tax expense (200) (170)

Profit for the year 200 170

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.

Liquidity and working capital ratios

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:

Statement of profit or loss for the year ended 30 June

20X5 20X4
$000 $000
Revenue 1,391,820 1,159,850
Cost of Sales (1,050,825) (753,450)

Gross profit 340,995 406,400


Operating expenses (161,450) (170,950)

Profit from operations 179,545 235,450


Finance costs (10,000) (14,000)

Profits before tax 169,545 221,450


Tax (50,800) (66,300)

Profit for the year 118,745 155,150

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.

It would seem that Neville are showing signs of overtrading.

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%

Operating profit 235,450 179,545


= 20.3% = 12.9%
1,159,850 1,391,820

ROCE 235,450 179,545


= 48.0% = 29.5%
490,520 607,765

Asset turnover 1,159,850 1,391,820


= 2.36 = 2.29
490,520 607,765

Inventory days 88,760 𝑥 365 109,400 𝑥 365


= 43 = 38
753,480 1,050,825

Receivables days 206,550 𝑥 365 419,455 𝑥 365


= 65
1,159,850 1,391,820
= 110

Payables days 179,590 𝑥 365 295,480 𝑥 365


= 87 = 102
753,450 1,050,825

Current ratio 390,710 528,855


= 1.62 = 1.23
241,590 430,680

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:

Statement of profit or loss


$000
Revenue 2,425
Cost of sales (1,870)

Gross profit 555


Other operating expenses (215)

Profit from operations 340


Finance costs (34)
Exceptional item (note (ii)) (120)

Profit before tax 186


Income tax expense (90)

217
Profit for the year 96

Extract from statement of changes in equity


$000
Retained earnings – 1 October 20X2 179
Profit for the year 96
Dividends paid (interim $60,000, final $30,000) (90)

Retained earnings – 30 September 20X3 185

Statement of financial position


$000 $000
Non-current assets 540
Current assets
Inventory 275
Receivables 320
595
1,135
Equity
Ordinary shares (25 cents each) 150
Retained earnings 185
335
Non-current liabilities
8% loan notes 300
Current liabitilities
Bank overdraft 65
Trade payables 350
Taxation 85
500
1,135

Notes:
(i) The details of non-current assets are:

Cost Accumulated Carrying


depreciation amount
$000 $000 $000
At 30 September 20X3 3,600 3,060 540
(ii) The exceptional item relates to losses on the sale of a batch of computers that
had become worthless due to improvements in microchip design.
(iii) The market price of Comparator’s shares throughout the year averaged $6 each.

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

Subject: Analysis of Comparator’s financial performance compared to sector


average for the year to 30 September 20X3

Operating performance

The return on capital employed of Comparator is impressive being more than


50% higher than the sector average. The components of the return on capital
employed are the asset turnover and profit margin. In these areas Comparator’s
asset turnover is more than double the average, but the net profit margin after
exceptionals is considerably below the sector average. However, if the

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.

The accounts receivable collection figure appears reasonable, but at 68 days,


Comparator takes longer to pay its accounts payable than do its competitors.
Whilst this is a source of ‘free’ finance, it can damage relationships with suppliers
and may lead to a curtailment of further credit.

220
Gearing

As referred to above, gearing (as measured by debt/equity) is more than twice


the level of the sector average. Whilst this may be an uncomfortable level, it is
currently beneficial for shareholders. The company is making an overall return of
34.6%, but only paying 8% interest on its loan notes. The gearing level may
become a serious issue if Comparator becomes unable to maintain the finance
costs. The company already has an overdraft and their ability to make further
interest payments could be in doubt.

Investment ratios

Despite reasonable profitability figures, Comparator’s dividend yield is poor


compared to the sector average. From the extracts of the statement of changes
in equity it can be seen that total dividends are $90,000 out of available profit for
the year of only $96,000 (hence the very low dividend cover). It is worthy of note
that the interim dividend was $60,000 and the final dividend only $30,000.
Perhaps this indicates a worsening performance during the year, as normally final
dividends are higher than interim dividends. Considering these factors it is
surprising the company’s share price is holding up so well.

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.

221
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:

222
A. LIMITATION OF FINANCIAL STATEMENTS:

a) Problems of historical cost information:


Historical cost information is reliable and can be verified, but it becomes less
relevant as time goes by. The value shown for assets carried in the statement of
financial position (SOFP) at historical cost may bear no relation whatever to what
their current value is and what it may cost to replace them. The corresponding
depreciation charge will also be low, leading to the overstatement of profits in real
terms. The financial statements do not show the real cost of using such assets.

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.

f) Acquisitions and disposals:


A company may have acquired or disposed of a subsidiary or division during the
year and the effect of this will need to be isolated in order to assess the underlying
performance.

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

2. Presentation of a Statement of Cash 3. Disclosure of some items


Flows
4. Preparing of SoCF
2.1. Classification
2.2. Examples 5. Interpretation of SoCF

2.3. Operating activities 2.4. Investing and Financing activities


2.3.1. Direct Method 2.4.1. Investing Activities
2.3.2. Indirect Method 2.4.2. Financing Activities

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1. IAS 7 – Statement of Cash Flows
1.1. Objective

OBJECTIVE To ensure that all entities provide information


about the historical changes in cash and cash
equivalents

To classify cash flows (inflows and outflows)


(operating, investing, financing)

1.2. Scope

Applies to All Entities

(a) Users of SoCF are interested in (b) Entities need cash


cash generation regardless of the for essentially the
nature of the entity’s activities. same reasons:

• To conduct •
• To pay To provide
operations; returns to
obligations;
and investors.

1.3. Importance of Cash Flows

(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

(a) Provides information enabling (b) Useful in assessing ability to generate


users to evaluate changes in: cash and cash equivalents.
• Net assets;
• Financial structure; and (c) Users can develop models to assess
• Ability to affect amounts and compare the present value of
and timing of cash flows. future cash flows of different entities.

(d) Enhances comparability of operating


performance reported by different
(f) A focus on cash management entities by eliminating the effects of
can improve results (e.g. with alternative account treatments.
lower interest charges) and lead
to having cash resources
(e) Historical cash flow information may
available on a timely basis (e.g.
provide an indicator of the amount,
for investment).
timing and certainty of future cash
flows.

2. Presentation of a Statement of Cash Flows

2.1. Classification

CASH FLOW ACTIVITIES

3. Operating (CFO) 2. Investing (CFI) 1. Financing (CFF)

• Principal revenue- • Acquisition and disposal • Results in changes in the size


producing activities and of long-term assets and and composition of equity
other activities which are other investments not capital and borrowings. Bank
not investing or financing included in cash borrowings generally
activities. equivalents. included.

228
2.2. Examples

STATEMENT OF CASH FLOWS (Indirect method)


$m $m
Cash flows from operating activities
Profit before taxation 3,570
Adjustments for:
Depreciation 450
Investment income (500)
Interest expense 400
3,920
Increase in trade and other receivables (500)
Decrease in inventories 1,050
Decrease in trade payables (1,740)
Cash generated from operations 2,730
Interest paid (270)
Income taxes paid (900)
Net cash from operating activities 1,560
Cash flows from investing activities
Purchase of property, plant and equipment (900)
Proceeds from sale of equipment 20
Interest received 200
Dividends received 200
Net cash used in investing activities (480)
Cash flows from financing activities
Proceeds from issue of share capital 250
Proceeds from long-term borrowings 250
Dividends paid* (1,290)
Net cash used in financing activities (790)
Net increase in cash and cash equivalents 290
Cash and cash equivalents at beginning of period 120
Cash and cash equivalents at end of period 410
*This could also be shown as an operating cash flow

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2.3. Operating activities

REPORTING CASH FLOW FROM OPERATING ACTIVITIES

Cash flows from operating activities can be reported using direct method or indirect
method

DIRCT METHOD INDIRECT METHOD

Discloses major Information is


classes of gross obtained
cash receipts from accounting Adjusts profit or loss for effects of:
and gross cash records; or
payments. by adjusting
sales, cost of
sales,
for:

Changes in Other Other Non-cash Any Items of


inventories, non- items for transactions deferrals income or
operating cash which (e.g. or expense
receivables items; cash depreciation); accruals of associated
and and effects are past or with
payables investing future investing
during the or operating or
period; financing cash financing
cash receipts or cash
flows. payments; flows.
and

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

2.3.3. Indirect versus Direct


The Direct method is encourage where the data is not costly to obtain, but IAS 7 does not
require it. In practice the Indirect method is more commonly used, since it is quicker and
easier

231
2.4. Investing and Financing activities

INVESTING ACTIVITIES FINANCING ACTIVITIES

Cash Cash Cash Cash Cash payments Cash


advances receipts payments receipts to acquire PPE, receipts
and loans from sales to acquire from sales intangibles and from the
made to of shares or shares or of PPE, other non- repaymen
other debentures debenture intangibles current assets, t of
parties. of other s of other and other including those advances
entities. entities. non-current relating to and loans
assets. capitalized made to
development other
costs and self- parties.
constructed
PPE.

Cash proceeds Cash payments to Cash proceeds Principals


from issuing owners to acquire from issuing repayments of
shares. or redeem the debentures, loans, amounts borrowed
entity’s shares. notes, bonds, under leases.
mortgages and
other short or long-
term borrowings.

232
3. Disclosure of some items

1. Interest and dividends 2. Taxes on income 3. Components of cash 4. Other disclosures


and cash equivalents

• CF from interest and • CF arising from


dividends received Taxes on income • The components of • All entities
and paid should be should be C&CE should be should disclose,
disclosed separately disclosed disclosed and together with a
separately. and classified as CF reconciliation commentary by
• Each should be from operating should be presented management,
classified in a activities unless they showing the any other
consistent manner. can be specially amounts in the SoCF information
identified with reconciled with the likely to be of
financing and equivalent items importance.
investing activities. reported in SoFP.
Dividends paid by the • It is also necessary
entity can be classified to disclose the
in two ways: accounting policy.

• 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.

(c) By contrast, an increase in payables is positive.

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

STATEMENTS OF FINANCIAL POSITION AS AT 31 DECEMBER


20X1 20X2
$’000 $’000
Non-current assets
Cost 1,596 1,560
Depreciation (318) (224)
1,278 1,336
Current assets
Inventories 24 20
Trade receivables 76 58
Cash and cash equivalents 48 56
148 134
Total assets 1,426 1,470

Equity and liabilities


Equity
Share capital 360 340
Share premium 36 24
Retained earnings 716 514
1,112 878
Non-current liabilities
Long-term loans 200 500
Current liabilities
Trade and other payables 12 6
Taxation 102 86
114 92

Total equity and liabilities 1,426 1,470

234
Additional information

Dividends paid were $66,000


During the year, the company paid $90,000 for a new piece of machinery.

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

STEP 1 Set out the proforma SoCF required in IAS 7

STEP 2 Begin with cash flows from operating activities

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

STEP 4 Start with profit before tax

STEP 5 Completing the statement by slotting in the figures given or calculated

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

4 – Working capital changes

Inventories Trade Trade


receivables payables
$’000 $’000 $’000

236
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:

The Cash Financing Operating Investment can A comparison of


relationship equivalent inflows cash flows be compared tax outflow to
between and and to distribution operating cash flow
profit and outflows investment to indicate the minus investment
cash cash flows proportion of flow will establish a
can be total cash ‘cash basis tax rate’
related to outflow
match cash designated
recovery specifically to
from investor return
investment and
to reinvestment
investment

5.2. Worked example


Here is a full example of how the position and performance of a company can be analyzed
using the SoFP, profit and loss extracts and the SoCF.

The following draft FSs relate to Tabba Co, a private company.


Statement of financial position at: 30 September 20X5 30 September 20X4
$’000 $’000 $’000 $’000
Non-current assets
Property, plant and equipment (Note 10,600 15,800
(ii))
Current assets
Inventories 2,550 1,850
Trade receivables 3,100 2,600
Insurance claim (Note (iii)) 1,500 1,200
Cash and cash equivalents 850 nil
8,000 5,650
Total assets 18,600 21,450

Equity
Share capital ($1 each) 6,000 6,000
Reverse:

237
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

Bank overdraft nil 550


Trade and other payables 4,050 2,950
Government grants (Note (ii)) 600 400
Lease obligations (Note (ii)) 900 800
Current tax payable 100 1,200
5,650 5,900
Total equity and liabilities 18,600 21,450

The following additional information is relevant:


(i) Profit or loss extract for the year ended 30 September 20X5: $’000
Operating profit before interest and tax 270
Interest expense (260)
Interest receivable 40
Profit before tax 50
Net income tax credit 50
Profit for the year 100
NOTE: The interest expense includes lease interest.

(ii) The details of the property, plant and equipment


are:
Cost Accumulated Carrying
depreciation amount
$’000 $’000 $’000
At 30 September 20X4 20,200 4,400 15,800
At 30 September 20X5 16,000 5,400 10,600

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.

238
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.

Amortization of government grants has been credited to cost of sales.


(iii) The insurance claim related to flood damage to the company’s inventories which
occurred in September 20X4. The original estimate has been revised during the year
after negotiations with the insurance company. The claim is expected to be settled
in the near future.

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)

Cash flows from investing activities


Interest received 40
Proceeds of grants (From question) 950
Proceeds of disposal of property (From question) 12,000
Purchase of property, plant and equipment (W1) (2,900)

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)

Net increase in cash and cash equivalents 1,400


Opening cash and cash equivalents (550)
Closing cash and cash equivalents 850

Workings

1 Property, plant and equipment and right-of-use assets


$’000
Carrying amount 30 September 20X4 15,800
Disposal (8,600 – 1,200) (7,400)*
Acquisitions under leases 1,500
Depreciation (5,400 – 4,400 + 1,200) (2,200)
Other additions (ß) 2,900
Carrying amount 30 September 20X5 10,600

*Profit on disposal = (12,000 – 7,400) = 4,600

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)

240
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

(b) Changes in Tabba Co’s financial position


The last section of the SoCF reveals a healthy increase in cash of $1.4m.
However, Tabba Co is losing cash on its operating activities and its going concern
status must be in doubt.

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

▪ Amounts used are objective and free


form bias
▪ Understatement of assets and
▪ Amounts are reliable, can be verified
overstatement of depreciation may
on invoices and documents
occur, causing a depress on share price
▪ Amounts in the FS can be matched
▪ Understatement of cost of sales can lead
perfectly with those in cashflow
the overstatement of revenue, profit and
statement
tax bill.
▪ Less creative accounting opportunity
▪ Easy to understand

2. Current value 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

1. Concepts of capital maintenance and the determination of profit

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

Financial capital maintenance Physical capital maintenance

Profit is the increase in normal money Profit is the increase in the physical
capital over the period productive capacity over the period

This is the concept used in Current


This is the concept used in Current cost
purchasing power (CPP) and used under
accounting (CCA)
historical cost accounting

2. Capital maintenance in times of inflation

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.

1. The unit of measurement

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.

3. Monetary and non-monetary items

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.

4. The advantages and disadvantages of CPP accounting

Advantages Disadvantages

▪ It provides a more meaningful basic of


▪ Generalized purchasing power as
comparison with other companies.
measures by a retail price index, or any
▪ Profit is measured in real terms and
other general price index has no
excludes inflationary value increments.
obvious practical significance.
▪ CPP avoids the subjective valuations of
▪ The use of indices inevitably involves
current value accounting.
approximations in the measurements of
▪ CPP provides a stable monetary unit
value.
with which to value profit and capital.
▪ The value of assets in a CPP statement
▪ Raw data is easily verified based on
of financial position has less meaning
historical cost accounting and
than a current value statement of
measurements of value can be readily
financial position.
audited.

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IV. Current cost accounting (CCA)

1. Value to the business (deprival value)

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

2. CCA accounts and deprival 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.

CCA accounts will include the following adjustments:

To amend depreciation in line with the gross replacement


Depreciation adjustment
cost of the asset

To take account of increases in inventory prices and


Cost of sales adjustment
remove any element of profit based on this.

To remove any element of profit or loss based on holding


Working capital adjustment
payables or receivables in a period of inflation.

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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:

Central government departments and agencies


Local or federal government departments
Public sector entities
Publicly funded bodies providing healthcare and social housing

Further and higher education institutions


Charitable bodies Private not-for-profit entities

1. Conceptual framework for not-for-profit entities

The International Federation of Accountants (IFAC) published Phase 1 of a Public Sector


Conceptual Framework in January 2013.

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.

3. Users and user groups

The primary user group for not-for-profit entities is providers of funds.

Not-for-profit entities Primary user group


Public bodies (government departments) Taxpayers
Private bodies (charities) Financial supporters

II. Regulatory framework


There is a general move to get public bodies reporting under the accruals system. Many
private not-for-profit organizations still use cash accounting.

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).

1. International public sector accounting standards

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

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2. Characteristics of Not-for-profit Entities

Private sector Public sector


The Providing goods and services to Providing goods and services to
objectives various recipients and not to make a various recipients or to develop or
profit. implement policy on behalf of
governments and not to make a
profit.

Be characterized by the absence of Be characterized by the absence of


defined ownership interests (shares) defined ownership interests that can
that can be sold, transferred or be sold, transferred or redeemed.
redeemed.
Having a wide group of stakeholders Having a wide group of stakeholders
to consider (including the public at to consider (including the public at
large in some cases). large).

The Arising from contributions Arising from taxes or other similar


revenues (donations or membership dues) contributions obtained through the
rather than sales. exercise of coercive powers.

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.

III. Performance measurement


Not-for profit and public sector entities are required to manage their finds efficiently but are
not expected to show a profit. Their performance is measured in terms of achievement of
their stated purpose.

1. The reason of using performance measurement

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.

2. Performance measurement method

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.

Best Value is based on the principle of “four Cs”:


▪ Challenging why, how and by whom a service is provided
▪ Comparing performance against other local authorities
▪ Consulting service users, the local community
▪ Using fair Competition to secure efficient and effective services.

251
LESSON 24: FOREIGN CURRENCY

IAS 21 – The effects of changes


in foreign exchange rates

Initial treatment

Settled transactions

Unsettled transactions

1. IAS 21 – The effects of changes in foreign exchange rates

Foreign Transactions in foreign currencies


Presentation currency
activities
Foreign operation

How to include foreign currency transactions and foreign operations in


Objective the financial statements (functional currency)
IAS 21

How to translate the amounts to presentation currency


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Basic Exchange rates Historic rate: rate in place at the date the transaction takes place, sometimes referred to as the spot rate.
concepts
Closing rate: rate at the reporting date.

Average rate: average rate throughout the accounting period.

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

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2. Translating transactions

Mechanics of translation

Initial transactions Settled transactions Unsettled transactions Treatment of exchange


differences
• Translate using the If a transaction is settled • If a transaction is still unsettled at • If the exchange difference
historic rate prevailing (payment or receipt the reporting date, there will be an relates to trading transactions it
at the transaction occurs) during the outstanding asset or liability on the is disclosed within other
date. accounting period: statement of financial position. operating income/operating
• The average rate can • Translate at the date of • If the asset/liability is a monetary expenses.
also be used if it does payment / receipt using item it should be retranslated at the • If the exchange difference
not fluctuate the historic rate prevailing closing rate. relates to non-trading
significantly during the at that date. • If the asset/liability is a non- transactions it is
accounting period. • As this may be different monetary item it should remain at the disclosed within interest
to the initial transaction an historic rate. receivable and similar
exchange difference may • Exchange differences will arise on income/finance costs.
arise, this is posted to the the retranslation of the monetary
statement of profit or loss. items,
and these are also posted to the
statement of profit or loss.
Initial treatments Settled transactions Unsettled transactions Exchange gains/losses
Transactions are Settlement is translated at • Monetary items are retranslated Recorded in statement of profit
translated at historic spot rate. at closing rate. or loss unless movement in fair
rate. • Non-monetary items remain value recorded in equity, in
translated at historic rate when which case the exchange
cost was first measured. gain/loss is also taken to equity.

Non-monetary Items:

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• 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

Required: At the reporting date


Record the journal entries for these transactions. Leave closing inventory at the original cost, as inventory is a non-
monetary item
Dr Inventory $30,000
Cr Cost of sales $30,000

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

Note: The inventory would not be restated and would remain


at the
original transaction price of $25,627.

Data for Questions 4 to 6 4. On the sale:


An entity based in the US sold goods overseas for Kr200,000 on 28 Translate the sale at the spot rate prevailing on the transaction
March 20X3 when the exchange rate was Kr0.65:$1. date.
The customer paid in April 20X3 when the rate was Kr0.70:$1. Kr200,000/0.65 = $307,692
The exchange rate at the year ended 30 June 20X3 was Kr0.75:$1.
Dr Receivables 307,692
4. Prepare the journal entries to record the sale of the goods by Cr Revenue 307,692
the US entity.
5. Loss on translation = $307,692 – $285,714 = $21,978
5. Show the journal entries to record the payment in April 20X3. The journal entries would be as follows:
Dr Bank (Kr200,000/0.70) 285,714
6. If the amount was outstanding at the year-end, what would the Cr Receivables (Original amount) 307,692
gain or loss in the statement of profit or loss be? Dr SPL (Balancing figure) 21,978
$ __________
6. $41,025. The monetary item must be retranslated at the
7. An entity based in the US purchased goods for Kr200,000 on 28 reporting date rate of exchange:
March 20X3 when the exchange rate was Kr0.65: $1.
The exchange rate at the year ended 30 June 20X3 was Kr0.75:$1. Dollar value at the reporting date = Kr200,000/0.75 = $266,667
If the goods were unsold at the year-end, what should be the
value of inventory? This results in a reduction in the receivables (and therefore a
$ __________ foreign
exchange loss) of $41,025
8. An entity bought land on credit for Kr100,000 when the exchange
rate was 1Kr/$0.85. At the year end the entity had not paid its

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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.

For tutorial purposes the transactions would be recorded as


follows:

Purchase:
Translate the sale at the spot rate prevailing on the transaction
date.
Kr200,000/0.65 = $307,692 (Dr Purchases, Cr Payables)

Inventory would remain unchanged at the reporting date,


$307,692.

The payables would be restated at the year-end.

Dollar value at the reporting date = Kr200,000/0.75 = $266,667

Gain on translation = 307,692 – 266,667= 41,025


Dr Payables 41,025
Cr SPL 41,025

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8. A, C, E
At acquisition:
Kr100,000 × 0.85 = $85,000

Dr Non-current asset 85,000


Cr Payables 85,000

The land is a non-monetary asset and remains at $85,000 at the


year end. Payables, as a monetary item, must be retranslated
at the reporting date rate of exchange:
Value at the reporting date = Kr100,000 × 0.92 = $92,000
This results in an increase in the payables of $7,000
Loss on translation = $92,000 – $85,000 = $7,000
Cr Payables 7,000
Dr P/L (loss) 7,000

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