Professional Documents
Culture Documents
Financial Reporting: J. Haslam and D. Chow
Financial Reporting: J. Haslam and D. Chow
Financial
reporting
AC2091
2021
Financial reporting
J. Haslam and D. Chow
AC2091
2021
Undergraduate study in
Economics, Management,
Finance and the Social Sciences
This subject guide is for a 200 course offered as part of the University of London
undergraduate study in Economics, Management, Finance and the Social
Sciences. This is equivalent to Level 5 within the Framework for Higher Education
Qualifications in England, Wales and Northern Ireland (FHEQ).
For more information, see: london.ac.uk
This subject guide was prepared for the University of London by:
Dr D. Chow, Maynooth University, Ireland
University of London
Publications Office
Stewart House
32 Russell Square
London WC1B 5DN
United Kingdom
london.ac.uk
The University of London asserts copyright over all material in this subject guide except where
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or by any means, without permission in writing from the publisher.
We make every effort to respect copyright. If you think we have inadvertently used your
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Contents
Contents
Introduction to the guide........................................................................................ 1
Aims and objectives of this course.................................................................................. 1
Learning outcomes......................................................................................................... 1
Syllabus.......................................................................................................................... 2
How to use this guide..................................................................................................... 3
Essential reading............................................................................................................ 4
Further reading .............................................................................................................. 4
Online study resources.................................................................................................... 6
Preparation for the examination...................................................................................... 7
Overview of the guide.................................................................................................... 8
Index of abbreviations used in this guide......................................................................... 9
Chapter 1: Rationale for financial reporting and its regulation........................... 11
1.1 Introduction.......................................................................................................... 11
1.2 Financial accounting and reporting delineation...................................................... 11
1.3 Considering accounting’s role in context................................................................ 12
1.4 Financial accounting regulation............................................................................. 14
1.5 Accounting standards: what form should they take?............................................... 16
1.6 Descriptions of accounting and its regulation: the regulatory framework in the
UK as an exemplar....................................................................................................... 18
1.7 Overview of financial accounting regulation: UK accounting regulation and
the influence of international accounting standards ...................................................... 18
1.8 Institutional setting for accounting regulation: the UK.....................................................19
1.9 Mandatory regulation............................................................................................ 21
1.10 A reminder of your learning outcomes.................................................................. 26
1.11 Sample examination questions............................................................................. 26
Chapter 2: Conceptual framework........................................................................ 27
2.1 Introduction.......................................................................................................... 27
2.2 Definition of a conceptual framework.................................................................... 28
2.3 Rationale for a conceptual framework.................................................................... 28
2.4 Advantages claimed for a conceptual framework.................................................... 29
2.5 The US, IASC/IASB and UK initiatives compared...................................................... 29
2.6 Objectives of financial reporting............................................................................. 33
2.7 Qualitative characteristics of accounting ............................................................... 35
2.8 Further comments................................................................................................. 39
2.9 Recognition and measurement in financial statements........................................... 40
2.10 Presentation of financial information................................................................... 43
2.12 A reminder of your learning outcomes.................................................................. 45
2.13 Sample examination questions............................................................................. 46
Chapter 3: Preparation and presentation of financial statements....................... 47
3.1 Introduction.......................................................................................................... 47
3.2 IAS 1..................................................................................................................... 47
3.3 Comparative information....................................................................................... 48
3.4 Statement of profit or loss (or income statement) and statement of other comprehensive
income under IAS 1.............................................................................................................. 50
3.5 Statement of changes in equity.............................................................................. 52
3.6 Statement of cash flows........................................................................................ 52
3.7 Notes to the financial statements........................................................................... 53
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AC2091 Financial reporting
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Contents
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AC2091 Financial reporting
Notes
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Introduction to the guide
Learning outcomes
At the end of this course and having completed the Essential reading and
activities you should be able to:
• explain and apply a number of approaches to financial accounting
• record and analyse data
• prepare financial statements under alternative accounting conventions
• describe a number of regulatory issues relating to financial accounting
• critically evaluate theories and practices of, and other matters relating
to, financial accounting.
Throughout this subject guide, you will also find chapter-specific learning
outcomes.
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AC2091 Financial reporting
Syllabus
Chapter 1: Introduction (including conceptual framework and approach
taken by the guide)
Chapter 2: Rationale for financial reporting and its regulation
Chapter 3: Preparation of financial statements (comprehensive income,
changes in equity and financial position)
Chapter 4: Ethics for accountants
Chapter 5: Accounting for equity and earnings per share
Chapter 6: Provisions, contingent liabilities and contingent assets: events
after the reporting period
Chapter 7: Changing prices: current purchasing power (CPP) and its
applications
Chapter 8: Accounting for changing prices/values
Chapter 9: Income and deferred taxation
Chapter 10: Property, plant and equipment (including investment
properties)
Chapter 11: Leasing
Chapter 12: Intangible assets
Chapter 13: Construction contracts
Chapter 14: Revenue recognition (including construction contracts)
Chapter 15: Consolidated accounts: at date of acquisition
Chapter 16: Consolidated accounts: after date of acquisition
Chapter 17: Consolidated accounts: income statement, changes in equity
and cash flows
Chapter 18: Consolidated accounts: associates and other joint
arrangements
Chapter 19: Foreign currency translation and consolidation of foreign
subsidiaries
Chapter 20: Analysis and interpretation of financial reports
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Introduction to the guide
Websites
It is also recommended that you use the internet and investigate the
different professional bodies and government organisations’ websites,
which are a useful source of information on current developments in
financial reporting and regulation. Examples include:
• www.frc.org.uk for the UK Accounting Standards Board (ASB)
• www.fasb.org for the US Financial Accounting Standards Board (FASB)
• www.ifrs.org for the IASB.
Unless otherwise stated, all websites in this subject guide were accessed
in March 2021. We cannot guarantee, however, that they will stay current
and you may need to perform an internet search to find the relevant
pages.
Activities
This subject guide is divided into 20 chapters, most of which are self-
contained. Chapters contain worked numerical examples, where
appropriate, and activities appear throughout the guide. It is strongly
recommended that you attempt to answer, or consider the implications of,
all activities. Many require you to do additional reading. Solutions to some
of the activities can be found on the virtual learning environment (VLE).
Reading advice
There is no single wholly satisfactory textbook covering all the topics
discussed in this course. References are given to one of the main advanced
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AC2091 Financial reporting
Essential reading
Detailed reading references in this subject guide refer to the editions of
the set textbook listed below. New editions of this textbook may have been
published by the time you study this course. You can use a more recent
edition of the book; use the detailed chapter and section headings and
the index to identify relevant readings. Also check the VLE regularly for
updated guidance on readings.
The Essential reading for this course is:
Alexander, D., A. Britton and A. Jorissen International financial reporting
and analysis. (Andover: Cengage Learning, 2020) 8th edition
[ISBN 9781473766853]. Hereafter, we refer to this book simply as
International financial reporting.
Further reading
Please note that as long as you read the Essential reading you are then free
to read around the subject area in any text, paper or online resource. You
will need to support your learning by reading as widely as possible and
by thinking about how these principles apply in the real world. To help
you read extensively, you have access to the VLE and University of London
Online Library (see below).
Other useful texts for this course include:
Collins, B. and J. McKeith Financial accounting and reporting. (London:
McGraw-Hill, 2010) [ISBN 9780077114527].
Elliott, B. and J. Elliott Financial accounting and reporting. (Harlow: Pearson,
2019) 19th edition [ISBN 9781292255996]. Please note that this book is
listed as Essential reading for several chapters.
Picker, R., K. Clark, J. Dunn, D. Kolitz, G. Livne, J. Loftus and L. van der Tas
Applying IFRS standards. (Hoboken: Wiley, 2016) 4th edition
[ISBN 9781119159223].
You might find it helpful to refer to a dictionary of accounting when you
encounter a new term. Two such dictionaries are:
Law, J. A dictionary of accounting. (Oxford: Oxford University Press, 2016)
5th edition [ISBN 9780198743514].
Nobes, C. The Penguin dictionary of accounting. (London: Penguin Books Ltd,
2006) 2nd edition [ISBN 9780141025254].
Those of you who have studied AC1025 Principles of accounting may
find it useful to keep your subject guide to hand as you study this course.
The following is a list of all other reading listed in the Further reading
category in the subject guide.
Baxter, W.T. Depreciation. (London: Sweet & Maxwell, 1978) revised edition
[ISBN 042114470X].
Baxter, W.T. Inflation accounting. (Oxford: Philip Allan, 1984)
[ISBN 0860036235]. Chapters 3, 8 (pp.103–15) and 12 (pp.182–201).
Baxter, W.T. ‘Accounting standards – boon or curse’, Accounting and Business
Review Winter 1981, pp.3–10.
Beaver, W.H. Financial reporting: an accounting revolution. (Harlow: Prentice-
Hall, 1981) [ISBN 9780133161335] Chapter 7.
Beaver, W.H. and J.S. Demski ‘The nature of income measurement’, Accounting
Review 54(1) 1979.
4
Introduction to the guide
The VLE
The VLE, which complements this subject guide, has been designed to
enhance your learning experience, providing additional support and a
sense of community. It forms an important part of your study experience
with the University of London and you should access it regularly.
The VLE provides a range of resources for EMFSS courses:
• Course materials: Subject guides and other course materials
available for download. In some courses, the content of the subject
guide is transferred into the VLE and additional resources and
activities are integrated with the text.
• Readings: Direct links, wherever possible, to essential readings in the
Online Library, including journal articles and ebooks.
• Video content: Including introductions to courses and topics within
courses, interviews, lessons and debates.
• Screencasts: Videos of PowerPoint presentations, animated podcasts
and on-screen worked examples.
• External material: Links out to carefully selected third-party
resources.
• Self-test activities: Multiple-choice, numerical and algebraic quizzes to
check your understanding.
• Collaborative activities: Work with fellow students to build a body
of knowledge.
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Introduction to the guide
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AC2091 Financial reporting
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AC2091 Financial reporting
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Chapter 1: Rationale for financial reporting and its regulation
1.1 Introduction
1.1.1 Aims of the chapter
This chapter introduces:
• the role of accounting in society
• the regulatory framework (discussion focused upon the international
framework)
• arguments for and against forms of accounting regulation, including
consideration of voluntary disclosure.
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Chapter 1: Rationale for financial reporting and its regulation
but often used to justify actual policy decisions is explicit reference to the
costliness of a possible provision (the UK’s ASB refers to it in its stated
aims – and points out that it is not in favour of revolutionary changes to
financial reporting).
Those considering further dimensions of the imperfect character of
real world economies have added further layers of complexity in their
prescriptions. The assumption that more transparency is better than less
is brought into question beyond simple cost-benefit analysis. Lipsey and
Lancaster (1957) argue that in imperfect markets improving information
such as accounting without improving other aspects of the economic
system might even reduce social welfare. Possible reasons include that
in a competitive economy businesses need to have incentives to innovate
that might be countered if too much is made transparent. Thus, even
shareholders have an interest in keeping some information within the firm.
If more information is publicly available it may be easier for monopolistic
firms to strengthen monopolistic positions (to the detriment of social
welfare) (Gallhofer and Haslam, 2007).
Factors such as these, including information’s simple costliness, as well as
lack of shareholder control over corporate management, may explain why
in practice many commentators believe financial accounting falls short of
the information that one might assume, from a more mainstream position,
capital providers would want (Tinker, 1985, refers to ‘shareholder
alienation’ in this regard). This is in spite of the apparent shareholder and
investor orientation of the influential policy makers. Perhaps it is the case
that financial accounting does reflect the conventionally assumed interests
of shareholders – but in an imperfect market – or perhaps those interests
are only partially – or imperfectly – satisfied.
Returning to prescription, another view from someone well versed in an
information economics perspective takes further the notion of context
imperfection (towards appreciating the imperfect character of the socio-
economic and political context) and fuses with a more interdisciplinary
perspective, indicating that financial accounting cannot be understood to
have only narrowly conceived economic consequences. Joseph Stiglitz,
a Nobel prize winner in economics, notes that when information like
financial accounting enters the public realm it enters a complex context
of conflicting forces. One cannot assume that information produced
for purpose X will not (also) be used for another purpose, say purpose
Y. Purpose Y may include the desire to impose stricter regulations on
business and/or enhance the general democratic control over business.
The prescriptive implication may not be so clear but the suggestion is that
some kind of trade off may be envisaged in an imperfect context so that
some caution over transparency might be taken.
Drawing from such an insight, some researchers point to financial
accounting’s role in potentially changing (for the better) the character of
the socio-political and economic system as well as serving it (Gallhofer
and Haslam, 2007). Similar prescriptive thinking is behind other socio-
economic and socio-political theorising, in which forms of corporate
social responsibility accounting are envisioned that transform the
narrower economistic financial accounting towards a more holistic form
of accounting that reflects (from advocate perspectives) all things relevant
to social well-being (in relation to corporate operations). The concern for
a more holistic external accounting involves going beyond mainstream
perceptions and includes prescriptions of non-financial information
(Gallhofer and Haslam, 2007).
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AC2091 Financial reporting
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Activity 1.1
Read Beaver (1981) Chapter 7 and Gallhofer and Haslam (2007), taking notes.
Critically appraise the main arguments that Beaver puts forward for increased regulation.
How do Gallhofer and Haslam see accounting regulation?
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Chapter 1: Rationale for financial reporting and its regulation
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AC2091 Financial reporting
Activity 1.2
What criteria are relevant in deciding upon accounting standards? Should standards
specify the detail or be more like general guidelines?
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Chapter 1: Rationale for financial reporting and its regulation
The Act makes it clear that the true and fair requirement is overriding:
If in special circumstances compliance with any of those
provisions is inconsistent with the requirement to give a true
and fair view, the directors shall depart from that provision to
the extent necessary to give a true and fair view. Particulars
of any such departure, the reasons for it and its effect shall be
given in the note to the accounts.
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(s.226(5))
AC2091 Financial reporting
The CAs have never defined ‘true and fair’. Within the financial accounting
literature, Lewis and Pendrill (2004, p.27) quote a definition by G.A. Lee
(1981, p.270):
Today ‘true and fair’ has become a term of art. It is generally
understood to mean a presentation of accounts, drawn up according
to accepted accounting principles, using accurate figures as far as
possible, and reasonable estimates otherwise; and arranging them
so as to show, within the limits of current accounting practice, as
objective a picture as possible, free from wilful bias, distortion,
manipulation or concealment of material facts.
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Chapter 1: Rationale for financial reporting and its regulation
One should not take at face value that such advocacy is truly global. It can
be interpreted as attempts to derive a common set of global standards by
representatives of some of the largest capital markets in the world.
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AC2091 Financial reporting
Accounting practices were much less than harmonised. The ASSC (set up
in 1970) was re-formed as the ASC in 1976. The latter’s objectives were to:
Accountancy
Accounting Auditing Board for Professional Financial
Investigation
Standards Practices Actuarial Oversight Reporting
and Discipline
Board Board Standards Board Review Panel
Board
Committee on
Urgent Corporate
Issues Governance
Task Force
Executive
Figure 1.1: Organisational chart for the accounting standard-setting body in the
UK. Source: www.frc.org.uk/about/chart.cfm
• Financial Reporting Council (FRC)
Established in 1990, this is made up of representatives of users,
preparers and accountants in practice. It provides guidance to the
ASB on work programmes, priorities and issues of concern, and is
responsible for financing arrangements (most of the ASB funds come
from the FRC). The chair is appointed by the Secretary of State for
Business, Enterprise and Regulatory Reform with the Governor of
the Bank of England, the accountancy profession and the financial
community. The FRC is financed by the government, the accountancy
profession and financial institutions (the government contributing
about one-third). The FRC aims ‘to promote confidence in corporate
reporting and governance’.
Read updates on the FRC as it tackles corporate scandals (Financial
Times, 5 February 2020, https://www.ft.com/content/0abe6718-47ed-
11ea-aee2-9ddbdc86190d).
• Financial Reporting Review Panel (FRRP)
Established in 1990 with a QC as its Chair, the FRRP examines
material departures from standards by large companies. The
Introduction to accounting standards requires it to:
enquire into annual accounts where it appears that
Companies Act requirements, including the requirement that
annual accounts shall show a true and fair view, might have
been breached.
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Chapter 1: Rationale for financial reporting and its regulation
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AC2091 Financial reporting
Mary Arden QC stated that whether accounts satisfy true and fair
requirements is for the courts to decide, but they will look to the practices
and views of accountants; the more authoritative these are, the more the
courts will be ready to follow them.
Just as a custom which is upheld by the courts may properly
be regarded as a source of law, so too, in my view, does an
accounting standard which the court holds must be complied
with to meet the true and fair requirement become, in cases
where it is applicable, a source of law in itself in the widest
sense of that term.
(Mary Arden QC, ‘The true and fair requirement’.)
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Chapter 1: Rationale for financial reporting and its regulation
The London Stock Exchange was regulated from 2000 to 2013 by the
Financial Services Authority, an independent body (if set up by the
Financial Services and Markets Act 2000).
UK-listed companies must also comply with the Corporate Governance
Code, which provides general guidance on governance and internal
control for organisations. Corporate governance has come under great
scrutiny following a string of high-profile corporate collapses such
as Enron and WorldCom, associated with fraud, abuse of managerial
power and social irresponsibility. This triggered accelerated reviews of
governance frameworks and engendered an increased number of practical
pronouncements. In the USA the Sarbanes-Oxley Act 2002 on corporate
governance was the most comprehensive law affecting accounting and the
audit profession since the Securities and Exchange Act 1934. By changing
guidelines into formal law, this represents a divergent emphasis from the
UK’s corporate governance model (Friedman and Miles, 2006, p.258).
Since 2005, listed companies in the EU have been required, as noted
above, to follow IASs/IFRSs in their published consolidated accounts.
Activity 1.3
In the UK, the Stock Exchange was one of the earliest sources of rules and regulations
relating to financial statements. In many other countries, the rules and regulations of the
relevant stock exchange are important.
a. Why do stock exchanges take such an interest in rules and regulations relating to
financial statements?
b. What are the main requirements of the stock exchange in your country?
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AC2091 Financial reporting
Activity 1.4
The Company Law Review was set up to examine the whole framework of company
law. Study its recommendations in Company law reform. Modern company law for a
competitive economy: developing the framework (www.berr.gov.uk/files/file23245.pdf).
A Companies Act was introduced in 2006. To what extent did it implement the
recommendations? What do you see as the major issues facing accounting regulation at
the Nation State level in future?
Question 1.2
What factors should be considered in deciding upon the form of
accounting regulation?
Question 1.3
Discuss both traditional and economic arguments for and against the
regulation of accounting.
26
Chapter 2: Conceptual framework
2.1 Introduction
2.1.1 Aims of the chapter
This chapter considers what a conceptual framework is and then addresses
some of the key principles related to setting one up. These principles have
been examined by different groups of standard-setters around the world
(including in Australia, Canada, the UK and the USA). We shall look at
the UK Statement of Principles (SOP) and the US Concept Statements.
The ASB modelled the SOP on the IASB Framework for the Preparation
and Presentation of Financial Statements (FPPFS), which in turn was
based on the US conceptual framework. The IASB has been working on a
revised conceptual framework for some time and has issued a conceptual
framework in 2018 on its own. This framework is separate from the original
joint project it undertook with the FASB.
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AC2091 Financial reporting
The ASB states that their Statement of Principles (SOP) (equivalent to the
US conceptual framework):
sets out the principles that the [ASB] believes should underlie
the preparation and presentation of general purpose financial
statements…A coherent frame of reference to be used by the
Board in the development and review of accounting standards.
Macve (1981) stated that a conceptual framework would:
provide a consistent approach for making decisions about
choices of accounting practice and for setting standards.
He also recognised, however, that it would be difficult to implement such a
framework.
All three definitions suggest that a conceptual framework provides an
explicit description of how accounting rules should be formulated and
the environment in which they apply. More specifically, a conceptual
framework is supposed to address some fairly fundamental questions
about accounting itself. For instance:
• What are the objectives of accounting?
• For whom and by whom are accountings required?
• What information do users of accountings require?
• What accountings would best satisfy these users’ needs?
• Do current accountings meet these requirements?
• How could current accountings be improved?
Although these questions are basic, to what extent have they been
addressed?
…the various standard-setting bodies around the world have too
often attempted to resolve practical accounting and reporting
through the development of accounting standards, without such
an accepted theoretical frame of reference.
(Ernst and Young, 2015)
It seems that too often standard-setting is reactive (to particular problems)
rather than proactive.
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Chapter 2: Conceptual framework
a clear basis for reaching conclusions that those with vested interests
would find hard to resist
• to provide a common framework of reference so as to avoid
both waste of effort in addressing such issues from first principles for
each specific standard and the dangers of inconsistency
• to reduce the need for many detailed standards on specific issues
by enabling accountants to resolve issues by reference to general
principles.
The rationale is common to the frameworks including that of the IASB.
One way of thinking about the conceptual framework is that it delineates
the objectives of the reporting and the characteristics of reporting that
should properly follow from those objectives.
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Chapter 2: Conceptual framework
Chapter Topic
1 The objective of general-purpose financial reporting
2 Qualitative characteristics of useful financial information
3 Financial statements and the reporting entity
4 The elements of financial statements
5 Recognition and de-recognition
6 Measurement
7 Presentation and disclosure
8 Concepts of capital and capital maintenance
The Ernst and Young (2018) summary of the IASB’s (2018) CF (available
at https://www.ey.com/en_gl/ifrs-technical-resources/iasb-issues-
conceptual-framework-for-financial-reporting) highlights some interesting
facts.
Chapter 1
In the (2018) CF, the IASB reintroduced stewardship in Chapter 1, a
concept that was removed from the (2010) CF – perhaps to align with the
American interpretation of the need for financial reporting to be decision-
useful (see International financial reporting, p.75 for further discussions on
decision-usefulness theory).
See https://www.youtube.com/watch?v=7wMWcRpCqz8 for an
overview of the FASB’s conceptual framework. For discussions of decision-
usefulness, this is about two minutes into the video.
Chapter 2
The (2018) CF, Chapter 2 clarified what ‘prudence’ means, which is to
support the ‘neutrality’ of information and the ‘exercise of caution when
making judgements under conditions of uncertainty’. In other words,
it does not mean that prudence is to always adopt a ‘conservative’
stance (i.e. recognise uncertain expenses but not uncertain revenues, or
systematic asymmetry). The concept of ‘substance over form’ (relevant
for leasing and for the treatment of certain liabilities such as preference
shares, for example) was also clarified as being a component of ‘faithful
representation’.
Chapter 3
Chapter 3 is a new chapter that aims to define the reporting entity’s
(accounting) boundaries and suggests (but not enforce or coerce) that
entity into preparing financial statements. In contrast, the older ASB SOP
does not define the entity but discusses the qualitative characteristics of
financial information.
Chapter 4
Chapter 4 of the (2018) CF has significantly changed the definition of
what is an asset, liability and equity. Compare the (2010) with the (2018)
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AC2091 Financial reporting
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Chapter 2: Conceptual framework
Chapter 5
The guidance provided on de-recognition of assets and liabilities is new.
According to EY (2018), this can be interpreted as the IASB endorsing both
the ‘control’ approach and the ‘risk and rewards’ approach as being valid.
Chapter 6
Two different measurement bases were identified – historical cost and
current value. Historical cost here is taken to include modified historical
cost, meaning that such values can be updated over time. Current values
(which are discussed in other chapters of this module) meanwhile can
include:
• fair value
• value in use
• fulfilment value
• current cost.
Chapter 7
The requirement here is that all income and expenses are to be included in
the profit or loss statement. The CF does not give specific guidance on what
items to be included in ‘other comprehensive income’ or whether such items
should subsequently be recycled. For more information on the concept of
recycling, please consult:
https://www.accaglobal.com/lk/en/student/exam-support-resources/
professional-exams-study-resources/strategic-business-reporting/technical-
articles/pl-concepts.html
Chapter 8
This chapter is largely unchanged from the IASB (2010) CF, but is different
to the ASB’s SOP. The argument here is relevant for the study of Chapters
7 and 8 of this course. Concepts of maintaining nominal financial capital
(e.g. historical cost), real financial capital (e.g. current purchasing power in
Chapter 7) and physical capital (e.g. current or replacement cost in Chapter
8) are discussed in the (2018) CF.
In the case of the FASB, the statement identifies many potential users
and their interests, but argues that those most directly concerned with
a business share a common interest in the company’s ability to generate
favourable cash flows. In developing objectives for general-purpose
external financial reports, the statement focuses on the needs of investors
and creditors (though it suggests that information prepared to meet
these needs is likely to be generally useful to other groups which have
substantively the same interest) and argues that:
Financial reporting should provide information that is useful
to present and potential investors, creditors and other users in
making rational investment, credit and similar decisions.
Its principle conclusion is:
Financial reporting should provide information to help
investors, creditors and others assess the amounts, timing
and uncertainty of prospective net cash flows to the related
enterprise.
Activity 2.1
Do you think that the investor’s perspective is the most appropriate?
With reference to a selected ‘conceptual framework’, satisfy yourself that you are aware
of the range of stated objectives of accounting.
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AC2091 Financial reporting
• relevance
• reliability
• comparability
• understandability.
The IASB stresses ‘faithful representation’ and ‘relevance’ in its framework.
The FASB, in SFAC 2 Qualitative Characteristics of Accounting Information,
examines the characteristics that make accounting useful, establishing a
‘hierarchy of accounting qualities’ (see Figure 2.1).
Users of accounting Decision makers
information and their characteristics
User-specific Understandability
qualities
Decision usefulness
Primary
decision-specific Relevance Reliability
qualities
Ingredients
of primary Predictive Feedback Timeliness Verifiability Representational
qualities value value faithfulness
Secondary and
interactive Comparability Neutrality
qualities (including consistency)
Threshold for
recognition Materiality
Figure 2.1: FASB’s hierarchy of accounting qualities.
Similarly, the ASB, in Chapter 3 of the SOP, sets out the qualitative
characteristics of useful financial information in a diagram which is more
detailed than the FASB’s but based on the same characteristics discussed
above (see Figure 2.2).
What makes financial information useful?
Giving information that is not
Threshold quality MATERIALITY material may impair the usefulness
of the other information given
Predictive Confirmatory Faithful Neutral Free Complete Prudence Consistency Disclosure User’s Aggregation
value value representation from abilities and
material error classification
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Chapter 2: Conceptual framework
The various terms used in the two figures are discussed below.
2.7.1 Materiality
To begin with there must be some assessment of whether the information
is material (i.e. could this information influence users’ decisions?).
Materiality is viewed as a threshold characteristic because if any
information is immaterial then users are not interested in it whatever
other characteristics it has. Immaterial information should not be given
as this may impair understanding of the financial statements. But what is
material? Does the assessment of materiality vary between users?
2.7.2 Relevance
The FASB defines relevance as the capacity of information to make a
difference in a decision by helping users to form predictions about the
outcomes of past, present and future events to confirm or correct prior
expectations. Similarly, the ASB defines relevant information as that which
is able to ‘influence the economic decisions of users and is provided in
time to influence those decisions’.
2.7.3 Reliability
The ASB states that reliable information is:
• faithful representation (i.e. it can be depended upon to represent what
it purports to represent or could reasonably be expected to represent –
reflects the substance of a transaction or event)
• free from deliberate or systematic bias (i.e. is neutral)
• complete and free from material error
• prepared on a prudent basis (i.e. under conditions of uncertainty,
a degree of caution has been exercised in making the necessary
judgements or estimates).
The FASB states:
To be reliable, financial statements must portray the important
relationships of the firm itself. Information is reliable if it is
verifiable and neutral and if users can depend on it to represent
that which it is intended to represent.
2.7.4 Comparability
The ASB states that comparability enables users to discern similarities
and differences in the effect and nature of transactions and events
between entities, and over time for the same entity (very similar to the
FASB definition). It requires consistency and disclosure of accounting
policies. The SOP notes, however, that consistency should not prevent the
introduction of improved accounting policies.
2.7.5 Understandability
To be useful, information must be understandable. This depends on how
it is aggregated, classified and presented, and on the ability of users (who
are presumed to have reasonable knowledge of business and accounting
and are prepared to study the information with reasonable diligence).
2.7.6 Conservatism/prudence
In the FASB hierarchy of accounting qualities, conservatism does not
appear within the diagram, unlike prudence for the ASB. The FASB
statement notes there is a place for conservatism, but that if it is not
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Activity 2.2
1. Often an accounting standard will have to make a trade-off between reliability and
relevance:
a. What is the difference between reliability and relevance?
b. How should accounting standards rank these two qualitative characteristics?
c. Which user groups need to be considered when determining the relative
importance of reliability and relevance?
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Chapter 2: Conceptual framework
Activity 2.3
What do the definitions of assets and liabilities above actually mean? Explain in your own
words.
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40
Chapter 2: Conceptual framework
The concept of realisation does not appear among the criteria for
recognition in the SOP. In Appendix III the Board points out that, over
time, even wider notions of ‘realisation’ have become irrelevant and, rather
than choosing to ‘bend a term so that it has meaning other than its natural
meaning’, the Board has chosen to focus on the underlying objective of
recognising a gain only if there is reasonable certainty that it exists and
can be measured reliably. ‘Although the realisation notion is one means of
determining whether the existence of a gain is reasonably certain…in the
Board’s view it is not necessarily the best way.’ In Appendix I the Board
points out that although this appears to conflict with the Companies Act
(which states that only profits realised at the balance sheet date may be
included in the income statement), ‘the way in which the Act defines a
realised profit means that the exact effect of this difference is not clear’.
However, the FASB states that to recognise revenues and gains the items
should be (a) realised or realisable and (b) earned.
Activity 2.4
What typically gives rise to ‘change’ needing to be considered for recognition?
If there is a change in an asset which is not offset by a change in a liability then where
should the gain or loss be recognised? What are the conditions under which gains can be
recognised in the income statement either in the UK or internationally?
2.9.2 Measurement
Assuming that financial items satisfy the recognition criteria, at what
amount should they be recorded in the financial statements? Should
they be at cost, at market value or at some other amount? There are a
number of different theoretical approaches to measurement, for example
replacement cost or deprival value. Many of the different approaches
are reviewed in this subject guide. The underlying argument regarding
measurement is that there is no single valuation method that can
meet all financial reporting purposes in all circumstances.
In the USA, SFAC No. 5 dealt more with current practices than actual
recommendations (it received much criticism). For instance, it did
not prescribe a particular measurement attribute to be used in given
circumstances. Instead it listed five measurement attributes used in
practice:
• historical cost
• current cost
• current market value
• net realisable value
• present value of future cash flows.
It concluded that ‘rather than attempt to select a single attribute and
force changes in practice…this statement suggests that use of different
attributes will continue’. It notes that an ideal measuring unit would be
stable over time but that at times of low inflation nominal units of money
are relatively stable; ‘the Board expects that nominal units of money will
continue to be used to measure items recognised in financial statements’
but suggests that this might change if increased inflation led to ‘intolerable’
distortions. This is similar to the ASB who note that although most
financial statements are prepared using the financial capital maintenance
concept and measured in nominal units, adjustments will be needed if the
problem of general price change is acute, and if the problem of specific
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42
Chapter 2: Conceptual framework
• The need for relevant information means that the measurement basis
should be one that provides information useful for assessing the
entity’s ability to generate cash flows and its financial adaptability.
• If both historical cost and current value measures are available, the
better one to use will be the one that is more relevant.
• Current value measures are not necessarily less reliable than historical
cost measures; for example, provisions for bad and doubtful debts
under historical cost accounting involve estimates similar to (and of
similar reliability to) those involved in ascertaining current values not
derived from an active market.
• ‘Assessment of relevance and reliability needs to take into account
what the asset or liability represents.’ It suggests that an investment
which represents a ‘store’ of spare cash will best be measured at
current value since its relevance to the entity will be the future cash
flows that it represents the right to.
An earlier Exposure Draft of the SOP was criticised by many as being an
attempt to introduce a current cost accounting system. The SOP appears
to play down the importance of fully blown, current-cost systems by
suggesting that a mixed measurement system will continue to be used,
though it refers to many advantages of current value. It refers to choosing
the most relevant basis when both historical cost and current value are
available and reliable, and the need to choose a measurement basis
according to the nature of the assets, the particular circumstances, the
objectives of financial statements and the qualitative characteristics of
financial information. But can the mixed measurement system be justified
in terms of ‘principles’? It also raises questions of comparability. Baxter
comments that ‘such muddled figures hardly add to accounting dignity’
(Accountancy, October 1999).
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44
Chapter 2: Conceptual framework
Activity 2.5
How might a conceptual framework be used to counter lobbying by pressure groups
whenever a new (contentious) accounting standard is proposed?
Contrast the UK approach to standard-setting (often allowing choices of accounting
method) with the US approach (more detailed, specific).
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Question 2.2
The FASB’s conceptual framework was expected to:
• guide the body responsible for establishing standards
• provide a frame of reference for resolving accounting questions in the
absence of a specific promulgated standard
• determine bounds of judgement in preparing financial statements
• increase users’ understanding of, and confidence in, financial
statements
• enhance comparability.
How feasible do you think are all of these expectations? What difficulties
can you identify that the FASB might have in their attempt to satisfy all
five expectations?
Question 2.3
What are the main arguments for and against regulating accounting
information provision? Explain how a conceptual framework might helo to
improve standard setting.
Question 2.4
The revised IASB (2018) Conceptual Framework endorses both a ‘control’
approach and a ‘risk and rewards’ approach as being valid.
How do these approaches differ in the definition of a leased asset?
A solution is provided in Appendix A.
46
Chapter 3: Preparation and presentation of financial statements
3.1 Introduction
3.1.1 Aim of the chapter
This chapter is concerned with the preparation and presentation of
financial statements. Throughout this chapter, you will find it helpful to
refer to the accounts of a real world organisation. We suggest that you use
the Marks and Spencer annual report for the current year for this purpose:
http://annualreport.marksandspencer.com
3.2 IAS 1
International Accounting Standard 1 (IAS 1), the current version issued in
2007 (with some provisions mandatory at a later date) and last amended
in 2011, sets out the minimum requirements in respect of the content of
financial statements and provides guidelines for the presentation of those
financial statements. It is applicable for financial statements based on
international standards. It states that:
• Financial statements should normally be presented for a 12-month
period (and at least annually). Exceptions to this should be explained.
• Financial statements claiming to follow IASs/IFRSs have to be clearly
distinguished from any other information included in the same
published document.
It includes prescription in relation to key statements including the
statement of financial position, the statement of income, the statement of
comprehensive income and the statement of changes of equity.
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Chapter 3: Preparation and presentation of financial statements
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Chapter 3: Preparation and presentation of financial statements
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Question 3.2
Critically assess the ‘recycling’ provisions of IAS 1, which are outlined in
the ACCA article.
54
Chapter 4: Ethics for accountants
4.1 Introduction
In this chapter, we consider ethics for accountants. On the face of it,
ethics are relevant for deciding upon issues integral to the conceptual
framework. They are also relevant to the practice of accountants as
professionals and as people. Indeed, ethics are clearly pervasive in
accounting and questions of what should accountants do and how
should accountants behave are clearly basic to a practice and profession.
Concerns about the ethics of accountants and ethics in accounting are
often more prominently expressed in the face of corporate scandals, such
as Enron and WorldCom. We consider how ethics have been considered
in the context of professional accounting practice, reflecting in part issues
deemed to arise, and we present an overview of ethical positions.
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Chapter 4: Ethics for accountants
• Watch the movie Enron – The Smartest Guys in the Room, directed by
Alex Gibney [https://vimeo.com/424073216]
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Chapter 4: Ethics for accountants
Question 4.2
Should ethics pervade the education and training of accountants and
accounting students?
Question 4.3
Explain five different possible risks that may threaten compliance with
the International Federation of Accountants (IFAC) code for professional
ethics.
Question 4.4
Does the need for a professional accountant to embody ethical codes
reduce accounting scandals?
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Notes
62
Chapter 5: Accounting for equity and earnings per share
5.1 Introduction
5.1.1 Aims of the chapter
This chapter considers:
• accounting for equity which includes share capital and reserves
• the impact of equity and debt financing on accounting ratios.
The share capital can be divided into equity (i.e. ordinary shares) and non-
equity (i.e. preference shares).
In this chapter we will consider ordinary and preference shares, and the
distinction between distributable and non-distributable reserves. We will
illustrate the accounting treatment of shares issued at premium.
Activity 5.1
Why do you think the UK uses the above treatment for premiums? Why is the premium
not credited to the income statement?
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Chapter 5: Accounting for equity and earnings per share
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£
Profit on ordinary activities after tax 5,000,000
Less: Preference dividend (120,000)
Profit attributable to ordinary shareholders 4,880,000
Example 5.2 effect of the debt/equity mix on earnings per share (EPS)
Consider two companies, Saunders Plc and French Plc, both of which have
total financing of £200,000. We consider the EPS of both companies under
two scenarios (a good year and a bad year).
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Question 5.2
The draft statement of financial position of Ewan Plc at 30 September
2016 was as follows:
£000 £000
Product development Ordinary shares of £1 each,
costs 2,800 fully paid 24,000
12% preference shares of £1
Sundry assets 64,340 each, fully paid 16,000
Cash and Bank 10,900 Share premium 8,000
Retained (distributable) profits 9,200
Payables 20,840
78,040 78,040
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Chapter 5: Accounting for equity and earnings per share
Question 5.3
A public company purchases 4 million 50p ordinary shares for £3.50 each
on 1 April 20X0 and holds these as Treasury Shares. On 1 September
20X0, 1 million shares are sold at a price of £3.30 per share and on 1
December 20X0, the remaining 3 million shares are sold at a price of
£3.80 per share. How should the company record these transactions in the
accounts to 31 December 20X0?
Question 5.4
A public limited company has 100,000 ordinary shares at £1 in issue.
These shares had originally been issued at par. A total of 5,000 ordinary
shares of £1 are to be redeemed at premium of £0.50 out of distributable
profits making a capital repayment of £7,500. How should this transaction
be recorded?
The entries are:
Dr. Share capital £5,000
Dr. Retain profit £7,500
Cr. Capital redemption reserve £5,000
Cr. Bank £7,500
Question 5.5
a. You are given the following information in relation to High-jump Ltd:
Sales £18,000,000
Gross profit margin 15%
General expenses £1,700,000
Tax £600,000
Number of shares issued at start of the period 200,000
Number of shares issued at full market price of £55 per 80,000
share for cash, half way through the period
Required
Define and calculate the price earnings ratio for High-jump Ltd.
b. On 1 July 2016, Hockey Ltd issued an additional 4 million ordinary
shares with nominal value of 50p for £12.50 per share. The costs of
this share issue totalled 1% of the total money raised in the share
issue. After this share issue, Hockey Ltd issued bonus shares, in respect
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of all its shares, on a 1 for 5 basis. Before the share issue and the
bonus issue Hockey Ltd’s share capital and reserves were as follows:
£
Ordinary share capital 5,000,000
Ordinary share premium 15,000,000
Preference share capital 4,000,000
Retained earnings 160,000,000
Required
Show how Hockey Ltd’s share capital and reserves would be affected
by the share issues outlined above.
Solutions are provided in Appendix A.
72
Chapter 6: Provisions, contingent liabilities and contingent assets: events after the reporting period
6.1 Introduction
Liabilities and assets may be uncertain as to their existence or their
financial amount. IAS 37 Provisions, contingent liabilities and contingent
assets reflects this, addressing issues in relation to provisions, contingent
liabilities and contingent assets. Items resulting from executory contracts
(contracts where both parties have not performed any of their obligations
or have partially performed obligations to an equal amount) are usually
not covered by IAS 37 and nor are items effectively covered in other IASs/
IFRSs (such as retirement benefits and construction contracts).
IAS 37 was issued by the IASB in 1998, updating those parts of IAS 10
relating to contingencies and providing substantial guidance in relation to
‘provisions’. IAS 37 bans the creation of provisions where no obligation to
a liability exists and the use of provisions to smooth profits or to effectively
write down profits during good times and subsequently protect future
profits (sometimes referred to as ‘big bath’ accounting). It aims to apply
appropriate recognition criteria and measurement bases to provisions,
contingent liabilities and contingent assets. It also prescribes disclosures in
these areas.
Note that at the time of writing (2020), the IASB is still in the process of
receiving comments on its proposal to amend IAS 37. The original 1998
standard was considered for revision in 2005, in Exposure Draft (ED) IAS
37. This proposal was subsequently suspended, but the IASB has recently
restarted its consultation on revising IAS 37 in a research project. You can
follow these updates through the following links:
• Proposed amendments to IAS 37 – Onerous contracts
• Onerous contracts [https://www.iasplus.com/en/projects/narrow-
scope/ias-37-onerous-contracts]
• Onerous contracts – Cost of fulfilling a contract [https://www.ifrs.
org/-/media/project/onerous-contracts-cost-of-fulfilling-a-contract-
amendments-to-ias-37/ed-onerous-contracts-december-2018.
pdf?la=en]
• IAS 37 – Non-financial liabilities [https://www.iasplus.com/en/
projects/research/short-term/non-financial-liabilities]
For the purposes of the assessment on this module, you can assume that
the original 1998 standard and discussions from the 2005 Exposure Draft
form the current basis of the standard.
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6.2 Provisions
IAS 37 was first created to restrict the use of judgement within boundaries.
In other words, the standard restricted the managerial use of provisions
to create provisions when no obligation to a liability exists – the reason
for doing so is to be able to move (projected) costs between different
reporting periods. In this regard, the standard attempts to mitigate against
the use of ‘big bath’ accounting (i.e. reporting all of the costs/losses in a
single reporting period, so that other reporting periods are untainted by
the costs/losses) and the use of provisions for income-smoothing.
The following quote from David Tweedie, the former IASB chairperson,
illustrates this issue:
A main focus [of IAS 37] is ‘big-bath’ provisions. Those who use
them sometimes pray in aid of the concept of prudence. All too
often however the provision is wildly excessive and conveniently
finds its way back to the statement of comprehensive income
in a later period. The misleading practice needed to be stopped
and [IAS 37] proposed that in future provisions should only be
allowed when the company has an unavoidable obligation – an
intention which may or may not be fulfilled will not be enough.
Users of accounts can’t be expected to be mind readers. (Elliott
and Elliott (2019)).
IAS 37 uses the word ‘provisions’ to mean a liability of uncertain timing or
amount, which is a different usage of the word than is found in other areas
of accounting (e.g. depreciation provision or provision for doubtful debts –
in both these cases a provision adjusts the carrying amount of an asset.
If the conditions for a provision are met and a reliable estimate can be
made of the amount then the provision will be shown in the statement
of financial position and the amount will be recognised in the income
statement. A key question is whether the liability could be (legally)
avoided (e.g. by selling a machine to avoid a future overhaul cost,
although the standard could arguably be clearer on this) – if so, a
provision would not be recognised.
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Chapter 6: Provisions, contingent liabilities and contingent assets: events after the reporting period
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START
Present
obligations as No Possible No
a result of an obligations?
obligating
event?
Yes Yes
Probable No Yes
outflow? Remote?
Yes No
Reliable No (rare)
estimate?
Yes
Disclose
Provide contingent Do nothing
liability
Example 6.1
Question
A customer slips on company X’s floor and is injured. X accepts that
there is a present obligation and is not disputing the claim. X estimates
that there is an 80% probability of a payment of £100,000 and a 20%
probability of a payment of £10,000; both amounts include associated
costs. Ignore the time value of money.
Answer
• Is there a present obligation?
• Yes, there is no dispute and a past event (the slip) has already
happened creating a present obligation?
• Is the obligation probable?
• Yes, if P has not disputed the claim then it is more likely than not
that a payment will be made
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Example 6.2
Question
A company owns a piece of land that has been contaminated as a result of
the company’s activities. New legislation has been enacted which require
the company to clean up the land. The company estimates that there is a
60% chance that the land will be cleaned at a cost of £300,000 and a 40%
chance that the land will be cleaned at a cost of £500,000. Should the
company make a provision for the cost of the clean-up at the year end?
Answer
• Is there a present obligation?
• The land has become contaminated – this is a past event.
There may be a legal obligation for the company to clean-up.
Alternatively, the company may have created a constructive
obligation if it has created a public expectation that it would
do so (e.g. by preaching of its adherence to operate in an
environmentally responsible manner).
• Is the obligation probable?
• Yes, it is more likely than not that a payment of £300,000 will be
made
• What is a reliable estimate of the most likely outcome?
• Best estimate of the expenditure required to settle the obligation
therefore a payment of £300,000
Example 6.3
(Illustration taken from IAS 37, para.39)
An entity sells goods with a warranty under which customers are covered
for the cost of repairs of any manufacturing defects that become apparent
within the first six months after purchase. If minor defects were detected
in all products sold, repair costs of 1 million would result. If major defects
were detected in all products sold, repair costs of 4 million would result.
The entity’s past experience and future expectations indicate that, for the
coming year, 75 per cent of the goods sold will have no defects, 20 per cent
of the goods sold will have minor defects and 5 per cent of the goods sold
will have major defects. In accordance with para.24, an entity assesses the
probability of an outflow for the warranty obligations as a whole.
Question
What is the cost of repairs that should be recognised?
Answer
The expected value of the cost of repairs is:
(75% of nil) + (20% of 1m) + (5% of 4m) = 400,000
Illustration 6.1
Refer to Unilever group’s (2019) annual reports [https://www.unilever.
com/investor-relations/annual-report-and-accounts/archive-of-annual-
report-and-accounts/], Note 20 ‘Commitments and contingent liabilities’,
p.133.
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Chapter 6: Provisions, contingent liabilities and contingent assets: events after the reporting period
Activity 6.1
Assess the following situations in terms of the value of the provision to be recorded in the
financial statements:
1. Experience of past transactions suggests that 70% of goods sold under warranty will
have no defects, 20% will have minor defects (rectification costs £10m if all goods
had minor defects) and 10% will have major defects (rectification costs £20m if all
goods had major defects).
2. The company faces a substantial legal claim of £7m. It is estimated by experts that
there is a 30% chance of a successful defense.
The IASB has recently clarified its position on onerous contracts [https://
www.iasplus.com/en/news/2020/05/ias-37]. The amendments to IAS 37
(required from 1 January 2022)
Example 6.4
The application of onerous contracts has taken greater importance
now, with the IASB publishing guidance (Accounting provisions relating
to COVID-19 [https://play.buto.tv/9Kkkl]) on how to account for the
significant disruption to business caused by the coronavirus crisis
(COVID-19).
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Chapter 6: Provisions, contingent liabilities and contingent assets: events after the reporting period
Question 6.2
X Plc identifies a provision (already risk-adjusted) for £500,000 at the
year end 31 December 2016. The actual cash flow is expected to be paid
in two years’ time. The risk-free discount rate is identified as 5%. Show
the provision and related entries in the accounts, 31 December 2016 to 31
December 2018.
Question 6.3
At the balance sheet date, 31 December 2018, inventory was valued at
£600,000 by Hub Ltd. On 1 February 2019, the auditors discovered that
the inventory had been incorrectly valued and should have been valued at
£100,000. On 1 March, the company entered into an agreement to sell a
major subsidiary of the company. The accounts have not been signed off as
at 1 March 2019. What are events after the reporting period? Outline how
the above transactions should be dealt with in the financial statements of
Hub Ltd as at 31 December 2018.
A solution is provided in Appendix A.
Question 6.4
(Question and solutions adapted from Elliott and Elliott (2019), Chapter
4, Exercise Q1 (p.92) and the Instructor’s manual accompanying the text.)
a. A customer made a claim for £50,000 for losses suffered by the late
delivery of goods. The main part (£40,000) of the claim referred to
goods due to be delivered before the year-end. Explain how this would
be dealt with under IAS 10.
b. After the year-end a substantial quantity of inventory was destroyed
in a fire. The loss was adequately covered by insurance. This event
is likely to threaten the ability of the business to continue as a going
concern. Discuss the matters you would consider in making a decision
under IAS 10.
c. The business entered into a favourable contract after the year end
that would see its profits increase by 15% over the next three years.
Explain how this would be dealt with under IAS 10.
A solution is provided in Appendix A.
82
Chapter 7: Changing prices: current purchasing power (CPP) and its applications
7.1 Introduction
7.1.1 Aims of the chapter
This chapter revises the topic of historical cost accounting (HCA). It
considers characteristics of HCA, its advantages and disadvantages and
introduces alternatives to HCA. We look at an approach that has tried
to convert the accounting figures into current purchasing power (CPP)
to adjust for general price changes. In Chapter 8, we then turn to an
approach that concentrates on the effects of specific price changes and the
current values of the assets and other items in the financial statements.
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Chapter 7: Changing prices: current purchasing power (CPP) and its applications
Activity 7.1
Why do you think that changing prices might create problems in interpreting both the
balance sheet and the income statement?
Activity 7.2
The following short presentation by the chairperson of the IASB also presents a useful
debate between historical cost versus fair value measurement systems:
http://archive.ifrs.org/Alerts/PressRelease/Pages/Historical-cost-and-fair-value.aspx
Activity 7.3
Four specific concepts/conventions are discussed in FRS 18. These are characteristics of
HCA. Check that you can explain what each of the following mean:
• going concern
• accruals
• consistency
• prudence.
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• It enables comparability.
• For Ijiri (1971) HCA is ‘unique’. It reduces the problems of allocating
costs since outside users may duplicate the allocation themselves.
The uniqueness of the historical cost system actually reduces
the problems caused in allocating costs. The uniqueness of
the system renders valuation a simpler business than when
a number of possible valuations are available. Moreover,
unbiased outsider observers will have little difficulty in
duplicating any allocation used with historical cost systems,
providing that the method being used is explained.
(Bromwich, 1992)
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Chapter 7: Changing prices: current purchasing power (CPP) and its applications
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are rising, then the balance sheet could look rather antiquated and
jumbled.
Balance sheet as at 31 December 2010
Property (at 1953 cost less depreciation) 10,000
Plant and equipment (at costs between 1993–2010 less 50,000
depreciation)
Inventories (bought at 2010 cost) 18,000
78,000
Share capital (at 1953 when company first formed) 10,000
Income statement (1953–2010) 68,000
78,000
What does £50,000 really mean in relation to plant and equipment? Is
this value particularly useful? When specific prices are changing then
this value is out of date. Indeed, even when there are just general price
changes this affects the measuring unit. So is it really valid to add up
these amounts from different periods, such as 1993–2010?
• HCA also results in time-lag errors in the income statement,
particularly with inventory and depreciation. Is it really valid to
compare £s of different dates?
For example:
Income statement for the year ending 31 December 2010
Sales (evenly throughout the year, e.g. assume on average) £JUNE
Matched with inventories (hold three months’ inventory so assume £MARCH
average cost)
Depreciation for various dates between £1953–2010
Other expenses evenly throughout the year so on average £JUNE
Profit ______?
• If prices are rising, profit is overstated and losses/gains on holding
monetary assets/liabilities are not recognised. Also, trends may be
distorted and hence the accounts may be misleading.
For example, what if sales in 2009 were £1,500 and sales in 2010 were
£1,620 (a rise of 8% over the year)? If inflation increased by 8% also
over the year then, in real terms, the sales growth is in fact zero
because the increase in sales is solely due to inflation.
• Certain items are or have not been included under HCA, for example:
leases, financial instruments and executive share options.
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Chapter 7: Changing prices: current purchasing power (CPP) and its applications
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Chapter 7: Changing prices: current purchasing power (CPP) and its applications
See the following link for indicators of how hyperinflation and how the
current cost (i.e. CPP) financial statements are to be produced under IAS29:
https://www.bdo.global/getmedia/ccf981fa-46c8-4166-af36-
1abe983c87f6/IAS-29.pdf.aspx
At the time of writing, Venezuela, Argentina, South Sudan, Sudan
and Zimbabwe are some of the countries deemed to be experiencing
hyperinflation, as defined by IAS 29. An updated list of countries (January,
2020) with hyperinflation can be found at:
https://www.iasplus.com/en/news/2020/01/hyperinflationary-economies
For more real-world examples of how hyperinflation has been accounted
for, see International financial reporting, Chapter 23 for how inflation in
Russia in the late 1990s affected Aeroflot’s annual reports and Unilever’s
reporting (see below).
Unilever, a British-Dutch multinational that has extensive operations in
economies with hyperinflation, is also a useful illustration of IAS29 being
applied in practice.
The company’s 2019 annual reports (available at: https://www.unilever.
com/investor-relations/annual-report-and-accounts/archive-of-annual-
report-and-accounts/), pp.28–29, highlights the overall effects of
hyperinflation on the company’s sales performance. The net monetary
gain/loss arising from hyperinflationary economies are reported in the
consolidated income statement (p.87) and consolidated statement of
changes in equity (p.88).
Note that companies whose functional currency is in a hyperinflationary
economy are now no longer able to avoid restatement under IAS
29 through a stable currency. For example, an Argentinian group of
companies with a functional currency of Argentine Pesos are not allowed
to report using US$ as its presentational currency (see also Chapter 19 on
the definition of functional and presentational currency).
See Grupo Supervielle’s financial reports using Argentinian Pesos (a
currency under hyperinflation) and how IAS29 (and IFRS 9) impacts on
the group’s statement of financial position and income statement:
https://s21.q4cdn.com/714080446/files/doc_financials/EN/2019/IAS-29-
Financial-Reporting-in-Hyperinflationary-Economies.pdf
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Chapter 7: Changing prices: current purchasing power (CPP) and its applications
Activity 7.4
Let us assume you wish to stabilise HCA for sales to 31 December 2010.
The total sales in HCA total £80,000 and these took place evenly throughout the year
ending 30 June 2010. The RPI at the dates shown was as follows:
Date RPI
1 January 2010 100
30 June 2010 120
31 December 2010 150
What would the stabilised value of the sales be in the CPP income statement?
A solution is provided in Appendix A.
(
£12,000 ×
32 – 115
×
150
( = £2,016
115 132
Activity 7.5
Try to explain the nature of the holding gain of £2,016 on the monetary item above.
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Activity 7.6
Why do you think the monetary items are not converted?
Activity 7.7
Let us assume that you wish to stabilise HCA for non-current assets to 31 December
2010. The non-current assets in the HCA total £20,000 and these were all purchased on
1 June 2010. The RPI for the following months was:
Date RPI
1 January 2010 100
31 March 2010 110
1 June 2010 120
31 October 2010 135
31 December 2010 150
What would be the stabilised value of non-current assets in the CPP accounts?
A solution is provided in Appendix A.
Anderson Ltd
On 1 January 2010 Anderson Ltd started business. Anderson issued, for cash
and at par, 260,000 ordinary shares of £1 and £80,000 of debentures (payable
in 2018) at an interest rate of 15%. £136,000 was immediately invested
in factory premises and £70,000 in inventory, and on 1 February plant and
equipment was bought for £100,000; all of these were paid for in cash.
The following transactions occurred evenly throughout the year:
Sales £600,000 Additional purchases £344,000
Wages £150,000 Sundry expenses £80,000
All of these were cash transactions except for one sale for £40,000 which
took place on 30 June 2010; the trade receivable paid in full on 30
September 2010. In addition to the above, debenture interest for the year
was paid in full on 31 December 2010.
The plant and machinery has a useful economic life of 10 years with no
residual value, and it is depreciated on a straight-line basis with a full
year’s charge in the year of purchase. The factory premises are made up of
land, £56,000, and buildings, £80,000; the buildings are depreciated on a
straight-line basis at 4% per annum.
On 30 September 2010, 20,000 ordinary shares were issued at a premium of
20%.
At 31 December 2010 inventories at cost were £120,000; they may be
assumed to have been bought on average two months before the end of the
year.
During the year the RPI in the UK moved as follows:
1 January 2010 100 1 February 2010 102
30 June (=average for year) 110 30 September 2010 115
30 October 2010 117 31 December 2010 121
The requirement is to draw up an income statement for the year ended 31
December 2010, and a balance sheet at that date, both stabilised in £s of 31
December 2010.
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Chapter 7: Changing prices: current purchasing power (CPP) and its applications
Note: the use of cash throughout the period is not explicitly shown in the
worked solutions, hence you would first need to work out a cash account
ledger to trace the movements/transactions in the cash at bank asset
account.
414,000 463,100
30 October Less closing inventory (120,000) × 121/117 (124,103)
294,000 338,997
(255,200) (280,735)
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AC2091 Financial reporting
(£40,000 ×
115 – 110
( ×
121
= £1,913
110 115
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Chapter 7: Changing prices: current purchasing power (CPP) and its applications
Note that the loss of 13,364 = 1,913 + 11,452 (with rounding errors). In
other words, the combined loss on net short term monetary items is equal
to the loss on trade receivables + loss on cash in this example.
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Activity 7.8
Why has HCA profit (£50,800) become £43,704 (£CPP at 31 December 2010) profit?
Activity 7.9
How would the reported profit above differ if the balance sheet at 31 December 2010
included trade receivables in respect of the credit sales made on 30 June and creditors in
respect of the closing inventory?
A solution is provided in Appendix A.
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Chapter 7: Changing prices: current purchasing power (CPP) and its applications
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AC2091 Financial reporting
184
Net current assets 141
Net assets 357
Shareholders’ funds
Ordinary shares of £1 200
Share premium account 35
Income statement 122
357
940
Less closing inventory 140 800
Gross profit 300
Less expenses
Depreciation 24
Sundry expenses 145
169
Operating profit 131
Dividends
Interim dividend paid 9
Retained profit 122
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Chapter 7: Changing prices: current purchasing power (CPP) and its applications
Question 7.2
Del Ltd started trading on 1 January 2018. The income statement and the
statement of financial position for the first year of trading are given as
follows:
Income statement for the year ended 31 December 2018
£ £
Revenue 5,700,000
Cost of sales
Opening inventory 1,500,000
Purchases 3,600,000
Closing inventory (820,000)
(4,280,000)
Gross profit 1,420,000
Expenses (700,000)
Depreciation (240,000)
Profit for the year 480,000
Non-current assets
Inventory 820,000
Cash 1,100,000
Total assets 4,080,000
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The price change indices for the year were identified as follows:
All non-current assets and opening inventory were acquired on the first
day of trading.
Closing inventory was acquired on 15 December 2018.
Sales and purchases accrue evenly throughout the year.
Required:
a. Discuss four advantages and four limitations of current purchasing
power accounting.
b. Prepare the current purchasing power income statement of Del Ltd for
the year ended 31 December 2018 and the current purchasing power
statement of financial position as at 31 December 2018.
Solutions are provided in Appendix A.
Question 7.3
Current Purchasing Power (CPP) accounting was used briefly in the UK
in the late 1970s. Under what circumstances is CPP still used? Do the
benefits of using CPP here exceed its limitations?
Solutions are provided in Appendix A.
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Chapter 8: Accounting for changing prices/values
8.1 Introduction
8.1.1 Aims of the chapter
This chapter builds on the topic of alternatives to HCA discussed in the
previous chapter. We then turn to an approach that concentrates on the
effects of specific price changes and the current values of the assets and
other items in the financial statements. We consider an alternative that
tries to combine these two approaches.
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AC2091 Financial reporting
While NRV in its original form may not be used as a current system of
measurement, the current fair value (FV) approach is a form of exit value
not dissimilar to NRV. We will discuss FV further in Section 8.12.
Activity 8.1
How do you think NRV accounting reconciles with the going concern concept?
In general, do you consider RCA or NRV to be the more prudent?
deprival value will either be replacement cost (RC), net realisable value
(NRV) or present value (PV is alternatively known as value-in-use).
The formula for deprival value is:
The lower of replacement cost (RC) or
(higher of net realisable value (NRV) or Present Value (PV)).
The concept of DV is no longer examined in AC2091 Financial reporting. It
is now considered in AC3193 Accounting theory (Chapter 5).
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Chapter 8: Accounting for changing prices/values
Activity 8.2
Suppose that you actually only sold six of the T-shirts discussed above. What would your
realised and unrealised holding gains be?
Prepare a CCA income statement and balance sheet assuming all realised holding gains
go to the income statement and unrealised holding gains go to the statement of financial
position.
A solution is provided in Appendix A.
You will notice that HCA makes no distinction between these two types
of profit (current operating profit and realised holding gains). Another
problem with CVA, once you have ascertained what the current value
should be, is determining how much of an increase in asset values enters
into income. At this stage we are only considering specific price changes
under CVA.
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For example, based on the T-shirt transaction above, under financial capital
maintenance in money terms you could consume all of the £50 income
and still be as ‘well off’ as you were at the start (closing and opening
statement of financial positions both equalling £100). However, under
physical (or operating) capital maintenance, by consuming all the profit of
£50, you would be ‘worse-off’ since you have not retained your operating
capabilities (i.e. you would not be able to sell 10 T-shirts in the next period
because the cost of replacement has risen by £2). Therefore, to sell 10
T-shirts next period you must set aside the additional cost of £20 (£2 x 10
units). Thus, your closing statement of financial position would need to
be £120 to maintain your operating capacity (now comparable with the
opening balance of £100, i.e. the opening and closing balance sheet values
are equal in terms of their ability to buy 10 T-shirts). Therefore, under
physical capital maintenance your income is now £30 and the holding
gain of £20 is in your statement of financial position under the heading
of ‘capital maintenance reserve’. This would enable you to maintain
your capital and hence does not form part of your income:
CVA income statement
£
Sales 150
Cost of sales 120 (£12 × 10 units at replacement cost)
Profit 30
CV statement of financial position
£
Cash 150
Shareholders’ funds
Opening capital 100
Profit 30
Capital maintenance reserve 20
150
Note: A third possibility would be to take realised holding gains to profit
but unrealised holding gains to reserves on the grounds of prudence. This
approach would amount to analysing historical cost profit into current
operating profit and realised holding gains.
for example, for commodity dealers who buy and sell in the same
market. The concept of operating capability maintenance does not seem
relevant to one-off ventures where there is no intention of repeating the
same activity, nor to value-based companies (such as investment trusts
and production companies) and other companies which do not have
an operating capability to maintain. A concept of income based on an
economic benchmark that does not apply to all business may be thought
questionable.
Even in relation to companies with a more easily defined operating
capability, physical capital maintenance (by charging against profit the
amounts needed to replace assets consumed but excluding from income
the gains made as a result of having bought those assets more cheaply,
or losses made as a result of having bought them at greater cost), may be
thought to be confusing questions of financing replacement with issues of
income measurement. If the market price of the company’s assets has risen,
and replacement is justified at the higher prices, the capital markets should
be prepared to provide any necessary finance. If managers choose instead
to use shareholders’ funds for this purpose, it would seem right that they
should show this as a reinvestment of profit rather than adopt a capital
maintenance concept which suggests that profits are lower and that there
is no profit until provision has been made for the additional investment.
Charging the current value of assets consumed at the time of sale or
consumption will not ensure that sufficient funds are retained to replace
those assets if there is a delay in replacing them during which time prices
have continued to rise. In particular, there may be a problem over ‘backlog
depreciation’ for non-current assets whereby the sum of the annual
current value depreciation charges is likely to fall short of the sum needed
to replace the asset at the time of replacement. Although there may be
circumstances in which the annual current value depreciation charge will
equal the annual amount spent on replacement (e.g. if a company has, say,
seven identical assets each with a seven-year life and wishes to replace one
each year), this will not necessarily be the case.
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AC2091 Financial reporting
Other information:
• The non-current assets were purchased on 1 January 2010 and are
expected to have a 10-year life with no residual value.
• On 30 June 2010 inventory which cost £12,000 was sold on credit for
£26,000.
• Expenses of £6,000 were paid evenly throughout the year ended 31
December 2010.
• Debenture interest for the year was paid on 31 December 2010.
• On 31 December 2010, £20,000 was received from trade receivables
and inventory costing £14,000 was purchased on credit.
The following movements occurred during 2010 in the indices of
replacement cost:
1 January 30 June 31 December
Inventory 100 132 144
Non-current assets 100 110 125
The following are required:
a. An income statement for the year ended 31 December 2010,
and a balance sheet at that date prepared under the historical cost
convention.
b. A current value income statement for the year ended 31
December 2010 and a statement of financial position at that date,
incorporating replacement costs for assets sold, consumed and held,
on a physical capital maintenance basis.
c. A current value income statement for the year ended 31
December 2010 and statement of financial position at that date,
incorporating replacement costs for assets sold, consumed and held,
on a financial capital maintenance basis.
Note: Base depreciation on the year-end cost of non-current assets for (b)
and (c).
The income statement for (a), (b) and (c), along with other relevant
information, can be seen in the spreadsheet provided on the VLE
[https://emfss.elearning.london.ac.uk/mod/page/view.php?id=32388].
Transaction date
• For inventory: cost of sales
The date the inventory was purchased – 1 January 2010. Thus the
index is 100.
• For non-current assets: depreciation
The date the non-current assets were purchased – 1 January 2010.
Thus the index is 100.
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AC2091 Financial reporting
Activity 8.3
Why do holding gains arise?
Discuss the different treatment of holding gains under HCA and CVA in terms of capital
maintenance concepts.
A solution is provided in Appendix A.
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Chapter 8: Accounting for changing prices/values
and value than HCA would since, providing the company is acting
rationally in its decision to replace, replacement cost measures the
minimum value of expected cash flows. The better the market, the
nearer will replacement cost be to present value of future cash flows. It
follows, therefore, that it will also be a better predictor of future cash
flows.
8.10.2 Disadvantages
• Particularly for highly specific assets for which there is no good
market, ascertainment of RC might prove highly subjective.
• Like historical cost, it is also subject to arbitrary allocations against
income.
• There is the ‘aggregation’ problem (i.e. does one replace individual
assets, which might prove more expensive than the cost of replacing
the whole team of assets with a new technology?)
• Some complain that RC is a cost and not a value. For example:
RC…does not represent worth, being a cost based measure.
Business activity is about the adding value, so financial
statements should reflect this. A value basis rather than a cost
basis is therefore predicated. The value of an asset is either the
net proceeds which could be realised by selling it or the net
present value of the cash flows that can be derived from it. RC is
not, in principle, a measure of value.
(ICAS, Making corporate reports valuable, 1988, p.64)
Others, however, regard it as an ‘entry value’ (and NRV and FV are ‘exit
values’).
Level 2:
These relate to inputs that, while not actual quoted prices, are based on
observable prices (e.g. in another active market) or, in the case of non-
active markets, can be derived from observable value-relevant information
such as interest rates, yield curves and other observable market-based data
being generated.
Level 3:
These relate to unobservable inputs which are used to measure FV based
on ‘assumptions that market participants would use when pricing the
asset or liability, including assumptions about risk [which] might include
the entity’s own data’. Alexander et al. point out that the IASB was
clear that FV should be seen as a market-based value, as opposed to an
entity-specific value such as NRV or PV. The mitigation in this regard to
overcome problems of the non-existence of active or observable markets
is disclosure. Disclosure in this regard could include information on the
sensitivity of the FV-based measurement to changes in unobservable inputs
(Alexander et al., 2014, p.123).
There are some exceptions to the requirement to use FV:
1. Share-based payments under IFRS 2 – entry/exchange values continue
to be used.
2. Leasing under the updated IAS 17 (and possibly under the forthcoming
IFRS 19) – entry/exchange values continue to be used.
3. Impairment of assets (IAS 36); Inventory measurement under NRV
(IAS 2).
The disclosure requirements under Level 3 also do not apply to reporting
on employee benefits (IAS 19) and retirement/pensions (IAS 26).
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Chapter 8: Accounting for changing prices/values
Cost of sales
Opening inventory 300,000
Purchases 3,600,000
Closing inventory (360,000)
(3,540,000)
Gross profit 1,860,000
Expenses (600,000)
Depreciation (168,000)
Comprehensive income 1,092,000
The price change indices for the year were identified as follows:
RPI Non-current
Inventory
assets
1 January 2015 150 200 180
Average 2015 160 210 190
30 November 2015 170 220 215
31 December 2015 180 230 250
Closing inventory was acquired on 30 November 2015. 50% of the non-
current-assets were acquired on 1 January 2015 and 50% were acquired
on 30 June 2015.
Opening inventory was acquired on the first day of trading.
Sales and purchases accrue evenly throughout the year.
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Question 8.2
Critically assess the practical and theoretical issues of historic cost
accounting versus fair value accounting in financial reporting. In
particular, comment on how the following items are currently accounted
for, and the potential limitations of doing so.
i. Financial instruments.
ii. Investment property.
Question 8.3
What are the issues arising from the use of exit values as a basis of
measuring assets and liabilities? You should discuss your answer in the
context of IFRS’s adoption of fair value accounting.
Question 8.4
Tennis Ltd started trading on 1 January 2016. The statement of
comprehensive income and the statement of financial position for the first
year of trading are given as follows:
£ £
Statement of comprehensive income for 2016
Revenue 7,600,000
Cost of sales
Opening inventory 1,200,000
Purchases 4,800,000
Closing inventory (960,000)
(5,040,000)
Gross profit 2,560,000
Other expenses (1,040,00)
Depreciation (320,000)
Profit before tax 1,200,000
Tax (400,000)
Profit after tax 800,000
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Chapter 8: Accounting for changing prices/values
The price change indices for the year are given as follows:
RPI Non-current assets Inventory
1 January 2016 150 200 180
Average 2016 160 210 190
30 November 2016 170 220 215
31 December 2016 190 230 250
All non-current assets and opening inventory were acquired on the first
day of trading. Closing inventory was acquired on 30 November 2016.
Sales and purchases accrue evenly throughout the year.
Required
a. Identify and explain the capital maintenance concept most closely
associated with current value (replacement cost) financial statements.
b. What are realised and unrealised holding gains?
c. Prepare the current value (replacement cost) statement of
comprehensive income for the year ended 31 December 2016 and the
current value (replacement cost) statement of financial position as at
31 December 2016 for Tennis Ltd, showing realised and unrealised
holding gains.
Solutions are provided in Appendix A.
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Notes
118
Chapter 9: Accounting for employee benefits
9.1 Introduction
Most employers provide employees with benefits beyond, if including, the
wages paid. IASs/IFRSs aim to account for these benefits where they give
rise to liabilities and expenses for the entity. Some of these benefits may be
long-term in nature, increasing the uncertainty surrounding them.
The accounting treatment pursued by IAS 19 for employee benefits
applies if the benefits result from formal agreements between employees
and the entity, legislative requirements, the requirements derived from
industry arrangements and the requirements derived from informal
practices engendering a ‘constructive obligation’ (this could occur where,
for example, a departure from the informal practice would unacceptably
damage the entity’s relationship with employees).
Relevant standards
IAS 19 (2011) Accounting for employee benefits.
IFRS 2 Share-based payment.
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Chapter 9: Accounting for employee benefits
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Chapter 9: Accounting for employee benefits
9.4.7 The net interest on the net defined benefit liability (asset)
Looking back at the simple illustration of Mr Linn, the interest or interest
accrual is the interest cost component or the net interest on the net
defined benefit liability (asset). The current service cost plus the interest
cost component is the total pension cost that is allocated to the profit and
loss part of the statement of comprehensive income. Note that there is no
interest cost component in the first year in the simple illustration because
the calculations are at the end of each year.
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Component Recognition in
financial statement
Service cost attributable to the current and past periods Profit or loss
Net interest on the net defined benefit liability or asset, determined Profit or loss
using the discount rate at the beginning of the period
Remeasurements of the net defined benefit liability or asset, comprising: Other comprehensive
• actuarial gains and losses income
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AC2091 Financial reporting
Example 9.2
An illustration of how pension liability and the income statement charge
is calculated under IAS 19 (2011). The example makes a number of
simplifying assumptions for illustrative purposes:
1. The illustration does not include the effect of curtailments or
settlements.
2. All transactions are assumed to occur at the year end.
3. There were no actuarial gains and losses brought forward into 2019.
The pension scheme had a market value of assets of £6,500,000 and a
present value of pension liabilities of £7,100,000
The details of the pension are as follows.
Question:
Show how the pension scheme would be presented in the financial
statements for the period 2019–2021 under IAS 19 (2011).
Answer:
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Chapter 9: Accounting for employee benefits
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AC2091 Financial reporting
Calculate the amount that Aggi Limited would recognise in the profit and
loss account and in other comprehensive income for the years ended 31
December 2015 and 31 December 2016. How does the benefit obligation
build up over the five years to 2020?
Solutions are provided in Appendix A.
Question 9.2
Mint Limited promises a 60-year-old employee, Mrs Pear, who will retire at
65, a lump-sum retirement package equal to 1% of final salary multiplied
by the number of years of service.
Mrs Pear’s 60th birthday is on 1 January 2015 and her 2015 yearly salary
is £75,000, to increase at 5% compound each year. The discount rate is
10% per annum.
There is assumed to be a 20% probability that Mrs Pear will leave Mint
Limited before 1 January 2020.
On 1 January 2016, the company revises its actuarial assumptions, so that
Mrs Pear’s salary should increase by 15% per annum rather than 5% and
the probability of Mrs Pear leaving before her scheduled retirement falls to
10%. The obligation is not funded.
Required:
a. What are defined contribution and defined benefit plans? (4 marks)
b. Calculate the total pension cost that Mint Limited would recognise
in the profit and loss section of the income statement for the year 31
December 2016. (11 marks)
c. Calculate the actuarial loss for 2016 which would be recorded in other
comprehensive income. (5 marks)
Solutions are provided in Appendix A.
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Chapter 10: Accounting for taxation
10.1 Introduction
10.1.1 Aims of the chapter
This chapter considers how to account for corporation tax and deferred
tax. The objective of IAS 12 Income taxes is to prescribe the accounting
treatment for income taxes (such as corporation tax). However, the
calculation of tax is determined by the taxation authorities of the country
in which the company is domiciled. Different countries adopt different
taxation rules. For illustration we consider the UK tax system (up to
around 2008 to illustrate tax changes). This chapter will then consider
the issue of deferred tax. Deferred tax arises as an accounting entry where
accounting policy-makers deem it appropriate to adjust the taxation
arising as it is out of line with the accounting profits. This occurs where
accounting profit and taxable profit differ (as is the case in the UK). We
examine three approaches to how differences between accounting profit
and taxable profit are reflected in calculating deferred taxation. We also
briefly introduce accounting for value added tax (VAT) in relation to
financial reporting.
Historical UK standards
FRS 16 Current tax.
FRS 19 Deferred tax.
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AC2091 Financial reporting
Activity 10.1
Do all countries’ business/corporate legislation allow the use of deferred taxation?
£ £
Sales 4,950,000
Less cost of sales 2,175,000
Gross profit 2,775,000
Less overhead expenses
Wages and salaries 563,000
Rent and rates 180,000
Light and heat 50,000
Depreciation 70,000
Sundry expenses 92,000 955,000
Profit per accounts before tax and dividends 1,820,000
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The income statement for the year ended 30 June 2017 would now show:
Profit before tax (Note: this is the accounting profit,
£1,820,000
not taxable profit)
Less taxation charge 534,000
Profit after tax £1,286,000
£
Taxation charge 524,000
Represented by:
Corporation tax based on the profits for the year
534,000
ended 30 June 2017
Less overprovision for prior year (10,000)
524,000
Under the old standard FRS 19, permanent differences relate to those
expenses that will be permanently disallowed and will not be allowed in
any future period (e.g. political donations). Under the old standard FRS
19, there is no recognition of permanent differences. This contrasts with
the temporary difference approach adopted by IAS 12. IAS 12 states that
an entity should provide for deferred tax whenever there is a difference
between the carrying amount and the tax base of an asset or liability,
giving rise to the possibility of providing for some permanent differences.
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AC2091 Financial reporting
Timing differences relate to those items for which tax relief and charges
to the income statement occur in different periods. The most obvious and
significant timing difference is the purchase of a non-current asset for
which the cost is spread over a number of years according to different
rules when using either capital allowances (in effect tax allocation of cost
or part thereof) or depreciation (accounting allocation of cost).
Capital allowances for non-current assets is a good example to use when
considering the implications of deferred tax. Typically, capital allowances
provide a rapid write-off of the cost of the non-current asset in early
years for tax purposes. In contrast, the company will have to pay higher
tax bills in the future once the effect of the rapid write-off reverses and
depreciation charges are higher than tax allowances. Consequently,
deferred tax accounting attempts to match accounting income and the tax
charge.
These are the potential differences between tax rules and accounting
treatments:
Deductible temporary differences:
• Retirement benefit costs charged as an expense when incurred but
may only be allowed by the tax authorities when paid.
• Revaluation losses, which are recognised in the income statement
when they occur, but may only be allowed by the tax authorities when
the assets are sold.
• Research costs charged as an expense in arriving at the accounting
profit but which may only be allowed by the tax authorities when paid.
• Unrealised profit on intra-group sales.
Taxable temporary differences:
• Interest income recognised as it is earned but only taxed when it is
received.
• Revaluation gains.
• Interest capitalised in producing or constructing an asset (per IAS 23
Borrowing Costs) would be charged to the future income statements
when the asset is depreciated. But the interest is normally allowed by
tax authorities when it is incurred.
Other temporary differences:
• Accelerated capital allowances which result in a difference between
the tax written down value and the NBV of an asset.
• Certain current assets such as investments valued at market price: the
change in value would go to the income statement but is only included
in the taxable profit when realised.
Activity 10.2
How do we recognise a deferred tax asset or deferred tax liability? For each of the
scenarios below, indicate whether a deferred tax exists, and if it does, whether it is a
deferred tax asset or liability.
1. A machine with an original cost of £100,000 has been depreciated using IAS 16
and has a carrying value of £40,000. The tax writing down or capital allowance is
£30,000 is given.
2. Income receivable £40,000 included in current assets. Income is taxed on a cash
basis.
3. Trade receivables of £50,000.
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Chapter 10: Accounting for taxation
As you will see in the example below, if you do not account for deferred
tax then the implicit tax rate changes year by year and as a result has no
obvious relationship to the actual tax charge of 30%.
Income statement
1 2 3 4 Total
£ £ £ £ £
Net cash flow 25,000 25,000 25,000 25,000 100,000
Depreciation 5,000 5,000 5,000 5,000 20,000
Profit before taxation 20,000 20,000 20,000 20,000 80,000
Taxation (30%) 1,500 7,500 7,500 7,500 24,000
Profit after taxation 18,500 12,500 12,500 12,500 56,000
Workings
1 2 3 4
Profit before taxation 20,000 20,000 20,000 20,000
Depreciation 5,000 5,000 5,000 5,000
25,000 25,000 25,000 25,000
Capital allowance 20,000 – – –
Taxable profit 5,000 25,000 25,000 25,000
Tax @ 30% = 1,500 7,500 7,500 7,500
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Chapter 10: Accounting for taxation
The CT rate is 33% and on 1 January 2013 there was a nil balance on the
deferred tax account.
The income statement and balance sheet extract for the three methods –
flow-through, full provision, partial provision – are as follows.
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Chapter 10: Accounting for taxation
Year 1 2 3 4 5 Total
£ £ £ £ £ £
Capital allowance (given) 11,500 9,000 7,500 4,500 2,500
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Under the deferred method, the deferred tax charge in the income
statement is first calculated based on the timing difference, followed
by the provision in the statement of financial position. This can be said
to emphasise the income statement as matching tax rates with the tax
expense is prioritised. Under the liability method, however, it can be
said to emphasise the statement of financial position as the tax provision
(liability) is first calculated, from which differences in provision are used
to work out the tax expense in the income statement.
Note that the final provision on 31 March 2020 under the deferred
method (£431.56) is higher than the liability method (£300.94), as the
deferred method cumulates tax expenses using four different tax rates
(22%, 25%, 19% and 18%). The final provision on 31 March 2020 in the
liability method, in contrast, uses a rate of 18% for the entire cumulative
difference (i.e. for all four years). This means that as tax rates change,
the provisions for previous years also readjust to the most recent tax rate,
unlike the deferred method, which matches and retains the historical tax
rates in the provision on the statement of financial position.
For example, as the tax rates rise from 22% to 25%, the provision for
deferred tax also rises faster for the liability method (£687.50) compared
with the deferred method (£627.50) as the deferred taxes for the year
ending 31 March 2017 and 2018 are rebased to 25% for both years
under the liability method (but calculated on the 22% and 25% basis
respectively for the deferred method). However, as taxes fall (e.g. from
25% to 19%) then the liability method also shows a greater fall (£486.88)
compared with the deferred method (£591.88). This suggests that when
taxes fluctuate, the liability method will produce more volatile upward or
downward movements in provisions compared with the deferred method.
Activity 10.3
How do the two central approaches to deferred tax (the deferred approach versus the
liability approach) reconcile with the measurement basis outlined in the IASB’s conceptual
framework?
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Chapter 10: Accounting for taxation
Question 10.2
Flower Plc has the following projected information:
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Notes
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Chapter 11: Tangible non-current assets
11.1 Introduction
11.1.1 Aims of the chapter
Non-current (fixed) assets can be divided into three categories:
• tangible
• intangible
• investments.
This chapter considers how tangible non-current assets (owned and
not owned) are treated in the financial statements. Investment properties
(as distinct from investments in other companies) are briefly covered.
Tangible non-current assets which are not owned are known more
commonly as leases. Intangible assets are covered in other chapters.
The main issue of tangible assets is at what cost/value they should be
recorded in the statement of financial position and how the carrying
amount should be treated over time (with income statement implications).
In the case of leases, it must first be ascertained whether or not these
tangible non-current assets should appear in the statement of financial
position at all.
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These are basic characteristics of assets. The cost of property, plant and
equipment is an asset if, and only if:
it is probable that future economic benefits associated with
the item will flow to the entity; and the cost of the item can be
reliably measured.
(IAS 16, para.6)
In addition, para.51 of the FPPFS stipulates that regard must be had to
underlying substance and economic reality and not merely legal form. If
future economic benefits are very uncertain, assets are not recognised.
IAS 16 Property, plant and equipment sets out principles of accounting for
initial measurement, valuation and depreciation of tangible non-current
assets. Non-current assets are held for continuing use in the enterprise.
IAS 16 defines property, plant and equipment as:
Tangible assets that:
a. are held by an entity for use in the production or supply of
goods or services, for rental to others, or for administrative
purposes; and
b. are expected to be used during more than one period.
(para.6)
such as delivery charges or legal and architect’s fees), but what about
production costs?
One of the recurring themes in accounting is whether a particular cost
should be expensed (charged to the income statement) or capitalised
(added to the cost of the non-current asset in the statement of financial
position for subsequent charging to the income statement as depreciation).
Activity 11.1
Which of the following would not be included as part of the cost of a tangible non-
current asset?
A. The invoice price of the asset.
B. The labour costs of own employees engaged in constructing the asset.
C. The normal cost of design errors relating to the asset.
D. The administration overheads indirectly related to acquiring the asset.
A company buys a new machine from abroad at an invoice price of £20,000.
Transportation costs amounted to £2,000 and installation costs a further £1,500. The
company was granted a discount of £1,000 for early payment. The cost of the asset to be
recognised in the financial statements would be:
A. £19,000
B. £21,000
C. £23,500
D. £24,500
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Activity 11.2
Put forward an argument to support the capitalisation of the above expenses. In
particular, what are the arguments for and against the capitalisation of interest?
11.5 Depreciation
Depreciation is a measure of the wearing out, consumption or other
reduction in the useful life of a non-current asset. Non-current assets
must be depreciated over their useful economic life to their residual
value. The important consideration is how depreciation is charged to the
income statement so that there is a fair allocation of the cost/value to each
accounting period. This allocation is in accordance with the ‘matching
concept’.
IAS 16 defines depreciation as:
...the systematic allocation of the depreciable amount of an
asset over its useful life.
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SL RB SD
Year 3 11,000 8,710 8,000
Year 4 8,000 6,602 6,000
Year 5 5,000 5,000 5,000
Activity 11.3
a. Given these figures, what are the disadvantages of each of these methods? Can you
think of any reason why a particular one of these methods might be preferred?
b. Sugar Plc bought an item of machinery for £100,000 on 1 January 2009. It is
envisaged that the machinery could be sold in 10 years’ time for £20,000. Sugar Plc
uses straight-line depreciation to depreciate its machinery, and sells the machinery
to its rival Venables Plc on 31 December 2010 for £80,000. What is the accounting
profit and loss on the sale of this machinery?
• –£20,000?
• –£4,000?
• nil?
• +£4,000?
A solution is provided in Appendix A.
Note that on disposal of a revalued asset, the gain or loss in the income
statement is the difference between the sale proceeds and the depreciated
revalued amount (i.e. carrying amount).
Activity 11.4
A non-current asset (building) has been acquired by a company and it wishes to account for
this as an investment property. The non-current asset cost £1,400,000 on 1 January 2019 and
its market value on 31 December 2019 is £1,800,000. The company’s depreciation policy for
similar non-current assets is the reducing balance method using a rate of 10%.
Required:
• What are investment properties and how are they accounted for?
• Show how the non-current asset would be accounted for in the income statement for
the year ended 31 December 2019 and in the statement of financial position as at 31
December 2019 if it could be classed as an investment property using the fair value model
and the cost model.
Solutions are provided in Appendix A.
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Question 11.2
On 1 October 2014 Ballina acquired a machine under the following terms.
Hours £
Manufacturer’s base price 2,500,000
Trade discount (applying to base price only) 20%
Early settlement discount taken (on the payable
amount of the base cost only) 4%
Freight (carriage) charges 30,000
Installation cost 52,000
Staff training in use of machine 85,000
Pre-production testing 45,000
Purchase of a three-year maintenance contract 120,000
Estimated residual value 50,000
Estimated life in machine hours 15,000
Hours used – year ended 30 September 2015 3,000
– year ended 30 September 2016 3,600
– year ended 30 September 2017 (see below) 1,500
On 1 October 2016 Ballina decided to upgrade the machine by adding new
components at a cost of £410,000.
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This upgrade led to a reduction in the production time per unit of the
goods being manufactured using the machine. The upgrade also increased
the estimated remaining life of the machine at 1 October 2016 to 9,000
machine hours and its estimated residual value was revised to £75,000.
Prepare extracts from the income statement and statement of financial
position for the above machine for each of the three years to 30 September
2017.
Question 11.3
A company acquired a machine as follows:
Question 11.4
What are ‘non-current tangible assets’ and ‘investment properties’? Discuss
the differences in the accounting treatment of ‘non-current tangible assets’
and ‘investment properties’ and discuss how the different accounting
treatments affect the financial statements.
Solutions are provided in Appendix A.
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Chapter 12: Leases
12.1 Introduction
12.1.1 Aims of the chapter
This chapter considers how leases are treated in the financial statements.
The main issue is in understanding the implication of different treatments
for leases (primarily financial leases versus operating leases). In particular,
we need to consider the attraction of particular lease treatments and
its distortionary effect on financial statements and analysis. We will
also consider the reactions of standard setters to mitigate against such
distortions.
12.2 Leases
In recent years, the accounting standard for leases has had major revisions.
IFRS 16 Leases replaced IAS 17, which was deemed to be inadequate in a
number of ways. To understand the problems caused by IAS 17, we first
consider the way in which IAS 17 accounts for assets that are leased. Note
that from a technical accounting viewpoint, the way in which leases are
calculated are similar. The main difference between IFRS 16 and IAS 17 is
the change in the threshold criteria that determines how leases should be
classified.
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Activity 12.1
Read the articles below, which will help you contextualise the debates behind leasing and
provide you with empirical examples to use in essays.
• Thornton, G. and Tomlin ‘What does IFRS 16 mean for landlords?’, Estates Gazette, 3
November 2018, pp.64–66. (Available in the Online Library.)
• Ryland, Philip ‘Debt by any other name’, Investor’s Chronicle, 16 August 2019, p. 33.
(Available in the Online Library.)
• Quinn, James ‘On balance, companies would rather not show debt’, The
Telegraph, 13 January 2016. [https://www.telegraph.co.uk/finance/newsbysector/
banksandfinance/12098359/On-balance-companies-would-rather-not-show-debt.html]
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• Eley, Jonathan ‘New rules force retailers to rethink lease accounting’, Financial
Times, 28 October 2018. [https://www.ft.com/content/9657cd82-c891-11e8-ba8f-
ee390057b8c9] The Financial Times is available to EMFSS students in the Online
Library. You can access the newspaper to browse editions or search for individual
articles through the Online Library A–Z journal list.
Summarise the key impact of IFRS 16 as reported in the articles. Consider the following in
your summary:
1. What are the key differences in criteria for recognising finance and operating leases
under IFRS 16 versus IAS 17?
2. What are the key industries or companies that are affected by the move to IFRS 16?
3. What are the key arguments used to support the move to IFRS 16?
4. What are the key arguments against IFRS 16 (i.e. retaining the old standard IAS 17?)
Solutions are provided in Appendix A.
Step 1
Find the value of the annuity factor for five periods that sets the minimum
lease payments equal to the fair value (these payments here being the sum
the lessor expects to receive and retain).
(NB: the annuity factor here is calculated for only five periods, since the
first payment under the lease is made in advance.)
Step 2
Analyse the rental payments under the lease as follows.
Rental Finance Reduction in Balance of obligation
payment charge obligation under finance lease
Date
1/1/20X1 23,450 (initial balance)
1/1/20X1 4,500 – 4,500 18,950
1/7/20X1 4,500 1,137 3,363 15,587
1/1/20X2 4,500 935 3,565 12,022
1/7/20X2 4,500 721 3,779 8,243
1/1/20X3 4,500 495 4,005 4,238
1/7/20X3 4,500 254 4,246 – (Small difference due
to rounding)
Income statement
In the income statement for 20X1 a finance charge of £2,072 will be
shown. This is made up of the amount of £1,137 deemed paid on 1 July
20X1 and an accrual for the finance charge of £935 payable on 1 January
20X2 (but which relates to the six months from 1 July 20X1 to 1 January
20X2). There will also be a depreciation charge.
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Activity 12.2
On 1 January 2010 EZH Plc entered into the following lease agreements with Lease
Services Ltd:
a. The rental of plant ‘Z’. The lease was for four years, with a quarterly rental of £3,864
payable in advance, the first payment being due on 1 January 2010. The fair value of
the plant is £50,000. EZH Plc is responsible for all repairs and maintenance of the
plant, which has a useful life of four years with no residual value.
b. The rental of plant ‘Y’ for five years at a quarterly rental, payable in arrears, of
£2,420, the first payment being due on 31 March. The plant has a useful economic
life of five years, with no residual value, and EZH is responsible for all repairs and
maintenance. The interest rate implicit in the lease is 3% per quarter.
EZH’s depreciations on all its non-current assets are on a straight-line basis.
Show how the above transactions will be reflected in the income statement of EZH Plc for
the year ended 31 December 2010 and its balance sheet at that date in accordance with
standard accounting practice.
A solution is provided in Appendix A.
Activity 12.3
Helena Plc acquired an item on a lease with the following conditions:
• 10 annual instalments of £20,000 each, the first payable on 1 January 2010.
• The machine was completely installed and first operated on 1 January 2010 and its
purchase price on that date was £160,000.
• The machine has an estimated useful life of 10 years at the end of which it has no
value.
Calculate the charges to the income statement for 2010 and 2011 if this is treated as an
operating lease.
A solution is provided in Appendix A.
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Table 1: IFRS 16’s effect on Card Factory (London Stock Exchange: FTSE 250)
Year to end January 2019 (£m)
The balance sheet The income statement
Actual IFRS 16 Actual IFRS 16
Non-current assets 362 362 Revenue 436 436
Ebitda (Earnings before
Leased assets – 127 interest, tax, depreciation 89.4 132.4
and amortisation)
Current assets 93 93 Depreciation –10.9 –37.9
Total assets 455 582 Operating profit 78.5 94.5
Debt 144 144 Interest –3.9 –17.9
Lease liabilities 0 145 Pre-tax profit 74.6 76.6
Other liabilities 83 83 Tax –14.5 –14.5
Equity 228 210 Net profit 60.1 62.1
Debt/equity (%) 63 188 EPS (p) 17.6 18.2
Net debt/Ebitda (Earnings
before interest, tax, 1.58 2.15 Profit margin (%) 18.0 21.7
depreciation and amortisation)
Return on capital (%) 21.1 18.9
(Source: Ryland, P. ‘Debt by any other name’, Investor’s Chronicle, 15 August 2019.)
Carefully analyse the excerpts to Card Factory’s balance sheet and income statement above (year end 31 Jan 2019)
in Ryland, P. ‘Debt by any other name’, Investor’s Chronicle, 15 August 2019, p.33. (Available in the Online Library.)
• What are the major effects of IFRS 16 on the company’s balance sheet (Statement of financial position) and
income statement?
• How would this change the perspective of an investor?
• The company’s profits (net profit/profit margin) and total assets has increased. If you are an investor, do you
see this as a good thing?
Solutions are provided in Appendix A.
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Activity 12.5
• Kostolansky, J. et al., ‘Financial reporting impact of the operating lease classification’,
The Journal of Applied Business Research 28 (6) 2012, pp.1509–514.
• In particular, pay example to the data presented in Tables 1 and 2 and the following
questions:
1. What is the sample of companies used in the analysis?
2. What is the hypothetical impact in capitalising operating leases on key financial
ratios?
3. What are the industries most affected by the capitalisation?
4. How does the analysis by Kostolansky et al. (2012) relate to the discussion
surrounding the transition from IAS 17 to IFRS 16?
Discount rate
N 3% 6% 9%
Average % Increase in
Total Assets
Full Sample 3,064 11.09% 9.89% 8.91%
Total Assets > $25M 2,808 10.68% 9.48% 8.50%
Total Assets > $100M 2,513 10.54% 9.34% 8.36%
Average % Increase in Total
Liabilities
Full Sample 3,064 25.20% 22.53% 20.32%
Total Liabilities > $5M 2,891 24.21% 21.60% 19.44%
Total Liabilities > $100M 2,114 20.23% 17.94% 16.06%
Average % Increase in
Debt-to-Assets
Full Sample 3,064 10.68% 9.83% 9.09%
Total Assets > $25M 2,808 10.49% 9.64% 8.90%
Total Assets > $50M 2,678 10.12% 9.29% 8.57%
Average % Decrease in
Return on Assets
Net Income > $0 2,189 –7.35% –6.75% –6.23%
Total Assets > $10M/Net
2,121 –7.17% –6.58% –6.06%
Income > $1M
Total Assets > $100M/Net
1,788 –6.91% –6.33% –5.82%
Income > $10M
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Chapter 12: Leases
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Chapter 12: Leases
Question 12.2
What is the intended effect of introducing IFRS 16 to replace the existing
IAS 17 on Leasing? Critically evaluate the extent to which IFRS 16’s
principles are based on the IASB’s conceptual framework principles.
Question 12.3
Refer to Elliott and Elliott (2019) and attempt Question 2 in Chapter 18
(pp.481–482). Solutions are provided in the textbook.
Question 12.4
Discuss off balance sheet finance and substance over form, covering
the importance of these concepts, the issues leading to the need for the
concepts and the impact they have on financial statements. Illustrate your
answer with two examples.
See Appendix A for an outline of a solution.
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Notes
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Chapter 13: Intangible assets and goodwill
13.1 Introduction
An intangible asset is defined in IAS 38 Intangible assets (para.8) as ‘an
identifiable non-monetary asset without physical substance’. The IASB’s
conceptual framework (FPPFS) states that assets are resources controlled
by an enterprise as a result of past events from which future economic
benefits are expected to flow to the enterprise. Such assets are not
recognised unless the future economic benefits are ‘probable’ and it is
possible to measure the cost of the asset reliably. Certain items which you
may think of as intangible assets are excluded (i.e. can not be capitalised
as assets) as not meeting the recognition criteria, for example research,
training, advertising, internally generated brands, publishing titles,
customer lists and internally generated goodwill. Those intangible assets
that meet the recognition criteria commonly include the following (note
that the list of intangibles below is not exhaustive):
• purchased brands and their associated trade marks
• patents
• copyrighted material
• customer contracts (and customer relationships under certain
circumstances)
• databases
• computer software
• licences and franchises
• development assets.
Businesses have changed over the past 30 years, and now spend relatively
high levels of expenditure on intangible assets (e.g. brands, goodwill,
R&D, website development, software, etc.) that were not previously
commonplace.
For example, John Wood Group PLC’s intangible assets are valued in
their 2019 consolidated balance sheet (see 2019 Report and Accounts,
p.112) at $6,299 million – more than half (50.7%) of total assets. These
intangibles consist of goodwill, software and development costs, customer
contracts and relationships, order backlog and brands (see 2019 Report
and Accounts, Table 9, p.133). Goodwill itself (net book value = $5,208.9
million) is nearly 83% (5208.9/6299) of the total net book value of the
group’s intangibles. Note that the group uses the terminology ‘balance
sheet’ instead of ‘statement of financial position’.
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13.2.1 Definition
The IASB’s conceptual framework (FPPFS) defines an ‘intangible asset’
as an ‘identifiable non-monetary asset without physical substance’. This
is expanded to state that an asset meets the identifiability criterion in the
definition of an intangible asset when it:
• is separable, that is, is capable of being separated or divided from
the entity and sold, transferred, licensed, rented or exchanged, either
individually or together with a related contract, asset or liability; or
• arises from contractual or other legal rights, regardless of whether
those rights are transferable or separable from the entity or from other
rights and obligations.
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13.2.3 Amortisation
The general accounting treatment of intangibles other than goodwill is:
1. for the asset to be initially recognised at cost or fair value (which
is subjected to the existence of active markets in which the asset is
traded)
2. amortise the capitalised value of the intangible asset over its useful
life.
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IAS 38 states:
The depreciable amount of an intangible asset with a finite
useful life shall be allocated on a systematic basis over its useful
life. Depreciable amount is the cost of an asset, or other amount
substituted for cost, less its residual value. Amortisation shall
begin when an asset is available for use i.e. when it is in the
location and condition necessary for it to be capable of operating
in the manner intended by management. Amortisation shall
cease at the earlier date that the asset is classified as held for
sale… in accordance with IFRS 5… and the date that the asset
is derecognised. The amortisation method used shall reflect
the pattern in which the asset’s future economic benefits are
expected to be consumed by the entity. If the pattern cannot be
determined reliably, the straight-line method shall be used.
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Chapter 13: Intangible assets and goodwill
Activity 13.1
Map Plc has provided you with the following information on research and development
projects:
Project A
Project A is a new project which has just been started in 2018 and the company spent
£200,000 on the new project during the year. The directors of Map Plc are very excited
by initial results and think that in 5 years’ time they will be able to develop some new
products based on the initial results.
Project B
Project B has been running for several years and accumulated costs on this project at the
start of 2018 are £5,000,000. The project relates to the development of a new product
which is in the final stages of testing before being manufactured for sale to customers.
The prototype product has worked well and the directors of Map Plc are sure that the
product is technically feasible. The directors expect that the product will be very successful
and are happy to provide technical and financial resources to complete the project. The
costs of the project during the year can be reliably measured and include the following:
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The testing equipment is depreciated using a rate of 20% on the straight line basis.
Required:
a. Define research and development and discuss the accounting treatment of research
and development.
b. Show how project A and B will be treated in the financial statements. Give reasons
for your answers.
A solution is provided in Appendix A.
13.3.1 Definition
Research costs and development costs are generally distinguished as
different types of costs in accounting standards. This distinction is
important because different accounting treatments could apply. IAS 38,
para 8 defines the different costs as follows (which is comparable with the
UK and US standards):
Research is original and planned investigation undertaken with
the prospect of gaining new scientific or technical knowledge
and understanding.
Development is the application of research findings or other
knowledge to a plan or design for the production of new or
substantially improved materials, devices, products, processes,
systems or services prior to the commencement of commercial
production or use.
Classification Accounting
Research (pure and applied) Write-off through income statement
Development (not meeting stringent criteria) Write-off through income statement
Development (meeting stringent criteria) May be capitalised as an asset
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Activity 13.2
Suppose a company has incurred a total of £500,000 on a project that meets the
recognition criteria to be classed as development (capital) expenditure. In the non-current
assets section, a deferred development expense will be set up with the initial recognised
amount of £500,000. From the year when the developed product is sold, the company
would amortise this development over its intended duration of sales.
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Goodwill
Goodwill is initially recognised based on the accounting
policy f or business combinations (see note 21). Goodwill
is subsequently measured at cost less amounts provided for
impairment.
Intangible assets
Separately purchased intangible assets are initially measured
at cost, being the purchase price as at the date of acquisition.
On acquisition of new interests in group companies, Unilever
recognises any specifically identifiable intangible assets
separately from goodwill. These intangible assets are initially
measured at fair value as at the date of acquisition.
Development expenditure for internally-produced intangible
assets is capitalised only if the costs can be reliably measured,
future economic benefits are probable, the product is
technically feasible and the Group has the intent and the
resources to complete the project. Research expenditure to
support development of internally-produced intangible assets is
recognised in profit or loss as incurred.
Indefinite-life intangibles mainly comprise trademarks and
brands. These assets are not amortised but are subject to a
review for impairment annually, or more frequently if events
or circumstances indicate this is necessary. Any impairment is
charged to the income statement as it arises.
Finite-life intangible assets mainly comprise software, patented
and non-patented technology, know-how and customer lists.
These assets are amortised on a straight-line basis in the income
statement over the period of their expected useful lives, or the
period of legal rights if shorter. None of the amortisation periods
exceeds ten years.
The excerpts to John Wood Group PLC’s Annual Reports (2019, p.119)
provide an illustration of the group’s accounting policies on the treatment
of intangibles and goodwill, which includes an estimation of the useful life
for certain intangible assets.
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Chapter 13: Intangible assets and goodwill
Activity 13.3
Drawing on principles from the IASB’s conceptual framework (see Chapter 1) and from
arguments presented in this chapter and your textbook (e.g. Activity 13.2), summarise
the strengths and limitations (using a table if it helps) of the following approaches in
accounting for (i) purchased goodwill; (ii) internally generated goodwill; (iii) research and
development; (iv) all other intangible assets.
a. capitalisation and predetermined life; amortisation expense to the income statement
b. capitalisation and predetermined life; amortisation expense to (profit) reserves
c. capitalisation and annual review
d. immediate write-off to reserves
e. immediate write-off to the income statement.
In other words, you should construct a table with the following:
Issue (i) Purchased (ii) Internally (iii) (iv) All other
goodwill generated Research & intangible
goodwill Development assets
Treatment
(a) Strengths: Strengths: Strengths: Strengths:
Limitations: Limitations: Limitations: Limitations:
(b) Strengths: Strengths: Strengths: Strengths:
Limitations: Limitations: Limitations: Limitations:
(c) Strengths: Strengths: Strengths: Strengths:
Limitations: Limitations: Limitations: Limitations:
(d) Strengths: Strengths: Strengths: Strengths:
Limitations: Limitations: Limitations: Limitations:
(e) Strengths: Strengths: Strengths: Strengths:
Limitations: Limitations: Limitations: Limitations:
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Activity 13.4
Go to https://www.accaglobal.com/gb/en/technical-activities/technical-resources-
search/2015/february/frs-102-intangibles-goodwill.html. Read this to understand the
historical development of accounting for goodwill in the UK. (Although our aim is not
to emphasise UK-specific standards/discussions, due to the UK’s role in international
standard setting, understanding its historical development has general implications as the
international development of standards on goodwill and intangibles).
What does this tell you about how accounting standards are developed? Who were or
are the key players in the standard-setting process and what were their arguments for
favouring a particular accounting treatment for goodwill? What do you think were the
underlying or implicit reasons why these key players were upset with the standard-setter’s
explanation for removing the option to expense goodwill immediately?
3. capitalisation and annual review for impairment (IFRS 3, revised IAS 38)
4. immediate write-off to reserves (SSAP 22)
5. separate write-off reserve
6. separate write-off reserve with recoverability assessment
7. immediate write-off to the income statement
8. annual revaluation to incorporate non-purchased goodwill created.
Comments on the various treatments:
1. Straightforward application of matching principle, which emphasises the
income statement approach previously used in the UK. Now no longer in
favour as the IASB has decided to take the FASB approach of option (3).
2. Amortisation is a form of expense in the current period, so to write it off
against profit reserves earned in other periods contradicts the matching
principle.
3. Current treatment: potential for double-counting, as impaired asset
written down, but there is also an added implicit cost to maintaining
the asset’s value. Elliott and Elliott (2019) also suggests that this is a
net realisable value approach that emphasises the statement of financial
position. The issue is that the asset is only being impaired after its value
has been reduced, therefore mismatching the consumption of the goodwill
asset (which is at the time in which the asset is producing the highest
profits) with the recognition of its expenses (which comes after the asset’s
productive capacity is in decline).
4. Assumes asset does not exist and overly conservative; could lead to
over-stated profitability ratios in subsequent accounts when reserves are
immediately reduced. This approach also suggests that the timing of the
asset’s consumption (use) and its (eventual) accounting recognition are
mismatched.
5. Same problem as in (4), where it is assumed that goodwill as an asset
does not exist, but where it is still ‘accounted’ for (recognised) in the
creation of a special profit reserve to indicate that diminution in reserves
is solely due to goodwill. This can be confusing and does not improve on
(4).
6. Same problems as in (4) and (5), but even more confusing when goodwill
as an asset may reappear at a later date after being written-off and
languishing in a written-off reserves account. Method (3) is a much easier
way of conditionally retaining goodwill as an asset but allowing for write-
down values if it is judged that the asset is impaired.
7. Same problem as in (4), but further distorting measurement of current
year’s performance as write-off does not distinguish gains from profits
(i.e. income generated during the normal course of business).
8. Consistent with the idea of fair value approaches to accounting, but it is
a subjective measure that is open to abuse. Also potentially contradictory
with other standards (e.g. on research and development) that disallow
the creation of an intangible asset without a transaction occurring.
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If, and only if, the recoverable amount of an asset is less than its
carrying amount, the carrying amount of the asset shall be reduced to
its recoverable amount. This reduction is an impairment loss (IAS 36,
para.56) to be recognised in the income statement.
When impairment is applied to an asset with a finite useful life, ‘after the
recognition of an impairment loss, the depreciation (amortisation) charge
for the asset shall be adjusted in future periods to allocate the asset’s
revised carrying amount, less its residual value (if any), on a systematic
basis over its remaining useful life’ (IAS 36, para.63).
An important distinction relevant for the discussion here is the
introduction of a cash-generating unit (CGU), which is the smallest
identifiable group of assets that generates cash inflows that are largely
independent of the cash inflows from other assets or group(s) of assets.
If, for example, it is not possible to estimate the recoverable amount of an
individual asset, an entity should determine the recoverable amount of
the CGU to which the asset belongs (IAS 36, para.66). This determination,
however, is a call to exercise judgement.
There are, however, some concerns that the impairment is rather costly
and complex, with the IASB considering the merits (or otherwise) of
reintroducing amortisation as a way to deal with the diminution of the
value of goodwill. This was met by concerns from the US standard setter
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Activity 13.5
Example 1
A machine has a net book value of £170,000. It has 4 years remaining as its useful
economic life. The company estimates that it can produce a net cash flow of £50,000 for
the next 4 years if it is continued to use in its operations. Alternatively, it can be sold for
£100,000 now. Cost of capital = 10%. How much impairment loss should be recognised?
Value in use (VIU) = 50,000 × Annuity (4 years at 10%) = 50,000 × 3.1699 = £158,493
Recoverable amount = higher of VIU or net realizable value. As VIU = £158,493 > NRV
= £100,000, the recoverable amount = VIU.
Since the carrying value exceeds the recoverable amount, the impairment loss recognized
is 170,000 – 158,493 = £11,507 in the comprehensive income statement and the asset’s
carrying value should be reduced to £158,493 in the statement of financial position.
Example 2
A mining entity owns a private railway to support its mining activities. The private railway
could be sold only for the scrap value and it does not generate cash inflows that are
largely independent of the cash inflows from the other assets of the mine. In this case, the
private railway will be included as part of the CGU together with the mine for the purpose
of the impairment review.
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Question 13.2
Define research and development activities. Compare and contrast the
accounting treatment of the research and development activities for the
two companies, Alpha and Beta and discuss how the different treatments
will impact the financial statements of both companies. How will the
different accounting treatments impact the net profit margin and the
gearing ratio?
Question 13.3
What are intangible assets? Discuss, and critically assess, IAS 38 in relation
to intangible assets. Illustrate your answer with two examples.
See Appendix A for a suggested approach.
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Notes
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Chapter 14: Revenue recognition (including construction contracts)
14.1 Introduction
14.1.1 Aims of the chapter
This chapter considers construction contracts and the forthcoming standard
on revenue recognition.
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Key considerations:
• Could the warranty be sold separately from the product and is it providing or does it
just provide assurance that the product won’t fail?
• Can the training services be sold separately?
See Appendix A for a suggested solution.
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No: Recognise revenue at the point in time at which control of the good
or service is transferred IFRS15.BC121: The analysis of when control
transfers is performed primarily from the perspective of the customer.
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Contracts Total
Data (£) 1 2 3 4 5
Contract revenue recognised 145 520 380 200 55 1,300
Contract expenses recognised (110) (450) (350) (250) (55) (1,215)
Contract costs incurred in period (110) (510) (450) (250) (100) (1,420)
Contract costs relating to future
0 60 100 0 45 205
activity
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Additional information:
For some of the above contracts (e.g. 2, 3 and 5), costs incurred during the
period relate to both current activity (i.e. contract expenses recognised)
and future activity.
There are two ways in which revenue for the period can be recognised.
In the proportion of cost method, for example, the contract revenues
recognised would be (110/200)*250 = 137.50 for Contract 1, and
(450/800)*1000 = 562.50 for Contract 2. As the contract revenues
recognised here are instead 145 and 520 respectively, these are probably
computed either on the basis of surveys of work performed or on the
proportion of physically completed contract work (55% for Contract 1 and
56.25% for Contract 2).
Income statement
a. An appropriate proportion of total contract value should be recognised
as turnover each year (contract revenue recognised). See contracts 1–5.
b. The costs incurred in reaching that stage of completion should be
matched with that turnover as cost of sales (contract costs recognised).
See contracts 1–5.
c. Under IAS 11, provisions (accruals) should be made for any
foreseeable loss on the contract as a whole (to the extent that such
loss has not already been recognised in matching turnover with
costs incurred under (a) and (b) above). In other words, 100% of
the expected loss on the entire contract is to be recognised, with
appropriate provisions made as an adjustment. The expected loss is
not to be apportioned using the percentage completion method. This
should be included as part of cost of sales. See contracts 4 and 5.
Contracts Total
Income statement (£) 1 2 3 4 5
Contract revenue recognised 145 520 380 200 55 1,300
Contract expenses recognised (110) (450) (350) (250) (55) (1,215)
35 70 30 (50) 0 85
Provision for losses on contracts (40) (30) (70)
Gross profit (loss) 35 70 30 (90) (30) 15
Under IFRS 15, however, no provision for any foreseeable loss is allocated.
Instead, it is treated as an onerous contract under IAS 37.
An onerous contract is a contract in which the unavoidable costs (i.e.
the lower of the cost of fulfilling the contact and any compensation or
penalties arising from failure to fulfil it) exceed the economic benefits
expected to be received under the contract.
Note that the definition of ‘unavoidable costs’ under an onerous contract
is still under discussion at the time of writing (see KPMG 2014, pp.10–11
and the IASPlus discussion of IAS37 [https://www.iasplus.com/en/
meeting-notes/ifrs-ic/2018/march/ias-37-onerous-contracts]).
The IASPlus discussion above notes that ‘Even if the overhead costs are
expected to give rise to operating losses, the expectation of losses would
not be enough to justify recognising a provision for those costs. Paragraph
63 of IAS 37 prohibits recognition of provisions for future operating losses.
Paragraph 64 explains that this is because future operating losses do not
meet the definition of a liability.’
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For costs that are not considered ‘unavoidable’, these are expensed as
incurred because it is treated as a cost to operate the business.
Note that under IFRS 15, the provision for foreseeable losses is not shown
in the statements.
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Chapter 14: Revenue recognition (including construction contracts)
Note that under IFRS 15, the provision for foreseeable losses is not shown
in the statements.
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Activity 14.3
Handy Plc has two construction contracts underway – Y and Z – which began on 1
January 2010. The position on each contract at 31 December 2010 was as follows:
Y Z
£’000 £’000
Contract price 4,000 6,000
Cost of work certified (recognised) 1,400 4,400
Costs carried forward 100 200
Value of work certified (recognised) 1,800 4,000
Estimated additional costs to completion 1,500 2,600
Progress billings (payments on account) 1,620 3,600
The cost of work certified equals costs incurred in reaching the stage of completion
represented by the value of work certified. The costs carried forward represent costs
incurred subsequently, but before the year-end.
Handy’s accounting policy is to recognise no profit until a contract is one-third complete
by value. Thereafter, it recognises each year a proportion of total expected profit,
measured as the difference between turnover for the year and cost of sales. Cumulative
turnover is calculated as the value of work certified except where the contract is not one-
third complete by value, in which case turnover is recorded at an amount equal to cost of
sales.
Show how each of these contracts will be reflected in the income statement and
statement of financial position of Handy Plc at 31 December 2010 in accordance with
standard accounting practice.
A solution is provided in Appendix A.
Activity 14.4
Read the example on the following website and pick out an instance where significant
judgement is applied: https://www.ifrsbox.com/example-construction-contracts-ifrs-15/
A solution is given in Appendix A.
Activity 14.5
Read the following excerpts from the annual reports of Utilitywise, which can be obtained
at https://beta.companieshouse.gov.uk/company/05849580/filing-history
• 2017 Annual Report, filed on 04 Apr 2018: Read pp. 2-10, 25-28, 32-38, 42-44 and 47;
• 2016 Annual Report, filed on 12 Jan 2017: Read first 2 unnumbered pages and
pp. 20-24.
1. What is the core business of Utilitywise and how does it generate its revenues?
2. What are the key assumptions in its recognition of revenues?
3. What is the key effect on revenue recognition in the transition from IAS 18 to IFRS 15?
4. How are the changes reflected in the Statement of financial position and cash flows?
Brief solutions are provided in Appendix A.
For more analysis, read: Burgess, K. ‘Utilitywise is a sorry tale that might yet serve
a purpose’. Financial Times, 17 February 2019, available at https://www.ft.com/
content/3f294d12-3081-11e9-ba00-0251022932c8 in the Online Library.
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A B
£’000 £’000
Contract price 8,000 4,000
Cost of work recognised (certified) 5,100 600
Costs carried forward 300 160
Value of work recognised (certified) 6,000 800
Estimated additional costs to completion 1,400 2,200
Progress billings (payments on account) 6,400 720
Question 14.2
Complete Question 6 in the Exercises section of Chapter 21 ‘Construction
contracts’ in Elliott and Elliot (2019).
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Chapter 15: Accounting for financial instruments (excluding hedge accounting)
15.1 Introduction
In this chapter, we consider accounting for financial instruments,
excluding hedge accounting.
Accounting for financial instruments was deemed an important accounting
issue by those representing the world’s stock exchanges. The IASB was
keen to promote its international standards through these exchanges and
sought a feasible way forward in relation to this area of accounting. While
achieving the issue of key standards, this is a complex area for financial
accounting and many issues continue.
In this chapter, we discuss the issues and reflect upon the standards by
reference to some key areas of accounting for financial instruments. Note
that there is a new IFRS 9 to replace IAS 39 effective on or after 1 January
2018. It does not significantly impact on the matters discussed here but is
worth assessing in terms of the detail of provisions.
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Chapter 15: Accounting for financial instruments (excluding hedge accounting)
Activity 15.1
Does the definition of equity and liabilities in the FPPFS help with the classification of
preference shares?
Discussion
IAS 32 follows a substance over form approach to determining whether
preference shares are equity or liability. For instance, preference shares
should be treated as a liability instrument if the following conditions are
attached to the shares:
i. Dividend payments are compulsory and paid regularly (e.g. annually).
ii. The share requires mandatory redemption by the issuer at a fixed
amount at a future date (i.e. there’s no option to keep the shares as
preference shares come the redemption date).
iii. Shares give the holder the option to redeem at a future event that is
highly likely to occur.
Activity 15.2
According to IAS 39, which of the following financial instruments should be classified by
the issuer as an equity instrument?
a. A company has issued a perpetual preference share redeemable only at the issuer’s
discretion. Dividend of 10% is paid annually provided that there are sufficient
distributable profits.
b. A company has issued a perpetual preference shares. Dividend of 8% on the
preference shares is paid if a dividend is paid on the ordinary shares of the company.
c. A company has issued a perpetual preference share carrying a fixed dividend rate
of 5%. If the dividend is deferred then the dividend will be accumulated for future
payout together with an additional interest at 20%.
d. A company has issued specific preference shares to its fund managers. They carry the
right to an annual payment based on 20% of the realised gains on the fund recorded
in the period.
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15.4.2 Definitions
IAS 32 classifies financial instruments into financial assets, financial
liabilities and equity instruments.
An equity instrument is ‘any contract that evidences a residual interest
in the assets of an entity after deducting all of its liabilities’.
A financial asset is:
any asset that is:
a. cash;
b. an equity instrument of another entity;
c. a contractual right:
i. to receive cash or another financial asset from
another entity; or
ii. to exchange financial assets or financial liabilities
with another entity under conditions that are
potentially favourable to the entity; or
d. a contract that will or may be settled in the entity’s
own equity instruments and is:
i. a non-derivative for which the entity is or may
be obliged to receive a variable number of the
entity’s own equity instruments; or
ii. a derivative that will or may be settled other than
by the exchange of a fixed amount of cash or
another financial asset for a fixed
iii. number of the entity’s own equity instruments.
For this purpose the entity’s own equity
instruments do not include instruments that are
themselves contracts for the future receipt or
delivery of the entity’s own equity instruments.
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15.4.8 Impairment
Financial assets measured at (amortised) cost have to be reviewed for
impairment at each statement of financial position date. The IASB has
moved to an expected loss model under IFRS 9. Impairments should be
reversed if the impairment loss decreases.
The following applied under IAS 39 but will not under IFRS 9: for loans/
receivables and held-to-maturity investments carried at (amortised) cost,
the impairment loss (not reversible) is measured as the difference between
the asset’s carrying amount and the present value of estimated future cash
flows using the original effective interest rate as the discount rate. For
available for sale assets measured at cost it is the same except the current
market rate of return for a similar asset is used as the discount rate (for
those, as is more typically the case, measured at fair value, an impairment
test is made at each reporting date) – this impacts on the amount included
in other comprehensive income that has to be recycled to profit or loss.
Example 15.2
Dafferty Finance lends £500,000 for two years at a compoundable annual
interest rate of 4%. The interest and principal amount are payable at
maturity (i.e. at the end of two years).
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Chapter 15: Accounting for financial instruments (excluding hedge accounting)
General &
Approach Interest simplified Credit adjusted
Under the previous approach, the loan interest was recognised in the profit
or loss account (20,000 in year 1, 20,800 in year 2, a total of 40,800).
Under the IASB’s revised approach to impairment however, the interest
income is recognised at an interest rate that takes into account the
premium a lender expects in return for the risk that the loan will default.
In this example, the risk premium is 4% – 2% = 2% per annum. The loan
interest recognised in the profit or loss account is 10,000 in year 1 and
10,200 in year 2, a total of 20,200 (reflecting the risk-free rate of 2%).
The incremental interest earned at 4% (over the 2% risk free rate) is
recognised as an ‘impairment allowance’ = 20,600.
Under the credit adjusted approach, ECL are used to calculate the
impairment allowance and risk adjusted interest.
• After initial recognition, the impairment allowance is adjusted, up or
down, through profit or loss at each statement of financial position
date as the probabilities of collection and recoveries change.
• If there is no default on the loan at the end of the period, expected
losses would fall to nil as the probability of non-payment declines and
impairment losses are reversed through the profit or loss account.
• If the loan becomes riskier, the probability of default is increased,
which increases ECL and the additional impairment allowance charges
through the profit or loss account.
• Should a default on the loan occur with no possibility of recovery of
any amount, ECL will equal that shortfall and the amount written off
in the profit or loss account.
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When to apply:
General approach
All other loans and receivables not covered by another approach
Simplified approach
Qualifying trade receivables, IFRS 15 contract assets and lease receivables
Credit adjusted approach
Assets that are credit impaired at initial recognition
Note that the credit adjusted approach applies very rarely. For instance,
when an entity acquires a loan or receivable that is ‘credit impaired’ at the
date of its initial recognition. An illustration would be when, in a takeover
of a (soon to be) subsidiary, the parent company acquires a loan at a deep
discount due to credit concerns.
IFRS 9 definition of an asset that is credit impaired (the list is
not exhaustive)
• Significant financial difficulty of the issuer or borrower
• A breach of contract (e.g. a borrower fails to make a contractually due
payment)
• It is becoming probable that the borrower will enter bankruptcy or
other financial reorganisation
• The disappearance of an active market for that financial asset because
of financial difficulties.
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Chapter 15: Accounting for financial instruments (excluding hedge accounting)
Example 15.3
On 1 January 2019 Marta Ltd issued a convertible debenture for £200
million carrying a coupon interest rate of 5%. The debenture is convertible
at the option of the holders into 10 ordinary shares for each £100 of
debenture stock on 31 December 2023. Marta Ltd considered borrowing
the £200 million through a conventional debenture that repaid in cash;
however, the interest rate that could be obtained was estimated at 7%,
therefore Marta Ltd decided on the issue of the convertible.
Question 1
Show how the convertible bond issue will be recognised on 1 January
2019 and determine the interest charges that are expected in the
statement of comprehensive income over the life of the convertible bond.
Solution
Convertible debenture 200 5%
(£m and coupon interest)
Conversion into number 10 100
of shares for each £
Standard debenture rate 7%
Equity value:
Proceeds less debt value 200 –183.60 = 16.4
Proceeds Debt value Equity value
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Question 2
Why would an investor be interested in subscribing (i.e. purchasing) to
Marta Ltd’s convertible debenture when the returns (i.e. coupon rate) is
only 5% per annum, when they are able to obtain 7% per annum through
investment in a more conventional debenture?
Solution
Investors may place a positive value the option to convert their debentures
into ordinary shares at the end of the debenture. Investors are therefore
willing to accept lower returns from ‘loan interest’ as they anticipate
that they will benefit from having the option to turn their debentures
into equity later on. This value is reflected in the interest premium of
(7 – 5 = 2%), which is valued as equity at £16.4m on the day of issue.
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Chapter 15: Accounting for financial instruments (excluding hedge accounting)
Example 15.4
On 1 January 2011 a company receives £835,500 on the issue of 8%
debentures with a nominal value of £1,000,000 redeemable at par on 31
December 2013. Interest payable on 31 December each year. The proceeds
are after all direct issue costs. Consequently, the company is paying
£80,000 per annum (8% of £1,000,000). However, 8% does not represent
the implicit interest rate, which needs to be calculated as follows:
The rate of interest implicit in this financing arrangement is found by
solving for r such that:
80,0000a¬ r6 + 1,000,000 = £835,000
(l + r)6
15.6 Disclosures
Per IFRS 7, the following disclosures are required:
• fair value of financial instruments (details regarding assets/liabilities
at fair value through profit/loss)
• qualitative as well as quantitative information on risk
• details of asset transfers
• details of offsets
• reclassifications
• carrying amounts by category
• collateral pledged/held
• defaults/breaches
• allowances for credit losses
• income, expenses, gains, losses.
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Question 15.2
A company has two investments. One, an investment in listed shares, is an
available for sale financial asset. The current market value is £6,000 but
the shares were bought for £10,000. The other is an investment in a three-
year bond with an amortised cost of £120,000 with a stated and effective
interest rate of 7% (current market rates are 10%). But after two years the
entity is not expecting the last year’s interest and expects only half of the
principal.
What impairment should be recorded in the accounts of the company?
A solution is provided in Appendix A.
Question 15.3
Aileen Ltd has loaned £100,000 to Maebh Ltd and £80,000 to Sorcha
Ltd on 1 January 2020, the start of the company’s financial year. Both
loans are at an annual rate of interest of 2.5% and the loan period is for
three years. The conditions of the loans are such that Aileen Ltd will only
receive all of the principal and (compounded) interest at the end of the
loan period (i.e. three years). In addition, Aileen Ltd can invest in risk-free
government bonds that pay 1.5% per annum, with principal and the total
interest payable at the end of three years.
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Notes
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Chapter 16: Accounting for groups: consolidated statement of financial position
16.1 Introduction
16.1.1 A group
When companies make fixed asset investments (e.g. purchase shares in
another company), it is important to determine how the investment should
be classified. The first distinction is whether or not the investment is a
subsidiary undertaking (or some other form, such as an associate, joint
venture or special purpose vehicle). Although all fixed investments are
treated identically in the holding company’s accounts, the way in which
these investments are treated in the consolidated accounts depends on
their classification. If a company holds a fixed asset investment that is
classified as a subsidiary undertaking then the investing company (the
parent/holding company) together with the investee company (the
subsidiary) are referred to as a group.
S
A more complex group is where H either holds several subsidiaries or
holds one subsidiary that then holds other subsidiaries:
H H
S S S
S
S
16.1.3 Why own other companies/entities?
There are numerous motives for acquiring or merging with other
companies, for example:
• For growth reasons: rather than growing internally by increasing
market share it may be cheaper and simpler to grow externally via
an acquisition of another company who may be, for example, your
competitor or supplier/distributor.
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• To prevent take-overs: the larger you are and the more complex your
business combination the lower the probability of your company
becoming a take-over target.
• Synergies, such as economies of scale.
• To acquire new sources of supply.
• To utilise financial strengths of an acquired company (e.g. tax credits,
borrowing capacity).
• To purchase undervalued assets.
• To reduce competition.
• ‘Irrational’ and other reasons, for example, ego, fashion or managerial
motives.
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Chapter 16: Accounting for groups: consolidated statement of financial position
Activity 16.1
At this stage, how do you think the investing company should account for this investment
in the accounts to illustrate the economic reality of the investment?
See if your answer changes following a review of this chapter.
Activity 16.2
Is there a difference if Company X acquires varying stakes in Company Y – say 1%, 25%,
51%, 75% or 100%? What are the important factors you would take into consideration
in differentiating between varying stakes? How would you account for these stakes? .
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16.2.2 Control
IFRS 10 removes the classification of the nature of the relationship of the
investing company and investees, focusing on control as the sole criteria
by which relationships between the investor and investee are defined.
IFRS 10 (para.5) defines the control of a parent (investing company) over
its subsidiary (investee) as:
• power over the investee
• exposure, or rights, to variable returns from its involvement with the
investee
• the ability to use its power over the investee to affect the amount of
the investor’s returns.
An investor has to have all three elements before they can conclude they
control the investee. The change in focus towards control means that, even
in the absence of the investing company having a majority (i.e. more than
50%) of the shares, control can still be exerted through other means (for
example, over dual class shares or other mechanisms).
There has been widespread recognition of the need to adopt a definition
for a subsidiary based on de facto control rather than de jure control. The
impending collapse of Enron in 2001 was hidden from investors for a
significant period due to the use of a number of special purpose entities
(SPEs) which were excluded from the consolidated accounts of Enron on
the basis that each did not qualify as a subsidiary undertaking, despite
Enron having de facto control over the operations of these SPEs.
IFRS 10 seeks to remedy the issue over the (non) consolidation of
SPEs by bringing into consideration issues such as the principal – agent
relationships and ‘economic substance’ notion.
The density of new criteria incorporated into IFRS 10 can be interpreted as
reflective of increasingly complex business transactions.
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Chapter 16: Accounting for groups: consolidated statement of financial position
Activity 16.3
Identify whether Big (B) exercises control over Small (S) in each of the following scenarios.
a. B has 30% voting rights of S. B also has an arragement with Outsider 1 (O1), who
has 25% of voting rights over S, that allows B to use all of O1’s rights.
b. B owns 30% of S and 100% of O1. O1 owns 25% of S.
c. B has 30% voting rights of S but can influence the appointment/removal of three out
of five directors of S.
d. B has 40% ownership of S but can cast a ‘golden share’ which allows it to have a
majority vote.
e. B has 45% voting rights of S but has special statutory rights to influence the
development of S’s financial and operating policies.
f. B has 49% voting rights of S.
g. B owns 30% of S.
h. B owns 30% of S and 40% of O1. O1 owns 60% of O2. O2 owns 70% of S.
A solution is provided in Appendix A.
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Following the publication of IFRS 5 (Non-current assets held for sale and
discontinued operations), a subsidiary for which control is intended to be
temporary is exempted from consolidation, if the subsidiary was acquired
and is held exclusively with a view to its subsequent disposal in the near
future (within 12 months); in such a case, the parent should account for
its investment in the subsidiary under IFRS 5 as an asset held for sale,
rather than consolidate it.
Kothari and Barone (2011, p.537), there are three models commonly used.
All examples are based on the following exemplar relationship:
Big (B) owns 60% of Small (S), its subsidiary. 40% of S is thus
controlled by non-controlling interest(s) or NCI (IFRS usage:
NCI was formerly known as minority interest. Accounting for
NCI will be discussed further on in this chapter).
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Activity 16.5
Parent P owns 80% of Subsidiary S. P issued £80 in new shares to fund the acquisition of
S. Prepare the consolidated accounts of the group using (i) the economic entity model; (ii)
the parent entity model; and (iii) the proprietary model.
£ £
P S
Assets
Net assets 500 100
500 100
Equity
Share capital 300 100
Retained earnings 200 0
500 100
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In all three examples, the equity of S is not included in the CSFP because
we view the consolidation from the vantage of H acquiring the net assets
of S.
In practice, life is not always as simple as the above example. Suppose
instead that the market price of H’s ordinary shares is £6 each rather
than £4 each. H is now issuing shares worth £3,600 (600 ordinary shares
× £6) to acquire a company whose net assets are worth only £2,400
(which equals their fair value). Consequently, we have to account for this
difference of £1,200 in the consolidated accounts, which is known as
purchased goodwill.
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cost £400 and is being fully depreciated over 10 years. At the time of
acquisition, the book value of the asset is £200, but its fair value is £300.
The asset will be depreciated in the consolidated income statement over
the remaining five years of its life at £60 each year, even though in the
subsidiary’s own accounts the depreciation is £40 each year.
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H Ltd S1 S2 CSFP
£ £ £ £
Non-current assets 6,000 2,400 3,600 12,000
Goodwill 320
Cash 4,000 4,000
10,000 2,400 3,600 16,320
Example 16.14
The statements of financial position for Hi Plc, Fi Ltd and Ti Ltd as at 31
December 2018 are given below:
£ Workings £000s
Non-current assets – land 4,500,000 870 + 3,630
Investments 465,000 4,200 – 2,505 –1,200 – 30
Goodwill 600,000
Share in A 1,824,000
3,000,000
Share capital 3,975900
Ret earnings 1,061,500
NCI 2,400,000 1,620 + 780
payables 21,600 24 – 2.4
interest payable 270,000 300 – 30
Bonds 10,729,000
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Workings:
Goodwill
S = £2,505,000 − 75%(£960,000 + £780,000) = £1,200,000.
A = £1,200,000 − 40%(£900,000) = £840,000.
Goodwill S = £600,000.
Impairment S = 50% × £1,200,000 = £600,000.
Impairment A = 50% × £840,000 = £420,000.
Net assets or H S A
equity and
reserves
£ £ £
Ret earnings 2,070,000 2,610,000 3,000,000
Purp (20,000) (90,000)
Interest payable (24,000)
Interest receivable 2,400
16.7 Discussion
Now that we have (hopefully!) mastered the core techniques of
consolidation, we return to our conceptual discussion focusing on the
way in which different models were developed to account for groups of
companies.
To recap: the ‘economic entity method’ is concerned with H as a whole,
and treats NCI as if it were part of equity (shareholding). The ‘parent
entity method’ treats NCI as if it were a liability – this is because its main
concern is to show the relationship between equity and net assets of
the business. The ‘proprietary method’ does not include any NCI in the
calculations, but only includes the proportion of net assets that H owns/
controls in the consolidation. Differences in the value of the CSFP arise
between these methods when H acquires less than 100% of S.
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£ £
NCI (20% × £2,625) 525
Recap that the economic entity approach treats the NCI as if it were
another shareholder in the group, and therefore considers the entire
fair value of S’s net assets as part of the group. The emphasis here is on
showing how the entire entity’s assets are utilised and funded.
The parent entity approach only considers the share of S’s net assets that
are within control of the group, and the perspective means that some of
the goodwill attributable to NCI is not represented on the CSFP, unlike in
the economic entity approach.
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£ £ £
NBV FV CSFP
Goodwill 20
We see that the proprietary entity only shows the proportion of S’s net
assets controlled, completely removing NCI.
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Chapter 16: Accounting for groups: consolidated statement of financial position
Question 16.1
Widget Plc is a long-established widget company. In 2011, Widget made
an offer for the share capital of Gidget Plc, one of its competitors. Widget’s
offer was accepted by Gidget’s shareholders and became unconditional on
1 July 2011, when Widget issued one of its ordinary shares in exchange
for every two ordinary shares in Gidget. Widget took advantage of the
merger relief provisions in its own accounts. Following the transaction, the
businesses of the two companies remained within their existing corporate
entities, but Widget was renamed ‘Widget-Gidget Plc’ to reflect the
business combination.
The summarised financial statements of Widget Plc (from 1 July 2011,
Widget-Gidget plc) and Gidget Plc for 2011 with comparative figures for
2010 are as follows.
Widget Gidget
2011 2010 2011 2010
£m £m £m £m
Statement of financial
positions
Tangible non-current assets 840 780 460 420
Investment in Gidget 80 – – –
920 780 460 420
Net current assets 160 140 120 80
1,080 920 580 500
Loan capital 200 200 160 160
880 720 420 340
Ordinary shares of £1 480 400 160 160
Income statement 400 320 260 180
880 720 420 340
Income statements
Sales 2,540 1,960 1,520 1,380
Cost of sales 1,420 1,080 840 760
Gross profit 1,120 880 680 620
Other expenses 820 600 520 584
Profit before taxation 300 280 160 36
Taxation 100 120 80 12
Profit for the financial year 200 160 80 24
Gidget rather than their existing book value would be to increase the
depreciation charge in a six-month period by £8 million.
3. The market price of the ordinary shares in the companies on the
following dates was:
Widget Gidget
31 December 2010 £9.00 £1.50
1 July 2011 £9.50 £4.75
31 December 2011 £13.50 N/A
4. In the financial statements for 2010, the reported figures for earnings
per share of the companies were: Widget 40p, Gidget 15p.
Prepare summarised consolidated statements for Widget-Gidget Plc for
2011 using acquisition accounting.
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Chapter 17: Accounting for groups: consolidated income statement, associates and joint ventures
17.1 Introduction
17.1.1 Aims of the chapter
This chapter builds on Chapter 16 and considers how to construct the
consolidated income statement between two or more entities. It also
considers other types of group combinations, such as associates and joint
ventures. Throughout the chapter, guidance will be given as to how to
apply these accounting techniques. We will also consider the effect on the
accounts of employing these different approaches, including the effect on
the perception of users of financial statements.
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Note that the line-by-line addition goes down only to the profit for the
financial year. In the statement of changes in equity (SoCE), where
previous years’ retained profits are accumulated with the current year’s
it is dangerous to add together the figures for retained profits brought
forward, as it is likely that some of the subsidiary’s retained profits are
pre-acquisition. Only post-acquisition profits may be included in group
retained profits brought forward.
For example, if S had been acquired by H on the first day of the financial
year, S’s entire retained profits brought forward of £400 would be pre-
acquisition1, and the SoCE would show retained profits carried forward at 1
Remember that
the end of the year of £2,000 being: pre-acquisition reserves
are included in the
Group profits for the year as above £1,000 analysis of equity for S
for the determination of
Retained profits brought forward (=H’s retained profits) £1,000
goodwill.
Group retained profits carried forward £2,000
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We can check that the profit for the financial year is correct since it must
equal the total profit for the year for H plus half of the profit for the year
for S. Therefore:
£
Profit for the year for H 600
Six months of S’s profit for the year 200
800
In preparing an analysis of S’s equity to determine any goodwill arising
on consolidation, it is necessary to reflect in the calculations that S has
been acquired part-way through the year, by including the appropriate
proportion of S’s profits arising during the year of acquisition, up to the
effective date of acquisition, as pre-acquisition profits.
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Suppose that H owns 60% of the ordinary shares of S, which has been a
subsidiary throughout the year. Then the NCI in S’s results after taxation is
40% × £400 = £160 (the £400 being S’s profit for the year ending
31 December 20x1).
H Ltd S Ltd CIS
£ £ £ £ £ £
Sales 3,600 2,400 6,000
Cost of sales:
Opening inventories 200 300 500
Purchases 2,200 1,300 3,500
2,400 1,600 4,000
Closing inventories 400 2,000 200 1,400 600 3,400
Gross profit 1,600 1,000 2,600
Expenses 600 300 900
Profit on ordinary activities
before tax 1,000 700 1,700
Taxation 400 300 700
Profit for the financial year 600 400 1,000
Non-controlling interest (NCI) 160
Profit for the year attributable to shareholders in H Ltd 840
Similarly, if H sold goods to S for £200 which had originally cost £100,
and then S sold them to a third party for £300 then we need to eliminate
the inter-company sale of £200 and the purchase of £200 (because we
only want to reflect the original cost to the group and the subsequent sale
outside the group). Otherwise, we would overstate the purchases and sales
of the group – although, as you will notice in the example below, this does
not affect the total group’s gross profit.
17.3 Dividends
A somewhat more complicated situation arises when a subsidiary pays a
dividend to the holding company. This dividend, being inside the group,
must be eliminated. Where the dividend is paid during the year, and
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£
Gross profit of H 1,600
Gross profit of S 1,000
2,600
Less: unrealised profit at 31 December 20x1 20
2,580
Add: unrealised profit at 1 January 20x1 now realised 40
Gross profit 2,620
As well as adjusting the CIS for unrealised inter-company profits, it is also
necessary to adjust the CSFP, so as to show inventories at original cost to
the group as a whole. Thus, unrealised profits on inter-company trading
must be eliminated from the amount at which inventory is shown in
the CSFP. In the above example, the inventory shown on the CSFP at 31
December 20x1 would be £580, eliminating the unrealised profits of £20,
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and the group retained profits on the CSFP would also be reduced by £20.
Where a wholly owned subsidiary sells goods to its holding company, the
same adjustment must be made (i.e. if S sells to H).
IAS 28 provides that an entity holding 20% or more of the voting rights
should be presumed to exercise a significant influence unless the contrary
is shown.
If an investor holds, directly or indirectly (e.g. through subsidiaries),
20% or more of the voting power of the investee, it is presumed that the
investor has significant influence unless it can be clearly demonstrated
(through other means) that this is not the case. Conversely, if the investor
holds, directly or indirectly (e.g. through subsidiaries), less than 20% of
the voting power of the investee, it is presumed that the investor does not
have a significant influence, unless influence can be clearly demonstrated
(through other means). A substantial or majority ownership by another
investor does not necessarily preclude an investor from having significant
influence.
In terms of disclosure of associates, IFRS 12 Disclosure of interest in other
entities requires investors to disclose information to enable investors to
evaluate the risks of the parent company’s dealings with its associates. This
disclosure can take the form of information in financial statements, as well
as narrative disclosures on the nature of the relationship
14,000 4,000
Net current assets 4,000 2,000
18,000 6,000
Loan capital 6,000 3,000
12,000 3,000
12,000 3,000
Step 2: Add the cost of the investment with the share of post-acquisition
profits
£
Consideration (cost of the investment) 1,400
H’s 40% share of post-acquisition profits 80
Investment in associated company 1,480
Therefore, within the CSFP the associate will be valued at £1,480 and will
be placed beneath the tangible non-current assets.
Extract from the CSFP
£
Non-current assets
Tangible non-current assets 12,600
Investment in associated company 1,480
14,080
Step 3: Calculate the group’s share of profits or losses from the associate
£
Share of the profits before interest and taxation 200
[40% of 500]
Taxation [40% of £100] 40
Therefore, within the CIS the share of the associate’s profits will be
included and placed beneath the group’s operating profit. Note that the
share of the associate’s tax will be added to the total tax for the year.
Extract from the CIS
Operating profit 1,320
Share of profits of associated company 200
1,520
Taxation [400 + 40] 440
Profit for the financial year 1,080
Notes to the accounts: associated taxation 40
Thus, following the above workings, the consolidated accounts would look
as follows.
Statement of financial position as at
H A Group Notes
31/12/11
£ £ £
Tangible non-current assets 12,600 4,000 12,600
Investment in associated company 1,400 1,480 a
14,000 4,000 14,080
Net current assets 4,000 2,000 4,000
18,000 6,000 18,080
Loan capital 6,000 3,000 6,000
Net assets 12,000 3,000 12,080
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companies that have agreed the joint operations). In other words, all
parties to the joint operation have a share in the output of the venue.
For joint ventures, the rights to the net assets typically mean that
the venturers have a share of the overall profit or loss earned by the
(separate) company formed by the joint venture.
The following example illustrates how joint ventures should be accounted
for under the equity method (the previous requirement to use proportional
consolidation is discussed in Chapter 18).
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The interest income in Bread Ltd includes interest income on its 70%
holding of bonds issued by Cheese Ltd. Bread Ltd acquired these bonds
from Cheese Ltd, without any goodwill arising, on 1 January 2003. The
interest expense recorded by Cheese Ltd represents the interest on the full
bond issue. All companies have accounted for interest income and interest
expense correctly.
During the year Cheese Ltd sold goods costing £9,000 to Bread Ltd for
£63,000. 20% of this inventory is included in Bread Ltd’s inventory at the
year end.
During the year Cake Ltd sold goods costing £27,000 to Bread Ltd for
£36,000. 50% of this inventory is still in Bread Ltd’s inventory at the year
end.
Goodwill is capitalised. Impairment of 50% of the value of the goodwill of
Cheese Ltd was seen in 2010 and impairment of 20% of the value of the
goodwill in Cake Ltd is seen in 2015.
At the year-end Bread Ltd charges both Cheese Ltd and Cake Ltd a
management fee of 10% of turnover. None of the companies have
accounted for this management fee.
The retained earnings brought forward as at 1 January 2015 and dividend
expense for the year ended 31 December 2015 for Bread Ltd, Cheese Ltd
and Cake Ltd were as follows:
Question 17.2
How does accounting standards define a joint operation and a joint
venture? How would you distinguish between the two?
A solution is provided in Appendix A.
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Question 17.3
The Statements of financial position for Accrington PLC, Birmingham Ltd
and Crewe Ltd as at 31 December 2016 are as follows:
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Required:
Prepare a consolidated statement of financial position for Accrington
group for the year ended 31 December 2016.
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Notes
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Chapter 18: Accounting for groups: historical and alternative approaches
18.1 Introduction
18.1.1 Aims of the chapter
In this chapter, we consider historical and alternative approaches to
current standards in accounting for groups. These approaches are no
longer allowed under IFRS, but it is nevertheless instructive to understand
different perspectives on how groups of companies should be accounted
for.
We will revisit historical approaches such as the pooling method, which
was previously the standard for mergers between two equivalent
companies. We will also consider the principles behind proportional
(or proportionate) consolidation, which was previously used by IAS
31 to account for joint ventures and also used in countries such as the
Netherlands. Finally, we will recap the method of equity consolidation
that explicitly recognises the goodwill of the associate on consolidation
– the current method of equity consolidation does not show goodwill as
it implicitly embeds the figures within the net investment figure of the
associate.
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18.2.1 Definition
A merger is defined in para.2 of FRS 6 as:
A business combination that results in the creation of a new
reporting entity formed from the combining parties, in which
the shareholders of the combining parties come together in a
partnership for the mutual sharing of the risks and benefits of
the combined entity, and in which no party to the combination
in substance obtains control over any other, or is otherwise
seen to be dominant, whether by virtue of the proportion of its
shareholders’ rights in the combined entity, the influence of its
directors or otherwise.
In other words, there is a mutual agreement between two (or more)
companies to merge or pool their resources as equal partners, trading as
a combined group. This would need to be accompanied by an agreement
to exchange shares, so that the resources of the combined groups are the
aggregate of the individual companies’ resources.
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7,500
7,500
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10,000 4,000
On that date, A’s shares have a market value of £5 each, and A acquires all
the shares of B via a share-for-share exchange of three shares in A Ltd for
four shares in B Ltd.
The fair value of B’s net assets is agreed to be £5,000 at 31 December 2016.
Applying merger relief, the statement of financial position of A Ltd after
the acquisition would be (i.e. step 1):
A Ltd
£
Net assets 10,000
Investment in S 1,500 = (2,000 × 3/4)
11,500
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Note that:
• Fair values at acquisition date are ignored, and there is no goodwill to
capitalise, thus no amortisation/write-off.
• The income statements are simply added together.
• S is treated as if always part of the group (no pre-acquisition profits).
• All A’s retained profits are included in the consolidation statement of
financial position, whether pre- or post-acquisition.
• If there had been any inter-group items, these would have been
cancelled as usual.
• Any accounting policy differences need to be harmonised for the
purpose of consolidation.
Activity 18.1
Review the recommended texts so that you fully understand the difference between
the accounting treatment of subsidiary undertakings in both the consolidated income
statement and the consolidated statement of financial position under the acquisition and
merger methods.
Why do you think that an investing company might prefer to classify their investment as a
merger as opposed to an acquisition?
Activity 18.2
Given the information above about A and B what would the CSFP be if the share-for-
share exchange was three shares in A for two shares in B (instead of three shares in A for
four shares in B)?
Activity 18.3
Outline the main differences between the merger (pooling of interest) and acquisition
accounting methods and discuss the reasons why merger accounting has been
discontinued in favour of acquisition (full consolidation) methods.
Activity 18.4
On 1 January 2009, X Ltd merged with Y Ltd, with X Ltd gaining 90% of the shares of Y
Ltd, issuing ten shares in X Ltd for every four shares in Y Ltd. The summarised statements
of financial position of X Ltd and Y Ltd before the merger are given below:
X Ltd Y Ltd
£ £
Net assets 50,000 20,000
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14,000 4,000
Net current assets 4,000 2,000
18,000 6,000
Loan capital 6,000 3,000
12,000 3,000
12,000 3,000
Step 3: Calculate the group’s share of profits or losses from the associate
£
Share of the profits before interest and taxation [40% of 500] 200
Taxation [40% of £100] 40
Therefore, within the CIS the share of the associates’ profits will be
included and placed beneath the group’s operating profit. Note that the
share of the associate’s tax will be added to the total tax for the year.
Extract from the CIS
Operating profit 1,320
Share of profits of associated company 200
1,520
Taxation [400 + 40] 440
Profit for the financial year 1,080
Notes to the accounts: associated taxation 40
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Chapter 18: Accounting for groups: historical and alternative approaches
Thus, following the above workings, the consolidated accounts would look
as follows.
Statement of financial position as at H A Group Notes
31/12/11
£ £ £
Activity 18.5
Why was there a change from explicitly recognising goodwill of associates under IAS 28
(2003) towards an implicit system under the revised IAS 28 (2011) and IFRS 3?
Both implicit (i.e. the current standard IAS 28 (2011) – see Chapter 17)
and explicit (the previous standard IAS 28 (2003)) goodwill methods
produce the same result in the investment in associate of £1,480. However,
the explicit recognition method was relevant when goodwill amortisation
was allowable under IAS 28 (2003). With the change over to the implicit
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Activity 18.6
Note that this question uses the historical accounting standard IAS 28 (2003), which uses
an explicit goodwill approach and amortisation (rather than impairment) of goodwill for
Associates.
1. The profit and loss accounts for the year ended 31.12.2007 for Red Plc, Green Ltd and
Pink Ltd are given as follows:
Red Plc Green Ltd Pink Ltd
£ £ £
Sales 230,000 190,000 100,000
Cost of sales (60,000) (30,000) (20,000)
Gross profit 170,000 160,000 80,000
Administration costs (17,100) (14,000) (26,000)
Distribution costs (14,000) (22,000) (10,000)
Dividend receivable from Green Ltd and Pink Ltd 3,100
Red Plc acquired 80% of Green Ltd for £200,000 on 1.1.2004 when Green Ltd’s share
capital and reserves were £100,000. The share capital of Green Ltd equals £80,000.
Red Plc acquired 30% of Pink Ltd for £50,000 on 1.1.2005 when Pink Ltd’s share capital
and reserves were £20,000. The share capital of Pink Ltd equals £10,000.
Goodwill is capitalised and amortised over 20 years.
During the year Green Ltd sold goods to Red Plc for £10,000. These goods had cost Green
Ltd £2,000. 50% of these goods are with Red Plc at the year end.
During the year Pink Ltd sold goods to Red Plc for £8,000 and these goods had cost Pink
Ltd £4,000. 50% of these goods are with Red Plc at the year end.
Red Plc charges a management fee to Green Ltd and Pink Ltd of 5% of turnover – these
have been included in administration costs for Green Ltd and Pink Ltd and in the sales
figure for Red Plc.
Required:
Prepare the consolidated profit and loss account for Red Plc for the year ended 31.12.2007.
A solution is provided in Appendix A.
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CSFP
Statement of financial position H JV 10% of JV line-by-line
as at 31/12/11 £ £ £ £
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Let y equal the investor’s share, and (1–y) equal the ‘outside shareholders’
interest.
Income statement: R – C = π
Statement of financial position: A – L = E
Where R = revenues, C = costs, π = profit, A = assets, L = liabilities, E =
equity.
Basis of ‘equity accounting’ for investee:
Income statement: Bring in y(π)
Statement of financial position: Bring in y(E)
Whereas the basis of ‘proportional consolidation’ of investee is:
Income statement: Bring in y(R–C) = y(π)
Statement of financial position: Bring in y(A–L) = y(E)
Activity 18.7
Read the impact of the move away from proportional consolidation towards equity
accounting for all joint operations in No more proportionate consolidation for joint
ventures: (KPMG 2011), https://home.kpmg/content/dam/kpmg/pdf/2011/05/In-the-
headlines-O-201105-15.pdf
Question 18.2
Top-of-Prop Plc is a substantial property investment company. On 1
January 2011, Top-of-Prop subscribes for 40% of the share capital of £20
million in BestProp Plc, a new company set up to buy large buildings in
central London, which Top-of-Prop has agreed to manage. Top-of-Prop
appoints two of the five directors of BestProp. The other 60% of BestProp’s
shares are subscribed for by a large number of small private investors.
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The office building costs £200 million, of which £20 million is financed by
BestProp’s share capital and the remaining £180 million by loans, all of
which are fully guaranteed by Top-of-Prop.
The summarised 2011 accounts for Top-of-Prop and BestProp are as
follows.
Statement of financial positions as at 31 December 2011
Top-of-Prop BestProp
£m £m
Investment properties at valuation 400 240
Investment in BestProp at cost 8 –
Net current assets/(liabilities) 80 20
488 220
Loan capital (120) (180)
368 40
368 40
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Chapter 19: Accounting for foreign currency transactions and consolidation of foreign enterprises
19.1 Introduction
There are two main types of foreign currency operation:
• Direct business transactions denominated in foreign currency (e.g.
a contract to purchase a fixed asset from the USA where the price is
stated in $US).
• Foreign operations conducted abroad through a foreign enterprise
(e.g. subsidiary, associate or branch).
In each case a UK company will need to state these transactions in its
accounts in £UK. This exercise would be straightforward if exchange rates
were fixed.
In the first case, we must consider how an individual foreign transaction
should be accounted for if there is a change in exchange rates between the
time that the transaction was entered into and the time at which it was
settled.
In the second case, we must consider how the accounts of a foreign
operation (e.g. a branch or subsidiary) should be translated from the
foreign currency into the parent’s currency at the accounting year-end.
Translation is the process whereby financial data denominated in one
currency are expressed in terms of another currency. It includes both the
expression of individual transactions in terms of another currency and
the expression of a complete set of financial statements prepared in one
currency in terms of another currency.
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Example 19.1
Winterholder Plc purchased a pasta-making machine for $15,000 on 30
September 2011. On 30 September 2011 the exchange rate was £1:$2.
Winterholder Plc actually paid for the machine on 1 December 2011 when
the exchange rate was £1:$2.5.
• How should the non-current assets be recorded in the accounts of
Winterholder Plc?
• How should the difference on the exchange be treated?
The fixed asset is recorded at its historical cost at the date of the
transaction when the exchange rate was £1:$2. Therefore the fixed asset
will be recorded as £7,500 ($15,000/$2).
Dr Assets £7,500
Cr Trade payable £7,500
The cash payment is £6,000 ($15,000/$2.5), therefore there is a realised
gain on exchange of £1,500 (£7,500–£6,000). Following IAS 21, this gain
is credited to the income statement.
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Chapter 19: Accounting for foreign currency transactions and consolidation of foreign enterprises
Example 19.2
Winterholder Plc purchased a pasta-making machine for $15,000 on 30
September 2011. On 30 September 2011 the exchange rate was £1:$2.
Winterholder Plc actually paid for the machine on 1 December 2011 when
the exchange rate was £1:$1.5.
• How should the fixed asset be recorded in the accounts of
Winterholder Plc?
• How should the difference on exchange be treated?
Once again, the fixed asset is recorded at its historical cost at the date of
the transaction when the exchange rate was £1:$2. Therefore, the fixed
asset will be recorded as £7,500.
Dr Assets £7,500
Cr Trade payable £7,500
The cash payment is £10,000 ($15,000/$1.5); therefore there is a realised
loss on exchange of £2,500. Following IAS 21, this loss is charged to the
income statement.
Example 19.3
Winterholder Plc purchased a pasta-making machine for $15,000 on 30
September 2011.
On 30 September 2011 the exchange rate was £1:$2. At the statement
of financial position date of 31 December 2011 the exchange rate was
£1:$2.5. Winterholder Plc eventually paid for the machine on 31 January
2012 when the exchange rate was $1:$3.
• How should the non-current assets be recorded in the accounts of
Winterholder Plc?
• How should the difference on exchange be treated both at the balance
sheet date and in the following year?
The fixed asset is recorded at its historical cost at the date of the
transaction when the exchange rate was £1:$2. Therefore, the fixed asset
will be recorded as £7,500.
Dr Assets £7,500
Cr Trade payable £7,500
At the statement of financial position date the transaction is unsettled; it
shows a balance of £7,500. However, this is incorrect because if the debt
was paid at this date Winterholder Plc would only pay £6,000 ($15,000
÷ 2.5). Thus, according to IAS 21, this transaction should be translated
at the closing rate (see more about the closing rate later in Section 19.4),
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that is, the rate of exchange ruling at the statement of financial position
date. Therefore, an exchange gain of £1,500 (£7,500–£6,000) is credited
to the income statement for the year ending 31 December 2011.
Activity 19.1
What is the rationale for crediting exchange gains on unsettled transactions at the year-
end to the income statement? What would happen if the exchange rate at 31 January
2012 was £1:$1.5?
A solution is provided in Appendix A.
Example 19.4
Winterholder Plc trades in the USA and issues its price list in $. On 1
March it sells pasta to a US customer for $2,950 when the exchange rate is
$1:$2.95.
In Winterholder’s books the transaction will be recorded at the rate of
exchange ruling at the date of the transaction:
Example 19.5
Suppose that the sales Winterholder made to the US customer in Example
19.4 were not settled at the statement of financial position date. At the
statement of financial position date the exchange rate was £1:$2.5. How
would these be shown in Winterholder’s accounts?
The trade receivable of $2,950 would still be outstanding at that date. IAS
21 requires that the trade receivable of $2,950 be translated at the closing
rate (i.e. the rate of exchange prevailing at the statement of financial
position date, unless there is an agreed rate or matching forward contract).
The trade receivable would therefore appear in the statement of financial
position as £1,180 and there would be a gain on exchange of £180, which
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• Whether cash flows from the activities of the foreign operation directly
affect the cash flow of the reporting entity and are readily available for
remittance to it.
• Whether the cash flows from the activities of the foreign operations are
sufficient to service existing and normally expected debt obligations
without funds being made available by the reporting entity.
When the above indicators are mixed and the functional currency is not
obvious, management uses its judgement to determine the functional
currency that most faithfully represents the economic effects of the
underlying transactions, events and conditions (IAS 21, para.12).
The closing rate method is used where the foreign enterprises are
quasi-independent entities. The key determinant appears to be whether
or not the foreign enterprise operates primarily in the functional currency.
If this is the case, the closing rate method applies. This would be true for
most foreign business operations (typically subsidiaries).
If the functional currency is that of the investing company rather than the
foreign enterprise, the temporal method should be used.
Hence, the temporal method is to be used where the trade of the
foreign enterprise is more dependent on the economic environment of
the investing company’s currency than that of its own reporting currency.
By using the temporal method, the consolidated accounts reflect the
transactions of the foreign enterprise as if they had been carried out by the
investing company itself.
Activity 19.2
From an economic point of view, why might companies wish to set up a foreign subsidiary
or branch?
Activity 19.3
An entity operating in the Republic of Ireland owns several buildings in Dublin and Cork
that are rented to US multinational corporations basing the European offices there. The
contracts for the lease of the buildings are determined in US$ and payment can be made
either in US$ or Euros €. How is the functional currency determined?
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Activity 19.3
Why are these exchange differences recorded as movements in reserves rather than
included in the income statement? For instance, do differences reflect actual or
prospective cash flows? Think about these questions before reading further.
Activity 19.4
Why do you think these exchange differences are taken to the income statement, yet the
closing rate method’s exchange rate differences are taken to the reserves?
What is the difference in the nature of the exchange difference between the two methods
of translation?
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IAS 21 requires that the average rate should be used (£1:$10) to translate
the income statement into Radmond Plc’s presentation currency (£UK).
Activity 19.5
What would the net profit be if we used the closing rate (rather than the average rate) to
translate the income statement?
A solution is provided in Appendix A.
Current assets:
Inventory 4,000 12 333
Trade receivables 24,000 12 2,000
Cash 100,000 12 8,333
128,000 10,666
208,000 17,333
Share capital 200,000 5 40,000
Retained profit or (loss) 8,000 (= balancing figure) (22,667)
208,000 17,333
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IAS 21 requires that the exchange gain (loss) is taken to reserves. The
balancing figure inserted for the retained profit can thus be broken down
into movement in reserves:
Balance brought forward £–
Profit for the year £800
Exchange difference (£23,467)
(£22,667)
This exchange difference (£23,467) can be analysed in terms of the
exchange difference on the opening net investment and on the net profit.
Opening net assets at opening rate $200,000 @ £1:$5 = £40,000
Opening net assets at closing rate $200,000 @ £1:$12 = £16,667
Exchange loss on net investment (£23,333)
Activity 19.6
What would the exchange difference reconciliation be if the closing rate (rather than the
average rate) was used to translate the income statement?
A solution is provided in Appendix A.
Points to note
The share capital is translated at the historical rate applicable.
• IAS 21 argues that the exchange difference should be taken to equity:
‘movement on reserves’. It could be argued (conceptually) that the
gain on short-term monetary items should be taken to the income
statement and only the difference on translation relating to long-
term items should be taken to equity. This could be justified on the
following basis, using the old UK standard (SSAP 20):
If exchange differences arising from the retranslation of
a company’s net investment in its foreign enterprise were
introduced into the income statement, the results from
trading operations, as shown in the local currency financial
statements, would be distorted. Such differences may result
from many factors unrelated to the trading performance or
financing operations of the foreign enterprise; in particular,
they do not represent or measure changes in actual or
prospective cash flows. It is therefore inappropriate to
regard them as profits or losses and they should be dealt
with as adjustments to reserves.
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Current assets:
Inventory 4,000 5 800
Trade receivables 24,000 12 2,000
Cash 100,000 12 8,333
128,000 11,133
208,000 27,133
Points to note
• The depreciation is translated at the rate applicable to the non-current
assets.
• The net profit is the balancing figure from the statement of financial
position. The translation loss is the balancing figure that ensures a net
loss of £12,867.
Activity 19.7
Why do we use an exchange rate of $5 to £1 to translate inventory figures? (See earlier
in the chapter.)
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Points to note
• Monetary items are translated at the closing rate.
• Non-monetary items are translated at their original rate.
The exchange difference is taken to the income statement.
Example 19.8
Parent established a 100% ownership of Subsidiary on 1 January 2019
by acquiring GBP £40,000 worth of shares in cash, when the exchange
rate was Wongas (W$) = 12 for £1. The Subsidiary raised a long-term
loan of W$125,000 in the local (foreign) economy on 1 January 2019.
On the same day, the company acquired equipment worth W$400,000,
which is expected to last for a period of 10 years with no residual value.
Depreciation is to be accounted for on a straight-line basis. The relevant
exchange rates for 2019 were:
W$ to £
1 January 2019 15
Average for the year 12
Average closing inventory 10
31 December 2019 11
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Depreciation (40,000)
Other expenses (20,000)
Net profit for the year 85,000
* There was no balance of retained profits from prior years, so all profits are
from trading in 2019 only.
Question
Translate the accounts for the foreign operation using both the closing rate
and temporal rate method. Your calculations should clearly identify the
treatment for the exchange differences.
Solutions
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Practical tips:
Those attempting this question for the first time may find it easier, under
the Temporal Rate Method, to start with the statement of financial Position
first to work out the retained profits balancing figure, which can then be
used to calculate the Profit for the year.
For the Closing Rate Method, start from the income statement, which
would give you the figures you need to calculate the retained profits in the
statement of financial position, which is needed to calculate the (changes
to) translation reserve.
In this example, there was no prior retained profits nor translation reserve.
If either balance (or both balances) were carried forward from the prior
year, there would then be a need to adjust the carried forward balance
with the current year’s figures.
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Equity
Share capital 20,000 40,000
Share premium 10,000
Retained earnings 123,000 32,000
143,000 82,000
The exchange rates are as follows:
€ to £1
1 January 2019 1.30
Average for the year 1.20
Opening inventory 1.08
Closing inventory 1.10
31 December 2019 1.15
Required:
1. Prepare the consolidated income statement for the group.
2. Prepare a consolidated statement of financial position for the group,
showing:
a. The goodwill
b. The non-controlling interest
c. Hint: The group retained earnings can be calculated as a balancing
figure
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Solution
Equity
Share capital 20,000 40,000 1.15 34,783 20,000
Share premium 10,000 1.15 8,696
Retained earnings 123,000 32,000 1.15 27,826 87,957 c
Non-controlling interest 17,826 b
143,000 82,000 71,304 125,783
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Goodwill (notes a)
€’000 €’000 Rate £’000
Cost of investment 27,300 1.30 21,000
Share capital 40,000
Share premium 10,000
Retained earnings (at
acquisition) 14,000
64,000
Parent’s share of Subsidiary 48,000
Goodwill at date of
acquisition (20,700) 1.30 –15923.0769
Goodwill (restated to
year-end) (20,700) 1.15 –18000
Activity 19.8
From the workings in Example 19.9 above, reconcile the retained earnings figure,
showing the exchange gains or losses.
A solution is provided in Appendix A.
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Activity 19.9
• Why are the income statement retained profit figures different?
• What is the reasoning for the different outcomes produced by each method?
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Question 19.2
On 1 January 2010, Club Ltd acquired 80% of the ordinary shares of a
subsidiary, Golf Org for £900,000. Golf Org trades in ‘potts’. On 1 January
2010 the balance on the accumulated profits of Golf Org was 640,000
‘potts’ and the share capital of Golf Org was 4,800,000 ‘potts’.
The summary income statements and statements of financial position of
Golf Org are given as follows:
Statement of financial position as at 31 December 2016
Golf ‘potts’
Non-current assets 7,200,000
Inventories 300,000
Cash 1,220,000
Total assets 8,720,000
Share capital 4,800,000
Retained earnings 3,920,000
Capital and reserves 8,720,000
The following information is also available:
1. Non-current assets were acquired on 1 January 2010.
2. Opening inventories were acquired on 12 November 2015 and closing
inventories were acquired on 15 December 2016.
3. The net profit for 2016 in the statement of comprehensive income for
Golf Org is 580,000 potts.
4. Exchange rates:
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Notes
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Chapter 20: Analysis and interpretation of financial reports
20.1 Introduction
In this chapter we are interested in interpreting accounts. This chapter
extends the ratio analysis discussed in the subject guide for AC1025
Principles of accounting and includes a number of other approaches.
In short:
• Can you say something sensible about what the accounts mean?
• How can users of accounts interpret them in a meaningful way?
Ratio analysis should be used in conjunction with:
• business analysis (i.e. what is the company’s risk and what are its
profit drivers?), which enables you to place your ratio analysis
• accounting analysis (i.e. assess the accounting policies of the company)
• trend analysis
• review of other qualitative information (e.g. Chairman’s statement, the
Operating and Financial Review)
• comparison of income with cash flow information (i.e. is a company
reporting profits also generating cash?).
You are strongly advised to read International financial reporting, Chapter
30, to appreciate that ratio analysis is merely one of several forms of
analysis. It should not be conducted in isolation.
Activity 20.1
What problems could arise when defining a ratio such as return on assets?
Hints:
• What does ‘return’ mean? (Does it include interest received, exceptional/
extraordinary items; is it before or after tax?)
• What is included in assets (e.g. tangible/intangible assets, net/total)?
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Chapter 20: Analysis and interpretation of financial reports
Activity 20.2
a. The definition of capital employed is very important. Here it is defined as non-current
assets + current assets. Can you think of any alternative appropriate definitions? If so,
for what purpose are these used?
b. The gearing (or leverage) ratio measures the proportion of total financing provided by
long-term debt. Consider the arguments for and against using long-term, rather than
total debt in this ratio.
c. Explain what inventory days, trade receivable days and creditor days mean.
2016 2015
Return on equity Return on equity
17.8% (3,308/1,627) 9.4% (1,627/17,227)
ROCE ROCE
8.5% (3,308/39,016) 4.5% (1,627/35,896)
FLM FLM
2.09 (39,016/18,627) 2.08 (35,896/17,227)
The pyramid of ratios is a starting point for our analysis. The most obvious
changes are that the return on equity, ROCE and net profit margin have
nearly doubled from 2015 to 2016. The question is what is FJ Plc doing
better in 2016 than in 2015? The financial structure of FJ Plc (in terms of
the financial leverage multiplier) has not changed much, but the ROCE
appears to be driving the return on equity improvement. The increase in
ROCE could be due to either:
1. more productive assets (e.g. more productive non-current assets)
2. better control of trade receivables, inventory, creditors and so on
3. better margins (i.e. reduced costs or improved profitability).
As we can see, the net profit margin is driving the ROCE improvement.
How has FJ Plc managed to improve the net profit margin from 3.9% to
7.4%? We need to examine the gross profit margin, the administration
cost, and the distribution cost. It does not appear that the gross profit
margin is the main reason for the improved net profit margin.
Additional information
2016 2015
Administration expenses 9,600 9,370
Distribution expenses 6,494 7,600
Administration/sales 21.3% 22.3%
Distribution/sales 14.4% 18.1%
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Activity 20.4
This exercise combines the concepts of ratio analysis with real world concerns from the
chapter on leasing.
Read p.16 of the Effects Analysis (https://www.ifrs.org/-/media/project/leases/ifrs/
published-documents/ifrs16-effects-analysis.pdf) on the impact of the lease accounting
standard IFRS 16 replacing IAS 17.
Questions:
1. Of the industry sectors outlined in the document, which industry is forecasted to be
most affected by the move from IAS 17 to IFRS 16?
2. What is the implication of the move to IFRS 16 on the return ratios (Return on Capital
Employed; Return on Assets, etc.)?
3. What implication does the move to IFRS 16 have on the way in which debt is
reported? How would this change the debt ratios?
4. What is the implication on the overall profitability of a company the move to IFRS 16?
Solutions are provided in Appendix A.
Class of business
Turnover Gross profit
2016 2015 2016 2015
£’000 £’000 £’000 £’000
Paints 8,171 15,543 5,350 8,496
Explosives 9,382 6,133 4,802 2,659
Industrial chemicals 7,898 6,564 4,746 2,291
25,451 28,240 14,898 13,446
Merchanting 19,549 13,731 4,376 5,018
45,000 41,971 19,274 18,464
Initial observations suggest business changes. For instance, merchanting sales
are up by 42% but the gross profit on merchanting has fallen between 2015
and 2016. What is the explanation for this? Total sales for the three chemical
businesses have fallen but their gross profit has increased. Is the company
aware of this shift between the different classes of business?
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Activity 20.5
Calculate the gross profit change for 2016 and 2015 for all classes of business. Comment
on your results.
For the reason that segmental reporting provides an insight into the
(changing) composition of a company’s core business, large multinationals
like Unilever provide segmental information that summarises the
breakdown of their core activities. (Unilever, Annual report and accounts
(2019), pp.94–95, available https://www.unilever.com/investor-relations/
annual-report-and-accounts/archive-of-annual-report-and-accounts/)
The breakdown is by category within the three segments of their business
(Beauty & Personal Care, Foods & Refreshment and Home Care), by time
series (2017 to 2019), and by geographical area (Netherlands/UK, United
States and all others).
The turnover has increased each year over the past five years, but more
specifically we can calculate the percentage change each year or rebase
figures in terms of a 2006 index.
% change +1.6 +6.3 +6.5 +7.2
Index 100 102 108 115 123
Activity 20.6
a. Consider the possible effects of price changes on the use and interpretation of trend
analysis.
b. Consider how trend analysis could be adjusted for inflation. What measure
of inflation might be used to adjust sales and profit figures in a trend analysis?
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Activity 20.7
Carry out a common-size statement of the balance sheet, of FJ Plc (above), expressing all
items in terms of shareholders’ funds (i.e. capital and reserves).
Activity 20.8
Where do you think the accounting systems used in your country fit in each of the above
continua?
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Question 20.2
Analyse the following segmental information:
Class of business Turnover Operating profit
2016 2015 2016 2015
£’000 £’000 £’000 £’000
Paints 905.3 894.1 110.8 111.1
Explosives 2,637.0 2,539.4 97.7 86.1
Industrial chemicals 160.7 143.7 32.0 44.7
3,703.0 3,577.2 240.5 241.9
Question 20.3
Try applying the ratio analysis approach of this chapter (starting with the
ratio pyramid) to a set of accounts of your choice. Try to obtain a set of
accounts of a large company.
Question 20.4
You are given the following information in relation to Guitar Ltd and
Banjo Ltd:
Required:
Define and calculate the earnings per share and the price earnings ratio for
Guitar Ltd and Banjo Ltd. Discuss two limitations of ratio analysis.
Solutions are provided in Appendix A.
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Appendix A
Note to students
Solutions are provided only for selected activities and Sample examination
questions.
Chapter 2
Question 2.4
The old IAS 17 standard adopts a risk and reward approach to incidental ownership, but
the new IFRS 16 adopts a ‘control’ approach. This significantly shifts the balance of asset
recognition on the statement of financial position.
Chapter 5
Question 5.1
This question requires an appreciation of how the share premium account can be used
and how the debit balance on the issue of bonus shares should be treated.
Ordinary shares (50p) 750,000 + (200,000 × 50p) £850,000
Bonus shares {[(1,500,000 + 200,000) × 4] – 1,700,000} x 50p 2,550,000
3,400,000
Share premium
2,250,000 + [(1.50 – 1) × 200,000] 2,450,000
Maximum debit of bonus shares (2,450,000)
£NIL
Preference share capital – unaffected £600,000
Retained profits
24,000,000 – (2,550,000 – 2,450,000) £23,900,000
[surplus debit balance, bonus share]
Question 5.2
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Workings:
Share premium b/d £8,000,000
Premium on issue 1,200,000
Discount on debs (120,000)
Premium on redemption (320,000)
Question 5.5
a. This question requires a complete but brief definition of the price earnings ratio and
calculations of this ratio. These are provided below:
Gross profit = 15% × £18,000,000 = £2,700,000.
Profit after tax = £2,700,000 – £1,700,000 – £600,000 = £400,000.
Earnings per share = 400,000/(200,000/2 + 280,000/2) = £1.67.
Price earnings ratio = £55/£1.67 = 32.93.
b. This question requires accounting for the share capital changes as follows:
After new issue:
£
Ordinary share capital (nominal value 50p) 7,000,000
Ordinary share premium 62,500,000
Preference share capital 4,000,000
Retained earnings 160,000,000
After bonus issue:
£
Ordinary share capital (nominal value 50p) 8,400,000
Ordinary share premium 61,100,000
Preference share capital 4,000,000
Retained earnings 160,000,000
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Appendix A: Solutions to activities and Sample examination questions
Chapter 6
Question 6.3
A good answer would define events after the reporting period and discuss clearly how
different events should be accounted for. More specifically, what events are deemed
as ‘adjusting’ and what are ‘non-adjusting’. The examples in the question would be
addressed and the accounting treatment for each of the two scenarios should be
discussed, that is adjustment for the inventory is required but no adjustment is required
for the sale of subsidiary. Instead, disclosure of this transaction needs to be made.
Question 6.4
a. The liability for £40,000 existed at the date of the statement of financial position
and, as the amount is known, the accounts should be adjusted. The £10,000 liability
occurred after the year-end and, if significant, should be disclosed as a non-adjusting
event in the notes to the accounts.
b. The loss did not arise until after the year-end. It is, therefore, a non-adjusting event
that needs to be disclosed by way of a note to the accounts. However, there is an
additional consideration if the going concern is threatened. If the business ceases to
be a going concern, then the non-current assets would be restated to net realisable
value.
c. This is a non-adjusting event. Appropriate disclosure should be made in the notes to
the financial statements.
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Chapter 7
Question 7.2
This question requires you to explain advantages and disadvantages of CPP accounts and
to prepare CPP financial statements.
a. This question required you to discuss some advantages and disadvantages of CPP.
These are detailed in the subject guide.
b. The detailed calculations for this question are shown below:
£ adjustment CPP
Non-current assets 2,160,000 120/105 2,468,571
Inventory 820,000 120/110 894,545
Cash 1,100,000 1,100,000
Total assets 4,080,000 4,463,116
Share capital 2,000,000 120/105 2,285,714
Retained earnings 480,000 Bal 577,402
Trade payables 1,600,000 1,600,000
Capital, reserves and liabilities 4,080,000 4,463,116
Income statement
Question 7.3
CPP is still used for hyperinflationary economies, under IAS 29. The principle of materiality
here can be applied given the significant uncertainty caused by highly fluctuating prices in
a hyperinflationary economy.
The benefit of CPP is to give an estimate of the monetary losses/gains from transacting in
such economies. As the portfolio of such trade with such hyperinflationary economies are
usually relatively small compared to operations in more stable currencies, one can argue
that the benefits of having an estimate of monetary gains/losses exceeds the limitations
of its inaccuracies from estimating the actual underlying price movements of a company
operating in a hyperinflationary economy.
In the example of Unilever’s (2019) annual reports, the net monetary gain from trading in
hyperinflationary economies is less than 1% of the group’s operating profit for both 2018
and 2019 (see Unilever, Consolidated income statement, p.87 (available at https://www.
unilever.com/investor-relations/annual-report-and-accounts/archive-of-annual-report-and-
accounts/)
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Appendix A: Solutions to activities and Sample examination questions
Activity 7.4
£80,000 × (150/120) = £100,000.
Activity 7.7
£20,000 × (150/120) = £25,000.
Activity 7.9
Since these are all monetary items there would be no effect on profit.
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Chapter 8
Activity 8.2
The realised holding gain would be on the six T-shirts you had sold and therefore
would equal
(6 × 2) = £12
The unrealised holding gain is from the four remaining T-shirts that you still own and
this would equal
(4 × 2) = £8
Activity 8.3
Review the discussion, in this chapter, on capital maintenance concepts and holding gains
and losses.
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Appendix A: Solutions to activities and Sample examination questions
Question 8.4
a) This part of the question requires you to identify the capital maintenance
concept most closely associated with current value (replacement cost) financial
statements which is physical capital maintenance and to provide a clear
explanation of this concept.
b) This part of the question requires you to provide a clear explanation of both
realised holding gains and unrealised holding gains.
c) This part of the question requires you to prepare the financial statements under
current value replacement cost (CV-RC) as follows:
Statement of comprehensive income
£ £ adjustment £ CV-RC
Sales 7,600,000 7,600,000
Opening inventory 1,200,000 190/180 1,266,667
Purchases 4,800,000 4,800,000
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Chapter 9
Question 9.1
At 31 December 2015:
Current service cost recognised in the profit/loss section of the statement of
comprehensive income:
Expected final salary = £100,000 × 1.05 × 1.05 × 1.05 × 1.05 = £121,551
Benefit for the current year = £121,551 × 1% = £1,216
Adjustment for vesting condition:
[(80% × 1216) + (20% × 0)] = £973
Present value = 973/(1.1 × 1.1 × 1.1 × 1.1) = £664.
At 31 December 2016:
Current service cost:
Expected final salary = £105,000 × 1.15 × 1.15 × 1.15 = £159,692
Benefit for current year = 1% × 159,692 = £1,597
Adjustment for vesting condition:
[(90% × 1597) + (10% × 0)] = £1,437
Present value = 1437/(1.1 × 1.1 × 1.1) = £1,080
The interest cost component = £664 opening obligation × 10% = £66
Total pension cost to the profit and loss section of the statement of comprehensive
income = 1,080 + 66 = £1,146
Actuarial loss:
Expected final salary £105,000 × 1.15 × 1.15 × 1.15 = £159,692
Benefit for 2015 and 2016 = 2 × (1% × 159,692) = £3,194
Adjustment for vesting = [(90% × 3,194) + (10% × 0)] = £2,875
Present Value = 2,875/(1.1 × 1.1 × 1.1) = £2,160 closing obligation
Thus, 2,160 – 1,080 – 66 – 664 = £350 Actuarial Loss (to Other Comprehensive Income).
How the obligation builds up:
2015 2016 2017 2018 2019
Opening obligation – 664.17 2159.63 3563.38 5226.29
Interest (10%) – 66.42 215.96 356.34 522.63
Actuarial loss – 349.23 – – 798.44
Current service cost 664.17 1079.81 1187.79 1306.57 1437.23
Closing obligation 664.17 2159.63 3563.38 5226.29 7984.59
Question 9.2
The question requires you to discuss and calculate costs relating to employee benefits.
a. You are required to explain defined contribution and benefit pension plans.
b. The detailed calculations required for this question are shown below:
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At December 2015
Current service cost recognised in the income statement:
Expected final salary = £75,000 * 1.05 * 1.05 * 1.05 * 1.05 = £91,163.
Benefit for the current year = £91,163 * 1% = £912.
Adjustment for vesting condition: (80% * £912) + (20% * 0) = £730.
Present value = £730/(1.1 * 1.1 * 1.1 * 1.1) = £498.
At 31 December 2016
Current service cost:
Expected final salary = £78,750 * 1.15 * 1.15 * 1.15 = £119,769.
Benefit for the current year = 1% of £119,769 = £1,198.
Adjustment for vesting condition: 90% * £1,198 + 10% * 0 = £1,078.
Present value = £1,078/(1.1 * 1.1 * 1.1) = £810.
The interest component = £498 opening obligation * 10% = £49.
Total pension cost to the profit and loss section of the income statement
= £810 + £49 = £859.
c. The detailed calculations required for this question are shown below:
Expected final salary £78,750 * 1.15 * 1.15 * 1.15 = £119,769.
Benefit for 2015 and 2016 = 2 * (1% * 119,769) = £2,396.
Adjustment for vesting = (90% * £2,396) + (10% * 0) = £2,156.
Present value = £2,156/(1.1 * 1.1 * 1.1) = £1, 620 closing obligation.
Actuarial loss:
Closing obligation – present value of benefit in income statement – interest – opening
obligation = £1,620 – £810 – £49 – £498 = £263 actuarial loss (to other comprehensive
income).
Chapter 10
Activity 10.2
1 Carrying amount = £40,000; tax base = £70,000
Deductible temporary differences
Deferred tax asset
2 Carrying amount = £40,000; tax base = nil
Taxable temporary difference
Deferred tax liability
3 Carrying amount = tax base = £50,000
No deferred tax
4 Carrying amount = tax base = £15,000
No deferred tax
5 The expense is allowable for tax on a cash basis.
Carrying amount = –£20,000; tax base = nil
Deductible temporary difference
Deferred tax asset
6 Carrying amount = tax base = £200,000
No deferred tax
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Question 10.2
This question requires you to discuss different aspects of accounting for deferred tax and
prepare tax and deferred tax calculations.
a. This part of the question required you to define deferred tax and discuss permanent and
temporary differences in relation to deferred tax.
b. This part of the question requires you to discuss deferred tax under the flow through, partial
provision and full provision methods.
c. The detailed calculations for deferred tax in the years 2015 to 2018 are shown below:
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Chapter 11
Activity 11.3
(b) – 4,000 is the loss on disposal (net book value of £84,000 less sales proceeds of £80,000).
The discounted present value depreciation (here, ‘annuity depreciation’ as the expected cash
flows are constant) for each of the relevant years may be calculated as follows (again to the
nearest £’000):
Year 1 204,000 – 2,000,000 (0.08) = 44,000
Year 10 204,000 – 1,456,000 (0.08) = 88,000
Year 20 204,000 – 189,000 (0.08) = 189,000
Operating profit after depreciation would be:
Year 1 £160,000
Year 10 £116,000
Year 20 £15,000
Subject to rounding to the nearest £’000, these represent returns of 8% on the written-down
value at the start of each year.
Annual straight-line depreciation would be £100,000, and the difference between annuity
depreciation and straight-line depreciation would therefore be:
In year 2 (£56,000)
In year 10 (£12,000)
In year 20 £89,000.
If the company sets its prices so as to generate a constant annual revenue of £204,000 (to
the nearest £’000) it will earn the required rate of return on capital invested. Given that
the equipment produces a constant annual output, a constant annual revenue would seem
appropriate. Use of the discounted present value method of depreciation would then show
that, if all goes according to plan, the company is achieving its stated aim of setting prices so
as to earn 8% per annum.
If however, it used straight-line depreciation in its accounts, operating profits after
depreciation would be £104,000 in each year. The written-down value of the equipment at
the start of each relevant year would be:
Year 1 £2,000,000
Year 10 £1,100,000
Year 20 £100,000.
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The return on the asset would then be 5.2% in year 1, 9.45% in year 10 and 104% in year
20. Uninformed users of the financial statements might think the company is not achieving
its stated aim.
Activity 11.4
Definition: IAS40 on Investment property – property held (by the owner or by the lessee
under a finance lease) to earn rentals or for capital appreciation or both, rather than for:
1. use in the production or supply of goods or services or for admin purposes, or
2. sale in the ordinary course of business
Current standards use two different approaches – cost valuation and fair values.
The difference is about the way in which property is used. Under tangible assets, property is
used as part of a range of assets to generate revenue. Under investment property, the asset
is treated more like a type of inventory, for shorter term use and immediately profitable.
Fair value model
Statement of financial position
Non-current asset 1,800,000
Income statement
Revaluation reserve 400,000
Cost model
Statement of financial position
Non-current asset: Cost 1,400,000
Depreciation (140,000)
Non-current asset: Net book value 1,260,000
Question 11.3
This question requires you to discuss different aspects of accounting for non-current
assets and depreciation and to prepare calculations in relation to non-current assets and
depreciation.
1. This part of the question requires you to define non-current assets and depreciation
and discuss three areas of judgement in relation to non-current assets and These may
include any three of the following:
• the value or cost of the non-current asset
• which depreciation method to use
• useful economic life of the assets
• the residual value of the asset
• revaluations in relation to non-current
2. The detailed calculations required for this question are shown below:
Calculating the initial cost of the assets
£
Base price 5,000,000
Less trade discount (1,000,000)
Base price after discount = payable cost 4,000,000
Add:
Freight 60,000
Installation 104.000
Pre-production testing 90,000
Initial capital cost of asset 4,254,000
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Depreciation
31 March 2016
Cost less residual £4,154,000
Hours used/estimated life in hours (3,000/15,000) 0.2
Depreciation for the period £830,800
30 September 2017
Cost less residual £4,154,000
Hours used /estimated life in hours (3,600/15,000) 0.24
Depreciation for the period £996,960
Accumulated depreciation to 2017 £1,827,760
31 March 2018
Revised carrying value – see below £3,246,240
Revised residual value (£150,000)
Depreciable amount £3,096,240
Hours used revised estimated life in hours (1,500/9,000) 0.167
Depreciation for the period £517,072*
Revised carry value after upgrade – see below
Original cost £4,254,000
Accumulated depreciation (£1,827,760)
Revised carrying amount £2,426,240
Upgrade cost £820.00
Revised carrying amount £3.246.240
* Different rounding is acceptable
Income statement
2016 2017 2018
£ £ £
Depreciation 830.800 996.960 517,072*
Maintenance 240,000 240,000 240,000
Discount received (160,000)
Staff training 170,000
1,080,800 1,236,960 757,072
* different rounding is acceptable
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Question 11.4
Suggested approach for consideration:
Non-current tangible assets and investment properties are key components of financial
statements. Candidates need to be able to define the two from an accounting
standards perspective. They should also analyse and discuss the professional accounting
requirements in these areas, illustrated appropriately with examples.
Answers should contain definitions of both non-current tangible assets and investment
properties, identifying the different accounting treatments (depreciation/revaluation).
A comparison of different accounting treatments and their impact on financial statements
is important. For example, what are the different impacts on the statement of financial
position and income statement (e.g. when comparing returns and gearing)? Does any of
the standards affect the cash flow? What is the impact between the fair value versus cost
approach? How does investment property from ‘ordinary’ property differ in terms of its
treatment in the financial statements?
Chapter 12
Activity 12.1
1. Major difference is the near removal of options to classify leases as operating leases
unless they are on a very temporary basis.
2. Companies that utilise sale and lease back arrangements are affected by IFRS 16.
Industries that traditionally rely on leases (airlines; retailers and supermarkets;
property) are also affected.
In the Investor’s Chronicle article, the US securities regulator (SEC) estimated that
US based companies had approximately £1 trillion (£1,000,000,000,000) worth of
leases that are accounted for off balance sheet). In the Daily Telegraph article, the IASB
estimates that for some retailers the off balance sheet debt is 66 times that of the on
balance sheet debt. Globally, companies have US$3.3 trillion lease commitments (85%
of which are off balance sheet).
3. Key arguments for the new requirements of IFRS 16 are:
a. that it improves the accuracy of financial numbers reported (which improves the
accuracy of analysis through financial ratios – this will be discussed further below)
b. that it discourages companies from engaging with creative methods of off-balance
sheet financing
c. that it encourages international comparisons
4. Key arguments against the new requirements of IFRS 16 are:
a. Some companies operate a very large number of leases (e.g. Greggs has 2,100
operating leases) that would have a significant cost burden
b. It does not still remove the element of judgement despite its stringency
The for and against arguments here are not exhaustive. You should consider other
possibilities.
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Activity 12.2
Plant Z
Since the lease covers the whole of the economic life of the asset, and EZH Plc has to
maintain and repair it, it may be deemed to transfer substantially all the risks and rewards
of ownership and is therefore a finance lease. It is necessary to ascertain the interest rate
implicit in the lease.
Find the value of the annuity factor that sets the minimum lease payments equal to the
fair values, that is, £50,000 = £3,864 + £3,864a15 (the annuity factor is for 15 periods
as the first payment is made in advance):
£3,864a15 = £46,136
a15 = £46,136/£3,864 = 11.94
Reading from the 15 periods column of annuity tables it can be seen that this annuity
factor relates to an interest rate of 3% per quarter.
The analysis of rental payments under the lease may be made as follows:
Date Rental Finance Repayment Obligation under
payments charge of capital finance lease
1/01/10 50,000
1/01/10 3,864 3,864 46,136
1/04/10 3,864 1,384 2,480 43,656
1/07/10 3,864 1,310 2,554 41,102
1/10/10 3,864 1,233 2,631 38,471
1/01/11 3,864 1,154 2,710 35,761
1/04/11 3,864 1,073 2,791 32,970
1/07/10 3,864 1,310 2,554 41,102
1/10/10 3,864 1,233 2,631 38,471
1/01/11 3,864 1,154 2,710 35,761
1/04/11 3,864 1,073 2,791 32,970
1/07/11 3,864 989 2,875 30,095
1/10/11 3,864 903 2,961 27,134
Of the amount owing at 31 December 2010 (£38,471), £27,134 will be due after one
year (the balance owing at 31 December 2011) and the difference of £11,337 (which
equals the capital repayments made in 2011) will be due within one year.
The finance charge for 2010 will be amounts shown on 1 April, 1 July, 1 October 2010
and 1 January 2011; the amount payable on 1 January 2011 will be an accrual. The asset
will be depreciated over the shorter of its useful economic life or the lease term – which
here coincide. Using straight-line depreciation there will be a charge of £12,500.
Therefore in the income statement will appear:
Finance charge £5,081
Depreciation £12,500
In the balance sheet will appear:
Non-current assets:
Leased assets at net book value £37,500
In creditors due within one year:
Accrual £1,154
Obligation under finance lease £11,337
In creditors after more than one year:
Obligation under finance lease £27,134
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Plant Y
Again, this lease transfers substantially all the risks and rewards of ownership and should
therefore be accounted for as a finance lease. No fair value is given; it is necessary to
calculate this by discounting the lease payments at the interest rate implicit in the lease.
Fair value = Initial obligation under finance lease = £3,420a20 (the annuity factor is for
20 periods as payment under this lease are made in arrears). With an annuity factor of
14.88 this gives a fair value of £36,000.
Analysis of rental payments under the lease may be made as follows:
Date Rental Finance Repayment Obligation under
payments charge of capital finance lease
01/01/10 36,000
31/03/10 2,420 1,080 1,340 34,660
30/06/10 2,420 1,040 1,380 33,280
30/09/10 2,420 998 1,422 31,858
31/12/10 2,420 956 1,464 30,394
30/06/11 2,420 867 1,553 27,333
30/09/11 2,420 820 1,600 25,733
31/12/11 2,420 772 1,648 24,085
Of the amount owing at 31 December 2010 (£30,394), £24,085 will be due after one
year (the balance owing at 31 December 2011) and the difference of £6,309 (which
equals the capital repayments made in 2011) will be due within one year.
The finance charge for 2010 will be the amounts shown on 31 March, 30 June, 30
September and 31 December 2010. The asset will be depreciated over the shorter of
its useful economic life or the lease term – which here coincide. Using straight-line
depreciation there will be a charge of £7,200.
Therefore, in the income statement will appear:
Finance charge £4,074
Depreciation of leased asset £7,200
In the balance sheet will appear:
Non-current assets
Leased asset at net book value £28,800
In creditors due within one year
Obligation under finance lease £6,309
In creditors due after one year
Obligation under finance lease £24,085
Activity 12.3
The charges to the income statement would be £20,000 in both 2010 and 2011.
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Appendix A: Solutions to activities and Sample examination questions
Activity 12.4
Major effects are:
• Statement of financial position
• Increase in the total assets (from recognition of lease assets in the non-current
assets)
• Increase in total liabilities (from recognition of lease liabilities)
• Increase in the leverage ratio (debt/equity) and reduction in return on capital
• Income statement
• Improvement in EBITDA (earnings or profit before interest, tax, depreciation and
amortisation). Why? This is because the expense for operating lease has been
removed under a ‘finance lease’ classification
• Increase in depreciation. Why? This is because the finance lease assets have to be
depreciated (previously no asset was recognised and hence no depreciation)
• Increase in interest. Why? This is because there is an interest charge/expense on the
debt used to finance the leased asset (under operating leases these interest charges
are embedded in the operating lease expense)
The article Ryland, P. ‘Debt by any other Name’ Investor Chronicle, 16 August 2019, p.33
(available in the Online Library) contains more analysis.
Activity 12.5
1. The sample used is a database of US companies.
2. The average debt ratios (e.g. debts/assets) increase between 8.5% to 10.7%, depending
on the discount rate used (Table 1). The return on assets decreased between 5.8% and
7.4% (Table 1).
3. The focus should be on the average increase in debt/asset and return on asset ratios
in Table 2. Therefore the most affected industries are Apparel, Education services and
Furniture. Note that all industries rely heavily on operational leases and no industry is
untouched should their operational leases be reclassified to finance leases. All will have
a projected increase in debt/asset ratios and a decrease in return on assets.
4. The study by Kostolansky et al. (2012) gives an estimate of the size of negative impact
if operating leases have to be reclassified as finance leases. Given that IFRS 16 severely
restricts the use of operating leases, the study provides a projection of how the average
balance sheet of various industries may be affected by a move to a more stringent
accounting standard.
Question 12.4
Outline of solution
This question tests knowledge of off balance sheet finance and substance over form. A good
answer should explain and discuss the concepts of off balance sheet finance and substance
over form. The importance and impact of these concepts should be discussed and illustrated
using two examples. Any two examples may be given such as leases, sale and leaseback,
quasi subsidiaries, debt factoring or any other suitable example, for example from FRS 5.
Discussion in relation to the two examples should explain and define the transaction, why
the area was problematic, how off balance sheet finance and substance over form are
applied in the area, the impact this makes on the financial statements and key ratios. A less
well answered question would not explain the concepts of substance over form and off
balance sheet finance in relation to the examples or only discuss one example.
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Interest 6,000
Obligation under
finance lease 43,958 43,958
76,250 20,250 22,400 20,250 22,400
Share capital 70,000 20,000 20,000 20,000 20,000
Profit 6,250 250 2,400 250 2,400
76,250 20,250 22,400 20,250 22,400
Rate of return on initial equity 8.9% 1.25% 12% 1.25% 12%
Comments
Some points that might be made:
• Buying the asset outright shows the asset employed in the business on the face of the
balance sheet, and when this is financed by a loan the loan finance also appears on the
face of the balance sheet. However, the income statements for Apple and Pear show
very different rates of return, and neither of them meets the company’s cost of capital.
If, however, instead of using straight-line depreciation they both used discounted
present value depreciation for the asset, they would both show a rate of return of 12%
on the initial equity investment.
• Treating the lease as an operating lease gives no indication of the assets actually
employed in the business, nor the obligation the company has undertaken to make
rental payments for the next 10 years; this obligation would be shown in a note to the
accounts but would not appear on the balance sheet or enter into balance sheet ratios.
• Treating it as a finance lease reflects the fact that it is akin to borrowing money and
buying an asset; hence both the asset and the obligation appear on the face of the
balance sheet. As a result, when Kiwi uses straight-line depreciation like Pear, it reports
an identical profit and identical rate of return to Pear.
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Appendix A: Solutions to activities and Sample examination questions
However, it may be argued that by using the actuarial method to ascertain the finance
charge, but using straight-line depreciation for the asset, the accounts are distorting
the position. Presumably the rent paid reflects the reality of the property market (i.e. the
true annual cost of using the asset) and this is shown as £8,850 in Banana’s accounts,
where it is treated as an operating lease. However, Kiwi’s accounts show the total cost
of using the asset (finance charge and deprecation) as being £12,750. Orange uses
discounted present value depreciation for the asset and shows a total charge equal to
the annual equivalent cost of the asset (i.e. £8,850). In Orange’s case, the total liability
outstanding under the finance lease (made up of the amounts due after one year plus
the amounts due within one year included in net current assets) equals the written-
down value of the asset (£47,150).
A case can therefore be made for requiring companies to depreciate capitalised leased
assets by the discounted present value method. This will become all the more important
if the ASB decides to capitalise operating leases.
Note that if each company used discounted present value depreciation they would
show an identical rate of return equal to the cost of capital rate.
Workings
If Kiwi and Orange treat the lease as a finance lease it is necessary to find the interest rate
implicit in the lease such that £8,850 a10? = £50,000. This gives an annuity factor of 5.65
which tables show to represent a rate of interest of 12%. Thus:
• the finance charge will amount to 12% × £50,000 = £6,000 and
• the balance outstanding at the end of the year will be £47,150 (i.e. there will be a
repayment of £8,850 – £6,000 = £2,850), of which £3,192 (= £8,850 – (12% ×
£47,150)) will be due within one year and £43,958 after one year.
Using straight-line deprecation will give a charge of £5,000. Using annuity depreciation
will give a charge in 2010 of £2,850 (the same amount by which the obligation under the
finance lease is reduced using the actuarial method). This depreciation charge is calculated
in the usual way:
£50,000
= £8,850
a10
¬
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Chapter 13
Activity 13.1
The question requires you to discuss and account for research and development.
a. You are required to define research and development and discuss how these are
accounted for, including the criteria for capitalising development expenditure.
b. This part of the question requires you to show how the projects are to be accounted
for as follows:
Project A
This is research and the £200,000 written off as an expense in the income statement.
Project B
This project fulfils the above criteria for development.
The following costs can be capitalised since the project fulfils the criteria for
capitalisation:
£5,000,000
£300,000 staff costs
Depreciation on testing equipment = 20% of £100,000 = £20,000
£50,000 of overheads
These costs will be capitalised and added to the costs bfwd to give research and
development asset at the end of the year as follows:
Research costs cfwd = £5,370,000.
These costs are not amortised.
Question 13.3
Suggested approach
You must define intangible assets in general and discuss the general treatment of such
assets, according to IAS 38. You must provide a summary of the main provisions of IAS 38
and discuss the advantages and disadvantages of IAS 38.
Your answer should discuss two intangibles in detail; including defining these assets; a
discussion of their accounting treatment under IAS 38; and any issues or inconsistencies
arising in the accounting of the intangible assets you have chosen; as well as the impact
the accounting treatment has on the financial statements. Intangible assets that you may
choose include goodwill, research and development, and brands. Other examples are also
acceptable.
The critical assessment of IAS 38 should include a general critique of the standard and a
critique of the standard as applied to the two intangibles you have chosen to discuss.
The essay should include an introduction, main body and conclusion and you need to link
the issues you discuss. You should avoid just briefly listing points. Your answer should
address all parts of the question and not just focus on one element of the question.
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Appendix A: Solutions to activities and Sample examination questions
Activity 13.2
Revised carrying amount of intangible = fair value = new book value = £12,000
The accumulated amortisation of £4,000 needs to be reversed (Dr intangible: accumulated
amortisation and Cr licence: cost by £4,000).
Next, the net book value of the intangible has to be increased to the revalued amount of
£12,000. The increase in revaluation is calculated as:
FV less (intangible less accumulated amortisation) = £(12,000 – 10,000 + 4,000 = 6,000).
Therefore, the transactions are recorded as Dr Licence and Cr revaluation reserve by £6,000.
The journal entries are as follows:
Intangible asset: License
Dr Cr
Cost 10,000 Accum amort. 4,000
Bal c/f 16,000
Accum amort 4,000
Revaluation Res. 6,000
20,000
Bal c/f 20,000
Accumulated amortisation
Dr Cr
Licence 4,000 Licence 4,000
4,000 4,000
Revaluation reserve
Dr Cr
License 6,000 License 6,000
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Chapter 14
Activity 14.1
It is not probable that the entity will collect the consideration in exchange for the transfer
of the building.
The intention to pay in doubt because of the following factors:
a. the customer intends to repay the loan primarily from income derived from its
restaurant business;
b. the customer lacks other income or assets that could be used to repay the loan;
c. the customer’s liability under the loan is limited because the loan is non-recourse.
The correct outcome is therefore ‘D – Do not recognise any revenue and treat the
£50,000 as a liability’
• The collection of consideration is not probable therefore we must look at treatment
of deposit
• The deposit does not represent substantially all of the consideration
• Cannot be treated as revenue instead treated as a deposit liability
• Dr Cash at bank
• Cr Deposit liability
• Treat as revenue if collection of remainder of consideration is probable or contract
terminated
For more examples, you can consult the illustrations in Revenue – IFRS 15 handbook
(KPMG 2019) [https://home.kpmg/xx/en/home/services/audit/international-financial-
reporting-standards/ifrs-toolkit/ifrs-handbook-revenue-ifrs-15.html].
Activity 14.2
• The product could be sold separately from the training and the training
separately from the product
• There is no indication that the training services modify or customise the product
• The warranty does not provide the entity with a good or service in addition to
assurance
The correct outcome is therefore ‘B – Treat the product and the warranty as a
single performance obligation and the training as a separate performance
obligation’.
Activity 14.3
Contract Y
This is more than one-third complete and as profit is expected overall, a proportion of
that profit will be recognised this year.
Income statement
Turnover £1,800
Cost of sales £1,400
Profit for the year £400
Balance sheet
As the amount recognised as turnover exceeds payments on account by £180, this
difference will be shown in the balance sheet among trade receivables:
Amounts recoverable on contract £180
In inventories and work in progress we include the costs carried forward on the contract:
Construction contract cost £100
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Appendix A: Solutions to activities and Sample examination questions
Contract Z
Here the company is expected to make an overall loss of £1,200. This must be provided
for in full.
Income statement
Turnover £4,000
Cost of sales £5,200
Loss for the year £1,200
(The cost of sales figure comprises the cost of work completed (£4,400) plus the
additional provision for foreseeable loss of £800. £400 of the expected loss is already
accounted for in charging the cost of work completed against the certified value.)
Balance sheet
The amount recognised as turnover exceeds payments on account by £400. This will be
included in trade receivables:
Amount recoverable on contract £400
In inventories and work in progress:
Construction contract cost £200
Provision for losses £200
—
Contract A
This is more than one-third complete and as profit is expected overall, a proportion of
that part of the profit will be recognised this year.
Income statement
Turnover £6,000
Cost of sales £5,100
Profit for the year £ 900
Balance sheet
Total payments on account of £6,400 exceed the amount recognised as turnover by
£400. This sum will be deducted first from the contract costs carried forward, and any
excess will be shown among creditors as payments on account.
Thus:
In inventories and work in progress:
Construction contract cost £300
Payments on account £300
–
In creditors:
Payments on account £100
Contract B
As this contract is not yet one-third complete no profit will be recognised. Since no loss
is expected, in accordance with the company’s accounting policy, the contract activity will
be reflected in the income statement using a zero estimate of profit:
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AC2091 Financial reporting
Income statement
Turnover £600
Cost of sales £600
Profit for the year £ –
Balance sheet
The payments on account exceed turnover by £120. This will be deducted from the
contract costs carried forward:
Thus:
In inventories and work in progress:
Construction contract cost £160
Payments on account £120
£40
An alternative presentation would be to recognise neither turnover nor cost of sales, but
to carry the contract forward, in inventories, at cost less payments on account.
Construction contract cost £760
Payments on account £720
£ 40
Commentary
For ordinary inventories and work in progress, standard practice under SSAP 9 is to value
them at the lower of cost or net realisable value. They may not be valued above cost,
however good the market in which they are traded, and profit may not therefore be
recognised until sale. This is in accordance with the prudence concept.
For construction contract work in progress, standard practice is to recognise profit (and
turnover) while the contract is still in progress. Although the standard requires companies
to be prudent in recognising attributable profit, and not to recognise profit until the
outcome of the contract is reasonably certain, companies are not to wait until the
contract is completed before recognising profit.
These practices do not appear consistent. Since the uncertainties surrounding the
outcome of a construction contract are normally much greater than those surrounding
NRV of normal inventory (because of, for example, cost escalation, technical errors or
credit-worthiness of client), it is not clear how both these practices may be reconciled
with ‘prudence’.
Activity 14.4
Judgement is applied in appreciating that the cost of windows is a significant percentage of
the overall contract cost AND that it has to be left out as there is no relationship between the
construction inputs and the transfer of goods and services to the customer.
Activity 14.5
1. The company is an energy broker, helping small and medium enterprises save money on energy
bills by matching them with suppliers who offer discounts.
2. It had optimistic estimates of revenues based on unrealistic assumptions of customers’ energy
usage.
3. Compare the 2016 accounts under IAS 18 (the original statements) and IFRS 15 (the
restatements):
• Income statement: Revenue recognised has fallen significantly (£84.4m to £67.7m)
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Chapter 15
Question 15.2
The £4,000 decline is significant, more than 30%, so the full amount should be
recognised as impairment and transferred to profit and loss; regarding the bond the
expected remaining cash flow is £60,000 and the present value at the original effective
interest rate is £56,074, the new carrying amount; the impairment is £63,926.
Question 15.3
Aileen Ltd can use the General & Simplified approach to treating the loan to Maebh
Ltd as there are no expected issues with the repayment of the loan. As the loans to
Sorcha Ltd was made knowing that there is a possibility of default (as the borrower has
significant financial difficulty), this should be accounted for under the credit adjusted
approach, with the impairment allowance shown.
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Appendix A: Solutions to activities and Sample examination questions
Chapter 16
Activity 16.3
• (a), (c), (d) and (e) are subsidiary relationships.
• In (f), S is not a subsidiary as B does not have majority voting rights.
• In (g), S is not a subsidiary.
• (b) is a mixed subsidiary relationship – B has control over 55% of S (30% + (100% ×
25%)) through its control over all of O1’s voting rights of S1. (Note O1 is a subsidiary
of B.)
• In (h) no subsidiary relationship exists between B and S, as B only owns 46.8%
of S (30% + (40% × 60% × 70%)). However, S is a subsidiary of O2 and O2 is a
subsidiary of O1.
£m
Balance sheets
Tangible non-current assets 1,432
Goodwill arising on consolidation 240
1,672
Net current assets 280
1,952
Loan capital 360
1,592
Ordinary shares of £1 480
Share premium account 680
Income statement 432
1,592
Income statements
Turnover 3,300
Cost of sales 1,840
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EPS 52.7p
Workings
Acquisition accounting
For the purposes of acquisition accounting, the fair value of the consideration given is
£9.50 × 80 million shares issued, that is, £760 million. As nominal value of shares issued
is £80 million, the share premium account therefore is £680 million. The fair value of net
assets acquired is:
£m
Net equity of Gidget at 31 December 340
Proportion of profits to 30 June 2011: 40 = (1/2 × 80)
Excess of fair value over book value of tangible 140
non-current assets
520
Goodwill arising on consolidation is therefore £240 million (capitalised subject to an
impairment review).
The calculation of EPS for 2011 is based on the average number of Widget shares in issue
during 2011 for £440 million.
Chapter 17
Question 17.2
A joint operation is a joint arrangement whereby the parties that have joint control of the
arrangement have rights to the assets, and obligations for the liabilities, relating to the
arrangement. Those parties are called joint operators (IFRS 11, para.15).
A joint venture is a joint arrangement whereby the parties that have joint control of the
arrangement have rights to the net assets of the arrangement. Those parties are called
joint venturers (IFRS 11, para.16).
The substantive difference is that, under a joint operation, no new entity is formed
(i.e. the operations are run through the existing companies that have agreed the joint
operations). In other words, all parties to the joint operation have a share in the output of
the venue. For joint ventures, the rights to the net assets typically mean that the venturers
have a share of the overall profit or loss earned by the (separate) company formed by the
joint venture.
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Appendix A: Solutions to activities and Sample examination questions
Chapter 18
Activity 18.6
Red Plc, Green Ltd and Pink Ltd
Sales (230+190-9.5-10) 400.5
Cost of sales(60+30-10+4) (84)
Gross profit 316.5
Administration costs (17.1+14-9.5) (21.6)
Distribution costs (36)
Management fee from Associate 5
Share in Associate 30% * (44-2) 12.6
Goodwill – workings (8.2)
Profit before tax 268.3
Tax 40+10+30%*6 (51.8)
Profit after tax 216.5
Minority interest 20% * (114-4) (22)
Dividends payable (20)
Profit for the year 174.5
Retained profit brought forward 120.2
Retained profit carried forward 294.7
Workings in £’000
Goodwill
Subsidiary Green 200 – 80%(100) = 120,
Subsidiary Green Amortisation per annum = 120/20 = 6
Associate Pink 50 – 30*(20) = 44, A amort per annum = 44/20 = 2.2
Subsidiary Green brought forward amortisation = 18
Associate Pink brought forward amortisation = 4.4
Profit and loss account brought forward= 100 + 80%(62 – 20) + 30%(40 – 10) – 22.4
Notes:
1. Goodwill is explicitly shown for both subsidiary and associate under the historical
standard IAS 28 (2003). In this calculation, this is shown as:
Goodwill = Subsidiary (6) + Associate (2.2) = (8.2)
2. Prior to IFRS 3 (Valid from 2009 onwards), goodwill was amortised rather than tested
annually for impairment.
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Chapter 19
Activity 19.1
The rationale for the accounting treatment of gains and losses on unsettled transactions
at the year end in the income statement is that the exchange differences have already
been reflected in cash flows, in the case of settled transactions, or will be settled in future
in the case of unsettled transactions. This is consistent with the accruals concept; it results
in reporting the effect of a rate change that will have cash flow effects when the event
causing the effect takes place.
If the exchange rate at 31 January was £1:$1.5 then this would result in a total realised
loss on exchange of £2,500 (£7,500–£10,000). As the gain of £1,500 was credited to
the previous year’s income statement, the balance of £4,000 is debited to the income
statement for the year ending 31 December 2012.
(£22,667)
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Appendix A: Solutions to activities and Sample examination questions
Activity 19.8
Alternative method:
Functional currency is the currency of the primary economic environment in which the
entity operates. Presentation currency is the currency in which the financial statements are
presented
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Chapter 20
Sample examination question 20.1
The correct answer is the final statement. Although the quick ratio has decreased, we
cannot identify the exact cause (or combination) without further information.
Activity 20.4
1. The Airlines, Retail and Travel and Leisure industries are most affected by the move
to IFRS 16, in mostly a negative way for the company reporting, but positive way
for investors wanting increased transparency. This is because these three industries
mentioned have the highest proportion of their off-balance sheet leases that will
probably become on-balance sheet. In other words, this would mean that both the
carrying value of the leased asset and its liabilities (current/non-current) will now be
added to the balance sheet.
2. The return ratios would deteriorate as more assets are included in the calculations as
denominators.
3. There will be more transparency over hidden debt in the form of operating leases.
Such debt will now be included on the balance sheet. Gearing ratios will deteriorate
(i.e. companies will now have to show the lease contracts as debt).
4. Ironically, overall profitability may increase, as the lease payments are no longer
expensed, which increases profitability as the company’s overall expenses are
reduced. However, this may be counterbalanced by an increase in interest payments
on the leases, which are now treated as on-balance sheet debt.
Question 20.4
This question requires you to both calculate and define and comment on ratios and ratio
analysis.
The calculations are given below.
Guitar Ltd
Gross profit = 10% x £19,500,000 = £1,950,000.
Profit after tax = £1,950,000 – £450,000 – £1,350,000 = £150,000.
Earnings per share = £150,000/(150,000/2 + 240,000/2) = £0.769 per share.
Price earnings ratio = £30/£0.769 = 39.01.
Banjo Ltd
Gross profit = 15% x £27,000,000 = £4,050,000.
Profit after tax = £4,050,000 – £2,550,000 – £900,000 = £600,000.
Earnings per share = £600,000/(150,000/2 + 210,000/2) = £3.33.
Price earnings ratio = £30/£3.33 = 9.
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