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ACCA F7

Financial Reporting
For exams in December 2014 and June 2015

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Key to icons
Syllabus

Case study

Technical content

Real world example

Question to consider

Diagram

Answer

Key model

Past exam question

Tackling the exam

Answer to past exam


question

Summary

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Exam Format from December 2014


Section
A

Marks
40

Question Type
20 MCQs worth two marks each
2 15-mark questions
1 30-mark question

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60

The 30-mark question will be a financial


statement(s) preparation question either a
single company or a group (consolidated).

Syllabus 1
The F7 syllabus sections are as follows.
A

The conceptual and regulatory framework for financial reporting

1.

The need for a conceptual framework and the characteristics of


useful information

2.

Recognition and measurement

3.

Specialised, not-for-profit and public sector entities

4.

Regulatory framework

5.

The concepts and principles of groups and consolidated financial


statements

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Syllabus 2
B

Accounting for transactions in financial statements

1.

Tangible non-current assets

2.

Intangible assets

3.

Impairment of assets

4.

Inventory and biological assets

5.

Financial instruments

6.

Leasing

7.

Provisions and events after the reporting period

8.

Taxation

9.

Reporting financial performance

10.

Revenue

11.
Government grants
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Syllabus 3
C

Analysing and interpreting financial statements

1.

Limitations of financial statements

2.

Calculation and interpretation of accounting ratios and trends to


address users and stakeholders needs

3.

Limitations of interpretation techniques

4.

Specialised, not-for-profit and public sector entities

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Syllabus 4
D

Preparation of financial statements

1.

Preparation of single entity financial statements

2.

Preparation of consolidated financial statements including an


associate

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Tackling the exam


The F7 exam comprises 20 MCQs, two 15-mark questions and
one 30-mark question.
All questions are compulsory, so there is no need to spend
time working out which questions to answer.
During the 15 minutes reading time, go through the written
questions, especially the 30-mark question, and highlight the
important points. Pay particular attention to dates especially
acquisition and disposal dates and work out shareholdings if
they have not been given to you.
You are allowed to write on the question paper, so write down
anything that occurs to you which you might otherwise forget.

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Tackling the exam


It is probably a good idea to begin with the MCQs. If there are
any to which you absolutely dont know the answer guess.
You have a 25% chance of being right and you are not
penalised for incorrect answers.
For accounts preparation questions start by writing down the
format you need to be able to write these from memory.
Make sure you remember to include lines relating to associates
or discontinued operations, if these apply.
Your workings must be legible and cross-referenced. If you
have arrived at the wrong figure but used the correct method,
the marker can give you credit for using the correct method if
they can understand your working.

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Tackling the exam


If the amount you end up with is wrong and your workings are
illegible or indecipherable or non-existent you wont get any
marks.
As you do each working, transfer the amounts to the format.
Students sometimes forget to do this, which is a waste of all
that work.
If you are preparing a statement of profit or loss or statement of
profit or loss and other comprehensive income, you need to
arrive at final profit for the year, because you may need to
allocate some of it to the non-controlling interest, for which
there are marks available.
If you are doing a statement of cash flows, you need to total it
down to get to the reconciliation of cash and cash equivalents
b/f and c/f, for which there are marks available.
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Tackling the exam


However, in a statement of financial position there are no
marks available for adding up the two sections. You can spend
time in the exam doing this just to see if it balances (it wont)
and then spend more time worrying about where the difference
comes from and scrabbling back through your workings looking
for it. This is not a good idea. Leave it and move on. Come
back to it if you have time at the end.
There is likely to be a question on analysis of financial
statements. These are often badly answered. It is important to
read the information carefully, preferably twice, and be really
clear about what the question is asking. You are not being
tested on your ability to work out lots of ratios and if you
produce any that are not relevant you will get no marks for
them.
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Tackling the exam


Having produced a few, relevant ratios, you then have to say
something intelligent about them. The examiner does not want
to be told that they have gone up or gone down. He can see
that. He also does not want information that he has provided in
the question fed back to him as your answer.
What you need to do is look for how the information in the
question perhaps an acquisition or disposal or a
restructuring, or even a major investment in non-current assets
will have impacted the financial situation and how that is
reflected in the ratios. So spend some time thinking about this.
One page of proper, reasoned argument will earn you more
marks than six pages of everything you know about ratios.

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December 2014 Specimen exam


http://
www.accaglobal.com/uk/en/student/acca-qual-student-jour
ney/qual-resource/acca-qualification/f7/specimen-exams.
html

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Chapter 1

Conceptual framework and GAAP

The conceptual
framework

The objective of general purpose


financial reporting

The IASB's Conceptual Framework

Underlying assumption
Qualitative characteristics of financial
statements
The elements of financial statements
Recognition and measurement of the
elements of financial statements
Fair presentation and compliance with
IFRS

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Syllabus learning outcomes 1


Describe what is meant by a conceptual framework of
accounting
Discuss whether a conceptual framework is necessary and
what an alternative system might be
Discuss what is meant by relevance and faithful
representation and describe the qualities that enhance
these characteristics
Discuss whether faithful representation constitutes more
than compliance with accounting standards

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Syllabus learning outcomes 2


Discuss what is meant by understandability and verifiability
in relation to the provision of financial information
Discuss the importance of comparability and timeliness to
users of financial statements
Discuss the principle of comparability in accounting for
changes in accounting policies

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Syllabus learning outcomes 3


Define what is meant by 'recognition' in financial
statements and discuss the recognition criteria
Apply the recognition criteria to assets and liabilities and
income and expenses
Explain the measurement bases of historical cost, fair
value/current cost, net realisable value and the present
value of future cash flows and compute amounts using
these bases

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Chapter summary diagram


Need for a
conceptual
framework

Advantages and
disadvantages

Generally accepted
accounting practice
(GAAP)

Conceptual framework and


GAAP

The conceptual framework

The IASB's conceptual


framework
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True and fair view

Conceptual Framework and GAAP 1


What is a conceptual framework?
A statement of generally accepted theoretical principles
which form a frame of reference for financial reporting.
These provide a basis for developing new accounting
standards and a platform to evaluate those already in
existence.

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Conceptual Framework and GAAP 2


Advantages of a conceptual framework
Having a consistent conceptual base should avoid
contradictions and inconsistencies in basic concepts
and so produce standardised consistent accounting
practices.
The development of standards is less subject to
political pressure.
A consistent statement of financial position driven or
profit or loss driven approach is used.

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Conceptual Framework and GAAP 3


Disadvantages of a conceptual framework
Financial statements have many users all with differing
needs:
A single framework cannot satisfy the needs of all
users.
There may be a need for a variety of accounting
standards, each produced for a different purpose
with different conceptual bases.
Having a conceptual framework may not make it any
easier to prepare accounting standards.

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Conceptual Framework and GAAP 4


Generally accepted accounting practice (GAAP)

Comprises the rules, from all sources, which govern accounting

The major components include:


National accounting standards, for example the Financial
Accounting Standards Board (FASB) in the USA
National company law, for example the Companies Act in the
UK
Local stock exchange requirements
Regional bodies, such as the European Union. For example, an
Accounting Directive issued by the EU now requires companies
listed on an EU stock exchange to prepare their consolidated
financial statements using IFRSs.

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The IASB's Conceptual Framework 1


Published in September 2010 to update the IASB
Framework for the Preparation and Presentation of
Financial Statements which was issued in 1989
Joint project by the IASB and FASB to be completed in
two phases

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The IASB's Conceptual Framework 2


Currently comprises four chapters:
Chapters 13 are from the new Conceptual
Framework for Financial Reporting.
Chapter 4 consists of the parts of the former 1989
Framework which will be updated in Phase 2 of the
project.

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The IASB's Conceptual Framework 3


Chapter 1
The objective of general purpose financial reporting
Chapter 2
The reporting entity (still to be issued)
Chapter 3
Qualitative characteristics of useful financial
information

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The IASB's Conceptual Framework 4


Chapter 4
Remaining text of the 1989 Framework
Underlying assumption
The elements of financial statements
Recognition of the elements of financial statements
Measurement of the elements of financial statements
Concepts of capital and capital maintenance

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The objective of general purpose financial reporting 1


Chapter 1: The objective of general purpose financial
reporting
To provide 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
Such decisions are likely to include:
Decisions to buy, hold or sell equity investments
Assessment of management stewardship and
accountability
Assessment of the entity's ability to pay employees
Assessment of the security of amounts lent to the entity
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The objective of general purpose financial reporting 2


Chapter 1: The objective of general purpose financial
reporting (continued)
The information required therefore relates to:
The economic resources of the entity
The claims against the entity
Changes in the entity's economic resources and claims
This information should be prepared on an accruals basis

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Underlying assumption
Chapter 4: The Framework (1989) remaining text
Underlying assumption
Going concern:
The financial statements are normally prepared on the
assumption that the entity is a going concern and will
continue to trade for the foreseeable future.
It is assumed that the entity has neither the intention not
the need to liquidate the business or curtail major
operations.
If it did the financial statements would be prepared on a
different basis and this basis would be disclosed.

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Qualitative characteristics of financial information 1


Chapter 3: Qualitative characteristics of useful financial
information
These describe the attributes that information needs to
have in order for it to be most useful for existing and
potential investors, lenders and other creditors for making
decisions about the reporting entity.
They are divided into two categories:
Fundamental qualitative characteristics
Enhancing qualitative characteristics

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Qualitative characteristics of financial information 2


Fundamental qualitative characteristics
Relevance

Faithful representation

Relevant financial information is


capable of making a difference in the
decisions made by users, ie if it has:
Predictive value, and/or
Confirmatory value.

To be useful, financial information


must faithfully represent the
phenomena it purports to represent.
A perfect faithful representation
would be:
Complete
Neutral
Free from error

Materiality
Information is material if omitting it
or misstating it could influence
decisions that users make on the
basis of financial information.

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Qualitative characteristics of financial information 3


Enhancing qualitative characteristics
Comparability
Information is more
useful if it can be
compared with similar
information about:
Other entities, and
Other periods.
Consistency helps
achieve comparability.

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Verifiability
Assures users that
information faithfully
represents the
economic phenomena
it purports to
represent
Verification can be
direct or indirect

Timeliness

Understandability

Having information
available to
decision-makers in
time to be capable
of influencing their
decisions

Classifying,
characterising and
presenting
information clearly
and concisely

The elements of financial statements 1


Chapter 4: The Framework (1989) remaining text
The elements of financial statements
An item can only be recognised in the financial
statements if it can be defined as one of the following
elements.
Asset
Liability
Equity
Income
Expense

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The elements of financial statements 2


ASSET

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

LIABILITY A present obligation of the entity arising from past


events, the settlement of which is expected to result in
an outflow of resources embodying economic benefits
EQUITY

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The residual interest in the assets of an entity after


deducting its liabilities

The elements of financial statements 3

INCOME

Increases in economic benefits during the period other


than contributions from equity participants

EXPENSE Decreases in economic benefits during the period


other than distributions to equity participants

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Recognition and measurement 1


Chapter 4: The Framework (1989) remaining text
Recognition of the elements of financial statements
Recognition is the process of recording or showing an
item in the financial statements.
An item can only be recognised in the financial statements
when it satisfies the recognition criteria.

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Recognition and measurement 2


Chapter 4: The Framework (1989) remaining text
Recognition of the elements of financial statements
Recognition criteria:
An item meets the definition of an element of the
financial statements; and
It is probable that any future economic benefit
associated with the item will flow to or from the entity;
and
The item has a cost or value that can be measured with
reliability.

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Case study: Footballers 1

Are transfer fees paid for footballers an asset?

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Case study: Footballers 2


Are the recognition criteria satisfied?
Firstly, is there an asset?
Control
Past event
Expected generation of future economic benefit

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Case study: Footballers 3


Asset?
Control: the football club has purchased the right to
use the player for match fixtures/training and
merchandising (player rights)
Past event: the transaction to purchase the player
Future economic benefits

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Case study: Footballers 4

What are the future economic benefits?

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Case study: Footballers 5


Asset?
Yes, an intangible asset
Secondly, is there probable future economic benefit?
Yes as discussed above
Thirdly, can the amount be measured with reliability?
Fee paid yes
Value of future ticket sales and merchandising no
Capitalise only the transfer fee paid as an intangible
non-current asset

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Recognition and measurement 3


Chapter 4: The Framework (1989) remaining text
Measurement of the elements of financial statements
The process of determining the monetary amounts at
which the elements of the financial statements are to be
recognised and carried in the statement of financial
position and the statement of profit or loss
There are four choices available:
Historical cost
Realisable value
Current cost
Present value
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Recognition and measurement 4


Measurement
basis

Definition

Historical cost

Assets are recorded at the amount of cash or


cash equivalents paid or the fair value of the
consideration given to acquire them at the time of
their acquisition.
Liabilities are recorded at the amount of proceeds
received in exchange for the obligation.

Realisable value

The amount of cash or cash equivalents that


could currently be obtained by selling an asset in
an orderly disposal.

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Recognition and measurement 5


Measurement
basis

Definition

Current cost

Assets are recorded at the amount of cash or


cash equivalents that would have to be paid if the
same or an equivalent asset was acquired at the
current time.
Liabilities are carried at the undiscounted amount
of cash or cash equivalents that would be required
to settle the obligation at the current time.

Present value

A current estimate of the present discounted value


of the future net cash flows in the normal course
of business.

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Fair presentation and compliance with IFRS 1


Financial statements should present fairly the financial
position, financial performance and cash flows of an entity.
It is presumed that this fair presentation will be achieved
where an entity complies with both the Conceptual
Framework and IFRSs.
Fair presentation also requires an entity to:
Select and apply appropriate accounting policies
Present information in a manner that provides relevance
information and which is a faithful representation
Provide additional disclosures where further information
is required to enable users to understand the impact of
transactions
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Past exam questions


Nature of question

Exam details

Discuss the meaning of understandability Q4 (a) Dec 2012


and comparability and the role of
consistency when preparing financial
statements
Use specific examples to show how IFRS Q4 (a) June 2011
disclosure can assist the predictive
nature of historic financial statements
Note that past exam questions were all
under the previous exam format.
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Under new format


some topics will be
examined by MCQ

Chapter 2
The regulatory
framework

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The need for a regulatory


framework
The International Accounting
Standards Board (IASB)
Setting of International Financial
Reporting Standards (IFRS)

Syllabus learning outcomes 1


Explain why a regulatory framework is needed, also
including the advantages and disadvantages of IFRS over
a national regulatory framework
Explain why accounting standards on their own are not a
complete regulatory framework
Distinguish between a principles based and a rules based
framework and discuss whether they can be
complementary

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Syllabus learning outcomes 2


Describe the IASB's Standard setting process including
revisions to and interpretations of Standards
Explain the relationship of national standard setters to the
IASB in respect of the standard setting process

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Chapter summary diagram


The regulatory framework
The need for a
regulatory
framework

The IASB

The IASB's
structure
Principlesbased versus
rules-based
approach
The standard
setting process
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The IASB's
relationship with
other standard
setters

The need for a regulatory framework 1


A regulatory framework is required for two main
reasons:
To act as a central source of reference of generally
accepted accounting practice (GAAP) in a given
market
To designate a system of enforcement of that GAAP
to ensure consistency between companies
Its aim is to narrow the areas of difference and choice
in financial reporting and to improve comparability.

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The need for a regulatory framework 2


Principles-based vs rules-based systems
A principles-based system works within a set of laid
down principles.
International Financial Reporting Standards use a
principles-based system: they are written based on the
definitions of the elements of financial statements and
the recognition and measurement principles as detailed
in the Conceptual Framework for Financial Reporting.
These principles are designed to cover a wide range of
scenarios without the need for a set of rules which
govern every eventuality.

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The need for a regulatory framework 3


Principles-based vs rules-based systems (continued)
A rules-based system regulates for issues as they
arise, this means that accounting standards contain
rules which apply to specific scenarios.
US GAAP has historically used a rules-based system
however many of the recent corporate accounting
scandals have arisen as a direct result of companies
acting in a way that avoids rules.
Consequently the US is moving towards a more
principles-based system.

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The need for a regulatory framework 4


There are both advantages and disadvantages of a principles vs
rules-based system:
Advantages:
A principles-based approach on a single conceptual
framework ensures that standards are consistent with each
other.
Rules can be broken and 'loopholes' found whereas
principles are more likely to offer a 'catch all' scenario.
Principles reduce the need for excessive detail in
standards.
Disadvantages:
Principles can become out of date and can be overly
flexible and therefore subject to manipulation.
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The IASB 1
The International Accounting Standards Board (IASB) is an
independent accounting standard setter established in 2001.
It has three formal objectives:
To develop, in the public interest, a single set of high quality,
understandable and enforceable global accounting standards
that require high quality, transparent and comparable
information in general purpose financial statements
To promote the use and vigorous application of those
standards
To work actively with national accounting standard setters to
bring about convergence of national accounting standards and
IFRS to high quality solutions

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Setting of IFRS 1
Below are the key steps in the process used to issue an International Financial
Reporting Standard.
Issues Paper

IASB staff prepare an issues paper including studying the


approach of national standards setters.
The IFRS Advisory Council is consulted about the
advisability of adding the topic to the IASB's agenda.

Discussion Paper

A Discussion Paper may be published for public comment.

Exposure Draft

An Exposure Draft is published for public comment.

International
After considering all comments received, and IFRS is
Financial Reporting approved by a majority of the IASB. The final standard
Standard
includes both a basis for conclusions and any dissenting
opinions.

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Setting of IFRS 2
For the IASB to achieve its objective in relation to the
harmonisation of accounting standards it is important
that it works closely with other national standard setters.
The IASB is trying to co-ordinate its work plan with
national standard setters such that when it adds an item
to its agenda that national standard setters do the same
thing so that a standard can be agreed which has
international consensus.
There are also plans to review all standards where there
are significant differences between IFRS and national
standards.

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Setting of IFRS 3
Current standards examinable in paper F7 are:
IAS 1 (revised)
IAS 2
IAS 7
IAS 8
IAS 10
IAS 11
IAS 12
IAS 16
IAS 17
IAS 18
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Setting of IFRS 4
Current standards examinable in paper F7 are:
IAS 20
IAS 23
IAS 27 (revised)
IAS 28
IAS 32
IAS 33
IAS 36

IAS 37
IAS 38

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Setting of IFRS 5
Current standards examinable in paper F7 are:
IAS 39
IAS 40
IAS 41
IFRS 1
IFRS 3 (revised)
IFRS 5
IFRS 7
IFRS 9
IFRS 10
IFRS 13

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Past exam questions


Nature of question

Exam details

Explain the difference between a


principles-based and a rules-based
system and state which system is used
by International Financial Reporting
Standards

Q5 (a) June 2012

Note that the contents of this chapter


could now be examined by MCQ

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Chapter 3
Presentation of
published financial
statements

IAS 1 (revised) Presentation of


Financial Statements
Statement of financial position
The current/non-current distinction
Statement of profit or loss and
other comprehensive income
Changes in equity
Notes to the financial statements
Revision of basic accounts

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Syllabus learning outcomes 1


Prepare an entity's statement of financial position and
statement of profit or loss and other comprehensive
income in accordance with the structure prescribed within
IFRS and content drawing on accounting treatments as
identified within the syllabus
Prepare and explain the contents and purpose of the
statement of changes in equity

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Chapter summary diagram


Presentation of published
financial statements

IFRS financial
statements

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Formats

Financial statement
preparation questions

IAS 1 (revised) 1
IAS 1 applies to the preparation and presentation of general
purpose financial statements in accordance with IFRSs and
states that a complete set of financial statements comprises:
A statement of financial position at the end of the period
A statement of profit or loss and other comprehensive
income for the period
A statement of changes in equity for the period
A statement of cash flows for the period
Notes to the financial statements including a summary of
significant accounting policies an other explanatory
information

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IAS 1 (revised) 2
Financial statements should also disclose:
The name of the reporting entity
Whether the accounts relate to the single entity only or a
group of entities
The date of the end of the reporting period or the period
covered by the financial statements
The presentation currency
The level of rounding used in presenting amounts in the
financial statements
Financial statements must be prepared on a timely basis in
order to provide useful information to users.

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Statement of financial position 1


XYZ GROUP STATEMENT OF FINANCIAL POSITION FOR THE YEAR ENDED 31
DECEMBER 20X2
20X2
20X1
$'000
$'000
ASSETS
Non-current assets
Property, plant and equipment
X
X
Goodwill
X
X
Other intangible assets
X
X
Investments in associates
X
X
Investments in equity instruments
X
X
X
X
Current assets
Inventories
X
X
Trade receivables
X
X
Other current assets
X
X
Cash and cash equivalents
X
X
X
X
Total assets
X
X
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Statement of financial position 2


EQUITY AND LIABILITIES
Equity
Share capital
Retained earnings
Other components of equity
Total equity

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$'000
X
X
X
X
X

$'000
X
X
X
X
X

Statement of financial position 3


Non-current liabilities
Long-term borrowings
Deferred tax
Long-term provisions
Total non-current liabilities
Current liabilities
Trade and other payables
Short-term borrowings
Current portions of long-term borrowings
Current tax payable
Short-term provisions
Total current liabilities
Total liabilities
Total equity and liabilities

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$'000

$'000

X
X
X
X

X
X
X
X

X
X
X
X
X
X
X
X

X
X
X
X
X
X
X
X

Statement of financial position 4

The following items must be presented on the face of the


statement of financial position (minimum disclosure).
Property, plant and equipment
Investment property
Intangible assets
Financial assets
Investments accounted for using the equity method
(associates)

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Statement of financial position 5


Biological assets (not in syllabus)
Inventories
Trade and other receivables
Cash and cash equivalents
Assets classified as held for sale under IFRS 5
Trade and other payables
Provisions
Financial liabilities

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Statement of financial position 6


Current tax liabilities and assets as in IAS 12
Deferred tax liabilities and assets
Liabilities included in disposal groups under IFRS 5
Non-controlling interests
Issued capital and reserves

Other items can be presented in the notes to the financial


statements unless they need to be disclosed on the face of the
statement of financial position in order for users to properly
understand the entity's financial position.

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Statement of financial position 7

Further sub-classification of the above items should be made either


on the face of the statement of financial position or in the notes.

The degree of further sub-classification depends on the requirements


of IFRSs and the nature of the business.

They include:
Property, plant and equipment classified by class of asset
Receivables analysed between amounts receivable from trade
customers, other group members, related parties, prepayments
and other amounts
Inventories sub-classified into materials, work in progress and
finished goods
Provisions
Equity capital and reserves classified into classes of capital, share
premium and reserves
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Statement of financial position 8


Additional specific disclosures must be made.

Share capital disclosures:


Authorised share capital and issued share capital (issued and fully
paid and issued but not fully paid)
Par value of each share
Reconciliation of the number of shares outstanding at the
beginning and the end of the year
Rights, preferences and restrictions attaching to the class of
shares (including restrictions on distributing dividends and the
repayment of capital)
Shares in the entity held by itself or by related group companies
Shares reserved for issuance under options and sales contracts

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Statement of financial position 9

A description of the nature and purpose of each reserve within


owners' equity.

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The current/non-current distinction

Assets and liabilities should be classified as either current or noncurrent on the face of the statement of financial position.

Current assets and liabilities comprise assets and liabilities which


relate to the operating cycle of the entity.

The operating cycle of an entity is the time between the acquisition of


assets for processing and their realisation in cash and cash
equivalents.

Non-current assets and liabilities are used in the long term operations
of the entity and will typically be recovered or settled after more than
twelve months.

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Statement of profit or loss and OCI 1


IAS 1 (revised) allows income and expense items to be presented either:

In a single statement of profit or loss and other comprehensive


income; or

In two statements: a separate statement of profit or loss and a


statement of other comprehensive income

BPP LEARNING MEDIA

Statement of profit or loss and OCI 2


XYZ GROUP STATEMENT OF PROFIT OR LOSS AND OTHER COMPREHENSIVE
INCOME FOR THE YEAR ENDED 31 DECEMBER 20X2
20X2
20X1
$'000
$'000
Revenue X
X
Cost of sales (X) (X)
Gross profit
X
X
Other income X
X
Distribution costs (X) (X)
Administrative expenses (X) (X)
Other expenses
(X) (X)
Finance costs (X) (X)
Profit before tax
X
X
Income tax expense (X) (X)
PROFIT FOR THE YEAR
X
X
Other comprehensive income:
Gains on property revaluation X
X
Investments in equity instruments (X) X
Income tax relating to components of other comprehensive
income (X) X
Other comprehensive income for the year, net of tax
X
(X)
TOTAL COMPREHENSIVE INCOME FOR THE YEAR X
X
BPP LEARNING MEDIA

Statement of profit or loss and OCI 3


XYZ GROUP STATEMENT OF PROFIT OR LOSS FOR THE YEAR ENDED
31 DECEMBER 20X2 20X2
20X1
$'000
RevenueX

$'000
X

Cost of sales (X) (X)


Gross profit X

Other incomeX

Distribution costs (X) (X)


Administrative expenses

(X) (X)

Other expenses (X) (X)


Finance costs

(X) (X)

Profit before tax X

Income tax expense

(X) (X)

PROFIT FOR THE YEAR X


BPP LEARNING MEDIA

Statement of profit or loss and OCI 4


XYZ GROUP STATEMENT OF PROFIT OR LOSS AND OTHER
COMPREHENSIVE INCOME FOR THE YEAR ENDED 31 DECEMBER 20X2
20X2

20X1

$'000

$'000

Profit for the year

Other comprehensive income:


Gains on property revaluation

Investments in equity instruments

X
(X) X

Income tax relating to components of other comprehensive


income (X) X
Other comprehensive income for the year, net of tax X

(X)

TOTAL COMPREHENSIVE INCOME FOR THE YEAR

BPP LEARNING MEDIA

Statement of profit or loss and OCI 5


IAS 1 offers two formats for the statement of profit or
loss.
The most common format is to classify income and
expenses by function as above.
Income and expenses can also be classified by nature
as detailed on the next slide:

BPP LEARNING MEDIA

Statement of profit or loss and OCI 6


XYZ GROUP STATEMENT OF PROFIT OR LOSS FOR THE YEAR ENDED 31
DECEMBER 20X2 20X2
20X1
$'000
Revenue X

$'000
X

Other operating income X

Changes in inventories of FG and WIP

(X) X

Work performed by the entity and capitalised X


Raw material and consumables used
Employee benefits expense

(X) (X)

(X) (X)

Depreciation and amortisation expense (X) (X)


Impairment of property, plant and equipment (X) (X)
Other expenses

(X) (X)

Finance costs (X) (X)


Profit before tax

Income tax expense(X) (X)


PROFIT FOR THE YEAR
BPP LEARNING MEDIA

Statement of profit or loss and OCI 7

IAS 1 (revised) also requires the following items to be disclosed


on the face of the statement of profit or loss (minimum
disclosure).
Revenue
Finance costs
Tax expense
Profit or loss

Note that dividends do not meet the IASB Conceptual Framework


definition of an expense and so are not included in the statement
of profit or loss and other comprehensive income.

Rather they are shown as a deducted from retained earnings in


the statement of changes in equity.

BPP LEARNING MEDIA

Changes in equity

Balance at 1 January 20X1


Changes in accounting policy
Restated balance
Changes in equity for 20X1
Dividends
Total comprehensive income
Balance at 31 December 20X1
Changes in equity for 20X2
Issue of share capital
Dividends
Total comprehensive income
Transfer to retained earnings
Balance at 31 December 20X2

BPP LEARNING MEDIA

Share
capital
$'000
X

Ret'd
earnings
$'000
X
(X)
X

Revaluation
surplus
$'000
X

Total
equity
$'000
X
(X)
X

(X)
X
X

(X)
X

(X)
X
X

(X)
X
X
X

X
(X)
X

X
(X)
X

Notes to the financial statements


Notes to the accounts amplify the information given in the
financial statements.
Notes perform the following functions.
Provide information about the basis on which the financial
statements were prepared and which specific accounting
policies were chosen
Disclose information required by IFRSs which has not
been disclosed elsewhere in the financial statements
Show any additional information relevant to understanding
the financial statements

BPP LEARNING MEDIA

Revision of basic accounts 1


In the exam you will be required to prepare a basic set of
company accounts from a trial balance incorporating
additional information provided in the question.
To be successful in these questions you must:
Practice as many examples of these questions as you
can
Adopt a methodical approach to completing them

BPP LEARNING MEDIA

Revision of basic accounts 2


1. Read the requirements and scan the information in the
question.
2. Set up four pages as necessary:
. Proforma statement of profit or loss and other
comprehensive income
. Proforma statement of financial position
. Proforma statement of changes in equity
. A page for workings
3. Read the additional information given and make a mark by
each caption in the trial balance that is going to change.

BPP LEARNING MEDIA

Revision of basic accounts 3


4. Transfer the figures from the trial balance:
. Unaffected figures may be entered directly on your proforma
. Figures requiring adjustment can either be put into a
working or brackets opened up on the face of your proforma
solution
5. Work through the adjustments in the additional information
dealing with both sides of the double entry. Once you have
attempted all adjustments, balance off your workings and
transfer the final figures to your proforma.

BPP LEARNING MEDIA

Question: AZ Co
AZ Co is a quoted manufacturing company. Its finished
products are stored in a nearby warehouse until ordered
by customers. AZ Co has performed very well in the past,
but has been in financial difficulties in recent months and
has been reorganising the business to improve
performance.
The trial balance for AZ Co at 31 March 20X3 was as
follows.

BPP LEARNING MEDIA

Question: AZ Co (cont'd)
TRIAL BALANCE AT 31 MARCH 20X3
Sales
Cost of goods manufactured in the year to
31 March 20X3 (excluding depreciation)
Distribution costs
Administrative expenses
Restructuring costs
Interest received
Debenture interest paid
Land and buildings (including land $20,000,000)
Plant and equipment
Accumulated depreciation at 31 March 20X2:

Buildings

Plant and equipment


Investment properties (at market value)
Inventories at 31 March 20X2
Trade receivables
Bank and cash
Ordinary shares of $1 each, fully paid
Share premium
Revaluation surplus
Retained earnings at 31 March 20X2
Ordinary dividends paid
7% debentures 20X7
Trade payables
Proceeds of share issue

BPP LEARNING MEDIA

$'000
94,000
9,060
16,020
121
639
50,300
3,720

24,000
4,852
9,330
1,190

1,000

214,232

$'000
124,900

SPLOCI
1,200

6,060
1,670

20,000
430
3,125
28,077
18,250
8,120
2,400
214,232

SOFP

Question: AZ Co (cont'd)
Additional information provided:
i. The property, plant and equipment are being depreciated as follows.

Buildings: 5% per annum straight line

Plant and equipment: 25% per annum reducing balance

Depreciation of buildings is considered an administrative cost


while depreciation of plant and equipment should be treated as a
cost of sale

ii. On 31 March 20X3 the land was revalued to $24,000,000.


iii. Income tax for the year to 31 March 20X3 is estimated at $976,000.
Ignore deferred tax.

BPP LEARNING MEDIA

Question: AZ Co (cont'd)
iv.

The closing inventories at 31 March 20X3 were $5,180,000. An


inspection of finished goods found that a production machine had
been set up incorrectly and that several production batches, which
had cost $50,000 to manufacture, had the wrong packaging. The
goods cannot be sold in this condition but could be repacked at an
additional cost of $20,000. They could then be sold for $55,000.
the wrongly packaged goods were included in closing inventories at
their cost of $50,000.

v.

The 7% loan notes are ten year loans due for repayment by 31
March 20X7. Interest on these loan notes needs to be accrued for
the six months to 31 March 20X3.

vi.

The restructuring costs in the trial balance represent the cost of a


major restructuring of the company to improve competitiveness and
future profitability.

BPP LEARNING MEDIA

Question: AZ Co (cont'd)
vii. No fair value adjustments were necessary to the investment
properties during the period.
viii. During the year the company issued 2 million new ordinary shares
for cash at $1.20 per share. The proceeds have been recorded as
'proceeds of share issue'.

BPP LEARNING MEDIA

Question: AZ Co (cont'd)
Required
Prepare the statement of profit or loss and other
comprehensive income and statement of changes in equity
for AZ for the year to 31 March 20X3 and a statement of
financial position at that date.
Notes to the financial statements are not required, but all
workings must be clearly shown.

BPP LEARNING MEDIA

Answer: AZ Co
AZ STATEMENT OF PROFIT OR LOSS AND OTHER COMPREHENSIVE INCOME
FOR THE YEAR ENDED 31 MARCH 20X3
$'000
124,900
Revenue
Cost of sales
Gross profit
Distribution costs
Administrative expenses
Other expenses
Finance income
Finance costs
Profit before tax
Income tax expense
PROFIT FOR THE YEAR
Other comprehensive income:
Gain on property revaluation

TOTAL COMPREHENSIVE INCOME FOR THE YEAR

BPP LEARNING MEDIA

Answer: AZ Co (cont'd)
1

Expenses
Per question

Cost of sales Distribution


$'000
$'000
9,060
94,000

BPP LEARNING MEDIA

Admin
$'000
16,020

Other
$'000
121

Answer: AZ Co (cont'd)
AZ STATEMENT OF PROFIT OR LOSS AND OTHER COMPREHENSIVE INCOME
FOR THE YEAR ENDED 31 MARCH 20X3
$'000
Revenue
124,900
Cost of sales
Gross profit
Distribution costs
Administrative expenses
Other expenses
1,200
Finance income
Finance costs
(639)
Profit before tax
Income tax expense
PROFIT FOR THE YEAR
Other comprehensive income:
Gain on land revaluation

TOTAL COMPREHENSIVE INCOME FOR THE YEAR

BPP LEARNING MEDIA

Answer: AZ Co (cont'd)
2

Property, plant and equipment

Cost
Accumulated depreciation b/d
Carrying amount b/d
Charge for year

Revaluation (balancing figure)


Carrying amount c/d

BPP LEARNING MEDIA

Land

Buildings

$'000
20,000

$'000
30,300
(6,060)

Plant &
equipment
$'000
3,720
(1,670)

Total
$'000

Answer: AZ Co (cont'd)
Non-current assets
Property, plant and equipment
Investment properties
Current assets
Inventories
Trade receivables
Cash and cash equivalents
Equity
Share capital
Share premium
Retained earnings
Revaluation surplus
Non-current liabilities
7% loan notes 20X7
Current liabilities
Trade payables
Income tax payable
Interest payable

BPP LEARNING MEDIA

24,000

Answer: AZ Co (cont'd)
1

Expenses
Per question
Opening inventories

Cost of sales Distribution


$'000
$'000
9,060
94,000
4,852

BPP LEARNING MEDIA

Admin
$'000
16,020

Other
$'000
121

Answer: AZ Co (cont'd)
Non-current assets
Property, plant and equipment
Investment properties
Current assets
Inventories
Trade receivables
Cash and cash equivalents
Equity
Share capital (20,000
Share premium (430
Retained earnings (28,077 1,000
Revaluation surplus (3,125
Non-current liabilities
7% loan notes 20X7
Current liabilities
Trade payables
Income tax payable
Interest payable

BPP LEARNING MEDIA

24,000

9,330
1,190

18,250
8,120

Answer: AZ Co (cont'd)
2

Property, plant and equipment

Cost
Accumulated depreciation b/d
Carrying amount b/d
Charge for year 30,300 5%
2,050 25%
Revaluation (balancing figure)
Carrying amount c/d

BPP LEARNING MEDIA

Land

Buildings

$'000
20,000

$'000
30,300
(6,060)

20,000

24,240
(1,515)

(1,515)
(513)
(513)

Plant &
equipment
$'000
3,720
(1,670)

2,050

Total
$'000

Answer: AZ Co (cont'd)
1

Expenses

Cost of sales Distribution


$'000
$'000
9,060
94,000
Per question
Opening inventories
4,852
Depreciation Buildings (W2)
P&E (W2)
513

BPP LEARNING MEDIA

Admin
$'000
16,020

Other
$'000
121

1,515

Answer: AZ Co (cont'd)
2

Property, plant and equipment

Cost
Accumulated depreciation b/d
Carrying amount b/d
Charge for year 30,300 5%
2,050 25%
Revaluation (balancing figure)
Carrying amount c/d

BPP LEARNING MEDIA

Land

Buildings

$'000
20,000

$'000
30,300
(6,060)

20,000

24,240

Plant &
Total
equipment
$'000
$'000
3,720 54,020
(1,670)

(7,730)
2,050 46,290

(1,515)

(1,515)
(513)
(513)

22,725

22,725

1,537 44,262

4,000
1,537 48,262

20,000
4,000
24,000

Answer: AZ Co (cont'd)
Non-current assets
Property, plant and equipment (W2)
Investment properties
Current assets
Inventories
Trade receivables
Cash and cash equivalents
Equity
Share capital (20,000
Share premium (430
Retained earnings (28,077 1,000
Revaluation surplus (3,125 + (W2) 4,000)
Non-current liabilities
7% loan notes 20X7
Current liabilities
Trade payables
Income tax payable
Interest payable

BPP LEARNING MEDIA

48,262
24,000

9,330
1,190

7,125

18,250

8,120

Answer: AZ Co (cont'd)
AZ STATEMENT OF PROFIT OR LOSS AND OTHER COMPREHENSIVE INCOME
FOR THE YEAR ENDED 31 MARCH 20X3
$'000
Revenue
Cost of sales
Gross profit
Distribution costs
Administrative expenses
Other expenses
Finance income
(639
Finance costs
Profit before tax
Income tax expense
PROFIT FOR THE YEAR
Other comprehensive income:
Gain on land revaluation (W2)
TOTAL COMPREHENSIVE INCOME FOR THE YEAR

BPP LEARNING MEDIA

124,900

1,200

(976)

4,000

Answer: AZ Co (cont'd)
Non-current assets
Property, plant and equipment (W2)
Investment properties
Current assets
Inventories
Trade receivables
Cash and cash equivalents
Equity
Share capital (20,000
Share premium (430
Retained earnings (28,077 1,000
Revaluation surplus (3,125 + (W2) 4,000)
Non-current liabilities
7% loan notes 20X7
Current liabilities
Trade payables
Income tax payable
Interest payable

BPP LEARNING MEDIA

48,262
24,000

9,330
1,190

7,125

18,250
8,120
976

Answer: AZ Co (cont'd)
3

Inventories
Defective batch
Selling price
Costs to complete repackaging
NRV
Cost
Write-off required

BPP LEARNING MEDIA

$'000

55
(20)

$'000

35
(50)
(15)

Answer: AZ Co (cont'd)
Non-current assets
Property, plant and equipment (W2)
Investment properties
Current assets
Inventories (5,180 (W3) 15)
Trade receivables
Cash and cash equivalents
Equity
Share capital (20,000
Share premium (430
Retained earnings (28,077 1,000
Revaluation surplus (3,125 + (W2) 4,000)
Non-current liabilities
7% loan notes 20X7
Current liabilities
Trade payables
Income tax payable
Interest payable

BPP LEARNING MEDIA

48,262
24,000

5,165
9,330
1,190

7,125

18,250

8,120
976

Answer: AZ Co (cont'd)
1

Expenses

Cost of sales Distribution


$'000
$'000
9,060
94,000
Per question
Opening inventories
4,852
Depreciation Buildings (W2)
P&E (W2)
513
Closing inventories
(5,180 (W3) 15)
(5,165)

BPP LEARNING MEDIA

Admin
$'000
16,020

Other
$'000
121

1,515

Answer: AZ Co (cont'd)
AZ STATEMENT OF PROFIT OR LOSS AND OTHER COMPREHENSIVE INCOME
FOR THE YEAR ENDED 31 MARCH 20X3
$'000
124,900
Revenue
Cost of sales
Gross profit
Distribution costs
Administrative expenses
Other expenses
1,200
Finance income
Finance costs (639 + ((18,250 x 7%) 639)
(1,278)
Profit before tax
Income tax expense
(976)
PROFIT FOR THE YEAR
Other comprehensive income:
4,000
Gain on land revaluation (W2)
TOTAL COMPREHENSIVE INCOME FOR THE YEAR

BPP LEARNING MEDIA

Answer: AZ Co (cont'd)
Non-current assets
Property, plant and equipment (W2)
Investment properties
Current assets
Inventories (5,180 (W3) 15)
Trade receivables
Cash and cash equivalents
Equity
Share capital (20,000 + (2m $1))
Share premium (430 + (2m $0.20))
Retained earnings (28,077 1,000
Revaluation surplus (3,125 + (W2) 4,000)
Non-current liabilities
7% loan notes 20X7
Current liabilities
Trade payables
Income tax payable
Interest payable (1,278 639)

BPP LEARNING MEDIA

48,262
24,000

5,165
9,330
1,190

22,000
830
7,125

18,250
8,120
976
639

Answer: AZ Co (cont'd)
1

Expenses

Cost of sales Distribution


$'000
$'000
9,060
94,000
Per question
Opening inventories
4,852
Depreciation Buildings (W2)
P&E (W2)
513
Closing inventories
(5,180 (W3) 15)
(5,165)

9,060
94,200

BPP LEARNING MEDIA

Admin
$'000
16,020

Other
$'000
121

1,515

17,535

121

Answer: AZ Co (cont'd)
AZ STATEMENT OF PROFIT OR LOSS AND OTHER COMPREHENSIVE INCOME
FOR THE YEAR ENDED 31 MARCH 20X3
$'000
124,900
Revenue
(94,200)
Cost of sales (W1)
30,700
Gross profit
(9,060)
Distribution costs (W1)
(17,535)
Administrative expenses (W1)
(121)
Other expenses (W1)
Finance income
1,200
(1,278)
Finance costs (639 + (18,250 7%) 639)
3,906
Profit before tax
(976)
Income tax expense
2,930
PROFIT FOR THE YEAR
Other comprehensive income:
Gain on land revaluation (W2)
4,000
TOTAL COMPREHENSIVE INCOME FOR THE YEAR
6,930

BPP LEARNING MEDIA

Answer: AZ Co (cont'd)
Non-current assets
Property, plant and equipment (W2)
Investment properties
Current assets
Inventories (5,180 (W3) 15)
Trade receivables
Cash and cash equivalents
Equity
Share capital (20,000 + (2m $1))
Share premium (430 + (2m $0.20))
Retained earnings (28,077 1,000 + 2,930)
Revaluation surplus (3,125 + (W2) 4,000)
Non-current liabilities
7% loan notes 20X7
Current liabilities
Trade payables
Income tax payable
Interest payable (1,278 639)

BPP LEARNING MEDIA

48,262
24,000
72,262
5,165
9,330
1,190
15,685
87,947
22,000
830
30,007
7,125
59,962
18,250
18,250
8,120
976
639
9,735
87,947

Answer: AZ Co (cont'd)
AZ
STATEMENT OF CHANGES IN EQUITY
Share
Share
capital premium
$'000
$'000
20,000
430
Balance at 1 April 20X2
2,000
400
Issue of share capital
Dividends
Total comprehensive income
22,000
830
Balance at 31 March 20X3

BPP LEARNING MEDIA

Ret'd
Rev'n
Total
earnings surplus
$'000
$'000 $'000
28,077
3,125 51,632
2,400
(1,000)
(1,000)
2,930
4,000 6,930
30,007
7,125 59,962

Past exam questions


Nature of question

Exam details

There will be a financial statements


preparation question in the ACCA F7
exam.
You should expect to see one or more of
the following requirements.
i. Prepare the statement of profit or
loss and other comprehensive
income
ii. Prepare the statement of changes in
equity
iii. Prepare the statement of financial
position

Q2 in all past
exams.
Should be in part
B under the new
format.
Questions could
be 15 or 30
marks.

BPP LEARNING MEDIA

Chapter 4
Non-current assets

IAS 16 Property, Plant and


Equipment
Depreciation accounting
IAS 40 Investment Property
IAS 23 Borrowing Costs

BPP LEARNING MEDIA

Syllabus learning outcomes 1


Define and compute the initial measurement of a noncurrent (including a self-constructed and borrowing costs)
asset
Identify subsequent expenditure that may be capitalised,
distinguishing between capital and revenue items
Discuss the requirements of relevant accounting standards
in relation to the revaluation of non-current assets
Account for revaluation and disposal gains and losses for
non-current assets

BPP LEARNING MEDIA

Syllabus learning outcomes 2


Compute depreciation based on the cost and revaluation
models and on assets that have two or more significant
parts (complex assets)
Discuss why the treatment of investment properties should
differ from other properties
Apply the requirements of relevant accounting standards
for investment property

BPP LEARNING MEDIA

Chapter summary diagram


Tangible non-current assets

Borrowing Costs
(IAS 23)

Property, Plant and


Equipment (IAS 16)
Definition

Investment Property
(IAS 40)

Recognition

Measurement
at recognition

BPP LEARNING MEDIA

Measurement
after recognition

Depreciation

Disclosure note

IAS 16 Property, Plant and Equipment 1


Definition
Property, plant and equipment are tangible items that:
Are held by an entity for use in the production or supply
of goods or services, for rental to others, or for
administrative purposes
Are expected to be used during more than one period

BPP LEARNING MEDIA

IAS 16 Property, Plant and Equipment 2


Recognition
Property, plant and equipment should be recognised once
the recognition criteria from the Conceptual Framework
have been met:
It is probable that future economic benefits that are
attributable to the asset will flow to the entity
The cost of the asset can be reliably measured

BPP LEARNING MEDIA

IAS 16 Property, Plant and Equipment 3


Initial measurement at recognition
Initially recognise at cost.
Cost includes:
Purchase price including import duties and nonrefundable purchase taxes less trade discounts and rebates
Directly attributable costs:
Cost of site preparation
Initial delivery and handling costs
Installations and assembly costs
Costs of testing
Professional fees
BPP LEARNING MEDIA

IAS 16 Property, Plant and Equipment 4


Initial measurement at recognition (continued)
Cost includes (continued):
Estimated cost of dismantling/removing the item
(IAS 37)
Finance costs (IAS 23)

BPP LEARNING MEDIA

IAS 16 Property, Plant and Equipment 5


Subsequent expenditure
Capitalise as a non-current asset if the asset
recognition criteria are met
Consider:
Complex assets assets which are made up of
separate components
Assets requiring overhauls

BPP LEARNING MEDIA

IAS 16 Property, Plant and Equipment 6


Subsequent expenditure (continued)
Examples:
Furnace
Aircraft
Treat each component separately for depreciation
purposes and capitalise the costs when they are
replaced/overhauled

BPP LEARNING MEDIA

IAS 16 Property, Plant and Equipment 7


Eg airframe, depreciate over 20 years
Eg seating, depreciate over eight years
Eg engines, depreciate over six years

BPP LEARNING MEDIA

IAS 16 Property, Plant and Equipment 8


Subsequent expenditure cont.
Where subsequent expenditure does not meet the
asset recognition criteria the expenditure should be
included as part of the profit or loss for the period.
Recognise as an expense

BPP LEARNING MEDIA

IAS 16 Property, Plant and Equipment 9


Measurement after recognition
Choice of accounting treatment, the entity can either
maintain the asset at cost or revalue it to fair value.
Cost model:
Property, plant and equipment is carried in the
financial statements at cost less accumulated
depreciation and impairment losses.

BPP LEARNING MEDIA

IAS 16 Property, Plant and Equipment 10


Measurement after recognition (continued)
Revaluation model:
Property, plant and equipment is carried in the
financial statements at fair value less accumulated
depreciation and impairment losses.
Fair value is 'the price that would be received to sell
an asset or paid to transfer a liability in an orderly
transaction between market participants at the market
date'.

BPP LEARNING MEDIA

IAS 16 Property, Plant and Equipment 11


What is the fair value of an asset?
Land and buildings market value where the valuation
is usually carried out by a professionally qualified valuer
Plant and equipment market value
Specialised assets depreciated replacement cost if
the market value is not available

BPP LEARNING MEDIA

IAS 16 Property, Plant and Equipment 12


Revaluations
Where an item of property, plant and equipment is
revalued the whole class of assets to which it belongs
should be revalued.
Revaluations should be performed sufficiently often so
that the carrying amount of the asset is not materially
different from the fair value of the asset.
Where an asset has increased in value, the revaluation
gain is reported in other comprehensive income and in
the revaluation surplus in the statement of financial
position unless the gain reverses a previous revaluation
loss which was charged to profit or loss.
BPP LEARNING MEDIA

IAS 16 Property, Plant and Equipment 13


Revaluations (continued)
A revaluation loss is charged first to other
comprehensive income (and the revaluation surplus)
with any excess reported in profit or loss.
Where an asset is revalued depreciation is charged on
the revalued amount.
If the asset has been revalued upwards the depreciation
charge will be higher than before the revaluation.
The excess depreciation can be transferred to retained
earnings from the revaluation surplus.
This adjustment will be shown in the statement of
changes in equity.
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Question: Xavier
Xavier has a year end of 30 September and purchased a piece of
production equipment on 1 July 20X5 incurring the following costs.
$
List price of machine

8,550

Trade discount

(855)

Delivery costs

105

Set-up costs incurred internally


8,156

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356

Question: Xavier (cont'd)


Notes
1

The machine was expected to have a useful life of 12 years and a


residual value of $2,000.

Xavier's accounting policy is to charge a full year's depreciation in the


year of purchase and no depreciation is the year of retirement or sale.

Xavier has a policy of keeping all equipment at revalued amounts. No


revaluations had been necessary until 30 September 20X8 when one
of the major suppliers of such machines went bankrupt causing a rise
in prices. A specific market value for Xavier's machine was not
available, but an equivalent machine would now cost $15,200
(including relevant disbursements). Xavier treats revaluation surpluses
as being realised through use of the asset and transfers them to
retained earnings over the life of the asset. The remaining useful life
and residual value of the machine remained the same.

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Question: Xavier (cont'd)


Required
Show the accounting effect of the above transaction at 30 September
20X5, 20X8 and 20X9.

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Answer: Xavier
At 30 September 20X5
Plant and equipment

Cost (8,550 855 + 105 + 356)

8,156

Accumulated depreciation (8,156 2,000) / 12 years

(513)
7,643

At 30 September 20X8
Plant and equipment
Revalued amount (W1)
Accumulated depreciation

$
10,800
0
10,800

Equity
Revaluation surplus (10,800 (W1) 6,104 (W2))
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4,696

Answer: Xavier (cont'd)


Working 1
Revalued amount (depreciated replacement cost)

Gross replacement cost

15,200

Depreciation (15,200 2,000) 4/12

(4,400)
10,800

Working 2
Carrying amount before revaluation
Cost
Accumulated depreciation (8,156 2,000) 4/12

$
8,156
(2,052)
6,104

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Answer: Xavier (cont'd)


At 30 September 20X9
Plant and equipment

Revalued amount

10,800

Accumulated depreciation (10,800 2,000) / 8 years

(1,100)
9,700

Equity
Revaluation surplus (4,696 (4,696 / 8 years))

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4,109

Depreciation accounting 1
Definition
The systematic allocation of the depreciable amount of
an asset over its estimated useful life.
Where the depreciable amount of an asset is its
historical cost (or other amount) less the estimated
residual value.
Where the useful life is the period over which a
depreciable asset is expected to be used by the entity or
the number of production or similar units expected to be
obtained from the asset by the entity.

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Depreciation accounting 2
Definition (continued)
The useful life, residual value and depreciation method
must be reviewed at least each financial year end and
adjusted where necessary.

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IAS 40 Investment Property 1


Definition
Property (land or buildings or part of a building or
both) held (by the owner or by the lessee under a
finance lease) to earn rentals or for capital appreciation
or both, rather than for:
Use in the production or supply of goods or services
or for administrative purposes; or
Sale in the ordinary course of business.

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IAS 40 Investment Property 2


Recognition
An investment property is recognised when and only
when:
It is probable that the future economic benefits
associated with the investment property will flow to the
entity
The cost of the investment property can be measured
reliably

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IAS 40 Investment Property 3


Measurement at recognition
The investment property is initially recognised at cost.
Cost comprises:
Purchase price plus
Any directly attributable expenditure (for example
professional fees)
For self-constructed investment properties, cost is the
cost at the date when the construction/development is
complete.

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IAS 40 Investment Property 4


Measurement after recognition
There is a choice of accounting policy which must be
applied to all investment properties held by the entity.
Cost model:
The investment property is carried in the financial
statements at cost less accumulated depreciation and
impairment losses, ie it is treated as a non-current
asset under IAS 16.

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IAS 40 Investment Property 5


Measurement after recognition (continued)
Fair value model:
The investment property is measured at fair value at
the end of each reporting period.
Any gain or loss on remeasurement is included in
profit or loss for the period.
The investment property is not depreciated.

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Question: Propex Co
Propex Co has the following properties but is unsure how to account
for them:
(1) Tennant House which cost $150,000 five years ago. The property
is freehold and is let out to private individuals for six monthly
periods. The current market value of the property is $175,000.
(2) Stowe Place which cost $75,000. This is used by Propex Co as
its headquarters. The building was acquired ten years ago.
(3) Crocket Square is a recently started development which is two
thirds complete. Propex Co intends to let this out to a company
called Speedex Co in which it has a controlling interest.
Propex Co depreciates its buildings at 2% per annum on cost.
Required
Describe the most appropriate accounting treatment for each of these
properties.
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Answer: Propex Co (cont'd)


(1) Tennant House

Held for its investment potential and not for use by Propex Co

Treat as investment property in accordance with IAS 40

Rental income to profit or loss

If following fair value model revalue to market value of


$175,000. The difference of $25,000 credited to profit or loss

If following cost model depreciate based on cost and do not


revalue. Depreciation for current period is $3,000 and carrying
amount is $135,000 (150,000 (5 3,000)).

Need to be consistent and use either fair value or cost model


for all investment properties

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Answer: Propex Co (cont'd)


(2) Stowe Place

Held for use by Propex Co therefore cannot be an investment


property

Depreciate over useful life $75,000 2% = $1,500 per annum


charge as an expense to profit or loss

Carrying amount of $75,000 ($1,500 10) = $60,000 to be


shown in statement of financial position

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Answer: Propex Co (cont'd)


(3) Crocket Square
Not yet complete so accounting treatment relates to the cost
incurred to date.
Propex Co does not wish to sell the property so no need to treat it as
inventories or work in progress.
Costs should be capitalised and disclosed under 'Assets in course
of construction' until construction is complete.
Intention to rent the property out to a group company and so will not
be treated as an investment property in the group financial
statements as it is owner-occupied. However, in the separate
financial statements of Propex Co the property can be classified as
investment property when construction is complete.
In the group financial statements, it will be depreciated as soon as it
comes into use. This will also apply in Propex Co's separate
financial statements if the cost model of IAS 40 is used.
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IAS 23 Borrowing Costs 1


Definition
Borrowing costs:
Interest and other costs incurred by an entity in
connection with the borrowing of funds
Qualifying asset:
An asset that necessarily takes a substantial period of
time to get ready for its intended use or sale
Accounting treatment
Borrowing costs that directly relate to the acquisition,
construction or production of a qualifying asset must be
capitalised as part of the cost of that asset.
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IAS 23 Borrowing Costs 2


Types of borrowing costs
Funds borrowed specifically:
Capitalise actual borrowing costs incurred less
investment income on temporary investment of funds
Funds borrowed generally:
Capitalise borrowing costs calculated as the weighted
average cost of borrowings for the period multiplied by
the expenditure on the qualifying asset
Note that the amount capitalised should not exceed
total borrowing costs incurred in the period

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IAS 23 Borrowing Costs 3


Commencement of capitalisation
Capitalisation of borrowing costs should begin when:
Expenditures for the asset are being incurred
Borrowing costs are being incurred
Activities that are necessary to prepare the asset for
its intended use or sale are in progress

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IAS 23 Borrowing Costs 4


Suspension and cessation of capitalisation
Capitalisation of borrowing costs should be suspended
during extended periods when development is
interrupted. For example due to workforce strikes or
inclement weather.
Capitalisation of borrowing costs should cease when
substantially all of the activities necessary to prepare
the qualifying asset for its intended use or sale are
complete.
This is likely to be when the asset is ready for use (even
if it is not being used).

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Exam questions
Nature of question

Exam details

Adjustments relating to property, plant


and equipment are frequently examined
in the financial statement preparation
question. These may involve
adjustments for depreciation,
revaluations, acquisitions and disposals.

Q2 in all past
exams under the
pre-Dec 2014
format.
Likely to appear
in 15- or 30-mark
questions under
the new format.

Under the new format there could also


be MCQs on PPE.
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Past exam questions


Nature of question

Exam details

Investment properties: definitions,


accounting treatment and application of
knowledge to a scenario.

Q5 June 2013

Borrowing costs: criteria for capitalising


borrowing costs and the value at which
they should be capitalised and
application of knowledge to a scenario.

Q5 June 2010

These topics could now be tested by


MCQ.
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Chapter 5

IAS 38 Intangible assets

Intangible assets

Goodwill (IFRS 3)

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Research and development costs

Syllabus learning outcomes 1


Discuss the nature and accounting treatment of internally
generated and purchased intangibles
Distinguish between goodwill and other intangibles
Describe the criteria for the initial recognition and
measurement of intangible assets
Describe the subsequent accounting treatment, including
the principle of impairment tests in relation to goodwill

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Syllabus learning outcomes 2


Indicate why the value of purchase consideration for an
investment may be less than the value of the acquired
identifiable net assets and how the difference should be
accounted for
Describe and apply the requirements of relevant
accounting standards to research and development
expenditure

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Chapter summary diagram


Definition

Intangible assets

Disclosure note
Amortisation/impairment
tests

Recognition

Finite useful life


Measurement at
recognition

Measurement after recognition


Cost model

Separate
acquisition
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Indefinite
useful life

Acquired as part
of a business
combination

Internally
generated
goodwill

Revaluation model

Internally
generated
intangibles

IAS 38 Intangible assets 1


Definition
An identifiable non-monetary asset without physical
substance
Examples:
Patents
Copyrights
Brands
Goodwill

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IAS 38 Intangible assets 2


Recognition
An intangible asset should be recognised when the
recognition criteria from the Conceptual Framework are
met:
It is probable that future economic benefit from the
asset will flow to the entity.
The cost of the asset can be reliably measured.

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IAS 38 Intangible assets 3


Measurement at recognition
Depends on how the intangible was acquired:
Separate
acquisition

Cost

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Acquired as
part of
business
combination

Internally
generated
goodwill

Fair value
(IFRS 3)

NOT
recognised

Internally
generated
intangible
assets

Only
recognised
if PIRATE
criteria met

Acquired by
government
grant

Asset/grant @
FV
or
Nominal
amount + direct
expenditure

Research and development costs 1


Research definition
Costs incurred to gain new scientific or technical
knowledge and understanding
Accounting treatment
No certainty of future economic benefit
Recognise as an expense in profit or loss as incurred

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Research and development costs 2


Development costs definition
Application of research findings to a plan/design for the
production of new or substantially improved materials,
products or processes prior to commercial production
or use
Accounting treatment
Expenditure incurred now will lead to future revenues
Capitalise expenditure as an intangible non-current
asset if all IAS 38 criteria are met

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Research and development costs 3


Capitalisation criteria
All six criteria must be met:
P robable future economic benefits
I ntention to compete and use/sell the asset
R esources adequate and available to complete and use/
sell asset
A bility to use/sell asset
T echnical feasibility of completing asset for use/sale
E xpenditure can be reliably measured
Should any of the criteria not be met, the expenditure must
be treated as an expense.

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Research and development costs 4


Expenditure on internally generated brands,
mastheads, publishing titles, customer lists and similar
items should be treated as an expense because they
cannot be distinguished from the cost of developing the
business as a whole.
Start-up, training, advertising, promotional, relocation
and reorganisation costs are all recognised as
expenses as they relate to ongoing business costs.

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Research and development costs 5


Measurement after recognition
Choice of accounting policy
Cost model:
The intangible asset is carried at cost less accumulated
amortisation and impairment losses.
Revaluation model:
The intangible asset is carried at a revalued amount
(fair value) less accumulated amortisation ad
impairment losses.
The fair value must be determined by reference to an
active market.

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Research and development costs 6


An active market is a 'market in which transactions for
the asset or liability take place with sufficient frequency
and volume to provide pricing information on an
ongoing basis' (IFRS 13).
It is uncommon for an active market to exist for
intangible assets because by their very nature they
tend to be unique.
Active markets do exist however for intangibles such as
freely transferable taxi licences and quotas.

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Research and development costs 7


Revaluations should be carried out sufficiently often so
that the carrying value of the intangible is not materially
different from its fair value at the end of the reporting
period.
Where intangibles are revalued all intangibles in the
same class must be revalued unless there is no active
market for them. In this case they would be recognised
according to the cost model.

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Research and development costs 8


Amortisation
Intangible assets with a finite useful life should be
amortised over their useful life.
The depreciable amount of an intangible is the cost /
revalued amount less residual value, although the residual
value is generally assumed to be zero.
Amortisation should begin when the asset is available for
use and the method used should reflect the pattern in
which the asset's future economic benefits are consumed.
The useful life and amortisation method used should be
reviewed at least every financial year end and adjusted
where necessary.
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Research and development costs 9


Amortisation (continued)
Intangible assets with an indefinite useful life should not be
amortised.
The appropriateness of the indefinite useful life assessment
should be reviewed each period to determine whether the
assessment is still appropriate.
Intangible assets with an indefinite useful life should be
subject to annual impairment reviews.

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Question: Stauffer
Stauffer is a public listed company reporting under IFRSs. It has asked
for your opinion on the accounting treatment of the following items.
(a) The Stauffer brand has become well known and has developed a
lot of customer loyalty since the company was set up eight years
ago. Recently, valuation consultants valued the brand for sale
purposes at $14.6m. Stauffer's directors are delighted and plan to
recognise the brand as an intangible asset in the financial
statements. They plan to report the gain in the revaluation surplus
as they feel that crediting it to profit or loss would be imprudent.
(b) On 1 October 20X5 the company was awarded one of 6 licences
issued by the government to operate a production facility for 5
years. A 'nominal' sum of $1m was paid for the licence, but its fair
value is actually $3m.

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Question: Stauffer (cont'd)


(c) The company undertook an expensive, but successful advertising
campaign during the year to promote a new product. The campaign
cost $1m, but the directors believe that the extra sales generated by
the campaign will be well in excess of that over its four year
expected useful life.
(d) Stauffer owns a 30-year patent which it acquired two years ago for
$8m which is being amortised over its remaining useful life of 16
years from acquisition. The product sold is performing much better
than expected. Stauffer's valuation consultants have valued its
current market price at $14m.

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Question: Stauffer (cont'd)


(e) On 1 August 20X6, Stauffer acquired a smaller company in the
same line of business. Included in the company's statement of
financial position was an in-process research and development
project, which showed promising results (and was the main reason
why Stauffer purchased the other company), but was awaiting
government approval. The project was included in the company's
own books at $3m at the acquisition date, while the company's net
assets were valued at a fair value of $12m (excluding the project).
Stauffer paid $18m for 100% of the company and the research and
development project was valued at $5m by Stauffer's valuation
consultants at that date. Government approval has now been
received, making the project worth $8m at Stauffer's year end.
Required
Explain how the directors should treat the above items in the financial
statements for the year ended 30 September 20X6.

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Answer: Stauffer
(a) Stauffer brand
The Stauffer brand is an 'internally generated' intangible asset
rather than a purchased one. IAS 38 specifically prohibits the
recognition of internally generated brands, on the grounds that
they cannot be reliably measured in the absence of a commercial
transaction. Stauffer will not therefore be able to recognise the
brand in its statement of financial position.

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Answer: Stauffer (cont'd)


(b) Licence
The licence is an intangible asset acquired by a government grant. It
can be accounted for in one of two ways:
The asset is recorded at the nominal price (cash paid) of $1m and
depreciated at $200,000 per annum of its five year life; or
The asset is recorded at its fair value of $3m and a government
grant is shown as deferred income at $2m. The asset is
depreciated over the five years at annual rate of $600,000 per
annum. The grant is amortised as income through profit or loss
over the same period at a rate of $400,000 per annum. This results
in the same net cost of $200,000 in profit or loss per annum as the
first method.

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Answer: Stauffer (cont'd)


(c) Advertising campaign
The advertising campaign is treated as an expense. Advertising
expenditure cannot be capitalised under IAS 38, as the economic
benefits it generates cannot be clearly identified so no intangible
asset is created.

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Answer: Stauffer (cont'd)


(d) Patent
The patent is amortised to a nil residual value at $500,000 per
annum based on its acquisition cost of $8m and remaining useful
life of 16 years.
The patent cannot be revalued under the IAS 38 rules as there is
no active market as a patent is unique. IAS 38 does not permit
revaluation without an active market as the value cannot be
reliably measured in the absence of a commercial transaction.

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Answer: Stauffer (cont'd)


(e) Acquisition
The difference between the price that Stauffer paid and the fair
value of the net assets of the acquired company will represent
goodwill.
The research and development project must also be valued at
fair value in a business combination to ensure the goodwill is
stated accurately, while in the acquiree's own financial
statements it would not be revalued as there is no active market
because it is unique.
Consequently, in a business combination IAS 38 requires
intangible assets that are separable or arise from contractual or
other legal rights that do not have an active market to be valued
using fair value measurement techniques (IFRS 13).

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Answer: Stauffer (cont'd)


(e) Acquisition (continued)
The values attributed in the group financial statements on the
acquisition date are therefore:
Net assets (excluding R&D project)
R&D project
Goodwill (remainder)
Purchase price

12

5
1
18

The fair value of the research and development project is measured


at the acquisition date, not at the year end and so it is not recorded at
$8m. The project will be amortised over the expected useful life of the
product developed once the product is available for production.

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Goodwill (IFRS 3) 1
Definition
Goodwill is the future economic benefits arising from
assets that are not capable of being individually
identified and separately recognised.
Arises due to factors such as an entity's reputation and
branding.
There are two types of goodwill:
Internally generated goodwill (IAS 38)
Purchased goodwill (IFRS 3) (Chapter 9)

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Goodwill (IFRS 3) 2
Goodwill
Purchased (IFRS 3)
Positive
Capitalise and test
annually for impairment
'Negative' (acquired net
assets exceed cost)
Reassess and then credit
any remainder to profit or
loss attributable to the
parent
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Internally generated
Not recognised in the books

Past exam questions


Nature of question
Intangibles have not been examined
specifically to date however they could
be tested in a financial statements
preparation question in terms of the
capitalisation and amortisation of
development costs.
This topic could now be examined by
MCQ.

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Exam details

Past exam questions


Nature of question

Exam details

Goodwill is examined in a group context


and you will be required to calculate
goodwill and account for any impairment
in relation to goodwill.

Consolidation
questions will be
either 15 or 30
marks.

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Chapter 6

IAS 36 Impairment of assets

Impairment of assets

Goodwill and the impairment of


assets

Cash generating units

Accounting treatment of an
impairment loss

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Syllabus learning outcomes 1


Define an impairment loss
Identify the circumstances that may indicate impairments
to assets
Describe what is meant by a cash generating unit
State the basis on which impairment losses should be
allocated, and allocate an impairment loss to the assets of
a cash generating unit

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Chapter summary diagram


Impairment of assets

After the
impairment
review

Recoverable
amount

Impairment
indicators

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Cash-generating
units

Recognition of
impairment
losses

IAS 36 Impairment of assets 1


IAS 36 aims to ensure that the carrying amount of
assets in the financial statements is not more than their
recoverable amount.
Carrying amount:
The value at which the asset is included in the
financial statements
Cost / valuation less accumulated depreciation and
impairment losses

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IAS 36 Impairment of assets 2

Recoverable amount
Higher of

Fair value less


costs to sell

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Value in
Use

IAS 36 Impairment of assets 3


Fair value less costs to sell:
The price that would be received to sell the asset in
an orderly transaction between market participants at
the measurement date
Less the direct incremental costs attributable to the
disposal of the asset
Value in use:
The present value of future cash flows expected to
be derived from the asset or cash-generating unit

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IAS 36 Impairment of assets 4


If the carrying value of an asset in the statement of
financial position is higher than the recoverable amount
of the asset then the asset is said to be impaired.
The impairment loss is the amount by which the
carrying amount exceeds the recoverable amount.
An entity should consider whether there are indications
that an asset might have been impaired at the end of
each reporting period.

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IAS 36 Impairment of assets 5


Impairment indicators external sources
Indicators that an asset's value has declined during the period
significantly more than would have been expected due to the passage of
time or normal use
Significant changes with an adverse effect on the entity in the
technological. Market, economic or legal environment in which the entity
operates
Increased market interest rates or other market rates of return affecting
discount rates and therefore reducing value in use
The carrying amount of the entity's net assets exceeds market
capitalisation

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IAS 36 Impairment of assets 6


Impairment indicators internal sources
Evidence of obsolescence or physical damage
Adverse changes to the asset's use
Internal evidence that the asset's performance will be worse than
expected

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Cash-generating units
Definition
Where it is not possible to estimate the recoverable
amount of an individual asset, an entity should
determine the recoverable amount of the cashgenerating unit to which the asset belongs.
A cash-generating unit is the smallest identifiable
group of assets that generates cash inflows that are
largely independent of the cash inflows from other
assets or groups of assets.

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Goodwill and the impairment of assets


Goodwill and corporate assets (such as a head office)
should be allocated to a cash-generating unit in order
to determine its carrying amount and recoverable
amount.
Where an impairment loss is allocated to reduce the
carrying amount of the assets in a cash-generating
unit, it will firstly be taken against any goodwill
allocated to the cash-generating unit.

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Accounting treatment of an impairment loss 1


It may be possible to identify a specific asset which has
suffered an impairment.
Where an individual asset is impaired:
If the asset is held at historic cost, the impairment loss
is recognised as an expense in profit or loss
If the asset is held at a revalued amount, the
impairment loss is charged:
Firstly to other comprehensive income (to remove
any previous revaluation surplus relating to the asset)
Any remainder is recognised as an expense in profit
or loss
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Accounting treatment of an impairment loss 2


Where a cash-generating unit is impaired, the impairment
loss is allocated in the following order.
Firstly to an goodwill allocated to the cash-generating
unit
Then to the other assets of the unit on a pro-rata basis
based on the carrying amount of each asset in the
cash-generating unit

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Accounting treatment of an impairment loss 3


After the recognition of an impairment loss the asset's
carrying value should be depreciated/amortised over its
remaining useful life.

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Question: Invest
On 31 December 20X1 Invest purchased all the shares of MH for $2
million. The net fair value of the identifiable assets acquired and
liabilities assumed of MH at that date was $1.8 million.
MH made a loss in the year ended 31 December 20X2 and at 31
December 20X2 the net assets of MH based on fair values at 1
January 20X2 were as follows.
$'000
Property, plant and equipment

1,300

Capitalised development expenditure


Net current assets

250
1,750

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200

Question: Invest (cont'd)


An impairment review on 31 December 20X2 indicated that the
recoverable amount of MH at that date was $1.5 million.
The capitalised development expenditure has no ascertainable
external market value and the current fair value less costs of disposal
of the property, plant and equipment is $1,120,000.
Value in use could not be determined separately for these two items.

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Question: Invest (cont'd)


Required
Calculate the impairment loss that would arise in the consolidated
financial statements of Invest as a result of the impairment review of
MH at 31 December 20X2 and show how the impairment loss would
be allocated.

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Answer: Invest
Asset values
at 31.12.X2
before
impairment
$'000 $'000 $'000 Goodwill
(2,000 1,800)
200
PPE
1,300
Development exp.
200
Net current assets
250
1,950

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Allocation of
impairment
loss
(W1)/(W2)

Carrying
amount
after
imp. loss

Answer: Invest (cont'd)


(W1) Calculation
of impairment loss
$'000
Carrying value (1,750 + 200 (GW))
Recoverable amount

(1,500)

450
Impairment loss to write off goodwill 200
Impairment loss to write off other assets
on a pro-rata basis

BPP LEARNING MEDIA

250

1,950

Answer: Invest (cont'd)


Asset values
at 31.12.X2
before
impairment
$'000

$'000 $'000
Goodwill
(2,000 1,800)
PPE
Dev exp
Net current assets

BPP LEARNING MEDIA

200
1,300
200
250
1,950

Allocation of
impairment
loss
(W1)/ (W2)
(200)

Carrying
amount
after
imp. loss

Answer: Invest (cont'd)


(W2) Allocation of impairment loss to other assets (pro-rata basis)

$'000
PPE (250 1,300 / 1,500)

1,083
217

Dev exp (250 200 / 1,500) 33


250

37

Loss
allocated
$'000
180
70
250

However, PPE cannot be reduced below FV CTS of


$1,120,000

BPP LEARNING MEDIA

Answer: Invest (cont'd)


Asset values
at 31.12.X2
before
impairment
$'000
Goodwill (2,000 1,800) 200
1,300
PPE
200
Dev. exp.
250
Net current assets
1,950

BPP LEARNING MEDIA

Allocation of
impairment
loss
(W1)/(W2)
$'000
(200)
(180)
(70)

(450)

Carrying
amount
after
imp. loss
$'000

1,120
130
250
1,500

Past exam questions


Nature of question

Exam details

Explain the meaning of an impairment


Q4 June 2012
review. Calculate the carrying amount of
assets after impairment losses.
The impairment of goodwill is often
examined in consolidated financial
statement questions.
These topics could now be examined by
MCQ or as part of a longer question in
section B.
BPP LEARNING MEDIA

Q1 all past exams


under pre-Dec
2014 format

Chapter 7
Reporting financial
performance

IAS 8 Accounting Policies,


Changes in Accounting Estimates
and Errors
Changes in accounting policies
Errors
IFRS 5 Non-current Assets Held
for Sale and Discontinued
Operations
IAS 10 Events After the Reporting
Period

BPP LEARNING MEDIA

Syllabus learning outcomes 1


Discuss the principle of comparability in accounting for
changes in accounting policies
Account for changes in accounting estimates, changes in
accounting policy and correction of prior period errors
Discuss the importance of identifying and reporting the
results of discontinued operations

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Syllabus learning outcomes 2


Define and account for non-current assets held for sale
and discontinued operations
Distinguish between and account for adjusting and nonadjusting events after the reporting date
Identify items requiring separate disclosure, including their
accounting treatment and required disclosures

BPP LEARNING MEDIA

Chapter summary diagram


Accounting Policies,
Changes in Estimates
and Errors (IAS 8)

Accounting policies

Reporting financial
performance

Prior period errors

Non-current Assets Held for


Sale and Discontinued
Operations (IFRS 5)

Changes in
accounting policies

Changes in
accounting estimates
BPP LEARNING MEDIA

Non-current assets
held for sale

Discontinued
operations

IAS 8 Accounting Policies, Changes in Estimates and Errors 1

IAS 8 addresses the following situations.


The selection and application of accounting policies
Changes in accounting policies
Changes in accounting estimates
Accounting for errors

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IAS 8 Accounting Policies, Changes in Estimates and Errors 2


Definition:

Accounting policies are the specific principles, bases, conventions,


rules and practices applied by an entity in preparing and presenting
the financial statements.

For example an entity may have the following accounting policy in


relation to its plant and equipment.
Plant and equipment are carried at historical cost less
accumulated depreciation and impairment losses with the
depreciation charge presented as part of cost of sales.

Also, an entity may have the following accounting policy in relation to


its buildings.
Buildings are carried at revalued amounts less accumulated
depreciation and impairment losses with the depreciation charge
presented as an administration expense.
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IAS 8 Accounting Policies, Changes in Estimates and Errors 3

Generally speaking the entity will determine its accounting policy for
each item in the financial statements by applying the requirements of
the relevant International Financial Reporting Standard.

Where there is no International Financial Reporting Standard relating


to a particular transaction or area then management should use their
judgement in order to develop and apply a policy which will result in
information in the financial statements that is relevant and reliable as
required by the Conceptual Framework for Financial Reporting.

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IAS 8 Accounting Policies, Changes in Estimates and Errors 4

Management should consider the following when making their


judgement.
The requirements of any International Financial Reporting
Standard which addresses any similar or related issues
The definitions, recognition criteria and measurement concepts
detailed in the Conceptual Framework for Financial Reporting
Any recent pronouncements of other standard setting bodies that
use a similar conceptual framework or accepted industry practices
Such bodies may include the IFRS Interpretations Committee or
the Accounting Standards Board in the United Kingdom.

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IAS 8 Accounting Policies, Changes in Estimates and Errors 5

Once an entity has selected an accounting policy it should be applied


consistently to all transactions of a similar nature during the same
accounting period.

The same accounting policies should be used by the entity year on


year in order to enhance the comparability of financial reporting.

An entity should not change its accounting policies without good


reason.

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Changes in accounting policies 1


A change in accounting policy should be only be made if:
The change is required by an International Financial
Reporting Standard; or
The change will result in the information in the financial
statements being reliable and more relevant.

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Changes in accounting policies 2


A good example of the first category is IAS 23 Borrowing
Costs.
Previously there were two allowed accounting treatments in
relation to borrowing costs: an entity could choose to
capitalise borrowing costs or an entity could choose to
recognise them as an expense in profit or loss.
The accounting standard was amended and withdrew the
choice to recognise borrowing costs as an expense.
Consequently any entity which had previously recognised
borrowing costs as an expense would need to change their
accounting policy and capitalise them.

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Changes in accounting policies 3


Accounting for changes in accounting policy
Unless the transitional provisions in the new International
Financial Reporting Standard prescribes otherwise, a change in
accounting policy must be made retrospectively.
This means that the entity will need to restate comparative
amounts for each prior period presented as if the accounting
policy had always been applied.
Essentially the entity would need to redraft the comparative
amounts using the current accounting policies.

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Changes in accounting policies 4


Accounting for changes in accounting policy (continued)
As well as restating the comparative amounts it is also
necessary to:
Adjust the opening balances of each affect component of
equity (often retained earnings) for the earliest prior period
presented
Include the adjustment to opening equity as the second line
of the statement of changes in equity

BPP LEARNING MEDIA

Changes in accounting policies 5


Disclosure requirements:
There are also key disclosures which need to be made in the
financial statements where there has been a change in
accounting policy and these are required so that the users of
the financial statements can fully understand the reason for and
the effect of the change.
The disclosures comprise:
The nature of the change in accounting policy
The reasons for the change
The amount of the adjustment for the current year and each
prior period presented for each line item affected
The amount of the adjustment to periods before those
presented
BPP LEARNING MEDIA

Question: Lecture example 1


STOCKER
DRAFT STATEMENT OF PROFIT OR LOSS AND OTHER COMPREHENSIVE INCOME
(SUMMARISED) FOR THE YEAR ENDED 31 DECEMBER 20X4
20x420X3
$'m $'m
Revenue 1,150

960

Cost of sales (1,002)


Gross profit

(720)

148 240

Operating expenses and income tax expense (130)


PROFIT FOR THE YEAR

18

(112)

128

Other comprehensive income for the year, net of tax

146 82

TOTAL COMPREHENSIVE INCOME FOR THE YEAR 164 210

BPP LEARNING MEDIA

Question: Lecture example 1 (cont'd)


DRAFT STATEMENT OF FINANCIAL POSITION (SUMMARISED) AS AT 31
DECEMBER 20X4
20X4
20X3
20X2
$'m $'m $'m
Non-current assets
2,660
2,378
2,190
Inventories 0 120 100
Other current assets 130 108 90
2,790
2,606
2,380
Share capital 200 200
Retained reserves
2,374
2,210
Liabilities
416 396
2,790
2,606

BPP LEARNING MEDIA

200
2,174
2,000
380
2,380

2,010

1,800

Question: Lecture example 1 (cont'd)


Stocker has traditionally used the FIFO method of valuing its interchangeable
inventories, which represent a large proportion of the entity's trading activities. Due to
the changing nature of its business and the nature of products sold, the company has
decided to switch to the weighted average method of valuation as the directors believe
it gives a more accurate inventory valuation for the new nature of the business,
effective for the first time for the year ended 31 December 20X4.
Inventory valuation (valuing interchangeable inventories on the weighted average
basis) is as follows.
20X4

20X3

20X2

$'m

$'m

$'m

Valuation

179

151

121

The closing inventory adjustment for 20X4 has not yet been made, but the opening
inventory adjustment re 20X3's stock balance has been made.
No dividends were paid in any of the three years. No adjustment to tax figures is
necessary as a result of the change in policy. No new share capital has been issued
since the company's incorporation.

BPP LEARNING MEDIA

Question: Lecture example 1(cont'd)


Required
Prepare the summarised statement of profit or loss and
other comprehensive income, statement of financial
position and statement of changes in equity for Stocker
Co for the year ended 31 December 20X4 in accordance
with IAS 8.

BPP LEARNING MEDIA

Answer: Lecture example 1 (cont'd)


Stocker Co
STATEMENT OF PROFIT OR LOSS AND OTHER COMPREHENSIVE
INCOME (SUMMARISED) FOR THE YEAR ENDED 31 DECEMBER 20X4

20X4

20X3
restated
$'m
$'m
Revenue
1,150
960
Cost of sales (1,002 179 + 31)/(720 31 + 21) (854)
(710)
Gross profit
296
250
Operating expenses and income tax expense
(130) (112)
PROFIT FOR THE YEAR
166
138
Other comprehensive income for the year, net of
146
82
tax
TOTAL COMPREHENSIVE INCOME FOR THE
312
220
YEAR
BPP LEARNING MEDIA

Answer: Lecture example 1 (cont'd)


Stocker Co
STATEMENT OF CHANGES IN EQUITY FOR THE YEAR ENDED 31
DECEMBER 20X4
Share
Retained Total
capital
reserves
$'m
$'m
$'m
Balance at 1 January 20X3
200
1,800
2,000
Change in accounting policy

21
21
Restated balance
200
1,821
2,021
Changes in equity for 20X3:
Total comprehensive income for the

220
220
year
Balance at 31 December 20X3
200
2,041
2,241
Changes in equity for 20X4:
Total comprehensive income for the

312
312
year
BPP LEARNING MEDIA

Answer: Lecture example 1 (cont'd)


Stocker Co
STATEMENT OF FINANCIAL POSITION (SUMMARISED) AS AT 31
DECEMBER 20X4
20X4
20X3
20X2
restated restated
$'m
$'m
$'m
Non-current assets
2,660
2,378
2,190
Inventories
179
151
121
Other current assets
130
108
90
2,969
2,637
2,401
Share capital
200
200
200
Retained reserves (2,174 + 179) /
2,353
2,041
1,821
(2,010 + 31) / (1,800 + 21)
2,553
2,241
2,021
Liabilities
416
396
380
2,969
2,637
2,401
BPP LEARNING MEDIA

Answer: Lecture example 1 (cont'd)


Working
1

Difference in inventory valuation

Weighted average
FIFO

BPP LEARNING MEDIA

20X4

20X3

20X2

$'m

$'m

$'m

179

151

121

(120)

(100)

179

31

21

Changes in accounting policies 6


Changes in accounting estimate
Definition
A change in accounting estimate is an adjustment of the carrying
amount of an asset or liability, or the amount of the periodic
consumption of an asset, that results from the assessment of the
present status of, and expected future benefits and obligations
associated with, assets and liabilities.

BPP LEARNING MEDIA

Changes in accounting policies 7


Changes in accounting estimate (continued)
Examples include:
Changes in the allowance for doubtful debts
Changes in adjustments for inventory obsolescence
Changes in the estimated useful lives/residual values of noncurrent assets
Changes in warranty obligations

BPP LEARNING MEDIA

Changes in accounting policies 8


Changes in accounting estimate (continued)
These changes result from new information or new
developments and as such they are not a correction of errors.
Changes in accounting estimate are applied prospectively.
This means that the change is made in the current accounting
period and to any future periods.
Some changes such as a change in the allowance for doubtful
debts only affects the current accounting period.
Whereas a change in the estimated useful life of a non-current
asset will affect both the current and future accounting periods.

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Changes in accounting policies 9


Changes in accounting estimate (continued)
Disclosure:
The nature and amount of changes in accounting estimates
that affect current and/or future periods must be disclosed

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Errors 1
Definition
Prior period errors are omissions from, and misstatements in, the
entity's financial statements for one or more prior periods arising
from a failure to use, or misuse of, reliable information that:
(a) Was available when the financial statements for those periods
were authorised for issue
(b) Could reasonably be expected to have been obtained and
taken into account in the preparation and presentation of those
financial statements

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Errors 2
Errors may arise from:
Mathematical mistakes
Errors in applying accounting policies
Oversights
Misinterpretation of the facts
Fraud

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Errors 3
Accounting treatment
Errors are accounted for retrospectively.
This is the same accounting treatment as for changes in
accounting policies.
The financial statements should be restated and
presented as if the error had never occurred.

BPP LEARNING MEDIA

IFRS 5 NCA Held for Sale and Discontinued Operations 1


Objective
IFRS 5 deals with two separate topics:
Non-current assets held for sale
Discontinued operations
IFRS 5 requires assets which management have decided to sell
to be measured and disclosed separately from other noncurrent assets.
It also requires separate disclosure of the results of
components of the business which will not recur in future years.
As such it aims to enhance the ability of users to make
predictions about the future profitability, cash flows and
financial position of an entity.
BPP LEARNING MEDIA

IFRS 5 NCA Held for Sale and Discontinued Operations 2


Assets held for sale
Non-current assets are held for sale if their carrying amount will
be recovered through the sale of the non-current asset rather
than through the asset's continuing use in the business.
In order to be classified as held for sale the following criteria
must be met:
The asset must be available for immediate sale in its
present condition
The sale must be highly probable
Where an asset satisfies these criteria it will be remeasured
and disclosed separately in the statement of financial position.

BPP LEARNING MEDIA

IFRS 5 NCA Held for Sale and Discontinued Operations 3


Measure the asset in accordance with the applicable IFRS (for example property,
plant and equipment held under the IAS 16 revaluation model is revalued)

Classify as held for sale, at the lower of:


Carrying amount
Fair value less costs to sell (FV CTS)

Do not provide any further depreciation/amortisation on the asset

Disclose separately under current assets on the face of the statement of financial
position

BPP LEARNING MEDIA

Question: Lecture example 2


A company has an asset with a carrying amount of
$150,000 at 1 January 20X3 held under the cost model
(cost $200,000) and being depreciated straight line over
an eight-year life to a nil residual value.
At 1 July 20X3, the company classifies the asset as held
for sale (and all necessary criteria are met).
At that date it is estimated that the asset could be sold for
$135,000 and that it would cost $1,000 to secure the sale.
Required
Show the required accounting treatment for the asset.

BPP LEARNING MEDIA

Answer: Lecture example 2


(1) Measure the asset in accordance with applicable IFRS. Here the
asset simply needs to be depreciated for the six months from 1
January 20X3 to 31 July 20X3.
At 1 July 20X3 the carrying amount of the asset is $137,500.
This is calculated by deducting the depreciation for the six
months from 1 January to 31 July from the carrying amount at 1
January 20X3 ($150,000 [$200,000 / 8 years 6/12]).
(2) Value the asset at the lower of its carrying amount ($137,500)
and its fair value less costs to sell.
Fair value less cost to sell is $134,000 ($135,000 $1,000).
Therefore the asset needs to be decreased in value by $3,500
($137,500 $134,000).

BPP LEARNING MEDIA

Answer: Lecture example 2 (cont'd)


(3) As the asset is measured at historic cost the loss of $3,500 is
recognised in profit or loss.
No further depreciation should be charged on the asset.
(4) The asset should be classified separately as a 'non-current asset
held for sale' under current assets and shown at a value of
$134,000.

BPP LEARNING MEDIA

IFRS 5 NCA Held for Sale and Discontinued Operations 4


Discontinued operations
Definition
A discontinued operation is a component of an entity that has either been
disposed of or is classified as held for sale and either:
(a) Represents a separate major line of business or geographical area
of operations;
(b) Is part of a single coordinated plan to dispose of a separate major
line of business or geographical area of operations; or
(c) Is a subsidiary acquired exclusively with a view to resale.
Note that a component of an entity is one whose operations and cash
flows can be clearly distinguished, operationally and for financial
reporting purposes, from the rest of the entity.
BPP LEARNING MEDIA

Discontinued example Vodafone


29. Disposals and discontinued operations
India Bharti Airtet Limited
On 9 May 2007 and in conjunction with the acquisition of Vodafone
Essar, the Group entered into a share sale and purchase agreement
in which a Bharti group company irrevocably agreed to purchase the
Group's 5.60% direct shareholding in Bharti Airtel Limited. During the
year ended 31 March 2008, the Group received 654 million in cash
consideration for 4.99% of such shareholding and recognised a net
gain on disposal of 250 million, reported in non-operating income
and expense. The Group's remaining 0.61% direct shareholding was
transferred in April 2008 for cash consideration of 87 million.

http://www.vodafone.com/content/dam/vodafone/investors/annual_reports/annual_report_accounts_2007.pdf

BPP LEARNING MEDIA

Discontinued example Vodafone (cont'd)


Japan Vodafone K.H.
On 17 March 2006, the Group announced an agreement to sell its
97.7% holding in Vodafone K.K. to SoftBank. The transaction
completed on 27 April 2006, with the Group receiving cash of
approximately 1.42 trillion (6.9 billion), inducing the repayment of
intercompany debt of 0.16 trillion (0.8 billion). In addition, the
Group received non-cash consideration with a fair value of
approximately 0.23 trillion (1.1 billion), comprised of preferred
equity and a subordinated loan. Softbank also assumed debt of
approximately 0.13 trillion (0.6 billion). Vodafone K.K. represented
a separate geographical area of operation and, on this basis,
Vodafone K.K. was treated as a discontinued operation in Vodafone
Group Plc's annual report for the year ended 31 March 2006.
http://www.vodafone.com/content/dam/vodafone/investors/annual_reports/annual_report_accounts_2007.pdf

BPP LEARNING MEDIA

Discontinued example Vodafone (cont'd)


Income statement and segment analysis of discontinued operations

Segment revenue
Inter-segment revenue
Net revenue
Operating expenses
Depreciation and amortization(1)
Impairment loss

2007

2006

520

520
(402)

7,268
(2)
7,266
(5,667)
(1,144)
(4,900)
(4,445)
(3)
(4,448)
7

Operating profit/(loss)
118
Net financing costs
8
Profit/(loss) before taxation
126
Taxation relating to performance of discontinued operations
(15)
Loss on disposal(2)
(747)

Notes:
Taxation
relating to the classification of the discontinued operations
145
(147)
(1) Including gains and losses on disposal of fixed assets.
(3)
(491) on (4,588)
Loss
for the794
financial
year from
discontinued
operations
(2) Includes
million foreign
exchange
difference transferred
to the income statement
disposal.

(3) Amount attributable to equity shareholders for the year to 31 March 2008 was nil (2007: (494) million;
2006: (4.598 million).
http://www.vodafone.com/content/dam/vodafone/investors/annual_reports/annual_report_accounts_2007.pdf
BPP LEARNING MEDIA

Discontinued example Vodafone (cont'd)


Loss per share from discontinued operations

Basic loss per share


Diluted loss per share

2007

2006

Pence

Pence

per share

per share

(0.90)

(7.35)

(0.90)

(7.35)

http://www.vodafone.com/content/dam/vodafone/investors/annual_reports/annual_report_accounts_2007.pdf

BPP LEARNING MEDIA

IFRS 5 NCA Held for Sale and Discontinued Operations 5


Discontinued operations (continued)
Disclosure required:
On the face of the statement of profit or loss and other comprehensive
income:
A single amount comprising the total of:
The post-tax profit or loss of the discontinued operations
The post-tax gain or loss recognised on the remeasurement to
fair value less costs to sell or the disposal of the assets held for
sale that relate to the discontinued operation

BPP LEARNING MEDIA

IFRS 5 NCA Held for Sale and Discontinued Operations 6


Discontinued operations (continued)
Disclosure required:
On the face of the statement of profit or loss and other comprehensive
income or in the notes the discontinued operation's:

Revenue

Expenses

Profit before tax

Income tax expense

Post-tax gain or loss on disposal recognised on the remeasurement to


fair value less costs to sell or the disposal of the assets held for sale
that relate to the discontinued operation

BPP LEARNING MEDIA

IFRS 5 NCA Held for Sale and Discontinued Operations 7


Minimum disclosure on the face:
XYZ GROUP STATEMENT OF PROFIT OR LOSS AND OTHER COMPREHENSIVE
INCOME FOR THE YEAR ENDED 31 DECEMBER 20X3

Revenue
Cost of sales
Gross profit
Other income
Distribution costs
Administrative expenses
Other expenses
Finance costs
Profit before tax
Income tax expense
Profit for the year from continuing operations
Loss for the year from discontinued operations
PROFIT FOR THE YEAR
Other
comprehensive income for the year, net of tax
BPP LEARNING MEDIA

20X3

20X2

$'000

$'000

X
(X)
X
X
(X)
(X)
(X)
(X)
X
(X)
X
(X)
X
X

X
(X)
X
X
(X)
(X)
(X)
(X)
X
(X)
X
(X)
X
X

IFRS 5 NCA Held for Sale and Discontinued Operations 8


In the notes:
On 1 October 20X2 the company entered into a plan to sell its toys manufacturing operations. The sale
was completed on 30 June 20X3 and the toys manufacturing business is reported as a discontinued
operation for 20X2 and 20X3.
The results of the discontinued operation were as follows.

BPP LEARNING MEDIA

IFRS 5 NCA Held for Sale and Discontinued Operations 8


In the notes:
On 1 October 20X2 the company entered into a plan to sell its toys manufacturing operations. The sale
was completed on 30 June 20X3 and the toys manufacturing business is reported as a discontinued
operation for 20X2 and 20X3.
The results of the discontinued operation were as follows:

Revenue
Cost of sales
Gross profit
Other income
Distribution costs
Administrative expenses
Other expenses
Finance costs
Loss before tax
Income tax expense
Loss after tax
Post-tax gain on remeasurement and disposal of assets and disposal
groups
LOSS FOR THE YEAR
BPP LEARNING MEDIA

20X3

20X2

$'000

$'000

X
(X)
X
X
(X)
(X)
(X)
(X)
(X)
X
(X)

X
(X)
X
X
(X)
(X)
(X)
(X)
(X)
X
(X)

(X)

(X)

Question: Lecture example 3


A&Z
STATEMENT OF PROFIT OR LOSS AND OTHER COMPREHENSIVE INCOME
FOR THE YEAR ENDED 31 DECEMBER 20X1

Revenue
Cost of sales
Gross profit
Distribution costs
Administrative expenses
Profit before tax
Income tax expense
PROFIT FOR THE YEAR
Other comprehensive income for the year, net of tax
TOTAL COMPREHENSIVE INCOME FOR THE YEAR
BPP LEARNING MEDIA

20X1

20X0

$'000
3,000
(1,000)
2,000
(400)
(900)

700
(210)

490

40

530

$'000
2,200
(700)
1,500
(300)
(800)
400
(120)
280
30
310

Question: Lecture example 3 (cont'd)


During the year the company ran down a material business operation with all activities
ceasing on 26 December 20X1. The results of the operation for 20X0 and 20X1 were as
follows.

Revenue
Cost of sales
Gross profit
Distribution costs
Administrative expenses
Loss before tax
Income tax expense
LOSS FOR THE YEAR
Other comprehensive income for the year, net of tax
TOTAL COMPREHENSIVE INCOME FOR THE YEAR

BPP LEARNING MEDIA

20X1

20X0

$'000

$'000

320
(150)
170
(120)
(100)
(50)
15
(35)
5
(30)

400
(190)
210
(130)
(90)
(10)
3
(7)
4
(3)

Question: Lecture example 3 (cont'd)


The company recognised a loss of $30,000 on initial
classification of the assets of the discontinued operation as
held for sale, followed by a subsequent gain of $120,000 on
their disposal in 20X1. These have been netted against
administrative expenses. The income tax rate applicable to
profits on continuing operations and tax savings on the
discontinued operation's losses is 30%.

BPP LEARNING MEDIA

Question: Lecture example 3 (cont'd)


Required
Prepare the statement of profit or loss and other
comprehensive income for the year ended 31 December
20X1 for A&Z Co complying with the provisions of IFRS 5.

BPP LEARNING MEDIA

Answer: Lecture example 3


A&Z Co
STATEMENT OF PROFIT OR LOSS AND OTHER COMPREHENSIVE
INCOME FOR THE YEAR ENDED 31 DECEMBER 20X1 20X1 20X0
$'000
Revenue (3,000 320) / (2,200 400)
Cost of sales (1,000 150) / (700 190)
Gross profit
Distribution costs (400 120) / (300 130)
Administrative expenses (900 100) / (800 90)
Profit before tax
Income tax expense (210 + 15) / (120 + 3)
Profit for the year from continuing operations
Loss for the year from discontinued operations
PROFIT FOR THE YEAR
Other comprehensive income for the year, net of tax
TOTAL COMPREHENSIVE INCOME FOR THE YEAR
BPP LEARNING MEDIA

$'000

2,680 1,800
(850) (510)
1,830 1,290
(280) (170)
(800) (710)
750
410
(225) (123)
525
287
(35)
(7)
490
280
40
30
530
310

Answer: Lecture example 3 (cont'd)


Note. Discontinued operations
During the year the company ran down a material business operation with all
activities ceasing on 26 December 20X1. The results of the operation were as
follows.
20X1
20X0
Revenue
Cost of sales
Gross profit
Distribution costs
Administrative expenses (100 + 90)
Loss before tax
Income tax expense (15 + (90 30%))
Loss after tax
Post-tax gain on remeasurement and subsequent
disposal of assets classified as held for sale (90 70%)
LOSS FOR THE YEAR
Other comprehensive income for the year, net of tax
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TOTAL
COMPREHENSIVE INCOME FOR THE YEAR

$'000
320
(150)
170
(120)
(190)
(140)
42
(98)

$'000
400
(190)
210
(130)
(90)
(10)
3
(7)

63
(35)
5
(30)


(7)
4
(3)

IAS 10 Events after the Reporting Period 1


Definition
Events after the reporting period are those events, both favourable and
unfavourable, that occur between the end of the reporting period and the
date when the financial statements are authorised for issue.
There are two types of event after the reporting period:
Adjusting events:
These provide evidence of conditions which existed at the end of
the reporting period.

Non-adjusting events:
These relate to conditions which arose after the reporting period.

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IAS 10 Events after the Reporting Period 2


Adjusting events

Examples of adjusting events include:


Insolvency of a customer with a balance owing at the reporting
period
Sale of inventory after the reporting period for less than its carrying
value at the end of the reporting period
Evidence of an impairment of a non-current asset prior to the end
of the reporting period
The outcome of a legal case which was provided for at the
reporting period
Discovery of fraud or errors which shows that the financial
statements were incorrect

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IAS 10 Events after the Reporting Period 3


Adjusting events

The financial statements should be amended to include the effect of


adjusting events.

This is likely to require the recognition of a loss in profit or loss.

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IAS 10 Events after the Reporting Period 4


Non-adjusting events
Examples of non-adjusting events include:
Announcement of a plan to discontinue an operation
Share transactions after the reporting period
Major purchases and disposals of assets
Litigation commenced after the reporting period
The acquisition of or disposal of a subsidiary after the
reporting period

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IAS 10 Events after the Reporting Period 5


Non-adjusting events
The nature of the event and an estimate of the
financial effect is disclosed in financial statements.
This assumes that the non-adjusting event is material to
the financial statements.

BPP LEARNING MEDIA

Past exam questions


Nature of question

Exam details

Calculations relating to non-current


assets held for sale and application of
knowledge to a scenario.

Q4 June 2013
Q5 Dec 2010
Q2 June 2010

Define discontinued operations, state


why the disclosure is important and
calculate relevant amounts .

Q4 June 2013
Q5 Dec 2010

These topics are likely to appear in


single-company accounts preparation
questions.

Could also be
examined by
MCQ.

BPP LEARNING MEDIA

Chapter 8
Introduction to
groups

Group accounts
Consolidated and separate
financial statements
Content of group accounts and
group structure
Group accounts: the related
parties issue

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Syllabus learning outcomes 1


Describe the concept of a group as a single economic unit
Explain and apply the definition of a subsidiary within
relevant accounting standards
Identify and outline using accounting standards and other
applicable regulation the circumstances in which a group is
required to prepare consolidated financial statements

BPP LEARNING MEDIA

Syllabus learning outcomes 2


Describe the circumstances when a group may claim
exemption from the preparation of consolidated financial
statements
Explain why directors may not wish to consolidate a
subsidiary and when this is permitted by accounting
standards and other applicable regulation
Explain the need for using coterminous year ends and
uniform accounting policies when preparing consolidated
financial statements

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Syllabus learning outcomes 3


Explain the objective of consolidated financial statements
Explain why it is necessary to eliminate intra group
transactions

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Chapter summary diagram


Introduction to groups

Concept

Parent's separate
financial statements

Group financial
statements

Non-controlling interests
and mid-year acquisitions

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Definition of a
subsidiary

Group accounts 1

Companies may grow organically or by acquisition.

Where companies grow by acquisition they acquire control of


other companies as below.
Shareholders
ABC Holdings plc
100%
ABC Professional
Services Ltd

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95%
ABC International
Ltd

51%
ABC Online
Services Ltd

Group accounts 2
The method used to account for the acquisition of
shares by one company in another company depends
on the type and extent of the investment acquired.
Principal terms to be aware of are:
Investments in subsidiaries
Investments in associates

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Group accounts 3
Definitions
Subsidiary: an entity that is controlled by another entity.
Control: an investor controls an investee if and only if the
investor has all of the following.
Power over the investee
Exposure, or has rights, to variable returns from its
involvement with the investee
The ability to affect those returns through its power over
the investee

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Group accounts 4
Definitions (continued)

Examples of rights that, either individually or in combination, can give


an investor power include:
Rights in the form of voting rights (or potential voting rights) of an
investee
Rights to appoint, reassign or remove members of an investee's key
management personnel who have the ability to direct the relevant
activities
Rights to appoint or remove another entity that directs the relevant
activities
Rights to direct the investee to enter into, or veto any changes to,
transactions for the benefit of the investor
Other rights (such as decision making rights specified in a
management contract) that give the holder the ability to direct the
relevant activities
BPP LEARNING MEDIA

Group accounts 6
Definitions (continued)
Parent: an entity that controls one or more subsidiaries.
Group: a parent and all its subsidiaries.
Associate: an entity over which an investor has
significant influence and which is neither a subsidiary
nor an interest in a joint venture.
Significant influence: the power to participate in the
financial and operating policy decisions of an investee
but not control or joint control over those policies.

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Group accounts 7
The different types of investment and the required
accounting treatment in both the parent's individual
(separate) financial statements and the group financial
statements is explained over the next few chapters.
It is also summarised as follows.
Investment

Criteria

Required treatment in group accounts

Subsidiary

Control (>50% rule)

Full consolidation (IFRS 10)

Associate

Significant influence

Equity accounting (IAS 28)

(20% + rule)
Investment

Asset held for

which is none of accretion of wealth


the above
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As for single company accounts (IFRS 9)

Question: Control?
Which one (or more) of the following would be accounted for as a
subsidiary of A?
(1) A holds no shares in B; however through an agreement with B's
shareholders, A chooses 6 of the 10 Board members.
(2) A owns 45% of C's shares. No other individual shareholder owns
more than 5%.
(3) A owns 55% of D's shares. Under an contract in place, A must make
all decisions in agreement with E, who owns 45% of the shares.
(4) A controls F, a partnership, under an agreement.

BPP LEARNING MEDIA

Answer: Control?
Which one (or more) of the following would be accounted for as a
subsidiary of A?
(1) A holds no shares in B; however through an agreement with B's
shareholders, A chooses 6 of the 10 Board members
(2) A owns 45% of C's shares. No other individual shareholder owns
more than 5%.
(3) A owns 55% of D's shares. Under an contract in place, A must make
all decisions in agreement with E, who owns 45% of the shares.
(4) A controls F, a partnership, under an agreement.

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Consolidated and separate financial statements 1

When a parent entity acquires control of a subsidiary it acquires


the company's shares rather than its individual assets and
liabilities.

Both the parent and the subsidiary continue to exist as separate


legal entities and are required to produce financial statements at
the end of each reporting period.

Under IAS 27 the investment in the subsidiary can be recorded in


the parent's separate financial statements either:
At cost; or
At fair value

In ACCA paper F7, the investment is recorded at cost.

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Consolidated and separate financial statements 2


Requirement to produce group accounts

This does not provide the parent's shareholders with complete


information about the parent and so the parent is required to
produce an additional set of financial statements called group or
consolidated financial statements.

These:
Present the results and financial position of the group as if it
were a single entity
Are issued to the shareholders of the parent
Provide information about all companies controlled by the
parent

This is an example of recording the substance of a relationship


rather than its strict legal form.

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Consolidated and separate financial statements 3


Exemption from producing group accounts

A parent does not need to present group accounts if and only if all
of the following are present.
The parent is itself a wholly-owned subsidiary or a partially
owned subsidiary of another entity and the owners do not
object to the parent not presenting consolidated financial
statements.
Its securities are not publically traded.
It is not in the process of issuing securities in public securities
markets.
The ultimate or intermediate parent publishes consolidated
financial statements that comply with IFRSs.

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Consolidated and separate financial statements 4


Other issues

A subsidiary cannot be excluded from consolidation on the


grounds that control is intended to be temporary or that the
activities are dissimilar as disclosure under IFRS 5 and IFRS 8
can overcome this.

All group companies should have the same reporting date. The
financial statements of a subsidiary with a non-coterminous year
end may be consolidated provided that the gap between reporting
dates is three months or less and adjustments are made for the
effects of significant transactions or events that occur between the
two reporting periods.

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Consolidated and separate financial statements 5


Other issues (continued)

The consolidated financial statements should be prepared using


uniform accounting policies (the parent's policies).

The results of subsidiaries should be consolidated for all periods


when the parent has control.

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Content of group accounts and group structure 1


Group accounts show the results and financial position
of all companies controlled by the parent.
In simple terms consolidated accounts are produced by
adding together the assets and liabilities of the parent
company and each subsidiary.
If the parent company has control, all of the assets and
liabilities are added together even if the parent does
not own 100% of the subsidiary.

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Content of group accounts and group structure 2


The 'equity' section of the statement of financial
position indicates the actual equity (share capital and
reserves) owned by the parent's shareholders.
Where a subsidiary is not 100% owned by the parent
there will be an account within the equity section
showing how much of the subsidiary's net assets are
owned by outside investors.
These outside investors are called the 'non-controlling
interest'.
Definition: non-controlling interest is the equity in a
subsidiary not attributable, directly or indirectly, to a
parent.
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Content of group accounts and group structure 3

P Co controls S Co
because it has > 50%
of voting power
although it does not
own all of S Co

P Co
80%

S Co
Eg if S Co pays a $100 dividend:
P Co receives $80
The non-controlling interest receive $20

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Group accounts the related parties issue 1


Two parties are related under IAS 24 if one party can
exercise control over another.
Consequently a parent and its subsidiary are presumed
related parties.
Sometimes transactions between related parties may not
be at 'arm's length' especially where one party uses their
control over the other to force trade to happen at noncommercial rates.
Disclosure must be made of material related party
transactions in the separate financial statements of both
the parent and the subsidiary.

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Group accounts the related parties issue 2


This disclosure will highlight:
If the subsidiary sells to the parent at an artificially low
rate, thus reducing the subsidiary's profit and increasing
the parent's profit
If a parent sells to a subsidiary at an artificially high
price (same effect as above)
If inter-company loans are at artificially low rates; and
If assets are sold between group companies at an
amount in excess of carrying amount

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Group accounts the related parties issue 3


In the group or consolidated financial statements, intercompany transactions are cancelled and so there is much
less disclosure concerning related parties.
Therefore in order to assess the relative strengths and
weaknesses of the subsidiary an investor should reviewed
the subsidiary's separate financial statements as
information about trading, loans and asset transfers which
are not on commercial terms will only be made in the
subsidiary's financial statements.

BPP LEARNING MEDIA

Past exam questions


Nature of question

Exam details

Written requirements relating to the


concept of a group and how it is an
illustration of substance over form.

Q1 June 2011

This is now most likely to be examined


by MCQ.

BPP LEARNING MEDIA

Chapter 9
The consolidated
statement of financial
position

IFRS 10: summary of consolidation


procedures
Non-controlling interests
Dividends paid by a subsidiary
Goodwill arising on consolidation
Non-controlling interest at fair value
Intra-group trading
Intra-group sales of non-current
assets
Summary: consolidated statement of
financial position
Acquisition of a subsidiary during its
accounting period
Fair values in acquisition accounting

BPP LEARNING MEDIA

Syllabus learning outcomes 1


Explain why it is necessary to eliminate intra-group
transactions
Describe and apply the required accounting treatment of
consolidated goodwill
Explain why it is necessary to use fair values for the
consideration of an investment in a subsidiary together
with the fair values of a subsidiary's identifiable assets and
liabilities when preparing consolidated financial statements

BPP LEARNING MEDIA

Syllabus learning outcomes 2


Prepare a consolidated statement of financial position for a
simple group (parent and one subsidiary) dealing with pre
and post acquisition profits, non-controlling interests and
consolidated goodwill
Explain and account for other reserves (eg share premium
and revaluation reserves)
Account for the effects (in the financial statements) of intragroup trading

BPP LEARNING MEDIA

Syllabus Guide detailed outcomes 3


Account for the effects of fair value adjustments (including
their effect on consolidated goodwill) to depreciating and
non-depreciating non-current assets; inventory; monetary
liabilities and assets and liabilities not included in the
subsidiary's own statement of financial position, including
contingent assets and liabilities
Account for goodwill impairment

BPP LEARNING MEDIA

Chapter summary diagram


Types of investment
Approach to the
consolidated
statement of
financial position

The consolidated
statement of financial
position
Other reserves

Exemption from
preparing
consolidated
financial statements
The effect of related
party transactions

Goodwill and fair


values

Intragroup trading

Calculation of fair
values

Inventories sold at a
profit

Consideration
transferred

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Fair value of
identifiable assets,
acquired and
liabilities assumed

Transfer of property,
plant and
equipment

IFRS 10: summary of consolidation procedures


The aim of the consolidated financial statements is to
show the results and financial position of a parent and
its subsidiaries as if they were one single entity.
Given that the parent has control over its subsidiaries,
their assets, liabilities, equity, income and expenses
are added together on a line-by-line basis albeit with
some consolidation adjustments.
It is important to follow a step by step approach to
consolidation questions.
We will see this build through the examples in this
course.

BPP LEARNING MEDIA

Question: Lecture example 1


At 31 December 20X4 the statements of financial position of Portus and Sanus were as follows.
Portus
$'000

Sanus
$'000

Non-current assets
Property, plant and equipment
Investment in Sanus (at cost)

56,600
13,800
70,400

16,200

16,200

2,900
3,300
1,700
7,900

1,200
1,100
100
2,400

78,300

18,600

8,000
54,100
62,100

2,400
10,600
13,000

Current assets
Inventories
Trade receivables
Cash

Equity
Share capital ($1 shares)
Reserves

Note:

1
On 31 December
20X4 Portus purchased a 100% holding in Sanus for $13.8m in cash.
Non-current
liabilities
Long-term borrowings
BPP LEARNING MEDIA

13,200

4,800

Question: Lecture example 1 (cont'd)


Required
Prepare the consolidated statement of financial position of the Portus
Group as at 31 December 20X4.
Method:
(a) Cancel the investment in Sanus in Portus' books with the share
capital and reserves in Sanus' books (at the date of acquisition).
Any difference on cancellation is goodwill.
(b) Aggregate the two statements of financial position.

BPP LEARNING MEDIA

Answer: Lecture example 1


Portus Group
CONSOLIDATED STATEMENT OF FINANCIAL POSITION AS AT 31 DECEMBER 20X4
$'000
Non-current assets
Property, plant and equipment (56,600 + 16,200)
Goodwill (W2)

72,800
800
73,600

Current assets
Inventories (2,900 + 1,200)
Trade receivables (3,300 + 1,100)
Cash (1,700 + 100)

4,100
4,400
1,800
10,300
83,900

BPP LEARNING MEDIA

Answer: Lecture example 1 (cont'd)

Equity attributable to owners of the parent


Share capital ($1 shares)
Reserves (W3)

8,000
54,100
62,100

Non-current liabilities
Long-term borrowings (13,200 + 4,800)

18,000

Current liabilities
Trade and other payables (3,000 + 800)

BPP LEARNING MEDIA

3,800
83,900

Answer: Lecture example 1 (cont'd)


Workings
1

Group structure
Portus
31.12.X4
100%
Cost $13.8m
Sanus
Pre acquisition
reserves

BPP LEARNING MEDIA

$10.6m

Answer: Lecture example 1 (cont'd)


2

Goodwill

$'000
Consideration transferred
Less:

$'000
13,800

Fair value of identifiable net assets at acquisition:


Share capital
Reserves

2,400
10,600
(13,000)
800

BPP LEARNING MEDIA

Answer: Lecture example 1 (cont'd)


3

Consolidated reserves (proof)

Per question
Pre-acquisition reserves

Portus

Sanus

$'000

$'000

54,100

10,600
(10,600)
0

Group share of post acquisition reserves:


Sanus (0 100%)

0
54,100

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Non-controlling interests 1
In Lecture example 1 Portus acquired 100% of Sanus
and we saw how the consolidated statement of
financial position would look immediately after the
acquisition.
In exam questions and in reality is it unlikely that a
parent will own 100% of the subsidiary.
Remember that you don't need to own 100% of a
company to control it.
Where a parent owns less than 100% of a subsidiary,
the portion not owned by the parent belongs to the
non-controlling interest.

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Non-controlling interests 2

P Co controls S Co
because it has > 50%
of voting power
although it does not
own all of S Co

P Co
80%

S Co
Eg if S Co pays a $100 dividend:
P Co receives $80
The non-controlling interest receive $20

BPP LEARNING MEDIA

Non-controlling interests 3
Consolidation method
(a) Aggregate the assets and liabilities on the statement of financial position ie
100% P + 100% S irrespective of how much P actually owns.
This shows the amount of net assets controlled by the group.
(b) Share capital (and share premium if any) is that of the parent only.
(c) Calculate goodwill using the standard working.
Consideration transferred

Non-controlling interests at acquisition

Net assets at acquisition represented by:


Share capital

Reserves

X
(X)

Goodwill at acquisition

BPP LEARNING MEDIA

Non-controlling interests 4
Consolidation method (continued)
(d) Calculate consolidated reserves

Per question
Pre-acquisition reserves

Parent

Subsidiary

X
(X)
Y

Group share of postacquisition reserves:


Subsidiary (Y %)

X
X

BPP LEARNING MEDIA

Non-controlling interests 5
Consolidation method (continued)
(e) Calculate non-controlling interests ie the extent to which assets and liabilities
have been consolidated in the consolidated statement of financial position but
are not owned by the group.
NCI at acquisition
NCI share of post acquisition reserves (Y NCI%)

X
(X)
X

BPP LEARNING MEDIA

Non-controlling interests 6
Mid year acquisitions

Again in Lecture example 1 Portus acquired 100% of Sanus and


this transaction occurred at the end of the reporting period when
Sanus had produced a statement of financial position. This
enabled us to calculate the reserves at acquisition (pre-acquisition
reserves) and therefore only consolidate the post-acquisition
reserves.

Also in exam questions and in reality is it unlikely that the


acquisition will happen at the end of the reporting period when a
statement of financial position is readily available and so you will
need to calculate the pre-acquisition reserves.

BPP LEARNING MEDIA

Non-controlling interests 7
Rule for mid year acquisitions

When calculating the reserves at the date of acquisition assume


that the subsidiary's profits accrue evenly throughout the period.

Therefore if the year end is 31 December and the subsidiary was


acquired on 1 April, the reserves at the date of acquisition would
be:
The cumulative reserves brought forward at 31 December in
the previous year plus 3/12 of the profit for the year; or
The cumulative reserves carried forward at 31 December the
end of the current year less 9/12 of the profit for the year.

BPP LEARNING MEDIA

Question: Lecture example 2


At 31 December 20X4 the statements of financial position of Portus and Sanus were as follows:
Portus

Sanus

$'000

$'000

56,600
13,800
70,400

16,200

16,200

Non-current assets
Property, plant and equipment
Investment in Sanus (at cost)
Current assets
Inventories
Trade receivables
Cash

2,900
3,300
1,700
7,900

1,200
1,100
100
2,400

78,300

18,600

8,000
54,100
62,100

2,400
10,600
13,000

Equity
Share capital ($1 shares)
Reserves
Non-current liabilities
BPP LEARNING MEDIA

Question: Lecture example 2 (cont'd)


Notes
1 On 1 April 20X4 Portus purchased a 80% holding in
Sanus for $13.8m in cash. Sanus' total comprehensive
income for the year ended 31 December 20X4 was
$2.0m, accruing evenly over the year. Sanus did not
pay any dividends in the year.
2 The non-controlling interest in Sanus is to be valued at its
fair value of $3.2m at the date of acquisition.

BPP LEARNING MEDIA

Question: Lecture example 2 (cont'd)


Required
Prepare the consolidated statement of financial position of
the Portus Group as at 31 December 20X4 (incorporating
the changes from the previous example identified in bold
text).

BPP LEARNING MEDIA

Answer: Lecture example 2


Portus Group
CONSOLIDATED STATEMENT OF FINANCIAL POSITION AS AT 31 DECEMBER 20X4

$'000
Non-current assets
Property, plant and equipment (56,600 + 16,200)
Goodwill (W2)

Current assets

72,800
5,500
78,300

Inventories (2,900 + 1,200)


Trade receivables (3,300 + 1,100)
Cash (1,700 + 100)

4,100
4,400
1,800
10,300
88,600

BPP LEARNING MEDIA

Answer: Lecture example 2 (cont'd)


Equity attributable to owners of the parent
Share capital ($1 shares)
Reserves (W3)

Non-controlling interests (W4)


Non- current liabilities
Long-term borrowings (13,200 + 4,800)
Current liabilities
Trade and other payables (3,000 + 800)

BPP LEARNING MEDIA

8,000
55,300
63,300
3,500
66,800
18,000

3,800
88,600

Answer: Lecture example 2 (cont'd)


Workings
1

Group structure
Portus
1.4.X4
80%
Cost

$13.8m
Sanus

Pre acquisition
reserves

$9.1m

($10.6m ($2.0m 9/12))


or ($10.6m $2.0m + ($2.0 3/12))

BPP LEARNING MEDIA

Answer: Lecture example 2 (cont'd)


2

Goodwill

$'000
Consideration transferred

13,800

Non-controlling interests (at fair value)


Less:

$'000
3,200

Fair value of identifiable net assets at acquisition:


Share capital

2,400

Reserves (10,600 (2,000 9/12))

9,100
(11,500)
5,500

BPP LEARNING MEDIA

Answer: Lecture example 2 (cont'd)


3

Consolidated reserves

Per question
Pre-acquisition reserves (10,600 (2,000 9/12))

Portus

Sanus

$'000

$'000

54,100

10,600
(9,100)
1,500

Group share of post acquisition reserves:


Sanus (1,500 80%)

1,200
55,300

BPP LEARNING MEDIA

Answer: Lecture example 2 (cont'd)


4

Non-controlling interests
$'000
NCI at acquisition (W2)
NCI share of post acquisition reserves ((W3) 1,500 20%)

3,200
300
3,500

BPP LEARNING MEDIA

Dividends paid by a subsidiary 1


When a subsidiary pays a dividend during the year it is
important that the subsidiary has fully accounted for the
dividend and that any intra-group amounts paid to the
parent are eliminated on consolidation.
The dividend will reduce the subsidiary's retained
earnings.
The element paid to the non-controlling interest will
have left the group and will not appear in the
consolidated statement of financial position.
The element received by the parent will be cancelled on
consolidation.

BPP LEARNING MEDIA

Dividends paid by a subsidiary 2


The remaining balance on the subsidiary's retained
earnings will be consolidated in the usual way:
The percentage of post-acquisition retained earnings
owned by the parent will be added onto the
consolidated retained earnings.
The percentage of post-acquisition retained earnings
will be added onto the amount for non-controlling
interest in the consolidated statement of financial
position.

BPP LEARNING MEDIA

Goodwill arising on consolidation 1


Definition

Goodwill is the excess of the consideration transferred plus the


amount of non-controlling interest over the fair value of the net assets
of the subsidiary.

It is calculated as:
$

Consideration transferred (cost of investment)

Non-controlling interests (NCI)

Less net acquisition-date fair value of identifiable


assets acquired and liabilities assumed

(X)
X

BPP LEARNING MEDIA

Goodwill arising on consolidation 2


Fair value definition (IFRS 13)

The price that would be received to sell an asset or paid to transfer a


liability in an orderly transaction between market participants at the
measurement date.

BPP LEARNING MEDIA

Goodwill arising on consolidation 3


Goodwill
Purchased (IFRS 3)
Positive
Capitalise and test annually
for impairment
'Negative' (acquired net assets
exceed cost)
Reassess and then credit any
remainder to profit or loss
attributable to the parent

BPP LEARNING MEDIA

Internally generated
Not recognised in the books

Goodwill arising on consolidation 4


Fair value of identifiable assets acquired and liabilities
assumed
Many entities use the cost model to account for assets and so
the assets and liabilities in an entity's own financial statements
are often not stated at their fair value.
If the subsidiary's financial statements are not adjusted to their
fair values, where, for example, an asset's value has risen since
it was originally purchased, goodwill would be overstated (as it
would include the increase in value of the asset).

BPP LEARNING MEDIA

Goodwill arising on consolidation 5


Fair value of identifiable assets acquired and liabilities
assumed (continued)
Therefore IFRS 3 requires the identifiable assets acquired and
liabilities assumed of subsidiaries to be brought into the
consolidated financial statements at their fair value rather
than their book value.
The difference between fair values and book values is a
consolidation adjustment made only for the purposes of the
consolidated financial statements.

BPP LEARNING MEDIA

Goodwill arising on consolidation 6


Fair value of consideration transferred
The consideration transferred (which is the same as the figure
recorded as the cost of the investment in the parent's separate
financial statements) is also measured at fair value and is
calculated as the acquisition-date fair values of:
The assets transferred by the acquirer
The liabilities incurred by the acquirer (to former owners of
the acquiree)
Equity interests issued by the acquirer (fair value = market
value)
Costs involved in the transaction are charged to profit or loss.

BPP LEARNING MEDIA

Goodwill arising on consolidation 7


Consideration transferred can also include:
Deferred consideration:
Consideration that is to be paid in the future
Discount the amount to present value to calculate fair
value
Contingent consideration:
Consideration which may be payable dependent on
whether specified future events occur or conditions are
met (for example, profit targets are achieved)
Measure at the fair value at the acquisition date (provided
in the question)

BPP LEARNING MEDIA

Question: Lecture example 3


ABC acquired 300,000 of DEF's 400,000 ordinary shares during the year
ended 28 February 20X5. DEF was purchased from its directors who will
remain directors of the business.
The purchase consideration comprised:
$250,000 in cash payable at acquisition
$88,200 payable two years after acquisition
$100,000 payable in two years' time if profits exceed $2m.
New shares issued in ABC on a 1 for 3 basis.
The consideration payable in two years after acquisition is a tough target
for the directors of DEF and so its fair value (taking into account the time
value of money) has been measured at only $30,750.
The market value of ABC's shares on the acquisition date was $7.35.
An appropriate discount rate for use where relevant is 5%.

BPP LEARNING MEDIA

Question: Lecture example 3 (cont'd)


Required
Calculate the consideration transferred to acquire DEF at
the date of acquisition.

BPP LEARNING MEDIA

Answer: Lecture Example 3

ABC
28.2.20X5
DEF

BPP LEARNING MEDIA

300,000
400,000

=75%

Answer: Lecture Example 3 (cont'd)

Consideration transferred
Cash

Deferred consideration (88,200 1.052 )


Contingent consideration
Shares in ABC (300,000 / 3 $7.35)

BPP LEARNING MEDIA

250,000
80,000
30,750
735,000
1,095,750

Non-controlling interest at fair value 1


IFRS 3 allows the non-controlling interests in a subsidiary to be
measured at the acquisition date in one of two ways:
At their fair value (ie how much it would cost for the acquirer
to acquire the remaining shares) (ie as we have done so far);
or
At the non-controlling interest's proportionate share of the
fair value of the acquiree's identifiable net assets
Measurement of the non-controlling interest at proportionate
share of the fair value of the acquiree's identifiable net assets
means that no non-controlling interest in goodwill is
recognised. This is sometimes called the 'partial goodwill'
approach.

BPP LEARNING MEDIA

Non-controlling interest at fair value 2


The examiner has stated that he will only test this area as a
comparison to the 'full goodwill' approach we have used so
far.
Note that a parent can choose which method to use on a
transaction by transaction basis.

BPP LEARNING MEDIA

Question: Lecture example 4


At 31 December 20X4 the statements of financial position of Portus and Sanus were as follows.
Portus

Sanus

$'000

$'000

56,600
13,800
70,400

16,200

16,200

2,900
3,300
1,700
7,900

1,200
1,100
100
2,400

78,300

18,600

8,000
54,100
62,100

2,400
10,600
13,000

13,200

4,800

Non-current assets
Property, plant and equipment
Investment in Sanus (at cost)
Current assets
Inventories
Trade receivables
Cash

Equity
Share capital ($1 shares)
Reserves
Non-current liabilities
BPP LEARNING MEDIA

Long-term borrowings

Question: Lecture example 4 (cont'd)


Notes
1

On 1 April 20X4 Portus purchased a 80% holding in Sanus for $13.8m in cash. Sanus'
total comprehensive income for the year ended 31 December 20X4 was $2.0m,
accruing evenly over the year. Sanus did not pay any dividends in the year.

At the date of acquisition, the fair value of Sanus' assets were equal to their
carrying amounts with the exception of the items listed below which exceeded
their carrying amounts as follows.

$'000
Inventories

300

Plant and equipment (ten year remaining useful life) 1,200


1,500
Sanus has not adjusted the carrying amounts as a result of the fair value
exercise. The inventories were sold by Sanus before the year end.
3

The non-controlling interest in Sanus is to be valued at its fair value of $3.2m at the
date of acquisition.
An impairment test conducted at the year end revealed that the consolidated
goodwill of Sanus was impaired by $150,000.
BPP LEARNING MEDIA

Question: Lecture example 4 (cont'd)


Required
(a) Prepare the consolidated statement of financial position of the Portus
Group as at 31 December 20X4 (incorporating the changes from the
previous example identified in bold text).
(b) Show how the goodwill and non-controlling interest would change if
the non-controlling interest were measured at acquisition at the
proportionate share of the fair value of the acquiree's identifiable net
assets.
(c) Explain how the goodwill would have been treated if the calculation
had resulted in a negative figure, and how such a negative figure may
arise.

BPP LEARNING MEDIA

Answer: Lecture example 4


Part (a)
Portus Group
CONSOLIDATED STATEMENT OF FINANCIAL POSITION AS AT 31 DECEMBER 20X4
$'000
Non-current assets
Property, plant and equipment (56,600 + 16,200 + (W5) 1,110)
Goodwill (W2)

Current assets
Inventories (2,900 + 1,200)
Trade receivables (3,300 + 1,100)
Cash (1,700 + 100)

73,910
3,850
77,760
4,100
4,400
1,800
10,300
88,060

BPP LEARNING MEDIA

Answer: Lecture example 4 (cont'd)


Equity attributable to owners of the parent
Share capital ($1 shares)
Reserves (W3)

Non-controlling interests (W4)

8,000
54,868
62,868
3,392
66,260

Non-current liabilities
Long-term borrowings (13,200 + 4,800)

18,000

Current liabilities
Trade and other payables (3,000 + 800)

BPP LEARNING MEDIA

3,800
88,060

Answer: Lecture example 4 (cont'd)


Workings
1

Group structure
Portus
1.4.X4
80%
Cost

$13.8m
Sanus

Pre acquisition
reserves

$9.1m

($10.6m ($2.0m 9/12))


or ($10.6m $2.0m + ($2.0 3/12))

BPP LEARNING MEDIA

Answer: Lecture example 4 (cont'd)


2

Goodwill
$'000
Consideration transferred

13,800

Non-controlling interests (at fair value)


Less:

$'000
3,200

Fair value of identifiable net assets at acquisition:


Share capital

2,400

Reserves (10,600 (2,000 9/12))

9,100

Fair value adjustments (W5)

1,500
(13,000)
4,000
(150)

Less impairment losses

BPP LEARNING MEDIA

3,850

Answer: Lecture example 4 (cont'd)


3

Consolidated reserves

Per question
Fair value movement (W5)

Portus

Sanus

$'000

$'000

54,100

10,600
(390)

Pre-acquisition reserves (10,600 (2,000 9/12))

(9,100)
1,110

Group share of post acquisition reserves:


Sanus (1,110 80%)
Less impairment losses:

888
Sanus (150 80%)

(120)
54,868

BPP LEARNING MEDIA

Answer: Lecture example 4 (cont'd)


4

Non-controlling interests
$'000
NCI at acquisition (W2)

3,200

NCI share of post acquisition reserves ((W3) 1,110 20%)

222

NCI share of impairment losses ((W2) 150 20%)

(30)
3,392

BPP LEARNING MEDIA

Answer: Lecture example 4 (cont'd)


5

Fair value adjustments

At acquisition

Movement

At year

date
Inventories
Plant and equipment

end

$'000

$'000

300
1,200
1,500

(300)
(90)*
(390)

*Extra depreciation $1,200,000 1/10 9/12

Goodwill
COS
& reserves

BPP LEARNING MEDIA

SOFP

$'000

1,110
1,110

Answer: Lecture example 4 (cont'd)


Part (b)
Non-controlling interests at the proportionate share of the fair value of the acquiree's identifiable net
assets at acquisition

Goodwill

$'000
Consideration transferred

13,800

Non-controlling interests (at % FVNA) (13,000 20%)


Less:

$'000
2,600

Fair value of identifiable net assets at acquisition:


Share capital

2,400

Reserves (10,600 (2,000 9/12))

9,100

Fair value adjustments (W5)

1,500
(13,000)
3,400
(120)

Less impairment losses (150 80%)


BPP LEARNING MEDIA

3,280

Answer: Lecture example 4 (cont'd)


Non-controlling interests
$'000
NCI at acquisition (W2)
NCI share of post acquisition reserves ((W3) 1,110 20%)
NCI share of impairment losses

2,600
222
(0)
2,822

BPP LEARNING MEDIA

Answer: Lecture example 4 (cont'd)


Part (c)
Where the goodwill calculation results in a negative figure (ie where
the fair value of net assets at acquisition exceeds the consideration
paid and value attributed to non-controlling interest), the full amount
is treated as a 'bargain purchase'.
It is credited directly to profit or loss (and retained earnings)
attributable to the parent.
There is no non-controlling interest effect.
This situation could arise for several reasons:
The seller needed to make a quick/forced sale (eg due to liquidity
or regulatory reasons) resulting in a bargain purchase of the net
assets at less than their fair value.

BPP LEARNING MEDIA

Answer: Lecture example 4 (cont'd)


An expectation that losses will be made lowering the value of the
net assets acquired before the business can be turned around
An expectation that the business will need to be broken up and
sold off with significant break-up costs
The existence of liabilities that did not meet the recognition
criteria for recognition in the fair value of the net assets acquired
(for this reason, IFRS 3 actually requires a review of the
calculations of net assets acquired to ensure no contingent
liabilities that can be recognised have been missed before a
credit is allowed to be made to profit or loss).

BPP LEARNING MEDIA

Intra-group trading 1
IFRS 10 Consolidated Financial Statements states, 'Intragroup
balances, transactions, income and expenses shall be
eliminated in full'.
The purpose of consolidation is to present the parent and its
subsidiaries as if they are trading as one entity.
Therefore, only amounts owing to or from outside the group
should be included in the statement of financial position, and
any assets should be stated at cost to the group.

BPP LEARNING MEDIA

Intra-group trading 2

Trading transactions will normally be recorded via a current account


between the trading companies, which would also keep a track of
amounts received and/or paid.

The current account receivable in one company's books should equal


the current account payable in the other.

These two balances should be cancelled on consolidation as intragroup receivables and payables should not be shown.

Where current accounts do not agree at the year end this will be due
to items such as inventories in transit and cash in transit.

Prior to consolidation, adjustments will need to be made in the


separate company financial statements for the inventories or cash in
transit. This is usually done by following through the transaction to its
ultimate destination (IFRS 10 is not specific).

BPP LEARNING MEDIA

Intra-group trading 3
The accounting entries to do this are:

For cash in transit:


DEBIT Cash
CREDIT Receivables

For inventories in transit:


DEBIT Inventories
CREDIT Payables
Then to eliminate the now reconciled current account balances:

DEBIT Intra-group Payables

CREDIT Intra-group Receivables

This adjustment is only done as a consolidation adjustment.

BPP LEARNING MEDIA

Intra-group trading 4
Inventories must be valued at the lower of cost and net realisable
value to the group.
Inventories transferred at a profit within group

BPP LEARNING MEDIA

Sold to a
third party

Remain in
inventories

Profit realised

Profit unrealised

Intra-group trading 5
Method
Calculate the unrealised profit included in inventories and mark
the adjustment to inventories on your proforma answer and to
retained earnings in your workings.
To eliminate the unrealised profit from retained earnings and
inventories a provision is usually made in the books of the
company making the sale (IFRS 10 is not specific).
This adjustment is only done as a consolidation adjustment, no
changes are recorded to the company's separate financial
statements.

BPP LEARNING MEDIA

Intra-group trading 6
Method (continued)
The entries required on consolidation are:
If the inventories are sold by P to S. Make the adjustment in
P's books:
DEBIT Cost of sales/retained earnings of P
CREDIT Consolidated inventories

BPP LEARNING MEDIA

Intra-group trading 7
Method (continued)
If the inventories are sold by S to P. Make the adjustment in
S's books:
DEBIT Cost of sales/retained earnings of S
CREDIT Consolidated inventories
Where S is the seller the non-controlling interest will be
affected by this adjustment because the amount of the
subsidiary's retained earnings which have been
consolidated are reduce and this will impact the share of
post acquisition profits allocated to the non-controlling
interest.

BPP LEARNING MEDIA

Question: Lecture example 5


At 31 December 20X4 the statements of financial position of Portus and Sanus were as follows.
Portus

Sanus

$'000

$'000

56,600
13,800
70,400

16,200

16,200

2,900
3,300
1,700
7,900

1,200
1,100
100
2,400

78,300

18,600

8,000
54,100
62,100

2,400
10,600
13,000

Non-current assets
Property, plant and equipment
Investment in Sanus (at cost)
Current assets
Inventories
Trade receivables
Cash

Equity
Share capital ($1 shares)
Reserves
Non-current liabilities
BPP LEARNING MEDIA

Question: Lecture example 5 (cont'd)


Notes
1

On 1 April 20X4 Portus purchased a 80% holding in Sanus for $13.8m in cash. Sanus'
total comprehensive income for the year ended 31 December 20X4 was $2.0m,
accruing evenly over the year. Sanus did not pay any dividends in the year.

At the date of acquisition, the fair value of Sanus' assets were equal to their carrying
amounts with the exception of the items listed below which exceeded their carrying
amounts as follows.

$'000
Inventories

300

Plant and equipment (ten year remaining useful life)

1,200

1,500
Sanus has not adjusted the carrying amounts as a result of the fair value exercise.
The inventories were sold by Sanus before the year end.
3

The non-controlling interest in Sanus is to be valued at its fair value of $3.2m at the
date of acquisition.
An impairment test conducted at the year end revealed that the consolidated goodwill
of Sanus was impaired by $150,000.
BPP LEARNING MEDIA

Question: Lecture example 5 (cont'd)


4

On 1 October 20X4, Sanus sold goods to Portus for $200,000 at a gross profit margin
of 40%. The goods were still in Portus' inventories at the year end. No other sales
were made between Portus and Sanus in the year.
At 31 December 20X4 Portus' current account with Sanus was $130,000 (credit). This
did not agree with the equivalent balance in Sanus' books due to cash in transit of
$70,000 which was not received by Sanus until after the year end.

BPP LEARNING MEDIA

Question: Lecture example 5 (cont'd)


Required
Prepare the consolidated statement of financial position of the Portus
Group as at 31 December 20X4 (incorporating the changes from the
previous example identified in bold text).

BPP LEARNING MEDIA

Answer: Lecture example 5


Portus Group
CONSOLIDATED STATEMENT OF FINANCIAL POSITION AS AT 31 DECEMBER 20X4
$'000
Non-current assets
Property, plant and equipment (56,600 + 16,200 + (W5) 1,110)
Goodwill (W2)

Current assets
Inventories (2,900 + 1,200 (W6) 80)
Trade receivables (3,300 + 1,100 (W6) 70 (W6) 130)
Cash (1,700 + 100 + (W6) 70)

73,910
3,850
77,760
4,020
4,200
1,870
10,090
87,850

BPP LEARNING MEDIA

Answer: Lecture example 5 (cont'd)


Equity attributable to owners of the parent
Share capital ($1 shares)
Reserves (W3)

Non-controlling interests (W4)

8,000
54,804
62,804
3,376
66,180

Non-current liabilities
Long-term borrowings (13,200 + 4,800)

18,000

Current liabilities
Trade and other payables (3,000 + 800 (W6) 130)

BPP LEARNING MEDIA

3,670
87,850

Answer: Lecture example 5 (cont'd)


Workings
1

Group structure
Portus
1.4.X4
80%
Cost

$13.8m
Sanus

Pre acquisition
reserves

$9.1m

($10.6m ($2.0m 9/12))


or ($10.6m $2.0m + ($2.0 3/12))

BPP LEARNING MEDIA

Answer: Lecture example 5 (cont'd)


2

Goodwill
$'000
Consideration transferred

13,800

Non-controlling interests (at fair value)


Less:

$'000
3,200

Fair value of identifiable net assets at acquisition:


Share capital

2,400

Reserves (10,600 (2,000 9/12))

9,100

Fair value adjustments (W5)

1,500
(13,000)
4,000
(150)

Less impairment losses

BPP LEARNING MEDIA

3,850

Answer: Lecture example 5 (cont'd)


3

Consolidated reserves

Per question
Fair value movement (W5)

Portus

Sanus

$'000

$'000

54,100

10,600
(390)

Provision for unrealised profit (W6)

(80)

Pre-acquisition reserves (10,600 (2,000 9/12)

(9,100)
1,030

Group share of post acquisition reserves:


Sanus (1,030 80%)
Less impairment losses:

824
Sanus (150 80%)

(120)
54,804

BPP LEARNING MEDIA

Answer: Lecture example 5 (cont'd)


4

Non-controlling interests
$'000
NCI at acquisition (W2)

3,200

NCI share of post acquisition reserves ((W3) 1,030 20%)

206

NCI share of impairment losses ((W2) 150 20%)

(30)
3,376

BPP LEARNING MEDIA

Answer: Lecture example 5 (cont'd)


5

Fair value adjustments

At acquisition

Movement

At year

date
Inventories
Plant and equipment

end

$'000

$'000

300
1,200
1,500

(300)
(90)*
(390)

*Extra depreciation $1,200,000 1/10 9/12

Goodwill
& reserves

BPP LEARNING MEDIA

COS

SOFP

$'000

1,110
1,110

Answer: Lecture example 5 (cont'd)


6

Intragroup trading
(1) Cash in transit
$'000
DEBIT Group cash

70

CREDIT Trade receivables

70

(2) Cancel intragroup balances


$'000
DEBIT Group payables

130

CREDIT Group receivables

130

BPP LEARNING MEDIA

Answer: Lecture example 5 (cont'd)

(3) Eliminate unrealised profit


Sanus:
Profit element in inventories: $200,000 40% = $80,000
$'000
DEBIT Cost of sales (and reserves) (of Sanus the seller)

80

CREDIT Group inventories

80

BPP LEARNING MEDIA

Intra-group sales of non-current assets 1


The transfer of property, plant and equipment at a profit within
the group gives rise to the same kind of issues as the transfer
of inventories, namely that the property, plant and equipment
should be stated at cost to the group and the profit on the sale
is unrealised.
An additional issue is that the items of property, plant and
equipment will subsequently be depreciated based on the new
carrying amount.
This is in effect a realisation of the unrealised profit through use
and therefore reduces the consolidation adjustment.
The adjustment should be made in the books of the company
making the sale.

BPP LEARNING MEDIA

Intra-group sales of non-current assets 2


Method

Firstly, calculate the unrealised profit:


Unrealised profit on transfer

Less proportion depreciated by year-end

(X)

Then make the adjustment in the books of the company making the
sale:
DEBIT Retained earnings
CREDIT Property, plant and equipment

BPP LEARNING MEDIA

Question: Lecture example 6


Required
How would the double entry for the unrealised profit in the
previous lecture example change if plant with a remaining
useful life of four years and a carrying value equal to the
cost of the inventories ($120 million) was sold by Sanus to
Portus (for the same $200 million) rather than
inventories?

BPP LEARNING MEDIA

Answer: Lecture example 6

Eliminate unrealised profit


$'000
DEBIT Cost of sales (and reserves) (of Sanus the seller)

75

CREDIT Group property, plant and equipment

75

Working
1

Unrealised profit
$'000
Profit on transfer (200 120)

80

Less proportion depreciated (realised) by the year end (80 3/12 )

(5)
75

BPP LEARNING MEDIA

Summary: consolidated SOFP


Step 1Work out the group structure
Step 2Set up your proforma
Step 3Transfer figures to face of proforma/working
Step 4Calculate the required adjustments and add
across
Step 5Goodwill working
Step 6Retained earnings working
Step 7Investment in associate working (see later)
Step 8Non-controlling interest working

BPP LEARNING MEDIA

Acquisition of a subsidiary during its accounting period


Reminder: rule for mid year acquisitions

When calculating the reserves at the date of acquisition assume


that the subsidiary's profits accrue evenly throughout the period.

Therefore if the year end is 31 December and the subsidiary was


acquired on 1 April, the reserves at the date of acquisition would
be:
The cumulative reserves brought forward at 31 December in
the previous year plus 3/12 of the profit for the year; or
The cumulative reserves carried forward at 31 December the
end of the current year less 9/12 of the profit for the year.

BPP LEARNING MEDIA

Fair values in acquisition accounting


Recap:

Goodwill is the excess of the consideration transferred plus the


amount of non-controlling interest over the fair value of the net assets
of the subsidiary.

In order to ensure that goodwill is reliably measured, it is necessary to


calculate both ;
The fair value of the consideration transferred
The fair value of the identifiable assets acquired and liabilities
assumed

Fair value definition (IFRS 13)

The price that would be received to sell an asset or paid to transfer a


liability in an orderly transaction between market participants at the
measurement date.

BPP LEARNING MEDIA

Past exam questions


Nature of question

Exam details

The consolidated statement of financial


position (or part of it) may be tested in
Section B of the exam including
adjustments for goodwill, impairments of
goodwill, fair value adjustments, noncontrolling interest, intra-group balances
and unrealised profit.

Q1 all pre-Dec
2014 exams.
Will now be 15 or
30-mark
question.

Note that consolidation question may


involve a statement of profit or loss,
rather than a SFP.
BPP LEARNING MEDIA

Chapter 10
The consolidated
statement of profit or
loss and other
comprehensive
income

BPP LEARNING MEDIA

The consolidated statement of


profit or loss
The consolidated statement of
profit or loss and other
comprehensive income

Syllabus learning outcomes


Prepare a consolidated statement of profit or loss and
consolidated statement of profit or loss and other
comprehensive income for a simple group dealing with an
acquisition in the period and non-controlling interest

BPP LEARNING MEDIA

Chapter summary diagram


The consolidated statement of profit
or loss and other comprehensive
income

Introduction

Intra-group trading

Intra-group loans
and interest

BPP LEARNING MEDIA

Approach to the
consolidated
statement of
profit or loss and
other
comprehensive
income

The consolidated statement of profit or loss 1


The purpose of consolidated financial statements is to
show the parent and its subsidiaries as if they were
one single entity.
In the consolidated statement of financial position this
means that the assets and liabilities (net assets)
controlled by the parent are combined with those of the
parent on a line by line basis.
The equity section shows who owns the net assets and
presents the amounts owned by the parent's
shareholders separately from those owned by the noncontrolling interest.

BPP LEARNING MEDIA

The consolidated statement of profit or loss 2


The consolidated statement of profit or loss (and the
consolidated statement of profit or loss and other
comprehensive income) follows the exact same
process.
The income, expenses and other comprehensive
income controlled by the parent are combined with
those of the parent on a line by line basis.
There is there an additional section at the bottom of the
statement showing who owns the profits and other
comprehensive income consolidated for the period.
This is disclosed as the amounts owned by the parent's
shareholders and the amounts owned by the noncontrolling interest.
BPP LEARNING MEDIA

The consolidated SPLOCI 1


The consolidated statement of profit or loss shows an
entity's revenue earned less costs incurred from the
revenue down to the profit for the year line.
The consolidated statement of profit or loss and other
comprehensive income shows the revenue down to
profit for the year plus other comprehensive income for
the year.
In the ACCA F7 syllabus the only item of other
comprehensive income is revaluation gains and losses
and so producing the consolidated statement of profit
or loss and other comprehensive income is no more
onerous than producing the consolidated statement of
profit or loss.
BPP LEARNING MEDIA

The consolidated SPLOCI 2


Revenue
Profit for year (PFY)

Add 100% P + 100% S as


this represents what is
controlled by P

Other comprehensive income


Profit attributable to:
Owners of P
Non-controlling interest
Total comprehensive income
attributable to:
Owners of P
NCI

S's PFY NCI%

S's TCI NCI%

NB: Exclude dividend income from S


BPP LEARNING MEDIA

The consolidated SPLOCI 3


Mid year acquisitions
Consolidate subsidiaries in the normal way but only from the
date that control is achieved.
Assume that revenue and expenses accrue evenly unless
specified otherwise in the question.
Impairment losses
The consolidated statement of financial position is at a point
in time and so shows the cumulative impairment losses.
The current year impairment loss is shown in the
consolidated statement of profit or loss.

BPP LEARNING MEDIA

Question: Lecture example 1


The statements of profit or loss and other comprehensive income of Portus
and its subsidiary Sanus for the year ended 31 December 20X4 are as
follows.
Portus
Sanus
Revenue
Cost of sales
Gross profit
Expenses
Finance costs
Profit before tax
Income tax expense
PROFIT FOR THE YEAR
Other comprehensive income:
Gains on property revaluation
TOTAL COMPREHENSIVE INCOME FOR THE
YEAR

BPP LEARNING MEDIA

$'000
28,500
(17,100)
11,400
(4,400)
(400)
6,600
(2,100)
4,500

$'000
11,800
(7,000)
4,800
(2,200)
(200)
2,400
(800)
1,600

900
5,400

400
2,000

Question: Lecture example 1 (cont'd)


Note
1

On 1 April 20X4 Portus purchased a 80% holding in Sanus for


$13.8m in cash. Sanus' total comprehensive income for the year
ended 31 December 20X4 was $2.0m, accruing evenly over the
year. Sanus did not pay any dividends in the year.

Required
Prepare the consolidated statement of comprehensive income for the
Portus Group for the year ended 31 December 20X4 (excluding
consolidation adjustments).

BPP LEARNING MEDIA

Answer: Lecture example 1


Portus Group
CONSOLIDATED STATEMENT OF COMPREHENSIVE INCOME FOR THE
YEAR ENDED 31 DECEMBER 20X4
Revenue (28,500 + (11,800 9/12))
Cost of sales (17,100 + (7,000 9/12))
Gross profit
Expenses (4,400 + (2,200 9/12))
Finance costs (400 + (200 9/12))
Profit before tax
Income tax expense (2,100 + (800 9/12))
PROFIT FOR THE YEAR
Other comprehensive income:
Gains on property revaluation (900 + (400 9/12))
Other comprehensive income for the year
TOTAL COMPREHENSIVE INCOME FOR THE YEAR
BPP LEARNING MEDIA

$'000
37,350
(22,350)
15,000
(6,050)
(550)

8,400
(2,700)

5,700
1,200
1,200
6,900

Answer: Lecture example 1 (cont'd)


Profit attributable to:
Owners of the parent ()
Non-controlling interests (W2)
Total comprehensive income attributable to:
Owners of the parent ()
Non-controlling interests (W2)

BPP LEARNING MEDIA

5,460
240
5,700
6,600
300
6,900

Answer: Lecture example 1 (cont'd)


Workings
1

Group structure
Portus
1.4.X4
80%
Cost $13.8m
Sanus
Pre acquisition
reserves

$9.1m

($10.6m ($2.0m 9/12))


or ($10.6m $2.0m + ($2.0 3/12))

BPP LEARNING MEDIA

Answer: Lecture example 1 (cont'd)

1.1.X4

1.4.X4

31.12.X4

Portus all year


Sanus Income and expenses and 20% NCI x 9/12

Sanus
acquired

BPP LEARNING MEDIA

Answer: Lecture example 1 (cont'd)


2 Non-controlling interests (SPLOCI)
Profit for
the year
PFY/TCI per question (1,600 9/12) / (2,000 9/12)

BPP LEARNING MEDIA

$'000
1,200
20%
240

Total comp
income
$'000
1,500
20%
300

The consolidated SPLOCI 4


Intra-group trading
It is likely that the parent and subsidiary will trade with
each other.
The consolidated SPLOCI shows the results of the
group as if it were a single entity and so to be
consistent with the consolidated statement of financial
position, the effects of intra-group trading need to be
stripped out.
There are two possible adjustments.

BPP LEARNING MEDIA

The consolidated SPLOCI 5


Intra-group trading (cont.)
Always eliminate intra-group transactions from the
revenue and cost of sales figures:
DEBIT Group revenue
CREDIT Group cost of sales
This will reduce both revenue and cost of sales so
that the revenue and cost of sales reported in the
consolidated SPLOCI relate solely to those earned
and incurred from third parties.

BPP LEARNING MEDIA

The consolidated SPLOCI 6


Intra-group trading (continued)
Where inventories at the year end include inventories
transferred between group companies a second
adjustment is also required:
DEBIT Cost of sales/retained earnings(seller)
CREDIT Inventories
This is the same adjustment as in the consolidated
statement of financial position and aims to eliminate
the unrealised profit on inventories at the year end.

BPP LEARNING MEDIA

Question: Lecture example 2


Continuing from the previous example, the statements of profit or loss and
other comprehensive income of Portus and its subsidiary Sanus for the year
ended 31 December 20X4 are as follows.
Portus
Revenue
Cost of sales
Gross profit
Expenses
Finance costs
Profit before tax
Income tax expense
PROFIT FOR THE YEAR
Other comprehensive income:
Gains on property revaluation
TOTAL COMPREHENSIVE INCOME FOR THE
BPP LEARNING MEDIA

Sanus

$'000
28,500
(17,100)
11,400
(4,400)
(400)
6,600
(2,100)
4,500

$'000
11,800
(7,000)
4,800
(2,200)
(200)
2,400
(800)
1,600

900
5,400

400
2,000

Question: Lecture example 2 (cont'd)


Notes
1

On 1 April 20X4 Portus purchased a 80% holding in Sanus for $13.8m in


cash. Sanus' total comprehensive income for the year ended 31 December
20X4 was $2.0m, accruing evenly over the year. Sanus did not pay any
dividends in the year. Portus paid dividends of $3m in the year.

At the date of acquisition, the fair value of Sanus' assets were equal to their
carrying amounts with the exception of the items listed below which exceeded
their carrying amounts as follows.
$'000
Inventories
300
Plant and equipment (ten year remaining useful life)
1,200
1,500

Sanus has not adjusted the carrying amounts as a result of the fair value exercise.
The inventories were sold by Sanus before the year end.

BPP LEARNING MEDIA

Question: Lecture example 2 (cont'd)


3

The non-controlling interest in Sanus is to be valued at its fair value of $3.2m


at the date of acquisition.
An impairment test conducted at the year end revealed that the consolidated
goodwill of Sanus was impaired by $150,000.

On 1 October 20X4, Sanus sold goods to Portus for $200,000 at a gross


profit margin of 40%. The goods were still in Portus' inventories at the year
end. No other sales were made between Portus and Sanus in the year.
At 31 December 20X4 Portus' current account with Sanus was $130,000
(credit). This did not agree with the equivalent balance in Sanus' books due to
cash in transit of $70,000 which was not received by Sanus until after the
year end.

BPP LEARNING MEDIA

Question: Lecture example 2 (cont'd)


Required
(a) Prepare the consolidated statement of profit or loss and other
comprehensive income for the Portus Group for the year ended
31 December 20X4 (incorporating the changes from the previous
example identified in bold text).
(b) Explain how the consolidated statement of profit or loss and other
comprehensive income would differ if Portus had sold the goods
in Note 4 to Sanus.

BPP LEARNING MEDIA

Answer: Lecture example 2


Portus Group
CONSOLIDATED STATEMENT OF PROFIT OR LOSS AND OTHER COMPREHENSIVE INCOME
FOR THE YEAR ENDED 31 DECEMBER 20X4

Revenue (28,500 + (11,800 9/12) (W6) 200)


Cost of sales (17,100 + (7,000 9/12) + (W5) 390 (W6) 200 + (W6) 80)
Gross profit
Expenses (4,400 + (2,200 9/12) + (W3) 150)
Finance costs (400 + (200 9/12))
Profit before tax
Income tax expense (2,100 + (800 9/12))
PROFIT FOR THE YEAR
Other comprehensive income:

$'000

37,150
(22,620)
14,530
(6,200)
(550)
7,780
(2,700)
5,080

Gains on property revaluation (900 + (400 9/12))


Other comprehensive income for the year
TOTAL COMPREHENSIVE INCOME FOR THE YEAR
Profit attributable to:

1,200
1,200
6,280

Owners of the parent ()


Non-controlling interests (W2)

4,964
116
5,080

Total
comprehensive
income attributable to:
BPP LEARNING
MEDIA

Answer: Lecture example 2 (cont'd)


Workings
1

Group structure
Portus
1.4.X4
80%
Cost $13.8m
Sanus
Pre acquisition
reserves

$9.1m

($10.6m ($2.0m 9/12))


or ($10.6m $2.0m + ($2.0 3/12))

BPP LEARNING MEDIA

Answer: Lecture example 2 (cont'd)


Timeline
1.1.X4

1.4.X4

1.7.X4

31.12.X4

Portus all year


Sanus Income and expenses and 20% NCI x 9/12

BPP LEARNING MEDIA

Answer: Lecture example 2 (cont'd)


2 Non-controlling interests (SPLOCI)
Profit for
the year
PFY/TCI per question (1,600 9/12)/(2,000 9/12)
Less impairment losses (W3)
Less fair value movement (W6)
Less unrealised profit (W7)

BPP LEARNING MEDIA

$'000
1,200
(150)
(390)
(80)
580
20%
116

Total comp
income
$'000
1,500
(150)
(390)
(80)
880
20%
176

Answer: Lecture example 2 (cont'd)


3

Goodwill

Note. The goodwill and reserves SOFP workings are not needed for
this SOCI example but are reproduced here for clarity
$'000

Consideration transferred

13,800

Non-controlling interests (at fair value)

Less:

3,200

Fair value of identifiable net assets at acquisition:


Share capital

$'000

Reserves (10,600 (2,000 9/12))


Consolidated reserves
Fair value adjustments (W5)

Per question
Less
impairment
losses
Fair value
movement
(W5)

2,400
9,100
Portus

1,500
Sanus

$'000

$'000

54,100

10,600
(390)

Provision for unrealised profit (W6)

(80)

Pre-acquisition reserves (10,600 (2,000 9/12)

(9,100)
1,030

Group share of post acq'n reserves:


BPP LEARNING MEDIA

Sanus (1,030 80%)

824

(12,000)
4,000
(150)
3,850

Answer: Lecture example 2 (cont'd)


5 Fair value adjustments

Inventories
Plant and equipment

At acquisition
date
$'000
300
1,200
1,500

Movement

Goodwill

COS
& reserves

$'000
(300)
(90)*
(390)

At year
end
$'000

1,110
1,110

*Extra depreciation
$1,200,000 1/10 9/12

BPP LEARNING MEDIA

SOFP

Answer: Lecture example 2 (cont'd)


6 Intra-group trading
(1)

Cash in transit
$'000

(2)

DEBIT Group cash

70

CREDIT Trade receivables

70

Cancel intra-group trading and balances


$'000
DEBIT Group revenue

200

CREDIT Group purchases (Cost of sales)

200
$'000

(3)

DEBIT Group payables

130

CREDIT Group receivables

130

Eliminate unrealised profit

BPP LEARNING MEDIA

Sanus:

Answer: Lecture example 2 (cont'd)


Part (b)
If Portus (the parent) sold the inventories rather than Sanus, there would be no change on the top
half of the statement of profit or loss and other comprehensive income. However, in the
reconciliation of profit and total comprehensive income attributable to owners of the parent and to
non-controlling interests, unrealised profit would no longer affect profit attributable to noncontrolling interests. Non-controlling interests would therefore be:
Non-controlling interests (SPLOCI)

Profit for the year

Total comp income

$'000

$'000

PFY/TCI per question (1,600 9/12) / (2,000 9/12)


Less impairment losses (W3)

1,200
(150)

1,500
(150)

Less fair value movement (W5)

(390)

(390)

(80)

(80)

600 580

960 880

Less unrealised profit (W7)

20%
132 116
BPP LEARNING MEDIA

20%
192 176

Answer: Lecture example 2 (cont'd)


Profit and total comprehensive income attributable to
owners of the parent would therefore decrease by the
amount of the increase in the respective non-controlling
interest, as they are calculated as residual figures.

BPP LEARNING MEDIA

The consolidated SPLOCI 7


Intra-group loans and interest

Often a parent may advance a loan at a preferential interest rate to a


subsidiary or similarly, a cash-rich subsidiary may make a loan to its
parent.

These items are intra-group borrowings which do not represent


additional finance or finance costs from the group point of view, and
must therefore be eliminated on consolidation.

Adjustments are required to:


Cancel the intra-group loan balances in the consolidated SOFP:
DEBIT Loan payable, CREDIT Loan receivable
Cancel the intra-group interest payable by one party to the other in
the consolidated SPLOCI:
DEBIT Group finance income, CREDIT Group finance costs
BPP LEARNING MEDIA

The consolidated SPLOCI 8


Illustration

P acquired 100% of S on its incorporation. On the same date P made


a fixed rate 4% loan to S. The loan has not been repaid at the year
end.

BPP LEARNING MEDIA

The consolidated SPLOCI 9


Statements of financial position
Non-current assets

PPE
investment in S
4% loan to S

Current assets
Share capital
Retained earnings
Non-current liabilities bank loan
4% loan from P
Current liabilities

BPP LEARNING MEDIA

P
$'000
6,200
1,000
400
7,600
1,350
8,950

S
$'000
3,050

3,050
850
3,900

Consol
$'000
9,250


9,250
2,200
11,450

800
6,900
7,700
200

200
1,050
8,950

1,000
1,800
2,800

400
400
700
3,900

800
8,700
9,500
200

200
1,750
11,450

The consolidated SPLOCI 10


Statements of profit or loss:
Revenue
Cost of sales and expenses
Profit before interest and tax
Finance income (from S)
Finance costs
Profit before tax
Income tax expense
Profit for the year

BPP LEARNING MEDIA

P
$'000
2,200
(1,540)
660
16
(20)
656
(196)
460

S
$'000
1,100
(770)
330

(16)
314
(94)
220

Consol
$'000
3,300
(2,310)
990

(20)
970
(290)
680

Approach: Consolidated SPLOCI


Step 1
Step 2
Step 3
Step 4
Step 5
Step 6

BPP LEARNING MEDIA

Work out the group structure


Set up your proforma
Transfer figures to face of proforma/working
Calculate the required adjustments and add
across
Share of profit of associate working (see later)
Non-controlling interest working

Past exam questions


Nature of question

Exam details

The consolidated statement of profit or


Q1 Dec 2012
loss or profit or loss and other
Q1 June 2011
comprehensive income is tested
Q1 Dec 2010
regularly including adjustments for
impairments of goodwill, fair value
adjustments, non-controlling interest,
intra-group trading and unrealised profit.
Under the new format this question will
have 15 or 30 marks.
BPP LEARNING MEDIA

Chapter 11

Accounting for associates

Accounting for
associates

Statement of profit or loss and


statement of financial position

BPP LEARNING MEDIA

The equity method

Syllabus learning outcomes 1


Define an associate and explain the principle and
reasoning for the use of equity accounting
Prepare consolidated financial statements to include a
single subsidiary and an associate

BPP LEARNING MEDIA

Chapter summary diagram


Accounting for associates

Definition

Significant
influence

BPP LEARNING MEDIA

Accounting
treatment

Consolidated
financial
statements

Accounting for associates 1


Definition (IAS 28)
An associate is an entity over which the investor has
significant influence.
Where significant influence is the power to participate
in the financial and operating decisions of the investee
but is not control or joint control over those policies.

BPP LEARNING MEDIA

Accounting for associates 2


In the exam you should apply the '20% rule'.
If an investor holds, directly or indirectly, 20% of the
voting power it is presumed that the investor has
significant influence. Therefore the investment is
presumed to be an associate unless it can be
demonstrated otherwise.
Conversely, if an investor holds, directly or indirectly
< 20% of the voting power it is presumed that the
investor does not have significant influence. Therefore
the investment is not presumed to be an associate
unless it can be demonstrated otherwise.

BPP LEARNING MEDIA

Accounting for associates 3


IAS 28 also states that significant influence can be
shown by:
Representation on the board of directors
Participation in policy making processes
Material transactions between the investor and the
investee
Interchange of managerial personnel
Provision of essential technical information

BPP LEARNING MEDIA

Accounting for associates 4


Investor's separate financial statements
Just as with the subsidiary, the investor can record the
investment in the investee in its separate financial
statements either:
At cost; or
At fair value.

BPP LEARNING MEDIA

The equity method 1

An investment in an associate is accounted for in the consolidated


financial statements using the equity method.

CONSOLIDATED STATEMENT OF FINANCIAL POSITION


Non-current assets
Investment in associate (Working)

Working
Cost of associate
Share of post-acquisition retained reserves
Less impairment losses on associate to date

BPP LEARNING MEDIA

X
X/(X)
(X)
X

The equity method 2


CONSOLIDATED STATEMENT OF PROFIT OR LOSS AND OTHER
COMPREHENSIVE INCOME
Profit or loss
A's Profit for the year Group %
X
Shown before group profit before tax
Other comprehensive income
A's OCI x Group %
X
Note. In order to be able to account for an associate using the equity
method a parent must already be producing consolidated accounts, ie it
must have at least one subsidiary.
BPP LEARNING MEDIA

The equity method 3


Points to note

The associate is not a group company and so no cancellation of


'intra-group' transactions is performed.

However, to avoid double counting, the investor's share of


unrealised profits and losses on transactions between the investor
and the associate are eliminated in the same way as for group
accounts.

The adjustments are (if the sale is by the associate):


DEBIT Cost of sales of A*/group retained earnings (P's column)
CREDIT Group inventories
*The convention is to increase (dr) the cost of sales of the seller and
so when we DEBIT Cost of sales of A we actually debit the share of
associate's profit line.

BPP LEARNING MEDIA

The equity method 4


Points to note (continued)

The adjustments are (if the sale is by the parent):


DEBIT Cost of sales of P/group retained earnings (P's column)
CREDIT Investment in associate*
*Here, we debit the investment in associate rather than group
inventories because A holds the inventories

The value of the adjustment at all times is the group percentage of the
unrealised profit amount. So if there was a 30% associate and the
unrealised profit was $100 the adjustment would be:
PUP A%, ie $100 30% = $30

BPP LEARNING MEDIA

Statement of P/L and SOFP

The following lecture examples demonstrate how the


associate is treated in the consolidated financial
statements.

BPP LEARNING MEDIA

Question: Lecture example 1


At 31 December 20X4 the statements of financial position of Portus, Sanus and Allus were as follows.

Portus

Sanus

Allus

$'000

$'000

$'000

56,600
13,800
70,400

16,200

16,200

16,100

16,100

2,900
3,300
1,700
7,900

1,200
1,100
100
2,400

500
1,100
300
1,900

78,300

18,600

18,000

8,000
54,100
62,100

2,400
10,600
13,000

2,800
9,200
12,000

Non-current assets
Property, plant and equipment
Investment in Sanus (at cost)
Current assets
Inventories
Trade receivables
Cash

Equity
Share capital ($1 shares)
Reserves
Non-current liabilities
BPP LEARNING MEDIA

Question: Lecture example 1 (cont'd)


Notes
1

On 1 April 20X4 Portus purchased a 80% holding in Sanus for $13.8 in


cash. Sanus' total comprehensive income for the year ended 31
December 20X4 was $2.0m, accruing evenly over the year. Sanus did
not pay any dividends in the year.
Portus also acquired a 30% holding in Allus on 1 July 20X4 for
500,000 of its own shares. The stock market value of Portus' shares
at the date of this share exchange was $9.40 each. Portus has not
yet recorded the investment in Allus. Allus' reserves were $8.6m on
1 July 20X4.

BPP LEARNING MEDIA

Question: Lecture example 1 (cont'd)


2

At the date of acquisition, the fair value of Sanus' assets were equal to their
carrying amounts with the exception of the items listed below which
exceeded their carrying amounts as follows.
$'000
Inventories
300
Plant and equipment (ten-year remaining useful life)
1,200
1,500
Sanus has not adjusted the carrying amounts as a result of the fair value
exercise. The inventories were sold by Sanus before the year end.

The non-controlling interest in Sanus is to be valued at its fair value of $3.2m


at the date of acquisition.
An impairment test conducted at the year end revealed that the consolidated
goodwill of Sanus was impaired by $150,000.
Additionally, an impairment loss of $40,000 is to be recognised in
respect of Portus' investment in Allus in the group financial
statements.

BPP LEARNING MEDIA

Question: Lecture example 1 (cont'd)


(4) On 1 October 20X4, Sanus sold goods to Portus for $200,000 at a gross
profit margin of 40%. The goods were still in Portus' inventories at the year
end. No other sales were made between Portus and Sanus in the year.
At 31 December 20X4 Portus' current account with Sanus was $130,000
(credit). This did not agree with the equivalent balance in Sanus' books due
to cash in transit of $70,000 which was not received by Sanus until after the
year end.
After the acquisition, Allus sold goods to Portus for $400,000 at a markup on cost of 25%. A quarter of these goods remained in Portus'
inventories at the year end.

BPP LEARNING MEDIA

Question: Lecture example 1 (cont'd)


Required
Prepare the consolidated statement of financial position of the Portus Group as
at 31 December 20X4.

BPP LEARNING MEDIA

Answer: Lecture example 1


Portus Group
CONSOLIDATED STATEMENT OF FINANCIAL POSITION AS AT 31
DECEMBER 20X4

$'000

Non-current assets
Property, plant and equipment (56,600 + 16,200 + (W6) 1,110)
Goodwill (W2)
Investment in associate (W3)

73,910
3,850
4,840
82,600

Current assets
Inventories (2,900 + 1,200 (W7) 80 (W7) 6)
Trade receivables (3,300 + 1,100 (W7) 70 (W7) 130)
Cash (1,700 + 100 + (W7) 70)

4,014
4,200
1,870
10,084
92,684

BPP LEARNING MEDIA

Answer: Lecture example 1 (cont'd)


Equity attributable to owners of the parent
Share capital ($1 shares) (8,000 + (W8) 500)
Share premium (W8)

8,500
4,200
54,938
67,638

Non-controlling interests (W5)

3,376
71,014

Non-current liabilities
Long-term borrowings (13,200 + 4,800)

18,000

Current liabilities
Trade and other payables (3,000 + 800 (W7) 130)

BPP LEARNING MEDIA

3,670
92,684

Answer: Lecture example 1 (cont'd)


Workings
1 Group structure

Portus

Cost

1.4.X4
80%
$13.8m

1.7.X4
30%

Sanus
Pre acquisition
reserves
$9.1m
$8.6m
($10.6m ($2.0m 9/12))
or (10.6m $2.0m + ($2.0 3/12))

BPP LEARNING MEDIA

(W8) $4.7m

Allus

Answer: Lecture example 1 (cont'd)


2

Goodwill
$'000
Consideration transferred
Non-controlling interests (at fair value)

$'000
13,800
3,200

Less: Fair value of identifiable net assets at


acquisition:
Share capital
Reserves (10,600 (2,000 9/12))
Fair value adjustments (W6)

Less impairment losses

BPP LEARNING MEDIA

2,400
9,100
1,500
(13,000)
4,000
(150)
3,850

Answer: Lecture example 1 (cont'd)


3

Investment in associate
Cost of associate
Add post-acquisition reserves (W4)
Less impairment losses on associate to date

BPP LEARNING MEDIA

$'000
4,700
180
(40)
4,840

Answer: Lecture example 1 (cont'd)


4

Consolidated reserves

Per question
Fair value movement (W6)
Provision for unrealised profit (W7)

Portus

Sanus

Allus

$'000

$'000

$'000

54,100

10,600
(390)

9,200

(6)

(80)

Pre-acquisition reserves
(10,600 (2,000 9/12))

(9,100)
1,030

Group share of post acq'n reserves:


Sanus (1,030 80%)

824

Allus (600 30%)

180

Less: impairment losses:


Sanus (150 80%)
Allus

(120)
(40)
54,938

BPP LEARNING MEDIA

(8,600)
600

Answer: Lecture example 1 (cont'd)


5

Non-controlling interests (SOFP)


NCI at acquisition (W2)
NCI share of post acquisition reserves ((W4) 1,030 20%
NCI share of impairment losses ((W2) 150 20%)

BPP LEARNING MEDIA

$'000
3,200
206
(30)
3,376

Answer: Lecture example 1 (cont'd)


6 Fair value adjustments

Inventories
Plant and equipment

At acquisition
date
$'000
300
1,200
1,500

Movement

Goodwill

COS
& reserves

$'000
(300)
(90)*
(390)

At year
end
$'000

1,110
1,110

*Extra depreciation
$1,200,000 1/10 9/12

BPP LEARNING MEDIA

SOFP

Answer: Lecture example 1 (cont'd)


7

Intra-group trading
(1)

Cash in transit
$'000

(2)

DEBIT Group cash

70

CREDIT Trade receivables

70

Cancel intragroup balances (only with subsidiary)


$'000
DEBIT Group revenue

200

CREDIT Group purchases (Cost of sales)

200
$'000

DEBIT Group payables

130

CREDIT Group receivables

130

BPP LEARNING MEDIA

Answer: Lecture example 1 (cont'd)


(3)

Eliminate unrealised profit


Sanus:
Profit element in inventories: $200,000 40% = $80,000
$'000
DEBIT Cost of sales (and reserves) (of Sanus the seller)
CREDIT Group inventories

80
80

Allus:
Profit element in inventories: $400,000 25% / 125% = $20,000
Associate share $20,000 30% = $6,000
$'000
DEBIT Cost of sales (and reserves) (of Allus the
seller)

6 (ie in share of
profit of

CREDIT Group inventories

associate)
6 (as the

BPP LEARNING MEDIA

inventories are

Answer: Lecture example 1 (cont'd)


8

Acquisition of Allus
$'000
DEBIT Investment in Allus (500 $9.40)
CREDIT Share capital (500 $1)
CREDIT Share premium (500 $8.40)

BPP LEARNING MEDIA

4,700
500
4,200

Question: Lecture example 2


Continuing from Lecture example 1 and the previous chapter, the statements of
profit or loss and other comprehensive income of Portus, its subsidiary Sanus
and its associate Allus for the year ended 31 December 20X4 are as follows.
Portus

Sanus

Allus

$'000

$'000

$'000

Revenue
Cost of sales
Gross profit
Expenses
Finance costs
Dividend income from Allus

28,500
(17,100)
11,400
(4,400)
(400)
60

11,800
(7,000)
4,800
(2,200)
(200)

9,500
(5,800)
3,700
(1,600)
(200)

Profit before tax


Income tax expense
PROFIT FOR THE YEAR
Other comprehensive income:

6,660
(2,100)
4,560

2,400
(800)
1,600

1,900
(600)
1,300

900

400

300

Gains on property revaluation


TOTAL COMPREHENSIVE INCOME FOR
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Question: Lecture example 2 (cont'd)


Required
Prepare the consolidated statement of profit or loss and other
comprehensive income for the Portus Group for the year ended 31
December 20X4.

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Answer: Lecture example 2


Portus Group
CONSOLIDATED STATEMENT OF PROFIT OR LOSS AND OTHER COMPREHENSIVE
INCOME FOR THE YEAR ENDED 31 DECEMBER 20X4
$'000
Revenue (28,500 + (11,800 9/12) LE1 (W7) 200)
Cost of sales (17,100 + (7,000 9/12) + (W6) 390 (W7) 200 + (W7) 80)
Gross profit
Expenses (4,400 + (2,200 9/12) + LE1 (W2) 150)
Finance costs (400 + (200 9/12))
Share of profit of associate [(1,300 30% 6/12) LE1 (W7) 6 40
imp losses)]
Profit before tax
Income tax expense (2,100 + (800 9/12))
PROFIT FOR THE YEAR

37,150
(22,620)
14,530
(6,200)
(550)
149
7,929
(2,700)
5,229

Other comprehensive income:


Gains on property revaluation (900 + (400 9/12))

1,200

Share of gain on property revaluation of associate (300 30% 6/12)


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Other
comprehensive income for the year

45
1,245

Answer: Lecture example 2 (cont'd)


Profit attributable to:
Owners of the parent ()
Non-controlling interests (W2)
Total comprehensive income attributable to:
Owners of the parent ()
Non-controlling interests (W2)

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5,113
116
5,229
6,298
176
6,474

Answer: Lecture example 2 (cont'd)


Workings
1

Timeline
1.1.X4

1.4.X4

1.7.X4

31.12X4

Portus all year


Sanus Income and expenses and 20% NCI 9/12
Allus PFY and OCI 30% 6/12

PUP
adjustment

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Answer: Lecture example 2 (cont'd)


2

Non-controlling interests (SOCI)


Profit for the Total comp
year
income
$'000
$'000
PFY/TCI per question (1,600 9/12) / 2,000 9/12)
Less impairment losses (LE1 (W2))

1,200
(150)

1,500
(150)

Less fair value movement (LE1 (W6))

(390)

(390)

(80)

(80)

580

880

20%

20%

116

176

Less unrealised profit (LE1 (W7))

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Past exam questions


Nature of question

Exam details

Often questions examining the


consolidated statement of financial
position include an associate within the
group structure.
Additional workings are required for the
investment in associate and the
cancellation of any unrealised profit on
the sale of inventory.

Q1 June 2010
Q1 Dec 2011
Q1 June 2012

Associates are likely to appear in a 15or 30-mark question in Section B.


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Chapter 12
Inventories and
biological assets

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Inventories and short-term WIP


(IAS 2)
Biological assets (IAS 41)

Syllabus learning outcomes 1


Describe and apply the principles of inventory valuation
Apply the requirements of relevant accounting standards
for biological assets

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Chapter summary diagram


Inventories and biological
assets

Inventories

Valuation

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Interchangeable
items

Biological assets
Accounting
treatment

Inventories and short-term WIP (IAS 2) 1


Inventories are assets:
Held for sale in the ordinary course of business; or
Used in the production of goods for resale or the
rendering of services
Inventories include:
Goods purchased and held for resale
Finished goods produced
Work in progress being produced
Materials and supplies awaiting use in the production
process

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Inventories and short-term WIP (IAS 2) 2


Inventories must be measured at the lower of:
Cost
Net realisable value
The lower of cost and net realisable value should be
calculated on a line by line basis (ie taking each item
separately).

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Inventories and short-term WIP (IAS 2) 3


The cost of inventory comprises:
Costs of purchase
Costs of conversion
Other costs incurred in bringing inventories to their
present location and condition

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Inventories and short-term WIP (IAS 2) 4


Costs of purchase
Purchase price
Import duties and other taxes
Transport, handling and any other costs directly attributable
to the acquisition of finished goods, materials and services
Less trade discounts, rebates and other similar items
Costs of conversion
Direct materials and labour
Variable production overheads
Fixed production overheads (these must be allocated to
items of inventory based on the entity's normal level of
activity)

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Inventories and short-term WIP (IAS 2) 5


Other costs incurred in bringing inventories to their
present location and condition.
For example: the non-production overheads of
designing a product for a specific customer
But not:
Abnormal wastage (materials, labour or overheads)
Storage costs
Administrative overheads
Selling costs

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Inventories and short-term WIP (IAS 2) 6


An approximation to the cost of inventories may also be
calculated using one of two techniques:
Standard costs: here a cost card is produced to value
the normal production values in an item of inventory
(raw materials used, labour hours incurred).
Standard costs should be reviewed regularly to
ensure that they approximate to current costs.
Retail method: here the cost of inventories is
calculated by taking the selling price of the
inventories less the average profit margin realised on
the sale of the inventories.

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Inventories and short-term WIP (IAS 2) 7


Interchangeable items

Where inventories comprise interchangeable items it may not be possible to


determine which items of inventories are held at the year end and therefore
their associated cost.

IAS 2 allows their cost to be determined by reference to one of two estimation


techniques:
First in, first out (FIFO):
The cost of inventories is calculated on the basis that the inventories held
at the end of the reporting period represent the latest purchases or
production.
Weighted average cost:
The cost of inventories is calculated by using a weighted average price
which is calculated by dividing the total cost of items by the total number of
such items. The price is recalculated on a periodic basis or as each
additional shipment is received and items taken out of inventory are
removed at the prevailing weighted average cost.
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Inventories and short-term WIP (IAS 2) 8


Inventories must be measured at the lower of cost and
net realisable value.
Net realisable value:
Estimated selling price

Less estimated costs of completion


Less estimated selling costs*

(X)
(X)

X
*Marketing, selling and distribution costs

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Inventories and short-term WIP (IAS 2) 9


Inventory item

Cost

NRV

Lower
$

27

32

27

14

43

55

43

4
29
40
29
The inventories figure is $107 not $113.
113
135
107
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Inventories and short-term WIP (IAS 2) 10


Measuring inventories at the lower of cost and net
realisable value will result in any loss being recognised
in the financial statements as soon as it is foreseen.
Net realisable value may be lower than cost due to:
An increase in costs or fall in sales price
Physical deterioration of inventories
Obsolescence of products
A management decision to sell products at a loss
Errors in production or purchasing

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Biological assets (IAS 41) 1


IAS 41Agriculture applies the requirements of IFRS to the
treatment of biological assets.
Biological assets are living animals or plants.

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Biological assets (IAS 41) 2


Harvest is the detachment of produce from a biological
asset or the cessation of a biological asset's life process
(as in slaughter).
Agricultural produce is the harvested product of an
entity's biological assets (such as apples or carcasses).

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Biological assets (IAS 41) 3


IAS 41 distinguishes between two broad categories of
agricultural production system:
(a) Consumable: animals and plants themselves are
harvested (such as beef cattle and wheat).
(b) Bearer: animals and plants bear produce for harvest
(such as dairy cows and apple trees).

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Biological assets (IAS 41) 4


Recognition
Animals and plants are recognised as assets when:
(a) The entity controls the asset as a result of past events
(b) It is probable that future economic benefits associated
with the asset will flow to the entity
(c) The fair value of the asset or its cost to the entity can be
measured reliably

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Biological assets (IAS 41) 5


Measurement
IAS 41 requires all biological assets to be measured at the
year end at fair value less estimated point-of-sale costs.
Fair value can usually be taken to be market value.
Any gain or loss arising from changes to fair value is
recognised in profit or loss.

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Biological assets (IAS 41) 6


Agricultural produce is recognised prior to harvest at fair
value less estimated point of sale costs.
Following harvest agricultural produce is classified as
inventory and accounted for in accordance with IAS 2.

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Past exam questions


Nature of question

Exam details

Calculate the value of closing inventory

Q2 Dec 2011

Calculate the value of closing inventory


Prepare financial statement extracts for a construction
contract

Q2 June 2011
Q5 June 2011

Comment on the appropriateness of changing from


AVCO to FIFO to value inventory

Q4 (b) Dec 2010

Questions on inventories and biological assets are


most likely to appear as MCQs.

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Chapter 13

Provisions

Provisions,
contingent liabilities
and contingent
assets

Contingent liabilities and


contingent assets

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Provisions for restructuring

Syllabus learning outcomes 1


Explain why an accounting standard on provisions is
necessary
Distinguish between legal and constructive obligations
State when provisions may and may not be made and
demonstrate how they should be accounted for
Explain how provisions should be measured

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Syllabus learning outcomes 2


Define contingent assets and liabilities and explain their
accounting treatment
Identify and account for:
Warranties/guarantees
Onerous contracts
Environmental and similar provisions
Provisions for future repairs or refurbishments

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Chapter summary diagram


Provisions, contingent
liabilities and contingent
assets
Contingent
liabilities

Provisions

Contingent assets

Application of the recognition and


measurement rules

Future
operating
losses

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Onerous
contracts

Restructuring

Decommissioning
and environmental
costs

Provisions 1
Issue
When an entity makes a provision, generally speaking,
the double entry is 'DEBIT Expense, CREDIT
Provision'.
This reduces an entity's profit.
When an entity releases a provision the double entry is
'DEBIT Provision, CREDIT Expense'.
This increases an entity's profit.
Businesses were creating and releasing provisions to
manipulate profit figures.

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Provisions 2
What was the solution?
A strict definition of what a provision is.
Three criteria which must be satisfied before a
provision can be recognised in the financial
statements.

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Provisions 3
A provision is a liability of uncertain timing or
amount.
A provision should be recognised in the financial
statements when all three recognition criteria are
satisfied:
An entity has a present obligation (legal or
constructive) as a result of a past event.
It is probable that an outflow of economic
resources will be required to settle the obligation.
A reliable estimate can be made of the amount of
the obligation.

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Provisions 4
An obligation can be legal or constructive:
A legal obligation is one that derives from a
contract or legislation.
A constructive obligation is one that derives from
the actions of an entity where:
An established pattern of past practice, published
policies or a specific statement has indicated to
other parties that the entity will accept certain
responsibilities
The entity has created a valid expectation on the
part of those other parties that it will discharge
those responsibilities
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Question: Services Co
Under new legislation enacted on 30 June 20X0, Services
Co is required to fit smoke filters to its factories by 30
June 20X1. The entity has not fitted the filters.
Should a provision be recognised at the end of the
reporting period:
(a) 31 December 20X0?
(b) 31 December 20X1?

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Answer: Services Co
(a) At 31 December 20X0, there is no obligation as there is no
obligating event either for the costs of fitting the smoke filters
(the filters have not yet been fitted) or for fines under the
legislation.
No provision should be recognised.
(b) At 31 December 20X1 there is still no obligation for the costs
of fitting the filters as no obligating event has occurred (the
fitting of the filters).
However, an obligation may arise to pay fines or penalties
under the legislation because the obligating event has
occurred (the non compliant operation of the factory).
A provision is made for the best estimate of any fines or
penalties that are more likely than not (probable) to be
imposed under the legislation.
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Provisions 5
The amount recognised as a provision should be the
best estimate of the cost required to settle the
obligation at the end of the reporting period.
Where the provision involves a large population of
items, such as a warranty provision, the provision
should be calculated using expected values.
Where a single obligation is being measured, such as
the outcome of a court case, the individual most
likely outcome should be provided.
The amount of the provision should be discounted
where the time value of money is material.

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Question: Proviso Co
Discuss the accounting treatment of the above situations:
(1) Proviso Co issued a one-year guarantee for faulty workmanship
on an item of specialist equipment that it delivered to its
customer. At Proviso's year end, the company is being sued by
the customer for refusing to replace or repair the item of
equipment within the guarantee period, as Proviso believes the
fault is not covered by the guarantee, but instead has arisen
because of the customer not following the operating instructions.
Proviso's lawyer has advised them that it is more likely than not
that they will be found liable. This would result in Proviso being
forced to replace or repair the equipment plus pay court costs
and a fine amounting to approximately $10,000.
Based on past experience with similar items of equipment,
Proviso estimates that there is a 70% chance that the central
core would need to be replaced which would cost $40,000 and a
30% chance that the repair would only cost about $15,000.
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Question: Proviso Co (cont'd)


(2) Proviso also manufactures small items of equipment which it
sells via a retail network. The company sold 12,000 items of this
type this year, which also have a one-year guarantee if the
equipment fails. Based on past experience, 5% of items sold are
returned for repair or replacement. In each case, one third of the
items returned are able to be repaired at a cost of $50, whilst the
remaining two thirds are scrapped and replaced. The
manufacturing cost of a replacement item is $150.

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Answer: Proviso Co
(1) At the end of the reporting period, Proviso disputes liability
(and therefore whether a present obligation exists).
However, given that it is more likely than not that Proviso will
be found guilty, a present obligation is assumed to exist
(IAS 37 Para 1516).
Given that a single obligation is being measured, a
provision is made for the outflow of the most likely outcome
(IAS 37 Para 40).
Consequently a provision is recognised for
$10,000 + $40,000 = $50,000.

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Answer: Proviso Co (cont'd)


(2) A present obligation exists at the end of the reporting period
based on historical evidence of items being repaired under the
guarantee agreement.
Here, a large population of items is involved.
A provision is therefore made for the expected value of the
outflow:
12,000 5% 1/3 $50 =
$10,000
12,000 5% 2/3 $150 = $60,000
$70,000

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Provisions 6
Specific situations
Future operating losses:
Provisions should not be recognised for future operating losses.
They do not meet the definition of a liability or the recognition
criteria.
Onerous contracts:
An onerous contract is a contract where the unavoidable costs
of completing the contract exceed the benefits expected to be
received under it.
Where an onerous contract exists, the entity should provide for
the net loss which is the lower of the costs of fulfilling the
contract and the penalties from failing to fulfill the contract.

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Question: China Co
You have a contract to buy 300 metres of silk from China
Co each month for $9 per metre. From each metre of silk
you make one shirt. You also incur labour and other direct
variable costs of $8 per shirt.
Usually you can sell each shirt for $22 but in late July
20X8 the market price falls to $14. You are considering
ceasing production since you think the market may not
improve.
If you decide to cancel the silk purchase contract without
two months' notice you must pay a cancellation penalty of
$1,200 for each of the next two months.

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Question: China Co (cont'd)


(1) Is there a present obligation at the year end of 31 July
20X8?
(2) What will appear in respect of the contract in your
financial statements for the year ended 31 July 20X8?

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Answer: China Co
Honour contract
Revenue (300 m $14 2 months)
Costs (300 m ($9 + $8) 2 months)
Loss

Cancel contract
$8,400

Penalties $1,200 2 months = $2,400

($10,200)
($1,800)

The unavoidable cost is the lower of these two costs: $1,800.


This will be shown as a provision in the statement of financial
position and as an expense in the statement of profit or loss.

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Provisions 7
Specific situations (continued)
Decommissioning and other environmental costs:
Provisions for these costs should only be recognised
from the date on which the obligating event occurs.

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Question: Oilfield Co
An entity operates an offshore oilfield where its licensing
agreement requires it to remove the oil rig at the end of
production and restore the seabed. 90% of the eventual costs
of this work relate to the removal of the oil rig and restoration
of damage caused by building it, and 10% through the
extraction of oil. At the year end, the rig has been constructed
but no oil has been extracted.
(1) When do the obligations arise in respect of the two
portions of the cost?
(2) How should these be dealt with in the financial
statements?

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Answer: Oilfield Co
(1) The obligation for 90% of the cost which relates to the removal
of the oil rig arises at the point when the oil rig is constructed,
as there is a legal obligation to incur these costs.
The obligation for the final 10% of the cost relating to the
rectification of damage caused by extraction of the oil only
arises as the oil extraction progresses.
(2) At the year end a provision should be recognised for the best
estimate of the 90% of the costs relating to the removal of the
rig and restoration of the damage caused by building it. These
costs should be included as part of the cost of the oil rig.
The 10% of costs that arise through extraction of the oil will be
recognised as a liability in future periods over the period the oil
is extracted.
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Provisions for restructuring 1


A restructuring is a planned programme which
materially changes the scope of business undertaken
by an entity or the manner in which that business is
conducted.
A provision for restructuring costs is recognised only
when the entity has a constructive obligation to
restructure.
This will only be where an entity:
Has a detailed formal plan for the restructuring, and
Has raised a valid expectation in those affected that
it will carry out the restructuring

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Question: Restructuring Co
On 12 December 20X0 the board of an entity decided to
close down a division.
Explain the appropriate accounting treatment.
(1) Assuming that no steps were taken to implement the
decision and the decision was not communicated to
any of those affected by the end of the reporting period
31 December 20X0.
(2) If a detailed plan had been agreed by the board on 20
December 20X0, letters sent to notify customers and
the staff of the division have received redundancy
notices.
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Answer: Restructuring Co
(1) There has been no obligating event, so no provision is
recognised.
(2) The communication of the decision to the customers
and employers gives rise to a constructive obligation
because it creates a valid expectation that the division
will be closed.
The outflow of resources embodying economic benefits is
probable so, at 31 December 20X0 a provision should
be recognised for the best estimate of the costs of
closing the division.

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Provisions for restructuring 2


A restructuring provision should only include direct
expenditure arising from the restructuring and which
are:
Necessarily entailed by the restructuring
Not associated with the ongoing activities of the
entity
A restructuring provision does not include:
Retraining/relocating continuing staff
Marketing
Investment in new systems and distribution networks

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Contingent liabilities and contingent assets 1


A contingent liability is:
A possible obligation that arises from past events whose
existence will be confirmed only by the occurrence of one
or more uncertain future events not wholly within the
control of the entity; or
A present obligation that arises from past events but which
is not recognised because:
It is not probable that an outflow of economic benefits
will be required to settle the obligation; or
The amount of the obligation cannot be measured with
significant reliability.

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Contingent liabilities and contingent assets 2


A contingent liability is not recognised in the financial
statements.
Instead it is disclosed in a note to the financial
statements unless the possibility of an outflow of
economic benefits is remote in which case the item is
not included in the financial statements.

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Contingent liabilities and contingent assets 3


The following disclosure should be made for each class
of contingent liability.
The nature of the contingent liability
An estimate of its financial effect
An indication of the uncertainties relating to the
amount or timing of any outflow
The possibility of any reimbursement

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Contingent liabilities and contingent assets 4


A contingent asset is:
A possible asset arising from past events whose
existence will be confirmed only by the occurrence of
one or more uncertain future events not wholly within
the control of the entity
A contingent asset is not recognised unless the inflow
of the related economic benefits is virtually certain.
A contingent asset is disclosed where the inflow of
economic benefits is probable.

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Contingent liabilities and contingent assets 5


Contingent assets
Inflow:

Treatment:

Virtually certain

Recognise

Probable

Disclose

Possible

Do nothing

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Contingent liabilities and contingent assets 6


An entity must have more certainty relating to
contingent assets.
A contingent liability is disclosed when possible but a
contingent asset can only be disclosed when it is
probable.

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IAS 37 Summary diagram


Start
Present
obligation as a
result of an
obligating
event?

No

Yes

Yes

Probable
outflow?

No

Yes

Provide

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Remote?

Yes

No

Yes

Reliable
estimate?

Possible
obligation?

No

No (rare)

Disclose
contingent
liability

Do nothing

Past exam questions


Nature of question

Exam details

Provision for directors' bonuses


Closure costs, onerous contracts

Q2 June 2013
Q4 (c) June 2013

Provision for environmental costs

Q5 Dec 2012

Calculations of provisions for


decommissioning costs and guarantees

Q4 Dec 2011

Decommissioning costs
Provisions for closure costs and future
operating losses

Q2 Dec 2010
Q5 Dec 2010

These topics could now be tested by


MCQ.
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Chapter 14

Financial instruments

Financial
instruments

Disclosure of financial instruments

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Presentation of financial
instruments
Recognition and measurement of
financial instruments

Syllabus learning outcomes 1


Explain the need for an accounting standard on financial
instruments
Define financial instruments in terms of financial assets
and financial liabilities
Indicate for the following categories of financial
instruments how they should be measured and how any
gains and losses from subsequent measurement should
be treated in the financial statements:
Amortised cost
Fair value (including option to elect to present gains and
losses on equity instruments in comprehensive income)

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Syllabus learning outcomes 2


Distinguish between debt and equity capital
Apply the requirements of relevant accounting standards to
the issue and finance costs of:
Equity
Redeemable preference shares and debt instruments
with no conversion rights (principle of amortised cost)
Convertible debt

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Chapter summary diagram


Financial assets and
liabilities
Need for a
standard

Definitions

Financial asset

Financial liability

Types of
financial asset

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Debt
instruments

Classification

Equity
instruments

Convertible
debt

Financial instruments 1
Issue
In recent years there have been many changes to number
and variety of financial instruments which are available to
companies.
The main issues have surrounded how they are measured
and classified/presented in the financial statements.
Whether a financial instrument should be classified as
debt or equity is an important consideration mainly
because of the effect this decision could have on a
company's gearing ratio.
There is a definite need for consistency.

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Financial instruments 2
Definitions
A financial instrument is:
A contract that gives rise to both a financial asset of
one entity and a financial liability or equity instrument of
another
For example a loan agreement from a bank signed by a
company would be a financial instrument because the
bank would show a financial asset in its financial
statements (in the form of a receivable) and the company
would show a financial liability (in the form of a loan).

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Financial instruments 3
Definitions:
A financial asset is:
(a) Cash
(b) An equity instrument of another entity (for example
shares, share options or share warrants)
(c) A contractual right to receive cash or another financial
asset from another entity (for example a trade
receivable)
(d) A derivative standing at a gain

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Financial instruments 4
Definitions
A financial liability is:
(a) A contractual obligation to deliver cash or another
financial asset to another entity (for example a trade
payable, debenture loan and redeemable preference
shares)
(b) A derivative standing at a loss
An equity instrument is any contract that gives the holder
a residual interest in the assets of an entity after deducting
all of its liabilities.

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Presentation of financial instruments 1


IAS 32 deals with the classification of financial instruments
between liabilities and equity and the presentation of
certain compound instruments such as convertible debt.
It states that financial instruments should be classified as
debt (financial asset or liability) or equity depending on
their substance rather than their legal form.

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Presentation of financial instruments 2


Debt instruments
Debt instruments are those which meet the definition of a
financial asset or a financial liability.
Illustration
Consider the following scenario: a company issues
$100,000 6% redeemable preference shares.

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Presentation of financial instruments 3


Discussion of illustration
You might see the term 'shares' and think that the transaction
should be recorded in equity.
However it is much more important to look beyond the wording
and consider the substance.
The preference shares are redeemable and so having issued
them, the company has an obligation to repay them at some point
in the future.
This seems to correlate closely to the definition of a liability from
the Conceptual Framework and the definition of a financial liability.
Furthermore the 6% dividend payable on the preference shares
seems to indicate that the preference shareholders will be paid a
lender's return.
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Presentation of financial instruments 4


Conclusion
The redeemable preference shares will be reported under
non-current liabilities in the statement of financial
position (assuming they are redeemable after more than
one year).
The 6% annual dividend ($6,000) would be reported in the
statement of profit or loss and other comprehensive
income as part of the finance costs charge for the year.

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Presentation of financial instruments 5


Equity instruments
An equity instrument is defined as 'any contract which
evidences a residual interest in the assets of an entity
after deducting all of its liabilities'.
Illustration:
Consider the following scenario: a company issues
100,000 $1 shares when the market price is $2.60 per
share. Issue costs of $3,000 are incurred.

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Presentation of financial instruments 6


Discussion and conclusion of illustration

Here there is no indication that the shares have limited rights or that
the company has any obligations in relation to the shareholders.

As such the shares should be recorded in equity.

IAS 32 states that the shares should be recorded at their net


proceeds and so any issue costs would reduce the value recorded for
the shares and be deducted from premium at which the shares are
issued.

The company should record the following in equity:


$
Share capital (100,000 $1)

100,000

Share premium [(100,000 $1.60) ($3,000)]

157,000

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Presentation of financial instruments 7


Compound financial instruments

This term describes financial instruments which contain both a liability


and an equity element.

IAS 32 states that each component part of the instrument should be


classified and valued separately according to the substance of the
arrangement.

The most common type of compound instrument is convertible debt.

The compound instrument should be separated as follows.


Firstly determine the carrying amount of the debt component by
reference to a similar liability that does not have conversion rights
Then value the equity component as the balancing figure
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Question: Lecture example 1 (cont'd)


A company issued 3,000 convertible bonds at par on 1 January
20X1.
The bonds are redeemable 31 December 20X4 at their par value of
$100 per bond.
The bonds pay interest annually in arrears at an interest rate (based
on nominal value) of 5%. Each bond can be converted at the maturity
date into 5 $1 shares.
The prevailing market interest rate for four year bonds that have no
right of conversion is 8%.
The present value at 8% of $1 receivable at end of:
Year 1 0.926
Year 2 0.857
Year 3 0.794
Year 4 0.735
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Question: Lecture example 1 (cont'd)


Required
Show the accounting treatment of the:
(a) Bond at inception
(b) Financial liability component at 31 December 20X1 using
amortised cost
Note. The examiner has stated that he will not test the treatment of
the equity component after inception.

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Answer: Lecture example 1


(a) At 1 January 20X1

$
Non-current liabilities
Financial liability component of convertible bond
(W1)

270,180

Equity
Equity component of convertible bond
(300,000 (W1) 270,180)

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29,820

Answer: Lecture example 1 (cont'd)


Working 1
Fair value of equivalent non-convertible debt
Present value of principal payable at end of four years

$
220,500

(3,000 $100 = $300,000 0.735)


Present value of interest payable annually in arrears for four
years:
Year 1 (300,000 5%) = 15,000 0.926
Year 2 (300,000 5%) = 15,000 0.857
Year 3 (300,000 5%) = 15,000 0.794
Year 4 (300,000 5%) = 15,000 0.735

13,890
12,855
11,910
11,025
49,680
270,180

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Answer: Lecture example 1 (cont'd)


(b) At 31 December 20X1

$
Finance costs (profit or loss)
Effective interest on financial liability component of
convertible bond (W2)

21,614

Non-current liabilities
Financial liability component of convertible bond (W2)
Working 2
1.1.X1
1.1.X1 31.12.X1
31.12.X1
31.12.X1
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Liability b/d
Interest at 8%
Coupon interest paid (5%)
Liability c/d

276,794
$
270,180
21,614
(15,000)
276,794

Disclosure of financial instruments

IFRS 7 requires specific monetary disclosures of financial instruments


and also encourages the preparers of financial statements to include
a narrative commentary on the entity's financial instruments.

This commentary would help users understand management's


attitude to risk.

IFRS 7 does not however prescribe the format or location of these


disclosures thus allowing management to exercise judgement.

Common sense should also be applied and where there are a large
number of similar financial instrument transactions they may be
grouped together. Similarly where a single significant transaction
requires full disclosure this should also be made.

The examiner has stated that he will not set questions relating to the
risks of financial instruments.

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Recognition and measurement of financial instruments 1

IFRS 9 states that a financial asset or financial liability should initially


be recognised in the statement of financial position when the
reporting entity becomes a party to the contractual provisions of the
instrument.

A financial asset should be derecognised when:


The contractual right to the cash flows from the financial asset
expire; or
The entity transfers substantially all the risks and rewards of
ownership of the financial asset to another party.

A financial liability should be derecognised when it is extinguished,


namely when the obligation specified in the contract is discharged,
cancelled or expires.

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Recognition and measurement of financial instruments 2


Classification of financial assets:
On recognition IFRS 9 requires that financial assets are classified as
measured in one of three ways:
(a) At amortised cost

This is determined on the basis that the entity's business model


for managing financial assets is that they are held to collect
interest and principal cash flows.

(b) At fair value through other comprehensive income

This is used where the financial asset is an investment in the


equity instruments of another entity and such investments are not
held for trading.

This treatment is optional and an irrevocable election must be


made on purchase of the investment to be able to carry them at
fair value through other comprehensive income.

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Recognition and measurement of financial instruments 3


Classification of financial assets (continued):
(c) At fair value through profit or loss

This is used where the financial assets are held for trading,
comprise derivatives and all other financial assets.

Therefore if the entity has an investment in the equity instruments


of another entity which is not held for trading but the election was
not made on purchase of the investment then the investment will
be held at fair value with any movements in fair value being
shown in profit or loss.

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Recognition and measurement of financial instruments 4

In a financial statement preparation question, you may


have to account for:
A financial instrument held at amortised cost
The change in fair value of a financial instrument held
at fair value

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Recognition and measurement of financial instruments 5

Financial assets at amortised cost


The amortised cost of a debt instrument (financial asset or
financial liability) is:
The amount at which the debt was initially recorded
Less any principal repayments
Plus the cumulative amortisation of the difference
between the initial and maturity values
The initial value may include a discount on inception and
the maturity value could include a premium on
redemption.

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Recognition and measurement of financial instruments 6

Financial assets at amortised cost (continued)


The difference between these two values is amortised
using the effective interest rate of the debt instrument,
namely the internal rate of return of the debt.
This is essentially the way a mortgage on a property
works from the lender's perspective.
Transaction costs are added to the cost of the asset
acquired.

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Question: Lecture example 2


Financial asset held at amortised cost
A company purchases a deep discount bond with a par value of
$500,000 on 1 January 20X1 for proceeds of $440,000.
Annual coupon payments of 5% are payable on 31 December each
year.
The entity incurred transaction costs of $5,867. The bond will be
redeemed on 31 December 20X3 at par.
The effective interest rate on the bond has been calculated at 9.3%.
Required
Show the profit or loss impact and carrying value of the bond for
each of the years of the bond's life. (20X120X3)

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Answer: Lecture example 2


At inception the bond is classed as a financial asset and is
initially recognised at the amount paid plus the associated
transaction costs.
This is $440,000 + $5,867 = $445,867.
The entry to record the financial asset is:
DEBIT
CREDIT

Financial asset
Cash

445,867
445,867

IFRS 9 requires financial assets held to collect the cash flows


to be held at amortised cost based on their effective rate of
interest (internal rate of return).
This is shown in the table on the next slide.
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Answer: Lecture example 2 (cont'd)


$
Financial asset b/d (cash paid on 1.1.X1)

445,867

Interest income 20X1 (9.3% $445,867)

41,466

Less coupon received (5% $500,000)

(25,000)

Financial asset c/d at 31.12.X1

462,333

Interest income 20X2 (9.3% $462,333)

42,997

Less coupon received (5% $500,000)

(25,000)

Financial asset c/d at 31.12.X2

480,330

Interest income 20X3 (9.3% $480,330)

44,670

Less principal and coupon received 20X3


($500,000 + (5% $500,000))
Financial asset c/d at 31.12.20X3

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(525,000)

Recognition and measurement of financial instruments 7


Financial assets at fair value
These assets are remeasured to fair value at the end of the
reporting period.
Any gain or loss will be shown:
In other comprehensive income if the financial asset is
classified as measured at fair value through other
comprehensive income; or
In profit or loss if the financial asset is classified as measured
at fair value through profit or loss.
In either case, dividends received on the shares are reported
as income.
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Recognition and measurement of financial instruments 8


Financial assets at fair value (continued)
Illustration
An entity holds an investment in shares in another company,
which cost $45,000.
At the date of purchase the election was made to record
changes in value in other comprehensive income.
At the year end their value has risen to $49,000.
How would the change in value be reported?

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Recognition and measurement of financial instruments 9


Financial assets at fair value (continued)
Conclusion on illustration
The investment has increased in value by $4,000 ($49,000 $44,000).
This will be shown as an increase in the investment in the statement of
financial position and the gain will be reported in other comprehensive
income (per the illustration).
The following adjustment would need to be made in an accounts
preparation question:
DEBIT
Investment in shares ($49,000 $44,000) $4,000
CREDIT
Other comprehensive income
$4,000

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Past exam questions


Nature of question

Exam details

A financial statement preparation


question often requires you to calculate
the value / movement year on year for
financial assets and liabilities held at
amortised cost and or fair value (through
other comprehensive income or profit or
loss).

Q2 Dec 2012
Q1 June 2012
Q2 Dec 2011
Q2 Dec 2010
Q2 June 2010

Financial instruments could now also be


examined by MCQ.
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Chapter 15
Revenue

Off-balance sheet finance explained


Substance over form
The IASB Conceptual Framework
Common forms of off-balance sheet
finance
Revenue recognition
IAS 11 Construction Contracts
IAS 20: Government grants

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Syllabus learning outcomes 1


Apply the principle of substance over form to the
recognition of revenue
Explain the importance of recording the commercial
substance rather than the legal form of transactions give
examples where recording the legal form of transactions
may be misleading
Describe the features which may indicate that the
substance of transactions differs from their legal form
Apply the principle of substance over form to the
recognition and derecognition of assets and liabilities

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Syllabus learning outcomes 2


Recognise the substance of transactions in general, and
specifically account for the following types of transactions:
Goods sold on sale or return/consignment inventory
Sale and repurchase/leaseback agreements
Factoring of receivables
Define a construction contract and discuss the role of
accounting concepts in the recognition of profit
Describe the acceptable methods of determining the stage
(percentage) of completion of a contract
Prepare financial statement extracts for construction
contracts

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Syllabus learning outcomes 3


Apply the provisions of relevant accounting standards in
relation to accounting for government grants

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Chapter summary diagram


Revenue
Construction
contracts

Government grants

Revenue (IAS 18)

Recognition

Sale of goods

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Measurement

Rendering of
services

Off-balance sheet finance explained 1


Issue
In the 1980's many complex arrangements were developed
where the legal form of the transaction was different from the
substance of the transaction.
These are particularly related to financing arrangements.
Entities were essentially funding their operations with financing
arrangements which in legal terms were not a liability and so no
liability was recognised in the statement of financial position.
In reality though, the substance of the transaction was that the
financing arrangement did give rise to a liability and so should
have been recognised on the statement of financial position.
In this way companies were essentially able to manipulate their
financial statements.
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Off-balance sheet finance explained 2


Issue (continued)
One major effect of this manipulation was the distortion of key
financial ratios, in particular the gearing ratio.
The gearing ratio is calculated as:
Debt/Equity; or
Debt/Debt + Equity.
Generally speaking companies do not like to appear to be too
highly geared.
Classifying a financing arrangement as equity when it should
have been a liability (and part of debt) will improve the gearing
ratio.
Off-balance sheet financing soon became a key issue for
standard setters.
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Substance over form 1


Definition
The principle that transactions and other events are accounted
for and presented in accordance with their substance and
economic reality and not merely their legal form.
IAS 8 Accounting policies, changes in accounting estimates
and errors states that:
'Management shall use judgement in developing and
applying an accounting policy that results in information that
is ... Reliable, in that the financial statements reflect the
economic substance of transactions, other events and
conditions and not merely the legal form.'

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Substance over form 2


Several other accounting standards also address the issue of substance
over form:

IAS 17 Leases
If under a lease, the lessee bears substantially all of the risks and
rewards of ownership, they should recognise the asset and
associated liability in the financial statements even though they do
not legally own the asset.

IAS 18 Revenue
Revenue from the sale of goods is recognised once the risks and
rewards of ownership of the good have been transferred to the
buyer.

IAS 11 Construction contracts


An entity should account for the attributable profit earned on a
construction contract.

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Substance over form 3

IAS 27 and quasi-subsidiaries:


A quasi-subsidiary is a company, trust, partnership or other
vehicle, which whilst it doesn't fulfill the definition of a
subsidiary is controlled (directly or indirectly) by the entity and
gives rise to benefits which are in substance no different from
those which would arise were the vehicle a subsidiary.
This changed the definition of a subsidiary to being based on
control rather than simply ownership.
It meant that many entities now had to consolidate vehicles
which they previously had not.

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The IASB Conceptual Framework 1


The issue of substance over form is further considered in the
IASB Conceptual Framework.
One of the fundamental qualitative characteristics of useful
financial information is that it should show a faithful
representation of the entity's activities.
This implies that to account for an item according to its legal
form but not its economic substance would not be a faithful
representation.
Note that for the majority of transactions there is no difference
between the legal form and the economic substance and so the
issue does not arise.

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The IASB Conceptual Framework 2

The Conceptual Framework uses the definitions of the elements of


financial statements to enforce the concept of substance over form.

It defines both assets and liabilities and states the criteria which must
be met in order for new assets and liabilities to be recognised in the
financial statements and for existing assets and liabilities to be
changed.

Essentially it is the presence of the word 'control' and 'obligation' in


the definitions which facilitates this.
Asset
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

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The IASB Conceptual Framework 3


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

It is also important to realise that IFRSs and IASs are based on the
Conceptual Framework.

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Common forms of off-balance sheet finance 1


Consignment inventory
Definition:
An arrangement where inventory is held by one party
(for example a distributor) but owned by another party
(for example a manufacturer)
It is a common arrangement in the motor trade and is
similar to goods sold on a 'sale or return basis'.

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Common forms of off-balance sheet finance 2

Considerations:
In order to identify the correct accounting treatment (namely which
party should record the inventory) it is necessary to determine the
point at which distributor acquired the benefits of the inventory
rather than the point at which they acquired legal title.
You should also consider whether the manufacturer has the right
to require the return of the inventories and whether that right is
likely to be exercised. If it is then the inventories are not the assets
of the distributor.
Furthermore if the distributor is rarely required to return the
inventories, then this part of the transaction has little effect on the
substance of the transaction and so can be ignored for accounting
purposes.
Where it appears that the risks and rewards of ownership have
been passed to the distributor they should recognise the
inventories and the associated liability.
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Question: Lecture example 1


Rover Co runs a number of car dealerships throughout London. The
terms of the arrangement between Rover Co and the manufacturer are
as follows.

Legal title passes when the cars are either used by Rover Co for
demonstration purposes or sold to a 3rd party.
The price of vehicles is fixed at the date of transfer.
Rover Co has no right to return vehicles.
Rover Co pays a finance charge between delivery and the date that
legal title passes.

Required
(i) What are the risks inherent in holding inventories?
(ii) What features of the arrangement indicate risk?
(iii) On the basis of the above how should Rover Co account for the
transaction?
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Answer: Lecture example 1


(i)

(ii)

(iii)

Risks inherent in holding inventories:


Obsolescence
Fall in sales price
Slow movement of inventory leading to high holding costs
Features of the arrangement which indicate risk:
Rover Co has no right of return
Rover Co pays a financing charge whilst in possession of
the inventories
Price of vehicles is fixed at the date of transfer.
Accounting treatment?
On the basis of the above it would appear that Rover Co
bears substantially all the risks and rewards associated with
the inventory.
Rover Co should recognise the inventories in its books at
the date of delivery and a corresponding liability.

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Common forms of off-balance sheet finance 3


Sale and repurchase transactions:

Definition:
An arrangement under which company sells the asset to another
person on terms that allow the company to repurchase the asset in
certain circumstances.

Considerations:
Is the transaction a straightforward sale or is it a secured loan.
Examine the scenario in the exam question to determine which
party has the rights to the economic benefits which the asset
generates and the terms on which the asset is to be repurchased.

If the seller has the right to the benefits of the use of the asset and if
the repurchase terms are such that repurchase is likely to take place,
the transaction should be accounted for as a secured loan.

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Question: Lecture example 2


X Co are brandy distillers. They normally hold inventories for six years
before selling it.
A large quantity of two year old inventories have been sold to a bank at
cost.
The normal selling price is cost + 100% profit.
X Co has an option to buy back the brandy in four years' time at a price
which represents the original sale price plus interest at current market
rates.
Required
Outline the principal features of the transaction and how it should be dealt
with in the books of X Co.

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Answer: Lecture example 2


Principle features of the transaction:
The bank is an unusual customer.
The brandy has been sold at an unusual time in the distilling
process and for an unusual price.
X Co has an option to buy back the brandy.
The option to buy back is likely to be exercised as X Co can then
sell the brandy on to a third party.
The bank receives a lender's return.
Accounting entries:
The inventories should remain in X Co's statement of financial
position at cost
An amount equivalent to the 'sales proceeds' should be
recognised as cash and reflected as a non-current liability
The annual interest charge should be accrued and recognised as
an expense in profit or loss
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Common forms of off-balance sheet finance 4


Factoring of receivables

Definition:
An arrangement where the original creditor sells the debts to the
factor.
The sales price may be fixed at the outset of may be adjusted later.
It is also common for the factor to offer a credit facility that allows
the seller to draw upon a proportion of the amounts owed.

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Common forms of off-balance sheet finance 5


Factoring of receivables (continued)

Considerations:
Has the benefit of the debts been passed on to the factor or is the
factor providing a loan on the security of the receivables balances.
Examine the scenario in the exam question to determine whether
the seller has to pay interest on the difference between the
amounts advanced to him and the amounts the factor has
received.
Also determine if the seller bears the risks of non-payment by the
receivable.
If the seller appears to retain substantially all the risks and rewards
of ownership of the receivables then this would indicate that the
transaction is, in effect, a loan rather than the sale of the debts.

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Question: Lecture example 3


Apple Co sells all of its trade receivables to Factor Co, the terms of the
arrangement being as follows.
Factor Co administers the sales ledger of Apple Co charging 1% of
factored debts.
Factor Co maintains a ledger detailing transactions with Apple Co.
The account is debited with any amounts advanced to Apple Co (the
amount is restricted to 75% of all factored debts) and credited with
amounts collected by Factor Co from the trade receivables.
Interest is charged on a daily basis at national base rate + 3%.
Any debts not recovered after 90 days are transferred back to Apple
Co for immediate cash payment.
On termination the balance on the factoring account is settled in cash.

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Question: Lecture example 3


Required
(1) Identify who has legal title to the debts.
(2) What are the risks inherent in receivables and which party bears
those risks?
(3) How should Apple Co account for the arrangement?

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Answer: Lecture example 3


(1) Factor Co has the legal title to the debts as they were sold by Apple Co to
Factor Co.
(2) The risks inherent in receivables include:
Non-payment

Slow payment

The scenario indicates that both these risks are borne by Apple Co
because Factor Co will pass back any amounts not collected after 90
days and also Apple Co has to pay interest on a daily basis for any
monies outstanding.

(3) Accounting treatment:


Apple Co should leave the receivables balances in its statement of
financial position.
Any amounts received by Apple Co from Factor Co should be recognised
as cash and a corresponding liability.
The interest charge should be recorded by Apple Co as an expense in
profit or loss.
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Revenue recognition 1

IAS 18 Revenue governs how the revenue from certain types of


transactions and events should be recognised.

These transactions and events comprise:


The sale of goods
The rendering of services
Interest revenue, royalties and dividends

Revenue includes only those amounts receivable by an entity on its


own account.

Amounts collected on behalf on third parties, such as sales taxes, are


excluded from sales revenue as they are not economic benefits that
flow to the entity.

Note that the IASB Conceptual Framework defines income to include


both revenue and gains. IAS 18 only covers revenue.

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Revenue recognition 2
Sale of goods
Revenue from the sale of goods is recognised when all of the
following are met:
(a) The entity has transferred the significant risks and rewards
of ownership to the buyer.
(b) The entity retains no continuing managerial involvement nor
effective control over the goods sold.
(c) The amount of revenue can be measured reliably.
(d) It is probable that economic benefits associated with the
transaction will flow to the entity; and
(e) Costs incurred in the transaction can be measured reliably.

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Revenue recognition 3
Rendering of services
Once the outcome of a transaction involving the rendering of
services can be estimated reliably, revenue is recognised
according to the stage of completion.
Unlike the sale of goods there are no risks and rewards of
ownership to transfer and no managerial involvement to give up
however the other criteria are still relevant:
(c) The amount of revenue can be measured reliably.
(d) It is probable that economic benefits associated with the
transaction will flow to the entity.
(e) Costs incurred in the transaction can be measured reliably.
Additionally the stage of completion must be measured reliably.
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Revenue recognition 4
Stage of completion
This can be determined in various ways, the most reliable method
should be used:
Surveys of work performed;
Services performed to date as a percentage of total services to
be performed; or
Costs incurred to date and a percentage of total costs.
Note that where the latter method is used the costs incurred to date
must reflect the services performed to date.
Where the outcome of the rendering of services cannot be
estimated reliably, revenue is recognised only to the extent that the
expenses recognised are expected to be recoverable.
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Revenue recognition 5
Interest, royalties and dividends
Revenue is recognised on the following bases:
Interest is recognised on a time proportion basis that takes
into account the effective yield on the asset.
Royalties are recognised on an accruals basis in
accordance with the substance of the relevant agreement.
Dividends are recognised when the shareholder's right to
receive payment is established.

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Revenue recognition 6
Measurement of revenue
Revenue should be measured at the fair value of the
consideration received or receivable.
Where revenue is receivable more than 12 months after it has
been earned, it will usually be discounted to present value.
For example, if an entity sells goods for $1,000 today and the
payment will be received in two year's time, this amount should
be discounted to present value.
Assuming an interest rate of 5%, this amounts to $907.03
calculated as:
$1,000 [1 / (1.05)2]

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Revenue recognition 7
Measurement of revenue (continued)
Revenue (and receivables) would be recognised as $907.03.
The difference between the revenue recognised and the $1,000
which will be received in Year 2 is accounted for as interest
income in profit or loss.
In Year 1, interest income would be $45.35:
$907.03 5% = $45.35
In Year 2, interest income would be $47.62:
($907.03 + $45.35) 5% = $47.62
The interest is added on to the receivable so that the receivable
is stated at $1,000 ($907.03 + $45.35 + $47.62) when the
payment falls due from the customer.

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Revenue recognition 8
If you need to discount an amount to its present value the
interest rate will be provided in the exam.
You will however need to be confident calculating the
appropriate discount factor and present value amount.

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Question: Lecture example 4


Marianne Alltraders entered into the following transactions in the year
ended 31 December 20X2:
(1) A six-month contract to undertake IFRS training for Louise over
the period 1 September 20X2 to 28 February 20X3. The value of
services performed to date amounts to $45,000 out of a total
contract value of $60,000. All costs are expected to be
recoverable.
(2) Sold some bicycles to Graham for $15,000 on 1 October.
Graham has the right to return any unsold bikes before 30 April
20X3 for a full refund.

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Question: Lecture example 4 (cont'd)


(3) Performed advertising services for Ben costing $4,450 relating to
a fixed price $20,000 contract covering the period 1 December to
31 March. Due to fluctuating advertising costs, the expected total
costs cannot be reliably measured at the year end, but Marianne
is certain that Ben will pay the costs incurred to date.
(4) Sold some technical accountancy books on 1 November to
Jennie for $106,152 not due for payment until 1 May 20X3.
Jennie cannot return the books.
Required
How much revenue should be recognised in Marianne Alltraders'
financial statements for the year ended 31 December 20X2?
For item (4) assume a discount rate of 1% per month (12.7%
compound). No other transactions require discounting.

BPP LEARNING MEDIA

Answer: Lecture example 4


$
Sale of goods (45,000
Rendering of services
Interest
(1) Accrue revenue based on work performed (not time
elapsed)
(2) Do not recognise revenue in relation to the bicycles as
the significant risks and rewards of ownership have not
been transferred as Graham has the right to return the
bikes.

BPP LEARNING MEDIA

Answer: Lecture example 4 (cont'd)


$
Sale of goods100,000
49,450
Rendering+of4,450)
services
(45,000
2,010
Interest
151,460
(3) Outcome cannot be measured reliably, recognised only
recoverable costs as revenue
1
6
(4) Fair value of revenue is $106,152
= $100,000.
1.01
Interest accrued to the year end (two months) is:
($100,000 1.012) $100,000 = $2,010.

BPP LEARNING MEDIA

IAS 11 Construction Contracts 1


Definition
A contract specifically negotiated for the construction
of an asset or a combination of assets that are closely
interrelated or interdependent in terms of their design,
technology and function or their ultimate purpose or
use.
Examples include the construction of ships and
buildings.
Note that the contract does not have to be more than
one year long, the activity however must take place
over more than one accounting period.

BPP LEARNING MEDIA

IAS 11 Construction Contracts 2


There are two types of construction contract:
Fixed price contract: the contractor agrees to a fixed
contract price, or a fixed rate per unit of output, which
in some cases is subject to cost escalation causes.
Cost plus contract: the contractor is reimbursed for
allowable or other defined costs, plus a percentage
of these costs or a fixed fee.

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IAS 11 Construction Contracts 3

Contract revenue: the amount of revenue specified in the contract,


subject to variations in the contract work, incentive payments and
claims if these will probably give rise to revenue and they can be
reliably measured.

Measured at the fair value of revenue received or receivable.

Some uncertainties may affect the measurement of contract revenue:


Agreed variations (may increase or decrease revenue)
Cost escalation clauses (will increase revenue in a fixed price
contract)
Penalties imposed due to delays by the contractor (will decrease
revenue)
Varying the number of units (may increase or decrease revenue in a
contract for fixed prices per unit)
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IAS 11 Construction Contracts 4


Contract costs comprise:
Costs relating directly to the contract
Site labour costs
Cost of materials used in construction
Depreciation of plant and equipment used on the
contract
Cost of moving plant and equipment and materials to
and from the contract site
Cost of hiring plant and equipment
Estimated costs of rectification and guarantee work
Claims from third parties
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IAS 11 Construction Contracts 5


Costs attributable to general contract activity which can be
allocated to the contract, for example:
Insurance
Cost of design and technical assistance not directly
related to a specific contract
Construction overheads
Any other costs which can be charged to the customer
under the contract
Note that general administration and development costs
should not be included unless they are to be reimbursed by
the customer per the contract.

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IAS 11 Construction Contracts 6


Issue
Imagine you have been awarded a contract to build a
sports stadium for a price of $13.5 million.
The stadium will take three years to complete and cost
a total of $3.5 million to construct.
When should the $10 million profit on the contract be
recognised?

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IAS 11 Construction Contracts 7


Solution
On completion of the contract?
Over the life of the contract?

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IAS 11 Construction Contracts 8


Where the outcome of a construction contract can be
estimated reliably contract revenue and contract
costs are recognised as revenue and expenses
according to the stage of completion of the contract
at the end of the reporting period.
However any expected loss on the construction
contract is recognised as an expense immediately.

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IAS 11 Construction Contracts 9


Methods to determine the stage of completion include:
Proportion of contract costs incurred
Costs to date Total estimated costs
Surveys of work performed
Work certified Contract price
Physical proportion completed
This may be verified independently

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IAS 11 Construction Contracts 10


Accounting treatment

Statement of profit or loss and other comprehensive income:

$
Revenue (x% Total contract revenue)

(X)

Expenses (x% Total contract costs)

(X)

Expected loss

(X)

Recognised profits/ losses

Where x% is the stage of completion

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IAS 11 Construction Contracts 11


Accounting treatment

Statement of financial position:


Gross amounts due from/ to customers

Contract costs incurred to date

Recognised profits less recognised losses

X
X

Less progress billings to date

(X)
X/(X)

Trade receivables

Progress billings to date

Less cash received

(X)
X

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Question: Example 1 Progress billings


$
Total contract price

100,000

Costs incurred to date

48,000

Estimated costs to completion

32,000

Progress billings

58,000

Cash received

50,000

Stage of completion (proportion of contract


costs incurred)
Required

60%

(a) Prepare relevant extracts from the statement of profit or loss and
statement of financial position.
(b) Show how the statement of financial position would differ if progress
billings were $64,000 (of which $50,000 was received).

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Question: Example 1 Progress billings (cont'd)


Approach
Determine whether contract is profitable
Calculate stage of completion (here given in example)

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Answer: Example 1 Progress billings


Is the contract profitable?
Total revenue
Total expected costs (48,000 + 32,000)
Overall expected profit

Stage of completion
60% per question

BPP LEARNING MEDIA

$
100,000
(80,000)
20,000

Answer: Example 1 Progress billings (cont'd)


(a)

$
STATEMENT OF PROFIT OR LOSS (extract)
Revenue (60% 100,000)
Expenses (60% 80,000)
Profit

STATEMENT OF FINANCIAL POSITION (extract)


Current assets
Gross amounts due from customers
Contract costs incurred to date
Recognised profits

Less progress billings to date

Trade receivables

Progress billings to date


BPPLess
cash
LEARNING
MEDIA received

60,000
(48,000)
12,000

48,000
12,000
60,000
(58,000)
2,000
58,000
(50,000)

Answer: Example 1 Progress billings (cont'd)


(b)

STATEMENT OF FINANCIAL POSITION (extract)


Current assets
Trade receivables

Progress billings to date

Less cash received

Current liabilities

Gross amounts due to customers


Contract costs incurred to date
Recognised profits

Less progress billings to date

BPP LEARNING MEDIA

4,000
(50,000)
14,000

48,000
12,000
60,000
(64,000)
(4,000)

IAS 11 Construction Contracts 12


Expected losses
When it is probable that the total contract costs will
exceed total contract revenue, the expected loss is
recognised as an expense immediately.
The full loss is recognised in the statement of profit or
loss.
This also reduces the gross amounts due from
customers in the statement of financial position.

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Question: Example 2 Expected losses


$
Total contract price

100,000

Costs incurred to date

72,000

Estimated costs to completion

48,000

Progress billings

58,000

Cash received

50,000

Stage of completion (proportion of contract


costs incurred)

60%

Required
(a) Prepare relevant extracts from the statement of profit or loss and
statement of financial position.

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Question: Example 2 Expected losses (cont'd)


Approach
Determine whether contract is profitable

Calculate stage of completion (here given in example)

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Answer: Example 2 Expected losses


Is the contract profitable?
$
Total revenue
Total expected costs (72,000 + 48,000)
Overall expected loss

Stage of completion
60% per question
Recognise full loss immediately

BPP LEARNING MEDIA

100,000
(120,000)
(20,000)

Answer: Example 2 Expected losses (cont'd)


$
STATEMENT OF PROFIT OR LOSS (extract)
Revenue (100,000 60%)
Expenses (120,000 60%)
Expected loss (balancing item)
Recognised loss (100,000 120,000)

BPP LEARNING MEDIA

60,000
(72,000)
(8,000)
(20,000)

Answer: Example 2 Expected losses (cont'd)


$
STATEMENT OF FINANCIAL POSITION (extract)
Current assets
Trade receivables
Progress billings to date
Less cash received

58,000
(50,000)
8,000

Current liabilities
Gross amounts due to customers
Contract costs incurred to date
Recognised losses
Less progress billings to date

BPP LEARNING MEDIA

72,000
(20,000)
52,000
(58,000)
(6,000)

IAS 11 Construction Contracts 13


Outcome cannot be estimated reliably
Where the outcome of a construction contract cannot
be estimated reliably:
Revenue is recognised only to the extent of contract
costs incurred which are expected to be recoverable
Contract costs are recognised as an expense in the
period in which they are incurred.

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Question: Example 3 Outcome not reliable


WB entered into a five-year contract with the national
government to extend a metro line for an agreed fee of
$6,000 million (including costs).
At the end of the first year, total costs incurred were $850
million. At this stage surveyors estimated that the total costs
of the contract would be in the range $4,000 million to
$5,500 million. This was based on the fact that delays had
meant that the project may take substantially more than five
years to complete together with their experience of similar
contracts where costs had spiralled out of control.

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Question: Example 3 Outcome not reliable (cont'd)


Billing was to be undertaken at regular stages of the
contract. By the end of the first year of the contract invoices
to the value of $1,130 million had been issued and $675
million had been received in settlement of the debt. There is
no indication that the government would be unable to pay the
rest of the invoices.
Required
Prepare the numerical financial statement disclosures for the
contract.

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Answer: Example 3 Outcome not reliable


$'m
STATEMENT OF PROFIT OR LOSS (extract)
Revenue (match to recoverable costs)
Expenses (costs incurred)
Profit

850
(850)
0

STATEMENT OF FINANCIAL POSITION (extract)


Current assets
Trade receivables
Progress billings to date
Less cash received

BPP LEARNING MEDIA

1,130
(675)
455

Answer: Example 3 Outcome not reliable (cont'd)


STATEMENT OF FINANCIAL POSITION (extract)
Current liabilities
Gross amounts due to customers
Contract costs incurred to date
Recognised profits less recognised losses
Less progress billings to date

BPP LEARNING MEDIA

850
0
850
(1,130)
(280)

IAS 20: Government grants 1


Definition
Assistance by government in the form of transfers of
resources to an entity in return for past or future
compliance with certain conditions relating to the
operating activities of the entity.
Government grants exclude forms of government
assistance which are not subject to reliable
measurement and transactions with government which
cannot be distinguished from normal trading activities.
Government assistance: action by government designed
to provide an economic benefit specific to an entity or
range of entities qualifying under certain criteria.
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IAS 20: Government grants 2


Recognition
Government grants are only recognised once there
reasonable assurance that the conditions of the grant
will be complied with and the grant will be received.

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IAS 20: Government grants 3


Accounting treatment
There are two types of government grants:
Grants which relate to income:
For example, grants to assist with wages and
salaries costs
These are recognised in profit or loss either
separately as part of 'other income' or as a deduction
from the related expense
Grants relating to assets:
For example, grants to assist with the acquisition of
non-current assets
Choice of accounting treatment
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IAS 20: Government grants 4


Grants relating to assets
Presented in the statement of financial position either:
As deferred income
This is then released over the useful life of the asset
with the reduction being shown as 'other income'; or
By deducting the grant from the carrying amount of the
asset
This means that the carrying amount of the asset and
therefore the associated depreciation is lower.
Either way the depreciation charge less the 'other income'
will show the same net expense.
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IAS 20: Government grants 5


Repayment of grants
Where a government grant becomes repayable it is accounted
for as a change in accounting estimate under IAS 8.
Repayment of grants relating to income are applied first
against any unamortised deferred credit and then in profit or
loss.
Repayments of grants relating to assets are recorded by:
Reducing the deferred income balance; or
Increasing the carrying amount of the asset; or
The cumulative additional depreciation that would have
been recognised to date had the grant not been received is
recognised in profit or loss immediately.

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Past exam questions


Nature of question

Exam details

Adjustments relating to revenue


recognition and identifying the
substance of transactions tend to be
examined in financial statement
preparation questions.

Q2 Dec 2012
Q2 Dec 2011
Q2 June 2011
Q2 June 2010

Questions on construction contracts and


government grants could appear as
MCQs or as part of a financial statement
preparation question.
BPP LEARNING MEDIA

Chapter 16
Leasing

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Types of lease
Lessees

Syllabus learning outcomes


Explain why recording the legal form of a finance lease can
be misleading to users (referring to the commercial
substance of such leases)
Describe and apply the method of determining a lease type
(ie an operating lease or a finance lease)
Discuss the effect on the financial statements of a finance
lease being incorrectly treated as an operating lease
Account for assets financed by finance leases in the
records of the lessee
Account for operating leases in the records of the lessee

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Chapter summary diagram


Issue

Leases

Finance lease

Operating leases

Definition

Definition

Accounting
treatment

Accounting
treatment

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Sale and
leaseback
transactions

Types of lease 1
IAS 17 is another example of the concept of substance over
form as assets held under leases are accounted for according
to their economic substance rather than their legal form.
There are two types of lease: a finance lease and an operating
lease.
Definition:
A finance lease is a lease that transfers substantially all the
risks and rewards incident to ownership of an asset (to the
lessee). Title may or may not be eventually be transferred.
Definition:
An operating lease is a lease other than a finance lease.

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Types of lease 2
Identifying a finance lease
IAS 17 identifies five situations which would normally lead to a lease
being classified as a finance lease:
(a) The lease transfers ownership of the asset to the lessee at the end of
the lease term.
(b) The lessee has the option to purchase the asset at a price
sufficiently below fair value at exercise date, that it is reasonably
certain the option will be exercised.
(c) The lease term is for the major part of the asset's economic life even
if title is not transferred.
(d) The present value of the minimum lease payments amounts to
substantially all of the asset's fair value at inception.
(e) The leased asset is so specialised that it could only be used by the
lessee without major modifications being made.
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Types of lease 3
Why does the type of lease matter?
The type of lease has a huge impact on the accounting
treatment in the financial statements.
The accounting treatment is covered in more detail later in this
chapter, however:
A finance lease is essentially accounted for as if the entity
had acquired the non-current asset outright and funded the
acquisition with a 'loan'
With an operating lease the entity is essentially just renting
the asset and so the costs incurred are treated as rental
expense in profit or loss

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Types of lease 4
Land and buildings

Under IAS 17 the land and buildings elements of a lease of land and buildings
are considered separately for the purposes of lease classification.

The lease relating to the land is treated as a operating lease unless, as may
be the case with a long lease, it is considered that the risks and rewards of
ownership have been transferred, in which case it will be treated as a finance
lease.

The lease relating to the building is similarly treated as either a finance or an


operating lease depending on whether substantially all of the risks and
rewards of the building have been transferred to the lessee.

Where the land and buildings elements are classified as different types of
leases the minimum lease payments are allocated between the land and
buildings elements in proportion to the relative fair values of the leasehold
interests in the land and buildings.

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Lessees 1
Finance leases - accounting treatment
The leased property is capitalised at

The fair value of


leased asset

OR
(if lower)

The present value of the


minimum lease payments

At inception of the lease:


DEBIT Property, plant and equipment
CREDIT Finance lease liability account

The asset is also depreciated as a normal asset but over the shorter of the
lease term and the useful life of the asset. If ownership will be transferred at
the end of the lease term, the asset is depreciated over its useful life.
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Lessees 2

The lease payments include both a capital and an interest element.

The interest element is referred to as an interest charge or a finance


charge and is shown in profit or loss.
In ACCA paper F7 the finance charge is allocated using the
actuarial method. This allocates a higher finance charge in the
earlier years of the lease to be consistent with the fact that a
greater liability is owed to the finance lease company in the earlier
years.
This uses the interest rate implicit in the lease (essentially the
lease's internal rate of return).
The interest rate implicit in the lease will be provided in the
question.
The actuarial method of allocating the finance charge on a finance
lease is essentially the way a mortgage on a property works.
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Lessees 3

The capital element of the lease payment reduces the amount owed
to the finance lease company and reduces the finance lease liability in
the statement of financial position.

It is therefore important to have a methodical approach to calculating


the finance lease liability at the end of the reporting period.

To do this you must first identify from the question whether the lease
payments are made:
In arrears (ie at the end of the reporting period); or
In advance (ie at the beginning of the reporting period).

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Lessees 4
Calculation of lease liability

Payments
in arrears
$

Payments
in advance
$

1.1.X1

Liability b/d (FV property/PVMLP)

1.1.X1

Any initial non-refundable deposit

(X)

(X)

1.1.X1

Instalment in advance

(X)

(X)

1.1.X131.12.X1

Interest at x%

31.12.X1

Instalment in arrears

31.12.X1

Liability c/d

1.1.X2

Instalment in advance

(X)

Liability > 1 year (advance)

1.1.X231.12.X2

Interest at x%

31.12.X2

Instalment in arrears

(X)

31.12.X2

Liability > 1 year (arrears)

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Can be
analysed
separately as
interest payable
as not paid at
y/e, but no IAS
requirement to
do so

Question: Lecture example 1


A company leases an asset on 1 January 20X1.
The terms of the lease are to pay a non-refundable deposit of $575
followed by seven annual instalments of $2,000 payable in arrears.
The fair value of the asset (equivalent to the present value of
minimum lease payments) on 1 January 20X1 is $10,000.
The interest rate implicit in the lease is 11%.
Required
Calculate the interest charge in the statement of profit or loss and
the finance lease liability in the statement of financial position for
the year ended 31 December 20X1.

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Answer: Lecture example 1


STATEMENT OF PROFIT OR LOSS (extract)
Finance costs (Working)

$
1,037

STATEMENT OF FINANCIAL POSITION (extract)


$
Non-current liabilities
Finance lease liability (Working)

7,393

Current liabilities
Finance lease liability (Working) (8,462 7,393)

1,069

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Answer: Lecture example 1 (cont'd)


Working
1.1.X1
1.1.X1

Liability b/d
Non-refundable deposit

1.1.X131.12.X1
31.12.X1
31.12.X1
1.1.X231.12.X2
31.12.X2
31.12.X2

Interest at 11%
Instalment 1 (in arrears)
Liability c/d
Interest at 11%
Instalment 2 (in arrears)
Liability c/d

BPP LEARNING MEDIA

$
10,000
(575)
9,425
1,037
(2,000)
8,462
931
(2,000)
7,393

Question: Lecture example 2


Company A makes up its accounts to 31 December each year. It enters
into a lease (as lessee) to lease an item of equipment with the following
terms.
Inception of lease:
Term:
in advance

1 January 20X1
Five years at $2,000 per annum payable

Fair value:

$8,000

Useful life:

Eight years

Interest rate implicit in the lease: 12%


Required
Prepare the relevant extracts in respect of the above lease for the year
ended 31 December 20X1.
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Answer: Lecture example 2


STATEMENT OF PROFIT OR LOSS (extract)
Depreciation (8,000 / 5 years)
Finance costs (Working)

$
1,600
720

STATEMENT OF FINANCIAL POSITION (extract)


$
Non-current assets
Equipment (8,000 1,600)

6,400

Non-current liabilities
Finance lease liability (Working)

4,720

Current liabilities
Finance lease liability (Working)

2,000

BPP LEARNING MEDIA

Answer: Lecture example 2 (cont'd)


Working
1.1.X1
1.1.X1

Liability b/d
Instalment 1 (in advance)

1.1.X131.12.X1
31.12.X1
1.1.X2
1.1.X2

Interest at 12%
Liability c/d
Instalment 2 (in advance)
Liability c/d

BPP LEARNING MEDIA

$
8,000
(2,000)
6,000
720
6,720
(2,000)
4,720

Lessees 5
Sale and leaseback transactions
These describe the situation where an entity sells an asset to a
third party and then leases it back from them.
The accounting treatment depends on two key elements:
Whether the asset is leased back under a finance lease
arrangement or an operating lease arrangement
For an operating leaseback how the sales proceeds
compare to the fair value of the asset

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Lessees 6
Leaseback as a finance lease
If the leaseback transaction is a finance lease then the entity
still bears substantially all of the risks and rewards of ownership
of the asset just as it did before the sale and leaseback.
In substance therefore the asset has not been sold.
Therefore the asset should remain in the statement of financial
position at its previous value.
The 'sales proceeds' received should be treated as a finance
lease liability and the following entry made.
DEBIT Cash, CREDIT Finance lease liability
The finance lease is then accounted for in the same way as
any other finance lease would be
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Lessees 7
Leaseback as a finance lease (continued)
When the 'sales proceeds' are compared to the carrying value
of the asset a 'notional' profit or loss may be made.
This apparent profit or loss is deferred and amortised over the
lease term.
The previous carrying amount of the asset continues to be
depreciated as normal however it may be necessary to restrict
the asset's useful life to the period of the lease term.

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Question: Lecture example 3


A company preparing financial statements for year ending 30
September 20X3 included within revenue $100 million for an item of
plant sold on 1 June 20X3.
The plant had a carrying amount of $80 million at the date of its
sale, which was charged to cost of sales. On the same date, the
company entered into an agreement to lease back the plant for the
next five years (being the estimated remaining life of the plant) at a
cost of $28 million per annum payable annually in arrears.
An arrangement of this type is deemed to have a financing cost of
12% per annum.
No depreciation has been charged on the item of plant in the
current year.
Required
Comment on the substance of the sale and the treatment of it.
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Answer: Lecture example 3


The sale of the plant has been incorrectly treated on two
counts.
Firstly even if it were a genuine sale it should not have been
included in revenue and cost of sales, it should have been
treated as the disposal of an item of plant and only the profit or
loss on the disposal would be included in profit or loss
(requiring separate disclosures under IAS 1 if material).
However, this treatment would also be incorrect.
As the company will continue to use the plant for the remainder
of its useful life, the substance of this transaction is a secured
loan.
Thus the receipt of $100 million for the 'sale' of the plant should
be treated as a loan.
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Answer: Lecture example 3 (cont'd)


The rentals, when they are eventually paid, will be applied
partly as interest (at 12% per annum), and the remainder will
be a capital repayment of the loan. In the financial statements
an accrual for loan interest of 12% per annum on $100 million
for four months ($4 million) is required.
The plant remains within non-current assets in the statement of
financial position.
The apparent profit of $20 million ($100 million less $80 million
carrying amount) should be recorded as an increase in the
value of the asset and as deferred income.
Annual depreciation of $20 million ($100 million over five
years) is charged to profit or loss and deferred income of $4
million ($20 million over five years) is credited to profit or loss
each year.
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Lessees 8
If leaseback is operating lease

Compare sales proceeds (SP) to the fair value (FV) of the asset

SP = FV

SP < FV

SP > FV

Sale is an arm's
length transaction.

Recognise any profit/


loss immediately
unless loss
compensated by
future rentals.
If so defer loss and
amortise.

Excess over FV
defer excess and
amortise over period
the asset is
expected to be used

Recognise any
profit or
loss immediately.
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Question: Lecture example 4


On 1 January 20X2 a company held a freehold building in its books
with a carrying amount of $18m and a remaining useful life of 30
years.
On the same date, it entered into an agreement to sell the building to
a bank for $30m, but to continue to occupy it for the next six years at
an annual rental of $3m per annum payable in advance.
The market value of the building at the date of sale was
approximately $25m and an 'arm's length' rental would be
approximately $2m per annum. Assume any finance costs are 8%
per annum.
Required
Describe how the above transaction should be treated in the financial
statements of the company for the year ended 31 December 20X2.

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Answer: Lecture example 4


The transaction the company has entered into is an example of a sale
and leaseback transaction, which is governed by IAS 17 Leases. The
transaction provides the company with a cash injection which improves
liquidity and cash flow.
Given that the remaining useful life of the property is 30 years, but the
leaseback is only for six years, this appears to be an operating
leaseback.
Consequently, the property should be derecognised and a profit on sale
recognised.
However, the future rentals paid are above the market (arm's length) price
as is the sale price of the property. This suggests that the excess sale
proceeds above the property's fair value is in substance a loan rather
than part of the sale proceeds, given that it is linked to the higher than
market rental payments, and so it should be accounted for as a loan.
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Answer: Lecture example 4 (cont'd)


The rental payments above market price will be treated as loan payments
paying off capital and accrued interest.
Given that the rental payments are made in advance, the first payment
will be treated as paying back the loan rather than including any interest
element.
The profit recognised on sale of the building should therefore be $7m
($25m fair value less $18m carrying amount).

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Answer: Lecture example 4 (cont'd)


The excess $5m will be shown in the statement of financial position as a
loan payable as follows.
$m
Excess sale proceeds (30 25)
5.0
First rental payment in excess of market value (3 2)
(1.0)
4.0
Interest accrued at 8%
0.3
Balance at 31 December 20X2
4.3
The market rental of $2m will be charged as an expense in profit or loss
along with the $0.3m of interest on the loan.

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Past exam questions


Nature of question

Exam details

Adjustments for finance and operating


leases can be examined in both the
financial statement preparation
questions and questions relating to the
statement of cash flows.

Q2 June 2012
Q3 June 2010

Leases can now also be examined by


MCQ.

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Chapter 17

Current tax

Accounting for
taxation

Taxable temporary differences

Deferred tax
Deductible temporary differences
Measurement and recognition of
deferred tax
Taxation in company accounts

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Syllabus learning outcomes


Account for current taxation in accordance with relevant
accounting standards
Explain the effect of taxable temporary differences on
accounting and taxable profits
Compute and record deferred tax amounts in the financial
statements

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Chapter summary diagram


Taxation

Current tax

Recognition

Deferred tax

Depreciating
assets

Revaluations of
non-current
assets

Presentation

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Losses that can


be carried
forward

Current tax 1
IAS 12 Income Taxes covers both current tax and deferred
tax.
Current tax relates to the 'proper' tax paid to the
taxation authorities.
Deferred tax is an accounting adjustment.

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Current tax 2
Definition
Current tax is the amount of income taxes payable or
recoverable in respect of taxable profit or loss for the
period.
Taxable profit (or loss) is the profit (or loss) for a period,
determined in accordance with the rules established by
the taxation authorities, upon which income taxes are
payable (recoverable).
Current tax is essentially the amount of tax an entity will
need to pay to the tax authorities in respect of its profit for
the period.

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Current tax 3
The tax charge for the period is shown as an expense in
profit or loss.
Any unpaid amounts of tax are recognised as a liability in
the statement of financial position.
The accounting entry to record the tax expense is:
DEBIT Tax expense
CREDIT Tax liability

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Deferred tax 1
Deferred tax is not a tax which is paid, rather it is an
accounting adjustment.
It deals with situations where the accounting treatment of
a transaction is different from the tax treatment.
Some differences are permanent (for example customer
entertaining), while others are temporary differences
because of the timing of when a transaction is recognised
for accounting purposes and when it is considered for tax.

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Deferred tax 2
Temporary differences
Differences between
Carrying amount of
an asset/liability

Tax base of an
asset/liability
There are two types

Taxable
temporary
differences

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Deductible
temporary
differences

Deferred tax 3
The temporary difference is calculated by comparing the
carrying amount of an asset or liability in the statement of
financial position to its tax base.
The carrying value of an asset or liability is its value in
the statement of financial position at the reporting date.
The tax base of an asset is its value for tax purposes at
the reporting date.
Deferred tax is provided on temporary differences.

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Deferred tax 4
Definition
Deferred tax liabilities are amounts of income taxes
payable in future periods in respect of taxable temporary
differences.
Deferred tax assets are the amounts of income taxes
recoverable in future periods in respect of:
Deductible temporary differences
The carry forward of unused tax losses
The carry forward of unused tax credits

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Question: Lecture example 1


Consider the following transactions.
(a) Interest receivable has a carrying amount of $300. The
related interest revenue will be taxed on a cash basis.
(b) Current liabilities include accrued expenses with a carrying
amount of $100. The related expense will be deducted for
tax purposes on a cash basis.
Required
Calculate the carrying amount and tax base of the above items
and consider whether there is a temporary difference in these
values. Calculate the amount of the temporary difference and
state whether this would give rise to a deferred tax asset or
liability.
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Answer: Lecture example 1


(a) The interest receivable of $300 is showing as income in the
statement of profit or loss and as an asset in the statement of
financial position in accordance with the accruals concept. It has
carrying amount of $300.
However the tax authorities do not intend to tax the interest
revenue until it is actually received in cash (namely on a cash
basis) and so the interest has a tax base of $nil.
This difference between the carrying amount and the tax base is
temporary because the interest has been recognised from an
accounting perspective and will also eventually be taxed.
The value of the temporary difference is $300 ($300 $nil).
This will give rise to a deferred tax liability (of $300 multiplied by
the tax rate) because the entity will have to pay more tax in the
future when the interest is received in cash.
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Answer: Lecture example 1 (cont'd)


(b) An expense of $100 is recognised under the accruals concept in
the statement of profit or loss and is included as a current liability
in the statement of financial position. It has carrying amount of
$100.
However the tax authorities will not give tax relief on the expense
until it is actually received paid in cash (namely on a cash basis)
and so the expense has a tax base of $nil.
This difference between the carrying amount and the tax base is
temporary because the expense has been recognised from an
accounting perspective and will also eventually receive tax relief.
The value of the temporary difference is $100 ($100 $nil).
This will give rise to a deferred tax asset (of $100 multiplied by
the tax rate) because the entity will save tax in the future when
tax relief is given for the accrued expense.
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Taxable temporary differences 1


Taxable temporary differences describe the situation
where because of a temporary difference in the
accounting and tax treatment of an item the entity will end
up paying more tax in the future.
Taxable temporary differences give rise to deferred tax
liabilities.
One of the most common types of taxable temporary
differences are accelerated depreciation for tax
purposes.
This is because tax depreciation tends to be available at a
higher rate in the earlier years of the asset's life than the
accounting depreciation charged on the same assets.
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Taxable temporary differences 2


When calculating taxable profits the accounting
depreciation is added back to the profit before tax figure
and the tax depreciation is deducted.
This essentially means that an entity is taxed on a lower
taxable profit figure in the earlier years of the asset's life
and therefore pays less tax.
Eventually the situation will reverse and the tax
depreciation will be less than the accounting depreciation.
At this point in time the entity will start to be taxed on a
higher taxable profit figure and so will pay more tax.
Hence there is a deferred tax liability.

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Leisure Tours 1
Illustration
Leisure Tours buys a coach on 1 January 20X1 for
$60,000. The coach has a useful life of four years and will
be scrapped at the end of its life.
The company pays tax at 25% and tax depreciation is
available at 50% of cost in Year 1 and 25% on cost less
tax depreciation in Year 2 onwards. Leisure Tours has a
profit before tax of $100,000 in each of the years 20X1
and 20X2.

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Leisure Tours 2
Scenario 1
If we ignore all tax adjustments, Leisure Tours would
have the following financial statements.

Profit before tax


Tax at 25%
Profit for the year

20X1
20X2
$
$
100,000 100,000
(25,000) (25,000)
75,000
75,000

However it does not seem very realistic or in keeping with


the accruals concept to ignore tax.

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Leisure Tours 3
Scenario 2
If we adjust for tax depreciation but ignore deferred taxation, Leisure
Tours would have the following financial statements.
20X1
20X2

$
$
Profit before tax
100,000
100,000
Add back depreciation (W1)

15,000
15,000
Less tax depreciation (W2)
(30,000)
(7,500)
Taxable profit
85,000
107,500
Tax at 25%
21,250
26,875

(W1) Accounting depreciation: $60,000 4 years = $15,000 per annum


(W2) Tax depreciation
50% tax depreciation in 20X1: $60,000 50% = $30,000
25% of (cost less tax depreciation) in 20X2:
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Leisure Tours 4
Here you can see that effectively some of the tax that
should have been paid in 20X1 has been 'deferred' to
20X2.
This is due to the timing as to when the accounting and
tax depreciation fall.
This is a temporary difference because eventually, over
the asset's life accounting depreciation of $60,000 will be
charged and tax depreciation of $60,000 will be given.
Deferred tax cannot be ignored because it does not seem
reasonable that a company which has the same
accounting profit before tax in 20X1 and 20X2 should
have such different tax charges.
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Question: Lecture example 2


Required
Using the information for Leisure Tours in the illustration
above, show how the company would provide for deferred
tax on the temporary difference.
Use the proformas on the next slide.

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Question: Lecture example 2 (cont'd)


Extracts from statement of financial
position

Deferred tax provision

Extracts from statement of profit or loss

Profit before tax


Current tax (Scenario 2)
Deferred tax
Profit for the period

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20X1

20X2

20X1
$

20X2
$

Question: Lecture example 2 (cont'd)


(W1) Deferred tax

Carrying
amount
$

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Tax value Difference


$

Tax at
25%
$

Answer: Lecture example 2


Extracts from statement of financial
position

Deferred tax provision

Extracts from statement of profit or loss

Profit before tax


Current tax (Scenario 2)
Deferred tax
Profit for the period

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20X1
$
3,750

20X1
$
100,000
(21,250)
(3,750)
75,000

20X2
$
1,875

20X2
$
100,000
(26,875)
1,875
75,000

Answer: Lecture example 2 (cont'd)


(W1) Deferred tax

Cost at 1 Jan 20X1


Accounting depreciation

Carrying
amount
$

Tax value
$

60,000

60,000

(15,000)

Tax depreciation (50%)

30,000

At 31 December 20X1
Accounting depreciation

45,000
(15,000)

Tax depreciation (25% $30,000)


30,000

*Double entry to create deferred tax provision in 20X1:


Tax expense

CREDIT

Deferred tax provision

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30,000

15,000

3,750*

7,500

1,875^

7,5000

At 31 December 20X2

DEBIT

Difference
$

Tax at
25%
$

3,750
3,750

22,500

Question: Lecture example 3 (cont'd)


A company buys an item of equipment on 1 January 20X1 for
$1,000,000. It has a useful life of ten years and an estimated
residual value of $100,000. The equipment is depreciated on
a straight line basis. For tax purposes, a tax expense can be
claimed on a 20% reducing balance basis.
The rate of income tax can be taken as 30%.
Required
In respect of the above item of equipment, calculate the
deferred tax charge/credit in the company's profit or loss for
the year to 31 December 20X2 and the deferred tax balance
in the statement of financial position as at that date.

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Answer: Lecture example 3 (cont'd)


The deferred tax liability in the statement of financial position at 31 December
20X2 will be the potential tax on the difference between the accounting
carrying amount of $820,000 and the tax base of $640,000. The temporary
difference is $180,000 and the deferred tax on the difference is a $54,000
charge/liability.
The charge (or credit) for deferred tax in profit or loss for the year is the
increase (or decrease) in the deferred tax liability during the year. The closing
deferred tax liability of $54,000 is greater than the opening deferred tax
liability of $33,000, so there is a deferred tax charge of $21,000 to profit or
loss in respect of this year.
Movement in the deferred tax liability for the year ended 31 December 20X2
Deferred tax liability b/d
Profit or loss change
Deferred tax liability c/d
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$'000
33
21
54

Answer: Lecture example 3 (cont'd)


Workings

Deferred tax liability


Tax base

Temporary
differences

20X1

Accounting
carrying
amount
$'000

$'000

$'000

Cost

1,000

1,000

110

(33)

180

(54)

Depreciation
c/d

(W2)

(90)

(W3)

Deferred
tax liability
@ 30%
$'000

(200)

910

800

b/d

910

800

Depreciation

(90)

c/d

820

20X2

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(W3)

(160)
640

Answer: Lecture example 3 (cont'd)


2

Depreciation
$1,000,000 cost $100,000 residual value / 10 years = $90,000
per annum

Tax depreciation/capital allowances


20X1:

$1,000,000 20% = $200,000

20X2:

$800,000 Carrying amount b/d 20% = $160,000

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Taxable temporary differences 3


Another type of taxable temporary differences are revaluations
of non-current assets.
This is because when an entity revalues a non-current asset its
carrying amount increases.
However there is no corresponding adjustment to the tax base
of the asset.
The gain arising on the increase in value of an asset will be
taxable on the use or sale of the asset and therefore a deferred
tax liability is recognised since the gain itself has been
recognised.
IAS 12 requires deferred tax on revaluations to be charged
to other comprehensive income. This is because the gain
itself is reported in other comprehensive income.
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Question: Lecture example 4


A company purchased some land on 1 January 20X7 for
$400,000. On 31 December 20X8 the land was revalued to
$500,000.
In the tax regime in which the company operates revaluations
do not affect either the tax base of the asset or taxable profits.
Required
Show the deferred tax effect of the revaluation in the statement
of profit or loss and other comprehensive income and
statement of financial position.

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Answer: Lecture example 4


STATEMENT OF PROFIT OR LOSS AND OTHER COMPREHENSIVE
INCOME FOR THE YEAR ENDED 31 DECEMBER 20X8 (extract)

PROFIT FOR THE YEAR


Other comprehensive income:
Gain on property revaluation
Deferred tax relating to other comprehensive income (Working)
Other comprehensive income for the year, net of tax
TOTAL COMPREHENSIVE INCOME FOR THE YEAR

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$'000
850
100
(30)
70
920

Answer: Lecture example 4 (cont'd)


STATEMENT OF FINANCIAL POSITION AS AT 31 DECEMBER 20X8
(extract)
Non-current assets
Land (400 + 100)

500

Equity
Revaluation surplus (100 30)

70

Non-current liabilities
Deferred tax liability (Working)

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(30)

Answer: Lecture example 4 (cont'd)


Working
Accounting carrying amount
Tax base
Temporary difference

$'000
500
(400)
100

Deferred tax liability @ 30%

(30)

DEBIT

Other comprehensive income (and revaluation


surplus)
CREDIT Deferred tax liability

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$'000
30
30

Deductible temporary differences


Deductible temporary differences are less common than
taxable ones and result in a deferred tax asset on the
statement of financial position.
One example of a deductible temporary difference is tax
losses.
IAS 12 requires that a deferred tax asset be recognised in
relation to tax losses provided that the likelihood of
future taxable profits is probable.
The amount of the deferred tax asset is the value of the
loss multiplied by the tax rate.

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Question: Lecture example 5


BG is a company which has unused tax losses of
$10,000.
BG has recently made positive operational changes and
expects to return to profitability in the next year or two.
The income tax rate is 25%
Required
Calculate the amount of any deferred tax asset or liability
and show the accounting entry BG should make to
provide for deferred tax on the tax losses.

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Answer: Lecture example 5


BG has a deferred tax asset because the tax losses
suffered previously can be offset against future profits and
so BG will pay less tax in the future.
The amount of the deferred tax asset is $2,500 ($10,000
tax losses 25% tax rate).
It should be accounted for using the following journal:
DEBIT

Deferred tax asset 2,500

CREDIT Tax expense

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2,500

Measurement and recognition of deferred tax


Deferred tax assets and liabilities are measured at the tax rates
expected to apply to the period when the asset is realised or
liability settled, based on tax rates (and tax laws) that have
been enacted (or substantively enacted) by the end of the
reporting period.
IAS 12 states that deferred tax assets and liabilities should not
be discounted because of the complexities and difficulties
involved.
The carrying amount of deferred tax assets should be reviewed
at the end of each reporting period and reduced where
appropriate (for example if there are insufficient future taxable
profits).
Where a deferred tax asset has been reduced the reduction
may be reversed in future years.
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Taxation in company accounts 1


As mentioned previously:
Current tax relates to the tax payable to the tax authorities
based on the taxable profits for the year
Deferred tax is the tax relating to temporary differences
The tax expense in the statement of profit or loss has three
component parts:
Income tax on taxable profits
Transfers to of from deferred taxation during the period
Any under provision or over provision of income tax on
profits of previous years

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Taxation in company accounts 2


The income tax charge for the period is usually an
estimate and it is possible that a different income tax
charge might eventually be agreed with the tax authorities.
If in the previous periods the income tax charge was
under provided then the shortfall will be added on to the
charge for the current year.
If in the previous periods the income tax charge was over
provided then the excess will be deducted from the
charge for the current year.

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Question: Lecture example 6


The following trial balance extracts relate to Senso at 30 September 20X6.
Current tax
Deferred tax
Retained earnings at 1 October 20X5
Revaluation surplus at 1 October 20X5
Profit before tax is $30m.

$'000
700

$'000
9,600
82,400
14,000

The directors have estimated the provision for current tax for the year ended 30
September 20X6 at $5.4m. The balance of current tax in the trial balance
represents the under/over provision of the current tax liability for the year ended
30 September 20X5.
The deferred tax figure is the amount brought down from the year ended 30
September 20X5. During the year the company's taxable temporary differences
increased by $8m of which $5m related to gains on the revaluation of property.
The deferred tax relating to the remainder of the increase should be taken to
profit or loss. The applicable income tax rate is 20%.
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Question: Lecture example 6 (cont'd)


Required
Show relevant extracts of Senso's statement of profit or
loss and other comprehensive income and statement of
financial position for the year ended 30 September 20X6
(in so far as the information permits).

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Answer: Lecture example 6


Senso
STATEMENT OF PROFIT OR LOSS AND OTHER COMPREHENSIVE
INCOME FOR THE YEAR ENDED 30 SEPTEMBER 20X6 (extract)
$'000
Profit before tax

30,000

Income tax expense (700 + 5,400 + ((8,000 5,000) 20%))


PROFIT FOR THE YEAR

(6,700)
23,300

Other comprehensive income:


Gain on property revaluation

5,000

Deferred tax relating to other comprehensive income (5,000 20%)


Other comprehensive income for the year, net of tax

(1,000)
4,000

TOTAL COMPREHENSIVE INCOME FOR THE YEAR

27,300

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Answer: Lecture example 6 (cont'd)


STATEMENT OF FINANCIAL POSITION AS AT 30 SEPTEMBER
20X6 (extract)
Equity
Retained earnings (82,400 + 23,300)
Revaluation surplus (14,000 + 4,000)
Non-current liabilities
Deferred tax liability (9,600 + (8,000
20%))
Current liabilities
Current tax payable

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105,700
18,000

(11,200)

(5,400)

Taxation in company accounts 3


The skills tested in lecture example 6 are typical of the tax
adjustments you are required to do in the financial
statement preparation question.
These adjustments would typically be worth 4 marks.

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Past exam questions


Nature of question

Exam details

Adjustments relating to both current and Q2 in all past


deferred tax are examined in the
exams.
financial statement preparation question. 15- or 30-mark
question under
the new format
An MCQ on deferred tax is possible.

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Chapter 18

IAS 33 Earnings Per Share

Earnings per share

Effect on EPS of changes in


capital structure

Basic EPS

Diluted EPS
Presentation, disclosure and other
matters

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Syllabus learning outcomes 1


Calculate EPS in accordance with relevant accounting
standards dealing with:
Bonus issues
Full market value issues
Rights issues
Explain the relevance of the diluted EPS and calculate the
diluted EPS involving convertible debt and share options
(warrants)

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Syllabus learning outcomes 2


Explain why the trend of EPS may be a more accurate
indicator of performance than a company's profit trend and
the importance of EPS as a stock market indicator
Discuss the limitations of using EPS as a performance
measure

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Chapter summary diagram


Earnings per share
Basic earnings per
share
Calculation

EPS as a
performance
measure

Diluted earnings
per share

Convertible debt

Share
option/warrants

Changes in equity
share capital

Issue at full market


price
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Bonus issue

Rights issue

Limitations

IAS 33 Earnings Per Share 1


Earnings per share or EPS is a ratio which measures the
amount of profits earned by a company for each ordinary
share in issue.
The objective of IAS 33 was to provide a consistent
method for the calculation of EPS in order to improve the
comparison of the performance of different entities in the
same period and of the same entity over time.

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IAS 33 Earnings Per Share 2


Scope
IAS 33 only applies to companies whose ordinary shares
are publicly traded (including companies in the process
of obtaining a listing).
EPS need only be presented on the basis on consolidated
results in a set of consolidated financial statements which
include the parent's separate financial statements.
Where companies choose to present EPS information
even though they are not required to they must do so in
accordance with IAS 33.

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Basic EPS

Calculation:
The basic earnings per share figure should be calculated as follows.
Profit or loss for the period attributable to ordinary shareholders
Weighted average number of ordinary shares in issue during the period
Where the profit or loss for the period is the consolidated profit after
income tax, non-controlling interest and preference dividends.

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Effect on EPS of changes in capital structure 1


The EPS calculation essentially divides the profit figure by
the weighted average number of shares in issue during the
period.
One of the ideas behind the EPS calculation is that if an
entity issues shares during the period it will have additional
resources with which it will be expected to generate an
increased return.
Any change in the number of ordinary shares during the
period therefore will impact the EPS calculation.

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Effect on EPS of changes in capital structure 2


SHARE ISSUES

Full market price


(FMP)

Bonus issue

Use
weighted
average

Apply
retrospectively
(use bonus
fraction)

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Rights issue

Treat as a FMP
issue followed by
bonus issue

Effect on EPS of changes in capital structure 3


Issue at full market price
Where an entity has issued shares at the current market
price it will have received a true price for its shares.
It will therefore be expected to generate a return on these
shares in the form of increased profits.
However if the share issue occurred part way through the
year the entity will only be expected to generate extra
earnings for the time during which it had use of the
additional funds.
As such the number of shares in issue must be time
apportioned.

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Effect on EPS of changes in capital structure 4


Illustration
A company has earnings of $100,000 and a year end of
31 December.
On 1 October 20X2 the company issued 300,000 shares
at full market price.
The share capital before the share issue was 600,000
shares.

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Effect on EPS of changes in capital structure 5


Illustration (continued)
The weighted average number of shares is calculated as:
Date

No. shares

Time

Weighted

Bal b/d

600,000

period
9/12

average
450,000

1.10.X2 Full market price

300,000
900,000

3/12

225,000

1.1.X2

Narrative

675,000

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Effect on EPS of changes in capital structure 6


Illustration (continued)
$100,000

The EPS is: = 14.8 cents per share


675,000

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Effect on EPS of changes in capital structure 7


Bonus issue of shares
Bonus shares are issued at no consideration and therefore
the company cannot be expected to generate the same
return after a bonus issue.
In order to make the EPS comparable year on year where
there has been a bonus issue, it is necessary to restate
the prior year EPS figure.
This is done using the reciprocal of the bonus fraction.

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Effect on EPS of changes in capital structure 8


Illustration
A company has the following assets, earnings and share
capital.
20X2
20X1
Assets (eg cash)
$100,000 $100,000
Earnings
$20,000 $20,000
Shares
200,000 100,000
EPS

10 cents 20 cents

On 1 January 20X2 the company makes a bonus issue on a


1:1 basis.
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Effect on EPS of changes in capital structure 9


Illustration (continued)
As it stands it looks like the company has not performed as
well in 20X2 as it did in 20X1.
In 20X1 every share you owned would have earned you 20
cents of profit whereas this had fallen to 10 cents in 20X2.
However following the bonus issue in 20X2 for every one
share you previously owned in the company you were issued
one further share for free.
Therefore for every one share you owned in 20X1 which
earned you 20 cents you now own two shares earning you
10 cents each.
Therefore you are no worse off.
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Effect on EPS of changes in capital structure 10


Illustration (continued)
In order for the financial statements to show this we need to
restate the prior year EPS using the reciprocal of the bonus
fraction.
The bonus fraction is 2/1 because for every one share you
previously owned you now own two shares.
The reciprocal of the bonus fraction is therefore 1/2.
The restated EPS for 20X1 is 20 cents 1/2 = 10 cents.
It is the restated EPS for 20X1 which should be compared
with 20X2.

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Effect on EPS of changes in capital structure 11


Rights issue of shares
When an entity wants to raise additional finance it may
choose to do so through a rights issue.
Here existing shareholders are offered the opportunity to
buy more shares in the entity.
The price they will have to pay for the shares (the rights
price) will be lower than the current market price in order to
encourage existing shareholders to subscribe to the rights
issue.
Consequently a rights issue includes both an issue of
shares at full price and a bonus issue.

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Effect on EPS of changes in capital structure 12


Rights issue of shares (continued)
Consistent with the bonus issue it is necessary to calculate
the bonus fraction.
This is calculated as:
Fair value per share immediately before the exercise of rights
Theoretical ex rights price (TERP)

It is applied to all periods (months) prior to the rights issue


and the prior year EPS is restated using the reciprocal of
the bonus fraction in order for the EPS to be comparable
year on year.

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Effect on EPS of changes in capital structure 13


Rights issue of shares (continued)
The easiest way to see how the theoretical ex rights price
(TERP) is calculated is through an example.
Assume a company makes a rights issue on a 1:4 basis,
the share price immediately before the exercise of rights is
$10 per share and the rights price is $6.50.
For every 4 shares @ $10
1 share @ $6.50
A group of 5 shares @
TERP:
BPP LEARNING MEDIA

$46.50 = $9.30
5

$
40.00
6.50
46.50

Effect on EPS of changes in capital structure 14


Rights issue of shares (continued)
Bonus fraction =

10
9.3

Reciprocal of the bonus fraction =

9.3
10

BPP LEARNING MEDIA

Effect on EPS of changes in capital structure 15


Exam questions on this topic can be reasonably
straightforward if you approach them in a methodical way.
Make sure that you identify the dates on which each of
the share transactions happen from the question.
Set up a table to record the number of months each
different number of shares were in issue.

BPP LEARNING MEDIA

Question: Lecture example 1


On 1 January 20X1 Saunders Co had 2,000,000 ordinary shares
in issue.
On 30 April 20X1 the company issued at full market price,
270,000 ordinary shares.
On 31 July 20X1 the company made a rights issue of 1 for 10 at
a rights price of $2.00. The fair value of the shares on the last
day before the issue of shares from the rights issue was $3.10.
Finally, on 30 September 20X1 the company made a 1 for 20
bonus issue.

BPP LEARNING MEDIA

Question: Lecture example 1 (cont'd)


Profit for the year was $400,000.
The reported EPS for year ended 31 December 20X0 was
18.6c.
Required
Calculate the EPS for year ended 31 December 20X1 and
the restated EPS for year ended 31 December 20X0.

BPP LEARNING MEDIA

Answer: Lecture example 1


EPS for year ended 31.12.X1
$400,000 / 2,431,508 (W1) = 16.5 cents
Restated EPS for year ended 31.12.X0
18.6c(3.00/3.10) 20/21 = 17.1 cents

BPP LEARNING MEDIA

Answer: Lecture example 1 (cont'd)


Workings
1

Weighted average number of shares

Date

Narrative

Shares

1.1.X1

Time
4/12

Bonus fraction

2,000,000
30.4.X1

Full market price

3.00
3/12

270,000

3.10 21/20

Weighted
average
723,333

(W2)

3.10 21/20

615,738

3.00
(W2)

2,270,000
31.7.X1

Rights issue (1/10)

2/12

21/20

436,975

227,000
2,497,000
30.9.X1

Bonus issue (1/20)

3/12
124,850

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2,621,850

655,462

Answer: Lecture example 1 (cont'd)

10 @ $3.10

31.00

1 @ $2.00

2.00

11

TERP

$3.00

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33.00

Diluted EPS 1
The basic EPS is calculated by comparing the profits with the
weighted average number of shares currently in issue.
However it is possible that an entity might have a commitment
to issue shares in the future, for example on the exercise of
share options or the conversion of convertible debt.
These commitments are known by IAS 33 as 'potential ordinary
shares' and they may result in a change to the basic EPS.
The diluted EPS shows how the basic EPS would change if
the 'potential ordinary shares' such as convertible debt became
ordinary shares.
The diluted EPS therefore warns current shareholders of what
may happen to the EPS in the future.

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Diluted EPS 2
The most efficient way to calculate the diluted EPS is to:
Take the earnings figure used in the basic EPS
calculation and determine how it would change if the
'potential ordinary shares' became shares
Take the weighted average number of shares used in
the basic EPS calculation and increase it for the
number of 'potential ordinary shares'

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Diluted EPS 3
Convertible debt
Adjustments to basic earnings and number of shares
where an entity has convertible debt:
Earnings:
Basic earnings X
Add back loan interest saved net of tax X
Diluted earnings X

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Diluted EPS 4
Convertible debt (continued)
Number of shares:
Basic weighted average number of shares X
Add additional shares on conversion
(use maximum dilution)

Diluted weighted average number of shares X

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Question: Lecture example 2


Acorn Co had the same 10 million ordinary shares in issue on both 1 April
20X1 and 31 March 20X2.
On 1 April 20X1 the company issued 1,200,000 $1 units of 5% convertible
loan stock.
Each unit of stock is convertible into 4 ordinary shares on 1 April 20X9 at
the option of the holder.
The following is an extract from Acorn Co's statement of profit or loss and
other comprehensive income for the year ended 31 March 20X2.
Profit before interest and tax
Interest payable on 5% convertible loan stock
Profit before tax
Income tax at 30%
Profit for the year
BPP LEARNING MEDIA

$'000
980
(60)
920
(276)
644

Question: Lecture example 2 (cont'd)


Required
Calculate the basic and diluted earnings per share for the year
ended 31 March 20X2.

BPP LEARNING MEDIA

Answer: Lecture example 2


Basic EPS

$644,000 = 6.4c
10,000,000

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Answer: Lecture example 2 (cont'd)


Diluted EPS
Earnings

Basic
Interest saving 1,200,000 @ 5% 70%
Number of shares
Basic
On conversion
Diluted EPS = $686,000 = 4.64c
14,800,000

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$
644,000
42,000
686,000
10,000,00
4,800,000
14,800,000

Diluted EPS 5
Share options or warrants
Where an entity has issued share options or warrants,
individuals will have the right to buy shares at a certain point in
the future.
The price they will be required to pay will almost certainly be
below the current market price.
This amounts to a situation where some of the shares can be
deemed to have been issued at full price and the remainder will
effectively have been issued for no consideration.
It is only the shares deemed to have been issued for no
consideration which are dilutive.
These are added on to the basic weighted average number of
shares.
BPP LEARNING MEDIA

Diluted EPS 6
Share options or warrants (continued)

Proforma calculation:
Number of shares under option X
Number that would have been issued at average
market price (AMP)
[(no. of options exercise price) AMP)]

(X)

Number of shares treated as issued for nil consideration X

BPP LEARNING MEDIA

Question: Lecture example 3


Galaxy Co has a profit for the year of $3m for the year.
1.4m ordinary shares were in issue during the year.
Galaxy Co also had outstanding 250,000 options for the whole
year with an exercise price of $15.
The average market price of one ordinary share during the
period was $20.
Required
Calculate the basic and diluted EPS.

BPP LEARNING MEDIA

Answer: Lecture example 3


Basic EPS

$3,000,000 = $2.14
1,400,000
Diluted EPS
Number of shares under option
No. that would have been issued at average market price
[(250,000 $15)/$20]
No. shares treated as issued for nil consideration

$3,000,000
= $2.05
Diluted EPS = 1,400,000
+ 62,500

BPP LEARNING MEDIA

250,000
(187,500)
62,500

Presentation, disclosure and other matters 1


The basic and diluted EPS should be presented on the
face of the statement of profit or loss and other
comprehensive income for each class of ordinary share.
The basic and diluted EPS should be presented with
equal prominence.
Disclosure should still be made even if one or both of the
EPS figures are negative (indicating a loss for the period).

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Presentation, disclosure and other matters 2


Significance of EPS

EPS is frequently used to compare company performance.

The EPS calculation is also used in Price/Earnings (P/E) ratio which


is often used for investment decisions.

It should however be noted that EPS is based on historical not


prospective data, and so is an indication of past rather than future
performance.

The IAS 33 calculation of EPS includes one-off income/ expense


items which distort the EPS figure.

IAS 33 does allow additional EPS calculations to be disclosed in the


financial statements but they must be disclosed in the notes to the
financial statements rather than on the face of the statement of profit
or loss and other comprehensive income.

BPP LEARNING MEDIA

Past exam questions


Nature of question

Exam details

The calculation of the basic earnings per Q2 June 2013


share figure can be tested as a part (b) Q2 June 2012
in the financial statement preparation
question for three or four marks.
More detailed questions requiring the
calculation of both basic and diluted
earnings per share can be tested in
other questions.

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Q4 June 2011

Past exam questions


Nature of question
It is also important to consider EPS in
an interpretation question and to be able
to discuss the limitations of the ratio as
well.
An MCQ on EPS is also possible.

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Exam details

Chapter 19

The broad categories of ratios

Analysing and
interpreting financial
statements

Liquidity, gearing and working


capital

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Profitability and return on capital

Shareholders' investment ratios


Presentation of financial
performance

Syllabus learning outcomes 1


Define and compute relevant financial ratios
Explain what aspects of performance specific ratios are
intended to assess
Analyse and interpret ratios to give an assessment of an
entity's performance and financial position in comparison
with:
An entity's previous periods' financial statements
Another similar entity for the same reporting period
Industry average ratios

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Syllabus learning outcomes 2


Interpret an entity's financial statements to give advice
from the perspective of different stakeholders
Discuss how the interpretation of current value based
financial statements would differ from those using historical
cost based accounts

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Chapter summary diagram


Calculation and
interpretation of
accounting ratios and
trends
Types of interpretation
scenarios

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Financial ratios

Approach to
interpretation
questions

The broad categories of ratios 1


Purpose of ratio analysis
Ratio analysis is a tool which is often used to help users
understand the results and position of a company using its
financial statements.
It aims to highlight unusual results or confirm or clarify
trends so that users can make informed economic
decision.
Ratios however are only meaningful if they are compared
to something, for example prior year results or industry
averages.

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The broad categories of ratios 2


In the exam you could be presented with the following types of
interpretation scenario.
Comparison with an entity's previous period financial
statements
Comparison with a similar entity
Comparison with industry benchmark ratios
To approach these questions you should calculate selected
ratios (some required ratios may be stated) and prepare a
report for the specified user.
Alternatively you may be given pre-calculated ratios to
interpret.
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The broad categories of ratios 3


Q3 December 2012 exam
Quartile sells jewellery through stores in retail shopping centres throughout
the country. Over the last two years it has experienced declining profitability
and is wondering if this is related to the sector as a whole. It has recently
subscribed to an agency that produces average ratios across many
businesses. Below are the ratios that have been provided by the agency for
Quartile's business sector based on a year end of 30 June 2012.
Return on year-end capital employed (ROCE)
16.8%
Net asset (total assets less current liabilities) turnover

1.4
times

Gross profit margin


Operating profit margin
Current ratio

35%
12%
1.25:1

Average inventory turnover


Trade
payables' payment period
BPP LEARNING MEDIA

3 times
64 days

The broad categories of ratios 4


Q3 December 2012 exam (continued)
The financial statements of Quartile for the year ended 30 September 2012 are:
Income statement
$'000
Revenue
Opening inventory
Purchases
Closing inventory
Gross profit
Operating costs
Finance costs
Profit before tax
Income tax expense
Profit for the year
BPP LEARNING MEDIA

8,300
43,900
52,200
(10,200)

$'000
56,000

(42,000)
14,000
(9,800)
(800)
3,400
(1,000)
2,400

The broad categories of ratios 5


Q3 December 2012 exam (continued)
STATEMENT OF FINANCIAL POSITION

$'000

$'000

Assets
Non-current assets
Property and shop fittings

25,600

Deferred development expenditure

5,000
30,600

Current assets
Inventory
Bank
Total assets

10,200
1,000

11,200
41,800

Equity and liabilities


Equity
Equity shares of $1 each

Note. The deferred development expenditure relates to an investment in a process to manufacture artificial
precious gems for future sale by Quartile in the retail jewellery market.

15,000

Property revaluation reserve

3,000

Retained
earnings
BPP LEARNING
MEDIA

8,600

The broad categories of ratios 6


Q3 December 2012 exam (continued)
Required
(a) Prepare for Quartile the equivalent ratios that have been provided by the
agency.
(9 marks)
(b) Assess the financial and operating performance of Quartile in
comparison to its sector averages.
(12 marks)
(c) Explain four possible limitations of the usefulness of the above
comparison.
(4 marks)
(25 marks)

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The broad categories of ratios 7


Q3 June 2013 exam (requirement only)
Required
(a) Prepare a statement of cash flows for Monty for the year ended 31
March 2013, in accordance with IAS 7 Statement of Cash Flows, using
the indirect method.
(15 marks)
(b) Comment on the comparative performance of Monty in terms of its return
on capital employed, profit margins, asset utilisation and gearing.
Note. Up to four marks are available for the calculation of the ratios.
(10 marks)
(25 marks)

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The broad categories of ratios 9

There are four main categories of ratios:


Profitability ratios
Liquidity ratios
Gearing ratios
Investors' ratios

We will review examples of each type of ratio in turn however it is


important to assess which ratios are most relevant to the exam
scenario rather than simply reproduce a list of pre-learned ratios.

Always make use of the additional information provided in a question


as this can often help explain the movements in ratios.

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Profitability and return on capital 1

These ratios measure the company's use of its assets and control of
its expenses to generate an acceptable rate of return.

Gross profit margin


Calculation:

(gross profit revenue) 100%

Meaning:
The gross profit margin measures how well a company is running its core
operations. The gross profit percentage should be similar from year to
year for the same company.
Significant change may be due to:
A change in sales price
A change in product mix
An incorrect inventory valuation (will affect two years of results)
A change in cost of sales due to efficiency or price movements
BPP LEARNING MEDIA

Profitability and return on capital 2


Operating profit margin
Calculation:

(profit before interest and tax revenue) 100%

Meaning:
The operating profit margin is usually compared to the gross profit margin
to determine how well the company is controlling its overheads.
The ratio uses PBIT because it avoids distortion when comparisons are
made between two different companies where one is heavily financed by
means of loans and the other is financed entirely by ordinary share
capital.
Significant change may be due to:
The reasons previously stated for the movement in gross profit
margin
Changes in control over administration and distribution costs

BPP LEARNING MEDIA

Profitability and return on capital 3


Return on capital employed (ROCE)
Calculation:

(PBIT [debt + equity]) 100%

Meaning:
The return on capital employed measures how efficiently a company uses
its capital to generate profits.
A potential investor/ lender should compare the return to a target return or
a return on other investments/ loans.
Consider the industry carefully the ROCE for a manufacturing company
is likely to be lower than that of a services company as the manufacturing
company tends to have a higher level of assets (factories, plant and
machinery and inventories).
Significant change may be due to:
New assets acquired during the year which are not yet running at
capacity

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Profitability and return on capital 4


Return on equity (ROE)
Calculation:

(Profit after tax and preference dividend


total equity) 100%

Meaning:
The return on equity focuses on the return for the ordinary shareholders.
Significant change may be due to:
The reasons previously stated for the changes in ROCE
Considerations of changes in interest paid and gearing (debt :
equity) levels
This is because the ROE uses profit after tax in the ratio whereas the
ROCE uses PBIT.

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Profitability and return on capital 5


Asset turnover
Calculation:

Revenue total assets less current liabilities

Meaning:
This ratio measures the efficiency of the use of net assets in generating
revenue. Ideally the ratio should be increasing but you need to be careful
when making assessments based on this ratio due to timing issues as
stated below.
Significant change (especially a decrease) may be due to:
The company buying new assets late in the year these assets will
be included in the total assets less current liability figures but may
not yet have had sufficient time to start generating revenue.

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Liquidity, gearing and working capital 1

These ratios measure the company's ability to meet its debts in both
the short term (liquidity) and the longer term (gearing).

Current ratio
Calculation:

Current assets Current liabilities

Meaning:
The current ratio measures a company's ability to pay its current liabilities
out of its current assets.
Working capital is needed by all companies in order to finance day-to-day
trading activities and hold adequate inventories, allow credit to its
customers and pay its suppliers on the due date.
The industry in which the entity operates is particularly relevant in terms
of the expected levels of inventories, receivables and payables.
Significant change may be due to:
A change in the levels of inventories, receivables and payables held
BPP LEARNING MEDIA

Liquidity, gearing and working capital 2


Quick ratio (liquid capital ratio or acid test)
Calculation:

(Current assets inventories) Current liabilities

Meaning:
This is similar to the current ratio except that it omits the inventories figure
from current assets.
This is because inventories are the least liquid current asset that a
company has, because they have to be sold, turned into receivables and
then the cash has to be collected.
A ratio of less than 1:1 could indicate that the company would have
difficulty paying its debts as they fall due.
Significant change may be due to:
A change in the levels of receivables and payables held

BPP LEARNING MEDIA

Liquidity, gearing and working capital 3


Inventory turnover period (days)
Calculation:

(Inventories Cost of sales) 365 days

Meaning:
This ratio measures the number of days inventories are held on average
by a company before they are sold.
This figure will depend on the type of goods sold by the company. A
company selling fresh fruit and vegetables should have a low inventory
holding period as these goods will quickly become inedible.
A manufacturer of aged wine will by default have very long inventory
holding periods. It is important for a company to keep its inventory days as
low as possible whilst still meeting customer demand.
Significant change may be due to:
A change in the type of inventory held
Improved or worsened inventory controls

BPP LEARNING MEDIA

Liquidity, gearing and working capital 4


Receivables collection period (days)
Calculation:

(Trade receivables Revenue) 365 days

Meaning:
This ratio shows, on average how long it takes for the trade receivables to
settle their account with the company.
The average credit term granted to customers should be taken into
account as well as the efficiency of the credit control function within the
company.
Significant change may be due to:
Increased/decreased credit terms offered to customers
A change in the mix between cash and credit transactions
Better/worse credit control.

BPP LEARNING MEDIA

Liquidity, gearing and working capital 5


Payables payment period (days)
Calculation:

(Trade payables Purchases) 365 days

Meaning:
This ratio measures the time it takes the company to settle its trade
payable balances.
Trade payables provide the company with a valuable source of short term
finance, but delaying payment for too long a period of time can cause
operational problems as suppliers may stop providing goods and services
until payment is received.
Significant change may be due to:
Increased/decreased credit terms from suppliers
Increase/decrease the cash the company has available to make
payments
Better/worse management of the payables ledger
BPP LEARNING MEDIA

Liquidity, gearing and working capital 6

Inventory days
Receivables days Receive
Buy
Sell
inventories
inventories
cash from
receivables

Payables
days
Pay
payables

BPP LEARNING MEDIA

Working
capital cycle

What's Tesco's current ratio & why?

Notes

2008

2007

Non-current assets
Goodwill and other intangible assets
Property, plant and equipment
Investment property
Investments in joint ventures and associates
Other investments
Derivative financial instruments
Deferred tax assets

2,336
10
2,045
11 19,787 16,976
1,112
12
856
305
13
314
4
14
8
216

20
104
6
32
23,864

20,231

2,430
1,311
97

1,931
1,079
108

360

1,783

1,042

Current assets
Inventories
Trade and other receivables
Derivative financial instruments

15
16
20

Current tax assets


Short-term investments
Cash and cash equivalents

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17

5,992

What's Tesco's current ratio & why? (cont'd)

Current liabilities
Trade and other payables

18

(7,277) (6,046)

19
20

(2,084) (1,554)
(443)
(87)

Financial liabilities
Borrowings
Derivative financial instruments and other liabilities
Current tax liabilities
Provisions

22

(455)

(461)

(4)

(4)

(10,263) (8,152)
Net current liabilities

BPP LEARNING MEDIA

(3,963) (3,576)

Liquidity, gearing and working capital 7


Debt/equity ratio
Calculation:

(Interest bearing debt Equity) 100%

Meaning:
This ratio measures a company's gearing and is concerned with the long
term financial stability of the company.
It looks at how much debt the company has in relation to its equity funding
and gives a percentage for gearing.
Interest bearing debt describes the long term debt on which a company is
required to pay interest. In some cases a persistent bank overdraft may be
classified as long term debt.
Significant change may be due to:
An issue of shares during the year
Repayment or taking out of new debt financing
BPP LEARNING MEDIA

Liquidity, gearing and working capital 8


Debt/(debt + equity) ratio
Calculation:

(Interest bearing debt [Interest bearing debt +


Equity]) 100%

Meaning:
This ratio is simply a different method used to calculate gearing.
Significant change may be due to:
An issue of shares during the year
Repayment or taking out of new debt financing

BPP LEARNING MEDIA

Liquidity, gearing and working capital 9


Interest cover
Calculation:

Profit before interest and tax finance costs

Meaning:
This ratio considers the number of times a company could pay its interest
payments using its profit from operations.
A company should always ensure that it does not have so much debt
finance that it risks not being able to settle the debt as it falls due.
Significant change may be due to:
Factors which have a significant impact on profit before interest and
tax
A change in interest bearing debt

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Shareholders' investment ratios 1

These ratios measure the returns the company makes to


shareholders in terms of dividends and earnings.

Dividend yield
Calculation:

Dividend per share Mid market price 100%

Meaning:
The dividend yield ratio expresses the dividend per share as a percentage
of the current mid market price of the share and provides an indication of
the return the investment is giving relative to the company's share price.
Significant change may be due to:
A change in the levels of dividends paid by the company
Fluctuations in the company's share price

BPP LEARNING MEDIA

Shareholders' investment ratios 2


Dividend cover
Calculation:

Earnings per share Dividend per share

Meaning:
This ratio shows the proportion of profit for the year that is available for
distribution to shareholders that has been paid or proposed and what
proportion will be retained in the business to finance future growth.
For example a dividend cover of two times would indicate that the
company has paid 50% of its distributable profits as dividends and
retained 50% in the business to help finance future operations.
Significant change may be due to:
A change in the level of profits earned by the business
The need to keep the dividend level consistent year on year

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Shareholders' investment ratios 3


Price/earnings ratio
Calculation:

Mid market price Earnings per share

Meaning:
This ratio compares the company's current share price to the earnings per
share.
A high P/E ratio indicates strong shareholder confidence in the company
and its future because the market has valued its shares at a high price
relative to the earnings per share made by the company.
Significant change may be due to:
A change in the level of profits earned by the company
A change in value shareholders' perceive in the company

BPP LEARNING MEDIA

Question: Lecture example 1


Consider the following stakeholders:
(a) Shareholders
(b) Potential investors
(c) Bank and other capital providers
(d) Employees
(e) Management
(f) Suppliers
(g) Government
Required
What are these stakeholders looking for in an analysis of an
entity's financial statements?
BPP LEARNING MEDIA

Answer: Lecture example 1


(a),(b) Shareholders and potential investors will use ratios to
help them come to a decision on buying or selling the
shares of the company.
(c)

Banks and other providers of loan capital will assess


whether further loans should be made to the company.

(d)

Employees may use them as a basis for wage


negotiation.

(e)

Management will use ratios to highlight weak


performing areas in order to focus their attention on
these areas.

(f)

Suppliers may use ratios to assess creditworthiness.

(g)

Governments may use them for statistics or for


assessing the worthiness of a government grant.

BPP LEARNING MEDIA

Presentation of financial performance 1


Step 1

Read requirements

Step 2

Identify the user and format required

Read question and analyse data


Look for obvious changes/differences in the
figures without calculating any ratios other than
percentage movements year on year

Step 3

Calculate key ratios


Do not calculate too many as marks for these will
be capped, state formula and include as an
appendix

BPP LEARNING MEDIA

Presentation of financial performance 2


Step 4

Group analysis into categories


For example profitability, liquidity and gearing or by
issue (especially if there are several different issues
identified in the narrative information in the question)

Step 5

Write up your answer summarising performance


Structure using the above categories
Comment on the main features first
Bring in relevant ratios to support your arguments
Suggest reasons for key changes
Use the information given in the question

Step 6

Consider limitations of ratio analysis


If relevant to the question

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Question: Lecture example 2


Below are the summarised financial statements for the year to 31 March 20X5 and 20X6 of Heywood
Bottles, a company which manufactures bottles for many different drinks companies.
Note. The statements for the year to 31 March 20X6 have not been audited.
Heywood Bottles
STATEMENTS OF PROFIT OR LOSS AND OTHER COMPREHENSIVE INCOME FOR THE YEARS
ENDED 31 MARCH
20X6
20X5
$m

Depreciation
Cost of sales

$m

300

Revenue
Manufacturing costs

$m

$m
120

261

83

7
(270)

(90)

30

30

(28)

(10)

20

(10)

(2)

Profit/(loss) before tax

(8)

18

Income tax expense

(4)

(6)

Gross profit
Other expenses
Profit before interest and tax
Finance costs

PROFIT/LOSS
TOTAL COMPREHENSIVE
BPP LEARNING MEDIA

Question: Lecture example 2 (cont'd)


Heywood Bottles
STATEMENTS OF FINANCIAL POSITION AS AT 31 MARCH

20X6

20X5

$m

$m

5
58

5
38

63

43

18
94
6

118

12
25

8
45

181

88

Non-current assets
Land and buildings
Plant and equipment

Current assets
Inventories
Receivables
Deferred expenditure
Bank

BPP LEARNING MEDIA

Question: Lecture example 2 (cont'd)


Equity
$1 ordinary shares
Capital reserves
Retained earnings

25
10
(12)
23

25
11
8
44

32

19

80
12
34
126
181

15
10

25
88

Non-current liabilities
Finance lease liabilities
Current liabilities
Trade payables
Other payables
Bank overdraft

BPP LEARNING MEDIA

Question: Lecture example 2 (cont'd)


Note
Plant and equipment is made up as follows.
At 31 March
Owned plant
Leased plant

BPP LEARNING MEDIA

20X6
$m
18
40
58

20X5
$m
10
28
38

Question: Lecture example 2 (cont'd)


The directors were disappointed in the profit for the year to 31 March 20X5
and held a board meeting in April 20X5 to discuss future strategy. The
Managing Director was insistent that the way to improve the company's
results was to increase sales and market share. As a result the following
actions were implemented.
(a) An aggressive marketing campaign through trade journals costing $12
million was undertaken. Due to expected long-term benefits $6 million of
this has been included as a current asset in the statement of financial
position at 31 March 20X6.
(b) A 'price promise' to undercut any other supplier's price was announced in
the advertising campaign.
(c) A major contract with Koola Drinks was signed that accounted for a
substantial proportion of the company's output. This contract was
obtained through very competitive tendering.
(d) The credit period for receivables was extended from two to three months.

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Question: Lecture example 2 (cont'd)


A preliminary review by the board of the accountants to 31 March 20X6
concluded that the company's performance had deteriorated rather than
improved. There was particular concern over the prospect of renewing the
bank facility because the maximum agreed level of $30 million had been
exceeded. The board decided that it was time to seek independent
professional advice on the company's situation.
Required
In the capacity of a business consultant, prepare a report for the board of
Heywood Bottles based on a review of the company's performance for the
year to 31 March 20X6 in comparison with the previous year. Particular
emphasis should be given to the effects of the implementation of the actions
referred to in points (a) to (d) above.

BPP LEARNING MEDIA

Answer: Lecture example 2


REPORT
To: The directors of Heywood Bottles
From:

Business Consultant

Date:

May 20X6

Subject: Company performance year to 31 March 20X6


Introduction
This report was commissioned in order to assess the financial performance
of Heywood Bottles for the year to 31 March 20X6 in the light of the strategic
actions taken in April 20X5.
Specific areas addressed include profitability, liquidity and solvency. An
appendix sets out the calculations of selected ratios used.

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Answer: Lecture example 2 (cont'd)


Financial performance
Growth
Heywood Bottles' revenue has grown by approximately 150% in the year. This
appears to be due to increased sales volume as a result of:
The marketing campaign undertaken during the year successfully
attracting new customers
The 'price promise' to undercut other supplies winning customers from
competitors
The new contract won with Koola Drinks
Extending the credit period from two to three months, so attracting new
customers

BPP LEARNING MEDIA

Answer: Lecture example 2 (cont'd)


Profitability
The gross margin has deteriorated from 25% in 20X5 to 10% in 20X6. This is
because increased sales volume has been achieved at the cost of profit
margins. The two main causes of this appear to be:
Lowering the sales price as a result of the 'price promise'
Competitive tendering for the new contract with Koola Drinks, which implies
a lower than usual sales price
The operating profit margin has also deteriorated (from 16.7% to 0.7%). This is
partly due to the fall in gross margin (as explained above) but also due to the
one off marketing expenses of $12m, half of which ($6m) have been
recognised in operating expenses. Half of the marketing expenses ($6m) were
recorded as a current asset but this accounting treatment is not correct as
marketing expenses do not meet the definition of an asset. Therefore the $6m
asset should be written off as additional operating expenses. Once this has
been adjusted for, the decline in operating margins is even more severe,
resulting in an operating loss of $4m.
BPP LEARNING MEDIA

Answer: Lecture example 2 (cont'd)


Profitability (continued)
Profitability has been further eroded by a fivefold increase in interest payable,
due to Heywood Bottles' large overdraft and the new finance leases entered
into during the year.
Efficiency
Return on capital employed has deteriorated from 31.7% to 3.6% implying a
decline in efficiency in the use of assets to generate profit. This is as a result of
the decline in margins (explained above) and also because Heywood Bottles
purchased new assets under finance leases during the current year.
Depending on the date of purchase of these assets, Heywood Bottles may not
have been able to take advantage of these assets to generate additional profit
this year.
The improvement in net asset turnover implies that Heywood Bottles are
successfully using their assets to generate revenue but have been unable to
convert that into improved profitability.
BPP LEARNING MEDIA

Answer: Lecture example 2 (cont'd)


Financial position
Liquidity
Both the current and quick (acid test) ratios have deteriorated (from1.8/1.3 to
0.9/0.8). The expansion during the year has come at a cost of declining
profitability and liquidity problems. The liquidity problems are due to:
Poor working capital management
Reliance on the overdraft as a source of long term finance
An overdraft is not a good source of long term finance as it is both expensive
and risky ie it could be withdrawn by the bank at any time. Heywood Bottles is
particularly at risk of having their overdraft facility withdrawn because the
current balance of $34m is in excess of the $30m agreed limit.
Working capital management
Working capital management has worsened in the year:
Receivable days have increased from 76 days to 114 days. This is largely
because Heywood Bottles increased their credit terms from two to three
months.
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Answer: Lecture example 2 (cont'd)


Working capital management (continued)
The new contract with Koola Drinks was obtained through competitive
tendering, which may imply longer than usual credit terms for this new
customer.
As a result of customers taking longer to pay, a need for extra finance arose.
This resulted in Heywood Bottles taking longer to pay their suppliers (61 days
in 20X5 and 108 days in 20X6) and heavy reliance on the overdraft facility. If
this continues, there is a risk that Heywood Bottles' suppliers might stop their
credit or even stop supply.
Even though Heywood Bottles appears to be struggling to pay suppliers, the
suppliers are being paid more quickly than debts are being collected from
customers. This has exacerbated the liquidity problems.
Inventory days have gone down from 49 days to 24 days this is probably
due to increased sales demand as a result of the marketing, price promise,
new customer and increased credit terms. It could also be due to suppliers
restricting supplies due to slow payment.

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Answer: Lecture example 2 (cont'd)


Solvency
Gearing has increased from 43% to 139%. This increase would have been even
higher if the overdraft were to be included as long term debt in the 20X6
calculation.
This is due to the fact that new assets were purchased under finance leases
during the year (increasing long term debt) and because the loss for the year
has created negative retained earnings (decreasing equity). This means that
Heywood Bottles are unable to pay a dividend in the current year which will
make investors unhappy. This combined with the risk associated with increased
non-discretionary interest payments each year, means that it might well be
difficult to raise further finance from investors in the future.
The decline in interest cover from ten times to 0.2 times shows that whilst
Heywood Bottles could easily afford to pay their interest in 20X5, they are now
struggling to do so. This could cause serious problems in the future as interest is
non-discretionary so non-payment could result in withdrawal of the overdraft
facility and/or seizure of non-current assets by the lessor.

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Answer: Lecture example 2 (cont'd)


Conclusion
The company is overtrading and will fail without an immediate injection of new
capital and a change in strategy.
The board actions in April 20X5 were, with hindsight, disastrous as although
they resulted in expansion, it was at the cost of both profitability and liquidity.
Increased turnover and market share are only worthwhile while the company is
trading profitably.
It will be very difficult to retain the loyalty of customers if prices are increased
and relationships with suppliers and other payables are severely strained.

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Answer: Lecture example 2 (cont'd)


APPENDIX
Selected ratios
Calculation 20X6

Calculation 20X5

ROCE

2 / (23 + 32) 100

3.6%

20/(44 + 19) 100

31.7%

Net asset turnover

300 / (181 126)

5.5

120 / (88 25)

1.9

Non-current asset turnover

300/63

4.8

120/43

2.8

Gross profit margin

30 / 300 100

10%

30 / 120 100

25%

Operating profit margin

2/300 100

0.7%

20 / 120 100

16.7%

Current ratio

118 / 126

0.9

45/25

1.8

Acid test

(118 18) / 126

0.8

(45 12) / 25

1.3

Inventory days

18 / 270 365

24 days

12 / 90 365

49 days

Receivables days

94 / 300 365

114 days

25 / 120 365

76 days

Payables days

80 / 270 365

108 days

15 / 90 365

61 days

Gearing (long-term debt/ equity)

32 / 23 100

139%

19 / 44 100

43%

Interest cover

2/10

0.2 times

20/2

10 times

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Past exam questions


Nature of question

Exam details

Question 3 in the exam under the old


Q3 in all past
format was often an interpretation
exams
question. This includes calculating ratios
in order to interpret the information
contained in the financial statements.
Under the new exam format this is likely
to appear as a long question in Section
B. Ratios could also be tested as MCQs.

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Chapter 20
Limitations of
financial statements
and interpretation
techniques

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Limitations of financial statements


Accounting policies and the
limitations of ratio analysis

Syllabus learning outcomes 1


Indicate the problems of using historic information to predict
future performance and trends
Discuss how financial statements may be manipulated to
produce a desired effect (creative accounting, window
dressing)
Recognise how related party relationships have the potential to
mislead users
Explain why figures in the statement of financial position may
not be representative of average values throughout the period
for example, due to:
Seasonal trading
Major asset acquisitions near the end of the accounting
period
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Syllabus learning outcomes 2


Discuss the limitations in the use of ratio analysis for
assessing corporate performance
Discuss the effect that changes in accounting policies or
the use of different accounting policies between entities
can have on the ability to interpret performance
Indicate other information, including non-financial
information, that may be of relevance to the assessment of
an entity's performance

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Chapter summary diagram


Limitations of financial
statements and interpretation
techniques
Limitations of financial
statements
Problems of
historical
information

Related party
transactions

Creative
accounting
Limitations of
interpretation
techniques
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Unrepresentative
figures
Events after the
reporting period

Limitations of financial statements 1


Problems of historical information
The financial statements are produced at a point in time and can
quickly become out of date.
There is often too little information in the financial statements for
users to make detailed future predictions, for example users would
not necessarily know information about the entity's planned future
capital expenditure and financing plans from the financial statements.
There is no guarantee that trends in historical data will continue into
the future.
A change in company strategy may have occurred since the financial
data was published.
Similarly, a change in management since the results were published
can lead to different market expectations about the future.

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Limitations of financial statements 2


Creative accounting

Creative accounting describes the situation where management use


accounting methods to work in their favour to achieve a desired effect.

Often the desired effect is to provide markets and analysts with what
they expect to see. Examples include:
A trend of steady profit growth
A stable level of dividends
Either no changes in key ratios or improvements therein

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Limitations of financial statements 3


Creative accounting (continued)
Examples of creative accounting include:
Removing 'peaks' and 'troughs' or achieving a desired profit target:
Making provisions which are subsequently reversed post year end
Manipulating cut-off, for example invoicing in advance to boost
revenue and profits
'Bed and breakfast' selling an asset to realise a profit and
repurchasing it post year end
Reducing apparent gearing:
'Off-balance sheet' financing, for example sale and operating
leaseback transactions
'Window dressing', for example paying back a loan just before the
year end and taking it out again at the beginning of the next year
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Limitations of financial statements 4


The effect of related parties

A related party transaction is:


A transfer of resources or obligations between related parties,
regardless of whether a price is charged

A party is related to an entity if it has control or the ability to exercise


significant influence over the entity.

Examples of related parties include:


Other group companies (parent, subsidiaries, associates and joint
ventures)
Key management personnel (and their close family)
Companies in which key management personnel or their family
have influence

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Limitations of financial statements 5


The effect of related parties (continued)

IAS 24 requires disclosure of material related party transactions


regardless of whether a price was charged.

However it is inherently difficult to ensure that all related party


disclosures have been made.

Possible effects of related party transactions on the financial


statements include:
Higher or lower revenue and profit due to artificial prices on
transactions with related parties
Costs or savings due to different terms and conditions other
than prices (for example, lost interest due to offering longer credit
terms to related parties)

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Limitations of financial statements 6


The effect of related parties (continued)

Further possible effects of related party transactions on the financial


statements include:
Revenue that would not occur without the influence of the related
party
Suppliers determined by personal relationships or financial
interests of key management personnel
Loans to related parties at preferential interest rates

Note. IAS 24 is not in itself examinable but relationships between parents


and subsidiaries are important to consider in this context.

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Question: Lecture example 1


Related party relationships and transactions are a normal
feature of business.
Entities often carry on their business activities through
subsidiaries and associates and it is inevitable that
transactions will occur between group companies.
Required
Explain why the disclosure of related party relationships
and transactions is an important issue.

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Answer: Lecture example 1


Related party relationships are part of normal business activity.
Related parties exist for sound commercial reasons and often have a
material impact on the financial position of companies. Intra-group
trading between members of a group is a common example.
However, the existence of related parties should be disclosed in order
that users appreciate that not all transactions have been undertaken
genuinely at arm's length. Users will expect that, in the absence of
disclosure of the details of a related party, all the transactions have
been undertaken at arm's length.
Even if there are no transactions between related parties, the results of
a group can still be affected by the relationship. For example, a newly
acquired subsidiary can be compelled to finish a trading relationship
with another company in order to benefit other group companies.

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Limitations of financial statements 7


Seasonal trading
A business may be subject to seasonal trading and this can
distort results.
This is because those businesses with seasonal trade tend to
have their year end just after their busy season so that they can
minimise the time spent on inventory counting.
However at this point in time, as well as having few inventories,
the business will have a good level of cash or receivables.
Consequently the statement of financial position is produced at
a point in time when the company is at its most solvent and the
financial statements can therefore be unrepresentative of any
other time of the year.

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Limitations of financial statements 8


Asset acquisitions
The timing of the purchase of non-current assets can also have
a significant impact on the financial statements.
Assets purchased just before the end of the reporting period
are unlikely to have had time to generate any sales revenue.
However they will be included in the statement of financial
position at the end of the year and so this will adversely affect
ratios such as the return on capital employed.

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Question: Lecture example 2


Required
Identify limitations in the data provided for analysis on
Heywood Bottles in Chapter 19.

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Answer: Lecture example 2


There is an incentive for management to make the financial
statements appear more healthy to secure a renewal of bank
financing.
Only two years' data are provided: this means that ratios that
compare statement of financial position and profit or loss
figures, eg return on capital employed, average collection
period, will be distorted because year end statement of
financial position figures are used rather than average
statement of financial position figures (for which three years'
statement of financial position data would be required).
No notes to the financial statements are provided. Notes break
down the key figures in the financial statements and may
reveal a different picture to the summary figures.

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Answer: Lecture example 2 (cont'd)


There is no management commentary on the figures. A
management commentary allows management to highlight key
economic performance figures and explain the reasons behind
them, and the expected impact this will have on the future,
allowing an analyst to understand the background and make
valid comment rather than entering into conjecture.
Management commentary may of course be biased, but it is an
additional source of information.
There are also no industry averages. This would allow a
comparison of where Heywood Bottles stands at the present
time relevant to other companies in the market.
A volume and price analysis of sales by type of bottle would
allow detailed analysis of the effectiveness of the price
promise.
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Answer: Lecture example 2 (cont'd)


The market (fair) value of the land and buildings is not known,
but we know they are held under the cost model because there
is no revaluation surplus. Similarly, the date the non-current
assets were acquired (and therefore their age) is not known.
Both of these affect capital employed (relatively lower versus
companies with newer/revalued assets, reduced to some
extent by the effect of a higher depreciation charges based on
recent/revalued amounts in those companies' books). This
makes comparisons with other companies less valid.

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Accounting policies and the limitations of ratio analysis 1


Accounting policies

An entity should disclose its accounting policies in the financial


statements, especially where an accounting standard allows a choice of
accounting treatment.

Under IAS 8 an entity should only change its accounting policy if the
new policy will present the information in the financial statements in a
more relevant and more reliable way.

Changes in accounting policy should not be made to manipulate results.

Where an entity has changed its accounting policy it is required to


restate its comparative figures so that its financial statements are
comparable year on year.

One further reason why accounting policy information is disclosed is so


that users can understand the way in which the financial statements
have been drawn up and make comparisons between companies which
have different accounting policies.
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Accounting policies and the limitations of ratio analysis 2


Limitations of ratio analysis
The usefulness of ratio analysis is limited by distorting factors including:
Inflation when comparing to previous years
The use of different accounting policies/classifications (for example
the ROCE of a company that uses the historic cost model for noncurrent assets will be higher than one which uses a policy of
revaluation)
Lack of information/lack of breakdown of information
Year end figures not being representative

Related party transactions making ratios incomparable with other


companies
The use of different ratio definitions by different companies
Manipulation of financial statements
The fact that new companies have no comparative information.
BPP LEARNING MEDIA

Past exam questions


Nature of question

Exam details

An interpretation question, as well as


Q3 Dec 2012
requiring you to interpret the financial
Q3 Dec 2011
information, may also include a
requirement relating to the limitations of
ratio analysis or the financial statements
themselves.

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Chapter 21
Statements of cash
flows

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IAS 7 Statement of Cash Flows


Preparing a statement of cash
flows
Interpretation of statements of
cash flows

Syllabus learning outcomes


Prepare a statement of cash flows for a single entity (not a
group) in accordance with relevant accounting standards
using the direct method and the indirect method
Compare the usefulness of cash flow information with that
of a statement of profit or loss or statement of profit or loss
and other comprehensive income
Interpret a statement of cash flows (together with other
financial information) to assess the performance and
financial position of an entity

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Chapter summary diagram


Statements of cash flows

Interpretation of
statements of cash
flows

Definitions

Formats

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Approach to
preparation of
statements of cash
flows

IAS 7 Statements of Cash Flows 1


Purpose
To show the effect of a entity's commercial transactions on
its cash balance.
Cash is a relatively better understood concept than profit
and is also less subject to manipulation by the use of
different accounting policies.
Cash flows are also used in investment appraisal
techniques which involve net present values and so the
statement of cash flows will also allow users to evaluate a
business.

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IAS 7 Statements of Cash Flows 2


Definitions
Cash:
Comprises cash on hand and demand deposits
Cash equivalents:
Are short-term, highly liquid investments that are readily
convertible into known amounts of cash and which are
subject to an insignificant risk of changes in value
Cash flows:
Are inflows and outflows of cash and cash equivalents

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IAS 7 Statements of Cash Flows 3


Format

IAS 7 Statement of Cash Flows splits cash flows into the following
headings:
Cash flows from operating activities:

The principal revenue-producing activities of the entity and


other activities which are not investing or financing activities.

Cash flows from investing activities:

Relate to the acquisition and disposal of non-current assets and


other investments not included in cash equivalents.

Cash flows from financing activities:

Are activities that result in changes in the size and composition


of the equity capital and borrowings of the entity.

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IAS 7 Statements of Cash Flows 4


Consolidated Cash Flow Statement
in millions
EBIT (earnings before interest and taxes)

Taxes paid
Depreciation and write-ups of non-current assets
Capital gains/losses
Change in provisions for pensions
Change in other provisions
Other effects
Change in net working capital
Cash flow from operating activities

http://www.bertelsmann.de/

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2006
3,028

2005
1,671

(301)
730
(1,410)
(64)
8
(128)
(190)
1,673

(253)
699
(258)
(22)
52
(46)
(52)
1,791

IAS 7 Statements of Cash Flows 4 (cont'd)


Investments in:

Intangible assets
Property, plant and equipment
Financial assets
Purchase price for consolidated investments (net of acquired cash)

(154)

(204)

(502)

(568)

(31)

(59)

(405)

(1,734)

Proceeds from disposal of investments


Proceeds from disposal of other non-current assets
Proceeds from disposal of marketable securities and short-term
investments
Funding of Bertelsmann Pension Trust e.V. (CTA)
Cash flow from investing activities

1,648
122
20

353
83

(200)
498

(360)
(2,489)

http://www.bertelsmann.de/

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IAS 7 Statements of Cash Flows 4 (cont'd)


Proceeds from issues of bonds and promissory notes
Redemption of bonds and promissory notes
Change in financial debt
Interest paid
Change in shareholders' equity

1,488
(50)
1,587
(291)
(4,506)

495
(185)
(120)
(165)

Dividends to Bertelsmann shareholders and minorities


Additional payments to shareholders (IAS 32)
Cash flow from financing activities

(385)
(41)
(2,198)

(414)
(39)
(428)

(27)

(1,126)

(23)
1,036
986

70
2,092
1,036

Change in cash and cash equivalents


Currency effects and other changes in cash and cash equivalents
Cash and cash equivalents at the beginning of the period
Cash and cash equivalents at the end of the period

http://www.bertelsmann.de/

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IAS 7 Statements of Cash Flows 5


Cash flows from operating activities
Profit before taxation
Adjustments for:
Depreciation
Amortisation
Interest expense
Profit on disposal of equipment
Increase in trade receivables
Increase in inventories
Decrease in trade payables
Increase in provisions
Cash generated from operations
Interest paid
Income taxes paid
Net cash from operating activities

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$'000

$'000

IAS 7 Statements of Cash Flows 6


Cash flows from investing activities
Development expenditure
Purchase of property, plant and equipment
Proceeds from sale of equipment
Net cash used in investing activities
Cash flows from financing activities
Proceeds from issue of share capital
Proceeds from issue of debentures
Dividends paid
Net cash from financing activities
Net increase in cash and cash equivalents
Cash and cash equivalents at beginning of year
Cash and cash equivalents at end of year

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$'000

$'000

Preparing a statements of cash flows 1


Just as we have seen with the financial statement
preparation questions (for both a single company and in a
group context) it is important to follow a methodical
approach to long calculation questions.
Inevitably these long questions are completed using a
series of shorter workings.
The next four lecture examples show some of the typical
workings required in the preparation of a full statement of
cash flows question.

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Question: Lecture example 1


Debs Co statement of financial position extract for the year
ended 31 December 20X3:
20X3
20X2
Current liabilities
$'000 $'000
Accrued debenture interest


15
Interest payable is shown in the statement of profit or loss and
other comprehensive income of 20X3 as being $30,000.
There are no bank loans or overdrafts.
Additionally you are told that a new finance lease agreement was
taken out in the year. Total repayments are $5,000, of which
$1,500 is interest only. At present all $5,000 has been debited to
the finance lease liability account.
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Question: Lecture example 1 (cont'd)


Required
Prepare relevant extracts from Debs Co's statement of cash
flows.

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Answer: Lecture example 1


Extracts from the statement of cash flows
$'000
Cash flows from operating activities
Adjustments for:
Interest expense (30 + 1.5)
Cash generated from operations

31.5
X

Interest paid (45 + 1.5)

(46.5)

Cash flows from financing activities


Payment of finance lease liabilities (5 1.5)

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(3.5)

Answer: Lecture example 1 (cont'd)


Interest payable
Interest paid
c/d

$'000
45 b/d
0 P/L
45

$'000
15
30
45

Additionally, the interest element of the finance lease


instalment ($1,500) is included in interest paid.
The capital repayments on the lease only ($3,500) are
shown under financing activities.

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Question: Lecture example 2


In the statements of financial position of Tacks Co as at 31
December 20X1 and 31 December 20X2 were the following
liabilities for income tax.

Current income tax due


Deferred tax liability

31 December
20X2
20X1
$'000
$'000
94
87
62
81
156
168

The total charge for income taxes in the year ended 31 December
20X2 was $104,000.
None of the deferred tax liability movement was taken to reserves
in 20X2.
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Question: Lecture example 2 (cont'd)


Required
What is the amount of income taxes paid during the year?

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Answer: Lecture example 2


Income taxes paid:
Income taxes payable
$'000
Tax paid
c/d current
deferred

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116 b/d current


94
deferred
62 Profit or loss
272

$'000
87
81
104
272

Question: Lecture example 3


On 31 December 20X3/20X2 the value of plant and equipment in
the books of Erosion Co was as follows.

Plant and equipment at cost


Accumulated depreciation
Carrying amount

20X3

20X2

$'000
280
(111)
169

$'000
200
(80)
120

On 1 January 20X3 an item of plant was sold for $8,000 which


had originally cost $20,000 when new, but had a carrying amount
of $11,000 at the time of sale.
The asset values shown above do not show that this sale has
taken place.
BPP LEARNING MEDIA

Question: Lecture example 3 (cont'd)


Required
Show the relevant entries for plant and equipment which would
appear in a statement of cash flows for Erosion Co in 20X3.

BPP LEARNING MEDIA

Answer: Lecture example 3


The entries in the statement of cash flows for 20X4 would be:
$'000
Cash flows from operating activities
Profit before taxation
Adjustments for:
Depreciation
Loss on sale of plant
Cash flows from investing activities
Purchase of plant and equipment
Proceeds from sale of plant

X
40
3
(100)
8
92

Profit/loss on disposal:
$'000
Carrying amount of asset sold
Sale proceeds
BPP LEARNING MEDIA
Loss
on sale

11
(8)
(3)

Answer: Lecture example 3 (cont'd)


Plant and equipment cost
$'000

$'000

b/d

200 Disposal

20

Additions

100 c/d

280

300

300

Plant and machinery accumulated depreciation


$'000
Disposal
c/d

9 b/d
111 charge
120

BPP LEARNING MEDIA

$'000
80
40
120

Question: Lecture example 4


Cher Co has the following share capital for the years 20X1 and
20X2.

$1 ordinary share capital


Share premium
General reserve

20X2 20X1
$'000
$'000
2,000
1,200
400
100
9,600
10,000
12,000
11,300

During the year the company had a 1 for 3 bonus issue


capitalising its general reserve followed by an issue at full market
price.
Required
Calculate cash proceeds from issue of shares.
BPP LEARNING MEDIA

Answer: Lecture example 4


STATEMENT OF CASH FLOWS (extract)
Cash flows from financing activities
$'000
Proceeds from issue of share capital
[2,400 1,.300 (1,200 1/3) bonus issue]

BPP LEARNING MEDIA

700

Preparing a statements of cash flows 2


Operating activities alternative methods
IAS 7 allows two possible layouts for the statement of
cash flows in respect of operating activities:
(1) The indirect method, where profit before tax is
reconciled to operating cash flow
(2) The direct method, where the cash flows themselves
are shown

BPP LEARNING MEDIA

Preparing a statements of cash flows 3


Direct method

When using the direct method the key difference from the indirect
method is the way in which the cash generated from operations is
presented.
The amount of cash generated from operations is the same
regardless as to which method you use!

Cash flows from operating activities


Cash receipts from customers
Cash paid to suppliers and employees
Cash generated from operations
Interest paid
Income taxes paid
Net cash from operating activities

BPP LEARNING MEDIA

$'000

Preparing a statements of cash flows 4


Indirect vs. direct method
The direct method is the preferred method to use under
IAS 7 Statement of Cash Flows.
However the indirect method is more common in the
exam.

BPP LEARNING MEDIA

Preparing a statements of cash flows 5


1. Read the question and set up a proforma
2. Transfer statement of financial position figures to face
of statement of cash flows or working
3. Transfer statement of profit or loss and other
comprehensive income figures to face of statement of
cash flows or working
4. Deal with additional information
5. Finish off workings and transfer figures to answer
6. Do additional workings for direct method (if required)
7. Finish off statement of cash flows

BPP LEARNING MEDIA

Question: Lecture example 5


Below are the statements of financial position for Thorstved at 31 December 20X7
and 31 December 20X8 and the statement of profit or loss and other
comprehensive income for the year ended 31 December 20X8.
STATEMENTS OF FINANCIAL POSITION

20X8
$'000

20X7
$'000

ASSETS
Non-current assets
Property, plant and equipment
Development costs

528
110
638

447
93
540

Inventories
Trade receivables
Investments
Cash

413
238
28
111
790

380
215

4
599

TotalBPP
assets
LEARNING MEDIA

1,428

1,139

Current assets

Question: Lecture example 5 (cont'd)


EQUITY AND LIABILITIES
Equity
$1 ordinary shares
Share premium
Revaluation surplus
Retained earnings

240
140
100
538
1,018

200
120

530
850

30
150
180

25

25

37
193
230

32
232
264

1,428

1,139

Non-current liabilities
Provision for warranties
6% loan notes

Current liabilities
Income tax payable
Trade payables
BPP LEARNING MEDIA

Total equity and liabilities

Question: Lecture example 5 (cont'd)


STATEMENT OF PROFIT OR LOSS & OTHER COMPREHENSIVE INCOME
$'000
Revenue
Cost of sales
Gross profit
Expenses
Finance costs
Profit on sale of equipment
Profit before tax
Income tax expense
PROFIT FOR THE YEAR
Other comprehensive income:
Gain on property revaluation
TOTAL COMPREHENSIVE INCOME FOR THE YEAR

BPP LEARNING MEDIA

900
(550)
350
(245)
(9)
7
103
(30)
73
100
173

Question: Lecture example 5 (cont'd)


Notes
1

Deferred development expenditure amortised during 20X8


was $25,000.

Additions to property, plant and equipment totalling


$167,000 were made. Proceeds from the sale of equipment
were $58,000, giving rise to a profit of $7,000. No other
items of property, plant and equipment were disposed of
during the year.

Finance costs represent interest paid on the new 6% loan


notes 20Y220Y4 issued on 1 January 20X8.

Current asset investments represent treasury bills


acquired. The company deems these to represent cash
equivalents.

BPP LEARNING MEDIA

Question: Lecture example 5 (cont'd)


5

Dividends paid during the year amounted to $65,000.

The company revalued its property at the year end.


Company policy is to treat revaluations as realised profits
when the asset is retired or disposed of.

Expenses include wages paid of $44,000 and bad debts of


$12,000.

There is no deferred tax in Thorstved's books as no


deferred tax is necessary.

BPP LEARNING MEDIA

Question: Lecture example 5 (cont'd)


Required
(a) Prepare a statement of cash flows for Thorstved Co for the
year ended 31 December 20X8, using the indirect method
in accordance with IAS7.
(b) Prepare the 'Cash flows from operating activities' section
using the direct method.

BPP LEARNING MEDIA

Answer: Lecture example 5


(a) Thorstved Co
Statement of cash flows for year ended 31 December 20X8 (indirect method)
Cash flows from operating activities
Profit before taxation

$'000
103

Adjustments for:
Depreciation (W1)

135

Amortisation
Interest expense
Profit on disposal of equipment

25

9
(7)
265

Increase in trade receivables (238 215)

(23)

Increase in inventories (413 380)

(33)

Decrease in trade payables (193 232)

(39)

Increase in provisions (30 25)


Cash generated from operations
Interest
paid
BPP LEARNING
MEDIA

5
175
(9)

$'000

Answer: Lecture example 5 (cont'd)


$'000

$'000

Cash flows from investing activities


Development expenditure (W2)

(42)

Purchase of property, plant and equipment

(167)

Proceeds from sale of equipment


Net cash used in investing activities

58
(151)

Cash flows from financing activities


Proceeds from issue of share capital (380

60

320)

150

Proceeds from issue of debentures

(65)

Dividends paid
Net cash from financing activities
Net increase in cash and cash equivalents
Cash and cash equivalents at the

145
135

beginning of year
BPP LEARNING
Cash
andMEDIA
cash equivalents at end of year

4
139

Answer: Lecture example 5 (cont'd)


Working 1
Property, plant and equipment (Carrying amount)
b/d

447

c/d

BPP LEARNING MEDIA

528

Answer: Lecture example 5 (cont'd)


Working 2
Development expenditure
b/d

93

c/d

BPP LEARNING MEDIA

110

Answer: Lecture example 5 (cont'd)


Cash flows from operating activities
Profit before taxation
Adjustments for:
Depreciation
Amortisation
Interest expense
Profit on disposal of equipment
Increase in trade receivables (238 215)
Increase in inventories (413 380)
Decrease in trade payables
Increase in provisions
Cash generated from operations
Interest paid
Income taxes paid
Net cash from operating activities
BPP LEARNING MEDIA

$'000

(23)
(33)

$'000

Answer: Lecture example 5 (cont'd)


Cash flows from investing activities
Development expenditure
Purchase of property, plant and equipment
Proceeds from sale of equipment
Net cash used in investing activities

$'000 $'000

Cash flows from financing activities


Proceeds from issue of share capital (240 + 140 200 120)
Proceeds from issue of debentures
Dividends paid
Net cash from financing activities
(0 + 4)
Net increase in cash and cash equivalents
+ 111)
Cash and cash equivalents at beginning of(28
year
Cash and cash equivalents at end of year
BPP LEARNING MEDIA

60

4
139

Answer: Lecture example 5 (cont'd)


Cash flows from operating activities
Profit before taxation
Adjustments for:
Depreciation
Amortisation
Interest expense
Profit on disposal of equipment
Increase in trade receivables (238 215)
Increase in inventories (413 380)
Decrease in trade payables
Increase in provisions (30 25)
Cash generated from operations
Interest paid
Income taxes paid
Net cash from operating activities
BPP LEARNING MEDIA

$'000

(23)
(33)
5

$'000

Answer: Lecture example 5 (cont'd)


Cash flows from investing activities
Development expenditure
Purchase of property, plant and equipment
Proceeds from sale of equipment
Net cash used in investing activities

$'000 $'000

Cash flows from financing activities


Proceeds from issue of share capital (240 + 140 200 120) 60
150
Proceeds from issue of debentures (150 0)
Dividends paid
Net cash from financing activities
(0 + 4)
Net increase in cash and cash equivalents
+ 111)
Cash and cash equivalents at beginning of(28
year
Cash and cash equivalents at end of year
BPP LEARNING MEDIA

4
139

Answer: Lecture example 5 (cont'd)


Working 3
Income tax payable
b/d

c/d

BPP LEARNING MEDIA

37

32

Answer: Lecture example 5 (cont'd)


Cash flows from operating activities
Profit before taxation
Adjustments for:
Depreciation
Amortisation
Interest expense
Profit on disposal of equipment
Increase in trade receivables (238 215)
Increase in inventories (413 380)
Decrease in trade payables (193 232)
Increase in provisions (30 25)
Cash generated from operations
Interest paid
Income taxes paid
Net cash from operating activities
BPP LEARNING MEDIA

$000
103

(23)
(33)
(39)
5

$'000

Answer: Lecture example 5 (cont'd)


Working 3
Income tax payable

c/d

BPP LEARNING MEDIA

37

b/d

32

P/L

30

Answer: Lecture example 5 (cont'd)


Working 1
Property, plant and equipment
b/d

447

Rev'n (OCI)

100

BPP LEARNING MEDIA

c/d

528

Answer: Lecture example 5 (cont'd)


Cash flows from operating activities
Profit before taxation
Adjustments for:
Depreciation
Amortisation
Interest expense
Profit on disposal of equipment
Increase in trade receivables (238 215)
Increase in inventories (413 380)
Decrease in trade payables (193 232)
Increase in provisions (30 25)
Cash generated from operations
Interest paid
Income taxes paid
Net cash from operating activities
BPP LEARNING MEDIA

$'000
103
25

(23)
(33)
(39)
5

$'000

Answer: Lecture example 5 (cont'd)


Working 2
Development expenditure
b/d

BPP LEARNING MEDIA

93
Amortisation

25

c/d

110

Answer: Lecture example 5 (cont'd)


Working 1
Property, plant and equipment
b/d

447

Additions

167

Rev'n (OCI)

100

BPP LEARNING MEDIA

Disposal (58 7) 51

c/d

528

Answer: Lecture example 5 (cont'd)


Cash flows from investing activities
Development expenditure
Purchase of property, plant and equipment
Proceeds from sale of equipment
Net cash used in investing activities

$'000 $'000
(167)
58

Cash flows from financing activities


Proceeds from issue of share capital (240 + 140 200 120) 60
Proceeds from issue of debentures (150 0)
150
Dividends paid
Net cash from financing activities
Net increase in cash and cash equivalents
(0 + 4)
Cash and cash equivalents at beginning of(28
year
+ 111)
Cash and cash equivalents at end of year
BPP LEARNING MEDIA

4
139

Answer: Lecture example 5 (cont'd)


Cash flows from operating activities
Profit before taxation
Adjustments for:
Depreciation
Amortisation
Interest expense (150 6%)
Profit on disposal of equipment
Increase in trade receivables (238 215)
Increase in inventories (413 380)
Decrease in trade payables (193 232)
Increase in provisions (30 25)
Cash generated from operations
Interest paid
Income taxes paid
Net cash from operating activities
BPP LEARNING MEDIA

$'000
103
25
9
(7)
(23)
(33)
(39)
5
(9)

$'000

Answer: Lecture example 5 (cont'd)


Cash flows from investing activities
Development expenditure
Purchase of property, plant and equipment
Proceeds from sale of equipment
Net cash used in investing activities

$'000 $'000
(167)
58

Cash flows from financing activities


Proceeds from issue of share capital (240 + 140 200 120) 60
150
Proceeds from issue of debentures (150 0)
(65)
Dividends paid
Net cash from financing activities
(0 + 4)
Net increase in cash and cash equivalents
+ 111)
Cash and cash equivalents at beginning of(28
year
Cash and cash equivalents at end of year
BPP LEARNING MEDIA

4
139

Answer: Lecture example 5 (cont'd)


Working 1
Property, plant and equipment
b/d

447

Disposal (58 7) 51

Additions

167

Depreciation

135

Rev'n (OCI)

100

c/d

528

714

BPP LEARNING MEDIA

714

Answer: Lecture example 5 (cont'd)


Cash flows from operating activities
Profit before taxation
Adjustments for:
Depreciation (W1)
Amortisation
Interest expense
Profit on disposal of equipment
Increase in trade receivables (238 215)
Increase in inventories (413 380)
Decrease in trade payables (193 232)
Increase in provisions (30 25)
Cash generated from operations
Interest paid
Income taxes paid
Net cash from operating activities
BPP LEARNING MEDIA

$'000
103
135
25
9
(7)
(23)
(33)
(39)
5
(9)

$'000

Answer: Lecture example 5 (cont'd)


Working 2
Development expenditure
b/d

93

Paid

42

135

BPP LEARNING MEDIA

Amortisation

25

c/d

110
135

Answer: Lecture example 5 (cont'd)


Cash flows from investing activities
Development expenditure (W2)
Purchase of property, plant and equipment
Proceeds from sale of equipment
Net cash used in investing activities

$'000 $'000
(42)
(167)
58

Cash flows from financing activities


Proceeds from issue of share capital (240 + 140 200 120) 60
150
Proceeds from issue of debentures (150 0)
(65)
Dividends paid
Net cash from financing activities
Net increase in cash and cash equivalents
(0 + 4)
Cash and cash equivalents at beginning of(28
year
+ 111)
Cash and cash equivalents at end of year
BPP LEARNING MEDIA

4
139

Answer: Lecture example 5 (cont'd)


Working 3
Income tax payable
Cash paid

25

c/d

37
62

BPP LEARNING MEDIA

b/d

32

P/L

30

62

Answer: Lecture example 5 (cont'd)


Cash flows from operating activities
Profit before taxation
Adjustments for:
Depreciation (W1)
Amortisation
Interest expense
Profit on disposal of equipment
Increase in trade receivables (238 215)
Increase in inventories (413 380)
Decrease in trade payables (193 232)
Increase in provisions (30 25)
Cash generated from operations
Interest paid
Income taxes paid (W3)
Net cash from operating activities
BPP LEARNING MEDIA

$'000

$'000

103
135
25
9
(7)
265
(23)
(33)
(39)
5
175
(9)
(25)

141

Answer: Lecture example 5 (cont'd)


Cash flows from investing activities
Development expenditure (W2)
Purchase of property, plant and equipment
Proceeds from sale of equipment
Net cash used in investing activities

$'000 $'000
(42)
(167)
58

Cash flows from financing activities


Proceeds from issue of share capital (240 + 140 200 120) 60
150
Proceeds from issue of debentures (150 0)
(65)
Dividends paid
Net cash from financing activities

(151)

145

135
(0 + 4)
Net increase in cash and cash equivalents
4
Cash and cash equivalents at beginning of year
(28 + 111)
Cash and cash equivalents at end of year
139
BPP LEARNING MEDIA

Answer: Lecture example 5 (part (b))

Cash flows from operating activities


Cash receipts from customers
Cash paid to suppliers and employees
Cash generated from operations
Interest paid
Income taxes paid
Net cash from operating activities

BPP LEARNING MEDIA

$'000

Answer: Lecture example 5 (part (b)) (cont'd)


Working 1
Trade receivables
b/d

215 Bad debts

Sales

900 Cash rec'd


c/d
1,115

BPP LEARNING MEDIA

12
865
238
1,115

Answer: Lecture example 5 (part (b)) (cont'd)

Cash flows from operating activities


Cash receipts from customers (W1)
Cash paid to suppliers and employees
Cash generated from operations
Interest paid
Income taxes paid
Net cash from operating activities

BPP LEARNING MEDIA

$'000
865

$'000

Answer: Lecture example 5 (part (b)) (cont'd)


Working 2
Trade payables
b/d
Purchases (W3)
c/d

BPP LEARNING MEDIA

193

232

Answer: Lecture example 5 (part (b)) (cont'd)


Working 3
Purchases:
Cost of sales
550
Expenses
245
Inventories Opening
Closing
413
Non cash Depreciation
Amortisation
(25)
Bad debts
(12)
Increase in provision
651
BPP LEARNING MEDIA

(380)
(135)
(5)

Answer: Lecture example 5 (part (b)) (cont'd)


Working 2
Trade payables
b/d
Cash paid

690 Purchases (W3)

c/d

193
883

BPP LEARNING MEDIA

232
651

883

Answer: Lecture example 5 (part (b)) (cont'd)

Cash flows from operating activities


Cash receipts from customers (W1)
Cash paid to suppliers and employees (W2)
Cash generated from operations
Interest paid
Income taxes paid
Net cash from operating activities

BPP LEARNING MEDIA

$'000

$'000

865
(690)
175
(9)
(25)
141

Interpretation of statements of cash flows 1


As well as being able to calculate the amounts in the
statement of cash flows, it is also important that you
can interpret what the information actually means.
As we saw in a previous chapter the interpretation of
financial information is usually done using a
combination of ratio analysis and the narrative
information in a question.

BPP LEARNING MEDIA

Interpretation of statements of cash flows 2


Points to consider when interpreting the statement of
cash flows include:
What has happened to the overall level of cash and
cash equivalents (increase vs. decrease)?
How have the main components of cash flows
changed:
Operating activities main cash flows
Investing activities main cash flows and the
timing of non-current asset acquisitions
Financing activities main cash flows, has there
been a movement from debt to equity funding or
vice versa?
BPP LEARNING MEDIA

Interpretation of statements of cash flows 3


Examine the reconciliation of profit before tax to cash generated
from operations:
Consider the impact of the entity's accounting policies on profit
vs. cash flow, for example:
Where development costs have been deferred (capitalised)
under IAS 38; or
Where revenue has been recognised but no cash has been
generated (such as for an early stage construction contract
under IAS 11)
Consider the movements in working capital, for example:
Is there a build up of inventories which may not be saleable
Are receivables escalating which might indicate the entity is
overtrading
BPP LEARNING MEDIA

Interpretation of statements of cash flows 4


Consider whether the calculation of cash flow ratios might
improve your interpretation:

Cash return on capital employed


=

Cash generated from operations


100%
Total assets less current liabilities

Cash generated from operations to total debt


Cash generated from operations
=
Total debt

Net cash from operating activities to capital expenditure


=

Net cash from operating activities


100%
Net capital expenditure

BPP LEARNING MEDIA

Question: Lecture example 6


Required
Comment on the cash flow management of Thorstved
(from the previous lecture example) as revealed by the
statement of cash flows and the information provided by
the above financial statements.

BPP LEARNING MEDIA

Answer: Lecture example 6


Operating cash flows
Thorstved's operating cash inflows at $175,000 (before interest and
taxes paid) are considerably higher than the equivalent profit before
interest and tax figure of $105,000. This shows a satisfactory cash
generating ability and is more than sufficient to cover finance costs, tax
and dividends. Net cash inflows from operating activities after
considering dividend payments was $76,000 ($141,000 less $65,000
dividends paid).
The main reasons for the cash flows being higher than the operating
profit are due to the non-cash increases in depreciation and
amortisation. Working capital changes have resulted in a net outflow
versus profit as more cash is tied up in receivables and inventories,
while it appears that creditors may be being paid earlier than the
previous year (assuming Thorstved had a similar or higher trading
volume in 20X7 as in 20X8).
BPP LEARNING MEDIA

Answer: Lecture example 6 (cont'd)


Operating cash flows (continued)
This overall net cash outflow in working capital terms has been partially
financed by the healthy operating cash inflows or by proceeds from new
finance received during the year.
Assuming tax is paid after the year end, the fact that Thorstved's tax
charge is $30,000 in 20X8 versus cash payments of $25,000 in the year,
indicates an additional $5,000 cash burden during 20X9 to cover tax
payments (a fact also borne out by the $5,000 increase in tax creditor).

BPP LEARNING MEDIA

Answer: Lecture example 6 (cont'd)


Investing activities
There has been a significant investment in property, plant and
equipment. The carrying value at 31 December 20X8 is substantially
higher than a year earlier (admittedly $100,000 is due to revaluation
rather than a purchase). It is difficult to be sure whether this represents
an increase in operating capacity or is the replacement of the plant
disposed of. However, judging by the level of the increase and the
(apparent) overall improvement in profit position (based on increase in
tax), it seems likely that there has been an increase in capacity.
It is not unusual for there to be a time lag before increased investment
reaches its full beneficial effect and in this context it could be speculated
that further improvements could be expected in 20X9.

BPP LEARNING MEDIA

Answer: Lecture example 6 (cont'd)


Investing activities (continued)
There has also been a significant investment in a development project
($42,000), and evidently the company already has previous development
that is being amortised. This could be taken as a positive indicator in
that companies that are in financial or operational difficulties are unlikely
to invest such a high proportionate amount versus operating inflows in
development.

BPP LEARNING MEDIA

Answer: Lecture example 6 (cont'd)


Financing activities
It would appear that Thorstved's financial structure has changed during
the year. A significant amount of debt capital has been issued
($150,000), whereas Thorstved was previously financed solely by equity
capital. Whilst bringing additional finance to the company, it also brings
its own risks, namely gearing risk, in that whilst dividend payments can
be postponed in times of difficulty, interest payments cannot, and interest
ranks above dividends in priority of payment. However, at the year end,
overall gearing is still relatively low.

BPP LEARNING MEDIA

Answer: Lecture example 6 (cont'd)


Financing activities (continued)
The finance cost of the loan note is 6% (nominal). If return on capital
employed (ROCE) falls below this, it may call into question the wisdom
of the choice of finance. Currently, ROCE is showing only 9% based on
profit before interest and tax vs. debt and equity finance. This would
have been slightly higher if the revaluation (which increased equity)
had not been made.
In addition, a (comparatively) small amount of additional equity finance
has been generated from existing shareholders ($60,000). This brings
total cash available for financing to $268,000 ($60,000 + $150,000 +
$58,000). Most of this ($209,000) has been invested in the development
project and new property, plant and equipment.

BPP LEARNING MEDIA

Answer: Lecture example 6 (cont'd)


Cash position
The overall effect of the year's cash flows is that they have improved the
company's cash position dramatically. A modest cash balance of $4,000
has increased to $111,000 even after the payment of a $65,000
dividend. This increase represents the unspent finance (see above) and
operating cash inflows.
It may be that the company's expansion plans for which the additional
finance was obtained have not yet been fully brought into play.

BPP LEARNING MEDIA

Answer: Lecture example 6 (cont'd)


Summary
The above analysis indicates that Thorstved has invested substantially in
renewing and/or increasing its property, plant and equipment. This has
been financed largely by new finance plus positive operating cash flows.
The company appears to be expanding, and based on the information
available, the indications are that the future financial position and
performance will remain solid or continue to improve.

BPP LEARNING MEDIA

Past exam questions


Nature of question

Exam details

Question 3 under the old format often


combined the statement of cash flows
and the interpretation of financial
statements.

Q3 June 2013
Q3 June 2012
Q3 Dec 2011
Q3 June 2011
Q3 June 2010

A statement of cash flows could appear


as a 15-mark question or as an MCQ.

BPP LEARNING MEDIA

Chapter 22

Historical cost versus current value

Alternative models
and practices

Current purchasing power (CPP)

Concepts of capital and capital


maintenance
Current cost accounting (CCA)
Asset valuation methods

BPP LEARNING MEDIA

Syllabus learning outcomes


Describe the advantages and disadvantages of the use of
historical cost accounting
Discuss whether the use of current value accounting
overcomes the problems of historical cost accounting
Describe the concept of financial and physical capital
maintenance and how this affects the determination of
profits

BPP LEARNING MEDIA

Chapter summary diagram


Alternative models and
practices
Historical cost
accounting

Capital maintenance

Financial capital
maintenance
Current value
accounting

BPP LEARNING MEDIA

Operating capital
maintenance

Asset valuation
methods

Historical cost versus current value 1


Historical cost accounting is the traditional form of
accounting used in the West.
It means that transactions are recorded at the
transaction amount when the transaction occurred.
There are certain cases where historical cost
accounting is modified and this due to the revaluation
of certain assets such as property, plant and
equipment.

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Historical cost versus current value 2


Advantages
Historical cost accounting is objective as it is more difficult to manipulate
cost-based figures.
This means that the figures used in the financial statements are perceived
to be more reliable.
The statement of cash flows uses the actual (historic cost) cash inflows and
outflows and so the use of historical cost accounting means that the assets
and liabilities in the statement of financial position are on a consistent basis
to the statement of cash flows.
The use of historical cost accounting means that it is more difficult for the
financial statements to be manipulated through the use of 'creative
accounting'.
Historical cost is a readily understood concept.

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Historical cost versus current value 3


Disadvantages

The use of historical cost accounting means that revenues are


shown at their current invoice amounts whereas they are matched
to older and possibly out of date costs. This could lead to an
overstatement of profit.

Recording assets at their historical costs means that the asset


values in the statement of financial position are out of date.

Key ratios such as the return on capital employed and the return
on assets both use revenue, cost and asset figures in their
calculation and use of historical cost accounting can mean that
these ratios are distorted.

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Historical cost versus current value 4


Disadvantages (continued)
There is no distinction in the financial statements between operating
results (profits from trading) and holding gains/losses (the fact that an
item might be worth more or cost more over time simply due to price
rises).
Historical cost accounting does not measure any gain/loss on monetary
items which are due to inflation. For example in times of inflation savers
lose out because their purchasing power is depleted whereas borrowers
gain as the amount they owe has fallen in real terms.
The use of historical cost accounting can mean that the trend of an
entity's results are misleading over time because the comparative
information is not restated for the effects of inflation.

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Concepts of capital and capital maintenance 1


There are two views of capital:
CAPITAL

FINANCIAL
CAPITAL
A fund attributable to
shareholders

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OPERATING
CAPITAL
Physical operating
capital

Concepts of capital and capital maintenance 2


Financial capital
The objective of financial capital maintenance is to
maintain shareholders' wealth.
Financial capital is represented by:
$
Share capital

40

Reserves

60
100

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Concepts of capital and capital maintenance 3


Financial capital (continued)
Assume that the general level of inflation is 10% and
that equity at the beginning of the year is $100.
In order for shareholder wealth to be maintained the
entity must generate a profit of $10 ($100 10%) in
order for the shareholders' wealth to be the same at
the end of the year as it was at the beginning of the
year.

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Concepts of capital and capital maintenance 4


Financial capital (continued)
Therefore under the financial capital view the first
portion of profit made by the entity during the year an
entity must reimburse shareholders for the effects of
general inflation.
Any profit over and above this level represents a 'true'
profit.
This is the method used in financial statements
prepared under International Financial Reporting
Standards and by historical cost accounting and
current purchasing power (CPP) accounting.

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Concepts of capital and capital maintenance 5


Operating capital
The objective of operating (or physical) capital maintenance
is to maintain the operating capacity of the business.
Operating capital is represented by:
$
Non-current assets

30

Inventories

20

Monetary working capital

50
100

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Concepts of capital and capital maintenance 6


Operating capital (continued)
Operating capital maintenance requires that specific price
changes are incorporated in the financial statements.
Therefore when calculating the profit for the year the closing
inventories would be valued at actual year end market
prices so that the actual profit reported is lower.
This represents the fact that a certain level of profit has
been generated so that the business can continue to
operate at the same level in future periods.
The profit actually reported is the excess over this amount.
This is the method used in the financial statements
prepared under current cost accounting (CCA).

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Current purchasing power (CPP) 1


Current value accounting
This attempts to address the particular problems that
arise from using historical cost accounting in an
inflationary environment.
There are two different theoretical approaches to
accounting for price changes:
The current purchasing power approach
The current cost accounting approach

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Current purchasing power (CPP) 2


Current purchasing power
This aims to adjust certain items in the financial statements for
changes in general price inflation.
The method used is:
Non-monetary items (for example inventories and noncurrent assets) are restated at the year end by general
inflation as their worth alters due to inflation.
Monetary items (for example cash, receivables, payables
and loan capital) are not restated as they are fixed in value.
For example if we have a bank loan of $10,000 to buy a car
and general inflation is 4% we are not required to now pay
back $10,400.

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Current purchasing power (CPP) 3


Current purchasing power (continued)
The method used is (continued):
Gains/losses on monetary items are reported in profit
or loss. For example, with the bank loan it would cost 4%
more to buy the car at the end of the year and so a bank
loan of $10,400 would be needed. Therefore a gain of
$400 has been made in current purchasing power terms.
Similarly losses are made on monetary assets as their
purchasing power falls if prices rise.

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Current purchasing power (CPP) 4


Current purchasing power (continued)
Current purchasing power measures profit as the increase
in current purchasing power of equity.
Profits are stated after allowing for the declining purchasing
power of money due to price inflation.

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Current purchasing power (CPP) 5


Illustration
A company was set up on 1 January 20X1. Contributed
capital was $200,000 of share capital and $100,000 of
loan capital. On that date the company bought inventories
for $300,000 in cash and sold a quarter of them for
$90,000 cash on 31 December 20X1. Loan interest of
$5,000 was also due and paid on 31 December 20X1.
General price inflation was 4% for the year, spread evenly
over the year.

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Current purchasing power (CPP) 6


HCA

CPP

$'000

$'000

Statement of profit or loss and other comprehensive income


Revenue
Cost of sales (300 ) / (300 104% )
Gross profit
Loan interest
Gain on monetary item ((100 104%) 100)
Profit for the year

90
(75)
15
(5)

10

90
(78)
12
(5)
4
11

225
85
310

234
85
319

200
10
210

208
11
219

Statement of financial position


Current assets
Inventories (300 ) / (300 104% )
Cash (90 5)

Equity
Share capital (200 104%)
Profit for the year
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Current purchasing power (CPP) 7


Advantages of current purchasing power
Restatement of assets values gives companies greater
comparability.
Year by year comparisons are more valid.
Current purchasing power avoids the problems of other
current value measurements being subjective.
The financial statements are based on historic cost data
and inflation adjustments which are both capable of
being audited.
It highlights gains/losses to a company as a result of
inflation.

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Current purchasing power (CPP) 8


Disadvantages of current purchasing power
There is a debate over how useful the restatement of
asset values actually is as the asset values may not
represent realisable value or value in use to the
business.
Users of financial statements may not fully understand
the restatement for the general price index and gains/
losses made on monetary items.
Using indices are themselves an approximation.

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Current cost accounting (CCA) 1


Under current cost accounting, the value of the assets
consumed or sold, and those is the statement of
financial position are measured at their fair value to the
business.
This is their deprival value.

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Current cost accounting (CCA) 2


Deprival value
Lower of

Replacement
cost (RC)

Higher of

Fair value less


costs of disposal

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Value in use
(VIU)

Current cost accounting (CCA) 3


Inventories sold are charged to cost of sales at their
replacement cost.
Depreciation on non-current assets is generally
calculated based on the assets' replacement cost.

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Current cost accounting (CCA) 4


Illustration
A company was set up on 1 January 20X1. Contributed
capital was $200,000 of share capital and $100,000 of
loan capital. On that date the company bought inventories
for $300,000 in cash and sold a quarter of them for
$90,000 cash on 31 December 20X1. Loan interest of
$5,000 was also due and paid on 31 December 20X1.
General price inflation was 4% for the year, spread evenly
over the year. The inventories would have cost
$328,000 at actual year end market prices.

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Current cost accounting (CCA) 5


HCA

CPP

CCA

$'000

$'000

$'000

Statement of profit or loss and other comprehensive income


Revenue
Cost of sales (300 ) / (300 104% ) / (328 )
Gross profit
Loan interest
Gain on monetary item ((100 104%) 100)
Profit for the year

90
(75)
15
(5)

10

90
(78)
12
(5)
4
11

90
(82)
8
(5)

225
85
310

234
85
319

246
85
331

200
10

210

208
11

219

200
3
28
231

Statement of financial position


Current assets
Inventories (300 ) / (300 104% ) / (328 )
Cash (90 5)

Equity
Share capital (200 104%)
Profit for the year
CCA reserve (328 300)
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Current cost accounting (CCA) 6


Advantages of current cost accounting
It provides useful information to users of asset values
and helps assess:
The stability of the company
The vulnerability/liquidity of the company
The entity's future prospects
Current cost accounting excludes holding gains and so
can be used to indicate whether dividends will reduce
operating capacity.

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Current cost accounting (CCA) 7


Disadvantages of current cost accounting
Identifying suitable indices can be very difficult.
Determining the fair value less costs of disposal and
value in use required to calculate the deprival value can
also be difficult.

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Asset valuation methods 1


Method

Assets carried at

Historical cost

The amount of the cash and cash equivalents


paid or fair value of the consideration given

Fair value

The amount at which an asset could be


exchanged between knowledgeable willing
parties in an arm's length transaction

Current cost

The amount of the cash and cash equivalents


that would have to be paid if the same or an
equivalent asset was acquired currently

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Asset valuation methods 2


Historical cost
Method

Assets carried at

Net realisable
value

The amount of the cash and cash equivalents


that could currently be obtained by selling the
asset in an orderly disposal, net of the
estimated costs of completion and the
estimated costs necessary to make the sale

Present value of
future cash flows

The present discounted value of the future net


cash inflows that the item is expected to
generate in the normal course of business

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Question: Lecture example 1


You have been asked to show the effect of various asset
valuation methods for an item of equipment which was
purchased on 1 January 20X3 for $140,000. The
equipment is depreciated as 25% per annum using the
diminishing balance method.
The equipment is still available and its list price at 31
December 20X4 is $180,000, although the current model
is 20% more efficient than the model the entity purchased
in 20X3.
It is estimated that the equipment could be sold second
hand for $44,000 although the company would have to
spend about $500 in advertising costs to do so.
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Question: Lecture example 1 (cont'd)


The asset is expected to generate net cash inflows of
$20,000 for the next five years after which time it will be
scrapped. The company's cost of borrowing 6%.
Discount factors at 6% at the end of year:
10.943
20.890
30.840
40.792
50.747

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Question: Lecture example 1 (cont'd)


Required
Calculate the statement of financial position value of the
equipment as at 31 December 20X4 using:
(a) Historical cost
(b) Fair value
(c) Current cost
(d) Net realisable value
(e) Net present value

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Answer: Lecture example 1 (cont'd)

(a)
(b)
(c)
(d)
(e)

Historical cost (W1)


Fair value
Current cost (W1)
Net realisable value
Net present value (W2)

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Asset valuation
$
78,750
44,000
84,375
43,500
84,240

Answer: Lecture example 1 (cont'd)


Workings
1

Historical cost and current cost carrying amount


Historical
cost
$

1.1.X3

1.1.X331.12.X3

b/d /
(180,000
100%/120%)

Current cost
(restated)
$
150,000

140,000

Dep'n @ 25%

(37,500)
(35,000)

31.12.X3

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Carrying amount

112,500

Answer: Lecture example 1 (cont'd)


2

Net present value


Cash flow

Discount
factor

Present value
$

31.12.20X5

20,000

0.943

18,860

31.12.20X6

20,000

0.890

17,800

31.12.20X7

20,000

0.840

16.800

31.12.20X8

20,000

0.792

15,840

31.12.20X9

20,000

0.747

14,940
84,240

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Past exam questions


Nature of question
This topic has only rarely been
examined in the past.
Under the new format, this is most likely
to be examined as an MCQ.

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Exam details

Chapter 23

Primary aims

Specialised, not-forprofit and public


sector entities

Performance measurement

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Regulatory framework

Syllabus learning outcomes 1


Distinguish between the primary aims of not-for-profit and
public sector entities and those of profit oriented entities
Discuss the extent to which International Financial
Reporting Standards (IFRSs) are relevant to specialised,
not-for-profit and public sector entities
Discuss the different approaches that may be required
when assessing the performance of specialised, not-forprofit and public sector organisations

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Chapter summary diagram


Specialised, not-for-profit and
public sector entities

Primary aims of not-forprofit and public sector


entities

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Relevance of IFRS
accounting

Approach to
performance
measurement

Primary aims 1
Examples and objectives of not-for-profit and public sector entities
Public sector entities
Examples include:

Government departments and agencies


Public-funded bodies providing health and/or social services (for
example the National Health Service in the United Kingdom)
Public-funded further and higher education institutions
The objectives of such entities include:
To provide an efficient, high quality service to the public
To use public resources and funds wisely

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Primary aims 2
Examples and objectives of not-for-profit and public sector entities
(continued)
Private sector entities
Examples include:
Charities

The objectives of such entities include:


To provide a service to the charity's beneficiaries
To raise funds for this purpose
To ensure that the maximum possible amount of funds are utilised
on charitable purposes

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Primary aims 3
Conceptual framework for not-for-profit entities
The Conceptual Framework for Financial Reporting we saw in Chapter 1 and
the accounting standards which are based on it are aimed at profit-making
organisations.
However Phase G of the new Conceptual Framework is entitled 'Application to
not-for-profit entities in the public and private sector' and is trying to adapt the
Conceptual Framework so that it can be used by not-for-profit entities.
There are several issues to consider.

Firstly it is important to recognise that not-for-profit entities have different


objectives, operating environments and other different characteristics from
private sector businesses.

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Primary aims 4
Conceptual framework for not-for-profit entities (continued)
There are also several specific issues in applying the proposals to not-forprofit entities:
(1) There is insufficient emphasis on accountability and stewardship.
Unlike for-profit entities not-for-profit entities do not report to
shareholders however they must be able to account for the funds
received and show how they have been spent, especially where funds
are designated.
(2) There is a need to broaden the definitions of users and user groups.
The main user group of financial statements relating to for-profit
entities is the shareholder. With not-for-profit entities however the
main user group is providers of funds. This is the taxpayers in the
case of public sector bodies and financial supporters and potential
future supporters in the case of charities. Another user group is those
receiving the goods and services provided by the not-for-profit entity.

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Primary aims 5
Conceptual framework for not-for-profit entities cont.
(3) The emphasis on future cash flows is inappropriate to not-for-profit
entities.
Not-for-profit entities do need to generate future cash flows however it
is more important to focus on being able to deliver future goods and
services and meeting its organisational objectives.
(4) There is insufficient emphasis on budgeting.
Currently financial reporting does not require the inclusion of forecast
financial information. Budgets are extremely important for not-for-profit
entities and it is sometimes the case that funding is supplied on the
basis of a formal, published budget.

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Regulatory framework 1
Many private not-for-profit entities produce financial
statements on a cash basis and so there is a need to get
them to report under the accruals basis.
Regulation of public not-for-profit entities and
government departments and agencies is carried out
by the International Public Sector Accounting
Standards Board (IPSASB), which is part of the
International Federation of Accountants (IFAC)
They are developing a set of International Public Sector
Accounting Standards (IPSASs) which are based on
IFRSs.

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Regulatory framework 2
To date the following IPSASs have been issued
1

Presentation of financial statements

Cash flow statements

Net surplus or deficit for the period, fundamental errors and


changes in accounting policies

The effect of changes in foreign exchange rates

Borrowing costs

Consolidated financial statements and accounting for controlled


entities

Accounting for investments in associates

Financial reporting of interests in joint ventures

Revenue from exchange transactions

10

Financial reporting in hyperinflationary economies

MEDIA
11BPP LEARNING
Construction
contracts

Regulatory framework 3
To date the following IPSASs have been issued
12

Inventories

13

Leases

14

Events after the reporting date

15

Financial instruments: disclosure and presentation

16

Investment property

17

Property, plant and equipment

18

Segment reporting

19

Provisions, contingent liabilities and contingent assets

20

Related party disclosures

21

Impairment of non-current assets

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Regulatory framework 4
Private not-for-profit entities tend to be regulated
nationally.
For example in the United Kingdom charities are regulated
by the Charities Commission.
In the United Kingdom there is a Statement of
Recommended Practice (SORP) which gives guidance on
how to prepare financial statements for charities. Whilst it
is not compulsory, it is seen as best practice.
In other countries the requirements will be different.

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Performance measurement

Not-for-profit and public sector entities are required to manage their


funds efficiently and remain solvent but are not expected to show a
profit.

In fact were a public sector not-for-profit entity to show a profit or


underspend their budget then this might lead to budget cuts in future
years.

In such entities performance is measured by whether or not they have


achieved their stated purpose.

The 'Three E's' (or value for money) are often a good way of
assessing the performance of not-for-profit and public sector entities:
Economy buying the resources needed at the cheapest cost
Efficiency using the resources purchased as wisely as possible
Effectiveness fulfilling the organisation's objectives

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Question: Lecture example 1


Required
How would the business aims and objectives differ between:
(1) A stock market quoted clothes retailer; and
(2) A state-funded hospital run as a not-for-profit organisation?

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Answer: Lecture example 1


(1) Stock market quoted clothes retailer

The main objective of a stock market quoted company will generally


be to maximise profit, net assets and share price for the shareholders.

Individual companies may have slightly different objectives depending


on who their shareholders are, for example maintaining a constant
dividend payment if their main shareholders are looking for income.

Consequently, main objectives of management will be:

Revenue maximisation (at the right price)

Maintaining or increasing market share

Product innovation to attract new customers and retain existing


ones

Cost minimisation, eg purchasing fabric at the best price for the


quality required

Profit maximisation and growth

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Answer: Lecture example 1


(1) Stock market quoted clothes retailer (continued)

Public companies may also have secondary aims imposed by


government or by their stakeholders, such as producing their goods
ethically (eg paying decent wages where clothes are made in
developing countries) or minimising the negative effects of their
activities on the environment (the so called 'carbon footprint').

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Answer: Lecture example 1


(2) State-funded not-for-profit hospital

A state-funded hospital will presumably have a fixed income or grant


from the government, or at least a budget that must be adhered to.

The primary objective of a hospital will therefore be to treat the


maximum number of patients without exceeding the funds available.

This will require similar budgeting skills to a profit-oriented


organisation to ensure that funds are used in the most efficient way,
but a hospital will also have other social considerations:
The need to prioritise treatment to those most in need
To minimise waiting lists for treatment
The need to set aside funds to cover an unexpected public health
crisis

The 'three Es' (Economy, Efficiency and Effectiveness) would be


relevant objectives here, which would provide a good basis for
assessment.

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Past exam questions


Nature of question

Exam details

Explain the benefits to an entity of


reporting in accordance with IFRS

Q5 June 2012

Explain the ratios than could be


calculated in order to measure
performance and/or solvency for a notfor-profit entity

Q3 June 2010

This topic is now most likely to appear


as an MCQ.

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