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# TeCHniCal

THiS aRTiCle diSCuSSeS and SHowS boTH wayS of meaSuRing goodwill following THe aCquiSiTion of a SubSidiaRy, and How eaCH meaSuRemenT of goodwill iS SubjeCT To an impaiRmenT Review.

IMPAIRMENT
RelevanT To aCCa qualifiCaTion papeRS f7 and p2
Required 1 Calculate the goodwill arising on the acquisition of High on a proportionate basis. 2 Calculate the gross goodwill arising on the acquisition of High, ie using the fair value of the NCI. Solution 1 The proportionate goodwill arising is calculated by matching the consideration that the parent has given, with the interest that the parent acquires in the net assets of the subsidiary, to give the goodwill of the subsidiary that is attributable to the parent. Parents cost of investment at the fair value of consideration given \$500 Less the parents share of the fair value of the net assets of the subsidiary acquired (80% x \$400) (\$320) Goodwill attributable to the parent \$180 2 The gross goodwill arising is calculated by matching the fair value of the whole business with the whole fair value of the net assets of the subsidiary to give the whole goodwill of the subsidiary, attributable to both the parent and to the NCI. Parents cost of investment at the fair value of consideration given \$500 Fair value of the NCI \$100 Less the fair value of the net assets of the subsidiary acquired (100% x \$400) (\$400) Gross goodwill \$200 Given a gross goodwill of \$200 and a goodwill attributable to the parent of \$180, the goodwill attributable to the NCI is the difference of \$20. In these examples, goodwill is said to be a premium arising on acquisition. Such goodwill is positive goodwill and accounted for as an intangible Following the revisions to IFRS 3, Business Combinations and IAS 27, Consolidated and Separate Financial Statements in January 2008, there are now two ways of measuring the goodwill that arises on the acquisition of a subsidiary and each has a slightly different impairment process. This article discusses and shows both ways of measuring goodwill following the acquisition of a subsidiary, and how each measurement of goodwill is subject to an impairment review. How to calculate goodwill The traditional measurement of goodwill on the acquisition of a subsidiary is the excess of the fair value of the consideration given by the parent over the parents share of the fair value of the net assets acquired. This method can be referred to as the proportionate method. It determines only the goodwill that is attributable to the parent company. The new method of measuring goodwill on the acquisition of the subsidiary is to compare the fair value of the whole of the subsidiary (as represented by the fair value of the consideration given by the parent and the fair value of the non controlling interest) with all of the fair value of the net assets of the subsidiary acquired. This method can be referred to as the gross or full goodwill method. It determines the goodwill that relates to the whole of the subsidiary, ie goodwill that is both attributable to the parents interest and the non-controlling interest (NCI). Consider calculating goodwill Borough acquires an 80% interest in the equity shares of High for consideration of \$500. The fair value of the net assets of Borough at that date is \$400. The fair value of the NCI at that date (ie the fair value of Highs shares not acquired by Borough) is \$100.

## STudenT aCCounTanT 08/2009

Studying Papers F7 or P2? performance objectives 10 and 11 are linked

asset in the group accounts, and as we shall see be subject to an annual impairment review. In the event that there is a bargain purchase, ie negative goodwill arises, then this is regarded as a profit and immediately recognised in income. basic principles of impairment An asset is impaired when its carrying value exceeds the recoverable amount. The recoverable amount is, in turn, defined as the higher of the fair value less cost to sell and the value in use; where the value in use is the present value of the future cash flows. An impairment review calculation looks like this. This is the net book value, ie the figure that the asset is currently recorded at in the accounts. Impairment review Carrying value of the asset X > Recoverable amount (X)

an aSSeT iS impaiRed wHen iTS CaRRying value exCeedS THe ReCoveRable amounT, wHeRe THe ReCoveRable amounT iS THe HigHeR of THe faiR value leSS CoSTS To Sell and THe value in uSe.

OF GOODWILL
Consider an impairment review A company has an asset that has a carrying value of \$800. The asset has not been revalued. The asset is subject to an impairment review. If the asset was sold then it would sell for \$610 and there would be associated selling costs of \$10. (The fair value less costs to sell of the asset is therefore \$600.) The estimate of the present value of the future cash flows to be generated by the asset if it were kept is \$750. (This is the value in use of the asset.) Required Determine the outcome of the impairment review. Solution An asset is impaired when its carrying value exceeds the recoverable amount, where the recoverable amount is the higher of the fair value less costs to sell and the value in use. In this case, with a fair value less cost to sell of only \$600 and a value in use of \$750 it both follows the rules, and makes common sense to minimise losses, that the recoverable amount will be the higher of the two, ie \$750. Impairment review Carrying value of the asset Recoverable amount Impairment loss \$800 (\$750) \$50

This is the estimate of how much cash the company thinks it will get from the asset, either by selling it or using it. This loss must be recognised, and the asset written down to the recoverable amount.

Impairment loss

The impairment loss must be recorded so that the asset is written down. There is no accounting policy or choice about this. In the event that the recoverable amount had exceeded the recoverable amount then there would be no impairment loss to recognise and as there is no such thing as an impairment gain, no accounting entry would arise.

TeCHniCal

As the asset has never been revalued, the loss has to be charged to income. Impairment losses are non-cash expenses, like depreciation, so in the cash flow statement they will be added back when reconciling operating profit to cash generated from operating activities, just like depreciation again. Assets are generally subject to an impairment review only if there are indicators of impairment. IAS 36, Impairment of Assets lists examples of circumstances that would trigger an impairment review. External sources market value declines negative changes in technology, markets, economy, or laws increases in market interest rates company share price is below book value Internal sources obsolescence or physical damage asset is part of a restructuring or held for disposal worse economic performance than expected goodwill and impairment The asset of goodwill does not exist in a vacuum; rather, it arises in the group accounts because it is not separable from the net assets of the subsidiary that have just been acquired. The impairment review of goodwill therefore takes place at the level of a cash-generating unit, that is to say a collection of assets that together create an independent stream of cash. The cash-generating unit will normally be assumed to be the subsidiary. In this way, when conducting the impairment review, the carrying value will be that of the net assets and the goodwill of the subsidiary compared with the recoverable amount of the subsidiary.

aSSeTS aRe geneRally SubjeCT To an impaiRmenT Review only if THeRe aRe indiCaToRS of impaiRmenT. iaS 36, impaiRmenT of aSSeTS liSTS exampleS of CiRCumSTanCeS THaT would TRiggeR an impaiRmenT Review.

When looking to assign the impairment loss to particular assets within the cash generating unit, unless there is an asset that is specifically impaired, it is goodwill that is written off first, with any further balance being assigned on a pro rata basis. The goodwill arising on the acquisition of a subsidiary is subject to an annual impairment review. This requirement ensures that the asset of goodwill is not being overstated in the group accounts. Goodwill is a peculiar asset in that it cannot be revalued so any impairment loss will automatically be charged against income. Goodwill is not deemed to be systematically consumed or worn out thus there is no requirement for a systematic amortisation. proportionate goodwill and the impairment review When goodwill has been calculated on a proportionate basis then for the purposes of conducting the impairment review it is necessary to gross up goodwill so that in the impairment review goodwill will include an unrecognised notional goodwill attributable to the NCI. Any impairment loss that arises is first allocated against the total of recognised and unrecognised goodwill in the normal proportions that the parent and NCI share profits and losses. Any amounts written off against the notional goodwill will not affect the consolidated financial statements and NCI. Any amounts written off against the recognised goodwill will be attributable to the parent only, without affecting the NCI. If the total amount of impairment loss exceeds the amount allocated against recognised and notional goodwill, the excess will be allocated against the other assets on a pro rata basis. This further loss will be shared between the parent and the NCI in the normal proportion that they share profits and losses.

## STudenT aCCounTanT 08/2009

THe impaiRmenT Review of goodwill iS Really THe impaiRmenT Review of THe neT aSSeTS SubSidiaRy and iTS goodwill aS TogeTHeR THey foRm a CaSH geneRaTing uniT foR wHiCH iT iS poSSible To aSCeRTain a ReCoveRable amounT.

Consider an impairment review of proportionate goodwill At the year-end, an impairment review is being conducted on a 60%-owned subsidiary. At the date of the impairment review the carrying value of the subsidiarys net assets were \$250 and the goodwill attributable to the parent \$300 and the recoverable amount of the subsidiary \$700. Required Determine the outcome of the impairment review. Solution In conducting the impairment review of proportionate goodwill, it is first necessary to gross it up. Proportionate goodwill Grossed up Goodwill including the notional unrecognised NCI \$500

Only the parents share of the goodwill impairment loss will actually be recorded, ie 60% x \$50 = \$30. The impairment loss will be applied to write down the goodwill, so that the intangible asset of goodwill that will appear on the group statement of financial position will be \$270 (\$300 - \$30). In the group statement of financial position, the accumulated profits will be reduced \$30. There is no impact on the NCI. In the group income statement, the impairment loss of \$30 will be charged as an extra operating expense. There is no impact on the NCI. gross goodwill and the impairment review Where goodwill has been calculated gross, then all the ingredients in the impairment review process are already consistently recorded in full. Any impairment loss (whether it relates to the gross goodwill or the other assets) will be allocated between the parent and the NCI in the normal proportion that they share profits and losses. Consider an impairment review of gross goodwill At the year-end, an impairment review is being conducted on an 80%-owned subsidiary. At the date of the impairment review the carrying value of the net assets were \$400 and the gross goodwill \$300 (of which \$40 is attributable to the NCI) and the recoverable amount of the subsidiary \$500. Required Determine the outcome of the impairment review. Solution The impairment review of goodwill is really the impairment review of the net assets subsidiary and its goodwill, as together they form a cash generating unit for which it is possible to ascertain a recoverable amount.

\$300 x

100/60 =

Now, for the purposes of the impairment review, the goodwill of \$500 together with the net assets of \$250 form the carrying value of the cash-generating unit. Impairment review Carrying value Net assets Goodwill Recoverable amount Impairment loss \$250 \$500 \$750 (\$700) \$50

The impairment loss does not exceed the total of the recognised and unrecognised goodwill so therefore it is only goodwill that has been impaired. The other assets are not impaired. As proportionate goodwill is only attributable to the parent, the impairment loss will not impact NCI.

TeCHniCal
in THe equiTy of THe gRoup STaTemenT of finanCial poSiTion THe aCCumulaTed pRofiTS will be ReduCed by THe paRenTS SHaRe of THe impaiRmenT loSS on THe gRoSS goodwill, ie \$160 (80% x \$200) and THe nCi ReduCed by THe nCiS SHaRe, ie \$40 (20% x \$200).

Impairment review Carrying value Net assets Goodwill Recoverable amount Impairment loss \$400 \$300 \$700 (\$500) \$200

The impairment loss will be applied to write down the goodwill, so that the intangible asset of goodwill that will appear on the group statement of financial position, will be \$100 (\$300 - \$200). In the equity of the group statement of financial position, the accumulated profits will be reduced by the parents share of the impairment loss on the gross goodwill, ie \$160 (80% x \$200) and the NCI reduced by the NCIs share, ie \$40 (20% x \$200). In the income statement, the impairment loss of \$200 will be charged as an extra operating expense. As the impairment loss relates to the gross goodwill of the subsidiary, so it will reduce the NCI in the subsidiarys profit for the year by \$40 (20% x \$200). observation In passing, you may wish to note an apparent anomaly with regards to the accounting treatment of gross goodwill and the impairment losses attributable to the NCI. The goodwill attributable to the NCI in this example is stated as \$40. This means that goodwill is \$40 greater than it would have been if it had been measured on a proportionate basis; likewise, the NCI is also \$40 greater for having been measured at fair value at acquisition. The split of the gross goodwill between what is attributable to the parent and what is attributable to the NCI is determined by the relative values of the NCI at acquisition to the parents cost of investment. However, when it comes to the allocation of impairment losses attributable to the write off of goodwill then these losses are shared in the normal proportions that the parent and the NCI share profits and losses, ie in this case 80%/20%.

you may wiSH To noTe an appaRenT anomaly wiTH RegaRdS To THe aCCounTing TReaTmenT of gRoSS goodwill and THe impaiRmenT loSSeS aTTRibuTable To THe nCi. THe goodwill aTTRibuTable To THe nCi in THiS example iS STaTed aS \$40. THiS meanS THaT goodwill iS \$40 gReaTeR THan iT would Have been if iT Had been meaSuRed on a pRopoRTionaTe baSiS; likewiSe, THe nCi iS alSo \$40 gReaTeR foR Having been meaSuRed aT faiR value aT aCquiSiTion.
This explains the strange phenomena that while the NCI are attributed with only \$40 out of the \$300 of the gross goodwill, when the gross goodwill was impaired by \$200 (ie two thirds of its value), the NCI are charged \$40 of that loss, representing all of the goodwill attributable to the NCI. Tom Clendon and Sally Baker are tutors at Kaplan Financial

01 technIcal

## Relevant to acca qualIFIcatIon papeR F7

IFRS 3, Business Combinations was issued in January 2008 as the second phase of a joint project with the Financial Accounting Standards Board (FASB), the US standards setter, and is designed to improve financial reporting and international convergence in this area. The standard has also led to minor changes in IAS 27, Consolidated and Separate Financial Statements. The requirements of the revised IFRS 3 have been examinable since December 2008. This article relates to the relevance of IFRS 3 to Paper F7, Financial Reporting. This article is also of interest to candidates studying UK-based papers, as under UK regulation consolidated goodwill is calculated using the non-controlling interests (NCI) proportionate share of the subsidiarys identifiable net assets (referred to as method (ii) below). The revised IFRS 3 introduces: Restrictions on the expenses that can form part of the acquisition costs New principles for the treatment of contingent consideration A choice in the measurement of non-controlling interests (which have a knock-on effect to consolidated goodwill), considerable guidance on recognising and measuring the identifiable assets and liabilities of the acquired subsidiary, in particular the illustrative examples discuss several intangibles, such as market-related, customer-related, artistic-related and technology-related assets. acquISItIon coStS All acquisition costs, even those directly related to the acquisition such as professional fees (legal, accounting, valuation, etc), must be expensed. The costs of issuing debt or equity are to be accounted for under the rules of IAS 39, Financial Instruments: Recognition and Measurement. contIngent conSIdeRatIon IFRS 3 defines contingent consideration as: Usually, an obligation of the acquirer to transfer additional assets or equity interests to the former owners of an acquiree as part of the exchange for control of the acquiree if specified future events occur or conditions are met. However, contingent consideration also may give the acquirer the right to the return of previously transferred consideration if specified conditions are met (this would be an asset). IFRS 3 requires the acquirer to recognise any contingent consideration as part of the consideration for the acquiree. It must be recognised at its fair value which is the amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arms length transaction. This fair value approach is consistent with the way in which other forms of consideration are valued. Applying this definition to contingent consideration may not be easy as the definition is largely hypothetical; it is highly unlikely that the acquisition date liability for contingent consideration could be or would be settled by willing parties in an arms length transaction. An exam question would give the fair value of any contingent consideration or would specify how it is to be calculated. The payment of contingent consideration may be in the form of equity, a liability (issuing a debt instrument) or cash.

IFRS 3, buSIneSS combInatIonS , RequIReS the acquIReR to RecognISe any contIngent conSIdeRatIon aS paRt oF the conSIdeRatIon FoR the acquIRee.

## Student accountant issue 14/2010

Studying Paper F7? performance objectives 10 and 11 are relevant to this exam

02

combinations
If there is a change to the fair value of contingent consideration due to additional information obtained after the acquisition date that affects the facts or circumstances as they existed at the acquisition date, it is treated as a measurement period adjustment and the contingent liability (and goodwill) are remeasured. This is effectively a retrospective adjustment and is rather similar to an adjusting event under IAS 10, Events After the Reporting Period. Changes in the fair value of contingent consideration due to events after the acquisition date (for example, meeting an earnings target which triggers a higher payment than was provided for at acquisition) are treated as follows: Contingent consideration classified as equity shall not be remeasured, and its subsequent settlement shall be accounted for within equity (eg Cr share capital/share premium Dr retained earnings). Contingent consideration classified as an asset or a liability that: is a financial instrument and is within the scope of IAS 39 shall be measured at fair value, with any resulting gain or loss recognised either in profit or loss, or in other comprehensive income in accordance with that IFRS is not within the scope of IAS 39 shall be accounted for in accordance with IAS 37, Provisions, Contingent Liabilities and Contingent Assets, or other IFRSs as appropriate. Note that although contingent consideration is usually a liability, it may be an asset if the acquirer has the right to a return of some of the consideration transferred if certain conditions are met. goodwIll and non-contRollIng InteReStS The acquirer (parent) measures any non-controlling interest either: (i) at fair value as determined by the directors of the acquiring company (often called the full goodwill method); or (ii) at the non-controlling interests proportionate share of the acquirees (subsidiarys) identifiable net assets (this is the UK method). The differential effect of the two methods is that (i) recognises the whole of the goodwill attributable to an acquired subsidiary, whereas (ii) only recognises the parents share of the goodwill. eXample 1 Parent pays \$100m for 80% of Subsidiary which has net assets with a fair value of \$75m. The directors of Parent have determined the fair value of the NCI at the date of acquisition was \$25m. Method (i) Consideration Parent NCI Fair value of net assets Consolidated goodwill on acquisition \$ 100 25 125 (75) 50

In the consolidated statement of financial position the non-controlling interests would be shown as \$25m. In the above example the value of the non-controlling interests of \$25m as determined by the directors of Parent is proportionate to that of Parents consideration (\$100m x 20%/80%). This is not always (in fact rarely) the case. Method (ii) Consideration Parent Share of fair value of net assets acquired (\$75m x 80%) Consolidated goodwill \$ 100 (60) 40

In the consolidated statement of financial position the non-controlling interest would be shown at its proportionate share of the subsidiarys net assets of \$15m (\$75m x 20%).

03 technIcal

The two methods are an extension of the methodology used in IAS 36, Impairment of Assets when calculating the impairment of goodwill of a cash generating unit (CGU) where there is a non-controlling interest. eXample 2 Parent owns 80% of Subsidiary (a CGU). Its identifiable net assets at 31 March 2010 are \$500. Scenario 1 Net assets included in the consolidated statement of financial position Consolidated goodwill (calculated under method (i)) NCI Scenario 2 Net assets included In the consolidated statement of financial position Consolidated goodwill (calculated under method (ii)) NCI An impairment review of Subsidiary was carried out at 31 March 2010. Required: For scenarios 1 and 2, calculate the impairment losses and show how they would be allocated if the recoverable amount of Subsidiary at 31 March 2010 if the impairment review concluded that the recoverable of Subsidiary was: (i) \$450 (ii) \$550 answer Scenario 1 (i) The impairment loss is \$250 (700 - 450). This loss will be first applied to goodwill (eliminating it) and then to the other net assets reducing them to \$450, ie equal to the recoverable amount of the CGU. The statement of financial position would now be: \$ 500 200 700 140 \$ 500 160 660 100

Net assets (to be consolidated) Consolidated goodwill NCI (140 - (250 x 20%)) (see below))

## \$ 450 nil 450 90

Note: IFRS 3 requires that any impairment loss should be written of to the controlling and non-controlling interests on the same basis as that in which profits loss are allocated. (ii) With a recoverable amount of \$550, the impairment loss will be \$150 and applied to the goodwill reducing it to \$50. The statement of financial position would now be: Net assets (to be consolidated) Consolidated goodwill (under method (i)) NCI (140 - (150 x 20%)) \$ 500 50 550 110

Scenario 2 Where method (ii) has been used to calculate goodwill and the non-controlling interests, IAS 36 requires a notional adjustment to the goodwill of Subsidiary, before being compared to the recoverable amount. This is because the recoverable amount relates to the value of Subsidiary as a whole (ie including all of its goodwill). The notional adjustment is always based on the non-controlling interest in goodwill being proportional to that of the parent. Goodwill Net assets \$ \$ Carrying amount re Parent Notional adjustment re NCI (see below) 160 40 200 500 Total \$ 660 40 700

500

If the goodwill of Parent is \$160 and this represents 80%, then the goodwill attributable to the NCI is deemed to be \$40 (\$160 x 20%/80%).

## Student accountant issue 14/2010

04

In this case, because the fair value of the non-controlling interests in scenario 1 is proportional to the consideration paid by Parent, the notional adjustment leads to the same impairment losses of \$450 for (i) and \$550 for (ii) as under scenario 1 (see *). Applying these: (i) the impairment loss of \$250 is again applied to eliminate goodwill and the remaining \$50 is applied to reduce the other net assets. The non-controlling interest will be reduced by \$10 being its share (20%) of the reduction of other net assets. This gives exactly the same statement of financial position as under scenario 1. Net assets (to be consolidated) Consolidated goodwill \$ 450 nil 450 NCI (100 - 10 (50 x 20%)) 90

The problem with this methodology is that goodwill (or what is subsumed within it) is a very complex item. If asked to describe goodwill, traditional aspects such as product reputation, skilled workforce, site location, market share, and so on, all spring to mind. These are perfectly valid, but in an acquisition, goodwill may contain other factors such as a premium to acquire control, and the value of synergies (cost savings or higher profits) when the subsidiary is integrated within the rest of the group. While non-controlling interests may legitimately lay claim to their share of the more traditional aspects of goodwill, they are unlikely to benefit from the other aspects, as they relate to the ability to control the subsidiary. *Thus, it may not be appropriate to value non-controlling interests on the same basis (proportional to) as the controlling interests (see method (i) below). IFRS 3 illustrates the calculation of consolidated goodwill at the date of acquisition as: Consideration paid by parent + non-controlling interest - fair value of the subsidiarys net identifiable assets = consolidated goodwill. The non-controlling interest in the above formula may be valued at its fair value (method (i)) or its proportionate share of the subsidiarys net identifiable assets (method (ii)). Subsequent to acquisition the carrying amount of the non-controlling interest (under either method) will change in proportion it is share of the post acquisition profits or losses of the subsidiary. Consolidated goodwill (under either method) will remain the same unless impaired. The standard recognises that there may be many ways of calculating the fair value of the non-controlling interest (method (i)), one of which may be to use the market price of the subsidiarys shares prior to the acquisition (where this exists). In the Paper F7 exam this is the most common method; an alternative would be to simply give the fair value of the non-controlling interests in the question. eXample 3 This comprehensive example is an adaptation of Question 1 from the December 2007 Paper F7 (INT) paper, and calculates goodwill based on the fair value of the non-controlling interests (method (i) above) by valuing the non-controlling interests using the subsidiarys share price at the date of acquisition (see note (iv) of the question).

(ii) the impairment loss of \$150 would be applied to goodwill leaving the other net assets unaffected. As only Parents share of goodwill is recognised, only 80% of the loss is applied, giving: Net assets Goodwill (160 - (150 x 80%)) NCI (unaffected) \$ 500 40 540 100

From this it can be seen that the carrying amount of the CGU is now \$540, which is less than the recoverable amount (\$550) of the CGU. This is because the recoverable amount takes into account the unrecognised goodwill of the NCI which would be \$10 (goodwill of \$200 - \$150 impairment) x 20%).

05 technIcal

On 1 October 2006, Plateau acquired the following non-current investments: Three million equity shares in Savannah by an exchange of one share in Plateau for every two shares in Savannah, plus \$1.25 per acquired Savannah share in cash. The market price of each Plateau share at the date of acquisition was \$6, and the market price of each Savannah share at the date of acquisition was \$3.25. Thirty per cent of the equity shares of Axle at a cost of \$7.50 per share in cash. Only the cash consideration of the above investments has been recorded by Plateau. In addition, \$500,000 of professional costs relating to the acquisition of Savannah are included in the cost of the investment. The summarised draft statements of financial position of the three companies at 30 September 2007 are: Plateau \$000 Assets Non-current assets: Property, plant and equipment 18,400 Investments in Savannah and Axle 13,250 Financial asset investments 6,500 38,150 Current assets: Inventory 6,900 Trade receivables 3,200 Total assets 48,250 Equity and liabilities Equity shares of \$1 each Retained earnings at 30 September 2006 for year ended 30 September 2007 Non-current liabilities 7% Loan notes Current liabilities Total equity and liabilities 10,000 16,000 9,250 35,250 5,000 8,000 48,250 Savannah \$000 Axle \$000

10,400 nil nil 10,400 6,200 1,500 18,100 4,000 6,000 2,900 12,900 1,000 4,200 18,100

18,000 nil nil 18,000 3,600 2,400 24,000 4,000 11,000 5,000 20,000 1,000 3,000 24,000

The following information is relevant: (i) At the date of acquisition, Savannah had five years remaining of an agreement to supply goods to one of its major customers. Savannah believes it is highly likely that the agreement will be renewed when it expires. The directors of Plateau estimate that the value of this customer based contract has a fair value of \$1m, an indefinite life, and has not suffered any impairment. (ii) On 1 October 2006, Plateau sold an item of plant to Savannah at its agreed fair value of \$2.5m. Its carrying amount prior to the sale was \$2m. The estimated remaining life of the plant at the date of sale was five years (straight-line depreciation). (iii) During the year ended 30 September 2007, Savannah sold goods to Plateau for \$2.7m. Savannah had marked up these goods by 50% on cost. Plateau had a third of the goods still in its inventory at 30 September 2007. There were no intra-group payables/receivables at 30 September 2007. (iv) At the date of acquisition the non-controlling interest in Savannah is to be valued at its fair value. For this purpose Savannahs share price at that date can be taken to be indicative of the fair value of the shareholding of the non-controlling interest. Impairment tests on 30 September 2007 concluded that neither consolidated goodwill nor the value of the investment in Axle had been impaired. (v) The financial asset investments are included in Plateaus statement of financial position (above) at their fair value on 1 October 2006, but they have a fair value of \$9m at 30 September 2007. (vi) No dividends were paid during the year by any of the companies. Required Prepare the consolidated statement of financial position for Plateau as at 30 September 2007. (20 marks)

## Student accountant issue 14/2010

06

tutorial note Note (iv) may instead have said that the fair value of the NCI at the date of acquisition was \$3,250,000. Alternatively, it may have said that the goodwill attributable to the NCI was \$500,000. All these are different ways of giving the same information. answer Consolidated statement of financial position of Plateau as at 30 September 2007: \$000 \$000 Assets Non-current assets: Property, plant and equipment (18,400 + 10,400 - 400 (w (i))) 28,400 Goodwill (w (ii)) 5,000 Customer-based intangible 1,000 Investments associate (w (iii)) 10,500 financial asset 9,000 53,900 Current assets: Inventory (6,900 + 6,200 - 300 URP (w (iv))) 12,800 Trade receivables (3,200 + 1,500) 4,700 17,500 Total assets 71,400 Equity and liabilities Equity attributable to equity holders of the parent Equity shares of \$1 each (w (v)) Reserves Share premium (w (v)) Retained earnings (w (vi)) Non-controlling interest (w (vii)) Total equity Non-current liabilities 7% Loan notes (5,000 + 1,000) Current liabilities (8,000 + 4,200) Total equity and liabilities Workings (figures in brackets are in \$000).

the conSIdeRatIon gIven by plateau FoR the ShaReS oF Savannah woRkS out at \$4.25 peR ShaRe, Ie conSIdeRatIon oF \$12.75m FoR 3 mIllIon ShaReS.
(i) Property, plant and equipment The transfer of the plant creates an initial unrealised profit (URP) of \$500,000. This is reduced by \$100,000 for each year (straight-line depreciation over five years) of depreciation in the post-acquisition period. Thus at 30 September 2007, the net unrealised profit is \$400,000. This should be eliminated from Plateaus retained profits and from the carrying amount of the plant. (ii) Goodwill in Savannah \$000 \$000 Controlling interest: Shares issued (3,000/2 x \$6) 9,000 Cash (3,000 x \$1.25) 3,750 12,750 Non-controlling interests (1 million shares at \$3.25) 3,250 Total consideration 16,000 Equity shares of Savannah Pre-acquisition reserves Customer-based contract Consolidated goodwill 4,000 6,000 1,000

11,500 7,500 30,300 37,800 49,300 3,900 53,200 6,000 12,200 71,400

(11,000) 5,000

tutorial note The consideration given by Plateau for the shares of Savannah works out at \$4.25 per share, ie consideration of \$12.75m for 3 million shares. This is higher than the market price of Savannahs shares (\$3.25) before the acquisition and could be argued to be the premium paid to gain control of Savannah. This is also why it is (often) appropriate to value the NCI in Savannah shares at \$3.25 each, because (by definition) the NCI does not have control.

07 technIcal

(iii) Carrying amount of Axle at 30 September 2007 Cost (4,000 x 30% x \$7.50) Share post-acquisition profit (5,000 x 30%) (iv)

## \$000 9,000 1,500 10,500

Note that subsequent to the date of acquisition, the non-controlling interest is valued at its fair value at acquisition plus its proportionate share of Savannahs (adjusted) post acquisition profits. FuRtheR ISSueS The original question contained an impairment of goodwill; lets say that this is \$1m. IAS 36 (as amended by IFRS 3) requires a goodwill impairment of a subsidiary (if a cash generating unit) to be allocated between the parent and the non-controlling interests in on the same basis as the subsidiarys profits and losses are allocated. Thus, of the impairment of \$1m, \$750,000 would be allocated to the parent (and debited to group retained earnings reducing them to \$29.55m (\$30,300,000 - \$750,000)) and \$250,000 would be allocated to the non-controlling interests, writing it down to \$3.65m (\$3,900,000 - \$250,000). It could be argued that this requirement represents an anomaly. It can be calculated (though not done in this example) that of Savannahs recognised goodwill (before the impairment) of \$5m only \$500,000 (ie 10%) relates to the non-controlling interests, but the NCI suffers 25% (its proportionate shareholding in Savannah) of the goodwill impairment. Steve Scott is examiner for Paper F7

The unrealised profit (URP) in inventory Intra-group sales are \$2.7m on which Savannah made a profit of \$900,000 (2,700 x 50/150). One third of these are still in the inventory of Plateau, thus there is an unrealised profit of \$300,000. (v) The 1.5 million shares issued by Plateau in the share exchange, at a value of \$6 each, would be recorded as \$1 per share as capital and \$5 per share as premium, giving an increase in share capital of \$1.5m and a share premium of \$7.5m. (vi) Consolidated retained earnings \$000 Plateaus retained earnings 25,250 Professional costs of acquisition must be expensed (500) Savannahs post-acquisition (2,900 - 300 URP) x 75% 1,950 Axles post-acquisition profits (5,000 x 30%) 1,500 URP in plant (see (i)) (400) Gain on financial asset investments (9,000 - 6,500) 2,500 30,300 (vii) NCI Fair value at acquisition Post-acquisition profit (2,900 - 300 URP) x 25% 3,250 650 3,900

the oRIgInal queStIon contaIned an ImpaIRment oF goodwIll; letS Say that thIS IS \$1m. IaS 36 (aS amended by IFRS 3) RequIReS a goodwIll ImpaIRment oF a SubSIdIaRy (IF a caSh geneRatIng unIt) to be allocated between the paRent and the non-contRollIng InteReStS In on the Same baSIS aS the SubSIdIaRyS pRoFItS and loSSeS aRe allocated.

## RELEVANT TO ACCA QUALIFICATION PAPER F7 AND P2

Studying Paper F7 or P2? Performance objectives 10 and 11 are relevant to this exam

## The IASBs Conceptual Framework for Financial Reporting

I am from England, and here in the UK, unlike most countries, our system of government has no comprehensive written constitution. Many countries do have such constitutions and in these circumstances the laws of the land are shaped and influenced by the constitution. Now while the International Accounting Standards Board (IASB) is not a country it does have a sort of constitution, in the form of the Conceptual Framework for Financial Reporting (the Framework), that proves the definitive reference document for the development of accounting standards. The Framework can also be described as a theoretical base, a statement of principles, a philosophy and a map. By setting out the very basic theory of accounting the Framework points the way for the development of new accounting standards. It should be noted that the Framework is not an accounting standard, and where there is perceived to be a conflict between the Framework and the specific provisions of an accounting standard then the accounting standard prevails. Before we look at the contents of the Framework, let us continue to put the Framework into context. It is true to say that the Framework: seeks to ensure that accounting standards have a consistent approach to problem solving and do not represent a series of ad hoc responses that address accounting problems on a piece meal basis assists the IASB in the development of coherent and consistent accounting standards is not a standard, but rather acts as a guide to the preparers of financial statements to enable them to resolve accounting issues that are not addressed directly in a standard is an incredibly important and influential document that helps users understand the purpose of, and limitations of, financial reporting used to be called the Framework for the Preparation and Presentation of Financial Statements is a current issue as it is being revised as a joint project with the IASB's American counterparts the Financial Accounting Standards Board . Overview of the contents of the Framework The starting point of the Framework is to address the fundamental question of why financial statements are actually prepared. The basic answer to that is they are prepared to provide financial information about the reporting entity that is useful to existing and potential investors, lenders, and other creditors in making decisions about providing resources to the entity. In turn this means the Framework has to consider what is meant by useful information. In essence for information to be useful it must be considered both relevant, ie capable of making a difference in the decisions made by users and

2011 ACCA

2 THE IASBS CONCEPTUAL FRAMEWORK FOR FINANCIAL REPORTING MARCH 2011 be faithful in its presentation, ie be complete, neutral and free from error. The usefulness of information is enhanced if it is also comparable, verifiable, timely, and understandable. The Framework also considers the nature of the reporting entity and, in what reminds me of my school chemistry lessons, the basic elements from which financial statements are constructed. The Framework identifies three elements relating to the statement of financial position, being assets, liabilities and equity, and two relating to the income statement, being income and expenses. The definitions and recognition criteria of these elements are very important and these are considered in detail below. The five elements An asset is defined as a resource controlled by the entity as a result of past events and from which future economic benefits are expected to flow to the entity. Assets are presented on the statement of financial position as being noncurrent or current. They can be intangible, ie without physical presence, eg goodwill. Examples of assets include property plant and equipment, financial assets and inventory. While most assets will be both controlled and legally owned by the entity it should be noted that legal ownership is not a prerequisite for recognition, rather it is control that is the key issue. For example IAS 17, Leases, with regard to a lessee with a finance lease, is consistent with the Framework's definition of an asset. IAS 17 requires that where substantially all the risks and rewards of ownership have passed to the lessee it is regarded as a finance lease and the lessee should recognise an asset on the statement of financial position in respect of the benefits that it controls, even though the asset subject to the lease is not the legally owned by the lessee. So this reflects that the economic reality of a finance lease is a loan to buy an asset, and so the accounting is a faithful presentation. A liability is defined as 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. Liabilities are also presented on the statement of financial position as being noncurrent or current. Examples of liabilities include trade payables, tax creditors and loans. It should be noted that in order to recognise a liability there does not have to be an obligation that is due on demand but rather there has to be a present obligation. Thus for example IAS 37, Provisions, Contingent Liabilities and

2011 ACCA

3 THE IASBS CONCEPTUAL FRAMEWORK FOR FINANCIAL REPORTING MARCH 2011 Contingent Assets is consistent with the Framework's approach when considering whether there is a liability for the future costs to decommission oil rigs. As soon as a company has erected an oil rig that it is required to dismantle at the end of the oil rig's life, it will have a present obligation in respect of the decommissioning costs. This liability will be recognised in full, as a non-current liability and measured at present value to reflect the time value of money. The past event that creates the present obligation is the original erection of the oil rig as once it is erected the company is responsible to incur the costs of decommissioning. Equity is defined as the residual interest in the assets of the entity after deducting all its liabilities. The effect of this definition is to acknowledge the supreme conceptual importance of indentifying, recognising and measuring assets and liabilities, as equity is conceptually regarded as a function of assets and liabilities, ie a balancing figure. Equity includes the original capital introduced by the owners, ie share capital and share premium, the accumulated retained profits of the entity, ie retained earnings, unrealised asset gains in the form of revaluation reserves and, in group accounts, the equity interest in the subsidiaries not enjoyed by the parent company, ie the non-controlling interest (NCI). Slightly more exotically, equity can also include the equity element of convertible loan stock, equity settled share based payments, differences arising when there are increases or decreases in the NCI, group foreign exchange differences and contingently issuable shares. These would probably all be included in equity under the umbrella term of Other Components of Equity. Income is defined as the increases in economic benefits during the accounting period in the form of inflows or enhancements of assets or decreases of liabilities that result in increases in equity, other than those relating to contributions from equity participants. Most income is revenue generated from the normal activities of the business in selling goods and services, and as such is recognised in the Income section of the Statement of Comprehensive Income, however certain types of income are required by specific standards to be recognised directly to equity, ie reserves, for example certain revaluation gains on assets. In these circumstances the income (gain) is then also reported in the Other Comprehensive Income section of the Statement of Comprehensive Income. The reference to other than those relating to contributions from equity participants means that when the entity issues shares to equity shareholders,

2011 ACCA

4 THE IASBS CONCEPTUAL FRAMEWORK FOR FINANCIAL REPORTING MARCH 2011 while this clearly increases the asset of cash, it is a transaction with equity participants and so does not represent income for the entity. Again note how the definition of income is linked into assets and liabilities. This is often referred to as the balance sheet approach (the former name for the statement of financial position). Expenses are defined as decreases in economic benefits during the accounting period in the form of outflows or depletions of assets or incurrences of liabilities that result in decreases in equity, other than those relating to distributions to equity participants. The reference to other than those relating to distributions to equity participants refers to the payment of dividends to equity shareholders. Such dividends are not an expense and so are not recognised anywhere in the Statement of Comprehensive Income. Rather they represent an appropriation of profit that is as reported as a deduction from Retained Earnings in the Statement of Changes in Equity. Examples of expenses include depreciation, impairment of assets and purchases. As with income most expenses are recognised in the Income Statement section of the Statement of Comprehensive Income, but in certain circumstances expenses (losses) are required by specific standards to be recognised directly in equity and reported in the Other Comprehensive Income Section of the Statement of Comprehensive Income. An example of this is an impairment loss, on a previously revalued asset, that does not exceed the balance of its Revaluation Reserve. The recognition criteria for elements The Framework also lays out the formal recognition criteria that have to be met to enable elements to be recognised in the financial statements. The recognition criteria that have to be met are that that an item that meets the definition of an element and it is probable that any future economic benefit associated with the item will flow to or from the entity and the items cost or value can be measured with reliability. Measurement issues for elements Finally the issue of whether assets and liabilities should be measured at cost or value is considered by the Framework. To use cost should be reliable as the cost is generally known, though cost is not necessary very relevant for the users as it is past orientated. To use a valuation method is generally regarded as relevant to the users as it up to date, but value does have the drawback of not always being reliable. This conflict creates a dilemma that is not satisfactorily resolved as the Framework is indecisive and acknowledges that

2011 ACCA

5 THE IASBS CONCEPTUAL FRAMEWORK FOR FINANCIAL REPORTING MARCH 2011 there are various measurement methods that can be used. The failure to be prescriptive at this basic level results in many accounting standards sitting on the fence how they wish to measure assets. For example IAS 40, Investment Properties and IAS 16, Property, Plant and Equipment both allow the preparer the choice to formulate their own accounting policy on measurement. Applying the Framework A company is about to enter into a three-year lease to rent a building. The lease cannot be cancelled and there is no certainty of renewal. The landlord retains responsibility for maintaining the premises in good repair. The directors are aware that in accordance with IAS 17 that technically the lease is classified as an operating lease, and that accordingly the correct accounting treatment is to simply expense the income statement with the rentals payable. Required Explain how such a lease can be regarded as creating an asset and liability per the Framework. Solution lease Given that it is reasonable to assume that the expected life of the premises will vastly exceed three years and that the landlord (lessor) is responsible for the maintenance, on the basis of the information given, the risks and rewards of ownership have not passed. As such IAS 17 prescribes that the lessee charges the rentals payable to the income statement. No asset or liability is recognised, although the notes to the financial statements will disclose the existence of the future rental payments. However, instead of considering IAS 17 let us consider how the Framework could approach the issue. To recognise a liability per the Framework requires that there is a past event that gives rise to a present obligation. It can be argued that the signing of the lease is a sufficient past event as to create a present obligation to pay the rentals for the whole period of the lease. On the same basis, while substantially all the risks and rewards of ownership have not passed, the lessee does control the use of the building for three years and has the benefits that brings. Accordingly, when considering the Framework, a radically different potential treatment arises for this lease. On entering the lease a liability is recognised, measured at the present value of the future cash flow obligations to reflect the time value of money. In turn an asset would also be accounted for. After the initial recognition of the liability, a finance cost is charged against profit in respect of unwinding the discount on the liability. The annual cash rental payments are accounted for as a reduction in the liability. The asset is systematically written off against profit over the three years of the agreement (depreciation).

2011 ACCA

6 THE IASBS CONCEPTUAL FRAMEWORK FOR FINANCIAL REPORTING MARCH 2011 There is, at present, a conflict between IAS 17 and the Framework. The IASB is currently reviewing IAS 17 because the current accounting treatment of lessees not recognising the future operating lease rentals as liabilities arguably amounts to off balance sheet financing. The Frameworks definition of a liability is at the heart of proposals to revise IAS 17 to ensure that the statement of financial position faithfully and completely represents all an entitys liabilities. Accordingly this conflict should soon be resolved. Tom Clendon FCCA is a subject expert at Kaplan

2011 ACCA

## The need for and an understanding of a conceptual framework

This topic forms most of Section A (and has an influence on Section B) of the syllabus for Paper F7, Financial Reporting. A conceptual framework is important to the understanding of the many principles and concepts that underpin International Financial Reporting Standards (IFRS) and is an often-neglected part of candidates studies. Questions from these areas regularly appear in Paper F7 exams usually as Question 4 and I often comment in my examiners report that they are the least well-answered question in the exam paper; the questions also have a high incidence of candidates not attempting them at all. This article is intended to illustrate the relevance and importance of this topic. What is a conceptual framework? In a broad sense a conceptual framework can be seen as an attempt to define the nature and purpose of accounting. A conceptual framework must consider the theoretical and conceptual issues surrounding financial reporting and form a coherent and consistent foundation that will underpin the development of accounting standards. It is not surprising that early writings on this subject were mainly from academics. Conceptual frameworks can apply to many disciplines, but when specifically related to financial reporting, a conceptual framework can be seen as a statement of generally accepted accounting principles (GAAP) that form a frame of reference for the evaluation of existing practices and the development of new ones. As the purpose of financial reporting is to provide useful information as a basis for economic decision making, a conceptual framework will form a theoretical basis for determining how transactions should be measured (historical value or current value) and reported ie how they are presented or communicated to users. Some accountants have questioned whether a conceptual framework is necessary in order to produce reliable financial statements. Past history of standard setting bodies throughout the world tells us it is. In the absence of a conceptual framework, accounting standards were often produced that had serious defects that is: they were not consistent with each other particularly in the role of prudence versus accruals/matching they were also internally inconsistent and often the effect of the transaction on the statement of financial position was considered more important than its effect on income the statement

2011 ACCA

## THE NEED FOR AND AN UNDERSTANDING OF A CONCEPTUAL FRAMEWORK OCTOBER 2011

standards were produced on a fire fighting approach, often reacting to a corporate scandal or failure, rather than being proactive in determining best policy. Some standard setting bodies were biased in their composition (ie not fairly representative of all user groups) and this influenced the quality and direction of standards the same theoretical issues were revisited many times in successive standards for example, does a transaction give rise to an asset (research and development expenditure) or liability (environmental provisions)?

It could be argued that the lack of a conceptual framework led to a proliferation of rules-based accounting systems whose main objective is that the treatment of all accounting transactions should be dealt with by detailed specific rules or requirements. Such a system is very prescriptive and inflexible, but has the attraction of financial statements being more comparable and consistent. By contrast, the availability of a conceptual framework could lead to principles-based system whereby accounting standards are developed from an agreed conceptual basis with specific objectives. This brings us to the International Accounting Standards Boards (IASB) The Conceptual Framework for Financial Reporting (the Framework), which is in essence the IASBs interpretation of a conceptual framework and in the process of being updated. The main purpose of the Framework is to: assist in the development of future IFRS and the review of existing standards by setting out the underlying concepts promote harmonisation of accounting regulation and standards by reducing the number of permitted alternative accounting treatments assist the preparers of financial statements in the application of IFRS, which would include dealing with accounting transactions for which there is not (yet) an accounting standard. The Framework is also of value to auditors, and the users of financial statements, and more generally help interested parties to understand the IASBs approach to the formulation of an accounting standard. The content of the Framework can be summarised as follows: Identifying the objective of financial statements The reporting entity (to be issued) Identifying the parties that use financial statements The qualitative characteristics that make financial statements useful The remaining text of the old Framework dealing with elements of financial statements: assets, liabilities equity income and expenses and
2011 ACCA

## THE NEED FOR AND AN UNDERSTANDING OF A CONCEPTUAL FRAMEWORK OCTOBER 2011

when they should be recognised and a discussion of measurement issues (for example, historic cost, current cost) and the related concept of capital maintenance. The development of the Framework over the years has led to the IASB producing a body of world-class standards that have the following advantages for those companies that adopt them: IFRS are widely accepted as a set of high-quality and transparent global standards that are intended to achieve consistency and comparability across the world. They have been produced in cooperation with other internationally renowned standard setters, with the aspiration of achieving consensus and global convergence. Companies that use IFRS and have their financial statements audited in accordance with International Standards on Auditing (ISA) will have an enhanced status and reputation. The International Organisation of Securities Commissions (IOSCO) recognise IFRS for listing purposes thus companies that use IFRS need produce only one set of financial statements for any securities listing for countries that are members of IOSCO. This makes it easier and cheaper to raise finance in international markets. Companies that own foreign subsidiaries will find the process of consolidation simplified if all their subsidiaries use IFRS. Companies that use IFRS will find their results are more easily compared with those of other companies that use IFRS. This should obviate the need for any reconciliation from local GAAP to IFRS when analysts assess comparative performance. It is not the purpose of this article to go through the detailed content of the Framework; this is well documented in many textbooks. At this point I would stress that it is important to think about what the content of the Framework really means; it is not enough merely to rote learn the principles/definitions. This is because an understanding and application of these topics will be tested in exam questions and it is on these aspects that candidates perform rather poorly. As previously mentioned, this topic is generally examined as Question 4 (worth 15 marks). Typically, the question will identify two or three areas of the Framework and ask for a definition or explanation of them for example, the definition of assets and liabilities, an explanation of accounting concepts such as substance over form or materiality, or qualitative characteristics such as relevance and reliability. This section will usually be followed by short scenarios intended to test candidates understanding and their ability to apply the above knowledge.
2011 ACCA

## THE NEED FOR AND AN UNDERSTANDING OF A CONCEPTUAL FRAMEWORK OCTOBER 2011

Here are a few examples of past questions. June 2008 exam (a) The IASBs Framework for the Preparation and Presentation of Financial Statements requires financial statements to be prepared on the basis that they comply with certain accounting concepts, underlying assumptions and (qualitative) characteristics. Five of these are: Matching/accruals Substance over form Prudence Comparability Materiality Required Briefly explain the meaning of each of the above concepts/assumptions. (5 marks) (b) For most entities, applying the appropriate concepts/assumptions in for inventories is an important element in preparing their financial statements. Required Illustrate with an example how each of the concepts/assumptions in (a) may be applied to accounting for inventory. (10 marks) (15 marks) Observations This question illustrates the progression of the topic from Paper F3 to F7. Part (a) is not much more than expected knowledge from F3, however Part (b) progresses this knowledge. It requires the application of each of the concepts, not to just any situation, but specifically to inventory thus illustrating how a single transaction (inventory in this case) can be subject to many different accounting concepts. June 2010 exam (a) An important aspect of the International Accounting Standards Boards (IASB) Framework for the Preparation and Presentation of Financial Statements is that transactions should be recorded on the basis of their substance over their form. Required Explain why it is important that financial statements should reflect the substance of the underlying transactions and describe the features that may

2011 ACCA

## THE NEED FOR AND AN UNDERSTANDING OF A CONCEPTUAL FRAMEWORK OCTOBER 2011

indicate that the substance of a transaction may be different from its legal form. Observations Part (a) is based on the important topic of substance over form. Note the question does not ask for a definition of the concept (this would be more for Paper F3); instead it asks why the concept is important and what features may indicate that the substance of a transaction may be different to its legal form. In other words, how do we identify such transactions? Most answers to this question merely gave a definition of substance and an example (inevitably leasing) of its use in financial statements. Part (b) consisted of a numerical example related to a sale and re-purchase agreement to illustrate the difference that the application of substance has on financial statements (compared to the legal form). June 2011 exam (a) Your assistant has been reading the IASBs Framework for the Preparation and Presentation of Financial Statements (the Framework) and, as part of the qualitative characteristics of financial statements under the heading of relevance, he notes that the predictive value of information is considered important. He is aware that financial statements are prepared historically (ie after transactions have occurred) and offers the view that the predictive value of financial statements would be enhanced if forward-looking information (for example, forecasts) were published rather than backward-looking historical statements. Required By the use of specific examples, provide an explanation to your assistant of how IFRS presentation and disclosure requirements can assist the predictive role of historically prepared financial statements. (6 marks) Observations Again Part (a) is themed on the Framework: the important characteristic of relevance. This is such an import characteristic that the Framework says (implicitly) that if information is not relevant, it is of no use. This question focuses on a particular aspect of relevance; that of predictability. Predictability recognises that users of financial statements are very interested the future performance of an entity. The core of this question was about how historical information can be presented, such that it enhances the predictive value of financial statements.

2011 ACCA

## THE NEED FOR AND AN UNDERSTANDING OF A CONCEPTUAL FRAMEWORK OCTOBER 2011

From memory I would say that this (section) question had the highest number of candidates that did not give any answer; and of those that did, very few scored more than half of the available marks. Part (a) was followed by a section on continuing and discontinued operations, and a calculation of diluted earnings per share. If these topics had been mentioned in Part (a) alone, it would have gained two of the six marks available. Conclusion Simply look out for more of this type of question it is an important area and should not be neglected. Steve Scott is examiner for Paper F7

2011 ACCA

01

TeChniCal

not-for-profit
relevanT To paperS f1, f5, f7, f8, p2, p3 and p5
What is a not-for-profit organisation? It would be simplistic to assume that any organisation that does not pursue profit as an objective is a not-for-profit organisation. This is an incorrect assumption, as many such organisations do make a profit every year and overtly include this in their formal plans. Quite often, they will describe their profit as a surplus rather than a profit, but as either term can be defined as an excess of income over expenditure, the difference may be considered rather semantic. Not-for-profit organisations are distinguished from profit maximising organisations by three characteristics. First, most not-for-profit organisations do not have external shareholders providing risk capital for the business. Second, and building on the first point, they do not distribute dividends, so any profit (or surplus) that is generated is retained by the business as a further source of capital. Third, their objectives usually include some social, cultural, philanthropic, welfare or environmental dimension, which in their absence, would not be readily provided efficiently through the workings of the market system. Types of not-for-profit organisation Not-for-profit organisations exist in both the public sector and the private sector. Most, but not all, public sector organisations do not have profit as their primary objective and were established in order to provide what economists refer to as public goods. These are mainly services that would not be available at the right price to those who need to use them (such as medical care, museums, art galleries and some forms of transportation), or could not be provided at all through the market (such as defence and regulation of markets and businesses). Private sector examples include most forms of charity and self-help organisations, such as housing associations that provide housing for low income and minority groups, sports associations (many football supporters trusts are set up as industrial and provident societies), scientific research foundations and environmental groups.

Several paperS in The aCCa QualifiCaTion may feaTure QueSTionS on noT-for-profiT organiSaTionS. aT The fundamenTalS level, TheSe inClude paperS f1, f5, f7 and f8. aT The profeSSional level They inClude paperS p2, p3 and p5.

Several papers in the ACCA Qualification may feature questions on not-for-profit organisations. At the Fundamentals level, these include Papers F1, F5, F7 and F8. At the Professional level they include Papers P2, P3 and P5. Although many of the principles of management and organisation apply to most business models, not-for-profit organisations have numerous features that distinguish them from the profit maximising organisations often assumed in conventional economic theory. This article explains some of these features. The first part of the article broadly describes the generic characteristics of not-for-profit organisations. The second part of the article, to be published in the October 2009 digital issue of Student Accountant, takes a specific and deeper look at charities, which are one of the more important types of not-for-profit organisations.

## STudenT aCCounTanT 09/2009

02

organisations
Some CounTrieS permiT CerTain CaTegorieS of noT-for-profiT organiSaTion ThaT have been SeT up aS CompanieS To diSpenSe WiTh The Suffix limiTed or plC (or loCal language eQuivalenT) provided The Company CommiTS To never diSTribuTing a dividend.
Corporate form Not-for-profit organisations can be established as incorporated or unincorporated bodies. The common business forms include the following: in the public sector, they may be departments or agents of government some public sector bodies are established as private companies limited by guarantee, including the Financial Services Authority (the UK financial services regulator) in the private sector they may be established as cooperatives, industrial or provident societies (a specific type of mutual organisation, owned by its members), by trust, as limited companies or simply as clubs or associations. A cooperative is a body owned by its members, and usually governed on the basis of one member, one vote. A trust is an entity specifically constituted to achieve certain objectives. The trustees are appointed by the founders to manage the funds and ensure compliance with the objectives of the trust. Many private foundations (charities that do not solicit funds from the general public) are set up as trusts. formation, constitution, and objectives Not-for-profit organisations are invariably set up with a purpose or set of purposes in mind, and the organisation will be expected to pursue such objectives beyond the lifetime of the founders. On establishment, the founders will decide on the type of organisation and put in place a constitution that will reflect their goals. The constitutional base of the organisation will be dictated by its legal form. If it is a company, it will have a Memorandum and Articles of Association, with the contents of the latter entrenched to ensure that the objectives cannot be altered easily in the future. Not-for-profit organisations that are not companies most commonly have a set of Rules, which are broadly equivalent to Articles of Association. As with any type of organisation, the objectives of not-for-profit organisations are laid down by the founders and their successors in management. Unlike profit maximisers, however, the broad strategic objectives of not-for-profit organisations will tend not to change over time. The purposes of the latter are most often dictated by the underlying founding principles. Within these broad objectives, however, the focus of activity may change quite markedly. For example, during the 1990s the British Know-How Fund, which was established by the UK government to provide development aid, switched its focus away from the emerging central European nations in favour of African nations.

noT-for-profiT organiSaTionS are invariably SeT up WiTh a purpoSe in mind, and The organiSaTion Will be expeCTed To purSue SuCh objeCTiveS beyond The lifeTime of The founderS. on eSTabliShmenT, The founderS Will deCide on The Type of organiSaTion and puT in plaCe a ConSTiTuTion ThaT Will refleCT Their goalS.

03
iT iS imporTanT To reCogniSe ThaT alThough noT-for-profiT organiSaTionS do noT maximiSe profiT aS a primary objeCTive, many are expeCTed To be Self-finanCing and Therefore generaTe profiT in order To Survive and groW.

TeChniCal

It is important to recognise that although not-for-profit organisations do not maximise profit as a primary objective, many are expected to be self-financing and, therefore, generate profit in order to survive and grow. Even if their activities rely to some extent on external grants or subventions, the providers of this finance invariably expect the organisation to be as financially self-reliant as possible. As the performance of not-for-profit organisations cannot be properly assessed by conventional accounting ratios, such as ROCE, ROI, etc, it often has to be assessed with reference to other measures. Most not-for-profit organisations rely on measures that estimate the performance of the organisation in relation to: effectiveness the extent to which the organisation achieves its objectives economy the ability of the organisation to optimise the use of its productive resources (often assessed in relation to cost containment) efficiency the output of the organisation per unit of resource consumed.

Many service-orientated organisations use value for money indicators that can be used to assess performance against objectives. Where the organisation has public accountability, performance measures can also be published to demonstrate that funds have been used in the most cost-effective manner. It is important within an exam question to read the clues given by the examiner regarding what is important to the organisation and what are its guiding principles, and to use these when assessing the performance of the organisation.

alThough many of The prinCipleS of managemenT and organiSaTion apply To moST buSineSS modelS, noT-for-profiT organiSaTionS have feaTureS ThaT diSTinguiSh Them from The profiT maximiSing organiSaTionS ofTen aSSumed in ConvenTional eConomiC Theory.

management The management structure of not-for-profit organisations resembles that of profit maximisers, though the terms used to describe certain bodies and officers may differ somewhat. While limited companies have a board of directors comprising executive and non-executive directors, many not-for-profit organisations are managed by a Council or Board of Management whose role is to ensure adherence to the founding objectives. In recent times there has been some convergence between how companies and not-for-profit organisations are managed, including increasing reliance on non-executive officers (notably in respect of the scrutiny or oversight role) and the employment of career executives to run the business on a daily basis. Robert Souster is examiner for Paper F1 Read the second part of this article on charities in the October 2009 digital issue of Student Accountant

01

TECHnICAL

not-for-profit
PART 2: CHARITIES RELEVAnT TO PAPERS F1, F5, F7, F8, P2, P3 And P5

SEVERAL PAPERS In THE ACCA QuALIFICATIOn MAy FEATuRE QuESTIOnS On nOT-FOR-PROFIT ORgAnISATIOnS. AT THE FundAMEnTALS LEVEL, THESE InCLudE PAPERS F1, F5, F7 And F8. AT THE PROFESSIOnAL LEVEL THEy InCLudE PAPERS P2, P3 And P5.

## STudEnT ACCOunTAnT 10/2009

02

organisations
CHARITIES wITH HIgH VALuE nOn-CuRREnT ASSETS, SuCH AS REAL ESTATE, uSuALLy VEST THE OwnERSHIP OF SuCH ASSETS TO IndEPEndEnT guARdIAn TRuSTEES, wHOSE ROLE IS TO EnSuRE THAT THE ASSETS ARE dEPLOyEd In A MAnnER REFLECTIng THE OBJECTIVES OF THE CHARITy.
FORMATIOn, COnSTITuTIOn And OBJECTIVES Charities are always formed with specific philanthropic purposes in mind. These purposes may be expanded or varied over time, provided the underlying purpose remains. For example, Oxfam was originally formed as the Oxford Committee for Famine Relief in 1942, and its original purpose was to relieve the famine in Greece brought about by the Allied blockade. Oxfam now provides famine relief on a worldwide basis. The governing constitution of a charity is normally set down in its rules, which expand on the purposes of the business. Quite often, the constitution dictates what the organisation cannot do, as well as what it can do. Charities plan and control their activities with reference to measures of effectiveness, economy and efficiency. They often publish their performance outcomes in order to convince the giving public that the good causes that they support ultimately benefit from charitable activities. MAnAgEMEnT Most charities are managed by a Council, made up entirely of volunteers. These are broadly equivalent to nonexecutive directors in limited companies. It is the responsibility of the Council to chart the medium to longterm strategy of the charity and to ensure that objectives are met. Objectives may change over time due to changes in the external environment in which the charity operates. Barnardos is a childrens charity that was originally founded as Doctor Barnados Homes, to provide for orphans who could not rely on family support. The development of welfare services after World War II and the increasing willingness of families to adopt and foster children resulted in less reliance on the provision of residential homes for children but greater reliance on other support services. As a result, the Barnardos charity had to change the way in which it looked at maximising the welfare of orphaned children. Local charities are dependent on the support of a more limited population and therefore have to consider whether their supporters will continue to provide the finance necessary to operate continuously. For example, a local charity supporting disabled sports could be profoundly affected by the development of facilities funded by central or local government. Every charity is confronted by distinctive strategic and operational risks, of which the Council must take account in developing and implementing its plans. International aid charities are vulnerable to country risk and currency risk, so plans have to take account of local conditions in countries whose populations they serve. Many such countries may, of course, be inherently unstable politically. Operational risk for charities arises from the high dependence on volunteer workers, including the extent to which they can rely on continued support, as well as problems of internal control. For example, many charities staff their shops with the help of unpaid retired people, but there is some debate as to whether future generations of retired people will be as willing to do this for nothing. As many charities have to contain operating expenses in order to ensure that their objectives can be met, it is often difficult or impossible for them to employ fulltime or parttime paid staff to replace volunteer workers. Risks also arise from the social environment, particularly in times of recession, when members of the public may be less disposed to give to benefit others as their discretionary household income is reduced. There is some evidence of charity fatigue in the UK. This arises when the public feel pressurised by so many different competing charities that they feel ill disposed to give anything to anyone at all. Robert Souster is examiner for Paper F1 Test how much of this article, and Part 1 of the article published in the September 2009 issue of Student Accountant, you have understood on the next page

Answer 3 The council would wish to ensure that: the commercial value of the premises/business has been assessed by a suitably qualified valuer an appropriate rent would be included in the lease to ensure that income would be at least that received under existing arrangements, and that appropriate steps would have been taken to secure the highest possible rent the lessee would sign a covenant to be bound by the rules of the charity, as well as any covenants applicable to the title to the land the property belonging to the charity could not be used in any manner inconsistent with the aims and objectives of the charity any conditions applicable to the lease would be applicable to any subsequent sublease, or that subletting would be prohibited/restricted the tenant would be a fit and proper person. Question 3 XYZ Charity provides local community facilities for disabled persons participating in sports. Its management committee wishes to outsource the operation of its club premises and land to a specialist organisation. What conditions might be imposed by the governing council of XYZ Charity?

Answer 2 There are many motives for giving to charities. In relation to charities that finance research into illnesses and diseases, such as cancer research, many people give because they or their families have been affected personally by the illnesses and diseases. They may give to similar charities such as Marie Curie nurses (who provide help for those affected by cancer) in order to give something back to those who have supported them. Some give to charities because they have a deepseated belief in what the charity does. A good example of this is Amnesty International. A purely financial motive for giving is to avail oneself of tax breaks, as most charitable donations can be set against tax liabilities. Some give because they regard it as an expectation of society, or because they follow the example of family and friends. Another motive for giving is simply that it makes some people feel good, or raises their profile with others.

Answer 1 The measures that might be used include: income in donations and changes in income over time income by source personal donations, corporate donations etc responses to campaign initiatives such as television adverts, newspaper coupon advertising, appeals relating to specific crises, and collection envelopes cost containment measures, such as management costs and other operating expenses (this is a particularly important factor, as some charities are criticised if administration costs absorb a high proportion of income) income from commercial activities numbers of volunteers attracted changes in mortality and sickness in areas where relief has been provided.

03

CHARITIES PLAn And COnTROL THEIR ACTIVITIES wITH REFEREnCE TO MEASuRES OF EFFECTIVEnESS, ECOnOMy And EFFICIEnCy. THEy OFTEn PuBLISH THEIR PERFORMAnCE OuTCOMES In ORdER TO COnVInCE THE gIVIng PuBLIC THAT THE gOOd CAuSES THAT THEy SuPPORT uLTIMATELy BEnEFIT FROM CHARITABLE ACTIVITIES.

TECHnICAL

CHECK yOuR undERSTAndIng Test your knowledge by answering these self-test questions the questions are based on both this article and Part 1, published in the September 2009 issue.

## measurement and depreciation

This is the first of two articles which consider the main features of IAS 16, Property, Plant and Equipment (PPE). Both articles are relevant to students studying the International or UK stream. The series will primarily focus on the requirements of IAS 16, but will also compare IAS 16 with the equivalent UK standard, FRS 15, Tangible Fixed Assets. These standards deal with the four main aspects of financial reporting of PPE that are likely to be of major relevance in the exams, namely: initial measurement and depreciation covered in this article revaluation and derecognition covered in the second article. Note: There are no significant differences between IAS 16 and FRS 15 as far as either initial measurement or depreciation of PPE are concerned. IAS 16 defines PPE as tangible items that are: held for use in the production or supply of goods or services, for rental to others, or for administrative purposes and expected to be used during more than one accounting period. THE INITIAL MEASUREMENT OF PPE IAS 16 requires that PPE should initially be measured at cost. The cost of an item of PPE comprises: the cost of purchase, net of any trade discounts plus any import duties and non-refundable sales taxes any costs directly attributable to bringing the asset to the location and condition necessary for it to be capable of operating in the manner intended by management. These are costs that would have been avoided if the asset had not been purchased or constructed. General overhead costs cannot be allocated to the cost of PPE. Directly attributable costs include: employee benefits payable to staff installing, constructing, or initially testing the asset site preparation professional fees directly associated with the installation, construction, or initial testing of the asset any other overhead costs directly associated with the installation, construction, or initial testing of the asset. Where these costs are incurred over a period of time (such as employee benefits), the period for which the costs can be included in the cost of PPE ends when the asset is ready for use, even if the asset is not brought into use until a later date. As soon as an asset is capable of operating it is ready for use. The fact that it may not operate at normal levels immediately,

54 student accountant

technical

## property, plant and equipment, and tangible xed assets

relevant to CAT Papers 3 and 6, and new ACCA Qualication Papers F3 and F7

June/July 2007

56 student accountant

technical
because demand has not yet built up, does not justify further capitalisation of costs in this period. Any abnormal costs (for example, wasted material) cannot be included in the cost of PPE. IAS 16 does not specifically address the issue of whether borrowing costs associated with the financing of a constructed asset can be regarded as a directly attributable cost of construction. This issue is addressed in IAS 23, Borrowing Costs. IAS 23 requires the inclusion of borrowing costs as part of the cost of constructing the asset. In order to be consistent with the treatment of other costs, only those finance costs that would have been avoided if the asset had not been constructed are eligible for inclusion. If the entity has borrowed funds specifically to finance the construction of an asset, then the amount to be capitalised is the actual finance costs incurred. Where the borrowings form part of the general borrowing of the entity, then a capitalisation rate that represents the weighted average borrowing rate of the entity should be used. The cost of the asset will include the best available estimate of the costs of dismantling and removing the item and restoring the site on which it is located, where the entity has incurred an obligation to incur such costs by the date on which the cost is initially established. This is a component of cost to the extent that it is recognised as a provision under IAS 37, Provisions, Contingent Liabilities and Contingent Assets. In accordance with the principles of IAS 37, the amount to be capitalised in such circumstances would be the amount of foreseeable expenditure appropriately discounted where the effect is material. EXAMPLE 1 On 1 October 20X6, Omega began the construction of a new factory. Costs relating to the factory, incurred in the year ended 30 September 20X7, are as follows: \$000 10,000 500 6,000 Employment costs (Note 1) Production overheads directly related to the construction (Note 2) Allocated general administrative overheads Architects and consultants fees directly related to the construction Costs of relocating staff who are to work at the new factory Costs relating to the formal opening of the factory Interest on loan to partly finance the construction of the factory (Note 3) 1,800 1,200 600 400 300 200 1,200 Note 1 The factory was constructed in the eight months ended 31 May 20X7. It was brought into use on 30 June 20X7. The employment costs are for the nine months to 30 June 20X7. Note 2 The production overheads were incurred in the eight months ended 31 May 20X7. They included an abnormal cost of \$200,000, caused by the need to rectify damage resulting from a gas leak. Note 3 Omega received the loan of \$12m on 1 October 20X6. The loan carries a rate of interest of 10% per annum. Note 4 The factory has an expected useful economic life of 20 years. At that time the factory will be demolished and the site returned to its original condition. This is a legal obligation that arose on signing the contract to purchase the land. The expected costs of fulfilling this obligation are \$2m. An appropriate annual discount rate is 8%. Requirement Compute the initial carrying value of the factory (see Table 1 for solution). DEPRECIATION OF PPE IAS 16 defines depreciation as the systematic allocation of the depreciable amount of an asset over its useful life. Depreciable amount is the cost of an asset, cost less residual value, Purchase of the land Costs of dismantling existing structures on the site Purchase of materials to construct the factory June/July 2007

or other amount (for more on the revaluation of the asset, see the second article in the August 2007 issue of student accountant). Depreciation is not providing for loss of value of an asset, but is an accrual technique that allocates the depreciable amount to the periods expected to benefit from the asset. Therefore assets that are increasing in value still need to be depreciated. IAS 16 requires that depreciation should be recognised as an expense in the income statement, unless it is permitted to be included in the carrying amount of another asset. An example of this practice would be the possible inclusion of depreciation in the costs incurred on a construction contract that are carried forward and matched against future income from the contract, under the provisions of IAS 11. A number of methods can be used to allocate depreciation to specific accounting periods. Two of the more common methods, specifically mentioned in IAS 16, are the straight line method, and the reducing (or diminishing) balance method. The assessments of the useful life (UL) and residual value (RV) of an asset are extremely subjective. They will only be known for certain after the asset is sold or scrapped, and this is too late for the purpose of computing annual depreciation. Therefore, IAS 16 requires that the estimates should be reviewed at the end of each reporting period. If either changes significantly, then that change should be accounted for over the remaining estimated useful economic life. EXAMPLE 2 An item of plant was acquired for \$220,000 on 1 January 20X6. The estimated UL of the plant was five years and the estimated RV was \$20,000. The asset is depreciated on a straight line basis. On 31 December 20X6 the future estimate of the UL of the plant was changed to three years, with an estimated RV of \$12,000. At the date of purchase, the plants depreciable amount would have been \$200,000 (\$220,000 - \$20,000). Therefore, depreciation of \$40,000 would have been charged in 20X6, and the carrying value would

have been \$180,000 at the end of 20X6. Given the reassessment of the UL and RV, the depreciable amount at the end of 20X6 is \$168,000 (\$180,000 - \$12,000) over three years. Therefore, the depreciation charges in 20X7, 20X8 and 20X9 will be \$56,000 (\$168,000/3) unless there are future changes in estimates. Where an asset comprises two or more major components with substantially different economic lives, each component should be accounted for separately for depreciation purposes, and each depreciated over its UL. EXAMPLE 3 On 1 January 20X2, an entity purchased a furnace for \$200,000. The estimated UL of the furnace was 10 years, but its lining needed replacing after five years. On 1 January 20X2 the entity estimated that the cost of relining the furnace (at 1 January 20X2 prices) was \$50,000. The lining was replaced on 1 January 20X7 at a cost of \$70,000.

Requirement Compute the annual depreciation charges on the furnace for each year of its life. Solution 20X220X6 inclusive The asset has two depreciable components: the lining element (allocated cost \$50,000 UL five years); and the balance of the cost (allocated cost \$150,000 UL 10 years). Therefore, the annual depreciation is \$25,000 (\$50,000 x 1/5 + \$150,000 x 1/10). At 31 December 20X6, the lining component has a written down value of zero. 20X720Y1 inclusive The \$70,000 spent on the new lining is treated as the replacement of a separate component of an asset and added to PPE. The annual depreciation is now \$29,000 (\$70,000 x 1/5 + \$150,000 x 1/10). Paul Robins is a lecturer at FTC Kaplan

technical

TABLE 1: SOLUTION TO EXAMPLE 1 Solution Component Purchase of the site Dismantling costs Materials Employment costs Production overheads Administrative overheads Architects fees Relocation costs Costs of opening the factory Capitalised interest Restoration costs Total cost of factory

Amount \$000 10,000 500 6,000 1,600 1,000 Nil 400 Nil Nil 800 429 20,729

Reason Cost includes cost of purchase Site preparation costs represent a direct cost of getting the asset ready for use All used in constructing the factory Allowed to include employment costs in the construction period, so 8/9 x 1,800 included Production overheads a direct cost of getting the asset ready for use but must exclude abnormal element Only direct costs allowed to be capitalised Architects fees a direct cost of getting the asset ready for use Specifically disallowed by IAS 16 not part of getting the asset ready for use Specifically disallowed by IAS 16 not part of getting the asset ready for use As per IAS 23, can capitalise interest for the period of construction (ie 12,000 x 10% x 8/12) The present value of \$2m payable in 20 years at 8%

57

## revaluation and derecognition

This is the second of two articles, and considers revaluation of property, plant and equipment (PPE) and its derecognition. The first article, published in the June/July 2007 issue of student accountant, considered the initial measurement and depreciation of PPE. There are rather more differences between IAS 16, Property, Plant and Equipment (the international standard) and FRS 15, Tangible Fixed Assets (the UK standard) in relation to revaluation and derecognition compared to initial measurement and depreciation. For both topics addressed in this article, the international position is outlined first, and then compared to the UK position. REVALUATION OF PPE IAS 16 POSITION General principles IAS 16 allows entities the choice of two valuation models for PPE the cost model or the revaluation model. Each model needs to be applied consistently to all PPE of the same class. A class of assets is a grouping of assets that have a similar nature or function within the business. For example, properties would 64 student accountant August 2007 typically be one class of assets, and plant and equipment another. Additionally, if the revaluation model is chosen, the revaluations need to be kept up to date, although IAS 16 is not specific as to how often assets need to be revalued. When the revaluation model is used, assets are carried at their fair value, defined as the amount for which an asset could be exchanged between knowledgeable, willing parties in an arms length transaction. Revaluation gains Revaluation gains are recognised in equity unless they reverse revaluation losses on the same asset that were previously recognised in the income statement. In these circumstances, the revaluation gain is recognised in the income statement. Revaluation changes the depreciable amount of an asset so subsequent depreciation charges are affected. EXAMPLE 1 A property was purchased on 1 January 20X0 for \$2m (estimated depreciable amount \$1m useful economic life 50 years). Annual depreciation of \$20,000 was charged from 20X0 to 20X4 inclusive and on 1 January 20X5 the carrying value of the property was \$1.9m. The property was revalued to \$2.8m on 1 January 20X5 (estimated depreciable amount \$1.35m the estimated useful economic life was unchanged). Show the treatment of the revaluation surplus and compute the revised annual depreciation charge. Solution The revaluation surplus of \$900,000 (\$2.8m - \$1.9m) is recognised in the statement of changes in equity by crediting a revaluation reserve. The depreciable amount of the property is now \$1.35m and the remaining estimated useful economic life 45 years (50 years from 1 January 20X0). Therefore, the depreciation charge from 20X5 onwards would be \$30,000 (\$1.35m x 1/45). A revaluation usually increases the annual depreciation charge in the income statement. In the above example, the annual increase

technical

## property, plant and equipment, and tangible xed assets part 2

relevant to ACCA Qualication Papers F3 and F7

is \$10,000 (\$30,000 - \$20,000). IAS 16 allows (but does not require) entities to make a transfer of this excess depreciation from the revaluation reserve directly to retained earnings. Revaluation losses Revaluation losses are recognised in the income statement. The only exception to this rule is where a revaluation surplus exists relating to a previous revaluation of that asset. To that extent, a revaluation loss can be recognised in equity. EXAMPLE 2 The property referred to in Example 1 was revalued on 31 December 20X6. Its fair value had fallen to \$1.5m. Compute the revaluation loss and state how it should be treated in the financial statements. Solution The carrying value of the property at 31 December 20X6 would have been \$2.74m (\$2.8m - 2 x \$30,000). This means that the revaluation deficit is \$1.24m (\$2.74m - \$1.5m). If the transfer of excess depreciation (see above) is not made, then the balance in the revaluation reserve relating to this asset is \$900,000 (see Example 1). Therefore \$900,000 is deducted from equity and \$340,000 (\$1.24m - \$900,000) is charged to the income statement. If the transfer of excess depreciation is made, then the balance on the revaluation reserve at 31 December 20X6 is \$880,000 (\$900,000 - 2 x \$10,000). Therefore \$880,000 is deducted from equity and \$360,000 (\$1.24m - \$880,000) charged to the income statement. REVALUATION OF PPE FRS 15 POSITION Although the basic position in FRS 15 is similar to that of IAS 16, there are differences: FRS 15 is more specific than IAS 16 regarding the frequency of valuations. FRS 15 states that, as a minimum, assets should be revalued every five years. 66 student accountant August 2007

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Under FRS 15 the amount to which a fixed asset is revalued is different than under IAS 16. As far as properties are concerned (these probably being the class of fixed asset most likely to be carried at valuation) the basic valuation principle is value for existing use not reflecting any development potential. Notional, directly attributable acquisition costs should also be included where material. However, specialised properties may need to be valued on the basis of depreciated replacement cost, since there may be no data on which to base an existing use valuation. If properties are surplus to the entitys requirements, then they should be valued at open market value net of expected directly attributable selling costs. Revaluation losses that are caused by a clear consumption of economic benefits, for example physical damage to an asset, should be recognised in the profit and loss account. Such losses are recognised as an operating cost similar to depreciation. Other revaluation losses, for example the effect of a general fall in market values on a portfolio of properties, should be partly recognised in the statement of total recognised gains and losses. However, if the loss is such that the carrying amount of the asset falls below depreciated historical cost, then any further losses need to be recognised in the profit and loss account. EXAMPLE 3 State how the answers to Examples 1 and 2 would change if FRS 15 were applied rather than IAS 16. Solution The answer to Example 1 would not change at all. For Example 2, if the revaluation loss was caused by a consumption of economic benefits, then the whole loss would be recognised in the profit and loss account. If the revaluation loss was caused by general factors, then it would be necessary to compute the depreciated historical cost of the property. This is the carrying value of the property at 31 December 20X6 if the first revaluation on 1 January 20X5 had not been carried out and would be \$1.86m (\$2m - 7 x \$20,000). The actual carrying value of the property at 31 December 20X6 was \$2.74m (see Example 2). Therefore, of the revaluation loss of \$1.24m (see Example 2), \$880,000 (\$2.74m - \$1.86m) is charged to the statement of total recognised gains and losses, and the balance of \$360,000 (\$1.24m - \$880,000) charged to the profit and loss account. DERECOGNITION OF PPE THE IAS 16 POSITION PPE should be derecognised (removed from PPE) either on disposal or when no future economic benefits are expected from the asset (in other words, it is effectively scrapped). A gain or loss on disposal is recognised as the difference between the disposal proceeds and the carrying value of the asset (using the cost or revaluation model) at the date of disposal. This net gain is included in the income statement the sales proceeds should not be recognised as revenue. Where assets are measured using the revaluation model, any remaining balance in the revaluation reserve relating to the asset disposed of is transferred directly to retained earnings. No recycling of this balance into the income statement is permitted. DISPOSAL OF ASSETS IFRS 5 POSITION IFRS 5, Non-current assets held for sale and discontinued operations is another standard that deals with the disposal of non-current assets and discontinued operations. An item of PPE becomes subject to the provisions of IFRS 5 (rather than IAS 16) if it is classified as held for sale. This classification can either be made for a single asset (where the planned disposal of an individual and fairly substantial asset takes place) or for a group of assets (where the disposal of a business component takes place). This article considers the implications of disposing of a single asset. IFRS 5 is only applied if the held for sale criteria are satisfied, and an asset is classified as held for sale if its carrying amount will be recovered principally through a sale transaction rather than through continued use. For this to be the case, the asset must be available for immediate sale in its present condition and its sale must be highly probable. Therefore,

technical

This is the second of two articles, and considers revaluation of property, plant and equipment (PPE) and its derecognition. The rst article, published in the June/July 2007 issue of student accountant, considered the initial measurement and depreciation of PPE.

an appropriate level of management must be committed to a plan to sell the asset, and an active programme to locate a buyer and complete the plan must have been initiated. The asset needs to be actively marketed at a reasonable price, and a successful sale should normally be expected within one year of the date of classification. The types of asset that would typically satisfy the above criteria would be property, and very substantial items of plant and equipment. The normal disposal or scrapping of plant and equipment towards the end of its useful life would be subject to the provisions of IAS 16. When an asset is classified as held for sale, IFRS 5 requires that it be moved from its existing balance sheet presentation (non-current assets) to a new category of the balance sheet non-current assets held for sale. No further depreciation is charged as its carrying value will be recovered principally through sale rather than continuing use. The existing carrying value of the asset is compared with its fair value less costs to sell (effectively the selling price less selling costs). If fair value less costs to sell is below the current carrying value, then the asset is written down to fair value less costs to sell and an impairment loss recognised. When the asset is sold, any difference between the new carrying value and the net selling price is shown as a profit or loss on sale. EXAMPLE 4 An asset has a carrying value of \$600,000. It is classified as held for sale on 30 September 20X6. At that date its fair value less costs to sell is estimated at \$550,000. The asset was sold for \$555,000 on 30 November 20X6. The year end of the entity is 31 December 20X6. 1 How would the classification as held for sale, and subsequent disposal, be treated in the 20X6 financial statements? 2 How would the answer differ if the carrying value of the asset at 30 September 20X6 was \$500,000, with all other figures remaining the same? Solution 1 On 30 September 20X6, the asset would be written down to its fair value less costs

to sell of \$550,000 and an impairment loss of \$50,000 recognised. It would be removed from non-current assets and presented in non-current assets held for sale. On 30 November 20X6 a profit on sale of \$5,000 would be recognised. On 30 September 20X6 the asset would be transferred to non-current assets held for sale at its existing carrying value of \$500,000. When the asset is sold on 30 November 20X6, a profit on sale of \$55,000 would be recognised.

Where an asset is measured under the revaluation model then IFRS 5 requires that its revaluation must be updated immediately prior to being classified as held for sale. The effect of this treatment is that the selling costs will always be charged to the income statement at the date the asset is classified as held for sale. EXAMPLE 5 An asset being classified as held for sale is currently carried under the revaluation model at \$600,000. Its latest fair value is \$700,000 and the estimated costs of selling the asset are \$10,000. Show how this transaction would be recorded in the financial statements. Solution Immediately prior to being classified as held for sale, the asset would be revalued to its latest fair value of \$700,000, with a credit of \$100,000 to equity. The fair value less costs to sell of the asset is \$690,000 (\$700,000 - \$10,000). On reclassification, the asset would be written down to this value (being lower than the updated revalued amount) and \$10,000 charged to the income statement. DERECOGNITION OF PPE FRS 15 POSITION The FRS 15 position is effectively identical to that of IAS 16 in as far as derecognition of PPE is covered by IAS 16. However, there is no UK standard equivalent to IFRS 5, although the UK Accounting Standards Board has issued an exposure draft that is very similar to IFRS 5. Paul Robins is a lecturer at FTC Kaplan August 2007 student accountant 67

01 technIcAl

## accounting for property, plant and equipment

relevAnt to AccA quAlIFIcAtIon PAPer F7
The accounting for IAS 16, Property, Plant and Equipment is a particularly important area of the Paper F7 syllabus. You can almost guarantee that in every exam you will be required to account for property, plant and equipment at least once. This article is designed to outline the key areas of IAS 16, Property, Plant and Equipment that you may be required to attempt in the F7 exam. IAS 16, ProPerty, PlAnt And equIPment overvIew There are essentially four key areas when accounting for property, plant and equipment that you must ensure that you are familiar with: initial recognition depreciation revaluation derecognition (disposals). InItIAl recognItIon The basic principle of IAS 16 is that items of property, plant and equipment that qualify for recognition should initially be measured at cost. One of the easiest ways to remember this is that you should capitalise all costs to bring an asset to its present location and condition for its intended use. Commonly used examples of cost include: purchase price of an asset (less any trade discount) directly attributable costs such as: cost of site preparation initial delivery and handling costs installation and testing costs professional fees the initial estimate of dismantling and removing the asset and restoring the site on which it is located, to its original condition (ie to the extent that it is recognised as a provision per IAS 37, Provisions, Contingent Assets and Liabilities) borrowing costs in accordance with IAS 23, Borrowing Costs. exAmPle 1 On 1 March 2008 Yucca acquired a machine from Plant under the following terms: List price of machine Import duty Delivery fees Electrical installation costs Pre-production testing Purchase of a five-year maintenance contract with Plant How should the above information be accounted for in the financial statements? (See page 5 for the solution to Example 1.) exAmPle 2 Construction of Deb and Hams new store began on 1 April 2009. The following costs were incurred on the construction: Freehold land Architect fees Site preparation Materials Direct labour costs Legal fees General overheads \$000 4,500 620 1,650 7,800 11,200 2,400 940

The store was completed on 1 January 2010 and brought into use following its grand opening on the 1 April 2010. Deb and Ham issued a \$25m unsecured loan on 1 April 2009 to aid construction of the new store (which meets the definition of a qualifying asset per IAS 23). The loan carried an interest rate of 8% per annum and is repayable on 1 April 2012. Required Calculate the amount to be included as property, plant and equipment in respect of the new store and state what impact the above information would have on the income statement (if any) for the year ended 31 March 2010. (See page 5 for the solution to Example 2.) Subsequent costs Once an item of PPE has been recognised and capitalised in the financial statements, a company may incur further costs on that asset in the future. IAS 16 requires that subsequent costs should be capitalised if: it is probable that future economic benefits associated with the extra costs will flow to the entity the cost of the item can be reliably measured. All other subsequent costs should be recognised as an expense in the income statement in the period that they are incurred. exAmPle 3 On 1 March 2010 Yucca purchased an upgrade package from Plant at a cost of \$18,000 for the machine it originally purchased in 2008 (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? (See page 5 for the solution to Example 3.)

## \$ 82,000 1,500 2,050 9,500 4,900 7,000

In addition to the above information Yucca was granted a trade discount of 10% on the initial list price of the asset and a settlement discount of 5% if payment for the machine was received within one month of purchase. Yucca paid for the plant on 25 March 2008.

## Student AccountAnt issue 19/2010

Studying Paper F7? Performance objectives 10 and 11 are relevant to this exam

02

A gAIn on revAluAtIon IS AlwAyS recognISed In equIty, under A revAluAtIon reServe (unleSS the gAIn reverSeS revAluAtIon loSSeS on the SAme ASSet thAt were PrevIouSly recognISed In the Income StAtement In thIS InStAnce the gAIn IS to be Shown In the Income StAtement). the revAluAtIon gAIn IS known AS An unreAlISed gAIn whIch lAter becomeS reAlISed when the ASSet IS dISPoSed oF (derecognISed).

depreciation Depreciation is defined in IAS 16 as being the systematic allocation of the depreciable amount of an asset over its useful economic life. In other words, depreciation applies the accruals concept to the capitalised cost of a non-current asset and matches this cost to the period that it relates to. depreciation methods There are many methods of depreciating a non-current asset with the most common being: Straight line % on cost or Cost residual value Useful economic life Reducing balance % on carrying value

exAmPle 6 A company purchased a property with an overall cost of \$100m on 1 April 2009. The property elements are made up as follows: \$000 Land and buildings (Land element \$20,000) Fixtures and fittings Lifts 65,000 24,000 11,000 100,000 Estimated life 50 years 10 years 20 years

Calculate the annual depreciation charge for the property for the year ended 31 March 2010. (See page 6 for the solution to Example 6.) revAluAtIonS This is an important topic in the exam and features regularly in Question 2, so you should ensure that you are familiar with all aspects of revaluations. IAS 16 rules IAS 16 permits the choice of two possible treatments in respect of property, plant and equipment: The cost model (carry an asset at cost less accumulated depreciation/impairments). The revaluation model (carry an asset at its fair value at the revaluation date less subsequent accumulated depreciation impairment). If the revaluation policy is adopted this should be applied to all assets in the entire category, ie if you revalue a building, you must revalue all land and buildings in that class of asset. Revaluations must also be carried out with sufficient regularity so that the carrying amount does not differ materially from that which would be determined using fair value at the reporting date. AccountIng For A revAluAtIon There are a series of accounting adjustments that must be undertaken when revaluing a non-current asset. These adjustments are indicated below. the initial revaluation You may find it useful in the exam to first determine if there is a gain or loss on the revaluation with a simple calculation to compare: Carrying value of non-current asset at revaluation date Valuation of non-current asset Difference = gain or loss on revaluation X X X

exAmPle 4 An item of plant was purchased on 1 April 2008 for \$200,000 and is being depreciated at 25% on a reducing balance basis. Prepare the extracts of the financial statements for the year ended 31 March 2010. (See page 5 for the solution to Example 4.) useful economic lives and residual values IAS 16 requires that these estimates be reviewed at the end of each reporting period. If either changes significantly, the change should be accounted for over the useful economic life remaining. exAmPle 5 A machine was purchased on 1 April 2007 for \$120,000. It was estimated that the asset had a residual value of \$20,000 and a useful economic life of 10 years at this date. On 1 April 2009 (two years later) the residual value was reassessed as being only \$15,000 and the useful economic life remaining was considered to be only five years. How should the asset be accounted for in the years ending 31 March 2008/2009/2010? (See page 5 for the solution to Example 5.) component depreciation If an asset comprises two or more major components with different economic lives, then each component should be accounted for separately for depreciation purposes and depreciated over its own useful economic life.

03 technIcAl

revaluation gains A gain on revaluation is always recognised in equity, under a revaluation reserve (unless the gain reverses revaluation losses on the same asset that were previously recognised in the income statement in this instance the gain is to be shown in the income statement). The revaluation gain is known as an unrealised gain which later becomes realised when the asset is disposed of (derecognised). Double entry: Dr Non-current asset cost (difference between valuation and original cost/valuation) Dr Accumulated depreciation (with any historical cost accumulated depreciation) Cr Revaluation reserve (gain on revaluation) exAmPle 7 A company purchased a building on 1 April 2007 for \$100,000. The asset had a useful economic life at that date of 40 years. On 1 April 2009 the company revalued the building to its current fair value of \$120,000. What is the double entry to record the revaluation? (See page 6 for the solution to Example 7.) revaluation losses A revaluation loss should be charged against any related revaluation surplus to the extent that the decrease does not exceed the amount held in the revaluation reserve in respect of the same asset. Any additional loss must be charged as an expense in the income statement. Double entry: Dr Revaluation reserve (to maximum of original gain) Dr Income statement (any residual loss) Cr Non-current asset (loss on revaluation) exAmPle 8 The carrying value of Zens 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 reserve relating to the original gain of the property was \$10,000. What is the double entry to record the revaluation? (See page 6 for the solution to Example 8.) depreciation The asset must continue to be depreciated following the revaluation. However, now that the asset has been revalued the depreciable amount has changed. In simple terms the revalued amount should be depreciated over the assets remaining useful economic life. reserves transfer The depreciation charge on the revalued asset will be different to the depreciation that would have been charged based on the historical cost of the asset. As a result of this, IAS 16 permits a transfer to be made of an amount equal to the excess depreciation from the revaluation reserve to retained earnings.

Double entry: Dr Revaluation reserve Cr Retained earnings Be careful, in the exam a reserves transfer is only required if the examiner indicates that it is company policy to make a transfer to realised profits in respect of excess depreciation on revalued assets. If this is not the case then a reserves transfer is not necessary. This movement in reserves should also be disclosed in the statement of changes in equity. exAmPle 9 A company revalued its property on 1 April 2009 to \$20m (\$8m for the land). The property originally cost \$10m (\$2m for the land) 10 years ago. The original useful economic life of 40 years is unchanged. The companys 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 2010? (See page 6 for the solution to Example 9.) exAm FocuS In the exam make sure you pay attention to the date that the revaluation takes place. If the revaluation takes place at the start of the year then the revaluation should be accounted for immediately and depreciation should be charged in accordance with the rule above. If however the revaluation takes place at the year-end then the asset would be depreciated for a full 12 months first based on the original depreciation of that asset. This will enable the carrying amount of the asset to be known at the revaluation date, at which point the revaluation can be accounted for. A further situation may arise if the examiner states that the revaluation takes place mid-way through the year. If this were to happen the carrying amount would need to be found at the date of revaluation, and therefore the asset would be depreciated based on the original depreciation for the period up until revaluation, then the revaluation will take place and be accounted for. Once the asset has been revalued you will need to consider the last period of depreciation. This will be found based upon the revaluation rules (depreciate the revalued amount over remaining useful economic life). This will be the most complicated situation and you must ensure that your working is clearly structured for this; ie depreciate for first period based on old depreciation, revalue, then depreciate last period based on new depreciation rule for revalued assets. exAmPle 10 A company purchased a building on 1 April 2005 for \$100,000 at which point it was considered to have a useful economic life of 40 years. At the year end 31 March 2010 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 2010? (See page 7 for the solution to Example 10.)

## Student AccountAnt issue 19/2010

04

exAmPle 11 At 1 April 2009 HD Ltd carried its office block in its financial statements at its original cost of \$2 million less depreciation of \$400,000 (based on its original life of 50 years). HD Ltd decided to revalue the office block on 1 October 2009 to its current value of \$2.2m. The useful economic life remaining was reassessed at the time of valuation and is considered to be 40 years at this date. It is the companys policy to charge depreciation proportionally. How will the office block be accounted for in the year ended 31 March 2010? (See page 7 for the solution to Example 11.) derecognition Property, plant and equipment should be derecognised when it is no longer expected to generate future economic benefit or when it is disposed of. When property, plant and equipment is to be derecognised, a gain or loss on disposal is to be calculated. This can be found by comparing the difference between: Carrying value Disposal proceeds Profit or loss on disposal X X X

be cAreFul, In the exAm A reServeS trAnSFer IS only requIred IF the exAmIner IndIcAteS thAt It IS comPAny PolIcy to mAke A trAnSFer to reAlISed ProFItS In reSPect oF exceSS dePrecIAtIon on revAlued ASSetS. IF thIS IS not the cASe then A reServeS trAnSFer IS not neceSSAry. thIS movement In reServeS Should AlSo be dIScloSed In the StAtement oF chAngeS In equIty.

Tip: When the disposal proceeds are greater than the carrying value there is a profit on disposal and when the disposal proceeds are less than the carrying value there is a loss on disposal. exAmPle 12 An asset that originally cost \$16,000 and had accumulated depreciation on it of \$8,000 was disposed of during the year for \$5,000 cash. How should the disposal be accounted for in the financial statements? (See page 7 for the solution to Example 12.) disposal of previously revalued assets When an asset is disposed of that has previously been revalued, a profit or loss on disposal is to be calculated (as above). Any remaining surplus on the revaluation reserve is now considered to be a realised gain and therefore should be transferred to retained earnings as: Dr Revaluation reserve Cr Retained earnings In summary, it can be seen that accounting for property, plant and equipment is an important topic that features regularly in the Paper F7 exam. With most of what is examinable feeding though from Paper F3 this should be a comfortable topic that you can tackle well in the exam. Bobbie-Anne Retallack is a content specialist at Kaplan Publishing See pages 5, 6 and 7 for solutions to all the examples illustrated in this technical article.

05 technIcAl

ias 16 solutions
SolutIon 1 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: List price Less: trade discount (10%) Import duty Delivery fees Electrical installation costs Pre-production testing Total amount to be capitalised at 1 March \$ 82,000 (8,200) 73,800 1,500 2,050 9,500 4,900 91,750 Depreciation of the store. Even though 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 manner intended by management. Note: depreciation cannot be calculated in this question as information surrounding useful economic life has not been provided this is for illustrative purposes only. Depreciation is covered later in this article. SolutIon 3 The \$18,000 should be capitalised as part of the cost of the asset as the revenue earning capacity of the machine has significantly increased, which could in turn lead to the inflow of additional economic benefit and the cost of the upgrade can be reliably measured. SolutIon 4 Income statement extract Depreciation expense \$37,500 Statement of financial position extract Plant (200,000 50,000 37,500) \$112,500 Working for depreciation: 31/03/09 Cost Depreciation 25% Carrying value 31/03/10 Carrying value Depreciation 25% Carrying value 200,000 (50,000) 150,000 150,000 (37,500) 112,500

The maintenance contract of \$7,000 is an expense and therefore should be spread over a five-year period in accordance with the accruals concept and taken to the income statement. If the \$7,000 has been paid in full, then some of this cost will represent a prepayment. In addition the settlement discount received of \$3,690 (\$73,800 x 5%) is to be shown as other income in the income statement. SolutIon 2 This is an example of a 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 from 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 cease 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 the income statement. Property, plant and equipment Store: Freehold land Architect fees Site preparation Materials Direct labour costs Legal fees Borrowing costs (25,000 x 8%) x 9 /12 Total to be capitalised

## \$000 4,500 620 1,650 7,800 11,200 2,400 1,500 29,670

SolutIon 5 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) 31 March 2009 Income statement extract 2009 Depreciation Statement of financial position extract 2009 Machine (120,000 20,000) \$110,000

Income statement impact With regards to the income statement this should be charged with: General overheads of \$940,000 Remaining interest for JanMar which is now an expense \$500,000 (25,000 x 8% x 3/12) and;

\$10,000 \$100,000

## Student AccountAnt issue 19/2010

06

31 March 2010 As the residual value and useful economic life estimates have changed during the year ended 2010, the depreciation charge will need to be recalculated. The carrying value will now be spread according to the revised estimates. Depreciation charge: 100,000 15,000 = \$17,000 per annum 5 years Income statement extract 2010 Depreciation Statement of financial position extract 2010 Machine (100,000 17,000) SolutIon 6 Land and buildings (65,000 20,000)/50 years)) Fixtures and fittings (24,000/10 years) Lifts (11,000/20 years) Total property depreciation \$17,000 \$83,000 \$000 900 2,400 550 3,850

SolutIon 9 Statement of comprehensive income extract for the year ended 31 March 2010 Depreciation expense Other comprehensive income: Revaluation gain \$000 400 12,000

Statement of financial position extract as at 31 March 2010 \$000 Non-current assets Property (20,000 400) Equity Revaluation reserve (12,000 200) Statement of changes in equity extracts Revaluation reserve \$000 12,000 (200) Retained earnings \$000 200 19,600

11,800

SolutIon 7 Gain on revaluation: Carrying value of non-current asset at revaluation date (100,000 (100,000/40 years x 2 years)) Valuation Gain on revaluation Double entry: Dr Building cost (120,000 100,000) Dr Accumulated depreciation (100,000/40 years x 2 years) Cr Revaluation reserve SolutIon 8 Loss on revaluation: Carrying value of non-current asset at revaluation date Valuation Loss on revaluation Double entry: Dr Revaluation reserve (to maximum of original gain) Dr Income statement Cr Non-current asset

Revaluation gain Reserves transfer 95,000 120,000 25,000 Workings: Gain on revaluation:

## \$000 8,000 20,000 12,000

Carrying value of non-current asset at revaluation date (10,000 ((10,000 2,000)/40 years x 10 years)) Valuation Gain on revaluation Double entry: Dr Property (20,000 10,000) Dr Accumulated depreciation ((10,000 2,000)/40 years x 10 years) Cr Revaluation reserve Depreciation charge for year to 31 March 2010: Dr depreciation expense ((20,000 8,000)/30 years) Cr Accumulated depreciation Reserves transfer: Historical cost depreciation charge ((10,000 2,000)/40 years) Revaluation depreciation charge Excess depreciation to be transferred Dr Revaluation reserve Cr Retained earnings

400 400

## 10,000 3,000 13,000

The revaluation gain or loss must be disclosed in both the statement of changes in equity and in other comprehensive income.

## 200 400 200 200 200

07 technIcAl

SolutIon 10 Statement of comprehensive income extract 31 March 2010 Depreciation charge 2,500

Other comprehensive income: Revaluation gain 10,500 Statement of financial position extract 31 March 2010 Building at valuation 98,000 Statement of changes in equity extract Revaluation reserve Revaluation gain 10,500 Working paper: Note: revaluation takes place at year end, therefore a full year of depreciation must first be charged. (W1) Depreciation year ended 31 March 2010 100,0000 = \$2,500 40 years (W2) Revaluation 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 (100,000 (100,000/40 years x 5 years)) Valuation of non-current asset Gain or loss on revaluation Double entry: Dr Accumulated depreciation Cr NCA cost Cr Revaluation reserve 12,500 2,500 10,500 87,500 98,000 10,500

Working paper: Note: Revaluation takes place part way through the year and therefore 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. (W1) Depreciation 1 April30 September 2009 2,000,000 x 6/12 = \$20,000 50 years (W2) Revaluation The carrying value of the asset at 1 October 2009 can now be found and revalued. Carrying value of non-current asset at revaluation date (2,000,000 (400,000 20,000)) 1,580,000 Valuation of non-current asset 2,200,000 Gain on revaluation 620,000 Double entry: Dr NCA cost (2,200,000 2,000,000) Dr Accumulated depreciation Cr Revaluation reserve 200,000 420,000 620,000

(W3) Depreciation 1 October 31 March 2010 2,200,000 x 6/12 = \$27,500 40 years SolutIon 12 The asset and its associated depreciation should be removed from the statement of financial position and a profit or loss on disposal should be recorded in the income statement. The loss on disposal is: Carrying value at disposal date (16,000 8,000) Disposal proceeds Loss on disposal 8,000 5,000 3,000

SolutIon 11 Statement of comprehensive income extract 31 March 2010 Depreciation charge (20,000 (W1) + 27,500 (W2) 47,500

Other comprehensive income: Revaluation gain 620,000 Statement of financial position extract 31 March 2010 Office block (carrying value at 31 March): Valuation 2,200,000 Depreciation (27,500) Carrying value 2,172,500 Statement of changes in equity extract Revaluation reserve Revaluation gain 620,000

## RELEVANT TO ACCA QUALIFICATION PAPERS F7 and P2

Studying Paper F7 or P2? Performance objectives 10 and 11 are relevant to these exams

## How to account for property in Hong Kong

With very few exceptions, all land in Hong Kong is owned by the Government and leased out for a limited period. It does not matter if the properties are high-rise buildings, residential, offices or factories, they are built on land under a government lease. Developers of these properties lease lots of land from the Government and develop the land according to the lease conditions, such as to construct buildings on the land according to the specifications within a specified period. Individual units of these lots of land and buildings are usually sold as undivided shares in the lots. Interests of all parties, including future buyers of the units, are governed by the deeds of mutual covenant. In substance and in form, owners of these units are a lessee of a lease of land and buildings. According to IFRS, the land and buildings elements of these leases should be considered separately for the purposes of lease classification under IAS 17. Allocation of the interests in leases of land and building IAS 17 When a lease includes both land and buildings elements, we should assess the classification of each element as a finance or an operating lease separately. (Except, if the amount that would initially be recognised for the land element is immaterial, the land and buildings may be treated as a single unit for the purpose of lease classification. In such a case, the economic life of the buildings is regarded as the economic life of the entire leased asset.) In determining whether the land element is an operating or a finance lease, an important consideration is that land normally has an indefinite economic life, which makes most of the land elements operating leases. However, this is not always the case. Land elements can be classified as a finance lease if significant risks and rewards associated with the land during the lease period would have been transferred from the lessor to the lessee despite there being no transfer of title. For example, consider a 999-year lease of land and buildings. In this situation, significant risks and rewards associated with the land during the lease term would have been transferred to the lessee despite there being no transfer of title. Separate measurement of the land and buildings elements is not required when the lessees interest in both land and buildings is classified as an investment property in accordance with IAS 40 and the fair value model is adopted.

2011 ACCA

## 2 ACCOUNTING FOR PROPERTY JANUARY 2011

Classification as property, plant and equipment or as an investment property The issue is complicated when the separate elements of the land and buildings are further classified in accordance with IAS 16, Property, Plant and Equipment and IAS 40, Investment Properties. IAS 16 According to IAS 16, land and buildings are separable assets and are accounted for separately, even when they are acquired together. Land has an unlimited useful life and, therefore, is not depreciated. Buildings have a limited useful life and, therefore, are depreciable assets. An increase in the value of the land on which a building stands does not affect the determination of the depreciable amount of the building. IAS 40 A property interest that is held by a lessee under an operating lease may be classified and accounted for as investment property provided that: the rest of the definition of investment property is met the operating lease is accounted for as if it were a finance lease in accordance with IAS 17, Leases, and the lessee uses the fair value model for investment property The choice between the cost and fair value models is not available to a lessee accounting for a property interest held under an operating lease that it has elected to classify and account for as investment property. The standard requires such investment property to be measured using the fair value model. IAS 40 depends on IAS 17 for requirements for the classification of leases, the accounting for finance and operating leases and for some of the disclosures relevant to leased investment properties. When a property interest held under an operating lease is classified and accounted for as an investment property, IAS 40 overrides IAS 17 by requiring that the lease is accounted for as if it were a finance lease. Scenario summaries Scenario 1: Long-term lease of land Element Option 1 Option 2 Land IAS 16 IAS 16 (Cost (Revaluation) model) model) IAS 16 Buildings IAS 16 (Revaluation (Cost model) model)

## Option 4 IAS 40 (Fair model) IAS 40 (Fair model)

Land element is classified as a finance lease under IAS 17 as significant risks and rewards associated with the land during the lease period would have been transferred to the lease despite there being no transfer of title. The land should be recognised under IAS 16 (option 1 and 2) if it is owner-occupied or under IAS 40 (option 3 and 4) if it is used for rental earned. Option 1: Both land and buildings elements are measured at cost and presented under Property, Plant and Equipment in the statement of financial

2011 ACCA

## 3 ACCOUNTING FOR PROPERTY JANUARY 2011

position. No depreciation is required for the land element but it is required for the buildings element. Option 2: Both land and buildings elements are measured at fair value with changes being posted to equity and presented under Property, Plant and Equipment in the statement of financial position. No depreciation is required for the land element but it is required for the buildings element. Option 3: Both land and buildings elements are measured at cost and presented under investment property in the statement of financial position. No depreciation is required for the land element but is required for the buildings element. Option 4: Both land and buildings elements are measured at fair value and presented under investment property in the statement of financial position. No depreciation is required for either the land element or buildings element. Scenario 2: Short-term lease of land Elem ent Option 1 Option 2 Land IAS 17 IAS 17 IAS 16 Buildings IAS 16 (Revaluation (Cost model) model)

## Option 3 IAS 17 IAS 40 (Cost model)

Option 4 IAS 40 (Fair Value model) - for both land and building

Land element is classified as an operating lease under IAS 17 because it has indefinite economic life. The land element should be recognised under IAS 17, as prepaid lease payments that are amortised over the lease term. Except for, it can be classified as investment property and the fair value model is used (option 4) The buildings element should be recognised under IAS 16 (option 1 and 2) if it is owner occupied or under IAS 40 (option 3 and 4) if it is used for rental earned. Option 1: Land element is measured as prepaid lease payments that are amortised over the lease term. While the buildings element is measured at cost and presented under Property, Plant and Equipment in the statement of financial position. Depreciation is required for the building element. Option 2: Land element is measured as prepaid lease payments that are amortised over the lease term. While the buildings element is measured at fair value with changes being posted to equity and presented under Property, Plant and Equipment in the statement of financial position. Depreciation is required for the building element. Option 3: Land element is measured as prepaid lease payments that are amortised over the lease term. While the buildings element is measured at cost and presented under Investment property in the statement of financial position. Depreciation is required for buildings element.

2011 ACCA

## 4 ACCOUNTING FOR PROPERTY JANUARY 2011

Option 4: Both land and buildings elements are measured at fair value and presented under Investment property in the statement of financial position. No depreciation is required for the land element and buildings element. Scenario 3: Land element is immaterial Elem ent Option 1 Option 2 Option 3 Land All the purchase price will be treated element Buildings IAS 16 IAS 16 IAS 40 (Cost (Revaluation (Cost model) model) model)

## Option 4 as buildings IAS 40 (Fair model)

As the land element is immaterial, the land and buildings elements are treated as a single unit for the purpose of lease classification. The economic life of the buildings is regarded as the economic life of the entire leased property. Option 1: Property is measured at cost and presented under Property, Plant and Equipment in the statement of financial position. Depreciation is required. Option 2: Property is measured at fair value with change being posted to equity and presented under Property, Plant and Equipment in the statement of financial position. Depreciation is required. Option 3: Property is measured at cost and presented under Investment property in the statement of financial position. Depreciation is required. Option 4: Property is measured at fair value and presented under Investment property in the statement of financial position. No depreciation is required. Impairment review under IAS 36 is required to all assets at the reporting date except for those where the fair value model is adopted. Linda Ng, HKCA Learning Media

2011 ACCA

fresh beginnings
This article explains the accounting treatment for research and development (R&D) costs under both UK and International Accounting Standards. Both UK and International Accounting Standards recognise the importance of accounting for R&D, but take a different viewpoint as to the method used. WHY SPEND MONEY ON R&D? Many businesses in the commercial world spend vast amounts of money, on an annual basis, on the research and development of products and services. These entities do this with the intention of developing a product or service that will, in future periods, provide significant amounts of income for years to come. THE ACCOUNTING PREDICAMENT If, in the future, economic benefit is expected to flow to the entity as a result of incurring R&D costs, then it can be argued that these costs should be treated as an asset rather than an expense, as they meet the definition of an asset prescribed by both the Statement of Principles and the IASB Framework for the Preparation and Presentation of Financial Statements. Equally, the argument exists that it may be 42 student accountant September 2007 impossible to predict whether or not a project will give rise to future income. As a result, both the UK and International Accounting Standards provide accountants with more information in order to clarify the situation. INTANGIBLE ASSETS Intangible assets are business assets that have no physical form. Unlike a tangible asset, such as a computer, you cant see or touch an intangible asset. There are two types of intangible assets: those that are purchased and those that are internally generated. The accounting treatment of purchased intangibles is relatively straightforward in that the purchase price is capitalised in the same way as for a tangible asset. Accounting for internally-generated assets, however, requires more thought. R&D costs fall into the category of internally-generated intangible assets, and are therefore subject to specific recognition criteria under both the UK and international standards. R&D DEFINITIONS Research is original and planned investigation, undertaken with the prospect of gaining new scientific or technical knowledge and understanding. An example of research could be a company in the pharmaceuticals industry undertaking activities or tests aimed at obtaining new knowledge to develop a new vaccine. The company is researching the unknown, and therefore, at this early stage, no future economic benefit can be expected to flow to the entity. Development is the application of research findings or other knowledge to a plan or design for the production of new or substantially improved materials, devices, products, processes, systems, or services, before the start of commercial production or use. An example of development is a car manufacturer undertaking the design, construction, and testing of a pre-production model. UK TREATMENT OF R&D So far we have established that expenditure on R&D can fall into the category of intangible assets. Under UK accounting standards, intangible assets are accounted for using the rules from FRS 10, Goodwill and Intangibles. Even though R&D can be an intangible asset in the UK, accounting for R&D is governed by its own accounting standard

technical

## research and development

relevant to CAT Paper 6 and ACCA Qualification Papers F3, F7, and P2

SSAP 13, Accounting for Research and Development. Recognition Research SSAP 13 states that expenditure on research does not directly lead to future economic benefits, and capitalising such costs does not comply with the accruals concept. Therefore, the accounting treatment for all research expenditure is to write it off to the profit and loss account as incurred. Development As a basic rule, expenditure on development costs should be written off to the profit and loss account as incurred, as with the expenditure on research. However, under SSAP 13, there is an option to defer the development expenditure and carry it forward as an intangible asset if the following criteria are met: there is a clearly defined project expenditure is separately identifiable the project is commercially viable the project is technically feasible project income is expected to outweigh cost resources are available to complete the project. If these criteria are met, the entity may choose to either capitalise the costs, bringing them on balance sheet, or maintain the policy to write the costs off to the profit and loss account. Note that if an accounting policy of capitalisation is adopted it should be applied consistently to all development projects that meet that criteria. Treatment of capitalised development costs SSAP 13 requires that where development costs are recognised as an asset, they should be amortised over the periods expected to benefit from them. Amortisation should begin only once commercial production has started or when the developed product or service comes into use. Every capitalised project should be reviewed at the end of every accounting period to ensure that the recognition criteria are still met. Where the conditions no longer exist or are doubtful, the capitalised costs 44 student accountant September 2007

technical
should be written off to the profit and loss account immediately. Problems with SSAP 13 SSAP 13 is not in line with the newer International Accounting Standard covering this area. As seen previously, the UK allows a choice over capitalisation; this can lead to inconsistencies between companies and, as some of the criteria are subjective, this choice can be manipulated by companies wishing to capitalise development costs. INTERNATIONAL TREATMENT OF R&D One notable difference between the UK and international treatment is that the UK has a separate standard for the treatment of R&D (SSAP 13), whereas under International Accounting Standards the accounting for R&D is dealt with under IAS 38, Intangible Assets. Recognition IAS 38 states that an intangible asset is to be recognised if, and only if, the following criteria are met: it is probable that future economic benefits from the asset will flow to the entity the cost of the asset can be reliably measured. The above recognition criteria look straightforward enough, but in reality it can prove to be very difficult to assess whether or not these have been met. In order to make the recognition of internally-generated intangibles more clear-cut, IAS 38 separates an R&D project into a research phase and a development phase. Research phase It is impossible to demonstrate whether or not a product or service at the research stage will generate any probable future economic benefit. As a result, IAS 38 states that all expenditure incurred at the research stage should be written off to the income statement as an expense when incurred, and will never be capitalised as an intangible asset. Development phase Under IAS 38, an intangible asset arising from development must be capitalised if an entity can demonstrate all of the following criteria: the technical feasibility of completing the intangible asset (so that it will be available for use or sale) intention to complete and use or sell the asset ability to use or sell the asset existence of a market or, if to be used internally, the usefulness of the asset availability of adequate technical, financial, and other resources to complete the asset the cost of the asset can be measured reliably. If any of the recognition criteria are not met then the expenditure must be charged to the income statement as incurred. Note that if the recognition criteria have been met, capitalisation must take place. Treatment of capitalised development costs Once development costs have been capitalised, the asset should be amortised in accordance with the accruals concept over its finite life. Amortisation must only begin when commercial production has commenced (hence matching the income and expenditure to the period in which it relates). Each development project must be reviewed at the end of each accounting period to ensure that the recognition criteria are still met. If the criteria are no longer met, then the previously capitalised costs must be written off to the income statement immediately. EXAMPLE A company incurs research costs, during one year, amounting to \$125,000, and development costs of \$490,000. The accountant informs you that the recognition criteria (as prescribed by both SSAP 13 and IAS 38) have been met. What effect will the above transactions have on the financial statements when following either the UK or International Accounting Standards? (See page 45 for the answer.) Bobbie Retallack is a lecturer at Kaplan Financial in Birmingham, UK

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Example: Answer UK Option 1: expense all costs Profit and loss account extract Expenses: R&D 615,000 Balance sheet extract

Option 2: Expense research as required and capitalise development costs Profit and loss account extract Expenses: Research Intangible asset: Development costs 490,000 125,000 Balance sheet extract

International Income statement extract Expenses: Research Intangible asset: Development costs 490,000 125,000 Balance sheet extract

Summary UK SSAP 13 Research costs Development costs Expense Choice policy. If the recognition criteria are met, the company can choose to capitalise (if there is a reasonable expectation of future benefit) or expense. Amortise when commercial production begins. Review annually to ensure criteria are still met if not, expense. Expense if any of the recognition criteria are not met. International IAS 38 Expense Must capitalise if the recognition criteria are met (must be able to demonstrate future benefit).

Amortise when commercial production begins. Review annually to ensure criteria are still met if not, expense. Expense if any of the recognition criteria are not met. September 2007 student accountant 45

## presentation and terminology

The International Accounting Standards Board (IASB) reissued IAS 1, Presentation of Financial Statements, in September 2007. The main changes are amendments to presentation and terminology. Although the revised IAS 1 does not become effective until annual periods beginning on or after 1 January 2009, earlier adoption is permitted. ACCA operates a six-month rule for its exams, whereby accounting standards are not examined until six months after their date of issue. Therefore, the revised IAS 1 is examinable from the June 2008 exam session onwards. The reissue of IAS 1 affects all ACCA exam papers which refer to balance sheets or cash flow statements, as the revised standard has changed the name of these to statement of financial position and statement of cash flows respectively. For ALL international papers* (excluding CAT Papers 6 and 8, and ACCA Qualification Papers F3, F7, F8, P2, and P7): Balance sheet will become statement of financial position (balance sheet) in the June 2008 and December 2008 exams. From the June 2009 exams onwards, balance sheet will become statement of financial position. Cash flow statement will be statement of cash flows from the June 2008 exam sitting onwards. Income statements will continue to be examined in the existing format throughout 2008. From June 2009 onwards, examiners may choose to use a single statement of comprehensive income see Table 1. For CAT Papers 6 (INT) and 8 (INT), and ACCA Papers F3 (INT), F7 (INT), F8 (INT), P2 (INT), and P7 (INT): For exam purposes, the following applies to all companies, partnerships, and sole traders: Balance sheet will become statement of financial position from the June 2008 exam sitting onwards. 44 student accountant February 2008 Cash flow statement will be statement of cash flows from the June 2008 exam sitting onwards. Another amendment resulting from the reissue of IAS 1 is a requirement to present other comprehensive income items (such as revaluation gains and losses, and actuarial gains and losses), as well as the usual income statement items, on the face of the primary financial statements. IAS 1 allows this information to be presented in one statement of comprehensive income (see Table 1), or in two separate statements; an income statement and a statement of comprehensive income. In an exam, whenever a statement of comprehensive income is referred to, this always relates to the single statement format (see Table 1). (Please refer to the Study Guides for examinability of line items.) If income statements are referred to, this relates to the statement from revenue to profit for the year (see Table 1 (part a)). Exams may also refer to the other comprehensive income section of the statement of comprehensive income (see Table 1 (part b) (similar to the previous statement of recognised income and expense (SORIE)). Law and tax variant papers Law and tax variant papers continue to use the relevant local terminology. However, Paper F4 (GLO) will adopt the international format, where relevant. Ellie Griffiths is education adviser at ACCA

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## IAS 1, presentation of financial statements

relevant to all CAT and ACCA Qualification papers

*CAT Papers 1, 2, 3, 4, 5, 7, and 10 *ACCA Papers F1, F2, F5, F9, P1, P3, P4, and P5

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EXAMPLE 1: STATEMENT OF COMPREHENSIVE INCOME (IN ONE STATEMENT) GIVEN IN IAS 1 20X7 390,000 (245,000) 145,000 20,667 (9,000) (20,000) (2,100) (8,000) 35,100 161,667 (40,417) 121,250 121,250 20X8 355,000 (230,000) 125,000 11,300 (8,700) (21,000) (1,200) (7,500) 30,100 128,000 (32,000) 96,000 (30,500) 65,500

Revenue Cost of sales Gross profit Other income Distribution costs Administrative expenses Other expenses Finance costs Share of profit of associates Profit before tax Income tax expense Profit for the year from continuing operations Loss for the year from discontinued operations PROFIT FOR THE YEAR [a: income statement] Other comprehensive income: Exchange differences on translating foreign operations Available-for-sale financial assets Cash flow hedges Gains on property revaluation Actuarial gains (losses) on defined benefit pension plans Share of other comprehensive income of associates Income tax relating to components of other comprehensive income Other comprehensive income for the year, net of tax TOTAL COMPREHENSIVE INCOME FOR THE YEAR [b: other comprehensive income] Profit attributable to: Owners of the parent Minority interest Total comprehensive income attributable to: Owners of the parent Minority interest [statement of comprehensive income]

## 10,667 26,667 (4,000) 3,367 1,333 (700) (9,334) 28,000 93,500

The International Accounting Standards Board (IASB) reissued IAS 1, Presentation of Financial Statements, in September 2007. The main changes were amendments to presentation and terminology. Although the revised IAS 1 does not become effective until on or after 1 January 2009, earlier adoption is permitted. The reissue of IAS 1 affects all ACCA exam papers which refer to balance sheets or cash flow statements, as the revised standard has changed the name of these to statement of financial position and statement of cash flows respectively.

## 52,400 13,100 65,500 74,800 18,700 93,500

February 2008

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45

by Neil Stein 16 May 2003 This article looks at the other elements of financial statements required by FRS 3, Reporting Financial Performance and IAS 1, Presentation of Financial Statements other than the income statement/profit and loss account. UK requirements We'll look first at the UK requirements: 1. statement of total recognised gains and losses 2. note of historical cost profits and losses 3. reconciliation of movements in shareholders' funds. Statement of total recognised gains and losses FRS 3 argues that the profit and loss account is not sufficient on its own as a report of a company's financial performance. The statement of total recognised gains and losses (STRGL) is an attempt to present details of the other elements making up a company's total performance. The STRGL presents:

profit for the financial year before dividends unrealised gains and losses on revaluation of assets currency translation differences prior year adjustments.

## Figure 1: Statement of total recognised gains and losses m 29 4 (5) 28

Profit for the financial year Unrealised surplus on revaluation of properties Unrealised loss on trade investment Total recognised gains and losses relating to the year

Prior year adjustment (10) Total gains and lossed recognised since last annual report 18

## Note of historical cost profits and losses (no International equivalent)

Financial statements in the UK are usually prepared on the historical cost basis, but with the proviso that fixed assets - especially land and buildings - are often revalued to keep balance sheet values more in line with reality. FRS 3 requires this note to state what the profit would have been if the financial statements had been prepared on a strict historical cost basis, with no asset revaluations. The note is only required if the difference between the reported profit and the historical cost profit is material. There are two main possible causes of difference: 1. If assets are revalued, depreciation is based on the revalued amount. Using strict historical cost accounting, the depreciation would be based on original cost. 2. If a revalued asset is sold, the profit coming through in the profit and loss account is the difference between the proceeds of sale and the carrying amount in the records allowing for the revaluation. On strict historical cost accounting, the amount would be the difference between the proceeds and cost less depreciation, so that a larger profit (or a smaller loss) would emerge. The note should be presented immediately following the profit and loss account or the STRGL, as illustrated in Figure 2. Note that the opening figure is profit before taxation. (1) refers to a revaluation gain recognised in an earlier year. It is added to the reported profit because under strict historical cost accounting the gain on the disposal this year would be 9m more than the gain based on the revalued amount. Figure 2: Note of historical cost and losses m 45 9 5

Reported profit on ordinary activities before taxation 1. Realisation of property revaluation gains of previous year 2. Difference between a historical cost deprecialtion charge and the actual deepreciation

charge of the year calculated on the revalued amount 59 Historical cost profit for the year after taxation and dividends (retained profit) Why have the note? FRS 3 cites two reasons: 1. Companies have discretion as to when to make revaluations - and to what extent - so historical cost figures may make profits and losses of different reporting entities more comparable. 2. Some users may wish to know the historical cost based profit on the sale of an asset. Reconciliation of movements in shareholders' funds This statement overlaps somewhat with the STRGL, because naturally everything in the STRGL affects shareholders' funds and therefore has to appear in this reconciliation. However, it also includes issues or redemptions of shares during the year. The information in the reconciliation could be picked up from the company's balance sheet, but it is convenient to have a separate statement summarising the movements. Refer to Figure 3. Figure 3: Reconciliation of movements in shareholders' funds m 29 (8) 21 (1) 20 40 365 405

Profit for the financial year Dividends Other recognised gains and losses relating to the year (net) New share capital subscribed Net addition to shareholders' funds Opening shareholders' funds (originally 375m before deducting prior year adjustment of 10m) Closing shareholders' funds

In addition to these FRS 3 statements, the disclosure of movements on reserves is required. This is presented in tabular form in Figure 4. The difference between this 387m and the 405m with the reconciliation of shareholders' funds closed is, of course, the 18m of share capital. Figure 4: Movements in reserves Share premium account m 44 Revaluation reserve m 200 Profit and loss account m 120 Total m 364

At beginning of year as

## previously stated Prior year adjustment

44

200

(10) 110

(10) 354 13

Premium on issue of shares 13 (nominal value 7m) Transfer from profit and loss account of the year Transfer of realised profit Decrease in value of trade investment Surplus on property revaluations At end of year 57 That is the end of the coverage of the UK position. International requirements

## 21 (14) (5) 4 185 145 14

21 0 (5) 4 387

The main supplementary statement required by IAS 1, Presentation of Financial Statements is the statement of changes in equity. This is similar to the UK reconciliation of movements in shareholders' funds, and it also includes the statement of movements in reserves. It shows, in columnar form, the equity share capital and reserves, with details of all the movements that have taken place during the period. IAS 1 also illustrates a statement of recognised gains and losses that may be used as an alternative to the statement of changes in equity. Figures 5 and 6 show the statements, broadly presented as in IAS 1 (slightly abridged to exclude matters outside the scope of Paper F3). Figure 5 Share capital \$m X Share premium \$m X X Revaluation reserve \$m X X (X) X (X) Accumulated profit \$m X (X) X Total \$m X (X) X (X) X (X)

Balance from previous period Changes in accounting policy prior year adjustment* Restated balance X Deficit on revaluation of properties Surplus on revaluation of properties Net gains and losses not recognised in the income statement

Net profit for the period Dividends paid Issue of share capital Balance at end of period

X X

X X

X (X) X

X (X) X X

* The change in accounting policy is treated as a prior year adjustment. This is the treatment required in IAS 8 if the change is to be applied retrospectively - in other words, as if the new policy had always been in use. A change can also be applied prospectively - applied only to transactions after the change, with no adjustment to the opening balance of retained earnings. A fundamental error affecting prior periods would also normally be treated as a prior period adjustment as shown here. Figure 6: Statement of recognised gains and losses \$m Surplus/deficit on revaluation of properties X Surplus/deficit on revaluation of investments X Net gains not recognised in the income statement X Net profit for the period X Total recognised gains and losses X If this second presentation is adopted, the reconciliation of opening and closing balances of share capital, reserves and accumulated profit included in the statement of changes in equity would be shown in the notes to the financial statements. Neil Stein is former examiner for Paper 1.1

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## 2 ANNUAL REPORTS AUGUST 2012

imposition of unnecessary new disclosures. A listed company may have to comply with listing rules, company law, international financial reporting standards, the corporate governance codes, and if it has an overseas listing, any local requirements, such as those of the Securities and Exchange Commission (SEC) in the US. Thus, a major source of clutter is the fact that different parties require differing disclosures for the same matter. For example, an international bank in the UK may have to disclose credit risk under IFRS 7, Financial Instruments: Disclosures, the Companies Acts and the Disclosure and Transparency Rules, the SEC rules and Industry Guide 3, as well as the requirements of Basel II Pillar 3. A problem is that different regulators have different audiences in mind for the requirements they impose on annual reports. Regulators attempt to reach wider ranges of actual or potential users and this can lead to a loss of focus and structure in reports. There may a need for a proportionate approach to the disclosure requirements for small and mid-cap quoted companies that take account of the needs of their investors, as distinct from those of larger companies. This may be achieved by different means. For example, a principles-based approach to disclosures in IFRS, specific derogations from requirements in individual IFRS or the creation of an appropriately adapted local version of the IFRS for SMEs. Pressures of time and cost can understandably lead to defensive reporting by smaller entities and to choosing easy options, such as repeating material from a previous year, cutting and pasting from the reports of other companies and including disclosures of marginal importance. There are behavioural barriers to reducing clutter. It may be that the threat of criticism or litigation could be a considerable limitation on the ability to cut clutter. The threat of future litigation may outweigh any benefits to be obtained from eliminating catch-all disclosures. Preparers of annual reports are likely to err on the side of caution and include more detailed disclosures than are strictly necessary to avoid challenge from auditors and regulators. Removing disclosures is perceived as creating a risk of adverse comment and regulatory challenge. Disclosure is the safest option and is therefore often the default position. Preparers and auditors may be reluctant to change from the current position unless the risk of regulatory challenge is reduced. Companies have a tendency to repeat disclosures because they were there last year. Explanatory information may not change from year to year but it nonetheless remains necessary to an understanding of aspects of the report. There is merit in a reader of an annual report being able to find all of this information in one place. If the reader of a hard copy report has to switch to look at a website to gain a full understanding of a point in the report, there is a risk that the report thereby becomes less accessible rather than more. Even if the standing information is kept in the same document but relegated to an appendix, that may not be the best place to facilitate a quick understanding of a point. A new
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## 3 ANNUAL REPORTS AUGUST 2012

reader may be disadvantaged by having to hunt in the small print for what remains key to a full understanding of the report. Preparers wish to present balanced and sufficiently informative disclosures and may be unwilling to separate out relevant information in an arbitrary manner. The suggestion of relegating all information to a website assumes that all users of annual reports have access to the internet, which may not be the case. A single report may best serve the investor, by having one reference document rather than having the information scattered across a number of delivery points. Shareholders are increasingly unhappy with the substantial increase in the length of reports that has occurred in recent years. This has not resulted in more or better information, but more confusion as to the reason for the disclosure. A review of companies published accounts will show that large sections such as Statement of Directors Responsibilities and Audit Committee report are almost identical. Materiality should be seen as the driving force of disclosure, as its very definition is based on whether an omission or misstatement could influence the decisions made by users of the financial statements. The assessment of what is material can be highly judgmental and can vary from user to user. A problem that seems to exist is that disclosures are being made because a disclosure checklist suggests it may need to be made, without assessing whether the disclosure is necessary in a companys particular circumstances. However, it is inherent in these checklists that they include all possible disclosures that could be material. Most users of these tools will be aware that the disclosure requirements apply only to material items, but often this is not stated explicitly for users. One of the most important challenges is in the changing audiences. From its origins in reporting to shareholders, preparers now have to consider many other stakeholders including employees, unions, environmentalists, suppliers, customers, etc. The disclosures required to meet the needs of this wider audience have contributed to the increased volume of disclosure. The growth of previous initiatives on going concern, sustainability, risk, the business model and others that have been identified by regulators as key has also expanded the annual report size. The length of the annual report is not necessarily the problem but the way in which it is organised. The inclusion of immaterial disclosures will usually make this problem worse but, in a well organised annual report, users will often be able to bypass much of the information they consider unimportant, especially if the report is on line. It is not the length of the accounting policies disclosure that is itself problematic, but the fact that new or amended policies
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## 4 ANNUAL REPORTS AUGUST 2012

can be obscured in a long note running over several pages. A further problem is that accounting policy disclosure is often boilerplate, providing little specific detail of how companies apply their general policies to particular transactions. IFRS requires disclosure of significant accounting policies. In other words, IFRS does not require disclosure of insignificant or immaterial accounting policies. Omissions in financial statements are material only if they could, individually or collectively, influence the economic decisions that users make. In many cases, it would not. Of far greater importance is the disclosure of the judgments made in selecting the accounting policies, especially where a choice is available. A reassessment of the whole model will take time and may necessitate changes to law and other requirements. For example, unnecessary clutter could be removed by not requiring the disclosure of IFRS in issue but not yet effective. The disclosure seems to involve listing each new standard in existence and each amendment to a standard, including separately all those included in the annual improvements project, regardless of whether there is any impact on the entity. The note becomes a list without any apparent relevance. The IASB has recently issued a request for views regarding its forward agenda in which it acknowledges that stakeholders have said that disclosure requirements are too voluminous and not always focused in the right areas. The drive by the IASB has very much been to increase the use of disclosure to address comparability between companies and, in the short to medium term, a reduction in the volume of accounting disclosures does not look feasible although this is an area to be considered by the IASB for its post 2012 agenda.

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## What is a financial instrument?

Let us start by looking at the definition of a financial instrument, which is that a financial instrument is a contract that gives rise to a financial asset of one entity and a financial liability or equity instrument of another entity. With references to assets, liabilities and equity instruments, the statement of financial position immediately comes to mind. Further, the definition describes financial instruments as contracts, and therefore in essence financial assets, financial liabilities and equity instruments are going to be pieces of paper. For example, when an invoice is issued on the sale of goods on credit, the entity that has sold the goods has a financial asset the receivable while the buyer has to account for a financial liability the payable. Another example is when an entity raises finance by issuing equity shares. The entity that subscribes to the shares has a financial asset an investment while the issuer of the shares who raised finance has to account for an equity instrument equity share capital. A third example is when an entity raises finance by issuing bonds (debentures). The entity that subscribes to the bonds ie lends the money has a financial asset an investment while the issuer of the bonds ie the borrower who has raised the finance has to account for the bonds as a financial liability. So when we talk about accounting for financial instruments, in simple terms what we are really talking about is how we account for investments in shares, investments in bonds and receivables (financial assets), how we account for trade payables and long-term loans (financial liabilities) and how we account for equity share capital (equity instruments). (Note: financial instruments do also include derivatives, but this will not be discussed in this article.) In considering the rules as to how to account for financial instruments there are various issues around classification, initial measurement and subsequent measurement. This article will consider the accounting for equity instruments and financial liabilities. Both arise when the entity raises finance ie receives cash in return for issuing a financial instrument. A subsequent article will consider the accounting for financial assets. Distinguishing between debt and equity For an entity that is raising finance it is important that the instrument is correctly classified as either a financial liability (debt) or an equity instrument (shares). This distinction is so important as it will directly affect the calculation of the gearing ratio, a key measure that the users of the financial statements use to assess the financial risk of the entity. The distinction will also impact on the measurement of profit as the finance costs associated with financial liabilities will be charged to the income

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3 ACCOUNTING FOR FINANCIAL INSTRUMENTS JULY 2012 Equity instruments are not remeasured. Any change in the fair value of the shares is not recognised by the entity, as the gain or loss is experienced by the investor, the owner of the shares. Equity dividends are paid at the discretion of the entity and are accounted for as reduction in the retained earnings, so have no effect on the carrying value of the equity instruments. As an aside, if the shares being issued were redeemable, then the shares would be classified as financial liabilities (debt) as the issuer would be obliged to repay back the monies at some stage in the future. Financial liabilities A financial instrument will be a financial liability, as opposed to being an equity instrument, where it contains an obligation to repay. Financial liabilities are then classified and accounted for as either fair value through profit or loss (FVTPL) or at amortised cost. Financial liabilities at amortised cost The default position is, and the majority of financial liabilities are, classified and accounted for at amortised cost. Financial liabilities that are classified as amortised cost are initially measured at fair value minus any transaction costs. Accounting for a financial liability at amortised cost means that the liability's effective rate of interest is charged as a finance cost to the income statement (not the interest paid in cash) and changes in market rates of interest are ignored ie the liability is not revalued at the reporting date. In simple terms this means that each year the liability will increase with the finance cost charged to the income statement and decrease by the cash repaid. Example 2: Accounting for a financial liability at amortised cost Laxman raises finance by issuing zero coupon bonds at par on the first day of the current accounting period with a nominal value of \$10,000. The bonds will be redeemed after two years at a premium of \$1,449. The effective rate of interest is 7%. Required Explain and illustrate how the loan is accounted for in the financial statements of Laxman. Solution Laxman is receiving cash that it is obliged to repay, so this financial instrument is classified as a financial liability. There is no suggestion that the liability is being held for trading purposes nor that the option to have it classified as FVTPL has been made, so, as is perfectly normal, the liability will be classified and accounted for at amortised cost and initially measured at fair value less the transaction costs. The bonds are being issued at par, so there is neither a premium or discount on issue. Thus Laxman initially receives \$10,000. There are no transaction costs and, if there were, they would be deducted. Thus, the liability is initially recognised at \$10,000.

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4 ACCOUNTING FOR FINANCIAL INSTRUMENTS JULY 2012 In applying amortised cost, the finance cost to be charged to the income statement is calculated by applying the effective rate of interest (in this example 7%) to the opening balance of the liability each year. The finance cost will increase the liability. The bond is a zero coupon bond meaning that no actual interest is paid during the period of the bond. Even though no interest is paid there will still be a finance cost in borrowing this money. The premium paid on redemption of \$1,449 represents the finance cost. The finance cost is recognised as an expense in the income statement over the period of the loan. It would be inappropriate to spread the cost evenly as this would be ignoring the compound nature of finance costs, thus the effective rate of interest is given. In the final year there is a single cash payment that wholly discharges the obligation. The workings for the liability being accounted for at amortised cost can be summarised and presented as follows. Opening balance Year 1 Year 2 \$10,000 \$10,700 Plus income statement finance charge @7% on the opening balance \$700 \$749 Less the cash paid (Nil) (\$11,449) Closing balance, being the liability on the statement of financial position \$10,700 Nil

Accounting for financial liabilities is regularly examined in both Paper F7 and Paper P2 so let's have a look at another, slightly more complex example. Example 3: Accounting for a financial liability at amortised cost Broad raises finance by issuing \$20,000 6% four-year loan notes on the first day of the current accounting period. The loan notes are issued at a discount of 10%, and will be redeemed after three years at a premium of \$1,015. The effective rate of interest is 12%. The issue costs were \$1,000. Required Explain and illustrate how the loan is accounted for in the financial statements of Broad. Solution Broad is receiving cash that is obliged to repay, so this financial instrument is classified as a financial liability. Again, as is perfectly normal, the liability will be classified and accounted for at amortised cost and, thus, initially measured at the fair value of consideration received less the transaction costs. With both a discount on issue and transaction costs, the first step is to calculate the initial measurement of the liability. Cash received the nominal value less the discount on issue Less the transaction costs Initial recognition of the financial liability (\$20,000 x 90%) \$18,000 (\$1,000) \$17,000

In applying amortised cost, the finance cost to be charged to the income statement is calculated by applying the effective rate of interest (in this example 12%) to the 2012 ACCA

5 ACCOUNTING FOR FINANCIAL INSTRUMENTS JULY 2012 opening balance of the liability each year. The finance cost will increase the liability. The actual cash is paid at the end of the reporting period and is calculated by applying the coupon rate (in this example 6%) to the nominal value of the liability (in this example \$20,000). The annual cash payment of \$1,200 (6% x \$20,000 = \$1,200) will reduce the liability. In the final year there is an additional cash payment of \$21,015 (the nominal value of \$20,000 plus the premium of \$1,015), which extinguishes the remaining balance of the liability. The workings for the liability being accounted for at amortised cost can be summarised and presented as follows. Opening balance Plus income statement finance charge @ 12% on the opening balance \$2,040 \$2,141 \$2,254 \$2,380 \$8,815 Less the cash paid (6% x 20,000) Closing balance, being the liability on the statement of financial position \$17,840 \$18,781 \$19,835 Nil

1 2 3 4

## Total finance costs

Because the cash paid each year is less than the finance cost, each year the outstanding liability grows and for this reason the finance cost increases year on year as well. The total finance cost charged to income over the period of the loan comprises not only the interest paid, but also the discount on the issue, the premium on redemption and the transaction costs. Interest paid (4 years x \$1,200) = \$4,800 Discount on issue (10% x \$20,000) = \$2,000 Premium on redemption \$1,015 Issue costs \$1,000 Total finance costs \$8,815 Financial liabilities at FVTPL Financial liabilities are only classified as FVTPL if they are held for trading or the entity so chooses. This is unusual and only examinable in Paper P2. The option to designate a financial liability as measured at FVTPL will be made if, in doing so, it significantly reduces an accounting mismatch that would otherwise arise from measuring assets or liabilities or recognising the gains and losses on them on different bases, or if the liability is part or a group of financial liabilities or financial assets and financial liabilities that is managed and its performance is evaluated on a fair value basis, in accordance with an investment strategy. In addition, a financial liability may still be designated as measured at FVTPL when it contains one or more embedded derivatives that would require separation. Financial liabilities that are classified as FVTPL are initially measured at fair value and any transaction costs are immediately written off to the income statement.

2012 ACCA

6 ACCOUNTING FOR FINANCIAL INSTRUMENTS JULY 2012 By accounting for a financial liability at FVTPL, the financial liability is also increased by a finance cost and reduced by cash repaid but is then revalued at each reporting date with any gains and losses immediately recognised in the income statement. The measurement of the new fair value at the year end will be its market value or, if not known, the present value of the future cash flows, using the current market interest rates. The interest rate used subsequently to calculate the finance cost will be this new current rate until the next revaluation. Example 4: Accounting for a financial liability at FVTPL On 1 January 2011 Swann issued three year 5% \$30,000 loans notes at nominal value when the effective rate of interest is also 5%. The loan notes will be redeemed at par. The liability is classified at FVTPL. At the end of the first accounting period market interest rates have risen to 6%. Required Explain and illustrate how the loan is accounted for in the financial statements of Swann in the year ended 31 December 2011. Solution Swann is receiving cash that is obliged to repay so this financial instrument is classified as a financial liability. The liability is classified at FVTPL so, presumably, it is being held for trading purposes or the option to have it classified as FVTPL has been made. Initial measurement is at the fair value of \$30,000 received and, although there are no transaction costs in this example, these would be expensed rather than taken into account in arriving at the initial measurement. With an effective rate of interest and the coupon rate both being 5%, at the end of the accounting period the carrying value of the liability will still be \$30,000. This is because the finance cost that will increase the liability is \$1,500 (5% x \$30,000 the effective rate applied to the opening balance), and the cash paid reducing the liability is also \$1,500 (5% x \$30,000 the coupon rate applied to the nominal value). As the liability has been classified as FVTPL this carrying value at 31 December 2011 now has to be revalued. The fair value of the liability at this date will be the present value (using the new rate of interest of 6%) of the next remaining two years' payments. Cash flow Payment due 31 December 2012 (interest only) Payment due 31 December 2013 (the final interest payment and the repayment of the \$30,000) Fair value of the liability at 31 December 2011 \$1,500 x \$31,500 x 6% discount factor 0.943 0.890 = = Present value of the future cash flow \$1,415 \$28,035 \$29,450

2012 ACCA

7 ACCOUNTING FOR FINANCIAL INSTRUMENTS JULY 2012 As Swann has classified this liability as FVTPL, it is revalued to \$29,450. The reduction of \$550 in the carrying value of the liability from \$30,000 is regarded as a profit, and this is recognised in the income statement. If, however, the higher discount rate used was not because general interest rates have risen, rather the credit risk of the entity has risen, then the gain is recognised in other comprehensive income. This can all be summarised in the following presentation. Opening balance Plus income statement finance charge @ 5% on the opening balance \$1,500 Less the cash paid (5% x 30,000) Carrying value of the liability at the year end \$30,000 Fair value of the liability at the year end \$29,450 Gain to income statement

1/1/2011

\$30,000

(\$1,500)

\$550

We can briefly consider the accounting in the remaining two years. The finance charge in the income statement for the year end 31 December 2012 will be the 6% x \$29,450 = \$1,767, and with the cash payment of \$1,500 being made, the carrying value of the liability will be \$29,717 (\$29,450 plus \$1,767 less \$1,500) at the year end. If at 31 December 2012 the market rate of interest has fallen to, say, 4%, then the fair value of the liability at the reporting date will be the present value of the last repayment due of \$31,500 in one year's time discounted at 4% (ie \$31,500 x 0.962 = \$30,288), which in turn means that as the fair value of the liability exceeds the carrying value, a loss of \$571 (ie \$30,288 less \$29,717) arises which is recognised in the income statement. In the final year ending 31 December 2013 the finance cost to the income statement will be 4% x \$30,288 = \$1,212, increasing the liability to \$31,500 before the final cash payment of \$31,500 is made, thus extinguishing the liability. As you may know from your financial management studies, and as is demonstrated here, when interest rates rise so the fair value of bonds fall and when interest rates fall then the fair value of bonds rises. The next article will consider the accounting for convertible bonds and financial assets. Tom Clendon FCCA is a senior tutor at Kaplan Financial, London

2012 ACCA

## What is a financial instrument? Part 2

My previous article covered the classification, initial measurement and subsequent measurement of financial liabilities (eg loans and bonds) and issued equity instruments (eg ordinary shares). It was established that when issuing financial instruments to raise finance, the issuer had to classify instrument as either financial liabilities (and, in turn, financial liabilities were split into amortised cost and Fair Value Through Profit or Loss (FVTPL)) or equity instruments. This can be summarised in the following diagram. Issuing financial instruments (raising finance) Financial liabilities Contain an obligation to repay Equity instruments Evidence of an ownership interest in the residual net assets

If classified as amortised cost; initial measurement is at fair value less issue costs and then subsequent measurement is at amortised cost

If classified as FVTPL; initial measurement is at fair value, and then so is subsequent measurement with gains and losses being recognised in the income statement

Initial measurement is at fair value less issue costs and, subsequently, no change as equity instruments are not re-measured

Accounting for compound financial instruments While the vast majority of financial instruments create a financial asset in one entity and a financial liability or equity instrument in the accounts of another entity, it is possible that a single financial instrument can create a financial asset in one entity and a financial liability and an equity instrument in another entity. The classic example of this arises when an entity issues a convertible bond. Accounting for the issue of convertible bonds (debt and equity in a single instrument) Convertible bonds are basically debt instruments but they also contain an option to convert into equity shares and this means that a convertible bond contains both debt and equity elements. The option to convert into equity is strictly a derivative that is embedded into the host contract. The option will be exercisable by the holder of the bond who has the option to require settlement of the debt in equity shares rather than 2012 ACCA

2 ACCOUNTING FOR FINANCIAL INSTRUMENTS AUGUST 2012 being repaid in cash. For accounting purposes it will be necessary on initial recognition to split out the debt and equity elements so that they can be separately accounted for. The fair value of the option is highly subjective, but the fair value of the debt element is more easily measured by discounting the future cash flows. The assumption is then made that the fair value of the option is the balancing figure. Example 1 Graham Gooch issues a 3% \$200,000 two-year convertible bond at par. The effective rate of interest of the instrument is 8%. The terms of the convertible bond is that the holder of the bond, on the redemption date, has the option to convert the bond to equity shares at the rate of 10 shares with a nominal value of \$1 per \$100 debt rather than being repaid in cash. Transaction costs can be ignored. Graham Gooch will account for the financial liability arising using amortised cost. Required Explain the accounting for the issue of the convertible bond. Solution A convertible bond creates both an equity and a debt instrument. On initial recognition the debt element will be measured at fair value ie the present value of the future cash flow, with the equity element representing the balancing figure. Transaction costs have been ignored, but would have to split proportionately between the debt and equity elements. The value ascribed to the equity element is the balancing figure. Cash flow (3% x \$200,000) Discount factor @ 8% Present value of the future cash flow \$5,556 \$176,542 \$182,098 \$17,902 \$200,000

Year 1 \$6,000 X 0.926 Year 2 \$206,000 X 0.857 Fair value of the debt element Fair value of the equity element (balancing figure) Proceeds of the issue

In journal entry terms the initial issue of the convertible bond can be summarised as follows: Dr Cr Cr Cash Financial liability Equity \$200,000 \$182,098 \$17,902

The Cr to equity can be reported in a reserve entitled Other components of equity. Equity is not subsequently remeasured. The liability on the other hand will be accounted for using amortised cost charging income with a finance cost at the rate of 8%.

2012 ACCA

3 ACCOUNTING FOR FINANCIAL INSTRUMENTS AUGUST 2012 Opening balance \$182,098 \$190,666 Income statement Less cash Closing balance finance cost@8% of the liability \$14,568 (\$6,000) \$190,666 \$15,334* (\$6,000) \$200,000

Year 1 Year 2

*includes rounding

At the end of Year 2 the liability can be extinguished by the payment of \$200,000 in cash, or if the option is exercised by the bond holder, then it is extinguished by the issue of 20,000 \$1 ordinary shares at nominal value with a share premium of \$180,000 also being recorded. Financial assets Now let us turn our attention to the accounting for financial assets, as there have been some recent changes following the issue of IFRS 9, Financial Instruments which will supersede IAS 39, Financial Instruments: Recognition and Measurement. The new standard applies to all types of financial assets, except for investments in subsidiaries, associates and joint ventures and pension schemes, as these are all accounted for under various other accounting standards. IFRS 9, Financial Instruments has simplified the way that financial assets are accounted. As with financial liabilities the standard retains a mixed measurement system for financial assets, allowing some to be stated at fair value while others at amortised cost. On the same basis that when an entity issues a financial instrument it has to classify it as a financial liability or equity instrument, so when an entity acquires a financial asset it will be acquiring a debt asset (eg an investment in bonds, trade receivables) or an equity asset (eg an investment in ordinary shares). Financial assets have to be classified and accounted for in one of three categories: amortised cost, FVTPL or Fair Value Through Other Comprehensive Income (FVTOCI). They are initially measured at fair value plus, in the case of a financial asset not at FVTPL, transaction costs. Accounting for financial assets that are debt instruments A financial asset that is a debt instrument will be subsequently accounted for using amortised cost if it meets two simple tests. These two tests are the business model test and the cash flow test. The business model test is met where the purpose is to hold the asset to collect the contractual cash flows (rather than to sell it prior to maturity to realise its fair value changes). The cash flow test will be met when the contractual terms of the asset give rise on specified dates to cash flows that are solely receipts of either the principal or interest. These tests are designed to ensure that the fair value of the asset is irrelevant, as even if interest rates fall causing the fair value to raise then the asset will still be passively held to receive interest and capital and not be sold on. However, even if the asset meets the two tests there is still a fair value option to designate it as FVTPL if doing so eliminates or significantly reduces a measurement or recognition inconsistency (an 'accounting mismatch') that would otherwise arise from

2012 ACCA

4 ACCOUNTING FOR FINANCIAL INSTRUMENTS AUGUST 2012 measuring assets or liabilities or recognising the gains and losses on them on different bases. An example of where it is appropriate to use the fair value option and, thus, avoid an accounting mismatch is where an entity holds a financial asset that is debt and that carries a fixed rate of interest, but is then hedged with an interest rate swap that swaps the fixed rates for floating rates. The interest swap is a financial instrument that would be held at FVTPL and so, accordingly, the financial asset classified as debt also needs to be at FVTPL to ensure that the gains and losses arising from both instruments are naturally paired in income and, thus, reflect the substance of the hedge. If the financial asset classified as debt was accounted for at amortised cost, then this would create the accounting mismatch. All other financial assets that are debt instruments must be measured at FVTPL. Accounting for financial assets that are equity instruments (eg investments in equity shares) Equity investments have to be measured at fair value in the statement of financial position. As with financial assets that are debt instruments, the default position for equity investments is that the gains and losses arising are recognised in income (FVTPL). However, there is an election that equity investments can at inception be irrevocably classified and accounted as FVTOCI, so that gains and losses arising are recognised in other comprehensive income, thus creating an equity reserve, while dividend income is still recognised in income. Such an election cannot be made if the equity investment is acquired for trading. On disposal of an equity investment accounted for as FVTOCI, the gain or loss to be recognised in income is the difference between the sale proceeds and the carrying value. Gains or losses previously recognised in other comprehensive income cannot be recycled to income as part of the gain on disposal. For example, let us consider the case of an equity investment accounted for at FVTOCI that was acquired several years ago for \$10,000 and by the last reporting date has been revalued to \$30,000. If the asset is then sold for \$31,000, the gain on disposal to be recognised in the income statement is only \$1,000 as the previous gain of \$20,000 has already been recognised and reported in the other comprehensive income statement. IFRS 9 requires that gains can only be recognised once. The balance of \$20,000 in the equity reserves that relates to the equity investment can be transferred into retained earnings as a movement within reserves. The accounting for financial assets can be summarised in the diagram on the following page. Reclassification of financial assets As we have seen once an equity investment has been classified as FVTOCI this is irrevocable so it cannot then be reclassified. Nor can a financial asset be reclassified where the fair value option has been exercised. However if, and only if the entity's business model objective for its financial assets changes so its previous model assessment would no longer apply then other financial assets can be reclassified between FVTPL and amortised cost, or vice versa. Any reclassification is done prospectively from the reclassification date without restating any previously recognised gains, losses, or interest.

2012 ACCA

5 ACCOUNTING FOR FINANCIAL INSTRUMENTS AUGUST 2012 Financial assets Debt instruments Contain an obligation to be repaid Equity instruments Evidence of an ownership interest in the residual net assets If classified as FVTPL: initial measurement is at fair value, and then so is subsequent measurement with gains and losses being recognised in income If classified as FVTOCI: initial measurement is at fair value plus transaction cost and subsequent measurement is at fair value with gains and losses being recognised directly in reserves and OCI An irrevocable election at inception has to be made. On disposal no recycling of previously recognised gains or losses to income

If classified as amortised cost: initial measurement is at fair value plus transaction costs and then subsequent measurement is at amortised cost The business model and cash flow test have to be met

The default accounting treatment also used also where the asset is acquired for trading purposes or to avoid an accounting mismatch

Accounting for impairment losses on financial assets Under the suggested new requirements of IFRS 9, Financial Instruments, only financial assets measured at amortised cost will be subject to impairment reviews. It is also proposed that an expected loss model towards impairment reviews be introduced when reviewing these financial assets. The expected loss model requires that entities

2012 ACCA

6 ACCOUNTING FOR FINANCIAL INSTRUMENTS AUGUST 2012 determine and account for expected credit losses when the asset is originated or acquired rather than wait for an actual default. This is achieved by making an allowance for the initial expected losses over the life of the asset by considering a reduction in the interest revenue. Example 2: accounting for impairment losses Imran Khan holds a portfolio of financial assets that are debt instruments (ie Imran Khan is a lender). These assets are initially recognised at \$100,000 and accounted for at amortised cost as they meet the business model and cash flow tests. Each loan has a coupon rate of 8% as well as an effective rate of 8%. In the current period no loans have actually defaulted; however, it is felt that a proportion of loans will default over the loan period and, thus, in the long run the rate of return from the portfolio will be approximately 3%. Required Discuss the impairment review of these assets in the first accounting period using the expected loss model. Solution The gross interest income that is initially recognised in income is \$8,000 (as calculated using the effective rate of 8% on the initial carrying value of \$100,000). With no defaults, cash of \$8,000 will also be received (as calculated using the coupon rate of 8% on the nominal value). Thus, prior to any impairment review the carrying value at the end of the first reporting period is \$100,000. However, to recognise the impairment loss on an expected loss basis the actual net rate of return inclusive of expected defaults of 3% has to be considered. This gives a net \$3,000 (3% x \$100,000) to be recognised in income. Thus, there is an expected loss adjustment of \$5,000 (\$8,000 less \$3,000) leaving the asset written down to \$95,000 (\$100,000 less \$5,000). Historically impairment reviews had been accounted using an incurred loss model ie in order to recognise an impairment loss, there had first to be a specific past event indicating an impairment. In the above example, on this basis no allowance would have been made of the expected future losses so that the interest income recognised would be simply \$8,000 and the asset stated at \$100,000. The incurred loss model led to the failure of lenders to recognise what were arguably known losses and to overstate assets. The new approach of measuring impairment on an expected loss model is both in accordance with prudence, in that losses are anticipated and accruals in that the losses are in effect spread over the period of the life of the asset and not back loaded. Tom Clendon FCCA is a senior tutor at Kaplan Financial, London

2012 ACCA

technical page 38

## student accountant NOVeMBeR/DeCeMBeR 2008

CONSTRUCTION CONTRACTS

## RELEVANT TO ACCA QUALIFICATION PAPER F7

The correct timing of revenue (and profit) is crucial in order to faithfully represent the results shown in the income statement.
IAS 11 TREATMENT Where possible, IAS 11 applies the accruals concept to the revenue earned on a construction contract. If the outcome of a project can be reasonably foreseen, then the accruals concept is applied by recognising profit on uncompleted contracts in proportion to the percentage of completion, applied to the estimated total contract profit. If, however, a loss is expected on the contract, then an application of prudence is necessary and the loss will be recognised immediately. OUTCOME CAN BE RELIABLY MEASURED IAS 11 only allows revenue and contract costs to be recognised when the outcome of the contract can be predicted with reasonable certainty. This means that it should be probable that the economic benefit attached to the contract will flow to the entity. If a loss is calculated, then the entire loss should be recognised immediately. If a profit is estimated, then revenue and costs should be recognised according to the stage that the project has completed. There are two ways in which stage of completion can be calculated, and, in the exam, it is important to determine from the question scenario which method the examiner intends you to use, either the: work certified method (sometimes referred to as the sales basis) work certified to date contract price cost method costs incurred to date total contract costs EXAM FOCUS To answer an exam question on construction contracts, a step approach is required, which can be practised by looking at the following examples. EXAMPLE 1 Profit-making contract Lily is a construction company that prepares its financial statements to 31 December each year. During the year ended 31 December 2008, the company commenced a contract that is expected to take more than one year to complete. The contract summary at 31 December 2008 is as follows: \$000 1,400 2,736 1,824 2,160 2,520

Progress payments Contract price Work certified complete Contract costs incurred to 31 December 2008 Estimated total cost at 31 December 2008*

* The examiner sometimes presents information in this manner estimated total cost means costs incurred plus costs to complete. The agreed value of the work completed at 31 December 2008 is considered to be equal to the revenue earned in the year ended 31 December 2008. The percentage of completion is calculated as the value of the work invoiced to date compared to the contract price. Required: Calculate the effect of the above contract on the financial statements at 31 December 2008. Step approach Step 1: Set up extracts of the financial statements and a working paper. Step 2: Determine at W1 whether a profit or loss is expected on the contract. Step 3: In this example a profit will be calculated, so determine the accounting policy from the question and calculate the stage of completion. Step 4: Calculate how much profit should be shown this year from the stage of completion and include it in the income statement extract. Step 5: Build up the income statement. If it is a work-certified accounting policy, then the work certified for the year should be taken to the revenue line. If it is a cost-basis accounting policy, then the costs incurred should be taken to the cost of sales line.

technical page 39

linKed PeRFoRMance oBJectiVes studying paper F7? did you know that perForManCe oBJeCtiVes 10 and 11 are linked?

Step 6: Depending on what approach was taken at step 5, you are now in a position to find the balancing figure to complete the income statement. Step 7: Calculate the asset or liability outstanding on the construction contract. Income statement extract 31 December 2008 \$000 1,824 1,680 144

Required: Calculate the effect of the above contract in the financial statements at 31 March 2008. SOLUTION 1 Step 1: Set up extracts of the financial statements and a working paper. Step 2: Determine at W1 whether a profit or loss is expected on the contract. Step 3: A loss will be calculated in this example and should be recognised in the income statement immediately. Step 4: Build up the income statement. If it is a work-certified accounting policy, then the work certified for the year should be taken to the revenue line. If it is a cost-basis accounting policy, then the costs incurred should be taken to the cost of sales line. Step 5: Depending on the approach taken at step 4, you are now in a position to find the balancing figure to complete the income statement. Step 6: Calculate the asset or liability outstanding on the construction contract. Income statement extract 31 March 2008

during the year amount to \$700,000 and no cash had yet been received. What should the accounting entries be regarding the contract at the year end? Solution During the year, as costs have been incurred, the natural double entries occurring would have been: Dr Purchases \$700,000 Cr Bank/payables \$700,000 As the outcome cannot be reliably measured, and assuming all costs are recoverable, revenue should be taken as equal to the costs incurred: Dr Receivables \$700,000 Cr Revenue \$700,000 In processing the above journals, no profit will be taken on the contract during the financial year. WHAT IS INCLUDED IN CONTRACT REVENUE AND COSTS? Contract revenue will be the amount agreed in the initial contract, plus revenue from variations in the original contract work, plus incentive payments and claims that can be reliably measured, such as contract revenue which can be valued at the fair value of received or receivable revenue. Contract costs are to include costs relating directly to the initial contract plus costs attributable to general contract activity, plus costs that can be specifically charged to the customer under the terms of the contract. EXAM ADVICE There are two common technical areas that may feature in any exam question on construction contracts, and which could cause difficulties. The first is when unplanned rectification costs are included within the question information. Rectification costs must be charged to the period in which they were incurred, and not spread over the remainder of the contract life. Therefore, such costs should not be added in when calculating the profit or loss to be shown on a contract. The second difficulty is where a contract is already part way through, ie in its second year. If this is the second year of a contract, candidates must realise that some revenue and costs have previously been recognised. Candidates should take this into account in their calculations to make sure they show the current year revenue and costs. CONCLUSION IAS 11 could feature in the Paper F7 exam as part of Question 2 (on published accounts), or in its own right in Questions 4 or 5, for 15 marks and 10 marks respectively. It is therefore an extremely important accounting standard at this level and candidates are strongly advised to practise past questions relating to this area of the syllabus. Bobbie Retallack is Kaplan Publishings content specialist for Papers F3 and F7

Revenue (work certified) COS () Gross profit (W2) Statement of financial position extract 31 December 2008 Current assets Asset on a construction contract (W3) WORKING PAPER (W1) Expected outcome Contract price Total costs Expected profit

904

## \$000 2,736 2,520 216

(W2) Percentage of completion Accounting policy = Work certified complete Work certified to date Contract price 1,824 = 66.67% 2,736 (As a round percentage was not found, use the fraction to complete workings instead) Profit to be recognised = \$216 (W1) x \$1,824 / \$2,736 = \$144 (W3) Asset on construction contract Costs incurred to date Profit recognised to date Less: Progress payments

Revenue () COS (costs incurred) Gross loss (W1) Statement of financial position extract 31 March 2008 Current liabilities Liability on a construction contract WORKING PAPER (W1) Expected outcome Contract price Total cost (3,600 + 1,200) Expected loss (W2) Liability on construction contract Costs incurred to date Loss recognised to date Less: Progress payments Liability on construction

480

## \$000 4,500 (4,800) (300) 3,600 (300) (3,780) (480)

EXAMPLE 2 Loss-making contract Gladioli is a construction company that prepares its financial statements to 31 March each year. During the year ended 31 March 2008, the company commenced a contract that is expected to take more than one year to complete. The contract summary at 31 March 2008 is as follows: \$000 Progress payments 3,780 Contract price 4,500 Contract costs incurred to 31 March 2008 3,600 Estimated cost to complete at 31 March 2008 1,200 The percentage completion of this contract is to be based on the costs to date compared to the estimated total contract costs.

OUTCOME CANNOT BE RELIABLY MEASURED In following prudence, where an outcome cannot be reliably measured, any costs incurred during the financial year should be expensed immediately and revenue recognised as equivalent to the contract costs expected to be recoverable. EXAMPLE 3 Take no profit on contract A welding company negotiated a two-year project that commenced in the latter half of the year. The project manager has been reviewing the contract and, at the year end, is unsure whether the contract will make a profit or a loss as there are uncertainties surrounding the projects completion. The project managers records show that costs

This article sets out the accounting treatment for the impairment of trade receivables/debtors. The provision for bad debts is now, in effect, governed by IAS 39, Financial Instruments: Recognition and Measurement for International stream students or FRS 26, Financial Instruments: Measurement for UK stream students. Adapted papers generally follow the content of IAS 39. This article covers the general accounting principles and then outlines its applicability to CAT Scheme Papers 1, 3 and 6, and Professional Scheme Paper F3.

## General accounting principles (relevant to ACCA Qualification Papers F7 and P2)

Impairment of individually significant balances must be separately assessed and an allowance made when it is probable that the cash due will not be received in full. Impairment of individually non-significant balances can be measured on a portfolio or group basis. Any receivables that are not thought to be impaired are included in the group assessment. If information becomes available that identifies losses on a receivable in the group then it is removed and individually assessed. The collective assessment of impairment requires the splitting of the list of receivables into groups of trade receivables that share similar credit risk characteristics. The credit risk groups are to be assessed for impairment using historical loss experience for each group. Such historical loss experience would be adjusted to reflect the effects of current conditions. An individual receivable/debtor impairment factor is likely to be specific to that receivable/debtor - pending liquidation of the entity, for example. A collective impairment factor is likely to be as a result of past economic events that affect the receivables in general (eg interest rates). Impairment losses will be recognised only when they are incurred. Thus, if there is deterioration in the credit quality of the financial assets as a result of a past event, then an impairment loss may have occurred. The recognition of future losses based on possible or expected future trends is not in accordance with the IASB Framework and IAS 37/FRS 12, Provisions, Contingent Liabilities and Contingent Assets. General provisions would therefore not be allowed as the historical experience is zero and it is unlikely to produce an acceptable estimate of the cash flows to be received. Conclusion Trade receivables/debtors fall into the category of loans and receivables under IAS 39/FRS 26. They will be valued at fair value initially - which will be the invoiced amount. Because they are short-term receivables they will not normally be subject to discounting, nor will they normally have an effective interest rate. They will have to be assessed for impairment at each balance sheet date, and will be impaired if the present value of the cash flows is less than the carrying amount. The assessment can be on an individual or group basis. The old methods of calculating bad debt provisions are unlikely to produce a correct figure for the present value of the future cash flows and general provisions will not comply with the methodology set out in the IAS/FRS. IAS 39/FRS 26 states that the carrying amount of the asset should be reduced either directly or through the use of an allowance account (para 63). The amount of the loss should go to profit or loss. An allowance for impairment losses is possible, but it must be determined in a more logical and systematic way than has often been the case in the past.

## RELEVANT TO ACCA QUALIFICATION PAPER F7

Studying Paper F7? Performance objectives 10 and 11 are relevant to this exam

ACCOUNTING FOR LEASES The accounting topic of leases is a popular Paper F7 exam area that could feature to varying degrees in Questions 2, 3, 4 or 5 of the exam. This topic area is currently covered by IAS 17, Leases. IAS 17, Leases takes the concept of substance over form and applies it to the specific accounting area of leases. When applying this concept, it is often deemed necessary to account for the substance of a transaction, ie its commercial reality, rather than its strict legal form. In other words, the legal basis of a transaction can be used to hide the true nature of a transaction. It is argued that by applying substance, the financial statements become more reliable and ensure that the lease is faithfully represented. Why do we need to apply substance to a lease? A lease agreement is a contract between two parties, the lessor and the lessee. The lessor is the legal owner of the asset, the lessee obtains the right to use the asset in return for rental payments. Historically, assets that were used but not owned were not shown on the statement of financial position and therefore any associated liability was also left out of the statement this was known as off balance sheet finance and was a way that companies were able to keep their liabilities low, thus distorting gearing and other key financial ratios. This form of accounting did not faithfully represent the transaction. In reality a company often effectively owned these assets and owed a liability. Under modern day accounting the IASB framework states that an asset is a resource controlled by an entity as a result of past events and from which future economic benefits are expected to flow to the entity and 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. These substance-based definitions form the platform for IAS 17, Leases. So how does IAS 17 work? IAS 17 states that there are two types of lease, a finance lease and an operating lease. The definitions of these leases are vital and could be required when preparing an answer in the exam.

2010 ACCA

2 ACCOUNTING FOR LEASES OCTOBER 2010 Finance lease A finance lease is a lease that transfers substantially all the risks and rewards incidental to ownership of an asset to the lessee. Operating lease An operating lease is defined as being any lease other than a finance lease. Classification of a lease In order to gain classification of the type of lease you are dealing with, you must first look at the information provided within the scenario and determine if the risks and rewards associated with owning the asset are with the lessee or the lessor. If the risks and rewards lie with the lessee then it is said to be a finance lease, if the lessee does not take on the risks and rewards, then the lease is said to be an operating lease. Finance lease indicators There are many risks and rewards outlined within the standard, but for the purpose of the Paper F7 exam there are several important areas. The main reward is where the lessee has the right to use the asset for most of, or all of, its useful economic life. The primary risks are where the lessee pays to insure, maintain and repair the asset. When the risks and rewards remain with the lessee, the substance is such that even though the lessee is not the legal owner of the asset, the commercial reality is that they have acquired an asset with finance from the leasing company and, therefore, an asset and liability should be recognised. Other indicators that a lease is a finance lease include: At the inception of the lease the present value of the minimum lease payments* amounts to substantially all of the fair value of the asset The lease agreement transfers ownership of the asset to the lessee by the end of the lease The leased asset is of a specialised nature The lessee has the option to purchase the asset at a price expected to be substantially lower than the fair value at the date the option becomes exercisable Finance lease accounting Initial accounting The initial accounting is that the lessee should capitalise the finance leased asset and set up a lease liability for the value of the asset recognised. The accounting for this will be:

2010 ACCA

3 ACCOUNTING FOR LEASES OCTOBER 2010 Dr Non-current assets Cr Finance lease liability (This should be done by using the lower of the fair value of the asset or the present value of the minimum lease payments*.) *Note The present value of the minimum lease payments is essentially the lease payments over the life of the lease discounted to present value you will either be given this figure in the Paper F7 exam or, if not, use the fair value of the asset. You will not be expected to calculate the minimum lease payments.. Subsequent accounting Depreciation Following the initial capitalisation of the leased asset, depreciation should be charged on the asset over the shorter of the lease term or the useful economic life of the asset. The accounting for this will be: Dr Depreciation expense Cr Accumulated depreciation Lease rental/interest When you look at a lease agreement it should be relatively easy to see that there is a finance cost tied up within the transaction. For example, a company could buy an asset with a useful economic life of four years for \$10,000 or lease it for four years paying a rental of \$3,000 per annum. If the leasing option is chosen, over a four-year period the company will have paid \$12,000 in total for use of the asset (\$3,000 pa x 4 years), ie the finance charge in this example totals \$2,000 (the difference between the total lease cost (\$12,000) and the purchase price of the asset (\$10,000)). When a company pays a rental, in effect it is making a capital repayment (ie against the lease obligation) and an interest payment. The impact of this will need to be shown within the financial statements in the form of a finance cost in the income statement and a reduction of the outstanding liability in the statement of financial position. In reality there are several ways that this can be done, but the Paper F7 examiner has stated that he will examine the actuarial method only. The actuarial method of accounting for a finance lease allocates the interest to the period it actually relates to, ie the finance cost is higher when the capital outstanding is greatest, but as the capital gets repaid, interest payments become lower (similar to a repayment mortgage that you may have on your property). To allocate the interest to a specific period you will require the interest rate implicit within the lease

2010 ACCA

4 ACCOUNTING FOR LEASES OCTOBER 2010 agreement again this will be provided in the exam and you are not required to calculate it. One of the easiest ways to apply the actuarial method in the exam is to use a leasing table. Please take note of when the rental payment is actually due, is it in advance (ie rental made at beginning of the lease year) or is it in arrears (ie rental made at the end of the lease year)? This will affect the completion of the lease table as highlighted below: Rental payments in advance Year B/fwd Rental X X (X) Capital o/s X Interest (rate given) X To income statement (finance costs) C/fwd X To statement of financial position (liability) C/fwd X To statement of financial position (liability)

Rental payments in arrears Year B/fwd Interest (rate given) X X X To income statement (finance costs)

Rental (X)

Tip: to be technically accurate the lease liability should be split between a non-current liability and a current liability. Example 1 Rentals in arrears treatment On 1 April 2009 Bush Co entered into an agreement to lease a machine that had an estimated life of four years. The lease period is also four years, at which point the asset will be returned to the leasing company. Annual rentals of \$5,000 are payable in arrears from 31 March 2010. The machine is expected to have a nil residual value at the end of its life. The machine had a fair value of \$14,275 at the inception of the lease. The lessor includes a finance cost of 15% per annum when calculating annual rentals. How should the lease be accounted for in the financial statements of Bush for the year end 31 March 2010?

2010 ACCA

5 ACCOUNTING FOR LEASES OCTOBER 2010 Solution The lease should be classified as a finance lease as the estimated life of the asset is four years and Bush retains the right to use this asset for four years in accordance with the lease agreement therefore enjoying the rewards of the asset. Initial accounting: recognise the asset and the lease liability Dr Property, plant and equipment 14,275 Cr Finance lease obligations 14,275 Subsequent accounting: depreciation Dr Depreciation expense (\$14,275 / 4 years) Cr Accumulated depreciation 3,568 3,568

Subsequent accounting: lease rental/interest Tip: use the lease table and complete next year as well to help you complete the split between non-current and current liabilities. Year 1 2 B/fwd 14,275 11,416 Interest (15%) 2,141 1,712 3,568 2,141 Rental (5,000) (5,000) C/fwd 11,416 8,128 NCL

## Income statement extract Depreciation Finance costs

Statement of financial position extract Non-current assets Carrying value machine (14,275 3,568) Non-current liabilities Lease obligation Current liabilities Lease obligation Capital ((11,416 8,128)

10,707

8,128

3,288

Example 2 Rentals in advance treatment On 1 April 2009 Shrub Co entered into an agreement to lease a machine that had an estimated life of four years. The lease period is also four years at which point the asset will be returned to the leasing company. Shrub is required to pay for all maintenance and insurance costs

2010 ACCA

6 ACCOUNTING FOR LEASES OCTOBER 2010 relating to the asset. Annual rentals of \$8,000 are payable in advance from 1 April 2009. The machine is expected to have a nil residual value at the end of its life. The machine had a fair value of \$28,000 at the inception of the lease. The lessor includes a finance cost of 10% per annum when calculating annual rentals. How should the lease be accounted for in the financial statements of Shrub for the year end 31 March 2010? Solution The lease should be classified as a finance lease as the estimated life of the asset is four years and Shrub retains the right to use this asset for four years in accordance with the lease agreement therefore enjoying the rewards of the asset. In addition to this Shrub is required to maintain and insure the asset, therefore retaining the risks of asset ownership. Initial accounting: recognise the asset and the lease liability Dr Property, plant and equipment 28,000 Cr Finance lease obligations 28,000 Subsequent accounting: depreciation Dr Depreciation expense (\$28,000 / 4 years) Cr Accumulated depreciation 7,000 7,000

Subsequent accounting: lease rental/interest Year 1 2 B/fwd 28,000 22,000 Rental (8,000) (8,000) Capital o/s 20,000 14,000 Interest (10%) 2,000 C/fwd 22,000

## NCL 7,000 2,000

2010 ACCA

7 ACCOUNTING FOR LEASES OCTOBER 2010 Statement of financial position extract Non-current assets Carrying value machine (28,000 7,000) Non-current liabilities Lease obligation Current liabilities Lease obligation Accrued interest Capital ((22,000 14,000) 2,000)

21,000

14,000

2,000 6,000

Example 3 Split lease year treatment On 1 October 2008 Number Co entered into an agreement to lease a machine that had an estimated life of four years. The lease period is also four years with annual rentals of \$10,000 payable in advance from 1 October 2008. The machine is expected to have a nil residual value at the end of its life. The machine had a fair value of \$35,000 at the inception of the lease. The lessor includes a finance cost of 10% per annum when calculating annual rentals. How should the lease be accounted for in the financial statements of Number for the year end 31 March 2010? Solution The lease should be classified as a finance lease as the estimated life of the asset is four years and Number retains the right to use this asset for four years in accordance with the lease agreement therefore enjoying the rewards of the asset. Initial accounting: recognise the asset and the lease liability Dr Property, plant and equipment 35,000 Cr Finance lease obligations 35,000 Subsequent accounting: depreciation Tip: the depreciation for the year ended 31 March 2010 is a straightforward annual charge, but you will also have to take into account the depreciation for the first six months of the lease that was attributable to the year ended 31 March 2009 as this will be required to find the closing carrying value in the statement of financial position.

2010 ACCA

8 ACCOUNTING FOR LEASES OCTOBER 2010 1 October 2008 31 March 2009 Dr Depreciation expense (\$35,000 / 4 years x 6/12) Cr Accumulated depreciation 1 April 2009 31 March 2010 Dr Depreciation expense (\$35,000 / 4 years) Cr Accumulated depreciation 4,375 4,375 8,750 8,750

Subsequent accounting: lease rental/interest Tip: you are looking for the outstanding value of the lease 18 months after the lease agreement began. It is advisable that you extend your lease table so that you have two separate c/fwd balances the balance at the end of the accounting year (31 March) and the balance at the end of the lease year (30 September). Year B/fwd Interest (10%) (6 months) 35,000 (10,000) 25,000 1,250 27,500 (10,000) 17,500 875 19,250 (10,000) 9,250 NCL Income statement extract 31 March 2010 Depreciation 8,750 Finance costs 2,125 (1,250 + 875) Statement of financial position extract 31 March 2010 Non-current assets Carrying value machine 21,875 (35,000 4,375 (first 6 months depreciation) 8,750 (current year charge)) Non-current liabilities Lease obligation Current liabilities Lease obligation Interest Capital ((18375 - 9,250) - 875) 9,250 Rental Capital o/s C/fwd (31 Mar) 26,250 18,375 Interest (10%) (6 months) 1,250 875 C/fwd (30 Sep) 27,500 19,250

1 2 3

875 8,250

2010 ACCA

9 ACCOUNTING FOR LEASES OCTOBER 2010 Operating lease accounting As the risks and rewards of ownership of an asset are not transferred in the case of an operating lease, an asset is not recognised in the statement of financial position. Instead rentals under operating leases are charged to the income statement on a straight-line basis over the term of the lease, any difference between amounts charged and amounts paid will be prepayments or accruals. Example 4 Operating lease treatment On 1 October 2009 Alpine Ltd entered into an agreement to lease a machine that had an estimated life of 10 years. The lease period is for four years with annual rentals of \$5,000 payable in advance from 1 October 2009. The machine is expected to have a nil residual value at the end of its life. The machine had a fair value of \$50,000 at the inception of the lease. How should the lease be accounted for in the financial statements of Alpine for the year end 31 March 2010? Solution In the absence of any further information, this transaction would be classified as an operating lease as Alpine does not get to use the asset for most of/all of the assets useful economic life and therefore it can be argued that they do not enjoy all the rewards from this asset. In addition to this, the present value of the minimum lease payments, if calculated (you are not required to do this in the exam, only use if the examiner gives to you) would be substantially less than the fair value of the asset. The accounting for this lease should therefore be relatively straightforward and is shown below: Rental of \$5,000 paid on 1 October: Dr Lease expense (income statement) Cr Bank 5,000 5,000

This rental however spans the lease period 1 October 2009 to 30 September 2010 and therefore \$2,500 (the last six-months rental) has been prepaid at the year end 31 March 2010. Dr Prepayments 2,500 Cr Lease expense 2,500

2010 ACCA

10 ACCOUNTING FOR LEASES OCTOBER 2010 Income statement extract Lease expense 2,500 Statement of financial position extract Current assets: Prepayments 2,500 Example 5 Initial rent free incentive A Co entered into an agreement to lease office space on 1 April 2009 for a fixed period of five years. As an incentive to encourage the office space to be occupied, a first year rent-free period was included in the agreement after which A Co is required to pay an annual rental of \$36,000. How should the lease be accounted for in the year ended 31 March 2010? Solution The total cost of leasing the office space is \$144,000 (\$36,000 4 years). Despite there being a rent-free period the total cost of the lease should be matched to the period in which it relates. Therefore, in year 1: Income statement extract Rental (\$144,000 / 5 years) \$28,800

Statement of financial position extract Current liabilities Accruals \$28,800 In summary, the accounting topic of leases is a really important accounting area and is highly examinable. To master this topic, ensure that you know the definitions of both types of lease, the recognition criteria for a finance lease and practise plenty of examples of accounting for finance leases. Bobbie-Anne Retallack is a content specialist at Kaplan Publishing

2010 ACCA

TEchnical

deferred tax
rElEVanT To acca qualificaTion papErs f7 anD p2
DEfErrED Tax is accounTED for in accorDancE wiTh ias 12, incomE TaxEs. in papEr f7, DEfErrED Tax normally rEsulTs in a liabiliTy bEing rEcognisED wiThin ThE sTaTEmEnT of financial posiTion.
and the cumulative capital allowances claimed are different, the carrying value of the asset (cost less accumulated depreciation) will then be different to its tax base (cost less accumulated capital allowances) and hence a taxable temporary difference arises. Example 1 A non-current asset costing \$2,000 was acquired at the start of year 1. It is being depreciated straight line over four years, resulting in annual depreciation charges of \$500. Thus a total of \$2,000 of depreciation is being charged. The capital allowances granted on this asset are: Year 1 Year 2 Year 3 Year 4 Total capital allowances \$ 800 600 360 240 2,000 Deferred tax is a topic that is consistently tested in Paper F7, Financial Reporting and is often tested in further detail in Paper P2, Corporate Reporting. This article will start by considering aspects of deferred tax that are relevant to Paper F7, before moving on to the more complicated situations that may be tested in Paper P2. The basics Deferred tax is accounted for in accordance with IAS 12, Income Taxes. In Paper F7, deferred tax normally results in a liability being recognised within the Statement of Financial Position. IAS 12 defines a deferred tax liability as being the amount of income tax payable in future periods in respect of taxable temporary differences. So, in simple terms, deferred tax is tax that is payable in the future. However, to understand this definition more fully, it is necessary to explain the term taxable temporary differences. Temporary differences are defined as being differences between the carrying amount of an asset (or liability) within the Statement of Financial Position and its tax base ie the amount at which the asset (or liability) is valued for tax purposes by the relevant tax authority. Taxable temporary differences are those on which tax will be charged in the future when the asset (or liability) is recovered (or settled). IAS 12 requires that a deferred tax liability is recorded in respect of all taxable temporary differences that exist at the year-end this is sometimes known as the full provision method. All of this terminology can be rather overwhelming and difficult to understand, so consider it alongside an example. Depreciable non-current assets are the typical example behind deferred tax in Paper F7. Within financial statements, non-current assets with a limited economic life are subject to depreciation. However, within tax computations, non-current assets are subject to capital allowances (also known as tax depreciation) at rates set within the relevant tax legislation. Where at the year-end the cumulative depreciation charged

Table 1 shows the carrying value of the asset, the tax base of the asset and therefore the temporary difference at the end of each year. As stated above, deferred tax liabilities arise on taxable temporary differences, ie those temporary differences that result in tax being payable in the future as the temporary difference reverses. So, how does the above example result in tax being payable in the future? Entities pay income tax on their taxable profits. When determining taxable profits, the tax authorities start by taking the profit before tax (accounting profits) of an entity from their financial statements and then make various adjustments. For example, depreciation is considered a disallowable expense for taxation purposes but instead tax relief on capital expenditure is granted in the form of capital allowances. Therefore, taxable profits are arrived at by adding back depreciation and deducting capital allowances from the accounting profits. Entities are then charged tax at the appropriate tax rate on these taxable profits.

## sTuDEnT accounTanT 08/2009

Studying Papers F7 or P2? performance objectives 10 and 11 are linked

DEfErrED Tax liabiliTiEs arisE on TaxablE TEmporary DiffErEncEs ThosE TEmporary DiffErEncEs ThaT rEsulT in Tax bEing payablE in ThE fuTurE as ThE TEmporary DiffErEncE rEVErsEs.

TablE 1: ThE carrying ValuE, ThE Tax basE of ThE assET anD ThErEforE ThE TEmporary DiffErEncE aT ThE EnD of Each yEar (ExamplE 1) year 1 2 3 4 carrying value (cost - accumulated depreciation) \$ 1,500 1,000 500 Nil Tax base (cost - accumulated capital allowances) \$ 1,200 600 240 Nil Temporary difference \$ 300 400 260 Nil

In the above example, when the capital allowances are greater than the depreciation expense in years 1 and 2, the entity has received tax relief early. This is good for cash flow in that it delays (ie defers) the payment of tax. However, the difference is only a temporary difference and so the tax will have to be paid in the future. In years 3 and 4, when the capital allowances for the year are less than the depreciation charged, the entity is being charged additional tax and the temporary difference is reversing. Hence the temporary differences can be said to be taxable temporary differences. Notice that overall, the accumulated depreciation and accumulated capital allowances both equal \$2,000 the cost of the asset so over the four-year period, there is no difference between the taxable profits and the profits per the financial statements. At the end of year 1, the entity has a temporary difference of \$300, which will result in tax being payable in the future (in years 3 and 4). In accordance with the concept of prudence, a liability is therefore recorded equal to the expected tax payable.

Assuming that the tax rate applicable to the company is 25%, the deferred tax liability that will be recognised at the end of year 1 is 25% x \$300 = \$75. This will be recorded by crediting (increasing) a deferred tax liability in the Statement of Financial Position and debiting (increasing) the tax expense in the Income Statement. By the end of year 2, the entity has a taxable temporary difference of \$400, ie the \$300 bought forward from year 1, plus the additional difference of \$100 arising in year 2. A liability is therefore now recorded equal to 25% x \$400 = \$100. Since there was a liability of \$75 recorded at the end of year 1, the double entry that is recorded in year 2 is to credit (increase) the liability and debit (increase) the tax expense by \$25. At the end of year 3, the entitys taxable temporary differences have decreased to \$260 (since the company has now been charged tax on the difference of \$140). Therefore in the future, the tax payable will be 25% x \$260 = \$65. The deferred tax liability now needs reducing from \$100 to \$65 and so is debited (a decrease) by \$35. Consequently, there is now a credit (a decrease) to the tax expense of \$35. At the end of year 4, there are no taxable temporary differences since now the carrying value of the asset is equal to its tax base. Therefore the opening liability of \$65 needs to be removed by a debit entry (a decrease) and hence there is a credit entry (a decrease) of \$65 to the tax expense. This can all be summarised in the following working.

TEchnical
as ias 12 consiDErs DEfErrED Tax from ThE pErspEcTiVE of TEmporary DiffErEncEs bETwEEn ThE carrying ValuE anD Tax basE of assETs anD liabiliTiEs, ThE sTanDarD can bE saiD To TakE a balancE shEET approach. howEVEr, iT will bE hElpful To consiDEr ThE EffEcT on ThE incomE sTaTEmEnT.

The movements in the liability are recorded in the Income Statement as part of the taxation charge Year Opening deferred tax liability Increase/(decrease) in the year Closing deferred tax liability 1 \$ 0 75 75 2 \$ 75 25 100 3 \$ 100 (35) 65 4 \$ 65 (65) 0

The closing figures are reported in the Statement of Financial Position as part of the deferred tax liability. proforma Example 1 provides a proforma, which may be a useful format to deal with deferred tax within a published accounts question. The movement in the deferred tax liability in the year is recorded in the Income Statement where: an increase in the liability, increases the tax expense a decrease in the liability, decreases the tax expense. The closing figures are reported in the Statement of Financial Position as the deferred tax liability.

The income statement As IAS 12 considers deferred tax from the perspective of temporary differences between the carrying value and tax base of assets and liabilities, the standard can be said to take a balance sheet approach. However, it will be helpful to consider the effect on the Income Statement. Continuing with the previous example, suppose that the profit before tax of the entity for each of years 1 to 4 is \$10,000 (after charging depreciation). Since the tax rate is 25%, it would then be logical to expect the tax expense for each year to be \$2,500. However, income tax is based on taxable profits not on the accounting profits. The taxable profits and so the actual tax liability for each year could be calculated as in Table 2. The income tax liability is then recorded as a tax expense. As we have seen in the example, accounting for deferred tax then results in a further increase or decrease in the tax expense. Therefore, the final tax expense for each year reported in the Income Statement would be as in Table 3. It can therefore be said that accounting for deferred tax is ensuring that the matching principle is applied. The tax expense reported in each period is the tax consequences (ie tax charges less tax relief) of the items reported within profit in that period.

ExamplE 1 proforma Opening deferred tax liability Increase/(decrease) in the year Tax rate % x Increase / Decrease in year-end taxable temporary differences Closing deferred tax liability Tax rate % x Year-end taxable temporary temporary differences \$ X X/(X) As given in the trial balance This is taken to the taxation charge in the Income Statement This is reported in the Statement of Financial Position

## sTuDEnT accounTanT 08/2009

DEfErrED Tax is consisTEnTly TEsTED in ThE publishED accounTs quEsTion of ThE papEr f7 Exam. iT shoulD noT bE rulED ouT howEVEr, of bEing TEsTED in grEaTEr DETail wiThin quEsTion 4 or 5 of ThE Exam.

TablE 2: TaxablE profiT anD acTual Tax liabiliTy calculaTion (ExamplE 1) Year 1 \$ 10,000 500 (800) 9,700 2,425 Year 2 \$ 10,000 500 (600) 9,900 2,475 Year 3 \$ 10,000 500 (360) 10,140 2,535 Year 4 \$ 10,000 500 (240) 10,260 2,565

Profit before tax Depreciation Capital allowances Taxable profits Tax liability @ 25% of taxable profits

TablE 3: final Tax ExpEnsE for Each rEporTED incomE sTaTEmEnT yEar (ExamplE 1) Income tax Increase/(decrease) due to deferred tax Total tax expense ThE papEr f7 Exam Deferred tax is consistently tested in the published accounts question of the Paper F7 exam. (It should not be ruled out however, of being tested in greater detail in Question 4 or 5 of the exam.) Here are some hints on how to deal with the information in the question. The deferred tax liability given within the trial balance or draft financial statements will be the opening liability balance. In the notes to the question there will be information to enable you to calculate the closing liability for the SFP or the increase/decrease in the liability. It is important that you read the information carefully. You will need to ascertain exactly what you are being told within the notes to the question and therefore how this relates to the working that you can use to calculate the figures for the answer. Consider the following sets of information all of which will achieve the same ultimate answer in the published accounts. Year 1 2,425 75 2,500 Year 2 2,475 25 2,500 Year 3 2,535 (35) 2,500 Year 4 2,565 (65) 2,500

Example 2 The trial balance shows a credit balance of \$1,500 in respect of a deferred tax liability. The notes to the question could contain one of the following sets of information: 1 At the year-end, the required deferred tax liability is \$2,500. 2 At the year-end, it was determined that an increase in the deferred tax liability of \$1,000 was required. 3 At the year-end, there are taxable temporary differences of \$10,000. Tax is charged at a rate of 25%. 4 During the year, taxable temporary differences increased by \$4,000. Tax is charged at a rate of 25%.

TEchnical
rEValuaTions of non-currEnT assETs (nca) arE a furThEr ExamplE of a TaxablE TEmporary DiffErEncE. sincE ThE rEValuaTion surplus has bEEn rEcognisED wiThin EquiTy, To comply wiTh maTching, ThE Tax chargE on ThE surplus is also chargED To EquiTy.

TablE 4: ExamplE 2 publishED accounTs quEsTion situation 1 Opening deferred tax liability Increase in the year to be taken to IS as an increase in tax expense Closing deferred tax liability to be reported in SFP situation 2 Opening deferred tax liability Increase in the year to be taken to IS as an increase in tax expense Closing deferred tax liability to be reported in SFP situation 3 Opening deferred tax liability Increase in the year to be taken to IS as an increase in tax expense Closing deferred tax liability to be reported in SFP situation 4 Opening deferred tax liability Increase in the year to be taken to IS as an increase in tax expense Closing deferred tax liability to be reported in SFP Situations 1 and 2 are both giving a figure that can be slotted straight into the deferred tax working. In situations 3 and 4 however, the temporary differences are being given. These are then used to calculate a figure which can be slotted into the working. In all situations, the missing figure is calculated as a balancing figure. Table 4 shows the completed workings. revaluations of non-current assets Revaluations of non-current assets (NCA) are a further example of a taxable temporary difference. When an NCA is revalued to its current value within the financial statements, \$ 1,500 1,000 2,500 \$ 1,500 1,000 2,500 \$ 1,500 1,000 2,500 \$ 1,500 1,000 2,500 Provided in trial balance Balancing figure Provided in information

## Provided in trial balance Provided in information Balancing figure

Provided in trial balance Balancing figure Calculated from information (25% x \$10,000) Provided in trial balance Calculated from information (25% x \$4,000) Balancing figure

the revaluation surplus is recorded in equity (in a revaluation reserve) and reported as other comprehensive income. While the carrying value of the asset has increased, the tax base of the asset remains the same and so a temporary difference arises. Tax will become payable on the surplus when the asset is sold and so the temporary difference is taxable. Since the revaluation surplus has been recognised within equity, to comply with matching, the tax charge on the surplus is also charged to equity. Suppose that in Example 1, the asset is revalued to \$2,500 at the end of year 2, as shown in Table 5.

## sTuDEnT accounTanT 08/2009

TablE 5: rEValuED assET aT ThE EnD of yEar 2 (ExamplE 1) year 2 carrying value (cost - accumulated depreciation) \$ 1,500 (500) 1,500 2,500 Tax base (cost - accumulated capital allowances) \$ 1,200 (600) 600 Temporary difference \$ 300 100 1,500 1,900

## Opening balance Depreciation charge/capital allowance Revaluation Closing Balance

The carrying value will now be \$2,500 while the tax base remains at \$600. There is, therefore, a temporary difference of \$1,900, of which \$1,500 relates to the revaluation surplus. This gives rise to a deferred tax liability of 25% x \$1,900 = \$475 at the year-end to report in the Statement of Financial Position. The liability was \$75 at the start of the year (Example 1) and thus there is an increase of \$400 to record. However, the increase in relation to the revaluation surplus of 25% x \$1,500 = \$375 will be charged to the revaluation reserve and reported within other comprehensive income. The remaining increase of \$25 will be charged to the Income Statement as before. The overall double entry is: Dr Tax expense in Income Statement \$25 Dr Revaluation reserve in equity \$375 Cr Deferred tax liability in SFP \$400 ThE papEr p2 Exam In the pilot paper for the new syllabus, the theory of and accounting for deferred tax formed the basis of a 25-mark question in Section B. More recently in June 2009, it was tested within the group accounts in Question 1. It is important to appreciate that deferred tax can arise in respect of many different types of asset or liability and not just non-current assets as discussed above. Therefore, for Paper P2 it is more important that students understand the principles behind deferred tax so that they can be applied to any

given situation. Some of the situations that may be seen are discussed below. In all of the following situations, assume that the applicable tax rate is 25%. Deferred tax assets It is important to be aware that temporary differences can result in needing to record a deferred tax asset instead of a liability. Temporary differences affect the timing of when tax is paid or when tax relief is received. While normally they result in the payment being deferred until the future or relief being received in advance (and hence a deferred tax liability) they can result in the payment being accelerated or relief being due in the future. In these latter situations the temporary differences result in a deferred tax asset arising (or where the entity has other larger temporary differences that create deferred tax liabilities, a reduced deferred tax liability). Whether an individual temporary difference gives rise to a deferred tax asset or liability can be ascertained by applying the following rule: Carrying value of asset / (Liability) Tax base of asset / (Liability) Temporary = difference

If the temporary difference is positive, a deferred tax liability will arise. If the temporary difference is negative, a deferred tax asset will arise.

iT is imporTanT To bE awarE ThaT TEmporary DiffErEncEs can rEsulT in nEEDing To rEcorD a DEfErrED Tax assET insTEaD of a liabiliTy. TEmporary DiffErEncEs affEcT ThE Timing of whEn Tax is paiD or whEn Tax rEliEf is rEcEiVED.

TEchnical
To calculaTE ThE DEfErrED Tax implicaTions on consoliDaTion aDjusTmEnTs whEn prEparing ThE group accounTs, ThE carrying ValuE rEfErs To ThE carrying ValuE wiThin ThE group accounTs whilE ThE Tax basE will bE ThE Tax basE in ThE EnTiTiEs inDiViDual accounTs.

TablE 6: impairmEnT of non-currEnT assET (ExamplE 3) carrying value of the asset \$ 2,800 Tax base of the asset \$ 3,500 Temporary difference \$ (700) Deferred tax asset or liability? Asset

TablE 7: wriTE Down of inVEnTory (ExamplE 4) carrying value of the asset \$ 9,000 Tax base of the asset \$ 10,000 Temporary difference \$ (1,000) Deferred tax asset or liability? Asset

TablE 8: accruED pEnsion conTribuTions (ExamplE 5) carrying value of the asset \$ (25,000) Tax base of the asset \$ Nil Temporary difference \$ (25,000) Deferred tax asset or liability? Asset

Example 3 Suppose that at the reporting date the carrying value of a non-current asset is \$2,800 while its tax base is \$3,500, as shown in Table 6 above. In this scenario, the carrying value of the asset has been written down to below the tax base. This might be because an impairment loss has been recorded on the asset which is not allowable for tax purposes until the asset is sold. The entity will therefore receive tax relief on the impairment loss in the future when the asset is sold. The deferred tax asset at the reporting date will be 25% x \$700 = \$175. It is worth noting here that revaluation gains, which increase the carrying value of the asset and leave the tax base unchanged, result in a deferred tax liability. Conversely, impairment losses, which decrease the carrying value of the asset and leave the tax base unchanged, result in a deferred tax asset.

Example 4 At the reporting date, inventory which cost \$10,000 has been written down to its net realisable value of \$9,000. The write down is ignored for tax purposes until the goods are sold. The write off of inventory will generate tax relief, but only in the future when the goods are sold. Hence the tax base of the inventory is not reduced by the write off. Consequently, a deferred tax asset of 25% x \$1,000 = \$250 as shown in Table 8 should be recorded at the reporting date. Example 5 At the reporting date, an entity has recorded a liability of \$25,000 in respect of pension contributions due. Tax relief is available on pension contributions only when they are paid.

## sTuDEnT accounTanT 08/2009

whEn DEaling wiTh DEfErrED Tax in group accounTs, iT is worTh rEmEmbEring ThaT a group DoEs noT lEgally ExisT anD so is noT subjEcT To Tax. Tax is lEViED on ThE inDiViDual lEgal EnTiTiEs wiThin ThE group anD ThEir inDiViDual Tax assETs anD liabiliTiEs arE cross-casT in ThE consoliDaTion procEss.

The contributions will only be recognised for tax purposes when they are paid in the future. Hence the pension expense is currently ignored within the tax computations and so the liability has a nil tax base, as shown in Table 8. The entity will receive tax relief in the future and so a deferred tax asset of 25% x \$25,000 = \$6,250 should be recorded at the reporting date. group financial statements When dealing with deferred tax in group accounts, it is important to remember that a group does not legally exist and so is not subject to tax. Instead, tax is levied on the individual legal entities within the group and their individual tax assets and liabilities are cross-cast in the consolidation process. To calculate the deferred tax implications on consolidation adjustments when preparing the group accounts, the carrying value refers to the carrying value within the group accounts while the tax base will be the tax base in the entities individual accounts. Fair value adjustments At the date of acquisition, a subsidiarys net assets are measured at fair value. The fair value adjustments may not alter the tax base of the net assets and hence a temporary difference may arise. Any deferred tax asset/liability arising as a result is included within the fair value of the subsidiarys net assets at acquisition for the purposes of calculating goodwill. Goodwill Goodwill only arises on consolidation it is not recognised as an asset within the individual financial statements. Theoretically, goodwill gives rise to a temporary difference that would result in a deferred tax liability as it is an asset with a carrying value within the group accounts but will have a nil tax base. However, IAS 12 specifically excludes a deferred tax liability being recognised in respect of goodwill.

Provisions for unrealised profits (PUPs) When goods are sold between group companies and remain in the inventory of the buying company at the year-end, an adjustment is made to remove the unrealised profit from the consolidated accounts. This adjustment also reduces the inventory to the original cost when a group company first purchased it. However, the tax base of the inventory will be based on individual financial statements and so will be at the higher transfer price. Consequently, a deferred tax asset will arise. Recognition of the asset and the consequent decrease in the tax expense will ensure that the tax already charged to the individual selling company is not reflected in the current years consolidated income statement but will be matched against the future period when the profit is recognised by the group. Example 6 P owns 100% of the equity share capital of S. P sold goods to S for \$1,000 recording a profit of \$200. All of the goods remain in the inventory of S at the year-end. Table 9 shows that a deferred tax asset of 25% x \$200 = \$50 should be recorded within the group financial statements. measurement of deferred tax IAS 12 states that deferred tax assets and liabilities should be measured based on the tax rates that are expected to apply when the asset/liability will be realised/settled. Normally, current tax rates are used to calculate deferred tax on the basis that they are a reasonable approximation of future tax rates and that it would be too unreliable to estimate future tax rates. Deferred tax assets and liabilities represent future taxes that will be recovered or that will be payable. It may therefore be expected that they should be discounted to reflect the time value of money, which would be consistent with the way in which other liabilities are measured. IAS 12, however, does not permit or allow the discounting of deferred tax assets or liabilities on practical grounds.

TEchnical
ias 12 consiDErs DEfErrED Tax by Taking a balancE shEET approach To ThE accounTing problEm by consiDEring TEmporary DiffErEncEs in TErms of ThE DiffErEncE bETwEEn ThE carrying ValuEs anD ThE Tax ValuEs of assETs anD liabiliTiEs.

TablE 9: proVision for unrEalisED profiTs (ExamplE 6) carrying value of the asset within group accounts \$ 1,000 (200) 800 Tax base of the asset in individual entity accounts \$ 1,000 Temporary difference \$ (200) Asset Deferred tax asset or liability?

Cost to S PUP

The primary reason behind this is that it would be necessary for entities to determine when the future tax would be recovered or paid. In practice this is highly complex and subjective. Therefore, to require discounting of deferred tax liabilities would result in a high degree of unreliability. Furthermore, to allow but not require discounting would result in inconsistency and so a lack of comparability between entities. Deferred tax and the framework As we have seen, IAS 12 considers deferred tax by taking a balance sheet approach to the accounting problem by considering temporary differences in terms of the difference between the carrying values and the tax values of assets and liabilities also known as the valuation approach. This can be said to be consistent with the IASB Frameworks approach to recognition within financial statements. However, the valuation approach is applied regardless of whether the resulting deferred tax will meet the definition of an asset or liability in its own right.

Thus, IAS 12 considers the overriding accounting issue behind deferred tax to be the application of matching ensuring that the tax consequences of an item reported within the financial statements are reported in the same accounting period as the item itself. For example, in the case of a revaluation surplus, since the gain has been recognised in the financial statements, the tax consequences of this gain should also be recognised that is to say, a tax charge. In order to recognise a tax charge, it is necessary to complete the double entry by also recording a corresponding deferred tax liability. However, part of the Frameworks definition of a liability is that there is a present obligation. Therefore, the deferred tax liability arising on the revaluation gain should represent the current obligation to pay tax in the future when the asset is sold. However, since there is no present obligation to sell the asset, there is no present obligation to pay the tax. Therefore, it is also acknowledged that IAS 12 is inconsistent with the Framework to the extent that a deferred tax asset or liability does not necessarily meet the definition of an asset or liability. Sally Baker and Tom Clendon are tutors at Kaplan Financial

## How to approach performance appraisal questions

by Steve Scott 01 May 2006 Performance appraisal is an important topic in Paper F7, Financial Reporting. This article is intended to give candidates some guidance as to what is expected from a good answer to performance appraisal questions and how to approach such questions. The scenario of a performance appraisal question can take many forms.

## Vertical or trend analysis

A company's performance may be compared to its previous period's performance. Past results may be adjusted for the effects of price changes. This is referred to as trend or vertical analysis. A weakness of this type of comparison is that there are no independent benchmarks to determine whether the chosen company's current year results are good or bad. Just because a company's results are better than its results in the previous financial period - it does not mean the results are good. It may be that its results in the prior year were particularly poor.

Horizontal analysis
To try to overcome the problem of vertical analysis, it is common to compare a company's performance for a particular period with the performance of an equivalent company for the same period. This introduces an independent yardstick to the comparison. However, it is important to pick a similar sized company that operates in the same industry. Again, this type of analysis is not without criticism - it may be that the company selected as a comparator may have performed particularly well or particularly poorly.

## Industry average comparison

This type of analysis compares a company's results (ratios) to a compilation of the average of many other similar types of company. Such schemes are often operated on a subscription basis whereby subscribing companies calculate specified ratios and submit them to the scheme. In return they receive the average of the same ratios from all equivalent companies in the scheme. This has the advantage of anonymity and avoids the bias of selecting a single company. The context of the analysis needs to be kept in mind. You may be asked to compare two companies as a basis for selecting one (presumably the better performing one) for an acquisition. Alternatively, a shareholder may be asking for advice on how their investment in a company has performed. A bank may be considering offering a loan to a company and requires advice. It may be that your chief executive asks for your opinion (as say the chief financial accountant) on your company's results.

Question scenarios
Most questions on this topic will have information in the scenario that requires particular consideration. A common complaint from markers is that candidates often make no reference to such circumstances. In effect, the same answer would be given regardless of what the question said. It is worth noting that there are many 'clues' in the question - ignore them at your peril. Examples of such circumstance include: Related party relationships and transactions: these have the potential to distort the results of a company (either favourably or unfavourably). Examples of related party transactions are:

goods have been supplied to a company on favourable terms (in terms of price and credit arrangements) a subsidiary may enjoy the benefits of head office expertise (eg research knowledge) without any charge being made by the head office loans may be advanced at non-commercial interest rates.

A company may have entered into certain arrangements that mean its previous results are not directly comparable with its current results. Examples of this include:

a sale and leaseback of property, plant or equipment. Such an arrangement would lower the operating assets and thus improve asset utilisation entering into debt factoring (the sale of receivablesto a finance house). This would obviously reduce collection periods, but this would not be through improved credit control procedures a general revaluation of non-current assets would lead to higher capital employed (and thus a lower return on capital employed) without there being any real change in operating capacity or profitability a company may have implemented certain policy changes during the year (eg lowering profit margins in order to stimulate sales).

The possibilities of what might have happened are almost infinite, but what is important is that where the scenario describes events such as those described above, you take them into consideration when preparing your answer. Most performance appraisal is based on interpreting various comparative ratios. Some questions will leave it for you to decide which ratios to calculate, other questions may specify which ratios have to be calculated. However, some questions may give you ratios such that the majority of marks are for the analysis and interpretation of them. Another common complaint of markers is that when candidates are left to decide which ratios to calculate, they calculate far too many, thus spending very little time on their interpretation. Even in questions where there are marks available for calculating ratios, the majority of marks will still be for their interpretation.

Lack of interpretation/analysis

By far the most common complaint by markers is that candidates' comments explaining the movement or differences in reported ratios lack any depth or commercial understanding. A typical comment may be that receivables collection has improved from 60 days to 40 days. Such a comment does not constitute interpretation - it is a statement of fact. To say a ratio has gone up or down is not helpful or meaningful. What is required from a good answer are the possible reasons as to why the ratio has changed. There may be many reasons why a ratio has changed and no-one can be certain as to exactly what has caused the change. All that is required are plausible explanations for the changes. Even if they are not the actual cause, marks will be awarded. There is no single correct answer to an interpretation question, and remember there may be clues in the scenario that would account for some of the changes in the ratios.

Exam approach
In an exam there is a (time) limit to the amount of ratios that may be calculated. A structured approach is useful where the question does not specify which ratios to calculate:

limit calculations to important areas and avoid duplication (eg inventory turnover and inventory holding periods) it is important to come to conclusions, as previously noted, candidates often get carried away with the ratio calculations and fail to comment on them often there are some 'obvious' conclusions that must be made (eg liquidity has deteriorated dramatically, or a large amount of additional non-current assets have been purchased without a proportionate increase in sales).

## Suggested structure to a typical answer

Comment on company performance in the following areas:

profitability and asset utilisation liquidity (look for overtrading) gearing and security of borrowings prepare a cash flow statement - if specifically requested.

Profitability
The primary measure of profitability is normally considered to be the Return on Capital Employed (ROCE): (Profit before interest and tax/shareholders funds plus long-term borrowings) x 100 This is probably the most important single ratio, but it is open to manipulation. Secondary ratios indicate why the ROCE has changed:

1. Gross and net profit margin %: Profit (gross or net)/sales x 100 2. Asset utilisation: sales/net assets For example, an improvement in the ROCE is either because of improved margins or better use of assets. Increases may be due to increases in selling prices or reductions in manufacturing (or purchased) costs. They may also be caused by changes in sales mix or inventory counting errors. A change in the net profit margin is a measure of how well a company has controlled overheads. The asset utilisation ratio (sales/net assets) shows how efficiently the assets are being used.

Liquidity
Current ratio: current assets/current liabilities. Ideally it is thought that this should be between 1.5 and 2 to 1, but it can vary depending upon the market sector (eg retailers have relatively few receivables so the current, and quick, ratios may be meaningless for such businesses). Quick ratio (or acid test): current assets less inventory/current liabilities. This is expected to be at parity, ie 1 to 1. If the above liquidity ratios appear to be outside 'normal ranges' further investigation is required and inventory, receivables, and payables ratios should be looked at. These ratios can be calculated either as time periods (eg 'days') or as turnovers. Receivables collection period (in days): (trade receivables/credit sales) x 365 Inventory turnover: cost of sales/(average or closing) inventory Payables payment period (in weeks): (trade payables/purchases on credit*) x 52 *Note: you may have to use cost of sales if purchases figure is not available.

## Comments on the above ratios

Receivables collection period - when too high, it may be that some bad debts have not been provided for, or an indication of worsening credit control. It may also be deliberate, eg the company has decided to offer three-months' credit in the current year, instead of two as in previous years. It may do this to try to stimulate higher sales. Inventory turnover - generally the higher this is, the better. If it is low, it may be an indication of obsolete stock or poor sales achievement. Sales may have fallen (perhaps due to an economic recession), but the company has been slow to cut back on production, resulting in a build up of inventory levels. Payables payment period - if this is low, credit suppliers are being paid relatively early or there may be unrecorded payables. Although the credit period may represent a source of 'free' borrowing, if it is too high it may be an indication of poor liquidity (perhaps at the overdraft limit), and there may be a danger of further or renewed credit being refused by suppliers.

Liquidity problems may also be caused by 'overtrading'. In some ways this is a symptom of the success of the business. It is usually a lack of adequate financing and may be solved by an injection of capital.

Gearing
This is a far more important ratio than most candidates seem to be aware of. Company directors often spend a great deal of time and money to make this ratio appear in line with acceptable levels. Its main importance is that as borrowings rise, risk increases (in many ways) and as such, further borrowing is difficult and expensive. Many companies have limits to the amount of borrowings they are permitted to have. These may be in the form of debt covenants imposed by lenders or they may be contained in a company's Articles, such as a multiple of shareholders funds.

Measures of gearing
Gearing is basically a comparison of debt to equity. Preference shares are usually treated as debt for this purpose. There are two alternatives: Debt/equity or Debt/debt + equity. In any comparison of gearing it is important to use the same basis to calculate the gearing percentage in order for any interpretation to be meaningful. A question often asked is what level should a company's gearing be? There is no easy answer to this - a lot will depend on the nature of the industry and composition of the balance sheet assets. For example, companies with large property portfolios often have high levels of gearing without it troubling investors. But companies that have large amounts of intangible assets are not considered to have a desirable type of security to support large borrowings. It is important that the effect of debt is understood. Example 1 Realm is financed by \$5m 10% preference shares, and \$5m equity. Calculate the return to each provider of finance if Realm's profits are: i. ii. iii. \$1m \$1.3m \$700,000

Answer \$000 i 1,000 500 500 10% \$000 ii 1,300 (+30%) 500 800 16% \$000 iii 700 (-30%) 500 200 4%

## Profit Preference shareholders Equity shareholders % return on equity

(+60%)

(-60%)

Note that when profits increase by 30%, the increase in the return to equity shareholders is double this increase (a 16% return is 60% higher than a 10% return). However, the down side is that when profits fall by 30%, the reverse applies. The existence of debt increases the risks (favourable and unfavourable) to the equity shareholders. By contrast, the return to preference shareholders is 10% at all levels profit.

## Investment Ratios Earnings per share

In isolation, this ratio is meaningless for inter-company comparisons. Its major usefulness is as part of the P/E ratio, and as a measure of profit trends.

Price/earnings ratio
This is calculated by dividing a company's market price by its EPS. Say the price of a company's shares is \$2.40, and its last reported EPS was 20c. It would have a P/E ratio of 12. The mechanics of the movement of a company's P/E ratio are complex, but if this company's EPS improved to 24c in the following year, it would not mean that its P/E ratio would be calculated as 10 (\$2.40/24c). It is more likely that its share price would increase such that it maintained or even improved its P/E ratio. If the share price increased to say \$2.88, the P/E ratio would remain at 12 (\$2.88/24c). This demonstrates the real importance of EPS in the way it has a major influence on a company's share price.

Earning yield
This is a relatively 'old' ratio which has been superseded by the P/E ratio. It is in fact its reciprocal. Earnings yield is the EPS/share price x 100. In the above example, a P/E ratio of 12 would be equivalent to an earnings yield of 8.3%.

Dividend yield
This is similar to the above except that the dividend per share is substituted for the EPS. It is a crude measure of the return to shareholders, but it does ignore capital growth which is often much higher than the return for dividends.

Dividend cover
This is the number of times the current year's dividend could have paid out of the current year's profit available to ordinary shareholders. It is a measure of security. A high figure indicates high levels of security. In other words, profits in future years could fall substantially and the company would still be able to pay the current level of dividends. An alternative view of a high dividend cover is that it indicates that the company operates a low dividend distribution policy.

Example 2 Realm has 5 million ordinary shares of 25c each in issue. The stock market price of the shares just before its year end is \$3.00 each. The dividend yield for companies in the same sector as Realm is 5%. Realm has paid an interim dividend of \$200,000, and its profit after tax is \$1,250,000. Required, calculate: i. ii. iii. the final dividend (in pence per share) to be declared such that Realm's dividend yield would equal its market sector Realm's P/E ratio Realm's dividend cover.

Answer i. A dividend yield of 5% of a share price of \$3.00 would be achieved if total dividends for the period were 15c ((15/300) x 100 = 5%). An interim dividend of \$200,000 on 5 million shares would be 4c per share. Thus the final dividend would need to be 11c per share. Profits of \$1,250,000 on 5 million shares gives an EPS of 25c (\$1,250,000/5 million). The P/E ratio would be calculated as 12 (300c/25c) Dividends of 15c per share from earnings of 25c per share would give a dividend cover of 1.67 times (25c/15c).

ii. iii.

In conclusion, candidates may be required to explain the weaknesses or limitations of ratio analysis. As a summary, it may be useful to read and work through a question. The first section of the answer deals with the limitations of ratios. 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 of the companies in the same sector that subscribe to the service. The specified ratios and the average figures for Comparator's sector are shown overleaf. Ratios of companies reporting a full year's results for periods ended between 1 July 20X3 and 30 September 20X3 Return on capital employed 22.1% Net assets 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 holding period 46 days

Receivables collection period Payables payment period Debt to equity Dividend yield Dividend cover

## 45 days 55 days 40% 6% 3 times

Comparator's financial statements for the year to 30 September 20X3 are set out below: Income statement Turnover Cost of sales Gross profit Other operating expenses Operating profit Interest payable Exceptional item (note (ii)) Profit before taxation Taxation Profit after taxation \$000 2,425 (1,870) 555 (215) 340 (34) (120) 186 (90)

Balance sheet Non-current assets (note i) Current assets Inventory Receivables Bank Total assets Equity and liabilities Ordinary shares (25c each) Retained earnings Current liabilities Bank overdraft Trade payables

\$000

000 540

## 85 500 300 1,135

Notes i. The details of the non-current assets are: Cost \$000 3,600 Accumulated depreciation \$000 3,060 Net book value \$000 540

## At 30 Sept 20X3 ii. iii. iv.

The exceptional item relates to losses on the sale of a batch of computers that had become worthless due to improvements in microchip design. The market price of Comparators shares throughout the year averaged \$6.00 each. Dividends of \$90,000 were paid during the year.

Required: a. Explain the problems that are inherent when ratios are used to assess a company's financial performance. Your answer should consider any additional problems that may be encountered when using inter-firm comparison services such as that used by Comparator (7 marks). b. Calculate ratios for Comparator equivalent to those provided by the inter-firm comparison service (6 marks). c. Write a report analysing the financial performance of Comparator based on a comparison with the sector averages (12 marks). 25 marks Answer a. Ratios are used to assess the financial performance of a company by comparing the calculated figures to various other sources. This may be to previous years' ratios of the same company, it may be to the ratios of a similar rival company, to accepted norms (say of liquidity ratios) or, as in this example, to industry averages. The problems inherent in these processes are several. Probably the most important aspect of using ratios is to realise that they do not give the answers to the assessment of how well a company has performed, they merely raise the questions and direct the analyst into trying to determine what has caused favourable or unfavourable indicators. In many ways it can be said that ratios are only as useful as the skills of the person using them. It

is also true that any assessment should also consider other information that may be available including non-financial information. More specific problem areas are:

Accounting policies: if two companies have different accounting policies, it can invalidate any comparison between their ratios. For example, return on capital employed is materially affected by revaluations of non-current assets. Comparing this ratio for two companies where one has revalued its non-current assets and the other carries noncurrent assets at depreciated historic cost would not be very meaningful. Similar examples may involve depreciation methods, inventory valuation policies etc. Accounting practices: this is similar to differing accounting policies in its effects. An example of this would be the use of debt factoring. If one company collects its debts in the normal way, then the calculation of receivable days would be a reasonable indication of the efficiency of its credit control department. However if a company chose to factor its debts (ie 'sell' them to a finance company) then the calculation of its receivable days would be meaningless. A more controversial example would be the engineering of a lease such that it fell to be treated as an operating lease rather than a finance lease. Balance sheet averages: many ratios are based on comparing income statement items with balance sheet items. The above ratio of receivable days would be a good example. For such ratios to be meaningful, it is necessary to assume that the year-end balance sheet figures are representative of annual norms. Seasonal trading and other factors may invalidate this assumption. For example, the level of receivables and inventory of a toy manufacturer could vary largely due to the nature of its seasonal trading. Inflation can distort comparisons over time. The definition of an accounting ratio. If a ratio is calculated by two companies using different definitions, then there is an obvious problem. Common examples of this are gearing ratios (some use debt/equity, others may use debt/debt + equity). Also, where a ratio is partly based on a profit figure, there can be differences as to what is included and what is excluded from the profit figure. Problems of this type include the treatment of exceptional items and finance costs. The use of norms can be misleading. A desirable range for the current ratio may be between 1.5 and 2:1, but all businesses are different. This would be a very high ratio for a supermarket (with few receivables), but a low figure for a construction company (with high levels of work in progress). Looking at a single ratio in isolation is rarely useful. It is necessary to form a view when considering ratios in combination with other ratios.

A more controversial aspect of using ratio analysis is that management have sometimes indulged in creative accounting techniques in order that the ratios calculated from published financial statements will show a more favourable picture than the true underlying position. Examples of this are sale and repurchase agreements, which manipulate liquidity figures, and off balance sheet finance which distorts return on capital employed and flatters gearing. Inter-firm comparisons Of particular concern with this method of using ratios is:

They are themselves averages and may incorporate large variations in their composition.

Some inter-firm comparison agencies produce the ratios analysed into quartiles to attempt to overcome this. It may be that the sector in which a company is included may not be sufficiently similar to the exact type of trade of the specific company. The type of products or markets may be different. Companies of different sizes operate under different economies of scale, this may not be reflected in the industry average figures. The year-end accounting dates of the companies included in the averages are not going to be all the same. This highlights issues of balance sheet averages and seasonal trading referred to above. Some companies try to minimise this by grouping companies with approximately similar year-ends together as in the example of this question, but this is not a complete solution.

b. Refer to Figure 1. c. Analysis of Comparator's financial performance compared to the sector average for the period to 30 September 20X3: To: From: A N Allison Date: Figure 1: Calculation of specified ratios Comparator Return on capital employed ((186 + 34 loan interest/635) Net assets turnover (2,425/635) Gross profit margin (555/2,425 x 100) Net profit (excluding exceptionals) margin (306/2,425 x 100) Net profit (before tax) margin (186/2,425 x 100) Current ratio (595/500) Quick ratio (320/500) Inventory holding period (275/1,870 x 365) Receivables collection period (320/2,425 x 365) Payables payment period (350/1,870 x 365)(based on cost of sales) Debt to equity (300/335 x 100) Dividend yield (see below) Dividend cover (96/90) 34.6% 3.8 times 22.9% 12.6% 7.7% 1.19:1 0.64:1 54 days 48 days 68 days 90% 2.5% 1.07 times Sector average 22.1% 1.8 times 30% not available 12.5% 1.6:1 0.9:1 46 days 45 days 55 days 40% 6% 3 times

The workings are in \$000 (unless otherwise stated) and are for Comparator's ratios. The dividend yield is based on a dividend per share figure of 15p (\$90,000/(150,000 x 4)) and a share price of \$6.00. Thus the yield is 2.5% (15c/\$6.00 x 100%).

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 margins. In these areas, Comparator's asset turnover is much higher (nearly double) than the average, but the net profit margin after exceptionals is considerably below the sector average. However, if the 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 (ie 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 balance sheet that Comparator's non-current assets appear quite old. Their net book value is only 15% of their original cost. This has at least two implications: they will need replacing in the near future and the company is already struggling for funding; and their low net book value gives 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 anomaly some companies calculate the asset turnover using the cost of non-current assets rather than their net book value as this gives a more reliable trend. It is also possible that Comparator is using assets that are not on its balance sheet. It may be leasing assets that do not meet the definition of finance leases and thus the assets and corresponding obligations have not been recognised on the balance sheet. A further issue is which of the two calculated margins should be compared to the sector average (ie 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, 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 to be due to high levels of trade payables and a high bank overdraft. The high levels of inventory are also noteworthy and they may be indicative of further obsolete inventory (the exceptional item is due to obsolete inventory). The receivables collection figure is reasonable, but at 68 days, Comparator takes longer to pay its payables than do its competitors. While this is a source of 'free' finance, it can damage relations with suppliers and may lead to a curtailment of further credit. Gearing

As referred to above, gearing (as measured by debt/equity) is more than twice the level of the sector average. While 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 level of gearing may become a serious issue if Comparator becomes unable to maintain the finance costs. The company already has an overdraft and the 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. 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 surprising the company's share price is holding up so well. Summary The company compares favourably with the sector average figures for profitability. However, Comparator's liquidity and gearing position is quite poor and gives cause for concern. If it is to replace its old fixed assets in the near future, it will need to raise further finance. With already high levels of borrowing and poor dividend yields, this may become a serious problem for Comparator. Yours faithfully A N Allison Steve Scott is examiner for Paper F7

## Dealing with debtors

information becomes available that identifies losses on a receivable in the group then it is removed and individually assessed. The collective assessment of impairment requires the splitting of the list of receivables into groups of trade receivables that share similar credit risk characteristics. The credit risk groups are to be assessed for impairment using historical loss experience for each group. Such historical loss experience would be adjusted to reflect the effects of current conditions. An individual receivable/debtor impairment factor is likely to be specific to that receivable/debtor pending liquidation of the entity, for example. A collective impairment factor is likely to be as a result of past economic events that affect the receivables in general (eg interest rates). Impairment losses will be recognised only when they are incurred. Thus, if there is deterioration in the credit quality of the financial assets as a result of a past event, then an impairment loss may have occurred. The recognition of future losses based on possible or expected future trends is not in accordance with the IASB Framework and IAS 37/FRS 12, Provisions, Contingent Liabilities and Contingent Assets. General provisions would therefore not be allowed as the historical experience is zero and it is unlikely to produce an acceptable estimate of the cash flows to be received. Conclusion Trade receivables/debtors fall into the category of loans and receivables under IAS 39/FRS 26. They will be valued at fair value initially - which will be the invoiced amount. Because they are short-term receivables they will not normally be subject to discounting, nor will they normally have an effective interest rate. They will have to be assessed for impairment at each balance sheet date, and will be impaired if the present value of the cash flows is less than the carrying amount. The assessment can be on an individual or group basis. The old methods of calculating bad debt provisions are unlikely to produce a correct figure for the present value of the future cash flows and general provisions will not comply with the methodology set out in the IAS/FRS. IAS 39/FRS 26 states that the carrying amount of the asset should be reduced either directly or through the use of an allowance account (para 63). The amount of the loss should go to profit or loss. An allowance for impairment losses is possible, but it must be determined in a more logical and systematic way than has often been the case in the past. Applicability to CAT Papers 1, 3 and 6, and ACCA Qualification Paper F3 The main differences that will affect these exams are those in terms of terminology. The terms 'bad debts' and 'irrecoverable debts' will still be used and will relate to specific debts which are not considered to be collectible and so are written off to the income statement/profit and loss account. Effectively, they are 100% impaired. General allowances/provisions are in effect no longer allowed. However, allowances are still allowed if they are based on past experience, and on the amount of cash which will be collected. The effect on the CAT papers and ACCA Qualification Paper F3 is limited. Questions and

IAS 10 and FRS 21, events after the balance sheet date
by Neil Stein 15 Mar 2007 Events after the balance sheet date and before financial statements are issued can have important effects on the financial statements. For example, the bankruptcy of a major customer would normally be evidence that the trade receivable should be written off or an allowance made as at the balance sheet date. There is another type of event after the balance sheet date - one that does not affect the position at the balance sheet date, but which still needs disclosure in some way to prevent users being misled. An example of such an event might be a material fall in the market value of investments.

General provisions
Events after the balance sheet date are divided into two types, corresponding to the two examples just given. The definition in IAS 10 is: Events after the balance sheet date are those events, both favourable and unfavourable, that occur between the balance sheet date and the date when the financial statements are authorised for issue. Two types of events can be identified: (a) those that provide evidence of conditions that existed at the balance sheet date (adjusting events after the balance sheet date); and (b) those that are indicative of conditions that arose after the balance sheet date (nonadjusting events after the balance sheet date). Material adjusting events require changes to the financial statements. Examples of such events given in IAS 10 and FRS 21 are: (a) the resolution of a court case, as the result of which a provision has to be recognised instead of the disclosure by note of a contingent liability; (b) evidence of impairment of assets: (i) bankruptcy of a major customer;

(ii) sale of inventories at prices suggesting the need to reduce the balance sheet figure to the net value actually realised. Nonadjusting events do not, by definition, require an adjustment to the financial statements, but if they are of such importance that non-disclosure would affect the ability of users of the financial statements to make proper evaluations and decisions, the enterprise should disclose by note: - the nature of the event; - an estimate of its financial effect, or a statement that such an estimate cannot be made. Examples of such events given in IAS 10 and FRS 21 are: (a) decline in market value of investments; (b) announcement of a plan to discontinue part of the enterprise; (c) major purchases and sales of assets; (d) expropriation of assets by government; (e) destruction of a major asset by fire etc; (f) a major business combination after the balance sheet date; (g) sale of a major subsidiary; (h) major dealings in the company's ordinary shares; (i) abnormally large changes in asset prices or foreign exchange rates; (j) changes in tax rates with a significant effect on current and deferred tax assets; (k) entering into significant commitments or contingent liabilities; (l) commencing major litigation arising solely out of events after the balance sheet date.

## Further provisions of IAS 10 and FRS 21

(a) Authorisation for issue of financial statements An enterprise should disclose the date when the financial statements were authorised for issue and who gave that authorisation. If the owners or others have the power to amend the financial

statements after issue, that fact should be disclosed. (b) Going concern If the management decides after the balance sheet date that it is necessary to liquidate the enterprise, the financial statements should not be prepared on a going concern basis. (c) Dividends Proposed dividends may no longer be recognised as liabilities if, as will normally be the case, they are proposed or declared after the balance sheet date. The disclosure of proposed dividends may be given in one of two ways: (a) by note (b) on the face of the balance sheet as a separate component of equity.

01 technical

performance
releVant to acca QUalification paper f7 and p3
performance appraiSal iS an important aSpect of paper f7, financial reporting. at thiS leVel yoU are not only reQUired to prepare financial StatementS bUt UnderStand the information Underpinning the reSUltS.

## StUdent accoUntant issue 05/2010

Studying Paper F7 or P3? performance objectives 7, 8, 9, 10 and 11 are linked

02

appraisal

ratioS can be broKen down into profitability, liQUidity, gearing and inVeStmentS. paper p7 StUdentS will need to Know not only the formUlae for the releVant ratioS bUt alSo what moVementS in theSe ratioS coUld mean.

03

technical

profit margins Gross or Operating profit Revenue The gross profit margin looks at the performance of the business at the direct trading level. Typically variations in this ratio are as a result of changes in the selling price/sales volume or changes in cost of sales. For example, cost of sales may include inventory write downs that may have occurred during the period due to damage or obsolescence, exchange rate fluctuations or import duties. The operating profit margin (or net profit margin) is generally calculated by comparing the profit before interest and tax of a business to revenue, but, beware in the exam as sometimes the examiner specifically requests the calculation to include profit before tax. Analysing the operating profit margin enables you to determine how well the business has managed to control its indirect costs during the period. In the exam when interpreting operating profit margin it is advisable to link the result back to the gross profit margin. For example, if gross profit margin deteriorated in the year then it would be expected that operating margin would also fall. However, if this is not the case, or the fall is not so severe, it may be due to good indirect cost control or perhaps there could be a one-off profit on disposal distorting the operating profit figure.

when aSSeSSing both the cUrrent and the QUicK ratioS, looK at the information proVided within the QUeStion to conSider whether or not the company iS oVerdrawn at the year-end. the oVerdraft iS an additional factor indicating potential liQUidity problemS.
liQUidity current ratio Current assets Current liabilities The current ratio considers how well a business can cover the current liabilities with its current assets. It is a common belief that the ideal for this ratio is between 1.5 and 2 to 1 so that a business may comfortably cover its current liabilities should they fall due. However this ideal will vary from industry to industry. For example, a business in the service industry would have little or no inventory and therefore could have a current ratio of less than 1. This does not necessarily mean that it has liquidity problems so it is better to compare the result to previous years or industry averages. Quick ratio (sometimes referred to as acid test ratio) Current assets inventory Current liabilities The quick ratio excludes inventory as it takes longer to turn into cash and therefore places emphasis on the businesss quick assets and whether or not these are sufficient to cover the current liabilities. Here the ideal ratio is thought to be 1:1 but as with the current ratio, this will vary depending on the industry in which the business operates. When assessing both the current and the quick ratios, look at the information provided within the question to consider whether or not the company is overdrawn at the year-end. The overdraft is an additional factor indicating potential liquidity problems and this form of finance is both expensive (higher rates of interest) and risky (repayable on demand). receivables collection period (in days) Receivables Credit sales x 365

It is preferable to have a short credit period for receivables as this will aid a businesss cash flow. However, some businesses base their strategy on long credit periods. For example, a business that sells sofas might offer a long credit period to achieve higher sales and be more competitive than similar entities offering shorter credit periods.

## StUdent accoUntant issue 05/2010

04

If the receivables days are shorter compared to the prior period it could indicate better credit control or potential settlement discounts being offered to collect cash more quickly whereas an increase in credit periods could indicate a deterioration in credit control or potential bad debts. payables collection period (in days) Payables x 365 Credit purchases* *(or cost of sales if not available) An increase in payables days could indicate that a business is having cash flow difficulties and is therefore delaying payments using suppliers as a free source of finance. It is important that a business pays within the agreed credit period to avoid conflict with suppliers. If the payables days are reducing this indicates suppliers are being paid more quickly. This could be due to credit terms being tightened or taking advantage of early settlement discounts being offered.

inventory days Closing (or average) inventory x 365 Cost of sales Generally the lower the number of days that inventory is held the better as holding inventory for long periods of time constrains cash flow and increases the risk associated with holding the inventory. The longer inventory is held the greater the risk that it could be subject to theft, damage or obsolescence. However, a business should always ensure that there is sufficient inventory to meet the demand of its customers. gearing Debt or Debt Equity Debt + equity The gearing ratio is of particular importance to a business as it indicates how risky a business is perceived to be based on its level of borrowing. As borrowing increases so does the risk as the business is now liable to not only repay the debt but meet any interest commitments under it. In addition, to raise further debt finance could potentially be more difficult and more expensive.

If a company has a high level of gearing it does not necessarily mean that it will face difficulties as a result of this. For example, if the business has a high level of security in the form of tangible non-current assets and can comfortably cover its interest payments (interest cover = profit before interest and tax compared to interest) a high level of gearing should not give an investor cause for concern. conclUSion In the exam make sure all calculations required are attempted so that you can offer possible reasons for any change in the discussion part of the question. There is no absolute correct answer to a performance appraisal question. What sets a good answer apart from a poor one is the discussion of possible reasons for why (specifically in the given scenario) changes in the ratios may have occurred. Bobbie Retallack is Kaplan Publishings content specialist for Paper F7

in the exam maKe SUre all calcUlationS reQUired are attempted, So that yoU can offer poSSible reaSonS for any change in the diScUSSion part of the QUeStion. there iS no abSolUte correct anSwer to a performance appraiSal QUeStion. what SetS a good anSwer apart from a poor one iS the diScUSSion of poSSible reaSonS for why changeS in the ratioS may haVe occUrred.